Bsquare Corp (BSQR) 2005 Q1 法說會逐字稿

Good day, ladies and gentlemen, and welcome to the BSQUARE 2005 First Quarter Conference Call.

[OPERATOR INSTRUCTIONS.]

As a reminder, this conference is being recorded Thursday, May 5 of 2005.

I would now like to turn the conference over to Scott Mahan, Chief Financial Officer. Please go ahead, sir.

Good afternoon, and welcome to our first quarter 2005 conference call. With me today is Brian Crowley, our CEO, and Don Bibeault, Chairman of our Board of Directors.

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 www.bsquare.com.

Let me also remind you that, except for the historical statements and information contained herein, the 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, technologies, 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 ability to successfully support our operations, competition and intellectual property risks.

A more detailed description of certain factors that could affect the actual results include, but are not limited to, those discussed in BSQUARE's annual report on form 10K for the year ended December 31, 2004 in the section entitled, "Factors That Could Affect Future Results." 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 this quarter was 9.8 million compared to 10.6 million and 8.9 million in the first and fourth quarters of 2004 respectively. Overall, the increase from the fourth quarter was driven by higher software revenue, whereas the decline from the year-ago quarter was due to lower service revenue. I'll speak to these two revenue components in detail next. Software revenue was 7.5 million this quarter, or 76% of total revenue as compared to 7.7 million and 6.5 million in the first and fourth quarters of 2004 respectively. This quarter's software revenue results were roughly flat year-over-year, and were up 1 million sequentially.

Software revenue consists of two components. The majority comes from the sale of what we refer to as third-party software, primarily Microsoft-embedded operating systems. The remainder is comprised of sales of our own proprietary software. Third-party software revenue was 6.9 million this quarter, or 92% of total software revenue, compared to 7 million and 5.8 million in the first and fourth quarters of 2004 respectively. The roughly 1 million sequential increase in third-party software sales this quarter was the primary driver of the roughly 900,000 total sequential top-line revenue increase.

Sales of third-party software increased this quarter, despite the recently announced loss of Cardinal Healthcare Systems, our only 10% customer. As we discussed in a recent conference call, we were informed in March that Cardinal would begin purchasing Microsoft-embedded operating systems a competitor beginning in the second quarter. While we obviously wanted to retain Cardinal's business, and did everything possible to do so, we have understood the competitive pressures at Cardinal and in the marketplace in general, and had already undertaken activities to grow order volumes at existing customers other than Cardinal, as well as grow a new customer base. To some extent, you saw the impact of those activities this quarter. In fact, sales to customers other than Cardinal were up both year-over-year and sequentially by approximately 40%.

To appreciate this in absolute dollars, consider that this quarter sales of third-party software were roughly flat compared to the first quarter of last year, even as Cardinal’s order volumes dropped almost 1.9 million comparatively. Similarly, third-party software sales were up over 1 million compared to the fourth quarter, despite a roughly 700,000 comparative drop in Cardinal’s order volumes quarter-over-quarter. Cardinal contributed 711,000 to third-party software revenue this quarter compared to 2.6 million and 1.4 million in the first and fourth quarters of 2004 respectively. Although we will certainly stay in contact with Cardinal and will work hard to win back their business, we don't expect any orders from them in the second quarter, and we have received none so far.

While we are pleased with our third-party software results this quarter and expect order volumes to continue at healthy rate in the future, it's not clear that this quarter’s order activity from customers other than Cardinal will continue into the second quarter at the same rate. Given this and the fact that we don't believe Cardinal will place any orders in Q2, we expect third-party software revenue and, therefore, software revenue in total, to decrease some in the second quarter.

We had another relatively strong quarter in sales of BSQUARE proprietary software, particularly SDIO Now. This quarter's proprietary software revenue was 590,000, or 8% of total software revenue compared to 680,000 in the first and fourth quarters of 2004. Sales of the company's SDIO Now software product this quarter were 490,000, up 80% and 38% compared to the first and fourth quarters of 2004 respectively. Higher SDIO Now sales this quarter were driven by higher device shipment volumes at several Taiwanese customers.

Proprietary software revenue in the first and fourth quarters of 2004 included sales of our power handheld software stack, and our smart build reference design, the absence of which offset the increase in SDIO Now revenue this quarter on a comparative basis.

