SMITH MICRO SOFTWARE INC, 10-Q, 1998-05-12

SMITH MICRO SOFTWARE INC
10-Q, 1998-05-12
PREPACKAGED SOFTWARE

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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549

FORM 10-Q

[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES
EXCHANGE ACT OF 1934

FOR THE QUARTER ENDED MARCH 31, 1998

[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES
EXCHANGE ACT OF 1934

COMMISSION FILE NUMBER 0-26536

SMITH MICRO SOFTWARE, INC.
(EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER)

DELAWARE 33-0029027
(STATE OR OTHER JURISDICTION OF (I.R.S. EMPLOYER INCORPORATION OR
ORGANIZATION) IDENTIFICATION NUMBER)

51 COLUMBIA, SUITE 200, ALISO VIEJO, CA 92656
(ADDRESS OF PRINCIPAL EXECUTIVE OFFICES) (ZIP CODE)

REGISTRANT'S TELEPHONE NUMBER, INCLUDING AREA CODE: (949) 362-5800

SECURITIES REGISTERED PURSUANT TO SECTION 12(B) OF THE ACT: NONE

SECURITIES REGISTERED PURSUANT TO SECTION 12(G) OF THE ACT: COMMON STOCK,
$.001 PAR VALUE

Indicate by check mark whether the Registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
Registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days.

YES (X) NO ( )

As of March 31, 1998, there were 14,074,698 shares of Common Stock
outstanding.

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<PAGE> 2

SMITH MICRO SOFTWARE, INC.

FORM 10-Q

TABLE OF CONTENTS

<TABLE>
<S> <C>
PART I. FINANCIAL INFORMATION

CONSOLIDATED BALANCE SHEETS AS OF MARCH 31, 1998 (UNAUDITED)
AND DECEMBER 31, 1997 3

UNAUDITED CONSOLIDATED STATEMENTS OF OPERATIONS FOR THE THREE
MONTHS ENDED MARCH 31, 1998 AND MARCH 31, 1997 4

UNAUDITED CONSOLIDATED STATEMENTS OF CASH FLOWS FOR THE THREE
MONTHS ENDED MARCH 31, 1998 AND MARCH 31, 1997 5

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS 6

MANAGEMENT'S DISCUSSION AND ANALYSIS 9

PART II. OTHER INFORMATION

ITEM 1. LEGAL PROCEEDINGS 20

ITEM 2. CHANGES IN SECURITIES AND USE OF PROCEEDS 20

ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K 21

SIGNATURES 27
</TABLE>

FORWARD LOOKING STATEMENTS

THE PRIVATE SECURITIES LITIGATION REFORM ACT OF 1995 PROVIDES A "SAFE HARBOR"
FOR FORWARD-LOOKING STATEMENTS. THE STATEMENTS CONTAINED IN THIS QUARTERLY
REPORT ON FORM 10-Q THAT ARE NOT STATEMENTS OF HISTORICAL FACT MAY BE FORWARD
LOOKING STATEMENTS SUBJECT TO A NUMBER OF RISKS AND UNCERTAINTIES. THE FOLLOWING
FACTORS, TOGETHER WITH THOSE ADDITIONAL RISKS DISCUSSED IN THIS QUARTERLY REPORT
ON FORM 10-Q (PARTICULARLY IN "RISK FACTORS" COMMENCING ON PAGE 12), COULD CAUSE
THE ACTUAL RESULTS OF THE COMPANY TO MATERIALLY DIFFER FROM THOSE ANTICIPATED BY
FORWARD LOOKING STATEMENTS HEREIN SET FORTH: DEMAND FOR COMMUNICATION SOFTWARE;
DEMAND FOR MODEMS AND OTHER ELECTRONIC COMMUNICATION DEVICES; NATIONAL, REGIONAL
AND INTERNATIONAL ECONOMIC CONDITIONS AFFECTING THE SUPPLY OF AND DEMAND FOR
COMMUNICATION SOFTWARE, MODEMS OR OFFERINGS BY THE COMPANY; THE COMPANY'S
ABILITY TO COMPETE IN AND SELL ITS PRODUCTS THROUGH THE RETAIL CHANNEL AND
ORIGINAL EQUIPMENT MANUFACTURERS (OEM) DISTRIBUTION CHANNEL; THE COMPANY'S
ABILITY TO COMPETE AND SELL ITS PRODUCTS THROUGH THE CORPORATE AND GOVERNMENT
MARKETPLACE; DEMAND FOR THE COMPANY'S PRODUCTS; THE COMPANY'S ABILITY TO
MAINTAIN ITS CUSTOMER BASE AND TO EXPAND THAT BASE; AND THE COMPANY'S ABILITY TO
ANTICIPATE AND ADJUST TO TECHNOLOGICAL SHIFTS AND CHANGES IN THE ELECTRONIC
COMMUNICATION SOFTWARE AND HARDWARE INDUSTRIES. ALL FORWARD LOOKING STATEMENTS
CONTAINED IN THIS QUARTERLY REPORT ON FORM 10-Q SHOULD BE CONSIDERED IN THE
LIGHT OF THESE AND ANY OTHER FACTORS WHICH MIGHT CAUSE THE COMPANY'S FUTURE
PERFORMANCE TO MATERIALLY DIFFER FROM THAT ANTICIPATED BY THIS QUARTERLY REPORT
ON FORM 10-Q.
2
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SMITH MICRO SOFTWARE, INC.
CONSOLIDATED BALANCE SHEETS
(IN THOUSANDS, EXCEPT SHARE AND PER SHARE DATA)

<TABLE>
<CAPTION>
March 31, December 31,
1998 1997
--------- ------------
(unaudited)
<S> <C> <C>
ASSETS
CURRENT ASSETS:
Cash and cash equivalents $ 13,807 $ 14,367
Accounts receivable, net of allowances for doubtful accounts
and other adjustments of $754 (1998) and $1,413 (1997) 4,471 3,808
Income taxes receivable 1,049 1,127
Deferred tax asset 467 467
Inventories 574 553
Prepaid expenses and other current assets 663 503
-------- --------

Total current assets 21,031 20,825

EQUIPMENT AND IMPROVEMENTS, net 391 444
DEFERRED TAX ASSET 139 139
INTANGIBLE ASSETS, net 709 347
-------- --------
$ 22,270 $ 21,755
======== ========

LIABILITIES AND STOCKHOLDERS' EQUITY
CURRENT LIABILITIES:
Accounts payable $ 1,190 $ 877
Accrued liabilities 724 635
-------- --------
Total current liabilities 1,914 1,512

COMMITMENTS AND CONTINGENCIES

STOCKHOLDERS' EQUITY:
Preferred stock, par value $0.001 per share; 5,000,000 shares
authorized; none issued and outstanding
Common stock, par value $0.001 per share; 20,000,000 shares
authorized; 14,075,000 shares issued and outstanding (1998 and 1997) 14 14
Additional paid-in capital 21,250 21,250
Accumulated deficit (908) (1,021)
-------- --------
Total stockholders' equity 20,356 20,243
-------- --------
$ 22,270 $ 21,755
======== ========
</TABLE>

SEE NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

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SMITH MICRO SOFTWARE, INC.
UNAUDITED CONSOLIDATED STATEMENTS OF OPERATIONS
(IN THOUSANDS, EXCEPT PER SHARE DATA)

<TABLE>
<CAPTION>
FOR THE THREE MONTHS
ENDED MARCH 31,
1998 1997
------ -------
<S> <C> <C>
NET REVENUES $3,266 $ 2,658

COST OF REVENUES 866 1,246
------ -------

GROSS PROFIT 2,400 1,412

OPERATING EXPENSES:
Selling and marketing 768 995
Research and development 786 882
General and administrative 836 1,536
------ -------

Total operating expenses 2,390 3,413
------ -------

OPERATING INCOME (LOSS) 10 (2,001)

INTEREST INCOME 180 180
------ -------

INCOME (LOSS) BEFORE INCOME TAXES 190 (1,821)

INCOME TAX EXPENSE (BENEFIT) 77 (637)
------ -------

NET INCOME (LOSS) $ 113 $(1,184)
====== =======

NET INCOME (LOSS) PER SHARE, basic and diluted $ 0.01 $ (0.08)
====== =======
</TABLE>

SEE NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS.

