Socket Mobile, Inc. Q2 FY2022 Earnings Call

Welcome to the 2022 Second Quarter Financial Results for Socket Mobile. My name is Hilda, and I will be your operator for today's call. Before we begin, I'd like to remind everyone that this conference call may contain forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 as amended and Section 21E of the Securities and Exchange Act of 1934 as amended. Such forward-looking statements include, but are not limited to, statements regarding mobile data collection and mobile data collection products, including details on timing, distribution, and market acceptance of products, and statements predicting the trends, sales, market conditions, and opportunities in the markets in which Socket Mobile sells its products. Such statements involve risks and uncertainties, and actual results could differ materially from the results anticipated in such forward-looking statements. Because of a number of factors, including but not limited to the risk that the manufacture of Socket's products may be delayed or not rolled out as predicted due to technological, market, or financial factors, including the availability of product components and necessary working capital. The risk that market acceptance and sales opportunities may not happen as anticipated, the risk that Socket's application partners and current distribution channels may choose not to distribute the products or may not be successful doing so, the risk that acceptance of Socket's products in vertical application markets may not happen as anticipated, as well as other risks described in Socket's most recent Form 10-K and 10-Q reports filed with the Securities and Exchange Commission. Socket does not undertake any obligation to update any such forward-looking statements. At this time, all participants are in a listen-only mode. Later, we will conduct a question-and-answer session. Please note that this conference is being recorded. On the call with me today are Kevin Mills, Chief Executive Officer, Dave Holmes, Chief Business Officer, and Lynn Zhao, Chief Financial Officer. I will now turn the call over to Kevin Mills. Mr. Mills, you may begin.

Thank you, operator. Good afternoon, everyone, and thank you for joining us today. In Q2, our revenue increased slightly to $6.05 million compared to our revenue of $6 million in Q2 2021. Our gross margins were 50.2% compared to 54.7% in Q2 2021. Our margins were lower as we paid more for components and freight costs were higher due to the ongoing global supply issues. Our earnings per share were $0.01 compared to $0.27 in Q2 2021, which included a tax benefit of $0.20 per share. In Q2, we experienced some strong headwinds, and our results were impacted by supply chain issues and material shortages that were outside of our control. Historically, about 55% of our retail business is driven by the deployment of new whole point of sale system where the scanner is sold as a component. The remaining 45% of our retail revenue comes from scanners purchased some time after the initial deployment, which we refer to as upgrade business. In Q2, we saw the deployment portion of our retail business significantly impacted by a shortage of other hardware components, such as mobile printers and cash drawers. This reduced our app partner's ability to deploy new solutions. As a result, our deployment associated revenue dropped to 38% of our total retail revenue. These shortages were not expected and were outside our control and impacted our business despite the fact we worked hard to be in a position to deliver. The upgrade portion of our business for end customers who added scanners sometime after deploying the mobile point of sale system remains strong, and the upgrade portion of our business increased to 62% of the total retail business and we were able to deliver without any issue. In response to these market changes and the unforeseen supply issues, especially with shortages and pastures, we plan to focus more on the upgrade business for the remainder of the year. In Q2, we announced our SocketScan S720, an upgraded version of our best-selling S700 with enhanced scanning support. As many of you see in your daily life, QR codes have become ubiquitous and are increasingly used in payment-related activities. We believe many small retailers will need to support this requirement in the coming quarters, and the S720 has been designed to serve that requirement. The S720 is aggressively priced at $249 and is 8% higher than the S700. We also feel it will be a desirable option for the more than 400,000 S700 end-users, especially within an attractive trade program we will have. We expect to start shipping the S720 in late August; while its impact in Q3 will be small, we believe it will significantly impact Q4 and enable us to resume our growth regardless of the supply issues in the market. In Q2, we also made significant progress on initiatives that we believe will ensure our long-term growth and success. And I'd now like to hand the call over to Dave Holmes, our Chief Business Officer, to provide an update on those initiatives. Dave?

