Bsquare Corp (BSQR) 2006 Q1 法說會逐字稿

Good day, everyone, and welcome to the BSQUARE Corporation first quarter 2006 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, Chief Financial Officer. Please go ahead, sir.

Good afternoon and welcome to our conference call. With me today is Brian Crowley, our CEO.

Before we begin, let me remind you that this call is being recorded and broadcast live over the Internet and that a recording of this call, 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 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 macroeconomic conditions; a decline in the market for our products, technology licenses and services; our ability to successfully implement, execute and make adjustments in our business strategy, business model or product offerings; lack of customer acceptance of new products or initiatives; risks associated with the effects of our restructuring; our ability to successfully split 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, 2005, in the section entitled “Risk Factors” 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'll provide a recap of our financial performance for the quarter. During the discussion today, references to “this quarter” or “the quarter” mean the first quarter of 2006, references to the “fourth quarter” mean the fourth quarter of 2005, while references to the “second quarter” mean the second quarter of 2006.

Let me start by speaking to revenue. BSQUARE reported total revenue for the quarter of $11.6 million, an increase of 18% over the $9.8 million reported in the first quarter of last year and a 9% decrease from the $12.7 million reported in the fourth quarter. Although we modestly beat revenue expectations set on last quarter's call, this quarter's revenue was negatively affected by several contracts we were unable to get signed by quarter end, which should benefit the second quarter.

Sales of third-party software, most notably Microsoft's embedded operating systems, were $7.4 million this quarter compared to $6.9 million in the first quarter of 2005 and $8.2 million in the fourth quarter. Excluding sales of the $711,000 to Cardinal in the first quarter of 2005, third-party software sales increased 20% year over year and declined 9% sequentially.

Third-party software sales came in slightly than our expectations due to stronger-than-anticipated growth on our overall account base and average revenue per customer. During the quarter, we sold Microsoft's embedded operating systems to a record high of over 350 customers, which was up 23% year over year and 6% sequentially, a small portion of which also purchased our engineering services and proprietary software products.

We anticipate cross-sell opportunities to improve as our portfolio of software products targeted the general embedded market in North America expands in 2006.

Proprietary software revenue was $439,000 this quarter, compared to $587,000 in the first quarter of 2005 and $602,000 in the fourth quarter. Lower SDIO Now! revenue accounted for the year-over-year decline, whereas a $185,000 reference design sale to one customer in the fourth quarter accounted for the sequential decrease, partially offset by increased SDIO Now! revenue.

As we mentioned on the last call, we do expect our SDIO Now! revenue run rate to improve during 2006 based on account wins and further adoption of our new 2.x technology by existing customers. We were disappointed that SDIO Now! revenue didn't improve more this quarter, which was primarily driven by a delay in closing an SDIO Now! royalty contract, which should benefit the second quarter.

Service revenue was $3.7 million this quarter compared to $2.4 million in the first quarter of 2005 and $3.9 million in the fourth quarter. The year-over-year increase stemmed from improved market strength and sales execution, resulting in a 96% increase in billable hours, offset by a 17% decrease in realized rate per hour. The rate per hour decline was attributable to $235,000 in service work delivered this quarter, which we anticipate-- anticipate will be recognized as revenue in the second quarter, once the contracts are signed, coupled with the impact of several Asia-Pacific contracts on which we are performing services work at relatively low rates in exchange for guaranteed royalty payments in the future. Assuming the projects are completed and payment is received, these customers are obligated to pay us a minimum of $900,000 in royalties in the future, which should impact revenue beginning in the third quarter of 2006.

Service revenue is down slightly sequentially, as anticipated, due to $163,000 in revenue which was delayed from the third quarter into the fourth quarter of 2005, compounded by the $235,000 in service work delivered this quarter which we expect to recognize as revenue in the second quarter. Billable hours increased 9% sequentially while the realized rate per hour decreased 18% sequentially, largely for reasons just discussed.

Turning to gross margins, third-party and proprietary software margins remained relatively constant at approximately 14% and 90%, respectively, this quarter as compared to the fourth quarter. Service gross margin was 25% this quarter compared to 15% in the first quarter of 2005 and 39% in the fourth quarter. The fourth quarter of 2005 benefited from revenue delayed from the third quarter such that service margin would have been 36%. Service gross margin increased substantially year over year based on much higher revenue levels, whereas service gross margin declined sequentially due to a combination of lower revenue and higher costs.

