Bsquare Corp (BSQR) 2005 Q4 法說會逐字稿

Good day, everyone and welcome to the BSquare Corporation fourth quarter and year-end 2005 financial results conference call. As a reminder, today's conference is being recorded. [OPERATOR INSTRUCTIONS] It is now my pleasure to turn the call over to Mr. Scott Mahan, the Chief Financial Officer for BSquare Corporation. Please go ahead, sir.

Good afternoon. And welcome to BSquare's fourth 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 this call, as well as the text of our prepared remarks will be archived in the Investor Relations section of 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 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 markets to develop as anticipated, adverse changes in macro economic 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 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, in our subsequent quarterly reports on Form 10-Q, and in other SEC filings.

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.

Now, I will provide a recap of our financial performance for the fourth quarter and fiscal 2005, and highlight some key metrics. During the discussion today, references to this quarter, or the quarter, mean the fourth quarter of 2005, references to the third quarter, mean the third quarter of 2005, while references to the first quarter mean the first quarter of 2006. The majority of my discussion today will focus on our quarterly results.

Let me start by speaking to the progress we have made in growing and diversifying our revenue base. Total revenue for the quarter was 12.7 million, an increase of 42% from the 8.9 million reported during the fourth quarter of 2004, and a 26% increase from the 10.1 million reported in the third quarter. The fourth quarter of 2004 included 1.4 million in sales to Cardinal Healthcare, compared to none for the third and fourth quarters of 2005. Cardinal, which represented 19% of revenue in 2004, and only 2% this year, began purchasing from a competitor in the second quarter of 2005. As previously mentioned, we have made a concerted effort to broaden our account base and further penetrate our existing customer base, especially in our third party software revenue line. Those efforts paid dividends as sales to customers other than Cardinal increased to 69% year-over-year. From a revenue mix perspective, software revenue was 8.8 million this quarter. This included 8.2 million in sales of third party software products, primarily Microsoft embedded operating systems. The 8.8 million in software sales compares to 6.5 million in the fourth quarter of 2004, and 7.2 million in the third quarter, which included 5.8 million and 6.7 million in sales of third party software respectively.

Excluding sales to Cardinal, third party software sales increased 85% compared to the fourth quarter of 2004 and 23% sequentially. The significant comparative revenue increase was due to further penetration within the Company's existing customer base, new customer acquisitions, improved sales execution, and the beneficial impact of a customer referral relationship which began this quarter. Proprietary software revenue was 601,000 this quarter, compared to 682,000 in the fourth quarter of 2004, and 491,000 in the third quarter. Lower sales of the Company's SDIO Now! product accounted for the decrease as compared to the prior year, whereas increased reference design revenue, and revenue growth associated with the products acquired from Vibren accounted for the sequential increase.

We expected slower SDIO Now! sales as a function of our upgrade to the SDIO Now! 2.X product and Microsoft's introduction of a competing technology in its recent operating system release. This quarter included 185,000 in reference design royalty revenue generated from a single customer. This customer also placed a one-time royalty order of this size in the fourth quarter of 2004, and we anticipate additional orders in the future, but not in the first quarter. Service revenue for the quarter was 3.9 million, a 63% increase compared to 2.4 million in the fourth quarter of 2004, and a 33% increase compared to 2.9 million in the third quarter.

The increase was attributable to higher activity levels driven by overall market strength, higher realized rates per hour, sales improvements, improved personnel utilization, and strength in Asia Pacific service revenue. We saw an increase in billable hours of 71% year-over-year, and 12% sequentially. As we worked on 71 projects during this quarter, 10 more compared to the third quarter. The realized rate per hour increased 15% sequentially this quarter, recapturing the entire decline experienced in the third quarter. As we noted in our last call, we ended the third quarter with approximately 160,000 in service revenue we couldn't recognize, which beneficially impacted this quarter at both the top line, our service margin and in our realized rate per hour.

Turning to gross margins, overall gross profit this quarter was 3.2 million, or 25.2% of total revenue. Compared to 2.1 million, or 23.7% in the fourth quarter of 2004, and 2.3 million or 22.3% in the third quarter. Overall gross margins increased primarily due to improvements in service margins which I will speak to in a second. High revenue line for the quarter, software gross margin was 18.8%, compared to 24.4% for the fourth quarter of 2004, and 19.2% for the third quarter. Overall comparative software margins were down due to a lower mix of high margin proprietary software revenue to total software revenue.

