CSP Inc. (CSPI) Q2 2012 Earnings Report, Transcript and Summary

Good day, and welcome everyone, to CSP's Second Quarter Fiscal 2012 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 email. Later, we will be conducting a question-and-answer session. [Operator Instructions] With us today are CSP's President and Chief Executive Officer, Mr. Alex Lupinetti; 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.

Thank you, Jackie, and good morning, everyone. With me on the call is today is our Chairman, President and Chief Executive Officer, Alex Lupinetti. I'll take you through our second quarter financial results, then Alex will review our operations before we take your questions. But first, our Safe Harbor statement. During the 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 the 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. With that, I'll review our second quarter financial results. We followed up a strong start to the year in Q1, with another solid quarter in Q2. Total second quarter sales increased 8% to $19 million from $17.6 million in Q2 fiscal 2011. This growth was driven by a 9% increase in Service and Systems Integration revenue to $16.7 million, while Systems segment revenue was flat year-over-year at $2.3 million. Foreign currency had a 2% unfavorable effect on revenue on a year-over-year basis. CSPI's total cost of sales for Q2 was up 7%, to $14.3 million on the 8% increase in revenue. As a result, gross margins for the quarter grew 11% to $4.7 million, and gross margins increased 67 basis points to 24.8%, compared with Q2 of 2011. The increase in gross margin was primarily due to higher royalty revenues recorded at the Systems segment. The second quarter engineering and development expense decreased to $474,000 compared with $508,000 a year ago. As a percentage of sales, Q2 2012 engineering development expense was 2.5% of sales, compared with 2.9% last year. Engineering and Development expense was within our target range of between 2.2% and 2.6% of sales. SG&A expenses increased to $3.6 million in the quarter from $3.3 million a year ago, as a result of increased commissions, bonus accruals because of higher gross margin and operating results. SG&A as a percentage of sales stayed flat at 18.8% on a year-over-year basis. SG&A is slightly higher than our target range of between 17.9% and 18.6%. The income tax expense was $191,000 compared with $144,000 last year, as a result of higher net income. We expect our effective tax rate will be approximately 35% for the third quarter of fiscal 2012. Net income for the second quarter grew 55% to $442,000 or $0.13 per diluted share, compared with net income of $286,000 or $0.08 per diluted share, in the second quarter of fiscal 2011. For the 6-month period, net income grew 34% to $903,000 or $0.26 per diluted share, on a 5% increase in revenue to $40.1 million. Now let's turn to the balance sheet. Cash and short-term investments decreased to $14.8 million from $15.9 million at year end. The decline was primarily a result of a decrease in accounts payable and accrued expenses; an increase in other assets and prepaid items; and an increase in accounts receivable; and the payment of the annual dividend. These items were partially offset by an increase in deferred revenue, higher net income, and a decrease in inventory. We continue to manage the company with strict focus on controlling expenses and efficient working capital management while driving towards a long-term profitable growth. With that, I'll turn the call over to Alex.

Thanks, Gary, and welcome to our call this morning. With another strong quarter in the books, we're increasingly optimistic that fiscal 2012 will shape up to be a great year. Our gross margins for the first half of the year are up year-over-year by about 90 basis points to 23.8%. This was due to higher systems royalty revenue and our focus on consulting, as well as solutions and managed services in the Services and Systems Integration segment. As a result, we've leveraged 5% sales growth year-to-date, into a 34% increase in net income. With that as an introduction, let me give you a quick update on what is driving our top and bottom line growth with our 2 segments before taking your questions. Let's talk first about our Systems segment, which consists of our multicomputer business. This segment sells primarily to the major plant contractors that sells to the U.S. Defense Department. During the quarter, we recorded $2 million in royalty revenue from Lockheed Martin with 3 E2D Advanced Hawkeye intelligence, surveillance and reconnaissance aircraft, as part of Phases 3 and 4 with a Low Rate Initial Production Phase, or LRIP. We've now received royalty revenue for 4 planes thus far, under the purchase order for 10 planes. On prior calls, we have discussed our expectation to receive a royalty revenue from the 10 planes, about evenly split between fiscal 2012 and fiscal 2013. However, we now expect that we could receive royalty revenue for at least 6, and possibly up to the entire 10 planes in fiscal 2012. Products and technology innovation are critical success factors for the Systems segment. Shortly after the close of the quarter, we introduced CSP's latest next-generation multicomputer. The TeraXP Embedded Server for OpenVPX with Intel Xeon processors. Essentially, this exciting new product future-proofs the converged fabric embedded server that we introduced in 2011, by using a new fiber optic interconnect. Using the TeraXP, customers can now seamlessly upgrade to higher processing or switching speeds by simply changing out the processor blades or network cards, and not the entire chassis. These new servers are ideal for a broad range of radar, sonar, ISR and EW applications. Turning now to our Service and Systems Integration business, which includes our MODCOMP subsidiary. This segment provides solutions and services for patent complex IT environments, focusing on storage in servers, network security, unified communications and consulting and managed services. The Service and Systems Integration segment continued to perform well in the second quarter. The 9% increase in revenue was driven by growth at both the German and U.K. businesses. This growth was partially offset by sales decline in the U.S. It was primarily a result of lower sales to our large hosting customer. The sales of this customer have become more project-based, so the revenue is more lumpy by nature. We're encouraged by the demand environment in the U.S. and have a strong business pipeline. During the past several months, we've won 2 large university networking contracts, each with a value of $1 million or more. Universities and other large institutions remain a fertile area for growth of our U.S. business. In Germany, the revenue growth continues to be primarily driven by sales to Vodafone, one of the largest mobile telecommunications network companies in the world. As we have discussed, we are consulting on the build-out of the infrastructure for their Global Security Operations Center, or GSOC. We expect to benefit from this project through the end of fiscal 2012 and into fiscal 2013. In line with that strategy, we are growing the higher-margin consulting as well as solutions and managed services side of the business in Germany, and our partnerships with nCircle and TechPoint continue to be successful in generating opportunities. Service revenues in Germany were up 14% in Q2, versus the year-ago quarter. The overall landscape in Germany looks good, and we are encouraged by the local economy and demand environment. Our pipeline in Germany is robust, as a result of the Vodafone business and other opportunities. And finally, our U.K. operation reported a triple-digit decrease in revenues. Keep in mind, this is off a much smaller base than our German or U.S. operations. Our value-added reseller business in the U.K. has grown rapidly and our consulting utilization rates are up from a year ago. So to summarize, before we go to Q&A, fiscal 2012 is shaping up to be a great year. At our Systems segment, we expect to report, greater-than-anticipated royalty revenue for the year. And in the Service and Systems Integration segment, we are encouraged by the demand trends in Germany, in the U.S. and the U.K. and our business pipelines are solid. We are particular pleased with the success of our Services strategy; and expect it to continue to have a positive effect on margins. With that, let's go to your questions.