Cost of service was $2.8 million this quarter compared to $2.4 million in the fourth quarter. Increased fringe benefit expense, rebillables expense, stock-based compensation expense and facilities allocations totaling $280,000 impacted cost of service this quarter versus the fourth quarter whereas the remainder of the increase stemmed from increased personnel costs as we ramped our engineering headcount in anticipation of expected higher revenue levels throughout 2006. Most of the sequential expense increase was not driven by increased activity levels and was largely non-controllable.

We expected our service margin to be down this quarter sequentially based largely on the expense impacts just noted. Adjusting for the previously mentioned revenue timing impacts and the cost impacts seen this quarter not affecting the fourth quarter, such as fringe expense, the service margin this quarter was quite comparable to the fourth quarter.

We ended this quarter with a total of 93 personnel in our professional engineering services group, including contractors, as compared to 83 at December 31, 2005.

Taking a look at operating expenses, SG&A expenses increased $386,000 year over year and declined $429,000 sequentially. The year-over-year increase was driven primarily by sales investments made during 2005, coupled with $97,000 in stock-based compensation expense, which was not present last year.

The sequential decrease was attributable to net $399,000 in lower bad debt expense and reduced commissions, professional fees, contract labor and facilities expense, offset by $191,000 in increased fringe benefit expense and stock-based compensation charges. Excluding these relatively uncontrollable items, we did see a meaningful sequential decline in SG&A expense this quarter, coming off the sequential increase we experienced in the fourth quarter.

R&D expense increased $355,000 or 92% this quarter compared to the prior year, whereas it increased $117,000 or 19% sequentially. Increases in R&D expense to support our increased focus on proprietary accounts accounted for the year-over-year increase, whereas $81,000 in increased fringe benefit expense, stock-based compensation charge and facility allocation expense largely accounted for the sequential increase.

Including the impact on cost of service, we recognized total stock-based compensation expense of $154,000 this quarter versus none in 2005. We currently estimate our stock-based compensation expense to be approximately $150,000 to $200,000 per quarter throughout 2006.

Our company-wide fringe benefit expense increased $250,000 sequentially in this quarter.

Now let's speak to our bottom line results. The company reported a net loss for the quarter of $849,000 or $0.09 per share, including $154,000 in stock-based compensation, which compared to a net loss of $545,000 or $0.06 per share in the first quarter and a net loss of $246,000 or $0.03 per share in the fourth quarter. The fourth quarter included $399,000 of bad debt expense.

The combination of largely uncontrollable stock-based compensation, increased fringe benefit expense and a tax benefit recognized in the fourth quarter increased our loss by approximately $400,000 sequentially. Personnel headcount investments in our professional engineering group during the quarter in anticipation of higher revenue levels increased our loss by $139,000 sequentially. The remainder of the increased sequential loss came as a result of lower revenue and resulting margins, the vast majority of which had to do with delays in contract signings noted previously.

Now let me turn to the balance sheet. We ended the quarter with $10.9 million in the bank, of which $1.2 million is restricted, which was up $255,000 from December 31, 2005. Strong cash collections during the quarter drove the increase.

Before I end my remarks, I'd like to comment on two matters. The first item is Sarbanes-Oxley compliance. We are still waiting for the SEC to evaluate the Advisory Committee for Smaller Public Companies' recommendation, issued in April 2006, wherein compliance for companies of our size would be eliminated entirely. If necessary, we expect to begin our compliance activities in mid-2006, which will have an impact on our operating expenses, although difficult to predict at this time.

Lastly, I would like to comment on our previously discussed foreign tax withholding exposure related to SDIO Now! sales in Taiwan. We continue to apply to the government of Taiwan for withholding exemptions on all significant contracts, which would eliminate withholding tax, and have received approval for five of the seven exemptions applied for to date, with the other two currently pending. Based on review of the Taiwan tax regulations, consultation with our tax advisors and our success to date, we believe that we will be granted the remaining exemptions. If we were not to receive the additional exemptions, our potential liability at quarter end is estimated at $273,000 plus potential interest and penalties.

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

Thanks, Scott. I'll 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.

Our first quarter revenue estimates came in generally to our expectations, however, as Scott mentioned earlier, we had several contracts that we did work on during the quarter that we were not able to fully recognize the corresponding revenue by quarter end. We do expect to recognize the revenue from these contracts in Q2, however, we are still disappointed with our Q1 bottom line results.

