Earnings Call Transcript - CSPI Q1 2021

Operator, Operator

Good day, everyone, and welcome to the CSPI First Quarter 2021 Conference Call. Please note that this call is being recorded. And now it is my pleasure to turn the conference over to Michael Polyviou with EVC Group. Please go ahead, sir.

Michael Polyviou, EVC Group

Thank you, Pasila. Hello, everyone, and thank you for joining us to review CSPi's first fiscal quarter that ended on December 31, 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 conclude 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 intended to identify forward-looking statements. Forward-looking statements should not be interpreted as guarantees of future performance or results. The company warns that these statements reflect current expectations about 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 the segment and statements are based. Factors that may impact 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 at that time regarding future events. All forward-looking statements are qualified in their entirety by this cautionary statement, and CSP Inc. has no obligation to publicly revise or update any forward-looking statements, whether 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. Victor, please go ahead.

Victor Dellovo, CEO

Thanks, Michael, and good morning, everyone. Our first quarter performance continued to demonstrate our success navigating the challenging business climate. Specifically, our key objective of migrating to higher-margin products and services is delivering improved gross margins, and we remain well positioned to execute our long-term operating strategies. Despite being nearly a year into the pandemic, the entire CSPi team remains focused on achieving the primary objective of transforming our company into a cybersecurity, wireless and managed service company. CSPi is a nimble company, a distinct advantage that allowed us to develop exciting new offerings from scratch and ensure order, so we can compete with much larger companies. The awards, accolades, and industry recognition reflect our purposeful approach to developing much-needed and valued offerings. I believe that this nimbleness is inherent to our DNA and is why I believe our culture will allow us to emerge from the pandemic a much stronger company with a full complement of offerings to grow our top line and deliver a disproportionate level of profitability. Our managed service has continued to perform well as we added new customers, and the level of interest in our UCaaS and ARIA offerings is encouraging. Total revenue for the quarter was $11.4 million, down year-over-year, but in line with our internal projections. I also wanted to add that last year's Q1 was the last full quarter prior to the COVID pandemic. Further, the revenue mix and pursuit of higher-margin offerings allowed us to report our fifth consecutive quarter of year-over-year gross margin improvement, nearly 5.8 percentage points over fiscal Q1 2020. Given this gross margin performance, I would anticipate a steady improvement in the coming years as the portion of new higher-margin offerings contribute more heavily to the top line. As I have repeatedly said on these calls, the pandemic has exposed the weakness and limitations of network infrastructures. The pandemic did not create the issue; it only accelerated and exacerbated the underlying concern of security experts. We have already experienced record ransomware and phishing attacks. In this past December, 18,000 organizations were potentially impacted by some cyberattacks. The cyber infrastructure security agency classified the attacks that impacted a dozen agency, three states, and hundreds of commercial organizations as the advanced persistent threat or APT. For those who are not familiar, once the organization or agency was penetrated via SUNBURST, the hacker used the Orion Code to actively access as many vulnerable systems as possible while employing techniques to hide their actions. The ARIA advanced detection and response of our ADR solution was designed to detect such attacks as well as ransomware and malware, which are constant threats to all organizations. Out of the box, ARIA ADR requires no special configuration and is purpose-built to automatically find and stop all forms of attacks, including APTs. With over 73 models preloaded into our solution, it can detect any attacker's actions and behaviors, making it a highly effective threat detection and response solution. The ARIA ADR leverages advanced machine learning to pick up these behaviors by monitoring all network data, security, and