Gary Levine - Chief Financial Officer Victor Dellovo - President and CEO, CSPi and Acting General Manager, CSPi Technology Solutions, North America.

Joseph Nerges - Segren Investments.

Good day, ladies and gentlemen, and welcome to CSPI’s Fourth Quarter Fiscal 2018 Conference Call. My name is Chris, and I’ll be your coordinator for today. At this time, all participants are in a listen-only mode. We will conduct a question-and-answer session towards the end of this conference call.

I would now like to turn the call over to CSPi Chief Financial Officer, Gary Levine. Please proceed, sir..

Thank you. Good morning, everyone, and thank you for joining us. With me on the call today is Victor Dellovo, CSPi’s Chief Executive Officer.

Before we begin, I’d like to remind you that during today’s call, we’ll take advantage of the Safe Harbor provisions of the Private Securities Litigation Reform Act of 1995 with respect to statements that may be deemed to be forward-looking under the act.

The company cautions that numerous factors could cause actual results to differ materially from forward-looking statements made by the company. Such risks include general economic conditions, market factors, competitive factors, pricing pressures and others described in the company’s filings with the SEC.

Please refer to the section on forward-looking statements included in the company’s filings with the Security and Exchange Commission. During today’s call, after Victor provides an introduction, I’ll discuss our fourth quarter financials. Victor will come back for an update on our business segments and on our strategic progress.

And then we’ll open it up to your questions. With that, I’ll turn it over to Victor..

Thanks, Gary. We had a busy fourth quarter to end fiscal year 2018.

We closed on the sale of our German operation, transitioned the accounting for our UK office to Florida, continued to develop our next-generation cybersecurity solutions, including introducing a new cybersecurity application and recently signed two new partnerships to expand our reach.

Financially, fourth quarter revenues were down 31%, primarily due to lower multicomputer sales, product sales in the UK and in the U.S., and the delay of the launch of our ARIA Software Defined Security solution.

On the bottom line, we reported net income of $16.2 million or $4.07 per diluted share, which includes a gain on the sale of our German operation of $16.8 million.

In our High-Performance Products segment, we continued to experience stronger-than-expected demand for our legacy Myricom network adapters and further developed our next-generation ARIA SDS cybersecurity solution. In the Technology Solutions, our U.S. operations benefited from an increased demand for our IT managed services.

After Gary reviews the financial results for the quarter, I’ll come back with a detailed review of our achievements and our progress in Q4 by segment.

Gary?.

For the fourth quarter of fiscal 2018, revenues were $19.6 million, compared to $28.4 million a year ago, reflecting delays in launching the new ARIA SDS solution, lower multicomputer sales and products and royalties, and lower product sales in the U.S. and UK for the TS Division.

Our total cost of sales declined $14.8 million from $21.3 million in the prior year period, in line with the lower sales volume. Gross profit for the quarter was $4.8 million, down from $7.1 million a year ago. Gross margin, however, at 24.7% was essentially in line with 24.9% a year ago.

Fourth quarter engineering and development expenses were $925,000, up from $615,000 a year ago. As a percentage of sales, Q4 engineering and development expenses rose to 4.7% from 2.2% last year as a result of the higher level of investment in our ARIA solution. Engineering and development expenses were in line with Q3 of 2018 on a sequential basis.

We expect this level to continue through the development phase of our next-generation cybersecurity products. Q4 SG&A expenses were $5 million or 25.7% of sales compared to $4.7 million or 16.8% of sales in the previous year. The increase was primarily due to compensation, severance in the UK, and legal expenses.

We had a fourth quarter tax benefit of $341,000, compared to a tax expense of $623,000 last year. The effective tax rate for the quarter was 32.9% compared to 37.9% in the prior year. Net loss from continuing operations was $700,000 or $0.18 per share compared to net income of $1 million or $0.27 per diluted share a year ago.

