Bsquare Corp (BSQR) 2008 Q3 法說會逐字稿

Good afternoon, ladies and gentlemen, and thank you for standing by. Welcome to the BSQUARE Corporation Third Quarter 2008 Earnings Conference Call. (OPERATOR INSTRUCTIONS) As a reminder this conference is being recorded today, Thursday, November 6th, 2008.

I'd now like to turn the conference over to the host, Mr. Scott Mahan, Chief Financial Officer of BSQUARE. Please go ahead.

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 "Q3" means the third quarter of 2008, while references to the "second quarter of Q2" and the "fourth quarter of Q4" mean those respective quarters in 2008. Further references to "this year" or "the year" mean fiscal 2008, while references to "last year" mean fiscal 2007.

With that, let me recap our financial results. We reported total revenue this quarter of $16.2 million, up 19% from $13.6 million in the year-ago quarter and up 5.0% from $15.4 million in Q2. This quarter represented our twelfth consecutive quarter of year-over-year total revenue increases. We had expected total revenue to increase roughly 15% sequentially. Unexpected softness in third party software sales drove the shortfall, which I will discuss shortly.

Total revenue for the first nine months of 2008 was $48.7 million, up 11% from $43.8 million in 2007. Sales of third-party software were $7.9 million this quarter, down 2.0% from $8.1 million in the year-ago quarter and down 12% from $9.0 million in Q2. The sequential decline resulted from a decrease in Microsoft licensing sales and lower Solidcore revenue.

We had expected third party software sales to increase roughly 5.0% compared to Q2. Third party software sales fell below expectations due to two factors. First, we had expect several large Microsoft licensing customers to resume their normal ordering patterns this quarter, which did not occur. Second, order volumes from our middle tier account segment were down 18% sequentially, which we did not expect.

Generally speaking, we aren't losing this business to competitors. Rather, customers have been delaying orders in light of current economic conditions. We do currently expect Microsoft licensing sales to rebound in Q4 and have already generated close to $3.3 million in sales in October.

We generated $277,000 in Flash Lite revenue this quarter compared to none in the year-ago quarter and $237,000 in Q2. We currently expect Flash Lite revenue to increase sequentially in Q4.

We generated $23,000 in Solidcore revenue this quarter compared to none in the year-ago quarter and $345,000 in Q2.

Third-party software sales were $27.0 million for the first nine months of 2008, compared to $25.4 million in 2007, representing an increase of 6.0%.

Proprietary software revenue was $831,000 this quarter, compared to $$866,000 in the year-ago quarter and $676,000 in Q2. We had expected proprietary software revenue to decline roughly $125,000 sequentially, when in fact proprietary software increased due to an unexpected royalty order from a longtime SmartBuild reference design customer. We do expect royalty revenue from this customer in Q4, but at a lower level.

We recognized $172,000 in royalty revenue from royalty-bearing service contracts this quarter, as compared to $420,000 in the year-ago quarter and $303,000 in Q2. Proprietary software revenue was $2.4 million for the first nine months of 2008, compared to $2.9 million in 2007.

Service revenue was $7.5 million this quarter, up 60% compared to $4.7 million in the year-ago quarter and up 32% from $5.7 million in Q2. Most of the year-over-year and sequential increases were driven by growth in North America, which, in turn, was fueled by a large project with the Ford Motor Company.

During the quarter we generated $2.6 million in service revenue from the Ford project compared to none in the year-ago quarter and $219,000 in Q2.

Asia-Pacific service revenue also contributed to the growth and was up 227% year-over-year and 78% sequentially, driven by growth in both Taiwan and Japan, but particularly in Japan.

We fell slightly short of our 35 to 40% sequential service revenue growth expectation this quarter, due to general softness in North America, which, again, appears to be driven by our customers' cautious reaction to current economic conditions.

This quarter's billable hours were up 68% year-over-year and 28% sequentially, driven by growth in both the North American and the Asia-Pacific. Service revenue increased 25% to $19.3 million for the first nine months of 2008, compared to $15.5 million in 2007.