IT architecture in deployed applications. It uses artificial intelligence to find bad actors, verifies their activities, and correlates their actions before declaring a confirmed threat. Today, ARIA ADR has been targeted at midsized organizations. This market has been heavily impacted by the COVID pandemic, restricting budgets and lengthening sales cycles. Just when these customers most need a solution, we have just released our latest version of ARIA ADR called ARIA Cloud ADR. This solution helps in two ways: first, it allows us to sell the solution to companies that are cloud-centric. Second, it creates a lower price point for entry for midsized customer prospects, as we can protect their premises, remote workers, as well as their cloud presence. Cybersecurity threats pose serious issues and cost organizations valuable time and resources to remedy and stay secure. Midsized customers are finding that ransomware attacks typically cost $100,000 or more to clean up. At the other end of the spectrum, several articles placed the cost to clean up the SUNBURST hack as high as $100 billion, and it could take months to fully resolve the issue. Thus, I no longer believe it's a matter of if, but when companies will set aside budgets and commit resources to avoid such issues in the future. For the quarter, our technology solution, our TS revenue, was $9.8 million; we continue to receive orders from some of our larger customers. However, the COVID-related impact has caused some budget delays in our current and potential small and midsized customers. Our managed service practice remains a bright spot and continues to expand as we sign new cloud-based and UCaaS customers, including in Latin America, as customers are seeking to expand their bandwidth to meet the growing demand in the region. The cruise ship industry remains an important market for CSPi. Of course, it's still feeling the effects of the pandemic, and they continue to push out the expected return of operations. We have been told a large investor may start operations in the second quarter. While gaining access to the ships remains an obstacle, we continue to have regular scheduled communication with the operators. We are maintaining some of the team members so we can move forward quickly when the operators give us the green light. We continue to add new UCaaS customers during the fiscal first quarter. We've been increasing the number of virtual product demonstrations, and each quarter, the new business opportunity pipeline is higher than the previous quarter. We are confident that we will continue converting these opportunities and capture our pieces of the pie, which is expected to grow from $15.8 billion in 2019 to $24.8 billion in 2024. Moving to our high-performance product, or HPP. Revenue for the quarter is $1.6 million. We remain excited about ARIA, and earlier this month, we signed a new customer, SPE, a managed IT service provider for the healthcare and telecommunication industries, which selected the ARIA microHSM solution as a key management server for securing its internal VM environment. For those not familiar, the ARIA microHSM generates hundreds of encryption keys per minute and gives SPE a powerful, low-cost, zero-footprint, and highly scalable KMS solution. It also enables SPE to expand its managed IT service portfolio to offer its customers critical asset remote encryption services. While we remain well positioned within the leading cable companies and have created other OEM opportunities for ARIA, the pandemic is delaying physical deployment evaluation and decisions. I believe the recent hack and the SPE engagement will help raise the awareness of our brand, which will be critically important as we move forward. In addition, our direct sales team continues to vet potential partners for the official channel program, and during the quarter, we added three in the U.S. and EMEA market. We currently have over a dozen partners, and we are speaking to several others to ensure a robust channel program and increase our chances for success. To summarize, the markets we serve offer enormous opportunities for CSPi, and the recent external factors reinforce our transition to a cybersecurity, wireless, and managed service company. We have a solid base of recurring revenue and a diverse customer base and portfolio of products and services that ensure we are positioned for success. Our goal is to increase the pipeline, close customer transactions, and deliver stellar performance. With that, I will now ask Gary to provide a brief overview of our fiscal first quarter financial performance.

