CSP Inc. (CSPI) Q3 2013 Earnings Report, Transcript and Summary

Good day, and welcome, everyone, to CSP's Third Quarter 2013 Earnings Conference Call. Today's call is being recorded. The financial results news release is posted on the website at www.cspi.com, for those of you who did not receive it by email. [Operator Instructions] With us today are CSP's President and Chief Executive Officer, Mr. Victor Dellovo; and Chief Financial Officer, Mr. Gary Levine. At this time, for opening remarks and introductions, I would like to turn the call over to Mr. Levine. Please go ahead, sir.

Good morning, everyone. Thank you for joining us. With me on the call today is Victor Dellovo, CSP's Chief Executive Officer. Before we begin, I'd like to remind you that during today's call, we'll take advantage of the Safe Harbor provisions of the Private Securities and Litigation Reform Act of 1995 with respect to statements that may be deemed to be forward-looking under the act. The company cautions that numerous factors could cause actual results to differ materially from forward-looking statements made by the company. Such risks include general economic conditions, market factors, competitive factors and pricing pressures and others described in the company's filings with the SEC. Please refer to the section on forward-looking statements included in the company's filings with the Securities and Exchange Commission. During today's call, I'll start by reviewing our financial performance in the third quarter, then Vic will provide an overview of our 2 operating segments and the progress we're making on our growth strategy. Then we'll open it up to your questions. While we performed well in the first half of the year and expect to finish fiscal 2013 strong in Q4, our third quarter results were disappointing. During the quarter, we reported a loss of $0.14 per share on revenues of $19 million, which were down 15% from a year ago. The revenue decline was primarily due to a difficult comparison with the year-ago quarter due to $2 million in Systems segment royalty revenues related to the E-2D that we recorded in that quarter. We also recorded about $600,000 lower revenue at our Service and Systems Integration segment due to order timing. I'd like to note that our performance in the quarter should not obscure the excellent progress that we're making on our strategy, our optimism about the full year and our prospects for fiscal 2014. Vic will provide more detail on that in just a few minutes. Now let's dive deeper into the income statement. Our total cost of sales for Q3 was $15.2 million compared to $17.1 million in Q3 2012. Gross margin for the quarter was $3.8 million compared to $5.2 million as a result of the lower revenues. Gross margin declined to 20% from 23% due to a lower mix of products from the Systems segment, which typically carry higher margins. In addition, in the third quarter of 2012, we recognized $2 million in Systems segment royalty revenues compared with no royalty revenues in Q3 of 2013. Third quarter engineering and development expense was flat with a year ago at about $4.4 million. As a percentage of sales, Q3's 2013 engineering and development expense was 2.3% compared to 2% last year. We were just below our target range for engineering and development expense in 2013 between 2.4% and 2.7%. SG&A expenses were $4.1 million or 21.4% of sales compared to $3.6 million or 16% of sales in the year-ago quarter. The real dollar increase was due to the higher sales commission and higher headcount in the Service and Systems Integration segment. Our third quarter SG&A was higher than our target range between 14.5% and 16.2%. We're continuing to maintain a vigilant focus on cost control, and we are constantly reviewing every aspect of the business to ensure that we are operating at the most efficient manner possible. Our income tax rate in the quarter was 28% net of tax benefit of $187,000 compared to a tax provision -- income tax provision of $399,000 a year ago. Cash and short-term investments decreased slightly from $20.5 million at fiscal year end to $20.2 million at the end of the third quarter. We've paid out about $1 million in dividends through the first 9 months of this year. As we announced on our last call, we have increased our quarterly dividend from $0.03 per share to $0.10 per share. This reflects the board's confidence and our long-term prospects and commitment to shareholders. Before I turn the call over to Vic, I'd like to summarize by saying, in the past few quarters, we've done a great job in filling the performance gap from the Systems side of the business from our growth at MODCOMP. Our timing issue prevented us from doing it this quarter, but as Vic will describe now, we'll continue to execute well on our strategy, and we are bullish on our prospects for good growth in fiscal year 2013 overall.

