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BSQUARE CORP /WA - 10-Q - Management's Discussion and Analysis of Financial Condition and Results of Operations(Edgar Glimpses Via Acquire Media NewsEdge) As used in this Quarterly Report on Form 10-Q, "we," "us," "our" and "the Company" refer to BSQUARE Corporation, a Washington corporation, and its subsidiaries. The following Management's Discussion and Analysis of Financial Condition and Results of Operations should be read in conjunction with our condensed consolidated financial statements and related notes. Some statements and information contained in this Management's Discussion and Analysis of Financial Condition and Results of Operations are not historical facts but are forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended (the "Securities Act"), and Section 21E of the Securities Exchange Act of 1934, as amended (the "Exchange Act"). In some cases, readers can identify forward- looking statements by terms such as "may," "will," "should," "expect," "plan," "intend," "forecast," "anticipate," "believe," "estimate," "predict," "potential," "continue," or the negative of these terms or other comparable terminology, which when used are meant to signify the statement as forward-looking. These forward-looking statements include, but are not limited to, statements about our plans, objectives, expectations and intentions and other statements that are not historical facts. These forward-looking statements are not guarantees of future performance and involve known and unknown risks, uncertainties and situations that are difficult to predict and that may cause our own, or our industry's actual results, to be materially different from the future results that are expressed or implied by these statements. Accordingly, actual results may differ materially from those anticipated or expressed in such statements as a result of a variety of factors, including those discussed in Item 1A of Part I of our Annual Report on Form 10-K for the year ended December 31, 2012 entitled "Risk Factors," as well as those contained from time to time in our other filings with the Securities and Exchange Commission. Readers are cautioned not to place undue reliance on the forward-looking statements, which speak only as of the date made. Except as required by law, we undertake no obligation to update any forward-looking statement, whether as a result of new information, future events or otherwise. 13 -------------------------------------------------------------------------------- Table of Contents Overview We provide software solutions to companies that develop smart, connected systems. A smart, connected system is a dedicated purpose computing device that typically has a display, runs an operating system (e.g., Microsoft®Windows® CE or Google Android) and is usually connected to a network or data cloud via a wired or wireless connection. Examples of smart, connected systems include set-top boxes, home gateways, point-of-sale terminals, kiosks, voting machines, gaming platforms, tablets, handheld data collection devices, personal media players, smart phones and in-vehicle telematics and entertainment devices. We focus on smart, connected systems that utilize various Microsoft Windows Embedded and Windows Mobile operating systems, specifically Windows Embedded Compact, Windows Embedded Standard 7 and 8, Windows Mobile™, Windows Phone 8 and Windows Embedded 8 Handheld as well as devices running other popular operating systems such as Android, Linux, and QNX. We have been providing software solutions to the smart, connected systems marketplace since our inception. Our customers include world class original equipment manufacturers ("OEMs"), original design manufacturers ("ODMs") and enterprises, as well as silicon vendors and peripheral vendors which purchase our software solutions for purposes of facilitating processor and peripheral sales to the aforementioned customer categories. In the case of enterprises, our customers include those which develop, market and distribute smart devices on their own behalf as well as those that purchase devices from OEMs or ODMs and require additional device software or testing. The software solutions we provide are utilized and deployed throughout various phases of our customers' device life cycle, including design, development, customization, quality assurance and deployment. Critical Accounting Judgments Management's discussion and analysis of our financial condition and results of operations are based on our condensed consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these condensed consolidated financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, sales, cost of sales and expenses and related disclosure of contingent assets and liabilities. We evaluate our estimates on an on-going basis. We base our estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying value of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions. There have been no significant changes to our critical accounting judgments, policies and estimates as described in our Annual Report on Form 10-K for the year ended December 31, 2012. 14 -------------------------------------------------------------------------------- Table of Contents Results of Operations The following table presents certain financial data as a percentage of total revenue for the periods indicated. Our historical operating results are not necessarily indicative of the results for any future period. Three Months Ended March 31, 2013 2012 (unaudited) Revenue: Software 79 % 71 % Service 21 29 Total revenue 100 100 Cost of revenue: Software 63 57 Service 21 24 Total cost of revenue 84 81 Gross profit 16 19 Operating expenses: Selling, general and administrative 18 16 Research and development 3 4 Total operating expenses 21 20 Loss from operations (5 ) (1 ) Other income, net 1 0 Loss before income taxes (4 ) (1 ) Income tax benefit (expense) 0 0 Net loss (4 )% (1 )% Revenue Our revenue is generated from the sale of software, both our own proprietary software and software of third parties that we resell, and the sale of engineering services. Total revenue decreased $4.7 million, or 18%, to $20.9 million for the three months ended March 31, 2013, from $25.5 million in the year-ago period. This decrease was driven by lower sales of Microsoft Windows Mobile operating systems and lower service revenue. Revenue from our customers outside of North America decreased $3.6 million, or 67%, to $1.8 million for the three months ended March 31, 2013 compared to $5.4 million in the year-ago period. The decrease was primarily driven by a $1.2 million decline in sales of Windows Mobile operating systems into Korea given our rights to distribute there ended on October 31, 2012 and declines in service revenue in both Asia and Europe. We sold $4.5 million of Windows Mobile operating systems in Korea in fiscal 2012. 15 -------------------------------------------------------------------------------- Table of Contents Software revenue Software revenue consists of sales of third-party software and revenue realized from our own proprietary software products, which include software license sales, royalties from our software products, and support and maintenance revenue. Software revenue for the three months ended March 31, 2013 and 2012 was as follows (dollars in thousands): Three Months Ended March 31, 2013 2012 (unaudited) Software revenue: Third-party software $ 15,491 $ 17,079 Proprietary software 1,020 1,137 Total software revenue $ 16,511 $ 18,216 Software revenue as a percentage of total revenue 79 % 71 % Third-party software revenue as a percentage of total software revenue 94 % 94 % The vast majority of our third-party software revenue is comprised of sales of Microsoft Windows Embedded and Windows Mobile operating systems. Third-party software revenue decreased $1.6 million, or 9%, for the three months ended March 31, 2013, from the year-ago period. The decrease was driven by a $1.5 million decrease in sales of Windows Mobile operating systems which, in turn, was driven by a $1.2 million decline in sales of Windows Mobile operating systems into Korea given our rights to distribute there ended on October 31, 2012. Proprietary software revenue decreased $117,000, or 10%, for the three months ended March 31, 2013, compared to the year-ago period. This decline was driven by lower sales of our TestQuest products. Service revenue Service revenue for the three months ended March 31, 2013 and 2012 was as follows (dollars in thousands): Three Months Ended March 31, 2013 2012 (unaudited) Service revenue $ 4,359 $ 7,332 Service revenue as a percentage of total revenue 21 % 29 % Service revenue decreased $3.0 million, or 41%, for the three months ended March 31, 2013, from the year-ago period. This decrease was primarily due to a $1.5 million decline in North American service revenue driven by a $479,000 decrease associated with the MyFord Touch program and a $960,000 decline at three customers with whom we currently have no active programs. We also experienced declines of $835,000 and $573,000 in Japan and Europe, respectively, attributable to project transitions and we expect both of those geographies to improve in the second quarter of 2012. Microsoft Corporation ("Microsoft") became our largest engineering services customer during the first quarter of 2012, replacing Ford Motor Company ("Ford"), as Microsoft replaced Ford as the invoiced customer on the MyFord Touch program. We continue to work on the MyFord Touch, a project we began with Ford during the second quarter of 2008; however, we now conduct these services through an agreement with Microsoft. During the initial project with Ford, we provided hardware design and implementation, platform level software development, application level software development, quality assurance services and systems integration services. The project has transitioned since the initial project such that we are now primarily focused on developing and integrating new user applications for the MyFord Touch, enhancing existing applications and customizing the MyFord Touch platform for additional vehicle models. Service revenue from the MyFord Touch program declined $479,000 to $1.3 million, or 29% of total service revenue, for the three months ended March 31, 2013, compared to $1.8 million, or 24% of total service revenue, in the year-ago period. The decline is primarily attributable to a reduction in the number of engineers working on the MyFord Touch project. 16 -------------------------------------------------------------------------------- Table of Contents Gross profit and gross margin Cost of software revenue consists primarily of the cost of third-party software products payable to third-party vendors and support costs associated with our proprietary software products. Cost of service revenue consists primarily of salaries and benefits, contractor costs and re-billable expenses, related facilities and depreciation costs, and amortization of certain intangible assets related to acquisitions. Gross profit on the sale of third-party software products is also positively affected by rebate credits we receive from Microsoft for the sale of Windows Embedded operating systems earned through the achievement of defined objectives and treated as a reduction in the cost of software revenue. Under this rebate program we earned $220,000 for the three months ended March 31, 2013 compared to $209,000 for the three months ended March 31, 2012. Gross profit and related gross margin for the three months ended March 31, 2013 and 2012 were as follows (dollars in thousands): Three Months Ended March 31, 2013 2012 (unaudited) Software gross profit $ 3,344 $ 3,609 Software gross margin 20 % 20 % Service gross profit $ 3 $ 1,193 Service gross margin 0 % 16 % Total gross profit $ 3,347 $ 4,802 Total gross margin 16 % 19 % Software gross profit and gross margin Software gross profit decreased by $321,000, or 9%, for the three months ended March 31, 2013, from the year-ago period, while software gross margin was unchanged. The decrease in gross profit was primarily the result of lower Microsoft Windows Mobile operating system sales. Third-party software gross margin was 16% for the three months ended March 31, 2013, and for the year-ago period. Proprietary software gross margin was 83% for the three months ended March 31, 2013, compared to 78% in the year-ago period, with the increase driven by reductions in cost of sales as a result of cost reduction efforts which occurred in the third quarter of 2012. Service gross profit and gross margin Service gross profit decreased $1.2 million, or 100%, for the three months ended March 31, 2013, from the year-ago period. Service gross margin decreased by sixteen percentage points to 0% for the three months ended March 31, 2013, compared to the year-ago period. The decline in service gross profit was driven by a $3.0 million decline in service revenue without a commensurate decline in service cost of sales. The gross margin decline primarily resulted from a 29% increase in our cost per billable hour as our utilization rate declined by thirteen percentage points. We did reduce some excess service capacity in the fourth quarter of 2012 but did not continue to reduce excess capacity in-line with the revenue reduction during the first quarter of 2013 given our sales pipeline indicates this capacity will be needed in 2013. Operating expenses Selling, general and administrative Selling, general and administrative expenses consist primarily of salaries and related benefits, commissions for our sales teams, marketing and administrative personnel and related facilities and depreciation costs, as well as professional services fees (e.g., consulting, legal, tax and audit). Selling, general and administrative expenses decreased $508,000, or 12%, to $3.6 million for the three months ended March 31, 2013, from $4.1 million in the year-ago period. The decrease was driven by reductions in sales, marketing and general and administrative costs but sales accounted for the majority; down $340,000. Domestic and international sales staff reductions and corresponding declines in personnel costs including bonuses, commissions and stock-based compensation expense accounted for the decrease. Selling, general and administrative expenses represented 18% of our total revenue for the three months ended March 31, 2013 and 16% in the year-ago period. 17 -------------------------------------------------------------------------------- Table of Contents Research and development Research and development expenses consist primarily of salaries and benefits for software development and quality assurance personnel, contractor and consultant costs and related facilities and depreciation costs. Research and development expenses decreased $277,000, or 29%, to $663,000 for the three months ended March 31, 2013, from $940,000 in the year-ago period due primarily to headcount reductions and an office closure which took place in the third quarter of 2012. Research and development expenses represented 3% of our total revenue for the three months ended March 31, 2013 and 4% in the year-ago period. Other income (expense), net Other income or expense consists of interest income on our cash, cash equivalents and investments, gains and/or losses recognized on our investments, as well as gains or losses on foreign exchange transactions. Other income increased $99,000 to $90,000 for the three months ended March 31, 2013, from an expense of $9,000 in the year-ago period due to higher interest income and foreign currency gains. Income tax benefit (expense) Income tax expense was $5,000 for the three months ended March 31, 2013, compared to an income tax benefit of $98,000 in the year-ago period, a change of $103,000. Liquidity and Capital Resources As of March 31, 2013, we had $20.3 million of cash, cash equivalents, short-term and long-term investments and restricted cash, compared to $20.6 million at December 31, 2012. Of these amounts, $10.2 million and $9.9 million were classified as cash and cash equivalents at March 31, 2013 and December 31, 2012, respectively, and $875,000 was classified as long-term at both March 31, 2013 and December 31, 2012. Net cash used by operating activities was $195,000 for the three months ended March 31, 2013, driven by our operating loss of $947,000, offset in part by non-cash expenses of $462,000 and positive working capital changes. Net cash used in operating activities was $1.2 million for the three months ended March 31, 2012, driven by a $4.3 million increase in accounts receivable due to a relatively higher level of our sales in the final month of the quarter offset in part by a $2.4 million increase in third-party software fees payable also largely the result of a higher volume of third-party software sales at the end of the quarter, and $688,000 in non-cash charges. Investing activities provided cash of $561,000 for the three months ended March 31, 2013, due primarily to net proceeds of short-term investments of $579,000. Investing activities used cash of $55,000 for the three months ended March 31, 2012, primarily due to the purchase of property and equipment in the amount of $99,000. Financing activities generated $1,000 during the three months ended March 31, 2013, and $68,000 during the three months ended March 31, 2012, as a result of employees' exercise of stock options. We believe that our existing cash, cash equivalents and investments will be sufficient to meet our needs for working capital and capital expenditures for at least the next 12 months. Cash Commitments We have the following future or potential cash commitments: • Minimum rents payable under operating leases total $1.1 million for the remainder of 2013, $1.0 million in 2014, $265,000 in 2015 and 2016, $137,000 in 2017 and $91,000 thereafter; • Under the terms of our corporate headquarters lease signed in February 2004, the landlord has the ability to demand payment for cash payments forgiven in 2004 if we default under the lease. The amount of the forgiven payments for which the landlord can demand repayment was $339,000 at March 31, 2013; and • In conjunction with our activities under our ODAs with Microsoft, we enter OVRP commitments with Microsoft. Under these OVRPs, we are provided with volume pricing on a customer-by-customer basis assuming certain minimum unit volumes are met. The OVRP terms are 12 months. In the event we don't meet the committed minimum unit volumes, we are obligated to pay the difference between the committed per-unit volume rate and the actual per-unit rate we achieved based upon actual units purchased. The OVRP arrangements do not equate to a minimum purchase commitment but rather, the arrangements are a volume pricing arrangement based upon actual volume purchased. In substantially all instances, we have reciprocal agreements with our customers such that we will receive per-unit price adjustments, similar to the amounts we would subsequently owe to Microsoft if such OVRP volumes are not met. However, in the event a customer is unwilling or unable to pay us, we would be negatively impacted. Based upon the credit-worthiness of our customers, our historical OVRP experience with our customers and OVRP arrangements in general, we do not believe we will incur any material liability in the current or future periods. 18 -------------------------------------------------------------------------------- Table of Contents Recently Issued Accounting Standards See Note 1, "Summary of Significant Accounting Policies" in the Notes to Condensed Consolidated Financial Statements in Item 1. |