Bsquare Corp (BSQR) 2005 Q3 法說會逐字稿

Good day, ladies and gentlemen. My name is Holly, and I will be your conference facilitator today. At this time, I would like to welcome everyone to the BSQUARE Corporation third-quarter 2005 earnings conference call. All lines have been placed on mute to prevent any background noise. After the speakers' remarks, there will be a question-and-answer period. (OPERATOR INSTRUCTIONS).

It is now my pleasure to turn the floor over to your host, the Chief Financial Officer, Mr. Scott Mahan. Sir, you may begin.

Good afternoon and welcome to BSQUARE Corporation's third-quarter, 2005 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 the call as well as the text of our prepared remarks will be archived in the Investor Relations section of their Web site at 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 operating results 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; 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 acception (ph) of new products were initiatives; risks associated with the effects of our restructurings; our ability to successfully support our operations; competition, and intellectual property rights.

A more detailed description of certain factors that could affect actual results include but are not limited to those discussed in BSQUARE's annual report on Form 10-K for the year ended December 31, 2004 in the section entitled "Business Factors That Could Affect Future Results", and in our subsequent quarterly reports on Form 10-Q. 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 effects.

With that said, I will now turn to our results. I will focus my discussion today on this quarter's results as compared to the second quarter of 2005 with selected discussion of our results for the nine months ended September 30, 2005. During the discussion today, references to this quarter mean the third quarter of 2005; references to the second quarter mean the second quarter of 2005, while references to the fourth quarter mean the fourth quarter of 2005.

Let me start with an overview of our topline results. Total revenue was 10.1 million this quarter, compared to 10.6 million in the third quarter of 2004 and 10.3 million in the second quarter, decreases of 4.5% and 2.1% respectively. At a high level, total revenue was down sequentially due in large part to $525,000 OEM royalty segment, which impacted the second quarter, whereas revenue was down slightly year-over-year due to the fact that the year-ago quarter included 2.3 million in sales to Cardinal Healthcare, whereas this quarter included none.

As previously reported, Cardinal was our largest customer in 2004, representing 19% of total revenue, but moved their business to a competitor in the second quarter of 2005. Overall, total revenue came in about where we expected. As we mentioned in the second-quarter conference call, we expected softness in third-party and proprietary software sales but strength in our service revenue line in this quarter.

Encouragingly, we've seen an overall increase in activity since the end of this quarter and will quantify, to a certain degree, expected improvements in our revenue lines in the conversation today. These projections are not to be misunderstood for official guidance, but we believe that these are reasonable targets so as to judge the Company's performance.

Total revenue for the nine months ended September 30, 2005 was 30.2 million compared to 30.0 million in the prior year. The nine months ended September 30, 2005 included 828,000 in sales to Cardinal, whereas the prior-year period included 6.0 million. Sales to customers other than Cardinal increased 22% for the nine-month period.

Software revenue was 7.2 million this quarter, representing 71% of total revenue, compared to 8.1 million in the third quarter of 2004 and 7.8 million in the second quarter.

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 6.7 million this quarter or 93% of total software revenue, compared to 7.5 million in the third quarter of 2004 and 6.9 million in the second quarter. This quarter included no sales to Cardinal, whereas the second quarter included $83,000 and the year-ago quarter included 2.3 million. Consequently, sequential sales of third-party software were down marginally but up 29% year-over-year.

As we communicated on the second-quarter call, we expected softness in third-party software revenue this quarter, due to an anticipated drop in order volume from our most significant Microsoft licensing customer, as well as the $238,000 OEM royalty settlement, which impacted third-party software revenue in the second quarter. We anticipate a 10 to 15% increase in third-party software revenue in the fourth quarter, based on overall market strength.

Microsoft recently announced that mobile and embedded devices revenue was up more than 50% year-over-year, which speaks to some of the overall market momentum. Additionally, we recently entered into an arrangement that gives us access to a substantial list of North American customers with a history of purchasing embedded software. For every sale made to these customers, we will pay a referral fee through Q3 of 2006. Sales of these for proprietary software were down this quarter as we expected and communicated on the second-quarter conference call.

Specifically, proprietary software revenue was 491,000 this quarter, compared to 635,000 in the third quarter of 2004 and 970,000 in the second quarter. Sequential proprietary software revenue was down due to the $300,000 OEM royalty segment which impacted the second quarter, coupled with lower SDIO Now! revenue. We have been warning about potential SDIO Now! revenue softness now for several quarters, and we finally saw that materialize this quarter, as customers transitioned device designs from our older SDIO Now! product to our newer SDIO Now! 2.0 Platform.

