CSP Inc. (CSPI) Q3 2019 Earnings Report, Transcript and Summary

Good day, ladies and gentlemen, and welcome to the CSPi’s Third Quarter Fiscal 2019 conference call. My name is Priscilla, and I will be your coordinator for today. [Operator Instructions] I would now like to turn the call over to CSPi Chief Financial Officer, Gary Levine. Please proceed, sir.

Before we begin, I'd like to remind you that during today's call, we will 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 Securities and Exchange Commission. Please refer to the section on forward-looking statements included in the company's filings with the SEC. During today's call, after Victor's introductory remarks, I'll discuss our third quarter financials. Victor will then provide an update regarding our business segments and strategic progress, and then we'll open it up to your questions. With that, I'll turn it over to Victor.

Thanks, Gary, and good morning, everyone. We are continuing in our transformation to cybersecurity, wireless and managed services company. In the third quarter, strong demand for our managed services IT was partially offset by soft multi-computer sales. Overall, however, we had a solid year-over-year revenue growth as we invest in our cybersecurity products and pipeline including our ARIA platform, which is poised for growth over the next fiscal year. After Gary reviews our financial results for the quarter, I'll come back with a review of our progress in Q3 by segment. Gary?

Thanks, Victor. For the third quarter, revenues were up 8%, $21.6 million compared to $20 million a year ago. Our total cost of sales was $16.7 million compared to $14.8 million a year ago. Gross profit for the third quarter was $4.8 million, down from $5.2 million a year ago. Gross margin was 22.4% compared to 26% a year ago. Third quarter engineering and development expenses was $583,000, down from $895,000 a year ago. The decline is attributed to a reduction in contract labor required last year to help in building out the foundation of the ARIA software platform and a recovery of consulting expenses where the services were not completed. As a percentage of total sales, engineering and development expenses was 2.6 -- 2.7%, down from 4.5% last year. Q3 SG&A expenses were $4.1 million or 19.1% of sales compared with $4.1 million or 20.4% of sales in the previous year. We had a third quarter tax benefit of $326,000 compared with a tax expense of $249,000 last year. The tax benefit was a result of a higher effective tax rate due to no tax expense for the U.K. income due to a large pension contribution, adjustment of the taxes payable and reconciliation of the tax provision to the prior year's tax return and benefit of the research and development credit. The effective tax rate for the quarter was 158% compared to the 36.6% in the prior year. Net income from continuing operations was $532,000 or $0.12 per diluted share compared with income of $3,000 or 0 per diluted share a year ago. Net income in the third quarter of 2018 included a loss of $428,000 from discontinued operations. Cash and short-term investments were $16.8 million at the end of the third quarter, down from $25.1 million at the close of the fiscal year 2018. The decrease was due to $3.6 million increase in accounts receivable due to order timing, an increase in inventory of $2.7 million primarily for in-transit shipments that were not received by the customers until after the end of the quarter as well as $1.8 million paid in dividends. Lastly, our Board of Directors has voted to pay a quarterly dividend of $0.15 per share to shareholders of record on August 30, 2019, and payable on September 13, 2019. Looking to the fourth quarter, we will continue to focus on bottom line performance and to boost sales of our higher-margin products while managing costs around the company. I'll now turn the call back to Victor.

