Scott Mahan - SVP Operations, and Chief Financial Officer Jerry Chase - CEO

Ryan Vardeman - Palogic Value Management

Good afternoon ladies and gentlemen, thank you for standing by. Welcome to the BSQUARE Corporation 2013 Third Quarter 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). I would now like to turn the conference over to Scott Mahan, BSQUARE Corporation's CFO. Please go ahead, sir.

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 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. My focus today will be on quarter-over-quarter trends, and with that, I will recap our results. We reported total revenue this quarter of $23.6 million, up 8% quarter-over-quarter from $21.8 million. The growth was driven by anticipated increases in service revenue and third-party software sales, offset by a shortfall in proprietary software revenue. Total revenue for the nine months was $66.3 million, down 12%. Third-party software sales were $18.0 million this quarter, up 11% quarter-over-quarter from $16.3 million. The growth was driven by higher sales of Microsoft Embedded operating systems across all customer segments. Total third-party software sales for the nine months were $49.7 million, down 5%. Proprietary software revenue was $452,000 this quarter, down 24% quarter-over-quarter from $597,000. The decrease was driven by a lower TestQuest and legacy product revenue. Proprietary software revenue for the nine months was $2.1 million, down 36%. Service revenue was $5.1 million this quarter, up slightly quarter-over-quarter from $5.0 million. The increase was a result of improvement in Japan, due to a new Android handheld terminal project. The MyFord Touch program accounted for $1.2 million in service revenue this quarter on $1.3 million in Q2. Service revenue for the nine months was $14.5 million, down 27%, driven by softness in North America and Japan. Turning to gross profit; overall gross profit was $3.4 million this quarter, or 14% of total revenue, compared to $3.8 million, or 17% of revenue, in Q2. The decrease in total gross profit was driven by lower third-party and proprietary software gross profit, which in turn was driven by margin declines. Total gross profit for the nine months was $10.5 million, down 25%. Third-party software gross margin was 13% this quarter and 16% in Q2. The decline was driven by a reduction in Microsoft Windows Embedded margin, which we believe to be temporary; a shift in product mix towards lower margin Windows Embedded sales, and lower rebate. Due to changes in the Microsoft Rebate program, we began treating a portion of the rebate as market development funds, which will be accounted for as a reduction in marketing expense, as qualified program expenditures occur in the future. Had we accounted for the rebate in Q3 as we did in Q2, our third-party software margin would have been 14%. Proprietary software gross margin was 42% this quarter and 63% in Q2. The decline was driven by the revenue decrease. Service gross margin was 17% this quarter and 18% in Q2. Moving down to P&L, total OpEx was $4.8 million this quarter, up 4% quarter-over-quarter from $4.6 million. The increase was driven by severance costs associated with an executive departure. Total OpEx was $13.6 million for the nine months, up 1%. Now I will speak to our bottom line results. We reported net loss for the quarter of $3.6 million or $0.32 per share, compared to a net loss of $805,000 or $0.07 per share in Q2. We reported a net loss for the nine months of $5.2 million or $0.47 per share, compared to a net income of $220,000 or $0.02 per share in the year ago period. Both the three months and nine month periods in 2013, included the negative effect of a $2.2 million increase in the company's US deferred tax asset allowance, which represented a $0.19 per share effect for the three months, and $0.20 per share for the nine months. We generated negative adjusted EBITDA for $1.0 million this quarter, compared to negative adjusted EBITDA of $337,000 in Q2. We generated negative adjusted EBITDA of $1.8 million for the nine months, compared to positive adjusted EBITDA of $2.0 million in the year ago period. Cash and investments increased $562,000, to $21.5 million at quarter end from June 30. $250,000 of which is classified as long term. Cash didn't come in higher than the $1.0 million burn we had communicated last quarter, due primarily to sales frontloading, which had the effect of reducing our DSOs from 57 days in Q2 to 50 days in Q3. However, we expect sales patterns to return to historical norms in Q4, such that we will see a negative working capital effect and a cash burn currently expected to be approximately $1.8 million. I would also like to point out, that our restricted cash dropped from $875,000 at June 30th, to $250,000 at September 30, as a result of an amendment to our headquarters' lease. CapEx ran $216,000 for the nine months, the majority of which occurred in Q3. We currently expect FY 2013 CapEx to run approximately $300,000. Headcount, including contractors is currently 210, compared to 259 as of the date of our last call. Engineering Services headcount is currently 134, down from 159. The headcount relates to the restructuring that occurred in October. Now I would like to turn the call over to Jerry Chase, BSQUARE's Interim Chief Executive Officer and Board member.

