Earnings Call Transcript - CSPI Q4 2021

Operator, Operator

Good day, everyone, and welcome to the CSPI Fourth Quarter and Full Year 2021 Results Conference Call. Please note that this call may be recorded. It is now my pleasure to turn the program over to Michael with EVC Group.

Michael Polyviou, EVC Group

Thank you, Emma. Hello, everyone, and thank you for joining us to review CSPI's Fourth Quarter and Full Year ended September 30, 2021 financial results. 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 then open the call for questions. Statements made by CSPI'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, 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 based. 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 the future events. All forward-looking statements are qualified in their entirety by this cautionary statement, and CSPI 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. Vick, please go ahead.

Victor Dellovo, CEO

Thanks, Michael, and good morning, everyone. Even though significant supply chain issues at several of our component suppliers crimped our product sales during the quarter, our team continued to build business in orders. As a result, we ended fiscal 2021 with a record backlog of $13 million, up 165% from the September 30, 2020 level. The backlog growth reinforces our view that CSPI will emerge from these challenging times a stronger and more formidable company. Our team also firmly believes that our award-winning product and service portfolio is enabling CSPI to compete for increased market share. While the backlog is an encouraging development, our short-term revenue generation has been impacted by the pandemic and supply chain issues. Unfortunately, these factors will make it difficult to protect quarter-over-quarter performance. However, we are confident in our fiscal 2022 yearly projections. We are working with our customers and suppliers to resolve and mitigate these issues as quickly as possible. We are taking every step to build revenues in the areas where external forces aren't having as much of an impact. For example, we are increasing the resources we devote to our software sales since these products and services can deliver near-term revenue and higher margins and are delivered remotely. We grew our fourth quarter service revenue by 27% year-over-year as we continue to add new customers. Our goal of migrating to higher-margin products and services is being achieved as we reported our eighth consecutive quarter of year-over-year gross margin growth despite tougher year-over-year comps. The product mix being sold, the amount of revenue recorded and overall margin in the products are contributing to this increase from the prior year. The improved product gross margins as a percentage of revenue has been focused in fiscal 2021, particularly in the TS segment. Our Technology Solutions, or TS business, again led the way with revenues of $8.8 million in the fiscal fourth quarter. Our managed service practice, or MSP, continues to be a reliable source of growth and exceeded our internal expectations as we added new larger and several niche customers in the retail and consumer space. We remain focused and committed to building our recurring revenue business, which is contributing significantly to the bottom line. Now let me say a few words on the cruise line activity, which has steadily increased over the past few months. In fact, today, we are more bullish on this business compared to any other time during the COVID-19 pandemic, which effectively stopped our cruise activity. We received orders for 4 ships in Q4, which we expect to complete during the next few quarters. Aside from the revenue opportunity, this is a highly profitable business for CSPI, and our decision to maintain our cruise-related workforce early in the pandemic, despite there not being much work for them, is proving to be prudent because it is allowing our team to react quickly and meet the operators' timelines. However, the first and foremost is the health of our team, so we are taking all necessary precautions and adhering to local protocols to ensure a safe working environment. Now turning to our UCaaS offering. I'm pleased to report we experienced better-than-expected activity in the fourth quarter, and momentum has carried into the current first quarter. In fact, we have doubled the size of the business over the past few months, which is a big deal since we launched 2 years ago just prior to the worst imaginable business environment. Our goal in fiscal 2022 is to complement the team's progress with smaller accounts and pursue larger accounts. Regarding the high-performance product, or HPP division, we reported revenue of $1.2 million, which is slightly higher compared to fiscal Q3 revenue. While the Myricom business has steadily picked up, royalty revenue related to E2D was lower than expected, so we anticipate the balance will be recorded in the first half of fiscal 2022. ARIA remains the primary growth engine for this business segment, and we closed several deals in the quarter and recently announced the receipt of a multimillion-dollar, multi-site sale of ARIA SDS solution from a National Intelligence Agency. The ARIA SDS product will be a critical component of the government solution to improve network visibility, our networks provide to national security to detect communication performance in cybersecurity-related issues, which are and will continue to be on the rise. The ARIA SDS approach is ideal for this application, given its design for high-bandwidth processing, exceptional packet analytics, and real-time packet filtering capabilities. The ARIA SIA will easily upgrade the data up to 120 gig from the multi 10-gig network found in over 40 sites. Upon ingest, the ARIA Packet Intelligence application performs specified filtering to isolate traffic of interest. This traffic is then directed to a variety of cybersecurity tools such as an IDS for further threat hunting and investigation. We are especially pleased because the ARIA SIA and Packet Intelligence application was envisioned for exactly this purpose: to provide complete real-time visibility of the entire network for cybersecurity hunting. We were able to close several new ARIA deals that were included in Q3 sales funnel, but we also managed to grow the sales funnel as our messaging and marketing education efforts yield positive results. During Q4, we signed additional ARIA ADR customers, and our team is highly engaged with the prospects whose primary objective is to get later-stage opportunities over the finish line. We all recognize that this has the potential of generating significant top-line growth with a disproportionate benefit to the bottom line. To summarize, we ended the year with a record backlog that was up 165% from the prior year level. The manufacturing and supply chain issue remains a challenge. However, we are doing everything possible to get orders out, revenue and margins up. We continue to have a solid foundation even during these turbulent times, and we are laser-focused on business execution and exploring new opportunities that strengthen our long-term growth and profit ambitions. I expect, for at least the foreseeable future, that we will maintain prudent expense management that will allow us to have the necessary resources to execute multiyear growth strategies. With that, I will now ask Gary to provide a brief overview of the fiscal fourth quarter financial performance.

