BSQUARE CORP /WA - 10-K - Management's Discussion and Analysis of Financial Condition and Results of Operations.

(Edgar Glimpses Via Acquire Media NewsEdge) The following Management's Discussion and Analysis of Financial Condition and Results of Operations should be read in conjunction with our consolidated financial statements and related notes. This Management's Discussion and Analysis of Financial Condition and Results of Operations may contain some statements and information which are not historical facts but are forward-looking statements. For a discussion of these forward-looking statements, and of important factors that could cause results to differ materially from the forward-looking statements contained in this report, see Item 1 of Part I, "Business-Forward-Looking Statements," and Item 1A of Part I, "Risk Factors." Overview We provide software solutions and related engineering services 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® Embedded Compact) 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, in-vehicle telematics and entertainment devices. We primarily 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 connected device marketplace since our inception. Our customers include world class original equipment manufacturers ("OEMs"), original design manufacturers ("ODMs") and enterprises, as well as silicon vendors ("SVs") 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 Revenue Recognition We recognize revenue from software and engineering service sales when the following four revenue recognition criteria are met: persuasive evidence of an arrangement exists; delivery has occurred or services have been rendered; the selling price is fixed or determinable; and collectability is reasonably assured. Contracts and customer purchase orders are generally used to determine the existence of an arrangement. Shipping documents and time records are generally used to verify delivery. We assess whether the selling price is fixed or determinable based on the contract and/or customer purchase order and payment terms associated with the transaction and whether the sales price is subject to refund or adjustment. We assess collectability based primarily on the creditworthiness of the customer as determined by credit checks and analysis, as well as the customer's payment history. Periodically, we will begin work on engineering service engagements prior to having a signed contract and, in some cases, the contract is signed in a quarter after which service delivery costs are incurred. We do not defer costs associated with such engagements before we have received a signed contract.

We recognize software revenue upon shipment provided that no significant obligations remain on our part, substantive acceptance conditions, if any, have been met and the other revenue recognition criteria have been met. Service revenue from time and materials contracts, and training service agreements, is recognized as services are performed. Fixed-price service agreements, and certain time and materials service agreements with capped fee structures, are accounted for using the percentage-of-completion method. We use the percentage-of-completion method of accounting because we believe it is the most accurate method to recognize revenue based 25 -------------------------------------------------------------------------------- Table of Contents on the nature and scope of these engineering service contracts; we believe it is a better measure of periodic income results than other methods and better matches revenue recognized with the costs incurred. Percentage of completion is measured based primarily on input measures such as hours incurred to date compared to total estimated hours to complete, with consideration given to output measures, such as contract milestones, when applicable. Significant judgment is required when estimating total hours and progress to completion on these arrangements which determines the amount of revenue we recognize as well as whether a loss is recognized if one is expected to be incurred for the remainder of the project. Revisions to hour and cost estimates are incorporated in the period in which the facts that give rise to the revision become known.

We also enter into arrangements in which a customer purchases a combination of software licenses, engineering services and post-contract customer support and/or maintenance ("PCS"). As a result, contract interpretation is sometimes required to determine the appropriate accounting, including how the price should be allocated among the deliverable elements if there are multiple elements. PCS may include rights to upgrades, when and if available, telephone support, updates and enhancements. When vendor specific objective evidence ("VSOE") of fair value exists for all elements in a multiple element arrangement, revenue is allocated to each element based on the relative fair value of each of the elements. VSOE of fair value is established by the price charged when the same element is sold separately. Accordingly, the judgments involved in assessing the fair values of various elements of an agreement can impact the recognition of revenue in each period. Changes in the allocation of the sales price between deliverables might impact the timing of revenue recognition, but would not change the total revenue recognized on the contract. When elements such as software and engineering services are contained in a single arrangement, or in related arrangements with the same customer, we allocate revenue to each element based on its relative fair value, provided that such element meets the criteria for treatment as a separate unit of accounting. In the absence of fair value for a delivered element, revenue is first allocated to the fair value of the undelivered elements and then allocated to the residual delivered elements. In the absence of fair value for an undelivered element, the arrangement is accounted for as a single unit of accounting, resulting in a delay of revenue recognition for the delivered elements until the undelivered elements are fulfilled.

