Bsquare Corp (BSQR) 2010 Q2 法說會逐字稿

Ladies and gentleman, thank you for standing by. Welcome to the Bsquare Corporation second quarter 2010 earnings conference call. During today's presentation, all parties will be in a listen-only mode. Following the presentation, the conference will be open for questions.

(Operator Instructions)

This conference is being recorded today, Thursday, August 12 of 2010. I would now like to turn the conference over to Scott Mahan, Bsquare's Chief Financial Officer. Please go ahead, sir.

Good afternoon, everyone. Before I begin, let me remind you that 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 the Safe Harbor statement posted with these prepared remarks, both of which apply to the content of this call.

With that said, let me recap our financial results. We reported record total revenue this quarter of $26.9 million, up 67% from $16.1 million in the year ago quarter, and up 59% from $16.9 in Q1. Our revenue this quarter far surpassed the previous toppling record of $18.6 million back in Q1 of 2001. Growth in third-party software sales primarily accounted for the increases, with the sequential growth also driven by an increase in service revenue. Our largest customer, the Ford Motor Company, accounted for 23% of total revenue this quarter.

Total revenue for the first half of 2010 was $43.9 million, up 34% from $32.8 million in 2009. It's important to note that this quarter's results benefited from the Ford amendment signed just before quarter end. As we stated in our press release today, Ford agreed to pay us $3.2 million for overruns incurred in the first of 2010. Of the $3.2 million, $3.1 million was recognized as service revenue this quarter, with the remainder deferred to Q3. Of the $3.1 million, $2.5 million would have been recognized in Q1 under percentage of completion accounting on an as-is basis. Further, this quarter's results also benefited by the reversal of a lost contract accrual on the Ford program, established in Q1 in the amount of $390,000. Consequently, this quarter's service revenue was positively affected by $2.5 million and service gross profit, gross margin and net income were positively affected by $2.9 million or $0.29 per diluted share by these items. First-half results would not be affected in total.

Sales of third-party software were $16.3 million this quarter, up 147% from $6.6 million in the year ago quarter, and up 48% from $11.0 million in Q1. The year-over-year increase was driven by improved macroeconomic conditions, which benefited Microsoft's general embedded licensing sales and the addition of Windows Mobile license sales, a new product line added in Q4 of 2009. The sequential increase was driven by higher sales to our largest general embedded licensing customer, which accounted for $1.1 million of the increase, and higher average purchasing volumes, which were up 38% sequentially. Windows Mobile license sales were $2.5 million this quarter, compared to $1.2 million in Q2.

Proprietary software revenue was $952,000 this quarter, down 20% from $1.2 million in the year ago quarter, and down 3% from $978,000 in Q1. Year-over-year decline was driven by a $323,000 drop in TestQuest license sales, offset by $165,000 increase in TestQuest support and maintenance revenue. TestQuest revenue did increase slightly sequentially but was offset by declines in other product lines. Proprietary software revenue was $1.9 million for the first half of 2010, compared to $2.1 million in 2009.

Service revenue was $9.7 million this quarter, up 17% from $8.3 million in the year ago quarter, and up 96% from $4.9 million in Q1. Revenue generated from Ford drove the increases, with Ford accounting for $6.2 million or 64% of service revenue this quarter, $5.2 million in the year ago quarter, and $2.3 million in Q1. As I mentioned earlier service revenue benefited by $2.5 million this quarter as a result of the Ford amendment. Service revenue was $14.6 million for the first half of 2010, down 12% compared to $16.7 million in 2009. Ford accounted for $8.5 million of service revenue for the first of 2010 compared to $10.4 million in 2009.

Turning to gross profit and margins. Overall gross profit was $7.8 million this quarter, or 29% of total revenue, as compared to $4.4 million or 27% of revenue in the year ago quarter, and $1.2 million or 7% of revenue in Q1. Year-over-year and sequential growth profit improvements were driven by increases in service and third-party software gross profit. But as I mentioned earlier, service gross profit benefited by $2.9 million this quarter as a result of the Ford amendment and the lost contract accrual reversal.