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SMITH MICRO SOFTWARE, INC.
UNAUDITED CONSOLIDATED STATEMENTS OF CASH FLOWS
(IN THOUSANDS)

<TABLE>
<CAPTION>
For The Three Months
Ended March 31,
1998 1997
-------- --------
<S> <C> <C>
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income (loss) $ 113 $ (1,184)
Adjustments to reconcile net income (loss) to net cash
used in operating activities:
Depreciation and amortization 167 132
Provision for doubtful accounts and other adjustments
to accounts receivable (659) 1,057
Change in operating accounts:
Accounts receivable (4) (309)
Income taxes receivable 78 (732)
Inventories (21) (7)
Prepaid expenses and other current assets (160) (180)
Accounts payable and accrued liabilities 402 (268)
-------- --------

Net cash used in operating activities (84) (1,491)

CASH FLOWS FROM INVESTING ACTIVITIES:
Capital expenditures (18) (57)
Acquisition of technology (458)
-------- --------

Net cash used in investing activities (476) (57)
-------- --------

NET DECREASE IN CASH AND CASH EQUIVALENTS (560) (1,548)

CASH AND CASH EQUIVALENTS, beginning of period 14,367 14,487
-------- --------

CASH AND CASH EQUIVALENTS, end of period $ 13,807 $ 12,939
======== ========
</TABLE>

SEE NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS.

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SMITH MICRO SOFTWARE, INC.
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Basis of Presentation - The accompanying unaudited consolidated
financial statements have been prepared by Smith Micro Software, Inc. (the
"Company") pursuant to Securities and Exchange Commission regulations. The
accompanying unaudited consolidated financial statements reflect the operating
results and financial position of Smith Micro Software, Inc. and its
wholly-owned subsidiary, PCI Video Products, Inc. (PCI). All significant
intercompany amounts have been eliminated in consolidation. In the opinion of
management, such information contains all adjustments necessary for a fair
presentation of the results of such periods. These financial statements should
be read in conjunction with the audited financial statements included in the
Company's report on Form 10-K for the year ended December 31, 1997.

Cash Equivalents - Cash equivalents are considered to be highly liquid
investments with initial maturities of 3 months or less.

Accounts Receivable - The Company sells its products worldwide. The
Company performs ongoing credit evaluations of its customers and generally does
not require collateral. The Company maintains reserves for potential credit
losses, and those losses have been within management's expectations. Allowances
for product returns and price protection are included in other adjustments to
accounts receivable on the accompanying balance sheets.

Inventories - Inventories consist principally of manuals and diskettes
and are stated at the lower of cost (determined by the first-in, first-out
method) or market.

Equipment and Improvements - Equipment and Improvements are stated at
cost. Depreciation is computed using the straight-line method based on the
estimated useful lives of the assets, generally ranging from three to seven
years. Leasehold improvements are amortized using the straight-line method over
the shorter of the estimated useful life of the asset or the lease term.

Intangible Assets - Intangible assets relate primarily to goodwill,
existing technology and noncompete agreements, which are amortized over periods
ranging from three to five years. The Company assesses the recoverability of
intangible assets at each balance sheet date by determining whether the
amortization of the balance over its remaining useful life can be recovered
through projected undiscounted future operating cash flows.

Revenue Recognition - The Company recognizes revenues from sales of its
software as completed products are shipped and from royalties from customers who
are authorized to duplicate the Company's software as the individual duplication
rights are granted. The Company generally allows its retail distributors to
exchange unsold products for other products and provides inventory price
protection in the event of price reductions by the Company. Allowances for
product returns and price protection are estimated based on previous experience
and are recorded as a reduction of revenue at the time sales are recognized. The
Company provides technical support and customer services to its customers. Such
costs have historically been insignificant.

The Company has adopted Statement of Position (SOP) 97-2, Software
Revenue Recognition, issued by the American Institute of Certified Public
Accountants which supersedes SOP 91-1. SOP 97-2 provides guidance on when
revenue should be recognized and in what amounts for licensing, selling, leasing
or otherwise marketing computer software. The adoption of SOP 97-2 had no
material impact on the Company's recognition of revenue.

Software Development Costs - Development costs incurred in the research
and development of new software products and enhancements to existing software
products are expensed as incurred until technological feasibility has been
established. The Company considers technological feasibility to be established
when all planning, designing, coding and testing has been completed according to
design specifications. After technological feasibility is established, any
additional costs are capitalized. Through March 31, 1998, software has been
substantially completed concurrently with the establishment of technological
feasibility; and, accordingly, no costs have been capitalized to date.

Income Taxes - The Company accounts for income taxes under Statement of
Financial Accounting Standards (SFAS) No. 109, Accounting for Income Taxes. This
statement requires the recognition of deferred tax assets and liabilities for
the future consequences of events that have been recognized in the Company's
financial statements or tax returns. The measurement of the deferred items is
based on enacted tax laws. In the event the future consequences of differences
between financial reporting bases and
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the tax bases of the Company's assets and liabilities result in a deferred tax
asset, SFAS No. 109 requires an evaluation of the probability of being able to
realize the future benefits indicated by such asset. A valuation allowance
related to a deferred tax asset is recorded when it is more likely than not that
some portion or all of the deferred tax asset will not be realized.

Fair Value of Financial Instruments - Pursuant to SFAS No. 107,
Disclosures about Fair Value of Financial Instruments, the Company is required
to estimate the fair value of all financial instruments included on its balance
sheet at March 31, 1998. The Company considers the carrying value of such
amounts in the financial statements to approximate their fair value due to (1)
the relatively short period of time between origination of the instruments and
their expected realization, (2) interest rates which approximate current market
rates, or (3) the overall immateriality of the amounts.

Stock-Based Compensation - The Company accounts for stock-based awards
to employees using the intrinsic value method in accordance with Accounting
Principles Board (APB) Opinion No. 25, Accounting for Stock Issued to Employees.

Net Income (Loss) Per Share - The Company has adopted SFAS No. 128,
Earnings per Share (EPS), which replaces the presentation of "primary" earnings
per share with "basic" earnings per share and the presentation of "fully
diluted" earnings per share with "diluted" earnings per share. All previously
reported EPS amounts have been restated based on the provisions of the new
standard. Basic EPS amounts are based upon the weighted average number of common
shares outstanding. Diluted EPS amounts are based upon the weighted average
number of common and common equivalent shares outstanding. Common equivalent
shares include stock options using the treasury stock method. Common equivalent
shares are excluded from the calculation of diluted EPS in loss years, as the
impact is antidilutive. There was no difference between basic and diluted EPS
for each period presented. The number of shares used in computing EPS is as
follows:

<TABLE>
<CAPTION>
For the Three Months
Ended March 31,
-------------------------
1998 1997
---------- ----------
<S> <C> <C>
Weighted average number of shares outstanding 14,075,000 14,075,000
Common stock equivalents 1,000
---------- ----------
14,076,000 14,075,000
========== ==========
</TABLE>

Use of Estimates - The preparation of financial statements in conformity
with generally accepted accounting principles requires management to make
estimates and assumptions that affect the reported amounts of assets and
liabilities and disclosure of contingent assets and liabilities at the date of
the financial statements and the reported amounts of revenues and expenses
during the reporting years. Actual results could differ from those estimates.

Comprehensive Income - The Company has adopted SFAS No. 130, Reporting
Comprehensive Income. This statement establishes standards for the reporting of
comprehensive income and its components. Comprehensive income, as defined,
includes all changes in equity (net assets) during a period from nonowner
sources. For each of the three month periods ending March 31, 1998 and 1997,
there was no difference between net income, as reported, and comprehensive
income.

Reclassifications - Certain reclassifications have been made to the 1997
financial statements to conform to the 1998 presentation.

2. NEW ACCOUNTING PRONOUNCEMENTS

In June 1997, the Financial Accounting Standards Board issued SFAS No.
131, Disclosures About Segments of an Enterprise and Related Information. This
statement establishes standards for the way companies report information about
operating segments in annual financial statements. It also establishes standards
for related disclosure about products and services, geographic areas and

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major customers. The disclosures prescribed by SFAS No. 131 are effective for
the year ended December 31, 1998 but not required for interim periods in the
year of adoption.

3. ACQUISITION OF TECHNOLOGY

During the three months ended March 31, 1998, the Company acquired
certain fax technology assets from Mitek Systems, Inc. for $458,000 in cash. The
fax software acquired provides fax functionality over Local Area Networks, the
Internet and intranets.

8
<PAGE> 9

MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS

GENERAL

Smith Micro, founded in 1982, develops and sells personal computer
communication software. The Company's communication software products include
fax, video conferencing, video email, telephony and data transmission products.
The Company shipped its first data communication software product in 1985 and,
since that time, the Company's revenues have been primarily the result of the
market acceptance of its OEM fax and data communication software products. The
Company began providing video communication products in 1996 to both OEM and
retail customers. In January 1998, the Company purchased certain fax software
assets of Mitek Systems, Inc. to provide LAN, Internet and intranet fax
transmission solutions designed for the corporate market.