When engineering services and royalties are contained in a single arrangement, we recognize revenue from engineering services as earned in accordance with the criteria above even though the effective rate per hour may be lower than typical because the customer is contractually obligated to pay royalties on their device shipments. We recognize royalty revenue, classified as software revenue, when the royalty report from the customer is received or when such royalties are contractually guaranteed and the other revenue recognition criteria are met, particularly that collectability is reasonably assured.

There are two items involving revenue recognition that require us to make more difficult and subjective judgments: the determination of VSOE of fair value in multiple element arrangements and the estimation of percentage of completion on fixed-price service contracts. Historically, we have entered into very few multiple-element arrangements other than those involving the sale of PCS related to our TestQuest automated testing tools. We establish VSOE of fair value for TestQuest PCS based on the price when PCS is sold separately. VSOE of TestQuest PCS has been well established in the past as these products have been sold on a stand-alone basis for a number of years even prior to our acquisition of TestQuest assets in November 2008.

We measure our estimate of completion on fixed-price contracts, which in turn determines the amount of revenue we recognize, based primarily on actual hours incurred to date and our estimate of remaining hours necessary to complete the contract. The process of estimating the remaining hours on a contract involves detailed estimates of remaining hours by the engineers and project managers involved with the project, factoring in such variables as the remaining tasks, the complexity of the tasks, the contracted quality of the software to be provided, the customer's estimated delivery date, integration of third-party software and quality thereof and other factors. Every fixed-price contract requires various approvals within our company, including our Chief Executive Officer if significant. This approval process takes into consideration a number of factors including the complexity of engineering. Historically, our estimation processes related to fixed-price contracts have been accurate based on the information known at the time of the reporting of our results. However, percentage-of-completion estimates require 26 -------------------------------------------------------------------------------- Table of Contents significant judgment. As of December 31, 2012, we were delivering engineering services under 6 fixed-price service contracts. The percentage of completion calculations on these contracts represents management's best estimates based on the facts and circumstances as of the filing of this report. If there are changes to the underlying facts and circumstances, revisions to the percentage-of-completion calculations will be recorded in the period the changes are noted. If we were 10% under in our estimates of completion on every fixed-bid contract active on December 31, 2012, our revenue would be over-stated by $180,000 for 2012.

Intangible Assets and Goodwill We evaluate our intangible assets for indications of impairment whenever events or changes in circumstances indicate that the carrying value may not be recoverable. Our intangible assets were acquired through business acquisitions.

Our intangible assets consist of acquired technology, customer relationships, trade names and trademarks, and non-compete agreements. Factors that could trigger an impairment analysis include significant under-performance relative to historical or projected future operating results, significant changes in the manner of our use of the acquired assets or the strategy for our overall business or significant negative industry or economic trends. If this evaluation indicates that the value of the intangible asset may be impaired, we make an assessment of the recoverability of the net carrying value of the asset over its remaining useful life. If this assessment indicates that the intangible asset is not recoverable, based on the estimated undiscounted future cash flows of the technology over the remaining useful life, we reduce the net carrying value of the related intangible asset to fair value. Any such impairment charge could be significant and could have a material adverse effect on our reported financial results. During the fourth quarter of 2011, we recognized an impairment charge of $518,000 related to technology acquired from TestQuest in 2008.

We evaluate goodwill for impairment annually or more frequently when an event occurs or circumstances change that indicate that the carrying value may not be recoverable. Our annual testing date is December 31. We test goodwill for impairment by performing a qualitative assessment to determine whether it is more likely than not that the fair value of the reporting unit is less than the carrying amount. If it is more likely than not that the fair value of the reporting unit is greater than the carrying amount, further testing of impairment is not performed. If it is more likely than not that the fair value of the reporting unit is less than the carrying amount, we perform a quantitative two-step impairment test.

Stock-Based Compensation Our stock-based compensation expense for stock options is estimated at the grant date based on the stock award's fair value as calculated by the Black-Scholes-Merton ("BSM") option-pricing model and is recognized as expense over the requisite service period. The BSM model requires various highly judgmental assumptions including expected volatility and option life. If any of the assumptions used in the BSM model change significantly, stock-based compensation expense may differ materially in the future from that recorded in the current period. Restricted stock units ("RSUs") and restricted stock awards ("RSAs") are measured based on the fair market values of the underlying stock on the dates of grant as determined based on the number of shares granted and the quoted price of our common stock on the date of grant. In addition, we are required to estimate the expected forfeiture rate and only recognize expense for those shares expected to vest. We estimate the forfeiture rate based on historical experience. To the extent our actual forfeiture rate is different from our estimates, stock-based compensation expense is adjusted accordingly.

