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BSQUARE Corporation (NASDAQ:BSQR)

Q2 2014 Results Earnings Conference Call

August 14, 2014, 5:00 pm ET

Executives

Jerry Chase - President, Chief Executive Officer, Director

Analysts

Sheldon Grodsky - Grodsky Associates

Kevin Lyons - Moloco Capital

Operator

Good day, and welcome to the BSQUARE Corporation’s second quarter 2014 earnings conference call. Today's call is being recorded.

At this time, I would like to turn the conference over to Jerry Chase. Please go ahead, sir.

Jerry Chase

Good afternoon everyone. Given the previously announced resignation of Scott Mahan our CFO, I will be handling the call today. Before I begin, let me remind you that the call is being broadcast over the internet and that a recording and a text of my prepared remarks will be available on our website.

During the call, I will be making forward-looking statements. These statements are based on current expectations and assumptions that are subject to risks and uncertainties that could cause actual results to differ materially from what is described in those statements.

Please refer to the cautionary text regarding forward-looking statements contained in our earnings release issued today and in the posted version of 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 $23.1 million, up 6% year-over-year from $21.8 million and up 1% quarter-over-quarter from $22.7 million. The year-over-year increase was driven by both third-party software sales and service revenue. Total revenue for the six months was $45.8 million, up 7%.

Third-party software sales were $17 million this quarter, up 4% year-over-year from $16.3 million and down 4% quarter-over-quarter from $17.7 million. The year-over-year increase was driven by an increase in sales of Microsoft Embedded operating systems which, in turn, was driven by strength across all customer segments. The quarter-over-quarter decline was primarily driven by a large sale in the amount of $2.6 million, which benefited Q1. Third-party software sales for the six months were $34.7 million, up 9%.

Proprietary software revenue was $448,000 this quarter, down 25% year-over-year from $597,000 and down 41% quarter-over-quarter from $755,000. The quarter-over-quarter decline was driven by lower Texas Instruments OMAP royalty revenue. Proprietary software revenue for the six months was $1.2 million, down 26%.

Service revenue was $5.6 million this quarter, up 13% year-over-year from $5 million and up 32% quarter-over-quarter from $4.3 million. The year-over-year improvement was driven by $1 million increase in Japan, which was driven by two large handheld terminal projects.

Roughly half the Japan increase was driven by the recognition of $478,000 in revenue and gross profit resulting from the completion of one of the two handheld terminal projects which was being accounted for under the zero profit percent complete method. Under the zero profit percent complete method, revenue is recognized equal to delivery cost during the project and the gross profit is recognized as revenue at completion.

We are also accounting for the second handheld terminal project using the zero profit percent complete method and expect a similar revenue and gross profit pickup in Q4 upon completion of the second program. The quarter-over-quarter increase was driven by strength in all geographies, including the Japan accounting impact noted earlier.

The MyFord Touch program accounted for $821,000 of service revenue this quarter, $1.3 million in the year-ago quarter, and $670,000 in Q1. MyFord Touch revenue for the six months was $1.5 million compared to $2.5 million in the prior year. Service revenue for the six months was $9.9 million, up 6%.

Turning to gross profit and margins. Overall gross profit was $4.3 million this quarter, or 18% of total revenue compared to $3.8 million or 17% of revenue in the year-ago quarter and $3.5 million or 16% of revenue in Q1. The year-over-year and quarter-over-quarter increases in total gross profit were driven by improvement in service gross profit. Gross profit for the six months was $7.8 million or 17% of total revenue compared to $7.1 million or 17% of total revenue in the prior year.

Third-party software gross margin was 13% this quarter, 16% in the year-ago quarter, and 13% in Q1. The year-over-year decline was due to a number of factors including lower sales of Microsoft Windows Mobile and other higher margin third-party products, as well as previously disclosed modification to our rebate accounting.

Proprietary software gross margin was 58% this quarter, 63% in the year-ago quarter, and 78% in Q1. The quarter-over-quarter decline was driven by lower revenue compared to a relatively fixed cost of sales base.

Service gross margin was 31% this quarter, 18% in the year-ago quarter, and 15% in Q1. The year-over-year and quarter-over-quarter increases were driven by the previously mentioned Japan revenue pickup without which service margin would have been 24%. The remainder of the increases were driven by improvements in utilization in our realized rate per hour in North America and EMEA.

Moving down to P&L. Total OpEx was $3.6 million this quarter, down 21% year-over-year from $4.6 million and down 4% quarter-over-quarter from $3.7 million. The year-over-year decline largely resulted from cost reductions, which occurred in Q4 of 2013. OpEx was $7.3 million for the six months, down 17%.

