Bsquare Corp (BSQR) 2004 Q4 法說會逐字稿

Good afternoon, ladies and gentlemen and welcome to the BSquare Fourth Quarter and Year-end Conference Call. At this time, all participants are in a listen-only mode. Following today's presentation, instructions will be given for the question-and-answer session. If anyone needs assistance at any time during the conference, please press the star, followed by the zero. As a reminder, this conference is being recorded today, Thursday, March 3rd, 2005. I'd like to turn the call over to Mr. Scott Mahan, Chief Financial Officer. Please go ahead, sir.

Good afternoon and welcome to our conference call. With me today is Brian Crowley, our CEO. Before we begin, let me remind you that this call is being recorded and broadcast live over the Internet and that a recording of this call will be archived on our website at BSquare.com.

Let me also remind you that, except for the historical statements and information contained herein, matters discussed in this call, including any revenue and net income expectations, and comments regarding our product and other growth initiatives, are forward-looking statements that involve risks and uncertainties. Factors that could cause actual results to differ materially include but are not limited to a decline in the market for Windows-based or other smart devices or the failure of such market to develop as anticipated; adverse changes in macroeconomic conditions; a decline in the market for our products, technology licenses, and services; our ability to successfully implement, execute and make adjustments in our business strategy, business model, or product offerings; lack of customer acceptance of new products or initiatives, risks associated with the effects of our restructurings; our abilities to successfully support our operations; competition, and intellectual property risks. A more detailed description of certain factors that could affect our results include but are not limited to, those discussed in BSquare's annual report on Form 10k for the year ending December 31, 2003, in the section entitled risk factors, and in our subsequent quarterly reports on form 10q. Listeners are cautioned not to place undue reliance on these forward looking statements which speak only as of the date of this conference call. BSquare undertakes no obligation to update publicly any forward looking statements to reflect new information, events or circumstances, after the date of this call, or to reflect the occurrence of unanticipated events. With that said, I'll now turn to a discussion of our results.

Let me start with the top line. Total revenue for the fourth quarter was 8.9 million, compared to 10.7 million in the fourth quarter of 2003, and 10.6 million in the third quarter of '04. As you have seen in our public filings, we report two revenue lines, software and service. I'll speak to trends in each next.

Software revenue in the fourth quarter was 6.5 million, or 73 percent of total revenue, as compared to 8.6 million in the fourth quarter of '03, and 8.1 million in the third quarter of '04, a decline of 2.1 and 1.6 million, respectively. Software revenue consists of two components. First, the majority comes from the sale of what we refer to as "third-party software", primarily Microsoft-embedded operating systems. The second component is BSquare's own proprietary software. Third- party software revenue was 5.8 million in the third quarter, or 89 percent of total software revenue, compared to 7.8 million in the fourth quarter of '03, and 7.5 million in the third quarter of '04.

Virtually, the entire revenue shortfall this quarter stemmed from the decline in third-party software sales. This decline was, in turn, largely due to lower than anticipated order volumes from our largest customer, Cardinal Health Care, which managed inventory levels down unexpectedly. Cardinal represented 19 percent and 17 percent of total revenue for the years ending 2004 and 2003 respectively. As investors saw in this most recent quarter, Cardinal's ordering patterns can cause quite significant swings in our revenue. We do expect Cardinal to return to normal ordering patterns late in Q1. This fact, coupled, with the 20 percent sequential increase in sales of Microsoft embedded tool kits, lead us to expect sales of third party software to rebound in Q1.

We had another strong quarter in sales of BSquare proprietary products. BSquare software products contributed 680,000 of revenue in the fourth quarter, or 11 percent of software revenue, as compared to 796,000 and 635,000 in the fourth quarter of '03, and third quarter of '04, respectively. Sales were strong even as sales of SDIO Now declined in the quarter as expected. Sales of SDIO Now were 357,000 and 443,000 in the fourth quarters of '04 and '03 respectively and 578,000 in the third quarter of 2004. We generated 320,000 in non-SDIO BSquare software sales during the quarter.

We saw a purchase of our SmartBuild Reference Design in the amount of 190,000 from a military contractor we worked with previously. We expect future purchases from this customer but, likely not in Q1. Our SmartBuild Reference Design demonstrates the types of opportunities on which we plan to capitalize in 2005. Software revenue for the full-year 2004 was 28.4 million, including 25.7 million of third-party software sales and 1.8 million in sales of SDIO Now. This compared to software revenue of 28.2 million for the full-year 2003, which include 25.2 million in third-party software sales, and 1.6 million in sales of SDIO Now. Sales of third-party software were relatively flat year over year because of two soft quarters in 2004, driven by ordering lulls from Cardinal Health Care.

