One Stop Systems Q2 2024 Earnings Call Transcript

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August 8, 2024

There are 5 speakers on the call.

Operator

Good day, and welcome to the 1 Stop Systems Second Quarter 2024 Conference Call and Webcast. At this time, all participants are in a listen only mode. Later, you will have the opportunity to ask questions during the question and answer session. As a reminder, this conference is being recorded. As part of the discussion today, the representative of OSS will be making certain forward looking statements regarding the company's future financial and operating results as well as their business plans, objectives and expectations.

Operator

These statements are based on the company's current beliefs and expectations and should not be regarded as a representation of OSS that any of these plans or expectations will be achieved. Please be advised that these forward looking statements are covered under the Safe Harbor provision of the Private Securities Litigation Reform Act of 1995 and that OSS desires to avail itself to the protections of the Safe Harbor for these statements. Please also be advised that the actual results could differ materially from those stated or implied by the forward looking statements due to certain risks and uncertainties, including those described in the company's most recent annual report from Form 10 ks, subsequent quarterly reports of Form 10 Q and the recent press releases. Please read these reports and the future filings that OSS will be making with the SEC. OSS disclaims any duty to update or revise its forward looking statements except as required by applicable law.

Operator

It is now my pleasure to turn the conference over to OSS President and CEO, Mr. Mike Knowles. Please go ahead, sir.

Speaker 1

Thank you, John. Afternoon, everyone, and thank you for joining today's call. I'm pleased with the progress we made during the 2024 Q2 as we continue transitioning our business pursue emerging opportunities within large and growing defense and commercial markets. 2nd quarter performance was aligned with our plan as we continue to pursue opportunities in AI, machine learning and edge computing. Highlights for the 2024 Q2 include positive segment orders, which have outpaced quarterly revenue in 3 of the last four quarters sequential revenue growth of 4.3 percent expanded customer development revenue and year over year OSS segment revenue growth of 8.3% as adjusted to exclude revenue attributable to a former media customer.

Speaker 1

We believe these favorable trends are positioning OSS for continued sequential revenue growth throughout the remainder of 2024. This year, we've been focused on 2 important objectives to take advantage of favorable market dynamics and the healthy pipeline we have developed. 1st, we are focused on converting our pipeline to orders in our OSS segment and second, we are pursuing customer funded development opportunities that we believe will establish OSS as an incumbent on platforms driving future multi year production contracts. Across our global defense and commercial markets, customers are looking for technology partners like OSS to support their expanding needs for rugged enterprise class compute solution. Driving these trends are the emerging requirements for AI, machine learning, autonomy and sensor processing at the edge.

Speaker 1

The company's best in class hardware and software platforms bring the latest data center performance to harsh and challenging applications that we believe will allow OSS to take advantage of current and future demand trends. Our underlying performance during the Q2 and first half of the year is aligned with our plan. We continue to believe 2024 is creating strong foundation for sustainable year over year revenue growth and profitability in 2025. Even as we navigate growing economic and continued weakness in our European markets through 2024 with expected recovery in 2025. So with this introduction, let's take a look at the progress we made during the Q2 in more detail, starting with our efforts to convert our pipeline to orders.

Speaker 1

Our unfactored pipeline at the end of the second quarter remained over $1,000,000,000 Approximately 70% of our current pipeline is comprised of platform opportunities, which we believe will help drive predictable multiyear revenue and backlog to OSS. I'm pleased with the growth and transformation of our pipeline reflecting the positive contribution of our sales organization, the strategic investments we are making in product development and the growing demand for our hardware and software platforms. As we continue pursuing opportunities to grow our pipeline, our operating plan in 20 24 remains focused on increasing orders within our OSS segment. For the 2024 Q2, we saw orders outpace revenue by over 20% for the Q2 in a row. Order growth over the past 3 months was driven by existing customers in the ground intelligence, surveillance and reconnaissance market known as the ISR market and from customers in the commercial aerospace market.

