BSQUARE CORP /WA - Quarter Report: 2019 March (Form 10-Q)

250\‘I 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

For the quarterly period ended March 31, 2019  

OR

For the transition period from                      to                     

Commission File Number: 000-27687

BSQUARE CORPORATION

(Exact name of registrant as specified in its charter)

(425) 519-5900

(Registrant’s telephone number, including area code)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    Yes  ☒   No  ☐

Indicate by check mark whether the registrant has submitted electronically every Interactive Data File required to be submitted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit such files).    Yes  ☒   No  ☐

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, a smaller reporting company, or an emerging growth company. See the definitions of “large accelerated filer,” “accelerated filer,” “smaller reporting company,” and “emerging growth company” in Rule 12b-2 of the Exchange Act.

If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. ☐

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).    Yes  ☐    No  ☒

The number of shares of common stock outstanding as of April 30, 2019: 12,837,534

Securities registered pursuant to Section 12(b) of the Exchange Act:

BSQUARE CORPORATION

FORM 10-Q

For the Quarterly Period Ended March 31, 2019

TABLE OF CONTENTS

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PART I. FINANCIAL INFORMATION

BSQUARE CORPORATION

CONDENSED CONSOLIDATED BALANCE SHEETS

(In thousands, except share amounts)

See notes to condensed consolidated financial statements.

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BSQUARE CORPORATION

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS AND COMPREHENSIVE LOSS

(In thousands, except per share amounts)

(Unaudited)

See notes to condensed consolidated financial statements.

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BSQUARE CORPORATION

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(In thousands)

(Unaudited)

See notes to condensed consolidated financial statements.

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BSQUARE CORPORATION

CONSOLIDATED STATEMENT OF STOCKHOLDERS’ EQUITY

(In thousands, except share amounts)

(Unaudited)

See notes to condensed consolidated financial statements

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BSQUARE CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

1. Summary of Significant Accounting Policies

Basis of Presentation

The accompanying unaudited condensed consolidated financial statements of BSQUARE Corporation (“BSQUARE”) have been prepared pursuant to the rules and regulations of the Securities and Exchange Commission (“SEC”) for interim financial reporting and include the accounts of BSQUARE and our wholly owned subsidiaries. In the Condensed Consolidated Statements of Operations and Comprehensive Loss, prior period software revenue has been separately presented as third-party software and proprietary software to conform to current period presentation. Certain information and footnote disclosures normally included in the annual consolidated financial statements prepared in accordance with U.S. generally accepted accounting principles (“GAAP”) have been condensed or omitted pursuant to such rules and regulations. In our opinion, the unaudited condensed consolidated financial statements include all material adjustments, all of which are of a normal and recurring nature, necessary to present fairly our financial position as of March 31, 2019, our operating results for the three months ended March 31, 2019 and 2018 and our cash flows for the three months ended March 31, 2019 and 2018. The accompanying financial information as of December 31, 2018 is derived from audited financial statements as of that date.

Preparing financial statements requires us to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenue and expenses. Examples include provisions for bad debts and income taxes, estimates of progress on professional engineering service arrangements and bonus accruals. Actual results may differ from these estimates. Interim results are not necessarily indicative of results for a full year.

The information included in this Quarterly Report on Form 10-Q should be read in conjunction with our Annual Report on Form 10-K for the year ended December 31, 2018, as filed with the SEC on March 4, 2019.  

Basis of consolidation

The consolidated financial statements include the accounts of BSQUARE and our wholly owned subsidiaries. All intercompany balances and transactions have been eliminated.

Recently Adopted Accounting Standard

We adopted Accounting Standard Update (“ASU”) No. 2016-02, “Leases” (“ASU 2016-02”) on January 1, 2019.  See Note 6, “Leases.”