[Operator Instructions] Our first question is coming from Sheldon Grodsky of Grodsky Associates.

I'm relatively new in following the company. And this is -- well, one thing that's been confusing me a bit or bothering me a bit as the case maybe, I think you said on previous calls that the royalty income that you're getting from Lockheed Martin is essentially all pretax income. And then it looks to me that aside from that, that you're losing money. So just try to explain, if there's any confusion on my part, as whether that is all basically pretax profits, because that succeeds everything else, that you'll be losing money on everything else?

Well that's basically it's -- we have to look at the whole company. We can't segment that one piece. If you pulled that out, certainly it would have a dramatic effect. But this is a program that we've been built-in for years and we're looking for it to support the whole company, and its based on products that we build. And from that assumption, it's just part of our sales mix.

It doesn't come without the support of the company to get the business. You can't separate it out and say it will -- it's only a sure profit.

Why wouldn't Lockheed just buy you? It seems that the course of that royalty, that they're going to be paying, especially if this contract is extended to become a full-blown program, it would be cheaper to just buy all of CSP than pay the royalties?

That's an interesting question. We -- yes, it's interesting. I don't know the answer to that.

Our next question is coming from Brett Davidson of Investletter.

I just got a couple of questions here. Did both segments have positive operating income?

Yes.

So both of them, then during the quarter?

Yes.

Let's see, so maybe you can just clarify, the E2D shipments, there's been 4 so far this year, and the purchase order for 10, or LRIP 3 and 4, and the remaining 6, possibly could be billed for the remainder of this fiscal year?

Yes, the reason we've upped that is, we've been working with them, as you know for about 7 or 8 years and we've gone through the SD&D Phase and LRIP 1 and 2, and we based our forecast on their ability to produce this equipment. And up until now, their maximum production rate has been about 5 systems a year. Right now, they're producing at a higher rate. And if they continue on that path, it could well be maybe between 6 -- we're estimating, between 6 and 10. No guarantee of course, because that -- the production rate could change between now and October 1. But...

Have you guys received any indication yet that they're going to be putting out the purchase order for, I think it's LRIP 5?

It's actually -- no the full rate production, FRP will be next. Discussion have started on that. We expect an RFP by the end of the year, but we don't have it yet, and we've looked carefully at the President's budget to see what's included in there. And it looks like there's -- the full rate production is in there, and it could be up to 24 planes over the next 5 years, down from 31. But that's obviously all in the flux when you're looking at a 5-year budget at this point. And it does not include sequestration which is another cloud that's hanging out there. So all that aside, and these are the factors we deal with, we expect that we will be seeing an RFP, hopefully before the end of the year for the first part of the full rate production.

And maybe one more thing. Has any consideration been given to -- maybe dropping another dividend payment sometime this summer?

That's something Brett that we will review at the board meetings. We've talk about it every board meetings and we will take it under consideration.

Our next question is coming from William Gibson of North & Webster.

Just a couple of questions regarding the MODCOMP division. Can you guys breakout gross margin from that division for me?

Okay, it was 17% or 18%.

For the quarter it was 16%.

16% for the quarter, and what's the year-to-date? Okay, so that's the range though, it runs at between 16% and 18% on average, varies a little bit. 17% for the year, so far to-date.

