CSP Inc. (CSPI) Q4 2016 Earnings Report, Transcript and Summary

Good day, everyone, and welcome to today's CSPI Fourth Quarter Fiscal 2016 Conference Call. [Operator Instructions] Please note, this conference may be recorded. I will be standing by should you need any assistance. It is now my pleasure to turn the conference over to Gary Levine, CFO. 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. Before we begin, I'd like to remind you that during today's call, we will be taking 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 filings with the Securities and Exchange Commission. During today's call, Victor will provide an update on our business segments and on our strategic progress, and then I'll discuss the fourth quarter financials. Then we'll open it up to your questions. Victor?

Thanks, Gary. Fiscal '16 was a very good year for us. Total revenues increased 16% with High Performance Products up 17% and Technology Solutions up 15%. During the year, we've continued executing on our strategy and built upon the positive changes we implemented in 2015. In the Technology Solutions, we enhanced our managed service portfolio and we continue to develop new products in High Performance Products Division to take us into new commercial markets, all while advancing our cross-selling efforts to add more value to our end-user, customers and drive higher sales per transaction. We also added talented sales and engineering personnel across the globe. Positioning us better to capitalize on our growth -- many growth opportunities. Turning to the fourth quarter. Revenues were down 7%, reflecting short-term softness in the Technology Solutions Division due to large customer buying patterns, primarily in Europe. We reported EPS of $0.14 versus $0.18 a year ago. In the High Performance Product division, our Myricom legacy product suite continues to perform above our expectations, and we have seen early customer interest in the 10Gb Ethernet adapter product with a network sensor or packet capture market. In the Technology Solution division, our managed service pipeline remains strong, recurring revenue is growing and our cross-selling strategy has been a great success. With that, I'll get ready to the segment review starting with our High Performance Product division. HPP revenue were down 5% in the fourth quarter, driven by slower-than-anticipation adoption of our newest generation of 10Gb network adapters as well as slowing in the legacy product line. We received royalty revenues for 2 E-2D planes that were approximately the same number of planes in the quarter a year ago. Looking ahead, our expectation is to receive royalties from 1 plane in Q1 and 5 planes for the remaining of fiscal '17, including international shipments. Myricom's historic product suite continues to perform much better than we had anticipated at this point. The revenue from these legacy products is starting to slowly decrease. To offset this expected sales decline, we've been investing in next-generation products, which have the potential to expand the commercial markets' reach of the division and be the primary growth drivers for HPP. While the FPGA network adapter product for the financial service market have been slow to gain traction thus far, we have multiple customers that are excited about the product than we hope to build off that customer base in the new fiscal year. Most of our investment resources are now focused on advancing the 10Gb Ethernet adapters for the network sensor market, targeting both OEMs and hyperscale data center end-users. We're building a solid foundation that customer's interest has been strong to date, and we expect this product to gain sales momentum over time. Now turning to the Technology Solutions business. Quarterly revenues were down 8% year-over-year, driven by softer sales in Europe. In Germany, revenues were negatively impacted by a timing issues, driven by a large deal that were pushed out of Q4 and into Q1. Operationally, we continue to make tactical changes to drive higher managed service sales and we're beginning to see more managed service deals in the pipeline. Penetration testing also continues to be a very strong market for us, and we're seeking additional engineers and penetration testers to support the growth. Looking forward, we expect our performance in Germany will rebound in the first quarter as we are able to recognize some of the larger deals that previously have been pushed out. In the U.K., while the top line grew nicely during the quarter, lower product and service margins and additional investments associated with hiring a few new salespeople affected the bottom line. The good news is that our new salespeople are starting to generate larger, higher-margin opportunities, which should benefit the second half of fiscal 2017. Looking forward, our focus remains on cost savings and improved efficiency to drive better profitability out of the business. In the U.S., our Q4 performance was solid. Our managed service pipeline remains robust, and we closed a few new deals. We are closing managed service deals at a greater frequency, and the recurring revenue stream is increasing. We continue to have success in vertical markets such as hospitals, schools, systems and wireless. The wireless security area has been very consistent and especially strong for us. We recently hired 3 new wireless security engineers to keep up with the pace of the growing demand. In addition, we closed deals for the installation and service around Office 365 during the quarter. We're capitalizing on the growing trend towards cloud-based computing, as a large enterprise rely to move their Microsoft Office applications from internal exchange servers to the cloud. With that overview of the 2 divisions, I'll now turn it over to Gary for the financial review.

