CSP Inc. (CSPI) Q3 2014 Earnings Report, Transcript and Summary

Good day, and welcome, everyone, to CSP's Third Quarter 2014 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 e-mail. [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 to Mr. Levine. Please go ahead, sir.

Thank you. Good morning, everyone, and thank you for joining us. With me on the call today is Victor Dellovo, CSPI's Chief Executive Officer. But before we begin, I would like to remind you that during today's call, we'll take advantage of the Safe Harbor provisions of the 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 filing with the Securities and Exchange Commission. During today's call, I'll discuss our third quarter financials, and then Victor will provide an update on our business segments and on our strategic progress. Then, we'll open it up to your questions. As a reminder, beginning last quarter, we renamed our reporting segments to more accurately and clearly reflect the operating businesses in those segments. Our Systems segment is now called the High Performance Products & Solutions segment. This segment includes our MultiComputer business, as well as our new Myricom acquisition. Our Service and Systems Integration segment, which includes our Modcomp business, is now the Information Technology Solutions segment. Let's take a look at the financials for the quarter, starting with the income statement. Revenues increased 19% to $22.6 million compared to $19 million a year ago. The increase was due to $4.2 million of revenue increase from the High Performance Products & Solutions segment, offset by $600,000 decrease at the IT Solutions segment. Foreign exchange had a positive year-over-year effect of about $400,000. Our total cost of sales for Q3 was $16.5 million, up from $15.2 million in the prior year. Gross profit for the quarter was $6.1 million compared to $3.8 million as a result of the higher revenue. Gross margin for the third quarter increased to 27% from 20% in the prior year as a result of greater mix of the High Performance Products & Solutions segment revenue and $1.9 million in royalty revenue versus no royalty revenues last year. Third quarter engineering and development expenses were $0.9 million compared to $0.4 million a year ago, primarily as a result of the Myricom acquisition. As a percentage of sales, Q3 engineering and development expense was 4.2%, slightly above our target range of 3.7% to 3.9% and compared with a 2.3% last year. SG&A expenses were $4.2 million or 18.5% of sales compared to $4.1 million or 21.4% of sales in the year-ago quarter. On a dollar basis, the higher SG&A expense was due to increased costs from the Myricom acquisition and higher commissions at the High Performance Products & Solutions segment, offset by lower commissions at the IT Solutions segment. On a percentage basis, we are close to our target range of between 16.6% and 17.3%. We had a tax benefit of $36,000 in the quarter compared to a benefit of $200,000 a year ago. We reversed $360,000 of the liability from uncertain tax positions since the statute of limitations expired in the period, which offset the tax expense for the quarter. The effective tax rate for the quarter was a negative 4% compared to 28% in the prior year. We expect our overall tax rate going forward to be approximately 39%. We reported net income of $899,000 or $0.25 per diluted share compared with a loss of $478,000 or $0.14 per share a year ago. Cash and short-term investments decreased by $2.2 million from year-end. Key factors included: a $2.1 million increase in accounts receivable; a $1.2 million we paid in dividends; a $1.2 million increase in inventories, partially offset by $1.7 million in increased deferred revenues; and $700,000 increase in net income and other items. We will continue to focus on our growth initiatives, while improving on our bottom line performance by increasing our level of high-margin products and maintain a focus on cost containment across the organization. I'll now turn the call over to Victor for a review of the segments.

