CSP Inc. (CSPI) Q1 2013 Earnings Report, Transcript and Summary

Good morning, and welcome, everyone, to CSP's First Quarter 2013 Earnings Conference Call. Today's call is being recorded. The financial results news release is posted on the website at www.cspi.com, for those who did not receive it by e-mail. [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'd like to turn the call over to Mr. Levine. Please go ahead, sir.

Good afternoon, everyone, and thank you for joining us. With me on the call today is Victor Dellovo, CSP's Chief Executive Officer. 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 and 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, price pressures and others described in the company's filing 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 afternoon, everyone. I'll start by providing quarterly highlights and then Gary will take you through the first quarter financial results, as well as provide some commentary on our outlook. Then I'll provide an update on the execution of our new strategy. Given the headwinds that we're seeing on the Systems side of the business, our first quarter results were within our expectations. Revenue was about flat excluding the negative effect of foreign currency, and we reported a $0.03 profit, which was down from last year as a result of low mix of sales on the System business, including lower royalty revenue. Let's begin our discussion of operations with our Systems segment, which consists of our MultiComputer business. This business sells primarily to major prime contractors that sell to the U.S. Defense Department. Systems segment revenue declined 55% to $1 million due to lower sales to customers to support prior program wins as well as lower royalty revenue. The uncertainty relating to the federal budget certainly had an effect on the Systems segment performance this quarter. As we expected, we recorded royalty revenue for the final claim on the purchase order for Phase 3 and 4 of Low Rate Initial Production Phase [Audio Gap] of the E-2D Advanced Hawkeye intelligence, surveillance and reconnaissance aircraft. The next step for the E-2D is full-rate production. We are starting to see activity related to Lot 1 of full-rate production, which has been proved -- approved and for customer-request quotes. These products were being shipped this fiscal year, leading to royalties in fiscal 2014. At this point, we expect Lot 1 to involve the production of 5 planes. Beyond that, the government budget proposals for Lot 2 through 6, which not -- has not yet been approved, includes 32 to 37 planes through fiscal 2018. Our involvement is not guaranteed for Lots 2 through 6, but we have been asked to develop a quote for the associated costs. We are expecting a sequential increase of revenue for the Systems segment due to sales to international customers in the second quarter. Turning now to our Service and Systems Integration segment, which includes our MODCOMP subsidiary. This segment provides solutions for services of complex IT environments, focusing on storage and servers, network security, unified communication and consulting and managed services. Segment revenues for the quarter increased 6% year-over-year to $19.8 million. Sales were driven by success in new customer acquisition in our U.S. subsidiary. We've been enhancing our marketing efforts and working on manufacturers to obtain more leads and fill our new business pipeline. One market that has been focused on and where we've been particularly successful, is medical. For example, we've won new business with hospitals as well as medical diagnostics and medical billing companies. In addition, we're generating strong revenue from traditional hosting customers and expect this trend to continue. Our success in the U.S. was partially offset by lower sales in Germany as a result of order shipment timing to major customers as well as negative foreign exchange. Overall, the sales pipeline for this segment continues to be healthy and we expect further growth and profitability in the coming year. Before I turn over the call to Gary, I'd like to note that the first quarter is a perfect example of how the diversity of our business helps us at a time when one segment is facing significant headwinds. As expected, although we are facing difficult year-over-year comparison at our Systems segment, MODCOMP and especially those businesses that were acquired over the past several years are filling the gap. Of course, we see exciting long-term opportunities for both segments and especially from the sales synergies that we're just beginning to leverage. I'll speak more about that after Gary presents a detailed review of the financials.

Thank you, Vic. The 1% decrease in total sales of $20 million -- $20.9 million from $21.1 million a year ago is attributable to a $200,000 negative foreign exchange effect. At constant-currency basis, revenues were essentially flat. CSP's total cost of sales for Q1 was $16.7 million compared to $16.3 million in Q1 of 2012. Gross profit for the quarter decreased to $4.2 million or a 20% gross margin from $4.8 million or a 23% gross margin in Q1 2012. The decrease was primarily the result of a lower mix of sales from the Systems business including lower royalty revenues, as well as sales mix in Germany. First quarter engineering and development expense was $444,000 compared to $383,000 a year ago. As a percentage of sales, Q1 2013 engineering and development expense was 2.1% compared to 1.8% last year. Going forward, we expect to be in a -- in our target range for engineering and development expense for 2013 of between 2.4% to 2.7%. SG&A expenses decreased to $3.6 million or 17.1% of sales from $3.7 million or 17.4% of sales in the year-ago quarter, primarily due to lower sales commission in the Systems segment. Our target range for SG&A expense is between 14.5% and 8 -- and 15.8%. Our income tax rate in the quarter was 50%. Provision for income tax was $117,000 compared to $269,000 in Q1 2012, due to the change in the mix of revenues between Germany and the U.S. We expect our overall tax rate for Q2 to be approximately 50%. Net income for the first quarter was $115,000 or $0.03 per diluted share compared with net income of $461,000 or $0.13 per diluted share in the first quarter of fiscal 2012. Cash and short-term investments decreased from $20.5 million at September 30, 2012 to $17.7 million at the end of the first quarter, primarily -- due primarily to an increase in accounts receivable. The accounts receivable increase, by approximately $4.3 million, was due primarily to a large volume of sales to a significant customer who are granted extended payment terms, and timing of shipments through the end of the quarter. As we expected, the recording of royalties for 9 E2D planes in 2012 is creating a difficult year-over-year quarterly comparison to 2013. However, this should not mask the good performance we expect from the Service and Systems Integration business throughout the year. Fiscal 2013 marks an important transition year for us. We've already made good progress on the new growth strategy that we outlined for you on the last call. I'll now turn the call back over to Vic to provide you with some details on that progress.