Thank you, Kevin, and good afternoon, everyone. Today, I'd like to highlight a couple of the key milestones that we achieved in Q2 as we continue our journey of becoming a more comprehensive data capture company. We made significant strides with our capture SDK software tools. We continue to provide best-in-class development tools for our application partners, and we support all of the major development environments in the market today. The SDK team has grown, and we are very proud of the work that they have been delivering. In Q2, we upgraded Capture SDK to include SocketCam C820, our free camera-based scanning software that turns any mobile device into a high-performance barcode scanner. Our app developer partners can now begin offering free scanning to their customers. Capture SDK with C820 allows our developer partners to serve all of their end-users from price-sensitive to performance-sensitive with one integration. Socket Mobile scanners are primarily used in the performance-sensitive portion of the data capture market, but we have a commanding market share. That said, our application partners have end users with different data capture needs, and they're often not data capture experts. Historically, they typically only add Capture SDK to support socket scanners when their customers ran into performance or productivity issues. The addition of C820 will allow our development partners to bring socket scanning expertise and capabilities to a much wider audience. With the completion of phase one, by adding free camera scanning to Capture SDK, the team is now working hard to deliver enhanced camera scanning through the SDK in the second half of 2022, which we will offer on a monthly subscription basis. We think this is a critical piece in the data capture journey and it will make us a more complete hardware and software data capture company heading into 2023. Also, we're seeing positive signs with our NFC business as more developers begin embracing contactless technology. Initial commercial deployments of our S550 NFC reader for mobile ticketing, e-money, and loyalty applications are resulting in exceptional consumer experiences, happy app development partners, and follow-on projects. Finally, we introduced SocketScan S370, a universal NFC and QR code mobile wallet reader. This gives our app partners the flexibility to accept multiple formats with one device. With the myriad of credential types out there, S370 also provides our partners with the peace of mind that they can implement one device and not have to worry about choosing the wrong technology. S370 can also read credentials following ISO18013-5. This is the standard being adopted for mobile driver's licenses or MDL in most states and countries. We're seeing positive signs all around, and we continue to invest in the digital ID and MDL space. We feel this is a big opportunity and that Socket Mobile is well-positioned to become a significant player in the MDL reader space. This will mark another evolution in the data capture journey. In addition to reading barcodes to capture data about products and things, we will also be reading QR codes and NFC credentials about people and identities. With that, I'll turn it over to Lynn for more details on our financial results. Lynn?

Thanks, David. Thank you, everyone, for joining today's call. Our Q2 revenue was flat compared to last year at $6 million and decreased by 4% sequentially compared to $6.3 million in Q1. We believe that the slowdown in Q2 was due to our retail customers being unable to obtain their mobile printers and cash drawers, which are essential for our scanners to pair with. The second quarter's gross margin decreased by 450 basis points compared to the prior year quarter, but increased by 50 basis points compared to the preceding quarter. The decrease in margin versus the prior year quarter was driven by persistent higher component and freight costs. Q2 operating expenses were $2.85 million, an increase of 17% over the prior year quarter. We moved our business to a new location in Fremont, California. The lease agreement we entered was effective May 1, 2022. Although we are entitled to free rent in the first three months, the straight-line rent for May and June was charged to our expenses, contributing to the 3% increase in operating expenses. Spending on engineering increased by 15%, driven by hiring in our SDK team as we continue our commitment to research and development activities, which is essential to provide new product offerings, engineering support for key customers, and to maintain our existing products. Increases in sales, marketing, and customer support are at 31%, reflecting the costs associated with a higher headcount and consulting for external professional services. General and administrative expenses increased by 4%. Q2 operating income was $189,000, representing a 3% operating margin. Earnings were $104,000, or $0.01 per fully diluted share, compared to $0.27 per fully diluted share for the prior year quarter, which included an income tax benefit of $0.20 per fully diluted share. Adjusted EBITDA in the first quarter was $0.6 million, decreased by 46% from the prior year quarter of $1.2 million. In Q2, we generated free cash flow of $0.6 million and invested $0.4 million in capital assets, including equipment, software, and website development. We ended Q2 with a cash balance of $5.6 million. As of June 30, our inventory level net of reserves was at $4.9 million compared to $5.2 million at the end of 2021. Increased inventory was related to purchases committed prior to Q2 or even last year. Although the increased inventory helps us navigate the supply chain disruption, we are taking steps to manage the inventory for the remainder of 2022 in the face of near-term headwinds. We believe our balance sheet and liquidity continue to be in a healthy position to meet the challenging environment. This wraps up our prepared remarks. Now I will hand the call over to the operator for questions.

Thank you. We will now begin the question-and-answer session. We have a question from Charlie Chambers from C3. Please go ahead.

Thank you. Question about the share buyback. Can you shed some light on that? Thank you.

Okay. Yeah. We entered the 10B5 plan in April. So as of today, we have purchased 150,000 shares of the common stock from the market, and we will continue the purchasing of another 30,000 shares for this quarter. According to our 10B5 plan for the next quarter, we'll enter new purchases after we start the next quarter.

Thank you. The next question comes from Frank from Prudential Securities. Please go ahead.

Hi, Kevin, Hi Lynn. Frank here. One of my questions on the buyback was partially answered. My question is, it wasn't going to be my first question, but the criteria that you use, I hear you using shares. Is it predicated on the previous volume of the previous week or previous month on how many shares you can buy back at a certain percentage? That's the first question.