The other significant component of revenue is service revenue. Service revenue for the quarter was 2.4 million, or 27 percent of total revenue, compared to 2.1 million in the fourth quarter of 2003, and 2.4 million in the third quarter of 2004. As we stated in our earnings release, our Q4 service revenue results were disappointing, not having shown any upward movement for three quarters, despite adding sales capacity. A Q1 2005 focus is to strengthen sales management and execution in this area, which Brian will speak to later.

We expect service revenue to pick up in Q1 based on current activity levels. For the full year 2004, service revenue was 10.6 million, compared to 9.4 million in 2003. The year-over-year increase stemmed from several large Smart phone projects and a larger number of projects in general.

Now I'll turn to a discussion of gross profit margin. For the last four quarters, overall gross margin has been hovering at 22 percent to 25 percent, which is a vast margin over 2003 where our margin was lowest at 10 percent and ended at 17 percent for the full year. The year-over-year improvement stemmed almost entirely from improvements in our services area. A key focus of the company is to the gross margin line, given the variability of the top line which can stem from fairly significant swings in sale of low margin third-party software projects. Third party software margins generally run in the mid teens. In fact, margin contribution from sales of high-margin BSquare software and higher-margin engineering services, contributed approximately 1.5 million more in gross margin during 2004 than third-party software, despite representing only 34 percent of total revenue.

Software gross margin was 24 percent for the quarter, compared to 20 percent and 21 percent for the fourth quarter of 2003, and the third quarter of 2004 respectively. The increase in software margin in the fourth quarter was driven by high-margin BSquare products, comprising a larger percentage of software revenue. For the full-year 2004, software margin was 23 percent, compared to 24 percent in the prior year. Service gross margin was 22 percent in the fourth quarter, compared to a negative 16 percent in the fourth quarter of 2003, and a positive 24 percent in the third quarter of 2004.

In absolute dollars, fourth quarter service gross margin was down a negligible 46,000, from the third quarter of '04. For the full year, 2004, service gross margin was 25 percent, compared to a negative 4 percent in the prior year. The year-over-year increase reflects improvements in the areas of contract management, pricing, and resource utilization. It is unlikely we will see percentage margin improvement in third-party software during 2005 as margins on sales of Microsoft-embedded operating systems are increasingly competitive.

With regard to services, we are focusing on increasing our margin both in absolute dollars and as a percentage through top-line growth and increased operational efficiencies. Specifically, for the last several quarters, our service capacity has been under utilized due to lower than expected sales volumes. As billable hours and revenue increase, there should be little corresponding increase in service costs due to this capacity availability. As we do increase personnel to accommodate increased activity, we plan to do so largely through our lower-cost Taiwan operation. Additionally, we are implementing programs to increase resource utilization. Our overall goal is to raise our service gross margin, currently around 22 percent, into the mid-30 percent range or higher, on a quarterly basis by the end of 2005. This is, of course, contingent on increasing sales volumes, and maintaining our billing rates.

Moving down the queue now, let me now discuss trends in operating expenses. During the quarter, operating expenses were 2.1 million compared to 3.1 million in the fourth quarter of '03, and 2.4 million in the third quarter of '04. The decrease is due to a variety of items including [inaudible], head count, professional fees, and closure of our Japan operation. The decrease from the third quarter of 2004 was 220,000 of which the bulk stemmed from lower facility costs relating to head quarter move costs present in the third quarter, and related items. For the year ending 2004, total operating expenses were 10 million compared to 11.9 million in 2003, a decrease of 1.9 million. However, 2003 benefited from a restructuring gain of 3 million. The year-over-year decrease relates to the factors noted previously.

As we mentioned in our press release, we have made substantial progress right sizing our operating expenses, and believe there's leverage in our operating platform. Although we will certainly continue to watch expenses closely, we do not expect them to decrease further.

We have the following commentary relative to operating expense trends in 2005. First, we expect to prudently invest in R&D in the coming year to support our product initiatives, primarily through headcount additions. Our plan is, of course, that the revenue resulting from new products will more than offset incremental R&D but the timing of that revenue is unclear. Second, we don't foresee significant investments in sales or marketing in 2005. We currently have what we consider to be a healthy investment in those areas, other than internationally. We need to provide our sales team with additional products and services to sell to our already significant customer base.