Despite this, we still feel that we made tangible progress in our business goals and I am going to spend a few minutes discussing this progress.

Our third-party product line, which is the resale of Microsoft Embedded Windows licenses, as well as other third-party software, reported results slightly ahead of expectations. We sold to a record number of companies this quarter and we were able to hold margins constant around 14%. While sales of third-party software is a competitive business, we believe that due to our customer targeting efforts and value-added programs we have put in place, we will be able to hold margins around this level for the remainder of the year.

During the quarter we announced a new initiative to distribute an expanded line of Microsoft Embedded Server products. Embedded server products address the needs of OEMs who are looking to build dedicated server solutions. Selling Microsoft Embedded Server products allows us to expand our potential customer base and we expect that during that 2006 we can generate more than $2 million in incremental revenue from sales of embedded server products at margins generally 5% to 10% higher than the margins we receive for sale of other Microsoft embedded operating systems.

Overall, I'm happy with our third-party sales efforts. Demand for third-party products is good and our sales team has done a good job of diversifying our third-party products customer base such that we no longer have any 10% customer exposure as we have had in the past.

Our engineering services line showed better-than-expected strength in the quarter. Billable hours increased and we started or continued work for a number of blue-chip customers, including Microsoft, Motorola, Intel, H-P and Palm. Based on our sales pipeline and the number of proposals we are currently engaged in, we expect that demand for our engineering services will remain healthy throughout the year.

One of the constraints to growing our engineering services business has been the difficulty in finding qualified software engineers. In response to this, during the quarter we opened up a new design center in Vancouver, British Columbia, in order to tap into the pool of embedded engineering talent located in the Vancouver area. We currently have seven engineers in our Vancouver office and expect that number to grow to a dozen or more by year end. Of course, headcount growth is dependent upon continued demand for our engineering services.

With the opening of this design center, we now have engineering design centers in our Bellevue, Washington, headquarters, in Akron, Ohio, Vancouver, British Columbia, Taipei, Taiwan, and Hyderabad, India, where our Indian development partner is located. All told, we have over 100 engineers working in both our engineering services and proprietary products revenue lines.

We do not have any plans to open additional design centers in 2006, however we will continually evaluate our ability to match the supply of engineering talent with demand and make decisions according-- accordingly as the year progresses.

Turning to our proprietary products, I would like to discuss progress on our SDIO and reference design initiatives. During the quarter we released versions 2.2 of our SDIO technology. Version 2.2 is superior to previous versions for several important reasons.

Version 2.2 features improved performance such that we are now able to offer our customers WiFi data transfer rates in the 4 megabyte to 5 megabyte per second. This level of performance is demanded by users of smart devices who want to stream audio or video or download large files to their devices.

Version 2.2 adds support for multiple SDIO slots using a single SDIO host controller. This is a great feature in that our customers can now dedicate one SDIO slot to their-- internal to their device while exposing a second slot externally for the user to plug in an SD peripheral or memory card.

Our customers can do this using a single SDIO host controller without any reduction in SDIO performance. This allows our customers to reduce the size and cost of their devices when compared to previous solutions.

We have commitments from several of our Asian OEM customers to adopt our SDIO version 2.2 product and the product is being actively designed into new handheld devices.

During the quarter we also began to speak publicly about further extension to our SDIO product line, which will include performance improvements that more than double our current performance, support for higher-capacity memory cards and support for emerging smart SD card technology that will be used in enterprise and financial applications.

We have talked for several quarters that we expected SDIO revenues to soften in the second half of 2005 as customers evaluated our SDIO technology against what's available from Microsoft in Windows CE and Windows Mobile. We did see the softness in the second half of last year and there was some residual softness in Q1, however we do expect SDIO revenues to increase in the second quarter. SDIO royalty revenues can be lumpy in nature as our customers often ship devices in large lots during the quarter, which results in spikes and valleys in the royalty revenues to be BSQUARE.

Now looking at our reference design efforts, we continued development of our DevKitIDP270 and Portable Media Player reference designs during the first quarter and expect to release both of these reference designs to the market during the second quarter. As we mentioned in our press release, we began the sales and marketing efforts around these reference designs during the quarter and interest from potential customers has been good.