Net income from discontinued operations was $16.9 million or $4.29 per diluted share, which includes the gain of $16.8 million for the sale of our German subsidiary and includes $93,000 for the two months we owned the German operation in the quarter.

Cash and short-term investments were up to $25.1 million, with $14.4 million of proceeds from the sale of our German subsidiary. Lastly, our Board of Directors voted to pay a quarterly dividend of $0.15 per share to shareholders of record on January 7, 2019, payable January 22, 2019.

Our financial priorities in the first quarter of 2019 continue to be to improve our bottom line performed by increasing the level of high-margin products and contain costs across the organization. I’ll now turn the call back to Victor..

Thanks, Gary. Let’s jump into our segment review, starting with our High Performance Products division. HPP revenues were $3.1 million, down 28% from last year, primarily due to the delay in the launch of our ARIA SDS product as well as lower multicomputer revenues that Gary mentioned.

Multicomputer revenues were mainly for spare parts and boards for the E-2D and E-2D foreign military program. At this point, we have not been given details on the total order levels for 2019 for the U.S. We do anticipate revenues for the E-2D foreign military program, with most royalties being recorded in the second half of the year.

Demand for our legacy Myricom products were stronger than expected, as we continued to benefit from the sales of our ARC Series 10 gig network adapters.

By developing new software features and working with equipment manufacturers to integrate our Myricom technology into their own, we have been successful in stemming the anticipated decline in the product line. On a full-year basis, Myricom revenues were high, up high-single digits clearly reversing our original downwards forecast.

Equipment manufacturers are now using Myricom cards for two different purposes. First, the cards can be used as an intelligent add on to manage multiple MD [ph] ports and packet capture processes. By using our cards, manufacturers increase the performance of cybersecurity application in a cost-effective way.

And second, our adapters improved the speed of our financial trading, which we achieved by offloading the data from their application and processing the data at significantly higher speed. Our adapters enabled equipment manufacturers to track operations in real-time with more accuracy than expected packet capture devices.

These value-added capabilities have enabled us to slow the decline of our legacy product as we continue to develop our next-generation cybersecurity products including our new ARIA platform.

Our ARIA solution provides advanced cybersecurity protection capabilities for critical data assets that need to be assessed by the end users in applications both in the cloud and on-premise. During the past year, we worked on completing the ARIA platform, which can support various specific security applications.

The first is our ARIA SDS microHSM application that offloads encryption and key management away from the host CPU. This improves application performance and reduced costs, while delivering better performance than traditional hardware security modules.

In August, we announced the release of our second application, which focuses on virtualized key management, our new ARIA SDS KMS application simplifies the serving of encryption keys and certificates required to properly encrypt data.

Traditionally, with self-encrypting drives, the data was protected by just one key for the entire system, making the information vulnerable during cyberattacks. Our ARIA KMS application servers thousands of unique key per second, enables VMware and SAN Encryption and provide substantial more security environment.

The ARIA KMS application is unique in a fast set up, ease of use, flexible implementation options. In addition to fitting with the customer’s existing service, it is easy to integrate with an interested solutions, without the need for in-house cryptologist experts in high-deployment costs.

Overall, ARIA takes a radically different approach to enterprise-wide data security by focusing on enhanced network security and ensuring applications data impenetrability.

In September, ARIA was named the winner of the Enterprise Encryption Solution of the Year Award from CyberSecurity Breakthrough, an independent organization that recognizes top company technologies and products in a global information security market.

This year, the award affected more than 3,000 nominations from 14 different countries around the world. We view our win as proof that the market is demanding data security solutions that are both easy to deploy and cost-effective. As you know, we have been experiencing delay in the launch of our ARIA platform due to supplier issue.

We expect to be able to conduct testing and valuation in January and should see sales ramp-up in the second-half of fiscal 2019. As we work through the supplier issues, our team has been busy essentially, new partnerships to increase revenues and expand our reach.

In November, we added Chestnut Hill Technologies and Egoseal to our global network of resellers and distributors of our legacy Myricom adapters in future cybersecurity products.

