Bsquare Corp (BSQR) 2008 Q2 法說會逐字稿

Ladies and gentlemen, thank you for standing by and welcome to the BSQUARE Corporation Second Quarter 2008 Earnings Conference Call. At this time, all participants are in a listen-only mode. Later we will conduct a question-and-answer session, and instructions will be given at that time. (OPERATOR INSTRUCTIONS)

As a reminder this conference is being recorded today, Thursday, August 7th, 2008. I would now like to turn the conference over to Mr. Scott Mahan, Chief Financial Officer. 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 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.

During the discussion today, references to "this quarter," "the quarter" or "Q2" means the second quarter of 2008, references to "the first quarter" or "Q1" mean the first quarter of 2008 and references to "the third quarter" or "Q3" mean the third 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 $15.4 million, up 2% from $15.1 million in the year-ago quarter and down 10% from $17.1 million in Q1. This quarter represented our eleventh consecutive quarter of year-over-year total revenue increases. We had expected total revenue to be roughly flat sequentially. Softness in all major revenue components contributed to the expectation shortfall, which I will discuss shortly.

Total revenue for the first half of 2008 was $32.5 million, up 8% from $30.2 million in 2007. Sales of third-party software were $9.0 million this quarter, down 1% from $9.1 million in the year-ago quarter and down 11% from $10.1 million in Q1. Year-over-year decrease resulted from the effect of one large licensing sale of approximately $1.5 million that benefited the year-ago quarter, partially offset by sales of Flash Lite and Solidcore S3 Control.

Given the near-record performance of Microsoft licensing sales in Q1, we had expected third-party software sales to be roughly flat in Q2 as compared to Q1. Third-party software sales fell below our expectations this quarter due to lower-than-expected order volumes from several of our larger accounts. We expect these accounts to resume their normal ordering patterns in the second half of the year.

We generated $237,000 in Flash Lite revenue this quarter compared to none in the year-ago quarter and $450,000 in Q1. We generated $345,000 in Solidcore revenue this quarter compared to none in the year-ago quarter and $20,000 in Q1. Third-party software sales were $19.1 million for the first half of 2008, up 10% from $17.4 million in 2007. Proprietary software revenue was $676,000 compared to $1.0 million in the year-ago quarter and $863,000 in Q1. The decreases primarily resulted from lower SDIL revenue and lower service contract royalty revenue due to the expiration of certain guaranteed minimum royalties on these contracts. We recognize $303,000 in service contract royalty revenue this quarter as compared to $403,000 in the year-ago quarter and $372,000 in Q1.

We had expected the proprietary software revenue to be roughly flat sequentially versus the actual decline of 22%. Weaker-than-expected reference design revenue primarily associated with our IT-based OMAP products accounted for the shortfall. Proprietary software revenue was $1.5 million for the first half of 2008, down 25% compared to $2.0 million in 2007.

Service revenue was $5.7 million this quarter, up 16% compared to $4.9 million in the year-ago quarter and down 7% from $6.1 million in Q1. Year-over-year improvement was driven by growth in North America, partially offset by lower average project revenue and a decline in rebillable service revenue of $202,000. The sequential decrease in service revenue was driven by a $239,000 decline in rebillable service revenue and a $291,000 decline in APAC service revenue due to revenue recognition delays of $134,000 and the unexpected early termination of a customer contract. We do expect APAC service revenue to rebound in Q3 and contribute between $400,000 and $450,000 incrementally compared to Q2.

On last quarter's conference call we said that we expected service revenue to be roughly flat sequentially. Revenue recognition delays and the unexpected contract termination in APAC accounted for the shortfall. Service revenue was $11.8 million for the first half of 2008, up 9% compared to $10.8 million in 2007.

This quarter's billable hours were up 27% year over year and up 9% sequentially driven by growth in both North America and APAC. This quarter's effective bill rate declined 5% year over year and 10% sequentially due primarily to decreases in APAC stemming from the revenue recognition delays and the contract termination I just mentioned, which had a fairly high effective bill rate and which positively impacted both the year-ago quarter and Q1.

As we mentioned in today's press release, we are currently anticipating fairly significant growth in Q3, most of which will occur in service revenue. Consequently we have been ramping engineering service headcount fairly rapidly since late Q2. Brian will discuss this growth and the drivers behind it momentarily.

