Socket Communications, Inc. - the leading supplier of connectivity products for mobile devices

Technology

Communications Peripherals

INTERVIEW ON:

Socket Communications, Inc.

NASD: SCKT

Market Cap: $125.00 (Mil)

Michael Davis , Micro Cap Analyst 

Buckman, Buckman & Reid, Inc

75 West Front Street
Red Bank, NJ 07701
Phone: 800-531-0303 , Fax: 732-530-2473  

Interview conducted by: Walter Banks , Co-Publisher

CEOCFOinteriviews.com

January 2001

CEOCFOinterviews – Mr. Davis, please share some of your career highlights with us.

Mr. Davis – “I started with Value Line in 1959, and I had direct contact with Mr. Arnold Bernhard, who founded the Value Line.  This was a valuable experience because my schooling had been in the sciences and music, but not in finance.  I was at Value Line for about five or six years and then went on to a number of Hedge Fund experiences with A.W. Jones, Hedge Fund of America, and Marathon Securities, controlled by the New York-based Scheuer family.  After that, I worked at Anchor Corporation, which is now part of Capital Research.  Anchor Corporation founded one of the first Mutual Funds, “Fundamental Investors”.  From there, I went to Merrill Lynch, to manage the Special Value Fund, which was their small and emerging growth stock fund.  In 1989, I went off on my own after an aborted attempt to establish a mutual fund group for Multi-Bank Financial, which was later acquired by Bank Boston.  I’ve been working independently as a Micro Cap Analyst for the past eleven years, trying to find low multiple stocks that have a great deal of future potential.”

CEOCFOinterviews – Why should an Investor or Shareholder be excited about Socket Communications (NASD: SCKT)?

Mr. Davis – “Socket is a very unique company.  It is probably the only company that we know that can benefit from all of the trends that are converging among wireless, handheld devices, mobile computing and the new Bluetooth technology.  Socket is really at the epicenter of all this.  Those who have been following the computer industry know that there has been a slackening off in PC sales, and that the handheld segment is probably the one computer area in which we currently can see a long-term horizon of rapid growth.  Computer usage has migrated from desktops, to laptops, and now to pocketsize devices.  People who travel are tiring of carrying heavy laptops weighing seven to nine pounds.  Instead, they can now take a pocket size device—a PocketPC or a PalmPilot.”

“Socket was founded in the early 1990s to serve the connectivity needs of mobile devices, and it has continued to develop its product offerings in sync with the evolution of the industry.  They were one of the few companies that started to work on Windows CE, back in 1997, when Microsoft (NASD: MSFT) was developing this radical modular operating system for use in miniaturized smart devices. Windows CE can combine various elements modularly to match the kind of device that you want—it doesn’t come loaded, as most PCs do today, with lots of stuff we may never use.  With Windows CE, the operating system is much more streamlined—this means that you can include just the parts that you want—but devices using this operating system are still compatible with Windows-based PCs and laptops.  It’s important to realize that there is a tremendous installed base compatible with Windows CE.  When Socket got involved with Windows CE, it was just a gleam in someone’s eye.  We don’t think anyone, even Bill Gates realized how big the market might be.  The first version on Windows CE didn’t have many applications and the Graphic User Interface (GUI) was not very good.  Version 2.x added color with more applications and was a better device all around.  But with Version 3.x, called the PocketPC, Microsoft has really developed a killer app, in my opinion.  It’s now giving the PalmPilot a run for its money.  Things have radically changed in the last three years from the stand point of Microsoft’s foray into the handheld market.  It is now a formidable competitor, and I think International Data Corporation (IDC) sees the Microsoft Windows CE operating system ascending to near equality with Palm within a couple of years, for use in handheld devices.”  

“Socket was one of only two companies involved with Windows CE in 1997, the other being BSQUARE Corporation (NASD: BSQR), which just went public about a year ago.  Most of what BSQUARE does is contract work for Microsoft, engineering work on Windows CE, and it is not a direct competitor of Socket.  Socket’s focus is on how to get the devices to work in tandem with others, the connectivity aspects of it.”

CEOCFOinterviews – Has Socket had any other partnerships that you would like to mention.

Mr. Davis – “Socket has or has had important partnerships with Hitachi (NYSE: HIT), Hewlett Packard (NYSE: HWP), Compaq (NYSE: CPQ), Motorola (NYSE: MOT) and Symbol Technologies (NYSE: SBL), which is an important one because it involves the combination of handheld devices with scanners.  There is also the Sprint partnership, in which Sprint is including Socket’s Digital Phone Cards in its kits for wireless business applications.  And of course, the sales relationship with Targus International (privately held).”