Despite softness this quarter and potentially in the fourth quarter and early 2006, we remain confident regarding the longer-term revenue potential of SDIO Now! and our other proprietary products, which Brian will speak to in more detail later in the call. Although proprietary revenue remains a smaller topline contributor, proprietary software revenue growth is important to our overall strategy as it is extremely high-margin, recurring, and primarily addresses the high-growth converged device marketplace.

As we stated in the second quarter, we expect the proprietary software product acquired from Vibren to contribute 75,000 to 100,000 in revenue per quarter beginning in the fourth quarter, after the products have been fully integrated into our sales activities. These products generated $53,000 in revenue this quarter. We expect proprietary software revenue to increase 20 to 30% in the fourth quarter, depending on what sort of continued softness we see in SDIO Now! revenue.

The other significant component of revenue is service revenue. Service revenue was 2.9 million this quarter, compared to 2.4 million in the second quarter of 2004 and 2.5 million in the -- excuse me, 2.4 million in the third quarter of 2004 and 2.5 million in the second quarter, representing a sequential increase of 18%. If you exclude the impact of sequential changes in rebillable expense revenue, service revenue was up 534,000, or 22% sequentially, with most of that increase coming in North America.

This quarter represented the second straight sequential increase and our first real breakthrough in an area that has been a focus for several quarters. We've made a number of changes, primarily in the sales area, with the goal of increasing our service revenue line, which up until this quarter had been relatively stagnant. Improved sales activity, overall higher activity levels, the impact of the Vibren acquisition, improved market conditions and improved personnel utilization translated into a 41% sequential increase in worldwide billable hours and resulting service revenue.

Now, as I mentioned in our press release, we worked on 61 projects during the quarter, up 17% sequentially. This quarter's increase in billable hours was partially offset by a 10% decrease in our realized rate per hour. The decline in our realized rate per hour was driven by two factors. First, we ended the quarter with approximately 160,000 in revenue that couldn't be recognized for services that had already been performed. We expect to recognize this revenue in the fourth quarter.

Additionally, for various strategic reasons, we entered into two fairly sizable contracts in Asia-Pac where the upfront professional service revenue and resulting realized rate per hour are fairly low, in exchange for IP ownership and guaranteed (indiscernible) product royalties which should start impacting revenue in mid-2006. Service revenue from Asia-based customers was 97,000 this quarter, as compared to 25,000 in the second quarter, whereas billable hours were up 463% in Asia-Pac. These contracts will continue to impact our realized rate per hour in the fourth quarter. We expect worldwide service revenue to increase in the range of 10 to 15% in the fourth quarter, on a sequential basis, representing the third straight sequential increase, assuming we're not impacted extraordinarily by holiday slowdowns.

As discussed in the second quarter, we are in dispute with a customer regarding payment of amounts due under a contract under which we provided engineering services. We recognize service revenue from this customer of 615,000 for the six months ended June 30, 2005 and none this quarter. We have an Account Receivable outstanding with this customer of $475,000. As required under the contract, the parties engaged in the mediation proceeding in October 2005 in an attempt to resolve the dispute. The parties were unable to reach a resolution during the mediation, and we are currently exploring all options available to us to collect the amounts owed, including legal action. The Company believes that it has fulfilled all of its contractual obligations and believes it is entitled to collect all amounts due.

Now, I will turn to a discussion of gross profit margin. Overall gross profit this quarter was 2.3 million or 22.3% of total revenue, compared to 2.3 million or 21.8% in the third quarter of 2004 and 2.5 million or 24.5% in the second quarter. The software gross profit margin was 19.2% this quarter, compared to 21.3% in the third quarter of 2004 and 24.9% in the second quarter. Lower sales of our high-margin proprietary software product negatively impacted the margin mix this quarter, accounting for the sequential decline. Additionally, software cost of goods sold includes 51,000 in amortization of the Vibren intangible assets recorded in the second quarter.

Third-party software margin was approximately 14% in both this quarter and the second quarter and was down about 0.5 point compared to the third quarter of 2004. As we have said previously, sales of Microsoft embedded operating systems are extremely competitive, will remain competitive in the foreseeable future and it is unlikely we will see any margin improvement in third-party software without the addition of non-Microsoft third-party products to our product mix. Although it's difficult to predict at this time, we may see a small decrease in third-party software gross margins in the third quarter as margins from customers accessible through the customer referral arrangement discussed previously tend to be slightly lower than our own legacy account base.

