Csp Inc /Ma/ Q3 FY2020 Earnings Call

Good day, everyone, and welcome to the CSPi Fiscal 2020 Third Quarter Conference Call. Please note that this call is being recorded. And now it is my pleasure to turn the conference over to Mr. Doug Sherk with EVC Group. Please go ahead, sir.

Thank you, operator. Hello, everyone, and thank you for joining us to review CSP Inc.'s fiscal third quarter ended June 30, 2020. With me on the call today is Victor Dellovo, CSPi's Chief Executive Officer, and Gary Levine, CSPi's Chief Financial Officer. After Victor and Gary finish their opening remarks, we will open the call for questions. Statements made by CSP Inc.'s management on today's call regarding the company's business that are not historical facts may be forward-looking statements as defined in federal securities laws. The words may, will, expect, believe, anticipate, project, plan, intend, estimate, and continue, as well as similar expressions, are meant to identify forward-looking statements. These statements should not be interpreted as guarantees of future performance or results. The company reminds you that these statements represent current expectations about its future performance or events and are subject to various uncertainties, risks, and other factors, many of which are beyond the company's control and may affect the accuracy of the statements and projections on which they are based. Factors that may impact the company's results include, but are not limited to, the risks and uncertainties outlined in the Risk Factors section of the annual report on Form 10-K and the quarterly report on Form 10-Q filed with the Securities and Exchange Commission. Forward-looking statements rely on the information available at the time they are made and management's good faith belief at that time regarding future events. All forward-looking statements are fully qualified by this cautionary statement, and CSP Inc. has no obligation to publicly revise or update any forward-looking statements due to new information, future events, or otherwise after the date made. With that, I'll turn the call over to Victor Dellovo, Chief Executive Officer.

Thank you, and good morning, everyone. Before we begin, I want to acknowledge the impact of the coronavirus pandemic and express our heartfelt concern to those that have been affected. Since we last talked with you in May, our team has continued to adjust how we operate the business to maximize our opportunities in a manner that is safe for both our employees and our customers. We have been able to maintain most of our workforce executing for our clients and more than 90% of the team is working remotely. We are now several months into the new normal, and despite limiting our ability to visit our customers and potential customers, we continue to build our pipeline in all lines of our business. Total revenue for the fiscal third quarter was $13.5 million compared to $21.6 million we reported in the same period of fiscal 2019. While the year-over-year revenue decline was primarily related to the COVID-19 pandemic, our decision to also transition our business to higher-margin products and services enabled us to significantly improve our gross margin. I believe this achievement demonstrates the soundness of our execution of our profitable growth plan. Further, during this transition, our prospects remain quite high. And if nothing else, the suddenness of the COVID-19 pandemic and the unprecedented remote working environment is helping to highlight network vulnerabilities. Businesses of both large and small remain exposed to increased threats and there have been several well-publicized ransomware attacks. I believe this fear, in addition to providing a secure remote working environment, is a growing concern for many businesses. It is critical that businesses have a partner that understands the complex challenges. We are positioning CSPi to be that partner as our newest solutions ARIA and our Unified-Communications-as-a-Service, or UCaaS, seem readymade for today's critical network issues. For the quarter, our Technology Solution, or TS, revenue was $11.9 million. While the TS division was impacted by COVID-19, we were able to generate most of our revenue from our large customers. Our managed service practice, or MSP, continues to perform well as we signed new customers during the quarter, which include cloud business and UCaaS. Importantly, we have not lost a single customer as they value the service we are providing. This stickiness demonstrates our importance to our customers even during these unprecedented times. I believe that the three lines of recurring revenue business we created continue to bring stability to CSPi. Separately, the cruise ship industry remains one of the most COVID-19 impacted industries. When we spoke in May, many operators were looking to resume cruise during the summer months. However, in June, the Cruise Lines International Association, or CLIA, announced that the association's ocean-going cruise line members will voluntarily extend the suspension of cruise operations from the U.S. ports until mid-September 2020. However, some cruise operators have plans to restart in EU ports in the coming weeks. While the continued travel restrictions hampered the ability to gain access to the ships, we continue to communicate with the operators every other week, and we are prepared to move on a moment's notice. On the positive side, these upgrades need to occur, and the operators have already purchased the equipment, so we would expect these ships to be prioritized when business resumes. As we have consistently reported over the past few quarters, our Microsoft practice continues to perform well, and this latest quarter was no exception. We are a month through Q4, so I'm reaffirming our belief that we will achieve a greater growth rate for the business compared to a full year growth rate of 140% we achieved in 2019. Regarding our UCaaS offering, an all-in-one service for hard and soft phones, including 24/7 security and technical support with redundant data centers, both in Florida and Texas. As a reminder, the UCaaS market size is expected to grow from $15.8 billion in 2019 to $24.8 billion by 2024, being driven by growing trends toward mobility and bring your own device, or BYOD, to the workplace. During the quarter, we continued to have success as we added new customers and expanded sites at our current customers, all while continuing to increase the number of virtual product demonstrations we are performing on a weekly basis. The new business pipeline is promising, and the team is engaged with prospects and is maintaining constant communication. Now I will move to our High-Performance Products, or HPP division. Revenue for the quarter was $1.6 million, in line with our estimates and reflects revenue from our legacy business, being offset by the expected decline in the Myricom business. ARIA, our award-winning next-generation cybersecurity platform that helps organizations protect themselves from harmful hidden attacks without human intervention, is continuing to garner tremendous interest and customer success as we recently completed an installation for an international customer. Further, we continue to be well-positioned within a leading cable company and other OEMs opportunities for ARIA. I believe the testimony, along with the industry acknowledgment and robust lead flow we are generating from virtual trade shows will drive future sales in the HPP division. Additionally, we now have six partners for our official channel program, and we are speaking with several others to ensure a robust channel program. To summarize, the CSPi team is performing well and remained focused during these unprecedented times. We have made and will continue to make necessary adjustments to our operations to ensure business execution. Specifically, our new ARIA and UCaaS offerings are generating the expected interest as we sign up new customers and broaden our pipeline. We have a diverse customer base, both large and small, and this breadth will allow us to successfully navigate the near-term uncertainty. We are excited about our long-term growth prospects. With that, I will now ask Gary to provide a brief overview on the fiscal third quarter financial performance.

