One Stop Systems, Inc. (NASDAQ:OSS) Q2 2023 Earnings Call Transcript August 10, 2023

Operator: Good afternoon, and thank you for joining us today to discuss One Stop Systems Financial Results for the Second Quarter ended June 30, 2023. With us today are the Company’s President and Chief Executive Officer, Mike Knowles; and its Chief Financial Officer, John Morrison. They are joined by the Company’s Chief Product Officer, Jim Ison. Following their remarks, we will open the call to your questions. Then, before we conclude the call, I will provide some important information 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 call over to OSS, President and CEO, Mike Knowles. Sir, please go ahead.

Mike Knowles: Thank you, Darryl, and good afternoon, everyone. In the first half of 2023 OSS implemented strategic organizational changes designed to accelerate our growth, particularly focused on ramping up our defense business and our AI Transportable product sales. To support this strategy, on June 5th, the company appointed me President and CEO, allowing me to leverage my experience and expertise in the global defense and commercial markets to accelerate the implementation of our strategy and grow revenue. As an update to the Board of Director reprofiling that was previously disclosed, I’d like to announce that Jack Harrison, who has been serving as Chair of the Nominations and Governance Committee and Sita Lowman, who has been serving as Chair of the Compensation Committee, have resigned from the OSS Board of Directors effective as of the end of Q3.

I want to thank Jack and Sita for their numerous contributions. In their place, I’m pleased announce that effective as of the end of Q3, Michael Dumont and I will be joining the OSS Board of Directors. Mr. Dumont is a retired three-star admiral whose career includes having served as the deputy commander of U.S. Northern Command and Vice Commander of North American Aerospace Defense Command, otherwise known as NORAD. Admiral Dumont currently serves as Interim President of The California State University Maritime Academy. He is also a licensed attorney with both defense and commercial experience and currently serves on the Board of Directors of the Marines’ Memorial Association, the board of advisors of Dataminr and the national security advisory council of the U.S. Global Leadership Coalition, as well as the OSS Advisory Board.

We are actively pursuing additional reprofiling activities for Q4. I’d also like to note they’ve recently announced the addition of Robert Kalebaugh to the team as Vice President of Sales, reporting to me. Robert brings over 30 years of defense, business development and domain experience and defense and commercial markets. I’ve had the privilege to work with Robert for a decade and I’m confident that we will be able to leverage our experiences to enhance and improve our sales and marketing efforts to accelerate our strategy. Robert is taking leadership of our sales and marketing organization and is already active with customers driving the team and updating tools and processes to create added efficiency, growth pipeline, and drive near-term and long-term booking.

Jim Ison has retained the position as Chief Product Officer and now has the opportunity to focus his full attention and efforts within the product organization to assure we continue to bring a roadmap of leadership product to the market. I appreciate his efforts over the past six months, having led both the sales, marketing and product organization. Since assuming the position of CEO two months ago, I’ve had the opportunity to meet, engage with customers and companies in the defense and commercial markets. Through these engagements, I’ve been able to build my confidence and reaffirm the current company strategy and the opportunities in the AI Transportable space. Having done so, I don’t need to see the need for major adjustments to the strategy.

I’m confident to strategy and product focus remain valid because the markets continue to be backed by strong demand for AI, sensor fusion and [indiscernible]. I’ve observed how our products work across both defense and commercial applications and can serve as the underpinning for building a balanced defense and commercial business portfolio. I believe that our current business model will strategically serve our company and investors well. What I am focused on is leveraging my experience to further drive and accelerate the strategy and build greater momentum and pipeline. During these past two months, I’ve explored opportunities to create broader partnerships within our core markets and with artificial intelligence software providers. We believe that these partnerships will unlock our ability to deliver fully integrated higher value solutions for our customers so they can more successfully leverage artificial intelligence and machine learning operations for their direct mission or business objectives.

OSS has established a good foundation for operations in the defense market, and as I’ve familiarized myself with the business and its operations, I’ll be implementing further improvements towards executing on our strategy. For example, AI and sensor fusion applications within the defense market are consistently moving more into the classified space where additional opportunity exists. To participate in this environment and capture these opportunities, we will need to have a security cleared facility and create a cleared workforce. In this regard, I’ve already implemented actions on these efforts and we expect to receive our facility clearance from the U.S. government by the end of the year. In addition, we have already trained a facility security officer.

We have also initiated discussions with our customers based on classified opportunities, and we’ll leverage these to add a secured classified information facility referred to as a SCIF and further broaden and enhance our opportunities in the classified space. From a business and organizational perspective, we will work to strengthen our operations to better execute in the defense market. At the appropriate time, we will look to enhance our team by adding a contract specialist to deal with the complexities of defense contracting, auditing and negotiating. We will move to certify our cost and accounting systems and further mature our International Traffic in Arms Regulations or ITAR process. To this end, we have the opportunity to leverage the defense Mentor-Protege Program to assist and guide us in these areas through defense prime contractors.