Service gross profit margin was 30% this quarter, compared to 24% in the third quarter of 2004 and 23% in the second quarter. In absolute dollars, service revenue contributed 879,000 in gross profit, as compared to 572,000 in the third quarter of 2004 and 580,000 in the second quarter.

The service cost of sales base increased 232,000 sequentially when the impact of rebillable expenses is excluded, over half of which related to increased costs associated with personnel acquired as a result of the Vibren acquisition. The sequential increase in service gross margins was driven by higher revenue volume and improved personnel utilization, although the overall utilization for the quarter was still below our internal target due to underutilization early in the quarter in some geographic and practice areas. The incremental margin achieved on this quarter's service revenue increase was 56%, demonstrating some of the leverage attributable to our service revenue line.

Utilization continued to improve late in the quarter and into the early part of the fourth quarter, and we've been adding engineering headcount to deliver on increased demand. We have stated previously that our goal is to improve service margin to 35% and higher on a quarterly basis. Had we recognize the 160,000 in service revenue that was deferred for revenue-recognition reasons, we would've been very close to that goal this quarter.

Moving down the P&L, let me discuss our operating expenses. Operating expenses were 2.8 million this quarter, compared to 2.4 million in the third quarter of 2004 and 2.6 million in the second quarter. Roughly half of this sequential increase came as result of increased payroll, facilities and other operating costs associated with the Vibren acquisition. The remainder came from a slight increase in R&D expense, as well as increases in professional fees and recruiting costs. All of the increase in OpEx was expected and discussed in prior calls. We expect to increase R&D expense prudently on a go-forward basis in support of our product initiatives. We also expect a slight increase in other OpEx, such as referral fees, facility costs, international sales cost, and travel and entertainment, such that, in total, we expect OpEx to increase approximately 5 to 10% in the fourth quarter, depending on the ramp of our R&D activities.

One of the items discussed on recent conference calls has been the impact of Financial Accounting Standard 123R. FAS 123R requires stock options to be recognized as expense in our financials, based on the fair value, which contrast to our current accounting method, which generally requires no expense recognition. BSQUARE will adopt this new standard in the first quarter of 2006. We have not decided on an adoption methodology, but we do expect these options to have a material non-cash effect on our operating results.

During the quarter, we incurred no income tax expense related to our Taiwan subsidiary, although we have incurred 66,000 year-to-date. The Taiwan subsidiary has been increasingly profitable and earlier in 2005 fully utilized the net operating losses it generated in previous years. Also in the second quarter of 2005, we were informed that certain amounts remitted or that were planned to be remitted from our Taiwan subsidiary to the U.S. parent related to SDIO Now! software sales might be subject to withholding tax of 20%. We are currently applying to the government of Taiwan for withholding exemptions on all significant contracts, which would eliminate any significant withholding on these amounts, and received approval for our first such exemption in October. Such exceptions are applied for with respect to each individual customer contract and require that we submit certain documentation to the Taiwan authorities. In reviewing the Taiwan tax regulation and in consultation with our tax advisors, we believe that we will be granted such exemptions. However, there is no assurance that any additional exceptions will be granted or that exceptions will be granted covering all customer contracts for which we will be seeking exception. We are continuing to evaluate and take action on alternative tax planning strategies to minimize corporate income and withholding tax resulting from the activities of our Taiwan subsidiary. We expect some but not a significant amount of corporate income tax expense to flow through from our Taiwan operations in the fourth quarter. If the results of our withholding exemption application are not successful, we could see a significant amount of tax or withholding expense in the future.

We expect other income, primarily interest income on our cash and marketable securities, to approximate this quarter's run-rate in the fourth quarter.

Looking at the bottom line, the Company reported a net loss for the quarter of 469,000, or $0.05 per diluted share, compared to net income of 208,000 or $0.02 per diluted share for the third quarter of 2004 and a net loss of 37,000 or $0.00 per diluted share for the second quarter.

For the nine months ended September 30, 2005, the Company reported a net loss of 1.1 million, or $0.11 per diluted share, compared to a net loss of 7.1 million or $0.75 per diluted share for the first nine months of 2004, which included losses of 6.3 million from the now-discontinued hardware business unit. There was no activity for the hardware business unit in 2005.

Now, let me turn to the balance sheet. Our cash and cash equivalent and short-term investments were 10.2 million at September 30, 2005 compared to 11.8 million at June 30, 2005, 1.2 million of which is restricted. In total, we were down 1.6 million from June 30, 2005, whereas our Accounts Receivable balance increased by 1.7 million.