Incentive Compensation We make certain estimates, judgments and assumptions regarding the likelihood of attainment, and the level thereof, of bonuses payable under our annual incentive compensation programs. We accrue bonuses and recognize the resulting expense when the bonus is judged to be reasonably likely to be earned as of year-end and is estimable. The amount accrued, and expense recognized, is the estimated portion of the bonus earned on a year-to-date basis less any amounts previously accrued. These estimates, judgments and assumptions are made quarterly based on available information and take into consideration our year-to-date actual results and expected 27 -------------------------------------------------------------------------------- Table of Contents results for the remainder of the year. Because we consider estimated future results in assessing the likelihood of attainment, significant judgment is required. If actual results differ materially from our estimates, the amount of bonus expense recorded in a particular quarter could be significantly over or under estimated.

Taxes As part of the process of preparing our consolidated financial statements, we are required to estimate income taxes in each of the countries and other jurisdictions in which we operate. This process involves estimating our current tax expense together with assessing temporary differences resulting from the differing treatment of items for tax and accounting purposes. These differences result in deferred tax assets and liabilities. Net operating losses and tax credits, to the extent not already utilized to offset taxable income or income taxes, also give rise to deferred tax assets. We must then assess the likelihood that any deferred tax assets will be realized from future taxable income, and, to the extent we believe that recovery is not likely, we must establish a valuation allowance. Significant judgment is required in determining our provision for income taxes, deferred tax assets and liabilities and any valuation allowance recorded against our deferred tax assets. We estimate the valuation allowance related to our deferred tax assets on a quarterly basis.

Our sales may be subject to other taxes, particularly withholding taxes, due to our sales to customers in countries other than the United States. The tax regulations governing withholding taxes are complex, causing us to have to make assumptions about the appropriate tax treatment. Further, we make sales in many jurisdictions across the United States, where tax regulations are varied and at times complex. We must therefore continue to analyze our state tax exposure and determine what the appropriate tax treatments are, and make estimates for sales, franchise, income and other state taxes.

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.

Year Ended December 31, 2012 2011 Revenue: Software 75 % 71 % Service 25 29 Total revenue 100 100 Cost of revenue: Software 60 57 Service 21 23 Total cost of revenue 81 80 Gross profit 19 20 Operating expenses: Selling, general and administrative 14 17 Research and development 4 4 Total operating expenses 18 21 Income (loss) from operations 1 (1 ) Other income, net 0 0 Income (loss) before income taxes 1 (1 ) Income tax benefit (expense) 0 0 Net income (loss) 1 % (1 )% 28 -------------------------------------------------------------------------------- Table of Contents Comparison of the Years Ended December 31, 2012 and 2011 Acquisition of MPC Data Limited On September 11, 2011 we completed the acquisition of MPC Data Limited ("MPC"), a United Kingdom-based provider of embedded software engineering services. The acquisition is part of our overall growth strategy and is designed to capitalize on the growing market for smart, connected systems by expanding both the breadth of services offered and the geographies that we serve. As the acquisition took place late in the third quarter of 2011, the impact on our results of operations for 2011 was relatively insignificant for the year in total. Where applicable, the MPC-related impacts have been noted in the following commentary.

Revenue Our revenue is generated from the sale of software, both our own proprietary software and third-party software that we resell, and the sale of engineering services. Total revenue was $101.4 million in 2012 and was $96.8 million in 2011. An increase in sales of Microsoft Windows Embedded and Windows Mobile operating systems drove the increase, offset partially by a decline in service revenue.

Revenue from our customers outside of North America increased $7.4 million, or 33%, to $29.5 million in 2012, from $22.1 million in 2011. Revenue from our customers outside of North America represented 29% of our total revenue in 2012, compared to 23% in 2011. The increase in non-North American revenue in 2012 was attributable to higher service revenue in Europe driven by the September 2011 acquisition of MPC as well as an increase in service revenue and third party software sales in Asia.

