CSP Inc. (CSPI) Q4 2012 Earnings Report, Transcript and Summary

Good day, and welcome to CSP's Fourth Quarter and Fiscal Year 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 e-mail. Later, we will be conducting a question-and-answer session. [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 over to Mr. Levine. Please go ahead, sir.

Good morning, everyone. Thank you for joining us. With me on the call today is Victor Dellovo, CSP's Chief Executive Officer. Before we begin, I would 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 SEC. Please refer to the section on forward-looking statements included in the company's filings with the Securities and Exchange Commission. With that, I'll turn the call over to Victor Dellovo, Chief Executive Officer. Vic?

Thank you, Gary, and good morning, everyone. We've got an excellent fourth quarter this year that includes some exciting operational highlights that I'll discuss in a moment. First, however, I'd like to make some initial comments about my transition to the role of Chief Executive Officer. As many of you are aware, CSP was saddened by the sudden passing of our long-time CEO, Alex Lupinetti, in August of this year. The company had been preparing for Alex's planned retirement, so it was unexpected to have to accelerate the succession plan. I was fortunate to have the opportunity to work closely with Alex during my tenure at MODCOMP. And I'm honored to be taking the reins as CEO. Alex accomplished a great deal at CSP, and we are now working to take the company to the next level with the new corporate strategy that I will be discussing today. The format of the call represents a slight departure from the norm. I'll start by providing the quarterly highlights, and then Gary will be -- take you through the fourth quarter and year-end financial results, as well as provide some commentary on our outlook for next year. And then I'll spend some time outlining our new strategy and vision for the future before we go to your questions. As I mentioned previously, we had an excellent fourth quarter and fiscal year. Both our segments increased revenue, and we generated strong gross margin and significantly improved EPS. In light of CSP's strong performance this year, our Board of Directors, on December 10, 2012, approved a special annual dividend of $0.20 per share, payable on December 28, 2012, to shareholders of record as of December 20, 2012. The board carefully evaluated our current cash position, considered alternatives for deploying our cash, including stock repurchases, and determined that paying another dividend was a prudent way to generate value for our shareholders. Going forward, the board intends to review CSP's financial performance, balance sheet and working capital requirements to determine any future dividends. I'll now break down some of the operational highlights of the quarter. Let's talk first about our Systems segment, which consists of MultiComputer business. This business sells primarily to major prime contractors that sell to the U.S. Defense Department. Segment revenue increased 41% year-over-year to $3.1 million during the quarter. We recorded $1.3 million in royalty revenue from Lockheed Martin for E-2D Advanced Hawkeye intelligence, surveillance and reconnaissance aircraft as part of Phase 3 and 4 of Low Rate Initial Production Phase, or LRIP. As you may recall from last quarter's conference call, we expected to receive royalties for between 8 and 10 planes during the fiscal 2012. With the 2 royalty payments in the fourth quarter, the fiscal year totals came to 9. As a result, we now expect to record revenues for the final plane on the purchase order sometime in the first quarter of 2013. Now -- turning now to our Service and System Integration segment, which includes our MODCOMP subsidiary, this segment provides solutions and services for complex IT environments, focusing on storage and servers, network and security, unified communications and consulting and managed services. Segment revenue in the quarter increased 33% year-over-year to $19.2 million. Sales were driven by continued strength in the hosting customers, as well as customers in the banking and hospital markets. All 3 of our subsidiaries in this segment reported year-over-year sales growth in the quarter. I'd like to highlight another piece of good news from MODCOMP that emphasizes our company's expertise and service excellence. MODCOMP and our partner Cisco beat out several other firms for the opportunity to design a custom secure network environment for all data and voice communications for the final presidential debate at Lynn University. As you can imagine, the requirements for this system were extremely rigorous, and our team's ability to respond to our customers' needs and provide timely valuable solutions for such a demanding, high profile event is a testament to our world-class capabilities. The sales pipeline for this segment is healthy, and we expect further growth and profitability in the coming year. I'll now turn the call over to Gary for a detailed review of our financials.

