One Stop Systems, Inc. Q2 FY2021 Earnings Call

Good afternoon, and thank you for joining us today to discuss One Stop Systems' financial results for the second quarter ended June 30, 2021. With us today are the company's President and Chief Executive Officer, David Raun; and Chief Financial Officer, John Morrison. Also joining today is the company's Chief Sales and Marketing Officer, Jim Ison. Following the remarks, we will open the call to your questions. Before we conclude today's call, I will provide some important cautions regarding the forward-looking statements made by management during this call. I would also like to remind everyone that today's call will be recorded and will be made available for replay via the instructions in today's press release in the Investors section of the company's website. Now I would like to turn the call over to OSS President and CEO, David Raun. Please go ahead.

Thank you, Christie, and good afternoon, everyone. I'm happy to report that OSS achieved record revenues for the first half of 2021. Advancements across the company are the result of further execution on our growth strategy. During the second quarter of 2021, we exceeded our Q2 revenue expectations by over $500,000, closing the quarter with $14.9 million in total revenue, an increase of 12% over last quarter and up 28% over the same quarter last year. The growth reflects a broader number of customers, additional programs with major accounts and at least a few indications of return to normalcy. The strong top line performance in Q2 was backed by solid bottom line improvements, with net income increasing $1.7 million year-over-year and adjusted EBITDA up by $1.3 million, reaching 9% of the total quarterly revenue. Year-over-year gross margin improved 2.6 percentage points for the quarter and was up 5.3 percentage points for the first half of 2021, attributable to a refined product mix and a focus on increased efficiencies across our business segments. Additionally, executing on our long-term strategic vision and product roadmap continues to be a company priority. This plan includes strengthening our value proposition in the fast-growing edge computing industry and becoming nothing less than the market leader in the AI transportable space. As you may recall, the target market requires the highest performance computing in a challenging mobile environment. We believe our execution to this plan, company reorganization and improved Board composition has contributed towards a tripling of shareholder value over the past 2 years. There is significant focus these days on diversity in the boardroom and the SEC recently approved NASDAQ's proposal to include gender and race requirements as they relate to directors in its listing rules. We applaud this effort and thought you might be interested in knowing that 3 of our directors are women and 2 of our directors are from racial minorities far surpassing the new NASDAQ requirements. As a company, we remain committed to and find strength in our diverse and talented staff and directors. We'll provide operational highlights and our outlook for the rest of the year in a moment. But first, our CFO, John Morrison, will take you through our financial performance in the second quarter and the first half of the year. And then following John, our Chief Sales and Marketing Officer, Jim Ison, will provide insights into our AI transportable strategy and related customer activities. John?