Thank you, Victor. For the year, the revenues increased 16% to $103 million -- $103.4 million. We generated net income of $2.6 million or $0.67 per diluted share compared with a net loss of $210,000 or $0.06 per share for fiscal year 2015. For the quarters, revenues decreased 7% to $25.6 million from $27.7 million a year ago. Our total cost of sales for Q4 was $19.3 million, down 11% from the prior year. Gross profit for the quarter was $6.3 million compared to $5.9 million a year ago. Gross margins increased to 25% from 21% in the prior year as a result of increased gross margins in the High Performance Product and Technology Solutions U.S. businesses. Fourth quarter engineering and development expenses increased to $616,000 from $521,000 a year ago, from increased staff in the engineering department. As a percentage of sales, Q4 engineering and development expenses was 2.4% compared to 1.9% last year. This is below our expected range of between 3.5% to 4% because of the higher sales volume. SG&A expenses were $5 million or 19% of sales compared to $4.3 million or 16% of sales in the previous year. Based on our planned investment, we expect SG&A expenses in the range of 14.5% to 19.3% for fiscal 2017. The effective tax rate for the quarter was 18.8% compared to 43.5% in the prior year. The reduction in rate was due in part to the benefits from the research and development credits in the U.S. We expect our overall tax rate going forward to be approximately 40%. Net income decreased to $561,000 or $0.14 per diluted share compared to the net income of $653,000 or $0.18 per share a year ago. Cash and short-term investments increased to $13.1 million from $11.2 million a year ago as a result of increased profitability for the year. Lastly, our Board of Directors voted to pay a quarterly dividend of $0.11 per share to shareholders of record on January 27, 2017, payable on February 8, 2017. We aim to improve our bottom line performance by focusing on growth programs, increasing the level of high-margin products and aligning our cost-containment initiatives across the organization. Lastly, we delayed the filing of our annual report Form 10-K, which is due to expanded testing of revenue transactions for the company's European operations. As a result, the company's independent auditors had not completed their audit of the financial statements for fiscal year September 30, 2016. They have now completed the audit, and we will file our Form 10-K today. I'll now turn the call back over to Victor.

Thanks, Gary. Looking ahead, in the High Performance Product division, we're focused on the ramp-up of the 10Gb Ethernet adapters for the network sensor market, a space where we see good opportunity. We anticipate royalty revenue for 1 E-2D plane during Q1 and another 5 planes during the remainder of the year. As a result, we expect Q1 to be soft this quarter. The revenues would be higher as we proceed through the year. In our Technology Solution division, we remain focused on executing against our MSP strategy, which we expect to be an excellent driver of growth and recurring sales for the long term. Our pipeline is strong, and we look forward to capitalizing on the opportunity further. In addition, we expect to see continued progress on our cross-selling strategy between Technology Solution location as well as between Technology Solutions in the High Performance Products. We made very good progress during fiscal '16 against our strategic initiatives, and we're seeing positive results. We have created many opportunities for CSP, and we are looking to continue our momentum in the new year. And now we'll open it up to questions.

[Operator Instructions] And we'll go ahead and take our first question from Brett Davidson.

I just got a couple of questions for you. The tough quarter looked pretty good. I want to start off with the E-2Ds. You guys indicated that there's going to be 6 planes. Is there any indication that that's going to ramp-up over the next couple of years?

Right now, it's just -- we're going to go by what we're -- what they're saying. I don't think there's going to be any ramp-up. I think it's going to be consistent over the next 2, 3 years, 4 to 5 planes maybe. The international planes will I think ramp-up a little bit more, and the U.S. planes will kind of be ramping down over the next 2 or 3 years.

The indications that -- everything I've seen indicates that the expectations are they're going to ramp-up the 6 planes this year. Northrop is indicating that they expect 7 the following year and 8 the year after that. The -- they put out a -- I'm not totally sure the name of it, a request for bidder or whatever, but they mentioned a VIQ, a variable, oh geez, a variable -- oh, excuse me, a Variation in Quantity. So they put a bid out for 20 planes for lots 7 to 11, and the Variation in Quantity allows up to 40. Have you guys have any insight at all what a Variation in Quantity is?