Thanks Scott and good morning and good afternoon to everyone. The reason I say good morning is that I am speaking to you from Taipei, Taiwan, where it is already 6 o'clock on Wednesday morning. I am on the second leg of a journey that started in Japan to meet our international employees, partners and customers. As you may know, I am the member of the Board of Directors, having joined the board July 1st, and as of September 23rd and currently serving as the Interim CEO until the Board identifies a permanent replacement. Because of this unique situation, I am going to take the opportunity to speak a little more broadly about BSQUARE than we normally would. During the first nine months of 2013, BSQUARE continued to deliver important products and services to the smart connected device ecosystem worldwide. Highlights for this period included, the renewal of our contract with Microsoft to support the MyFord Touch program, in which BSQUARE has played a significant role throughout its development. Increasing our business with the Coca Cola Company, developing applications that manage customer data into cloud for Costa Coffee; launching our HTML5 porting product to enable developers to create rich user interfaces and experiences, including entertainment applications and adding two new global handset manufacturers to our portfolio of customers. For both customers, we provided services based on the Android operating system. However, despite these solid accomplishment and as Scott described, our financial results have not meeting our goals or expectations. Consequently, during the second half of this year, BSQUARE has taken significant steps to correct its situation, better position the company to service customers, and to return to a sound financial footing in 2014. In July of 2013, we added two new Board members, Harel Kodesh and myself. The purpose of this was to augment the board with specific operating and industry experience, and enhance the Board's ability to work closely with management, in the crafting of our strategic growth plans. In parallel, with the addition of two new board members, Andrew Harries was elected as Board Chair to lead the Board, as it works with Management to shape strategic direction of our company. In September 2013, Brian Crowley stepped down as CEO and I stepped in as Interim CEO, and in October, as the company implemented a restructuring that included a workforce reduction that impacted approximately 20% of the company's personnel. To ensure critical mass in our regional masses, we consolidated Asia regional operations into our Taiwan office, closing our office in Beijing, and we consolidated EMEA regional operations into our UK office, closing our Munich office. The restructuring targeted approximately $4 million in annual cost savings, and brought the company more into alignment with our customers' needs. Our shareholders should recognize, that the Board shares the frustration with our financial performance, during the first nine months of this year. We have a solid organization, and a team with tremendous expertise. We are well positioned to grow our revenue, as the demand for smart connected devices increases in many industries, creating opportunities for the sophisticated engineering we provide. The Board took decisive action, and we are extremely engaged as we work to put BSQUARE back on the path toward achieving its potential. Moving forward, BSQUARE will maintain its focus on building strategic solutions for our customers, while focusing on returning to a sound financial footing in 2014. In addition, we believe BSQUARE is well positioned to increase its participation in the rapidly growing Internet of Things market. As we try to grow in this market, we will seek to deepen our relationships with our enviable, world class, Fortune 500 customers, becoming more strategic to them going forward. We look forward to reporting our progress to you and [support] these goals during the coming year. Turning to Q4, we expect that revenue will be between $22 million and $24 million. We currently expect third party and proprietary software to be up sequentially, while we expect service revenue to be down. Before turning to Q&A, on behalf of the entire BSQUARE team, I wish to thank our investors and our customers for your interest and for your business. Douglas, please open it up for questions.

Thank you, sir. We will now begin the question-and-answer session. (Operator Instructions). Our first question is from the line of [David Kaman] with Aegis Capital. Please go ahead.

Good afternoon. First question is for Scott. Can you tell me what was the amount of severance in OpEx for Q3?

Little bit under $200,000.