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, sales of software development kits, support and maintenance revenue, and royalties from certain engineering service contracts. Software revenue for 2012 and 2011 was as follows (dollars in thousands): Year Ended December 31, 2012 2011 Software revenue: Third-party software $ 71,130 $ 62,703 Proprietary software 4,710 5,607 Total software revenue $ 75,840 $ 68,310 Software revenue as a percentage of total revenue 75 % 71 % Third-party software revenue as a percentage of total software revenue 94 % 92 % 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 sales increased $8.4 million, or 13%, in 2012 as compared to the prior year. This increase was due to higher sales of both Microsoft Windows Embedded and Windows Mobile operating systems which increased $8.6 million. Sales of Microsoft Windows Embedded operating systems increased $5.0 million or 11% in 2012 as compared to the prior year driven by expansion into the EMEA region as well as significant increases in sales to some of our existing customer base. Sales of Microsoft Windows Mobile operating systems increased $3.6 million or 26% driven primarily by the addition of a new customer in North America. Our rights to distribute Windows Mobile operating systems in Korea ended on October 31, 2012. We sold $4.5 million of Windows Mobile operating systems in Korea in 2012 and $4.6 million in 2011.

29 -------------------------------------------------------------------------------- Table of Contents Proprietary software revenue decreased $897,000, or 16%, in 2012 compared to 2011 due primarily to the fact that the sale of Qualcomm development platforms were classified as proprietary software revenue for the first three quarters of 2011, whereas in 2012 and for the fourth quarter of 2011, they were classified as third-party software sales. Proprietary software revenue in 2011 included $929,000 of Qualcomm development platform sales classified as proprietary software revenue.

Service revenue Service revenue for 2012 and 2011 was as follows (dollars in thousands): Year Ended December 31, 2012 2011 Service revenue $ 25,554 $ 28,533 Service revenue as a percentage of total revenue 25 % 29 % Service revenue decreased $3.0 million, or 10%, in 2012 as compared to the prior year. This decrease was due to a $6.7 million decline in North America service revenue offset in part by a $2.5 million increase in Europe service revenue resulting from the MPC acquisition in September 2011 and a $1.1 million increase in Asia service revenue driven by growth in Japan due to the signing of several significant OEM customers. The decline in North America service revenue was due to a $3.3 million decline in MyFord Touch-related service revenue as described below while the remainder was attributable to two large customers in 2011 which contributed $3.2 million in service revenue compared to no similarly large projects in 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. The MyFord Touch program contributed $6.4 million in service revenue in 2012 compared to $9.7 million in 2011 representing a decline of $3.3 million or 34%. The decrease is attributable to a reduction in the number of engineers working on the MyFord Touch project as the amount of work on the increasingly mature platform has declined.

Gross profit and gross margin Cost of revenue related to software revenue consists primarily of the cost of third-party software products payable to third-party vendors. Cost of revenue related to 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 was also positively affected by rebate credits of $888,000 in 2012 and $746,000 in 2011 from Microsoft which we earned through the achievement of defined objectives.

30 -------------------------------------------------------------------------------- Table of Contents The following table outlines software, services and total gross profit (dollars in thousands): Year Ended December 31, 2012 2011 Software gross profit $ 14,728 $ 13,200 Software gross margin 19 % 19 % Service gross profit $ 4,331 $ 6,249 Service gross margin 17 % 22 % Total gross profit $ 19,059 $ 19,449 Total gross margin 19 % 20 % Software gross profit and gross margin Software gross profit increased by $1.5 million, or 12%, in 2012, compared to 2011, while software gross margin was 19% in both years. The gross profit increase was driven by higher sales of Microsoft Windows Embedded and Windows Mobile operating systems which accounted for a $1.6 million increase in software gross profit. Third-party software gross margin was 16% in 2012 compared to 15% in 2011. Proprietary software gross margin was 78% in 2012 compared to 65% in 2011 with the improvement attributable to a $518,000 impairment charge related to acquired TestQuest technology which negatively affected the fourth quarter of 2011.

