Csp Inc /Ma/ Q3 FY2022 Earnings Call

Good morning, everyone, and thank you for joining the CSP Inc. Fiscal Third Quarter 2022 Results Conference Call. I am pleased to introduce your host, Michael Polyviou. Michael, you may take it from here.

Thank you, Tom. Hello, everyone, and thank you for joining us to review CSP Inc.'s fiscal third quarter, which ended June 30, 2022. With me on the call today is Victor Dellovo, CSP Inc.'s Chief Executive Officer; and Gary Levine, CSP Inc.'s Chief Financial Officer. After Victor and Gary conclude their opening remarks, we'll then 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 the term is identified in federal securities laws. The words may, will, expect, believe, anticipate, project, plan, intend, estimate, and continue as well as similar expressions are intended to identify forward-looking statements. Forward-looking statements should not be read as a guarantee of future performance or results. The company cautions you that these statements reflect current expectations about the company's future performance or events and are subject to a number of uncertainties and risks and other influences, many of which are beyond the company's control that may influence the accuracy of the statements and the projections upon which the segment and statements are made. Factors that may affect the company's results include, but are not limited to, the risks and uncertainties discussed 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 are based on the information available at the time those statements are made and management's good faith belief as of the time with respect to future events. All forward-looking statements are qualified in their entirety by these cautionary statements and CSP Inc. undertakes no obligation to publicly revise or update any forward-looking statements, whether as a result of new information, future events or otherwise after the date thereof. With that, I'll turn the call over to Victor Dellovo, Chief Executive Officer. Victor, please go ahead.

