CSP Inc. (CSPI) Q2 2018 Earnings Report, Transcript and Summary

Good day, ladies and gentlemen, and welcome to CSPi's Second Quarter Fiscal Year 2018 Conference Call. My name is Keith. I'll be your conference operator today. At this time all participants are in listen-only mode. We will conduct a question-and-answer session toward the end of this conference call. [Operator Instructions]. I would now like to turn the call over to CSPi Chief Financial Officer, Mr. Gary 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'd 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 those sections on forward-looking statements included in the company's filings with the Securities and Exchange Commission. During today's call, after Victor provides an introduction, I'll discuss our second quarter financials. Victor will come back for an update on our business segments and on our strategic progress. And then we'll open it up to your questions. With that, I'll turn it over to Victor.

Thanks, Gary. We had a busy second quarter as we made good progress on our strategy to move from a company focused on defense related multicomputers to a growing managed service business that capitalizes on the demand for cybersecurity products in the proliferation of wireless. We grew our base of managed service customers and focused time and resources on the development of a innovative new product that will open new market opportunities in cybersecurity. Financially, revenues were down 13% for the second quarter, due primarily to softness in the European Technology Solution business as well as the timing of the E-2D orders in the High Performance Products, coupled with the delay of new product launches in the segment. On the bottom line, we reported a loss of $0.16 versus net income of $0.11 a year ago due to lower year-over-year volume and planned investments in new product development. In the High Performance Products segment, we continued to work around the clock to advance our next generation cybersecurity products. During the quarter, we made progress in advancing the development of our ARIA security platform to capitalize on the opportunities in a new growth market. In Technology Solutions, we continuously increased demand for our managed IT services and wireless security offerings. After Gary reviews our financial results for the quarter, I'll come back with a detailed review of our achievements and our progress in Q2 by segment. Gary?

Thanks, Victor. For the second quarter of fiscal 2018, revenues decreased 13.2% to $22 million from $25.3 million a year ago. Our total cost of sales was $17.1 million, down 13.1% from the prior year, in line with the lower sales volume. Gross profit for the quarter was $4.9 million or 22.4% of sales compared to $5.7 million or 22.5% of sales a year ago. Second quarter engineering expense was $715,000, up 3.2% from $573,000 a year ago. As a percent of sales, Q2 engineering and development expenses rose 3.5% from 2.3% last year as a result of increased engineering staff in our ARIA software defined security platform. Q2 SG&A expenses were $4.9 million or 22.3% of sales compared to $4.5 million or 17.8% of sales in the previous year. The increase was due to the investment for our managed services business as well as in the sales operation to capitalize on growth opportunity in our managed services and security. Our second quarter earnings reflect a tax benefit of $128,000 compared with the tax expense of $211,000 in the second quarter of last year. Net loss was $590,000 or $0.16 per share compared with net income of $428,000 or $0.11 per share a year ago. Cash and short term investments were $12 million compared to $13.9 million at 2017 fiscal year-end, due mainly to payment of the quarterly dividend, reduction in accounts payable and accrued expenses, which was partially offset by the decrease in accounts receivable. Lastly, our Board of Directors voted to pay a quarterly dividend of $0.11 per share to shareholders of record on May 31, 2018, payable on June 15, 2018. Our financial priorities for Q3 and the remainder of 2018 will be to improve our bottom line performance by increasing the level of our high margin products and containing costs across the organization. I'll now turn the call back over to Victor.