We are actively engaged in discussions with multiple primes at this time. I also anticipate further developing our opportunity pipeline identification and forecast modeling process over the second half this year. I’ve seen a need for improvement in the existing models and approach. This is consistent with the stage of maturation of OSS in the defense market. Improvement in these areas will allow for better assessment of forecast and opportunity timing. Additional observations over the past few months indicate that we have a talented and motivated employee base. There are strong technical and product expertise in an innovation-driven environment that can deliver on products that will meet existing and future market requirements for rugged datacenter-class edge processing.

This will ensure we remain on the forefront of introducing the newest and highest level of performance for which OSS has made a reputation. I’m also excited that we have an experienced operations team and facilities with capacity to meet projected growth and demand. Overall, the company has an energetic culture with a sense of urgency to succeed. Reminiscent of environments I’ve worked in where I’ve seen the greatest success and growth. I’m pleased that my engagements with the customers have validated the capability and scale the solutions we can bring to both defense and commercial markets. The scale from our high-end Rigel products to our mid-tier SDS products and lower-end Cernis and Donati products give us the flexibility to deliver scalable performance at varying price points, which align to our customer’s requirements.

Additionally, our PCIe express and storage products provide an added dimension of performance and value to our customers and attaining not only the highest levels of compute, but also the lowest latency and most flexible storage solutions. As I look at the company’s forecasted performance, we will be met with revenue challenges due to opportunity delays. Fortunately, these delays, especially in the defense market, are not inconsistent with my experience and are not a reflection of the strategy, product offerings, or value of opportunity in this market. We are also seeing a softening in the timing of the commercial market, including consolidation and delays in autonomous trucking and a conservative approach to increasing hardware spending. Having said that, I have confidence in our strategy, our product offerings, and our ability to build a robust pipeline.

As we execute in Q3 and Q4, our focus will be to build upon what I have discussed here today to grow and accelerate sales and revenue. Now, before coming further, I’d like to ask John to provide the financial details for the quarter, and Jim to expand further on customer wins and products. John?

John Morrison: Thank you, Mike, and good afternoon, everyone. Thank you for joining us today. Today, we issued a press release with our results for the second quarter ended June 30, 2023. The release is available in the Investor Relations section of our website at onestopsystems.com. Our consolidated revenue in Q2 totaled $17.2 million, up 2.3% sequentially, but declined 6% from the same year-ago period. As anticipated, the decline was due to decreased shipments to our legacy media and entertainment customer and a reduction in product shipments into the autonomous trucking industry, which is going through consolidation and financial hardships. We also experienced delays in defense orders. We have substantially fulfilled the remaining orders associated with our media customer, and we do not expect further measurable business from them.

As covered in our previous calls, this drop in the entertainment business resulted from acceleration in our customer’s investment in cloud technology and a drive towards less intelligent compute capability at the edge. This is particularly true of the virtual products, which do not require the same level of ruggedization as this system is not typically operated in harsh environments. Approximately $3.3 million of our quarterly decline in revenue was from the low margin legacy media business, which was partly offset in the quarter by our AI Transportable revenue. While we’ve experienced some delays in orders during the second quarter, it is important to note that our win rate has remained at previous levels. As you know, our company’s business is comprised of two segments: OSS Classic and OSS Europe.

OSS Classic is involved in the design and manufacturer of high performance ruggedized computers, flash arrays, and connectivity. OSS Europe primarily operates as a value-added reseller with minimum product customization and an increased focus on selling OSS core products into the European community. In the second quarter, OSS Classic revenue declined 22.8% to $8.3 million due to the factors previously mentioned, while OSS Europe revenue increased 17.7% to $8.9 million. The OSS Europe increase was due to additional project-based business, including $1.2 million of OSS core products and an increase in the number of small accounts, as well as having more available inventory to ship as compared to the same year-ago quarter. Overall, gross profit in the second quarter was $4.8 million.

The overall gross margin percentage was 27.9% as compared to 28.4% in the same period in 2022. The gross margin for our OSS Classic business decreased 3.8 percentage points to 29.2%, which was also attributable to the predominance of lower margin sales to the company’s media customer and higher mix of third-party components. OSS Europe’s gross margin percentage improved 4.8 percentage points to 26.7%, as compared to 21.9% in the same period in 2022, due to product mix, the sale of higher margin OSS core products, and having sought-after products readily sold at a premium. Overall, quarterly operating expenses increased 71.1% to $8.2 million, with operating expenses as a percentage of revenue increasing to 47.7% compared to 26.2% in the same period in 2022.