Thank you, David, and good afternoon, everyone. Thank you for joining us for this call. Earlier today, we issued a press release with our results for the second quarter and the first half ended June 30, 2021. The release is available in the Investor Relations section of our new company website at onestopsystems.com. Reviewing our statement of operations, we achieved second quarter revenue of $14.9 million, which was up 12% from the $13.3 million in the first quarter and up 28% from the $11.6 million in the same year-ago period. The revenue increase for Q2 over the prior year quarter was due to proportionate growth from both OSS and Bressner, our European subsidiary. This growth was primarily driven by improvements in the sale of ruggedized servers into the media and entertainment markets, our differentiated military AI transportable data processing and storage products, as well as continued expansion of our customer base and new applications within key accounts. There was a notable increase in product orders and revenues from our media and entertainment customers, with their new virtual products gaining adoption and momentum. Our core OSS business increased 25% to $9.1 million compared to $7.3 million in the same year-ago quarter. Bressner revenue increased 34%, contributing $5.8 million in the second quarter compared to $4.3 million in the same year-ago period. OSS gross profit in the second quarter of 2021 was $4.7 million compared to $3.3 million in the second quarter of 2020. This represents an increase of $1.3 million in gross profit on a revenue growth of $3.3 million. Overall, we had a strong gross margin of 31.2%, an increase of 2.6 percentage points compared to the same year-ago period. The improvements in our quarterly gross margin were due to product mix, additional sales of high-value products, and increased efficiencies. Gross margin for our core OSS business increased 2.4 percentage points over the same year-ago quarter to 36.7%. Likewise, Bressner's gross margin increased to 22.6% in the second quarter compared to 19% in the same year-ago period. Overall, our operating expenses increased 11% to $4.1 million. Our operating expenses as a percentage of revenue decreased to 28% compared to 32% in the same year-ago quarter. This improvement was mainly due to cost containment programs integrated into our new growth strategy initiated last year and our continued focus on efficiencies. Income from operations improved to $517,000 compared to a loss from operations of $406,000 in the same year-ago quarter. Net income on a GAAP basis totaled $1.7 million or $0.09 per diluted share in Q2 2021. This compares to the net loss of $12,000 or basically $0.00 per share a year ago. Our net income improvement was attributable to our favorable gross margin and the debt and interest forgiveness on our PPP loan of approximately $1.5 million. On a non-GAAP basis, net income improved to a record $812,000 or $0.04 per basic and diluted share in Q2 2021 compared to $248,000 or $0.01 per diluted share in the same year-ago period. Adjusted EBITDA rose to $1.4 million, or 9% of quarterly revenue, compared to $73,000 in the same year-ago quarter. Non-GAAP net income and adjusted EBITDA exclude the $1.5 million PPP loan and interest forgiveness. Now looking at the results for the first half of 2021, revenue totaled $28.2 million, a new company record, which was up by 13% from $25 million in the same period last year. Gross profit improved by $2.4 million on incremental revenue of $3.2 million to $9.1 million, or 32% of revenue. This compares to $6.7 million or 27% of revenue a year ago. Gross margin for our core OSS business improved 6.7 percentage points to 37.3% in the first half compared to 30.6% in the prior year. Bressner's gross margin increased to 23.6% compared to 20.5% in the first half of last year. Our core OSS business grew 4% and contributed $17.7 million of total revenue compared to $15.7 million last year. Bressner contributed $10.5 million of revenue, an increase of 14% compared to last year's 9.2%. Our total operating expenses decreased 4% to $8.3 million compared to $8.6 million in the previous year. This decrease is primarily due to the cost containment efforts initiated in April 2020. Operating expenses as a percentage of revenue improved to 29% compared to 35% in the prior year period, reflecting the revenue increase and the success of our expense reduction program and improved efficiencies. Our income from operations rose to $792,000 compared to a $1.9 million loss in the same year-ago period. Net income on a GAAP basis was $1.7 million or $0.09 per diluted share compared to a loss of $1.1 million or a loss of $0.07 per share last year. This includes the $1.5 million PPP loan and interest forgiveness. Non-GAAP net income totaled $1.5 million or $0.08 per share compared to a loss of $466,000 or a loss of $0.03 per share in the same year-ago period. Adjusted EBITDA was $2.5 million or 9% of revenue compared to a negative $885,000 in the same year-ago period. The adjusted EBITDA improvement was driven by a higher gross margin percentage and cost containment, indicating a pathway to our EBITDA objective of no less than 10%. Non-GAAP net income and adjusted EBITDA exclude the $1.5 million PPP loan and interest forgiveness. Now turning to our balance sheet. As of June 30, 2021, cash and cash equivalents totaled $4 million, with short-term investments of $14.5 million, providing a combined total of $18.5 million. This compares to cash and cash equivalents of $19.6 million as of March 31, 2021. This concludes our financial review. Now I would like to turn the call over to our Chief Sales and Marketing Officer, Jim Ison. Jim?