Thanks, Gary. Let's jump into our segment review, starting with the High Performance Product division. HPP revenues were $1.8 million, down 48% from last year, primarily due to slower sales in our multicomputer product business as well as the delay in the launch of our new ARIA cybersecurity products. Multicomputer sales this quarter were primarily for boards for projects within the E-2D military programs. We continue to expect the bulk of the E-2D program royalty revenues in the second half of fiscal year. Sales of our legacy Myricom ARC Series 10-gig network adapters products were stable, although we continue to anticipate a long-term decline in the product line. As you know, in 2017 we began investing in the development of the next generation cybersecurity products to counter this decline. These next generation products include the new ARIA software platform, which provides advanced cybersecurity protection capabilities for critical data assets that need to be accessed by end users in applications in both the cloud and in on premise. What differentiates ARIA in the market is that it allows developers to build security into their applications without having to be a cybersecurity expert and enables enterprises to set specific security policies for those applications through ARIA, which will automatically implement these policies across the organization. During the second quarter, we worked closely with our customers to add new security services to the platform. For example, we developed a flow as a service functionality, which picks up critical data flows inside the data traffic, identifies applications and then steering critical data flow for further analysis that can be performed by Myricom nVoy series. By adding the flow as a service functionality, we now have the opportunity to grow ARIA revenues in a brand new market for us, the managed security service provider, or MSSP market. Some of the world's largest service providers are interested in the solution that is being addressed by the new ARIA functionality. So we have extended our development work to meet the MSSP needs and broaden our total available market. Because of this added work, we expect to go into beta in the current third fiscal quarter and then begin to realize some revenue from this new market by the end of the year. We're also working on development of new cybersecurity opportunities in the virtual storage in hyperconverged markets. Within these markets, we are leveraging the security intelligence adapter to capture revenues from the demand for better encryption services. At the 2018 RSA conference last month, we released microHSM, a new capability of our ARIA SDS platform that provides full encryption in key management, allowing these functions to run at wider rate, which improves application performance. This open standard-based approach saves our customer's money and delivers 10 times the performance of a traditional hardware security module. The microHSM announced in the partnership with KeyNexus and P6R allows us to deliver simple and seamless end-to-end key management interoperability protocol, an experience never before seen in the industry. We are also encouraged by the ARIA's industry recognition as an innovative security solution. In March, the ARIA platform advanced to the final round of the 2018 Edison Awards, which recognizes the most innovative new products, services and business leaders in the world. And in April, it won the 2018 Fortress Cyber Security award for taking a radical different approach to enterprise-wide data security. To summarize where we are with the new cybersecurity products, we believe the opportunity is significant and there is a near-term demand in multiple markets. The opportunity to expand product functionality to enter the exciting new growth markets has necessitated additional investment and time to market, but we believe the potential return will be worth it. We expect to see the fruits of those efforts beginning in the fourth quarter. Turning now to our Technology Solution business, quarterly revenues were down 7.8% year-over-year due to softness in Germany and the U.K., partially offset by the strength in the U.S. In Germany, we gained traction with our managed service business, but reported a decrease in revenues in the second quarter due to timing issues. We renewed a service contract with a large multinational telecommunication provider and added new projects with another provider in that space. In the U.K., revenues were down for the second quarter as a result of lower level of business for major existing customers. In the U.S., sales growth that was driven by our managed IT and wireless security services. In February, we announced an additional $1.9 million contract to provide IT managed services to Broward College in South Florida. As part of this contract, we will design, deploy, integrate and manage a private cloud to support the enterprise applications. In wireless security, we continue to grow our business with major cruise lines. Less than a year ago, we won a contract to install wireless networks for 2 ships, 1 cruise line. Due to the positive reference from our customer, we are now working with 2 different cruise line companies in a total of 6 ships in the U.S. and Australia for the remaining of the year. Work includes site surveys to assess wireless coverage, install of controllers and access points and network configurations. To support our growth in this market, we have hired 4 wireless engineers and 1 project manager. Our result in the Technology Solutions demonstrate that we are successful in executing on our strategy, our new products are gaining traction and our managed service continues to gain momentum. Before I close, I like to note that we have been recognized as one of the top 40 best places to work in the small business category in South Florida among a group of 1,600 businesses. Our company culture was the biggest influencer in the ranking and we are grateful to our team members for their contribution to the exceptional culture. In closing, we are confident in our strategy to transform CSP from a company focused on defense related multicomputers to a growing managed service business that can capitalize on the demand for cybersecurity products in the proliferation of wireless. We are at an important junction in our strategy and we anticipate the near-term launch of our new product late in the fiscal year. We look forward to updating you on the progress. With that, I'll turn it over to the operator to take your questions.

[Operator Instructions]. We can go first to Joe Nerges with Segren Investments.

Well, I might as well ask -- the last point you brought up, you said you are expecting a new product launch late in this fiscal year. In our fiscal year or calendar year?

Yes, calendar year.

Will that be on our ARIA product or connected with that or something completely different?