Gary Levine, CFO

Thanks, Victor. As he noted, our revenue for the fiscal fourth quarter was $10 million, reflecting a challenging business environment. We reported a gross profit of $4.2 million or 41.7% of sales, compared to $4.4 million or 31% of sales in the same quarter last year. This marks the eighth consecutive quarter of gross margin expansion as we continue to focus on higher-margin services. The increase in gross margin is attributed to the product mix, the net revenue recorded, and the overall margin contributions compared to last year. The gross to net adjustments for sales and cost of sales for the year and the fourth quarter amounted to $4.6 million and $12.7 million. Our near- and short-term goal is to sustain an annual gross margin in the mid- to high 20s and aim to increase it as higher-margin products make up a larger share of our revenue. Our engineering and development expenses in the fourth quarter totaled $696,000, down from $717,000 in the same period last year, mainly due to reduced ARIA development costs. Our SG&A expenses in Q4 were $3.8 million, slightly down from $4.2 million in the prior year. We incurred a tax expense for the year due to a full valuation allowance against our deferred tax asset, offset by the exclusion of income from the forgiveness of the Paycheck Protection Program loan. This also included the exclusion of the gain from our German subsidiary under U.K. law, current year federal R&D credits, and the benefit from federal carrybacks of net operating losses at a statutory rate of 34%. We reported net income from continuing operations of $353,000 in the fiscal fourth quarter, or $0.08 per share, compared to $36,000 or $0.01 per share for the same quarter in fiscal 2020. Additionally, we reported a one-time gain of $465,000 from the sale of our discontinued German operation, resulting in a net income of $818,000 or $0.19 per share for the fourth fiscal quarter of 2021. As of September 30, 2021, we had cash and cash equivalents of $20 million, an increase of over $700,000 from the previous year. We believe the measures taken during fiscal 2020, including pausing dividends and halting our stock buyback program, along with the PPP loan proceeds, helped us preserve cash and maintain a strong balance sheet throughout the pandemic. We plan to continue this careful cash preservation approach for the foreseeable future until the economy and business operations normalize. Now, I'll hand it over to the operator to take your questions.

Operator, Operator

And we will take our first question from Joseph Nerges with Segren Investments.

Joseph Nerges, Analyst

Congratulations on the fourth quarter. Although the revenue was lower than we expected, achieving an operating profit in this environment is truly commendable. I have a couple of quick questions. In the last conference call, you mentioned that many people were evaluating ARIA. Is the situation still the same today? Do we have many contracts and proposals currently under evaluation?

