CSP Inc. (CSPI) Q4 2013 Earnings Report, Transcript and Summary

Good day, and welcome, everyone, to CSP's Fourth 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 the 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, and thank you for joining us. With me on the call today is Victor Dellovo, CSPI's Chief Executive Officer. Before we begin, I would like to remind you that during the call today, we will take advantage of the Safe Harbor provisions of the Privacy (sic) [Private] Securities 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, Victor will provide an overview of our performance for the year and an update on our business segments and on our strategic progress. I'll then discuss our fourth quarter financials in more detail. And then we'll open it up to your questions. With that, I'll turn the call over to Victor.

Thanks, Gary. Fiscal 2013 was a successful year for CSP. While the year initially looked like it could be challenging due to the tough year-over-year comparison at our Systems or MultiComputer business, it turned out quite solid based on the strength of our Modcomp Service and System Integration business. For the year, we grew revenues 3% over last year and recorded $0.10 per share in profit despite recording royalty revenue at our Systems business of only $800,000 versus $6.3 million last year. We also distributed $1.4 million in dividends in fiscal 2013 and raised the quarterly dividend from $0.03 per share to $0.10 per share during the year. As you may have read in our news release this morning, the board has voted to raise the quarterly dividend again, beginning in the first quarter, for next year by 10% from $0.10 to $0.11. This reflects the board's commitment to enhancing shareholder value and its support for our new strategic direction. We continue to see significant growth potential for CSP, and we believe we have the right strategy to unlock the value in our company. Throughout the fiscal year, we made progress in the execution of that strategy, and the fourth quarter was no exception. During our call today, I'll discuss some of our strategic achievements as -- by providing operational overview. Let's start with our Systems segment, which consists of our MultiComputer business. This business sells primarily to major prime contractors that in turn sell to the U.S. Defense Department. Systems segment revenue was down $400,000 to $2.7 million in the fourth quarter. Sales in the Q4 last year included $1.3 million of royalty revenue from the E-2D Hawkeye intelligence, surveillance and reconnaissance aircraft. While we recorded no royalty revenue in Q4 this year, our Systems gross margin, therefore, was down significantly in the quarter and has been throughout the year given the difficult comparison with fiscal 2013. Let me give you a quick update on the E-2D, which provides us with significant sales opportunity in 2014 and beyond. As I mentioned on our last call, we had already secured parts to supply Lot 1 or first phase of full-rate production of the E-2D, and we shipped these parts during Q4. We continue to expect to receive royalty on 5 planes in fiscal 2014. In fact, in Q4, we received an order and shipped parts in support of production beyond Lot 1. We expect that Lots 2 through 6 will involve 32 to 37 planes through the fiscal 2018. One highlight of the quarter at the MultiComputer business was the acquisition of Myricom, a pioneer in high-performance computing interconnect technology. This asset purchase will be accretive. Through this acquisition, we now have an interconnect technology that is critical to the latest generation of multicomputer products. This essentially protects our ability to support our military and aerospace customers going forward. Additionally, Myricom give us a strong base of new customers in the commercial growth market. This reinforces our strategy to develop products in the MultiComputer division that are synergetic with the Modcomp division and its customers. In line with that strategy, during the fourth quarter, we introduced a new multicomputer product line for energy-efficient computing and signal processing that addresses commercial opportunity. The KeyDSP is a new product line that is based on recent announcement of the Keystone II multicore technology from Texas Instruments. Through the KeyDSP, we'll be able to open up new commercial markets. Turning now to our Service and System Integration segment, which includes our Modcomp subsidiary. This segment provides solutions and services for complex IT environments focusing on storage and servers, network security, unified communications and consulting and managed services. Service and System Integration revenue in the quarter were unchanged to $19.2 million. We continue to see strong growth in U.S. subsidiaries where the pipeline is robust and the result of our efforts to increase our sales force and work closely with manufacturers to obtain sales leads. The growth in the U.S., however, was offset continued -- by the continued weakness in our German -- in Germany. Our German division is now under new leadership, and we recognize a significant -- significantly reduce in cost structure. An important component of Modcomp's business strategy is to increase revenue and margin and grow our sales of managed services. On our last call, we discussed new clients that we had won during Q3. In Q4, we gained incredible traction and closed 11 new managed service and cloud customers. Keep in mind, this is still very small part of our business, but we're excited with the momentum in that the level of reoccurring revenue in our pipeline is growing quickly. Our plan is working, and we expect managed service to be an increasingly important component of our business. Also, as we grow this business, we'll be able to sell additional parts to our managed service customers. As we've discussed on a previous call, our managed service offering includes our network operations center or NOC. Having a NOC enables us to monitor our clients' network and proactively take care of any issues. We began using a new user-friendly platform in Q4, and we believe this is one of the reasons for the significant growth during the quarter. Another managed service opportunity is to help companies make a full or partial migration to the cloud. We are selling products and services to companies making this migration through a host of cloud providers like Microsoft, Google and Amazon, and our residual payments from these partners are starting to grow. We've recently hired a new global Vice President of Marketing and Communication, Michele Merrell. And one of her objectives is to raise the awareness of managed service offerings with the potential customers in key vertical markets. Michele was previous Senior Director of Global Marketing and Communications of a multibillion dollar global wireless distribution manufacturing and supply chain solution company. Michele will also support our efforts to cross-sell between Modcomp's geographic locations, which is another key element of our strategy. We will -- we have global customers with various network security, unified communication and storage and server needs in different parts of the world and we have an opportunity to help them. We now have a worldwide operation with an international pool of engineers to service customers anywhere around the globe. We continued to see traction in our cross-selling effort in the fourth quarter as about half of the revenue in the U.K. business came through the U.S. operations. Before I turn the call over to Gary for specifics on Q4, let me offer a few words regarding our expectations for next year. Overall, we believe that next year will be better than fiscal 2013 on both top and bottom line. We expect that next year will include royalty payments for 5 E-2D, planes and our cross-selling strategy at Modcomp also should enable us to record good growth on that side of the business. And with that, I will turn the call over to Gary.