No, on our ARIA product, yes.

It will be in the ARIA product line. Okay. So me being a little -- I picked up on your first part about this flow as a service. Could you please -- how can I say this -- explain that again to us so I understand a little more clearly what that service is that you're building it for the ARIA line?

To simplify it, it just allows us to look at the data quickly and accurately and then takes certain pieces of that data that looks incorrect and then to do further analysis on the nVoy recorder and broker.

Okay. So what you're saying to a certain extent is that you're tying that -- the capability into the nVoy recorder, broker and obviously managed service people can utilize that capability, even outside the [indiscernible] themselves. In other words, we as a managed service provider can utilize that with some of our managed service contracts.

In a secure -- yes, if we have a managed security customer, then yes. So lot of the big managed security providers, the big boys -- I can't mention who we're talking to, but you can kind of probably figure it out, that they have that offering and it's usually an add-on to their overall managed service or hosting in a co-lo. And if it's an option that the customer would want, they'd be able to use our product to do that analysis.

So it really opens up the potential for the managed -- any managed service contract provider offering this capability, utilizing this flow analysis that we've just built into the ARIA system.

Right. And the nice part about the whole thing, Joe, is it's on NIC card, right. So they can use it as a NIC card and they could -- just as a 25, 40-gig NIC or 10 if they want if they just have 10-gig. And then they can also -- it also does the security on the board and you don't have to have an appliance with it also. Right now it fits in a single slot. You need two of them for redundancy, but like I said, it replaces the current NIC card that they have and it can also offload the security on the NIC.

So it's like an adapter card that...

It's basically a NIC card. It's a card that fits in a server. It's a standard NIC.

So they wouldn't necessarily need our secure adapter. They could use just another -- a NIC card.

No, they -- it would function as both, as a NIC and a security adapter. It's has dual function.

Well, that seems like an exciting product with great potential to expand the capability of the area network.

Yes.

Let's go to the E-2D. What was the -- you say we got boards for the quarter. We have a few boards that we see. What kind of revenue did we get this quarter from E-2D, anything related, boards, versus what we did last year's quarter, 2017 quarter? Do we have that number?

Joe, it was very nominal in this quarter. We had...

And how about last year? Do you recall how much you shipped in the first quarter -- or the second quarter of last year?

To tell you the truth -- I think it was -- what?

2.5, I think.

Yes, I think it was about a little over $1 million.

Okay. So theoretically, if we had shipped -- if we had one royalty payment, which is around $600,000, right, approximately, we would have wiped out the loss for the quarter essentially.

Correct.

Right.

Yes.

Obviously, very important. And on that front, I did see -- and I don't know if you've got any more feeling -- you said you think there will be more deliveries in the -- is it the last part of -- half of -- or in other words, within this fiscal year or the calendar year?

I mean, our fiscal year. In our third and fourth quarter we're expecting royalties.

Some royalties, okay. On the -- I did see, and I don't know if you saw this, but the Navy asked the -- to be able to budget -- they're looking for multiyear contracts for two dozen more of these planes to be incorporated in the 2019 budget. So they're looking for some sort of a multiyear block purchase where they can save some dollars. I don't know if you saw that. But that was about a month ago they requested that information. So it looks like there's at least 24 more planes coming sooner or later. I'm a little confused -- not confused -- but let's go back to GDPR. That thing is set -- the GDPR compliance, European compliance is set as May 21st to start. Is that correct?

Right.

Then no delay on that front?

No, not that we're -- no.

Okay. I guess my question is, are we able -- we were able to of course ship the broker -- our nVoy broker and recorder. And currently are we not getting orders for those things, because -- are we finding any more interest as we get closer and closer to this May 25th start date? What has been the problem there or -- from shipping some of these -- some of that product? We don't seem to be getting a lot of revenue from this? And are we missing something here, am I missing something?

No. There's a lot of talk right now, but we haven't -- this conversation is happening, but no one is pulling the trigger at this point.

Well, I guess it depends -- how are they going to respond in 3 days if they don't -- do you think it's the -- when it finally gets implemented and a few people are actually...

Taking their -- yes, getting fined, probably.