Use of estimates

Preparing financial statements requires management to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenues and expenses. Examples include provisions for bad debts and income taxes, estimates of progress on professional engineering service arrangements, bonus accruals, fair value of intangible assets and property and equipment, fair values of stock-based awards, assumptions used to determine the net present value of operating lease liabilities, and the fair values of acquired assets and liabilities, among other estimates. Actual results may differ from these estimates.

Loss Per Share

We compute basic loss per share using the weighted average number of common shares outstanding during the period. We consider restricted stock units as outstanding common shares and include them in the computation of basic loss per share only when vested. We compute diluted loss per share using the weighted average number of common shares outstanding and common stock equivalent shares outstanding during the period using the treasury stock method. We exclude common stock equivalent shares from the computation if their effect is anti-dilutive.

The following potentially dilutive shares were excluded from the calculation of diluted net loss per share because their effect would have been anti-dilutive for the periods presented:

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2. Revenue Recognition 

Disaggregation of revenue

The following table provides information about disaggregated revenue by primary geographical market and includes a reconciliation of the disaggregated revenue with reportable segments (in thousands):

Contract balances

We receive payments from customers based upon contractual billing schedules; accounts receivable is recorded when the right to consideration becomes unconditional. Contract assets include amounts related to our contractual right to consideration for completed performance obligations not yet invoiced and deferred contract acquisition costs, which are amortized over time as the associated revenue is recognized. Contract liabilities, presented as deferred revenue on our condensed consolidated balance sheets, include payments received in advance of performance under the contract and are realized when the associated revenue is recognized. We had asset impairment charges related to contract assets for each of the three months ended March 31, 2019 and 2018. 

Significant changes in the contract assets and the deferred revenue balances during the three months ended March 31, 2019 were as follows (in thousands):

Contract acquisition costs

We capitalize contract acquisition costs for contracts with a life exceeding one year, as is more common with our DataV software bookings. Amortization of contract acquisition costs was $7,000 and $80,000 for the three months ended March 31, 2019 and 2018, respectively.  There were no asset impairment charges for contract acquisition costs for any of the periods noted above.  

Transaction price allocated to the remaining performance obligations

The following table includes estimated revenue expected to be recognized in the future related to performance obligations that are unsatisfied or partially unsatisfied at the end of the reporting period (in thousands). The estimated revenue does not include contracts with original durations of one year or less, amounts of variable consideration attributable to royalties, or contract renewals that are unexercised as of March 31, 2019:

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Practical expedients and exemptions

We apply a practical expedient and fully expense contract acquisition costs, such as sales commissions, as incurred because the amortization period is less than one year. We record these costs within selling, general and administrative expenses.

3. Cash, Cash Equivalents and Short-Term Investments

Cash, cash equivalents and short-term investments consisted of the following (in thousands):

4. Fair Value Measurements

We measure our cash equivalents and short-term investments at fair value. Fair value is an exit price, representing the amount that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants. As such, fair value is a market-based measurement that should be determined based on assumptions that market participants would use in pricing an asset or a liability. A three-tier fair value hierarchy is established as a basis for considering such assumptions and for inputs used in the valuation methodologies in measuring fair value:

We classify our cash equivalents and short-term investments within Level 1 or Level 2 because our cash equivalents and short-term investments are valued using quoted market prices or alternative pricing sources and models utilizing market observable inputs.

Assets measured at fair value on a recurring basis as of March 31, 2019 and December 31, 2018 are summarized below (in thousands):

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As of March 31, 2019 and December 31, 2018, contractual maturities of our short-term investments were less than one year, and gross unrealized gains and losses on those investments were not material.

5. Intangible Assets

Intangible assets are related to customer relationships that we acquired from TestQuest, Inc. in November 2008 and from the acquisition of BSQUARE EMEA, Ltd. in September 2011.

