Earnings Call Transcript - OSS Q3 2022

Operator, Operator

Please standby. Good afternoon. And thank you for joining us today to discuss One Stop Systems’ Financial Results for the Third Quarter ended September 30, 2022. With us today are the company’s President and Chief Executive Officer, David Raun; and Chief Financial Officer, John Morrison. Following their remarks, we will open the call to your questions. And before we conclude this call, I will provide some important cautions regarding the forward-looking statements made by management during the call. I would like to remind everyone that the call will be recorded and made available for replay in the Investors section of the company’s website. Now I’d like to turn the conference over to OSS President and CEO, David Raun. Please go ahead, sir.

David Raun, CEO

Thank you, James, and good afternoon, everyone. Q3 was another solid quarter at $18.8 million in revenue, setting a record for any quarter in the company history. Growth was 18% over the same year-ago quarter, and our year-to-date revenue of $54.2 million was also a record for the first nine months of any year, with growth over the same period of last year, up 23%. Our strong performance in Q3 was primarily attributable to the continued strength of our European unit Bressner, increased business in the media and entertainment space, as well as solid growth on the commercial side of our AI Transportable business. Shipments to customers in the autonomous trucking space, a strategic target of ours, was a key contributor for the AI Transportable growth in Q3. In fact, two of our autonomous trucking customers now rank in our top 10 customer list. While the autonomous truck market has continued to progress, including hundreds of thousands of miles driven to date using our products, it still must deliver a driverless solution to realize the full potential of the strong economics of this disruptive technology. We believe the market leaders in the best position to get to market first are those intent and utilize as much compute storage performance as possible at the challenge. During the past quarter, we invested considerable time focused on the compute storage needs of the autonomous trucks in production. Although there is some commonality between the various market leaders on the roadmap to production, they continue to search for the ideal solution. To this end, we have been developing and sharing a proposed production roadmap that we believe provides a superior cost-effective path. We believe we are uniquely well positioned to deliver solutions that can leverage our innovative PCIe, NVLink, ruggedization, and cooling technologies for use in the space. In addition to the potential for the great growth in the autonomous truck market, we believe the products, the skills, and proficiency we are building will also open up other AI Transportable segments that are critical to us. Now, before I provide additional insight into our program wins, sales pipeline, as well as an outlook for the remainder of the year, I’d like to turn the call over to our CFO, John Morrison, who will take you through the financial details of the quarter. John?

