Jerry Chase - President, Chief Executive Officer, Director Marty Heimbigner - Chief Financial Officer

Good day and welcome to the BSQUARE Corporation Third Quarter 2015 Financial Results Conference Call. Today's conference is being recorded. At this time, I would like to turn the conference over to Jerry Chase, CEO. Please go ahead sir.

Thank you and good afternoon, everyone. Before I begin, let me remind you that this call is being webcasted 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. BSQUARE achieved solid results during the third quarter with a $1.9 million increase in revenue, a $550,000 increase in net income and $870,000 increase in adjusted EBITDAS always compared to the year ago quarter. Net income was $1.2 million or $0.10 a share compared to $691,000 or $0.06 per share for the year earlier period. On a year-to-date basis we increased revenue by $11.3 million or 16% compared with the equivalent year earlier period. Year-to-date net income was $5 million compared with $949,000 or $0.08 per share for the equivalent year earlier period. As we have reported on prior calls, we have been for some time developing proprietary software targeted at the emerging market for Internet of Things or IoT. We believe our decades of experience developing intelligence for and connectivity to remote devices and corporate assets positions us well to innovate in the IoT market. The culmination of this effort is DataV, a complete software solution intended for business oriented IoT applications. BSQUARE DataV software and engineering services are targeted at helping enterprises implement business focused IoT systems designed to drive better business outcomes. These include; increasing uptime by predicting failures before they occur and taking corrective action, reducing overall warranty expenses, employing prescriptive diagnostics to reduce repair time and cost, providing insight into how assets are being employed in order to improve efficiency and guide product design, providing improved quality service and ultimately optimizing products in overall business processes. We also believe that DataV is well differentiated from competitive offerings. DataV is a complete business oriented IoT solution that can be deployed in its entirety or in a modular fashion. DataV uniquely places additional intelligence on board the devices themselves thereby improving reliability while reducing costs. As a complete IoT software solution DataV can enforce rules at the most optimal location, on the device, on the gateway or in the cloud. Whereas early IoT solutions merely displayed aggregated device data on dashboards for visualization purposes, DataV applies robust analytics, complex rule processing and automated corrective actions in order to close the loop and help directly drive business outcomes. As we have previously stated we continue to believe BSQUARE systems' integration and applications development capability complement DataV and offer significant added value to our customers. Based on feedback from potential customers, partners and industry analysts, we believe that DataV is a unique and innovative approach to the challenges confronting organizations deploying IoT. We also believe that the IoT market is at an early stage and that we are well-positioned with the right solution at the right time. We have been investing in R&D, sales and marketing for DataV and are engaged with several potential customers and partners. We are encouraged by active customers trials for DataV, some with Fortune 500 companies. We anticipate that early deployments with these customers will form the foundation for growth for years to come and that DataV gross margins will be more consistent with proprietary software businesses exceeding 70%. We continue to expect bookings and initial revenue beginning this quarter. Due to software revenue recognition criteria, actual revenue recognition related to DataV bookings may fall into later quarters. Moving on to third-party software sales, under the leadership of Scott Caldwell. This business generated 79% of our Q3 revenue at 15% gross margin. We have recently been notified of pricing for Windows 10, pricing changes for other Windows embedded software products and changes in the structure of the Microsoft Embedded License Distribution model. We believe these changes will result in increased competitive pressure and may negatively impact our third party software operating results in future quarters. However, we also believe there may be opportunities associated with these changes and we are in the process of evaluating how they may impact our business. At the same time and as mentioned in prior calls, we view our very large embedded software customer base as being well-suited to accept our DataV products and have trials underway with a set of these customers. Next I would like to focus like a move to Engineering services, under the leadership of Mark Whiteside, which drove 20% of our top line in Q3 at 26% gross margin. As a reminder this line of business provides engineering support to Fortune 500 customers, such as Google, Coca Cola and Ford and we anticipate reasonable stability regarding ongoing performance for this group. We expect gross margin for Engineering services will continue in the mid-20s for the near term. As noted above we expect Engineering services will be an important differentiator for DataV. Our proprietary software product revenue was $425,000 in Q3 at 74% gross margin. Marty Heimbigner, our CFO will address our financial performance in the second quarter.

