One Stop Systems, Inc. (NASDAQ:OSS) Q4 2022 Earnings Call Transcript

One Stop Systems, Inc. (NASDAQ:OSS) Q4 2022 Earnings Call Transcript March 23, 2023

Operator: Good afternoon, and thank you for joining us today to discuss One Stop Systems Financial Results for the Fourth Quarter and Year Ended December 31, 2022. With us today are the Company’s President and Chief Executive Officer, David Raun; and Chief Financial Officer, John Morrison, as well as the Company’s newly appointed Chief Product Officer, Jim Ison. Following their remarks, we will open the call to your questions. Then before we conclude this call, I will provide some important questions 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 would like to turn the conference over to OSS President and CEO, David Raun. Please go ahead, sir.

David Raun: Thank you, Lara, and good afternoon, everyone. It’s good to be here with you. I’m pleased to report that revenue for OFS in the fourth quarter was up 2.7% over the previous year to $18.2 million and up 16.8% for the year to a record $72.4 million. Our adjusted EBITDA for the year was also a record at $5.2 million driven by increased sales of our continued — increased sales and our continued controls on spending. Overall, gross margin for the year was 28.2% due to strong sales of lower margin products, and a midyear temporary reduction in sales to our largest military customer, during a successful re-qualification effort. Having completed this re-certification process, these higher margin shipments have now returned to normal.

In 2023, we expect a reduction in low-margin media and entertainment business to be replaced with higher margin military product sales. If you’ve been following along with us, you are aware of the AI Transportable strategy that we put in place in 2021. For those less familiar, OSS designs and manufactures innovative edge computing modules and systems or AI Transportable applications, including on-location AI data capture, storage, training and large-scale inference. These products include ruggedized servers, compute accelerators, flash storage arrays, and data recording software. We take the latest high performance, commercially available products normally only used in the state-of-the-art, environmentally controlled data centers and bring them into these challenging, traditionally embedded edge markets.

We are pleased with the progress this past year executing on this strategy, which leverages our unique strengths to enable AI and autonomous capabilities in anything that moves, delivering absolute highest performance without compromise in rugged compact form factors in these harsh environments. Earlier in the year, we announced that we partnered with three key autonomous truck companies, utilizing our Centauri, and SDS product lines. This resulted in two of these truck companies rising into the top 10 list for the year. Later in 2022, we announced additional wins, including the development of a store — the deployment of our storage products in vehicles of one of the nation’s largest cellular carriers. In parallel to these quicker to market industrial applications, our primary pursuit is that of AI Transportable opportunities within the military theater.

The Army, Navy, Marines, and the Air Force are all deploying autonomous and/or AI capabilities. Although budgets might hold off on funding another $10 billion aircraft carrier, we have been advised that demand for the absolute highest performance in compute systems — high performance storage and compute systems to assure technical and analytical superiority is a top priority for the Pentagon, creating new opportunities and tailwinds for OSS. Having started 2022 with just a few significant military customers, we are now engaged at various levels with 8 of the top 10 largest military prime contractors in the U.S. Several of these expanded engagements have led to multiple bids by the primes to the DOD using our products. During this process, we also work directly with several branches of the military, providing us more visibility into programs, developing relationships with decision makers, and in several cases, we are now in the enviable position of having influence on product specifications for RFQs. Driving this process is our innovative product called Rigel, our new well-positioned sales representatives, our military advisory board added in 2022, and the strengthening of our internal team.

When we initially introduced our flagship product, Rigel, the most compact super computer in the world, we received pushback from the DOD as it did not conform to the entrenched, slower, VPX standard that the military had embraced for years. Recognized for our innovation and market disruptive solutions, we eventually gained traction as decision makers realized they could not achieve elevated performance levels staying with the old standard. Although most would have followed the VPX crowd, we stuck to our strategy and it is now paying off. Armed with the validation of our military AI Transportable strategy, we elected to make some strategic changes to accelerate growth and increase shareholder value. In February of this year, we announced a reorganization, relocating resources to higher margin opportunities, which previously supported low-margin business.

