Bsquare Corp (BSQR) 2009 Q3 法說會逐字稿

Good afternoon, ladies and gentlemen, thank you for standing by. Welcome to the Bsquare Corporation Third Quarter 2009 Earnings Conference Call. During today's presentation, all parties will be in a listen-only mode. Following the presentation, the conference will be opened for questions. (Operator Instructions). This conference is being recorded today, Thursday, November 5, 2009.

I would now like to turn the conference over to Scott Mahan, Chief Financial Officer. Please go ahead, sir.

Thank you. Good afternoon, everyone. Before I begin, 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 press release issued today and that posted with these prepared remarks, both of which apply to the content of this call.

During the discussion today, references to this quarter, the quarter or Q3 mean the third quarter of 2009, references to the second quarter or Q2 mean the second quarter of 2009, and references to the fourth quarter or Q4 mean the fourth quarter of 2009. Further, references to this year or the year mean 2009, while references to last year mean 2008.

With that said, let me recap our financial results. We reported total revenue this quarter of $16.4 million, up slightly from $16.2 million in the year-ago quarter and $16.1 million in Q2. Our largest customer, the Ford Motor Company, accounted for 24% of total revenue this quarter, 16% in the year-ago quarter and 32% in Q2. Total revenue for the first nine months of 2009 was $49.2 million, up 1% from $48.7 million in 2008.

Sales of third-party software were $8.9 million this quarter, up 13% from $7.9 million in the year-ago quarter and up 35% from $6.6 million in Q2. An increase in Microsoft licensing sales drove both increases, coupled with a $640,000 Flash licensing sale, which also benefited the quarter. During the quarter, average sales per Microsoft licensing customer rebounded to something approximating historical levels, which drove the Microsoft licensing sales growth.

Third-party software sales were $22.9 million for the first nine months of 2009 compared to $27.0 million in 2008. Proprietary software revenue was $947,000 this quarter, up 14% compared to $831,000 in the year-ago quarter and down 21% from $1.2 million in Q2.

TestQuest product and support revenue was $273,000 this quarter, compared to none in the year-ago quarter and $741,000 in Q2, and accounted for a year-over-year increase and a sequential decline. Proprietary software revenue was $3.1 million for the first nine months of 2009 compared to $2.4 million in 2008. TestQuest product and support revenue was $1.3 million for the first nine months of 2009. TestQuest support and maintenance revenue was $149,000 this quarter compared to $87,000 in Q2. We are making steady progress in growing our TestQuest support and maintenance revenue run rate to something that hopefully approximates and ultimately exceeds that of TestQuest pre-acquisition, which was roughly $400,000 per quarter. To achieve this, we need to be successful with our TestQuest product efforts, including TQ Pro version 8.

Service revenue was $6.5 million this quarter, down 13% compared to $7.5 million in the year-ago quarter and down 22% from $8.3 million in Q2. A decrease in non-Ford North America and APAC service revenue accounted for the year-over-year decline, whereas a drop in Ford service revenue drove the sequential decline, partly offset by an increase in APAC revenue. Ford service revenue was $3.3 million this quarter or 51% of total service revenue, up from $2.5 million or 33% of service revenue in the year-ago quarter and down from $5.2 million or 63% of service revenue in Q2. As we stated last quarter, we modified our fee structure with Ford in Q2 from time-and-materials to time-and-materials with a fee cap, and agreed to cap the fees associated with the remainder of the project at an amount less than we would have realized under the previous structure.

Consequently, in Q2, we began accounting for the remainder of the Ford project using percentage-of-completion accounting. Due to unanticipated project overruns in Q3, Ford service revenue came in roughly $500,000 under what we expected for the quarter. This revenue will be recognized in subsequent quarters. The revenue shortfall and cost overruns also significantly affected our service gross profit, gross margin and effective bill rate this quarter. APAC service revenue declined $307,000 or 36% year-over-year due to poor economic conditions, but increased $509,000 or 1,900% sequentially. As we mentioned last quarter, we signed several deals in APAC, including an automotive win, which positively affected Q3 service revenue. However, it's still too early to conclude that things have returned to normal in that market. Total service revenue increased 20% to $23.2 million for the first nine months of 2009 compared to $19.3 million in 2008 driven by the Ford project. Ford service revenue was $13.6 million for the first nine months of 2009, compared to $2.7 million in 2008.