The Company recognizes revenues from sales of its software as completed
products are shipped and from royalties from customers who are authorized to
duplicate the Company's software. Any material reduction in demand for the
Company's products would have a material adverse effect on the Company's
business, results of operations and financial condition. The Company has
continued to expand its business by introducing new products and its future
success will depend in part on the continued introduction of new and enhanced
OEM, retail and corporate products that achieve market acceptance. Revenues are
net of estimated returns and other adjustments at the time the products are
shipped. The Company has allowed its customers to return unused software,
constituting 15.5%, 26.8% and 16.8% of the Company's net revenues for the three
months ended March 31, 1998 and for the years 1997 and 1996, respectively.

A small number of customers have historically accounted for a
substantial portion of the Company's revenues. In June 1997, 3Com Corporation
("3Com") acquired U.S. Robotics Corporation ("U.S. Robotics"), to date the
Company's largest customer based on the percentage of revenues, as a wholly
owned subsidiary. Sales to 3Com (primarily U.S Robotics and its subsidiaries),
accounted for approximately 36.3%, 43.4% and 46.4% for the three months ended
March 31, 1998 and the years 1997 and 1996, respectively. During the three
months ended March 31, 1998 and the years 1997 and 1996, the Company's three
largest OEM customers, including 3Com, accounted for 53.7%, 56.9% and 62.9%,
respectively, of net revenues. Any reduction, delay or change in orders from
such customers could have a material adverse affect on the Company's business,
results of operations and financial condition.

In April 1996, the Company entered into an OEM agreement having an
initial one year term with a wholly-owned subsidiary of U.S. Robotics (now a
subsidiary of 3Com). The agreement superseded a previous agreement between the
parties and automatically renews at the end of each one year term unless a party
provides at least 60 days notice of its intent to terminate the agreement at the
end of the then-current term. During 1997, the agreement automatically renewed
according to its terms and certain other 3Com entities (hereinafter 3Com, its
affiliates and their subsidiaries will be referred to as "3Com" entities) were
added as parties pursuant to new addenda to the agreement. Under the terms of
the agreement, the Company granted certain pricing incentives to the 3Com
entities in consideration for which the Company became the provider of fax,
data, voice and telephony communications software for such 3Com entities. The
agreement does not require any 3Com entity to purchase any minimum quantity of
Smith Micro products and may be terminated by a party thereto at any time for
any reason upon 90 days prior written notice. While the Company believes that it
has been the principal supplier of OEM communication software products to U.S.
Robotics, there can be no assurance that the 3Com entities, including U.S.
Robotics, will not seek additional sources for such products in the future.
Accordingly, there can be no assurance that sales to the U.S. Robotics and the
other 3Com entities to which the Company sells products in any future period
will reach or exceed the historical levels of sales to U.S. Robotics. A
substantial decrease or delay in sales to the 3Com entities would have a
material adverse effect on the Company's business, results of operations and
financial condition.

The OEM product ordering cycle beginning from placement of an order to
shipping is very short. OEM customers generally operate under a just-in-time
system and order software to be delivered as needed by their manufacturing
operations. The Company's products are generally shipped as orders are received
and, accordingly, the Company has historically operated with little backlog, and
does not consider backlog to be a significant indication of future performance.
As a result, sales in any quarter are dependent on orders booked and shipped in
that quarter and are not predictable with any degree of certainty. Moreover, the
Company does not generally produce software in advance of orders and therefore
has not maintained a material amount of inventory.

Inventory in the retail channel exposes the Company to product returns.
This exposure is considered when the allowance is made for product returns.
Substantial returns of product from the retail channel could have a material
adverse affect on the Company's business, results of operations and financial
condition.

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The following discussion should be read in conjunction with, and is
qualified in its entirety by, the Financial Statements and related notes thereto
included elsewhere. Historical results of operations, percentage relationships
and any trends that may be inferred from the discussion below are not
necessarily indicative of the operating results for any future period.

RESULTS OF OPERATIONS

The following table sets forth for the periods indicated, the
percentages of net revenues represented by each item in the Company's statement
of income.

<TABLE>
<CAPTION>
For The Three Months
Ended March 31,
----------------
1998 1997
----- -----
<S> <C> <C>
Net revenues 100.0% 100.0%
Cost of revenues 26.5% 46.9%
----- -----
Gross profit 73.5% 53.1%
Operating expenses:
Selling and marketing 23.5% 37.4%
Research and development 24.1% 33.2%
General and administrative 25.6% 57.8%
----- -----
Total operating expenses 73.2% 128.4%
----- -----
Operating income (loss) 0.3% -75.3%
Interest income 5.5% 6.8%
----- -----
Income (loss) before income taxes 5.8% -68.5%
Income tax expense (benefit) 2.3% -24.0%
----- -----
Net income (loss) 3.5% -44.5%
===== =====
</TABLE>

NET REVENUES

Net revenues increased 22.9% to $3.3 million in the three months ended
March 31, 1998 from $2.7 million in the three months ended March 31, 1997. This
increase was the combined result of higher sales allowances in the first quarter
of 1997, an increase in revenue from direct and corporate sales and an increase
in revenue from OEM customers that are not modem manufacturers.

GROSS PROFIT

Gross profit represents net revenues, less cost of revenues, which
includes costs of materials, costs related to the operations of the Company's
duplicating facilities, freight charges and royalties to licensors. Gross profit
increased 70.0% to $2.4 million in the three months ended March 31, 1998 from
$1.4 million in the three months ended March 31, 1997. As a percentage of net
revenues, gross profits increased to 73.5% in the three months ended March 31,
1998 from 53.1% in the three months ended March 31, 1997. The improved gross
profit percentage was driven by a number of factors including the previously
mentioned sales allowances in the first quarter of 1997, the utilization of
increased internal manufacturing capacity, a shift from printed manuals to
on-line help, various cost control and purchasing efforts and improved inventory
controls.

SALES AND MARKETING EXPENSES

Sales and marketing expenses consist primarily of personnel costs,
advertising costs, sales commissions and trade show expenses. These expenses
vary considerably from quarter to quarter based on the timing of trade shows and
new product introductions. Sales and marketing expenses decreased 22.8% to
$768,000 in the three months ended March 31, 1998 from $995,000 in the three
months ended March 31, 1997. The decrease in sales and marketing expenses is
primarily due to reduced marketing expenditures within

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the retail channel. As a percent of net revenues, sales and marketing expenses
decreased to 23.5% of net revenues in the three months ended March 31, 1998 from
37.4% in the three months ended March 31, 1997.

RESEARCH AND DEVELOPMENT EXPENSES

Research and development expenses consist primarily of personnel and
supply costs required to conduct the Company's software development activities.
Research and development expenses decreased 10.9% to $786,000 in the three
months ended March 31, 1998 from $882,000 in the three months ended March 31,
1997. This decrease is primarily due to reductions in headcount. As a percent of
net revenues, research and development expenses decreased to 24.1% for the three
months ended March 31, 1998 from 33.2% for the three months ended March 31,
1997.

GENERAL AND ADMINISTRATIVE EXPENSES

General and administrative expenses encompass expenses related to
general operations, which are not included as costs of sales, sales and
marketing or research and development. General and administrative expenses
decreased 45.6% to $836,000 in the three months ended March 31, 1998 from $1.5
million in the three months ended March 31, 1997. The decrease is primarily due
to a higher allowance for bad debt in the first quarter of 1997 and continued
efforts towards cost control. As a percent of net revenues, general and
administrative expenses decreased to 25.6% of net revenues in the three months
ended March 31, 1998 from 57.8% in the three months ended March 31, 1997.

INCOME TAXES

Income tax expense was $77,000 for the three months ended March 31, 1998
based on pre-tax earnings of $190,000 compared to an income tax benefit of
$637,000 for the three months ended March 31, 1997 based on a loss before income
tax expense of $1.8 million. The Company recognizes income tax expense at an
effective rate of 40%.

LIQUIDITY AND CAPITAL RESOURCES

Since its inception, the Company has financed its operations primarily
through cash generated from operations. Net cash used in operating activities
was $84,000 in the three months ended March 31, 1998 as compared to $1.5 million
used in operations in the three months ended March 31, 1997. The primary use of
cash during the three months ended March 31, 1998 was an increase in accounts
receivable that was offset by an increase in accounts payable and accrued
liabilities.

During the three months ended March 31, 1998, the Company used $476,000
in investing activities, consisting primarily of the $458,000 acquisition of the
fax technology assets of Mitek Systems, Inc.

At March 31, 1998, the Company had $13.8 million in cash and cash
equivalents and $19.1 million of working capital. The Company had $4.5 million
of accounts receivable, net of allowance for doubtful accounts and other
adjustments. The Company has no significant capital commitments and currently
anticipates that growth in capital expenditures will not vary significantly from
recent periods.

YEAR 2000 COMPLIANCE

Many currently installed computer systems and software products are
coded to accept only two digit entries in the date code field. These date code
fields will need to accept four digit entries to distinguish 21st century dates
from 20th century dates. As a result, in less than two years, computer systems
and/or software used in many companies may need to be upgraded to comply with
such "Year 2000" requirements. Significant uncertainty exists in the computer
industry concerning the potential effects associated with such compliance.