Victor Dellovo, CEO

Yes. Yes. Some we win, some we lose, and then we have new ones that get into the funnel.

Joseph Nerges, Analyst

And you're basically saying you've signed a few since the end of the year as well as in the fourth quarter?

Victor Dellovo, CEO

That's correct.

Joseph Nerges, Analyst

Regarding the government contract announced early last month, the $1.8 million one, you mentioned in the press release that the revenues would not be recognized until the second half of next year, 2022. Is that accurate?

Victor Dellovo, CEO

That's what we're aiming for. Currently, we are still facing challenges in obtaining some of the components.

Joseph Nerges, Analyst

That was going to be my question. What was delaying? Is that the component part of it? It's certainly not the software; you could release software.

Victor Dellovo, CEO

No, yes. That's correct. However, the chips we require from certain manufacturers have lead times that are gradually improving.

Joseph Nerges, Analyst

So what you're saying is, hopefully, sometime next year, we can roll that out. So right now, we're not getting any revenue whatsoever. Obviously, we haven't implemented anything on that contract.

Victor Dellovo, CEO

That's correct.

Gary Levine, CFO

Correct.

Joseph Nerges, Analyst

I would like to follow up on the press release you issued about a week ago regarding NVIDIA. They launched their Morpheus platform in April. The latest news is about a software upgrade on the DOCA software, which I believe was announced in early November.

Victor Dellovo, CEO

Well, they have AI software that is constantly being released, but we're also working with their Boards to integrate our software onto their new boards that are currently available and the new ones scheduled for April. So that's an ongoing process that we are always engaged in.

Joseph Nerges, Analyst

These are upgraded boards? Is that for the...

Victor Dellovo, CEO

It's their new version, yes.

Joseph Nerges, Analyst

New version.

Victor Dellovo, CEO

The new version, yes.

Joseph Nerges, Analyst

So are they beta testing that right now? They indicated in their press release that they're working with partners, and we're one of the partners...

Victor Dellovo, CEO

Yes. If you saw what they did, they announced about 10 of their key partners that they work with, and we happen to be one of them, which considering the thousands of partners they have, it was an honor to be mentioned as one of their top ones.

Joseph Nerges, Analyst

In their initial press release in April, they not only announced us, but they liked our link ARIA Cyber website. So obviously, that was a positive way to issue a press release. We didn't issue the press release; they did. But are we able to get involved? They mentioned partners and customers. So I'm assuming they've released some of their customer base to try to test the possibilities. Are they beta testing that with some of their customers, this whole platform?

Victor Dellovo, CEO

No, I'm not sure about their specific actions, but they are collaborating with us, and we are in discussions with several large customers. These customers are looking for some level of customization, which is where we come into play. We are potentially adapting their boards and software, and in some cases integrating our software to maximize the functionality of their boards. This is where our partnership is the strongest.

Joseph Nerges, Analyst

Well, that's great. I mean, because now we're at some pretty sizable customers that would want to customize, and if we customize them, then we get the business, I would hope?

Victor Dellovo, CEO

Yes, that's our OEM play that we integrate into their boards that would be integrated into other customers' products or services.

Joseph Nerges, Analyst

Have we seen considerable interest from that group, or is it mainly by request? I know they have...

Victor Dellovo, CEO

It's a work in progress, but there are a couple of things that their boards that they were supposed to have out have been slow due to some component issues they've encountered. Some of the boards we were expecting to receive early for development have been delayed, and everything is currently being pushed back a bit. However, progress is being made, and we do have customer meetings with NVIDIA and ourselves.

Joseph Nerges, Analyst

Okay. Great. Did you mention that we received minimal E2D revenue in the last fiscal year, and that we anticipate more of it in the first half of this fiscal year?

Victor Dellovo, CEO

Correct. Some of it, the planes got pushed.

Joseph Nerges, Analyst

Okay. Did we get any revenue in the fourth quarter, E2D revenue?

Gary Levine, CFO

Very small amounts of minimal. We expect to get some more in this...

Victor Dellovo, CEO

Very small.