Based in Massachusetts, Chestnut Hill Technologies, we provided our security technology consulting services and strategic IT application services, mainly serving companies on the East Coast.

In response to growing demand for our security development deployment, they will now integrate our solution for enterprise, looking to decrease time to incident response, improve breach in investigations and notifications and cost effectively enhance network security posture.

Egoseal, based in China, has a strong expertise in database, vulnerability scanning, assessment protection, monitoring and penetration testing. Together, we will be addressing the growing need for data and network security in China in broader Asia Pacific markets, including Taiwan, Hong Kong and Singapore.

We are excited to work with our new partners and look forward to expanding the reach of our security solution. Turning now to our Technology Solutions business. Quarterly revenues were down 31% year-over-year, mainly due to lower product sales in the U.S. and the UK, partially offset by the strength in the service business in the U.S.

On a full-year basis, the Technology Solutions business continues to deliver year-over-year growth and profitability. During the quarter, we closed on the sale of our German operations to European IT service provider and media conglomerate Reply, the €10 million, or about $11.7 million.

As we previously shared, the increase in difficult competitive environment in Germany and lower-than-expected profitability compelled us to divest the business. The positive financial effects for the sales provided us [the lease up and time] [ph] to invest in high-margin managed services opportunities.

In the UK, revenues were down for the fourth quarter, as well as reduced sales from a large multinational organization. We have right-sized the UK business by adjusting headcount and the team is in the process of moving our offices to reduce fixed cost.

We continue to serve our multinational customers with a team of engineers that work on a project basis. We expect a profitable Q1 2019 in the UK with our new streamlined structure. In the U.S., the increase in our service sales was driven by growth of our managed IT services.

During the quarter, we added new clients and established high billing rates for new and existing customers. In July, we began realizing additional monthly revenue from our private cloud contract and we are now fully managing the private cloud. Separately, we continue to expand the number of managed firewalls to other firewall partnerships.

Our sales in the U.S. continues to build our managed service pipeline [indiscernible] more profitable prospects. Taking all these factors into account, we are confident we will continue to deliver growth in this segment in Q1 2019 and beyond.

I would like to take a moment to thank our entire team for executing on our transformation strategy and for making our company a great place to work. We were recently named one of the Florida’s Best Companies To Work by Florida Trend magazine.

Our workplace was evaluated for policies, practice, philosophy, systems and demographics and overall employee satisfaction. In closing, we worked hard in fiscal 2018 to continue to transform CSPi from a company focused on defense-related multicomputers to one with significant growth opportunities in cybersecurity and wireless managed service markets.

As you can – as we discussed earlier on July 31, 2018, we sold all of the stock of our – outstanding stock of Myricom GmbH for $14.4 million cash and recognized a gain of $16.8 million.

The divestiture of the German operation and our increased cash position will enable us to focus time and resources on a higher-margin and greater potential growth opportunities. We are encouraged by the traction of our managed service business in the U.S.

and we tend to continue to invest and focus on our new ARIA SDS cybersecurity products and to capitalize on the proliferation of our wireless service business. We have done a good job making progress in those areas within our control.

For example, we are proud of our efforts to develop new cybersecurity applications for our legacy products and our new-generation platform for cybersecurity products. We have invested in engineering, talent and created new partnerships to continue our focus on innovation and to expand our market opportunities.

At the same time, we are simply focused on managing cost and improving profitability. We look forward to keeping you up-to-date on our transformation progress. With that, I’ll turn it over to the operator to take your questions. Thank you..

[Operator Instructions] And our first question comes from Brett Davidson who is an individual investor. Please go ahead..

Good morning.

How are you, guys?.

Good morning..

Good morning..

You’ve got a lot of sunshine down in Florida there?.

Yes, as always..

Yes. We got a rare day with a little fun peeking through, so that’s a good thing. So I’m looking to get– well, actually, let me give you a clarity first. I got a little bit of a writer’s cramp putting my questions together this morning, so I hope you bear with me here..

