Bsquare Corp (BSQR) 2006 Q3 法說會逐字稿

Good afternoon. At this time, I would like to welcome everyone to the BSQUARE Corporation third quarter 2006 results conference call. At this time, 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, Scott Mahan, CFO of BSQUARE Corporation. Sir, the floor is yours.

Good afternoon, and welcome to BSQUARE's third quarter 2006 conference call. With me today is Brian Crowley, our CEO.

Let me remind you that this call is being recorded and broadcast over the Internet, and that a recording of this call, as well as the text of our prepared remarks, will be available in the IR section of our website. I would also like to direct listeners' attention to the Safe Harbor statement contained in our earnings press release issued earlier today, which applies to the comments and content of this call.

With that said, let me provide a recap of our performance for the quarter and first nine months of 2006. My commentary will focus on our quarterly performance, both year-over-year and sequentially, with only selected commentary on our nine month results. During the discussion, references to this quarter or the quarter mean the third quarter of 2006, while references to the second quarter and fourth quarter mean those quarters of 2006.

Let me start by speaking to revenue. We reported total revenue this quarter of $11.5 million, a 14% increase from $10.1 million in the year ago quarter and a 9% decrease from $12.6 million in the second quarter. Total revenue for the first nine months of 2006 was $35.7 million compared to $30.2 million in the prior year, an increase of 18%.

Total quarterly revenue came in below expectations provided on last quarter's call due to weaker than expected performance in both third party and proprietary software sales, partially offset by better than expected performance in service revenue. Sales of third party software were $7.0 million this quarter, a 4% increase from $6.7 million in the year-ago quarter, and a 15% decrease from $8.2 million in the second quarter.

New customer revenue from a referral arrangement entered into in the fourth quarter of 2005 accounted for the year-over-year increase. We had expected this quarter's third party software sales to be flat or up slightly sequentially, but did warn that this quarter's sales were off to a slow start and we were reliant on a September rebound, which ultimately did not occur.

We typically receive a small number of large low-margin orders during a quarter which didn't materialize in the current quarter. However, we believe that some of this order activity was delayed by customers into the fourth quarter. Although third party software sales were down, higher-than-expected third party gross margin offset roughly half of the negative impact on the gross profit line.

Proprietary software revenue was $494,000 this quarter compared to $491,000 in the year-ago quarter and $810,000 in the second quarter. Lower SDIO Now! sales were offset by royalty and other software revenue stemming from combined service software engagements as compared to the year-ago quarter. Lower SDIO Now! sales and lower reference design revenue accounted for the sequential decline.

Although we expected a 15% sequential decline in proprietary software revenue, weaker than expected SDIO Now! sales and reference design revenue resulted in a 39% sequential decline. Reference design revenue was negatively impacted this quarter by unanticipated effects of the Intel Marvel announcement whereas the SDIO Now! softness was driven primarily by a lull in our SDIO Hx adoption. Brian will speak to both of these shortly.

Service revenue was $4.0 million this quarter, up 38% from $2.9 million in the year-ago quarter and up 11% from $3.6 million in the second quarter. Billable hours increased 44% year-over-year and 27% sequentially due to improved market strength and sales execution. The positive impact of the billable hour increase was partially offset by roughly 10% year-over-year and sequential decline and our realized rate per hour, driven by our Taiwan subsidiary.

We are engaged in several Asia-Pacific contracts where we are providing services at relatively low rates in exchange for royalty payments in the future which caused the rate decline. We recognized our first royalty revenue from these contracts this quarter and expect the amount to increase in the fourth quarter.

Certain of these contracts, not all of which are completed, provide for future minimum guaranteed royalty payments totaling $2.2 million which impacted proprietary software revenue this quarter by $56,000 with the bulk of the royalties expected to impact FY07 given current timing expectations, completion of the underlying contracts, and our belief that these customers will fulfill their contractual obligations.

We had expected a 5% sequential increase in service revenue this quarter versus an actual of 11%. Despite a relatively soft July, we gained significant momentum during the quarter in services and have seen that momentum continue such that we expect another sequential increase in service revenue in the fourth quarter.

Turning to gross margins, overall gross profit was $2.8 million this quarter or 24.6% of revenue as compared to $2.3 million or 22.3% of revenue in the year-ago quarter, and $3.0 million or 23.8% of revenue in the second quarter. Third party software margin was 16.6% this quarter compared to 14.2% in the year-ago quarter and 15.2% in the second quarter. Third party software margin came in higher than expected due to the lack of significant low margin orders which negatively impacted our topline as previously discussed.

