Earnings Call Transcript - CSPI Q3 2024

Operator, Operator

Good morning, everyone, and welcome to CSPi's Third Quarter Fiscal Year 2024 Conference Call. It is now my pleasure to turn the floor over to your host, Michael Polyviou. Sir, the floor is yours.

Michael Polyviou, Host

Thank you, Matt. Hello, everyone, and thank you for joining us to review CSPi's fiscal 2024 third quarter results, which ended June 30, 2024. 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'll then open the call for questions. During the Q&A session, we ask participants to limit themselves to one question and one follow-up question and then re-queue, if they have additional 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 terms 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 interpreted 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 several uncertainties, risks and other influences, many of which are beyond the company's control that may influence the statements and 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 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 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. Vic, please go ahead.

Victor Dellovo, CEO

Thanks, Michael, and good morning, everyone. Earlier this morning, we announced our fiscal 2024 third quarter results, and with the supply chain issue well passed, I'm pleased to report our business has returned to a more normalized revenue run rate, and we have focused on driving our higher-margin business while building the required infrastructure to drive the success of the emerging AZT PROTECT product line. We have been able to consistently grow the service business in the fiscal third quarter with no exception as the service revenue increased 10% and contributed 150 basis points improvement to the gross margin percentage over the prior year level. The AZT PROTECT offering has the capability to dramatically reshape our high-performance product business and our entire company. Customer enthusiasm for the product line remains high, and the team is generating leads and building an attractive pipeline. Moreover, we are continuing to extend the brand awareness of AZT PROTECT through multiple awards, including being named winner in the Application Security category at the 2024 Fortress Cybersecurity Awards presented by Business Intelligence Group. Overall, the team has done an incredible job as this was the ninth major industry award for the AZT PROTECT since the launch following the successful Cybersecurity Excellence Award, the Global InfoSec Award at RSA and the Global Award for Cybersecurity. During the quarter, we also signed some small mid-tier manufacturing customers located in the Midwest. We have many other similar opportunities that are being pursued to ensure we maintain the momentum and remain focused. We recently hired Greg Pysher, an experienced 20-year IT industry sales veteran as VP of Sales to head up the AZT PROTECT business. Throughout his career, Greg has consistently driven sales and is known for building and training high-performance teams in complex solution sales and mentoring them to achieve ambitious goals. Greg is already transforming our sales team, and in just a few weeks, his impact is being felt throughout the organization. While our multi-pronged sales strategy includes engaging with Fortune 500 companies, Greg's immediate goal is to ensure we have the right sales team to focus on small to mid-tier enterprises because of the shorter sales cycle. We will continue to pursue larger opportunities directly or through our partners despite the longer sales cycle because each one can represent multimillion-dollar contract opportunities, like the one we signed in the second quarter, which helped AZT PROTECT awareness in the market. Greg is also helping the team prepare for several upcoming events, such as the American Petroleum Institute Conference taking place in Houston. This conference is the only cybersecurity conference dedicated to the oil and natural gas industry and has a loyal and dedicated attendee base. As we engage with the largest oil companies in the world in the water treatment plants, the process to evaluate AZT in these large oil and water treatments has taken months. Just to get set up in the system to do a proof-of-concept has taken 4 to 6 months. The team will also attend the industrial control system cybersecurity conference being held in Atlanta. This conference is the largest and longest-running event series focused on industrial cybersecurity. Since 2002, the conference has gathered ICS cybersecurity stakeholders across various industries and attracts operations and control engineers, IT government vendors, and academics. We believe these and other conferences are ripe opportunities to further expand our brand presence within the OT marketplace. We have also successfully executed our AZT PROTECT Partnership program over the past few months. We entered a new integration partnership with Forescout Technologies, which offers comprehensive asset intelligence and control across IT, OT and IoT environments, trusted by Fortune 100 organizations, government agencies, and large enterprises for over 2 decades. Forescout serves as a cornerstone for managing cyber risk, ensuring compliance and mitigating threats. This full integration will take some time, but we believe the opportunity could be huge. In addition, Ebix, a managed security service provider, performed a lengthy in-house red team evaluation of AZT PROTECT prior to adding ARIA to its existing portfolio of technology partners. Ebix is a leading provider of innovative cybersecurity services and solutions to commercial as well as government and public sector customers in North America, EMEA and APAC regions. Lastly, Worldwide Technology, a large global reseller of IT and cybersecurity solutions, will supply the