As we have been cautioning investors for several quarters, we do expect some softening in SDIO Now revenue in the second quarter until customers fully adopt our SDIO Now version 2.x software. However, we expect any decrease to be offset by other BSQUARE proprietary software revenue in the second quarter. As we mentioned in our press release, one of our key initiatives the quarter was the introduction of our SDIO Now product roadmap to current and potential customers. Brian will speak to this and other proprietary product efforts in a minute.

The other significant component of revenue is service revenue. Service revenue this quarter was 2.4 million, or 24% of total revenue compared to 2.9 million and 2.4 million in the first and fourth quarters of 2004 respectively. This quarter's service revenue results were disappointing. Our recent focus in the service area has to strengthen sales management and execution, which included the hiring of a new Vice President of Sales. Partially as a result of these activities, we entered the second quarter with the highest services backlog we've seen in the last four quarters. We therefore expect service revenue to pick up in the second quarter. Further, we are already seeing a healthy firming up of the Q3 backlog.

Now, I’ll turn to a discussion of gross profit margin. A key focus of ours is the gross margin line, given the variability in the top line, which can occur through fairly significant swings in sales of low margin third-party software products. Software gross margin in total was 21% this quarter, compared to 21% and 24% for the first and fourth quarters of 2004 respectively. The two components of software vary significantly in their margin percentages. Third-party software margins are relatively low, and have ranged from 13 to 16% over the last five quarters. Third-party software margin was approximately 14% this quarter. Third-party software margin contrasts to our own proprietary software margin of close to 100%.

The decrease in software margin percentage this quarter from the fourth quarter was driven by high margin BSQUARE software products comprising a larger percentage of total software revenue in Q4 versus the current quarter. In absolute dollars, software revenue contributed 1.6 million in gross profit to cover operating expenses this quarter, and for both the first and fourth quarters of 2004.

Due to competitive forces impacting sales of Microsoft-embedded operating systems, it is unlikely we will see percentage margin improvement in third-party software sales during 2005 without the addition of non-Microsoft third-party products to our product mix. This is one of our strategic goals for 2005 that Brian will speak to later.

Service gross margin was 15% this quarter compared to 28% and 22% in the first and fourth quarters of 2004. In absolute dollars, service revenue contributed 350,000 in gross profit as compared to 790,000 and 530,000 in the first and fourth quarters of 2004 respectively. This quarter’s decline in our service gross margin percentage and gross profit contribution was driven by lower revenue volumes on a relatively flat service cost of sales base. Service cost of sales was 2 million this quarter compared to 2.1 million and 1.9 million in the first and fourth quarters of 2004 respectively. This quarter’s sequential increase in service cost of sales was primarily driven by higher facilities expense associated with an increase in our headquarters lease cost.

We remain focused on increasing our service margin, both as a percentage of revenue and in absolute dollars, through top-line growth and increased operational efficiencies, as this represents the key leverage point in our operating model. Specifically, for the last several quarters, our service delivery capacity has been under-utilized due to lower than expected sales volumes. We have partially addressed some of this over-capacity this quarter, and in the first part of Q2 by not backfilling recent attrition in the service delivery area. As billable hours and revenue increase, there should be no significant corresponding increase in service costs due to this capacity availability.

As we increase personnel to accommodate increased activity, we plan to do so as much as possible and appropriate through the use of lower cost offshore resources, primarily in our Taiwan office. Additionally, approximately 20% of our service cost of sales this quarter was represented by facilities, depreciation and service delivery overhead, which should not increase significantly as revenue levels rise, given their relatively fixed nature.

On our March 3 conference call, we discussed our goal to raise our service gross margin percentage into the mid-30% range or higher on a quarterly basis. Despite this quarter’s service margin performance, we still feel this goal is attainable within a reasonable time frame, assuming increased sales volumes. This is an important goal for us as an organization.

