Bsquare Corp (BSQR) 2006 Q4 法說會逐字稿

Good afternoon. My name is Naketa, and I will be your conference operator today. At this time, I would like to welcome everyone to the BSQUARE Corporation and Fiscal 2006 Conference Call. All lines have been placed on mute to prevent any background noise. After the speakers' remarks, there will be a question-and-answer period. If you would like to pose a question during this time, please press star, then the number one on your telephone keypad. If you would like to withdraw your question, press the pound key. Thank you. It's now my pleasure to turn the floor over to your host, Mr. Scott Mahan. Sir, you may begin your conference.

Good afternoon, and welcome to BSQUARE's Fourth Quarter and Fiscal 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 the 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 recap our financial performance.

During the discussion, references to this quarter or the quarter mean the fourth quarter of 2006, while references to the third quarter means the third quarter of 2006, and the first quarter means the first quarter of 2007.

Let me start by speaking to revenue. We reported total revenue this quarter of 14.1 million, an 11% increase from 12.7 million in the year-ago quarter and a 23% increase from 11.5 million in the third quarter. The 23% sequential increase topped the 17% estimate provided on last quarter's call due to better-than-expected performance in both service revenue and proprietary software sales.

Fiscal 2006 total revenue was 49.8 million, compared to 42.9 million in the prior year, an increase of 16%. We had no 10% customers this year.

Sales of third-party software were 7.7 million this quarter, a 6% decrease from 8.2 million in the year-ago quarter and a 10% increase from 7.0 million in the third quarter. Lack of large, low-margin orders accounted for the year-over-year decline, whereas the sequential increase was driven by strength in both new and existing customer sales.

While third-party software sales increased 10% sequentially, we had expected a sequential increase closer to 17%, representing a shortfall of approximately $0.5 million. We mentioned on last quarter's call that the lack of several low-margin orders negatively affected third quarter's results and that we expected those orders to hit this quarter. These orders, which are difficult to forecast and on which the gross profit is typically quite small, did not materialize, unfortunately.

Third-party software sales were 30.3 million for fiscal 2006, as compared to 28.6 million in the prior year, an increase of 6%.

Proprietary software revenue was 874,000 this quarter, compared to 601,000 in the year-ago quarter and 494,000 in the third quarter. Higher SDIO sales and royalties from certain Asia Pac contracts drove the year-over-year increase, while growth in virtually all product lines drove the sequential increase.

The 77% sequential increase bettered the 50% expectation provided on last quarter's call, driven by better-than-expected results in all product lines, with the exception of our new IDP 320 reference design.

Proprietary software revenue was 2.6 million for fiscal 2006, flat compared to the prior year.

Before I discuss service revenue, I would like to elaborate on the royalties impacting proprietary software revenue related to certain Asia Pac contracts. In these contracts, we accept a lower-than-typical rate per hour on our engineering services in exchange for downstream royalties, some of which may be guaranteed. There have been five of these contracts in total thus far, of which three are significant in terms of their expected royalty revenue. Of these three, two are complete, and we currently expect the third to be completed in the first quarter.

We recognized 113,000 in royalty revenue from these contracts this quarter as compared to 56,000 in the third quarter and expect this quarterly run rate to increase in 2007 as the last project is completed, which also carries the most significant guaranteed royalties.

Total guaranteed royalties under these three contracts is 2.2 million, of which 169,000 has been recognized. We expect royalties under these contracts to be roughly 1.4 million in 2007, assuming we complete the last product in the first quarter. These customers will report only their contractually guaranteed minimums and also honor their contractual obligations. We do expect to enter into more of these types of contracts in the future, primarily in Asia Pac.

Service revenue was 5.5 million this quarter, up 41% from 3.9 million in the year-ago quarter and 38% from 4.0 million in the third quarter, far surpassing the 13% sequential growth estimate provided on last quarter's call. The increases were driven by improved market and backlog strength and higher-than-expected rebillable revenue.

Rebillable revenue was 569,000 this quarter compared to 109,000 in the year-ago quarter and 95,000 in the third quarter, driven by one project in particular, which we also expect to contribute to significant rebillable revenue in the first quarter.

