Description

Note: SCKT is a $3 stock that trades approximately 10K shares per day on OTCQB. The market cap is about $20 million. I know that it is too small for many VIC members, but I think that microcap investors will be interested in this idea.

Summary: Socket Mobile (SCKT) is a tech company that is primarily focused on producing handheld wireless barcode scanners. SCKT is a play on the strong growth of Square and other tablet-based point-of-sale systems. Socket’s model 7Ci scanner is the only barcode scanner that Square lists as compatible with its Square Register on iPad: https://squareup.com/help/us/en/article/5084-supported-hardware-for-ipads

Introduction: Socket has produced two profitable years in a row after producing losses for most of its history. While the company has changed its focus several times, it has recently found a solid niche in producing barcode scanners for the fast-growing mobile point of sale (mPOS) industry. A big breakthrough for the company occurred in 2013 when Square announced that it supports Socket’s Bluetooth barcode scanner. SCKT’s devices remain the preferred, and often only, scanners for Square and other mPOS systems. SCKT is little-known on Wall Street as it is a lightly-traded OTC stock. It trades at a trailing P / S of 1x and a trailing EPS of 10x. I believe that SCKT could report EPS of about $0.50 for 2016.

Background

            Socket Mobile (SCKT) is a small producer of consumer electronics based in Newark, California. The company, originally called Socket Communications, was founded in 1992 and completed its IPO in 1995. SCKT moved to NASDAQ in 2000 and, believe it or not, briefly hit a split-adjusted stock price of $513.75 in March, 2000. The company, though, was consistently unprofitable and the stock price suffered. It changed its name to Socket Mobile in 2007 and underwent a 1 for 10 reverse stock split in 2008. SCKT was de-listed from NASDAQ in mid-2012. The company expects to regain its NASDAQ listing in the near future. SCKT has finally began to report positive net income after years of losses.

            Socket Mobile made the transition to mobile products several years ago when it became apparent that connections were going wireless. It has been involved in several markets, including handheld computers, data collection, networking, and barcode scanners. SCKT got a bit of a lucky break when the growth of the mPOS industry boosted demand for handheld wireless barcode scanners. SCKT has been involved in the scanner market for more than ten years. It is now designing Bluetooth-enabled barcode readers for the mPOS market and others. Scanners will likely represent 85 – 90% of SCKT’s revenues for the foreseeable future. Socket Mobile has a small, but stable, management team. Its CEO, Kevin Mills, has been with the company since 1993 and has served as CEO since 2000. Dave Dunlap has served as its CFO since 1995. CTO Leonard Ott has been with the company since 1994. Charlie Bass, a co-founder and former CEO, continues to serve as Chairman of the Board. A few of SCKT’s insiders have helped to fund the company over the years. The company, although not trading on a major exchange, reports its financials and holds earnings conference calls.

mPOS Industry

Mobile applications have changed business practices for many small- and mid-sized businesses. Many small- and mid-sized businesses haven’t seen a lot of technological progress over the decades. Many of them continue to utilize cash registers (invented in the 19^th century), calculators, and Excel. It is getting more common, though, for them replace traditional methods with apps on their tablets or smartphones. These apps allow retailers, restaurants, and other types of businesses to process payments, manage inventory, and track sales. Mobile apps are often very low cost or free and can be tested before implementation. They are especially useful at the point of sale. Mobile apps make the sales process faster and easier.

The mobile point of sale (mPOS) industry is developing quickly. It is estimated that 30-40% of small- and medium-sized businesses are currently using mPOS systems. The category is adding approximately 300K new businesses per year. BusinessInsider estimates that market penetration will be close to 80% by 2020. A group called 451 Research estimates that worldwide mPOS units will experience CAGR of 32% over the next four years. A large number of start-ups provide software and hardware to this market. Venture capitalists have invested more than $500 mil. in these start-ups. Some of the best-known providers of mPOS systems are Square, Vend, Lightspeed, Shopify, NCR, Bindo, and ShopKeep. SCKT makes scanners that are used in these and more than 100 other mPOS applications. The major mPOS firms are adding 5K – 15K new users per year. More than 50% of SCKT’s scanner sales are currently driven by mPOS applications.

