Bsquare Corp (BSQR) 2008 Q1 法說會逐字稿

Good afternoon, ladies and gentlemen, and welcome to the BSQUARE Corporation First Quarter 2008 Earnings Conference Call. At this time, all participants are in a listen only-mode. Following the presentation, the conference will be open for questions.

(OPERATOR INSTRUCTIONS.)

This conference is being recorded Thursday, May 8th, 2008. I would now like to turn the conference over to Scott Mahan, Chief Financial Officer of BSQUARE Corporation. Please go ahead, sir.

Good afternoon, everyone. 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 and the test of our prepared remarks will be available on our Web site.

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.

During the discussion today, references to this quarter, the quarter of Q1 mean the first quarter of 2008, references to the fourth quarter or Q4 mean the fourth quarter of 2007 and references to the second quarter or Q2 mean the second quarter of 2008. Further, references to this year or the year mean fiscal 2008, while references to last year mean fiscal 2007.

With that said, let me recap our financial results. We reported total revenue this quarter of $17.1 million, up 13% from $15.1 million in the year ago quarter and up 10% from $15.6 million in Q4. This quarter represented our 10th consecutive quarter of year-over-year total revenue increases.

The 10% sequential growth in total revenue topped the 6% expectation provided on last quarter's call for reasons I'll discuss in a minute. Our largest customer accounted for 8% of total revenue this quarter.

Sales of third party software were $10.1 million this quarter, up 23% from $8.2 million in the year ago quarter and up 16% from $8.7 million in Q4. This quarter represented a record quarter in third party software sales. An increase in Microsoft's licensing sales to a few large customers, coupled with growth in Flash Lite sales, primarily accounted for both increases.

We generated $450,000 in Flash Lite licensing revenue this quarter compared to none in the year ago quarter and $153,000 in Q4. We did make our first sale of the Solidcore S3 Control product this quarter, although it was not significant.

The 16% sequential growth in third party software sales beat the 9% expectation provided on last quarter's call due o higher than expected sales of both Microsoft and Flash Lite licenses.

Proprietary software was $863,000 this quarter compared to $970,000 in the year ago quarter and $1.4 million in Q4. Lower SDIL and reference design revenue drove the year-over-year decline. Lower reference design revenue and $364,000 in revenue relating to a customer settlement, which benefited Q4 drove the sequential decline.

We recognized $372,000 in service contract royalty revenue this quarter as compared to $356,000 in the year ago quarter and $384,000 in Q4. We had expected proprietary software revenue to decline approximately 28% sequentially versus the actual decline of 38%. Brian will discuss proprietary software more in a moment.

Service revenue was $6.1 million this quarter, up 3% compared to $5.9 million in the year ago quarter and up 11% from $5.5 million in Q4. On a year-over-year basis, a decrease in low margin rebillable service revenue of $587,000 was more than offset by growth in core engineering service revenue, driven by a 491% growth in APAC.

The sequential increase is also driven by growth in APAC, offset by a decline in North American service revenue relating to a $350,000 contract restructuring which benefited Q4.

The 11% sequential growth topped the 9% expectation provided on last quarter's call, driven by stronger than expected APAC performance.

This quarter's billable hours were up 6% year-over-year and up 13% sequentially, driven primarily by a growth in APAC. This quarter's effective bill rate increased % year-over-year and declined 3% sequentially. Year-over-year improvement was driven by APAC and the fact that the year ago quarter included contracts in which we were performing services at relatively low rates in exchange for downstream royalties.

The sequential decline was driven by the previously mentioned contract restructuring, which had the effect of improving our Q4 rate. Without this effect, our bill rate improved 4% sequentially.

Turning to gross profit and margins, overall gross profit was $4.7 million this quarter or 27% of total revenue as compared to $4.0 million 26% of revenue in the year ago quarter and $4.9 million or 32% of revenue in Q4. Third party software margin was 17% this quarter compared to 18% in the year ago quarter and in Q4, with both decreases driven by higher revenue contribution from our larger, lower margin customers. We continue to maintain a high gross margin on our proprietary software revenue 99% this quarter.

Service gross margin was 34% this quarter compared to 28% in the year ago quarter and 37% in Q4. The year-over-year increase was driven by bill rate improvement and a decline in low margin rebillable service revenue.