The Company currently offers software products that are designed to be
Year 2000 compliant. However, there can be no assurance that such products do
not contain undetected errors or defects associated with Year 2000 date
functions.

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<PAGE> 12

The Company has received confirmation from vendors of certain purchased
software used for internal operations that current releases or upgrades are
designed to be Year 2000 compliant, if installed. The Company is in the process
of determining whether to upgrade the current system or purchase a new system
that is designed to be Year 2000 compliant. The Company anticipates that all
internally used software will be designed to be Year 2000 compliant prior to
operational requirements for Year 2000 data.

The Company currently believes that becoming Year 2000 compliant will
not have a significant impact on the financial position or results of operations
of the Company. Although the Company is not aware of any material operational
issues or costs associated with preparing its software products or internal
information systems for the year 2000, there can be no assurances that the
Company will not experience serious unanticipated negative consequences and/or
material costs caused by undetected errors or defects in the technology used in
its internal systems, which are composed predominantly of third party software
and hardware.

RISK FACTORS

In addition to the other information contained in this Form 10-Q, the
following risk factors should be considered in evaluating the Company and a
decision to invest in the Company. This Form 10-Q contains forward looking
statements which involve risks and uncertainties and the Company's actual
results may materially differ from the results anticipated in those statements.
Factors that might cause such a difference include, without limitation, those
discussed in this section and elsewhere in this Form 10-Q.

Fluctuations in Quarterly Operating Results. Certain of the Company's
significant customers and other modem manufacturers have announced in recent
quarters that there was an increase of inventory in the channel and that the
slower than expected rollout of V.90 standard 56K modems may reduce their rates
of growth during subsequent quarters. The rate at which this inventory is moved
out of the channel could have a significant impact on the Company's operating
results in future quarters. The Company's operating results have in the past
fluctuated, and may in the future fluctuate, from quarter to quarter as a result
of a number of factors including, but not limited to, the size and timing of
orders from, and shipments to, major customers; the ability to maintain or
increase gross margins; the ability of the Company's customers to obtain
financing for the purchase of the Company's products; changes in pricing
policies or price reductions by the Company or its competitors; variations in
the Company's sales channels or the mix of product sales; the timing of new
product announcements and introductions by the Company or its competitors and
customers; the availability and cost of supplies; the financial stability of
major customers; market acceptance of new products, applications and product
enhancements; the Company's ability to develop, introduce and market new
products, applications and product enhancements; the Company's ability to
control costs; possible delays in the shipment of new products; the Company's
success in expanding its sales and marketing programs; deferrals of customer
orders in anticipation of new products, applications, product enhancements or
operating systems; changes in Company strategy; personnel changes; and general
economic factors. The Company's software products are generally shipped as
orders are received and accordingly, the Company has historically operated with
little backlog. As a result, sales in any quarter are dependent on orders booked
and shipped in that quarter and are not predictable with any degree of
certainty. In addition, the Company's expense levels are based, in part, on its
expectations as to future revenues. If revenue levels are below expectations,
operating results are likely to be adversely affected. The Company's net income
may be disproportionately affected by a reduction in revenues because of fixed
costs related to generating its revenues. While the Company has not historically
experienced seasonality in its sales, many of the Company's OEM customers
experience seasonality in their sales, and the Company's sales may, in the
future, be subject to seasonality particularly as its sales of retail products
increase. Quarterly results in the future may be influenced by these or other
factors and, accordingly, there may be significant variations in the Company's
quarterly operating results. Further, the Company's historical operating results
are not necessarily indicative of future performance for any particular period
and there can be no assurance that the Company's recent revenue growth or its
profitability will continue on a quarterly or annual basis. Due to all of the
foregoing factors, it is possible that in some future quarter the Company's
operating results may be below the expectations of public market analysts and
investors. In such event, the price of the Company's Common Stock would likely
be materially adversely affected.

Reliance on 3Com Corporation. In June 1997, 3Com acquired U.S. Robotics,
to date the Company's largest customer based on the percentage of revenues, as a
wholly owned subsidiary. There can be no assurance that 3Com's acquisition of
U.S. Robotics will not result in a change in U.S. Robotics' purchasing habits, a
decrease in new orders by U.S. Robotics, delays in orders previously made by
U.S. Robotics, or the loss of U.S. Robotics as a customer entirely.

Sales to 3Com (primarily U.S Robotics and its subsidiaries), accounted
for approximately 36.3%, 43.4% and 46.4% for the three months ended March 31,
1998 and the years 1997 and 1996, respectively. The Company expects that the
3Com entities, including U. S. Robotics and its subsidiaries, will continue to
account for a significant portion of the Company's revenues in future periods.
In April 1996, the Company entered into an OEM agreement having an initial one
year term with a wholly-owned subsidiary of U.S. Robotics.

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<PAGE> 13

The agreement superseded a previous agreement between the parties and
automatically renews at the end of each one year term unless a party provides at
least 60 days notice of its intent to terminate the agreement at the end of the
then-current term. During 1997, the agreement automatically renewed according to
its terms and certain other 3Com entities were added as parties pursuant to new
addenda to the agreement. Under the terms of the agreement, the Company granted
certain pricing incentives to the 3Com entities in consideration for which the
Company became the provider of fax, data, voice and telephony communications
software for such 3Com entities. In addition, under the terms of the agreement,
certain of the 3Com entities agreed to place Smith Micro retail products and
commercials for such products on certain of their compact disks. The agreement
does not require any 3Com entity to purchase any minimum quantity of Smith Micro
products and may be terminated by a party at any time thereto for any reason
upon 90 days prior written notice. As a result, there can be no assurance that
the 3Com entities will continue to purchase the Company's products.

While the Company believes that it has been the principal supplier of
OEM communication software products to U.S. Robotics, there can be no assurance
that U.S. Robotics and the other 3Com entities to which the Company sells
products will not seek additional sources for such products in the future.
Accordingly, there can be no assurance that sales to the 3Com entities will
reach or exceed in any future period the historical levels of sales to U.S.
Robotics. A substantial decrease or delay in sales to the 3Com entities would
have a material adverse effect on the Company's business, results of operations
and financial condition.

Concentration of Customer Revenues. In addition to the 3Com entities,
including U.S. Robotics, the Company has in the past derived, and expects in the
future to derive, a significant portion of its revenues from a relatively small
number of customers. Net revenue from the Company's three largest customers,
including the 3Com entities, represented approximately 53.7%, 56.9% and 70.8%
for the three months ended March 31, 1998 and the years 1997 and 1996,
respectively. The Company expects that it will continue to be dependent upon
relatively large orders from major OEM customers for a significant portion of
its revenues in future periods, although none of them is obligated to purchase
any products. Accordingly, there can be no assurance that any sales to these
entities, individually or as a group, will continue or, if continued, will reach
or exceed historical levels in any future period. Any substantial decrease or
delay in sales to one or more of these entities would have a material adverse
effect on the Company's business, results of operations and financial condition.
In addition, certain of the Company's OEM customers have in the past and may in
the future acquire competitors or be acquired by competitors, causing further
consolidation in the modem industry. Previous acquisitions in the modem industry
have often caused the purchasing departments of the combined companies to
reevaluate their purchasing decisions. There can be no assurance that such
acquisitions will not result in a change in a current customer's purchasing
habits, including a loss of the customer, a decrease in orders from that
customer or a delay in orders previously made by the customer. Moreover,
acquisitions involving existing OEM customers may cause the concentration of the
Company's customer revenues to increase if the combined companies continue to
purchase the Company's software products. Although the Company maintains
allowances for doubtful accounts, the insolvency of one or more of the other
major customers of the Company could substantially impair the Company's
business, results of operations and financial condition.

Product Concentration. The Company has in the past derived, and may in
the future derive, a significant portion of its revenues from a relatively small
number of products. The sale of QuickLink related products represented
approximately 72.1%, 81.3% and 69.4% of the Company's net revenues in the three
months ended March 31, 1998 and during the years 1997 and 1996 respectively. The
Company expects that revenues from these products will continue to account for a
substantial portion of the Company's total revenues in the foreseeable future.
Declines in the revenues from these software products, whether as a result of
competition, technological change, price pressures or other factors, would have
a material adverse effect on the Company's business, results of operations and
financial condition. Further, life cycles of the Company's products are
difficult to estimate due in large measure to the recent emergence of the
Company's market, the effect of new products, applications or product
enhancements, technological changes in the communication software industry in
which the Company operates and future competition. The Company's future
financial performance will depend in part on the successful development,
introduction and market acceptance of new products, applications and product
enhancements. There can be no assurance that the Company will continue to be
successful in marketing its current products or any new products, applications
or product enhancements.