Gary Levine, CFO

Thanks, Victor. As Victor mentioned in his opening remarks, our fiscal first quarter revenue was $11.4 million. We reported gross margin profit of $3.4 million compared to a gross profit of $4 million in last fiscal year. Despite the year-over-year revenue decline, we reported a gross margin of 29.7% compared to a gross margin of 23.9% last fiscal year. This is an improvement of 5.8%, which is an outstanding achievement. Our engineering and development expenses for the fiscal first quarter were $729,000 compared to $672,000 in the year ago period, due to the increase in headcount offset by reductions in consulting. Our SG&A expenses in Q1 were $3.2 million, approximately $575,000 decreased from the $3.2 million in last year's fiscal Q1, due to the decrease in variable compensation, payroll, and travel-related costs, as a result of the ongoing pandemic limiting on-site meetings with customers and prospective customers. The fiscal 2021 first quarter included a one-time income of approximately $2.2 million due to the forgiveness of the Paycheck Protection Program (PPP) loan under the CARES Act, which we received in the third quarter of fiscal 2020. We reported a net income of $1.2 million in the fiscal first quarter compared to a net loss of $540,000 in the fiscal quarter a year ago. The company's income tax expense for the fiscal first quarter was $110,000. The tax expense is primarily related to the write-off of deferred tax assets as a result of the change in the tax law allowing for the immediate deduction of covered expenses incurred through the PPP loan, combined with the associated change in the valuation allowance against our deferred tax assets from the prior period, offset by the forgiveness of the PPP loans for which the income is excluded from tax for cash purposes. We believe the measures we've implemented during fiscal 2020, including a suspension of our quarterly dividend and stopping our stock buyback program, along with the PPP loan proceeds, have enabled us to preserve our cash. We ended the first quarter with cash and short-term investments of $19.9 million, approximately $660,000 higher compared to the cash at the end of fiscal 2020. We will maintain a similar cash preservation process for the foreseeable future, allowing us the resources to execute our business plan. Our objective is to be positioned to benefit from the investments we've made over the past couple of years and leverage our business development efforts.

Operator, Operator

And we will take our first question today from Jonathan Hodnik with Compound Partners.

Unknown Analyst, Analyst

It's been a long time with investors. Obviously, we've met with you in the past; you're executing on all fronts. The market is realizing it. We've seen it and I just want to salute you on your accomplishments for investors. So thank you so much.

Victor Dellovo, CEO

Thank you.

Gary Levine, CFO

Thank you.

Victor Dellovo, CEO

I appreciate it.

Operator, Operator

And we will go next to Joseph Nerges with Segren Investments.

Joseph Nerges, Analyst

I'm going to ask you a challenging first question. It's an easy one. Do either of you know a CEO or CFO responsible for IT security who is satisfied with the amount they are paying or the rising costs to maintain security?

Victor Dellovo, CEO

No.

Joseph Nerges, Analyst

The answer is nobody is happy to pay that.

Victor Dellovo, CEO

Not at all.

Joseph Nerges, Analyst

Let me follow up on point two, which comes from your website. The ARIA ADR program provides your security operations center in a box that costs 90% less, requires one-hundredth of the manpower, and is one hundred times faster. I've spent my entire career in sales, and with any one of those three advantages, I should be able to sell this product easily. I should have a line of customers ready to implement it. I understand that the pandemic has created significant challenges for people, but you are offering a tremendous advantage by incorporating this solution. It's difficult to believe it hasn't gained traction sooner. Do you have any insights into why, despite these advantages?

Victor Dellovo, CEO

No, Joe, to be honest with you, we think it’s a crowded space with other products, and name recognition is what we are focusing on. We are building our customer base and obtaining referenceable accounts because we compete with some players who have been established for 10, 15, or 20 years or more. When we struggle to close a deal, it’s solely due to name recognition, and that’s the truth.

Joseph Nerges, Analyst

But again, it's so compelling what you're referencing regarding the advantages of incorporating and the ability to leverage demand power. That has to be the biggest challenge today, especially with the high costs associated with hiring in that area. I really think you should be moving faster, but I guess everyone feels that way. You probably feel the same, right?

Victor Dellovo, CEO

I agree with you.

Gary Levine, CFO

Yes.

Joseph Nerges, Analyst

I think you've clarified the question on ARIA Cloud. It is essentially a more cost-effective way to implement the ARIA platform while retaining nearly all of its capabilities. However, there are some areas where the cloud version does not provide the same level of coverage as the standard ARIA ADR platform. Is that correct?

Victor Dellovo, CEO

That's correct. The remediation aspect differs when you lack the appliance. In a fully cloud environment, there is no distinction. However, for on-premises or in-cloud options, if you require full remediation, you would need to line up our clients accordingly.

Joseph Nerges, Analyst

So there's people out there that could qualify. They wouldn't need the full ARIA platform? And they fit in perfectly with the cloud?