Thank you, Vic. Total sales increased 35% to $22.3 million compared with $16.6 million in the fourth quarter a year ago. Foreign currency had approximately a $1 million unfavorable impact on revenue year-over-year. On a constant-currency basis, revenues actually increased by $6.7 million or 40%. For the full year, consolidated sales increased 15% to $84.8 million from $73.6 million in the prior year. Foreign currency had a $2.4 million negative effect on the full year results. On a constant-currency basis, sales increased by $13.5 million or 18%. CSP's total cost of sales for Q4 were $16.7 million compared to $12.6 million in Q4 2011. Gross profit for the quarter increased to $5.7 million from $4 million as a result of the higher sales volume. Gross margin was 25% compared with 24% in Q4 2011. The slight increase in margins is attributed to higher systems royalties in Q4 of 2012 versus last year, as well as a higher percentage of sales from our Systems segment. Fourth quarter engineering and development expense was $400,000 compared to $300,000 a year ago. As a percentage of sales, Q4 2012 engineering and development expense was at 1.9% compared to 2% last year. As you may recall, our target range for engineering and development expense is 2.2% to 2.6% of sales. We expect in 2013 that the range will be between 2.4% and 2.7%. SG&A expenses increased to $5 million in the quarter from $3.6 million a year ago. Included in SG&A expenses for the quarter was $1 million from the cash surrender value of a life insurance policy death benefit, which offset the $2.1 million of proceeds from officer's life insurance settlement so that we have a total gain of $1.1 million. Excluding the cash surrender value of the life insurance policy from SG&A, the increase was the result of higher bonus and commission-based expense due to the improvement in gross profit and overall operating results. Our target range for SG&A expense is between 17.9% to 18.6%. Our target range for 2013 is 14.5% to 16.2%. We recorded a tax benefit in the quarter as a result of the reversal of valuation allowance on our deferred tax assets in the U.S. of $3 million. Management performed an assessment of the realizability of our deferred tax assets and concluded that it was more likely than not that the asset would be utilized based on our cumulative profits over the past few years and future earnings. In addition, we had the $1.1 million gain from the insurance benefit, which is tax-free. Net income for the fourth quarter was $4.9 million or $1.43 per diluted share compared with a net loss of $92,000 or $0.03 per share in the fourth quarter of fiscal 2011. For the year, we posted a profit of $6.6 million, or $1.91 per diluted share, compared with a profit of $369,000, or $0.10 per diluted share, in 2011. Cash and short-term investments increased to $20.5 million at September 30, 2012, compared to $15.9 million a year ago, due primarily to $6.3 million generated in cash from operations. Looking to fiscal 2013, we expect that the recording of royalties for 9 E-2D planes in 2012 versus the 5 that we had expected for the year will be -- will create a difficult year-over-year comparison. While we anticipate growth from our Service and System Integration segment, the timing of programs will most likely result in a loss at our Systems segment. Fiscal 2013 will mark an important transition year for us. And now I'll turn the call back to Vic to outline the unique strategy we are implementing to position the company for sustained, long-term growth and profitability.

Thank you, Gary. We believe there is a significant potential for growth in CSP's business. We have a new 5-pronged strategy to capitalize on those opportunities. The first element of our strategy is to cross-sell our Systems segment MultiComputers with our Service and System Integration software and services to become a more of an end-to-end supplier to our legacy customers, as well as to new customers and new markets. Our Systems segment has historically operated as 2 mutually exclusive businesses, with completely separate products and customers. With the advancements we made in our Service and System Integration business during the past few years, we are now seeing the opportunity to leverage our capability in this segment to enable our Systems segment to become a single-source solution for customers. This includes our traditional defense customers, as well as other government and commercial sector customers. When a customer buys a MultiComputer from our Systems segment, they also need to purchase networking storage and security products from companies such as Cisco, NetApp, EMC and VMware for the back end of the systems. In the past, customers have always made those purchases from other providers. However, these are all parts that MODCOMP can provide. We are taking action to be more fully integrated as a company with our sales, marketing and products so that our customers have the option to have one company configure, install, support and fulfill MultiComputer systems and software. There is no other company that is providing such a comprehensive offering. We've already had initial discussions with some of our customers about this strategic initiative with very positive feedback. Of course, this type of transition does not happen overnight. And we were working very hard to execute on this element of our strategy. We are cross-training salespeople at our Systems business to be able to sell our full suite of products and to further facilitate the process, we’re bringing on an additional salesperson with extensive knowledge of the Integration business to work with our Systems sales team. We are also developing co-branded marketing material for the sales force. One other area that we plan on -- to work on in the MultiComputer business is speeding our time-to-market, and we will be bolstering our engineering capabilities to effect the change. The second element of our strategy is to become a global partner to our customers by cross-selling between MODCOMP geographic locations. We have global customers of various network security, unified communications and storage and server needs in different parts of the world. To date, our subsidiaries in the U.S., Germany and the U.K. have not leveraged their customer relationships to cross-sell. For example, a global customer would typically buy the HP service from Germany subsidiary, and they also need Cisco and Juniper products in the U.K. or in need of EMC or NetApp products in the U.S. With a more integrated sales force, we plan to capture more of our global customers' worldwide spend. Much like we're doing in the Systems segment, we're also investing in talent at the Service and System Integration segment in order to take advantage of the opportunities we see before us. We've hired a full-time recruiter. And we're adding engineering capabilities in storage, virtualization and network security. We're also continuing to build our sales staff, including geographic diversification. The third element of our strategy, which Alex discussed on prior calls, is to focus on winning higher margin consulting, as well as managed service business. Our partnerships with nCircle and TechPoint continue to be successful in generating opportunities to extend our managed service and consulting business. That leads us to the fourth element of our strategy, which is to leverage and increase the number of partnerships on both the Systems and Service and System Integration sides of the business. As I mentioned earlier, at the Systems segment, we are looking at integrating partners' products into our MultiComputer to provide end-to-end solutions. And finally, the fifth element of our strategy, growth strategy, is to maintain a vigilant focus on cost control. We are reviewing every aspect of the business to ensure that we are operating in the most efficient manner possible. Reducing unnecessary spending enables us to invest in more critical areas, such as sales and engineering talent, to capitalize on strategic opportunities. I'd like to reiterate our enthusiasm for CSP's long-term prospects. While 2013 looks to be a transition year, we believe our new strategy will yield significant benefits down the road. The goal of our new strategy is not only to establish a track record of profitability growth, but to reduce the volatility that has been a characteristic of our business model. Of course, the timing of each of the E-2D shipment is a case in point. Broadening our opportunities, enhancing cross-selling across both the Systems and Service and System Integration segment should go a long way in reducing the extreme peaks and valleys in our sales from year-to-year. We look forward to reporting our progress to you in the quarters ahead. Before we go to questions, I'd like to note that I've enjoyed meeting with many of you after taking the reins at CSP. And I look forward to speaking with others in the weeks and months ahead as we meet with investors on the road and at headquarters. And with that, Gary and I will be happy to take your questions.

