Less Harvest Than Expected

When we added Smart Eye to the portfolio, our belif was that the coming revenue ramp-up would continue to fuel share price performance; in a nutshell, we were wrong. Topline Q2 was a disappointment, but what was even more worrisome was the indication of a much quicker growth fade than we earlier expected. That, combined with deteriorating incremental margins when the reverse should be in effect, made us exit our position. We have previously highlighted the risk of Smart Eye’s poor information disclosure practices; sadly, this is becoming an increasing issue and hopefully something management will address. If Smart Eye starts presenting sufficient financial information, we might change our view, but for now we stay Neutral.

We exited our speculative position in Smart Eye on Thursday Aug 27, which we initiated before the Q2 report, at close to a 30% loss. Since then, the share is down even further.

Never swing, never miss, right? We swung, and not in a good way in this case; despite our value assessments indicating quite a pricey valuation, we initiated the trade. We learned the lesson the hard way. The position were classified as speculatively, which meant it was only about 5% of our portfolio weight. The drop hurt, but it’s not a huge loss in total portfolio value. This is where risk management and position sizing are critical.

Our thesis in Smart Eye was that the revenue growth was fairly certain thanks to the GSR2 mandate, and we expected continued share price performance driven by the revenue ramp and profitability expansion. The biggest risks in the case, which we have stated many times, are the lack of financial disclosures. We wrote this in our recent deep dive:

And sadly, that came into play in the Q2 report. Smart Eye continues to drop small pieces of information rather than the whole picture, which raises the question of whether there are problems underneath that they don't want us to see.

Earnings calls are often a good source of additional nuggets of information, especially the Q&A, since the answers are less scripted. But for Smart Eye, earnings calls don't just drop nuggets; they sometimes drop boulders. We do not view this as sound information praxis, especially since the earnings calls are not stored on their website and are not sent out in transcript format. We suggest the company use a service that stores the transcript and distributes it through useful platforms like Quartr.

The following are some information pieces communicated in the earnings call that we believe should have been presented in the regular material:

What shone brightly with its absence was data we actually need. In Q1, Smart Eye purposely disclosed cars on the road. With that, car production for Q1 was easy to approximate; now, in Q2, there's no mention of that number. The reason? Likely because it was not as strong as in Q1. With that rant done, let’s move to the actual report.

Revenue and profitability showed sharp increases, and yet we see this as a disappointing report; how is that? Well, the GSR2 mandate has been in force since July, and competitor Seeing Machines showed a Q/Q increase in car production of 64% in the latest quarter, while Smart Eye (which doesn’t report that figure) had Automotive revenue increase "only" 13% Q/Q. Here is a table of our projections again for the outcome.

As expected, Smart Eye showed strong growth during the quarter, with revenue up 53% and 44% organically. Revenue came in at SEK 141m; we had projected SEK 164m.

The Automotive segment was the largest contributor, rising from SEK 42m to SEK 93m in the previous year. The royalties are stated to have increased by 200%, the same as in Q1, which is quite weird, as one would have expected car production and thus royalties to accelerate. Management also states that both AIG (hardware) and NRE grew (Y/Y; no comment on Q/Q). AIG growth is in all orders, but we do not fully understand why NRE is still increasing. To our understanding, this is a Y/Y growth, and not Q/Q, but still. We highlighted in the quarterly preview the unpredictability of the revenue ramp, and therefore we never expected to be correct in our quarterly projections. But the revenue ramp from Q1 was much smaller than we expected.

One of the more puzzling items in the whole report is that the gross margin did not expand, despite the stated high royalty growth, as it was flat at 90% compared to Q2 last year. To us, that does not really make sense. In the conference call, management also clearly stated that a 90% margin is the expected level going forward.

Despite growth, we are not seeing the results or cash flows truly expanding at the same rate. We do not know if it’s intentional; management might be fueling more OPEX costs for the long term, but they do not discuss it. There is a clear deterioration in incremental margins, from EBITDA to actual cash flow, in a quarter when the 100% margin royalties were set to explode (a little exaggeration, maybe). We assumed the profitable royalty revenue would show up more on the bottom line than it did. Especially R&D isn't showing scale as it should; to us, it seems like management is taking the royalty profits and deploying them directly into the business. That might be fine to some degree, but for a company with a history of unprofitability and no cash flow, it would be welcome to settle on at least a decent margin level.

Even more alarming is the trend in incremental margins. Incremental EBITDA has been acting in the opposite way we expected during the Q1 and Q2 car production ramp-up. Margins have been declining significantly.

The further down we go in the income statement and cash flow statements, the worse the incremental margins are. We know management says cash flow is hurt to some degree by late royalty payments, but the trend is very alarming. By the looks of it, the incremental margins are getting worse with more growth. The issue is that we do not know how much of future revenue growth will be captured in profits/cash flows.

We find that the most impactful information was dropped in the conference call, not the report:

One major issue is that earlier communication indicated this quarter would be the big breakthrough, but now it sounds like this was expected and the big revenue ramp is coming a little later (again). And to sugarcoat everything, management immediately starts talking about the next big opportunity (to fuel expectations) with interior sensing. That might be true, but first one has to face the current reality and explain why we aren't seeing profits when we are supposed to scale 100% margin income from royalties.

The share took a hit, clearly. But now this must be a screaming buy? For us…

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