This quarter's billable hours increased 50% year over year and 17% sequentially, driven predominantly by strength in North America. This quarter's realized rate per hour declined 14% year over year due primarily to the Asia Pac contracts noted previously and increased 9% sequentially, driven by strength in both North America and Asia Pac.

Service revenue for fiscal 2006 was 16.9 million, an increase of 44% compared to 11.7 million in the prior year.

Turning to gross profit margins, overall gross profit was 3.8 million for the quarter, or 27.0% of total revenue, as compared to 3.2 million, or 25.2% of revenue in the year-ago quarter, and 2.8 million, or 24.6% of revenue in the third quarter, with the increases driven by higher proprietary software sales and engineering service revenue.

Third-party software margin was 14.1% this quarter as compared to 13.6% in the year-ago quarter and 16.6% in the third quarter. We had expected a sequential decline in third-party software margin this quarter, although it did fall below our expectations due to lower-than-expected rebate credit from Microsoft.

We continued to maintain a high gross margin on our proprietary software revenue this quarter of 91.8%. Proprietary software cost of revenue is affected by 48,000 in amortization per quarter related to our Vibren acquisition. This amortization ends in the second quarter of 2007.

Service gross margin was 35.3% this quarter compared to 39.5% in the year-ago quarter and 31.3% in the third quarter. The year-over-year decline was driven by the drop in bill rates mentioned previously, coupled with the suppressive effect that much higher rebillable revenue had on our margin this quarter, as compared to the year-ago quarter. The sequential increase in service gross margin was driven by higher revenue and bill rates, again, partially offset by the suppressive effect of much higher rebillable revenue.

As noted earlier, this quarter's rebillable revenue was much higher than the year-ago quarter or the third quarter. Because we generated low margin on rebillable revenue, roughly 11% this quarter, it has the effect of suppressing our service margin, making comparables more difficult when it increases dramatically as it did this quarter.

If this quarter's rebillable revenue is normalized compared to the year-ago quarter and third quarter, this quarter's service margin would have been slightly higher than 38%, coming in above the 36% expectation provided on last quarter's call.

Excluding the effect of rebillable revenue, we generated an incremental service gross margin of 63% this quarter, demonstrating the leverage created through a combination of revenue growth and certain fixed-cost service components, such as facilities and depreciation.

Overall gross profit was 12.0 million, or 24.1% of total revenue, for fiscal 2006, compared to 9.9 million, or 23.1% of total revenue in the prior year.

Moving down the P&L, operating expenses were 3.2 million this quarter compared to 3.6 million in the year-ago quarter and 3.2 million in the third quarter. This quarter included 138,000 in stock comp expense compared to none in the year-ago quarter, whereas the year-ago quarter included 399,000 of bad debt expense.

Total operating expenses were 12.9 million for fiscal 2006, as compared to 11.5 million in the prior year. The increase was primarily driven by 525,000 in stock comp expense not present in 2005 and a $790,000 increase in R&D expense to support our products' efforts.

Now, I'll speak to our bottom-line results.

We reported net income for the quarter of 706,000, or $0.07 per share, including 201,000 in stock comp expense, which compared to a net loss of 246,000, or $0.03 per share, in the year-ago quarter, which included no stock comp expense.

In the third quarter, we reported a net loss of 235,000, or $0.02 per share, which included $185,000 of stock comp expense.

This quarter represented the best bottom line for the Company since the first quarter of 2001. For fiscal 2006, we reported a net loss of 466,000, or $0.05 per share, compared to a net loss of 1.3 million, or $0.14 per share in the prior year.

We made substantial progress at the bottom line this year compared to 2005, improving $828,000 year over year despite the effect of three significant items -- first, 2006 included 715,000 in stock comp expense not present in 2005; second, we increased our R&D investment $790,000 year over year; and, lastly, we made a significant investment, for lack of a better term, in the previously referenced Asia Pac contracts. Had we applied the average Asia Pac bill rate for 2005 to our 2006 Asia Pac billable hours, revenue and gross profit would have increased by approximately $1 million. We hope that the latter two investments will pay substantial dividends in 2007 and beyond.