Thanks, Michael, and good morning, everyone. Overall, we had a solid fiscal third quarter. I believe our team has adapted to the ongoing supply chain inflationary pressure to generate both short- and long-term growth, increasing returns to our shareholders. Our Technology Solution or TS business had another terrific quarter and continues to gain momentum in the marketplace. While the segment's revenue is relatively flat with the year-ago period, the backlog increased to $60 million due to a rise in demand for our products and services. Overall, we recorded net sales of $13.3 million for the quarter, which was slightly below the year-ago level, but represents an 11% sequential increase over fiscal 2022 second quarter results. We achieved this 11% sequential growth despite experiencing a very similar macroeconomic event. Services grew 37% compared to the year-ago third quarter and was up 30% from fiscal 2022 second quarter. And overall backlog as of June 30 was $20 million and $17.3 million on March 31, 2022. A key objective for our team is to continue the migration of CSPI's revenue to higher-margin products and services. We are executing well to this goal as evidenced by a record gross margin of 37% for the fiscal third quarter. At 37%, the gross margin grew over 6 full percentage points compared to a year-ago gross margin, despite relatively flat revenue. The gross margin improvement was the chief driver behind the net income for the quarter of $7.7 million or $0.15 per diluted share. We also benefited from favorable currency exchange as Gary will review with you in a few moments. Before I review our business segment, let me take a few minutes to review the challenges that continue to impact our operations. First, while the global supply chain pressures moderated in May, they remain at high levels. For instance, our overall component delivery timelines from our suppliers remain the same compared to our fiscal second quarter. Our suppliers are telling us that we should see some shortening of the timeline, but there isn't much clarity. Our solution to this situation is to focus our revenue-generating efforts on higher-margin products and services. This strategy has allowed us to build the backlog to record levels. However, our primary objective short-term is converting the backlog to revenue. Therefore, we are aggressively seeking other sources for acquiring components so that we can deliver finished goods. I'll note that the TS backlog of $60 million is far greater than the revenue we just reported for the entire quarter. We believe this backlog, which continues to grow despite improving revenue conversions, is an unprecedented asset to the company. The second challenge impacting our business is the pressure being put on our costs by inflationary forces in the tight labor market. The pressure is leading to increased wages and employee incentives in certain markets, where the unemployment rate is in the 3% range. Employment, recruitment, and retention are a challenge. And with the increase in work-from-home policies, we are now competing with out-of-state companies offering well above market wages. Our Technology Solution or TS business generated revenue of $12.6 million in the fiscal third quarter, similar to a year-ago level. We did achieve a 16% increase in segment revenue over fiscal 2022 second quarter as we were able to convert some of the older backlog to revenue. As I mentioned earlier, approximately 80% of the backlog is in TS. Despite all the backlog conversion, we still grew the backlog for the segment by $2 million from the fiscal second quarter. Our Managed Service Practice, or MSP, has been a stellar performer throughout the past couple of years as we continue to attract new customers while existing customers expand. We're finding that many of the companies still have poor cybersecurity practices in place, making them vulnerable to data loss from attacks. These companies are potential CSPI customers as they gradually recognize that they need to make cybersecurity awareness, prevention, and security best practices a part of their culture. Regarding the UCaaS business, I believe the incremental sales are getting closer and closer to achieving our goal while we continue to sign smaller companies that will take a concerted effort on our product to further educate the market on our solution merits if we want to penetrate this market in a meaningful way, our success over the years of internally developing award-winning business solutions. Regarding the cruise ship industry, it remains quiet for now. However, last month's decision by the Center of Disease Control and Prevention to discontinue its program of tracking cases of COVID-19 aboard cruise ships in the U.S. and reporting the findings to the public can only be viewed as favorable if the operators are more open to freeing budgets for their services. Regarding the High-Performance Product, or HPP division, we reported revenue of $0.7 million, which was below our objective for the quarter. We still maintain a multimillion dollar backlog in HPP as the supply chain issue continues to hinder the division's growth. Myricom revenue was lower than expected as we expect much of the same in fiscal Q4. We are also expecting the bulk of the royalty revenue related to the E-2D program to be recorded in the current quarter as the customer was still in the process of restructuring its business for most of Q3. During the quarter, we announced ARIA Zero Trust Gateway, a next-generation network security solution focused on automated 100-gig network response accelerated by the NVIDIA BlueField-2 DPU. The release in the webinar we hosted on June 7 generated a very positive response from customers and potential customers. We believe the interest generated could lead to significant revenue for the ARIA platform as we enter fiscal 2023. The ARIA Zero Trust or AZT Gateway is deployed as a compact in-line bump in the wire, a standalone network device that will stop attacks without impacting the delivery of other traffic crossing the wire. To do so, the AZT Gateway operates by sitting in line with data traffic, analyzing each packet at line rate, creating analytics for threat analysis while enforcing existing standing protection policies, as well as those dynamically rigged to stop detected attacks. Ami Badani, Vice President of Network at NVIDIA, said, 'ARIA Zero Trust Gateway solves a critical cyber problem for service providers who need a modern approach to protecting their customers' data from attack.' We see a lot of value in this product that we can bring to our customers. In addition to the direct sales team, we continue to vet potential partners for the official channel program as we added a few partners during the quarter, including one in Australia. We currently continue to speak with several others to increase our roster, which ensures a robust channel program and increases our chances for success. We also executed some operational efficiencies to rightsize the HPP business that had been in the works for some time. Specifically, we relocated the operations to a smaller space, resulting in lower rent due to the fact that many of our employees work from home. Additionally, we are managing salaries and wages through some personnel attrition and filling these voids with consultants to ensure that we have the talent to meet our customers' needs. To summarize, we increased our backlog and recorded record gross margins. Our strategy of focusing on higher-margin products and services is yielding solid progress each quarter. Despite converting some of the backlog to revenue, we simultaneously increased the backlog to over $20 million. This demonstrates the strength of our offering, yet it also highlights our continued engagement and customer loyalty during this period, since we have not lost a single order from the backlog. We have successfully transitioned our business during this unprecedented period, and today, we are an active player in the high-growth and margin business. We believe we have the resources, the wherewithal, and the strategy to realize our potential. 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 fiscal third quarter revenue was $13.3 million. We reported gross profit of $5 million or 37.3% of sales compared to $4.2 million or 30.8% of sales in the year-ago fiscal third quarter, representing an improvement of over 6 percentage points. Service revenue grew 37% compared to the year-ago third quarter and was up 30% from our second quarter, which is a combination of the growth in MSP as well as a higher ASP. This resulted in a 36% increase in service gross revenue when compared to the prior fiscal year, while the gross margin, as a percentage of revenue, remained relatively flat. We reported a decrease in product revenue of $1.7 million compared to the prior year quarter. Despite this decrease in revenue, we only reported a slight decrease in product gross margin of $100,000 due to an increase of 3% in product gross margin as a percentage of revenue compared to the year-ago third quarter. Additionally, the product-based backlog will also have a favorable gross margin. So rest assured, we will explore every option to get these shipped to our customers. Our engineering and development expenses for the fiscal third quarter was $884,000 compared to $700,000 in the year-ago period. This increase is primarily due to higher personnel costs, which includes outside consultants. Our SG&A expenses in Q3 were $4.1 million, a slight increase compared to the year-ago Q3 due to an increase in variable compensation. We reported net income of $684,000 in the fiscal third quarter, which is $0.15 per diluted share compared to a net loss of $423,000 or a $0.10 loss per share for the fiscal third quarter of fiscal 2021. The 2022 third quarter reflects a $0.6 million gain from the favorable impact of foreign currency rate exchange, primarily from cash in U.S. dollars and euros in our U.K. subsidiary. We ended the fiscal third quarter with cash and cash equivalents of $21.4 million as of June 30, 2022, which was approximately an increase of $1.4 million from September 30, 2021. This was due to an increase in receivable collections. During the fiscal third quarter, we purchased nearly 7,000 shares from the stock repurchase program. We have authorized buying up to 175,000 shares of CSPI shares of common stock. We continue to believe that the shares at these levels represent value, especially when you factor in the margin expansion we are generating and the growing backlog. However, we will continue to exercise prudent expense management to ensure that we have the resources to execute the multiyear growth strategy of transforming to a cybersecurity, wireless and managed service company. I also want to highlight that the Board's decision to restate and declare a quarterly dividend of $0.03 per share payable on September 9, 2022, to shareholders of record on the close of business on August 22, 2022. CSPI has always been a shareholder-friendly company, and while it was prudent to preserve resources during the uncertainty of the past couple of years, we believe returning cash to shareholders is paramount to this approach. With that, I will turn it over to the operator to take your questions.

