Bsquare Corp (BSQR) 2011 Q2 法說會逐字稿

Ladies and gentlemen, thank you for standing by. Welcome to the BSQUARE Corporation second-quarter 2011 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 4, 2011.

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

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 text of our prepared remarks will be available on our website.

I would also like to direct your attention to the Safe Harbor statement contained in our press release issued today and the Safe Harbor statement which will be posted with these prepared remarks, both of which apply to the content of this call. All per share amounts discussed today are fully diluted numbers.

With that said, let me recap our results. We reported total revenue this quarter of $23.4 million, down 13% year-over-year from $26.9 million and down 10% quarter-over-quarter from $26.0 million. A decline in Ford-related service revenue primarily accounted for the year-over-year decline, whereas a decline in service revenue and third-party software sales accounted for the quarter-over-quarter decrease.

Our largest customer, Ford, accounted for 10% of total revenue this quarter, 23% in the year-ago quarter, and 9% in Q1. Total revenue for the first half of 2011 was $49.4 million, up 13% from $43.9 million in 2010.

Third-party software sales were $15.3 million this quarter, down 6% year-over-year from $16.3 million and down 12% quarter-over-quarter from $17.3 million. The year-over-year decline was driven by a 21% drop in Microsoft General Embedded license sales due primarily to lower purchasing volumes from our larger customers offset by a $1.3 million or 53% increase of Windows Mobile license sales and a $598,000 or 107% increase in Adobe Flash products sales.

The quarter-over-quarter decline was driven primarily by a 17% drop in Microsoft General Embedded license sales due to lower purchasing volumes from our larger customers.

We mentioned last quarter that a number of our larger Microsoft General Embedded licensing customers had overbought in prior quarters and that we expected third-party software sales to be down sequentially in Q2. However, actual order volumes were even softer than anticipated and in total third-party software sales came in roughly $1 million under expectations.

Third-party software sales were $32.7 million for the first half, up 20% from $27.3 million in 2010.

Proprietary software revenue was $1.7 million this quarter, up 79% year-over-year from $952,000 and up 21% quarter-over-quarter from $1.4 million. The year-over-year, quarter-over-quarter growth were driven by higher royalty revenue from our OMAP board support packages and sales of Qualcomm's Snapdragon products.

Proprietary software revenue was in line with expectations for the quarter. Proprietary software revenue was $3.1 million for the first half, up 63% from $1.9 million in 2010.

Service revenue was $6.4 million this quarter, down 34% year-over-year from $9.7 million and down 12% quarter-over-quarter from $7.3 million. Ford accounted for $2.4 million in service revenue this quarter, down 61% year-over-year from $6.2 million and up 4% quarter-over-quarter from $2.3 million. Year-ago Ford revenue benefited from a cost overrun contract amendment in the amount of $2.5 million.

A decline in Ford-related revenue accounted for the year-over-year service revenue decline offset partially by growth in Asia and North America outside of Ford. Service revenue excluding Ford grew 14% year-over-year from $3.5 million to $4.0 million.

Service revenue excluding Ford declined 20% from $5.0 million in Q1 to $4.0 million in Q2. This decline was primarily driven by $600,000 of project overruns and a decline in service revenue from one customer in North America that was down $634,000 quarter-over-quarter. This is the same customer that has been contributing significantly to service revenue in the previous two quarters and with which we expect to continue to do business with at a higher run rate this quarter.

Service revenue did fall short of our expectations this quarter by roughly $1 million primarily as a result of these items and some other items that Brian will discuss later.

Service revenue declined 7% to $13.6 million for the first half from $14.6 million in 2010. Excluding Ford, service revenue increased 46% to $8.9 million for the first half compared to $6.1 million in 2010.

Turning to gross profit margins, overall gross profit was $5.1 million this quarter or 22% of total revenue as compared to $7.8 million or 29% of revenue in the year-ago quarter and $5.3 million or 20% of revenue in Q1.

Third-party software margin was 17% this quarter, 15% in the year-ago quarter, and 13% in Q1. The improvement in third-party software margin was to you to increased sales of higher-margin Adobe Flash products and decreased sales to our large lower margin Microsoft General Embedded licensing customers.