Our outstanding share count at year-end was 9.62 million shares, which increased by approximately 25,000 shares compared to the third quarter. We had 1.97 million options outstanding as of year-end, with an average strike price of approximately $4.

Total cash, cash equivalents, and short-term investments increased by $956,000 to 11.1 million at year-end compared to September 30 and increased 415,000, compared to December 31, 2005. 1.2 million of the ending cash balance is restricted in each case. This restricted balance will decrease by 150,000 in the first quarter and another 150,000 in the first quarter of 2008.

Our ending short-term investments balance was positively impacted by the recognition of an equity investment written off several years ago. Specifically, in the 2000/2001 timeframe, we did business with a customer which was unable to pay for -- us for amounts owed. The customer's outstanding receivable balance was ultimately converted into equity of the company, which went public this quarter. Our investment was valued at 226,000 at December 31, with the corresponding unrealized gain impacting shareholders' equity. Our current expectation is to liquidate this investment in the second quarter when the lock-up expires, which will likely result in a realized gain at that time.

Total non-cash expenses this quarter were 344,000 and 1.2 million for the year. CapEx was 70,000 this quarter and 357,000 for the year. We currently expect 2007 CapEx to approximate or be slightly less than this year's levels and total non-cash charges in 2007 to be equivalent to this year's run rate.

Headcount, including contractors, is currently 198, compared to 187 as of the date of our last conference call. Professional engineering services headcount is currently 128, up from 121 as of the date of our last call.

Lastly, I'd like to comment on our Sarbanes-Oxley compliance activities. We continued our activities this quarter, incurring an insignificant amount of external expense. We currently expect to incur approximately $150,000 in external expense in fiscal 2007 on a relatively straight-line basis throughout the year. It should be noted that based on our filing status and current SEC requirements, no auditor opinion will be necessary in 2007.

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

Thanks, Scott.

Today, I'll provide some additional color on our Q4 results, an update on our business initiatives, and we'll finish by speaking to our outlook for Q1, as well as for the year.

Let's start with our third-party software sales. As Scott mentioned, our third-party software sales fell below expectations by approximately $500,000. We attribute this shortfall to the absence of large orders during the quarter. We typically receive two to three large low-margin orders in a quarter. However, in Q4, we did not receive any orders that fit this profile.

Despite the lack of large, low-margin orders, we were able to make up the entire gross profit shortfall that large orders typically represent by focusing on customers where BSQUARE can add support or service value as these customers often tend to place orders which usually have margins in the low to mid-teens.

I'm also pleased to report that BSQUARE renewed its distribution agreement with Microsoft during the quarter, which allows us to continue selling embedded Windows licenses in North America. Our relationship with Microsoft is good, and we currently expect to continue selling embedded Windows licenses throughout 2007 and beyond.

We currently have two major initiatives underway in our third-party team. We are working on expanded referral arrangements with component distributors and single-board computer manufacturers, and we continue to work on the server initiatives that we have discussed in past quarters as we believe that embedded service sales represent a solid growth opportunity.

Now, let's look at our services revenue line. During Q4, we experienced good demand for our services, continuing the trend that began early in the third quarter. We expect that this demand will continue throughout 2007. At the end of last quarter's call, I indicated that we expected service revenue to be up by 13% sequentially, and I'm really pleased that we greatly exceeded that number.

For the past couple of quarters, our service revenue has been very balanced, with about 50% coming from Windows CE projects and about 50% from Windows Mobile projects. This revenue balance continued in Q4, and we expect it will continue throughout 2007.

From a market focus standpoint, the market segments that we are delivering services into are very consistent from last quarter. The largest segment we delivered services into was the smartphone market, which tends to be almost completely Windows Mobile focused. We continue to work with tier-one North America OEMs on their next-generation smart devices, as well as large Asian ODMs, primarily in Taiwan.

Our next largest service revenue segment is military/aerospace, based on a significant contract with a large North American defense contractor to create a new secure handheld device based on Windows CE. This is an ongoing contract that will continue at least through Q3 of 2007.

Data collection and consumer electronics are the next two largest market segments that we provide services into.