CEOCFOinterviews – Please give us your thoughts on Socket’s sales strategy.

Mr. Davis – “They are building up their sales team.  Their sales approach used to be ‘pull,’ rather than ‘push,’ where pull refers to selling things off the distributor’s shelves, and push, as the word implies, means selling through the concerted efforts of an integrated sales team.  In the past year, Socket has really gotten into sales-push in a big way.  They are trying to make sure that their products are known in the market place.  Obviously, it’s not much good if you have a great product if nobody knows that it’s there.  That is why the previous question about partnerships was so loaded: because they are a small company, they need to be able to convince other companies that are many times their size of the value of their products, and to work with them.”

“Their sales effort has improved immeasurably in the past year, and I think it is still gaining momentum.  Socket has traditionally been a highly techno-centric company.  Their technology is unparalleled as far as we are concerned.  There are very few small companies with this kind of techno-centricity and are able to map out an effective sales strategy.  You can have great technology, but you have to sell it.  And I think that recent changes in their sales team and the composition of their board of directors reflect increasing savvy in the sales area.  However, these evolutionary steps take time.  For instance, the Digital PhoneCard has been rolling out since the fall of 1999, and it’s just starting to take off.  After signing contracts with Socket, Sprint took what seemed like forever to get the product into their flagship stores, and they still haven’t said yet what they are going to do, if anything, in their Radio Shack kiosks.  I suspect that other phone companies will also use this product because it builds airtime and it is really the best all around solution from the standpoint of cost, reliability and efficiency.   Mobile devices are powered by batteries, so users will go for ancillary products that conserve battery power, and Socket’s products do just that—they are the best on the market from that standpoint.”

CEOCFOinterviews – How are Socket’s products manufactured?

Mr. Davis - “They don’t manufacture anything—they do some testing—but everything is produced overseas.  Their procurement is brilliant; they have this down to a science.  They maintain plenty of relationships with overseas suppliers in order to outsource product manufacture on a tight schedule. They apparently have this fine tuned very well. They are not going to have to build any new plants, or likely run short of capacity.  This may change when and if Socket becomes a billion dollar company.   Then they may want to do something different, but for the present and foreseeable future I think that it’s a perfect way to run this enterprise.”

CEOCFOinterviews – How has research and development spending affected the company, and its future?

Mr. Davis – “In the first few years of Socket’s existence, they spent themselves into poverty by maintaining an outsize R&D budget.  Today, they are at breakeven—they could have broken even a year or more ago, but they spent the money on R&D, and sales and marketing, which I think was the right thing to do, while holding the line on G&A.  I think that this is important to remember when seeing that the Company lost three cents a share in 2000, and eleven cents a share in 1999; those losses could have been a lot lower, and Socket could have even been profitable in 2000, had they not spent the money to make a better company.  By late 1999, management knew that they had sufficient funding to do this, so they weren’t concerned about showing modest losses at the bottom line—and I think that they did absolutely the right thing.  They continued to spend heavily on R&D and sales in the third and fourth quarters of last year, during which they posted nominal breakeven results.  This allowed the concurrent continuation of work on several major R&D programs, which will produce a number of major products that we think will eventuate in accelerating top line growth over the next several years.  The whole idea was to underwrite these projects with their total resources, which is exactly what they’ve done, and that pleases me to no end.”

CEOCFOinterviews – Will Socket’s research and development produce any new products that will enhance their revenue potential.

Mr. Davis – “Bluetooth is one major project that they are working on, and is a technology that will enable all kinds of devices to connect on the fly, which is really the major attraction of it.  With Bluetooth, you may also have four different computers, on different floors and hook them up cordlessly, including assorted peripherals; but the best thing about Bluetooth is being able to connect on the fly.  While these modules will be embedded in many of the big stationary devices such as printers and scanners, the real near-term impetus will derive from use by handheld devices.  Socket should benefit greatly from this technology, since after all, it is the leading supplier of connectivity products for mobile devices including PDAs (Personal Digital Assistants), handhelds and notebooks.  They will be bringing Bluetooth adapter modules to the market in the first half of 2001 in a limited way, and by 2002 their bluetooth product offerings will be in full swing.”