Third-party software margin was 15% and proprietary software margin was 85% this quarter, with both percentages roughly comparable year-over-year and sequentially. Service margin was 47% this quarter compared to 28% in the year ago quarter, and negative 24% in Q1. Normalizing for the effects of the Ford amendment and the lost contract accrual reversal, service margin would have been 23% this quarter, compared to 28% in the year ago quarter, and 23% in Q1. Overall gross profit was $9 million or 27% of total revenue for the first half of 2010, compared to $8.8 million or 27% of total revenue in '09.

Moving down to P&O, operating expenses were $3.8 million for the quarter, compared to $4 million in the year ago quarter and in Q1. Of the $260,000 sequential decrease in total OpEx, $105,000 was R&D related, and $130,000 was sales related, with G&A basically flat sequentially. The sequential decline in R&D was due to lower spend on several product development efforts. The sequential decline in sales was largely due to severance costs incurred in Q1, which did not reoccur this quarter, offset partially by higher commission expense. Total OpEx of $7.8 million for the first half of 2010, as compared to $8.7 million in 2009.

Now, I'll speak to our bottom line results. We reported net income for the quarter of $4 million or $0.39 per diluted share, up from net income of $348,000, or $0.03 per diluted share in the year ago quarter, and up from a net loss of $3.4 million or $0.34 per share in Q1. As I previously mentioned, this quarter positively benefited from the Ford amendment and lost contract accrual reversal by $2.9 million or $0.29 per diluted share. Neither of these items affected the first half of 2010 in total.

This quarter's bottom line was negatively affected by TestQuest results in the amount of $313,000 or $0.03 per diluted share, compared to $52,000 or $0.01 per diluted share in the year ago quarter, and $363,000 or $0.04 per share in Q1. For the first half of 2010, we reported net income of $532,000 or $0.05 per diluted share, compared to the net income of $258,000 or $0.03 per diluted share in '09. The first half of 2010 included $546,000 or $0.05 per diluted share of auction rate security write downs, the vast majority of which occurred in Q1, compared to none in '09.

We generated positive EBITDAS of $4.3 million this quarter, compared to positive EBITDAS of $832,000 in the year ago quarter, and negative EBITDAS of $2.5 million in Q1. We generated positive EBITDAS of $1.9 million for the first half of 2010, compared to $1.1 million in 2009. We incurred $356,000 of non-cash expenses this quarter, including $106,000 of TestQuest related amortization, and we expect it to be roughly our quarterly, non-cash expense run rate for the remainder of 2010.

Cash and investments increased $1.4 million to $17.2 million at June 30, compared to $15.8 million at March 31. The June 30 balance includes $875,000 of restricted cash and $843,000 of auction rate securities classified as long term. On the previous quarter's call, we mentioned that we expected to burn cash this quarter, but much better than expected sales and bottom-line performance drove the cash increase. Our accounts receivable balance did increase by $6.6 million over March 31, which is due to $6.8 million in invoices issued to Ford just before quarter end.

Of that amount, $600,000 related to changes in scope on the just-completed program. $3.2 million related to overruns on the just-completed program and $3 million related to a prepay on the new Competency Center statement of work. Of the $6.8 million, all but $946,000 was paid just subsequent to June 30 and we expect the remainder to be paid shortly.

Our current liabilities, primarily royalties payable to Microsoft in deferred revenue, increased by $3.5 million over March 31, due to higher sales of Microsoft operating systems and a $3 million prepay on the Competency Center. Ford represented $3.1 million of our total deferred revenue, $4.3 million, at quarter end. CapEx was $32,000 this quarter and $72,000 for the first half of 2010. We currently expect full-year CapEx to run approximately $200,000 to $300,000, down from prior estimates.

We typically don't provide a cash forecast on these calls, but I will this quarter in order to appropriately set expectations. Currently, we are expecting our cash and investments to increase by approximately $3.3 million in Q3, ending Q3 at roughly $20.5 million. This increase may seem low given my earlier comment about Ford collections after quarter end. However, it's important to remember that $3 million of the collections represented a prepay on the Competency Center and we will incur costs during Q3 for which no additional cash will be collected. Further, we are projecting third-party software sales to decline some in Q3 and consequently, we will experience a negative working capital effect as it relates to our Microsoft payables.