Joseph Nerges, Analyst

All right. I guess that's basically it. You mentioned in the press release that we anticipate some significant changes in revenue in HPP down the road as we roll out more of the ARIA and as we gain more ARIA customers, which is encouraging. One more thing, one more question. During the last conference call, you indicated that we are working with the ARIA ADR managed under our technology solutions and service contracts. Have we acquired additional customers in that area?

Victor Dellovo, CEO

Yes. I think all the customers have been ADR, except one. So yes. So mostly everything is being managed.

Joseph Nerges, Analyst

All right. The last time we introduced it, we got it out there, and we are making progress in Florida with the customer base. I appreciate it, and let's hope this supply situation resolves sooner rather than later.

Victor Dellovo, CEO

Absolutely.

Operator, Operator

And we'll go next to Brett Davidson, a private investor.

Brett Davidson, Investor

It's good to be here. I've got a couple of questions, hoping you guys can help me with. Press release that was welcome. Do you anticipate any more of those coming in the near future?

Victor Dellovo, CEO

Absolutely. As soon as we have something of value, we will definitely share it, Brett.

Brett Davidson, Investor

Okay. That's good to hear. The 27% increase in service revenue, can you just give a feel for how much of that is represented by ARIA? And how much of the increase is from UCaaS? Is one of them a bigger contributor than the other?

Victor Dellovo, CEO

The majority, I would say, of the service revenue on that side came from the TS side, and that's a mixture of professional services, of MSP services and UCaaS services, overall.

Brett Davidson, Investor

Okay. Is one of those driving that 27% increase? Or that's more like an across-the-board thing?

Victor Dellovo, CEO

It's pretty much across the board. All the services we do are at a much higher rate, and that's kind of where we've been trying to concentrate as much as we can on building that service business.

Brett Davidson, Investor

Yes. The recurring revenue stream.

Victor Dellovo, CEO

Yes, absolutely.

Brett Davidson, Investor

All right. The backlog. I mean, it's not something that we usually see reported. So I'm just trying to get a handle on what exactly backlog represents? So I'm thinking something like UCaaS doesn't really get...

Victor Dellovo, CEO

No, it's not UCaaS. No. Because we already built that platform. The current MSP and UCaaS setup is impacted by a large customer rollout involving over 50 sites, which requires their infrastructure to be ready for management. We are currently waiting on firewalls, switches, PCs, and servers. This backlog is delaying our ability to deliver the product to the customer, which in turn is slowing down billing for the recurring revenue on the MSP side. By now, we expected to have rolled out 50 locations, but we only have about 20. Until we receive the necessary equipment, I can’t proceed with upgrades or start billing for the MSP. Regarding UCaaS, while it hasn't significantly impacted us yet, there is a minor effect due to delays in the desktop phones needed for customers transitioning to our platform. The Cisco phones are backordered until March, April, or May, which illustrates the timeline we’re facing. Thus, we are currently implementing softphones for customers willing to use them until their hard phones arrive. Additionally, for other major products, such as those from key manufacturers providing firewall services, I cannot bill for installations that aren’t completed yet, which is also contributing to the slowdown. This issue seems to be widespread across all manufacturers, with delays being a common factor.

Brett Davidson, Investor

Got it. So hardware is converting some of these software-as-a-services to backlog, which with normal supply chains wouldn't necessarily end up there?

Victor Dellovo, CEO

Correct.

Brett Davidson, Investor

Got it. What are the typical components that make up the backlog in this case? I assume some of the UCaaS items could fit the example you mentioned. What else is included?

Victor Dellovo, CEO

The MSP aspect involves how the backlog functions in standard professional services. For instance, if I’m deploying 50 or 500 firewalls, there's a significant services deal we closed last quarter for just under $2 million. However, we are currently waiting for all the equipment, and until that arrives, I can’t recognize the $300,000, $400,000, or $500,000 worth of services. This situation is impacting every part of our business at the moment.

Brett Davidson, Investor

Got it. Does the cruise ship in the E2D stuff also land in the backlog total?