Turning to gross profit and margins, overall gross profit was $4.4 million this quarter, or 27% of total revenue, compared to $3.5 million, or 26% of revenue, in the year-ago quarter and $3.8 million or 25% of revenue in Q2. Year-over-year in sequential gross profit increases were driven by higher gross profit contribution from service revenue.

Third-party software margin was 15% for the quarter, compared to 17% in the year-ago quarter and 16% in Q2. The year-over-year and sequential margin decline was driven by a decrease in Microsoft licensing margins on our middle-tier account base. We continued to maintain a high gross margin on our proprietary software revenue of 97% this quarter.

Service gross margin was 33% this quarter, compared to 27% in the year-ago quarter and 31% in Q2. Year-over-year margin increase was driven largely by utilization improvements. The sequential increase was driven by a slight improvement in utilization, coupled with higher revenue compared to certain fixed costs of service.

On a year-to-date basis, service margin is running 33% versus 27% in the prior year. We currently expect to see some slight service margin improvement in Q4, but expect to fall short of our full year goal of roughly 35% in 2008 due to the Ford project.

Overall gross profit was $12.9 million or 26% of total revenue for the first nine months of 2008, compared to $11.0 million or 25% of total revenue in 2007.

Moving down the P&L, operating expenses were $3.6 million for the quarter compared to $3.2 million in the year-ago quarter and $3.5 million in Q2. Higher sales costs in North America and Asia-Pacific drove the bulk of the year-over-year increase.

Total OpEx was $10.8 million for the first nine months of 2008, as compared to $9.9 million in 2007.

Now I'll speak to the bottom line.

We reported net income for the quarter of $1.1 million, or $0.11 per diluted share, up 206% compared to net income of $359,000, or $0.03 per share in the year-ago quarter. The quarter was up 270% compared to net income of $310,000, or $0.03 per share in Q2. This quarter's results benefited from a $300,000 patent sale.

Q3 represented our eighth straight profitable quarter. For the first nine months of 2008, we generated net income of $2.5 million, or $0.24 per diluted share, up 67% compared to net income of $1.5 million, or $0.15 per share, in 2007.

We generated EBITDA this quarter of $1.6 million or $0.16 per diluted share and have generated EBITDA of $3.8 million, or $0.37 per share for the first nine months of 2009.

Cash and investments declined $300,000 to $16.1 million, or $1.59 per share, at quarter-end. The decline was due to a $466,000 temporary impairment reserve we took against our Auction Rate Securities as of quarter-end, which I will speak to shortly.

Our accounts receivable increased by $1.2 million this quarter, compared to June 30, which negatively affected our cash flow and DSOs. This accounts receivable buildup had to do with Ford, which had a $2.3 million balance outstanding as of quarter-end, which has now been collected.

Total non-cash expenses were $496,000 and CapEx was $190,000 this quarter. During the quarter we had significant CapEx related to headcount expansion, a new development center and the expansion of another existing development center. Currently expect 2008 non-cash expenses to be roughly $2.0 million and CapEx to be approximately $600,000.

As of quarter-end, $6.1 million of our $16.1 million in cash and investments is invested in Auction Rate Securities, or ARS. Given the current illiquidity of our ARS holdings, we have continued to classify the majority of long-term as of September 30. Subsequent to September 30, $625,000 of our ARS balance was redeemed at par by issuers and is classified as current. We also expect another $200,000 to be redeemed at par in November.

On October 10, the Financial Accounting Standards Board issued FSP 157-3, which clarified, among other things, how to value securities in inactive markets. FSP 157-3 specified that a valuation model must be used to determine fair value and adjustments must be made for liquidity risks. Consequently, we engaged a third party valuation firm whose valuation model calculated a 68% discount against the par value of our ARS holdings.