Thanks, Gary. I'll now provide a segment review, starting with our High-Performance Products division. HPP revenues were down $2.1 million compared to $3.1 million last year. The delay in our launch of our ARIA SDS cybersecurity platform related to supplier issues, we have discussed previously, is behind us and we are now shipping. In fact, we are looking to build up our sales resources for this exciting product. At the same time, as of right now, demand for our legacy Myricom products continues. In our multi-computer product business, we continued to see additional purchases for both parts and royalties for foreign military E-2D planes in the amount about $0.5 million during the third quarter. As it is typical for our military business, we have limited visibility into our E-2D order levels but expect similar performance in Q4. During the quarter, we saw a solid demand for our legacy Myricom ARC series products, including our first sale of Secure Intelligent Adapter, or SIA, which enhances threat detection and incident response of OEM products. We're also selling to companies that use dedicated teams of security operation centers to look for threats in their networks, including MSSPs. Moving now to our ARIA, our award-winning next-generation cybersecurity platform, which provides advanced protection for critical data assets that need to be assessed by end-users and applications, both in the cloud and on-site. As noted, we have put supplier issues that had delayed ARIA launch behind us. We are now shipping after ensuring that the ARIA card supports all the developed applications. While we do not anticipate a rapid initial ramp-up given the typical long sales cycle required when dealing with OEMs and MSSPs, we are excited about the growth prospects for the next year and are expanding our sales capabilities accordingly. First impressions from our customers have been very positive regarding ARIAs ease of deployment and ease of use. That is, of course, very encouraging for us. So from here, it is a matter of educating the market and staying committed to our sales and development efforts. We are seeing progress in the carrier/MSO segments for our ARIA products. We are in the formal planning process with one large operator who is looking to improve threat detection and investigations around the latest service offerings. Operators are motivated to add such capabilities for 2 reasons; first, as they roll out SD-WAN 5G and other services needed to ensure the infrastructure around offering, packages of advanced services is properly protected from attack. Much in the same way, commercial organizations have to protect their own internal networks. Second, they can offer their customer protection of their applications in data from network-borne threats as a value-added cybersecurity service. Such deals are complex and often require special integration efforts and have long sales cycles, but can provide a substantial long-term revenue impact for our business. We recently developed integration functionality with Demisto, SOAR product, that's a security orchestration, automation and response. The integration allows for greater automation of and push-button capabilities for security investigations when using ARIA out-of-the-box. This kind of functionality enables security teams to lower-level team members to identify and isolate threats. This is the first of many high-potential integration opportunities that we are working on. We continue to vet potential partners for our official channel program, which is aimed to expand to include resellers with security expertise in order to improve the sales funnel for our cybersecurity products. A robust channel program and expanded sales team will give us a strong platform for revenue growth. Turning now to our Technology Solutions business. Revenues in the third quarter were up 15% year-over-year. Our MSP or managed services practice continues to grow our existing customer base while bringing on new and exciting customers. We recently closed a significant deal with a large airline manufacturer, which we will start recognizing revenues in Q4. We also continued to grow our UCaaS, or Unified-Communications-as-a-Service, which is an all-in-one service for hard or soft phones, including 24/7 security and technical support, with redundant data centers located in Florida and Texas. We also continued to do well with our Microsoft practice after building up our engineering talent and investing in marketing. In closing, we remain committed to transforming CSPi from a focus on defense-related multi-computer to focusing on growth opportunities in cybersecurity, wireless and managed service markets. We are encouraged by our recent progress with ARIA, and expect to begin building revenues from this exciting product in the coming fiscal year. We look forward to sharing our progress with you in the quarters ahead. With that, I'll turn it over to the operator to take your questions.

[Operator Instructions] And we'll take over first question today from Joseph Nerges with Segren Investments.

Okay. So you did say, on the E-2D, you got about $0.5 million on E-2D planes, about $0.5 million this quarter in revenue?

Planes and parts, Joe.

Planes and -- was that $0.5 million? Is that the number...

Yes. That's correct.

And you're saying, you're expecting the same in the fourth quarter or something similar in the fourth quarter?

Right.

Yes. By the way, congratulations, we finally got the ARIA out the door. Are you saying that -- you did say, we shipped something in the third quarter, you said there was very little revenue, but something was shipped in the third quarter that was included in this report?

Correct.

But you are also saying that there was some supplier -- still supplier issues caused us to not ship some of the product that we could have probably if the supplier issue was taken care of?

No. It's just -- over the last 2, 3, 4 months, we were just -- we had the supplier issues, so it kind of slowed us down from developing our applications on the final chip that they had. And then when we finally were able to get a pretty much finished product from them then we're able to do a full testing on all the applications that we started to develop and then we had a finish test and go through the beta site and go through all that. So now, all of that is -- we will continue to develop applications and enhance performance. But right now, we were able to take what was available on the marketplace and load our applications on and we were able to make our first sale.

Okay. Great. And so we -- are we still beta testing some applications? Or is the beta testing pretty much complete?