Proprietary software gross margin was 80% this quarter, 85% in the year-ago quarter, and 82% in Q1. Service gross margin was 18% this quarter, a 29 percentage point drop from 47% in the year-ago quarter due primarily to the cost overrun contract amendment signed with Ford in the year-ago quarter as well as the reversal of a $390,000 lost contract accrual in the year-ago quarter that was recorded in Q1 of 2010.

Service gross profit was negatively impacted this quarter by project overruns in the amount of $600,000 or $0.05 per share. These overruns negatively affected service gross margin by 5 percentage points this quarter. Service gross margin declined 6 percentage points quarter-over-quarter. Total gross profit increased 16% to $10.4 million for the first half from $9.0 million in 2010.

Moving down the P&L, OpEx was $5.1 million for the quarter, up 34% year-over-year to $3.8 million and up 4% quarter-over-quarter from $4.9 million. The sequential and year-over-year increases were primarily driven by our international sales expansion and to a lesser extent domestic sales expansion.

In total, sales and marketing OpEx was up $858,000 year-over-year and $101,000 sequentially. Stock comp expense included in sales and marketing was up $271,000 year-over-year and $152,000 quarter-over-quarter. R&D expense was up $183,000 year-over-year, $71,000 quarter-over-quarter, which was driven by our HCP product and support of that product at our recently announced customer, China Mobile.

G&A expense was up $269,000 year-over-year and up $76,000 quarter-over-quarter, the majority of which was the result of lower facilities expense allocations and higher stock comp expense. Total OpEx was $9.9 million in the first half compared to $7.8 million in 2010.

Now I will speak to our bottom-line results. We reported net income for the quarter of $21,000 or $0.00 per share compared to net income of $4.0 million or $0.39 per share in the year-ago quarter and compared to net income of $184,000 or $0.02 per share in Q1. Excluding the service project overruns, net income would have been $621,000 or $0.05 per share this quarter, while the year-ago net income would have been $1.1 million or $0.11 per share excluding the Ford contract amendment and lost contract accrual reversal which benefited the prior year.

For the first half, we reported net income of $205,000 or $0.02 per share compared to net income of $533,000 or $0.05 per share in 2010. The first half was negatively affected by the service project overruns in the amount of $600,000 or $0.05 per share while the first half of 2010 was negatively affected by an auction rate security write down in the amount of $546,000 or $0.05 per share.

We generated EBITDA of $809,000 or $0.07 per share this quarter compared to EBITDA of $4.3 million or $0.42 per share in the year-ago quarter and EBITDA of $1.1 million or $0.10 per share in Q1. For the first half, we generated EBITDA of $1.9 million or $0.17 per share compared to $1.9 million or $0.18 per share in 2010.

Normalizing this quarter for the project overruns and normalizing the year-ago quarter for the Ford-related items, EBITDA would have been $1.4 million or $0.12 a share this quarter and $2.5 million or $0.22 per share for the first half of 2011 compared to EBITDA of $1.5 million or $0.14 per share in the year ago quarter and $2.4 million or $0.24 per share in the first half of 2010.

Cash and investments increased $1.8 million from $23.2 million at quarter end, $1 million of which is classified as long-term.

DSOs were 52 this quarter compared to 55 in Q1. CapEx was $219,000 this quarter and has run $339,000 for the first half. We still expect FY '11 CapEx to run approximately $600,000.

Headcount including contractors is currently 281 compared to 302 as of the date of our last call. Engineering Services headcount is currently 170, down from 192.

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

Thanks, Scott. I will start off with my perspective on Q2 results. Then I will provide you with an update on our investment initiative. And finally, I will discuss our outlook for Q3.

From my standpoint, Q2 was a disappointing quarter. My expectation going into the quarter was that we would grow both our revenue and EBITDA contribution as compared to Q1. They have both declined due to shortfalls in third-party and service revenue as well as service staffing and delivery issues.