During the fourth quarter, we reported a loss of $8,000 on revenue of $21.9 million, which were down 2% from a year ago. The revenue decline was due to slightly lower sales in both the Systems and Service and Systems Integration businesses. Our total cost of sales for Q4 was $17.1 million, slightly higher than the prior year. Gross profit for the quarter was $4.8 million compared with $5.7 million as a result of the absence of royalty revenues in Q4 2013 and a lower percentage of sales from Systems segment -- from the Systems segment. For those reasons, gross margins declined to 22% from 25% in Q4 last year. Fourth quarter engineering and development expense was $0.6 million, compared to $0.4 million a year ago. As a percentage of sales, Q4 engineering development expense was 2.7% compared to 1.9% last year. We were just in our target range for engineering and development of between 2.4% and 2.7%. SG&A expenses were $4.2 million or 19.3% of sales compared with $5 million or 22.5% of sales in the year-ago quarter. The decrease was primarily due to a $1 million reversal in Q4 2012 from a cash surrender value for an officer's life insurance policy. Our fourth quarter 2013 SG&A was higher than our target range of between 14.5% and 16.5%. 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 in the most efficient manner possible. We had a tax benefit of $66,000 compared with a tax benefit of $2.6 million a year ago. We expect our overall tax rate for next year to be approximately 40%. Cash and short-term investments decreased by $1.9 million to $18.6 million from $20.5 million at the fiscal year end last year. We've paid out about $1.4 million in dividends during the year. As Victor mentioned earlier in the call, beginning in the first quarter of 2014, we'll be raising the dividend from $0.10 to $0.11 per share. We have previously raised the dividend from $0.03 to $0.10 per share in the second quarter of 2013. This reflects the board's confidence in our long-term prospects and commitment to enhance shareholder value. Looking back at fiscal 2013, we performed well, especially with the very difficult comparison with last year. We grew sales, maintained profitability on significantly lower gross margins and distributed $1.4 million in cash back to the shareholders in the form of quarterly dividends. Given our expectations for the E-2D next year, we are encouraged by our prospects for fiscal 2014. We expect to report better results in the coming year as we continue to execute our growth strategy. We made excellent progress on that strategy in fiscal 2013 and plan to build on its momentum in 2014. With that, Victor and I will be happy to take your questions.

[Operator Instructions] Our first question today is coming from Daniel Zeff from Zeff Capital.

What is the margin moving forward on the E-2D royalty revenues? And why can't you give us a little bit more specific guidance moving forward?