John Morrison, CFO

Thank you, David, and good afternoon, everyone. Thank you for joining us today. Today, we issued a press release with our results for the third quarter and nine months ended September 30, 2022. The release is available in the Investor Relations section of our website at onestopsystems.com. The following are our results for the third quarter ended September 30, 2022, as compared to the same year-ago quarter. During the third quarter, OSS recognized revenue of $18.8 million, which was up 18% over the prior year quarter. Core OSS revenue was up 15%, contributing $10.7 million. This was largely due to the growth of our AI Transportable business, including autonomous trucks, as well as our media and entertainment business. Revenue from our European subsidiary Bressner increased 21%, contributing a record $8.1 million, which was marginalized by a quarterly year-over-year devaluation of the euro of 14%. This exceptional growth for Bressner was attributable to increased market share that was made possible by strong sales efforts, customer expansion, and strategic inventory buys. Gross profit decreased $439,000 to $5.1 million. Overall, our aggregate gross margin was 27% for the third quarter, a decrease of 7.5 percentage points. This was due to strong lower margin revenue from Bressner and our media and entertainment business, as well as a temporary decrease in our high margin military business. We experienced a deferral of military customer shipments due to a transition to a new storage product version. However, these products are now being shipped. Gross margin for our core OSS business decreased 10.3 percentage points from the same year-ago quarter to 30.7%. This decrease was attributable to the concentration of lower margin product sales to our media and entertainment customer and the delayed shipments of military storage products. For the fourth quarter of 2022, we expect a return to a higher mix of military storage business to improve our overall gross margin, both sequentially and as compared to the fourth quarter of 2021. Bressner’s gross margin percentage decreased 3.4 percentage points to 22.2% in the third quarter. This decrease was primarily due to increased material and transportation costs, as well as increased sales of a lower margin product line. Overall, quarterly operating expenses increased by $424,000 to $4.9 million. While operating expenses as a percentage of revenue decreased to 26.1%, compared to 28.1% in the same year-ago quarter. The dollar increase in operating expense was primarily due to our expenditures in marketing and selling activities and investments in the technology for the AI Transportable market. Income from operations decreased to $163,000, compared to $1 million in the third quarter of 2021. Net income on a GAAP basis was $133,000 or $0.01 per diluted share, a decrease from net income of $981,000 or $0.05 per diluted share in the prior year quarter. On a non-GAAP basis, net income was $691,000 or $0.03 per diluted share for the quarter, down from $1.5 million or $0.08 per diluted share. Adjusted EBITDA, a non-GAAP metric was $955,000 or 5.1% of quarterly revenue, as compared to $1.8 million or 11.3% of quarterly revenue. The following results are for the nine-month period ended September 30, 2022, and are compared to the same year-ago period. Revenue for the nine months totaled $54.2 million, a new company record, which was up 23%. OSS core revenue increased 18.5%, contributing $32 million. Bressner contributed $22.2 million of revenue, an increase of 29%. Gross profit improved $817,000 on incremental revenue of $10 million to $15.4 million or 28.5% of revenue. This compares to $14.6 million or 33% of revenue in the prior year period. Gross margin for our core OSS business decreased to 33.1%, as compared to 38.5% in the prior year period. This is largely due to a temporary decrease in military revenue and revenue increases from our lower margin business. Bressner’s gross margin decreased 21.8% due to higher transportation and material costs, as well as increased sales of a lower margin product line, as compared to 24.4% a year ago. Operating expenses increased 11% to $14.2 million. This increase is, again, primarily due to investments we have made in marketing and sales activity and the development of new standard products for the AI Transportable market. The increase in expenses was partially offset by a decrease in general and administrative expenses. Operating expenses as a percentage of revenue decreased to 26.2%, compared to 28.9% a year ago. Income from operations was $1.2 million, compared to $1.8 million from a year ago. Net income on a GAAP basis was $1 million or $0.05 per diluted share, compared to $2.7 million or $0.14 per diluted share, which included a one-time benefit of $1.5 million or $0.08 per share due to the forgiveness of our PPP loan and related interest. After giving effect to this one-time benefit on a pro forma basis, there was a year-over-year decrease of $170,000 of net income. Non-GAAP net income totaled $2.5 million or $0.12 per diluted share, as compared to $3 million or $0.15 per diluted share. Adjusted EBITDA, a non-GAAP measure, totaled $3.5 million or 6.5% of revenue, compared to $4.3 million or 9.6% of revenue. Non-GAAP net income and adjusted EBITDA both exclude the $1.5 million PPP loan and interest forgiveness. Now turning to our balance sheet. On September 30, 2022, cash and cash equivalents totaled $3.2 million and short-term investments totaled $9.5 million, totaling $12.7 million in capital resources. This represents a decrease of $1.7 million compared to our balances on June 30, 2022, primarily due to increases in working capital requirements. We believe the current financial resources available to OSS provide us the stability and flexibility to be responsive to changes in business demand and particularly those which require investments and working capital to be successful. This completes our financial review. Now I’d like to turn the call back over to David.