Sequential service margin decline resulted primarily from an increase in fringe benefits expense of $194,000, which negatively impacted service cost of sales compared to Q4 coupled with the $350,000 contract restructuring, which benefited Q4's gross margin. Adjusting for the effect of these items, service margin improved sequentially. Fringe benefits expense increases company-wide in Q1 of every year and then declines for the remainder, all other things being equal.

Moving down to P&L, operating expenses were $3.7 million for the quarter compared to $3.4 million in the year ago quarter and $3.7 million in Q4. The year-over-year increase was $211,000 and was driven by increases in international SG&A expense, both in Taiwan and Japan. We reinitiated sales activities in Japan in Q4.

Further, additional personnel costs associated with the Flash Lite acquisition and higher reference design development cost contributed to the increase.

On the Q4 conference call, we provided commentary that certain Q4 op ex items which caused that quarter to increase compared to Q3 of 2007 would not reoccur in Q1 totaling roughly $230,000. While that was indeed the case, a sequential increase in fringe benefits and stock comp expense of $280,000 offset this decline. Company-wide, our fringe benefits expense increased $388,000 from Q4.

Now, I'll speak to our bottom line results. We reported net income for the quarter of $1.0 million or $0.10 per diluted share, up 57% compared to net income of $638,000 or $0.06 per share in the year ago quarter and down 17% compared to net income of $1.2 million or $0.12 a share in Q4. If we adjust for the $527,000 sequential increase in largely uncontrollable fringe benefits and stock comp expense, we did show sequential improvement at the bottom line this quarter. Q1 represented our sixth straight profitable quarter.

We also generated EBITDA this quarter of 1.5 million or $0.15 per share compared to $891,000 in the year ago quarter and $1.6 million in Q4. Our outstanding share count at quarter-end was 10.09 shares, which increased 25,000 shares from Q4. We had 2.0 million options outstanding as of quarter-end with an average stock price of $4.28. We also have 100,000 warrants outstanding with a $4.50 exercise price which expire in June, and also have 109,000 restricted stock units outstanding.

Cash and investments increased $1.0 million to $16.0 million during the quarter, representing our sixth straight quarterly increase. Total non-cash expenses were $521,000 and cap ex was $101,000 this quarter. We currently expect 2008 non-cash expenses to be roughly $2.0 million and cap ex to be approximately $525,000.

It should be note that $8.3 million of our $16.0 million in cash is invested in auction rate securities or ARS. You have probably read many articles regarding the difficulties the ARS market is experiencing that has resulted and continues to result in failed auctions. These difficulties have also impacted BSQUARE.

ARS is a $330 billion securities market that has functioned very well for many years and only began experiencing difficulties in the mid-February timeframe. As a result of the failed auctions and our inability to predict when we would be able to liquidate our ARS holdings, we have reclassified $7.95 million of our ARS from short term to long term as of March 31.

Since March 31, $2.0 million of our ARS have been redeemed or will be redeemed shortly by [Ashores]. It's important to note that this is currently a liquidity issue, not a valuation issue and we have not taken any write-downs on our portfolio.

Our current ARS issues are either government backed or carry collateral coverage of at least two to one. Given the amount of cash not invested in ARS, the current -- the cash flow positive nature of current operations and borrowing capacity that exists both in our working capital and ARS portfolio, BSQUARE is not facing a liquidity crunch and still maintains sufficient financial flexibility to pursue strategic opportunities.

Headcount including contractors is currently 199 compared to 200 as of the date of our last conference call. Engineering services headcount is currently 129, up from 126.

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

Thanks, Scott. Today, I will provide my overall thoughts on BSQUARE's strategy and direction, and then I will discuss our Q1 accomplishments, and finally, I will finish with expectations for Q2.

For the past couple of years, our strategy has been to build out a complete set of products and service offerings that add value to our customers' device development efforts. Whenever a company develops a device based on a Microsoft imbedded or mobile operating system, we want that company to be compelled to call BSQUARE for help due to our deep product and service portfolio.

We seek to make it easier for companies to buy products and services from BSQUARE rather than proceed with their development using in-house resources. We are working to fill out our offering through our own internal development efforts, through external acquisitions or by creating partnerships. I'll have more detail in a moment on our accomplishments in each of these areas.

Our strategy has yielded 10 consecutive quarters of year-over-year total revenue growth and six straight quarters of profitability. I'm especially proud that we have been able to grow our revenues while maintaining control of our cost and driving leverage into our business model. We pride ourselves in running a lean operation and finding leverage wherever we can.