Speaker 1

In addition, we had new customer awards in the air ISR market. We expect many of these new engagements will evolve into multi year follow on revenue opportunities in future periods. 2nd important objective we are pursuing this year is focused on growing our presence on customer funded development programs. As we mentioned on our Q1 call, we started to disclose separate revenue and cost lines at our financial results associated with customer funded development projects to show our potential and track new wins. We have defined program related development work as customer funded development on our financial statements.

Speaker 1

Through customer funded development programs, we are typically providing a more integrated solution compared to the company's historic offerings. In addition, it establishes OSS as a platform incumbent on what is almost always a follow on production and multi year support As a result, we expect our business model to benefit from a higher mix of annual recurring revenue and contracted multiyear backlogs in the future. Development relationships are expected to take 1 to 2 years before leading to production orders. So as business scales, we expect to benefit steady quarter over quarter revenue growth, while building a solid foundation of potential large scale program opportunities. I'm pleased to report that customer funded development revenue increased to $1,400,000 in the 2024 Q2 compared to $365,000 just 3 months ago.

Speaker 1

This growth was driven principally by the expansion of an existing relationship with a commercial aerospace customer, refielding of a new product and follow on production. As expected, we are seeing increased interest from customers to support their development programs and we have multiple proposals currently submitted. As a result, we believe we will continue to experience sequential growth throughout the remainder of 2024 in customer funded development revenue. We also have expanded our product development efforts this year and currently have 5 product efforts under development in the OSS segment focused on edge computing for both defense and commercial applications. We expect to announce and demonstrate these products in the second half of this year and the first half of twenty twenty five.

Speaker 1

Our second quarter results also reflect strategic investments we are making to support current and future growth. Over the past 12 months, we have added new program management personnel with experience managing large complex development and production programs for government and defense customers. We believe their experience will allow us to pursue even larger programs for development and production in defense and commercial markets. As I mentioned last quarter, we are developing a new growth focused multi year strategic plan. Our markets are rapidly evolving, which has required additional time to finalize our 3 year strategic plan.

Speaker 1

We expect to communicate the growth strategies we are pursuing in a presentation later this year. As we look to the remainder of 2024, I'm excited by the long term strategies we are pursuing to scale our business and drive profitable growth. Though it has taken some time, I'm encouraged by the growing progress underway as we establish ourselves in our markets. We continue to execute against our near term transformation plan as we focus on driving orders, building backlog, growing revenue and improving profitability. While the timing of orders will remain a factor as we get to scale, I'm confident we are building a strong foundation to achieve our long term growth objectives.

Speaker 1

I want to thank our team for their continued hard work and dedication as we pursue compelling growth strategies aimed at building greater value for our shareholders. Looking forward, we anticipate consolidated revenue of approximately $13,300,000 in the Q3 of 2024, which accounts for approximately $1,600,000 of orders that we pushed to the Q4. Our guidance for the Q3 of 2024 also includes expected OSS segment revenue of $6,300,000 representing 15% year on year growth in the OSS segment, partially offset by lower Presenter revenue due to continued softness in the company's European markets. While uncertain economic conditions and softness in Europe may negatively impact our consolidated second half performance, we believe our leading enterprise class compute solutions, strong balance sheet and committed team are well positioned to take advantage of positive fundamentals across global markets and create long term value for shareholders. With this overview, I'd like to turn the call over to our CFO, John Morrison, to review our 2024 Q2 financial results in more detail.

Speaker 1

John, please go ahead.

Speaker 2

Thank you, Mike, and good afternoon, everyone. Our 2024 second quarter results reflect the ongoing transformation of our business model and continued improvement in orders. As a reminder, the company is comprised of 2 operating segments. Our OSS segment operates in the United States and is primarily focused and involved in the design and manufacture of high performance ruggedized edge processing, compute, storage and connectivity systems. Our pressure segment operates throughout Europe and is a system integrator with standard and custom all in one hardware systems and components.