Third party software margin was 13.6% of revenue this quarter, down from 15.6 in the fourth quarter of 2004 and 14.2% in the third quarter. Third party software margins fell slightly sequentially due to several large low margin orders captured through the referral relationship mentioned previously. Service gross margin was 39.5% this quarter, compared to 21.8% in the fourth quarter of 2004, and 21.9% in the third quarter. Service gross margin would have been roughly 36% without the benefit of the 160,000 in deferred revenue beneficially impacting this quarter. Service gross margins showed continued improvement from the third quarter, resulting in the attainment of our stated goal to achieve 35% service gross margin or higher, on a quarterly basis by the end of 2005.

Taking a look at operating expenses, operating expenses were 3.6 million for the quarter, compared to 2.1 million in the fourth quarter of 2004, and 2.8 million in the third quarter. SG&A expenses increased 636,000 sequentially, of which 399,000 related to bad debt expense, taken against a customer receivable, currently the subject of litigation. The remainder of the increase was driven by 105,000 higher commissions and bonuses resulting from higher sales, higher recruiting costs to support increased hiring and higher professional fees related to stock split, audit, and litigation activities. The remainder of the sequential increase was driven by 131,000 in increased R&D expenses. This R&D investment included our DevKit IDP 270 reference design and portable media player development efforts. A good portion of the SG&A operating expense increase seen this quarter we expect to be relatively nonrecurring. As further commentary on the bad debt expense mentioned above and previously discussed, the underlying account receivable in question relates to a services engagement, the bulk of which incurred in the first half of 2005.

During the second quarter, and throughout the rest of the year, we tried to reach resolution on this matter and collect the amount outstanding, but we're ultimately forced to pursue legal action. While we believe we have a strong contractual and legal position to enforce collections, and intend on exercising all prudent options available to us, we deemed it appropriate to reserve for this receivable in the quarter, given concerns regarding the customer's long-term viability. We have historically experienced a very low level of bad debt, or customer disputes with none approaching this magnitude. Now, I will speak to our bottom line results.

The Company reported a net loss for the quarter of 246,000, or $0.03 per share, inclusive of the 399,000 bad debt expense. This compared to net income of 77,000, or $0.01 per share in the fourth quarter of 2004, which included 55,000 in income from discontinued operations. The Company reported net loss of 469,000, or $0.05 per share in the third quarter. Now, I will provide a brief recap of the full-year results.

Total revenue for fiscal 2005 was 42.9 million, which included 831,000 in sales to Cardinal, compared to 38.9 million in 2004, which included 7.4 million in sales to Cardinal, representing a 34% year-over-year increase in revenue generated from customers other than Cardinal. Total software revenue for 2005 was 31.2 million, up 9.9% from 28.4 million in 2004. Sales of third party software products, primarily Microsoft embedded operating systems, represented 92% of software revenue in 2005, and increased 11.3% from the prior year.

Excluding sales to Cardinal, third party software sales increased 52% year-over-year. Proprietary software sales were 2.6 million for fiscal 2005, as compared to 2.7 million in 2004. Service revenue was 11.7 million this year, as compared to 10.6 million in 2004, representing an 11% increase. The majority of the year-over-year growth occurred in the second half of 2005, for reasons mentioned earlier.

Overall gross profit for fiscal 2005 was 9.9 million, or 23.0% of total revenue, compared to 9.0 million, or 23.2% in 2004. Improvements in service gross profit accounted for the overall dollar improvement. Operating expenses for fiscal 2005 were 11.5 million, or 26.7% of total revenue, compared to 10.1 million, or 25.9% in 2004, an increase of 1.4 million. R&D expense increases of 128%, to support the Company's increased focus on its software products, accounted for 1.1 million of the increase, with the remainder primarily attributable to higher sales expenses. For fiscal 2005, the Company reported a net loss of 1.3 million, or $0.14 per share, compared to a net loss of $7.1 million, or $0.74 per share in 2004, which included a loss from discontinued operations of 6.3 million, $0.66 per share. While the Company's loss from continuing operations increased in fiscal 2005 as compared to the prior year, the primary driver of this was increased R&D expense, which Brian will speak to later. Now, let me turn to the balance sheet.