Moving down the P&L, let me discuss operating expenses. During the quarter, operating expenses were 2.5 million compared to 2.7 million and 2.1 million in the first and fourth quarters of 2004 respectively. The most relevant comparison of this quarter’s operating expenses is to Q4 2004, considering that the first quarter of last year still included our Japan operation and the impact of other activities, which made comparability less meaningful. Increases in R&D expense to support our increased focus on proprietary product efforts accounted for 110,000 of the 380,000 increase in OpEx for the fourth quarter. The increase in R&D this quarter came from higher payroll expense associated with headcount additions, coupled with higher travel and facilities cost. The 270,000 increase in SG&A this quarter resulted primarily from higher fringe benefit expense and facilities cost.

As we commented on the last several conference calls, we expected operating expenses to increase this quarter as compared to Q4. Specifically, we expected an increase in fringe benefit expense, which occurs at the beginning of every year. Fringe benefit expense was up approximately 230,000 from the fourth quarter. Additionally, we expected rent expense to increase based primarily on an escalation in operating costs under our headquarters lease. Rent expense is up 140,000 over the fourth quarter.

As we mentioned in the press release, investors are seeing a relatively normalized OpEx run rate this quarter with the following exceptions -- we do expect fringe benefits expense to decrease some during the year. Additionally, we expect to continue to incrementally invest in R&D to support our product efforts, and expect to incur some incremental Sarbanes Oxley cost in the second half of 2005, although certainly less than originally anticipated, given the extension announced recently by the SEC.

One of the items discussed on our recent conference call was the potential impact of financial accounting standard 123(R). FAS 123 requires all share-based payments to employees, including grants of stock options, to be recognized as an expense in the financial statements based on their fair value. This contrasts with our current method accounting, wherein there is generally no recognition of expense.

Since our last call, the implementation of this standard has been deferred until the first quarter of 2006. We don’t expect to early adopt the standard, and have not decided on an adoption methodology, but we do expect the adoption to have a material non-cash effect on our operating results. We are currently evaluating changes to our equity compensation strategies in light of this announcement.

Let me now speak to the bottom line. The company reported a net loss for the quarter of 540,000, $0.01 per diluted share. This compared to a net loss of 2.2 million, or $0.06 per diluted share in the first quarter of 2004, and net income of 79,000, $0.00 per diluted share in the fourth quarter of 2004. Results for the first quarter of 2004 included a 2 million loss, $0.05 per diluted share, from the company’s now-discontinued hardware business unit. There was no significant activity for this business unit in the first quarter of 2005, or fourth quarter of 2004. We had effectively concluded all shutdown activities associated with the hardware unit in the fourth quarter of 2004, and don’t expect to report discontinued operations activity in 2005.

Now, let me turn to the balance sheet. Our cash and cash equivalents and short-term investments were 12.8 million at March 31, 2005, compared to 12.9 million at December 31, 2004, 1.2 million of which was restricted under the terms of our headquarters lease. The decrease this quarter was due to our loss of 545,000, and a payment of 160,000 to Microsoft under our previously announced audit settlement, offset by a positive effect on cash of changes in working capital. The positive working capital effect was primarily driven by a 1.6 million increase in our quarter-end royalties payable to Microsoft as compared to the fourth quarter.

As we discussed on our fourth quarter call, our working capital position is highly sensitive to sales volumes of Microsoft-embedded operating systems, and the timing within the quarter. In the fourth quarter of 2004, during which our sales of Microsoft-embedded operating systems dropped fairly significantly from the third quarter, we experienced a 1.9 million sequential decrease in our royalties payable, which impacted our cash position accordingly. This quarter, that effect reversed itself as Microsoft-embedded operating system sales increased.

Going forward, we expect our cash flow to closely approximate our bottom line, with two exceptions. First, we are obligated to pay Microsoft the final 160,000 owed to them under our audit settlement in the second quarter. Second, our cash position can be impacted significantly by changes in the royalty payable to Microsoft, as discussed previously. We do expect cash to decrease some in the second quarter based on the payment of the audit settlement and lower projected sales of Microsoft-embedded operating systems discussed earlier. We don’t expect significant CapEx or other non-operational cash uses in 2005, and we have no outstanding debt.

With that, I’d like to turn the call over to Brian.

Thanks, Scott.

Today, I will discuss a number of topics, including our efforts to grow third-party software revenue, an update on our product initiatives, our overall sales efforts with a specific focus on professional service sales, as well as sales in the Asian marketplace, and lastly, our mergers and acquisitions efforts. I'll wrap up by talking to our NASDAQ listing status, cash resources, and guidance.