Total value discount was $466,000, which is considered to be a temporary impairment and reported in "Other Comprehensive Income" and shareholders equity. It's important to note that all of our ARS continued to pay interest, maintain high credit ratings and that the underlying collateral has not currently been impaired.

Headcount, including contractors, is currently 276 compared to 241 as of the date of our last call. Engineering service headcount is currently 200, up from 163.

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

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

Starting first with third party software sales. We experienced a second straight quarter of reduced demand from Microsoft licenses. As Scott mentioned earlier, there was unexpected softness in all our Microsoft licensing segments during Q3. There is no question that customers are being cautious about their license purchase decisions in the current environment and we expect that this caution will continue into 2009.

However, the fourth quarter has traditionally been a strong licensing quarter for us and our licensed sales are off to a good start in October. Therefore, we are cautiously optimistic that we will show sequential growth in Microsoft licensing in the fourth quarter.

Our relationship with Microsoft remains very strong and we are working together on several sales and marketing campaigns to stimulate demand. Based on this work and several new opportunities that have presented themselves to distribute other Microsoft products, I'm cautiously optimistic that we can continue our licensing growth in 2009.

I also want to update you on two other best of class third party products that we sell, Solidcore S3 Control and Adobe Flash Lite. Sales of Solidcore were minimal in the third quarter and we do not expect to see any significant increase in Solidcore sales until the first quarter of 2009.

Solidcore sales are highly technical and we have learned that they usually involve a lengthy proof of concept period. Solidcore engagements take longer to close than we originally anticipated. Therefore, while we have fallen short of our sales goals for 2008, we've built a solid pipeline of accounts that are evaluating the Solidcore product and we expect sales to pick up in the first quarter of 2009.

We had another solid quarter selling the Adobe Flash Light Player and related services, generating $277,000 of Flash Lite licensing revenue in the quarter. We remain satisfied with our decision to purchase the Flash Lite assets from NEC last year. We have a strong pipeline of customers who are in the evaluation and certification stage, which leads us to believe that we should sequentially increase our Flash Lite license revenues in Q4.

Flash Lite license sales also have a nice payoff in cross-selling associated service revenue, as we have delivered roughly $0.5 million of Adobe Flash service revenue this year-to-date and we've been able to use the Adobe Flash capabilities to win other major service projects. We currently expect Adobe Flash Player sales and associated service revenues to continue at roughly the current run rate throughout 2009.

Turning to proprietary software sales. On our last call, we indicated that we expected proprietary software revenue to decline by approximately $125,000 sequentially. However, our actual proprietary software revenue increased sequentially by $155,000. This increase was due to an unexpected license order for our older SmartBuild reference design from a longstanding customer, as Scott mentioned earlier.

Our product and service teams are currently engaged with this customer to move their next generation product onto our PXA 270 reference design, using Schema, our Board Support Package generation tool, thus opening up the opportunity for us to earn additional Schema royalties from this customer during 2009.

On our last call, we discussed a large service contract with the Ford Motor Company that we had been awarded at the end of Q2. This was a good win for BSQUARE in the automotive space. This win was made possible by BSQUARE's unmatched expertise in building Windows CE-based products, coupled with the more recent expertise we gained from working with the Microsoft Auto team on the next generation Microsoft Auto platform.

Based on this win and our ongoing efforts with the Microsoft Auto team, we believe that there are over 100 potential customers who are interested in building products based on the Microsoft Auto platform and that these customers represent a substantial multi $10 million service, product and Adobe Flash licensing opportunity for BSQUARE.

We feel that BSQUARE is uniquely positioned to take advantage of this opportunity due to our size, expertise, and experience in successfully delivering on large and complex projects. We are in the process of restructuring and repositioning sales and business development personnel in order to take advantage of this opportunity, as I will discuss in a moment.

Outside of the automotive space there has been softening in demand for our services by our more traditional Windows CE and Windows Mobile clients. Customers are being cautious in their decisions to move forward on new projects and the number of new bids we worked on during the third quarter was down compared to the second quarter. We generally are not seeing existing projects being canceled. Rather, customers are delaying the start of new projects.