We also made some changes in senior management. For example, I asked Jim, who’s on the call today, to assume the role of Chief Product Officer. Jim is extremely talented and innovative in this regard, and he’s responsible to make sure we continue to design and develop market leading products for our target customers and drive clear market leadership. Additionally, we have initiated a search for new VP of sales, as well as two additional salespeople for our military markets. Consistent with our military product strategy and to accelerate company growth around these expanding opportunities, the Board and I decided it was time to begin the search for my successor. For this end, we hired a well-known national search firm, and we have some very talented candidates with solid experience and deep connections throughout the DOD and the ecosystems that support them.

As a member of the Board and a significant shareholder myself, I plan to stay fully engaged, driving our exciting vision with the team and facilitating a smooth transition. As a Board, we are taking the necessary time to make sure we hire the best candidate, and we currently expect that this transition will be complete by mid-year. I have told the Board I will be flexible on the timing, and they have my full support while I am in the CEO role and on the Board. I am proud of what we’ve accomplished over the past three years, particularly in financial stability, product leadership, and customer development. Prior to my role as CEO, I was an independent director on the Board of OSS. In February of 2020, based on my public technology company CEO background, and just prior to COVID outbreak, I accepted the CEO job on an interim basis upon release of the Founder CEO.

Although, it was not my initial intent to seek the full-time CEO role, after seeing a great opportunity taking shape and working with the team, I put my hat in the ring to take OSS to the next level. In June of 2020, we removed the interim part of my CEO title. I believe the Company is positioned well to improve shareholder value. The Company’s future is bright and the Company is poised to accelerate growth and valuation under the right leadership. I look forward to supporting the team and my successor as a member of the OSS Board. I’d ask John to comment on the financials and Jim to remark on customer wins and opportunities after which I will provide additional color and thoughts about 2023 and the future of the Company. John?

John Morrison : Thank you, David, and good afternoon, everyone. Thank you for joining us today. Today, we issued a press release with our results for the fourth quarter and the year ended December 31, 2022. The release is available in the Investor Relations section of our website at onestopsystems.com. The following results are for the fourth quarter and are compared to the same year-ago quarter. As David mentioned, our consolidated revenue in Q4 was up 2.7% to $18.2 million. During the quarter, we saw media and entertainment customer fall short of their projections, resulting in approximately $1 million less revenue than anticipated. This customer is projected to account for less than 10% of our consolidated revenue in 2023.

Our core OSS revenue decreased 1.8% to $11.3 million, representing 62% of our total quarterly revenue. Conversely, revenue from OSS Europe increased 10.8% to $6.9 million, which represents 38% of total quarterly revenue. However, excluding our lower margin media and entertainment business, our core OSS revenue increased 16.8% for the quarter. Overall, gross profit decreased $58,000 to $5 million, despite the company realizing improved margins over 30% as a result of starting to ship a greater mix of AI Transportable products. However, a fourth quarter increase in our allowance for realization of inventory associated with the customers — associated with the Company’s — excuse me — allowance for realization of inventory associated with the Company’s transition to higher margin edge AI Transportable military products resulted in an overall gross margin of 27.3% compared to 28.3% in the same year ago quarter.

The gross margin for the core OSS business decreased 1.8 percentage points to 31.4% due to the recognition of additional allowances for inventory realization. OSS Europe’s gross margin percentage improved 1.1 percentage points to 20.5% compared to 19.4%. Overall, quarterly operating expenses decreased 9.4% to $4.6 million with operating expenses as the percentage of revenue decreasing to 25.3% compared to 28.7%. This decrease in operating expense was primarily due to decreases of $138,000 in general and administrative expenses, $239,000 in marketing and selling expenses, and $105,000 in R&D expense. Income from operations increased $424,000 to $353,000 compared to a loss from operations of $71,000 in the fourth quarter of 2021. Net loss on a GAAP basis was $3.3 million or $0.16 per share, increasing from a net loss of $386,000 or a loss of $0.02 per share in the same year-ago period.