Thank you, John, and good afternoon, everyone. Over the last year, as COVID shuttered practically all in-person events, we adapted our marketing efforts to virtual outreach and events. For example, in April, we hosted a webinar called Turning Large Data Set IP into AI Gold, which featured speakers from OSS and KIOXIA. The webinar discussed collecting, encrypting and creating value quickly from large AI data sets in defense, aerospace, autonomous vehicles and security applications at the edge. With an improving business environment, our marketing efforts can now again include in-person events. We kicked off the return to in-person events with our demonstration last week of a long-range visual observation system utilizing AI at the Sea-Air-Space 2021 Conference that was sponsored by the U.S. Navy. We were pleased with the attendance and the presence of decision-makers, Navy leaders and senior management. At the event, we also demonstrated our market-leading AI on the Fly, high-speed PCI Express interconnect, NVMe storage and scalable GPU compute systems that are required by the most demanding military and aerospace applications. We expect the return to live interaction and face-to-face selling will be more productive and help fuel our future revenues. In the second quarter, we won 3 new major opportunities. As a reminder, major program wins are those expected to yield $1 million or more of revenue within 4 years. These new wins include a medical control system; an edge flash storage program primarily targeting edge data recording, storage and transportation applications; and lastly, a GPU accelerated training and inferencing system with a major vehicle supplier in Germany, increasing our footprint in the autonomous vehicle market. These successes brought our total wins year-to-date to 6. Regarding our pipeline, in addition to the confirmed wins, we have 17 major pending opportunities we are focused on closing. On the product front, we shipped 2 major products earlier this year into the AI transportable marketplace, including our flagship GAS-R GPU accelerator that has been in airborne trials with the Navy. We are also shipping this quarter our latest SDS rugged server that was designed into a military mobile data center application. Our sales team is eagerly anticipating the introduction of additional next-generation standard products currently under development and testing. Now with that, I'd like to turn the call back over to David for our Q3 outlook.

All right. Thank you, John and Jim. In summary, we have made better-than-expected top and bottom line progress. With adjusted EBITDA at 9% of revenues for the first half, we are making solid inroads towards our adjusted EBITDA objective of no less than 10%. We continue to validate our AI transportable market focus through wins and product introductions. And we have received positive feedback on our product roadmap with key customers under NDA. And we plan to introduce a number of innovative next-generation platforms later this year and next. While we expect the effects of the pandemic will continue through 2021, we are seeing improving customer demand. Even our commercial aerospace customers, which were severely affected by COVID, are reengaging with us on new programs as well as bringing back programs previously put on hold. And although product demand is increasing, the supply chain continues to be a challenge with price increases and longer lead times. Our team is managing the fluid landscape on multiple fronts, including qualifying additional vendors, implementing extended purchase planning and other strategic and tactical activities. For example, advanced purchases of the parts have minimized the adverse impact on revenue but have also increased inventory levels temporarily. We continue to proactively manage the challenges imposed by the pandemic. And in doing so, our team has become adept at optimizing engineering and manufacturing processes, shipping products on time and not only protecting but increasing margins. Looking forward, we are providing revenue guidance of $15.9 million for the third quarter, which would represent 8% growth over Q2, 23% growth over the same quarter last year and a new record for the company for Q3 revenues. Thank you to all our shareholders for your support and joining us on this journey of growth and innovation. I'd also like to invite all prospective investors to reach out to us to become more acquainted with our story. Finally, my appreciation to our entire OSS team for their dedication to the success of One Stop Systems and their commitment to quality and productivity. Now with that, I'd like to open it up to questions. Christie?

Nice job, guys, in a very difficult environment. Maybe for starters, I'm not sure if I heard this in the opening remarks, but on the gross margin front, certainly, a lot of issues as it relates to the overall global supply chain. It seems like you guys have been doing pretty well. I was wondering your thoughts in terms of what the impact was in the quarter and how you're seeing that impact in terms of gross margins going forward? I know you've beefed up your inventory a little bit on the balance sheet. But what was the second quarter impact? What are you seeing for the second half of this year?

Frankly, I think the following is the dynamic. First of all, as far as the question is, are we leaving revenue behind because we didn't have the product. Sure, we have supply issues, but I think the demand that we're shipping reflects the real demand in the market. And so if anything was held up a little bit, it's really more of a reflection of somebody building inventory. So we feel good about that. We've had dynamics where we've pulled stuff in, pushed stuff out to stay on track. As far as the margins go, because we're so focused with the culture of the company and every aspect of the company to be more efficient and focused on margins, that's helped us offset price increases. In addition to that, we have actually reduced our costs by continuing to ask for cost reductions. And so we're doing all these things together to really offset that, including price increases to our customers.

Got you. And if I could also ask about operating expenses, it appears that you are continuing to manage that area effectively. With the reported pro forma number in the second quarter, should we consider that as a baseline moving forward? I understand the PPP loan was excluded from that as well. Given your strategic plans and investments, should we anticipate a significant increase in those expenses over the next few quarters?