Yeah, according to the 10B5 plan, we only purchase the shares pursuant to Rule 10B18, which defines their volume and pricing. In general, it's their average four weeks trading volume preceding the 10B5 plan starting date.

Okay. Now the final question is twofold. One example, I recently tried to lease or buy a new car, the dealer very enthusiastic, and then as I'm ready to exit the car, he says, oh, we're missing a couple of chips, but we expect all the chips and everything, this is General Motors by the way, to settle by year-end. And my question is since, like locally here, there are houses well over $500,000 and with the interest rates now going up, most of the companies have had pretty good heads up with Powell telegraphing the Fed's move well in advance, but the housing market, which was booming, now it's subsiding to a point where the builders are reducing locks by some $50,000 to enable people to qualify for the houses. Now I see you have new products. Is it possible that you could come up with some new business plan that could denote each product and what your expectations are for them if all the things fell in place, meaning your supply chain and material shorts? I know it's been tough with the COVID. I know it's been tough with the gyrations that have gone on around the world, but there's a lot of people that still have their phones in their hands, and the businesses, the world is run by iPhones. I applaud you for your products. But the question is I'm a novice in the arena. The question is like, what is your projection for each product if everything was normal? What would each one contribute to the bottom line once your costs have abated and you're on the street? So that's my question.

All right. So it's a bit of a complicated question. So let me answer it in the following way. Seventy percent of our business is driven by activity in the retail space. Primarily we benefit as people deploy iPad-based cash registers in various boutiques and small businesses. We have a range of products that allow the end customer to choose at what level of scanning performance they need. The product we're introducing now, the S720, is an entry-level product that has the additional benefits of reading not only linear barcodes but also QR codes because we see from our customers that more and more people are coming into their stores with QR code-based coupons, QR code-based payment requirements, etc. Therefore, the merchant who needs to service this requirement needs to have a scanner that supports that requirement. And as you just bought a car, even with General Motors, they do offer the same car with a two-liter engine, a three-liter engine, a four-liter engine, a diesel option, a petrol option, electric option. We also have some of the same issues. It's very difficult to just have one car that is going to serve the market because different people, whether they're more fuel-conscious or performance-conscious, determines what they need to buy. Similarly, our products fall into a range where we offer variations, just like General Motors between diesel and petrol and electric and engine size. Ultimately, the consumer finds a fit that meets their requirement. So we get a lot of leverage through this model, and the benefits, the short-term interest rate impacts our customers because people have less disposable income, but ultimately if you're running a shop and you have a cash register system, even if you have less traffic, you do need to scan the items to make sure your inventory is correct and that your book balance at the end of the period. That's the answer to your question. Now, as Dave Holmes has pointed out, we have some new areas we're going into, and we believe the investment in those areas will open up new opportunities going forward. So, sorry that it's a bit of a circuitous answer, but I think it's the best I can do to kind of cover the question you asked.

Well, I appreciate the answer, and believe me, I have tried to understand the company from three years ago when I first got interested in your products and I saw this growth factor. I did not expect these huge bumps in the road. The larger companies, they've got a big everybody's sign and say, oh, well, so and so's got $50 billion loose, certain $12 billion loose and all that. I understand you're a small, but I consider you a little growth company, and I thank you for the understanding.

Thank you. Our next question comes from Steve Swanson, who's a private investor. Please go ahead.

Good afternoon. It looks like you sold about 27,500 scanners in the first quarter. What was the count that you had sold for the second quarter?

It was 26,537, I believe. About a thousand units left a little bit less, but not all.

Okay, thanks. Is Socket planning on increasing scanner prices going forward to help offset the increased component input prices? What I'm trying to ask is what's our long-term gross margin target going to be, and how are we going to get back to it?

We increased our gross margin by approximately 0.5% last quarter and feel confident that we've stabilized prices. We paid higher premiums in the previous nine months, but now we believe those costs are decreasing. On the component side, we have a plan to return to the 54-point gross margin range without raising prices. We are also introducing new products like the S720, which should positively impact margins while maintaining an attractive price point. In the short term, the main factor affecting margins is overhead allocation, which is fixed. Last quarter, producing fewer units affected our margins by around a quarter to half a percent. We believe we can return to the 54-point gross margin without increasing prices, and we don’t see raising prices in the short term as the right approach, as it makes us more competitive against those who have raised their prices.