Information regarding our intangible assets is as follows (in thousands):

Amortization expense was $25,000 for each of the three months ended March 31, 2019 and 2018. Amortization in future periods is expected to be as follows (in thousands):

6. Leases

In February 2016, the Financial Accounting Standards Board (“FASB”) issued ASU 2016-02, requiring most leases to be recognized by lessees on their balance sheets as right-of-use (“ROU”) assets, along with corresponding lease liabilities.  ASU 2016-02 is effective for annual periods beginning after December 31, 2018 and interim periods within that year, with early adoption permitted.  We adopted ASU 2016-02 effective January 1, 2019 and elected the modified retrospective transition method, recording a cumulative-effect adjustment as of that date and presenting comparative prior year periods in accordance with Accounting Standards Codification Topic 840.  On the date of adoption, we recorded a cumulative adjustment to recognize new net lease liabilities of $1.7 million and new ROU assets of $1.2 million, for operating leases on our consolidated balance sheets, based on the present value of remaining rental payments for existing operating leases. As part of adoption, we also de-recognized $0.5 million in deferred rent.  Adoption of the standard did not have a material impact on our statement of operations or statement of cash flows.  As part of adoption, we elected the short-term lease recognition exemption for our facility rental and equipment leases (all leases that qualified), which means that we did not recognize ROU assets or lease liabilities for existing short-term leases (leases of 12-months or less) as of the January 1, 2019 adoption date.  In addition, when adopting ASU 2016-02 we applied the following practical expedients to forego assessing:

We determine if an arrangement is a lease at inception.  On our balance sheet, our office leases are included in ROU assets and related lease liabilities are included in the Operating lease, current portion and Operating lease statement line items.  We determined that we do not currently have any leases that we are required to classify as finance leases.

ROU assets represent our right to use the underlying assets for the lease term and operating lease liabilities represent our obligation to make lease payments arising from the lease agreements.  Operating lease ROU assets and liabilities are recognized at the lease commencement date based on the present value of lease payments over the term of the lease.  For leases that do not provide an implicit rate, we use an incremental borrowing rate based on information available at the commencement date to determine the present value of lease payments.  We will use the implicit rate in the lease when readily determinable.  Lease expense for lease payments is recognized on a straight-line basis over the lease term.  

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Our leases have remaining terms of one to four years.  The only leases that contain renewal options are for office space leases at our Bellevue and Taiwan locations.  However, because of changes in our business, we are not able to determine with reasonable certainty whether either or both of these leases will be renewed.  As a result, we have not considered renewal options when recording ROU assets, lease liabilities or lease expense.

7. Shareholders’ Equity

Equity Compensation Plans

We have a stock plan (the “Stock Plan”) and an inducement stock plan for newly hired employees (together with the Stock Plan, the “Plans”). Under the Plans, stock options to purchase shares of our common stock may be granted with a fixed exercise price that is equal to the fair market value of our common stock on the date of grant. These options have a term of up to 10 years and vest over a predetermined period, generally four years. Incentive stock options granted under the Stock Plan may only be granted to our employees. The Plans also allow for awards of non-qualified stock options, stock appreciation rights, restricted and unrestricted stock awards, and restricted stock units (“RSUs”).

Stock-Based Compensation

The estimated fair value of stock-based awards is recognized as compensation expense over the vesting period of the award, net of estimated forfeitures. We estimate forfeitures based on historical experience and expected future activities. The fair value of RSUs is determined based on the number of shares granted and the quoted price of our common stock on the date of grant. The fair value of stock option awards is estimated at the grant date based on the fair value of each vesting tranche as calculated by the Black-Scholes-Merton (“BSM”) option-pricing model. The BSM model requires various highly judgmental assumptions including expected volatility and option life. If any of the assumptions used in the BSM model change significantly, stock-based compensation expense may differ materially in the future from that recorded in the current period. The fair values of our stock option grants were estimated with the following weighted average assumptions:

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The impact on our results of operations from stock-based compensation expense was as follows (in thousands, except per share amounts):  

Stock Option Activity

The following table summarizes stock option activity under the Plans:

At March 31, 2019, total compensation cost related to stock options granted but not yet recognized, net of estimated forfeitures, was $159,524. This cost will be amortized on the straight-line method over a weighted-average period of approximately 1.9 years. The following table summarizes certain information about stock options:

The aggregate intrinsic value represents the difference between the exercise price of the underlying options and the quoted price of our common stock for the number of options exercised during the period. We issue new shares of common stock upon exercise of stock options.