Based on our Ford contract, our service backlog is strong enough that we expect to sustain our current service revenue level through the first half of 2009. Beyond that, however, it is more difficult to predict what will happen, although we continue to position ourselves to drive growth on top of our current service revenue run rate, as I will talk about next. As always, we keep a close eye on the key metrics in our service business and we will adjust our capacity to meet demand.

We spoke on our last call of plans to conduct an assessment of our sales organization and strategy, and to make the changes necessary to drive revenue growth. I can report that the assessment is complete and we have already taken key actions.

We have geographically repositioned key sales positions. We have put into place a dedicated sales focus on selling our products. We have eliminated several non-quota-carrying positions, hired a new sales executive based in Europe to drive European automotive and other device business and we hired a new business development executive to manage and grow key partner relations.

I'm particularly excited about the opportunity in Europe. We believe that there are several near-term prospects for automotive business in Europe and we believe that Europe, with its advanced 3G networks, represents a good market for our new wireless 3G products. We believe that Europe represents at least a $5.0 million product and service expansion opportunity for us over the next three years and we want to hit the ground running.

Next I'd like to update you on the progress of key product initiatives.

During the quarter we released our new Flash UI Extender product, which is a development tool that extends the capabilities of the Adobe Flash Lite Player to provide Flash developers with easy access to device functionality that is normally difficult or impossible to access directly from Flash code.

For example, when using the existing Flash Lite Player without our UI Extender product, if a Flash developer wants to query and display battery status, that developer would be forced to make a call into native device code that would check and then return battery status. Developing this native code is not something that many Flash UI developers are comfortable with. Plus this native code is difficult to debug and maintain.

Using our new Flash UI Extender, BSQUARE has prepackaged the functionality needed to access many common device functions, such that a Flash developer can accomplish their task without leaving Flash code. We believe that for an average device, our Flash UI Extender will save developers up to 40% of the time they would need for UI development and testing, as compared to writing their own native code.

Our revenue expectations for this product over the next 12 months are modest, perhaps $500,000. However, we believe that this product will help to maintain our current $2.0 million per year run rate for Flash services and licensing.

Just after the quarter ended, we announced the release of our wireless 3G Development Kit designed to make it easy for our customers to add 3G radio capabilities to their devices. Today, adding 3G radio capabilities to a device is an expensive and complex undertaking, easily costing over $1.0 million in some devices.

Over the past couple of years, our service team has 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 built a body of intellectual property that we think is valuable to 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 series of products. And our 3G Development Kit is our first of several offerings we plan to release in the coming months.

The 3G Development Kit we just announced supports CDMA networks. We also expect to release versions for GS and data networks as well as versions that support both CDMA and GSM voice and data. We expect that our 3G Development Kits will earn more $2.0 million in proprietary software revenue over the next two years and that these software sales will also lead to substantial service engagements.

I would also like to update you on our investment into products based on the TI OMAP 35x processor series. We believe that the TI OMAP 35x will be adopted by many companies for their next generation devices, based on its Laptop Lite performance and handheld device power levels.

Over the past year BSQUARE, working in partnership with TI, has invested in creating a Windows CE 6.0 Board Support Package for the OMAP 35x family. We are co-marketing the software with TI into OEMs and ODMs worldwide.

During the quarter we entered into an agreement with TI whereby when customers download the software from BSQUARE and when a customer decides to build a new device based on the OMAP family and Windows CE, BSQUARE is paid a fee by TI. This is a win-win for BSQUARE and TI and our mutual customers.

TI has production-ready software supported by BSQUARE. BSQUARE receives an ongoing revenue stream that allows for investment, support and maintainance of the software. More importantly, the end customer gets to market sooner with a high quality device. Because customers will come to BSQUARE to receive the software and support for the software, BSQUARE has the opportunity to sell other products and services to these customers.