Go ahead, Brett..

I’m looking for a little clarity on the E-2D.

So it was just spares in the most recent quarter, and is that pretty much what’s come through in Q1 and what Q2 looks like?.

Well, we’ve got – yes, there’s some spare parts, and there was a few royalty boards not a plane or anything like that, Brett, it was very small. And we don’t have really much in the second quarter, and it really looks like we’ll have some stuff in the third and fourth quarter.

But as Victor noted, we haven’t really gotten in that much information out of Lockheed as to what the delivery schedule will be..

Yes. So – and I think you indicated too that some of that was for the Japanese planes.

Has that been a continuing trend there?.

Well, that – we know that they’re at least from what’s been written that they’re going to be getting planes. We haven’t really been told or -- we just anticipate..

Got it..

…I mean, Lockheed indicated last summer that we would probably get some foreign military. They don’t tell you what it’s going to be..

Got it. So I’m looking for a little clarity regarding accounts receivable and inventories.

Are the levels we’re seeing on the balance sheet currently, are those like reasonable ranges of what we can expect going forward?.

Well, first of all, the inventory, a lot of it is – a big portion of that is timing for orders within the TS group. So, a lot of it’s drop ship, so things shift. So under the revenue recognition rules a lot of times, we don’t get to do it and we don’t get notice, so that’s a big chunk of it.

And the receivables, probably, I mean, as far as there’s good flow on the cash, it’s just on the business side what happens, so as we get more growth, hopefully, we’ll have bigger numbers in there in the short term..

Got it.

So yes, I’m just trying to get a handle from the cleaving off the German subsidiary whether those are reasonable levels or if it’s further adjustment that’s going to be as a result of a sale or if that’s pretty much what we could normally expect?.

With the TS business, it’s just difficult, because the business, as Victor can tell you, comes in chunks. We get some big orders and it’s the timing of them from an inventory standpoint or a receivable standpoint. And as in many businesses, the end of the quarters, there’s a big rush to get things out, so you tend to have….

But there’s no..

…higher receivables..

There’s no further adjustments due to the German subsidiary sale?.

No..

Yes. So – got it.

Maybe if you guys could just clarify the statement in the press release that talks about growing our managed IT pipeline with larger, more profit – profitable prospects? So I mean, has that come to fruition in Q1 and looking good for Q2, or is that something you anticipate a little further out or how exactly does that shake out?.

A lot of the pipeline that we’re looking at right now with larger organization, multibillion dollar organizations, where our managed wireless practice, as I mentioned in the past, has been doing really, really well, and that’s one of the areas that a lot of companies – sometimes, when you look at managed services, they may not be as interested as taking over their full infrastructure, but a lot of companies, multibillion dollar companies don’t want to manage wireless, so that’s something that we’re talking to a lot of large organizations, whether financial or school systems that we’re looking at taking their wireless infrastructure over as a managed service recurring revenue model.

So that where that comment comes from..

And I mean, is this stuff that you anticipate closing soon, or there’s a timeframe that’s going to push this out sometime or…?.

Well, as you know, you can’t control customers, but it’s a thing that we have been working on, I would say, six months or more already.

So, if everything works out and we’re able to win the opportunities, I would say it’s more sooner than later, but I can’t guarantee anything right now, but they have been in the works for a long time, and like I said, I think that hopefully with some luck that they’re closed, but I can’t guarantee anything that will be awarded, but we have been working diligently with them for probably six months or so..

Okay.

But there’s so many moving parts, so with the big jump in the cash balance, I mean, all kinds of opportunities open up, and getting out of the Technology Solutions business over in Germany and weak sales over in the UK, I mean, you guys actively pursuing, moving some of those other divisions, or – and how does that look as far as deploying some of their cash? Is there any plans yet to put some of that to work?.