Thanks, Gary. We began to see the results from the execution of our new growth strategy in our financials during the first half of fiscal year. While these results weren't as evident in Q3, the progress we've made was actually even more exciting. As we said before, we see significant growth potential for CSP and are confident that we have the right strategy to unlock the value in our company. Let us begin our discussion of operations with our Systems segment, which consists of our MultiComputer business. This business sells primarily to major prime contractors that sell to the U.S. Defense Department. Systems segment revenue was down by $2.7 million to $0.6 million in the quarter. As Gary mentioned, sales in Q3 last year included $2 million of royalty revenue from the E-2D Hawkeye intelligence, surveillance and reconnaissance aircraft while we recorded no royalty revenue in Q3 of this year. Therefore, our gross margins were down significantly year-over-year. The sequester and continuing resolution is having a negative effect on our Systems segment performance as we expect that will continue in the near term. Let me give you a quick update on the E-2D, which provides us with significant sales opportunity in fiscal 2014 and beyond. We have secured the parts to supply Lot 1 of full rate production for the E-2D and expect to ship these products during the current fiscal year. We expect to receive royalty revenue on 5 planes in fiscal 2014 beginning in Q2. Lots 2 through 6 have not yet been approved, but we expect those lots to involve 32 to 37 planes through fiscal 2018. Turning now to our Service and System Integration segment, which includes our MODCOMP subsidiary. This segment provides solutions and services for complex IT environment focusing on storage and servers, network security, unified communications and consulting and managed services. Service and Systems Integration revenue in the quarter were down 4% year-over-year to $18.4 million. Demand continued to be very strong at our U.S. subsidiary where we generate more than $1 million in revenue from new customers. This has been a result of aggressive efforts to ramp up our marketing efforts, expand our sales force and work closely with manufacturers to obtain sales leads. We also continue to see strong demand from traditional customers, especially those in the hosting space. Weakness in Germany caused by order timing and slight year-over-year deadline -- decline in the U.K. more than offset the strong growth in the U.S. On the past few calls, we discussed our efforts to become a global partner to our customers by cross-selling between MODCOMP's geographic locations. We have global customers with various network needs, unified communication and storage and server needs in different parts of the world. We have already begun to see some traction with these efforts in the past few quarters, but we're really starting to see the progress accelerate. We've reached a whole new level of collaboration between our operations in the U.S., Germany and the U.K. In the past, our engineers in various locations would talk very infrequent. Now our U.S., Germany and U.K. subsidiaries are on the phone daily to discuss leveraging their customer relationships to cross-sell, and now we're starting to see orders coming in. We've reached the point where we have a real worldwide operation with international pool of engineers to service customers anywhere around the globe. By leveraging our worldwide engineers' resources through cross-selling, we've enhanced our margins and increased our utilization rates. Not only have we put the infrastructure in place to aggressively utilize our worldwide engineering resources, but we have the process in place to track our achievements and establish accountability across the organization for success of this strategy. On our last call, we discussed the traction that we started to generate from new customers to our Network Operations Center, or NOC. Having the NOC is a competitive advantage for us because it enables us to monitor their network and proactively take care of any issues. During the quarter, we began to use a new platform for our NOC, and, for the first time, our U.S. and German operations are using the same platform. This has generated some success and we have a growing number of customers. Sales from the NOC are not yet material, but we expect these recurring sales to continue to escalate. Let me give you an example of one recent NOC client win. A bank customer recently was on a 6-day trial of the NOC. During that time, we found gaps in their security infrastructure and they subsequently signed a 3-year contract. They have sent the ordered products and service to go along with the NOC contract. Another opportunity for us is the migration of companies to the cloud, recording on opportunities to help customers make the full migration to cloud or to migrate to a hybrid model where only parts of the business is in the cloud. We believe there is an excellent opportunity to sell products and services to companies making this migration through our host cloud provider partners: Microsoft, Google and Amazon. With this business model, we received an indefinite residual payment after we set up the customer on the cloud. As we continue to grow our managed services business, we'll be able to sell additional products to these customers as well. To help accelerate our managed service strategy going forward, we are currently in the process of hiring a new VP of Global Marketing. This person will be in charge of the company's global image and will help to provide the marketing resources we need to support the sales process. This is the first time we've had such a position in the organization and it demonstrates our commitment to capture the opportunities we see in front of us. Before we take your questions, let me provide you a brief summary. Our performance in the third quarter, notwithstanding, we performed above our expectations thus far in fiscal 2013. What was looking like a challenging year due to the tough year-over-year comparison at our Systems business, is now shaping up well due to the strength of our Service and System Integration business. On the next quarters -- as we discussed today, we expect that, next year, we'll include royalty payments for 5 E-2D planes and our cross-selling strategy at MODCOMP also will enable us to report good growth on that side of the business. With that, Gary and I will be happy to take your questions.