The Company's cash and cash equivalents and short-term investments increased to 10.7 million at December 31, 2005, as compared to 10.2 million at September 30, 2005, and 12.9 million at December 31, 2004. 1.2 million of our cash continues to be restricted as mandated by our corporate lease. The sequential cash increase was driven by improvements in receivables collections and increases in the royalty payable to Microsoft at quarter end compared to the third quarter. The full-year decrease of 2.2 million in cash was attributable to the net loss of 1.3 million, 500,000 paid to acquire the assets of Vibren Technologies in the second quarter of 2005, 226,000 in capital expenditures, and negative full-year changes in working capital.

The Company's cash flows and working capital are sensitive to the timing of Microsoft embedded operating system sales in the quarter due to collection patterns and the timing of royalty payments to Microsoft. DSOs for this quarter were 52 days compared to 50 days last year, and 69 days in the third quarter. DSOs improved sequentially due to improved collections, and a heavy concentration of sales late in the third quarter. Before I end my remarks, I would like to comment on three matters.

The first is our upcoming FAS 123-R which will be effective in the first quarter. As background, FAS 123-R requires that we expense the fair value of stock options versus our current method of accounting. We currently anticipate that we will adopt FAS 123-R using what is referred to as the modified prospective method of adoption, whereby we will recognize expense in the first quarter and future quarters but will not restate any of the prior periods presented. We also anticipate valuing our stock options using the Black-Scholes-Merton valuation methodology and amortizing related expense using the straight line method. We currently estimate our FAS 123-R noncash expense to be approximately 150,000 to 200,000 for the first quarter, and 600,000 to 800,000 for fiscal 2006.

The second matter is Sarbanes-Oxley section 404 compliance. In 2005, the SEC delayed 404 compliance for companies of our size, until December 31, 2007, and also formed the advisory committee for smaller public companies. In February, 2006, the advisory committee published a draft report of its recommendations. As it relates to public companies of BSquare size the advisory committee recommended that 404 compliance be eliminated entirely. The advisory committee is expected to finalize its report in April, 2006, after which the SEC will consider its recommendations. Should the SEC not adopt the advisory committee's recommendations, or delay in its consideration thereof, we expect to begin our 404 compliance activities in mid 2006. It is difficult to predict the timing of the costs associated with these compliance activities but they would be substantial, and would primarily affect 2007 results.

Lastly, I would like to comment on one tax-related item previously discussed and noted in our public filings. In the second quarter of 2005 we became aware 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. Since that time, we have received three additional approvals. Such exemptions are applied for with respect to each individual customer contract. Based on review of the Taiwan tax regulations, consultation with our tax advisors, and our successes to date, we believe that we will be granted the remaining exemptions. However, there is no assurance that the additional exemptions will be granted.

As of December 31, 2005, we estimate our liability exposure for these withholding taxes to be 261,000, plus potential interest and penalties. We are continuing to evaluate and take action on alternative tax planning strategies to minimize corporate income tax and withholding tax, resulting from the activities of our Taiwan subsidiary. Now, I would like to turn the call over to Brian.

Thanks, Scott. I will take a few minutes to update our view of the overall market for providing software and services to smart device makers and then I will discuss specific initiatives and progress in our business. During the fourth quarter, we reported not only the highest quarterly revenue since the third quarter of 2001, but we also further diversified our revenue base. Our software and service business segments are no longer exposed to one customer having the ability to dramatically impact our overall performance.

During 2006, we expect to see strong demand for our products and services, as we believe that market demand for converged devices with advanced functionality will continue to grow. We also believe that Microsoft will continue to gain market share, with their Windows embedded and Windows mobile operating systems, which bodes well for overall business. Our own experience in the market shows that Microsoft is continuing to win significant new designs. For example, in Q4, Microsoft and Palm announced the Palm Trails 700W device, based on the Windows mobile operating system. BSquare has been working with Palm to create this device for a number of quarters. BSquare performed substantial engineering work on several important subsystems of this device, including the audio power management systems and worked with Palm to create several new applications.