The most significant component of this increase was a $2.7 million write-down attributable to an impairment of goodwill resulting from the overall financial performance of OSS Classic as compared to plan, the transition of our focus to AI Transportables in the defense industry and lastly, the deferment of certain orders. Another significant component was an increase of $1.3 million in general and administrative expenses, with $1.1 million attributable to increased costs associated with our organizational restructuring and strategic transitioning of senior management and outside professional services. Such transition costs include additional wages, legal fees, search fees, stock compensation, and additional compensation attributable to the strategic transition committee.

This increase in operating expenses was partially offset by decreases of $241,000 in marketing and selling expenses and $297,000 in R&D expense. Loss from operations totaled $3.4 million, compared to income from operations of $402,000 in the same period in 2022. This reduction was predominantly attributable to lower revenue, the write-down attributable to the impairment of goodwill, and transition costs. Net loss on a GAAP basis was $2.4 million or loss of $0.12 per share, as compared to net income of $323,000 or $0.02 per share. Net loss in the second quarter also included a one-time benefit of $1.3 million attributable to the receipt of COVID-19 funds under the government’s employee retention credit program. Non-GAAP net loss was $84,000 or $0.00 per share compared to non-GAAP net income of $871,000, or $0.04 per share.

Adjusted EBITDA, a non-GAAP metric, was $487,000 or 2.8% of revenue, a decrease from $1.2 million or 6.5% of revenue. Each of these non-GAAP metrics include adjustments of $2.7 million for the impairment of goodwill and $1.3 million for the employee retention credit. Now, turning to the results for the first half of 2023, as compared to the first half of 2022. Our consolidated revenue decreased 3.9% to $34 million. The decrease in revenue in the first half of 2023 is due to the reasons discussed in reference to Q2. Our OSS Classic revenue decreased 20.6% to $16.9 million, while OSS core product revenue is growing year-over-year. OSS Classic is experiencing delays in orders from the commercial and defense markets, which represent $5 million to $6 million of revenue, which we believe will be pushed from 2023 to 2024 and represents deferral-only of revenue opportunities.

OSS Europe revenue increased 21.5% to $17.1 million, inclusive of $2.4 million of OSS core product sales. As a reminder, OSS Classic is defined as all shipments from U.S. operations delivered throughout the world. Similarly, OSS Europe is defined as all shipments originating from Europe operations. OSS core products are designed in the U.S. and sold through both operations and tend to yield higher margins. Overall gross profit was $9.9 million. The overall gross margin percentage was 29%, as compared to 29.2% in the same period in 2022. OSS’ Classic gross margin percentage was 32.8%, a decrease of 1.5 percentage points as compared to 34.3%. This was due to the predominance of lower margin sales to our media customer and a higher mix of products with third-party content.

OSS Europe contributed gross margin at a rate of 25.3%, as compared to 21.5%, an increase of 3.8 percentage points, due to product mix and increased sale of OSS core products, and having sought-after products sold at a premium. Total operating expenses increased 45.1% to $13.5 million. The increase was primarily due to an increase of $2.7 million write-down attributable to an impairment of goodwill and $1.8 million in general and operating expenses, of which $1.4 million of the increase is due to increased non-recurring costs associated with the company’s organizational restructuring and outside professional services. Such costs included wages, legal fees, search firm fees, equity compensation, and additional compensation attributable to the strategic transition committee.

The increase in operating expenses was partially offset by a decrease of $346,000 in R&D expense resulting from more engineers being deployed on chargeable work for which that expense is classified as a cost of revenue. Loss from operations totaled $3.6 million compared to income from operations of $1.1 million. Net loss on a GAAP basis was $2.8 million inclusive of the $1.3 million employee retention credit or $0.14 per diluted share compared to net income on a GAAP basis of $902,000, or $0.04 per diluted share. Non-GAAP net income totaled $6,000 or $0.00 per diluted share, as compared to $1.8 million or $0.09 per diluted share in the same year-ago period. Adjusted EBITDA totaled $1 million or 3% of revenue, compared to $2.6 million or 7.3% of revenue.

Both non-GAAP net income and adjusted EBITDA included adjustments of the $2.7 million impairment of goodwill and the $1.3 million employee retention credit. Now, turning to the balance sheet. On June 30, 2023, cash and cash equivalents totaled $6.1 million, with short-term investments of $9.3 million, for a combined total of $15.4 million. This combined total represents an increase of $2.7 million as compared to the prior quarter. The increase is primarily due to the employee retention credit and a decrease in working capital requirements. Consistent with our prior Form S-3 shelf registration statement filing that expired in May, 2022, we anticipate that we will renew such registration and file a new Form S-3 later this month. This completes our financial review for the quarter.