Thanks, Victor. As Victor mentioned in his opening remarks, our third-quarter revenues were $13.5 million compared to $21.6 million in the year-ago third quarter and reflects our pursuit of higher-margin business. We reported gross profits of $4.2 million compared to last year's third-quarter profit of $4.8 million, resulting in a gross profit of 31.2% compared to the year-ago gross profit of 22.4%, an improvement of 9%. Our engineering and development expenses for the third quarter was $693,000 compared to $583,000 in the year-ago quarter. In the prior year quarter, we received a refund of $150,000 from consulting cost for a project that wasn't completed. Our SG&A expenses in the quarter were $3.9 million, slightly decreased from $4.1 million in last year's fiscal Q3 due to a decrease in variable compensation costs. We reported a loss before income of $200,000 in Q3 compared to income before income taxes of $206,000 in the prior year third quarter. During the quarter, we had income tax expense of $10,000. The prior year quarter had a tax benefit of $326,000. In early April, when it became evident that the COVID-19 would have a severe economic impact, we took several actions to improve our cash flow, including the suspension of our quarterly dividend, stopped our stock buyback program, and applied for and received a PPP loan. These actions at the end of June strengthened our cash position by approximately $3 million. We ended the third quarter with cash and short-term investments of $20 million, which includes cash of $10 million in the U.K., and we have a pension liability of $5.2 million. Our actions are designed to ensure that we continue to drive our bottom-line performance and boost sales of our higher-margin products. With that, I will turn it over to the operator to take your questions.

We'll take our first question from Joseph Nerges with Segren Investments.

Just a couple of quick questions. From the last conference call, we were talking about proof-of-concept demos that you were attempting to do with the customers on this ARIA product line. What's the status of that? Have we been able to get access at all to some of these customer sites?

Not yet, Joe.

Not yet?

Not yet.

We should have a backlog of proof-of-concept demos available. Have you been conducting virtual demos?

We've been doing the virtual ones, and we've been trying to do like a try-and-buy, where they actually give us a purchase order, stuff like that. That's what we're offering. They want to see it working...