Thanks, Gary. Let's jump right into the segment review, starting with the High Performance Products & Solutions segment, which, again, includes our MultiComputer and Myricom business. Revenue in this segment was up $4.2 million to $4.8 million in the quarter. As Gary mentioned, this was driven by revenue contribution from Myricom, which we acquired in the first fiscal quarter last year. We also recorded $1.9 million in royalty revenue related to E-2D aircraft from Lockheed Martin versus no E-2D royalty revenue in the prior year quarter. The royalties in Q3 represented 3 planes, and we have already received royalty revenues related to 2 planes in the first half of the fiscal year. So we have reached our target of receiving royalty revenue related to 5 planes in fiscal 2014. We expect significant future opportunities as the production of the E-2D continues through fiscal year 2018. Let's turn to Myricom, which continues to perform very well for us. One of our growth strategies in the High Performance Products & Solutions segment is to diversify revenues, and Myricom gave us an immediate entry into commercial growth markets. By the end of fiscal year, about half of our revenues in the segment will be from commercial customers. Keep in mind that this is up from no revenues in the commercial customer in 2013. As we expect, their percentage will continue to expand as we introduce next-generation Myricom products that are aligned with our customers' requirements in fiscal 2015. Let's turn now to our IT Solutions segment, which includes our Modcomp subsidiary. Segment revenues in the quarter were down 3% year-over-year to $17.8 million. The year-over-year reduction in sales was primarily due to lower shipments to hosting customers in the U.S. subsidiary. We continue to see excellent traction in Germany, which reported another solid quarter. A double-digit increase in revenue was primarily driven by sales to an international technology solution provider and a large telecommunication company. During the quarter, we won a number of managed service contracts to run and maintain a system environment for the same large telecommunication customer. The initial contract is for 1 year, with a possibility to extend and grow in volume. This is another example of how our strategy to grow our managed service business is working. In fact, the percentage of our service revenue at our IT Solutions segment has increased 18% year-over-year to 27% of our total revenue in Q3. As we've discussed before, what managed service means for IT Solutions segment is a growing, recurring revenue stream at higher margins than our legacy commodity business. We also won a contract for professional service for a major international airport to provide a complete physical and wireless RF [ph] site survey and complete redesign of their wireless infrastructure. Wireless is a significant area of growth for us, and this is one of our largest wins to date. We have increased the number of our engineers in this area in line with our growing pipeline of wireless work with Aruba and Cisco, 2 of the key leaders in the market segment. We are enthusiastic about our prospects for long-term margin appreciation that we fully expect will result from our managed service efforts. In the meantime, we have made significant investments in the engineering talent to capitalize on the opportunities in front of us. Of course, such high-end service sales have long sales cycles, and consequently, our investments are resulting in short-term pressure on margins. Our U.K. business, while a small component of our IT Solutions segment, reported another excellent growth quarter. What's notable about the U.K. story is that about half of its growth was a result of cross-selling efforts in our IT Solutions business. You will remember that cross-selling between businesses is another important component of our strategy. Before we go to your questions, I'll leave you with a few thoughts. First, we recorded a good quarter on the strength of our High Performance Products & Solutions segment, driven by Myricom and royalty revenues for the E-2D. Second, we are making investments in our business to capitalize on excellent opportunities to accelerate our growth -- profitable growth. Third, we have the right strategy to take advantage of these opportunities. At IT Solutions, we are seeing the initial success of our efforts to focus on high-margin managed service business, and our pipeline is growing. We're also driving revenue growth through effective cross-selling. At the High Performance Products & Solutions segment, we are diversifying revenues by increasing our percentage of commercial customers. And finally, we are working very hard to execute on the strategy with the goal of enhancing shareholder value. And with that, Gary and I will take your questions.

[Operator Instructions] And we'll take our first question from Dan Zeff with Zeff Capital.

Can you discuss profitability moving forward? Do you expect to maintain profits? And what direction do you expect cash to go?

Well, we expect that we're -- we'll be profitable going forward. Yes, there's going to be ups and downs, Dan, just based on some of the lumpiness of the business, still. Obviously, cash will be positive definitely.

How is your internal visibility, even though you're not giving guidance? Is it increasing with more managed services business and the growing pipeline?

It's improving, yes. It's better, but it's still...

We're in the infancy stages of still changing more. As you can see, the professional service side of the business is growing. It's not where it needs to be, but we're in the right -- we're trending in the right direction.

How much cash is offshore now?

About 40%.

And we'll go next to William Kidston with North & Webster.

Can you just break out the profit from operations from both the IT segment and the High Performance segment?

Just one second. We had approximately $1.2 million in operations from the High Performance group, and then it was offset with a loss in the IT Solutions segment.

So about $300,000 in the IT Solutions segment, $350,000, somewhere there?

Right. Sorry about that.

And then -- perfect. And then in terms of engineering and development expenses, kind of going forward, is kind of a $950,000 range a good number?

Well, I think, at this point, we're doing a lot of development for the Myricom product. So I would expect at least -- we have to see how that business does. But it should be in probably a little less than that significantly.

I think it'll be a little less than that. It will be a little less. Right now, we're developing the next generation of Myricom products. So therefore, we want to go to market as fast as possible, so there's a little bit more investment on the R&D side currently. But we plan on -- to continue with the Myricom name and the product lines moving forward. So it's not going to be just 1 product in the commercial space. There's other avenues with life cycle of new products coming over the next years to come.

Sure, sure. And then, can you guys break out -- what majority -- of the $2.9 million in other revenue from the High Performance segment, excluding the royalties, what percentage of that -- or can you just break out what percentage was the Myricom product?

The Myricom was approximately half of it.

Yes.

Okay, perfect. And then was the other just other product for corporate and other defense?

Well, defense and...

Customer or...

Well, it's related to the defense business, both with services and product.

[Operator Instructions] And we'll go next to Joe Cenerges [ph] with Aserjan [ph] Investments.

I think my question is going back to High Performance. Do we see any visibility with the old MultiComputer line, with your -- the SERIES 3000 and the SERIES 4000 MultiComputer segment that's been out there for a number of years now in development? And I don't see any volume coming through on those. Any -- sales volume coming through with those. Am I correct in that? Or am I incorrect? Do we see any visibility on that front?

Well, we've got to number of proposals out there, and we do have some business with some customers on an ongoing basis with the 3000 SERIES product. But the wins that we have right now have been very limited.

Do you anticipate that increasing? Or are they -- you say that there are a number of proposals out there, likely to result in some decisions over the next year or 2 years?

As you know, any time in the government space, it takes years for decisions to be made. So there's no way to give you clearance around that. It could be a year. It could be 2. It's all on their timeline, which that's -- part of the strategy to take out some of that lumpiness is to go into that more commercial space, with the Myricom, to try to even out the serious dips when something's not coming in and we're riding out the timeline of those potential projects.

And just one other follow-up. Do you expect any additional deliveries of E-2D this year? Or are you looking for next fiscal year?

There is a potential of maybe 1 plane in Q4.

And we'll go next to William Kidston with North & Webster.

Just one follow-up quickly, guys. Can you comment on the inventory levels and the reasoning why it kind of spiked up a little bit and what you're going to see going forward for inventory levels?

Well, the inventory levels, obviously, there's -- some of that relates to having Myricom in there and other pieces of the inventory or timing within the Modcomp group from orders that we can't take revenue on so that the inventory hasn't been released from that, as well as we've had some part purchases for the MultiComputer.

Perfect. And so going -- are you guys expecting that to come back down into the $5 million range going forward?

Yes. It's going to be one of those things -- because the way that we have to buy products for the Myricom is that you do larger buys, first thing. So it will build and then come back down so -- at certain stages for delivery of products in that segment since we have to buy larger volumes of finished products.

Sure, sure. And just one other question. I've noticed that your days payable outstanding has kind of been ballooning over the last couple of quarters. Any comment there?

We have 3 large customers who have extended terms that are basically European customers, and so they have 90-day terms. So that's what happens, Sam, is that they extend out. And they're major customers.

Okay. So that was regarding days sales outstanding. But in regards to the payables, is that mirroring the sales? Do you guys get those similar terms as well from your vendors?

In some cases.

In some cases, we do, yes. We try to mirror that if possible. If we're giving 90, we get 90. But it doesn't always work that way.

[Operator Instructions] And it appears we have no further questions at this time. I'd like to turn the conference back over to Victor Dellovo for final remarks.

Thank you for joining us today and for your support of CSPI. We look forward to speaking with you again on our next year-end call.

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