Turning to gross profit and margins, overall gross profit was $3.4 million this quarter or 21% of total revenue, as compared to $4.4 million or 27% of revenue in both the year-ago quarter and Q2. The year-over-year and sequential total gross profit declines, as well as the sequential total gross margin decline, were largely driven by the Ford overruns. Third-party software margin was 17% this quarter compared to 15% in the year-ago quarter and 16% in Q2. Proprietary software gross margin was 84% this quarter, compared to 97% in the year-ago quarter and 88% in Q2. TestQuest-related amortization accounted for the year-over-year drop, whereas lower proprietary software revenue accounted for the sequential decline. Service gross margin was 17% this quarter, compared to 33% in the year-ago quarter and 28% in Q2. The declines were largely driven by the effect of the Ford overruns, which negatively impacted revenue and caused our service cost of sales to run higher than it typically would at this revenue level. Service margin was also negatively affected by the fact that a portion of our service cost of sales is fixed in nature and declining revenue levels will negatively affect margin. Excluding rebillable cost, approximately 12% of our Q3 service cost of sales was fixed in nature. Overall gross profit was $12.2 million or 25% of total revenue for the first nine months of 2009, compared to $12.7 million or 26% of total revenue in 2008.

Moving down the P&L, operating expenses were $3.3 million for the quarter compared to $3.6 million in the year-ago quarter and $4.0 million in Q2. This quarter's operating expenses benefited from the reversal of an accrued legal fees liability in the amount of $534,000, without which OpEx would have been $3.9 million. TestQuest-related operating expenses of $589,000 compared to none in the prior year accounted for the year-over-year increase, offset in part by a decline in SG&A expense. The legal liability reversal relates to securities class action litigation we have been involved with since 2001. On October 6, the court approved final settlement of this litigation at which point we determined the legal liability was no longer probable as of September 30, and therefore, no longer necessary. Under the settlement, we bear no financial obligation; with our insurers covering all settlement costs. While the settlement is subject to appeal, we currently have no reason to believe that our ultimate financial obligation would be impacted materially as a result of the appeals process. Total operating expenses were $12.0 million for the first nine months of 2009 compared to $10.8 million in 2008. TestQuest-related operating expenses of $1.9 million drove the nine-month increase.

Now, I'll speak to our bottom line results. We reported net income for the quarter of $71,000 or $0.01 per diluted share, down from net income of $1.1 million or $0.11 per diluted share in the year-ago quarter and down from net income of $348,000 or $0.03 per share in Q2. This quarter benefited from the legal liability reversal of $534,000 or $0.05 per share, whereas the year-ago quarter benefited from a $300,000 patent sale or $0.03 per share. For the first nine months of 2009, we reported net income of $329,000 or $0.03 per diluted share, compared to net income of $2.3 million or $0.23 per diluted share in 2008. TestQuest results negatively affected the bottom line for the quarter in the amount of $441,000 or $0.04 per share, and $967,000 or $0.10 per share for the first nine months of 2009 compared to no effect in the prior year.

We generated EBITDAS of $477,000 this quarter, our 12th consecutive quarter, compared to $1.6 million in the year-ago quarter and $833,000 in Q2. The Company's EBITDAS was $1.5 million for the first nine months of 2009, compared to $3.7 million in the prior year.

The 2009 three and nine-month EBITDAS amounts benefited from the legal liability reversal, whereas the year-ago amounts benefited from the patent sale. We incurred $407,000 of non-cash expenses this quarter, including $100,000 in TestQuest-related amortization and $1.3 million for the first nine months of 2009.

Cash and investments increased $3.8 million to $15.6 million at quarter-end, largely as a result of collecting $4.1 million in receivables that were past due from Ford as of June 30. As of quarter-end, there were $1.4 million in Ford receivables that were past due. The September 30 cash and investments balance includes $900,000 of restricted cash and $4.2 million of auction rate securities, both classified as long term. The auction rate amount is net of a valuation allowance of $726,000 such that our gross cash and investments were $16.3 million at quarter-end. At quarter-end, we had $4.9 million in auction rate securities at par value, which was down $525,000 from June 30 due to issuer redemptions. CapEx was $39,000 this quarter and $139,000 on a year-to-date basis. We currently expect FY '09 CapEx to come in under $200,000.

Headcount, including contractors, is currently 272 compared to 284 as of the date of our last call. Engineering services headcount is currently 179, down from 195.

Now, I'd like to turn the call over to Brian Crowley, Bsquare's Chief Executive Officer.

Thanks, Scott. Today I will review our results from Q3, provide an update on our key initiatives and then discuss our outlook for Q4. Microsoft licensing sales were quite strong, as several of our larger customers continued to pick up their pace of orders. We also saw a pick-up in orders from our second-tier Microsoft licensing customers. Revenue from second-tier customers came in at a level that we have not seen since the second quarter of 2008. Fourth quarter Microsoft licensing sales are off to a strong start and we are currently expecting a sequential increase in Microsoft licensing revenue. It's too early to tell if this increase represents pent-up demand or a sustainable return to a higher revenue level, but the fact that customers are once again purchasing licenses at a rate closer to their historical levels is a positive sign.