At quarter end, we had $4.3 million in auction rate securities at par value, which was down $500,000 from March 31 due to the sale of one of our holdings. Subsequent to June 30, we sold four of our student loan auction rates for $2.6 million, which had a par value of $3 million. The vast majority of the difference between the cash proceeds and par value was reserved for a via write down in Q1, but the sale did result in an incremental write down this quarter of $36,000.

We currently hold $1.35 million of auction rate securities at par value, on which the fair value is $843,000. As we mentioned last quarter, we are currently pursuing an arbitration claim against the firm that sold us our auction rate securities but don't expect the claim to be heard until mid-2011. Headcount, including contractors, is currently 252 compared to 266 as of the date of our last call. Engineering services headcount is currently 164, down from 179. Now, I'd like to turn the call over to Brian.

Thanks, Scott. Today, I'll provide my perspective on our Q2 results, update you on our key initiatives, and then discuss our outlook for Q3. The biggest impact on our bottom-line results this quarter was the Ford projects. So, let me start with a discussion of our recent announcement and our go-forward plan.

As you know, we've been working with Ford for over two years developing the Ford MyTouch solution, which Ford has announced will be available in select vehicles later this year. In early July, we announced an amendment to our original MyTouch contract, under which Ford agreed to pay us an additional $3.2 million for unanticipated work we performed on the project in the first half of 2010. Simultaneously, we entered into a new agreement with Ford to create a Telematics Competency Center tasked with continual development of the MyTouch solution.

The initial Competency Center agreement is for 20 engineers for one year and an additional 15 engineers for 90 days. We are relatively satisfied with the settlement we reached with Ford on the overruns, and we are very excited to continue our relationship with Ford for the next year. Our objective is to provide sufficient value to Ford such that the size of the Competency Center expands as the scope of new work is jointly understood.

Finally, just this week we were notified by Ford that our initial delivery of the MyTouch hardware and software has been accepted, thereby bringing to close our development responsibilities under the original MyTouch contract. We will now shift into warranty support mode, where we are responsible for fixing any new serious defects discovered over roughly the next two years. Our team has worked side-by-side with Ford to create what we think is the most advanced infotainment solution in the industry, and I want to thank them for the hard work and dedication to the program.

Outside of Ford, our overall service backlog entering the third quarter increased again sequentially. This is the first time since the second quarter of 2008 that we have had backlog increases in two sequential quarters, and I believe that this is a positive result of the actions that we have taken to grow our service revenue. Tempering this increase a bit, our overall service bid activity was down sequentially in Q2 and was down when compared to Q2 of 2009. I'm always concerned about the impact of lower bid activity on future quarters, but in this case I believe that the drop is not a reflection of reduced demand for our services, but rather a result of the sales force changes we made during this quarter. We brought in new sales executives in our northwest and northern California territories and added an incremental sales executive in the north-central territory, as we felt that we were under-represented in that territory and missing out on business.

I believe that all the sales changes we've made in the first half of 2010, which include bringing on a new Vice President of Worldwide Sales, a new Vice President of North American Sales, a complete retooling of sales compensation plans, and the territory changes I just discussed are all very positive for our future. It typically takes one or two quarters for new sales executives to come up to speed. So, a drop in bid activity during Q2 is not unexpected, and I have already seen the positive impact our new sales executives are having on our business, which gives me confidence in our future prospects.

Now turning to software sales, our third-party team turned in an absolutely outstanding quarter. We saw solid sequential increases in all third-party software lines we sell, Microsoft Embedded, Windows Mobile, Adobe Flash, and McAfee Solidcore. We've been analyzing what is driving the increased demand and if this increase in demand is sustainable. With such a diverse third-party customer base, it's difficult to attribute this increase to any one factor. Rather, we think several factors are contributing, including a general improvement in overall economic conditions, a bit of pent up demand by customers who have held their purchase levels low over past quarters, the addition of Windows Mobile license sales, and finally, structural changes we made to sales focused and compensation plans earlier this year.

One area that I would like to highlight is or Windows Mobile license sales efforts. We almost doubled our Windows Mobile license revenue from the first quarter and, more importantly, the majority of the increase came primarily from new accounts, which is a positive trend. We have said that we expect Windows Mobile to deliver between $5 million to $10 million of incremental revenue in 2010 at margins comparable to our Microsoft Embedded license sales. With $3.7 million of new Windows Mobile revenue and over $500,000 of gross margin in the door year-to-date, we are confident that we will achieve this goal.