The third-party sales decline was the result of lower than forecasted Microsoft Embedded licensing sales. We said in our last call that we did expect third-party revenue to decline sequentially from Q1 as several of our largest customers have slowed their purchasing because they overbought products in previous quarters and still had inventory on hand. We said that we expected these customers would work through their excess inventory mostly during Q2 and to a lesser extent in Q3 and then would return to their normal ordering volumes.

This scenario is playing out exactly as we predicted, with the exception that Q2 Microsoft Embedded license revenue dropped more than we had forecasted. Information shows that customers do appear to be working through their inventory issues and looking forward, we are expecting Microsoft Embedded and overall third-party software revenue to increase in Q3.

On a more positive note, sales of our not Microsoft third-party products such as the Adobe Flash player were strong in Q2 and because we earn higher margins on these sales, the gross margin impact of lower Microsoft Embedded revenue was offset by increased sales of our other third-party products resulting in our overall third-party product gross profit increasing by $249,000 compared to Q1.

Our service revenue was down almost $1 million over our forecast and our service gross margin percentage declined sequentially from Q1 to an unacceptable 18%. The revenue decline was the result of several issues including staffing constraints, an unanticipated drop -- revenue drop at a significant customer, an overrun on a fixed-price project and sales execution.

The mix of our new service engagements in the quarter was heavily slanted towards user interface applications and Android projects and we simply struggled to staff the engagements in a timely manner. We proactively took steps during the quarter to address the staffing issue including expanding our recruiting and staff partnership efforts and I expect to see better results in Q3.

We also had an overrun on a fixed-price project for a new customer that impacted revenue. This project has now been completed and under the leadership of Mark Whiteside, our new Vice President of Professional Services, who joined us in Q2, we have revamped our internal processes to avoid these overruns in the future.

I am very happy to have Mark on board. He has a successful track record of building and growing service organizations and his impact is already being felt as we continue our transition from a North America-focused service organization capable of delivering blended services from a worldwide footprint.

Now let me discuss our strategic initiatives -- growing sales through product and territory expansion and growing our Asia delivery capabilities and an update on our Handset Certification Platform.

In Q2, we announced an agreement with Microsoft that allows us to sell Microsoft Embedded products in Europe initially focused on selling in the UK and Germany. Since signing this agreement we have been busy building our Europe sales team and sales pipelines. As we stated in the last quarter's call, we expect that Europe will primarily be an investment for us in 2011. We are on track to earn approximately $2 million in revenues in Europe by the end of 2011 but we are forward investing ahead of the revenue and this investment will negatively affect our bottom line by about $500,000 this year.

In 2012, we believe that Europe represents up to $10 million in incremental revenue and will be accretive.

Another of our initiatives is the expansion of our sales and engineering capacity in Asia. Asia is a large market with a tremendous amount of design activity. By expanding our local sales and engineering presence, we expect to grow the sales of our products and services directly to customers in Asia.

Our investment in Asia is already showing results. In the first half of 2010, we earned just over $1 million in revenue out of Asia. In the first half of 2011, we have earned over $7.5 million in revenue out of Asia.

We have discussed in past calls the multiple millions of dollars of lost service revenue in North America because we are not always price competitive delivering services using only our North America engineering resources. Especially when we compete against larger companies who have low cost development centers in Eastern Europe or India.

As we expand our Asia engineering teams, we gain additional capacity and talent to blend higher cost North America resources with lower cost Asia resources and deliver services more cost-effectively to our North America customers. And we believe that we can do this while improving margins.

During the quarter, we added additional software development staff to our Taiwan development center and now have a total of 55 employees and contractors in Taiwan. The new leader of our China development center joined our Company in Q2 and he is actively interviewing employees to build our China staff.

During the quarter, we delivered 24% of the hours for North America service projects out of Asia. Our ultimate goal is to deliver around half of our North America service hours out of our Asia development centers and improve our service margins to the low to mid 30% range.

Finally, let me update the status of our other important strategic initiative, the Handset Certification Platform or HCP. To remind you, the HCP is designed to allow a mobile network operator to develop, manage, and publish portfolios of automated test cases to multiple smartphone OEMs. The OEMs in turn use the platform to pre-certify their devices before submitting them to the network operator for final certification and sale to customers.