The loss in the fourth quarter of 2022 included a write-down of the net deferred tax assets of $3.9 million, which was attributable to allowances for the Company’s ability to benefit from cumulative tax losses and R&D tax credits. On a non-GAAP basis, inclusive of the aforementioned write-down, the net loss was $2.7 million or $0.14 per share for the quarter, down from non-GAAP net income of $71,000 or $0.00 per share. Adjusted EBITDA, a non-GAAP metric was $1.6 million or 8.9% of quarterly revenue, an increase from $996,000. The following results are for the 12-month period ended December 31, 2022 as compared to the results for the year 2021. Revenue increased 16.8% to a record $72.4 million. This increase was primarily due to the growth of the edge AI Transportable and autonomous applications as well as our media and entertainment business.

Core OSS business increased 12.5%, contributing $43.3 million of revenue with OSS Europe increasing 24%, contributing $29.1 million of revenue. OSS aggregate gross profit improved $758,000 to $20.4 million. Overall gross margin was 28.2% of revenue in 2022 compared to 31.7% in 2021. The reduction in margin was primarily attributable to four factors. Those factors are: a higher proportion of sales to our low-margin media and entertainment customer; deferment of approximately $3.3 million of higher margin sales of data and storage equipment; and third, an increase in our allowance for realization of inventory; and fourth, an increase in the proportion of revenue derived from OSS Europe, which generally operates at a margin of approximately 22%.

Gross margin for the core OSS business decreased 32.7% as compared to 36.9% in 2021. OSS Europe’s gross margin decreased to 21.5%, due to higher transportation and material costs, as compared to 23.1% in 2021. Operating expenses increased 5.2% to $18.8 million. This increase is primarily due to an increase of $605,000 in marketing and selling expenses, resulting from additional marketing, trade shows, and travel. And there was also an increase in R&D expenses of $711,000 for the development of new standard products for the AI Transportable market. These two increases were partially offset by a decrease of $379,000 in general and administrative expenses. Operating expense as a percentage of revenue improved to 26% compared to 28.9% in 2021. Income from operations decreased $179,000 to $1.6 million due to reduced gross margins with income before taxes decreasing $744,000 compared to the prior year.

However, after giving effect to the prior year 1 time PPP loan and interest forgiveness on a pro forma basis, there was a year-over-year increase of $770,000 in income before taxes. Net loss on a GAAP basis was $2.2 million or a loss of $0.11 per basic and diluted share. This was inclusive of the write-down of the net deferred assets of $3.9 million, which as I explained earlier, was attributable to allowances for the Company’s ability to benefit from the cumulative tax losses and R&D tax credits. This was compared to 2021 when there was net income of $2.3 million or $0.12 per diluted share, which included the 1 time benefit of $1.5 million or $0.08 per diluted share due to the forgiveness of the Company’s PPP loan and related interest. Non-GAAP net loss totaled $175,000 or a loss of $0.01 per basic and diluted share, which included the write-down for the deferred taxes — deferred tax assets as compared to non-GAAP net income of $3.1 million or $0.16 per diluted share in 2021.

Adjusted EBITDA, a non-GAAP measure, totaled $5.2 million or 7.1% of revenue compared to $4.9 million or 7.9% of revenue in 2021. For both — for 2021, both non-GAAP net income and adjusted EBITDA excluded the PPP loan and interest forgiveness. Now, let’s turn to our balance sheet. On December 31, 2022, cash and cash equivalents totaled $3.1 million with short-term investments of $10.1 million for a combined total of $13.2 million. This represents increase of approximately $0.5 million compared to our balances as of September 30, 2022. We believe the current financial resources available to OSS provides us with the stability and flexibility to be responsive to — responsive to changes in business demands, and particularly those that require investment in working capital to be successful.