The revenue on the E-2D planes, Dan, is approximately $600,000 to $630,000. There's a discount level that -- as we continue to ship. We're -- and as far as giving more guidance, I think that we're just being cautiously optimistic. We just have not started to do that. We're trying to at least give you some color relative to what it's going to look like next year. But we do believe we will beat this current year.

Now the margin was my question on the royalties. It's very high, I assume. So wouldn't it be fair to assume that we would have at least $3 million in operating income next year based only on that and if Modcomp is not profitable?

Well, obviously, that's $3 million on the gross level, but you still have the operating expenses of the division. And the corporate expenses -- what was your question in relation to...

Is Modcomp profitable, and will it be profitable moving forward?

Yes, Modcomp was profitable. It was very profitable this year. They were the leader in the whole operation. Modcomp made the profit that we had.

And it has been for many years. It's always been profitable for at least the last 5 years.

[Operator Instructions] Our next question is coming from Sam Kidston from North & Webster. Samuel A. Kidston - North & Webster, LLC: Just one quick question. Could you just -- you talk a lot about revenue growth. What was the year-over-year revenue growth, and what do you expect going forward to next year?

The revenue growth was about 3%.

Yes.

This year. And we believe it's going to grow, Sam. We just haven't indicated what that will be. Samuel A. Kidston - North & Webster, LLC: Do you think it's still in those low-single digits, or do you pop up toward the double digits in '14?

As Victor was pointing out, I think one of the things that we're looking for growth is in the service business, which is obviously better margins, but smaller dollars in total compared to selling products. So there's -- we're in this -- the growth is important to the bottom line, and the top line growth may not be as brisk as we've had in the past, Sam.

No, I was just saying when you -- when making the transition to more managed services instead of selling a lot more product, the top line revenue, as Gary had mentioned, is not as important. We're trying to move the business to more profitable business of -- and reoccurring revenue. So that's -- I've mentioned that in the last couple meetings we've had about kind of a transition in part of the strategy. So that's -- so the top line revenue, we're not exactly sure how much that may grow at this point.

[Operator Instructions] Our next question is a follow-up from Daniel Zeff from Zeff Capital.

Are you looking at more M&A activity? And are there more opportunities to buy smaller companies?

Our eyes and ears are always open, and we look at a lot of things that we have over quite a few years. And if something makes sense that can be accretive immediately or gives us some value on other parts of the business, we will definitely look at everything.

Victor, are you going to be able to provide guidance moving forward on the next call or in 2 quarters or at some point in the future? And what is the 3- to 5-year plan to unlock shareholder value here? The stock is trading for an enterprise value of $15 million or $16 million on almost $100 million revenues.

The guidance, that's something we'll discuss with the board on how much more we divulge moving forward. And I think over the last year -- it's only been 12 months since I've been here. I think we've made a lot of changes with the dividend and increasing it and the strategy, which I think I have outlaid over the last 2 or 3 calls very specifically of where we're trying to grow the business. And if acquisitions and M&A is part of it, we'll definitely look at it.

Our next question is coming from Joseph Murges [ph] from [indiscernible] Investments.

A couple of quick questions. One, on the E-2D program, did you say you thought there would be a delivery of 32 to 37 planes through 2018? Is that the number? Is that correct?

That's correct.

So you're looking for something in the neighborhood of 6 to 7 planes a year subsequent -- after, let's say, next year, in that neighborhood, to come up with those numbers?

That's an estimate. As you may have heard on -- before, that each year the budget gets approved. So there's no guarantee, but that's just what's estimated at this point.

Right. In the government's budget, they show you projections of what they think the planes are -- and they show the rollout. If you get -- look at the Defense budget. So they give you at least the projected that they're going to have, and that's what we're saying. And that -- in that, that's 32 planes. And then talking to the customer, there is some upside that's potential. So that's where we get the numbers.

Okay. And if I recall, there are still -- on the total program, what the Defense Department wanted to buy was something in the neighborhood of 75. Now you've delivered, what, approximately 10?

There's been a delivery of 15.

15. So is there around -- around 60 planes would be the remainder of what they would initially wanted? Is that correct?

Well, it's -- I mean, that's what they -- when they give the initial procurement, but obviously, as you know, with the budget situation in Washington, it becomes very difficult to know exactly what the total program will be. As they tell us, it's a year-to-year item, and ultimately, they had originally said it was 75. They haven't adjusted that, but the rollout doesn't seem to include that many planes.