Third-party product sales this quarter were a bad news/news story. The bad news was that our largest customer, Cardinal Health, made the decision to take their business elsewhere. The good news was that we were able to grow the non-Cardinal portion of third-party revenue by almost 40% sequentially. This growth is a result of efforts that we put into place to win new third-party products customers, and to expand the amount of business we do with existing customers. In the first quarter of 2005, we kicked off initiatives to capture new customers in several vertical markets that show potential, including point-of-sale, kiosk, industrial automation, and others.

In addition, we are working to conclude on new partnerships that will bring us opportunities to sell additional third-party products, which are complementary to the embedded Windows licenses that make up the bulk of our third-party software sales.

Each quarter, we sell embedded Windows licenses to literally hundreds of customers. Having more to sell to these customers is a key to growing sales of third-party products. BSQUARE currently has partnerships with Sygate to sell Sygate Security Solution, and DataLife to sell DataLife's Flash F/X and Reliance products. We chose these products because they are complementary to the sales of embedded Windows licenses, and are a good fit for our sales channel. Based on the feedback from our customers and our own observations of market trends, we are now pursuing partnerships that will allow us to offer our customers prepackaged hardware solutions and antivirus technology. We expect to have partnerships concluded over the next two quarters.

Now I would like to discuss our overall sales efforts, including our focus on improving sales management and execution in professional services, as well as our efforts in Asia. As we discussed in our last call, we hired Larry Stapleton to lead our professional services sales efforts. We have been through a complete territory and account reviews, and have completed a reorganization of sales focus based upon what we believe to be our most significant opportunities. We believe that the focus and discipline that Larry is already bringing to our selling efforts, coupled with increasing productivity out of the sales executives we hired late last year and early this year, will result in increased professional services sales starting this quarter.

Now turning to our efforts in Asia. It is obvious that high-volume manufacturing of smart devices has been migrating to lower-cost regions of the world, such as Asia, for some time. This region has also become skilled at smart device hardware development, and come to a lesser extent, software development. Therefore, as one part of our strategy to increase our engineering service revenue, and also to open up a larger potential market for our products that we are currently developing, we have made the decision in to make further investment in the engineering capability of our Taiwan office, as well as increased sales capacity in key areas of Asia. We have already hired new engineering personnel in our Taiwan office, and we are currently looking to augment our Taiwan-based sales capabilities, as well as establish a greater sales presence in Japan, Korea and China. This will be an ongoing effort throughout 2005, and we expect to have additional sales coverage in place and contributing to our revenue by the end of this year.

To update you on our product development efforts, we feel we have made solid progress this quarter. As we announced in the beginning of Q1, we hired Paven Guptah (ph), an industry veteran from both Toshiba and Microsoft, to lead our product efforts. We have spent extensive time during the quarter in front of our SDIO customers, rolling out our SDIO version 2.x roadmap. As many who have followed us for some time know, SDIO stands for Secure Digital Input/Output. SDIO is the industry standard for internal and external expansion of smart device capabilities.

Using our SDIO technology, our customers are able to quickly add secure digital I/O capabilities to their devices, and are insured of wide compatibility with almost all SDIO peripherals currently on the market, as well as future compatibility with new peripherals as they are introduced. Our version 2.x roadmap adds several important new features, including, for the first time, support for the larger 2 GB and 4 GB memory cards that will be appearing on the market this year. The ability to secure data that is stored on SD cards, as well as performance up to four times faster than our current SDIO technology.

The trend in smart devices is for more memory, more processing power, and higher bandwidth communications. These capabilities are enabling new smart device applications that were not possible a few years ago, such as multimedia playback, back office connectivity, and local document storage and retrieval. We believe that these applications will help drive continued adoption of our SDIO technology, as our version 2.x roadmap provides our customers with the capabilities to store more data, secure the data, and vastly improve performance over previous versions. Our version 2.x roadmap has been previewed to many of our current SDIO customers, and has been well received, and we have received verbal commitments from our largest customers to adopt our SDIO version 2.x technology in their new device development plans.