Technological Change. The communication software market for personal
computers is characterized by rapid technological change, changing customer
needs, frequent product introductions and evolving industry standards. The
introduction of products incorporating new technologies and the emergence of new
industry standards could render the Company's existing products obsolete and
unmarketable. The Company's future success will depend upon its ability to
develop and introduce new software products (including new releases,
applications and enhancements) on a timely basis that keep pace with
technological developments and emerging industry standards and address the
increasingly sophisticated needs of its customers. There can be no assurance
that the Company will be successful in developing and marketing new products
that respond to technological changes or evolving industry standards, that the
Company will not experience difficulties that could delay or prevent the
successful development, introduction and marketing of these new products, or
that its new products will adequately meet the requirements of the marketplace
and achieve market acceptance. If the Company is unable, for technological or
other reasons, to develop and introduce new products in a timely manner in
response to changing

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<PAGE> 14

market conditions or customer requirements, the Company's business, results of
operations and financial condition would be materially adversely affected.

Microsoft is the leading developer of operating systems for personal
computers. There can be no assurance that the Company will successfully develop
new versions of its software products that will operate on future Microsoft
operating systems, or that any such development, even if successful, will be
completed concurrently with or prior to introductions by competitors of
communication software products for those new operating systems. Any such
failure or delay could affect the Company's competitive position or lead to
product obsolescence in the future.

While the Company ships software to a number of computer manufacturers,
its primary OEM customers are modem manufacturers. The Company is aware that
technology is being developed to enable the functions of the modem to be
performed by a chip embedded into the computer. This development, if and when it
comes to market, could impair the business of those of the Company's customers
that rely on the existence of a separate modem component for their continued
success. A downturn in the business of one or more of its principal customers
could adversely affect the Company's business, results of operations and
financial condition.

In March 1997, modem manufacturers shipped the first 56K modems for
retail sale. 56K modems were initially based on either one of two incompatible
standards, the x2 standard adopted by 3Com or the K56flex standard adopted by
Rockwell International and Lucent Technologies. This incompatibility, combined
with the failure of the modem industry to adopt an industry-wide standard for
such modems, caused some modem manufacturers to delay the launch of proprietary
56K modems and caused consumers to delay purchases of the new modems. The
company believes that its business, results of operations and financial
condition since the launch of the 56K modems have been directly and adversely
affected by the incompatibly of the 56K modem technology and the resulting
confusion created thereby in the marketplace. In February 1998, the ITU
(international standards governing body) voted on a draft of a 56K modem
standard, V.90, and plans to formally approve it during the next ITU meeting in
September 1998. Both competing 56K modem groups have announced that they intend
to support the V.90 standard by moving forward with all new modems and by
providing downloadable flash memory upgrades for currently owned X2 and K56flex
technology modems. The shipment of the V.90 compliant modems began in early 1998
and there can be no assurance that the Company will not continue to be adversely
affected by the previous incompatibility issues or that other technological
changes in the communications industry will not similarly affect the Company,
its results of operations or financial condition.

Competitive Threat from Microsoft and Other Operating Systems. The
Company faces competition from Microsoft, which dominates the personal computer
software industry. Due to its market dominance and the fact that it is the
publisher of the most prevalent personal computer operating platforms, DOS and
Windows, Microsoft represents a significant competitive threat to all personal
computer software vendors, including the Company. In addition, Windows 95 and
Windows NT, the latest Microsoft operating systems, include capabilities now
provided by certain of the Company's OEM and retail software products, including
the Company's principal product, QuickLink. If the communications capabilities
of Windows 95, Windows NT or other operating systems are adopted by users, sales
of the Company's products could decline. The Company is uncertain of the level
of communication capabilities that will be included in Microsoft's pending
release of Windows 98. The communication capabilities of Windows 98 may
adversely affect the purchasing decisions of OEMs and end users with regards to
the Company's communication software products. If so, sales of the Company's
products could be adversely affected.

Competition. The markets in which the Company operates are highly
competitive and subject to rapid changes in technology. The strategic directions
of major personal computer hardware manufacturers and operating system
developers are also subject to changes. The Company competes with other software
vendors for access to distribution channels, retail shelf space and the
attention of customers. The Company also competes with other software companies
in its efforts to acquire software technology developed by third parties. These
factors may result in increased price competition. Additionally, there can be no
assurance that competitors will not develop or acquire products that are
superior to the Company's products or that achieve greater market acceptance.

The Company's retail products face significant competition. For example,
HotFax MessageCenter and HotFax, the Company's principal retail products,
compete directly with Symantec's WinFax Pro. Symantec is well established in the
retail distribution channel. There can be no assurance that HotFax
MessageCenter, HotFax, AudioVision, VideoLink Mail Pro, HotPage or any other of
the Company's retail product lines will capture a significant share of the
retail market for communication software. In addition, the Company's retail
video conferencing product, AudioVision, competes in a new and rapidly changing
software market. Some of the current competitors in the video conferencing
retail software market are White Pine and VocalTech, and there can be no
assurance that the Company will compete successfully with these and any future
competitors in the retail video conferencing software market. In the OEM
distribution channel, the Company has several competitors, among them Symantec,
Cheyenne, White Pine, VocalTech and VDONet. Some of the Company's competitors
have a retail emphasis and offer OEM products with a reduced set of features.
The

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<PAGE> 15

opportunity for retail upgrade sales may induce these and other competitors to
make OEM products available at their own cost or even at a loss. Such a pricing
strategy could have an adverse affect on the Company's business, results of
operations and financial condition.

Symantec currently makes certain complementary products that are sold
separately. Symantec may be able to enhance its competitive position by bundling
certain of these products to attract customers seeking integrated,
cost-effective software applications. The Company also believes that the market
in which it competes has been characterized by the consolidation of established
communication software suppliers and that this trend, which may lead to the
creation of additional large and well-financed competitors, may continue. In
addition, other competitors have entered the market. Moreover, because there are
low barriers to entry into the software market, the Company believes that
competition will increase in the future. To remain competitive, the Company
believes that it will need to make continuing investments in research and
development and sales and marketing. There can be no assurance that the Company
will have sufficient resources to make such investments, or that it will be
successful in its research and development or sales and marketing efforts.

Symantec and many of the Company's current and prospective competitors
have significantly greater financial, marketing, service, support, technical and
other resources than the Company. Moreover, these companies may introduce
additional products that are competitive with those of the Company, and there
can be no assurance that the Company's products would compete effectively with
such products. The Company believes that its ability to compete depends on
elements both within and outside its control, including the success and timing
of new product development, product performance and price, distribution and
customer support and introduction by the Company and its competitors of new
products. There can be no assurance that the Company will be able to compete
successfully with respect to these and other factors. The Company believes that
the market for its software products has been and will continue to be
characterized by significant price competition. A material reduction in the
price of the Company's products could negatively affect the Company's
profitability.

Many of the Company's existing and potential OEM customers are major
manufacturers of modems and have substantial technological capabilities. These
customers may currently be developing, or may in the future develop, products
that compete directly with the Company's products and may, therefore,
discontinue purchases of the Company's products. The Company's future
performance is substantially dependent upon the extent to which existing OEM
customers elect to purchase communication software from the Company rather than
design and develop their own software. In light of the fact that the Company's
customers are not contractually obligated to purchase any of the Company's
products, there can be no assurance that the Company's existing OEM customers
will continue to rely, or expand their reliance, on the Company as an external
source for communication software.

Dependence on New Product Offerings. The Company's future success will
depend, in significant part, on its ability to successfully develop and
introduce new software products and improved versions of existing software
products on a timely basis and in a manner that will allow such products to
achieve broad customer acceptance. There can be no assurance that new products
will be introduced on a timely basis, if at all. If new products are delayed or
do not achieve market acceptance, the Company's business, results of operations
and financial condition will be materially adversely affected. In the past, the
Company has experienced delays in purchases of its products by customers
anticipating the launch of new products by the Company. There can be no
assurance that material order deferrals in anticipation of new product
introductions will not occur. There can also be no assurance that the Company
will be successful in developing, introducing on a timely basis and marketing
such software or that any such software will be accepted in the market.

Retail Product Strategy Unproven. The Company's revenues have
historically been generated almost entirely on the strength of its OEM sales.
The Company has developed retail products with expanded functionality from its
OEM products and expects to introduce other products in the retail distribution
channel as well. The Company's ability to maintain distributor and retailer
relationships is largely a function of volumes. If the Company does not meet
certain minimum volume requirements, it will not be able to maintain its
relationships. The Company continues to work on strengthening product
recognition and distribution and there can be no assurance that the Company's
retail marketing plan will succeed. Further, while retail products provide
higher unit revenues than OEM products, retail distribution entails
significantly higher costs. These costs include advertising, trade shows, public
relations and the expenses related to the development and maintenance of a sales
force dedicated to the retail distribution effort. Accordingly, there can be no
assurance that retail sales will provide the margins that the Company has been
able to achieve on its OEM sales or that distributor and retailer minimum volume
requirements will be met.