Victor Dellovo, CEO

Well, no, the E2D, as soon as we get the PO, there's a delivery date...

Gary Levine, CFO

We do have some in there, correct?

Victor Dellovo, CEO

Yes.

Gary Levine, CFO

There is some E2D because we expect some to be in December, and there are others scheduled for the year that have not yet been released. They provide us with a purchase order for a specific number of units, and then we receive them gradually. While we received many at the end of the year, we currently have a significant amount for royalties.

Brett Davidson, Investor

Okay. And some of those are folded into the backlog total?

Gary Levine, CFO

Absolutely. Those are hard quantities.

Brett Davidson, Investor

What is the estimated timeframe for addressing this backlog? Will it be next quarter, the following two quarters, next year, or will it extend beyond a year? How long will it typically take to get through this? I understand that supply chains may affect this, but generally, how quickly can we expect to resolve it?

Victor Dellovo, CEO

Under normal circumstances, everything takes a couple of weeks. If there were no disruptions, the maximum wait would be six weeks. Currently, everything has a minimum wait time of 12 to 15 weeks. In some cases, particularly for the chips we are awaiting on the ARIA side, the wait can extend to 26 to 52 weeks.

Brett Davidson, Investor

Wow. That's kind of crazy. Let's see. All right, UCaaS generating enthusiasm in Q1. So those generating enthusiasm in Q1 include adding new customers during the quarter?

Victor Dellovo, CEO

Absolutely. We've been consistently adding new customers every month in UCaaS of various sizes. Some of our newly signed customers have ended up being an MSP customer, a UCaaS customer, and then an ARIA customer, effectively purchasing all three services. Ideally, we would like all our customers to transition into this type of environment, and we're making efforts to achieve that.

Brett Davidson, Investor

You had many customers where you backed up and you cross-sold some of these products and handed them as customers to one of the other services?

Victor Dellovo, CEO

Yes, we make an effort. Sometimes customers choose two of our services, and other times they go with all three. We aim to encourage them to adopt all three, as that would be the ideal situation for us. However, it can take some time. Initially, they may prefer to start with UCaaS and MSP, wanting to assess our performance first. They want to ensure they are comfortable with our services before fully committing, which could take anywhere from six months to a year. When it's time for renewal, we may approach them to discuss adding another service. This involves timing and various considerations as well. Ultimately, our goal is to achieve recurring revenue across all three services.

Brett Davidson, Investor

So now these things have been rolled out for a little while. I would imagine that that opportunity is going to increase during this calendar year?

Victor Dellovo, CEO

That's our goal. That's our goal. It took a few years for MSP to really pick up stride and get those customer references and we're building up the UCaaS references. And of course, ARIA, we're building up some references there too. So little by little, we're moving in the right direction.

Brett Davidson, Investor

Got it. And the last thing I want to touch on is the cash balance back up to $20 million. And I guess that the timing might not be right, currently, but I know there was talk about reinstituting the dividend after a couple of profitable quarters. The buyback program is on hold. I'm just wondering what the current thought process is there, seeing the cash just keeps flowing?

Gary Levine, CFO

Well, I think we have numerous discussions at the Board level. And obviously, we bring it up at every Board meeting. So it's something we're scrutinizing. And I think once we get some continuing quarters correct, we'll take a good hard look and could consider implementing, but we need to get profitability on a consistent basis.

Brett Davidson, Investor

Has there been any talk about making the buyback program active again? Has that changed at all?

Gary Levine, CFO

We can address that as part of the discussion.

Brett Davidson, Investor

All right. That would be good to take a look at. I think at this point, it might be able to strategically to go in there and grab some shares on the cheap and might work out good.

Gary Levine, CFO

Yes.

Operator, Operator

There are no further questions for the program. Back over to Victor for any closing additional remarks.

Victor Dellovo, CEO

Thank you. As always, I want to thank our shareholders for your continued interest and support. Rest assured that your management team is committed to success and is diligently working to grow the business. Gary and I look forward to sharing our progress in fiscal 2022 first-quarter operating results in February. Until then, be well, stay safe and enjoy the holidays.

Operator, Operator

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