Thank you, Gary. We see significant growth potential for CSP and are confident that we have the right strategy to unlock the value in our company. Of course, we won't see the results overnight but we made good progress already. A key component of our strategy is to cross-sell our Systems segment multicomputers with the Service and System Integration software and services to become more of an end-to-end supplier to our legacy customers, as well to new customers in new markets. As I mentioned on our last call, our Systems segment has historically operated as 2 mutually-exclusive businesses of completely separate products and customers. But we are now leveraging the capabilities in our Service and System Integration segment to enable our Systems segment to become a single-source solution for defense, government and commercial customers. When a customer buys a multicomputer from the Systems segment, they also need to purchase networking, storage and security products from companies like Cisco, IBM, NetApp, EMC and VMware for the back-end of the systems. In the past, customers have always made those purchases from other buyers [ph]. However, these are all products that MODCOMP can provide. Since our last call, we have discussed this message with major MultiComputer customers and they are very receptive to the idea. In fact, they further validate the strategy by explaining additional ways that MODCOMP could save them valuable time and resources. For example, when a customer purchases networking, storage and security products from multiple vendors, they need to send multicomputer chassis out to one vendor at a time for installation and testing. And the time and resources to do this is significant. MODCOMP could procure all the product and complete the installation and testing all at once. In addition, we can lend our domain expertise in C4ISR and signal intelligence that the product manufacturers just don't have to do the installation and testing process. With this excellent validation from our customers, we're very hopeful that we will see results from the initial -- initiative following the resolution of many issues surrounding the federal military budget. Turning to MODCOMP. We are making progress in our goal to become a global partner to our customers by cross-selling between MODCOMP geographic locations. They are global customers with various networking, security, unified communications and storage and server needs in different parts of the world. For the first time, our subsidiaries in the U.S., Germany and the U.K. are leveraging their customer relationships to cross sell, and we're already beginning to see results. For example, during the quarter, 2 customers that typically buy from the U.S. subsidiary are also now purchasing product out of the U.K. for the first time as well. In addition, we're discussing with those -- we're discussing with one of these customers on how we can help them ship products to their locations in China. We've also hired a salesperson in the U.K. as a relationship manager for one of our major German customers that now have significant presence in the U.K. This new U.K. salesperson will work in conjunction with our sales force in Germany. Through this strategy, we plan to capture more of our global customers worldwide spend. Another element of our strategy on the MODCOMP side of the business is to focus on winning higher-margin consulting as well as managed service business. During the first quarter, we saw a significant increase in services revenue out of the U.S. subsidiary. We're also planning on leveraging an increased number of partnered ships on both the Systems and Service and System Integration sides of the business. For example, at the Systems segment, we are looking at integrating partnered products into our multicomputers to provide end-to-end solutions. And finally, we're continuing to maintain a vigilant focus on cost control. Our SG&A costs are slightly lower in the quarter and we'll continue to constantly review every aspect of the business to ensure that we are operating in the most efficient manner possible. Before I go to questions, let me provide you with a wrap-up. Q1 was a perfect example of how the diversity of our business enables us to fill in the gap when one of our segments is facing headwinds. Looking ahead, we are expecting improved sequential top line results in the second quarter as a result of an increase in multicomputer shipments to our international customers. We expect our German MODCOMP subsidiary to report improved performance as well, and for our U.S. MODCOMP subsidiary to continue to report impressive results. And finally, we are confident that our new growth strategy will lead us to sustainable long-term growth and profitability, as well as enhance shareholders value. Everyone across the CSPI organization understands their marching orders and we're all aggressively executing on our strategy. And with that, Gary and I will take your questions.

[Operator Instructions] Our first question comes from Gunther Karger of Discovery Group.

Question, the increased focus on cyber security, does this offer CSPI any opportunities?