Now I will speak to our bottom-line results. We reported net income for the quarter of $651,000 or $0.06 per share, compared to a net loss of $805,000, or $0.07 per share in the year ago quarter and compared to a net loss of $393,000 or $0.03 per share in Q1. Net income for the six months was $258,000 or $0.02 per share compared to a net loss of $1.7 million or $0.15 per share in the prior year.

We generated positive adjusted EBITDAS of $1.1 million this quarter compared to negative adjusted EBITDAS of $337,000 in the year-ago quarter and positive adjusted EBITDAS of 210,000 in Q1. We generated adjusted EBITDAS of $1.3 million for the six months compared to negative adjusted EBITDAS of $822,000 in the prior year. As a reminder, adjusted EBITDAS is our opening income or loss less depreciation, amortization, and stock compensation expense.

Cash and investments increased $1.2 million to $24.4 million at quarter-end from March 31; $250,000 of which is classified as long-term. We commented on last quarter's call that we expected cash to be down roughly $1.5 million, but we experienced better than expected working capital effects and operating results. Cash CapEx has ran $93,000 for the first half and we currently anticipate FY 2014 cash CapEx to run approximately $400,000. Cash and investments are currently expected to decline roughly $1.4 million at September 30 compared to June 30 due to negative working capital effects.

Now I would like to discuss what these numbers mean to BSQUARE and our investors. As we have stated previously, our top priority for 2014 is to execute cleanly on our existing business. Though we are encouraged by recent results, there is more work we need to do to grow the value of the company. In Q2, we continued to see positive effects from the restructuring and refocusing efforts we undertook in the second half of 2013. During the quarter, we made solid advances on our commitment to return BSQUARE to sustained profitability as evidenced by a $1.5 million positive swing in net income and $1.4 million positive swing in EBITDAS from the year-ago quarter.

Within that framework, a few comments about each of BSQUARE's three revenue lines; third-party software sales, engineering services, and proprietary products. Third-party software sales are the main driver of our topline revenue, generating 74% of our total Q2 revenue. Under the leadership of Vice President of Sales, Scott Caldwell, the underlying strength of our third-party software sales and the team supporting it remains strong. As I mentioned in last quarter's call, we are prudently investing in this business with a healthy basis for doing so.

Engineering services drove 24% of our topline in Q2 and operated at a 31% gross margin. Without the benefit of the previously mentioned favorable Japan margin in the quarter, gross margin was still 24%, a 6 point improvement from the year-ago quarter and a 9 point improvement from Q1. Under VP of Sales and Engineering, Mark Whiteside's leadership, we continue to focus on deepening and expanding our relationships with existing customers, selectively growing our customer base, and upgrading the sales team.

Our proprietary product revenue represented only 2% of our topline in Q2 with 58% gross margin. Some of the growth initiatives I will discuss in a moment are aimed at improving our product sales and margin profile.

To recap some additional activities and highlights from Q2, we continue to enjoy a good relationship with Google as a result of partnering with them to provide engineering services for Project Tango, Google's exciting new initiative to give mobile devices a human scale understanding of space and motion. Going forward, we expect that our engagement with Google will grow.

Coca-Cola remained a key and valued customer and we expect this to continue. We continue to support the MyFord Touch program in which BSQUARE has played a significant role throughout its development. Third-party software sales consisting primarily of Microsoft license sales is strong and sustained by momentum across our top accounts.

We continue to build our DataV family of Internet of Things products, applications, and services that will turn raw device data into useful, meaningful, actionable data. When implemented, DataV will help our customers improve equipment uptime, automate their field support forces, lower operational costs, lower their time-to-market risk, and enable new revenue opportunities for them and us. We currently anticipate revenue from this initiative beginning in 2015.

And to further align ourselves with Microsoft and Intel's tablet and handheld strategies, we signed a Microsoft Embedded licensing agreement with a vertical market tablet OEM to address the growing need for industry-specific tablets. Separately, we are making progress on our Intel-based handheld strategy for an existing multi-hundred-million-dollar market in traditionally strong Microsoft verticals. We plan to issue a press release regarding this new initiative in Q3.

We are continuing to bring our three revenue lines together to mutually support and grow our overall business. The teamwork amongst Scott Caldwell, Mark Whiteside, and our Chief Architect Dave Wagstaff is beginning to bear fruit. It is a competitive advantage for BSQUARE and is key to achieving our long-term objectives.