Okay. And as far as the cost savings going forward, which is about $1 million per quarter, would I go back to Q2 OpEx levels, which I think it was around $4.5 million and deduct $1 million or is there another way that I should look at it? I am just wondering, do I take -- there is a non-recurring item there in Q3, so what level do you ultimately expect to be at in 2014? 3.5, 3.6 level?

To be clear, the $1 million that we talked about, that was a combination of both OpEx, service cost of sales, and proprietary service cost of sales as well. So the right number to short a model off of, would be roughly the Q2 OpEx run rate, because as you pointed out, the Q3 OpEx run rate included the severance associated with Brian's departure, and if you take out Brian's severance, you get to roughly about the same run rate as Q2. So the $1 million of savings again, included all of the four components, the two cost of sales components and the two SG&A line items. And just to sort of help you think about that, you should assume that about, a little under $1.5 million of the $4 million, little under that $1.4 million, $1.45 million is coming out of cost of sales, and the rest is coming out of OpEx.

Okay. That clarifies. And as far as the margin improvements that you expect in third-party software sales, do you expect a return to your historic levels, which I think have been 15% to 18%?

Well its really consistent 15% to 16%, and as I mentioned in the script today, as a result of program changes from Microsoft, we modify the way we are accounting for the rebate. So lacking additional changes to the Microsoft program, which would have us changing our accounting again. The permanent effect of that rebate changes about a point. So all things being considered, just sit down from 15% to 16%, to 14% to 15%. And again, there are two other factors which drove the margin decline this quarter. One was, typically, there are various components that go into our third party software sales. There is Windows Mobile, there is Windows General Embedded Operating sales, and then there is other third party software products. And this quarter was particularly heavily skewed towards Microsoft Embedded product sales, and that's the lowest margin component of all of the third party product skews. Then the other one as I mentioned was, our Microsoft General Embedded margins did come in a little bit light this quarter, but there was nothing that stood out as a big deal, where that carried significantly lower margin on it. So the current expectation is, that should rebound, but because the change in the rebate, you do need to change your modeling expectations from 15% to 16%, down in the 14% to 15% range.

Okay. And then, moving to proprietary software, do you expect that to rebound into 2014 and to get back to $500,000, $600,000, $700,000 a quarter?

Well we do expect it to rebound in Q4, and that's all the guidance we have provided thus far.

Okay. I am going to step back and let other people ask questions. Thank you.

Thanks Dave.

(Operator Instructions). Our next question is from the line of Ryan Vardeman with Palogic Value Management. Please go ahead. Ryan Vardeman - Palogic Value Management: Thank you for the clarification, as it relates to the cost saves. Where are we on a permanent CEO search, and Jerry, how long would you stay here, if in a perfect world, then how long are you willing to stay? Thanks.

Okay. Hi Ryan. So the board is obviously very involved in the company at the moment. We are very involved in the decisions and getting the company back to financial footing, involved in the strategy. We feel like working closely with management, we have made very strong progress in that regard, and as soon as we get some more visibility on the strategy, we will have the confidence to look for the CEO, (inaudible) where to look. Speaking to the second part of your question, the board as well as myself are willing to do what it takes, as long as it takes, to make sure we are doing the right thing here for the company, and particularly for the shareholders. Ryan Vardeman - Palogic Value Management: Great. Do you have any sense of timing, when you might get more visibility on this strategy going forward?

We are making good progress. We are not ready to talk about it yet, publicly, but we would hope to start talking about that, as we reach out through various forums, whether it's investor conferences or press releases etcetera. But as soon as we are willing, or as soon as we are able to start talking about that, we are certainly going to come forward. Ryan Vardeman - Palogic Value Management: Then what about, as it relates to tangible milestones and objectives of the company, are those on the list of things to lay out too, as it relates to the strategy going forward?

We will. We will be as specific as we can, as we go forward, and of course, we are going to try to build on, as we mentioned in prepared remarks, on these great relationships that the company has. We feel like there is a good opportunity to get closer to the data, that the projects that we are working on are generating. So directionally, this is where we are going, and certainly, as soon as we can start talking specifics and having tangible objectives, we will share those. Ryan Vardeman - Palogic Value Management: Then you mentioned, getting BSQUARE to its potential, what do you think its potential is? That's a pretty open-ended question.