Going forward, investors should expect us to continue on the same course. We are actively working to expand our product and service offering and we have several internal R&D initiatives, acquisitions and partnership opportunities in process, which I will discuss in a moment.

Now, I'd like to speak to a few of our Q1 accomplishments. Our third party products team did a nice job in the quarter. Sales of Microsoft licenses were up significantly, both year-over-year and sequentially and we had a strong quarter in sales of the Adobe Flash Lite player. Flash Lite activity has been solid and has exceeded our expectations.

While our third party gross margin was down a percentage point both year-over-year and sequentially, this is a normal variation due to license sales in the quarter to several large lower margin customers. We are not seeing any dramatic margin pressure on Microsoft licensing sales and we still believe that our FY '08 third party gross margin will improve to 18% plus compared to 17% in FY '07.

We've had a few questions regarding Adobe's recent Open Screen announcement and how that announcement will impact BSQUARE. To recap, Adobe announced a new initiative in conjunction with several major device OEMs and silicon vendors to open the Flash file format, the Flash player program and interfaces and to remove licensing fees for the next generation of the imbedded Flash player. Adobe's intention is to make it easier for OEMs to adopt and use Flash technology in their devices.

For BSQUARE, this announcement has plusses and minuses. On the plus side, opening the Flash file format and removing license fees for the Flash player will make it more attractive for OEMs to adopt Adobe's technology, which in turn will drive demand for our services as OEMs will need help to implement, tune and certify the Flash player on their devices. With more service opportunities also come more opportunities to sell our products.

The minus is that we are deriving revenue today from selling Flash player licenses and with Adobe removing the license fee on the next generation player, our Flash revenue stream will eventually disappear. However, the next generation player is not scheduled to be released to market until the third quarter of 2009. Then, after the player is released, it will take time for devices using the player to reach the market.

In the interim, OEMs are still obligated to pay license royalties for the existing version of the player. Therefore, we do not expect to see any revenue impact from this announcement until late 2009.

Next, I would like to spend a minute updating you on progress with our partnership with Solidcore, wherein we sell Solidcore's S3 Control product to existing and new customers. S3 Control provides the ability to completely lock down and prevent unauthorized changes to a device that is using Microsoft's Windows XP, XP imbedded or Windows server operating system.

Solidcore's capabilities are important for industries that require very high level of security and control over devices such as ATM machines, point of sale terminals, medical devices that must comply with HIPAA requirements and regulated gaming devices. We made our first sale of the Solidcore S3 Control product in the quarter. However, we are behind our internal sales expectations.

We believe the reasons for this are largely training and market segment focus related and after meeting with our counterparts at Solidcore, we have put corrective actions in place that we believe will address these issues. Despite our slow start, we remain committed to making Solidcore a success in 2008.

Now, onto services - our service growth strategy is multi faceted. First, we seek to expand our service offerings to make them more attractive to existing customers and to capture new customers. Second, we are pursuing geographic expansion. And lastly, we will offer products that drive additional service revenue attached.

Due to the new strategies, we grew our service revenue 44% year-over-year in 2006 and 24% year-over-year in 2007 and we expect to grow our service revenue between 15% and 20% in 2008.

We entered Q2 with a near record service backlog and have not seen any signs of a slowdown thus far in the quarter. Demand for our services remains healthy, and if anything, has grown over the past few months. In fact, I think it's safe to say that the summer slowdown that's affected North America service revenue for the last two years will do so to a much lesser extent, if at all, in 2008. However, we will continue to monitor new sales activity and take appropriate actions should we detect any slowdown in demand.

We had several nice accomplishments during the quarter. We derived service revenue from 61 customers in Q1, up from 56 customers in the prior quarter. The increase in customers is primarily due to services related to porting the Adobe Flash player onto customer devices.

We successfully integrated the Adobe Flash personnel into BSQUARE and established an Adobe Flash consulting practice designed to help our customers port, optimize and certify the Adobe Flash player on their devices. We provided Adobe Flash consulting services to a dozen customers in the quarter using the Flash player in a variety of applications, including gaming, home automation, set top boxes, digital signage and home security.

Many of our customers ask us to help them to design and integrate wide area networking into their devices. Integrating a radio into a device is a complex undertaking and can be an expensive learning experience for a company that has never attempted to do before.