This is a great example of how a tier one OEM turned to BSquare for its expertise as a gold level Windows mobile systems integrator. We currently have other engagements of this type with well-known OEMs that we are not able to disclose until products actually begin shipping.

Now, to speak to specific product and service initiatives in our business. In previous quarters, we have discussed our expectation that we would see a drop in SDIO Now! revenue. Those that have followed BSquare will remember that by prior agreement with Microsoft, version one of our SDIO product was included in the recently released Windows CE5.0 and Windows Mobile 5 operating system. This left customers with a choice of using the Version 1 SDIO technology embedded in the operating system or licensing from BSquare our Version 2 product. Compared to Version 1, our latest SDIO product more than doubles the performance of SDIO devices, and adds functionality, such as data security, and support for multiple SDIO devices using a single host controller. This additional functionality allows our customers to offer higher performance and more features while lowering the manufacturing costs of their devices.

We have always expected that our Version 2 product would be compelling enough to convince customers to use our version, versus the free version from Microsoft. During the quarter, we demonstrated this to be true when we announced that Hewlett Packard had begun adoption of SDIO Version 2.1 across their iPAQ hand-held product line. We have several other SDIO customers who have agreed to adopt our Version 2 product and are in the process of embedding our SDIO technology in their devices. As these devices begin shipping in Q1, and throughout 2006, we expect our recent SDIO revenue run rate to grow. We have also continued the development of new SDIO technology, and during 2006, we expect to release enhanced versions of our product, providing even better performance, and additional functionality enhancements, that will further cement our value proposition to customers. Now, I would like to update you on the progress of our reference design initiatives.

A reference design consists of pre-packaged hardware and software, tailored to service specific markets. The hardware may be created by BSquare or come from a partner. BSquare creates the core reference design software, and may integrate other third party software in order to create a more complete solution. Customers license the reference design, and using either internal resources, or with the help of BSquare's service organization, modify the software and hardware to suit their particular needs. By starting with the pre-packaged solution, customers are able to quickly get their products to market, with increased quality, and less risk. We base our reference designs on Microsoft's Windows embedded and Windows Mobile operating systems, and add specific functionality that we believe will be important to targeted verticals that are experiencing high growth.

During the second half of 2005, BSquare began to invest in a series of reference designs targeting the hand-held wireless, and portable media player markets. The business model for our reference designs includes a modest upfront fee to license the design, and then a per unit royalty, when customers begin shipping their product, using our technology. During the fourth quarter, we announced our portable media player or PMP reference design initiative. Our PMP product is a hand-held form factor, digital media management player, that is based on Microsoft's Windows CE core operating system. The first version of our PMP is being created in conjunction with AMD, using the AMD Alchemy Au1200 development platform. The combination of BSquare's PMP software, Microsoft Window CE, and the AMD hardware gives OEMs the ability to swiftly create full featured innovative PMPs with minimal risk and reduced time to marked and cost.

We have previously announced our first customer for our PMP reference design and we recently demonstrated our PMP solution for the first time at the consumer electronics show. We have received strong interest in our PMP solution and are continuing to work on signing new customers. We have also announced our efforts in conjunction with Intel to create new versions of our DevKit IDP reference design for the Intel PXA 270 X scale processor. This new product, the DevKit IDP 270 is a full featured reference design, optimized for wireless hand-held applications, such as data collection devices and wireless PDAs. Just this week, we demonstrated our DevKit IDP 270 reference design at the Intel design forum and have received strong interest in the solution from customers. We expect to release our DevKit IDP 270 reference design in early 2Q. DevKit IDP 270 is a great example of how we are teaming with Intel on future reference design efforts. We are currently working with Intel on a new version of our DevKit IDP for Intel's forthcoming Monahan processor family and are looking to tailor this reference design with specific functionality, needed to be successful in vertical markets that we believe will offer growth opportunities.