This completes our financial review for the quarter and the year. I would now like to turn the call over to our Chief Product Officer — congratulations, Jim, to Jim Ison.

Jim Ison: Thank you, John, and good afternoon, everyone. In Q4, we added three new major program wins across three market segments, military, commercial aerospace and autonomous commercial vehicles. The military win is for a new compact airborne storage server for the Navy that quickly and easily transports mission data to ground stations and to the cloud. The commercial aerospace win involves an upgrade to aircraft network systems used in satellite communications and in-flight entertainment. The autonomous vehicle win with a tier one OEM in Germany continues to highlight OSS’s strength in commercial data logging and storage applications in the U.S. and Europe. These wins brought our total new major program wins for the year to 19, which tops our 14 wins from 2021.

Of the 19 winds, 13 were in the AI Transportable space, including 7 autonomous vehicles, 4 vehicle storage systems, and 2 military AI programs. We expect these new wins to generate approximately $10 million in 2023 and more in the following years. We added three new pending major programs during the fourth quarter. Two of the three opportunities are AI Transportable programs that include an agriculture AI solution and an autonomous vehicle data logging system. The third opportunity is for our latest Gen-5 acceleration systems. Our current pipeline of pending major programs totals 31 with 14 of these involving AI Transportable applications and 8 of those in military applications. Turning to products and certifications. Our Rigel Edge Supercomputer recently attained NVIDIA certified systems endorsement, simplifying our sales process.

It is the only edge certified AI system using four of the most powerful PCI express Gen 4 HGX A100 GPUs. NVIDIA certified systems are tested and evaluated by NVIDIA engineers for peak performance, functionality, scalability, and security, providing extra confidence in our AI workflow performance. In addition, last year we received AS9100 certification for our aerospace level quality system, as well as Cybersecurity Maturity Model Certification, otherwise known as CMMC 2.0, allowing us to qualify for a larger number of military AI programs and preparing us to potentially participate as a prime contractor to the U.S. government in the future. We anticipate additional wins with the DOD coming soon due to our unique high-performance product mix and corporate and product certifications.

As many of you know, military contracts often move more slowly and cautiously, but the diligence and expertise of our teams are starting to pay off. So far in Q1 of this year, we have already won two of these military applications. This includes an anti-electronic warfare system for fighter jets, and the recently announced $1.3 million Army contract to deliver a rugged visualization solution. The visualization solution will be based on NVIDIA GPUs that are interconnected with an OSS design PCI express fabric with this enabling in-vehicle 360 degree situational awareness. On the marketing front, in Q4, we exhibited at the association of the United States Army Annual Conference in Washington DC and at SC22, which is the annual international conference for high-performance computing, networking, storage and analysis that was held in Dallas.

We also attended the WEST Sea Services Conference in San Diego in Q1 of this year. At both SC22 and WEST, we teamed up with our partner TMGcore to demonstrate a technologically disruptive two-phase liquid immersion cooled version of our Rigel Edge Supercomputer. As the world’s first two-phase liquid immersion cooled supercomputer for AI Transportables, Rigel can now offer breakthrough levels of operating efficiency, compactness and ruggedness in the TMGcore edge box. And as we like to say, it delivers performance without compromise. The DOD has expressed interest in this technology as it will allow for a higher density of Rigel systems deployed into government transportables, allowing Rigel to address more harsh environments such as outside of a pressurized area of an aircraft, and reduce their noise signature used in sensitive applications.

With my recent transition from Chief Sales and Marketing Officer to Chief Product Officer, I look forward to leading the strategic direction of our technology, products, and customer adoption. Now with that, I’d like to turn the call back over to Dave.