Yeah. Well, obviously, I am excited about the company. I think with the engineering talent we have, the customers that we have, the areas that we are working. I think we can do a lot better for the shareholders, for our customers, for our employees. So we will be certainly looking to build on that and improve in those directions. Ryan Vardeman - Palogic Value Management: Since you have been in the CEO role, what have been some positive surprises, since you have been there and then may be some negative surprises as well? Maybe just keep with the positives?

Yeah, there is a lot right with BSQUARE. There is a lot of technology that we are working on, that is very appropriate to where the world is going. We are already working at the network edge by that. And point of connectivity, whether its with the Coca Cola Company on their machines, or Honeywell with their devices, we can just go on with whos-who of Fortune 500 companies around the world, and we are already working with them, on their device, [without the network edge]. There is a tremendous opportunity to work with them on their data, in addition to getting their device as part of the connected system. The quality of the people has been remarkable. We have some very talented technical talents and very talented managerial talent, with a good vision of where the company could go. So it has been a pleasure to work with people who have great ideas, and to be able to work with them to channel that enthusiasm or bring that enthusiasm together, as opposed to trying to [plow]. It has been very much -- it's there, its just tapping into it and channeling it. Customer reactions are very positive. We have good relationships. So it has just been -- my comment is that there is, despite the challenges and problems that we have to face and fix, there is a lot right with BSQUARE. Ryan Vardeman - Palogic Value Management: Okay. Fantastic, and then, last question is, in 2014, do you expect that you'd be operationally cash flow positive or, I don't know, how you want to fund profitability, but looking out to 2014?

Scott?

That would be the goal, Ryan. Ryan Vardeman - Palogic Value Management: Okay, great. Thank you all very much, and thank you for all your hard work and dedication.

Thank you very much.

(Operator Instructions). Our next question is a follow-up from the line of [Dave Kaman] with Aegis Capital. Please go ahead.

Scott, a follow-up question on the cost savings. With the reductions in personnel, do you expect engineering services gross margins to get back into the low to mid 20s at the current revenue levels, is that realistic?

Let me make sure I understand your question. Are you asking what the margin effect would be on $5 million per quarter run rate?

Let's say $4.5 million, more or less where we are now, low to mid 4s. Can we get to low to mid 20s and what kind of scalability is there, if we get that, doing 5 million, 6 million, 7 million a quarter?

At a $5 million run rate, the [costs] will definitely have a -- will have a positive improvement on margin. The issue we are in right now, we mentioned Q3 -- Q4 service revenue was expected to drop, and we obviously didn't say how much. But the issue we are running into right now, is simply one of scale, and I will answer the last part of your question as part of it. So as we have discussed in the past, we are at the point, where our service overhead, which is relatively fixed in nature, which includes facility costs and depreciation and the cost of non-billable personnel within that organization, is running close to 25% of our total service cost of sales. So when you are running that sort of leverage in the model, obviously when revenue drops, you are going to get negative leverage, and conversely Dave, when we get 5 million, 6 million, 7 million, we are going to see a nice hop in service margins, and yes, the 20s is very achievable.

Okay. Then question for Jerry in terms of the pipeline services. Are there particular verticals that you are going to be focusing on in 2014 and what are you seeing in your pipeline right now, do you think we can grow and get back to 5 million plus per quarter in 2014?

Obviously, we keep talking about the great customers that we have. We will be looking to deepen and widen those relationships, and as we have more visibility on that pipeline, we will be reporting it and as Scott mentioned, we are only going out as far as this quarter right now. But certainly understand your question, and we will be reporting against that, when we can.

Okay. Thanks guys. Good luck.

Thanks Dave.

At this time there are no further questions in queue. I would like to turn the call back over to management, for closing remarks.

Great. Just wanted to say again, that on behalf of the BSQUARE team, we want to thank our investors and customers for your interest and for your business, and we look forward to reporting our progress in the coming quarters. Thank you very much.

Ladies and gentlemen, that does conclude our conference for today. We'd like to thank you for your participation, and you may now disconnect.