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. In the past, we've discussed our desire to cross-sell these core products into our services customers and BSQUARE services into our products customers. We made substantial progress with these efforts during 2006, and we currently expect to receive approximately $1 million in royalty revenue from customers who, as part of their service engagement with BSQUARE, designed our SDIO, IDP, Schema, or Maui PIM technologies into their devices. Obviously, realizing these royalty revenues is dependent upon our customers shipping their products in volume and in the timeframes that we expect.

I also want to note for investors that this royalty revenue is over and above the royalty revenue from the Asia Pac contracts that Scott discussed earlier.

We dramatically expanded service headcount in 2006 based on customer demand. We believe that we have sufficient service capacity for the first half of 2007, and if we are successful in our efforts to grow our services revenue, we will begin adding capacity again in the second half, focused primarily in Taiwan and in our ODC partner in India.

Our Services team has a number of growth initiatives underway for 2007, including spanning the range of services we offer to include more application development, radio development, and application testing services. We believe this will expand our addressable market to include companies who create applications for mobile devices, as well as network operators.

We're strengthening the ties with our offshore development partner to give us additional staffing and pricing flexibility.

Finally, we're leveraging the IP we developed during the service engagement by integrating the IP we sell into our BSQUARE product efforts.

These initiatives, coupled with the additional capacity we have recently added to our direct sales force and Microsoft's continued success with Windows CE and Windows Mobile, lead us to conclude that we can continue to grow our services revenue line in 2007.

Next, I will comment on the sales of BSQUARE proprietary products.

Last time we spoke, I estimated that product revenue would grow 50% sequentially based on our expectations of incremental SDIO and reference design sales, as well as the expected royalty streams from all these core products. I'm happy to report that we exceeded those expectations by quite a bit, and we believe that we can be up again sequentially in the first quarter.

First, SDIO. Our overall SDIO revenues increased 138% sequentially, driven by increases in both sales of new development kits to customers who are embedding our SDIO technology into their devices, as well as higher royalties from customers shipping devices that already include our SDIO technology. Interest in our SDIO Hx product remains strong, and we believe that we are on track to meet our stated goal of increasing SDIO revenue to roughly a $500,000-per-quarter or $2 million-per-year run rate by mid-2007.

During 2007, we will continue to invest in new versions of SDIO to support updates to the SD standard, the SmartSD and SecureMMC security standards, Windows CE 6.0, and to incorporate additional performance enhancements.

Along these lines, we will shortly be releasing Version 1.1 of our SDIO Hx product that adds support for larger SD memory cards, as well as optimized performance with popular SD WiFi chipsets, such as those from Marvell and NXP.

Looking further out, we continue our definition work around our Hx framework, which will expand our SDIO architecture beyond SD-compatible cards and peripherals and begins to incorporate support for non-SD peripherals, such as wireless USB and CE-ATA-compatible mass storage technology aimed at embedded and mobile devices. We continue to believe that our Hx framework can dramatically expand the addressable market for our technology and can ultimately become a 5 to $10 million-per-year revenue stream in the next three years.

The one area of disappointment for us in our product efforts this quarter was that we did not close any Media+ Portable Media Player customers. However, we continue to see interest in our Media+ reference design and are currently in discussions with several customers regarding adoption of our Media+ technology.

Turning to our hardware reference design efforts, sales of our IDP reference design and Schema board package -- Schema Board Support package development tool increased 124% sequentially, driven by sales to new customers, as well as increased royalty revenues from existing customers shipping products containing our IDP or Schema technology.

At the very end of this quarter, we shipped the first units of our newest reference design, the Devkit IDP 320 based on the Marvell PXA320 applications processor. The product was released very late in the quarter, which limited our sales; however, we do see good interest in this product, and we are hitting the market at the very front end of the PXA320 processor lifecycle, which gives us an opportunity to capture many design wins in the next few years.

We are currently working on our next set of reference designs in support of the follow-on PXA300 family members that Marvell will be releasing during 2007, as well as application processors from other silicon vendors. We look forward to telling you more about these efforts in future quarters.