Turning to gross profit and margins, overall gross profit was $3.8 million this quarter or 25% of total revenue compared to $3.5 million or $23% of revenue in the year-ago quarter and $4.7 million or 27% of revenue in Q1. Year-over-year dollar increase was driven by higher gross profit contribution from service revenue partially offset by lower contribution from proprietary software sales. Third-party software margin was 16% this quarter compared to 14% in the year-ago quarter and 17% in Q1. Year-over-year margin improvement was driven by higher margin sales of Flash Lite and Solidcore not present in the prior year. We continue to maintain a high gross margin on our proprietary software revenue of 90% this quarter.

Service gross margin was 31% this quarter compared to 26% in the year-ago quarter and 34% in Q1. Year-over-year margin increase was driven largely by utilization improvement and a decline in low margin rebillable service revenue. Sequential decline was driven by lower revenue coupled with an increase in service cost of sales necessary to accommodate the billable hour increase. Overall gross profit was $8.4 million for the first half of 2008 as compared to $7.5 million in 2007.

Moving down to P&L, operating expenses were $3.5 million for the quarter compared to $3.3 million in the year-ago quarter and $3.7 million in Q1. Year-over-year increase was driven by increased sales expense in North America and APAC, higher marketing program costs and higher stock-comp expense. Sequential decline was primarily due to lower fringe benefits expense. Total operating expenses were $7.2 million for the first half of 2008 as compared to $6.7 million in 2007.

Now let me speak to our bottom-line results. We reported net income for the quarter of $310,000 or $0.03 per diluted share, down 43% compared to net income of $542,000 or $0.05 per share in the year-ago quarter whereas the year-ago quarter included a $287,000 gain on the sale of a previously written-off equity investment. This quarter's net income was down 69% compared to the net income of $1.0 million or $0.10 per share in Q1.

Q2 represented our seventh straight profitable quarter. We generated EBITDA this quarter of $715,000 or $0.07 per share compared to $595,000 in the year-ago quarter and $1.5 million in Q1. Cash and investments increased $400,000 to $16.4 million as of June 30, representing our seventh straight quarterly increase. Total non-cash expenses were $483,000 and CapEx was $266,000 this quarter. CapEx was higher than usual this quarter due to the expansion of our Taiwan office. We currently expect 2008 non-cash expenses to be roughly $2.0 million and CapEx to be approximately $600,000. Our 2008 CapEx estimate has increased by $75,000 from our last conference call due to headcount and facilities-related expenditures related to the ramping of our engineering services headcount I referred to earlier. As at quarter end, $6.5 million of our $16.4 million in cash and investments is invested in Auction-Rate Securities, or ARS, which is down $1.8 million from March 31 due to redemptions by issuers.

Given the current illiquidity of our ARS holdings, we have continued to classify them as long term as of June 30. 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. Given the amount of cash not invested in ARS, the cash-flow positive nature of current operations and borrowing capacity that exists against both our working capital and the ARS portfolio, BSQUARE is not facing a liquidity crunch. Headcount including contractors is currently 241 compared to 199 as of the date of our last conference call. Engineering services headcount is currently 163, up from 129.

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

Thanks, Scott. Today I will provide additional color on this quarter's results and update on our initiatives, and then we'll finish with expectations for the third quarter.

This was a challenging quarter for us, especially in software sales. Starting with third-party software sales, demand was unexpectedly soft from a few of our larger customers, especially one customer in particular whose ordering volume was considerably lower than normal. We believe that this softness was due to reduced or delayed demand for our customer's products. However, indications are that these customers will return to their normal ordering patterns in the third quarter, and we will see a small sequential increase in third-party software sales as a result.

Sales of Solidcore products were higher this quarter, $345,000 versus $20,000 in Q1, but overall we are not happy with the ramp in our Solidcore sales. To review, we entered into a partnership with Solidcore in January of this year whereby we are the exclusive North America reseller of Solidcore's S3 Control security product. Customer interest in the Solidcore product is good, and customers tell us that the product satisfies a key security need. However, now that we have a couple of quarter's worth of selling experience in the field, we realize that customers are wanting to spend more time testing and evaluating the product than we expected. Our goal for this year was to sell at least $2 million of Solidcore product in North America, but looking at our sales pipeline and resetting our expectations for the length of the sales cycle, we believe that we will only reach about one-half of that goal.

Adobe Flash player sales of $237,000 for the quarter were down from $450,000 in Q1. However, we remain very happy with the overall Flash business. Our Flash activity is strong. We currently have 50 distinct Flash product and service opportunities in the US and Asia that we have either won or have provided a proposal to a potential customer. Based on this level of activity, we currently expect that our Flash revenue will increase sequentially in Q3.

Turning to BSQUARE's proprietary software sales, on our last call we indicated that we expected proprietary software revenue to be generally flat sequentially. However, our actual proprietary software revenue was down $187,000 sequentially. The primary reason for this expectation shortfall is a slower-than-expected pickup in sales of our Texas Instrument's based 25X and 35X OMAP board support package and development kit products.