Lastly, on the G&A front. We expect to incur some incremental costs associated with Sarbanes-Oxley compliance, but haven't had time to fully analyze the implications of the 404 compliance extension announced yesterday by the SEC. Our corporate rate expense will increase 80,000 per quarter under the terms of our lease, but will be partially offset by lower insurance and other costs. We foresee little growth in G&A expense in 2005 otherwise. The previous discussions does not consider the impact of the recently issued staple of financial accounting standard 123R, addressing a stock option accounting which will be effective for BSquare in Q3 2005. FAS 123R requires all share based payments to employees, including grant of stock options to be recognized as an expense in the financial statements based on the fair value. FAS 123R contrasts with our current method of accounting, where there is generally no recognition of expense in the financials,. we are evaluating FAS 123R and expect that its adoption will have a material impact on our results. Our FAS 123 pro forma expense, which we have disclosed in the footnotes to our financial statements, was 1.6 million for fiscal 2004.

Let me now speak to the bottom line for the quarter and full year. The company reported net income for the quarter of $78,000 per diluted share which included 23,000 in income from continuing operations. The fourth quarter marked the second straight profitable quarter for the company. This compared to a net loss of 3.7 million or $0.10 per diluted in the fourth quarter of 2003, and net income of 208,000 or $0.01 per diluted share, in the third quarter of 2004 on substantially higher revenue and income from discontinued operations of 169,000 in that quarter.

For the 12 months ending December 31st, 2004, the company reported a net loss of 7.1 million including a loss from continuing operations of 795,000, which compared to a net loss of 14 million in 2003, which included a loss from continuing operations at 4.5 million. In the fourth quarter, we had income from the previously discontinued Power Handheld operation of 55,000. This related primarily to the reversal of previously-established warranty reserves, as warranty activity has been minimal. On a going forward basis, we don't expect any discontinued ops activity.

Now I'd like to turn to our balance sheet. The company's cash and cash equivalents for short-term investments declined by 1.2 million to 12.9 million at December 31st, 2004. 1.2 million of that balance is restricted. Our unrestricted cash increased by 280,000 during the quarter. The overall decrease was due to the decline in sales of Microsoft-embedded systems during the quarter, the timing of those sales within the quarter, and the resulting impact on royalty payments to Microsoft. The royalty payable to Microsoft as of December 31st, 2004, declined by 1.9 million compared to the end of Q3. Additionally, the company made the last of its lease restructuring payments of 285,000 during the quarter. The company has no outstanding debts.

Going forward, we expect our cash flow to closely approximate our bottom line with two exceptions. First, we are obligated to pay Microsoft approximately 300,000 in Q1 as a condition of our audit settlement. Second, as we saw this quarter, our working capital can swing quite significantly, resulting from the volume of sales of Microsoft operating system and the timing thereof in the quarter. We don't expect significant CapEx or other nonoperational cash uses in 2005. Now, I'd like to turn the call over to Brian.

Thanks, Scott. I'll spend a few minutes reviewing our 2004 business results against the objectives that we set at the beginning of the year. Then I'll comment on our current results and on our 2005 initiatives.

At the beginning of 2004, we set four primary objectives. First, we wanted to stem our losses and return the company to profitability on a quarterly basis. We accomplished this objective, reporting two consecutive quarters of profitability. Second, we set out to improve the marketing and sales synergies between our Microsoft-embedded Windows software, professional services and BSquare-software product lines. We continue to feel these product lines are complementary and our licensing sales allow us to reach a large number of customers each quarter with the potential to up sell other products and services. We made progress in this area and can point to specific customers who are now purchasing multiple products and services from BSquare.

However, we are not satisfied with our results, and will continue to focus on this objective in 2005 by creating more integrated marketing and sales programs. Third, we committed to enhancing BSquare's own property position by creating a device solution road map, increasing our R&D efforts and looking for complementary acquisition. While we made progress in this objective during the year, there is much work to do. We developed a road map for our next generation SDIO Now technology, which we believe will extend the life of this product to 2005 and beyond. We released the BSquare Audio Manager the first tangible results of our efforts to leverage the great work we do in our professional services organization and we have put together a device-development solution road map that I will discuss further in a moment.