We spoke last time about our efforts to create reference design solutions for our customers. Reference design solutions take the form of prepackaged hardware and software components that give our customers a known, high quality starting point for their product designs. By adopting our reference solutions, our customers can dramatically improve their time-to-market, gain access to the latest technologies, and reduce their development risks and costs. We believe that, through adoption of our reference designs, BSQUARE will not only gain additional product revenue from licensing and royalties, but that we will recognize additional service revenues as customers engage us to customize our reference designs into specific product offerings.

We believe that there is a major industry shift towards incorporating wireless capabilities into devices. We also believe that, with wireless capabilities comes the need for integrated security, rights management and multimedia capabilities. Therefore, you can expect that our reference designs will provide our customers with solutions in these areas. As we indicated in our last call, we expect our first reference design efforts to come to the market the second half of 2005, and this will be an ongoing effort through 2006.

Finally, let me speak to our mergers and acquisitions efforts. We have discussed in the past that mergers and acquisitions will likely be a part of our overall strategy to grow our business. We are interested in finding companies possessing products and technologies that augment the roadmap that we have defined. During the last few quarters, we have had serious discussions with a number of companies, and we are currently in discussions with three companies that fit our M&A criteria. We will continue our M&A efforts, and will update you as we move forward.

Before I turn to our guidance commentary, I want to spend a minute discussing our current NASDAQ listing status and our cash resources. Let me start off by confirming the specifics of our listing status. On April 5, 2005, we received notification from NASDAQ stating that we had been out of compliance with the $1 minimum bid price listing requirement for 30 trading days. Our stock has continued to trade under $1 since that notification. BSQUARE is currently a NASDAQ national market issue, and, as such, has until October 3, 2005 to regain compliance with the $1 minimum bid price requirement. The company must also maintain compliance with all other continued national market listing requirements. To regain compliance with the minimum bid price requirement, our closing bid price must be at or above $1 for 10 consecutive trading days.

The obvious question is what are we going to do about this potential de-listing concern? First and foremost, our hope is that our continued progress towards our strategic goals will have a positive impact on our stock price, and eliminate our bid price compliance issue. However, if markets continue to value our stock below $1, and potential de-listing concerns continue, we are prepared to exercise the options available to us, including seeking a NASDAQ small-cap listing, or effecting a reverse split.

While a move to the NASDAQ small-cap market would have to be approved by NASDAQ, such a move would provide us in addition six-month grace period to address any minimum bid price compliance issues. A move to the NASDAQ small-cap market assumes we meet the initial listing requirements for a NASDAQ small-cap market issue, and must be approved by NASDAQ. For those not familiar with the NASDAQ small-cap market, it offers the same liquidity as the NASDAQ national market, and is certainly not to be confused with the pink sheets or bulletin board market in any way.

The potential de-listing concern is a serious issue for us. We feel that our public company status provides strategic advantages in our marketplace, such as acquisition currency, and we will take appropriate steps to preserve that status.

We have been asked if the company intends to raise additional capital. We currently have no plans to do so. There are two primary reasons for this. First, there is no compelling reason for us to do so, given our balance sheet stability. Second, to the extent raising additional capital did make sense, we would hope to do so when the market has fully reflected our achievement and go-forward potential in our stock price. The most likely scenario that would have us raising additional capital would be in an M&A context.

Now, I'll wrap up the call with some guidance commentary. Consistent with the practice adopted last quarter, we will be restricting our guidance to the upcoming quarter only. For the second quarter, we expect to report 9.5 to 9.9 million in top-line revenue. We expect software revenue, predominantly third-party software revenue, to be down in the second quarter, offset by an increase in higher-margin service revenue. As a result of the revenue component mix, we expect to report a loss of 100,000 to $300,000 for the second quarter. We expect to end the quarter with more than 12 million in cash, cash equivalents, and marketable securities, of which 1.2 million will be restricted.

This ends the prepared portion of the call today. These prepared remarks will be posted to the Investor Relations section of our website at www.bsquare.com. I would like to thank everyone for their time today and continued interest in BSQUARE. We will now open up the call for questions.

Thank you very much, sir.

[OPERATOR INSTRUCTIONS.]

Steve Green (ph).

I guess this question -- I made some notes here in regard to Scott. I have here strong balance sheet, no reason for additional capital. How come you find it necessary now to have serious discussions about M&A activity?