In 2006, you can expect that we will continue to expand the depth and breadth of our reference design offerings. We expect to add additional software functionality to our reference designs, such as expanded board support functionality, using our Schema software product, middleware functionality that expands on our SDIO technology by offering additional storage and security options, and additional application functionality. We remain enthusiastic about our reference design strategy, as we believe that the demand for converged mobile devices of all types will continue to grow. Given the continued shrinking of design and product lead times, we believe that OEMs are increasingly turning towards outsourced solutions, in order to reduce time to market and development risk.

We are also happy to report that our reference design strategy is allowing us to develop a closer relationship with Intel, which historically has been nonexistent. We recently announced that we have been accepted by Intel as a member of the Intel storage community, and through this partnership, we are already providing services to OEMs creating products using Intel's IXP line of X scale IO processor. Even more recently, BSquare has been accepted as a bronze member of the Intel Communications Alliance, a community of developers dedicated to building standards-based solutions on Intel's embedded technologies. We expect that our growing Intel relationship coupled with BSquare's reference designs supporting Intel processors will lead to many additional business opportunities in 2006.

As Scott mentioned earlier, we experienced a strong demand in the quarter for our professional services. This demand was driven by continued strong investment by our customers in new device development efforts and also by good execution from our sales team. Demand was so strong that finding adequate engineering talent to deliver the services became an issue during the quarter. In Q1, we have experienced a couple of customer initiated project delays. However, we expect that demand for our services will remain strong throughout 2006, and in response, we have been expanding our service delivery capabilities, in Bellevue, Taiwan, Akron, as well as with our offshore service partner in India.

As we look at the sales of our third party software for the fourth quarter, and the full year, you will remember that we experienced the very public loss of Cardinal Healthcare as a customer during the second quarter of 2005. Despite this loss, we were able to target new opportunities and grow our customer base, such that we accomplished our objectives of growing Microsoft licensing revenue without Cardinal, as well as growing our overall third party software revenue without taking on the risk of another 10% revenue customer.

During the fourth quarter, we worked with an industry partner to set up a customer referral program that gave us access to a new list of customers purchasing Microsoft licenses, and other third party software. This allowed us to add incremental business in the quarter, and was one of the drivers of our third party revenue growth. We are one of only four companies that are authorized by Microsoft to distribute embedded Windows licenses. The other authorized companies are largely -- are large distributors primarily focused on component and hardware distribution. Our focus on software and our deep technical depth in Microsoft operating systems differentiates us as we are able to offer customers software, training, and services, bundled with Microsoft licenses.

Throughout 2006, we expect to bundle new offerings such as our reference designs with our third party license sales in order to further differentiate our offerings. We made a conscientious decision during 2005 to increase our spending on R&D, so as to increase our offerings of proprietary products. We are getting very close to introducing those products to the market and are ready to start generating return on our invested capital. We are beginning to demonstrate our reference designs to our customers, and expect our product efforts to begin to pay off starting in the second quarter. With defined -- with definable growth prospects in our software and service revenue lines we are expecting to report meaningful profitability for the year.

Before I wrap up, I would like to spend a few minutes speaking in more depth to our short and longer-term outlook for the business. As we mentioned in our press release, we are expecting a near-term sequential decline in total revenue. This is primarily driven by a decrease in third party software revenue, driven by two factors. First, one of our large customers is forecasting lower order volumes based on current inventory levels, and second, we took several significant orders from new customers this quarter resulting from our referral relationships which won't occur in the first quarter. Despite the sequential decline for the year, we are expecting to grow our third party software revenue in line with industry rates of approximately 10 to 15%.

On the proprietary software revenue front, we are anticipating revenue to be flat to up slightly sequentially for the first quarter, based on renewed strength of SDIO Now!. As we move into Q2 and more significantly Q3, we are looking to add additional incremental revenue as our reference designs come to market and our SDIO revenue increases. Excluding the effect of the $160,000 in revenue which impacted this quarter, we expect service revenue to be roughly flat sequentially, in the first quarter, due to customer driven delays and a couple of large service projects. For the full year, we are expecting service revenue to increase and exceed the levels seen in the fourth quarter. In total for the first quarter, we expect to see total revenue decline sequentially from the fourth quarter, by 10% to 15%, but increase from 10% to 16%, versus the first quarter of 2005.