To review, our DevKitIDP270 reference design win is aimed at the general embedded market and specifically tailored for customers building smart devices with handheld and wireless capability. According to various industry data sources, the overall embedded market for operating systems, software, tools and services is estimated to be over $2 billion worldwide in 2006. The number of OEMs creating devices in this market number in the thousands worldwide.

The business model for our DevKitIDP270 is an upfront purchase of a design kit, which can range in price from $5000 to $50,000, followed by run-time royalties in the $5 to $15 range as customers begin to ship their devices. We expect that some customers will also hire our engineering services organization to customize the reference design for a particular application.

Based on our early marketing efforts, we currently have a pipeline of over 20 potential customers and subsequent to the end of the first quarter we received our first DevKitIDP270 purchase order.

During the quarter we also began work on our next reference design, based on Intel's next generation Xscale application processor, code named Monahans. Intel is expecting to release several versions of the Monahans processor aimed at consumer, smart phone and general embedded applications.

We expect to release our Monahans reference design to market in the second half of the year at the same time Intel begins releasing production Monahans chips and we expect to eventually have multiple variations of our Monahans reference design aimed into both the general embedded and consumer and mobile markets.

Our PMP reference design is more of an Asia-focused product, aimed at OEMs and ODMs who are creating handheld portable media players or who are looking to add media capabilities to existing devices. In the latter category, we are seeing interest from OEMs who have created GPS solutions and desire to add media capabilities to these solutions.

Our Portable Media Player solution is built on top of Microsoft's Windows CE core operating system and gives OEMs adopting our solution some distinct advantages. Our solution utilizes Microsoft's Direct Show architecture, which ensures compatibility with Windows Media Player and its supporting infrastructure. And our solution utilizes Microsoft's Media Transfer Protocol and is compatible with the “Plays for Sure” digital rights management scheme, which means that our solution is compatible out of the box with many download services as Rhapsody, Yahoo! Music and others. This gives us a big advantage when we talk to OEMs who are considering building a solution on top of Linux.

The number of potential customers for our PMP product is much smaller than our DevKitIDP reference design product, numbering in the low hundreds worldwide. However, the unit volumes for each customer are typically much larger, in the hundreds of thousands of units per year range.

The business model for our PMP reference design is the same as our DevKitIDP270 reference design. Customers purchase a development kit up front and pay royalties as they ship products. We expect that the upfront development kit purchases will usually include some engineering service work for customization of the reference design to the customer's requirements. We expect the upfront purchases to be in the $100,000 to $200,000 range while we expect that per product royalties will be in the $3 to $5 range.

We originally launched development of our PMP solution in conjunction with an Asian OEM who signed a contract guaranteeing $1.2 million in non-recurring engineering and royalty payments. We expected that this contract would fully cover the development expense of our PMP solution, which was estimated to be in the $400,000 to $500,000 range.

This customer has notified us that due to a change in their corporate strategy, they desire to terminate their contract with BSQUARE. This is extremely frustrating for us, as our contract called for royalty payments to begin in the current quarter and continue throughout 2006. It is now unclear to us how much of the total contract value we will be able to recover, however it is our intention to hold this customer to the guaranteed contract that they signed.

We are currently in discussions with several-- with several other Asian, North American and European OEMs regarding the adoption of our PMP reference design win and despite the developments around our launch customer, we still expect to sign additional customers in 2006 and that our PMP reference design will be successful.

Throughout 2006 we will continue to expand the depth and breadth of our reference design offerings by supporting new application processors as they become available from our semiconductor partners and by adding additional software functionality to our reference designs such as expanded port support functionality using our Schema software product, middleware functionality that expands on our SDIO technology offering additional storage and security options and additional application functionality. We remain enthusiastic about our product strategy as we believe that the demand for converged mobile devices of all types will continue to grow.

I am personally frustrated that we are one to two quarters behind where I wanted us to be in generating revenue from our product efforts, that our SDIO Linux product has had-- has not had as much demand as we had hoped for and that we have seen a change of plan from our PMP launch customer. This frustration does not take away from my overall feeling, based upon talking with our sales force and our customers, that we are on the right track with our product strategy and that our efforts will begin to pay off this year.

Before I wrap up, I would like to spend a few minutes speaking to the second quarter outlook for our business.

For the second quarter, we are expecting our revenues to increase approximately 18% to 24% year over year, and 5% to 10% sequentially. This increase will be driven from all areas of our business.