They want to see it work.

Yes, exactly. We haven't been able to access the site. Most of our customers still have restrictions that prevent anyone from entering the facilities unless they are employed there.

Okay. In the last conference call, you mentioned that you were conducting demos. I assume that means you were able to perform some kind of demonstration even without the proof-of-concept.

We're doing demos. We're doing 3 to 5 demos a week consistently. But getting it to the next level of the proof-of-concept is what's kind of slowing things down at this stage.

Okay. I assume that in the last three months, you have conducted quite a few virtual demos. Are you saying that you have not been able to visit most customer sites at all?

We have some strong long-term relationships that we're encouraging to trust us. You've relied on us for the past 10 years, and we believe this will succeed. These are the discussions we're trying to advance on the TS side more quickly than with new customers who may not be familiar with CSPi or ARIA.

Okay. Are there any E-2D royalties for this quarter or anticipated for the next quarter?

In this current quarter, we will have royalties, and we had a few last quarter. Looking into next year, we need to see how they develop because over the last few years, they haven't been able to get the products out promptly, which has resulted in effects rolling into the first quarter of the next fiscal year. We just need to monitor how they progress as they build the boards.

So basically, we had a little bit this quarter, you're saying? The current quarter, we just...

Yes, Q3. Yes, it was a small amount.

And we are expecting a little bit more in the fourth quarter?

Correct.

Correct.

Well, we know we're going to have royalties. We just don't know the timetable for the royalties coming in the next year.

I'm following up with Joe. He had some quick questions, and I have some slower ones. You mentioned growth in your comments, but I didn't catch all of it. Could you please elaborate on that again?

In relation to?

The prior year, I was uncertain about where we would end up this year.

I was saying the growth was just on the Microsoft piece of it, the Office 365. We had a good growth rate on the cloud business. That's what I was referring to.

Got it. There was a new customer installation you mentioned related to UCaaS. Did that revenue decrease in the last quarter, or is it all projected for future growth?

Well, we've had new customers in both UCaaS, MSP over the quarter. We also had an installation of the ARIA product. It was an international customer that was installed. And it wasn't large, but we did book it last quarter, so...

And the UCaaS, I mean, was that throughout the quarter last quarter or was that end of the quarter?

The UCaaS operates on a recurring revenue model. Currently, we are focused on three business lines that utilize this model. ARIA can also function as a recurring revenue model on a monthly basis. UCaaS typically involves three-year contracts. Therefore, both UCaaS and potentially ARIA can contribute to our recurring revenue. Additionally, our managed service practice, or MSP, also relies on recurring revenue models. We recognize revenue over a period of three years.

So I mean, the prior quarter was such a disruption. I'm just having a hard time figuring out exactly what's going on inside the business. I'm just trying to get an idea whether that was late in the quarter or during the course of the quarter. Or how that's going to impact revenues going forward? So, I mean, if it was the last week of the quarter and you guys booked some revenue, obviously, it's not representative of what this quarter will look like. I mean, can you comment on that at all or if it is...

Throughout the quarter, we experienced some fluctuations, similar to many other companies. Certain months were stronger than others, but overall, customers were making purchases. At times, when buying products, customers were opting for more comprehensive offerings, while our recurring revenue primarily came from new acquisitions. This created a varied landscape throughout the quarter as different items were introduced.

It's challenging to respond to your question because, for instance, you might have a $400,000 contract distributed over three years, along with a $1 million contract. Therefore, you won't see significant fluctuations each month; the expectation is consistent growth. However, there have been some substantial purchases from financial institutions that, throughout the quarter, spend millions of dollars at once. Essentially, as Gary mentioned, there are two types of transactions: one involves straightforward purchase orders where you sell the product, deliver it, and complete the transaction, while the other consists of recurring revenue, which occurs throughout the quarter. If a deal is signed in the last week of the quarter, for example, it won't be billed until the following month.

Yes. And that's just what I'm trying to get a handle on is, how is this distributed? So if this was distributed evenly over the quarter, you'd have about 1.5 months total representation in the quarter. So I mean if all this activity was spread out evenly, it's going to be a little different than if the majority of it was in the final month of the quarter.

As soon as we can gain the business, Brett, we book it.