“I think one of the big things that the market doesn’t quite realize is that Palm has come under siege.  Palm’s management has read the reviews of the Pocket PC, and they feel very vulnerable.  What they are doing to protect their market share is putting in a slot called SD I/O, which stands for Security Device Input/Output.  This slot will essentially enable their products to have a memory boost as well as give them improved connectivity possibilities like Bluetooth.  Palm’s operating system is not modular but unitary.  It was meant to do very simple things, such as keeping addresses and telephone numbers.  As the popularity of the device grew, it began to include more features, but consequently became more complex and contrived.  The Palm operating system has built-in limitations, but to make everything backward compatible it basically has been retained.  It is also not a multi-tasking device like the Pocket PC.  On a Pocket PC, you can do two or three things at once, just as on a regular PC, but you can’t do that on a Palm PDA.  However, the principal point about this SD I/O slot is that it will enable Palm products to do many of the things that the Windows devices can already do.  And for those people who are devotees of Palm, these enhanced capabilities may be a deciding factor in sticking with Palm instead of migrating to PocketPC.   Essentially, it gives Palm a new lease on life.  But from Socket’s standpoint, it gives the Company entree to a huge PDA area that they didn’t have before.  So now it doesn’t make any difference which way the market goes.  Whether it goes Windows CE, or Palm OS, Socket is involved.  They are immersed in virtually the entire handheld market now—we couldn’t say that a year ago, or even six months ago.  As well, Socket is very much involved technologically in establishing the SD I/O standard itself—in how it operates—just as it has been instrumental in setting standards in the CompactFlash area.  In December, Dell announced that they were going to establish a special division for handhelds.  It seems to me that they are going to include handheld devices as part of their total enterprise solutions, and sooner or later that will have to involve Socket, either embedded or not.  Indirectly Dell is telling the market where future growth is.  IDC thinks that worldwide handheld device production, excluding so-called smart phones and vertical application devices, will be approaching 20 million units annually by 2003.   It seems to me that most of these devices will ultimately have to be connected in some fashion.   This is Socket’s bailiwick-they consummately understand connectivity—really it’s the only thing they’ve been doing right along.”

CEOCFOinterviews – What is the revenue potential of the handheld area?

Mr. Davis – “I’d like to rephrase your question to ‘What is the revenue potential for connectivity in the handheld area?’  The market is so large that if they execute properly, Socket may be looking at a quarter of a billion dollars in revenues by 2005.  To some extent it also depends on attach-rates.   If for every ten new handhelds that are sold, one customer buys a phone card or a Bluetooth module, or an Ethernet card to connect it, that is an attach-rate of ten percent.  My projections are based on what IDC has said the numbers could be for Pocket PCs, looking out three, four or five years.  I have not yet included anything for Palms, for it is still too early to determine how the inclusion of the SD I/O slot will play out.”

CEOCFOinterviews – What would it take Socket to be extremely successful?

Mr. Davis – “For a large enterprise to put together what Socket currently has, it would take a lot more than what the Company is selling for—one hundred and twenty-five million dollars.  The market was as irrational at the top, when the stock was selling at over fifty-one dollars, as it was in December 2000, when the stock was selling at three and a quarter.  So from the investment standpoint, Socket should easily be a winner from current levels, because if the company doesn’t really execute within a year or so I think it will probably be sold out at significantly higher levels.  However, for the Company to be successful as a going enterprise, it needs to achieve attach-rates of 25% for the entire handheld market over the next three to five years.   This means that it would probably have something like over 50% of the connectivity market share for these devices, if we take into account that not everyone who purchases a handheld may necessarily want to be connected to other devices.” 

CEOCFOinterviews – Is Socket going to be able to execute their plan so that they have the lion’s share of all of the handheld connectivity market?

Mr. Davis – “Yes, I think so.  Even if things don’t play out the way we foresee, the handheld market is becoming so huge and dynamic that the Company will be just swept along with the prevailing current.  Also, we haven’t talked about cell phones and how they fit into the handheld picture.  It’s complex, but suffice it to say, that the large installed base of these devices is also contributing to Socket’s growth in a very significant way.  

CEOCFOinterviews – What are your estimated earnings for Socket?

Mr. Davis – “For 2001, I’m showing profits of three cents a share.   Earnings will be held back by the need to expand some sales functions in Europe, which will probably cut down their numbers for this quarter and the next quarter to nominal breakeven profitability, although sales should continue to grow substantially.  In the third and fourth quarters, we show earnings of a penny a share each.  I show them with eleven cents for 2002, and for 2003, I have them at twenty-seven cents a share.”

“In the many years that Socket was losing money, the Company still spent mightily on R&D.   At five million in sales, they’d have a million dollars-plus in R&D, and they stuck to that all through that   period of unprofitability.  One year, they spent twenty-five per cent of sales.  No one was sure if Socket was going to get the additional money, or where it was going to come from.  Once the company grows into a mid-size enterprise, it should have typical tech operating margins of around twenty percent, margins and it will then be a different world.  The numbers will really ratchet up as top line growth accelerates.  Margins may be constrained for the next four to six quarters, because the Company will keep plowing back resources into R&D and sales and marketing.  But after that, it should be up-up-and-away for earnings.  I think they could probably do more than eleven cents for next year if they choose to do so.”