Perfect. And can you guys comment on any M&A activity you guys are involved in right now? I know you guys had mentioned that you guys are always looking at acquisitions, can you mention that one, for now?

Not really, we don't have anything to report at this point. We are active in the market. We have people who we work with -- it's, to find the right thing for us. It's a tough search and it has to be strategic, it has to be accretive. It has to fit with what dealing with. We're not going to diversify anymore. So it is a needle in a haystack kind of exploration we're on. And when we got something that we think is -- we can talk about we'll let you know. But we're active, but obviously we haven't done anything in a few years. So, it takes time.

Our next question is coming from Vincent Staunton of Wedbush.

I'm just wondering if I can get operating profit for both the Systems segment and the Service and Systems Integration segment for the quarter?

Okay, Gary will dig it out.

And while he's looking for that, my another question is, the large hosting customer, what percent of revenue was it for the quarter? And do you have any outlook going forward on that?

I don't know the percentage for the quarter, but our outlook is improved, because we had such a big first quarter with them. At this point, we expect that we will, do at least as much as we did with them last year instead of -- our original thought process was that we might see a continuing decline in there because of the large competitor they acquired. But at this point, there's enough projects that we're working on, that we feel that, right now we will do as much as we did last year, which is roughly around $10 million.

So you might not have K&E [ph] reduction?

Yes, that's -- right now, we're expecting not too.

Okay.

It's $230,000 for the Service and Systems Integration, and $438,000 for the -- I mean the Systems operating profit.

[Operator Instructions] Our next question is coming from Will Lauber of Sterling Capital Management.

Yes, I guess I'm -- on those profits that you're giving out, that's not fully allocated with the SG&A, is that correct?

Yes, this is operating.

Yes, its operating. Yes, that's operating with SG&A.

Okay, but when you guys -- do you guys break it out -- the SG&A allocated to the 2 different businesses?

Correct.

Okay, what is that total for each of the businesses?

For the SG&A?

Yes, or the final bottom line on each side?

Well, the final -- you mean, at the net income level?

Yes.

Well the net income level is -- for the quarter was at -- one of the things I have Will is the tax allocation. I haven't found it on this sheet right now. We do it on a gross basis, the -- with the U.S. basis, going back and spread that back. So it's not a true reflection of -- what the tax number is. Consolidated U.S.

FFor Systems and MODCOMP.

For Systems and MODCOMP, included.

Okay, and how much of bonuses are you accruing for currently?

We don't give that out.

We don't really give that out right now. It's on a projected basis.

Okay, so is the bonus based off of the actuals versus whatever your plan was?

Right.

Okay, in the plan you have put in about 5 planes in there?

Sure.

Okay, will that be adjusted for next year? Because obviously, your going to beat that plan this year because of this -- the quarter orders are going to be accelerated and that's really at no doing of the management, would that be a factored into next year's budget, as well?

I don't understand what do you mean by next year's budget. I don't understand that process.

I mean, well for your bonuses, if you were budgeting 5 and you get 10, instead of 5 this year and 5 next year, you're going to get bonuses on 10. And that is really no doing of yourself and -- it was just basically, taking from next year. Would you -- next year in the plan will you put 5 planes in there, to make up for that?

We'll put what's ever in there that's going to be reasonably in the forecast. I mean it's -- we wouldn't load 5 in there unless there were 5 -- we had a purchase order for 5, or close to getting one for that.

I mean. I guess you understand what I'm saying is that, if you're going to get bonuses on 10 for this year, even though that you've -- you're management has nothing to do with that, that's something that you cannot control.

It goes both ways Will. There are years when we planned for 5 and get 3.

Well, I mean, there's no...

So it's -- this is -- you're into a theoretical situation here that -- I don't see where you're going with it.

Well I assume there is never any crawl backs.

Crawl backs?

Or that -- you don't ever have that give any money back if the plans go the other way, do you?

No.

They are 1-year plans, Will.

Our next question is coming from Daniel Zeff of Zeff Capital.

Thanks for a good quarter and for paying that dividend and buying back some stock. I appreciate it, as a shareholder. Have you -- first of all, do you expect to be profitable? And do you expect cash to increase on a year-over-year fiscal 2012 basis?

Yes. So cash is variable. Profitably definitely, it depends on how the accounts receivable hit at the end of the year. I mean I...

You should be cash positive.

It will. We were very -- yes, we're cash positive but we got very large customers, as you can see cause our accounts receivable over the last year or 2 to be quite large.

So it's timing of orders, to some extent.

Okay and have you considered a more aggressive shareholder actions in terms of seeking strategic alternatives, pursuing perhaps a Dutch [ph] tender offer, looking to sell the company, looking to sell parts of the company, based on your extremely low valuation?

Well, at least I'll have -- Dan these are always the things that we review. We reviewed them again at this board meeting, so we'll constantly looking for ways to create shareholder value.

There are no further questions at this time. I'd like to hand the floor back over to management for any closing remarks.

Thank you for joining us today. We look forward to speaking with you on our third quarter call.

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