Okay, thanks for that. Another question: sales and marketing costs are up 31% in the quarter and 33% for the first half of the year, which is just under a million dollar increase over last year's run rate for the full year. Is this more heads? What are we actually spending this money on, and is this spending going to be permanent or just a first-half kind of thing? And if it's permanent, what do we actually see long-term getting out of this extra money we're spending on sales and marketing?

We've spent a lot of money to revamp and upgrade our website to make sure that it is our primary go-to-market vehicle, including launching sites in other countries and other languages. To be honest, we were underspending for quite some time. I think the level is more in line with what we want to do. It's not going to increase much more, but in today's global world, a person in Japan who is buying our product expects to be able to read about the product and buy the product in Japanese. We have incurred the cost to do a lot of this work, which is largely a one-time investment. We will obviously have to maintain it, but at the moment, there's been a bit of a lift, particularly as we have, in my opinion, upgraded our website significantly over the last six months.

Well, I do agree that your website looks a lot more professional and user-friendly than it did in the past. So it sounds like there's about a $470,000 increase in sales and marketing for the first half of the year. You're saying that isn't going to be the run rate going forward. It'll tail off a bit. There will be some more spend due to maintenance, but you had a bigger push in the first half of the year to get that upgraded. Is that what I'm understanding?

Yeah, but we're not done yet. If we're honest, I think that we have to push and maintain the higher levels probably for another quarter or two, and then it'll level out, but we're still doing a lot of work to include things like product selectors and other things, which we believe will enhance the business going forward. Our webpage really is our flow case, our display window, if you will.

Okay, thanks for that, Kevin. Last question I got is, can you provide a little more color around this Q3 upgrade program where I think you're moving people from the S700 to the S720? Is that something that they're going to keep their existing scanner, and you just upgrade the software at a cost? Or do they send you their old scanner, and you send them a new scanner? Can you help me understand what we're trying to accomplish with this program?

Yeah, so the way that this would work is that you would be able to buy the upgraded scanner, and we would then send it to you. You would then return the old units, and we would rebate you something in the region of $50 to $100 depending on the unit you returned and whether you allowed us to use the motherboard from the old units in the unit that we upgraded. So we made it fairly straightforward. We do have return centers in most countries. So for a person in Germany, if they bought us, they would be returning their scanner to a local people in Germany. Thus, the cost of returning it is quite small, and then they get upgraded. They get the benefit of the new system, and they can then support QR codes. We'll have a pretty good plan and aggressive outreach to the people that already have scanners. We see that requirements have changed, and we want to make them happy customers going forward, as they've been in the past. So it'll work pretty well. Going back to your previous question, we've done a lot of work on the web to make this an automated process. All of your units are now tracked. You can see them in terms of the upgrade as we automatically check when your unit was manufactured; we can then customize the rebates based on how old it is, etc. We think it'll actually go quite well, but people will get a new or fully refurbished scanner, and it's not just a software update; it's a physical upgrade.

Okay. So it'll be if I'm a customer and I opt for this program, I'll send you some money, you'll send me a brand new scanner at 720, and I can keep working with my S700, I'll convert to that and send you back the old 700. I think you said there were about 100,000 of these in use currently that might be potentially upgraded over time. Does the return unit just get thrown in the trash, or are you scavenging that for parts? What happens with your return?

Well, when you select how much rebate we would, the motherboard in the return unit is fully usable and can be recycled, and we would encourage people to do that. Certainly, we don't want to be throwing good units into landfills, etc. The idea would be that we would refurbish and make sure that the return unit is fully functional and meets all respects. That would be reused in a 720, which we think is the responsible and environmentally friendly thing to do.

Got it. So if I wanted, I guess there'll be some pricing differences. If I wanted a refurbished unit, it'll be a lower cost, and if I wanted a brand new unit for the second one...

Exactly.

So you're going to try to scavenge these parts where you can so you don't end up throwing these all into a landfill, which is good to hear. I appreciate the feedback on the questions I had. So that's all I have for today. Thanks.

Thank you. Our next question comes from Chris Sakai from Singular Research. Please go ahead.

Hi, Kevin and Lynn. I just had a question on the 50 basis point increase in gross margin. What were the drivers? What led to the increase?

Well, there were a few things, but I think the main thing that led to the increase is that we compressed the reseller margins halfway through the quarter. So we didn't increase our end-user price, but we did reduce the discounts we give to certain elements of the channel. As a result, our effective price into distribution went up in certain categories, and that was part of how we started to reduce the margin. The other thing that I think is happening is that the premiums we paid on components during the first half of the year have come down somewhat, and therefore the component costs are slightly better. We did feel that we could get our margins back into the mid-fifties, and Q2 was kind of the first step on that product, but going forward, I think it'll be primarily based on less premium as opposed to adjustments in the distribution channel.