David Raun: Thank you, Jim. 2023 will be a transitional year for OSS on many fronts, ranging from bringing our inventory levels down, reducing the low-margin business, while increasing the high-margin AI Transportable business, delivering more military proof points and the addition of new talent. With current visibility, I anticipate that the revenue will likely be consistent with the prior year, but we expect to see a multiple point improvement in margins, driving higher margin dollars due to the stronger mix. We are projecting growth from our industrial portion of the business, including autonomous trucks, cellular carrier trucks, agricultural equipment and autonomous baggage equipment. While we expect the military AI Transportables to lead the growth and are targeting a 40% increase in 2023, this portion of the growth will be driven by the return of our largest military customer after the certification delays we experienced last year as well as new business layering in.

Over the past several months, you’ve seen OSS announce several accomplishments in the defense market, including a $3 million defense order, the extension of our storage contract with the Navy and the breakthrough announcement, where we won the program working directly with the Army. OSS has been contracted to design and deliver a much needed capability for Army ground vehicles, which may get deployed in thousands of Strykers, Bradley’s and Abram Tanks. This exposure has led to multiple additional opportunities with the Army as well as with a large defense prime contractor. In the case of the prime, which we had not previously worked with, they reached out to us and informed us that, they had also bid on this Army program and are interested in working with us on some other opportunities, leveraging our technology and expertise.

For years, OSS has provided storage product shipments to the Navy for the P-8 aircraft. To-date, we’ve shipped product totaling more than $30 million. Based on the deployments, we believe the contract extensions and the future business will yield a similar value. Our extended exclusive supplier agreement highlights our technology leadership and long history of delivering rugged storage solutions, including all the software for transportable applications in small, lightweight and portable form factors, particularly those involving secure, high-speed data recording. This program led to several other opportunities within the same prime contractor. Unfortunately for the most part, until recently, we have not been able to duplicate this widespread engagement at another top 10 prime contractor.

As shared in my opening remarks based on several factors related to our strategy implemented in 2021, we have made significant progress on a broader scale with the defense industry and expect to share more proof points with investors throughout 2023. OSS is proud that we are now working with multiple military organizations to modernize our country’s defenses by deploying strategic AI and autonomous capabilities. As recent — as a year ago, we had no position at one of the other top 10 prime contractors. Since that time, we have had multiple meetings, including as many 80 people — as many as 80 people in attendance from the contractor and the DOD. I have personally attended three of these meetings and have been pleased with the sincere interest in our capabilities and products.

Although, we’ve not formally won a contract at this prospect yet, they are proposing to use Rigel, our SDS servers, and our storage platform spanning multiple Air Force aircraft. If we close just the current opportunities, they could generate more revenue than our current largest military customer. They have lauded the performance and compactness of Rigel, as well as our disruptive roadmap that leverages next generation products from partners like NVIDIA, as well as a path to two-phase immersion technology. In another case, after overcoming the VPX military standard requirement, as I mentioned earlier in the call, the prospect included Rigel — included Rigel as the compute system being proposed to the Marines in a major program upgrade. Again, this is another top prime contractor.

Later, senior management from this customer visited us here in Escondido and said they were looking to leverage Rigel and the roadmap is potentially a scalable solution to use on all their aircraft proposals, where they will be retrofitting current aircraft as well as for use in next generation aircraft. We believe our products, technology expertise and skills are aligned well with AI and autonomous applications throughout the DOD. Programs we’re working on that have been in — that have not been announced span many applications including different types of aircraft, including surveillance, tankers, fighter jets, drones, and helicopters. On the land, it includes manned and unmanned vehicles, detection systems, battlefield communications, command centers, and low-signature remote supercomputers.

At sea, we’ve seen opportunities for autonomous ships, submarines and amphibious ships. Although most of these operatories that I’ve mentioned have not been awarded, we believe we’re in an excellent position to close a number of them while also securing new programs in the process. I often get asked what makes OSS different from others in the market, or what prevents others from entering? Unlike many of the — many in this fragmented space, it all starts with performance without compromise. Rather than bringing lower performance embedded solutions to this market, we bring the latest technology normally used only in the most advanced data centers. Our engineering development and manufacturing expertise provides the Company the flexibility to start from ground up to optimize for this market, using the latest products, capabilities to push the limits on thermodynamics, power density, and ruggedization, as well as switch fabric skills to tie everything together with the latest high-speed PCI express, and NVIDIA’s licensed NVLink protocols.