In implementing its retail sales strategy, the Company relies on
distributors, retailers, internet distributors and value added resellers
(collectively, "resellers") for the marketing and distribution of HotFax
MessageCenter, HotFax, AudioVision, VideoLink Mail Pro, HotPage and its other
retail products. The Company's agreements with resellers are not exclusive and
in many cases may be terminated by either party without cause. Many of the
Company's resellers carry product lines that are competitive with those of the
Company. There can be no assurance that these resellers will give a high
priority to the marketing of the Company's products or that

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<PAGE> 16

resellers will continue to carry the Company's products. These resellers
typically are allowed to return products without charge or penalty. A component
of the Company's revenue recognition policy is that the Company calculates an
allowance for product returns based on its historical experience. If retail
sales of the Company's products increase, the risk of product returns will
increase. While the Company's revenue recognition policy contemplates this risk,
it is possible that returns may occur in excess of the Company's previous
experience, causing the Company to revise its estimates and increase the
allowances for such returns. Excessive or unanticipated returns could materially
adversely affect the Company's business, results of operations and financial
condition. The Company's results of operations could also be materially
adversely affected by changes in reseller inventory strategies, which could
occur rapidly, and in many cases, may not be related to end user demand. There
can be no assurance that the Company will be successful in recruiting resellers
to represent it. Any of these anticipated changes in the Company's distribution
channels could materially adversely affect the Company's business, results of
operations and financial condition.

Corporate and Government Product and Marketing Strategy Unproven. The
Company's revenues have historically been generated almost entirely on the
strength of its OEM sales. Since the second quarter of 1997 the Company has been
adding, and plans to continue to add, the infrastructure necessary to support a
focus on the corporate and government markets. In January 1998, the Company
acquired network fax software technology from Mitek Systems, Inc. as a part of
its strategy to address this market. The corporate market includes vertical
applications that are industry specific and require the investment of
engineering resources. There can be no assurance that the additional
infrastructure required in sales and marketing to the corporate and government
markets, or the investment in engineering resources for applications specific to
such markets, will yield significant sales growth for the Company or provide the
margins the Company has achieved historically on its OEM sales.

Potential for Undetected Errors. Software products as complex as those
offered by the Company may contain undetected errors. The Company has in the
past discovered software errors in certain of its products and has experienced
delayed or lost revenues during the period required to correct these errors.
There can be no assurance that, despite testing by the Company and by current
and potential customers, errors will not be found in new or existing products
after commencement of commercial shipments, resulting in loss of or delay in
market acceptance or the recall of such products, which could have a material
adverse effect upon the Company's business, results of operations and financial
condition. The Company provides customer support for most of its products. The
Company is preparing to launch several new products. If these products are
flawed or are more difficult to use than traditional Company products, customer
support costs could rise and customer satisfaction levels could fall.

Pre-Load and Royalty Based Software Market. The Company primarily sells
its software in a form that includes a disk and a manual. Some of the Company's
customers "pre-load" the Company's software onto a CD, diskette or the hard
drive of a personal computer and pay a royalty based on units produced or
shipped. These arrangements eliminate the need for a disk and may eliminate the
need for a manual. The pre-load arrangements produce smaller unit revenues for
the Company and eliminate the Company's ability to generate revenues from its
production facilities. The Company believes these facilities contribute profits
to the Company. Currently, the Company has the capability to produce its
products in-house on 3 1/2-inch diskettes. The Company does not currently have
the capability to produce CD-ROMs and the cost to develop such production
capability may be prohibitive. As the size of software programs grow, CD-ROM is
becoming a more prominent medium. The Company currently contracts CD-ROM
production to specialized CD-ROM facilities. In the event of a shift of this
kind, more of the Company's relationships would involve product pre-loads and
CD-ROM production and the Company's business, results of operations and
financial condition could be adversely affected.

Acceptance of Video Related Products. The Company's video communication
software sales volume has achieved only modest growth and has not become a
significant part of net revenues. Video communication software products compete
in a new and rapidly changing market and there can be no assurance that such
products will receive or gain market acceptance. Lack of market acceptance of
such products, or delays in or non-completion of the development of new video
communication software products, could have an adverse impact on the Company's
business, results of operations and financial condition. In addition, video
communication software products compete against those of several competitors,
including White Pine, Connectix, Intel, Microsoft, VocalTech and VDONet, some of
whom have greater financial and other resources than the Company, and there can
be no assurance that the Company will be able to compete successfully against
these and any future competitors in the video conferencing software market.

Dependence Upon Key Personnel. The Company's future performance depends
in significant part upon the continued service of William Smith and Rhonda
Smith, the Company's co-founders, and other key technical and senior management
personnel. The Company is dependent on its ability to identify, hire, train,
retain and motivate high quality personnel, especially highly skilled engineers
involved in the ongoing research and development required to develop and enhance
the Company's communication software products and introduce enhanced future
applications. The industry is characterized by a high level of employee mobility
and aggressive recruiting of skilled personnel. There can be no assurance that
the Company's current employees will continue to work for the Company. Loss of

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services of key employees could have a material adverse effect on the Company's
business, results of operations and financial condition. In addition, the
Company may need to grant additional options and provide other forms of
incentive compensation to attract and retain key personnel.

Fluctuations in Gross Margins. The Company has experienced fluctuations
in gross margins from quarter to quarter, primarily as a result of changes in
the mix of retail and OEM sales. Other factors that can contribute to margin
fluctuations are inventory obsolescence as a result of new retail product
releases and return of retail product, price competition, expediting costs, and
changes in OEM sales mix and the related variances in OEM product pricing. An
erosion of the gross margins as a result of any of the aforementioned reasons or
for any other reasons not contemplated by the Company at this time, could have a
material adverse affect on the Company's operating results.

Duplication of Software. The Company duplicates all of its diskette
software at its Aliso Viejo, California facility. The Company believes that its
internal duplication capability provides it with a competitive advantage since
it eliminates the profit margin required by outside duplication sources and
enables a high degree of scheduling control. This concentration of production
does, however, expose the Company to the risk that production could be disrupted
by natural disaster or other events, such as the presence of a virus in the
Company's duplicators. The Company believes that it could retain outside
duplication alternatives quickly, but there is no assurance that it could do so
or, if such arrangements could be made, that duplication could take place in an
economical or timely manner. When CD-ROMs are required, the Company uses outside
third parties for CD-ROM replication. The equipment to replicate CD-ROMs is very
costly making it unlikely that the Company will add this capability internally.
Because the Company is dependent on CD-ROM replication facilities for both the
timing and pricing of the software produced in CD-ROM format, any adverse
changes in the timing of such replication could impair the Company's ability to
deliver products to customers and any price increases could reduce gross margins
which, in each case, could have a material adverse effect on the Company's
business, results of operations and financial condition.

Reliance on Third Party Suppliers; Shortage of Modem Chips. The Company
relies on third party suppliers who provide the components used in its kitted
products. These components include disks, CDs and printed manuals. Disk
shortages have occurred in the past and there can be no assurance that shortages
will not recur. If the Company cannot obtain a sufficient quantity of disks or
other components, or cannot obtain disks or other components at prices at least
comparable to prices paid currently, the Company's business, results of
operations and financial condition could be adversely affected.

Modem manufacturers purchase chips from a relatively limited number of
chip manufacturers. Production problems or product quality problems experienced
by a chip manufacturer could reduce modem sales or slow the growth of modem
sales. Chip manufacturers have a limited capacity to produce chips. This
capacity cannot be quickly expanded and the capital investment to expand
capacity is high. If chip suppliers are unable to meet demand, the growth of
modem sales will slow.

International Sales. The Company presently operates in foreign markets
and intends to expand its international presence. International revenues
represented 19.3%, 24.3% and 14.4% of the Company's net revenues in the three
months ended March 31, 1998 and in the years 1997 and 1996, respectively.
International business is subject to risks in addition to those inherent in the
Company's United States business including substantially different regulatory
requirements in different jurisdictions, varying technical standards, tariffs
and trade barriers, political and economic instability, reduced protection for
intellectual property rights in certain countries, difficulties in staffing and
maintaining foreign operations, difficulties in managing distributors,
potentially adverse tax consequences, foreign currency exchange fluctuations,
the burden of complying with a wide variety of complex foreign laws and treaties
and the possibility of difficulties in collecting accounts receivable. There can
be no assurance that the Company will be able to continue to generate
significant international sales. While the Company does not currently accept
payment in foreign currencies and invoices all of its sales in U.S. dollars,
there can be no assurance that the Company will be able to continue this policy
if it is able to grow international sales. If the Company begins to receive
payment in foreign currencies, it is likely to be subjected to the risks of
foreign currency losses due to fluctuations in foreign currency exchange rates.
In addition, in the event the Company is successful in doing business outside of
the United States, the Company may also face economic, political and foreign
currency situations that are substantially more volatile than those commonly
experienced in the United States. There can be no assurance that any of these
factors will not have a material adverse effect on the Company's business,
results of operations and financial condition.