Victor Dellovo, CEO

Yes. But if their infrastructure is in one of the major cloud players, then it would fit in perfectly.

Joseph Nerges, Analyst

That sounds great. Regarding the press release you recently issued about the SPE microHSM product line, you've had this product line for a couple of years. What is different about the recent news regarding SPE and the StorMagic product?

Victor Dellovo, CEO

You mentioned the StorMagic aspect. A smaller company assisted us with the integration and development of the product, and they were acquired by StorMagic. During their integration, our relationship was put on hold. Now that the integration is complete, we have resumed our relationship and are currently pursuing various leads and marketing events.

Joseph Nerges, Analyst

So is the product more robust with the StorMagic software as opposed to I guess, what is it? Nexus? KeyNexus?

Victor Dellovo, CEO

Yes, KeyNexus. Correct.

Joseph Nerges, Analyst

Has it been upgraded to any extent? Is it better?

Victor Dellovo, CEO

The majority of the product is the same, but there are a few things that have changed, but nothing major. At this stage, there are other talks about growing that product and developing it more, but the core is the same.

Joseph Nerges, Analyst

I found that StorMagic has a fairly large customer base.

Victor Dellovo, CEO

Absolutely.

Joseph Nerges, Analyst

Here you have over 1,300 customers.

Victor Dellovo, CEO

Correct.

Joseph Nerges, Analyst

So I would assume, is there a possibility of incorporating some of this into that, or hope into some of those 1,300 plus customers that they have?

Victor Dellovo, CEO

No. We're excited about the relationship. We've gotten to know the upper management, and there's a lot of things going on in the marketing and talking about working with that customer base. There's been training with their salespeople to educate them on how the two products are joined together where the value is, and that will continue. Salespeople only listen to a small portion. There will be multiple trainings over a period of time.

Joseph Nerges, Analyst

But it would seem that, that market opens up to some areas that they weren't addressing previously?

Victor Dellovo, CEO

Our product clearly filled a gap in their product line, and that's how our relationship began. However, for about six to nine months, progress was paused as they focused on integrating the company they acquired.

Joseph Nerges, Analyst

Okay. And did you say you added three channel partners? Is that what you said you added this last quarter or the last...

Victor Dellovo, CEO

Yes.

Joseph Nerges, Analyst

Is that okay? I wasn't sure I caught all of that. I appreciate it. It sounds like you're making good progress here. The speed of implementation is the key.

Victor Dellovo, CEO

We're working on it.

Operator, Operator

We'll go next to Terry Keratsopoulos with Upstream Investment.

Terry Keratsopoulos, Analyst

Yes, my question was about the cloud-centric companies you mentioned targeting. What do you think is the market potential for that specific market?

Victor Dellovo, CEO

It's a tremendous opportunity for us. There's a lot of small, mid-sized companies that have their full infrastructures into Azure or an Amazon or Rackspace that we're going to go after.

Terry Keratsopoulos, Analyst

And would this be something that's a recurring revenue type? Or is it a one-time?

Victor Dellovo, CEO

It just depends on whether they purchased it and manage it themselves or if they opt for us to manage it for them, which is an option we offer our customers. If they prefer a fully managed solution, we have our stock and can take care of that. However, if they would like to purchase either cloud services, licensing, or ARIA hardware, we can accommodate that as well. There is also maintenance and support that accompanies those options.

Operator, Operator

And we will move next to Brett Davidson, private investor.

Brett Davidson, Investor

I got a couple of questions. I'm sinking in all of these acronyms. So you're going to have to bear with me or I may twist a couple of these around. But the ARIA HSM, if I'm not mistaken, doesn't that address the largest issue with that SolarWinds hack being able to get in the network and issue keys, more or less to gain access at free will?

Victor Dellovo, CEO

Yes. Part of it is that. Not the full thing, but part of it was that. That's the biggest thing that we're touting, that a lot of these companies are using keys inside a VMware infrastructure, where it's a stationary key, you get in, where we're constantly changing. There’s definitely value in what we're positioning. It's just the methodology that the IT people are used to doing it one way.