No, I mean it's going to increase slightly with more trade shows and some additional travel. We are hiring a few people, but when it comes to hiring, our executive group meets to carefully assess the hiring requests and make decisions based on the return on investment. We're being very cautious about it. So, it will rise a little, but not significantly.

And lastly, if I could, just kind of shift into the RFP pipeline. I think you said the number is now 17 meaningful opportunities. I wonder if you could give a little bit more color in terms of some of the end market dynamics there. Maybe the timing, it seems like you've been hitting 2 or 3 a quarter. Is that the same sort of level we should be thinking about? And maybe the gross margin profile as well on some of those newer wins. I think you continue to refine your go-to-market, which should certainly help out on that gross margin front. Does that contribute to a more favorable mix going forward? And how are you thinking about getting to a 40% kind of gross margin out there? What sort of time line should we be thinking?

I'll address the first part of your question. Our pipeline is steadily progressing and we aim to expand it to 50% of AI transportable markets. By concentrating on those markets, we are adding accounts that align with this focus. This approach tends to be associated with higher margins. Over the past three years, we've maintained a success rate of around 60% or better, indicating that we have been successful in selecting opportunities where we believe we have a strong chance of winning.

Scott, I would just add that I'm hoping with us getting back to trade shows and meeting customers live, we can drive that number upward. And in the process, we're weeding out lower margin opportunities and focusing on the higher.

One last question, Dave. With some of your customers, especially in entertainment, showing signs of recovery, I would like to understand how sustainable that trend is. It seems that the customer base has moved largely online into a virtual setting, but we have started to see live concerts return before the new wave of Delta cases spreads across the country. Is there any risk regarding the entertainment sector as we look towards the second half of this year? Do you have confidence and clarity on this front given the changing dynamics in the U.S. and globally?

Yes, what we're observing and delivering has largely been focused on virtual products, which have seen significant growth. We're pleased with these numbers even though they haven't yet led to the return of large gatherings, something we anticipate will eventually occur. It's clear that there is renewed engagement with large events, and we expect to see that increase either later this year or next year. The current figures look promising, largely due to the success of our virtual offerings. This suggests that in 2022, our customer base may be stronger than ever.

Congratulations on the quarter, both in terms of revenue and EBITDA. The positive shift in profits highlights the benefits of an efficient organization, with revenue growth significantly enhancing the EBITDA. Great job on that. I have a question about revenue concentration. In 2020, you had two customers that contributed to 24% of the company's total revenue. Can you provide any insights on the quarter or the past six months regarding the impact those two customers have had on your top line?

Both those customers have returned quite strongly. As a result, the percentage of our total business has increased again. While I appreciate their strong return, we are also continuing to focus on developing relationships with other customers. Jim or John, would you like to add anything to that?

Yes. Even though you're referring to one of those that is a government contractor, we are actually participating in a greater number of programs. So even though it's within one name of a customer, we're actually selling into more programs within that customer.

Yes, that's a good point to bring up because there are different categories of funding. Regarding your question about the expansion of the customer base, I'm curious if you are noticing any trends, whether geographically or vertically, since you serve a wide range of clients. Is there anything showing up in the new customer numbers?

Not from a geographic standpoint, definitely more military type applications as we focus towards the AI transportable market. So that market space is pretty hot right now and especially with the budgeting and everything geared towards AI applications for the government continue to expand, and we expect to capture as much of that as we can.

And that is a focus to increase that portion of the business.

Okay. Now looking at your profit margins a year ago, the second half, you were pretty strong double-digit EBITDA margin despite some of the challenges that the business had, if I look at it on kind of a back half in its entirety. You're coming into the stronger part of your year when it comes to demand from defense and military and those have historically been higher gross margin. You also talked about a goal of north of 10% on the adjusted EBITDA margin. Is that to say we're kind of locked in there? Or could we still dip below that?