No. Beta testing will continue for as long as we hold, just we continue to work with other manufacturers like I mentioned, Demisto, with companies like -- just big manufacturers of networking securities gear. So it's just not integrating into their products as well as continue our custom applications that we can sell standalone.

Okay. And other question would be on our R&D expense, which you said, was about $583,000 or something like that for the quarter. That was down because of less consulting expenses as I -- as you indicated.

Correct.

So is that approximately the level that we're -- we anticipating you're approximately in that $600,000 range per quarter going forward?

A $600,000 to $700,000 kind of range, Joe, because we did have our credit that we got back from a vendor who didn't complete a project.

Okay. I also see where your -- and you indicated you're expanding your sales efforts, particularly in the ARIA product line. You're looking for a channel director for the both the central part of the country and the west according to your all-new website, let's put it that way.

We're looking for direct salespeople in those locations. We hired a channel person last quarter, that started, I don't, about 3, 4 months ago, who's developing the channel, the resellers in the marketplace across the U.S. So he may -- he's developing those and as we grow, we'll continue to develop the channel, but now that we have a viable product that's working we're looking to invest in it somewhere between 2 and 3 initial salespeople and then as they grow, continue to open up different marketplaces.

It sounds like things are rolling pretty well and this ARIA pipeline is very exciting.

[Operator Instructions] We'll go next to Brett Davidson, a private investor.

I'm a little confused this quarter. Looks like there is quite a few changes and I get the impression; I'm looking at the new CSP and -- just kind of response to some of these questions here. So if I -- so there was very little multi-computer revenue and I take it that it was maybe a little less than the prior year's quarter.

Correct.

Had any order showed up to it? Or it's still looking pretty thin through rest of the year?

For...

For the multi-computer?

The multi-computer products?

Yes.

Yes. That's -- it's very thin right now.

And I assume you did see the release for the next 24 planes are funded? And I believe the Japanese got a couple of orders in right now.

Right.

The change in receivables is that something that's going to be the new normal. I don't know, we're going to see higher receivable levels now because of increased shipments of the ARIA products or is that just a onetime end-of-quarter thing?

That was -- we got some large orders out of the TS group towards the end of the quarter, it's not any -- and obviously, we'll have some building in that as we get into the -- a cybersecurity product. But right now, the large volume is going through the TS group.

Yes. The growth in the TS side, both on some of the larger projects and managed services side of it has been really, really good this year as you can probably tell, which is generating a lot of the revenue and almost all the profit for the organization. So yes, it's just timing. The way some customers purchase, it's always at the last day, at the last day and hour of the quarter. So just based on us having to purchase the gear and then able to invoice it or ship it, so like Gary said, it's all a timing issue. And then it will fluctuate just depends on customers.

So -- the sales of the ARIA products, is that more likely to lead to receivables than on the service side or no real difference?

More on the services side.

Got it. So the change in inventory, I mean is that the same thing, is this going to be...

[indiscernible] receivables.

That's all TS, yes, that's all just timing. We probably went out the next day or 2 days later, just depends on when we receive it or sometimes the purchase orders from the customers, the FOB destination and that means, it has actually to land for us to be able to recognize revenue.

So at least in the next couple of quarters, next quarter, next 2 quarters, there is not going to be a real change in inventory levels from a switch-over to the new ARIA products versus the legacy stuff?

Right. We're not going to be building a lot of inventory balances. I mean there will be fluctuations, but we're not going to build it up.

Yes. No, if we're able to get the products fairly quickly to where we're able to meet deadlines at this stage of the game and then as -- with some of these larger customers that we are talking to right now, some of the MSSPs, where it's -- could be hundreds of thousands as they potentially give us a rollout, we may stalk a few months or whatever as that comes up and that's early stages right now, let's put it that way.

So is there anything like long-term purchase order for the others? You guys are just pretty much ordering as needed currently?

For?

For the ARIA products.

Right now, we're still just talking to -- building pipeline and trying to close large -- these large MSP -- MSSP opportunities or working with the OEMs, you're talking long-term potential contracts.

Long-term as in long-term before they're signed or long-term as far as the length of contracts?

The length. When you get specked into a potential manufacturers, as long as they sell their product and either we do a licensing software agreement or we sell our boards, either way, it could go on 4, 5, 6, 7 years.