We announced this morning that Microsoft has selected Bsquare as its first Mobile Indirect Channel distribution partner. Under this partnership, Bsquare will sell Windows Mobile to both handset manufacturers developing Windows Mobile phones for consumers and to rugged device manufacturers shipping data collection terminals to businesses and other OEMs.

Microsoft will retain a direct relationship with select Windows Mobile customers and over the next 12 months will transition approximately 30 other existing Windows Mobile customers to Bsquare with the majority transferring in the first half of 2010. In addition to selling Windows Mobile licenses to these customers, Bsquare will enter into paid support agreements with some customers in order to provide technical support, training and to act as the interface with Microsoft's Windows Mobile team.

Microsoft is setting up the Mobile Indirect Channel in order to expand the reach of Windows Mobile into a broader base of customers. The Windows Mobile sales and support team at Microsoft is organized effectively to support customers shipping hundreds of thousands or millions of devices, whereas Bsquare is ideally structured to support customers who are shipping at much lower levels, which makes this partnership ideal. Under our agreement, Microsoft and Bsquare will collaborate not only to service existing Windows Mobile customers, but also to sell Windows Mobile to new customers who may traditionally select other, non-Microsoft platforms for their devices. This is an exciting announcement for Bsquare. We expect that over the next 12 to 18 months, this partnership has the potential to generate an incremental $5 million to $10 million of third-party software revenue for Bsquare at margins somewhat comparable to our existing Microsoft licensing revenue. We also believe that through early exposure to new Windows Mobile projects, we can drive sales of other Bsquare products and services and in fact have already identified several opportunities for our services and our OMAP Windows Mobile BSP based on this new relationship. Overall, we expect that the Windows Mobile licensing will be accretive for Bsquare in 2010.

Now to discuss our outlook for services. The big driver for our service results for the past several quarters has been the Ford program and that program remained a big driver in Q3. We are currently in the final integration stages and the program has an aggressive schedule. In order to support our customer in meeting that schedule, we applied a number of extra resources during the quarter, not all of which we are able to bill Ford for under our existing arrangement. Our goal is to make our customers successful and to have a long relationship with the Ford Motor company and in pursuing that goal during the quarter, the needs of the program ran ahead of our ability to modify our agreement with Ford in a timely fashion. We are currently in discussions with Ford to recover our additional costs in Q3, and while we are confident that we will work out an equitable arrangement with Ford, there is no guarantee that we will receive additional funds.

Any additional funds we receive from Ford will benefit Q4 and future quarters. We are also in discussions regarding follow-on programs with Ford and if we are awarded new work, we expect that it would begin ramping up in early 2010, which means that Ford service revenue will decline again in the fourth quarter, absent any additional funds we receive to cover additional work, before potentially increasing again in 2010. We currently estimate Ford service revenue in Q4 to be $2.5 million as it compared to $3.3 million in Q3.

As we discussed on our last call, we are also working with The Coca-Cola Company, whereby Bsquare provides consulting and development services, as well as royalty-bearing Bsquare IP for the new Coca-Cola Freestyle beverage dispensers. These dispensers are currently being rolled out for testing at various restaurants in the Los Angeles and Atlanta areas. We expect that we will continue to work with Coca-Cola on the Freestyle program and follow-on programs throughout 2010. Overall, while it appears economic conditions are stabilizing, we still see that customers remain very cautious in committing to large new service programs.

Our service bid activity, which is our best forward-looking indicator for future service business, remained at about the same level as Q2, which is a level almost double where it was in the second half of last year, yet our service close ratio, while improved in Q3, is still not where we want it to be. We are fortunate to have a set of anchor customers for whom we will continue to do service work throughout 2010, and I believe that the Mobile Indirect Channel agreement we just signed with Microsoft will also have a positive impact on our service revenue next year. Our Windows Mobile-related service revenue has dropped to almost zero over the past year, as Microsoft has not released a new version of the platform for some time. With the release of Windows Mobile 6.5, we see renewed interest from OEMs and ODMs in upgrading their devices. This interest, coupled with our position as a Mobile Indirect Channel partner, leads us to believe that the early access we will gain to Windows Mobile designs will lead to incremental Windows Mobile service work in 2010.

Now to discuss our two main product initiatives, TestQuest and our Texas Instruments co-investment. Our TestQuest results in Q3 were a big disappointment. We had expected a small sequential increase over Q2 and what we ended up with was a large drop in revenue. We've spent a lot of time analyzing why we missed our expectations so badly, and can broadly lump the explanation into two buckets: economic conditions and our own sales execution issues. Regarding the former, we identified almost $1 million of potential sales that moved into Q4 or Q1 of 2010 based on customers deciding to delay their projects or their purchases. We never expected to win all that business in Q3, but we certainly expected to win a portion of it. Obviously, it is still a difficult selling environment. Even though we believe that TestQuest is a product that ultimately helps development teams to be more efficient and is a product with a strong ROI, we find that companies are still being stingy in spending on development tools. Beyond the difficult selling conditions, we have identified several internal issues with the way we target and sell TestQuest. This leads us to believe that we spent sales times on prospective deals that were not a good fit for the product or that were not in a position to close in the quarter, which negatively impacted our results. We've put several remedial actions in place to address these issues going forward.