[Operator Instructions] Our first question is from Vincent Staunton with Wedbush.

Can you provide the operating income for each segment for the quarter?

I don't have it right here, Vince, unfortunately. I can contact you with that.

All right, that's fine. Also, in terms of royalty revenue, how much royalty revenues should we expect in fiscal 2013? Just one plane?

Correct. There's only one plane that's been ordered at this point. And we don't believe there'll be any others in the year, at least in talking to our customer.

And are you having success in getting new business in the Systems segment? For the quarter, I think you had -- was it $1.8 million in royalties and like $1.3 million in other revenue?

Yes.

Yes, we've talked to some of our other customers, and there have been some new potential projects that we have bidded on recently. And you know it takes time for that process to go through.

For the reversal of the deferred tax asset valuation allowance, how much profit did you need to anticipate to reverse that?

Well, I mean, basically, within the calculation, obviously, we need to transact the $3 million that we've done over the period. We don't really disclose that calculation. We go through a long projected analysis and look at things, such as the E-2D program and the numbers, but we haven't put that out, Vincent. And we don't give any forward projections. So -- but we believe based on our analysis, that we will have future profitability to cover that entire deferred tax asset and realize those deductions.

Our next question comes from the line of Brett Davidson with Investletter.

That certainly was quite a bit to digest, and I just have a couple questions for you guys. The SG&A expense -- so back end LLP [ph] expenses, that relates to that insurance?

Correct.

Ends up net at $1.1 million?

Correct.

So the effect on the operating income would have been, then it would have been about $1.2 million prior to tax?

About $1.1 million prior to tax. That was the gain, yes, $1.1 million.

So if we back out the $1.1 million from the $2.3 million leaves us $1.2 million prior to tax? I mean, what -- I don't have the figure offhand, but do you know offhand, Gary, what taxes usually run at, is it upper 30s?

Yes, between the state and the federal, yes. We have a blended rate that runs and, yes, between 38% and 40%.

Got you. Did you guys have any success in buying back shares over the quarter?

We bought some, very few, in the quarter.

But that's still an active program?

Absolutely.

And is that up for renewal or anything? I can't remember how long.

We have -- we had accruals; I think we got about 200,000 shares left in the buyback.

Is that limited by a date?

No, it's open-ended.

And the E-2D, I mean, you guys indicated that you don't have anything yet that there's any activity that will occur in fiscal '13?

Right.

I have seen orders going out for spares and some other activity on that. Do you know offhand, is that the first regular production run that's coming up?

We haven't been told that -- we don't have any information related to that right now, specifically from our customer. I know there's been a lot of projections, but nothing specific.

Do you guys have any indication what that first full regular rate run is going to be at? Is that going to be in the neighborhood of 7 planes, or no?

We don't really have it. Because of the budget situation, it makes it difficult, and they don't really speak. They just give estimates and projections, but they're all sort of hunkering down, so we don't have any details. And as soon as we're made available, we'll try to make them available for the shareholders.

[Operator Instructions] Our next question comes from the line of Sheldon Grodsky with Grodsky Associates.

My question is a partial rerun of the one we just had. But what is the potential maximum of the E-2D program if it comes to fruition? And obviously, this could be the end or just be the beginning. Do you have any sense of where it could go?

Well, the fleet, they have 75 planes in the fleet. And initially, they were going to be replacing all of those planes. And at this point, I think the number through the LRIP has been about 14 planes. But there has been nothing put out, whether the whole fleet is going to be completed. But with the budget situation, it's very difficult to follow, and we don't have any visibility at least at our level of that kind of thing at this point. So we're not sure with the rollout and the timing and whether they're going to replace the whole fleet. But the initial concept, the discussion was to replace the whole plane because it's over 20 years old, the aircraft.

At this time, we have reached the end of the question-and-answer session. I will now turn the conference back over to Mr. Victor Dellovo for closing comments.

Thank you for joining us today, and we look forward to speaking with you all again in Q1 call. Thank you.

Thank you.

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