The third quarter is traditionally a little soft for third-party software sales as we typically see a bit of a summer slowdown. We are currently forecasting a sequential dip in total third-party software sales. But to put this into perspective, our Q3 results, if delivered to expectations would still represent the second-best third-party product revenue quarter in our history. Looking out into the next year, we believe that as long as economic conditions do not deteriorate, we should be able to maintain and grow our third-party sales from this level.

Finally, looking at our proprietary software results, I am unhappy to report that our Texas Instruments, or TI, Windows CE and Windows Mobile Board Support Package, or BSP, and our TestQuest product revenues were essentially flat sequentially. I still believe that TI, BSP revenue will ramp overtime, but it is taking longer than predicted when we started on this path with TI at the end of 2008. The investment portion of the TI initiatives is largely complete and the only engineering expense we can expect to incur over the coming quarters is minimal bug fixing and technical support for customers who adopt our Windows CE or Windows Mobile BSPs.

On the Windows mobile BSP, we have been disappointed by TI's inability to secure a Windows Phone 7 chassis design win with Microsoft for their OMAT 3 processor. This has hampered adoption of our Windows Mobile 6.5 BSP into second-tier consumer mobile device makers, as they do not see a future upgrade path to Windows Phone 7. The handheld terminal market is less sensitive to the Windows Phone 7 upgrade issues, as Microsoft has announced a separate upgrade path, Windows Embedded Handheld, for these manufacturers.

We have had some success licensing our Windows Mobile BSP to handheld terminal manufactures and we have several customers who have adopted our solution and several more in the pipeline. We expect that over time, each of these customers should represent between $50,000 to $200,000 of revenue for BSP licensing, royalties, and support, and that between 2010 and 2013, we can potentially earn anywhere from $1 million to $2 million from these customers and other new customers that we bring on over the coming quarters. In addition over the same time period, we expect to earn approximately $1.5 million of revenue from our Windows CE BSP efforts. All of our BSP revenue will be at nearly 100% gross margin.

These estimates only -- cover only the direct BSP license, support, and royalty revenues we expect to receive, and don't include additional Windows Mobile, Windows CE, or Adobe Flash licenses, as well as TestQuest and other products and services that we have or expect to sell to these customers in the coming quarters. Our TestQuest revenue was up only slightly sequentially in Q2. While I'm still disappointed by our inability to grow TestQuest's revenue to desired levels, I'm very excited about our recently announced TestQuest handset certification platform for mobile operators.

In our discussions with mobile operators, we've come to understand how they are struggling to maintain a quality user experience under the flood of new smartphones that they are launching. Because of device complexity, the number of applications, and the variety of connectivity options, smartphones represent a significant quality challenge for mobile operators. In response to this, we launched the TestQuest handset certification platform, which is a flexible, scalable and distributed automated test platform based on our countdown products.

The handset certification platform allows the mobile operator to develop, manage, and publish portfolios of test cases to multiple smartphone OEMs and enables OEMs to pre-certify devices before they are submitted to the mobile operators device certification centers. Optionally, Bsquare will develop and maintain the TestQuest portfolio for the mobile operator. The complete cycle from test development, distribution, testing, and mobile operator certification is automated, secure, and auditable. We believe that this product will give both mobile operators and smartphone OEMs a valuable tool to ensure incoming device quality and reduce the cycle time to bring new devices to market.

From a business perspective, the handset certification platform moves us from selling TestQuest licenses to individual OEMs or enterprises for around $40,000 to $60,000 per sale, to selling strategic distributed installations to mobile operators and their OEMs with potential $1 million plus multi-year revenue streams. There are over 900 mobile operators worldwide, with the largest 30 mobile operators representing over 3 billion subscribers. This is a large potential market that we are selling this product into. Of course, we will continue to sell TestQuest into our traditional OEM and enterprise customer base and do not intend to back off driving revenue from these customers. We are currently working on a handset certification platform sales opportunity at a major Asian mobile operator and are in initial discussion phase with two other mobile operators who have expressed interest in our solutions. While the sales cycle for these opportunities are long, the payoff can be large.