Thanks, Jerry. With that business overview let me recap our financial results reflecting the continued hard work and talent of the entire BSQUARE team. We reported total revenues this quarter of $26.4 million, up 8% from $24.5 million in the third quarter of 2014 and down 8% sequentially from $28.9 million in the second quarter of 2015. Third-party software sales were $20.8 million this quarter up 8% year-over-year from $19.2 million. The increase from the prior quarter was primarily attributable to strong Microsoft licensing sales, particularly Windows embedded licenses. Third-party software sales were down 11% sequentially from $23.3 million in the second quarter of 2015. The quarter-over-quarter decrease was impacted by Microsoft fiscal year-end incentives that brought forward some deals into Q2. Service revenue was $5.2 million this quarter up 10% year-over-year from $4.8 million and essentially flat sequentially. Service revenue was up year-over-year primarily due to stronger service revenue in North America as a result of the addition of a key global 100 customer, partially offset by lower revenue in Japan as a result of a nonrecurring large project completed in the 2014 period. Proprietary software revenue was $425,000 this quarter down 23% year-over-year from $551,000 and up 18% from $360,000 quarter-over-quarter. As we had previously noted, revenue from our proprietary software products can fluctuate significantly from one quarter to the next and investors should not extrapolate any of these reported result for future periods. Next I'll turn to our gross profit and margins. Overall gross profit was $4.9 million this quarter or 18% of total revenue compared to $4.0 million or 16% of revenue in the year ago quarter and $5.2 million or 18% of revenue in Q2 2015. Third-party software gross margin was 15% this quarter compared to 14% in the year ago quarter and 15% in Q2 2015. The improvement year-over-year was driven primarily by changing customer mix and operational efficiencies this quarter compared to the prior-year period. The improvement in third-party software margin during the past year is not expected to continue in 2016 due to recently announced changes regarding pricing and distribution model for embedded Microsoft Windows products. Engineering services gross margin was 26% this quarter as compared to 20% in the year ago quarter and 29% in Q2 2015. The year-over-year increase is as a result of higher realized rate per hour combined with improved utilization of engineering resources. The quarter-over-quarter decrease was due to higher than planned labor hours for a large engineering project that is expected to be completed in Q4. Proprietary software gross margin was 74% this quarter flat as compared to the year ago quarter and up from 64% in Q2 2015. Fluctuations in proprietary software gross margin are generally driven by changes in revenue as the cost of sales is relatively fixed. Gross margins from our proprietary software product can fluctuate significantly from one quarter to the next and investors not extrapolate year-to-date results for future periods. Moving down the income statement to operating expenses. Total operating expenses were $3.5 million this quarter up approximately 8% year-over-year from $3.2 million and up approximately 4% quarter-over-quarter from $3.4 million. The quarter-over-quarter and year-over-year increases were primarily as a result of seasonal timing of expenses as well as increased spending in support of DataV product development and marketing. Now I'll speak to our bottom line results. Net income for the third quarter was $1.2 million or $0.10 per share compared to net income of $691,000 or $0.06 per share in the year ago quarter and net income of $1.9 million or $0.15 per share in Q2 2015. This year-over-year improvement in net income reflects our continued focus on increasing the efficiency of our core business resulting in higher revenues and commitments to sustain profitability through focused expense control. The quarter-over-quarter decline is primarily as a result of the aforementioned decrease in third-party software revenue. We generated adjusted EBITDAS of $2.0 million this quarter up 79% compared to $1.1 million in the year ago quarter and down 15% compared to $2.3 million in Q2 2015. Adjusted EBITDAS is a non-GAAP measure defined as operating income before depreciation, amortization and stock based compensation. The reconciliation to the comparable GAAP financial measure can be found on our press release and on our website at www.bsquare.com. Cash and investments decreased slightly to $29.6 million at September 30, from $29.7 million at June 30, an increase from $26.6 million at December 31, 2014. Generally adjusted EBITDAS has been a proxy for cash flow from our business, however working capital changes impact the change in cash and investments as well. As we indicated last quarter our accounts receivable balance is expected to continue to increase into early 2016 as we selectively provided extended payment terms to a highly creditworthy customer beginning the year 2015. We believe this new arrangement will leverage our strong cash position to improve our third-party gross margins and profitability. Our Accounts Receivable balance and days sales outstanding metrics will therefore increase, with a commensurate decrease in cash or short-term investment balances. I will now turn the call back to Jerry to provide our outlook for the fourth quarter and also closing remarks.

Thank you, Marty. We currently have the following expectations for Q4 2015. Total revenue will be in the range of $23 million to $26 million. Gross margin for services will continue in the mid-20% range. We expect bookings and initial revenue from DataV and we expect continued GAAP profitability. Joe please open the call for questions.

Okay. 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.

And that conclude today's conference call. We thank you for your participation.