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CSP Inc. (NASDAQ:CSPI)

F3Q11 Earnings Conference Call

August 3, 2011, 10:00 AM ET

Executives

Gary Levine - Chief Financial Officer

Alex Lupinetti - Chairman, President and Chief Executive Officer

Operator

Good day, ladies and gentlemen, and welcome to CSP Inc.’s third-quarter fiscal 2011 conference call. My name is [Operator name], and I will be your coordinator for today.

At this time, all participants are in listen-only mode. We will conduct a question-and-answer session toward the end of this conference call. (OPERATOR INSTRUCTIONS.)

I would now like to turn the call over to Mr. Gary Levine, CSP’s chief financial officer. Please proceed, Gary.

Gary Levine

Thank you, [Operator name], and good morning, everyone. With me on the call today is our chairman, president and chief executive officer, Alex Lupinetti. I’ll take you through our third-quarter financial results, and then Alex will review our operations before we take your questions.

But first, our safe harbor statement. During the call, we will 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 and 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 Securities and Exchange Commission.

With that, let’s get right into our financial review.

Our financial results this quarter reflect difficult comparisons in both our Systems and Service and Systems Integration businesses.

Total sales were $19.7 million compared with $28.6 million in the third quarter a year ago. The revenue decline is primarily attributable to a 31% decrease at our Service and Systems Integration segment. This was the result of significantly reduced sales to a major hosting customer. As we have been discussing on the past few calls, that customer had acquired one of our largest competitors in 2010. I should note that this was slightly offset by an increase in revenues at our German subsidiary.

We reported a 28% decrease in revenues at our Systems segment, primarily due to $1.6 million in royalty revenues in the year-ago quarter from Lockheed Martin related to the E2D Advanced Hawkeye aircraft. We only reported a half million dollars from Lockheed Martin in the third quarter of 2011 for low-margin parts.

The effect of foreign currency was $0.9 million favorable on a year-over-year basis.

For the nine-month period, consolidated sales were down by about 14% to $61 million due to the relative strength we saw in the first half of the fiscal year.

CSP’s total cost of sales for Q3 declined to $16.1 million from $23.7 million in Q3 2010 due to the lower year-over-year volume. Gross profit for the quarter was $3.6 million compared with $4.9 million as a result of the lower sales. Gross margin was 18% compared with 17% in Q3 2010 as a result of better product mix and smaller average deal sizes.

Third-quarter Engineering and Development expense was approximately $400,000 compared with $500,000 a year ago. As a percentage of sales, Q3 2011 Engineering and Development was at about 2.2% of sales compared with 1.7% last year. Our target range for Engineering and Development expenses is 2.4% to 2.6% of sales.

SG&A expenses decreased on a real-dollar basis to $3.5 million in the quarter from $3.7 million a year ago as a result of lower commissions. SG&A was 17.5% of sales in Q3 of fiscal 2011, compared with 13.1% of sales in Q3 last year. Our target range for SG&A expense is between 16.1% to 16.6%.

Our effective tax rate for the quarter was 30%. This compares with an effective tax rate of 4% in the third quarter of 2010 due to the reversal of an accrual for a significant FIN 48 item for an uncertain tax position. We expect our effective tax rate will be approximately 34% for the fourth quarter of fiscal 2011.

Net loss for the third quarter was $214,000, or $0.06 per share, compared with net income of $621,000, or $0.17 per diluted share, in the third quarter of fiscal 2010.

Let’s now turn to the balance sheet . . .

Cash and short-term investments increased by approximately $2.0 million from fiscal year end September 30, 2010 to $17.5 million as of June 30, 2011. The increase was primarily due to a decrease in accounts receivable. We purchased approximately $60,000 in CSP stock during the quarter.

As we have discussed in the past, CSP’s cash position can vary significantly from quarter to quarter due to the high working capital requirements needed to fund large projects at both our Systems and our Services and Systems Integration segments.

Going forward, our financial priorities remain the same. We will manage the company cautiously with a strict focus on controlling expenses and efficient working capital management, all while driving toward long-term profitable growth.

With that, I’ll now turn the call over to Alex.

Alex Lupinetti

Thanks Gary. And welcome to our call this morning. With Gary’s financial review as background, I’d like to talk for a few minutes about the opportunities we see in each of our business segments and then turn the call over to you for questions.

Let’s start first with our Systems segment, which consists of our MultiComputer business. This business sells exclusively to the major prime contractors that sell to the U.S. Defense Department.

The Systems business reported revenues of $1.5 million compared with $2.1 million in the third quarter last year in which we benefited from $1.6 million in royalty revenue.

On last quarter’s call we discussed the budget approval of 10 new E2D Advanced Hawkeye intelligence, surveillance and reconnaissance aircraft. These aircraft are part of phases 3 and 4 of the Low Rate Initial Production Phase, or LRIP. We expect to begin benefiting from the production of these aircraft in 2012.

The E-2D is the Navy’s aircraft for “Early Warning and Battle Management Command and Control.” The E-2D analyzes information from internal and external sensors, disseminates the information to Joint Forces, and enables tactical decision making. Our multicomputers are an important component of the intelligence, surveillance and reconnaissance, or ISR, taking place on board the E-2D.

Going forward, we will continue to invest in technology to position CSP to capitalize on the military’s focus on ISR.

Let’s turn now to our Service and Systems Integration segment, which includes our MODCOMP subsidiary. This segment provides solutions and services for complex IT environments focusing on storage and servers, network security, unified communications, and consulting and managed services.

As Gary mentioned, while sales were down 31% in this segment, the lower sales actually obscure the excellent progress we’re making on our strategy to attract higher-margin consulting, as well as solutions and managed services business. In fact, while our US business was down dramatically as a result of the one large hosting customer, our German subsidiary reported a 34% increase in sales.

Strength in Germany was driven, in part, by sales to Vodaphone, one of the largest mobile telecommunications network companies in the world. As we’ve discussed previously, our work with Vodaphone is in part the result of our partnership with nCircle, a provider of automated IT security and compliance auditing solutions. nCircle provides the infrastructure for MODCOMP’s managed services offerings in addition to selling nCircle’s on-premise solutions to customers in Germany. We continue to see significant demand in the security market.

Another trend that we have been seeing relates to the proliferation of smart phones. As a result of the tremendous amount of data traffic generated by these ubiquitous phones worldwide, telecom operators need to upgrade their infrastructure and load balance their networks. This has been a real boon to sales for MODCOMP.

Our strategic success also was reflected in our gross margin, which was up 400 basis points to 16%. This was due to a better product mix with more higher margin solutions and managed services as well as fewer large deals, which typically carry lower margins.

Before we go to your questions, let me leave you with a few parting thoughts.

First, we are pleased with the progress of our strategy at our Service and Systems Integration segment to attract higher-margin consulting, as well as solutions and managed services business. Through this strategy, we expect to incrementally increase our margins over the long term.

Second, with the exception of the reduced sales to our large hosting customer, demand continues to be strong across our Service and Systems Integration segment.

Third, we are well positioned to capitalize on the military’s network-centric warfare priorities, as well as supporting LRIP phases 3 and 4 of the E-2D program.

And finally, in addition to organic growth, we are committed to accelerating revenues by executing on our acquisition strategy.

With that, Gary and I will take your questions.

Question-and-Answer Session

[Q&A]

Alex Lupinetti

Thank you for joining us today. We look forward to speaking with you on our Q4 call.

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