As we mentioned in our press release, we have released an early version of the software to well over 50 of TI's OMAP 35x early adopter customers for evaluation and feedback. Once the full production software is released in early 2009, we expect that the number of customers downloading and using and using the software will increase dramatically.

Over the next two-to-three years, we believe that the TI-OMAP relationship yield $2.0 million to $3.0 million in revenue from both ongoing revenue streams from TI and from new product and service opportunities that will come from customers adopting this software.

To summarize, we are focused on increasing the revenue and profits that we generate from our products. There are two key areas that we are very focused on -- 3G connectivity between devices and high performance multimedia.

We believe that in the future more and more devices will require one or both of these capabilities. Therefore, we are assembling a portfolio of products and services to support our customers. Based on past design wins and new products that are now coming to market, we believe that we have a multimillion-dollar opportunity to grow our product revenue in 2009.

In addition to building products internally, we are very interested in acquisitions that can accelerate our progress. We are currently engaged in several acquisition opportunities, one of which has advanced quite far down the road towards closure, such that we hope to be able to speak about it in more detail in the coming weeks.

I will finish our call today with expectations for the fourth quarter. We currently expect our total fourth quarter revenues to increase between 5.0% and 10% sequentially and increase roughly 10% to 15% year-over-year.

We expect proprietary software to decline approximately $180,000 sequentially, as we believe we still have another quarter before our new products begin to ramp and we do not expect a repeat of the large SmartBuild order that we received in the third quarter.

We expect third party software sales to increase 13% to 18% sequentially, based on the strong start to the quarter, our order backlog and outlook from our customers.

We expect our service revenue to be up slightly, sequentially, based on our current backlog. From a gross margin perspective, we expect third party software and service gross margins to improve slightly from Q3.

In closing, I would like to say that I think we turned in a solid quarter. I'm very excited about the opportunities our new success in the automotive space brings to us and I'm anxious to get more 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. We will now open up the call for questions.

Thank you (OPERATOR INSTRUCTIONS) And our first question comes from the line of Anthony Marchese with Monarch Capital. Please go ahead with your question.

Hi. It sounds like fourth quarter should be okay. What -- can you say anything about 2009 at this point? I know one of your goals was to increase sales of proprietary software. Do you still see that going forward?

Yes. As I just mentioned, Anthony, we are expecting to increase proprietary software sales next year. We typically give our more detailed guidance on 2009. We'll get that on our next call.

Okay, a final question. New, rather, M&A activity, what's your criteria for M&A? Does it need to be immediately accretive or can we anticipate that this is going to be a meaningful addition to the Company if it comes to fruition?

Our goal is always to try to keep things accretive, if possible, certainly if there was a strategic acquisition that we saw that might cause us to go into the red. We would be willing to look at it, but we've never wanted to take something on that cause us to go negative for a long period of time. Do you want to add to that, Scott?

Yes. Anthony, I would clarify that. The answer is it will be accretive, but obviously with some transactions there may be a short period of time - whether you're working through transition issues, transition costs, etc - that it may not be accretive. But we would certainly not be looking at anything in the current pipeline that have a significant short-term negative effect.

Right. Okay. Thank you very much.

And Anthony, to add to the B product answer that Brian gave you, I mean, we have obviously a number of products that Brian spoke to that we're getting out the door in Q4, a couple things the R&D team's working on. We also have -- we referred to this in the past quarter, we also have a couple key design wins out there with a couple very large companies that we expect, over time, to contribute in the neighborhood of $2.0 million to $4.0 million in royalties. Its really a question with this more of when we'll see it.

Right. Okay, very good. Thank you.

Thank you. (OPERATOR INSTRUCTIONS) And presenters, there's no further questions at this time. Please continue.

Okay. Well, thank you once again for listening, participating in our call today and we will look forward to speaking with you next quarter. And you can take it from here, operator.

Thank you. Ladies and gentlemen, that does conclude our conference for today. Thank you for your participation. You may now disconnect. 7