That will open up the market considerably more. And I was thinking -- if I'm not -- shouldn't our European people be more involved with that product. If anything else, they're right in -- that our German and U.K. people are going to be directly involved with that, the European -- that GDPR situation. So they should be gathering some more interest, should they not?

They are having conversations right now at this stage. The thing is, Joe, you're getting a lot -- the few sales people we have out there, they've been selling services for so many year. Getting to sell products, to be honest with you, you just have to retrain them. So that's part of the process.

Well, I'm assuming we have -- we at least have introduced the capability of the...

No, no, they've been fully trained. They have evaluation units in Europe, so they are able to demonstrate the product locally to their customers. Yes, that's all been done. Conversations are happening, just not as fast as -- no one is pulling the trigger as fast as we thought.

Okay. And have we been able to expand our channel partner network at all? I know we hired a new man last year to help on that front. Have we been able to expand the network somewhat over the last, let's say, 9 months or so?

We have.

And I assume that they're trained on the nVoy series or at least they're attempting to be trained on that front.

Right.

On the microHSM addition that you also added to the ARIA platform. That was done with -- what, P6R is that and KeyNexus.

Yes, KeyNexus. There's two partners that have been developing some of the software that we will be able to work on our boards. So instead of reinventing the wheel, we just partnered with them very recently, within the last 30 days.

I saw it on the last press release, yes. On the beta testing, were we not beta testing this a couple of months ago? Or what we do call it? We were testing ARIA to some extent, right? You were -- at least you mentioned --

We were testing again -- and that's kind of where we -- some of the options that our customers were giving us feedback on. We went back and started to develop. And that's kind of -- it definitely slowdown the launch of the product just due to their feedback.

Okay. And so you are expecting beta test this quarter, you said some time in the third quarter?

Correct. It's going to be towards end of the quarter. We are hoping to get it -- we are working -- we've added engineers. We're fully -- we're staffed. I brought in consultants. We're putting everything in there right now to try to get this launched as fast as possible.

Yes. You have no idea how long a beta test might take on something like that.

Absolutely, no idea. I have no idea.

Depending on how well it goes, obviously.

Correct. And then, Joe, you're always at the mercy of the customers, right, how much dedication they have too with their internal people to get a beta test. That is a factor that people need to take in consideration. But so far the customers we have talked to are excited and they are giving us time and energy to do this, which is good.

Okay, fine. And I guess -- so your engineering expenses went up to $715,000 versus -- was it $595,000 last year vis-a-vis the same quarter?

Yes, $759,000 versus $573,000, right.

$759,000 did you say?

Yes.

Yes.

So that was a considerable jump in R&D expenses?

Right.

And I guess the last question I have is on the -- well, you mentioned that the pipeline for managed services is expanding. I'll list -- are we same -- you've got a lot of quotes out there that haven't yet closed, am I correct in that assumption?

Yes.

And of course you never know how long that's going to take, but you're hoping for obviously...

It varies, Joe. Some of the contracts we have, some of the smaller ones, you can close sometimes in 30 days. And some of the small ones take 6 months. And then you have some of the big ones that could close in -- it usually takes at least 90 days, right. This is -- you're talking about taking someone's infrastructure over or at least modulating the whole infrastructure, so it does take time. It's never a 24 hours type of deal with this. But as long as the pipeline stay strong -- you win some, you lose some. But we've been winning a good portion of what we've been quoting out there. So it's been going good. With some of the referable accounts that we have also, where some of the articles were brought that we're doing -- things are going well with the customers we have, so we're definitely leveraging their responses back to our customers. We're introducing them to -- whether it's a marketing event or just calling up and giving a reference. We're trying to use that as much as possible.

Okay. One final question. Maybe you don't want to even answer this. Is Vodafone a customer -- a managed service customer of ours?

I can't answer that.

Okay. The only reason I brought that up is -- I don't even know if you realize this, but they made a major merger announcement this morning where they took over Liberty Media's cable TV assets in Europe. And it was like a EUR 19.8 billion merger, a buyout, so for the record, let's put it that way. Thank you very much. I appreciate the feedback and it sounds like this ARIA product could be outstanding once we get it launched.

Yes, we're counting on it.

[Operator Instructions]. And it appears we have no more questions at this time, so gentlemen I return the floor to you for any additional comments.

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

Thank you.