We expect our third party software margin to decline some in the fourth quarter on higher sales. We continue to maintain a high gross margin for our proprietary software this quarter of 82.6%, which includes $48,000 in amortization relating to our Vibren acquisition.

Service gross margin increased to 31.3% this quarter compared to 29.9% in the year ago-quarter and 28.3% in the second quarter. The year-over-year and sequential increases were driven by higher revenue levels and increased utilization offset by the realized rate per hour decline discussed previously.

We expect service margin to improve again sequentially in the fourth quarter driven by higher revenue and increased utilization. We posted an adjusted service margin of 36% in the fourth quarter of 2005, and expect our fourth quarter 2006 margin to be near that same level.

Moving down to P&L, total operating expenses were $3.2 million this quarter compared to $2.8 million in the year-ago quarter and $3.2 million in the second quarter. The year-over-year operating expense increase is attributable to $140,000 in stock comp expense not present in 2005, and sales and R&D investments made to support our domestic and international sales efforts as well as our increased focus on proprietary product development. We expect our fourth quarter operating expenses to be roughly similar to this quarter's levels based on current plans.

Now I will speak to our bottom-line results. The Company reported a net loss for the quarter of $235,000 or $0.02 per share including $185,000 stock comp expense, which compared to a net loss of $469,000 or $0.05 per share in the year-ago quarter, which included no stock comp expense.

In the second quarter, the Company reported a net loss of $88,000 or $0.01 per share, which included $175,000 in stock comp expense. For the first nine months of 2006, the Company reported a net loss of $1.2 million or $0.12 per share compared to a net loss of $1.1 million or $0.11 per share in the prior year.

The first nine months 2006 included stock comp expense of $514,000 or $0.05 per share as compared to none in the prior year, and the Company's R&D investment increased $769,000 year-over-year of which $55,000 is stock-based compensation expense.

Total cash, cash equivalents and short-term investments including restricted cash decreased $818,000 during the quarter based primarily on weaker than expected sales in the early part of the quarter, compounded by the effect of the timing of our Microsoft sales, and payment of royalties thereon. Our royalty payable to Microsoft declined $903,000 at quarter end as compared to the second quarter. We currently expect to make up a good portion of this quarter's cash shortfall in the fourth quarter.

Headcount including contractors is currently 187 compared to 170 as of the date of our last conference call. Professional engineering services headcount is currently 121, up from 97 as of the date of our last call.

Lastly, I would like to comment on our Sarbanes-Oxley compliance activities. We began our activities this quarter and will continue our efforts in the fourth quarter and into FY07. We will incur some external costs in the fourth quarter, but don't expect the expenses to be significant. The exact timing and amount of our external expenses in FY07 is currently under review.

Now I will turn the call over to Brian.

Thanks, Scott. Today I will provide additional color on our Q3 results, an update of our business initiatives, and we'll finish by speaking to our revenue outlook for Q4.

Overall, I was disappointed with our Q3 results, but I was pleased with our service results and I believe that our overall business is strengthening. Our third party software sales fell below expectations by approximately 15%.

The quarter started slow and while sales did ramp some in September, they didn't ramp to the levels that we expected. The shortfall in Q3 third party sales was not limited to just BSQUARE. Our intelligence indicates that other Microsoft embedded license resellers also experienced slow sales in the quarter, and that BSQUARE's overall marketshare remained steady and may even have increased slightly.

Q4 third party sales are off to a good start. I'm also pleased to report that BSQUARE renewed its distribution agreement with Microsoft during the quarter under which we will continue to distribute embedded Windows licenses. Our relationship with Microsoft is good and we currently expect to continue selling embedded Windows licenses throughout 2007 and beyond.

Looking at service revenue, we are experiencing good demand for our services and expect that this demand will continue for the foreseeable future. At the end of last quarter's call, I indicated that we expected service revenue to be up by 5% sequentially, and I am pleased that we greatly exceeded that number.

In the quarter, our service revenue was very balanced with about 50% coming from Windows CE projects, and about 50% from Windows mobile projects. Historically, our service revenue has been much more heavily weighted towards Windows CE, but over the past two years, we have seen a shift to the balanced split we see today, which we expect to remain consistent in the near-term.