We actually have been in discussions for some time with several companies on M&A. It’s been a part of our strategy for at least a year now.

So, would you say BSQUARE has been the initiator in these conversations, or have you been contacted by these other companies?

We have been the initiator.

You have been? And you said it’s three companies, or more than three companies?

Well, we’ve talked to many companies over the past year. We’re currently talking to three different companies.

On the company’s cash, I’d like to know what the cash is compared to cash equivalents and short-term investments. Can you describe those three?

As of the end of the quarter ...

Looks like you went down about 100,000 from last quarter. What I just specifically want to know is what is cash equivalent, and what is short-term investments?

You mean what is it comprised of?

Compared to cash, yes.

Short-term investments is basically anything with a maturity of greater than 90 days.

Greater than 90 days.

But it’s all relatively short-term. We have a conservative investment policy, with a target maturity range of no more than six months.

And up to this upcoming quarter, of the 12.8 million, all things staying the same, what’s that projected to be at after this upcoming quarter?

What we said on the call was we would be north of 12 million. I mean, again, one of the things I want to emphasize, I mean, the thing we know for sure is that we’re going to have to pay Microsoft $160,000 during the second quarter -- we’ll have a small loss -- and the thing that’s always a little hard for us to gauge is the timing of the sales of Microsoft-embedded operating systems within the quarter. And that can swing our cash balance a decent amount one way or the other. This quarter it worked for us. Last quarter it worked against us.

What I’m wondering, with the stock price being so low and you basically mentioning that it is this low, the serious discussions of the M&A activity, is it the most beneficial for shareholders to -- right now to do a merger, or to keep plugging away here?

Well, I think that the kind of mergers that we’re looking at are things that we think would be immediately accretive. So, we are trying to do what’s right for the shareholders, but we look at each individual acquisition as an individual acquisition.

And I would also say that, obviously, with our stock where it’s at, we’re going to be particularly sensitive to the valuation in any transaction, and I can tell you that, with companies we’ve talked to over the last -- Brian mentioned earlier we talked about M&A as part of our growth strategy quite a while ago. And there’s been lots of transactions where the other side thought that they were much more valuable than we thought they were, and that stopped the conversation. And I also wanted to -- obviously, as the concern that’s coming through in your question is let’s not get too ahead of ourselves, $.50 a share on the acquisition front, which we totally agree with. And to some extent, we also don’t think -- on the flip side, don’t think investors should set their expectations that there’s an M&A deal coming around the bend soon, either, but they’re hard. There’s lots of things which cause M&A deals not to happen, including valuation.

But would you say that the concentrated efforts for now of yourself and the Board is the M&A?

I’m sorry, say that again?

Currently right now, is the efforts primarily being based towards a merger or acquisition?

No, no, absolutely not. The primary efforts right now are really around our proprietary software initiatives, as well as getting our sales machine functioning the way it needs to be function, the way we think it should be functioning.

Shawn Matthews (ph) with Alcanas (ph) Capital.

Looking at the business going forward, do you have a sense of, (1) where SDIO plays into the equation, looking out a year or so, and (2) third-party software, the margins are so low. Is there a way to get margins up in that business, if it’s possible, or is it just not possible to have higher margins in that business?

Sure, sure. I’ll address both of those, Shawn. So, on SDIO, we have been, I guess, pleased with some of the reception that our roadmap has given us, and so we think that, at least for the rest of this year and potentially into next year, we are going to continue to see adoption of the technology by our customers. And there are some potential nice -- I’ll call it technology spin-offs that may come off of SDIO that maybe we can talk about in future quarters. So, we’re still bullish on the SDIO product and technology, as we go forward.

From a third-party perspective, when we talk about third party products, there’s really two sides of it. There’s the Microsoft side, and then there’s other third-party products, like Sygate and DataLife and others that we talked about today. The Microsoft licenses, we expect that those margins are going to stay about the same. Don’t really see -- there’s just a lot of competitive pressure there. But we do see an opportunity to take on other third-party products, which tend to have margins up a little higher. They tend to be in the 30, 35% range. And we think that, by bundling those with the Microsoft licenses, we can pull the overall margins up.