No, not at all, Brett. We have not heard any of that. We're in contact with them all the time. You know the way it works. It goes year-to-year. They put those potential numbers out, but we actually don't know until we get the POs in the beginning of each in every year. [indiscernible] and things change. Well, no one has mentioned that to us on our conversations with them.

Yes. So they gave you guys nothing.

Right.

Absolutely nothing.

Now you also mentioned the international. Does that have to do with the Japanese plane?

Yes, the international customers will bid. And as you know, it's not at the same rate that we're -- it's about a half a plane for each one in revenue.

Yes.

That's still a nice bonus, considering you guys weren't sure you're going to be on there a couple of years ago.

That is correct, yes.

Nice. I wanted to ask about the increase in the pension liability. Is that going to be explained thoroughly on the 10-K? Or is that something you guys could add some color to?

It's primarily the discount rate. The discount rates in all of our plans has dropped significantly with the Brexit and European -- and those are the 2 biggest. The U.S. pieces are very small. The discount rates have -- so it's all floating through other comprehensive income, Brett.

So it's all just the European stuff all related to the Brexit, got it.

Yes, the rates have dropped dramatically.

How nice. Let's see, so just for clarification, the late filing, that was all due to the auditors not being able to get it done timely? It didn't have anything to do with the controls weakness or a new controls weakness, it was all just related to the auditors.

Well, it's related to the auditors as well as -- I mean, we did expensive casting ourselves. We want to make sure everything was correct. So we spent a great deal of time going through simply because we had issues, as you remember at the end of the third quarter. So we have reviewed between ourselves and the auditors about 90% of the revenues in Europe.

It sounds like fun, too.

Yes, but we just want to make sure everything was correct, and they were satisfied.

Got it. Now you mentioned R&D, the targets between 3.5% and 4% and that it was reduced because of the revenues the past quarter. So going forward, it's still anticipated to be between 3.5% to 4%. Is that going to be due to an increase in R&D spending or a decrease in revenues?

It's a little -- well, I think consistent, at least from what we're planning. We want consistent revenues, and then there will be increases due to some additional personnel as we're looking at some newer markets, which we can't disclose now. But we need to bring in some additional talent.

Got it. And so the spending looks to increase, and the vast majority of that is due to the Myricom products.

Yes.

Right.

And the last thing I want to touch on is because of the timing of the release, now the first quarter of '17 is done, can you guys add any color as to what the first quarter looks like?

We don't comment on that. We're, right now, just finishing up the audit and we're scurrying to get the first quarter done. We don't want to make any comments at all on the quarter right now, Brett.

And we'll go ahead and take our next question from Joseph Nerges [ph] with Sea Green Investments [ph] .

Let me -- just a follow-up on R&D. What did you say, Gary, was the R&D spending in the fourth quarter? I missed the total number.

Spending was $616,000.

Which was up from 4 -- $521,000 previous -- the previous year.

Right. Mostly because of personnel, right?

Okay. Do we have the total number for the year on R&D? Or just offhand...

Yes, the total number of the year was $2.9 million.

$2.9 million, okay. Let me interject a little bit here about -- a follow-up on Brett's question about the variable amount of -- that is being put out there by the government. I read -- I've got the 1 website, one of the -- there's a numerous number of government websites that follow military purchases, and they seem to -- and that 40 number that Brett put out there, it seems like the 1 site indicated that they thought the 40 number indicated a possibility, now just as a possibility of 20 foreign military sales.

No.

No. That doesn't mean they got the business. The only business that I know of is the 4 planes that Japan is going to order, 2 are already in production and I guess 2 to follow quickly thereafter. But the variable is depending on obviously from what that website it said, it has to do with whether or not Northrop sells more planes into the foreign marketplace. But they're, I guess, providing the option or at least with the suppliers to get prepared. I'm guessing that's what the government does it for, be prepared to supply the additional planes if the orders come through. But I may be wrong, but that's what at least the 1 website was indicating. If you get them, that would be great. Let me just ask, just for a follow-up, a question here, what -- when you talk about penetration testing, what's the difference between penetration testing and our Hired Hacker Service? That seems like almost like what we're saying there. We're trying to penetrate operation test there. What are we talking about?

Well, when we're doing on the Myricom product, it's a product that allows packet capture to analyze the packets going through to see -- it is a security product also, but it also looked at the packets and analyzing each one, and that's a product that we make to go into a server. When we do penetration testing, that's on the TSI work, a physical person that goes in with tools that -- usually third-party tools that we buy. And then at that point, we go in and we analyze the network, the security all away around it and then we look for hole that may be inside, whether it's the PCs for simple and just have antivirus on it with all the issues that come through there or whether it's the firewalls or whether it's coming through somehow through the network of people where they go to websites and then they download a certain program and then that program, all of a sudden, before you know it, it gets all your passwords. So that's another analysis that we do for corporations, to find out if they have any open areas where they could -- someone can come in and hack them. Of course, that's a big piece going on right now with everybody, all the name brands, Target and so forth being hacked with people's personal data. So that's a service we offer to various companies.

So it's a pretty extensive test that you're offering to the company with penetrative testing.

Yes, there's different forms of it, right, where we do a full network assessment or a company-wide assessment. So some of the pace, reports we give them could be 200, 300 pages of reports and then we kind of -- there's a nice GUI we put in front of it, which it's a simple red, green and red, that green is your burden; and yellow, you need to work on; and red, these are all your open issues that need to be closed immediately.

Now going to the Hired Hacker Service, that's sort of a smaller obviously type of testing. That sounds like you're testing there, too, with a Hired Hacker Service.

Yes, Hired Hacker and penetration testing is basically the same. We just basically branded it Hired Hacker, just for marketing issues.

Okay. So we're -- so essentially, they are the same thing then, penetration testing and Hired Hacker Services. And it can be rather extensive and depending on how much the customer...

How much the customer wants, yes.

I've got you. Now you -- in your last conference call, you talked about putting an emphasis on the German division or the group anyway for marketing more of the managed services. How was that progressing? I guess, you changed the commission schedule and to kind of emphasize that.

It's actually doing much better. The pipeline is growing and some things are -- some larger opportunities are ready to come to fruition very, very soon, which probably on our next conference call I can give you a little bit more light on some of the things that have happened.

Okay, great. For my background on this, the German group has been always very strong on security, that's what you've indicated in the past. How long -- what are we talking about? Is this something that's been over the last decade, the last 5 years where they've kind of been -- that's been their area of emphasis?

I would say at least a decade. That's how long I've been here, and they've always pretty much focused on security for the most part. So they are -- back then, I would say, 10 years ago, they also sold some storage and stuff, things like that. But now, over the last 4, 5 years, I would say the majority of everything they do is security-centric.

So in effect, the market is coming through you, really, with the amount of hacking that's going on outside there.

That's correct.

It seems like an ideal place to be in this time and age.

Yes.

Okay, very good. And I'm assuming that since you put our German manager in charge of the U.K., that's another area where they also are starting to emphasize, is that correct?

That's correct, yes. They're leveraging all the engineers and a lot of their marketing focus and sales focuses have been around the security area also.

So that's secured. Now in the U.S., how are we addressing the security area? Have we added any people there in penetration testing? Or is this a minor part of the U.S. operation?

It's growing. It's definitely growing. It wasn't a focus a few years back. We've always done security products, but the services around it -- as you know, the engineers are very expensive so we kind of grown that slowly. And we have hired multiple engineers this year, I think they're 3 new ones in the last year that have been with us, that are security focused. They also have some networking background because it kind of bridges very closely together. So we have done that, and that piece of the business has definitely grown. Some of the larger deals we did this year was with Check Point, and that was a new -- kind of a new product line for us. Germany has been a Check Point security focus area for a while, but we picked that up and we closed some large opportunities in hospitals. So that's been a good area for us, and that is definitely a focus for us. Some of the penetration testing we have both used internal and some consultants locally because we haven't been able to -- hiring these penetration testers, A, they're very difficult to find. So we've actually been able to team up with some consultants also to work with that security side, but also do the penetration testing.