David Raun, CEO

Thank you, John. As we have stated previously, sales to our largest media and entertainment customer have challenging margins under 20% and this is not aligned with our long-term objectives of 35% to 40% overall. Price pressure within the media and entertainment market is accelerating investment by our customer into cloud technology and a drive towards less intelligent compute capability at the edge to reduce the cost of their system. This is particularly true of the virtual products, which tend to be fixed installed and do not require the same level of ruggedization as live event systems, which typically operate in a harsh environment. These less intelligent computers will have a higher reliance on our customer’s IT software, which is in development and is expected to eventually enable this real-time cloud solution. We anticipate this technology transition may start to impact our revenues as soon as the second half of 2023 as our customer transitions to lower cost, commodity-type equipment and a cloud-based software solution. We do not anticipate any financial exposure with inventory on hand. Based upon the strategies integral to our business plan and projected revenue from our sales pipeline and new programs we are pursuing, we foresee being able to backfill potential declining revenue from this customer. Based on our strategic and sales planning, over time, we will see the mix of our product sales move upward from the lower margin products towards higher margin products on which we are focused and expect that our aggregate margin will improve as a result. To this end, we have added six new program wins in the third quarter, with five in the AI Transportable space. The wins include two in autonomous trucks, two medical designs, and two mobile 5G AI applications. The first medical win in the quarter is for industrial dental manufacturing equipment in Europe. The second is for a GPU-accelerated genome sequencing solution for a very large OEM. The mobile 5G AI application deploys an OSS, SDS rugged server in trucks and vans for a cellular network market leader. These vehicles can gather and characterize data in real-time in the field and transport the data back to the hub where it is uploaded to the cloud and combined with larger data sets. This major program is expected to roll out to over 100 cities nationwide. Our pipeline of sales activity continues to grow, including in the autonomous truck space, where we had two new wins with Embark Trucks announced last month. These two wins include one for our Centauri rugged PCIe storage expansion system, which has now been adopted by two autonomous trucking customers, and another for our latest autonomous truck SDS rugged server. The new deployments involve equipping trucks from Embark’s latest test fleet with the latest highest performance rugged compute and transportable storage capabilities. Embark became one of our top accounts this quarter. As our strategic efforts continue to yield results, we ended the first nine months of 2022 with 16 new program wins, 11 of them are for AI Transportable applications. In addition, our pipeline of potential major programs or pending ones has now expanded to 30, with 18 of these involving AI Transportable applications. We believe the combination of building our sales pipeline, strong activity with the higher margin military market, and other opportunities we are currently pursuing, which are higher margin businesses will backfill the potential revenue downside in the media and entertainment business with quality, long-term, high-margin business. I am pleased to share with you that our engagements on the military front have progressed over the past 90 days. For many years, we have been mostly dependent upon one prime contractor for most of its high margin military revenue. Today, however, we are building relationships with several new prime contractors, and in parallel, are working more closely with the Department of Defense. We expect this to generate more excess revenue, less seasonality, and significantly improve our margins and profitability over time. Our progress within the military is attributable to several factors, including an intense focus on defining and bringing to market a superior roadmap of products, contracting with well-positioned sales representatives, and adding strategic personnel to our advisory board. Our advisory board is comprised of retired high-ranking military officials and corporate executives with decades of experience in AI, unmanned vehicles, technology, high performance computing, cooling technology, and M&A. Key to the strategy was the introduction of our flagship platform for the military that we call Rigel. As acknowledged by multiple key customers and partners, Rigel is currently the fastest, most compact supercomputer available. The growing interest in Rigel and the related design activity confirms that this powerful system can transform the use of real-time artificial intelligence for the most demanding vehicle, maritime and aerospace edge applications throughout the military. We will provide additional information as we advance or win these programs. But for now, I’d like to give you a sense of the magnitude of our customer interactions in the space with some current examples. First, we are working directly with the Army to fund an OSS solution targeted for land vehicles. As one of my advisers commented, if OSS can get into land vehicles for the Army, this would be a huge win for the company as the volumes are very high. Second, we are working with multiple primes and the DoD directly on a major compute upgrade that would add significant capabilities for a well-known large airframe drone. Third, yet at another prime, we are being proposed in multiple aircraft programs, including one similar to the multimillion-dollar contract we have enjoyed with the Navy in the PA, but this is with a different branch of the service. I was in a meeting with this customer earlier this week, where we had over 40 attendees, and we presented in conjunction with NVIDIA these solutions to a wider audience within their organization. Fourth, for years, we have been selling our storage systems via a large multiyear contract to a prime and the Navy. In parallel to those shipments, we have been working with them to deploy a supercomputer to process the vast data in flight rather than back at the Navy base. We recently heard that Tesla accomplished its objectives and was considered a big success by the high-ranking officials involved. Last month, we showcased our latest products debut at AUSA, a military trade show in Washington, D.C., where we identified several new opportunities in major programs for Rigel. We look forward to attending Supercomputer 22 Conference being held in Dallas next week. It is the world’s largest international conference for high-performance computing. We will be showcasing our AI Transportable products, including a demonstration of a disruptive additional capability in Rigel. We expect more information to follow in our press release next week. Looking ahead, we believe we are well on track for a strong final quarter of the year. In fact, our revenue outlook for the fourth quarter is approximately $19.2 million, which if achieved, would be another record revenue quarter. Also, as John mentioned, we expect significant margin improvement with the resumption of our military product shipments and assuming $19.2 million in revenue for Q4, we expect to close the year up more than 18% to a record $73.4 million in revenue. Now, with that, I’d like to open up the call and address your questions. Thank you.