We believe that there are two reasons for this slow ramp. First, TI is still running their early-adopters program for the OMAP 35X processor series, which limits access to the silicon for some customers. We expect this program will end in early October and that more customers will gain access to TI's product at that point. Second, we are finding that customers prefer to use TI's evaluation board or EVM over our development kit. Therefore, we are shifting strategy and moving our product initiatives to include support for TI's EVM board. We remain positive regarding the prospects of our overall TI OMAP initiative, and we believe that TI's OMAP products are well positioned for success in the markets that we serve.

We received a steady flow of quality OMAP leads from TI, Microsoft and directly from our own marketing efforts, and we have several nice TI-OMAP-related deals in our pipeline. In addition we are close to signing a contract with TI that will result in BSQUARE receiving an ongoing revenue stream to fund continued investment into our OMAP products. To that end, we are excited about the prospects for several new upcoming products that will support TI's OMAP processors as I will discuss in more detail in a moment.

On our last call we indicated that we expected BSQUARE services to be flat sequentially with a drop in low margin rebillable expenses offset by an increase in core service revenue. We did see the expected drop in rebillable expenses, but our core service revenue remained essentially flat sequentially due to both revenue recognition delays and the unexpected early contract termination in APAC which Scott spoke to earlier. Overall pipeline activity and new project bid activity during the quarter were good, and we have not experienced any significant project cancellations outside of the one in APAC discussed earlier.

In our press release we indicated that we expect to see a large sequential increase in overall revenue in Q3. This increase is primarily being driven by service demand and in particular by a large service project that we have been awarded and have already started work on. This project will require a significant expansion of our engineering services capacity, and we have already begun the recruiting and hiring process.

To give you a little more detail, over the past year we have worked with Microsoft as a partner and supplier on their MS auto platform. Our efforts with Microsoft led to a project opportunity with one of Microsoft's largest MS auto customers to help that customer develop their next-generation in-car system. After a lengthy proposal process, we were awarded this project during the quarter. Our confidentiality agreement with our customer does not allow us to discuss the identity of the customer or the scope of the project. This project, if it reaches its expected potential, will represent the largest non-Microsoft service project in BSQUARE's history. This project necessitates BSQUARE ramping headcount from approximately 200 employees at the time of our last call to around 280 employees which we expect to reach in Q1 of 2009. Almost all the hiring will occur in engineering services and not all of the hiring will be permanent employees.

It should be noted that we are currently working under an interim service order with this customer which covers a relatively small portion of the overall project while we negotiate a long-term master services agreement. Consequently, while we have been awarded the project and have started work, the long-term service agreement with our customer that covers the majority of the work under the project has not been signed, and there is a possibility we will not reach ultimate agreement with our customer. Assuming that we do agree on acceptable terms and conditions with our customer, it is currently our expectation that we will sign the long-term service agreement during the third quarter.

Our third quarter revenue expectations assume that either we reach agreement with our customer on a long-term service agreement during the quarter or continue to work under interim service orders until such an agreement can be reached. If we successfully conclude negotiation of a larger, long-term service agreement, this contract should provide a significant increase in our base service run rate for at least the next year and a half, and we believe that this initiative will provide us with a solid platform to expand our participation in the automotive segment.

While we are proud of this accomplishment, we do not intend to rest on our laurels, and we are aggressively targeting new service business opportunities. To that end, we have started an internal process to complete a full assessment of our sales strategy and the resulting impact on our sales force and our sales capacity, given that current market signs lead us to believe that we can do better than we are today and that there is additional opportunity we are missing due to sales constraints. Our goal is to increase the base service sales capacity of our existing sales force by $6 million to $8 million over the next 12 to 18 months and to add incremental strategic sales assets both in the US and other geographies that will provide for another $8 million to $12 million in incremental sales capacity over the same time period.

Next, I would like to discuss several new proprietary software offerings that we plan to release over the coming quarters. These products aren't--these products as well as others we aren't prepared to discuss or that may be acquired through M&A or partnership efforts are all intended to make the building, testing and shipping new devices faster, easier and more cost effective for our customers. We always seek to target products that facilitate the cross-sell of our engineering services and our best-of-breed third-party software products. We envision BSQUARE as the leading device technology company providing software solutions to device-makers worldwide, with that software solution coming in the form of our own proprietary software, best-of-breed third-party software and customer software built through our engineering services capabilities.