And we have a question coming from Joseph Nerges from Segren Investments.

Right up front. Thanks for the dividend. I could start to pay my bills now with the new dividend. A couple of clarifications. One, you reported the backlog in your PR as $23.8 million. Is that correct? Or did you refer to $20 million? I heard on the call here? What's the backlog that you reported? I mean...

$23.8 million.

I mean, the PR is $23.8 million.

That's correct.

Is that the correct number? Okay.

Yes.

And one other thing, and you mentioned the repurchase of shares. Is that 7,000 shares you repurchased or $7,000 worth?

7,000 shares.

Okay. Because I thought you said $7,000. Just a clarification. And of course, we're still having problems with the backlog as we did last quarter. I mean, not the backlog, but the delivery.

Right.

Fulfillment.

Yes.

Let me refer back to a press release from November of last year regarding the $1.8 million order for the High-Performance Products group, specifically the ARIA product for the National Intelligence Agency. In that release, it was mentioned that there was a possibility of delivery in the second half of calendar 2022. Is that still on track? In other words, I understand that if it occurs in the October quarter, it will fall into the next fiscal year, but is it still looking like we could possibly receive it this year?

No.

No.

No?

No. It'll be in October and it'll be in the first quarter.

Well, that's what I said. Calendar, it'll be in the calendar year, but in the next fiscal year, the first quarter in October.

Correct.

October, November, December quarter.

Correct.

Okay. Well, at least that's meeting the goal. It was sometime in the second half of 2022. Has there been any progress on managed services? Are there any particular services that are showing improvement? We have a lot of different services we offer. Are there any specific services that are performing well, or is it scattered? Are we acquiring a lot of new business across different types of services?

It varies. It varies, Joe. It could be managed firewalls. It could be desktop support. A lot of it's been switching and WiFi support. So the ultimate goal is to get it all. But we go piece by piece if we have to.

Is the Cisco UCaaS business where some of the problems are, delivering the phones or something that...

No.

No?

No. The phones are fairly available. It's all the equipment, switching, and firewalls from every manufacturer that are currently estimated to take, in the best case, 6 months; realistically, a year.

On the Zero Trust webinar you conducted with NVIDIA, our software seems to integrate seamlessly with the BlueField platform that NVIDIA is launching. I'm curious if there are any interested parties or potential prospects in that area. What steps do we need to take to engage with these prospects? Should we conduct tests or beta testing? I'd like to understand our current status with the prospects, considering it has only been two months since the webinar.

Yes. The customers we are engaging with are quite large, which means it takes time to move forward. They are not quick to make decisions, as you know. We are currently working on getting our solutions specified to meet their needs, which will lead to requests for proposals. We are progressing as quickly as possible, and I assure you of that.

Okay. The very large customers we're discussing are cloud-based customers and data centers, as mentioned in the webinar.