I understand, but at least initially they were looking at the 75.

You are correct.

That's correct.

Yes.

One other -- a little bit -- a little more color on this Myricom acquisition. Now you were saying they profitable for the last 5 years. But you didn't buy the company in whole. You bought assets.

That's correct.

So you didn't buy the entire operation. Why wasn't Myricom, if they were profitable -- why -- do we know why they couldn't sell the company in total to somebody?

They sold a portion of the company, so a portion -- a major portion of their technology was sold.

To us?

No, to someone else.

Okay. So there's -- and so of -- and how many people did we add with the Myricom acquisition? I assume some people came with our asset...

Well, we hired them.

Right, so I believe there was 11.

11. Do we have any idea of what kind of revenue that section that we bought in last year would have generated?

No, because everything was mixed together. It wasn't broken out. So it became difficult because you had cross-selling that went on. I mean, we -- in our due diligence, we pretty much were able to at least break out at least the product lines that we had. But there was a lot of cross items that went on because it was a technology sale, and pieces of what we had -- we got were included in that. But we do have numbers, but we just aren't disclosing those.

Okay. And the 11 people, I assume, are located still in California? Is that -- or do we have -- have we incorporated them in our offices in...

They're in the West Coast, right, and other locations.

And you didn't take over the lease from the facility, I [indiscernible]...

No.

So they have separate offices, in effect, on the West Coast?

Well, right now, we're subleasing part of their space until we determine what we're going to do.

[Operator Instructions] Our next question today is coming from Brett Davidson from Investletter.

My impression of what's been going on has been pretty darn exciting. I do have a question regarding Myricom. And I wonder if you guys can give me little color in exactly what it is that we bought and how that fits into CSP's business.

Well, we bought technology that we were buying from them for many, many years to continue supporting our CSPI customers. And also, they also another technology with some boards that are more in the commercial space. So that was a -- it's a building block for us to continue developing their technology, and it gives us another platform and new products to cross-sell, both into the current government space and also into commercial space, where you have commercials account that require a high fast processing -- speed boards. So that's kind of where we're moving forward with that. So it was a very good acquisition and it was a comfortable one based on the relationship we had for quite a few years, and it gives us a stepping stone to move forward for the future while we continue supporting our current customers.

So on the commercial side, would that be something typically like server firms, or am I going in the wrong direction here?

No, the board's going to server. That's correct.

And as far as integrating it in the CSP, I mean, is this -- so obviously, you guys have done business with these -- this firm for a while. Is this something that's integral to the servers that we're selling and are there, I mean, other supplies of these type of products?

There are components that they manufacture that go into our boards on the CSPI side, but they also have their own products that they have been selling through distribution, both here in the States and internationally. So we're leveraging distribution with their current technology in their software. They're in the process of developing the next generation of product to continue selling to distribution OEMs and potential end-user customers directly.

Now does that distribution network have advantages that we're going to be able to take advantage of over and above the products that Myricom provides?

I'm -- what do you mean by that?

Well, I mean, I'm -- we have distribution channels for our products. I mean, is there's something that the Myricom distribution channel has that we currently don't have?

Well, they have access to a lot of integrators, right? So if we sold to an Avnet, for instance, that distribution that hold the product, they have access to a lot of customers where it's other integrators selling their product to other end users.

And that's something a little different than what we currently have.

It's completed different. We really -- most of the CSPI customers are being filled directly. And as the Modcomp side of it, we are one of those integrators that buy from an Avnet or Ingram or Tech Data or whoever else, like an IBM or EMC or some of the normal products that we represent and resell.

And is that a channel that we possibly have a possibility to start selling into, based on this Myricom?

We're selling -- the customers, right now, in the Modcomp side of it, we're one of the distribution customers. We're now -- distribution becomes one of our customers on the Myricom side.

But I was thinking more along the lines of Modcomp finished products selling back into that...

No. We buy from those distributors. Modcomp buys from those distributors, where Myricom on the side, because they manufacture our products and software, that distribution is actually our customer on the Myricom side.

[Operator Instructions] 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 and for your support of CSP. We look forward to speaking with you, all, again, on our first quarter call.

Thank you.

And that does conclude our conference call. Thank you for joining us today.