I would like to now turn the call over to our Chief Product Officer, Jim Ison. Jim?

Jim Ison: Thank you, John, and good afternoon, everyone. In Q2, we added six new major program wins. We expect these wins to yield about $3.3 million in revenue this year across both OSS Classic and OSS Europe. Three of these wins were in AI Transportables, including commercial autonomous watercraft and autonomous trucking server, and a defense submersible application. The remaining wins included an industrial IoT and two datacenter composable infrastructure applications. The autonomous watercraft application is our second customer win for commercial harbor patrol craft that combine several AI applications into a single OSS SDS server. These customers combine the self navigation functionality with the ability to fuse data from high resolution video, infrared imagery and various sensors to provide full spatial awareness.

This sensor fusion allows the watercraft to perform vessel identification, escort, security, and other port services. The autonomous truck application is the first navigation server within a new customer providing autonomous company campus goods transportation. The third AI Transportable application was a defense customer win for submarine AI sonar processing. This win combines our highly capable SDS server platform with innovative OSS liquid cooling techniques to provide datacenter capabilities under the sea while reducing the noise signature well below that of our competition. During the quarter, we also announced the $3.5 million U.S. Air Force Electronic Warfare simulation program win through a new prime contractor for our SDS storage servers.

Our ability to expand our footprint with various customers then win multiple designs within an account is key to our growth strategy and for strengthening our leadership position in AI Transportable applications. We also added seven new pending major programs during the quarter. We expect such pending major programs to each generate $1 million or more in revenue over four years with a 60% or greater likelihood of closing. Our pipeline of pending major programs at the end of Q2, totaled 33 with 19 of those involving AI Transportable applications in the U.S., Asia Pacific and Europe. On the product front, over the last year, we have expanded our AI Transportable product line to target applications in multiple domains from the high performance Rigel Edge Supercomputer for government air and sea vehicle deployments to the highly integrated 3U SDS compute and storage systems that bridge rugged, commercial and government vehicles and the ultra-rugged Cernis and Donati for government land vehicle deployments.

This complete product line includes our core PCIe express switch fabric technologies that enhance storage and AI application performance while significantly reducing latency, which is critical to these edge deployments. As we complete plans to evolve our well positioned product line to the latest PCIe express Gen 5 switch fabric during the year, we continue to make improvements in cooling technologies in creating valuable software products to solve edge computing challenges. These licensable software products include fast data movement, storage and remote system management, monitoring and control. The full product line and more complete software offering are attracting full system solution opportunities that tend to make for larger and more sticky deployments where recurring higher margin software revenue and longer term customers in commercial and defense market.

On our previous quarterly conference call, I introduced our proprietary Unified Baseboard Management Controller or U-BMC. Since introducing our U-BMC, we have received initial orders for it to be used in composable infrastructure, autonomous truck and edged government deployments. Both Rigel and our Gen 5 4U Pro accelerator system include U-BMC with additional SDS and vehicle deployed products to be announced later in the year. Now, with that, I’d like to turn the call back over to Mike.

Mike Knowles: Thank you, Jim. We see OSS as a unique and promising inflection point with the growing adoption of our superior AI Transportable edge computing and storage technology. We believe our AI Transportable solutions can have a dramatic impact on warfighter readiness and commercial business objectives. In the defense market, edge computing is important because the U.S. and its allies have chosen a distributed or decentralized command and control strategy. This approach has been adopted by the Department of Defense and named The Joint All-Domain Command and Control or JADC2, and it has been driving the increased demand for AI-enabled edge processing sensor fusion autonomy and simulation. According to this strategy is ability for commanders at the battlefield edge to be able to integrate and fuse sensor, command and communications data to assess, decide, and act faster than the centralized command and control operations of its adversaries.

Our capabilities and products are key to this strategy and our ability to implement AI processing in the most rugged environment. In the commercial market, AI is now considered part of the fourth industrial revolution, so we see implementation similar to the military being required at the edge where sensor and decision systems can interact to support rapid conversion from assessment to action. Most notably, we see this in commercial industries where the sensor fusion elements such as radar, lidar, laser, and infrared are collated and processed by AI to support workflow or autonomous operations. In all during the first half of this year, we continue to advance our market position in AI Transportables with our solutions contributing to the future of commercial and military ruggedized edge processing.