[Operator Instructions] Our first question comes from the line of Samuel Kidston with North & Webster. Samuel A. Kidston - North & Webster, LLC: Just a couple simple ones. Could you tell me what the difference is between the income from continuing operations and net income? What's responsible for that difference?

Income from continuing operations and net income, there shouldn't be in the -- Sam, I don't... Samuel A. Kidston - North & Webster, LLC: Well, yes -- sorry, from operating income to income before -- profit before tax. What's that other income line?

Oh, that is foreign exchange and other income, the small amount we get on our cash, as well as some interest expenses. Samuel A. Kidston - North & Webster, LLC: Okay. That's fine, that's fine. And then just the other question is, in the MultiComputer Division, what do you guys think the breakeven is on a quarterly basis there?

It's -- because of the royalty situation, it's sort of difficult to say, but the run rate has to be at our normal margin for products in itself. Probably $2 million to $2.5 million, depending on operating expenses for the corporation. Samuel A. Kidston - North & Webster, LLC: Oh, so that -- what you're saying there is that's fully loaded when you're...

When we're doing it, yes.

Our next question comes from the line of Brett Davidson with BCIA.

I got a couple of questions, hoping you guys can add a little color to. The E-2D program, do you guys have an idea of how many planes you've shipped for -- prior to Lot 1, total?

I don't have the exact number, but I think it's in the 15 or 16 planes.

Somewhere in that ballpark?

And for the LRIP, 10. And then I think prior to that was 5 or -- I'm not sure. I think it's 5. So I think it's 15.

So your -- is the expectations, then, that we're going to ship for another 60 or so? I think the total program is around 75.

The -- that's what was originally said, that -- but they don't really talk about that, at least from the discussions we have with our customer right now. That's why we're talking about at least the numbers that they're talking about.

That's best information we have is 32 to 37 right now.

With the remainder.

With the remainder, yes.

Got it. So anything beyond that hasn't been discussed yet?

Right.

Now did you guys pick up any color yet as to how those orders are going to proceed? So I know that -- and I don't know if you guys saw, but they have release funding for Lot 2. Are both of those lots going to be 5 planes each?

That were -- I mean, that's -- I think the second lot, we believe, is going to be 5 planes. We're not -- within the first lot, it's 6, but we're not sure how that's going to roll out. Why we're seeing 5? Because that's what we believe will happen in the fiscal year. As you'll remember, we thought we would have -- we had 1 plane that leaped over into this fiscal year from the original -- the last LRIP. Yes, and we're not -- just not sure because we don't have a detailed schedule yet.

Got it. Did they provide any kind of color as to what's going to go on in the future years? Or they don't even mention it when they're discussing the orders?

They don't really know it. I mean, they don't really know any details.

I know -- the original information that was released on that showed like it ramping up to like 7 or 8 planes a year for a few years. I mean, from what we're seeing currently, it's -- you'll get a feel for exactly how that's all going to play out.

I think that was pre-sequester. It's just so difficult to say under this environment right now.

So the chance then the you -- that this may stretch out over a longer period than it initially was scheduled for?

Certainly has potential, Brett.

In next year, booking those revenue, do you guys expect that still to be lumpy like it's been in the past or you might book a couple in a particular quarter and none in other quarters?

Yes, that's always a possibility. We just -- we don't know. We get it from the customers, how they build them and once they ship them and the royalty is earned.

We think it's going to start in Q2 though. Right now, that's the best we can tell.

The revenues on each one of those, the chipset content, the revenues are somewhere around $1 million per plane with the royalties somewhere in the $700,000 range?

It's $100,000, I think, for the product and then...

. Well, $600,000 for the royalty and then you'll have parts there roughly, I think, about $100,000.

Yes, $100,000 a plane, give or take.

Got it. The pension expense, the reduction in pension expense, was that -- first, let me start off with -- are benefits still accruing due to compensation changes?

No.

Okay. So that's completely frozen, hard freeze. The change in the liability, is that a reflection of the reduction or -- excuse me, in interest rates?

Merely in the exchange rates.

Okay, I got it. So that still hasn't started working itself off yet or has the liability started working itself off due to...

Yes, but it's moderate in the foreign operations. We don't have a lot of pension that needs collecting.

Got it. Do you have like an idea of the average age of the beneficiary in it?

I don't -- we do, but I couldn't tell you right now, Brett.

