BSQUARE: More Than Simply a Reseller of Microsoft Software

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Includes: BSQR, MSFT
by: The Manual of Ideas

BSQUARE (NASDAQ:BSQR) has historically sold Windows software and related services to smart device manufacturers, carving out a niche with attractive growth. More recently, the company has emphasized development of proprietary software, the sale of which carries ~90% gross margins versus mid teens margins for the resale of Microsoft (NASDAQ:MSFT) software. Proprietary software revenue is a small part of the mix, but is growing and driving overall margin expansion. BSQUARE’s market value does not give the company credit for the value of the proprietary software income stream, in our view.

BUSINESS OVERVIEW

BSQUARE provides engineering services and production-ready software to the smart device market. Its software enables manufacturers of personal navigation devices, point-of-sale terminals, handheld data terminals and smart phones to get to market more quickly and cost effectively.

SELECTED OPERATING DATA

FYE December 31

2005

2006

2007

YTD

9/30/08

% of revenue by type:

Third-party software1

67%

61%

58%

55%

Proprietary software

6%

5%

7%

5%

Service

27%

34%

35%

40%

Revenue growth by type:

Third-party software1

11%

6%

13%

6%

Proprietary software

-2%

-1%

62%

-18%

Service

11%

44%

24%

25%

Total revenue growth

10%

16%

19%

11%

% of revenue by geography:

North America

95%

95%

94%

91%

Asia and other

5%

5%

6%

9%

Gross margin by type:

Software

21%

21%

25%

22%

Service

29%

31%

29%

33%

Total gross margin

23%

24%

27%

26%

Click to enlarge

1 The resale of Microsoft Embedded operating systems and related products accounts for substantially all third-party software revenue.

INVESTMENT HIGHLIGHTS

  • Focuses on smart devices that run on Microsoft Windows operating systems, i.e., Windows CE, Windows XP Embedded and Windows Mobile.

  • Acquisition of rights to Adobe Flash technology from NEC enables the company to support customers who are using Flash in non-Windows operating systems such as Linux or Symbian.

  • Software and engineering services address device life cycle, including design, development, customization, quality assurance, and deployment. Customers include OEMs, ODMs, silicon vendors, peripheral vendors, and enterprises that develop, market and distribute smart devices.

  • Intends to grow proprietary software revenue through product development and royalty-bearing service contracts. Proprietary software enjoys gross margins of close to 90%, while third-party software is associated with gross margins in the mid teens.

  • Positive business trend due to new service deals, including a large non-Microsoft deal. The company has also scored several SDIO (secure digital input output) design wins, with royalties tied to customer shipments. In addition, customer interest in OMAP technology should result in incremental revenue. Services backlog and pipeline remain strong.

  • Brian Crowley (47) became CEO in 2003 after serving as VP of product development for a year. He was previously VP of engineering and VP of marketing at DataChannel, and served in various roles at other technology companies.

  • Posted solid Q3 and guided for 5-10% sequential revenue growth in Q4. Service revenue rose 60% y-y in Q3, driven in part by 70-person incremental staffing on a project with Ford (NYSE:F). Excluding Ford, the company did see “some softness in demand.”

  • NOL of $65+ million, with entire $30 million deferred tax asset off the balance sheet.

INVESTMENT RISKS & CONCERNS

  • Dependent on Microsoft’s success in operating systems for smart devices. The vast majority of BSQUARE’s business is tied to adoption of the Windows operating system by device makers. If Windows’ market share declines, BSQUARE would be negatively affected. The company must also maintain its OEM distribution deal with Microsoft.

  • Windows-based embedded software market is competitive. Participants include engineering service firms such as Intrinsyc, Vanteon, Teleca, and Wipro; ODMs, particularly in Taiwan; contract manufacturers; and Microsoft Embedded operating system distributors such as Arrow and Avnet.

MAJOR HOLDERS

CEO Crowley 3% │ Other insiders 8% │ S Squared 10% │ H Partners 9% │ Bjurman Barry 6% │ RenTech 6%

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