BSQUARE Corporation's (BSQR) CEO Jerry Chase on Q2 2017 Results - Earnings Call Transcript

| About: BSQUARE Corporation (BSQR)

BSQUARE Corporation (NASDAQ:BSQR)

Q2 2016 Earnings Conference Call

Aug 3, 2016 05:00 PM PT

Executives

Jerry Chase - President and CEO

Analysts

Operator

Good day, ladies and gentlemen and welcome to the BSQUARE Corporation Second Quarter 2016 Financial Results Conference. Today's program is being recorded.

I would now like to hand this call over to Jerry Chase, Chief Executive Officer. Please go ahead, sir.

Jerry Chase

Thank you, and good afternoon, everyone. Before I begin, let me remind you that this call is being webcast and that a recording of the call and the text of our prepared remarks will be available on our website.

During this call, we 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.

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 where applicable.

While revenue within our traditional business segments declined during the second quarter, I am pleased to report that we achieved a significant milestone toward developing a strong, growing and high margin business around DataV or Internet of Things software offering. Towards that end, we announced our first large-scale DataV contract.

I would like to explain why we believe this was such an important event for BSQUARE, and what we believe it in the future. On May 31, we announced the three-year agreement with Fortune 500 industrial company, initially valued at $4.3 million.

This agreement validates the strategy we embarked on roughly two years ago, leveraging our prudent domain expertise and device level and cloud software in order to bring our own software offering to the industrial Internet of Things market. As a result of successful R&D initiatives followed by successful engagements with a variety of customers, we are now entering the scale deployment phase of DataV.

Due to revenue recognition rules with software products such as DataV, revenue for this contract will be recognized over a three -year period, although the cash proceeds are heavily weighted in the first year. This revenue treatment will results in reporting lower level revenue in the earlier periods of contract, but will result in high margin revenue stream going forward. We anticipate that many of our DataV contracts may be similarly structured.

To provide additional clarity and transparency on what we believe will be a very good business for BSQUARE, in coming quarters we anticipate providing additional DataV financial metrics. This may include such measures as DataV bookings and backlog. It is important for investors to fully appreciate the nature of the DataV business, relative to our traditional engineering services and third-party software businesses.

Our engineering services business operates with gross margins varying between 15% and 30% and our third-party software business typically operates at 12% to 18%, because DataV is primarily a licensed software sale, we expect DataV to ultimately deliver gross margins above 70%. This estimate represents a blend of DataV licensed software maintenance and DataV systems and integration system services.

We believe DataV is strongly differentiated from competing solutions and affords BSQUARE to opportunity to secure customer in a number of industrial verticals. The most significant point of differentiation is that DataV is engineered as a complete solution targeting major industrial IoT used cases.

Many of the competitors as we see are offering IoT components, which require additional development on the part of customers. Given the nascency of the IoT market many customers are not yet prepared to undertake that level of systems integration. We believe that stage of market development is still several years in front of us and that our approach gives us a meaningful window of opportunity.

DataV Software is offered in a modular fashion. This gives BSQUARE to additional competitive advantages. First, DataV can be deployed in whole or in part to optimal realign with actual customer requirements. Second, it allows us to opportunistically partner with major cloud-based IoT platform providers such as Amazon, web services and micro for Microsoft earlier.

For these reasons in addition to strong growing sales pipeline, we intend to invest more aggressively in DataV. These investments will be targeted at expanding our sales force, customer integration and support, marketing and R&D.

During Q2, third-party software sales generated 81% of topline revenue and saw gross margins improved to 16%. Although, Microsoft has made changes in its distribution business, this continues to be relatively stable business that operates quite efficiently.

With the increase investment in DataV, as well as the reduction in revenue associated with traditional engineering services, on July 28, our Board of Directors approved the restructuring plan that will reduce the size of our engineering services organization and reallocate certain personality to DataV.

These actions in the resulting severance and restructuring costs will negatively impact our Q3 results. And we anticipate that they will be mostly completed during the third quarter of 2016.

We anticipate approximately $1.8 million in annual savings and recurring pretax restructuring charges to our GAAP financial results of approximately $600,000 in the third quarter of 2016.

Now let me recap our financial results for the second quarter. We reported total revenue this quarter of $22.7 million, down 21% from $28.9 million and a very strong second quarter 2015, due to lower revenue from Microsoft embedded operating system sales and lower professional engineering services revenue compared to the prior year period.

Revenue was down 11% sequentially from $25.4 million in the first quarter of 2016, primarily due to lower engineering services revenue and lower Microsoft embedded systems software shipments.

Third-party software sales were $18.3 million this quarter, down 21% year-over-year from $23.3 million. Third-party software sales were down 8% sequentially from $19.9 million from the first quarter of 2016.