Brett Davidson, Investor

And you guys detach it from that. I guess it's sort of VMware. So it moves to a separate architect, a separate hardware?

Victor Dellovo, CEO

Well, it's just the keys are constantly changing.

Brett Davidson, Investor

Yes. Yes. All right. The SPE, I gathered they're a foreign entity?

Victor Dellovo, CEO

Correct.

Gary Levine, CFO

Yes.

Brett Davidson, Investor

And it's kind of hard to get an idea of the size of them. I mean, are they like a medium-sized business? Are these guys beginners? Or...

Victor Dellovo, CEO

No, they're a medium-sized business.

Brett Davidson, Investor

And is there, I mean, potential to follow-on with them? Or is this kind of just...

Victor Dellovo, CEO

Yes. So what they did, they adopted it internally, and now they're making it an offering to all their customers or potential customers, especially the ones that they're targeting are those up for renewal of their contracts, that this is an added feature that they would like to add on to it. So it's an early relationship right now, but they believe in the technology that they adopted for their internal purposes right now.

Brett Davidson, Investor

Now is this strictly SaaS? Or is this hardware also?

Victor Dellovo, CEO

No, it's both. In that particular case, it's hardware and software and support that goes along with it.

Brett Davidson, Investor

And they'll be providing the support? Or you guys will?

Victor Dellovo, CEO

Well, we provide the support for the product that they purchase, and the licensing, and everything that goes along with that. But they're in MSSP, so they would be providing their own support and maintenance to their existing account base.

Brett Davidson, Investor

So it would be kind of like a layered thing. They come to you for support for their purchase and their...

Victor Dellovo, CEO

Right. Correct.

Brett Davidson, Investor

So the next thing I want to discuss is the revenues. How are the revenues accounted for? Is there a hardware component and a software component, and will they be accounted for differently? I'm trying to understand how the revenues will be reflected.

Gary Levine, CFO

It's a bundled package, and revenue is recognized at that point. We will then provide details on maintenance and similar items, which could be spread over time. These contracts are generally longer-term, and the specifics will depend on their structure. Most of them do not have exit options as we set them up initially.

Brett Davidson, Investor

So does the revenue component change depending on how many of their customers adopt this? Or that has no factor in this?

Gary Levine, CFO

That would have a factor. Yes.

Victor Dellovo, CEO

It would. Yes. If we're doing the support, then we could recognize it over a period of time, and then if we don't, they're doing everything, then I think it's a one-time event.

Brett Davidson, Investor

Got it. So, going back to that press release I asked about last call, the one where you offered the free service for a limited time. Have you seen any uptake on that? Has anyone actually taken advantage of it?

Victor Dellovo, CEO

We've had some conversations with some clients right now.

Brett Davidson, Investor

I'm going to have another direction here. Government, USDA, PSA, it appears a lot of these have been hit by SolarWinds. Have you guys had any contact with any of the government agencies? Or do you have someone who can exploit context they had previously dealing with some of the government agencies?

Victor Dellovo, CEO

No, we are not focusing on the government or state at the moment. We have discussed it, but the cycle with the government takes years. If something happens, we will address it, but right now our main focus is on the commercial space.

Brett Davidson, Investor

All right. I think that's pretty much all I have. And I'm still going to be studying all those acronyms.

Victor Dellovo, CEO

We'll send you our glossary.

Brett Davidson, Investor

Speaking of that, is there something like that on the website? Is there...

Victor Dellovo, CEO

No. There isn't. But if you have any questions, Brett, feel free to call.

Operator, Operator

We'll go next to James Stewart from Investment Group.

Unknown Analyst, Analyst

Yes. Congratulations to both Victor and Gary. Boy, you're really knocking the lights out. I think the cloud business seems to be particularly exciting. I assume that it requires less manpower to implement from your standpoint? I know you're poised for explosive growth, but it seems like this is one area where you can really accelerate.