Mobile systems are spreading to retailers with physical inventory. The first markets for mPOS systems were restaurants and food trucks. These types of businesses do not really need barcode scanners because they do not use mPOS for inventory management. Fortunately for SCKT, much of the growth of mPOS is now coming from retailers with physical inventory. These retailers will want to use barcode scanners to track their inventory. Many of the mPOS apps, including Square, have inventory tracking functionality.

It is easy for a small business to purchase and implement mPOS systems. The owners of these businesses do not need to know much about technology. The mPOS systems typically cost $50 - $100 / month and require a few hundred dollars of hardware. They operate on tablets or smartphones. New mPOS users choose the software (e.g., Square or ShopKeep) first. Then, they purchase compatible peripheral hardware such as printers, card readers, and cash drawers. These items can be purchased individually or in bundles from software providers. Most new mPOS users choose to buy scanners separately, but approximately 15% of SCKT’s 2015 scanner sales were sold through hardware bundles. SCKT’s scanners are listed as the recommended scanners by many of the major mPOS software companies. The websites of these companies often do not even list scanners from any other companies. Below, I provide some web links to a few major mPOS companies that sell SCKT scanners:

https://shop.shopkeep.com/barcode-scanners

https://partner.posportal.com/square/square/scanners-and-swipers/socket-mobile-7ci-barcode-scanner-cx2870-1409-grey-new.html

https://www.shopify.com/pos/hardware/barcode-scanner

It is not necessary to purchase a wireless barcode reader to use an mPOS system, but many users choose to do so. They often discover that a scanner is a small expense that saves time and money and reduces errors. I have provided a link to a blog below. In the blog, the owner of a liquor store describes the process of installing a ShopKeep mPOS system. She notes that it would be very easy for an employee to press the wrong button on an iPad when making a sale. This kind of mistake could lead to an undercharge of hundreds of dollars. She explains that, “So we decided to with a handheld scanner to read the barcodes on bottles…The scanner is much more accurate than a person. And quicker.”

http://smallbizsurvival.com/2013/11/how-we-switched-to-an-ipad-point-of-sale-system.html

Socket’s Scanners

Socket Mobile is focused on producing cordless barcode scanners for the mPOS market. SCKT has produced barcode readers for years. They were originally developed for use in hospitals and other medical applications. The primary market now, though, is payment processing.  The scanners are mainly used by businesses that use smartphones and tablets that run on Apple, Android, or Windows operating systems. SCKT does not favor one operating system over another, but its scanners are widely used with Apple devices. The company was among the first to achieve Apple certification for its scanners in 2011. This certification gave SCKT a first-mover advantage and established it as a producer of barcode scanners for mPOS systems on Apple devices.

Socket’s scanners are cordless, small, and easy to use. They can be carried around, attached to a cellphone or tablet, or be worn around a user’s neck. They come in various shapes and colors. They do not need to be attached to anything as they connect to digital devices over Bluetooth. The retail prices for SCKT’s scanners vary from $200 - $500 (depending on the model). They are often sold as part of hardware bundles that can cost several hundred to two thousand dollars. If you want to see the scanners in action, SCKT has posted several videos of them on its website and YouTube channel. This brief video was produced by one of SCKT’s distributors and shows how easily a scanner can be used with a tablet: http://www.bluestarinc.com/us-en/socket.html

Socket is dependent on third-party software developers. SCKT does not produce the apps that work with its scanners. Instead, it sells software development kits (SDK) to outside programmers. SCKT updates its software development kits frequently to remain compatible with new operating systems. A software development kit can be purchased by anyone for a nominal fee of $19.95. More than 1,400 software development kits have been sold and there are approximately 450 apps on the market that use SCKT scanners. SCKT does work with programmers to help them develop apps. It takes an active role in field trials so that its scanners can be properly utilized. It also designs scanners based on feedback that it receives from developers. The large number of apps that use Socket scanners is one of its main competitive advantages.