The largest segment we delivered services into during the quarter was the Smart Fund market, which tends to be almost completely Windows mobile focused. In this market, we continued to work with Tier 1 North America OEMs such as Palm and Motorola on their Next Generation Smart devices, as well as large Asian ODMs primarily based in Taiwan.

Our next largest service revenue segment is military aerospace based upon a significant contract with a large North America defense contractor to create a new secure handheld device based on Windows CE. This is an ongoing contract that will continue into 2007.

Consumer electronics and data collection are the next two largest market segments that we provide services into. Our consumer electronics work has been done on a variety of devices such as media players and handheld devices for business professionals.

In the data collection segment, we have been working with leading OEMs in North America and in Asia, which are creating the Next Generation of handheld data collection devices. One of our largest data collection customers, a large service provider based in the midwest, has engaged BSQUARE to create an entire custom device including custom hardware, software, and an all-new industrial design. As part of the engagement, this customer is also licensing BSQUARE's IDP 270 reference design and our Schema software package, both of which will form the core technology of the new device.

Once the design is complete early next year, BSQUARE will work with the customer's contract manufacturer to ensure that the device is successfully produced. When the device begins shipping mid-next year, BSQUARE will receive royalties for each unit shipped.

This type of turnkey engagement is in BSQUARE's sweet spot and something that we want to do more of in the future. We maximize our value and differentiation over our competitors when customers engage us to create custom devices that include a full range of BSQUARE services and technology, including our IDP reference designs, SDIO and our Schema software product.

Demand for our services was so strong in the quarter that had we been able to more quickly expand our delivery capacity, our service results would have been higher. We worked aggressively to augment capacity and consequently, have established a new Engineering Development Center in Longmont, Colorado, with about a dozen very talented software engineers.

We are continuing to work on finding new engineering talents, not only in Colorado, but in our Vancouver, B.C. Development Center; our Akron, Ohio Development Center; our Taiwan Development Center; and of course, in our Bellevue headquarters. We expect that as demand continues to increase, we will increase our capacity through organic hiring, partnerships or potentially acquisitions.

With the continued success Microsoft is enjoying with their Windows embedded and Windows mobile operating systems, and the recent release of Windows CE 6.0, we believe that our service revenue line will continue to grow throughout 2007, assuming that we continue to be successful in finding new engineering talent to expand our delivery capacity.

Turning to our products efforts, we had a disappointing quarter. We did expect some decline in product revenues from Q2 to Q3 as we had a particularly large SDIO order in Q2 that we didn't expect to backfill completely in Q3. But our results still came in below expectations.

I would like to take a moment to speak to each of our major product categories. First, SDIO. Interest in our SDIO Hx product has been strong. Most customers that we engage with will choose our SDIO Hx solution over developing their own SDIO technology or using the SDIO technology built into Windows CE and Windows mobile due to our superior performance, our broad silicon and peripheral compatibility, and our support of the latest SB specification in a timely manner.

We had two significant SDIO Hx sales during the quarter -- one to a North America data collection OEM, and one to a Taiwanese data collection ODM, and we expect that these sales will begin yielding SDIO royalties in Q4. We currently have over a dozen customers in our SDIO Hx sales pipeline, including several significant deals with handset OEMs and we expect to close a number of these customers in Q4.

We are continuing to work on our SDIO roadmap which includes expanding the breadth of our technology to incorporate support for non-SDIO devices such as USB and Wireless USB peripherals; CE-ATA compatible mobile disk drives, and other similar components.

We also continue to make progress on our Smart SB and secure MMC editions, and we delivered Beta Code versions of our secure MMC technology to customers (technical difficulty) [during the quarter]. We believe that with the continued adoption of SDIO Hx and the addition of non-SDIO peripherals, Smart SD and secure MMC technologies into our framework, that we can increase our SDIO revenues to roughly a $2 million a year run rate by the middle of 2007, with the potential for additional upside.

We did not close any Media Plus portable media player deals in the quarter. However, we continued to see interest in our Media Plus reference design and are currently in late stage sales discussions with two customers, one in Europe and one in Japan. We have a pipeline of several customers behind these two.

We are still striving to close new Media Plus deals and will report progress to investors as soon as practical. Given the product cycles involved, if we are successful in closing a Media Plus deal in the near future, we will not generate any meaningful Media Plus revenue until mid to late 2007 at the earliest.