Yes.

Utilizing those specific areas that you're working on. On the financial side, I assume we're generating a bit more return on the cash we have in the bank. You can get 3-month treasuries and 6-month treasuries close to 3%. Are we managing some of that? Are we earning a bit more on our cash in the bank, Gary?

Yes, we are. Yes, we are. We have been managing that very closely and moving up where we have the opportunities. Absolutely.

Okay. That's all I have right now. It seems like we're moving forward. I don't know what we can do about the supply channel, but at least, hopefully, it will loosen up little by little going down the road.

And the next question is coming from Brett Davidson.

Just a couple of quick questions. One of them is that $4 million HPP backlog. If you guys had the components, would you be able to shift that tomorrow?

Yes.

Yes.

Got it. Interesting. The other thing I wanted to touch on is have you guys looked into buying talent? Has there been any investigation into merging or gobbling up a smaller competitor to tack on talent that way?

Yes. We've looked at a lot of different avenues of different companies, but just either it's pricing or just the integration doesn't make sense. It's not accretive.

Yes. The only other comment I have is that I appreciate the dividend at the level it was announced. I believe it makes a lot of sense at this point. It still allows you to continue increasing the cash balance and start providing some rewards for shareholders. Joe won't have to worry about covering his expenses with that.

Exactly, exactly.

And we do have a question from Will Lauber from Visionary Wealth Advisors.

If we didn't have the supply chain issues, what do you think the kind of the normal backlog would be by division?

It'd probably be $4 million, give or take.

That's all in total?

Yes. It's $4 million to $5 million, probably. Those were the normal run rates for years before this occurred.

Okay. So have the pace of the orders increased at all?

The pace of the orders? In the business, it's unpredictable on when customers are going to actually cut purchase orders. A lot of stuff happens towards the end of the quarter where, as you know, manufacturers will lower their price, and customers usually can get a better deal. So you always see things happening towards the end of each quarter. But I think it's been a consistent flow. I wouldn't say we're trying to push customers to think ahead just because, unfortunately, budgets move from year-to-year. And they're like, well, how do I spend dollars today, but it's going to move over to the following year before I get the product. So there's a lot of those conversations happening within organizations, and that kind of sometimes speeds things up and sometimes it slows it down just depending on how they can spend the budget with getting gear and paying for things literally a year later. So I would say it's consistent over the last 12 months. Some customers are moving a lot faster and some are just dragging just due to budgets and how they fall into the current year.

I guess, what I was referring to is before the supply chain problems were a big issue.

Yes. Under normal circumstances, the longest you would wait is 3 months, and that was pretty unheard of. Mostly everything was within 30 to 60 days. 90 days was really pushing it. Now if you get anything within 90 days, that's amazing. 6 months and under right now, that's, I would say, is fast. But most manufacturers, they just say 1 year. And then when things come in a little sooner, and in some cases, it's literally a year. The stuff that we've been waiting for HPP, they said a year, and it's going to be a year.

I'm trying to understand what our potential earnings and revenue growth would be if we weren't facing supply chain issues. Can you provide any insights on that?

They would definitely be expanded from that. We would be drawing from that. In the case of the cybersecurity products, the selling cycles are much longer than we initially expected. This is just the nature of the market due to significant competition and numerous comparisons, which means it takes a considerable amount of time for mid-market customers to make purchases.

The backlog, as we mentioned, is $4 million for the HPP, and the margins are quite high, so you can calculate that they range between 50% and 65%. From that alone, you could estimate what would impact the bottom line if we could shift that portion.

Thank you. And there are no further questions in queue at this time. This will conclude the Q&A session for today. And I would now like to turn the floor back to Victor Dellovo for closing remarks.

Thank you. As always, I want to thank our shareholders for your continued interest and support. Our record gross margin demonstrates the success effort to sell higher-margin products and services. While the growing and the record backlog highlights the high demand for these same products and services, we remain committed to growing the business, and we believe our backlog represents a substantial undervalued asset. However, we are exploring every alternative to procure components and deliver finished goods to our customers so we can convert the backlog to revenue and profit. Gary and I look forward to sharing our progress in fiscal 2022 full-year operating results in December. Until then, be well, stay safe.

Thank you. Ladies and gentlemen, this does conclude today's conference call. You may disconnect your phone lines at this time, and have a wonderful day. Thank you for your participation.