Operator, Operator

Thank you. Our first question comes from Brian Kinstlinger with Alliance Global Partners.

Unidentified Analyst, Analyst

Good evening. Thank you for taking my question. This is Aaron on for Brian. Can you talk about how the testing is going with autonomous trucking companies as it relates to your technology? Has it been a smooth process where trucks are being tested or are there some challenges that are in OSS's control?

David Raun, CEO

For the most part, the software used is entirely theirs. We are providing the hardware, and they are making progress. These trucks are currently on the road with someone in the driver’s seat, but the person is mainly not operating the steering wheel or pedals, allowing them to travel successfully for hundreds of thousands of miles. The key goal, as I previously mentioned, is to eventually eliminate the driver from the truck, as this is where the economics become favorable. I believe the company is still some time away from that, but I expect it to happen sometime next year or the year after.

Unidentified Analyst, Analyst

Great. And one more question. You discussed the government pipeline and its potential as a catalyst for future revenue growth. Do you have an estimate for when we might start seeing revenue impact from the military mix segment?

David Raun, CEO

Yeah. I mean, so first of all, fortunately, we are involved with some of the biggest most premier seat after programs. So that’s good. But like in the military program, they take some time and so the big revenue comes at multiple years out. But what we are seeing in parallel is people working on funding to get it going with us. And those can be fairly sizable, some of them might be $0.5 million or $1 million or $1.5 million at a time at least that gets it going, where they are bringing in Rigel’s into the lab and doing work on it. So that will help our revenue, but the big part of it will be more probably in the last part of 2023, into 2024 and beyond.

Unidentified Analyst, Analyst

Thank you. That’s all I have.

John Morrison, CFO

Thank you.

David Raun, CEO

Thank you.

Operator, Operator

Our next question comes from Joe Gomes with Noble Capital.

Joe Gomes, Analyst

Good evening. Thanks for taking the questions.

David Raun, CEO

Hi, Joe.

John Morrison, CFO

Hi, Joe.

Joe Gomes, Analyst

I just kind of want to follow up on the last question. You are talking about the autonomous trucks and the big revenue opportunity there is once the driver is out of the truck and that probably won’t happen to 2025 or later and you are talking about the revenue impact on the military side, and you said that’s years out. And then we have got Disguise that appears sounds like that revenue stream is at least a significant part of it is going to be coming to an end. I am just trying to figure out maybe you can walk us through how you are going to be bridging this gap on the revenue side?

David Raun, CEO

Overall, in the AI Transportable sector and some other successes we have that don't fit into that category, we are expecting a significant rebound in our military business next year, which is already starting. Additionally, we are actively pursuing other deals, including discussions with other CEOs that could generate short-term revenue. We have multiple avenues we are exploring to address this situation. Regarding the autonomous truck initiative, we currently have two projects in the prototyping phase that are among our top ten priorities. These projects are expected to grow next year, and we anticipate a pivotal point before 2025, which will lead to considerable revenue from them. The military contracts will also contribute significantly.

Joe Gomes, Analyst

Thank you for that information. Regarding the gross margin, in the first half of the year, there was minimal high-margin military revenue, with the first quarter gross margin at 30.1%, the second quarter at 28.6%, and this quarter at 27%. I am trying to understand the factors affecting the margins in the Disguise and Bressner business, which appear to be decreasing sequentially.