We believe that by using the Handset Certification Platform, mobile network operators and device OEMs will be able to introduce new devices faster with higher quality and that OEMs will see an overall reduction in cost and time to bring new devices to market.

We announced yesterday that our first HCP installation is up and running at China Mobile, the world's largest mobile network operator. We are working with China Mobile smartphone OEM partners who are certifying their smartphones for sale and use on China Mobile's network. Over the past months we have been performing test designs designed to assess the stability of smartphones before China Mobile offers these phones to their customers.

We've shown both China Mobile and our OEM customers that the HCP is able to expose problem areas that should be remedied before new phones are put into the hands of China Mobile's customers.

To remind you of the Handset Certification Platform business model, we partner with a mobile network operator to automate the testing process for that operator. We may choose not to charge the operator for the product or for the test automation. Once a set of automated tests exist, we charge handset OEMs a yearly per seat subscription fee to access the product and the automated test developed for that particular network operator.

We believe that the revenue opportunity per network operator once the system is up and running will be in the $1 million to $3 million per year range. OEMs will be required to subscribe to the product for each network operator we partner with since the suite of tests will be different and the product may be customized for a particular operator.

In addition to the subscription fee, we also offer OEMs bundled support packages and the full range of other BSQUARE products and services and hope to pull through sales of other BSQUARE offerings. Obviously it takes time to ramp up the full revenue potential for each network operator, as not all handset OEMs will be supplying new handsets to the operator at the same time.

For China Mobile, we currently expect that the total revenue opportunity from this installation should exceed $1 million between today and the end of 2012. We have already signed HCP subscriptions with six OEMs who are supplying smartphones to China Mobile and our goal is to sign four additional OEMs in Q3.

Generally we expect that the margin on description revenue will be in the 80% range.

We have other network operators in our immediate sales pipeline and have successfully completed a proof of concept with a major North American operator. Our objective is to start a trial with that operator during Q3 that will lead to a full production deployment by the end of 2011 or the first half of 2012.

Overall I remain bullish on the prospects for our Handset Certification Platform's. We overcame many difficulties during the process of bringing our product online at China Mobile. We took what we learned, improved our product and our processes, and those learnings helped us tremendously as we went through the proof of concept process at what we hope will become our second HCP customer.

Smartphone stability and quality is a big problem for both mobile network operators and smartphone OEMs who literally spend hundreds of millions of dollars every year on smartphone testing, customer support, and product returns. We believe that as phones become ever more complex and capable, the cost of providing support and managing product issues will only grow and that HCP is one tool that our customers can bring to bear to reduce this cost while improving customer satisfaction.

I will finish today -- our called today with expectation for the third quarter. Overall, I currently expect that revenue in Q3 will be in the $24 million to $26 billion range. I expect that our third-party sales will increase from Q2 as our customers work through the last of the inventory issues that I described earlier and increase their order volumes.

I expect services to be up from Q2 based on backlog, elimination of project overrun issues, increased demand for our services, and our ability to [satisfy] that demand. I expect the proprietary product revenue will be down from Q2 as we had a spike in revenue from our OMAP board support packages in Q2 that I do not expect to repeat in Q3.

We did recognize a small amount of HCP revenue in Q2 and I expect to recognize more in Q3, but the amounts are still relatively small and we will continue to grow in future quarters as we bring on more OEMs and build a backlog of subscription revenues.

In support of the investments I just discussed, we have increased our operating expenses substantially compared to 2010. However, we currently do not expect to add any substantial additional operating expenses in 2011. I currently expect profitability and EBITDA to improve sequentially.

Putting Q2 in perspective, while I am disappointed in the immediate results, I remain optimistic about our prospects. We operate an innovative, robust, and growing market segment that demand the kinds of products and services that we offer.

We are making substantial but exciting investments that should pay off in the relative near-term. We have retooled our management team over the past year and are in the midst of making fundamental transitions in our Company.

Our growth may be lumpy as our investments come to fruition but I believe these are good investments that are needed to propel our Company to the next level.