award-winning AZT PROTECT solutions to its customers. I believe this approach ensures we are using our resources and those of our partners to significantly raise the profile of the AZT offering and build revenue opportunities. In only 3 weeks, Greg has currently signed multiple resellers. And Greg is confident we can increase the number of OT-focused sales by December to over a dozen. Locations of these resellers are all over the world, including Chile, Peru, Brazil, Morocco, Norway, India, Australia, and Iberia. Our largest partnership is with Rockwell, and we have recently been selected to update the industry on how to measure the cybersecurity risk facing industrial operations and how to mitigate against them at the Rockwell Automation Fair in November. The event is being held in Anaheim, California; and Gary Selfe, Vice President and General Manager of the High Performance Products segment, will be a guest speaker. He will be presenting an in-depth review of the latest attack techniques and their financial impact. Gary will outline how insurance providers are measuring the risk and how companies can comply with the new insurance and regulatory requirements and will share a range of use cases to demonstrate how companies can apply reduction techniques to reduce measurable risk, including a high-profile ransomware attack on Merck, which resulted in a $1.4 billion impact and led to a lengthy legal battle with insurance to recover losses. Working with Rockwell, we will be delivering new solutions to the manufacturing environment that complement existing passive and active defenses, and address what they miss. Before I review the Technology Solutions business, I wanted to spend a couple of minutes highlighting the recent CrowdStrike-induced outage and the opportunity it presents for AZT. While the target market for AZT PROTECT was initially focused on operational technology, or OT, it was always our intent to engage with information technology or IT market professionals. We've already commenced discussions with IT professionals. So the timing of the outage was beneficial to our efforts. We believe had AZT PROTECT been previously deployed, the outage would have been controlled at the corporate level. It has been estimated that the cost of the outage is in the billions of dollars, and the Delta Airlines CEO has said it cost the company $500 million. We believe companies using AZT PROTECT can prevent both malicious code as well as disruptive updates from taking critical systems down. We've proven this capability in the field under real-life operational circumstances. We can ensure that untested updates do not become active on the systems, helping corporations and organizations at all levels avoid another CrowdStrike-type disaster. It has become the norm for IT applications and cybersecurity vendors to send updates directly to their applications. Unfortunately, as the CrowdStrike event has demonstrated, a few customers test these updates and allow them to update automatically, whether that is intentional or not, untested supply chain updates can have a greater impact on critical systems than most cyber-attacks. If an update to the system puts lives in danger due to an outage, it should not be deployed without formal verification testing. The same goes for servers running any critical business process. The Technology Solutions business continues to perform well and generate the majority of the quarter's revenue. The success of the Technology Solutions continues to be driven by our customers' increased use of implementation, installation, and training capabilities. We continue to add new managed service provider customers, and we are currently awaiting decisions on several big orders that, if they go in our favor, could positively impact our results in fiscal 2025 and beyond. The activity is encouraging. And to add more color, we are in the process of implementing a wireless conversion at over 70 to 80 locations of a global hospitality company. This work will continue through 2025. We are also working with one of the largest freight operators specializing in containerized ocean exports serving numerous ports worldwide, and we will be doubling the number of container ships for which we are performing equipment conversions and will continue to be their managed service provider for each and every ship. We also continued to generate higher levels of interest in our UCaaS offering. During the current fiscal fourth quarter, we have already signed several new customers; the momentum with the UCaaS is building, and we expect to enter the new fiscal year with an annual revenue run rate that is more than double what it was entering fiscal Q4. In summary, the strength of the Technology Solutions business has allowed us to fund and develop AZT PROTECT. The Technology Solutions business has three lines of recurring revenue: UCaaS, cloud practice, and managed service practice. This has been a slow, methodical process over the last few years, but we now have all three generating consistent profits. We are building the AZT practice with the same methodology and determination as we did with the other lines of business. I am highly confident we will be generating consistent profits in the near future. Today, we are in the process of deploying additional resources to ensure we have the organizational infrastructure to support the business in 2025 and beyond. AZT PROTECT has the potential to revolutionize how OT professionals approach their responsibilities. Recent events reinforce that IT professionals also need to be vigilant and ensure their businesses are not compromised, whether from external threats or third-party software updates. Our commitment to developing and innovating high-margin products and services has enabled us to expand our gross margins and grow our cash balance to a near-record level.