Speaker 2

Reger also serves as a channel for OSS products to the European and Middle East markets. The following comments are based upon comparison of 2nd quarter 2024 results to the Q2 of 2023. For the Q2, we reported consolidated revenue of $13,200,000 which exceeds our guidance of $13,000,000 The 23.3% year over year decline in consolidated revenue was primarily attributable to a $3,200,000 reduction in revenue related to our former media customer and a $1,300,000 decline in pressure revenue associated with slower economic activity in Europe. Lower second quarter revenue was partially offset by a new customer funded by new customer funded development orders and revenue growth to new and existing customers. Looking at our OSS segment and backing out the $3,200,000 impact from a former media customer, revenue at our OSS segment grew 8.3%, reflecting revenue growth from new and existing customers and the initial success adding new customer funded development project.

Speaker 2

As Mike mentioned, in the Q1 of 2024, we started to separately disclose revenue and cost of sales line items associated with customer funded development work in our financial statements. Customer funded development typically represents non reoccurring design and development work associated with the introduction of new products paid for by the customer. We expect customer funded development to grow throughout 2024. Consolidated gross profit in the 2nd quarter was 25.2% compared to 27.9% for the same period last year. The decline in our consolidated gross margin was primarily attributable to our under absorption of our OSS segment production capacity and additional inventory reserves.

Speaker 2

Total second quarter operating expenses decreased 31.9 percent to $5,600,000 which was attributable to the elimination of prior year costs associated with organizational restructuring and outside professional services and these were partially offset by planned program management investments made during the quarter. In addition, our financial results for the Q2 2023 were impacted by a $2,700,000 charge related to the impairment of goodwill and a 1.3 $1,000,000 charge related to the employee retention excuse me, dollars 1,300,000 benefit related to the employee retention tax credit. For the Q2, the company reported a GAAP net loss of 2,300,000 or $0.11 per share compared to a net loss of $2,400,000 or $0.12 per share in the prior year. The company reported a non GAAP net loss of $1,800,000 or $0.09 per share compared to a non GAAP net loss of $84,000 or $0.00 per share. Adjusted EBITDA, a non GAAP metric was a loss of $1,300,000 compared to a positive adjusted EBITDA of $520,000 in the prior year's Q2.

Speaker 2

Now looking at the balance sheet in more detail. As of June 30, 2024, OSS had total cash, cash equivalents and marketable securities of 11,800,000 and total working capital of $32,600,000 This is compared to total cash, cash equivalents and marketable securities of $11,800,000 and total working capital of $35,600,000 at December 31, 2023. OSS had no borrowings outstanding on its $2,000,000 revolving line of credit on June 30, 2024 and December 31, 2023 respectively. The company's treasury operations had a consolidated balance outstanding on its term loans at June 30, 2024 of $1,100,000 down from $2,100,000 at December 31, 2023 $3,000,000 at June 30, 2023. For the 6 months ended June 30, 2024, OSS generated $1,200,000 in cash from operating activities compared to $2,000,000 for the 6 months ended June 30, 2023.

Speaker 2

This completes our financial review for the quarter. We would like to now turn open the call to open the call to questions. Operator, John?

Operator

Yes, sir. Thank you. Ladies and gentlemen, we will now begin the question and answer Thank you for waiting. We now have our first question. And this comes from the line of Tony Felling from Lake Street Capital.

Operator

Please go ahead. Your line is now open.

Speaker 3

Good afternoon, guys. Yes, this is Tony Feling filling in for Eric Martinuzzi. Appreciate you taking my question. Yes, so do we feel the company is properly staffed for a tighter focus on the defense customers?

Speaker 1

Yes, Tony, I do. And we've made some really, really good progress over the year to where we are. I think we're very well set to actually scale really well too with the people we have. So going back over the course of the year, just quick summary. Of course, myself joined the team, run commercial and defense, but defense background of 30 plus years.

Speaker 1

And then we brought on a VP of Sales and Marketing, Robert Kaleval. He and I worked for a decade together in the defense market. He has over 35 years experience selling and marketing into not only the U. S, but global defense. And then as I mentioned in the script, we wanted to augment the team with experienced program managers who are used to running large scale defense programs that have development, production, sustainment, fielding, etcetera.