With that, I will wrap up by thanking you for attending our call today. This ends the prepared portion of our call. With that, I will now open up the call for questions.

(Operator Instructions). David Kaczorowski, private investor.

Hi, thanks for taking my questions. First, I wanted to ask you about your relationship with Ford. It looks like quarter-over-quarter you were about flat, maybe a little bit down. Are you -- do you expect growth from Ford over the long term? What is the trajectory you are thinking there?

Currently, David, we are on a contract with Ford that goes through the end of 2011 and we talked about that in previous quarters. So beyond that, we haven't really talked about any visibility as to up and down, but generally through the end of 2011, our contract is that we will be about at the same level that we are right now.

Okay, as far as margins for that contract, do you have anything that you could discuss about it?

David, this is Scott. We haven't publicly talked about the margins but it's certainly a vast improvement over what it was in the troubled times in the end of the '09, beginning of 2010. It is a what I would consider to be a relatively normal margin contract adjusted for the fact that it's a significant contract that some pricing concessions were made as a result, but nothing that's dragging the bottom line terribly.

Okay. And as far as your third-party software, you talked about some puts and takes between the Microsoft and non-Microsoft and that your non-Microsoft has a higher margin than your Microsoft I guess Embedded. As far as your Microsoft Mobile, is that -- can you -- what's the margin profile for that? Is it the same as the Embedded or is it higher or what?

David, this is Scott. So I will tell you this. We have said this in the past that margin on third-party products let's -- our other third-party products beyond Microsoft, can run significantly higher than a Microsoft margins but because Microsoft is such a dominant share of third-party software revenue, it ends up down in the 15% to 16% range, a little bit higher this quarter.

I would tell you that Windows Mobile margin runs a little bit higher than General Embedded licensing margin and what I would also would tell you -- and something we have talked to before -- relative to our expansion in Europe, from what we have seen and what we have heard from the channel over there, margins General Embedded license margins in Europe run higher than they run in the US.

And also to reinforce the point relative to some of Brian's commentary today, you saw that we had a drop in general -- in third-party software sales because of lower General Embedded -- Microsoft General Embedded licensing sales but yet our gross profit contribution from third-party software in total went up. One of the things we've talked in the past, we didn't emphasize it today is our strategic goal to add more third-party software offerings to our -- the products that we sell because we can make pretty decent money off these, not to mention the fact that it gives our salespeople more things to sell into existing customer base, etc.

Okay, have you -- what's your responsiveness to the new product rollouts? I guess on Microsoft Mobile like Mango for instance? Is there -- does that affect your business?

So Windows Phone 7 overall is a positive for us. Now the first customers for Windows Phone 7 -- Microsoft pretty much handled them all by themselves and didn't use a lot of ecosystem help. But as Microsoft expands the footprint of Windows Phone 7, we are now starting to get involved in Windows Phone 7 service projects. So overall, we expect that to be a positive driver for our business.

Okay, any very rough guess as to how positive, what kind of magnitude?

If you can tell me how successful you think Microsoft is going to be, then I could put a number on it. But I don't know an answer to that yet, David.

And then about your Handset Certification Platform, it sounds like a great product. You talk about the upfront investments and kind of getting things rolling and then the revenue comes with high margin on the backend.

The upfront investment, is this I guess with China Mobile or with a normal customer, how big an investment are you looking at in the beginning? How much time in order to get to that high margin revenue? Can you give some more detail on that?

Yes, so as far as the time goes, I'll tell you that we engaged with China Mobile back in probably the beginning of Q3 of last year and we really got going with them in a trial in Q4 of last year and the trial ended successfully in February. So one thing about dealing with these network operators is they don't move fast. And so now we are in the front end of hopefully getting started with the trial with the North American guy. I think this trial should go hopefully a little faster just because we learned so much with China Mobile and that is going to allow us to do a better job for our customer as we start going on our second trial. But I would say that you can probably expect it to take about six to nine months to get through the process with an operator.

I talked today about the fact that we've got a North America operator that we're hoping to get going on a trial and we have got at least two other operators that we are continuing to talk to. So we are also hoping to parallel up and separate a bit in the future, so that it's not just one -- [trial] after another.