Yes. Everything is on the table. Acquisitions are always a possibility, we’re looking at every – everything right now. So, with that cash stay, but it will need to be fit into the – our current strategy and would need to be accretive over some period of time, if we were looking at to do something like that, that’s the plan right now..

I know that there’s huge constraints regarding doing a buyback.

But has that been explored, and has a one-time special dividend also been discussed?.

Well, we look at that. And I think when we increased the dividend from $0.12 to $0.15, that was something that we were considering sort of one-time. We kind of look at it over a period of time..

And….

But everything is still on the table for discussions. We do bring it up every quarter at our Board meetings..

Yes.

I’m not even sure whether you could do an effective buyback, but has there been any discussion of maybe pulling some shares at the current prices?.

We’re viewing that, Brett. We’ve had some discussion. I mean, obviously, last quarter we were at some pretty high levels. And so now what’s going on in the market, maybe something we’ll take a closer look at..

Got it.

And maybe if you could just – the last one here just give me some color on what – how Q1 is shaping up?.

Yes. Brett, we don’t really give forward guidance on that. So, I know you use usually try to ask that, but….

I’m not looking so much for guidance or revenue or earnings, it’s just kind of a quality – or a qualitative look at what Q1 looks like.

I mean, you guys really active or…?.

Yes, things are going in the right direction. The only thing that we’re anxious on is delivery of some of the boards we need for the new ARIA. But everything else, Myricom has been, as I mentioned, been doing better than we anticipated. We thought it was going to be closer to 10% to 15%, 20% decline over the last two years.

We made some changes to kind of keep that acquisition now we did a few years back moving in the right direction. So we’re pretty happy with that. TS has been – it’s been doing well last year with a great year. The UK, it has a couple of big customers. If they all buy at the same time, it does really, really well.

One of the big customers we had bought so much last year that we knew this year that weren’t going to have the same spend, and that’s kind of way you saw some – the decrease in revenue and profitability in the UK would be basically just one customer who bought a huge deal last year that didn’t do that this year.

So, with – we – part of their realignment in the UK was to get rid of some of the people that we’re working with Germany. And that side, we got rid of them fortunately, but they had to move on. So we right-sided that ship, I think, on cost. So moving forward, I feel pretty comfortable with the UK.

And TS is over the years, every year, it’s profitable and it’s been growing. My focus is to continue with the managed service with our recurring revenue model and anxiously waiting to get the boards that we need from our supplier with the ARIA.

There is a lot of customers anxious to get their hands on the board to do some evaluation and that’s kind of what we’re waiting for right now. So everything that we’ve – I’ve been talking about, I think, is moving in the right direction. The only hold up that’s slowing us down is not at the software we’re developing.

We are on schedule with everything we’re supposed to be doing.

It’s just getting those boards to put the software on and it’s been delayed just to some chip issues that they had, that they’re working through, which I think, we’ve gone through most of it now and we’re anxiously just waiting for some more boards to test and to move into our customer’s hands..

That was perfect. That’s good. I get some good color as to how things are looking. Thank you so much and I’ll jump back in the line here..

Happy New Year..

Thanks, Brett. Happy New Year..

Thank you..

[Operator Instructions] Our next question comes from Joseph Nerges with Segren Investing. Please go ahead..

Good morning, guys.

How are you doing?.

Good..

Good morning, Joe..

A couple of quick – just a couple of quick ones.

Why don’t you say the severance cost was that you charged off in the couple of severance payments that – from new paying people, you mentioned that, Gary, right?.

Yes, right. Yes, we had a number of people that we’re working with Germans and the UK, we’re working together. So they were working in the security area, which we basically with the sale we lost the engineers and a lot of them were salespeople and support people.

So we lost a number of them go and then we realigned sort of the support staff in the UK, say that we can service our existing customer base, but cut back a number of people. So that’s what the severance cost worked for..

Yes, but what was the dollar amount for the quarter?.

It was, I think, about $150,000, Joe..

So that’s a one-time fourth quarter charge that….

Right..