Speaker 1

So we added 2 program managers to the staff, each who in their own right have experienced running 1 $100,000,000 plus programs on the defense side. So, if you're we're really well situated there. In addition as AS9,100 certified company and ISO 9,001 certified, we're really well set in policy process quality etcetera to meet the standards required for defense and commercial. So I think we're in really good place to execute against defense programs.

Speaker 3

That's great. And I mean do you think there's any risk in terms of revenue concentration with more focus on the defense customers going forward or is that kind of where we're headed?

Speaker 1

Can you maybe repeat the front end of that, Tony?

Speaker 3

Just revenue risk with or risk in terms of revenue concentration with more focus on defense customers?

Speaker 1

Yes, I don't think so. When I showed up the company, we were primarily on with a larger value on the commercial side. So as we've kind of increased up to about a fifty-fifty ratio right now, as we're projecting and we're looking at our pipeline for the next 3 to 5 years, we see that same ratio in our pipeline. So I don't think we'll get a revenue concentration specifically that would become a risk. If anything, we've seen quite decent success here in the 1st year in broadening out that revenue across more defense customers in addition to the commercial customers that we've had.

Speaker 1

So, I don't see a risk in the concentration in defense.

Speaker 3

For sure. Great. I appreciate you taking the questions. I'll jump back.

Speaker 1

Thank you. Thanks, Tony.

Operator

Thank you. And we now have our next question and this comes from the line of Brian Kinstlinger from AGP. Your line is now open. Please go ahead.

Speaker 4

Great. Thanks so much. Can you speak to the government procurement environment? Are you seeing reasonable sales cycles? Are they still elongated?

Speaker 4

And then as we enter the new fiscal year for the federal government, which always brings a set of budget delays, what can the company do to ensure a steady flow of orders if at

Speaker 1

all? Yes, Brian, the bane of existence doing business with the U. S. Government and defense actually it's the same in most global MODs also. So the interesting thing we've seen is the I would say the normal acquisition cycles from markets like I mentioned the ISR market, their kind of technology roadmap timeframes have generally been consistent.

Speaker 1

So not really concerned there in terms of where the markets are going, their needs. The biggest factor really has been and this has kind of been a trend over the last 3 to 5 years is, we're just seeing the procurement arms on the contract side taking exorbitantly longer time to award and contract out the contracts that have already been selected as winners or awarded as sole source. And when I say extensions, right, it used to be you might when a winner was selected or they're getting the end of a procurement, it might be 3 to 4 weeks for them to process. It's not uncommon now to see those sometimes take 12 to 14 weeks, which has really gotten a bigger impact now on the timing. So we worked through some timing issues a little bit.

Speaker 1

That's probably our biggest risk. In terms of their demand, the market needs and the technology and the process they've gone through, those are still remain fairly consistent. And then as for next year, yes, we always get concerned about CRs. The benefit you get on winning programs the year prior is the CRs usually affect new starts. So the more we win this year, the more stability we have in business into next year.

Speaker 1

But we do keep an eye on the CRs. We work with customers the best you can to plan for those. We did have 2 or 3 programs this year that were delayed close to 7 months past when we thought they would hit just because of the longer CR we had this year and then the follow on impact of them having to get the money appropriated. So timing issues definitely we have to deal with. Not much we can do rather than work closely with our customers, have things aligned and ready to go.

Speaker 1

We have seen some large primes have taken on considerations of funding smaller companies to protect schedules for awards they know they're going to get, but are waiting on award. And then the last thing we've been doing is we use some of our lobbying efforts just to help facilitate programs and timing and movement. Ultimately, if it's a CR, right, there's not much we can do, but we do work through our lobbying office to help resolve or pay or supplant or put in place anything we can.