Restricted Stock Unit Activity

The following table summarizes RSU activity under the Plans:

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At March 31, 2019, total compensation cost related to RSUs granted but not yet recognized, net of estimated forfeitures, was $161,747. This cost will be amortized on the straight-line method over a weighted-average period of approximately 0.3 years.

Common Stock Reserved for Future Issuance

The following table summarizes our shares of common stock reserved for future issuance under the Plans as of March 31, 2019:

8. Commitments and Contingencies

Lease and rent obligations

Our commitments include obligations outstanding under operating leases, which expire through 2021. We have lease commitments for office space in Bellevue, Washington; Boston, Massachusetts; Taipei, Taiwan; and Trowbridge, UK.   See Note 6, “Leases.”

Loss Contingencies

From time to time, we are subject to legal proceedings, claims, and litigation arising in the ordinary course of business including tax assessments. We defend ourselves vigorously against any such claims. When (i) it is probable that an asset has been impaired or a liability has been incurred and (ii) the amount of the loss can be reasonably estimated, we record the estimated loss. We provide disclosure in the notes to the consolidated financial statements for loss contingencies that do not meet both conditions if there is a reasonable possibility that a loss may have been incurred that would be material to the financial statements. Significant judgment is required to determine the probability that a liability has been incurred and whether such liability is reasonably estimable. We base accruals on the best information available at the time, which can be highly subjective. The final outcome of these matters could vary significantly from the amounts included in the accompanying consolidated financial statements.

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9. Information about Geographic Areas and Operating Segments

Our chief operating decision-makers (i.e. our Chief Executive Officer and certain direct reports) review financial information presented on a consolidated basis, accompanied by disaggregated information for purposes of allocating resources and evaluating financial performance. There are no segment managers who are held accountable by our chief operating decision-makers, or anyone else, for operations, operating results, or planning for levels or components below the consolidated unit level. We operate within a single industry segment of computer software and services. We have three major product lines – third-party software, proprietary software and professional engineering service – each of which we consider to be operating and reportable segments. We do not allocate costs other than direct cost of goods sold to the segments or produce segment income statements, and we do not produce asset information by reportable segment. The following table sets forth profit and loss information about our segments (in thousands):  

Revenue by geography is based on the sales region of the customer. The following tables set forth total revenue and long-lived assets by geographic area (in thousands):

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10. Significant Risk Concentrations

Significant Customer

No customers accounted for 10% or more of total revenue for three months ended March 31, 2019.  Honeywell International, Inc. and affiliated entities (“Honeywell”) accounted for $2.7 million or 13% of total revenue for the three months ended March 31, 2018. No other customers accounted for 10% or more of total revenue for the 2018 period noted above.

Honeywell had accounts receivable balances of $2.3 million or approximately 24% of total accounts receivable at March 31, 2019 and $2.8 million or approximately 24% of total accounts receivable at December 31, 2018. No other customer accounted for 10% or more of total accounts receivable at March 31, 2019 or December 31, 2018.