Yes, absolutely. We've -- the MODCOMP subsidiary has a security practice that entails best-of-breed products both in the Cisco, Juniper, RFA and many other manufacturers, and we have a complete practice, whether it's PCI compliance or many other security issues that are other out there. So we're going to continue building that practice, and as the products and needs change, we will continue to move with the market. And with that, we will also taking their practice and moving it over to the CSPI customers as well.

The next question comes from Bill Lauber of Sterling Capital Management.

Victor, as far as this -- we noticed that there was an announcement, Friday, from the initial operational tests and evaluation on the E2D2 -- or E2D and that it was -- you said it was ready for full-rate production. Is that a meaningful announcement? Is that why you're somewhat confident that you're going to be shipping planes in 2014?

Yes, absolutely, yes.

How -- I know you're a sub of a sub.

I guess we are.

How -- what kind of lines of communication do you have in terms of what's happening there in that -- with that contract? Because let's face it, it's pretty significant for our company.

We're in touch with the customer so that we get -- number one, they purchase parts from us that are utilized in the boards that they've developed or manufactured, and we have constant communication so we are updated as things are cleared. So we have a very good working relationship with Lockheed Martin.

Gary, as far as these parts are concerned, do you expect to ship these parts this year?

Yes, we anticipate that we should ship all of them this year. That's what the expectation is.

Right, and I'm a little bit confused as far as they're asking for quotes. I mean, you're not competing with someone else to supply these parts, are you?

No, I think it's more of a fiscal -- at least that Lockheed is getting things together. So it's information that's being requested by the Defense Department.

So if they're buying the parts from you all this year, I mean isn't it safe to assume that you're going to participate in the shipment? Are there royalties from the planes, certainly in Lot 1?

Lot 1. Yes.

1. Yes, Lot 1. We believe so, absolutely. We don't see anything that's going to change.

But Lots 2 and 6, Victor, you mentioned -- is there some question there?

No, it's -- they've requested the quotes also but there's no guarantee, just based on the government gets their budget every year. So we'll find out the following year. But they're just estimating those amount of planes from now into 2018 can range from 32 to 37. But every year we'll find out exactly what the -- what budget gets approved.

All right. And as far as the Systems business, other than the E2D business, I know, prior to you all getting this contract from Lockheed, you had other business and you have other business. That business, I assume, is what you're referring to that is suffering because of the uncertainty with the defense budget?

That's correct.

If something breaks and there is some agreement in Washington, which is highly unlikely, but if there is and there is no sequestration, is it possible that, that business could improve? Or you could get additional business that -- is in this fiscal year?

Yes, we have that potential, Bill.

These are the things that we're -- there is things that we are working on, that we have worked on in the past, that we're waiting for budgets to be released. And then there's also new things we've been working on with some old customers in other locations. And sometimes, there are new opportunities and brand new customers that we're starting to talk to. So we've been -- we've redone our website. We put new marketing material in there. The synergies between the company, I'm personally going to each and every one of the top customers in MultiComputer and positioning the new messaging strategy that we're trying to push through.

Okay. And as far as the accounts receivable, you refer to a -- I can't remember the word in your release, substantial or significant customer. Are they substantial or significant in terms of their size or in terms of the order? I guess, I'm a little bit confused as to why a big substantial customer would want delayed payment terms with today's interest rates. I don't -- can you give us a little color on that?

Well, they are substantial, and as you know, with some of the larger companies that's -- they're all looking for any edge from paying. So this is one of the things that they do as a company. So that's where we had given them extended terms and they pretty much honor that from that standpoint. So there's been no deterioration in the payments.

A big portion of that was just from a U.S.-based customer that just ordered it and it was shipped towards the end of the month in the quarter -- more than half of it, so...

Okay. And the ramp up from say 2% to 2.4% to 2.7% on engineering and development, is that more a function of the lower sales or is that -- are you spending more money in that area?

Well, we're going to be adding some resource, either from a consulting angle or some personnel.

Okay. And then my last question, you've led us to believe that this is going to be a challenging year, a transition year or something along those lines. And for shareholders that have been around a lot, we certainly understand the nature of the Defense Department and the lumpiness of that business and so on, but can you be a little bit more definitive? Should we assume that this is going to be a red-ink year for the company, this fiscal year?

Well we're going to do our darndest to make sure it isn't. So I mean we're doing everything we can. And I think Victor's efforts in changing the strategy and things [ph] hopefully will bring some things to fruition, but we'll keep the shareholders informed as to how things look. We're optimistic.

Well, I know we've had past conversations along these lines as far as guidance, and I know it's -- some companies do not provide guidance and some companies can't because of the nature of their business. But it's very difficult, as you -- as we've discussed before, to get a handle on what to expect. Last year was a great year but we'd like a little bit more visibility if you can provide it -- provide us with that as the year goes on. That's all I have.