Finally, we indicated that we would seek outside funding for the Power Handheld. As we discussed in previous periods, we were not successful in our funding efforts, and shut down our Power Handheld business unit in the second quarter of 2004. In summary, we feel that 2004 was a good year for BSquare and that we have created a solid operating platform from which we can grow.

Next, I would like to highlight a few specific items from our fourth quarter and then close by talking about our 2005 objectives. In November, we released version 2.0 of our SDIO Now technology. This version includes new functionality and enhancement that our customers have been asking for , including performance improvements and support for the latest SD Card association specification. Because much of our SDIO revenue comes from one-time royalties we expect to see a short-term lull in our SDIO revenue as our customers begin implementing version 2.0 technology into devices that will be released later this year.

We were disappointed in our sales of Microsoft-embedded operating systems in the quarter. However, we expect the sales to increase in Q1 for the reasons mentioned earlier. During 2005, we expect our Microsoft-embedded operating system to grow approximately 10 percent. Additionally, we believe that there is incremental revenue upside coming from new products that Microsoft is releasing into the channel, such as Windows XP with embedded restrictions, and Windows embedded for point of sales, otherwise known as WEPoS. Because of the competitive nature of licensing sales, we expect that margins will be generally flat during 2005.

Turning to our services revenue line, we were disappointed this quarter. We do not think the performance is market related, as we continued to see a healthy sales pipeline of service deals. Rather we think our issue is related to ramping the additional sales people we recently brought in and ensuring that all of our marketing and sales efforts are well coordinated and executed. We recently hired new sales management to drive our service-sales efforts, and will continue to focus on this during 2005.

During the quarter we completed 20 service engagements. Examples of projects we worked on include: we were selected by Data Evolution to provide a wide range of hardware and software engineering services for the next generation Cleo Tablet which is a device based on Windows CE50. We worked with several semiconductor partners including Texas Instruments, AMD, Prescale and Sharp to port Windows CE and Windows Mobile to their platforms. We worked with a large OE in Taiwan on a ruggedized Windows mobile device. It's notable that this is the second major project utilizing resources from both our Bellevue and Taiwan locations, proving that we can blend our onshore and offshore services organizations to gain both cost and locality advantages for our U.S. and Asian customers.

We recently announced the departure of Tracy Rees our former Executive Vice President of Sales, Marketing and International. Tracy made great contributions to our turn around and we were sorry to see him leave. We reassigned Tracy's responsibilities to other members of the management team and as mentioned earlier, we have recently hired new management to direct our professional service and sales force.

Finally, I'd like to spend a few minutes updating you on the investments we are making to grow our business. I talked to you in the last call about our efforts to define new smart device solutions based on discussions with our customers. Initial fruits of these efforts have been seen in the release of SDIO version 2.0 and the BSquare Audio Manager, both of which are based on direct customer feed back we received in the past year. We also discussed our efforts to provide embeddable technologies that can form the foundation of our customers' products. In the near term, these technologies will take the form of specific industry reference solutions that are made up of best -of-breed technologies developed by BSquare and by our partners. We think that BSquare is the best in the world at creating optimized board support software, that connects hardware to embedded Windows operating systems, as well as in creating specific device middleware solutions like our SDIO technology. We intend to combine our board support software with hardware platforms we obtained from our partners, and to add standardized middleware to create industry-specific reference solutions.

Because of our long experience in device development, and because we are starting with IP from our past and present product development and professional service efforts, we believe that our reference solutions will be highly optimized in the areas that are important to our customers, such as reliability, performance and power management. By adopting our solutions, our customers will have a head start in creating their devices and will be able to focus on creating their value-add applications in the future.

We've made good progress in these efforts. First, we've hired Pawan Gupta to lead our product efforts. Pawan has a great background, including time at both Toshiba and Microsoft, and in the short time he's been here, he's made a good contribution to executing our strategies. Second, we identified technologies that we will build and those that we will partner for, and we are executing down both paths. Third, we have engaged several key customers and partners to help guide us in our efforts, such that the solutions we deliver to the market will be well received.

I'd love to be able to describe the efforts in more detail because we're really excited about the path we are on. However, due to the competitive nature of the market and sensitivity of discussions with our partners, I cannot talk in more detail at this time. As we get closer to releasing our products, you should expect additional announcements for the next few quarters.