Got it. And maybe if you could just comment a little bit on the strategy going forward that said there's been significant progress on the strategy, and I know you guys provided some color during the call as to the cross-selling opportunities. And maybe you could just quantify that strategy a little better so I can get a better understanding of what you're talking about with the significant progress.

What we've done is we have engineers in Germany, over 60 there. We have some in the U.K. and some in the U.S. And we were at times using outside resources just to fulfill projects. Now what we've done is kind of brought down the walls and we've made it one big engineering department. And then we also started targeting our customers that have global presence in various locations that we're in. And evangelizing the message that if you need product or services in the U.S. or in the U.K. or anywhere, that we can help facilitate, not only procure the product but help with the engineering services, et al. And it's been working with some of our customers already. So -- and now that we have some success, it's easier to -- the salespeople see that it does work and we have a program, a process, and it gives them added advantage. There's something different to talk about with the current customers, so that's one aspect of it. And the NOC services, that we gained another 6 hours by leveraging Germany and Germany leveraging us, so we could, instead of putting a third shift in the U.S., we can just kind of leverage Germany to keep the lower cost in NOC down as we build that.

Our next question comes from the line of Dan Zeff with Zeff Capital.

My questions pertain to profitability and the timing issue. Could you quantify the timing issue? And would you have been profitable had that timing issues not have occurred this quarter? And by saying you expect to finish strong, again, a profitability question, do you expect profits in the fiscal fourth quarter this year?

Basically, whether -- there's a number of potential orders that we had that we had believed would have come in, in this quarter and it would probably not wipe out the entire loss but would have been a much better quarter, and we do believe that we will be profitable in the fourth quarter, definitely.

Okay. And moving forward, are we in a growth phase before profitability moving into fiscal 2014 and excluding the MultiComputer Division? In other words, is Service and System Integration a profitable business moving forward, in your views or are we in a different phase?

Yes, it's profitable moving forward.

It's profitable, yes. And there is investment in that, also, but the systems solution side of the business has been profitable this year overall and I believe will continue to be, even with the added investment that continue growing.

Okay, great. And on the dividend, which is now a very hefty dividend given the stock decline today. I want to thank you for paying that and I want to encourage the new board members to not dissuade you from continuing that dividend, which is incredibly important to your long-term shareholders. My other question is regarding the planes. I realize you addressed this, but could you go over that again regarding parts and royalties overall for each plane? Is it consistent with previous lot orders, et cetera? What is the revenue per plane?

The revenue per plane is approximately $600,000 on royalty and about $100,000 on parts, which are earned at different times.

Right.

Our next question comes from the line of Nick Sebral [ph] with CS Management.

2 questions for me. First, on the dividend policy. I mean, I understand that profitability should improve, but depending on how much it improves and how things might change from the loss that you experienced this quarter, is there any -- how would you handicap the potential for a change in the dividend policy? And another way to ask that would be, is your cash flow, your free cash flow generation, similar to what you're seeing on the P&L? Or are the 2 divided? And if the 2 are very different, then why is that? And then the second question, which is again complementing some of the others on the strategy is, what can we expect? Is there anything you can say about the coming quarters in terms of how you expect the revenue to change? In particular, going into next year, do you see from the order interest so far or your prospective pipeline, the ability to grow the top line significantly? Are there any numbers that you can put on that?

Okay. To answer your first question, in relation to the dividend, dividends will be reviewed at least annually by the board. We do look at, obviously, free cash flow. Profitability projections are all taken into account. The board is very -- is a big advocate to continue dividend-ing with this growth pattern that we have and that's going to be reviewed annually, at least annually, and we'll report on that as we go forward. As far as the other question, Victor?

Yes, moving forward to top line revenue, things change dramatically. Customers don't give us that 6-month outlook. All I can say is we're targeting net new customers and continue growth in our existing. So with that and with the partnerships that we have with our manufacturers, we believe we can continue to grow that division. To give you a hard core numbers on what that growth would be, there's really no way to tell at this point.

Our next question comes from the line of Jay Kumar [ph] with Midsouth Investment Fund.

I have 2 quick questions. One is, do you see booking any reviews on the planes for the next quarter? Or all the 5 planes are going to be for the 2014?

2014. There's no royalties that will be in 2013.

Okay. So all the 5 that you mentioned will be in 2014, right?

Correct. Fiscal, right.

Okay. And what part of business is cloud computing? I mean, I know you talked about that. I mean, how much of the revenues come from that business?