We layer on top of that software in many of these products and take pride in building solid relationships with our customers. Now, looking ahead, for the first quarter of 2023, we expect revenue of approximately $16.6 million with a higher mix of AI Transportable products as revenue from our lower margin media and entertainment customer continues to decline. We expect revenues to increase throughout the year as additional programs layer in, especially with the military business increasing margins. Our modeling of our pipeline and opportunities suggests that OSS may see revenue growth in the 25% to 30% range, starting in 2024. We appreciate your continued support and the contributions from all our teams. With that, I’d now like to open it up — the call to questions.

Lara?

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Q&A Session

Operator: Your first question comes from the line of Scott Searle from Roth Capital. Please go ahead.

Scott Searle: Guys, I appreciate all the color, a lot of color in there. So, I’ll cut through to a couple of things quickly, but first on the mundane front, just from a gross margin standpoint, John, I want to go back and clarify a couple things in the fourth quarter. Even with the decline in Disguise contribution, it sounds like that we didn’t have a lot of the higher end military product revenue that was going through re-certification. Is that correct? And could you quantify the allowances? And then as we look into the first quarter here, how much of a recovery in gross margin do we see or because of seasonality and absorption issues, it’s still a little bit of headwinds until we ramp up through the course of this year?

John Morrison: So, we saw a little over 2.5% on margin erosion as a result of the additional allowances that we recorded. It basically tied directly to our media — more of our business that we are — leaving, which is our lower margin business as we move into the more profitable military business. And we did a detailed analysis of our inventory and took a look at the realization of that and based upon that, we booked the digital adjustments for slow moving or obsolete inventory.

David Raun: I think — also, Scott, I’d just add that during the fourth quarter, although we had seen the military start to rebound, it has not rebounded as far as it will — as far as like the current quarter. In addition to that, although our media and entertainment customer was down and lower than expected, it was still a significant number and you’ll see quite a bit further drop moving forward, which is built into the 16.6 number

Scott Searle: Got it.

David Raun: Which implies — we should be able to continue to see — yes, we should continue to see margin improvement.

Scott Searle: So sequential margin improvement into the March quarter?

David Raun: Correct.

Scott Searle: And then, David, it sounds like Disguise is rolling off pretty quickly. I think the number that you said was less than 10% of revenue contribution in 2023. Just want to clarify that. And then also, I think you talked about the military AI Transportable is growing 40% this year. I was wondering if you could calibrate us what it was in €˜22. I guess you’re including some of the Raytheon into that as well, or it’s not clear to me. I just want to know what numbers I’m working off of.

David Raun: Yes, Raytheon is part of that. And basically the military portion of the business is growing from — from an overall company, it’s growing from about 20% to 30% year-to-year. If you look at just the OSS classic, it’s going from something like in the 30s to over half of about 55% of the business, during that period of time. On the media and entertainment customer front, yes, it’s fallen off faster than we projected, when we were visiting back in November. And so, we are just moving forward. And fortunately, the hard work we’ve been doing on the military front is starting to pay off for us.

Scott Searle: Got you. And then, to dive in on the outlook, the pipeline is really building on the military front in a very short period of time. It seems like it’s accelerating. I’m surprised to see that you are so comfortable talking about 25% to 30% growth in 2024. I just want to confirm that in terms of total revenues, because it implies you are basically back talking about $90 million in sales. And then if I was to strip out Bressner, if I was to strip out Disguise, it looks like you are growing into 2024, 60% to 70% on the core OSS business. Am I doing that correctly? Am I looking at it from a proper standpoint?