As we have mentioned previously, our cash and working capital positions are extremely sensitive to the amount and timing of sales of Microsoft embedded operating systems within the quarter. As we mentioned in our press release, this quarter was a prime example of that sensitivity. Sales of Microsoft embedded operating systems were extremely low in August but rebounded strongly in September, resulting in the buildup of our quarter-end AR balance and negative impact on cash. We expect to make up a good portion of this quarter's cash shortfall in the fourth quarter as we collect these receivables.

Additionally, although we can't say with certainty, we don't anticipate any peaks and valleys in Microsoft embedded licensing revenue in the fourth quarter and in fact are off to a strong start for the month of October. We don't expect significant CapEx in the fourth quarter and we have no outstanding debts.

Now, I'd like to turn the call over to Brian.

Thanks, Scott.

Today, I will discuss a number of topics, including SDIO Now! Version 2.0 and SDIO Now! for Linux, progress on our other products initiatives, progress in our service revenue, the renewal of our OEM distribution agreement with Microsoft, and our NASDAQ listing status. I will also update the integration activities of the acquisition of the embedded assets of Vibren Technologies, and I'll wrap-up the call with some comments on our business outlook.

We continued to expand our SDIO Now! productline during the quarter with the announcement of the availability of SDIO Now! for Linux. To remind you, SDIO Now! is the software that enables the use of multimedia card and secure digital memory cards for storing pictures, video and data, as well as the use of secure digital input/output peripheral devices such as digital cameras, GPS receivers and WiFi cards on mobile devices.

We expected some softness in SDIO revenues this quarter for a couple of reasons. First, we changed our SDIO licensing model, such that we are no longer offering customers one-time royalty buyouts as we did with our Version 1.0 technology and which several of our largest OEM customers took advantage of. Second, OEMs are evaluating our new SDIO technology against the basic technology embedded in the Microsoft Windows Mobile 5.0 product. We continue to believe that our solution is superior to the basic technology in Windows Mobile 5.0 and once the evaluations are complete, we believe that we will see additional adoption by OEMs.

Our SDIO Now! product for Linux announcement is significant, as BSQUARE has historically only provided its SDIO product for devices running Windows CE and Windows Mobile operating systems. By entering the Linux market, we expand our potential growth opportunities, as we offer our SDIO technology on this expanding software platform. We expect to see SDIO demand pick up in the first quarter of 2006, as our customers adopt our Version 2.0 technology on both Windows and Linux.

Now, I would like to update you on our product development efforts. As we have discussed previously, our product development efforts fall into two main areas -- reference designs that our customers adopt as the foundation of their device development efforts and device software, such as SDIO Now! and schema that was acquired earlier this year from Vibren. We sell our device software on a stand-alone basis and will also be funding this software with our reference designs.

We continue to make good progress on our reference design initiative. We currently have one reference design in the market, DevKit IDP acquired from Vibren, and we have three reference designs under development. The first design under development is a Next Generation Intel PSA270-based reference design which will be sold into wireless and handheld applications, such as retail and industrial automation, as well as other general embedded applications such as Telematics, medical and military cost applications.

Our Next Generation reference design is best off the acquired DevKit IDP technology and adds incremental wireless capabilities. We expect to fully announce this design by the end of the year and expect this product to contribute to revenues starting in Q1, 2006.

BSQUARE has also signed a joint development agreement with a Taiwan-based customer for the creation of an Intel PXA270-based reference design with advanced wireless communications capabilities. Under this agreement, BSQUARE will own the IP resulting from the project. This reference design will enable BSQUARE to serve customers creating products that require more advanced wireless communications, such as GSM and CDMA wide-area communication. We also expect to fully announce this design early next year and expect this product to contribute to revenues in the second half of 2006.

As we mentioned last quarter, we're working on developing a reference design aimed at the portable media player market for handheld media players. In addition to the handheld player market, BSQUARE believes that there are potential opportunities to provide portable media player technology into set-top boxes and converged mobile device applications, which should serve to expand the overall market opportunity.

I am happy to report that we signed our first customer, an Asian OEM, for our PMP reference design, or our Portable Media Player reference design, and we continue to work on building our sales pipeline. We expect a full announcement of our PMP reference initiative shortly and expect our PMP reference designs to contribute to revenue in the first half of 2006.

The business model for our reference designs is an upfront development kit purchase defined combined with upfront non-recurring engineering, followed by royalties as products shift. As mentioned earlier, we expect to see revenue from our reference designs starting early in 2006. However, we believe that the revenue ramp for our reference design initiatives will happen in the second half of 2006, as our customers are able to adopt our designs and put their resulting products into production. As stated last quarter, we believe that we can generate 3 to 5 million in incremental product and service revenue from our reference design initiatives in 2006 with approximately 1.1 million of that expected revenue already booked to date.