OK. And on the toolkit front, any color as far as how toolkits went this quarter?

Toolkits were down a little bit this quarter, but one of the reasons we didn’t talk about that in the press release as a forward-looking indicator, Shawn, is that, to some extent, it is a forward-looking indicator, but, right now, our revenue is driven by 10, 15 accounts, and these are accounts that -- an account doesn’t buy 50 toolkits. So, by looking at a toolkit number as going up or going down, it’s a good number for us to watch, but there isn’t necessarily a hard correlation that says, “OK, toolkits were up 20% this quarter. I expect third-party software to be up 20% two quarters from now.” I mean, the driver in the third-party software revenue line is device shipment volumes at our more significant third-party customers.

OK. And on the services front, it seems like it’s a never-ending battle there. I mean, you guys feel you have your hands around the situation now, where you’re going to start to see growth there, and are costs in line now?

Yes, we think so. I mean, as we mentioned in the script today, we have -- we’ve let our headcount attrit down a bit to where we think is a more comfortable level for us. And on top of that, we have the strongest backlog that we’ve seen in the past four quarters. And we have good sales activity. So, we’re feeling better about services going up this quarter than we have in the past.

Hank Bannister (ph) with Baxon (ph) Research.

I was just wondering, I sort of look at M&A as two different parts. One is merger and one is acquisition. Merger is kind of like a situation where you get involved with someone of equal size, or perhaps bigger, and acquisition -- it doesn’t have to be -- but acquisition being a little bit more of -- kind of folding in some technology, a smaller group, or maybe a little bit less of a thing. Could you further characterize the kind of things you’re looking at, and if there are mergers, what kind would make sense?

OK. Right now, Hank, the things we’re looking at are more in the acquisition side. They tend to be smaller entities that have technologies which fit nicely into the roadmap we’ve defined. We have in the past talked to a couple of companies that are a little bit larger that I suppose you could put into the merger, but there’s just less of them out there than there are the small companies with a really interesting technology that have maybe reached sort of the limit of where they can go on their own, and are looking to be wrapped into something bigger. And right now, that’s probably of more interest to us. Not that we wouldn’t look at anything that looks like it would further our goals.

On the other side, not that you’d be interested, but have you had any, over the last few months, few quarters, had people sort of knocking on your door saying, “Would you be interested in being merged into our company,” in other words, being an acquisition target, so to speak?

No, we haven’t had a whole lot of that activity.

So my second question is I went down to an Intel presentation the other day, which was really quite fascinating. I forget the guy’s name, but the new VP of their mobility division. They actually reorganized around a whole mobility space, where they’re putting their notebooks and their handhelds and their broadband areas under one VP, one division head. And the more I listened to them, the more it became apparent that Intel’s going to be a gorilla, again, in that space of emerging their laptop expertise into the smart phones, PDAs, whatever. And looking at what they’re doing, it sort of seems like they’re dragging Microsoft right behind them, and, if they’re dragging Microsoft right behind them, wouldn’t you be dragged right behind Microsoft?

To some extent, yes. Now, remember, too, that Intel also does quite a bit of Linux work on top of their Microsoft work, so they’re somewhat of a two-headed animal out there. We traditionally have not been very strong with Intel. We’ve been stronger with some of the other semiconductor vendors, although I would say, recently in the past quarter, we have seen a lot more activity with Intel than we have maybe seen in the past.

Is that because Intel’s having a little more success in the market, or is it because they’re more interested, or vice-versa, in what you’re doing, or whatever?

I would say it’s a combination of both. They seem to be getting some traction in certain areas of the market, and we have recognized that not having more traction with Intel is a hole for us, and we’ve put a more concerted effort into some of our business development efforts and sales efforts with Intel.

And on those areas that are sort of more on the smart phone, primarily, area, or the phone side, where it’s a Symbian operating system, you’d have almost no participation there, correct?

That’s correct. Today, we do almost no Symbian work.

But in any case, just from my point of view, it looked like Intel was starting to make lots of noises, like they’re very serious about this market.

Yes. They’ve -- this happened about a year ago as well, and they made some traction, and we think that they will ultimately be successful, along with TI is another big player in that market, as well, and we intend to continue to focus on Intel.

Charlotte Sharp (ph).