David Raun, CEO

Well, I mean, I will let John add to this. But bottom line is military revenue disappeared for those two quarters for the most part and now it’s coming back strong. Primarily, the biggest program because of the position change that got put on hold, but now again we are getting the orders plus other programs starting to layer in also. So that’s the biggest contributor on the margins. What else would you like to add, John?

John Morrison, CFO

I would agree that on the government side, our data storage units declined by about $5 million year-over-year due to a transition we are undergoing with a revision change, and we are now shipping that new revision starting in the fourth quarter. This is our strongest revenue driver and significantly contributes to our margins. This explains the difference, combined with the substantial revenue increase from Bressner and the majority of revenue coming from our media and entertainment sector.

Joe Gomes, Analyst

Okay. And one last one…

David Raun, CEO

In other words, that number should not go down further. We are expecting a reversal of that starting in the fourth quarter.

Joe Gomes, Analyst

Okay. Thank you for that. You have mentioned some of the previous calls about the supply chain, some of it going out 52 weeks for parts, inflation. Just wondering how that environment is looking today for parts and passing along costs from inflation increases.

David Raun, CEO

Yeah. So, in general, on the supply side, I think, what I am hearing from a lot of people is it seems to be getting somewhat better. We haven’t seen it get a whole lot better, frankly. But we continue to buy what we need. Our intent is to bring down the inventory levels over time. The vast majority of the inventory we have is secured by POs and so we think it will slowly improve over the coming year.

Joe Gomes, Analyst

Okay. Great. Thanks for taking the question. I will get back in queue.

John Morrison, CFO

Thank you, Joe.

David Raun, CEO

Thanks.

Operator, Operator

We will hear from David Williams with Benchmark.

David Williams, Analyst

John, thanks for taking the questions. I appreciate. I guess, quickly, I wanted to ask about the mobile 5G AI opportunity. That’s been very interesting, and I think you said, it’s expected to roll out to 100 other cities. Can you tell us if you have the design there for those other 100 cities and what do you think this opportunity could mean for the business overall?

David Raun, CEO

Yeah. Basically, so if we figure on only one vehicle per city, which is not necessarily the case, that would require at least 100 of our systems. These are expensive systems. So this is a multimillion dollar opportunity for the company. Probably it will yield over several years $10 million or more.

David Williams, Analyst

Okay. It is still up, it is not a...

David Raun, CEO

In other words, we don’t need to win those other 100. That’s what they are planning to do. They aim to integrate these into vehicles and trucks to reach those 100 cities with our product.

David Williams, Analyst

Okay. Thanks. And then maybe just kind of thinking about on the gross margin side, you have got a lot of moving pieces here. Bressner is still a headwind, but you have got some tailwinds from the military and then also the media and entertainment falling off. What should we think about in terms of margin next year? Can you snap back to where you were previously or should we still expect it to kind of stay around this range with a steady plotting kind of improvement next year?

David Raun, CEO

Yeah. We expect it to snap back to what you have seen in the past and we will build off of that.

David Williams, Analyst

Any thoughts on cadence, that improvement.

John Morrison, CFO

In the first quarter, we expect strong performance as we ship more military products, and it should align closely with the results seen in 2022.

David Williams, Analyst

Okay. All right. Very good. That’s helpful. And then one just last one for me real quick is, I know there’s a lot of activity in China on the autonomous trucking side and you saw some high-end components in your products. But just kind of curious if you are seeing or thinking about anything from the China restrictions. Just kind of on the fringe on the edges with the subsidiaries located there, are you seeing any pushback, I guess, or is there any ties or any relationship that we should be thinking about here in terms of the restrictions going into China?

David Raun, CEO

So, first of all, definitely, there’s worldwide activity on this primarily in the U.S. and China, but all our three customers that we are engaged with today are U.S.-based companies. So no issue there. And we are talking to other companies, which is a mixture of international. But for the most part, we don’t see the China situation impacting us on that front.

David Williams, Analyst

Okay. Thanks much. I appreciate the time and the help, guys.

John Morrison, CFO

Thank you.

David Raun, CEO

Thank you.

Operator, Operator

We will hear from Max Michaelis with Lake Street Capital Market.

Max Michaelis, Analyst

Hey, everyone. Congratulations on the quarter, and I appreciate you taking my question. Considering the strong opportunities you are seeing in the military sector, as well as with the advisory board, are some of these opportunities ones you might not have pursued in the past without the advisory board or its influence on these opportunities?

David Raun, CEO

Great question. They have been very helpful. It’s really the combination of the three things we have done. Rigel is just a great product, nothing like it out there, and it’s doing extremely well. But they have made introductions for us in place specifically directly with the DoD that we did not have before and so that’s helped. And they have been great team to work with.

Max Michaelis, Analyst

All right. Thank you. And then, just if you may, can you quantify the amount of military shipments that were deferred until Q4?

David Raun, CEO

Could you repeat that? You broke up a little.

Max Michaelis, Analyst

Oh! Sorry about that. The amount of shipments that you guys deferred to Q4 that are not being shipped. I was wondering if you could quantify that in the fourth quarter.

David Raun, CEO

John mentioned that we are down about $5 million in military year-to-date. This doesn't mean that we're expecting all of that to be recovered in the fourth quarter. Overall, 2022 will be a down year for military, but we anticipate a recovery starting in the fourth quarter and expect strong growth in 2023.

Max Michaelis, Analyst

Thanks. Thanks, guys.

David Raun, CEO

We will double or triple what we are shipping this past quarter and we will continue to step up.

Max Michaelis, Analyst

All right. Thanks, guys. Congrats on the quarter.

John Morrison, CFO

Thank you.

Operator, Operator

We have no more questions. I’d like to turn the conference back to our speakers for closing remarks.

David Raun, CEO

Thank you. And thank you everyone for joining us today. We continue to believe the best is yet to come and we look forward to meeting with you again in March and reporting our progress as we pursue the many opportunities ahead. Meanwhile, as always, please continue to stay safe, healthy, and feel free to reach out to John and myself anytime. And let’s go ahead and wrap up the call.

Operator, Operator

Thank you. Before we conclude today’s call, I would like to provide a Safe Harbor statement that includes important cautions regarding forward-looking statements made during the call. One Stop Systems wants to remind you that the statements in the presentation are not descriptions of historical facts or forward-looking statements. These statements reflect the company’s current beliefs and expectations. Forward-looking statements include expectations for revenue growth from new products, future business objectives, design wins, and M&A activity. The inclusion of these statements should not be viewed as a guarantee that any of our plans will be achieved. Actual results may differ due to risks and uncertainties in our business, such as the developing market for our products, military conflicts, global pandemics, and economic conditions. Our operating results may be adversely affected by factors like inflation, supply chain issues, increased interest rates, or fluctuating economic conditions. If we cannot offset expected future revenue declines in our media and entertainment sector with other business, our financial results may suffer. Successfully integrating operations, technology, product offerings, and personnel from acquired companies may also prove challenging and could negatively impact our financial performance. We face competition that may harm our sales and market share. Our future success relies on our ability to develop and launch new products that meet customer needs. There is uncertainty regarding our design proposals becoming design wins, and revenue may never materialize. Our products fulfill specialized functions in the technology industry, and changes in these needs could make our products less relevant. New competitors may also impact our position in the market. We depend on a limited number of suppliers for manufacturing processes, and failing to protect our intellectual property could harm our competitiveness and lead to significant enforcement costs. Our international operations expose us to additional risks that could negatively affect our results and financial condition. We may not always be able to accurately report our financial results, and you should refer to our prior press release and filings with the SEC, including the Risk Factors section of our annual report on Form 10-K and subsequent SEC filings. Please avoid placing excessive reliance on these forward-looking statements, which are valid only as of the date of this call, and we do not commit to updating this information after the call date. All forward-looking statements are subject to this cautionary statement provided under the Safe Harbor provision of the Private Securities Litigation Reform Act of 1995. Before we finish today’s conference, I want to remind everyone that this call will be available for replay starting later this evening until November 24, 2022. For dial-in and replay instructions, please refer to today’s press release available on our website. Thank you for joining us today. This concludes our conference call. You may now disconnect.