I’m excited to build on our strategy driving growth in both defense and commercial markets and creating a powerful business model. OSS now has the right team, products and innovation to succeed in the global marketplace. I’ve had the opportunity to share some of the same thoughts I communicated today while meeting and talking with investors over the past two months, and I’m encouraged by the commitment to our company and strategy. I believe it reflects the strong position and forward path for the company. As I look at the near-term, however, for the third quarter of 2023, we’ll witness the impact of the market delays we have discussed. As a result, we anticipate revenues of approximately $13.5 million. As stated earlier, this is a result of delays in the defense market and the forecasted timing expectations.

In the commercial market it is a result of the consolidation and delays in autonomous trucking market and overall conservative approachment to investment in spend. I’m confident with the addition of Robert Kalebaugh and the support of the team will successfully work through these issues, and I reiterate that we have the strategy, products and team to execute and grow the business. Now, with that, we’d like to open the call to your questions. Darryl?

Q&A Session

Operator: Thank you. [Operator Instructions] And we’ll first go to Scott Searle from ROTH MKM. Go ahead, Scott.

Scott Searle: Hey, good afternoon. Thanks for taking my questions. Mike, congrats again for coming on Board and thanks for all the color in the opening monologue. Hey, maybe just to dive in quickly on the third quarter, I want to clarify. I think I heard correctly that disguise will not be in the third quarter results. Just wanted to clarify that. And then sequentially, as you’re looking into the fourth quarter, is there a little bit of a recovery there despite the push outs? And when do you expect some of that $5 million to $6 million to start to come into the P&L? Is it in the first half or does it slide a little bit further than that?

Mike Knowles: Scott, thanks for the question. So as to the Disguise business, we principally have moved on from that business. There’s some small trailing bits that we’ll see in Q3, but very small and negligible. As to the delays we’re seeing and the push outs from this year, there is risk that we’ll see that in the fourth quarter also. Robert Kalebaugh and I are now working through the pipeline and our modeling of that to get a better feel of what that looks like and the timing. And so we’ll expect to be working on that in the coming months.

Scott Searle: Got it. And Mike, given your background, I’m wondering what you could provide in terms of color of the level of interest for Rigel and other products within the defense opportunity. Is there a tremendous amount of interest? Are you encouraged by the signs that you’re seeing? And what do you think the sales cycle looks like to try to start to get embedded and post some wins?

Mike Knowles: Yes. Scott, thanks. I’ll try to address those. If I miss one of the kind of the questions there just let me know. Yes. So I’ve been very encouraged by the product line and not just Rigel. Rigel is a great leadership door opener and provides great capability. But as I mentioned in my notes in the earnings call, it is the scale of opportunities of products that we have from top to bottom. And while I was able to meet with existing customers that the company had before I joined. I’ve worked through my Rolodex over the past two months working through some 75 plus contacts and been able to turn some of those in meetings over the past two months. And I’ve seen general response in the same as we’ve been able to explore with a number of customers and prime contractors, additional areas where they have opportunities and programs they’re going after.

And just I’ve been excited by the scalability that we can bring to that. As I mentioned, top-end Rigel, we slate in very nicely at a price point for large productions with our short-depth server or the SDS. And as we’re growing the entrance of Cernis and Donati at the next lowest level, it’s really drawing a lot of attention in those areas. So I’m encouraged by the full breadth of pipeline and by the defense market and that – where those could be adopted really across air, land and sea platforms.

Scott Searle: Got it. Very helpful. And if I could, it’s interesting to hear you talk about potential AI opportunities and partnerships there. I’m wondering if you could flush that a little bit in terms of what we should expect over the next several quarters as we will be looking for some more formal announcements and relationships on that front. And along with that, building up the defense and military opportunity, does that require some new costs from an infrastructure standpoint on behalf of OSS?

Mike Knowles: Yes. Great. Scott, so on the artificial intelligence partnerships that we’re looking at, so it’s something new we’ve engaged in starting to build and develop here. As I understand the market and places I’ve worked and we spoke to customers, we’ve generally been offering a hardware-only solution by potentially partnering with some AI providers. We do a couple things. We can bring a more developed or targeted, more fully integrated solution that allows us to maybe get more direct access to the actual services themselves than going through a prime that creates additional opportunity for us. The additional thing it does is there’s a lot of AI companies out there, software-only, that are doing the same thing. They’re trying to find application for their software with no hardware solution to go in to provide an end-to-end integrated solution.

So as we’re starting to open and explore these partnerships, we’re going to see opportunity not only to collaborate on programs and efforts, but obviously, potentially to develop more integrated products. I think that will span a range there of time and where we’ll expect to see some of these provide positive impact to the growth of the company. There’ll be near-term opportunities that ourselves or others maybe going after with stated programs and requests for proposal from the services. Those could provide near-term opportunity, as we build some partnerships and develop some concepts and more fully integrated solutions, we’ll then – it’ll look probably more so like a normal 18, 24, 36 month product line where you’re developing and building in a specific capability.