Well, first of all, one of the dynamics that we've tried to point out is that in 2021, because of the expansion of the programs and the additional customers we have in the military space, we've had that show up in the first half. So that percentage has actually more than doubled from 2020 to 2021. And so that's helped us on the margins and spread it out. So that's an addition to all the other things we're doing, but also in a dynamic world with the supply challenges. The second half, we would expect to be strong on margins like historically they are, probably nothing probably in the similar range as you've seen before from us in that area.

Okay. All right. And then just on the pipeline, the 17 major opportunities in the pipeline, is this also skewing towards military DoD in line with the wins that you've knocked down?

Higher percentage is in military and over 50% is in AI transportable, which, by definition, is higher margin.

Nice quarter. So I just wanted to go back to the gross margin for a second. They were down sequentially. I was just wondering is that product mix. Or is there anything else there that would cause the gross margins to decline sequentially?

It's mostly product mix and then also we had some costs associated with the military program that brought the margins down a little bit. But if you look at us year-over-year for the first half, we're up, what is it, 5 percentage points, John? Yes. So we're pretty pleased with that.

I just wanted some clarification. You mentioned that some of the commercial aerospace companies are reengaging. Can you provide some details about their activities before COVID, either in terms of revenue or potential impact on our top line if they return as customers? Also, how do the margins on these products compare to our core margins?

Yes. That business mainly originated from the acquisition of CDI years ago, and at its peak, it generated around $3 million. However, recently, that figure has significantly decreased. The challenge lies in how we can elevate that area since it is part of AI transportables. We are focusing less on entertainment systems for aircraft and more on data centers in the sky. Currently, we are not seeing much revenue from that sector yet, but we are beginning discussions about previously put-on-hold programs, and we expect to see orders coming in from those discussions. Additionally, there is renewed engagement on new programs aimed at data centers in the sky and various communication or safety-related products.

Okay. And then just I hate to keep going back. But on the RFPs and the wins. So you've got 6 wins year-to-date last year. Year-to-date, you had 8 including 5 that you won in the second quarter. I mean, is this just timing still thinking you're on that path that in the last two years, you've won 16 of these that you'll still be in that same range by the end of the year?

Yes. So yes, you're right. We're a little off where we've been, but I do not believe that is an indication of the activity moving forward. We've put a lot of focus on the AI transportable space. That creates a little bit of disruption because we're refocusing people on the higher-margin business, and we've been selling in this virtual world for about 18 months. So I think it's really those dynamics, but we feel good about where we're headed and the things we're going to be able to do. So yes, but in absolute numbers, you're right, they're down a little bit. But hopefully, will get stronger in the coming quarters and be really strong next year.

Right, right. Okay. And one more, if I may. I mean, you talked about the supply chain issues and some of the inflationary pressures. The other big issue that a lot of people companies seem to be having is in staffing. And just wondering, are you guys seeing any issues there? Are you fully staffed and happy with where you are today?

Yes, we're doing well in that area. We have noticed that finding candidates has become more difficult. One reason is that since we're located outside of San Diego in a more affordable region, people tend to stay put. Additionally, we're observing a trend of people relocating from the Bay Area to Southern California, which is positively influencing our situation. Overall, our staffing levels are where we want them to be at this time. We recently hired another salesperson we've been searching for and plan to hire another soon.

We'll go next to David Williams from Benchmark Company.

I wanted to explore the typical design cycle as we consider some of the significant customer wins. What does that usual design or win cycle look like, from the initial engagement to achieving revenue?

On the commercial side, it usually takes about 6 to 12 months to finalize designs and secure wins. For the military sector, the timeframe is typically 12 to 24 months, as the design phase lasts longer.

I would like to mention that we have several lists within the company that we are focusing on. We have a targeted list, and it takes a certain amount of time for that list. When Jim refers to the 17 pending opportunities, those are already further along in the process during that time frame.

And then maybe if you kind of think about the demand trends that you're seeing and maybe even through the quarter, where are you seeing the largest growth opportunities maybe outside of your focused AI transportables? But what other opportunities are you seeing? And where are you seeing the greatest level of demand, do you think?

Other opportunities outside.

We come across them, but we're really trying to focus on the AI transportables. I mean that's one of the things I'm really trying to drive with the organization. That's our focus. Now we do have other opportunities, and we can't just turn the ship too quick. So we continue to look at different things. Do you want to add to that, Jim?