Gary Levine, CFO

Thanks, Victor. For the third quarter ended June 30, we reported revenues of $13.1 million compared to revenue of $17.7 million for the fiscal third quarter ended June 30, 2023. I want to point out that at the year-ago fiscal third quarter, we converted a sizable portion of backlog to revenue as the supply chain issues had eased, and we were able to get key components to complete and ship customer orders. As Victor said earlier, we have returned to a more normalized business environment. In fact, revenue was relatively flat compared to the 2024 fiscal second quarter. Gross profit for the three months ended June 30, 2024, was $4.6 million or 35% of sales compared to $5.9 million or 33.5% of sales, representing a 150 basis point gross margin percentage improvement despite the lower year-over-year revenue as higher-margin services revenue fueled the improvement. For the third quarter, our engineering and development expenses were $734,000 compared to $741,000. Our SG&A costs include continuing investment required to build out the AZT sales, support, and marketing, and the amounts were $4.6 million for both fiscal years. For the fiscal third quarter, we reported a net loss of $185,000 or $0.02 per common share compared to a net income of $2.5 million or $0.26 per diluted common share for the fiscal third quarter ended June 30, 2023. In the prior year, our tax benefit was $1.7 million for the fiscal third quarter, primarily for the release of the valuation allowance against our deferred tax asset. For the third quarter, we generated operating cash flow of $2.4 million. As of June 30, 2024, we had cash and cash equivalents of $28.9 million compared to $13.9 million in the year-ago fiscal third quarter and $25.2 million at the end of our 2023 fiscal year. We believe that the continued success of the Technology Solutions business and our ability to focus on selling higher-margin products and services gives us the flexibility to leverage our resources to execute the multipronged sales strategy to target small, medium, and large enterprises for AZT PROTECT. During the fiscal third quarter 2024, the company repurchased 4,800 shares for a total cost of $70,000. We currently have 9.7 million shares outstanding. Lastly, the Board of Directors approved a quarterly dividend of $0.03 per share payable on September 10, 2024, to shareholders of record on the close of business on August 23, 2024. With that, I will turn it over to the operator to take your questions.

Operator, Operator

Your first question comes from Joseph Nerges from Segren Investments.

Joseph Nerges, Analyst

Well, first, congratulations on all the awards that AZT PROTECT has garnered. And of course, the expansion of the partnerships with some very large organizations is also positive going forward. My first question is really on the integration of AZT PROTECT into the Forescout platform. Where is that? And how long do you anticipate that to take?

Victor Dellovo, CEO

We haven't started it yet. They are currently in planning sessions, and it could take anywhere from 4 to 6 months for that to be fully integrated and tested.

Joseph Nerges, Analyst

Okay. So it's going to be obviously some from our end and some from their end.

Victor Dellovo, CEO

Yes. They've engaged a team that will work with us to build all the APIs, but it's a lengthy process. It could be faster. I'm just not exactly sure how fast the team is going to be, and there's going to be a lot of testing that will have to go through with them. So we're hoping it's faster, but we'll see.

Joseph Nerges, Analyst

I'm not sure if they have any external suppliers. Are you aware if Forescout is unique in this regard? It seems that almost all of their platform was developed in-house or through mergers, where they integrated other systems after acquiring companies. Do you know if there were any other external suppliers involved in their platform, similar to our situation?

Victor Dellovo, CEO

I didn't ask the question, to be honest with you. When we met them, we were pretty happy that they saw how we could complement their great product and not cannibalize anything they currently already have. I'm guessing, whether it was another outside partner or something that they own internally, if we were doing the same thing, they wouldn't have signed this up.

Joseph Nerges, Analyst

Yes. Well, I don't know of anything where they have a product that stops an attack like AZT PROTECT. What would you do? Just another follow-up here on with Rockwell. Of course, with the issue with the CrowdStrike faulty software download, there’s got to be a significant number of their clientele or customers that were affected. It has to be in the OT environment because such a dramatic amount of people were affected. So I would assume that they have a number of customers currently going through that problem. Do we know of anything? Have we gotten any update or any feel for what happened at Rockwell via the CrowdStrike incident?