It's something -- it's minimal at this point. We've had some few orders in Germany. I think, overall, that was combined. It's probably maybe $1 million combined with professional services and stuff like that over the last 6, 7 months. So it's something that -- that's the other piece of the strategy that we put together, was making sure the U.S., Germany and the U.K., all were partnerships evenly with Microsoft and Google and Amazon to be able to offer these types of cloud services, whether it's Microsoft 365. So we can do that in all locations. So we hope that's going to continue to grow. We're pointing to some marketing efforts behind it, but we'll see how it continues.

[Operator Instructions] Our next question comes from the line of Samuel Kidston with North & Webster. Samuel A. Kidston - North & Webster, LLC: Yes, just a quick follow-up, guys. Gary, when you said that breakeven in MultiComputer was $2 million to $2.5 million, is that annually?

No, quarterly. Samuel A. Kidston - North & Webster, LLC: That's quarterly, okay. So if you're looking at 5 planes next year, it was about $700,000 in revenue...

No, the thing, Sam, is that we split. Parts and royalties don't go together. We send parts -- like we have parts that have gone out this fiscal year to supply for the planes going forward. So they don't link together. We usually get the parts orders prior to the royalty, because they've used the parts in building the boards because they're not linked. Samuel A. Kidston - North & Webster, LLC: Yes, just so we can understand that a little bit better is, for instance, this quarter, you had $600,000 of revenue in that division. What was -- what's the breakdown of that revenue?

A major portion of it was parts. Off the top of my head, I'm not sure. It was, I think, about $300,000 -- $250,000 or $300,000 of that total was the parts for the procurement.

Some of it was parts repair to -- for other programs. Samuel A. Kidston - North & Webster, LLC: Okay. So about half of it was parts for the upcoming 5 planes?

Correct.

Correct, yes. But take them over time, we don't ship them all at once. They give us a delivery schedule as they want the items sent. Samuel A. Kidston - North & Webster, LLC: Sure, sure. And so just, again doing the math, does that division -- is that division profitable at a 5-plane annual run rate?

As a division, yes. With -- fully loaded with overheads, it would probably be -- yes, it would have been profitable. Samuel A. Kidston - North & Webster, LLC: Slightly profitable at a 5-plane run rate, okay. So -- all right. And then the other question was just on the increase in SG&A year-over-year. I'm sure that's related to some of the growth efforts, but could you just give us some color on that?

A big piece of it was commissioned because of the [indiscernible] solution division. That commission structure is a little different than the CSPI segment. So therefore, that's one piece of it. And the other half is just we've invested with some people, increased our sales staff and engineering. Samuel A. Kidston - North & Webster, LLC: But that's pretty much all on the Systems side?

No, Service and Systems Integration.

Our next question comes from the line of Bill Lauber with Sterling Capital Management.

First of all, Gary, could you explain this tax benefit that occurred in this quarter?

Well, the tax benefit is from the loss. But the benefit that we get from the calculation we've carried the loss, which means that you lower your...

Right. But there was no special items in the quarter?

No, there was nothing. It wasn't anything to do with the valuation allowance or any other items. It was just the standard tax provision, Bill.

Okay. And as far as the sequester affecting your business, are you -- do you sense that these are delays on business that you may be getting? Or is it outright cancellations? Can you...

So a lot of it. We still have items in the -- the opportunities are out there and the customers are not saying that they've been canceled but things are delaying. We've had some cancellations, though. Early on this year, we did get notification from a couple of customers that the programs they had said -- last year, we were told there was an attempt to buy more product, and this year, they came in and said that those have been canceled. So we have a little of both.

Okay. The other issue, and I don't know where -- how I got this impression, but it was something you all said on the conference call or whether it was through conversations that I had with you, Gary, or Vic, but I was under the impression that maybe somewhere along the line that we might be getting some guidance, and I think people have been kind of dancing around that issue with some of their questions, granted you're dealing with the government in a lot of these areas and so on and you're ramping up the MODCOMP business. But I guess, my question is, number one, are you planning to give us guidance some time here in the future? And if the answer to that is yes, when would that commence?

We will probably try to give some color where we see it, and I think we will try to do that at the beginning of the fiscal year.

Okay. So the next conference call?

That's right, yes.

At this time, we've reached the end of our Q&A session. I will now turn the conference back over to Mr. Victor Dellovo for any closing or additional remarks.

Thank you for joining us today. We look forward to speaking with you again on our next Q4 call.

Thank you. This concludes today's teleconference. You may disconnect your lines at this time. Thank you for your participation.