Service gross profit and gross margin Service gross profit decreased by $1.9 million, or 31%, in 2012 as compared to 2011, while service gross margin decreased by five percentage points to 17% in 2012, from 22% in 2011. The decline in service gross profit was largely driven by the decrease in engineering service revenue of $3.0 million. Service costs decreased by $1.1 million or 5% in 2012 compared to 2011. While cost per available hour decreased by approximately 10% primarily as a result of mix of resources internationally, it was more than offset by a decline in utilization rate of 12% and a decline in realized rate per hour of 2%. During 2012, we made adjustments to reduce service related expenses to better align with our future service revenue expectations.

Operating expenses Selling, general and administrative Selling, general and administrative expenses consist primarily of salaries and related benefits, commissions and bonuses for our sales, marketing and administrative personnel and related facilities and depreciation costs, as well as professional services fees (e.g., consulting, legal and audit). Selling, general and administrative expenses decreased $2.4 million, or 14%, to $14.3 million in 2012, from $16.7 million in 2011. Sales expense declined $2.7 million in 2012 compared to 2011, while marketing and general and administrative expense increased slightly. The decrease in sales expense was driven by a $1.6 million decline in headcount-related expenses, including incentive compensation and travel, due to reductions which occurred during 2012, a portion of which were backfilled in the fourth quarter of 2012 or may be backfilled in 2013. Further, sales-related stock compensation expense decreased $975,000 in 2012 compared to 2011 due largely to the departure of our previous Vice President of Sales in 2012 which resulted in a significant forfeiture of unvested stock options in the third quarter of 2012. Selling, general and administrative expenses represented 14% of our total revenue in 2012 compared to 17% of revenue in 2011.

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 $234,000, or 6%, to $3.6 million in 2012, from $3.8 million in 31 -------------------------------------------------------------------------------- Table of Contents 2011. The decline was driven by lower wage expense in the second half of 2012 associated primarily with reductions in headcount associated with our TestQuest development efforts. Research and development expenses represented 4% of total revenue in both 2012 and 2011.

Other income, net Other income consists of gains and losses we may recognize on our investments, gains or losses on foreign exchange transactions, interest income on our cash, cash equivalents and investments and other items. Other income was $103,000 in 2012 compared to $422,000 in 2011, representing a decline of $319,000. This decrease was primarily due to a $104,000 realized gain on the sale of an auction rate security ("ARS") investment in 2011 and the settlement of a lawsuit with our former broker dealer of our ARS investments which resulted in a gain of $213,000 in 2011, compared to no such similar items in 2012.

Income tax Our income tax expense was $366,000 in 2012 compared to an income tax benefit of $166,000 in 2011, a change of $532,000. The increase in expense was driven by the profitability of our United States parent company in 2012.

Liquidity and Capital Resources As of December 31, 2012, we had $20.6 million of cash, cash equivalents, short-term investments and restricted cash, compared to $19.0 million at December 31, 2011. The increase was driven by our net income and non-cash expenses offset in part by negative working capital changes.

Restricted cash is classified as long term and was $875,000 at both December 31, 2012 and 2011. This cash is restricted under the terms of our headquarters operating lease which will continue to secure that obligation through its expiration in 2014. Our working capital was $20.6 million at December 31, 2012, compared to $18.0 million at December 31, 2011.

Net cash provided by operating activities was $2.5 million in 2012 driven by net income of $916,000 and non cash expenses of $2.2 million, offset in part by net negative working capital changes. Net cash provided by operating activities was $1.1 million in 2011 driven by $3.1 million of non-cash expenses and a $518,000 impairment charge on our intangible assets associated with TestQuest acquired technology offset, in part, by net negative working capital changes.

Net cash used by investing activities was $1.2 million in 2012 driven primarily by capital expenditures. Net cash used by investing activities was $3.6 million in 2011 driven by the acquisition of MPC for $4.8 million in cash, net of cash acquired and $785,000 of capital expenditures, offset in part by net maturities of short-term investments. Financing activities generated cash of $205,000 in 2012 and $424,000 in 2011 as a result of employees' exercise of stock options.

We believe that our existing cash, cash equivalents, short-term investments and long-term 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 of $1.5 million in 2013, $1.0 million in 2014, $273,000 in 2015 and 2016, and $146,000 in 2017; and $97,000 in total thereafter.

32 -------------------------------------------------------------------------------- Table of Contents • 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 $400,000 at December 31, 2012, and decreases on a straight-line basis over the remaining term of the lease, which expires in 2014.

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