(Operator Instructions). Gene Weber, Weber Capital Management.

I would just like to go over what you talked about in terms of where you came out versus expectations this quarter just to make sure I'm getting it right. It sounds like on the third-party software side there was a bit of a revenue miss because it's hard to predict just what the inventory work down will be for those guys. That I understand. We don't need to discuss it.

Then the other thing you mentioned was on the service side, where it sounded like you had a couple things that worked. You had the cost overrun and then you had the revenue shortfall at one of the customers. Could we talk about each of those a little bit, what was behind them. And on the -- just start with the $600,000 shortfall. Because presumably that's a pretty big relative number given the size of that contract, I'm assuming. Maybe you could put it in context.

Sure, Gene. I will start and then Scott will probably jump in when we get to the deep numbers thing. So generally there was actually a couple of customers that we had some -- I'll call it project execution issues with -- and we ended up underbidding to some extent or underestimating what it was going to take to complete the project. Those were process issues and to some extent ongoing management issues on our side that as I talked about, I think we've got those resolved. I've got a new VP of Services here who has done some really good things for us to put some additional processes in place and we've made a couple of structural changes in the group as a result of that. So that was the one aspect.

The other aspect was that we did have a customer who we had an ongoing run rate with. The project was drawing to a close with that customer. We felt we were going to continue to do work for that customer during the second quarter, but the customer chose to stop the project and kind of do things their own way.

So it was unexpected from our standpoint. I think we did a decent job for the customers. Their product is out on the market and they are actively selling it. So it was just one of those things that just kind of happens at some point.

Then finally as I talked about, we did have demand that we just weren't able to staff during the quarter. One of the frustrating things about running the services business is you can't always predict the mix of engineering talent that you are going to need in a quarter and engineers aren't like Lego blocks. You just don't unplug them from one place and put them into another place. And so we had some demand come in that we just didn't quite have the skill set on the shelf to switch to and we put our recruiting into high gear. But nonetheless, we were not able to fulfill the demand in time and we lost revenue because of that.

So from a high level, that was -- that's the explanation for what happened this quarter.

Okay, Scott, I don't mean to cut you off, but just let me follow up on one thing you said, Brian, and that is that -- so the $600,000 was not one project, it was multiple projects?

Gene, it was primarily two projects. And to clarify on a comment you made earlier, you described this as cost overruns but this is something that had we had the available hours in these particular circumstances, we could've turned this into incremental revenue. So in other words, $600,000 that would have all gone to the bottom line.

Yes, these engineers --

Maybe you can help me with that a bit. So if it was $600,000 that could all be turned into bottom-line, it means that there's no cost associated with that revenue which couldn't be in a service project.

The cost in terms of examining the effect on the P&L for the period, the cost was incurred. The cost is the cost. What I am saying is that because of -- what we are saying is because of the overrun, these additional hours that we incurred were generating very little revenue to no revenue and have those hours been available and particularly given the demand in some of the areas that we weren't able to meet, translated that into revenue, but the costs would have been the same.

Okay, so it was a question -- so it was an issue then of the mix. You just didn't have the right people to help you get those projects done?

Well, no, the projects that we overran, we had the right people on the projects. We just didn't expect to have them on the projects for that long and so we couldn't -- if we could have taken them off the projects we had other projects we could have put them on and those other projects would have generated revenue, incremental revenue. The cost would have been the same. Costs wouldn't have been any different.

I see what you're saying. I see because of the way those projects worked out, it required more hours than you anticipated from your staff so you couldn't put them on and you couldn't charge for that, so you therefore then couldn't put them on another project that you could've charged them for.

Exactly.

Okay, sorry for the detail, but I just wanted to understand. Okay, well, I think unless you have anything else to add, Scott, I think that answers my question. Thank you.

Okay, thanks, Gene.

(Operator Instructions). At this time, I am not showing any further questions. I would now like to turn it back to management for any closing remarks. Please go ahead.

Well, as usual, I would like to thank everybody for their interest in BSQUARE and we will look forward to talking to you again next quarter.

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