Significant Supplier

Effective March 1, 2019, pursuant to a new Global Partnership Agreement with Microsoft Corporation (“Microsoft”), we are authorized to sell Windows Embedded operating systems in Canada, the United States, Argentina, Brazil, Chile, Mexico, Peru, Venezuela, Puerto Rico, Cuba, Haiti, Dominican Republic, Jamaica, Trinidad and Tobago, Guadeloupe, Martinique, Bahamas, Barbados, Saint Lucia, Curacao, Aruba, Saint Vincent and the Grenadines, U.S. Virgin Islands, Grenada, Dominica, Cayman Islands, Saint Kitts and Nevis, Sint Maarten, Turks and Caicos Islands, Saint Martin, British Virgin Islands, Sint Eustatius, Saba, Anguilla, Montserrat, Colombia, Saint Barthelemy, Antigua and Barbuda.  Our existing distribution agreement for sales of Windows Embedded operating systems in the E.U., the European Free Trade Association, Turkey and Africa, from which we generated approximately 3.7% of our third-party software sales in 2018, expires on June 30, 2019 and will not be renewed thereafter. We have also entered into ODAs with Microsoft pursuant to which we are licensed to sell Microsoft Windows Mobile operating systems to customers in North America, South America, Central America (excluding Cuba), Japan, Taiwan, Europe, the Middle East, and Africa. The ODAs to sell Windows Mobile operating systems are effective through April 30, 2022.

Software sales under these agreements constitute a significant portion of our software revenue and total revenue. There is no automatic renewal provision in any of these agreements, and these agreements can be terminated unilaterally by Microsoft at any time.

Microsoft currently offers a rebate program to sell Microsoft Windows Embedded operating systems pursuant to which we earn money for achieving certain predefined objectives. In accordance with Microsoft rebate program rules:  

Under this rebate program, we recorded rebate credits as follows (in thousands):

There was a balance of approximately $328,000 in qualified outstanding rebate credits at March 31, 2019, which will be accounted for as a reduction in marketing expense in the period in which qualified program expenditures are made.

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11. Credit Agreement

Line of Credit

In September 2015, we entered into a two-year unsecured line of credit agreement (the “Credit Agreement”) with JPMorgan Chase Bank, N.A. (the “Bank”) in the principal amount of up to $12.0 million. In September 2016, the Credit Agreement was modified to extend the final due date to September 2018, at which point it expired.  No borrowings were ever outstanding under the Credit Agreement.

12.  Subsequent Event

On May 9, 2019, our Board of Directors approved a severance plan that includes a workforce elimination of 38 positions, comprised of 32 employees and 6 consultants.  This one-time involuntary termination benefit plan reduced our workforce by approximately 25% and was done in order to reduce go-forward operating costs and re-align our go-forward business model to support future business initiatives.

We currently anticipate incurring pre-tax severance charges under this severance plan of approximately $1.1 million, representing one-time cash employee termination benefits including severance and other employment obligations, which will be paid out beginning in the second quarter of 2019 through early 2020.  We expect the workforce reductions will be substantially completed by the end of the third quarter of 2019 and anticipate that cost savings will be realized beginning in the third quarter of 2019.  

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As used in this Quarterly Report on Form 10-Q, “we,” “us,” “our” and “the Company” refer to BSQUARE Corporation, a Washington corporation, and its subsidiaries.

The following Management’s Discussion and Analysis of Financial Condition and Results of Operations should be read in conjunction with our condensed consolidated financial statements and related notes. Some statements and information contained in this Management’s Discussion and Analysis of Financial Condition and Results of Operations are not historical facts but are forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended (the “Securities Act”), and Section 21E of the Securities Exchange Act of 1934, as amended (the “Exchange Act”). In some cases, readers can identify forward- looking statements by terms such as “may,” “will,” “should,” “expect,” “plan,” “intend,” “forecast,” “anticipate,” “believe,” “estimate,” “predict,” “potential,” “continue,” or the negative of these terms or other comparable terminology, which when used are meant to signify the statement as forward-looking. These forward-looking statements include, but are not limited to, statements about our plans, objectives, expectations and intentions and other statements that are not historical facts. These forward-looking statements are not guarantes of future performance and involve known and unknown risks, uncertainties and situations that are difficult to predict and that may cause our own, or our industry’s actual results, to be materially different from the future results that are expressed or implied by these statements. Accordingly, actual results may differ materially from those anticipated or expressed in such statements as a result of a variety of factors, including those discussed in Item 1A of Part I of our Annual Report on Form 10-K for the year ended December 31, 2018 entitled “Risk Factors,” similar discussions in subsequently filed Quarterly Reports on Form 10-Q, including this Form 10-Q, as applicable, and those contained from time to time in our other filings with the Securities and Exchange Commission. Readers are cautioned not to place undue reliance on the forward-looking statements, which speak only as of the date made. Except as required by law, we undertake no obligation to update any forward-looking statement, whether as a result of new information, future events or otherwise.