Victor Dellovo, CEO

Well, to your first question, yes, we're excited about the cloud-based product because it allows for more conversations. We're hopeful that adoption will be faster, as gaining access to people's data centers has been a significant challenge. We anticipate that the proof-of-concepts will take place and that we can close deals more quickly. Regarding shows, we are still participating in virtual events, averaging one to two a month. The audience consists mostly of casual participants, but there are a few leads that have led to interesting conversations and potential proof-of-concept opportunities. Gary Southwell, whom you may have met, has been presenting for about half an hour to fifty minutes at these events about ARIA and our technology. We've conducted a couple of these virtual presentations, approximately one every other month.

Unknown Analyst, Analyst

Well, that sounds great. I'm going to be pushing hard to get our group of companies to start looking at your product because we're always faced with people trying to hack into our systems. Congratulations, and I really appreciate the work you're doing.

Operator, Operator

We will go now to Elizabeth Millet, a private investor.

Unknown Shareholder, Shareholder

I have a couple of questions. I'm interested in your strong relationship with your managed service customers. Given that you already have this trust established, wouldn't the challenge of name recognition be less of an issue? How many of these customers have adopted ARIA? Is there a natural sales cycle among that group?

Victor Dellovo, CEO

We are targeting all our MSP customers right now and having various conversations that happen to each one. Some of it is still because they're in the small to mid-budget constraints. And then some of them are ready to move forward with adoption.

Unknown Shareholder, Shareholder

So that leads me to a question on sort of your sales cycle and your competition. When you get to the point that you're speaking with people, are they deferring the purchase because of the budget? Are they going with someone else? Who are you seeing as your most likely competitor if they're going with someone else? Can you explain that sales cycle to us a little more?

Victor Dellovo, CEO

It's a mix of different factors. Some customers are going back to their management to discuss budgets that were initially expected to be finalized in January but have now been delayed. They believe these budgets could be available this month or next month, but there are concerns about whether they'll receive the amounts they requested. Some have opted for cheaper alternatives that offer less functionality, as they only had limited funds to work with. While we provide a high-quality product at a competitive price, there are other options available focused solely on endpoint protection. Customers have found services at $2 or $3 per user, while we sell a comprehensive product suite that exceeds just endpoint protection. As a result, we either lost these opportunities or they’ve been postponed until they secure more funding for the advanced SIM solutions they know they require but cannot afford right now. In a few instances, we lost business to some of the major players in the market, specifically large PC manufacturers that offer their own products at reduced prices, which was an unfavorable business decision for those customers.

Unknown Shareholder, Shareholder

I understand the impact of COVID, but I'm not quite sure why it's necessary to meet in person to make these sales since it's a software-related business. Can you elaborate on that?

Victor Dellovo, CEO

It's not strictly a software play. Up until just recently, on the cloud ADR, it was a hardware play with software, and we had to be in line to do the full remediation. We had our appliance that would go in line with taps, and we'd have to get inside the network to get in line, to do the remediation as the traffic was passing. So that they have.

Unknown Shareholder, Shareholder

My last question is on SPE; I googled them and also their CEO, and I can't find anything about them. Could you point us to their website so that we can learn a little bit more?

Victor Dellovo, CEO

Sure. We can put something on our website. I don't have it right now, at this second. We're going to put it on our message board or on LinkedIn.

Operator, Operator

And I am showing that we have no further questions at this time. I'll turn the call back to you, Victor for closing or additional remarks.

Victor Dellovo, CEO

Thank you. And as always, I want to thank our shareholders for their continued interest and support. We will continue to manage the business and leverage our opportunities where and when they exist. We remain excited about CSPi's long-term growth prospects and the industry dynamics will prompt increased interest in our offering. Gary and I look forward to sharing our fiscal second quarter results in May. Until then, stay safe.

Operator, Operator

This does conclude today's program. Thank you for your participation. You may disconnect at any time.