Regarding margins, we expect a rebound in third party software margins in the first quarter to roughly reach third quarter levels. Sales of third party software remains competitive, and we do not expect to increase margins significantly during the year. And in fact, could potentially see small margin declines. We expect that sales of our proprietary software will continue to yield 90% plus gross margins during the year. We are projecting a sequential drop in service margins in the first quarter based on lower revenue an increased in fringe benefits expense of approximately $160,000, as well as the fact that we have been ramping our service engineering head count in anticipation of several large contracts that we have started in the first quarter or expect to start over the next month.

As we have commented in the past, in the first quarter of each year, our fringe benefit costs increase due to FICA and state unemployment insurance and then tail off over the year. Based on the dropping fringe expenses during the year, our expectation of growing service revenue, and a fixed overhead in our service cost of sales, we expect service margins to ramp back to Q4 levels in the second half of the year lacking any competitive rate pressure. We expect operating expenses to be down sequentially in the first quarter, due to the absence of the aforementioned bad debt expense. Further, we are anticipating decreases in bonus and commission expense, professional fees, and entertainment costs, offset partially by an increase in fringe benefit costs in the first quarter. Overall, sans the bad debt expense in Q4, we expect G&A to remain roughly flat for the year. We expect to make small incremental sales investments during the year, based upon opportunity. We are currently expecting no significant sequential increase in R&D in the first quarter. Based on opportunity, we may make small incremental additions to our R&D team, however we will not be ramping R&D at the levels we saw in 2005. Not factored into our sequential estimates of service cost of goods sold and operating expenses is our FAS 123 stock option noncash expense costs which Scott discussed previously.

Going forward, we expect our cash flow from operations to closely approximate our bottom line performance, with the exception of working capital impacts from a Microsoft licensing sale. We aren't currently projecting any significant CapEx or other nonoperating cash expenditures in the near term. As we have stated in the past, we could spend cash on M&A or partnership activities but any related outflows are difficult to predict. We are striving to run our business profitably for the full year 2006, and we believe that the investments we have made in sales and R&D during 2005 have put us in a position to accomplish that goal. That 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.

[OPERATOR INSTRUCTIONS] Our first question comes from Orin Hirschman with AIGH Investments.

Hi, congratulations on the progress.

Thanks, Orin.

Let's see. In terms of -- a couple of areas I want to ask questions about. In terms of -- you mentioned that software hopefully will begin to grow in the SDIO Now! area. Talk to us in terms of royalties. The existing customer as mentioned, they pay yearly royalties, quarterly royalties? And when do we hope again to see royalties from some of the new designs?

So you were breaking up a little bit on us. I think you asked do customers pay yearly royalties or quarterly royalties and when do you expect to see royalties pick up again?

Yes. In other words you mentioned customer royalty -- you had -- one customer had royalties this quarter. Now that is a quarterly from that customer? A yearly from that customer? And when do we hope to see some of the reference designs begin to yield royalties, the new ones?

Orin, this is Scott. So our royalties take a couple of different forms. In the case of some of our SDIO relationships and then the reference design revenue, the 185,000 that we spoke to this quarter, in all of those cases these customers come and they buy run time royalties in advance, so these are nonrefundable, noncancellable payments they made to us. They'll come in and say buy 20,000 run-times and then they will churn through those as they chip devices and then they'll go back to us and buy more in the future. That is one model. With some of our larger SDIO customers, we had or are moving to models where they will report in arrears generally on a quarterly basis. And then some of the other royalty models are monthly reporting. Did that answer your question, Orin?

Yes. You mentioned specifically, I think it was about 185,000 from one customer this quarter.

Yes.

Is that -- do they pay you at the end of the year? I wasn't clear on that.

No, they come back to us, as their device shipment volumes, as they burn through their licenses, they will come back to us when they have burned through the allotment they have. So as I mentioned on the conference call, the same customer also bought a large tranche of run time royalties from us in Q4 of '04 and we expect them to buy again, at least once in 2005, of at least of the magnitude that we saw in Q4 but we don't see them to be back at the tranche, so to speak, in Q1.

And for which spotlight is that?

That was for a PXA 255 reference design.

And in terms of some of the new reference designs, when do you hope to see more royalties in the P&L?