Intellectual Property Rights. The Company's success is dependent upon
its software code base, its programming methodologies and other intellectual
properties. To protect its proprietary technology, the Company relies on a
combination of trade secret, nondisclosure and copyright and trademark law which
may afford only limited protection. The Company owns United States trademark
registrations for certain of its trademarks, including QuickLink Gold, HotFax,
HotPage, HotLine, HotDesk and CrossConnect but has not yet obtained
registrations for all of its trademarks in the United States or other countries,
such as for the mark QuickLink. Prior to becoming a publicly

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held entity, the Company did not require its employees to sign proprietary
information and inventions agreements stipulating, among other things, software
ownership rights. In addition, the Company has recently started the patent
application process for a number of technologies that could provide additional
protection for existing products and products under development. There can be no
assurance that the steps taken by the Company will be adequate to deter
misappropriation of its proprietary information or will prevent the successful
assertion of an adverse claim to software utilized by the Company or that the
Company will be able to detect unauthorized use and take effective steps to
enforce its intellectual property rights. In selling its products, the Company
relies primarily on "shrink wrap" licenses that are not signed by licensees and,
therefore, may be unenforceable under the laws of certain jurisdictions. In
addition, the laws of some foreign countries do not protect the Company's
proprietary rights to as great an extent as do the laws of the United States.
There can be no assurance that the Company's means of protecting its proprietary
rights will be adequate or that the Company's competitors will not independently
develop similar technology. Further, although the Company believes that its
services and products do not infringe on the intellectual property rights of
others, there can be no assurance that such a claim will not be asserted against
the Company in the future. The failure of the Company to protect its proprietary
information could have a material adverse effect on the Company's business,
results of operations and financial condition.

From time to time, the Company has received and may receive in the
future communications from third parties asserting that the Company's trade name
or features, content, or trademarks of certain of the Company's products
infringe upon intellectual property rights held by such third parties. Should
there be a successful challenge to the Company's use of any of its trademarks,
the Company could incur significant expenses in connection therewith and
experience a loss of goodwill related thereto.

The Company has received correspondence from third parties separately
asserting that the Company's fax products may be violative of certain patents
held by each of the parties. No litigation has been initiated by these parties
and the Company is attempting to resolve all such assertions.

As the number of trademarks, patents, copyrights and other intellectual
property rights in the Company's industry increases, and as the coverage of
these patents and rights and the functionality of products in the market further
overlap, the Company believes that products based on its technology may
increasingly become the subject of infringement claims. Such claims could
materially adversely affect the Company, and may also require the Company to
obtain one or more licenses from third parties. There can be no assurance that
the Company would be able to obtain any such required licenses upon reasonable
terms, if at all, and the failure by the Company to obtain such licenses could
have a material adverse effect on its business, results of operations and
financial condition. In addition, the Company licenses technology on a
non-exclusive basis from several companies for inclusion in its products and
anticipates that it will continue to do so in the future. The inability of the
Company to continue to license these technologies or to license other necessary
technologies for inclusion in its products, or substantial increases in royalty
payments under these third party licenses, could have a material adverse effect
on its business, results of operations and financial condition.

Litigation in the software development industry has increasingly been
used as a competitive tactic both by established companies seeking to protect
their existing position in the market and by emerging companies attempting to
gain access to the market. If the Company is forced to defend itself against a
claim, whether or not meritorious, the Company could be forced to incur
substantial expense and diversion of management attention, and may encounter
market confusion and reluctance of customers to purchase the Company's software
products.

Year 2000 Compliance. Many currently installed computer systems and
software products are coded to accept only two digit entries in the date code
field. These date code fields will need to accept four digit entries to
distinguish 21st century dates from 20th century dates. As a result, in less
than two years, computer systems and/or software used in many companies may need
to be upgraded to comply with such "Year 2000" requirements. Significant
uncertainty exists in the computer industry concerning the potential effects
associated with such compliance.

18
<PAGE> 19

preparing its software products or internal information systems for the year
2000, there can be no assurances that the Company will not experience serious
unanticipated negative consequences and/or material costs caused by undetected
errors or defects in the technology used in its internal systems, which are
composed predominantly of third party software and hardware.

Concentration of Ownership. As of March 31, 1998, William Smith and
Rhonda Smith beneficially owned, as community property, approximately 69.5% of
the outstanding shares of the Company. William Smith and Rhonda Smith are
married to one another and, acting together, will have the ability to elect the
Company's directors and determine the outcome of any corporate action requiring
stockholder approval, irrespective of how other stockholders of the Company may
vote. This concentration of ownership may have the effect of delaying or
preventing a change in control of the Company.

Potential Effect of Anti-Takeover Provisions. The Company's Certificate
of Incorporation and Bylaws contain provisions that may discourage or prevent
certain types of transactions involving an actual or potential change in control
of the Company, including transactions in which the stockholders might otherwise
receive a premium for their shares over then current market prices, and may
limit the ability of the stockholders to approve transactions that they may deem
to be in their best interest. In addition, the Board of Directors has the
authority to fix the rights and preferences of shares of the Company's Preferred
Stock and to issue such shares, which may have the effect of delaying or
preventing a change in control of the Company, without action by the Company's
stockholders. Certain provisions of Delaware law applicable to the Company,
including Section 203 of the Delaware General Corporation Law, could also have
the effect of delaying, deferring or preventing a change of control of the
Company. It is possible that the provisions in the Company's Certificate of
Incorporation and Bylaws, the ability of the Board of Directors to issue the
Company's Preferred Stock, and Section 203 of the Delaware General Corporation
Law may have the effect of delaying, deferring or preventing a change of control
of the Company without further action by the stockholders, may discourage bids
for the Company's Common Stock at a premium over the market price of the Common
Stock and may adversely affect the market price of the Common Stock and the
voting and other rights of the holders of Common Stock.

Possible Volatility of Stock Price. The trading price of the Common
Stock is likely to be subject to significant fluctuations in response to
variations in quarterly operating results, the gain or loss of significant
orders, changes in management, announcements of technological innovations or new
products by the Company, its customers or its competitors, legislative or
regulatory changes, general trends in the industry and other events or factors.
In addition, the stock market has experienced extreme price and volume
fluctuations which have particularly affected the market price for many high
technology companies similar to Smith Micro, and which have often been unrelated
to the operating performance of these companies. These broad market fluctuations
may adversely affect the market price of the Company's Common Stock. Further,
factors such as announcements of new contracts or product offerings by the
Company or its competitors and market conditions for stocks similar to that of
the Company could have significant impact on the market price of the Common
Stock.

Shares Eligible for Future Sale. No prediction can be made as to the
effect, if any, that future sales of Company Common Stock or the availability of
such Common Stock for future sales will have on the market price of the
Company's Common Stock. As of March 31, 1998, the Company had 14,074,698 shares
of Common Stock outstanding. Of this amount, the 9,781,670 shares held by
William Smith and Rhonda Smith became available for sale in the public market
(subject to the volume and other applicable restrictions of Rule 144) following
the expiration in September 1997 of a two year lock-up agreement with certain
representatives of the underwriters of the Company's initial public offering
which consummated in September 1995. Sales of a substantial number of shares of
Common Stock by William Smith, Rhonda Smith or any other person, either
individually or when aggregated with sales by other persons, could adversely
affect the market price of the Common Stock.

19
<PAGE> 20

PART II -- OTHER INFORMATION

ITEM 1. LEGAL PROCEEDINGS

The Company and its PCI Video Products, Inc. subsidiary ("PCI Video")
have been named parties to a lawsuit, Virtual Ambiance, Inc. v. Video
Conferencing Communications. Inc., et al., filed August 11, 1997 in the Superior
Court of the State of California for the County of Orange, Case No. 782856. The
complaint alleges causes of action against the Company and PCI Video for
negligent misrepresentation, fraud, declaratory relief, breach of covenant of
good faith and fair dealing, and civil conspiracy, involves a dispute over the
licensing of video conferencing software, and seeks consequential and punitive
damages against all defendants. The Company and PCI Video demurred to the
complaint, and the court on March 24, 1998 dismissed the causes of action for
declaratory relief and breach of the covenant of good faith and fair dealing,
and ordered the plaintiff to amend its remaining causes of action to conform
with state pleading requirements. Accordingly, the Company and PCI Video have
not answered the complaint. The Company and PCI Video believe the claims against
them lack any merit and have no factual basis. The Company and PCI Video are
vigorously defending the case and intend to continue to do so.