So I mean is that going to change how the orders for the product work? I mean are you guys going to need the change how that operates? Or is it just same thing? You guys just send out an order and they -- once they have it built; they send it back to you.

Exactly.

We'll keep the necessary inventory to keep our customers happy, not more, not less.

Got it. So you talk about it in terms of high growth, but that's kind of leaving me scratching my head a little. Can you just add a little bit of clarity to what you guys are looking at as far as high growth and how much of that will be at the extent of the legacy products? Or is this like a -- in total over and above what we've seen previously? Is this like a 10% to 20% high growth or 15% to 30% high growth, or maybe you can give us some idea what that looks like?

Well, the growth of the -- I don't compare it to the legacy products, that's a different animal whatsoever, that will continue until -- we're not investing much at all in the legacy stuff. So as that disintegrates and just falls off, this is the new life of the organization, is this new product line. So the growth -- we're looking at significant growth over the next 12 to 24 months. If it all goes well, it should dwarf all what we have ever done in the last 20 years.

So is that going to be at the expense of the legacy products? Or the customers are really kind of differentiating...

The legacy product is an old tech...

We haven't invested...

We haven't invested in that product in -- since I don't even know when.

Over the last...

What I'm trying to get -- are the customers that are ordering those products, those customers are going to switch over to new products down the road? Or is this -- are these 2 going to exist -- coexist with each other or is...

It's a different customer base. It's a different customer base, it's a different target.

So that might still just putter along like it's been for the next couple of years and just...

If I go back -- If you go back to where, I don't know, 2 years ago, 3 years ago, if you remember, I said, it was going to diminish at -- I think it was like 15% or 20% year-over-year. It's hung along way better than we thought it was ever going to and there's still a need and some of the things that we've done with it kept it going and there's definitely still need for the price and what we do out there, but it's something that -- we'll support as long as people want it, but the investment is all in this new technology.

Yes. But takes a lot of help to -- Those are going to continue at the same time the new product ramps up.

Absolutely. That was the goal and we'll keep taking the E-2D as long as that goes. And we aren't turning anything away. We're just kind of moving on. And then the other step that we've talked about where we talked about all the other stuff, but the stuff that with the TS side has been over the last 2, 3 years has really been generating all the profits of the organization. And now, we built the MSP 2, 3 years ago and that's a recurring-revenue model, right? Every month, we get -- we bill our customers and the profit margins are in -- they aren't in the low digits, they're in the middle 50%, 60% margin level. So it's like selling a product, but it's a recurring-revenue model.

Yes. So during the third quarter, how much of the sales was from the new ARIA products versus the legacy? Do they've started to transition at all? Or is it pretty much...

No.

It's just the initial.

No. It's just initial. And we expect it to continue for a little while until we close some of these opportunities.

So it's the big OEM deals are going to be the ones that are going to kind of drive this?

We're hoping to -- we're hearing all of it, the MSSPs, the OEMs and then direct commercial accounts like banks and all types of financial institutions, hospitals. We can focus on -- it fits into every organization. So there would be a commercial play that we develop with some of our partners, like a government play and then also selling to the OEMs and to the MSSPs, which, like I said, that's a -- when you're talking with those, it takes longer, but you're talking millions and millions of dollars for a long period of time.

Got it. So like the individual sales might be the first thing to come on board then?

Absolutely.

Right.

But they are a lot small. They maybe $100,000, $200,000, $500,000 type of opportunities depending how deep and wide and how big the organization is.

Got it. All right. That was a huge help. And I'm very excited to see that we're decently profitable with that.

That's the thing that we've -- I've mentioned on the call before, it's a start-up company, that's public, that's small, that's starting to drive profit at the same time and pay a dividend -- and paying dividend, all at the same time.

Yes. It's been a long time since the company has been profitable on a standalone -- standpoint minus the multi-computer stuff. Looks pretty good to me from my view.

Yes.

Good. Good.

So I hope that you're a little less confused, Brett, after that.

I am showing that we have no further questions at this time. I'll turn the call back to our presenters for any additional or closing remarks today.

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

Thank you.

This does include today's program. Thank you for your participation. You may now disconnect at any time.