CEOCFOinterviews – What are your valuations?

Mr. Davis – “Arnold Bernhard always told us, “In the best of times you can always look at a company taking on one times its earnings growth rate as its P/E multiple.”  It’s sort of a rule of thumb that he used as a yardstick, and he was a stickler for valuations. In Socket’s case, we have used revenue growth in our evaluation, because the bottom line is starting out from virtually a zero base.  In our latest report, we project revenue growth at 86% annually over the next five years.  We give price targets based on very conservative yardsticks of one-quarter and one-half the projected annual sales growth rates.  The numbers implied by such calculations work out to $31 and $62 a share, respectively, over a two- to three-year time horizon.  These numbers of course look ridiculous when compared to current prices, but we firmly believe that the market has become quite irrational in its current valuation of these shares.  Just on a technical basis alone, Socket could move back to 10 or more—that’s the magnitude of move we might normally expect from a stock that has come down more than ninety percent from its high.  Stocks did similar things in the 1973/19 74 bear market.  The so-called Nifty Fifty stocks like Polaroid (NYSE:PRD) and Avon Products (NYSE:AVP) collapsed to levels ninety percent off their highs, and later tripled from the lows over a relatively short period.  The market has behaved similarly before, but the thing that is different this time, is that the valuations have been more egregious, and such extreme moves more pervasive.  We have to remember that a fifty percent decline is equivalent to a hundred percent increase, geometrically.  And in Socket’s case, we’re not talking about a DOT COM that exists on a tenuous business plan, or is burning itself out of existence.  We’re talking about a company that is quite well capitalized and just coming into its own in terms of generating substantial earnings.” 

CEOCFOinterviews – When do you expect their numbers to go up to the mid-teens?

Mr. Davis – “Within a year or so.”

CEOCFOinterviews – Please give us your evaluation of Socket’s management team.

Mr. Davis – “I think their management is absolutely first class.  Socket is an enterprise with people in it that have been involved in running big companies.  Dave Dunlap, the CFO, was a partner at a big five accounting firm.  Kevin Mills, their current President and CEO was at LogiTech, a several billion-dollar company; and Charlie Bass, the current Chairman, and CEO up until a year ago, is legendary—an extremely well-known and respected individual within the technology community. He was a professor at USC until recently, and runs his own incubator firm for small hi-tech companies.  Mike Gifford, one of the Co-Founders of Socket, has always worked on his own.  He’s a real genius, quiet and unassuming.  He works on problems until he gets the answers.  These are people with a big company mind set, although they happen to be running a small company.  In my opinion, the current management would be comfortable running a three hundred million dollar company or a billion dollar company—and that’s what’s so different about Socket, from most other small companies that I have come in contact with.”

CEOCFOinterviews – What is their market cap?

Mr. Davis – “Since I issued my latest report on January 2, 2001, the stock has doubled, but has more recently given back a little.  Their current market cap is about one hundred twenty-five million dollars, based on twenty-three million shares outstanding.  Over time, the capitalization will expand by about twenty per cent, basically due options, warrants, and a lot of insider stuff that will likely be converted.”

CEOCFOinterviews – What is the rating that you’ve given Socket?

Mr. Davis – “I have a Strong Buy as my long-term rating, and Accumulate for the short term, due to the stock’s volatility.”

CEOCFOinterviews –What are your final thoughts to potential investors and shareholders?

Mr. Davis – “Be patient.  Socket has a long way to go from here.  And don’t think that either the rise or subsequent fall in the stock during the great technology bubble is indicative of the pure fundamentals—it was irrational on both ends.  The Company has bolstered its board of directors by adding people consummately attuned to the consumer area.  Socket’s products have tremendous consumer as well as enterprise appeal.   There is a metamorphosis going on that doesn’t happen all at once.  Availability of Socket’s products outside of its traditional distribution channels has expanded, with Amazon.com being added in the second quarter of 2000, and Sprint PCS in the flagship stores in late third quarter.  Targus, which maintains seven thousand retail storefronts in the U.S., including Circuit City, Best Buy, Office Max, Staples, Office Depot, Comp USA, and Fry’s, was also added in the fourth quarter.  D&H Distributing, a nationwide computer products distributor with strong government and education sales ties was added in the current quarter. All this adds up to huge exposure for Socket products in a wide array of marketplaces.   The big question still may remain, “Will everything be executed properly?” and that execution does hinge on management’s ability to get into more distribution channels.  But, as you see, this is gradually happening.  We have faith that management will continue to do the right things in this area.