From a development perspective, we continue to advance both TestQuest products, CountDown and TestQuest PRO. TestQuest PRO is the older of the two products and has the larger installed base. TestQuest PRO has not had a maintenance release in several years, and after visiting and talking to several of the larger TestQuest PRO customers, we

determined that in return for a modest investment to refresh TestQuest PRO, there is an opportunity to sell additional licenses and support agreements to these customers. We have developed a TestQuest PRO roadmap, which the team is executing against and we recently released TestQuest PRO version 8.0, which we are actively selling into the existing TestQuest PRO installed base.

Overall, even though this was a disappointing quarter in TestQuest sales, I still believe that the TestQuest products will ultimately be very successful for Bsquare. I believe that there is an appetite in the market for development and test tools that help teams solve their issues with shrinking development cycles, increasing code complexity and geographically distributed development teams. Based on the efforts I have described above and our sales pipeline, we are currently looking for a substantial sequential increase in TestQuest revenue in Q4.

Now turning to our TI Board Support or BSP initiative. You'll remember that we have two tracks of partnership with TI. he first is for the co-development of a Windows CE 6 BSP and the second is for a Windows Mobile 6.5 and 7 BSP. Our Windows CE BSP development efforts have progressed nicely. Our BSP has been released to the market and we have been receiving revenue from the BSP for several quarters. In Q3, we recognized our first Windows CE BSP design win. Our agreement with TI is such that we receive payments when specific design win criteria are met. We expect to recognize another four to six design wins in Q4, and expect that number will climb throughout 2010 as the OMAP 3 processor and Windows CE is adopted in more new designs. The development team is working with TI on a new OMAP 3 variant for which we expect to receive additional design win payments next year.

Regarding our Windows Mobile BSP project, the first Windows Mobile device using TI's OMAP 3 processor and the Windows Mobile BSP, the HTC Qilin, a smartphone focused on the Asia market, is expected to begin shipping in Q4 and we expect royalties from this device starting in 2010. In addition, there are currently four additional design wins for industrial and handheld data collection devices that are expected to close in Q4 and we expect these to also generate royalties next year. Between our Windows CE and Windows Mobile BSP efforts, we believe that there is an opportunity for $4 million to $6 million in licensing and royalty revenue from 2010 to 2013, which should run close to 100% margins. On top of this revenue, we believe that we will sell additional Bsquare products and services. However, that additional amount is difficult to quantify. Based on the Mobile Indirect Channel partnership with Microsoft that I described earlier, we are now able to offer our customers a complete reference solution for Windows Mobile, including a TI reference design, a production quality Windows Mobile BSP and Windows Mobile licenses. This is a unique offering that is unmatched in the market today and will bolster our efforts to drive incremental service and product revenue from our Windows Mobile BSP project.

In summary, our key initiatives are just beginning to deliver incremental high-margin proprietary software revenue. Moving into 2010, we expect our TI royalty streams and other royalty-bearing design wins to gain momentum as the year progresses. If we are successful in our TI and TestQuest initiatives, the result should be a substantial increase in high-margin product revenue beginning primarily in the second half of 2010 coupled with the fact that development expenses associated with the TI revenue should be wrapped up by early 2010.

I will finish our call today with expectations for the fourth quarter. Based on our current outlook, we expect overall revenue to be roughly flat sequentially. We expect that third-party software sales will be down slightly sequentially, as we see strength in Microsoft licensing demand continuing, offset by a drop in Adobe Flash licensing revenue, as we do not

expect a repeat of the very large Adobe Flash order we saw last quarter. We expect to sell some Windows Mobile licenses in Q4, but those sales will not begin to impact our results meaningfully until early 2010. We expect service revenue to be down slightly sequentially as the current Ford program continues to ramp down. We expect our proprietary software revenue to be up substantially sequentially, driven primarily by an increase in TestQuest license and support revenue.

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, sir. We will now begin the question-and-answer session. (Operator Instructions). And I am showing that there are no questions at this time.

Okay. Well, we will go ahead and close the call. Thank you for attending today and we will talk to you again next quarter.

Ladies and gentlemen, this does conclude the Bsquare Corporation third quarter 2009 earnings conference call. This conference will be available for replay today through November 19, 2009 at midnight. You may access the replay system at any time by dialing 1-800-406-7325 or 1-303-590-3030 by entering the access code of 4173762. Thank you for your participation. You may now disconnect.