In the third quarter we plan to release our first Design Verification Test or DVT package. This package results from years of QA projects executed by our services team. We have packaged that experience into a complete QA-in-a-box product that provides development and quality assurance teams with a significant head start in testing their Windows CE-based products. Our DVT package will initially support the TI OMAP 25X and 35X family, and we expect to support other processor families in the coming months. We believe that direct DVT revenue will be approximately $1 million over the next two years exclusive of other revenue attached.

In Q4 we expect to release our first Adobe Flash player add-on. As we have become more familiar with the Adobe Flash player over the past two quarters, our customers have told us that they would like to use the Adobe Flash player as the primary user interface for their device, but they are put off by the complexity of trying to control their device from Flash code running in conjunction with the Flash player. Adobe includes a mechanism that allows Flash code to interface with native device code. However, this method is very cumbersome and difficult to use, particularly for Flash developers, many of whom don't have the necessary software experience.

In fact, we have recently worked on a couple of service projects where we custom engineered a solution to this problem for our customers using our new technology. Our new Flash-focused product will include a set of pre-packaged libraries that enable Flash developers to control their device without requiring the engineering of any native device code.

In the near term, we believe that the revenue opportunity for this product is modest, perhaps $500,000 of direct product revenue over the next two years. However, we expect that this product will enable additional sales of the Adobe Flash player, resulting in incremental revenue and gross profits. And starting at the end of 2009 as Adobe's open-screen initiative takes hold and adoption of the Flash player and devices becomes even more widespread due to Adobe's change in pricing structure, we believe there will be additional opportunities for us to expand on this product concept and related revenue.

Finally in late Q4 or early Q1 we plan to release our first offering designed to make it easy for our customers to add 3G, GSM or CDMA radio capabilities to their devices. Today, adding 3G radio capabilities to a device is an expensive and complex undertaking, easily costing over $1 million in some devices. We have helped many customers add 3G radios to their devices, and we have developed an implementation recipe that has proved to be successful. In creating this recipe, we have created a body of intellectual property that we think is valuable for our customers. We believe that the converging forces of customer demand for 3G capabilities and the increasing availability and decreasing price of 3G data services presents a unique opportunity for us to turn this intellectual property into a product. Working in partnership with Sierra Wireless, we plan to offer a complete 3G reference design solution for Windows CE devices. We expect that this product will generate over $2 million in product revenue over two years, and expect that this product will also pull through additional service revenue.

To summarize, we have spent a good part of the last year rebuilding our products organization and re-energizing our new product efforts. We recruited a new leader for the team, Raj Khera, and Raj has done an outstanding job of bringing on new talent to help us drive our product initiatives. We expect these three new products to generate almost $4 million in revenue over the next two years before any associated service and third-party revenue attach.

On top of this we have in the past discussed $2 million to $4 million of media-plus and productivity-plus royalties that we have the potential to receive over the next two to three years as the two main customers for these products place their devices into production. We expect to deliver these and other products largely utilizing our existing R&D staff augmented with a small team out of our Taiwan office.

Finally, I will finish with our expectations for the third quarter. We currently expect our total third quarter revenues to be up roughly 15% sequentially and up approximately 30% year over year. We expect proprietary software to decline approximately $125,000 sequentially as it will take at least a quarter or two for our new products to begin to take hold, while we expect our third-party software to increase roughly 5% sequentially as we expect several of our larger Microsoft licensing accounts to resume normal ordering pattern. We currently expect our service revenue to be up roughly 35% to 40% sequentially, subject to the contract process discussed previously and contingent on no significant project delays.

From a gross margin perspective, we expect our proprietary gross margins to remain essentially flat from Q2 while we expect some modest improvement in our third-party software margin. We expect that our service margin will increase into the mid 30% range in Q3. From an operating expense standpoint, we have hired several new personnel in our R&D organization to support the new product work we have underway which, when coupled with increased sales costs associated to the higher revenue levels, will lead to an increase in Q3 operating expenses. We are also currently expecting a $400,000 sale of a patent to benefit other income in Q3.

In closing, I would like to say that while I am disappointed in our Q2 performance, I am very excited about the opportunities our new success in the automotive space brings to us, and I am anxious to get our new products to market. Proprietary product revenue has consistently been our weakest performing area over the last several years, and I'm intently focused on improving our performance.

Thank you for attending our call today. This ends the prepared portion of our call, and we will now open up the call for questions.

(OPERATOR INSTRUCTIONS) And I'm showing that we have no questions at this time.

Okay. Well, we'll go ahead and terminate the call at this point, then. Thank you very much for listening today, and we'll talk to you again next quarter.

And ladies and gentlemen, that does conclude our conference for today. Thank you for your participation. You may now disconnect.