…included with the severance cost. And obviously, the supplier issues, we’re talking about – so we’re having no promise you are saying with the software for we could tell.

Do we have some of the boards and not enough of the boards, so we’ve been able to internally test this, or do we – what seems to be drop…?.

Yes. So, Joe, I’ll give you a little more color on that. What we’ve done is, we pushed the supplier as hard as we could to get these brand-new boards with the latest and greatest technology on the chipset. So that shift, which is just being released is something that we need, because we need the power to support all the software we’re loading on it.

So what we did was, we get – they gave us a few board that were basically not even tested. We did a lot of the testing for them and then they had to really go back and make all the changes. We recently just got the next set of boards on hand and from what we can see everything is both being good.

But there’s a bunch of other testing they need to do for them to certify it. So they could do it and send it out to the public that it’s GA for them, and that’s kind of where we’re at right now..

Okay. So as far as we know the newest board looks pretty good and we’re just waiting for them assessing from the supplier standpoint and then the roll off. So we really don’t think we have a problem internally with the software at all my question has to be tested, I want to get this to the field.

But basically, we’re – the biggest problem is getting the board?.

Correct..

Just a couple – one other quick question. From your website, it looks like you guys have expanded your managed service offerings quite a bit.

My – is that incorrect that you added cloud services, you added backup services, these are things that [dig you] [ph]?.

What is, Joe, what we did was, I think, we offered all of those what we did with our new website. I’m glad you looked at it was we’re trying to put it out this, so it was a little clearer to potentially new customers what our offerings were.

So we just launched that probably less than 30 days ago with a clearer message of what the company looks like as – for the HPP side with the ARIA and all the products that go along with that and then we separated from the professional services and all the products that we sell, and then we kind of separated with the managed service offerings in a clear message of everything we can do so customers add.

It’s just easy of understanding of what CSPi does or can do..

What site is great? I mean, it really is very, very informative. And so, obviously, it highlights something that wasn’t as apparent before not exactly….

Exactly..

…the question about the demand in service. By the way, you might check that, you put out an incorrect phone number on the conference call on your press release today. It’s 877 number. You got 876-9173 is the one that you put out on – the number you put out, which was the correct number you put out a week ago.

And in today’s press release, it was 9193 is the last. So, I don’t know if anybody checked that, but that one is probably….

Obviously, yes. Okay, that’s my fault..

Okay. I just – I thought the number, I look back and said if I was wrong, I have your old number. Okay. So basically there, and then R&D, like you said for the quarter, was like $925,000.

So, obviously, a considerable amount of R&D versus what it was, like I said last year?.

Yes. We were understaffed last year, Joe..

Okay..

At that time, we had a lot of open positions..

I understand.

But what you’re basically doing is, obviously, we’re moving forward with – and the bulk of the R&D obviously is, I assume is the ARIA product line?.

That’s correct..

All right. Well, that’s what I’ve got. I’ll just – I’ll come back to what Brett said. Basically, when you look at the stock in a market like this get panicked, it comes in all the time in a market like an environment we’re having.

So with the – by the way, with the cash balance at the end of the quarter, that’s what I forgot actually, the cash balance at the end of the year – fiscal year?.

Right now?.

Yes. It was all of it.

In fiscal year, the September – your September 30 cash and equivalents – cash and cash equivalents?.

It’s like $25 million..

$20 million, okay, $25 million. I didn’t look at in the 10-K and the press release didn’t have that.

So it’s about $25 million at that point?.

Yes, it’s a little over $25 million, yes..

Okay, very good. Thank you very much. I appreciate the time you’re moving forward just if we can, we get everybody rolling the boat in the same direction with the suppliers here, I’m sure. Okay. I appreciate it..

Absolutely. Thanks, Joe. Happy New Year..

[Operator Instructions] And it appears, there are no further questions over the phone at this time..

Thank you all for joining us this evening – this morning. We look forward to speaking with you again on our next call..

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

Thank you..