So because of our innovation in the PCI Express Gen 4, generally quickly adopting that, going to Gen 5 when that's available. We get a lot of OEMs that may be not our $1 million accounts, but they do come to us for those technologies to be able to scale out GPU solutions or their own OEM I/O or instrumentation like test equipment, things like that for the early adopters. That tends to be very lucrative, and we've reported that in previous years as our PCIe Gen 4 business. So that's still a solid underlying business that really just takes its parts from our AI transportable strategy. So we won't lose that going forward.

We'll go next to Brian Kinstlinger from Alliance Global Partners.

Nice results. You mentioned a win rate has held up pretty steady on these major programs at 60% when you get to the point of putting them in this bucket. Are these RFP types, I think of the government, at least is where you're bidding against a number of competitors. And if so, then describe the competitive landscape and/or feedback you get when you're not selected.

Yes. So most of those accounts that we have there are usually firm fixed price agreements single source. So that includes the 5 different programs we have with our largest military customer. I believe maybe one of those is a bid for bid type of situation. We do get feedback from those customers as to why we weren't selected for, say, a bid for bid type of situation. But I'd say a good 60% to 75% of our contracts have been firm fixed price and are that sole source.

All right. So when you do lose, is it because they went with another solution? Did they not award the contract? I'm just trying to understand since you win so often as to high win rate. What's the feedback when you don't win? Someone else had a better solution or price?

Yes. Specifically concerning the military sector, we face competition from in-house resources. We encountered a situation where a customer opted for our PCI Express but ultimately decided to keep the project in-house and switch technologies. This type of feedback is common. It's not generally about pricing; we have won contracts even at higher prices due to our strong service record, which encourages customer loyalty.

Great. And just one follow-up. On the military side, are you always going direct as a prime? Or is there an opportunity to partner with larger either system integrators or prime contractors that you can be part of a bigger solution?

Yes. The biggest piece of our business is with the prime contractors. So we don't go direct to the military on, I'd say, 80% of our projects. Most of them are through VARs or a prime contractor. We do have some direct Navy business that we do with them, also with the Army. But typically, you'll see us going through there the main military primes like Raytheons, Lockheeds, General Dynamics, those type of companies.

Thank you, Christie, and thank you, everyone, for joining us today. We believe the best is yet to come and we look forward to meeting with you again and reporting our progress as we pursue the many opportunities ahead. Meanwhile, please stay safe and healthy and feel free to reach out to John, Jim, or me at any time. Christie, please go ahead and wrap up the call.

Thank you. Before we conclude today's call, I would like to share the company's safe harbor statement, which includes important cautionary notes regarding forward-looking statements made during the call. One Stop Systems reminds you that the statements in the presentation do not describe historical facts or future predictions. These statements are based on the company's current beliefs and expectations and include expectations for revenue growth from new products, design wins, or M&A activity. The inclusion of such statements should not be seen as a guarantee of achieving any plans. Actual results could differ due to risks and uncertainties in our business, which include the developing market for our products, global pandemics or other public health concerns impacting regions where we operate, fluctuations in our operating results, and challenges in integrating acquired companies. Our ability to succeed depends on continuously developing new products that meet customer needs. The likelihood of design proposals turning into wins is uncertain, and revenue may not be realized. Our products serve specialized needs within the technology sector, which could change over time, potentially diminishing our market position. We depend on a small number of suppliers, and failure to protect our intellectual property could harm our competitive edge or incur expenses. Our international operations introduce additional risks, and material weaknesses in internal controls or financial reporting may hinder accurate financial reporting. More risks are detailed in our previous press release and filings with the SEC, including the Risk Factors in our annual report on Form 10-K and subsequent filings. You are advised not to place too much reliance on these forward-looking statements, which reflect the situation only as of the call date, and we do not commit to updating this information afterward. All forward-looking statements are fully qualified by this cautionary note, made under the safe harbor provision of the Private Securities Litigation Reform Act of 1995. Before we wrap up today, I want to remind you that this call will be available for replay starting later this evening through August 26. Please check today's press release for dial-in and replay instructions on the company's website. Thank you for joining us today. This concludes our conference. You may now disconnect.