We expect our proprietary software revenue will increase sequentially in the second quarter based on renewed strength of SDIO Now! and in a smaller part due to the initial release of our new products starting to generate revenues. Growing this revenue line will have the largest impact on our bottom line, as gross margins typically exceed 90%.

We also expect our third-party software revenues to increase sequentially as our efforts to diversify our customer base and win new customers continue to pay off. Overall, we expect our total software revenue line to be up approximately 5% to 10% sequentially, highlighted by an expected increase of 30% to 50% in our proprietary software revenue.

We expect service revenue to be up sequentially by 5% to 10% in the second quarter based on continued demand from our customers.

Regarding margins, we expect our third-party software margin in the second quarter to roughly remain at the levels we saw in the first quarter. 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% gross margins during the year. We are projecting a sequential increase in service margin in the second quarter based on higher revenue, including recognition of revenue not recognized in the first quarter, and a gradual decrease of our fringe benefit expenses during the quarter.

We are currently expecting to hold R&D expenses relatively constant in dollar terms during 2006. We expect to make two to three incremental targeted headcount increases during the year, based on specific opportunities and needs. We are also expecting to hold sales expenses relatively constant in dollar terms during the year. We expect to add one to two targeted incremental headcount during the year in response to-- in response to specific opportunities that present themselves.

We currently have no plans to increase our overall G&A spending beyond the small incremental expense of adding our Vancouver office other than the potential effect of Sarbanes-Oxley compliance costs.

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.

Thank you. [OPERATOR INSTRUCTIONS] We'll take our first question from Orin Hirschman with AIGH Investments.

Hi, how are you?

Hi, Orin.

Can you kind of more in detail-- I mean, clearly it sounds like our leading candidate to start providing royalties on a per-unit basis is gone besides some of the non-consumer products that you currently have. Can you talk more about it? Is there anybody else who actually has a design that's getting close to market on the consumer end or is it really going to be-- end up being a next year affair for us?

Well, on our-- in our SDIO product there are several customers who have consumer devices that are either in market or close to market. In our PMP software line, we do not have another OEM today who has a device close to market.

Are there any other OEMs, though, that have actually signed on that are designing devices today?

For SDIO, yes, but PMP we have several OEMs who are very interested in the technology. We have not landed our second customer yet, Orin.

Okay. Based on the fact that we kind of know what the design cycle is like, more or less, here, does that mean we cannot hope for PMP royalties for at least a few quarters? Or not so?

Yes, I mean, typically-- this is a typical consumer product design cycle. Depending on how far along their soft-- their hardware is, if they are on top of the AMD reference design, which is what we used as the basis of our product, the customer could get to market very quickly. And that's the whole point of our product. You can take it, customize it and then you're to market.

We will receive upfront license fees as part of the deal from customers. They license the package typically in the $100K to $200K range. We always try to get prepaid royalties up front, sometimes successful, sometimes not.

Just to go back to that question, so is it still possible to have-- to have royalty income this current year or this is really a next year affair?

I would say that if we-- I mean, if we are able to sign some customers soon, we could potentially see some royalties at the end of the year. Customers are really pushing hard for the Christmas season. And that assumes that they're using the hardware that-- that's close to the AMD reference design. We also could potentially see some prepaid royalties this year.

Can you just go, again, once over in the guidance. You kind of gave some margin guidance. How should we read that-- all that margin together and what does that mean in terms of operating loss next quarter, exclusive of, say, option expense?

Orin, you were kind of breaking up there. I didn't quite hear what you said.

You made a number of comments on gross margin for the different pieces, can you weave that all together in terms of next quarter guidance and connect that down-- connect the lines-- connect the dots as to how that might play out in terms of a range of guidance on the operating loss?

We have-- by policy, we have typically given top-level guidance and we have talked about what we expect our expenses to be in the business, but we typically have not given bottom-line guidance.

So can you reiterate by the pieces the revenue and gross margin and then the overall company expense guidance, if I may, please?

So, Orin, the script that I read from--

Yes.

--will be posted to our website right after the call.

Yes.

And you can just read it right out of the script. It's probably easier to do it that way, frankly.

Okay. Thanks.

[OPERATOR INSTRUCTIONS] It appears we have no further questions. Mr. Crowley, I'll turn things back to you for any closing comments.

Okay. I'd like to thank everybody for their time today. We're going to continue to drive the business forward and we will talk to you again next quarter.

That does conclude today's conference call. Thank you all for your participation and have a great day.