Yes. But I'm just trying to get a handle on when this is coming, how it's going to impact this coming quarter now that's going to be recognized for 3 months' worth instead of 1 month or 1.5 or whatever.

Yes.

So you guys did book revenue from the UCaaS in the quarter?

Yes.

Press releases. I know in a prior call, you had talked about issuing press releases and looks like that's been dislocated by the COVID thing to some extent. How do you see that going forward in the next quarter or two? I mean, do you anticipate a flurry of press releases coming or nothing that you can really put your finger on at this point?

Nothing like the second. We have to just see how things roll out. There's still a lot of uncertainty, as you know, in the whole industry. So right now, we've just got to head down, trying to focus on the new products and just trying to prospect with customers in a time where customers are just trying to figure out what their business looks like. So it's one of those balance and acts to push as hard as you can without upsetting the potential customers. So as soon as we have some press releases that are worthy, we'll get them back out.

Do you have any internal metrics that provide insight into what revenues might look like? I understand you don't track anything like backlog.

Yes, we do.

Oh, you do that?

Yes.

We do that and we monitor the pipeline. We do all the metrics. But obviously, we don't report that, but we have a lot of internal data that we do monitor and we keep a pulse of what our business is doing and how we're doing. So we have many meetings going through those within all the operations of the company.

Can you just give an idea of what some of those things that you guys are actively monitoring?

Well, obviously, pipeline, backlog and items related to the sales metrics as well as the engineering schedules and those kinds of things are what we monitor very closely and watch that as well as we're always maintaining and watching the quality of our products going out the door.

How do you quantify the pipeline? Are you looking at the number of customers contacted or the potential contract size? What exactly are you monitoring?

No. When prospecting, you start at various close rates like 20%, 40%, 60%, and 80%. As you progress through the pipeline, you assess what is advancing, what is behind, and what you may have lost, which helps in managing the pipeline. Then you discuss it with your sales team and, based on communication with vendors or customers, you determine how to adjust those percentages. Situations change; for example, deals that were thought to have an 80% close ratio might be put on hold rather than canceled, causing you to lower that estimate to 40% or 60% as needed. This is how we manage it. We hold weekly sales meetings where the salespeople review their pipelines and new opportunities. Additionally, we have meetings involving project managers and the engineering leads to discuss all business dealings, whether they involve new statements of work sent to customers or existing ones that are signed, along with project rollouts and timelines for closing them so we can recognize revenue. This is part of our everyday operations.

And I'd imagine in March that might not have been a real favorable looking thing, but has that generally recovered during the course of the summer here?

No. It's inconsistent. Some customers perform better than others, and it's a mix of constant communication. May was definitely the hardest month for us. I believe we had sufficient backlog from March, which caught everyone off guard, but the business was already there. In April, we had enough backlog as well. For us, May was when activity significantly slowed down, but then June started to pick up again. So, there was some level of normalcy, though not back to the previous state, but at least communication has resumed.

So you guys kind of touched bottom in May and things are kind of pushing back in the other direction now?

Yes. They're significantly better than they were in May.

Got it. Can you provide some insight on the current thoughts regarding the dividend?

Well, I think one of the important things for us is to get profitability first as a company and then take a good close look at it because the cash requirements, if we're losing money and such that we just can't really do it. But we're certainly looking at that and discussing it every quarter with our Board.

I believe the economy remains too uncertain to make any definitive decisions. For instance, there was news this morning about a vaccine, but it raises questions about what that means for everyone and how it will be rolled out. Confidence levels are still not where we need them to be for a return to normalcy. We discuss options at each Board meeting, but for now, we remain cautiously optimistic.

So that's how we can think about it once we cross that divide back to profitability than the dividends are kind of back on the table?

Yes. That's certainly what to look at.

And there does appear to be no further questions at this time. I'll turn the call back over to the management team for any closing remarks.

Thank you, operator. As always, I want to thank our shareholders for your continued interest and support. Our strategy of pursuing higher-margin business is generating the desired results. And as we continue to transition the business, we are encouraged by the strong and growing interest in ARIA and UCaaS offering. We do have a bright future. Have a great day.

Thank you. Bye.

Thank you. And this does conclude your program. Thank you for your participation. You may disconnect at any time.