            Socket’s barcode scanner sales have nearly tripled over the past three years. The firm’s cordless barcode scanner revenues increased from $5.7 mil. in 2012 to $15.6 mil. in 2015. SCKT sold a total of 65,500 scanners in 2015, up from 55,000 in 2014. Scanner prices have declined over the past few years. SCKT’s revenues per scanner sold declined from approximately $300 in 2012 to approximately $240 in 2015. SCKT, though, has reported increasing gross profits as production costs have fallen. Its gross margins have moved up from the high-30s to the high-40s. Scanner sales represented 85% of SCKT’s 2015 revenues, up from 79% in 2014.          

New Applications

            Socket expects its scanners to be used in many different applications. While mPOS at retail is SCKT’s primary market at present, enterprise-driven applications are increasingly important. Enterprise-driven mobility develops slowly due its cost and complexity, but it is beginning to happen. Industries that are likely to see advances in mobility include hospitality, manufacturing, healthcare, and transportation. SCKT is working with programmers and developing scanners for new applications. One of SCKT’s new devices is designed for RFID data capture applications. There is a lag between the time that SCKT releases new scanners and the time that useful applications become available. The development work that the company has done over the past few years is likely to pay off over the next few years.

Socket will release a new model scanner on May 2, 2016. The company is so excited about this launch that it has installed a countdown clock on its website! The new scanner is called the DuraScan Series 750. SCKT designed this scanner after feedback from developers.  It is designed for use in harsh environments where it may be exposed to the weather or dropped on hard floors. It is more durable than SCKT’s existing scanners. SCKT’s management hopes that the DuraScan product will increase the number of applications for its products. The DuraScan scanner could, for example, be used in a warehouse or on a truck to track inventory. SCKT’s scanners are data collection products that can be used in a variety of ways.

Sellers and Competitors

Socket faces a number of existing and potential competitors. There are probably not a lot of technological barriers to entry in this industry. Barcode scanners have been commonplace in department stores and elsewhere for a long time. Most of them, however, have not been designed for the mobile market. Many of the major scanners, such as those made by Honeywell and Datalogic, are not Apple-certified. SCKT’s important direct competitors include Koamtac (based in New Jersey), Opticon (Japan), and Code Corporation (Utah). Opticon and Koamtac sell scanners on Amazon, but the selection is limited. Most industry participants do not work with outside developers to the degree that SCKT does. The primary barrier to entry is large number of apps that have been developed for its scanners. Developers have no great reason to rewrite their software for every scanner on the market. They know that SCKT maintains updated software development kits and that its scanners are widely available.

Socket sells most of its scanners to distributors and does not need a large salesforce. The entire company has only fifty employees. SCKT has worked with some distributors for twenty years. Its three largest distributors are Ingram Micro, ScanSource, and BlueStar. These distributors represent about 70% of SCKT’s sales. They sell scanners to mPOS systems providers and many online retailers. The largest individual retailer of SCKT’s scanners is, not surprisingly, Amazon.com. Other retailers that carry SCKT scanners include Staples, newegg.com, Overstock.com, and Office Depot. SCKT does not need to do a lot of marketing since its scanners are usually secondary purchases for new mPOS users. Also, the mPOS companies handle customer support issues. While approximately 80% of its SCKT’s sales are generated in the U.S., the company is hoping to see growth from international markets. It has built versions of its websites in French, German, and Japanese. The mPOS market has developed slower in Europe than in the U.S. due to greater complexity with payments. Here are some links to retail sites that sell SCKT scanners:

http://www.amazon.com/Socket-Mobile-CX2870-1409-Bluetooth-Cordless/dp/B007ZW3H6U/ref=sr_1_1?ie=UTF8&qid=1458163545&sr=8-1&keywords=socket+mobile

http://www.staples.com/SOCKET-MOBILE-Bluetooth-CHS-7Ci-V3-Apple-iOS-1D-HiD-SPP-iPad-iPhone-iPod-Touch-Blue-5-1-/product_IM1QX8666

http://www.newegg.com/Product/Product.aspx?Item=N82E16838133044&cm_re=socket_mobile-_-38-133-044-_-Product

Handheld Computers

            Socket generates some sales from its discontinued line of handheld computer products. The handheld computer market has been declining for years as tablets and smartphones have replaced handheld computers in the marketplace. SCKT introduced its first handheld computers in 2007 and released its most recent model in mid-2012. Its devices run on Microsoft’s Embedded Windows 6.5 operating system and retail for approximately $700. Microsoft has announced that it will continue to support Embedded Windows 6.5 until 2020. SCKT is no longer actively producing or marketing its handheld computers, but they are still available. Existing customers are likely to order more of them from time to time. In September, 2015, for example, SCKT announced that a Japanese land surveying company called CTS ordered 600 units. CTS has been a long-time user of SCKT’s handheld computers.