Overview

Since our inception, our business has largely been focused on providing software solutions (including reselling software from Microsoft Corporation (“Microsoft”)) and related engineering services to businesses that develop, market and sell dedicated-purpose standalone intelligent systems. Examples of dedicated-purpose standalone intelligent systems include smart, connected computing devices such as smart phones, set-top boxes, point-of-sale terminals, kiosks, tablets and handheld data collection devices, as well as smart vending machines, ATM machines, digital signs and in-vehicle telematics and entertainment devices. We focus on systems that utilize various Microsoft Windows Embedded operating systems as well as devices running other popular operating systems such as Android, Linux, and QNX, and that are usually connected to a network via a wired or wireless connection. Our customers include world-class original equipment manufacturers (“OEMs”), original design manufacturers (“ODMs”), corporate enterprises (“Enterprises”), silicon vendors (“SVs”) and peripheral vendors. A significant portion of our business historically has also been focused on reselling software from Microsoft, from which a majority of our revenue currently continues to be derived.

Beginning in early 2014, we initiated development efforts focused on new proprietary software products addressing the Industrial Internet of Things (“IIoT”) market, extracting data from uniquely identifiable devices and applying advanced analytics and machine learning to the data in order to derive meaningful and actionable insights. While IIoT is a relatively new market, we believe the work we have engaged in since our inception—namely adding intelligence to discrete standalone devices and systems—embodies much of what is central to the core functionality of IIoT. These software development efforts have driven a new business initiative for BSQUARE, which we refer to as DataV™. Our DataV solution includes software products, applications and services that are designed to turn raw IIoT device data into meaningful and actionable data for our customers.

We began marketing DataV late in the first quarter of 2016 and announced our first three major customer bookings later that year which comprised software licensing, software maintenance and related systems integration services. During 2017 we began selling data analytics services and DataV application pilots to major industrial customers primarily in the transportation, oil and gas, and manufacturing vertical markets. One of these pilots led to a multi-year SaaS and related services agreement in 2018. The remaining pilots were completed, and while no additional licensing arrangements resulted from these pilots, we believe there may be future opportunities with a number of these customers.

We believe that IIoT represents a large, expanding addressable market that industrial customers are only now starting to embrace. We also believe that many potential customers need assistance with their digital transformation activities prior to making long-term solutions commitments as they transition from a non-cloud business to a cloud-based business.  We also believe there is still a viable market for our legacy third-party Embedded OS license software.   In 2019, we intend to go to market with a pragmatic edge-to-cloud message and product strategy that allows us to build on our legacy of helping our customers build intelligent devices but now offers a complete solution that allows our customers to build and operate the next generation of intelligent devices and systems.  We will continue to support our existing DataV customer commitments but will stop marketing DataV as an IIoT platform.  Instead, we intend to offer customers a set of IIoT solution components, solution accelerators and software engineering services.  We intend to continue to run our legacy third-party embedded OS software resale business to maximize opportunities and cash flow within that market. Our legacy professional engineering service business is now managed as a part of our overall services business, which we anticipate will increasingly serve our IIoT customers.