In response to these requests, we announced an agreement with Sierra Wireless to create a packaged wide area networking solution offering that integrates BSQUARE developed radio interface [lawyer] software with CR Wireless' CDMA and GSM radio modules. Using this as a foundation, BSQUARE's service team then integrates the package into a customer device. BSQUARE will also earn royalties as customers ship their devices.

We are offering this solution for devices that are utilizing the Windows CE and Windows mobile operating systems. We believe that this offering can shave months off the typical device development schedule, thereby saving customers hundreds of thousands of dollars. We have already closed our first sale of this solution and have several other proposals pending. We are expecting to deliver this solution to at least a dozen customers in 2008.

We won several new service engagements in Japan and saw strong growth in our service revenue out of Asia this quarter. Our Japan offices ramped faster than we expected and the continuing level of activity in both Taiwan and Japan has been very good.

Our headcount in Taiwan has grown to the point that we ran out of space in our Taiwan facility. We expect to grow our headcount further during 2008, and therefore, we made the decision to move to a new larger facility in Taiwan, which occurred in April. Our new facility effectively doubles our available space and will allow us to house over 60 employees in Taiwan.

While sales of third party products and services exceeded our expectations, sales of proprietary products came in lower than expected, due primarily to weakness in sales of our Marvel PXA based development kit and associated software, and to a lesser extent, slow SDIO sales.

We have been fighting a slowdown in sales of our PXA development kits for several quarters now. We recently met with our counterparts in Marvel to discuss market conditions and joint sales and marketing programs to improve our results. We have started implementation of these programs and expect that it will take a quarter or two for these actions to take hold and improve our results.

On the positive side, we announced software support for the Texas Instruments OMAP 25X and 35X application processor family with a production quality board support package and BSQUARE development kit. We believe that we have the first production quality Windows CE solution available today and we have seen good sales activity and customer interest in our solution.

We have been busy porting other BSQUARE software to our OMAP development kit, including our SCIO software, the Adobe Flash player and the CR wireless real package that I discussed earlier. We expect to begin offering these solution bundles during Q2. Overall, I'm excited about our OMAP solution and I am expecting to see good sales growth in the coming quarters.

In addition to creating our own development kit for the OMAP processor family, we are working closely with TI to build a more strategic offering that extends BSQUARE's software technology onto non-BSQUARE OMAP platforms. I hope to be able to discuss this in more detail in future calls.

We believe that our strategy of offering complete reference solutions will continue to drive growth of all of our software and service offerings. Therefore, we plan to continue expansion of our reference design offerings, and in fact, are working on a new family of reference designs that I'm very excited about. We will also discuss this in more detail in future calls.

Before I close with Q2 expectations, let me provide a brief update on acquisition and partnership activities. In the past two years, we have completed two acquisitions that have been quite successful for us and we expect our Solidcore partnership to be successful, as well. We are currently in discussions with several companies on both the M&A and partnership front and we are hopeful that we can get at least one transaction completed in the near future.

Now, onto our expectations for the second quarter. We expect our total second quarter revenue to be relatively flat sequentially, but up approximately 12% year-over-year. We expect all three of our revenue lines, third party software, proprietary software, and services, to be generally flat sequentially.

In the case of proprietary products, I am very excited about our new TI based products. However, our offering is still new and I believe it will take another quarter before we start to see any significant ramp in our revenue. We expect that the mix of both our third party and service revenue will shift in the second quarter.

In the case of third party software, we don't expect to see the strong showing in Microsoft license sales that we saw in Q1, but we are expecting to see an increase in sales of Solidcore. This is expected to result in a positive effect on gross profit and margins, although the exact impact is difficult to predict since Solidcore is such a new offering.

Further, we expect our higher core engineering service revenue to increase approximately 5% sequentially while low margin rebillable service revenue will be down by roughly a similar amount, which should drive improvement in service gross profit and margin.

In closing, I would like to express how happy I am with the way our business is currently performing, particularly considering what a strong quarter we turned in at the bottom line, despite our relatively weak performance in proprietary software revenue and the spike in our fringe expenses this quarter. We certainly have work to do in a few areas - primarily, growing our products revenue streams. But, overall, we have positioned ourselves as a valuable supplier in the growing imbedded device market. I'm excited about our direction and the opportunities we have in front of us.

This ends the prepared portion of our call. We would now open up the call for your questions.