For our new reference designs, if you think about the model, the customers license our designs up front and then as their products hit the market, is when they actually start to buy royalties from us. So typically, the design cycle on these products is anywhere from 6 to 12 months. So we don't expect any significant royalty pickup from these new reference designs until towards the end of the year. But we do expect to start to see development kit purchases pick up starting in Q2, and then ramping through the year.

And in terms of -- I mean clearly, anything that is proprietary to you, such as royalties from the reference designs, or your own proprietary software, really makes a difference on the P&L, as I look through the year, particularly Q2, Q3, Q4, hopefully for the coming year, which products are going to really make the difference in terms of us not necessarily seeing huge incremental revenue gains but seeing the huge P&L leverage that we could hope for?

Well, the P&L leverage that we're looking for is primarily from our DevKit IDP reference design and the associated software that we sell with those, as well as our PMP reference designs. Now we also expect to see leverage out of our services business as well, as we grow that top line revenue, because the expenses associated with that not the cost of service expenses, but the overhead expenses associated with that service business are essentially fixed. We can continue to grow our service top line without having to add another VP of services, for example. The incremental margin on the service revenue this quarter was 68%. 62% if you scrub out that 160,000 we referred to.

Okay. Thank you.

Our next question comes from Dominic Marshal with Wells Capital Management.

Good afternoon.

Hi, Dominic.

How are you guys?

Doing good, thanks.

Well, you just answered a number of my questions, but I was just wondering if you could talk about the service business, it sounds like you expect it to dip down a little bit here in the first quarter, I was wondering if you expected the gross margins to stay above your 35% target level and if you could talk a little bit about utilization in that business, it sounds like it was probably quite high in the fourth quarter, but what do you anticipate going forward? Are you hiring new people there for the growth that you anticipate looking forward?

Sure. So overall, as we mentioned, we do expect at least kind of flat, if you scrub out the 160,000 of revenue that kind of bled over from the previous quarter, we expect essentially flat in Q1, on our service business, but because we have some increasing expenses in the business, associated with FICA resetting and that sort of thing, as well as some additional hiring we've done, we expect our margins to dip down a bit. Going through the year, we are expecting to continue to grow the top line of our service revenue. And we think we can get the margins back up into the range that we were in in Q4.

But probably not in the first quarter?

No. We will definitely be not in the first quarter, Dominic. If based on FICA alone, and remember, that we're -- so we did the 3.9 million in revenue in Q4, service revenue in Q4, we're going to be -- we said we would be roughly flat, if you excluded the 160K in Q4, so let's just call that number in the 3.7 million range, and the -- we've been ramping service personnel in advance of several big contracts that are either just getting started or we anticipate getting started in Q2, so you had the combination of adding some more people, fringe costs, increasing in Q1, and we -- and the fact that as Brian mentioned, there is a certain fixed cost to our service cost of sales. We do expect margin to drop in Q1, but again, as the fringe costs tail off, as revenue begins to expand and as we are able to cover our -- the fixed component of our service cost to sales with a higher revenue base, you will see that service growth profit pop back up throughout the year. About 20% of our service cost of sales in Q4 was fixed, as Brian mentioned, it seems like the facilities allocation, management salaries, those sorts of things.

And it sounds like utilization was quite high in the fourth quarter, but obviously what you're describing now is that is going to dip pretty significantly in the first part of the year?

I wouldn't say it is going to dip significantly, Dominic. We did have very strong utilization in Q4. Which, actually, I had to give hats off to my service group because Q4 is a tough delivery quarter, and they did a great job. So we expect to see some dip in utilization in Q1, but, you know, we're not expecting a huge drop. We were running in the red zone in Q4.

Sounds like it. The previous question kind of got at some of this, but I was hoping maybe you could just talk a little bit more about your model on the reference designs? I'm assuming that the back end royalties are much more meaningful long term potentially than the upfront development kits, and so forth, but I was just wondering if you could kind of talk about the contribution that you're expecting from each relatively speaking, and maybe just the timing of that a little bit more. Am I correct in understanding a PMP is what you're anticipating to see first revenue from and later on this year in terms of the back end royalties?