The decline of the handheld computer market has affected SCKT’s growth. The growth of SCKT’s scanner business has been masked by the decline of its handheld computer business. Handheld computers represented 34% of SCKT’s revenues in 2012, but only 11% in 2015. Revenues from handheld computers are likely to approach zero over the next couple of years. SCKT did, however, close a significant sale in 2015. In Q2 2015, SCKT announced that an unnamed OEM customer placed an end-of-life order for $1.6 mil. worth of handheld computers. Most of the revenues from this order have yet to be recognized. SCKT recognized $320K in revenues in Q4 2015 from this order and anticipates that it will recognize most of the remaining $1.3 mil. in revenues in Q1 and Q2 of 2016. The company does, from time to time, receive special orders for other discontinued products. It is willing to fill these orders if the price is high enough.

NOLs

            Socket has significant tax loss carryforwards. The company’s history of losses means that it will not be paying taxes any time soon. At 12/31/14, SCKT reported $29.0 mil. in federal and $18.0 mil. in state NOLs. SCKT’s management claims that these numbers are conservative, but that a full analysis has not been completed. There was little need to worry about NOLs in past years as the company was not profitable. SCKT’s federal and state NOLs will slowly expire on annual basis until the year 2033.

2015 Results

            Socket reported its best financial results ever in 2015. It reported $18.4 mil. in sales and net income of $1.82 mil. for 2015. Its revenue grew 8% year-over-year and its gross margin improved significantly from 43.6% to 48.6%. Operating expenses increased year-over-year by 5% due to an increase in sales and marketing. SCKT reported fully-diluted EPS of $0.30 for 2015 versus $0.08 in 2014. SCKT is trading at a trailing P / E of only 10x. It is only in the last couple quarters that the growth of SCKT’s scanner business has had much effect on the bottom line. SCKT reported fully-diluted EPS of $0.09 for Q3 2015 and fully-diluted EPS of $0.16 for Q4 2015. SCKT will file its 2015 10-K in the next few days and management does not expect to need to include a “going concern” clause. It has included such clauses in the last few years.

Capital Structure and Share Count

            Socket has issued warrants and stock options and has borrowed money from management. SCKT reported a fully-diluted share count of 6.0 million at the end of the last quarter. The actual fully-diluted share count, though, is closer to 9 million if all potential shares are included. SCKT has stock options, notes, and warrants which have not been reflected in the reported share counts. It has approximately 2 mil. stock options outstanding, most of which are now in-the-money. SCKT also has convertible notes outstanding which mature in 2017. The company issued notes to management when outside funding was difficult. The notes are convertible at $1.25 and would convert into 977K shares if held to maturity. Finally, SCKT has 175,000 warrants outstanding at an exercise price of $1.25. These warrants mature in June, so they are likely to be exercised soon. The warrants are held by NYC investment firm called Hudson Bay. Hudson Bay filed a lawsuit against SCKT in 2013 after SCKT issued the notes to insiders. Hudson Bay claimed that the company had triggered an anti-dilution clause in the warrants and had improperly disclosed Hudson Bay’s ownership. This case has been settled.

Socket’s share count will rise, but so will its cash. The firm’s actual share count depends on the stock price and timing of option exercises. The maximum share count appears to be approximately 8.8 mil. if all of the warrants, notes, and options are exercised or converted. SCKT would, of course, generate cash through these transactions. It appears that SCKT would take in approximately $4.3 mil. in cash. In my model, I assume that the reported share count slowly rises each quarter. SCKT’s cash balance should also slowly increase through earnings and financing transactions. The company generated more than $1 mil. cash from operations last year. SCKT also has a maximum $2.5 mil. credit line with Bridge Bank. This credit line was recently extended until 2018. I do not anticipate that SCKT will need to issue any significant amount of equity or new debt in the near future.