Now I'll wrap up the call with some guidance commentary. As you've heard in prior discussions, our historical results, particularly our top line performance have and will continue to experience, a great deal of variability driven by the swings in third-party software revenue specially Microsoft licensing. Additionally, we have been experiencing -- we have experienced lumpiness in our service revenue due to contract and project delays. These factors, coupled with the usual uncertainty associated with new proprietary growth initiatives, makes it difficult at this time to provide long-term guidance until we gain better visibility into our product initiatives. Therefore, we will be restricting our guidance to the next quarter only.

For Q1, we expect to report 9.8 million to 10.2 million in top line -- million -- in top-line revenue, with a small loss to break even at the bottom line. Although we expect top line improvement from Q4, operating expenses will increase in the first quarter to fund R&D, and our overall salary expenses will include as FICA and other fringe costs reach that in the first quarter of each year. That ends the the scripted portion of our call. I'd like to thank everyone for their time today and continued interest in BSquare. We will now open up the call for questions.

Thank year, sir. Ladies and gentlemen, at this time, we will begin the question-and-answer session. If you have a question, please press the star, followed by the one on your push button phone. If you would like to decline from the polling process, please press the star, followed by the two. You will hear a three-tone prompt acknowledging your selection and your questions will be polled in the order they are received. If you're using speaker equipment, you will need to lift the handset before pressing the numbers. One moment for our first question. Once again, ladies and gentlemen, if you have a question, please press the star, followed by the one. And our first question comes from Daniel Gonzalez, who is is a private investor. Please go ahead.

Yes. Did you -- fourth quarter, there were supposed to be sales that didn't follow through. Are they going to follow through on the first -- this first quarter?

Generally we are seeing that some of the sales that were delayed from Q4 to Q1 have been coming through in Q1.

Okay.

One of the big -- one of the big expectation gaps for Q4 was the Cardinal licensing volumes, and as we mentioned in the call, they had unexpectedly managed inventory levels down through the quarter. But as we did mention in the call, we are expecting and seeing already their volumes picking up toward the tail end of Q1 here.

Okay. Thank you.

Thank you. And our next question comes from Sean Matthews [ph] with Alchemist Capital Management.

Hello, everyone. With your SDIO product you're talking about having a little bit of a lull here as people wait for SDIO2. Looking at SDIO2, do you have any thoughts about what sort of ramp that will look like, or will it be consistent with SDIO, let's say a quarter or two ago?

I would expect, Sean, that will probably look a lot like SDIO did before. You know it takes some time for our customers to adopt the technology into their product-development cycles and then get the product to market.

Okay. And will the margins be roughly the same?

Yes, they will.

Okay. Thank you. Good luck.

thank you. Ladies and gentlemen, if you have an additional question, please press the star, followed by the 1. And as a reminder, if you're using speaker equipment you will need to lift the hand set before pressing the numbers. One moment for our next question. Once again, ladies and gentlemen, if you have a question, please press the star followed by the 1. Our next question comes from Steve Sullivan with Horizon Financial Group. Please go ahead.

Yes, I was wondering, can you give us a breakdown in the first quarter between Microsoft software revenues and your own? And secondly, did I hear you right? You're shooting for service-gross margins in the mid-30s for 2005?

Mid 30s or higher on a quarterly basis by the end of '05.

That helps. Fourth quarter?

Yeah, tail end of the year.

Tail end of the year. So, you think you would be able to derive that in the fourth quarter though?

No later than the fourth quarter, correct.

So, I gather that's a progression, each quarter should be better then?

Yeah. And, as we pointed out earlier, it's really a function of just adding more top-line revenue to what is today a relatively fixed-cost base.

Okay. And regarding your internal software versus Microsoft's, whether the mix will be what you anticipate in the first quarter?

We expect that it will likely be a higher percentage of revenue in Q1 than it was in Q4.

On an absolute basis, will your internal software be equal to or less than?

Less than what?

Less than your prior fourth quarter?

As a percentage it will likely be lower, give that third-party software will be higher.

And on an absolute basis, you -- you can't tell me?

Right.

Okay. Thank you.

Thank you. And gentlemen, at this time there are no further questions.

Okay. I want to thank everybody for attending the call today, and we look forward to talking to you again next quarter.

Thank you. And ladies and gentlemen, this concludes the BSquare Fourth Quarter and Year End Conference Call. If you'd like to LISTEN TO the replay of today's call, please dial 303-590-3000 or 1-800-405-2236 and you will need to enter the access code of 11022231, followed by the pound sign. Once again, thank you for participating in today's conference. At this time, you may now disconnect.