Overall, I am encouraged that our reference design efforts are gaining traction. We have initiatives underway to increase the number of reference designs we offer, to deepen our partnerships with silicon vendors, and to grow out the distribution channels selling our designs. These initiatives will continue throughout 2007, and you should expect to see announcements over the next couple of quarters.

Now, I would like to speak to our expectations for the first quarter.

In Q1, we expect to see increases in every revenue line. We are expecting total revenues to be up roughly 5% sequentially. We expect total software revenue to be up sequentially 4% to 8%, highlighted by a sequential increase in proprietary software of roughly 10%. We expect proprietary software increases to come from SDIO and reference design products and the Asia Pac royalties, as Scott discussed earlier. We expect our service revenue to increase slightly, aided by continued demand for our services.

During 2007, we have or expect to make small headcount additions to our sales and R&D teams. We will make incremental additions to our services team as demand dictates. We also expect our overall operating expenses to increase as a result of general pay raises to our employee base, which will incur -- which will occur in early Q2 in North America and Q3 in Taiwan.

We would like to remind investors that in Q1 and into Q2, our fringe benefit expenses increase significantly, primarily as a result of FICA and state unemployment insurance contributions made on behalf of our employees.

Finally, as Scott mentioned earlier, we also expect to incur expense for Sarbanes-Oxley compliance during the year.

Based on the strength of our services backlog, our reference design plans for the year, SDIO deals and royalties in our pipeline, and the expectation that we will collect increased royalty revenues as several of our Asia Pac royalty-bearing contracts are completed, in the absence of a major shift in our sales pipeline or service backlog, we will expect to be profitable each quarter of 2007.

That ends the prepared portion of the call today. I would like to thank investors for their interest in BSQUARE. We are excited about the progress we made in 2006 and are committed to continuing that progress in 2007. We will now open up the call for questions.

[OPERATOR INSTRUCTIONS]

Your first question comes from Rick Serafini from Elmwood Capital.

Hey, Rick.

Hey, guys. I can't complain about that quarter. So I wanted to ask you in terms of -- last quarter, you mentioned a large data collection customer based in the Midwest that is going to have a product out this year. You said the design will be complete early next year. Is that design -- has that been completed? And kind of where does that fit in -- you know, it's not one of the Asian companies, obviously, but can you give us more detail or perhaps name that company?

Can't name the company, Rick. We're still working on the design, and things are going quite well. This customer has licensed our IDP 270 and Schema, and they're also an SDIO licensee. So when they do begin shipping devices, you would expect to see the royalties show up in those revenue lines.

Okay. And with regards to the arrangement with Philips, specifically, which chips will your software be embedded in? And can you give us a better sense of the economics of that relationship?

So you're speaking of not Philips but NXP, right?

Oh, sorry, NXP, yes.

Yes, so this -- specifically, we did an announcement -- I think it was a couple of weeks ago -- around the [VG11] wireless, you know, 802.11 WiFi peripherals. It's that family, and unfortunately, we can't disclose the financial terms of that deal.

And so -- but the product family, when is it going to be into the marketplace?

That would be for NXP to decide when they are going to go to market with that product family.

Okay. So is it safe to say by Q3?

It'll be this year, yes.

Okay.

But I don't know their exact release date.

All right, and one last question on PMP. I've seen a lot of product out there, GPS product out there, with all the functionality features that you guys have talked about. Can you talk about where the opportunity lies or where the hurdles have been in closing some of these customers?

Well, I mean I think the hurdles primarily have been around the fact that this is something new for BSQUARE and a lot of these customers already have some of their own technology base. A lot of them are coming from Linux, as we've discussed in the past. And so what we've seen is just very extended sales cycles in several of these opportunities. And the opportunities lie in North America and in Japan primarily right now.

Oh. And so it's a decision of basically roll your own or go with you guys?

Yes, it's typically a make-versus-buy-type decision.

Okay. All right. Well, like I said, can't complain about that quarter. Thanks, guys.

Thanks, Rick.

[OPERATOR INSTRUCTIONS]

There appear to be no further questions at this time. I would like to turn the floor back over to Mr. Mahan. Sir?

Okay, so thank you very much for your interest today. We feel like we're pretty satisfied for this quarter, and we'll look forward to talking to you again next quarter.

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