Turning to our hardware reference design efforts, sales of our IDP 270 reference design were flat from Q2 to Q3, and our Q3 sales fell below our internal expectations. The single biggest reason for weaker than expected performance was unanticipated effects of Intel's sale of its PXA application processor family, which is the basis for our hardware reference design to Marvel.

Many customers who were considering purchasing our IDP 270 solution put their plans on hold or, in several cases, decided to switch to a competing application processor family from PI or Freescale. During the quarter, we attempted to get clarification from both Intel and Marvel on when the acquisition would close and what Marvel's ongoing go-to-market plans would look like.

You can imagine our frustration as there was not a lot of information coming out of either company as they sorted out a very complicated acquisition. Just after quarter end, we finally received clarification that Marvel would continue to market and sell the PXA processor family to the broad embedded market and would expand its efforts to use partners in these marketing and sales efforts.

Yesterday, Marvel announced the completion of the acquisition, the PXA processor line, and starting next week, the formal Intel employees responsible for the PXA processor family will be Marvel employees. This is very good news for BSQUARE.

Our next hardware reference design, based on the Next Generation PXA processor code-named Monahan, is expected to be released for sale starting in December. Demand for this design is strong and we are releasing the design at the front end of the processor lifecycle, which means that we should see steady demand for this reference design throughout 2007 and beyond.

Our Monahans reference design will support both Windows CE 5.0 and Windows CE 6.00 at release, furthering its appeal to partners and customers as forward compatibility between these two operating system versions is assured.

During the quarter, we also announced a relationship with Dialog Semiconductor, whereby the two companies will cooperate to develop and market reference designs that incorporate technology for both companies. The first product of this partnership will be the incorporation of Dialog's DA9034 power management and audio controller into BSQUARE's Monahans reference design. This integration will make BSQUARE's Monahans reference design more attractive to customers, in that the resulting solution will be highly integrated, saving both physical space and bill of materials costs, yet customers will not have to sacrifice any power management or audio capabilities. This partnership will also broaden BSQUARE's market reach as Dialog will use BSQUARE's Monahans reference design in their sales efforts.

Overall, while I'm disappointed in our hardware reference designs will soon begin to meaningfully contribute to our overall proprietary products results. I also expect that our reference design, combined with world-class engineering services, will be a powerful combination that many customers will find attractive. Through the end of 2007, we estimate that our IDP 270 and Monahans reference design will allow us to generate $2 million to $4 million in incremental product and service revenue with the revenue split evenly between products and services.

Now I would like to speak to our expectations for the fourth quarter. In Q4, we expect to see increases in every revenue line. We are expecting total revenues to be up sequentially, roughly 17%. We expect total software revenues to be up sequentially, roughly 20%, highlighted by a sequential increase in proprietary software of roughly 50%.

We expect proprietary software increases to come from both SDIO and our reference design products. We expect our service revenue to increase roughly 13% sequentially aided by continued demand and by our increase in delivery capacity. Based on the strength of our services backlog, our new Monahans reference design coming to market in Q4, SDIO deals in the pipeline, and the expectation that we will collect increased royalty revenues as several of our Asia-Pacific royalty-bearing contracts are completed, we are optimistic that the strength of our business will continue into 2007.

That ends the prepared portion of the call today. I would like to thank everyone for their time today and continued interest in BSQUARE. We will now open the call for questions.

(OPERATOR INSTRUCTIONS). Anthony Marchese, Monarch Capital.

It seems like good results coming up in the fourth quarter. I'm very encouraged to see insiders buying stock in the past quarter. Could you just review what the insider buying policy is in terms of Window and could we anticipate more buying at these levels, given the amount of cash that you have and potential prospects?

Anthony, this is Scott, I'll take that one. Our Window opens two full trading days after we release earnings, which will actually be Wednesday morning, given markets are closed Friday. It will be open for the rest of the calendar month.

As to cash balances and that portion of your question, I can't necessarily speak to my fellow members of the executive team and the Board members. I know Brian and I personally have purchase shares, I believe in each of the last three quarters.

Any prospects for -- hello?

We're here.

I'm relatively new to the story. Is there any research on the Company or do you anticipate any type of potential research?

No, no research currently. We would hope to get some research in place for the future.

(OPERATOR INSTRUCTIONS). At this time there appears to be no further questions.

Well, we would like to thank everybody again for their time today and interest in BSQUARE, and we look forward to talking to you again next quarter.

Thank you. That does conclude today's conference. You may disconnect your lines at this time and have a wonderful day.