Victor Dellovo, CEO

Yes, they pointed us to work with their partners that sold the systems, and that's kind of what we're building a food chain with their partners. The biggest thing with Siemens, Rockwell, and Emerson of the world and the process that we're going through is to get certified on the systems. And that's kind of what we do with Rockwell. They love what we have to offer. I think that's why they invited us to do a talk at the upcoming show, because they said we're very unique in how we market our protection applications at the core level. So that's kind of what we've been doing. Now that we’ve got approved and we’re working with the marketing team in the magazine and all that stuff, now we’ve had their blessing, we’re setting up each of their partners. But there's a process that goes through that. I think everybody has to understand is that when you sign up new partners, you have to educate them, and then you have to get mind share. It's definitely a process, and we're putting together training materials for companies outside the country and changing the language so they can read it. There's a lot that goes in. And because we're a small company, you can only do so much so fast.

Joseph Nerges, Analyst

My main point regarding the Rockwell situation is that many of their customers were impacted. There seems to be increased urgency from these customers, especially as they seek solutions to prevent similar issues in the future. I'm sure Delta would prefer not to experience those challenges again, and the same likely applies to the Rockwell group. Many of those affected likely want to avoid a repeat of past difficulties. Therefore, there is clearly an urgent need for a solution. Additionally, could you provide some insight into the differences in your IT version of AZT PROTECT? You mentioned launching an IT version, and how do you differentiate it? Can you elaborate on what you're aiming to achieve with that IT version?

Victor Dellovo, CEO

Well, the IT version, because of all these updates, in the OT space, it's a more stable environment with everything scheduled. We had to build a product that scans all the updates, looks at if they are from a valid source. In a lot of cases, the way we built it was for the individual to approve the update. We're going to check if it's from a valid source. At that stage, it will be up to the individual to approve the update. That's kind of where in the CrowdStrike case, it wouldn't have been an automatic update; we would have basically stopped to look at it and would have given the customer the time to test it and not just automatically let it go through. That's where I think the messaging on the CrowdStrike issue is that nothing happens unless you approve it, analyze it, and then you should be testing it. But of course, not every company is going to do that, and that's where they run into problems.

Joseph Nerges, Analyst

And this is not really available outside in many other cases. In other words, this idea of testing beforehand has not been implemented too often by other software competitors.

Victor Dellovo, CEO

Yes. Well, see, the other thing we do too is, while a lot of these patches are needed because they have a gap, right? So they're vulnerable potentially without that patch. If you had AZT to complement these products, we would still protect you 100% while products like CrowdStrike, Sophos, and Trend Micro are running their testing before they are updated.

Joseph Nerges, Analyst

Okay. Well, great. Sounds like the pieces are in place, just a matter of time.

Victor Dellovo, CEO

Yes, yes. As I’ve mentioned the last two quarters, I want to ensure everybody has a clear understanding that we have built three other profitable practices under the umbrella. It takes time; you build a food chain, you build a sales force, you have to build rebate programs, and you have to build marketing. With less than 30 people in the High Performance Products segment, just to give you a sense of how much the workload is spread out, most of those individuals are engineers that develop the product. We hire sparingly, and we try to do it where it makes sense. We're trying to hire the right people but can't hire enough salespeople. What we're trying to do is build a food chain using partners and getting the right partners with the right OT experience. We've never been in the OT space historically. All these partnerships are crucial. That's why when we chose to bring Greg on, he has 20 years of experience working primarily for the same company that only sold into the OT space. It's just a matter of time.

Operator, Operator

That concludes our Q&A session. I will now hand the conference back to Victor Dellovo for closing remarks. Please go ahead.

Victor Dellovo, CEO

Thank you. As always, I want to thank our shareholders for your continued interest and support. Good things are happening, and the industry is taking notice of CSPi's award-winning AZT PROTECT. The activity we are experiencing is exciting, and we look forward to sharing our progress in fiscal 2024 fourth quarter and full year results quarter in December. Until then, be well, stay safe and enjoy the rest of the summer.

Operator, Operator

Thank you, everyone. This concludes today's event. You may disconnect at this time and have a wonderful day. Thank you for your participation.