Turning to Q3. We currently expect that revenue will be between $23 million and $25 million and we expect to be GAAP profitable.

Before turning to Q&A, and on behalf of the entire BSQUARE team, I wish to thank Scott Mahan for over 10 years of exemplary service is BSQUARE's CFO and we wish Scott the best in his new endeavors. As always, I would like to thank our investors and our customers for your interest and for your business.

Jessica, please open the call for questions.

Question-and-Answer Session

Operator

(Operator Instructions). We will first go to Sheldon Grodsky from Grodsky Associates.

Sheldon Grodsky - Grodsky Associates

Good afternoon, everybody. I actually have a couple of questions. Of thought was what I think is an easy one. Microsoft acquired Nokia and I am wondering, is that something that should be a major event in the history of BSQUARE or is that just nothing special?

Jerry Chase

So far we have not seen a material impact on our day-to-day basis. Certainly, we remain open to all business opportunities with Microsoft and what might become of the Nokia acquisition, but so far we have not seen an impact.

Sheldon Grodsky - Grodsky Associates

And you don’t expect that to -- well, you don't have any clear expectations of how that will shake out?

Jerry Chase

Not at the moment. That's correct.

Sheldon Grodsky - Grodsky Associates

Okay. That was the easy question. Okay, now I want to go back to the accounting where you mentioned, I guess there were a couple projects in Japan. Why do you call it zero profit account? Say that slowly for people who’ve never heard that before, because I am one of the people who has never heard that accounting practice before. What does it mean in terms of recognition of expenses and revenues?

Jerry Chase

Yes. It's called zero profit accounting, and basically what it means is that, it is a judgment call that says if we think that there are certain qualities around the account, whether it's a new account or certain risks or whatever and we don't want to accidentally recognize profit upfront and then have to reverse it later, what we will do is just recognize cost as they occur and then wait until the contract is finished and then recognize all the profit at the end.

In this case, the contract went very well. It was well within expectations. It was the prudent thing to do. And as I mentioned, we are also doing it on a second program for the same customer that's going to conclude in Q4.

Sheldon Grodsky - Grodsky Associates

Okay. So the cost are recorded as incurred and so instead of percentage of completion, you just wait till the whole thing is done and see whether you have a profit?

Jerry Chase

Yes. That's correct.

Sheldon Grodsky - Grodsky Associates

Okay. I will let someone else take the floor. Thank you.

Jerry Chase

Thank you.

Operator

(Operator Instructions). We will now go to Kevin Lyons from Moloco Capital.

Kevin Lyons - Moloco Capital

Hi, Jerry.

Jerry Chase

Hi, Kevin.

Kevin Lyons - Moloco Capital

Hi. So a lot of things to like this quarter and a few things are new issues or questions. One would be the third-party margin now. You had a historical baseline of 15% with good times of 16%. How should we think about that going forward? Is 13% a new baseline or are we going to bounce back to the 15% range under the new situation?

Jerry Chase

Yes, we would expect that 13% to be the baseline.

Kevin Lyons - Moloco Capital

Okay. And as for the engineering services, the 24% that you referred to without the Japan bump, is that the new baseline going forward or do you have other comments on that?

Jerry Chase

I would say it’s good progress in the right direction. Under Mark Whiteside's leadership, we have adopted a land and expand strategy related to our customers to focus on bigger customers with deeper engagement which allows us to be more efficient and more profitable. We are seeing the benefits of that. Clearly, we are pleased with the 24%. Directionally, it's correct and we look forward to reporting the results of this quarter during the next earnings call, but we do believe that that's a new direction for us and we are improving towards that direction.

Kevin Lyons - Moloco Capital

Okay, great, and lastly about 58% in the proprietary, what's the plan there?

Jerry Chase

Yes. That's, as we proceed with DataV, we would expect to improve the amount of our revenue associated with products. And as I mentioned in my remarks, and as you know from our previous conversations, we are expecting revenue from net initiative in 2015 and have not offered guidance yet on that.

Kevin Lyons - Moloco Capital

So are you recognizing the expenses there under the proprietary software or in R&D at this point?

Jerry Chase

Under R&D. Yes.

Kevin Lyons - Moloco Capital

All right. Thanks very much.

Jerry Chase

Yes. Thanks, Kevin.

Operator

There are no further questions. I will turn the conference back over to you Mr. Chase for any additional or closing remarks.

Jerry Chase

Okay. Thank you, everyone. I really appreciate you listening in on this quarter's conference call. We look forward to reporting progress during the coming quarter. Thank you.

Operator

This concludes today's presentation. Thank you for your participation.

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