Additionally, we are actively developing new opportunities for the handset certification program. I believe that there is a good chance of closing our first handset certification platform opportunity in the second half of 2010. In addition to the handset certification platform, we are working on a couple of others strategic initiatives that I will briefly describe.

We are keenly focused on growing our service revenue and have been looking at new markets that we can serve, as well as examining the reasons we lose service business in the current markets that we serve. Bsquare has carved out for itself a high value, but high priced service delivery niche, primarily focused around Windows CE and Windows Mobile operating systems. In this niche, we have never tried to be the low-cost leader, but instead have positioned ourselves as the partner that can take on really tough projects and deliver with superior quality and low risk to our customers. We've done well with this approach, but we feel that in order to grow our service revenue more rapidly, we need to move more aggressively into Android and other operating systems development as well as more application development.

Our analysis suggests that as a company, we have the talent and customer relationships to serve these markets and we've had some initial success in winning new business. However, we are finding that we lose as much business as we win because we are generally priced higher than our competition. In analyzing our lost business data, we don't think that we need to reduce our prices dramatically in order to be competitive. We also believe that we can profitably deliver this incremental business by more aggressively using a mix of North America and offshore resources to deliver projects.

We've defined and rolled out a more aggressive pricing initiative to our sales force and have started expanding our Taiwan and India teams in anticipation of new business. We expect to eventually build a delivery team in China as well. It's too early to report on results. But if successful, we believe that this approach will open up much larger service markets to us compared to the markets that we serve today.

I talked last quarter about our focus on the mobile and automotive infotainment market verticals. We feel that these verticals are large and growing, and we have existing customer relationships in both. Our plan is to define solutions using a mix of products and services to serve both verticals. We have moved internal resources to head up our efforts in developing solutions, and are currently working with customers and partners to jointly identify areas where we can add value. The TestQuest handset certification platform that I discussed earlier is a great example of a solution that we came up with to solve a specific problem in the mobile vertical. I will continue to update you on this initiative in future quarters as we make additional progress.

I will finish our call today with expectations for the third-quarter. Based on our current outlook, we expect total revenue to decrease sequentially. We expect third-party software sales will be down sequentially for the reasons I discussed earlier. We also expect service revenue will be down sequentially due to the Ford amendments that positively impacted Q2 but will be absent in Q3. Let me provide a little more detail on our service revenue and margins than I normally do since Ford has caused our results to be very lumpy and I want to set appropriate expectations.

First, Q2 benefited by $2.5 million from the Ford amendment as Scott mentioned earlier, and that benefit will be absent in Q3. Second, the Telematics Competency Center involves far fewer resources than the recently completed program. We expect that these two items will cause Ford related service revenue to decline roughly $3.9 million sequentially, with total service revenue dropping approximately $3.5 million. Further, we expect service margin to run in the mid-20% range and should improve slightly over the normalized 23% in Q2 after adjusting for the effects of several Ford related items, which benefited service growths profit and margin in the quarter.

We expect our proprietary software revenue to be up slightly sequentially, driven by both TestQuest and other proprietary products. Even though our expectations for overall Q3 revenue is lower than Q2, if Q3 comes into our current expectations, it would still be our second best revenue quarter ever by a sizable amount. Thank you for attending our call today. This ends the prepared portion of our call. We will now open up the call for questions. Operator?

Thank you, sir. We will now begin the question-and-answer session.

(Operator Instructions)

Your first question comes from the line of Ryan Vardeman with Palogic Capital.

Hi, guys. Congratulations on a bunch of successful initiatives in the quarter.

Hi, Ryan.

A lot of my questions, I think, were answered in your prepared remarks. So, what about the Snapdragon announcement that you made during the quarter and maybe what does that business model look like and those sorts of things?

Sure. So for those who haven't seen we are announced that we're reselling the Snapdragon development board from Qualcomm. Qualcomm desires to push this forward into broader markets and they have chosen Bsquare as their partner to push the board into broader markets. From a revenue perspective, Ryan, I don't expect at least initially it's going to be a huge revenue driver for us. But what it does do is it allows us to reach Android and BREW customers, because that's the focus of the Qualcomm Snapdragon, this MDP platform is Android and BREW.