Are we able to use some of our German penetration testers in the U.S.? Or is that just -- aren't extended too far? Do we...

To be honest, they have done some work for us, but they're so busy that they have more than enough that they can actually handle themselves, but if they -- they have helped us with some opportunities over 2016. But like I said, they have it more than enough work just to handle their own customers and opportunities in Germany, in the U.K.

That's good news. That's a more...

Yes, it is good news. Just like I said, it's been very, very difficult to find really, really good penetration testers. And basically, they're hackers that go in and find all the holes inside the network, so...

Okay. And in the press release yesterday, I think you've answered this -- you explained this morning. But in the press release, you talked about what the HPP focusing on the network sensors market. Are we -- is that the same as the packet capture market? Is there any -- is that a subset of packet capture? Or are we talking about the same thing?

A packet capture with a new Sniffer product that we've come out just to do some of the application layer analytics on it. So we keep developing. You'll see some new stuff coming that I'm not -- in the next couple of weeks, you'll see some of the new things that we're going to be talking about soon. You'll see some releases and stuff like that. But we'll keep developing new products over the -- continuously over the next years at this point.

So what you're saying...

We had a good day when we bought the Myricom, and now we're just -- we're adding to the product family.

Okay, so you're saying that the Sniffer product has been, how can I say, upgraded to address some of the sensor areas even more so than it did in the past?

Well, the ARC Series is a multiple point network adapter, right? It has Sniffer 10G, deliver pure packet capturing with flexibility to configure advanced function, and that's kind of what we're -- that's what we're -- at the pricing, that's a real pricing value out there. Some of -- there are other adapters out there, but they're $10,000, $15,000. So I think we have -- there are loss reliability and then definable functionality for the customer with -- at a price point that they can afford. So that's kind of what we've started with, with our initial ARC Series product, and we just continue to develop more functionality over the last 12 months.

Are we still -- are the OEMs still in testing with this? I know it's a very long drawn-out testing procedure for those guys, but is that still ongoing? Or are we moving on from the OEMs?

No. We're definitely going to continue to focus with the OEM. As you said, it's a long process, but that's a focus that we believe in the long run will definitely pay off if we can hit 1 or 2 of these OEMs then -- as you know, every time they sell a box, we're in it. So that's kind of our long-term goal.

So the previous ones you talked about, is that still ongoing with the ones with our -- are we on renewal OEMs?

It's -- some have come on, some fall offs. Some come on or some get delayed. So sometimes, they're just stagnant.

And have we expanded the hybrid salespeople? You talked about having 1 hybrid sales in the last time. Or is that -- you're talking about the cross-selling strategy. What are we doing there with cross-selling, to advance cross-selling, let's put it that way?

No, we're -- we've only have that 1 person so far. We haven't expanded that yet.

All right, very good. I think you've answered pretty much all of my questions. Hold on, just one other quick thing. Do we have a number of managed services, a revenue number from, let's say, 2015 to 2016? Do we know, I mean, I assume you know, the total volume of managed services business from year-to-year?

We have it. We're just not breaking it out right now.

Okay. All right. I appreciate it and congratulations. It seems like to me that the network security business will keep you busy for a long time going forward. I can't see it falling down anytime soon.

Thank you.

We'll take our next question from Jay Kumar [ph] with Midsouth Fund [ph].

My question is, did I hear it right that he said the first quarter's going to be weak compared to the fourth quarter? Or...

We didn't say, no.

You did say?

No, we didn't say.

You didn't say because -- I was wondering because you had some orders moved out from the fourth quarter into the first quarter. So just wondering if -- how much of that is going to add up? How much moved out?

Well, we don't really give the information out. A matter of fact, due to the lateness of -- where things are, we're right -- still in the throes of getting the information in from the subs in the field. So at this point, we're still accumulating that data. But we don't disclose. We don't give any guidance.

[Operator Instructions] And it appears we have no further questions at this time. I'd like to turn the conference back over to our speakers for any additional or closing remarks.

Thank you all for joining us this morning. We look forward to speaking with you again on our next call.

Thank you.

Thank you.

Have a good day. Bye.

And this does conclude today's conference. Thank you for your participation. You may disconnect your line at any time, and have a wonderful day.