On these mergers/acquisitions that you’re focusing on, are we going to see much issuing of shares to cover the cost for doing an acquisition, and some dilution here?

Well certainly, I would expect that any acquisition we do is likely to include some stock base, as opposed to all cash based. How large that might be, I really couldn’t tell you at this point. I would say we’re as sensitive as you are as a shareholder. Obviously, our interests are aligned, that we not do any stupid, for lack of a better word, deals. And also, by NASDAQ rules, if we need to issue more than 20% that’s stock, we would have to go to the shareholders for approval.

Right. You’re not looking at anything near that, would you be? I mean, I know you haven’t gotten into any real letters of intents or anything, but you are going to be very conservative on that realm, aren’t you?

Absolutely.

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When you said you allowed a little bit of attrition in the professional services area, can you give us sort of a headcount, like how many fewer people that might mean and what the overall headcount is sort of comprised of, vis-à-vis here in the states and over in Taiwan, and how that might shift over next quarter or two?

Sure. So it was approximately five heads in our service organization that we’re down, if you compare to the end of December. On a worldwide basis, as of the end of April, we were at about 113 total heads, and, of that, we had about -- we have about nine right now in Taiwan. I would expect to see a few more heads going to Taiwan, and the additional heads that we would put into the U.S. operation would either be likely contractors that we might hire to soak up as we win more service projects that we don’t have bench or we don’t have additional capacity for here, and also, we stated that we intend to hire a few more R&D engineers to support our R&D efforts as we go through the year.

And at the end of December, you had how many total heads?

I don’t have that in front of me, Hank. I think it was around 121.

About 115.

115, OK. The 113 number I have, Hank, includes -- let me make sure I’ve got this right. I think this includes contractors. It does, yes. So, we were at, without contractors, we’re at 108 right now, or at the end of April.

Overall, Hank, we’re down in headcount quarter-over-quarter, of which five of that, sort of eight-ish drop came out of the services area.

And just out of curiosity, as you find your book of business starting to look better on the services side, does it look such that you would be at sort of capacity utilization if things continue to go reasonably well through the quarter at the end of the quarter, or do you have still some bench to fill in, so to speak?

We potentially could get pretty close toward the end of the quarter. We’re -- capacity isn’t a perfect science. In our particular line of service work, we do -- we get sort of three types of services projects. We get what we call platform work, which is the lower level board-to-port package driver work, we get application work, and we get hardware work. And there’s three different types of engineers in our organization that fulfill those needs, and so, when we get work, if it comes in and sort of matches the quantity of engineers on hand in those particular areas, great, we’re fine, we’re right on. But occasionally, we’ll get into a situation where we have more platform work and not enough apps work. Well, the apps people can’t flip over well and perform platform work, so we’ll be over-utilized in one area and under-utilized in the other.

So, to answer your first question, yes, there is the potential, by the end of this quarter, we’ll be at capacity.

And in terms of being able to use less expensive, equally qualified, whatever, Taiwanese folk, can they fill bench seats in all three of those areas, platform, apps and hardware, or do they tend to be in one area or another?

The folks in Taiwan tend to be more platform-related. Apps folks -- I guess the good news about apps folks is that they tend to be a little bit easier to find. And so, we are able to typically go out into the market and find, either in the U.S. or, in the past, we’ve found people in India who could do applications work, and we still have a relationship with a partner in India that we can always use if we need to for applications work.

And the hardware work, do you primarily do there?

Hardware work, yes, we primarily do here in Bellevue. We do have a little bit of hardware capability in Taiwan, as well. But that’s not traditionally been an area where we’ve really gotten very backed up. Typically, platform work is where we tend to see most of the demand for our resources.

Thank you. Gentlemen, at this time, there are no further questions. Please go ahead.

OK, I think we will end the call, and thank you very much for your interest in BSQUARE, and we will talk to you again next quarter.

Thank you very much, ladies and gentlemen, and this concludes the BSQUARE 2005 first quarter conference call. If you would like to listen to a replay of today’s conference, please dial 1-800-405-2236, or 303-590-3000, and the pass code for the replay is 11028181. Once again, those numbers are 1-800-405-2236, or 303-590-3000, with a pass code of 11028181.

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