Re-listing

            Socket may regain its NASDAQ listing in the next few months. There are several criteria that must be met for a company to list on NASDAQ Capital Market:

·         Stockholders’ equity: $4 mil.

·         Market value of publicly-traded shares: $5 mil.

·         Net income in last fiscal year: $750,000

·         Publicly-held shares: 1 mil.

·         Shareholders: 300

·         Market makers: 3

·         Stock price: $3

·         Average annual revenue of $6 mil. for three years

Socket is in good shape on all criteria except two: It needs to report stockholders’ equity of $4 mil. and it needs its stock price to stay above $3. SCKT’s stock price jumped up from the low-$2s after the strong Q4 financials were released. On 3/14/16, the stock price moved above $3 for the first time in more than a year. It appears likely that SCKT will be able to meet the minimum share price requirement. It also appears likely that SCKT will be able to meet the stockholders’ equity requirement. The firm ended 2015 with stockholders’ equity of $3.3 mil., up from $1.0 mil. at the end of 2014. I anticipate that SCKT will report a profitable Q1 ’16. The company should exceed $4 mil. in stockholders’ equity within the next two quarters.

Socket’s management has said that the company will apply for re-listing as soon as possible. This issue has been discussed on recent conference calls. Once the application is made, it will take a few weeks for NASDAQ to approve it. If everything goes well, SCKT may trade on NASDAQ by mid-2016. A successful re-listing could attract new investors and sell-side coverage. It would also allow SCKT to pursue shelf registrations and other sorts of financing that are difficult or impossible for OTC companies.

Earnings Expectations

            There are no formal earnings expectations for SCKT. There is no sell-side coverage of the stock and the management has not released any projections. I believe that SCKT can report EPS of $0.50+ for 2016. If I am correct, then SCKT is trading at a forward P / E in the mid-single digits. Here are my income statement expectations:

Valuation

            Socket Mobile appears to be inexpensive in relation to its earnings power. While the stock price has moved up from $2 to $3 since the Q4 earnings were announced, it is still inexpensive at a trailing P / E of 10x and a trailing P / S of 1.0 – 1.5x (depending on the share count used). Since SCKT’s expenses are mostly fixed, small increases in revenues have a significant impact on its bottom line. Its gross margin is approximately 50%. The company will not pay significant taxes for years (if ever) and is not planning any major increases in headcount or marketing expenses. SCKT’s net income margin was 9.9% for 2015, but it was 17.8% in Q4. The Q4 results were aided by some extraordinary sales. I think that a sustainable net income margin of about 15% is realistic if sales growth continues.

I expect that SCKT will report growth in revenues of 20 – 25% in 2016 and EPS of approximately $0.50. Since SCKT is primarily a hardware company, it is unlikely to trade at large multiples of earnings. The possible listing on NASDAQ could attract new investors and improve trading volumes. I think that a P / E of 10x is reasonable on 2016 earnings, so my 12-month price target is $5.00 (67% upside).

Conclusion

            Socket Mobile (SCKT) should continue to benefit from the growth of Square and the mPOS market. The opportunity exists because the stock is little-known to investors and the use of barcode scanners in the mPOS market is still in the early stages. Inventory tracking with mPOS systems is still relatively new. SCKT’s scanners have only been compatible with Square Register since 2013. The risk-reward of this investment is very favorable with the stock at $3.00. I believe that the stock price could hit $5.00 within the next year.

Legal Disclaimer: This research report expresses my research opinions, which I have based upon certain facts, all of which are based upon publicly available information. Any investment involves substantial risks, including complete loss of capital. Any forecasts or estimates are for illustrative purpose only and should not be taken as limitations of the maximum possible loss or gain. Any information contained in this report may include forward-looking statements, expectations, and projections. You should assume these types of statements, expectations, and projections may turn out to be incorrect. This is not investment advice nor should it be construed as such. You should do your own research and due diligence before making any investment decision with respect to securities covered herein. The author has a position in this stock and may trade this stock.

Catalyst

earnings growth; success of Square and other mPOS firms; listing on NASDAQ