So we’ll really win the range. We’ll have more to say on that as, Robert, myself and Jim and the team start to explore and expand those over the coming quarters.

Scott Searle: Very helpful. Thanks.

Mike Knowles: Yes. You had a question on infrastructure, Scott. Actually we’re well suited now, not only just from a production operation standpoint, but even moving into the clear facility aspect, given the operational layout we have in the facility here in Escondido. We have opportunities to take advantage of things like mobile SCIFs that are really well priced and we have space and opportunity to bring those in. So it should be negligible facility or capital impact as a result of the strategy.

Scott Searle: Got it. Very helpful. Hey, and two more quickly, if I could kind of sneak them in. With autonomous vehicle slowing down, I’m wondering what has you excited on the commercial side of the equation. And the reprofiling the Board is very encouraging to see some new military-based DNA coming on Board. It sounds like, I think you said there were some further changes to come in the fourth quarter. Just wanted to clarify, if I heard that correctly. And my assumption is that Dave Raun continues to be involved with the company from a Board level going forward. Just checking on the high level thoughts from that perspective? Thanks.

Mike Knowles: Yes. Thanks, Scott. I’ll maybe go to this reverse order. Yes. Commitment to reprofile the Board has been stated. We’re pleased to announce with the two changes being made here in Q3. The Board continues to look to those reprofiling activities with some more plans for Q4, and they’re actively working on those. Dave Raun is currently on the Board and continues to serve. So we’re in a good position there. Your other question on the commercial side, we’re still interested in the autonomous trucking space. We’re still getting some orders. We’re seeing some timing delays, I would say, in that large scale deployment or big move to production, what that inflection point looks like. So we’re still interested in where that’ll be and when that’ll happen and we remain engaged with the customers.

Ancillary to that, while I’ve spent kind of the majority of my two months really getting a lot of the defense stuff moving, Robert and I are going to spend a little bit more time here – extra time here now in the coming months, building out the commercial. But as you all have noticed or seen in the notes we just presented, we’ve seen some commercial move in harbor and maritime. We’ve seen some of that in Europe, so we have some commercial movement there. We’re doing some stuff in the commercial aerospace area, so there’s a number of areas where the composable infrastructure. So we’re seeing a number of areas where people are still are showing interest and still gives us promise. But as I mentioned, Robert and I are going to really work through that pipeline and definition here with some added focus now that Robert’s on Board and we’ve kind of, I would say, gotten the first big kickoff on defense.

Scott Searle: Great. Thanks so much.

Mike Knowles: Thanks, Scott.

John Morrison: Thank you, Scott.

Operator: And our next question comes from Brian Kinstlinger from Alliance Global Partners. Go ahead, Brian.

Brian Kinstlinger: Great. Thanks so much. Mike, welcome aboard. I’m hoping you can give some more detail on the decline in revenues in the third versus the second quarter for Classic OSS, obviously, specifically. Maybe from a high level, if you can help me with a couple of buckets. How much was defense revenue in 2Q? I assume it’s zero in 3Q, maybe I’m wrong. How much was Disguise revenue in 2Q? And I assume it’s close to zero in 3Q. And then how much pressure are you seeing on autonomous trucking and/or commercial?

Mike Knowles: Yes. Brian, I wouldn’t say we have those breakouts right now. We could clearly follow-up with you on the specific numbers and those buckets that you would be looking for. As we kind of mentioned in the call, as we’ve seen right in the defense side, if you will, those delays have been identified as existing opportunities that we had to have just moved back in time. The customers just haven’t moved to the actual placement of the order. And then, well, on the commercial side, very similar – very similar actions across a number of different vendors. Maybe if there’s something specific to ask.

Brian Kinstlinger: A different way to ask, in some past quarters there’s already been delays in defense side. So I’m curious, was defense a meaningful revenue contributor in the second quarter?

Jim Ison: So the answer there is yes. I mean, we’re still tracking to that 25% of total company revenue being in defense that we’re looking to move and more into the 50-50 range in the next two to three years.

Brian Kinstlinger: Okay. Now listening to your comments, fourth quarter sounds like it’s going to probably be similar to the third quarter, and assuming we don’t see a hockey stick recovery in 2024, but knowing defense, it’s gradual. Looking at expenses on the other side from the previous caller, what are you thinking in terms of right sizing the business? How do you balance as a new CEO investing, which doesn’t sound like you have to make a lot of investments in growth, but you’re keeping your current investments versus trying to manage to at least breakeven on the lower revenue?