The next question comes from Brett Davidson of BCIA.

I have a couple of questions. Northrop has given some indication that India is going to be interested in some E2D Hawkeyes. Anything yet that sifts down to CSP's level?

No, we haven't heard anything, Brett, at this point.

And would you guys automatically be included on planes that would be going to other countries? Or is that not necessarily the case?

We have to -- I mean, we can't answer that because we're not sure what they do relative to the electronics. So sometimes with some of our partners there's different electronics that go into planes. But at this point we don't know. We really can't answer.

That's not covered in any contract that you have currently, that these systems would necessarily be installed on any planes that were built for other countries?

Well, yes, there's nothing in the contract to that side. But we don't know at this point, Brett.

Got you. The receivable that Bill was just talking about, and it was I think -- was it a $4.3 million increase or $4.3 million balance?

The change in the balance between the end of the year and the first quarter.

Has most of that been collected?

Well, yes, a good portion of it.

Good portion.

I can tell you they're from 2 different customers that have been doing business with us for a long time, and are very secure customers, so there's no risk involved with that.

Well, I'm just trying to get a handle on the current cash balance. I mean, I'm assuming it's probably pushing back up in the $20 million range?

I mean, we're collecting -- I mean, I can't answer specifically because I haven't looked at it this week, but I mean, it's -- this includes.

The last time that I had tossed around the idea of a regular dividend, the cash balance was $14 million, $15 million. And the answer was, there's not sufficient cash to be able to pay a regular dividend. With cash balances averaging $3 million, $5 million above that the past couple of quarters, is there a chance that we'll see a regular dividend?

That's something we can discuss with the board. So I mean if -- we look at that periodically and make a determination, but we'll certainly take it under advisement.

I've heard repeatedly that you need that large cash balance to provide financing for customers and purchase equipment, but I've never seen the case where any large portion of that money has ever been tied up in a particular quarter?

The thing is though, because of that balance, that allows us to get the high level of credit we need with the distributors. Without that, we would have a challenging time to get the $5 million, $10 million lines that we have with distribution and manufacturers.

So that money is...

We'll certainly take this under advisement, Brett.

Got you. Was that money pledged against the purchases from these large customers?

No, it's not pledged.

Not pledged, no.

Got you. I have one or two other things here. The timing of this call, I think it gives the appearance that it's set up to prevent shareholders from having their say on the election of directors. Normally, conference calls are routinely held pre-market -- earnings release is pre -- or excuse me, earnings releases are pre-market, conference call is held in the morning, which in this case would provide shareholders time to vote or change their vote prior to tomorrow's election. I just don't think that's the right message to send, hosting the conference call and at this time of day, especially seeing this quarter was weaker than I think shareholders would like to see, with one of the E2D Hawkeye planes adding into the revenue for this quarter, and I'd just like to get your comments on that.

Well, I don't think the timing of -- we had a board meeting, we wanted to get the information out, so at the meeting we would be able to talk about the quarter, and the timing was such that we had it in the afternoon. There wasn't any predisposition to having it as we've done in the past. But we thought it was important to get the information out, get shareholders' access, so it's nothing to do with the vote.

Our next question comes from Graham Neihard [ph] Of Bobe [ph].

I've got few questions. One, I believe it was the last earnings calls, I've read about a buyback program. Is that still being implemented? And if so, sort of how many shares do we buyback this quarter?

It's implemented and we didn't purchase any this quarter.

Didn't purchase any this quarter?

Correct.

And I guess, sort of on -- sort of as an add-on to what the other caller was saying about the dividend. I mean, with your stock -- if your cash balance is back up around that $20 million level, I mean your stock is really being valued at 0.5 to 1/3x EBITDA. Now I know EBITDA is a little bit difficult for you on a run rate basis, given the lumpiness of the cash flows. But I'm wondering, concerning the dividend, has the board ever discussed any sort of more major buyback program? And I understand the importance of the cash balance. But I mean, your cash balance really hasn't been appeared [ph] under $15 million for a while now and you're stock just trades so cheaply. I mean, has this been brought up?

It certainly has been discussed at many of the board meetings at the last year, few years.

And last year was a good year for the dividend and we're taking it into consideration every quarter.

Sure, sure. And then I guess sort of on a final note, any sort of new releases or new information in terms of the offer from North & Webster or no?

No, I think we -- as we said in our last release, we want to get the election and then we will turn to it.

Right. Okay. So post-election you guys will prudently consider that? Have you guys hired bankers, financial advisors or anything?

We're not in a position to really discuss what we're doing at this point.

There are no more further questions at this time. I'd like to pass the call back to management for closing comments.

Thank you for joining us today. We look forward to speaking with you all again on our next Q2 call. Thank you.

Thank you.

Thank you for participating in this teleconference. You may now disconnect your lines at this time, and have a wonderful day.