Thank you. Ladies and gentlemen, at this time, we will begin the question and answer session.

(OPERATOR INSTRUCTIONS.)

Our first question comes from Brian Roth of SMH Group. Please go ahead with your question.

Hey, guys. Congratulations. Great quarter. I had a quick question for you. I had a couple of questions, but you seemed to answer them in the last couple of minutes. The first was having to do with acquisitions, which you say things are on their way, so I'm not going to get into what we've talked about the last few quarters during this session about potentially using cash for other things because obviously, you have things in the work.

But, I did want to -- wanted to commend you guys as far as giving a little more detail into next quarter. I know something that's been stressed is that it's a lot easier knowing that you're going off of six quarters in a row of profit. I mean, now that you're a securely profitable company, it's good to give maybe more precise numbers, details that investors can work with as far as earnings per share and revenues. So, you might even pick up an analyst or two along the way.

So, is it safe to say, I mean, with the numbers you're saying, we're looking at revenues flat sequentially, so in the same $17 million range and with the positive impact on gross margin and profit that you went through the last couple of minutes, are you looking at like this $0.10 earnings per share as like a base and then working up from there? And can we take that out even to the third and fourth quarter?

Well, what we would say is that we're always careful about our operating expenses. We don't have any large operating expenses planned. And so, if we can continue to drive gross margin, it should generally follow the bottom line.

So, Brian, I guess I would say, based on what we're seeing right now, the answer to your question would be yes. And obviously, with all these caveats that we could get a major contract cancellation over in services, etc., etc. And as we said coming off Q4, in the second half of '08, we have some guaranteed minimum royalties that are coming offline and that's why we had guided total proprietary software revenue for FY '08 flat. And so, the challenge for us to maintain that sort of what you call that baseline $0.10 a share is that we've got to backfill those guaranteed minimum royalties with things like the TI software revenue and some of those things. Does that make sense?

Yes, it does. All right, that's really it. Again, congratulations and I appreciate the clarity going forward.

(OPERATOR INSTRUCTIONS.)

And our next question comes from Meredith Jones from Hancock Securities Group. Please go ahead with your question.

Hi. I was wondering if you would talk a little bit more about the ARS portfolio you mentioned and what your intention with that is to get out of that as soon as you can, I guess?

Pardon me? Say that, again, Meredith.

To get out of it as soon as we can.

Yeah, our intention -- I mean, we've got sell orders in on everything, but so does everybody else on the planet.

Right.

And that's why the auctions are failing. And so, our current intention is to sit tight. I mean, there are somewhat secondary markets opening up on some of the stuff, but these secondary markets will all be selling off this stuff at say $0.90 on the dollar. And since we don't need the cash, our intent is to hold tight.

And based on what we're seeing in the market right now, my comments -- we basically said that we ended the quarter with about $8 million in auction rate securities that we moved to long term. Of that 8, about $2 million of that either has been redeemed subsequent to quarter end or will shortly. And so, we've got about roughly an even mix in our auction rate securities of government backed issues and closed end funds, preferred stock.

And so, we believe, based on what we're hearing from our cash manager and other people, that the closed end stuff will clean itself up hopefully pretty quickly. In fact, crossing our fingers that tomorrow, we're gonna get another announcement that another $1 million is going to be redeemed.

Okay.

So, we expect the closed end stuff, about half of our portfolio, to clean itself up in say three to four months. The government backed stuff will take a little bit longer. And there's currently some legislation in front of Congress that will basically take care of it and have the government step in and buy up the paper.

Okay, great. Nice quarter.

Okay, thank you.

Thank you. Ladies and gentlemen, at this time, we will give the participants a final opportunity to ask any additional questions.

(OPERATOR INSTRUCTIONS.)

Management, at this time, there are no further questions. Please continue with any further remarks that you would like to make.

Okay. Well, we'll go ahead and close the call at this point. Thank you, everybody, for listening and we will speak to you again next quarter.

Ladies and gentlemen, this concludes the BSQUARE Corporation First Quarter 2008 Earnings Conference Call. This conference will be available for replay after five p.m. Eastern time today through five -- or, I'm sorry -- May 15th, 2008 at midnight. You may access the replay system at any time by dialing 1-800-706-37 -- 1-800-406-7325 or 303-590-3030 using the access code of 3870202. Once again, thank you for your participation.