Mike Knowles: Yes. I think as we had mentioned, we don’t see a number of large investments coming. The opportunity in the pipeline that’s there should give us room for growth. And that’s what Robert and I are working through now. I feel confident and good in the pipeline as I’ve gone through it. The first set, I think with Robert on Board, we’ll have opportunity to actually grow that pipeline in both the commercial and defense. And so we’ll be able to leverage the existing investments products and strategies that we have just to build that growth.

Brian Kinstlinger: And sorry, to be clear, because the heart of the question is, you’re not thinking at this point with the much lower revenues than you’ve had in the first half of the year to be rightsizing expenses. Is that what I’m gathering? You’ll be holding SG&A and operating expenses where they are, there’s not going to be significant cuts?

Mike Knowles: That’s correct, yes. I’m sorry if I missed that in first part of your question, Brian.

Brian Kinstlinger: No worries.

Mike Knowles: And manage those prudently.

Brian Kinstlinger: Okay. And then my last question is, as revenue in Classic OSS lacks the scale that it’s had in the last several quarters. Are there a significant number – a significant scale of fixed cost that will need to get absorbed? And so now you’ll see significant pressure on the gross margin line until you see that recovery.

Mike Knowles: Yes. The risk will be there for that with the fixed facilities and manufacturing overhead that we have with the declining revenue. We are taking internal even cost actions now to help manage that prudently against the delays in revenue.

Brian Kinstlinger: Okay. Those are all my questions. Thank you.

John Morrison: Thank you, Brian.

Operator: And up next we have Joe Gomes from Noble Capital. Go ahead, Joe.

Joe Gomes: Good afternoon. Thanks for taking my questions. So I’m going to hit you guys up with the question of the day here about the outlook on revenues from a different angle. If I’m calculating here correctly from reading the releases, the first half of the year Disguise was accounted for about $6.3 million of revenue. But you also got 13 new wins that are supposed to contribute about $8.3 million of revenue in 2023, I think. So I’m just trying to wrap my head around how we go from that to the sharp decline in projected revenue definitely for the third quarter. And again, the previous caller said sounds like in the fourth quarter also.

John Morrison: So I can help answer some of that. The Disguise revenue is – there were 25% customer right then the prior years, and they’re going to zero here, negligible in the next two quarters. At the time that’s tailing off our OSS core product revenue is actually growing. That’s what is – where we’re coming in with the third quarter number. It’s just not growing at the same rate that we had hoped it would be that we had planned for and that’s where we’re at.

Joe Gomes: Okay. On the autonomous truck customer that exited, was that one of your top 10 customers that you talked about in past calls? And with the slowing – that exit and the slowing growth there, is there the concern about any types of inventory write-off that would be necessary?

John Morrison: So that was one of our top 10 was one of the companies that left. And at this point, no, we’re not concerned with the inventory write-off across the product we had for that market.

Joe Gomes: Okay. And one more for me. You talked about kind of moving into some of the classified work, and getting the secured facility. And I think you’re going to need some secure on the labor side. And some of the other defense companies that I cover, people with security clearances are unicorns these days in terms of trying to get them costing an arm and a leg because there’s so much demand for them. How are you guys set from a labor market on employees would have – that have current security clearances or will you need to ramp hiring up to bring more people on that have security clearances?

Mike Knowles: Yes. Joe, thanks for that question. So we have a couple people with security clearances right now. With the arrival of our facility clearance, we’ll be able to start to process some additional people. I think – and you’re correct, there is a market especially at those with special compartmentalized tickets that are difficult to find those employees and bring them in. I think what you’re going to see in our journey is that at the secret level and that level of classification, we’ll be able to do initial operation and find opportunities of where we’re going and we’ll be able to – as I mentioned here, we’ll be able to put in very quickly a number of our employees to do just that. So I’m confident we can pull that.

There’s a couple of us that have had the higher tickets and security clearance that’ll allow us to open up the doors to find opportunities. And then the nice thing about it we can secure those types of programs. If we’ll either find people or have find it, time to transition them to get those tickets or those types programs that we’re able to move those costs to bring the higher priced employees in if we needed to go find them. So we’ll be able to make that happen. But for the market we’ll be going and the initial opportunities we’ll be going at, we’ll be able to operate well at the lower classified level and we’ll need a couple people to help translate mission applications. But we’ll be able to most likely operate the product development, especially in our commercial products, still in the unclassified level.

So the SCIF and the clearances will allow us to communicate more directly for requirements and customer understanding of implementation to start, and we’ll be able to use our products and develop in the unclassified space.

Joe Gomes: Okay. Great. Thank you.

John Morrison: Thanks, Joe.