We are actually expecting to see revenue from both the reference designs roughly around the same time period. PMP, we've actually been able to go out and demonstrate a little bit sooner than our IDP270 reference design. The reference design, Dominic, the business models I mentioned, is two components. There is the upfront development kit that the OEM purchases, and then as -- hopefully they also purchase our services, to help them customize that for their needs. And then as they ship, they pay us royalties.

I guess we are expecting both the PMP and the IDP to contribute about the same. One of the things about our IDP reference design is we have -- are bundling in other software, for example we bundle our SDIO software and we're bundling the Schema software that we acquired from Vibren last year. So we're hoping that over time, as these royalties continue to go, we can get some additional pop, by bundling more of our software components in with the reference designs.

Okay. And then you made the comment in your prepared remarks that you expected meaningful profitability for the year. I was wondering if that is before or after the stock option expense, and if you could give any more detail as to what you define as meaningful?

So when we've been talking about profitability, we have been generally talking about before our stock option expense. And as far as defining what we mean by meaningful, at this point, we are choosing really to talk more about guidance on the top line as opposed to the bottom line.

Okay. But meaningful profitability means profitability at least before stock option expense?

Yes, for the full year.

Okay. And then just the last question real quick. I was wondering if you guys could talk a little bit about what your plans are in terms of Investor Relations sort of activities? Sounds like you had picked that up a little bit in the fourth quarter. What is your kind of philosophy on that going forward?

Yes, we did do some additional Investor Relations work in Q4. We expect to continue that throughout the year. And we think it is important to get out and start telling the BSquare story more, especially now that we expect to have products as a more meaningful component of our business. So we are planning on another run outside probably in the end of March, early April time frame. And we will schedule other trips during the year. We are trying to get out once or twice a quarter, Dominic.

Sounds good, thank you.

Our next question comes from the Peter Rosenberg with Bear Stearns.

Hey, guys. How are you doing?

Hi, Peter.

Congrats on a nice turn-around.

Thank you.

Some of the questions were already answered as well for me. But I was curious on this AMD initiative that you guys are working on, if you could elaborate on that, and I know you -- I don't want to pinpoint you into figuring out what could be, but the projections that you're guessing now, are there any potential X factors to these products, or could they change the model significantly if there is an acceptance to either one of these?

Okay. So let.me start with your question on the AMD initiative. What we have done, this is really driven by a lot of our customers in Asia. We recognized last year in the second half of last year that there was an opportunity to create a portable media player reference design, and what we saw were many customers had created reference designs based upon the Linux operating system, and what was lacking in those designs was really the connectivity to the Windows PC. Specifically, some of the Microsoft digital rights management. And so we undertook to create a reference design based upon the low cost version of the Windows CE operating system. We realized that we did not want to invest in the hardware so we went to AMD who has an optimized platform for media playback and for multimedia type capability, their Au1200. So we partnered up with AMD. We're using their Au1200 hardware platform which they have a form factor correct version. So they've already done sort of a handheld hardware version of this platform and we built a software platform on top of that that we are now out marketing to our customers. So in current status as we demoed it at CES, we have a pipeline of customers over in Asia that we're talking to, and we think it is going to be a nice addition to our product line.

As far as sort of a changer for our overall P&L, up until now, our revenues have been dominated by our third party software sales to Microsoft, which are fairly low margin sales. A good steady business but a low margin business. And we spent a lot of time last year, if you were on any of our calls, talking about some of the sales issues we had around our services business and how we felt like we could get leverage out of our service business if we just got our sales machine fixed, and this last quarter, we demonstrated some good momentum in sales, and now that third leg of the stool we feel we need is that products components because service revenues are going to be in the 30 to 40% range but product sales are in the 90 to 100% range. So I guess that's a long-winded answer to your question, which is if any of these products hit, we feel like the leverage to the bottom line is going to be very high.

Okay. That's great. Nice job, guys. Keep up the good work.

Thank you.

[OPERATOR INSTRUCTIONS] It does appear we have no further questions at this time. I would like to turn it back to Mr. Crowley for any closing remarks.

Okay. Well, thank you very much for your interest in BSquare. And we will plan on talking to you again next quarter.

Ladies and gentlemen, this does conclude today's teleconference. Once again we thank you for your participation and you may disconnect at this time.