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Critical Accounting Judgments

Management’s discussion and analysis of our financial condition and results of operations are based on our condensed consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these condensed consolidated financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, sales, cost of sales and expenses and related disclosure of contingent assets and liabilities. We evaluate our estimates on an on-going basis. We base our estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying value of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions. There have been no significant changes to our critical accounting judgments, policies and estimates as described in our Annual Report on Form 10-K for the year ended December 31, 2018.

Results of Operations

The following table presents our summarized results of operations for the periods indicated. Our historical operating results are not necessarily indicative of the results for any future period.

Revenue

We generate revenue from the sale of software, both third-party software that we resell and our own proprietary software, and the sale of professional engineering service. Total revenue decreased for the quarterly period ended March 31, 2019 compared to the prior year period, primarily due to lower sales of Microsoft Windows Embedded operating systems and Microsoft Windows Mobile operating systems, and lower revenue from professional engineering service and other (non-DataV) proprietary software.

Additional revenue details are as follows:

Third-party software revenue

Third-party software revenue decreased for the quarterly period ended March 31, 2019, primarily due to lower sales of Microsoft Windows Embedded operating systems to Honeywell. During the first quarter of 2018, we decided not to compete for sales in intense price competitive situations in an effort to maintain a certain gross margin level, and therefore decided not to pursue sales opportunities with Honeywell in Europe. As a result, our sales to Honeywell decreased by $2.0 million, from $2.7 million for the three months ended March 31, 2018 to $0.7 million for the three months ended March 31, 2019.

Sales of Microsoft operating systems represented approximately 84% and 75% of our total revenue and 74% and 44% of our total gross margin for the three months ended March 31, 2019 and 2018, respectively.

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Proprietary software revenue

Proprietary software revenue decreased for the quarterly period ended March 31, 2019, primarily due to lower DataV software revenue recognized in the current quarter compared to the prior year quarter due to the timing of license acceptance.  We expect revenue from both DataV and our other proprietary software will continue to fluctuate in timing and amount in future periods and will decline over time as they approach the end of their life cycles.

Professional engineering service revenue

Professional engineering service revenue decreased for the quarterly period ended March 31, 2019, largely due to a decrease in service revenue in North America with the completion of several existing customer DataV projects in 2018. We expect that professional engineering service revenue will vary in timing and amount in future periods as we continue to align our organizational structure.

Gross profit and gross margin

Cost of software revenue consists primarily of the cost of third-party software products payable to third-party vendors and support costs associated with our proprietary software products. Cost of service revenue consists primarily of salaries and benefits, contractor costs and re-billable expenses, related facilities and depreciation costs, and amortization of certain intangible assets related to acquisitions.

Gross profit and gross margin were as follows:

Third-party software gross profit and gross margin

Third-party software gross profit decreased for the quarterly period ended March 31, 2019 due to lower sales of third-party software. Third-party software gross margin decreased as a result of a $178,000 reduction in the amount of Microsoft rebate credits recognized in the current quarterly period compared to the prior year period.

Gross profit on third-party software is positively impacted by rebate credits that we receive from Microsoft for the sale of Windows Embedded operating systems earned through the achievement of defined objectives. Under the Microsoft rebate program, we recognized $82,000 of rebate credits during the three months ended March 31, 2019, compared to $260,000 during the three months ended March 31, 2018, all of which were accounted for as reductions in cost of revenue. 

Proprietary software gross profit and gross margin

Proprietary software gross profit decreased for the quarterly period ended March 31, 2019 primarily due to lower proprietary software revenue. Proprietary software gross margin decreased for the quarterly period ended March 31, 2019 largely due to higher cost of sales related to maintenance and support activities for DataV.

Professional engineering service gross profit and gross margin

Professional engineering service gross profit decreased for the quarterly period ended March 31, 2019 primarily due to lower professional engineering service revenue. Professional engineering service gross margin decreased for the quarterly period ended March 31, 2019 primarily due to a higher utilization of engineering services in the prior year period.

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Operating expenses

The following table presents our operating expenses for the periods indicated: