Bsquare Corp (BSQR) 2007 Q1 法說會逐字稿

Good afternoon, ladies and gentlemen. At this time, I would like to welcome everyone to the BSQUARE Corporation first-quarter 2007 earnings conference call. All lines have been placed on mute to prevent any background noise. After the speakers' remarks, there will be a question-and-answer period. (OPERATOR INSTRUCTIONS).

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

Thank you. Good afternoon and welcome to BSQUARE's first-quarter 2007 conference call. With me today is Brian Crowley, our CEO.

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

With that said, let me recap our financial results. During the discussion, references to this quarter or the quarter mean the first quarter of 2007, while references to the fourth quarter means the fourth quarter of 2006, and the second quarter means the second quarter of 2007.

Let me start by speaking to revenue. We reported total revenue this quarter of $15.1 million, a 30% increase from $11.6 million in the year-ago quarter and a 7% increase from $14.1 million in the fourth quarter. The 7% sequential increase slightly bettered the 5% estimate provided on last quarter's call.

One customer represented 12% or $1.8 million of our revenue this quarter, which included $845,000 of rebillable service revenue. Sales of third-party software were $8.2 million this quarter, an 11% increase from $7.4 million in the year-ago quarter and a 6% increase from $7.7 million in the fourth quarter. Both increases were driven by growth in our customer base.

Proprietary software revenue was $970,000 this quarter, compared to $439,000 in the year-ago quarter and $874,000 in the fourth quarter. Higher reference design revenue and royalties from certain Asia-Pac service contracts not present in the year-ago quarter drove the year-over-year increase, whereas the sequential increase was driven by higher reference design revenue and higher royalty revenue from these same Asia-Pac contracts, partially offset by lower SDIO revenue.

This quarter's reference design revenue benefited from a one-time royalty order in the amount of $195,000. This customer purchases one-time royalties once or twice a year, and has submitted an order of a roughly similar size for the fourth quarter of 2007. The 11% sequential increase in proprietary software revenue slightly bettered the 10% expectation provided on last quarter's call, although, as we mentioned in our earnings release, several SDIO orders slipped at quarter end, and lack of available silicon delayed any shipments of our PXA320 reference design this quarter.

We have commented previously regarding royalties impacting proprietary software revenue related to five Asia-Pac contracts. In these contracts, we accept a lower than typical bill rate on our engineering services in exchange for downstream royalties, some of which may be guaranteed. All five of these projects are now complete, which had the effect of increasing the amount of royalty revenue we recognized this quarter. Further, we should see future improvement in our Asia-Pac bill rate as a result.

We recognized $322,000 in royalty revenue from these contracts this quarter, as compared to none in the year-ago quarter and $113,000 in the fourth quarter. Total guaranteed royalties under these contracts is $2.2 million, of which $491,000 has been recognized. We still expect royalties under these contracts to be roughly $1.4 million for all of 2007, assuming these customers report only their guaranteed minimums and honor their contractual obligations. We do expect to enter into more of these contracts in the future.

Service revenue was $5.9 million this quarter, up 59% from $3.7 million in the year-ago quarter and 7% from $5.5 million in the fourth quarter. The year-over-year increase was driven by improved market strength, better sales execution and higher rebillable revenue, whereas the sequential increase was driven by higher rebillable revenue. Rebillable revenue was $921,000 this quarter, compared to $175,000 in the year-ago quarter and $569,000 in the fourth quarter. Gross margin on this quarter's rebillable revenue was 13%.

As previously mentioned, one customer accounted for $845,000 of this quarter's rebillable revenue. We expect to complete the current project with this customer in the second quarter, and recognize service and proprietary software revenue of roughly $470,000. We expect rebillable service revenue on the current project to decline by roughly $650,000 in the second quarter, as compared to this quarter.

This quarter's billable hours increased 33% year over year and declined 3% sequentially. The year-over-year increase was driven by strength in North America, whereas the sequential decline was due to a drop in our Asia-Pac billable hours, stemming from the contract completions mentioned previously. This quarter's bill rate increased 8% year over year, due largely to a revenue recognition delay in the year-ago quarter, whereas our bill rate increased 6% sequentially, due to the decline in the number of lower-rate Asia-Pacific billable hours incurred this quarter.

Turning to gross profit and margins, overall gross profit was $4.0 million for the quarter or 26% of total revenue, as compared to $2.3 million or 20% of revenue in the year-ago quarter and $3.8 million or 25% of revenue in the fourth quarter. Third-party software margin was 18% this quarter, as compared to 14% in the year-ago quarter and 14% in the fourth quarter, with the increases driven by margin improvement in all customer segments.

We continued to maintain a high gross margin on our proprietary software revenue of 91% this quarter. Proprietary software cost of revenue includes $48,000 in amortization per quarter, which ends in the second quarter.

Service gross margin was 28% this quarter, compared to 25% in the year-ago quarter and 35% in the fourth quarter. The year-over-year increase was driven by the bill rate increase mentioned previously, coupled with the margin leverage created through higher revenue, partially offset by the suppressive effect of low-margin rebillable revenue.

The sequential decrease in service gross margin was driven by higher service cost of sales, excluding the effect of rebillables. Specifically, fringe benefits expense increased $179,000 and wages and contract labor increased $267,000. We have mentioned previously that our fringe benefits expense increases companywide in the first quarter and then ramps down throughout the year. The sequential increase in wages and contract labor resulted from the full-quarter impact of the additional engineering capacity we added in the fourth quarter and the redeployment of offshore contract resources that were focused on R&D projects in the fourth quarter. We expect declining fringe benefits expense, declining rebillable revenue, utilization of our current excess engineering capacity and improvement in our Asia-Pac bill rate to positively impact service gross margin in the future.

Moving down the P&L, operating expenses were $3.4 million this quarter, compared to $3.3 million in the year-ago quarter and $3.2 million in the fourth quarter. We provide a commentary on the year-over-year increase in today's earnings release. In today's call, I would like to focus discussion on the sequential OpEx increase.

SG&A expense increased $375,000, whereas R&D expense declined $180,000 this quarter, resulting in a net sequential increase of $195,000. The decrease in R&D expense was due to higher contract labor in the fourth quarter related to Maui software stack development and completion of our PXA320 development board, both of which were completed in the fourth quarter. The sequential increase in SG&A expense was primarily driven by an increase in bonuses and commissions of $119,000, an increase in fringe benefits expense of $75,000 and Sarbanes-Oxley compliance costs of $45,000, compared to none in the fourth quarter. There were a number of items impacting SG&A expense this quarter which we expect won't reoccur in the second quarter, or will decline.

Now, I'll speak to our bottom-line results. We reported net income for the quarter of $638,000 or $0.06 per diluted share, which compared to a net loss of $849,000 or $0.09 per diluted share in the year-ago quarter and net income of $706,000 or $0.07 per diluted share in the fourth quarter. This quarter represented our second straight profitable quarter, with bottom-line results coming in only slightly lower than the fourth quarter, despite an increase in fringe benefits expense of $300,000. Over the last two quarters, we have generated EBITDA of $1.8 million.

Our outstanding share count at quarter end was 9.8 million shares, which increased 164,000 shares compared to year end, due to stock option exercises, from which we received proceeds of $348,000. We had 1.96 million options outstanding as of quarter end, with an average strike price of slightly over $4.

Total cash, cash equivalents and short-term investments increased $957,000 to $12.1 million at quarter end, as compared to December 31, representing the second straight quarter of increases close to $1 million. $1.1 million of the ending balance is restricted.

Total non-cash expenses were $336,000, and CapEx was $96,000 this quarter. We still expect fiscal 2007 non-cash expenses and CapEx to approximate 2006 levels, wherein we incurred $1.2 million in non-cash expenses and $357,000 in CapEx.

As mentioned on last quarter's call, the fourth quarter's short-term investments balance was positively impacted by the recognition of a $226,000 equity investment we had previously written off, which did not affect operating results. We expect to liquidate this investment shortly, which, assuming an investment value identical to quarter end, would result in other income in the second quarter of $348,000.

Headcount including contractors is currently 196, compared to 198 as of the date of our last conference call. Professional engineering services headcount is currently 125, down from 128 as of the date of our last call.

Lastly, I would like to comment on our Sarbanes-Oxley compliance activities. We still expect to incur approximately $150,000 in external expense in fiscal 2007, $45,000 of which was incurred this quarter.

Now, I would like to turn the call over to Brian.

Thanks, Scott. Today, I will provide additional color on our Q1 results, an update on our business initiatives, and will finish by speaking to our outlook for Q2. I'll start with our third-party software sales.

Third-party software sales of $8.2 million came in right around our expectations for the quarter, while the resulting gross margin exceeded our expectations, coming in at 18%, up 4% from Q4. The gross margin improvement is partially a result of our success this quarter in focusing sales efforts towards acquiring new, less cost-sensitive customers and to cross-sell our other products and services to third-party customers, which has the effect of reducing competitive margin pressure.

While we will continue with this selling approach, we do not believe that we will be able to sustain gross margins at 18% for the remainder of the year, due to the competitive nature of third-party software sales. We currently expect margins to decline some in the second quarter.

During the quarter, we announced a referral arrangement with Bell Microproducts, one of the largest value-added distributors of storage and computing technology. In this arrangement, Bell and BSQUARE will work together to create preconfigured embedded software solutions, such that Bell can offer to its customers turnkey storage, security, kiosk and Internet acceleration solutions.

We also recently announced an agreement with Corvalent, whereby BSQUARE and Corvalent will work together to provide Windows Embedded based software solutions to Corvalent's North America OEM customers. In this arrangement, BSQUARE will develop and test software and applications aimed at specific verticals that Corvalent sells into.

These solutions will be based primarily on Windows XP Embedded and Windows XP Embedded for Point of Sale. Corvalent will integrate the resulting solutions with Corvalent's line of single-board computers and sell the solution to Corvalent's customers. BSQUARE will then provide ongoing Windows Embedded licensing to customers who adopt the solutions. Going forward, we intend to create more of these types of partnerships as a way to expand our licensing sales, and to pull through opportunities to sell other BSQUARE products and services.

Next, I would like to discuss our services revenue. During last quarter's call, I indicated that we expected service revenue to be up slightly sequentially, whereas we were up 7% in the fourth quarter, due largely to higher-than-expected rebillable revenue. The rebillable increase was driven primarily by a large amount of rebillable revenue from a single customer in North America, for which BSQUARE created a complete mobile device.

Our service revenue, excluding rebillables, was basically flat sequentially, with North America service revenue up slightly, offset by a drop in Asia. Late in the quarter, we did see some softening in demand from a couple of our larger service customers, which I will discuss more in a moment.

Continuing the trend from past quarters, our service revenue has been very balanced, in terms of operating system focus, with about 50% coming from Windows CE projects and about 50% from Windows Mobile projects. We worked on 68 projects during the quarter, including several handheld data collection devices based on the Windows CE and Windows Mobile operating systems, several new Windows CE and Windows Mobile board support packages for silicon vendors, and we created new applications for a portable navigation device and for mobile phones based on Windows CE and Windows Mobile.

As I mentioned earlier, we did see a decrease in Asia-Pac service revenue during the quarter. This was a result of overruns in the completion of two Asia-Pac service projects for which we had accepted lower-than-normal upfront billing rates in exchange for downstream royalties, coupled with a delay in starting a significant new project I will speak to momentarily. We had expected these projects to be completed in Q4 of 2006, but the overruns took the projects into this quarter. Both projects are now complete, and our engineers have moved on to new billable projects.

Our Asia-Pac team recently won a significant project to create a new boards support package for an Asian silicon manufacturer. This win, combined with the completion of the contracts I mentioned earlier, should result in improved bill rates and service revenue from Asia-Pac in 2007. We continue to have discussions with Asia-Pac customers regarding new projects, whereby we will perform services at lower upfront rates in exchange for guaranteed royalties, as the customer ships devices. We expect that we will win one or more of these types of projects in Asia during 2007, and in fact have a fairly significant project that we expect to close very soon.

As I mentioned earlier, we saw some softening in North America services late in Q1, as one of our larger customers, a large North America handset OEM, delayed two large projects as they worked through their own internal restructuring initiatives; and a second large customer, a North America silicon vendor, ramped their project down more quickly than we expected.

One of the two delay projects has since resumed. However, is not clear if the second project will resume. We continue to do work for the silicon vendor, but at a lower revenue run rate. Our sales force did a good job in backfilling the delayed projects with other work, such that our overall Q1 service results were not materially impacted.

We face a couple of challenges in services over the next couple of quarters. First, we are working to understand the level of business we will see with a North American handset OEM. Second, we mentioned a large project where we created an entire custom device for a North America customer. We expect that this project will largely be complete during Q2.

This is the customer that drove our large rebillable revenue in this quarter. While we do expect follow-on business with this customer for the remainder of 2007, we believe that the new business will be at a much lower run rate than we saw previously, and we are working hard to close several large opportunities in our pipeline to replace this revenue.

We currently have more than enough capacity to fulfill our backlog of service business. We do not expect to be adding any service capacity until the second half of 2007, and any additions we do make will be based upon demand.

Generally, we are seeing good sales activity for our services, and our pipeline is rebuilding. For some perspective, we faced a similar situation in Q2 of 2006, where we had softness in our services backlog during the quarter. Last year, we were able to successfully rebound and show strong services growth in the second half of the year. We feel that the service revenue level we established in Q4 of 2006 is a baseline revenue level that we expect to roughly maintain and grow upon. However, given the expected large decline in rebillable revenue and the uncertainties just discussed, we currently expect our service revenue to be down sequentially in Q2.

Looking past Q2, we are bullish on our service prospects and believe that the market conditions, driven by the proliferation of new devices and the success that Microsoft is enjoying with Windows Mobile and Windows CE, bodes well for BSQUARE.

Next, I will comment on the sales of BSQUARE proprietary products. Our overall SDIO revenue was down. We saw several SDIO deals that we expected to close in the quarter push into the second quarter, and we did not see the level of royalty revenue in the quarter that we expected. Since the end of the quarter, we have since closed two of the three delayed deals, and we expect that the third will close shortly. Despite the lower SDIO revenue this quarter, interest in our SDIO Hx product remains strong, and we believe that we will meet our goal of increasing our SDIO revenue to roughly a $500,000 a quarter or $2 million per year run rate by the second half of 2007.

We continued to invest in our SDIO technology this quarter to support the latest processors available from our silicon vendor partners, as well as the new revisions in the SD specification. This investment was recently demonstrated with the release of our SDIO Hx Version 1.1 technology, which supports new silicon from Marvell, TI, QUALCOMM as well as Windows CE and Windows Mobile Version 6.0, and the new high-capacity SD cards that are expected to support up to 32 GB of storage.

We also continue to work on our new Hx framework architecture. Our Hx framework will be a family of plug-in software that is designed to enable specific device functionality. We expect that we will port our current SDIO technology into our Hx framework, and we will add new modules in support of other storage and connectivity technologies that we believe will be important, as mobile devices add new functionality.

Current modules that we are either working on or considering include wireless USB, which is a new specification designed to replace the tangle of USB cables we all have on our desktop with a clean wireless connection. We are also interested in supporting some of the existing and emerging mass storage specifications for embedded devices, as well as other wireless connectivity options for devices such as WiMAX and digital video broadcast.

Development work on our Hx framework is underway, using our existing R&D staff. We may add two or three R&D staff during the year, based upon specific opportunities, but in general believe that we can handle our current development projects with existing staff.

Our overall reference design sales in the quarter were up from Q4, driven by a large order for SmartBuild licenses which Scott mentioned previously. SmartBuild is an old reference design family which was discontinued in the 2003 timeframe. Before it was discontinued, SmartBuild was adopted by several customers, and we continue to receive one-time royalty orders as customers ship devices that incorporate SmartBuild.

This SmartBuild order demonstrates the business model we are building with our new DevKit reference designs. Customers creating embedded systems tend to build products that have lifespans that go out 5 to 10 years. Once a BSQUARE technology is designed into an embedded product, BSQUARE can expect to see royalties for a number of years afterwards. This business model takes a couple of years to fully realize, as BSQUARE has to get new designs to market and then customers have to adopt those designs and begin shipping their products.

Our first PXA270 design reached market in mid-2006, and we expect that products based on this design will begin shipping in the second half of 2007, resulting in royalty streams to BSQUARE. Our reference designs are also designed to pull through sales of our services and other BSQUARE products. For example, the customer that we mentioned earlier who drove our large rebillable revenue in Q1 licensed our IDP270 reference design for their product, hired our professional services organization to customize our design, and we expect to receive royalty and licensing revenue from this customer as their device is deployed for the remainder of 2007.

We are seeing the demand we expected for our PXA320-based reference design, and are currently working on releasing additional modules of this design that allow it to support the PXA310 and PXA300 processors. Supporting all members of the PXA300 family with one design not only lowers our development costs, but it makes our designs more attractive to partners and customers because of the additional flexibility that a single design that supports all family members brings. We expect to release our PXA310 module during Q2 and our PXA300 module during Q3, subject, of course, to silicon availability from Marvell.

We are currently working on a new reference design which will support a processor family offered by a major silicon vendor other than Marvell. We expect to fully announce this design in Q3, and will provide more details at that time.

Finally, I would like to speak to our expectations for the second quarter. In Q2, we expect to see overall revenue down 4% to 6% from Q1, due primarily to the drop in rebillable service revenue previously mentioned. We expect total software revenue to be up slightly from Q1. We expect proprietary software increases to come from SDIO, our reference design products and Asia-Pac royalties, which will offset the SmartBuild revenue this quarter, which will reoccur in Q2.

We expect our service revenue to be down roughly 14%, with 80% of the drop attributable to rebillable revenue and the remainder attributable to the short-term challenges we discussed earlier. Remember that margins on rebillable revenue were 13% in Q1, such that the gross profit effect of the sequential decline won't be nearly as dramatic as the topline effect. We will continue to hold our headcount flat, and will flex our headcount up or down to respond to market conditions. Based on our services backlog, our software products pipeline, our current royalty revenue expectations and the expected gain on the sale from the the equity investment Scott mentioned, we expect to be profitable in Q2.

That ends our prepared portion of the call today. I would like to thank investors for their interest in BSQUARE. We believe that we turned in a solid quarter, and are committed to continuing our performance in 2007. We will now open up the call for questions.

(OPERATOR INSTRUCTIONS). [John Schwartz], Parvest Asset Management.

Just a couple quick questions; I just want to make sure I understand this right. Were you saying that you expect proprietary software revenue to be up slightly? Did I hear that correctly?

That's correct.

So both total software revenue and proprietary software revenue, think of those both being up slightly?

We expect proprietary software to be up slightly, which will make our total software up slightly.

Then, assuming you come in line with your service revenue guidance, and it's kind of breaks out the way that you laid it out, that most of it is a drop in rebillable service revenue, could you maybe give an estimate of what you expect service gross margins to be, then?

We have not typically provided margin guidance. We typically just provide guidance at the revenue level.

Can you give sort of a directional idea? I think you did 28% gross margins this quarter. Is it fair to assume that the gross margin should be up, based on your commentary about the drop in rebillable service revenue?

I would expect the margin to be on par with this quarter.

The total service gross margins?

Total service gross margin to be on par with this quarter.

Okay, despite the dropoff in lower-margin rebillable?

Well, that plus, as Brian mentioned, not all of the sequential drop that we're forecasting is coming from rebillable revenue.

Could you give me an idea -- it sounds like you think that OpEx was higher than it will be going forward in Q1. I guess, is that correct? If so, can you give me a flavor for what you see OpEx coming in at in Q2?

I think the comment we made in the prepared remarks was that there was a number of items that affected the quarter that we don't see reoccuring in the second quarter or declining. It was a hodgepodge of things that affected SG&A during Q1. I would say that best guess right now is that SG&A would probably decline $150,000 -- somewhere in that range, for Q2. Maybe a little bit (multiple speakers).

I'm not sure if you gave it out, but did you say how much SDIO revenue was in proprietary software in Q1?

No, we didn't break out SDIO revenue specifically. We typically just give our proprietary software revenue line.

Can you remind me -- because you talk about you believe it will be at $0.5 million a quarter in the back half of the year. Can you roughly remind be what sort of run rate it had been at?

Last year, it was at about $1.3 million for the full year.

And you commented that it was somewhat weak in Q1?

Yes. You should think in terms of SDIO revenue in Q1 in the sort of $150,000 range.

(OPERATOR INSTRUCTIONS). [Gary Goetz], Private Investor.

I wanted to, first, thank you all. I think you guys are doing a great job. Second of all, did you say what the gain on the sale would be?

Yes, we did. We said that assuming the stock price of our investment was identical to quarter end, it would result in other income in Q2 of right around $350,000.

What sort of visibility do you have beyond Q2?

In terms of visibility, our visibility ranks in order of engineering services -- so we have the concept of a backlog going into each quarter, and that is a function of signed contracts and how many people are working on that contract and our knowledge of the particular bill rates for those contracts. Our next level of visibility is proprietary software revenue, in terms of both our pipeline but also reoccurring royalty reports that come in from our customers for SDIO, for example, and also these guaranteed royalties that are rolling through from Taiwan. The last revenue line of third-party software, and that is a revenue line we have the toughest time within terms of visibility, and that is the one of where, as we have commented many times in prior quarters, the topline third party can whipsaw $1 million in either direction, based primarily on the receipt of 2 or 3 or $400,000 orders. But the margin on these orders tends to be fairly small, lower than our average margin, such that the gross profit effect from those orders, whether we get them or not, is not very dramatic.

To specifically answer your question beyond Q2, we have obviously the visibility into the royalty streams, and also our service backlog does extend beyond Q2 for some of our contracts, goes into Q4.

We said last quarter that we as a company expected to be profitable every quarter this year. That feeling hasn't changed.

I'm glad to hear that. Personally, I think there's a lot of upside in this, a lot of upside. Thank you very much.

(OPERATOR INSTRUCTIONS). There do appear to be no further questions. I would like to turn the floor back over to Mr. Mahan for any closing comments.

Okay, we want to thank everybody for spending some time with us today. As always, we will speak to you again next quarter. Thank you.

Thank you. This does conclude today's BSQUARE Corporation conference call. You may now disconnect.