Service revenue was $4 million this quarter, down 23% year-over-year from $5.2 million and down 24% sequentially from $5.3 million in Q1, 2016. Service revenue was down year-over-year sequentially, primarily due to the completion of several large consulting projects.

Proprietary software revenue was $398,000 this quarter, up 11% from $360,000 year-over-year and up 59% from $250,000 quarter-over-quarter. As we have previously noted, revenue and gross margin from our proprietary software products can fluctuate significantly from going quarter to the next and investors should not extrapolate individual quarterly results for future periods.

Next, I will turn to our gross profit and margins. Overall, gross profit was $3.9 million this quarter or 17% of total revenue compared to $5.2 million or 18% of revenue in the year ago quarter and $4.3 million or 17% of revenue in Q1, 2016.

Third-party software gross margin was 16% this quarter, up from 15% during both Q2, 2015 and Q1, 2016. As you may recall at the end of 2015, Microsoft announced changes regarding pricing and distribution for their embedded Windows products. Although, we entered into transition agreements with Microsoft and the majority of our customers under substantially the same terms until December 31, 2016, there can be no assurance that our third-party software gross margins will remain at current level to future periods.

Engineering services gross margin was 15% this quarter, 29% in the year ago quarter and 24% in Q1, 2015. The decreases were primarily due to lower revenue combined with lower utilization of engineering resources this quarter.

Non-DataV proprietary software gross margin was 69% this quarter, up from 64% in the year ago quarter and from 56% in Q1, 2016. Fluctuations in non-DataV proprietary software gross margins are generally driven by changes in revenue as the cost of sales is relatively fixed.

Next, moving down the income statement to operating expenses. Total operating expenses were $4 million this quarter, up from $3.4 million in Q2, 2015 and from $3.6 million in Q1, 2016.

Compared to the prior year quarter, R&D expenses increased by approximately $350,000 and SG&A expenses increased by approximately $360,000. The majority of the increase in SG&A expenses was due to DataV sales commissions, investments in DataV marketing and executive severance.

Now, I will speak to our bottom line results. Net loss for the second quarter was $185,000 or $0.02 per share. This is compared to net income of $1.9 million or $0.15 per share in the year ago quarter and net income of $500,000 or $0.04 in Q1 2016.

We generated positive adjusted EBITDA of $300,000 quarter, down $200 million compared to $2.3 million in the year ago due to lower overall revenue and higher DataV expense as compared to last year and down $900,000 compared to $1.2 million in Q1, 2016.

Adjusted EBITDA to the non-GAAP measure is defined as operating before depreciation, amortization and stock-based compensation. The reconciliation to the comparable GAAP financial measure can be found in our press release and on our website at www.bsquare.com. We use this non-GAAP measure to monitor our ability to generate cash from the operations of our business.

Cash and investments were $27.1 million as of June 30, 2016, a decrease of $800,000 from $27.9 million as of March 31, 2016, and a decrease of $2.9 million from $30 million as of December 31, 2015. Generally, adjusted EBITDA has historically been a proxy for cash flow for business. However, working capital changes impact the change in cash and investments as well.

We currently have the following expectations for the third quarter 2016. With regard to DataV, bookings will increase sequentially. Cash collections for previously booked DataV software and services will commence. DataV revenue will generally be recognized over the life of the contract. Operating expenses will continue to reflect increased investments for DataV sales, customer integration and support, marketing and R&D personnel in an effort to capitalize on our growing customer pipeline.

Regarding overall financial expectations, total revenue will be in the range of $20 million to $22 million. Gross margin percentage for engineering services will continue to be lower than we have historically achieved as a result of our business transition to DataV. Despite increased investment in DataV, cash flow will be positive.

We will experience the Q3 GAAP net loss with the implementation of our restructuring plan, including approximately $600,000 in estimated severance charges and the accounts receivable balance which has been growing due to extended payment terms granted to a highly credit worthy consumer is expected to plateau or decline marginally during Q3.

Additionally, we expect that increased investments in DataV combined with the timing of revenue recognition will result in net losses in the upcoming quarters. However, we expect that these investments will be funded by ongoing positive cash flow.

In summary, while we have continued to focus on execution within our traditional businesses, we will continue to accelerate activity around DataV in order to capitalize on what we perceive to be a substantial market opportunity.

[Indiscernible] open the call for the questions.

Question-and-Answer Session

Operator

Jerry Chase

Thank you. Before concluding the call on behalf of the entire BSQUARE team, I would like to thank our investors and our customers for your interest and for your business. We look forward to reporting back to you next quarter. Thank you for joining us.

Operator

Ladies and gentlemen, that does conclude today's conference. Thank you all for your participation today.

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