ITEM 2. CHANGE IN SECURITIES AND USE OF PROCEEDS

The effective date of the Company's first registration statement (the
"Registration Statement") filed on Form S-1 (Registration No. 33-95096) under
the Securities Act of 1993, as amended, was September 18, 1995. The class of
securities registered was Common Stock. The offering commenced on September 19,
1995 and all securities were sold in the offering. The managing underwriters for
the offering were Hambrecht & Quist LLC and Oppenheimer & Co., Inc.

Pursuant to the Registration Statement, the Company sold 1,700,000
shares of its Common Stock for an aggregate offering price of $20,400,000, and
certain selling shareholders sold 2,210,000 shares of the Common Stock of the
Company for an aggregate offering price of $26,520,000.

The Company incurred expenses of $2,262,000 of which $1,428,000
represented underwriting discounts and commissions and $834,000 represented
other expenses. All such expenses were direct or indirect payments to others.
The net offering proceeds to the Company after total expenses was $18,138,000.

Of the net proceeds from the offering, $4,188,000 were used to repay
amounts due under a promissory note issued by the Company to certain of its
stockholders as part of a distribution of retained earnings in connection with
the Company's prior S corporation status, $3,011,000 was used in the Company's
acquisition of Performance Computing Incorporated which was consummated in March
1996, $458,000 was used in the acquisition of assets from Mitek Systems, Inc.
and the remainder has been invested in U.S. Government obligations and corporate
bonds. The use of the proceeds from the offering does not represent a material
change in the use of the proceeds described in the prospectus which is part of
the Registration Statement.

20
<PAGE> 21

ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K

<TABLE>
<CAPTION>
Exhibit
No. Title Method of Filing
------- ----- ----------------
<S> <C> <C>
3.1 Amended and Restated Certificate of Incorporated by reference to Exhibit 3.1
Incorporation of the Company. to the Registrant's Registration Statement
No. 33-95096

3.2 Amended and Restated Bylaws of the Incorporated by reference to Exhibit 3.2
Company. to the Registrant's Registration Statement
No. 33-95096

4.1 Specimen certificate representing Incorporated by reference to Exhibit 4.1
shares of Common Stock of the to the Registrant's Registration Statement
Company. No. 33-95096

10.1 Form of Indemnification Agreement. Incorporated by reference to Exhibit 10.1
to the Registrant's Registration Statement
No. 33-95096

10.2 1995 Stock Option/Stock Issuance Incorporated by reference to Exhibit 10.2
Plan. to the Registrant's Registration Statement
No. 33-95096

10.3 Form of Notice of Grant of Stock Incorporated by reference to Exhibit 10.3
Option under 1995 Stock Option/Stock to the Registrant's Registration Statement
Issuance Plan. No. 33-95096

10.4 Form of 1995 Stock Option Agreement Incorporated by reference to Exhibit 10.4
under 1995 Stock Option /Stock to the Registrant's Registration Statement
Issuance Plan. No. 33-95096

10.5 Form of 1995 Stock Purchase Incorporated by reference to Exhibit 10.5
Agreement under 1995 Stock to the Registrant's Registration Statement
Option/Stock Issuance Plan. No. 33-95096

10.6 Distribution License Agreement dated Incorporated by reference to Exhibit 10.6
September 30, 1991, by and between to the Registrant's Registration Statement
the Company and Crandell Development No. 33-95096
Corporation.

10.7 Application Program Interface Retail Incorporated by reference to Exhibit 10.7
License Agreement July 28, 1992 by to the Registrant's Registration Statement
and between the Company and Rockwell No. 33-95096
International Corporation.

10.8 Application Program Interface Incorporated by reference to Exhibit 10.8
License Agreement July 28, 1992 by to the Registrant's Registration Statement
and between the Company and Rockwell No. 33-95096
International Corporation.

10.9 Rockwell High Speed Interface Incorporated by reference to Exhibit 10.9
License Agreement dated June 2, to the Registrant's Registration Statement
1994, by and between the Company and No. 33-95096
Rockwell International Corporation.

10.10 Letter Agreement dated February 22, Incorporated by reference to Exhibit 10.10
1994, by and between the Company and to the Registrant's Registration Statement
Rockwell International Corporation. No. 33-95096

10.11 Letter Agreement dated April 22, Incorporated by reference to Exhibit 10.11
to the
</TABLE>

21
<PAGE> 22

<TABLE>
<S> <C> <C>
1993, by and between the Company and Registrant's Registration Statement
Rockwell International Corporation. No. 33-95096

10.12 Software Distribution Agreement Incorporated by reference to Exhibit 10.12
dated May 8, 1995, by and between to the Registrant's Registration Statement
the Company and International No. 33-95096
Business Machines Corporation.

10.13 Office Building Lease, dated June Incorporated by reference to Exhibit 10.13
10, 1992, by and between the Company to the Registrant's Registration Statement
and Developers Venture Capital No. 33-95096
Corporation.

10.14 Amendment No. 1 To Office Building Incorporated by reference to Exhibit 10.14
Lease, dated July 9, 1993, by and to the Registrant's Registration Statement
between the Company and Pioneer Bank. No. 33-95096

10.15 Amendment No. 2 To Office Building Incorporated by reference to Exhibit 10.15
Lease, dated August 15, 1994, by and to the Registrant's Registration Statement
between the Company and T&C No. 33-95096
Development.

10.16 Fourth Addendum to Office Building Incorporated by reference to Exhibit 10.16
Lease, dated April 21, 1995, by and to the Registrant's Registration Statement
between the Company and T&C No. 33-95096
Development.

10.17 Form of Promissory Note related to S Incorporated by reference to Exhibit 10.17
Corporation Distribution. to the Registrant's Registration Statement
No. 33-95096

10.18 Smith Micro Software, Inc. Amended Incorporated by reference to Exhibit 10.21
and Restated Software Licensing and to the Registrant's Quarterly Report on
Distribution Agreement, dated April Form 10-Q for the quarter ended September
18, 1996, by and between the Company 30, 1996
and U.S. Robotics Access Corp.

10.19 Office Building Lease, dated March Incorporated by reference to Exhibit 10.19
1, 1994, by and between Performance to the Registrant's Annual Report on Form
Computing Incorporated and Petula 10-K for the fiscal year ended December
Associates, Ltd./KC Woodside. 3l, 1995

10.20 Agreement and Plan of Merger by and Incorporated by reference to Exhibit 2 to
between Smith Micro Software, Inc., the Registrant's Current Report on Form
Performance Computing Incorporated 8-K filed with the Commission on March 28,
and PCI Video Products, Inc. dated 1996
as of March 14, 1996.

10.21 Amendment No. 1, dated as of March Incorporated by reference to Exhibit 10.21
10, 1997, to Agreement and Plan of to the Registrant's Annual Report on Form
Merger by and between Smith Micro 10-K for the fiscal year ended December
Software, Inc., Performance 31, 1996
Computing Incorporated and PCI Video
Products, Inc. dated as of March 14,
1996.

10.22 Amendment No. 6 to Office Building Incorporated by reference to Exhibit 10.22
Lease, dated February 19, 1998, by to the Registrant's Annual Report on Form
and 10-K for the
</TABLE>

22
<PAGE> 23
<TABLE>
<S> <C> <C>
between the Company and World fiscal year ended December 31, 1997
Outreach Center.

20.1 1996 Investment Profile. Incorporated by reference to Exhibit 20.1
to the Registrant's Quarterly Report on
Form 10-Q for the quarter ended March 31,
1997

21.1 Subsidiaries of Registrant. Incorporated by reference to Exhibit 21.1
to the Registrant's Annual Report on Form
10-K for the fiscal year ended December
31, 1995

27 Financial Data Schedule. Filed Herewith
</TABLE>

(B) REPORTS ON FORM 8-K

No Current reports on Form 8-K were filed during the quarter ended March
31, 1998.

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<PAGE> 24
SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the
Company has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.

SMITH MICRO SOFTWARE, INC.

May 11, 1998 By /s/ WILLIAM W. SMITH, JR.
William W. Smith, Jr.
Chairman of the Board, President and
Chief Executive Officer
(Principal Executive Officer)

May 11, 1998 By /s/ MARK W. NELSON
Mark W. Nelson
Chief Financial Officer
(Principal Financial Officer)

<PAGE> 25
EXHIBIT INDEX
<TABLE>
<CAPTION>
Exhibit
No. Title Method of Filing
------- ----- ----------------
<S> <C> <C>
3.1 Amended and Restated Certificate of Incorporated by reference to Exhibit 3.1
Incorporation of the Company. to the Registrant's Registration Statement
No. 33-95096