Okay. All right. Thanks for that. Your operating expenses increased 17% year-over-year. Just wanted to get a sense - will these expenses, I know it was a 7% increase sequentially, but will we see a decrease in operating expenses back to lower levels?

Well, in Q2 you also had about $100,000 due to this GAAP requirement to straight-line our rent. To answer your question, our expenses will come down a little bit, but we find ourselves in a position where we have what we feel is an enormous opportunity with the free scanning and the enhanced scanning in the camera-based segment, plus we have a lot of early traction in the NFC world. So we're not overly inclined to reduce our engineering or sales and marketing expenses. We may tighten our belt a little bit, but because we think the opportunity we have in front of us is too good not to keep our foot down on the gas, if you will, even in these tough times over the next six months.

The next question comes from Charlie Chambers from C3.

Yes. Thank you. Stock buyback, the average strike price for Q1 and Q2 year-to-date is the first question. I think the total was mentioned as about 150,000. I think Q1 was about 96,000 shares. And then my second question is going to be on the QR code strategy moving forward. Do you see it something like WeChat in China combined with QR codes for access, which is barely used here in the United States? Thank you.

All right, so I'll let Lynn answer the first question on the number, the prices we paid, but we do have in the 10B5, when we did the 10B5, we are limited to 1.5% of the outstanding shares in any given quarter, which is about 90,000 shares. I don't know the exact prices, so maybe Lynn could answer that question.

Yes, it's 1.25% of the outstanding shares per quarter. In the first quarter, we purchased 91,000 shares at an average price of about $4.10. As of yesterday in Q2, we have bought about 68,000 shares at an average price of about $3.

As regards to QR, I think you're accurately framing your question. In much of Asia, particularly in China, QR codes are used for payments everywhere, which has not been the case in the US and to a large extent in Europe. However, this is changing. You can now even, on an airplane, convert your credit card into a QR code so that they can do the payment using that mechanism instead of having to swipe or insert the half of the card. We do see this as a big wave, especially as QR codes became the norm during COVID with certifications and other types of identification. Many of the merchants that use our product have a reader that was designed for product and it doesn't support QR codes, which is why we're doing the upgrades. The newer version will do everything the S700 does in the one-day world, but also support QR codes, as well as a few other codes that they may need for the payment activities we foresee coming at them. We're not really in charge of the timing of these activities, but we do see a lot of indicators that you will have a similar situation emerging globally, driven by PayPal or credit card companies in the future. The merchant will be positioned to respond and have a device that we set. So going back, I think that you're exactly correct, that issues that have been common in Asia, especially China, will go global based on QR over the next 12 months.

Thank you. We have a question from Frank from Prudential Securities. Please go ahead.

One more question on the sales force, national and international. I don't see Vietnam for example. I had my Japanese friends. I was showing them golf courses in Florida; the cost is too high. We ended up in Hawaii; they ended up selling out. Now their major businesses are in Vietnam. What is our potential for salesmen directing potential customers to your website? Why would they tune into your website versus the larger competitors?

Right. So we don't have any Vietnamese website. We have a Japanese website, and we sell a significant number of products in Japan. Our business model follows with the iPad, and the iPad is too expensive in some countries, and Apple products, even though they sell very well in the US, China, Japan, and Western European countries, they don't sell well in Asian countries due to the price point. Primarily, we've been focused on being the companion scanners for the Apple. Now this is changing, and one of the things we're doing with the free camera scanning is, we will be able to service the Android market, which is much bigger, and by starting people at a lower price point, we feel we'll be able to support more of the world with these options going forward. We would not contemplate adding a Vietnamese or other websites unless we already had some business in that area. So it's a little bit further down the track before we would consider that. Today, I think we have six or seven websites, including Germany, France, Spain, and obviously UK, and Ireland, English. We have Japanese, Australian, etc. All that takes maintenance and support.

Okay. And going back to your iPad situation, too expensive abroad, all I can tell you is my grandkids, eight and 12 years old, they are up to date. They nagged their mother and father; they have to have that new iPad and of course games, but they're selling like crazy either way whenever they update. Okay. Thank you.

At this moment, we show no further questions. I would like to turn the call back to Mr. Mills for final remarks.

Thank you, operator. In summary, in Q2, we delivered solid results and made significant progress in a very challenging environment. We believe we are continuing to build a solid foundation that will enable us to grow our revenue and importance over the next two years. I'd like to thank everyone for your time and interest in Socket Mobile and wish you all a good afternoon.

Thank you. Ladies and gentlemen, this concludes today's conference. Thank you for participating. You may now disconnect.