So, we will be not only providing the board but providing technical support, providing services, hopefully selling them Flash licensing, selling them TestQuest. We think it's going to have more of a leveraging effect on the business as opposed to a direct revenue effect on the business. And I will say that we just announced it, but we've already had at least a half a dozen customers that have been introduced to us by Qualcomm and so that, just from a lead generation standpoint, I think it's going to be very successful as well.

So that board design is a Qualcomm design and we're just acting as a reseller?

Exactly right.

The Windows Phone 7 apps third-party developers that was announced by Microsoft. Is that any work that Bsquare is doing?

We are currently not engaged actively in that, but we may be. We're looking at it as well just like everybody else is.

Okay. And then, as it relates to the Telematics Competency Center, it's a pretty fancy name. What does that -- is that just for Ford and Ford providers or how does that work as it relates to functionally? And then secondly, that way you structured it, having the 20 engineers on for a year, how should we think about revenues throughout the contract, et cetera? And the possibility in prospects for that relationship getting larger?

So the initial Competency Center is for Ford, and it's tasked with continuing the development of the MyTouch solution. There's new functionality planned, there's additional vehicle platforms planned and that's all Ford's roadmap. And as I mentioned, we are working with Ford to understand exactly how big it needs be, so we got started with the 20 people and the additional 15 for 90 days because that gives us time to really size what's required going forward. We've all been so heads down on trying to get the initial MyTouch delivery completed, which we're very happy to say was completed this week, and now it's time to get on to the next set of tasks.

Now, we are actively pursuing other automotive companies as well. We have done work for a couple of others, as I mentioned in previous quarters, and we're talking about Competency Center type arrangements with others as well. You want to talk about the revenue aspect, Scott?

So Ryan, we talk about the initial disclosed the Ford amendment, the new statement of work, just after quarter end. The total guaranteed commitment on the Competency Center is a little less than $5.6 million. So to put the run rates in perspective, as Brian mentioned in his forward-looking guidance, we expect Ford to drop $3.9 million sequentially coming off of Q2, and if you look in the queue, which just got filed as well, that we expect Ford revenue to run about $2.3 million in Q3, and most of that is the Competency Center. So, that gives you a pretty good feeling for what the go-forward baseline Competency Center run rate will look like on Ford. But remember that a portion of that, 15/35 would wind out in 90 days unless Ford would recommit for those 15 engineers again.

Okay, great that's very helpful. Thank you very much for providing a little detail that you did in your prepared remarks and the best of luck. Thank you very much.

Thanks, Ryan.

(Operator Instructions)

Our next question comes from the line of Chris Lahiji with LD Micro. Please go ahead.

Gentlemen, well done.

Yes, thanks Chris.

Quick question, how much money is in dispute with the auction rate securities?

Currently, we're sitting on $1.35 million, but the amount that's in dispute is closer to $5.5 million, I believe.

$5.5 million, okay. And, just one broad-based question, would you guys say that overall business pipeline has never been better in the history of Bsquare.?

That's a bold statement.

I would say that neither Scott or I have been around for the entire history of Bsquare, but I would say that right now, the business pipeline is strong. And I think -- I attribute a lot of it to the changes that we've made in retooling our sales force, where we're seeing a lot of opportunities. And we think that's going to payoff well, and obviously if the economy turns around on us, we're all going be the same boat, but right now looks pretty good. How is that for an answer, no-answer, Chris?

No, that's a great answer. It's just that I don't beat around the bush.

So, back to the auction rate question. We're pursuing the firm that sold us these on two fronts. One is to essentially get us out from whatever we might be left in by the time we actually got to the arbitration hearing, and to the extent that we've liquidated securities prior to that, we'd be looking to be reimbursed for the losses we have incurred. So, in round numbers the losses we have either actually occurred to date or are projecting to occur and are sitting on our balance sheet in terms of valuation reserve are in the $900,000 range.

Got it. Gentlemen, thank you so much and looking forward to the next quarter.

Thanks, Chris.

Thank you and there are no further questions in the queue. I would like to turn the call to management for any closing remarks at this time.

Thank you very much for listening today and your interest in Bsquare, and we'll look forward to talking to you again next quarter. You can disconnect now, Operator.

Thank you. Ladies and gentlemen, this concludes the Bsquare Corporation second quarter 2010 earning conference call. We thank you for your participation. You may now disconnect.