Mike Knowles: Thanks, Joe.

Operator: And our next question comes from Max Michaelis from Lake Street Capital. Go ahead, Max.

Max Michaelis: Hey guys. Thanks for taking my question. First one from me, just with the exit of one of your autonomous trucking customers, what gives you the confidence that you won’t potentially lose another one, and then some other things you’ve been hearing from your economist trucking customers as well?

Mike Knowles: Sure. I’m going to let, Jim, who’s been doing some recent work in that area, take you through some wins and where we stand in some place in that market.

Jim Ison: Yes. So the market in general has had the Silicon Valley type of feel to it and the consolidation that’s going on in there. So while there’s some that are exiting, like too simple and embark were ones that were announced. There are still many like those that are backed by the large trucking companies like Daimler who owns Torc Robotics, and those are robust, and those are the types of customers that we also have. And those are the ones that you heard there was another design win that we had in a new autonomous truck customer. That’s the type of a player in the market that we keep designing our products towards and keep bringing in.

Max Michaelis: Okay. Thanks guys. That’s it for me.

John Morrison: Thank you.

Mike Knowles: Thanks, Max.

Operator: And we have no more questions at this time. I’d like to turn the conference back to Mike for closing remarks.

Mike Knowles: Thank you, Darryl, and thanks everybody for joining us today. We’ve enjoyed sharing the latest progress at OSS with you today, and believe the company and strategy is solid and its future is bright. OSS management look forward to speaking with you again in November, if not sooner. In the meantime, as always, feel free to reach out to John, Jim, or myself at any time. With that, let’s go ahead and wrap up the call. Darryl?

Operator: Thank you. Now, before we conclude today’s call, I would like to provide the Company’s Safe Harbor statement that includes important cautions regarding forward-looking statements made during today’s call. One Stop Systems cautions you that statements made in this presentation that are not a description of historical facts are forward-looking statements. These statements are based on company’ current beliefs and expectations. Such forward-looking statements include, for example, those regarding the Company’s expectations for revenue growth generated by new products, future changes to its business objectives and members of management and the board, design wins and M&A activity amongst other things. The inclusion of such forward-looking statements and others should not be regarded as a representation by OSS that any of its plans will be achieved.

Actual results may differ from those set forth in the presentation due to the risks and uncertainties inherent in our business, including, without limitation, that the market for our products is developing and may not develop as we expect, military conflicts, global pandemics and other disasters or public health concerns, and economic instability in regions of the world where we have operations, customers or source material or sell products may affect such markets. Our operating results could be negatively impacted by inflationary pressures, supply chain constraints, increased interest rates or other economic conditions. Our operating results may fluctuate significantly, which would make our future operating results difficult to predict and could cause operating results to fall below expectations or guidance.

If we are unable to offset anticipated future decreases in revenue in our media and entertainment space with other business, our operating financial results may be adversely affected. Our ability to successfully integrate the operation systems, technologies, product offerings and personnel with acquired companies, if any, may prove difficult and adversely affect our financial results. Our products are subject to competition, including competition from the customers to whom we may sell and competitive pressure from new and existing companies may harm our business sales, growth rates and market share. Our future success depends on our abilities to develop and successfully introduce new and enhanced products that meet the needs of our customers.

The likelihood of our design proposals becoming design wins is uncertain and revenue may never be realized. Our products fulfill specialized needs and functions within the technology industry and such needs or functions may become unnecessary or the characteristics of such needs and functions may shift in such a way as to cause our products to no longer fulfill such needs or functions. New entrants into our market may harm our competitive position. We rely on the limited number of suppliers to support a manufacturer design process. And we cannot protect our proprietary design rights and intellectual property rights, our competitive position could be harmed or we could incur significant expenses to enforce our rights. Our international sales and operations subject us to additional risks that can adversely affect our operating results and financial condition.

We may not be able to accurately report our financial results and other risks described in our prior press release and in our filings with the Securities and Exchange Commission, SEC, including under the heading Risk Factors in our annual report on Form 10-K and any subsequent filings with the SEC. You are cautioned not to place undue reliance on these forward-looking statements, which speak only as of the date of the conference call, and we undertake no obligation to revise or update this information to reflect events or circumstances after this date hereof. All forward-looking statements are qualified in their entirety by this cautionary statement, which is made under the Safe Harbor provision of the Private Securities Litigation Reform Act of 1995.

Before we end today’s conference, I would like to remind everyone that this call will be available for a replay starting later this evening through August 24, 2023. Please refer to today’s press release for dial-in and replay instructions available via the Company’s website at ir.onestopsystems.com. Thank you for joining us today. This concludes our conference. You may now disconnect.