Now, looking at our services business, activity was strong in the quarter and the strength has continued into October. As Scott mentioned earlier, we saw sequential increases in the number of billable hours, as well as the actual number of service projects we worked on. Some notable accomplishments in the service areas include -- we completed an agreement with an offshore partner in India, giving us additional engineering capacity at an attractive price; we have started executing service projects with this partner during the fourth quarter and expect that this partnership will continue to grow.

We worked on 61 projects during the quarter, ranging from videophones based on Windows CE to smart phones based upon Windows Mobile. Our customers during the quarter included well-known OEMs such as Motorola, silicon vendors such as Intel and AMD, and other OEMs who are creating a wide variety of Windows Mobile and Windows embedded devices, including at least one OEM who is new to the Windows Mobile space, having previously offered devices on other operating systems.

We executed our first service project with Intel in the quarter. This project represents the first significant engagement that the Company has done for Intel and is a direct result of our acquisition of Vibren's embedded business. We are currently working with Intel on several new opportunities and expect this exciting relationship to strengthen going forward.

Overall, we've taken our service business from being underutilized earlier this year to being oversubscribed in the fourth quarter. We continue to see strong demand for our services, and we are aggressively looking for additional talent to fulfill the opportunities that our sales organization is bringing in the door.

Moving to our third-party software revenue line, during the quarter, we successfully renewed our OEM distribution agreement with Microsoft. This allows us to continue to distribute Microsoft's complete line of Windows embedded operating systems to North America OEMs. BSQUARE continues to enjoy a good relationship with Microsoft, and the renewal of this agreement signals that both BSQUARE and Microsoft view the agreement as a strategic partnership that benefits both companies.

As the only North America value-added reseller that is primarily a software company, BSQUARE expects that customers who purchase Windows embedded operating systems will continue to be prospects for BSQUARE's other products and services. Also, based on Microsoft's continued effort and success in growing market share for Windows embedded operating systems, BSQUARE expects to continue to grow sales of Windows embedded operating systems in Q4 and into 2006.

Turning to issues regarding our continued NASDAQ listing, we made the difficult decision in October to enact a one-for-four reverse split in order to increase the price of our stock and meet the NASDAQ's minimum bid price continued listing requirement. As a result of our decision, the number of outstanding shares was reduced from 38.1 million shares to approximately 9.5 million shares. Following this reverse split, we regained compliance with the continued listing requirement and were advised by NASDAQ that we are now in compliance with all NASDAQ continued listing requirements.

To update you on our Vibren acquisition, as a reminder, we announced on June 30 that we had acquired in the embedded assets of Vibren Technologies for 500,000 in cash. In return, we received several products, a number of in-process service contracts, Vibren's embedded customer list, and we hired eight new employees based in Akron, Ohio. This acquisition increases the range of products and services that we can offer to customers and fits nicely into our product development roadmap. Integration activities are essentially complete at this point, and our Akron office is fully functional as a BSQUARE satellite office.

During the quarter, we generated approximately 240,000 incremental revenue from the Vibren acquisition with 53,000 coming from sales of Vibren products and the remainder, service revenue, from customers acquired through the acquisition.

As mentioned earlier, we are utilizing DevKit IDP technology in our Next Generation reference designs, and we will be integrating the schema product into our reference designs as a bundled solution. Additionally, we've made important strides with several customers who transitioned to BSQUARE, the most notable customer being Intel.

Now, I will wrap up the call by providing some comments on our business. Activity in our core business is strong. We believe that this is a result of not only strength in our customers' businesses but also a result of our focus on improving the leadership and quality of our sales team. Based on the good start to the fourth quarter, we believe that it is possible to see a 10 to 15% growth in our sequential topline results in Q4. It is our intention to continue to carefully manage our current business while investing in new initiatives that we believe will provide future growth. We expect that our investment will be prudent and will not significantly change the operating posture of our business in the near term, but will be positive for our business in the long term.

That ends the prepared portion of the call today. These prepared remarks will be posted to the Investor Relations section of our Web site at www.BSQUARE.com.

I would like to thank everyone for their time today and continued interest in BSQUARE.

Holly, we will now open the call for questions.

Thank you, sir. (OPERATOR INSTRUCTIONS). Gentlemen, it appears we've no questions.

Okay. Well, thanks, everybody, for your time, and we will talk to you again next quarter.

Thank you. This concludes today's BSQUARE conference call. You may now disconnect.