Speaker 4

Great. And then when you talk about customer funded development, I assume growth in these programs are leading indicators of larger awards. And if that's the case, how do you think about the average time of a government a customer funded development program? And how long might it take or typically take until it turns into something that I might call production or I'm not sure how to describe it?

Speaker 1

Yes. No, Brian, I think what you could safe to say now for the kinds of programs that we're bidding and we've started to win, we'll generally see the NRE or the development period beyond the order of 6 to 12 or 18 months. So we're in that 6 to 18 month range depending on the size and scope of the development and the system we're developing. Usually at the end of that 18 months, you have the first fieldings, usually that's the low RIF, the LRIP, the low rate initial production. That's usually the first 4, 5 or 6 prototypes.

Speaker 1

It's usually delivered within the first kind of 3 to 6 months after that development period. And then you roll into production period, that can usually run anywhere from 1 to 2 to 3 to 5, 5 years. And usually have a technology refresh cycle that rolls up on the back end of that. So perfect example is the Raytheon P8 program we have. There was initial front end development.

Speaker 1

We've been on that program for the better part of 7, 8 years now and we're on I think second or third tech refresh. We're just finishing some development right now for the next technology refresh update for our system there. So that's the benefit of getting in on these front end customer development programs. So a little bit of long answer, but between 6 to 18 months depending on the scope is what I would say is average for us on those front end developments.

Speaker 4

Thank you. Last question I have, as we start to think about the revenue expectations that we like to think about from the OSS segment, is there any way you can quantify either the 1st 6 months or the trailing 12 months book to bill?

Speaker 1

Yes. So we've been tracking this year. So the as I mentioned in the earnings call, right, the percent. I'm sorry, go ahead.

Speaker 4

1.2% maybe in this last so maybe like 1.2% in this last quarter is that kind of the initial?

Speaker 1

Yes. I would say for the trailing 6 months for this year, we've been probably a little bit closer to 1.26. The last quarter here was a little bit stronger. We were upwards of a little over 1.3. So we're starting to see some pickup on the booking side from a lot of work we initiated last year.

Speaker 1

And then we're forecasting that to see that continued positive book to bill ratio greater than 1 through the next two quarters based on where we see things. The biggest impact would be timing on some, making sure the awards come in as planned. But based on where we're sitting, the majority of the pipeline that we have bid right now, we're waiting on awards is either competitions we've won or sole source work. So we're feeling pretty confident in the scope and the value that we could potentially pull through. We're working the timing as I mentioned on processing it through the systems.

Speaker 4

May I ask I'm going to squeeze one more in. Back to we're headed to the end of the government fiscal year. Some businesses in government obviously have a budget flush at the end of the year. Obviously, that also helps for the year after because you've had some budget this year and it protects you against CR. Do your business have a budget flush in September generally a benefit from that or is that not typically the case?

Speaker 1

So not much last year. So generally on the government side when they get to year end and they're trying to use up budget at the end of the year, they will generally go for buying additional production buys or spare buys. So generally, if you're incumbent on a platform, you'll see a better return on those year end sweep up funds. So we've started to position ourselves in some of those programs, so we could start to take advantage of that. Because of some of the positioning work we did last year, the other way you can grab sweep up funds is usually if some labs or organizations are interested in some early technology fielding, so they can work them in their lab or try them in exercises.

Speaker 1

We can sometimes see those pickups. So we've expanded our relationships across the defense so that we try to pursue opportunities where we can for people who might want to buy something for their lab or for some experiment in anticipation of a program in the following year. So as we get a bigger market share in defense, sweep up money will definitely be a lever that we can pull. We just need a little bit more penetration and incumbency across a few more platforms and then we'll I think we'll start to see that really add more to our opportunities.

Speaker 4

Great. Thanks for answering all my questions.

Speaker 1

Thank you, Brian. Thanks, Brian.

Operator

Thank you. And there are no further questions at this time, sir. Please continue.

Speaker 1

Okay, John. Thank you very much. We appreciate it.

Operator

Thank you. This concludes our conference for today. Thank you all for participating. You may now disconnect.

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