CSPI - CSP Inc.: Singular Research Special Situations Report

2023-03-17 10:09:12 ET

Summary

• Managed services driving momentum with speculative catalysts on the horizon.
• Major secular tailwinds in cybersecurity.
• Its partnership with Nvidia could be a game changer.
• Potential upside based on our $15 price target.

Company Overview

CSP Inc ( CSPI ) and its subsidiaries are involved in the development and marketing of IT integration solutions, advanced security and managed services, purpose-built network adapters, and high-performance cluster computer systems. The Company operates through two distinct segments, the High-Performance Products ((HPP)) and Technology Solutions ((TS)) divisions. The HPP division provides Ethernet products for various applications, including cybersecurity, financial trading, content creation/distribution, storage networking applications, and computer signal processing systems. The TS segment consists of Modcomp, a wholly owned subsidiary operating in the United States and the United Kingdom. Modcomp offers technology solutions for network solutions, wireless and mobility, unified communications and collaboration, data center solutions, advanced security, as well as professional and managed services across those technology focus areas. CSP Inc. was established in 1968 and has its headquarters in Lowell, Massachusetts, with a workforce of 117 employees.

Investment Thesis

The main driver of growth in recent years has been managed services. Many small companies are facing increasingly complex needs related to cybersecurity and cloud services, which their in-house staff may not have the expertise to handle or may find it difficult to attract highly skilled IT engineers to manage. As a result, these companies are outsourcing these responsibilities to firms like CSPI.

We believe that there is still significant momentum and potential for growth in this segment, especially among the Company's primary segment of small and medium-sized businesses, over the next few years. At the end of FY:22, this segment accounted for 33% of total revenue and has grown by 36% since pre-pandemic levels in FY:19. In contrast, total revenue has fallen by 30% in the same time frame, underscoring the importance of managed services to the Company's overall success and near-term stability. The services segment has exhibited a Compound Annual Growth Rate ((CAGR)) of 11% over the past three years, surpassing the sector's projected growth rate of around 10% and suggesting that the segment has been able to capture incremental market share.

The continued migration of our business to offer differentiated, higher value cybersecurity wireless, and managed services offerings is propelling our growth. Victor Dellovo, CEO

Speculative, Near-Term Catalysts

• One catalyst could be the improvement of the supply chain, which has caused a backlog to build up. The current backlog stands at $24M, significantly higher than the normalized backlog of $5M. However, management believes that $2M of this backlog can be shifted immediately if the supply chain improves. Furthermore, of the $4.4M backlog as of Q1:23, HPP products typically have higher margins, and management hopes to clear most of this backlog during the first half of FY:23. It is expected that nearly all customer orders in the backlog will be shipped or provided through fiscal year 2023.
• The Company's sales could potentially experience a boost if the cruise industry, a long-term client, begins to upgrade its WiFi and network equipment. Recently, SeaDream Yacht Club and brands under Royal Caribbean Group announced their plans to implement Starlink technology, which utilizes Low Earth Orbit ((LEO)) satellites operated by SpaceX, to provide a more stable and faster internet connection for small-ship and large cruise operators alike. As a result, many other cruise lines have followed suit and announced their plans to improve their bandwidth.
• Maintaining connectivity at sea has become increasingly important for many guests who wish to share their cruise experiences with friends and family. The extra bandwidth also enables cruise lines to debut new services and features for guests, improve connectivity for the crew, and better support shipboard operations such as equipment monitoring and ship-to-shore communications.

Nvidia Partnership

Although the Company's ARIA cybersecurity system's partnership with NVIDIA offers the potential for reduced manual intervention and labor cost savings for clients, the system faces challenges due to its low brand recognition and lack of coverage in Gartner's Magic Quadrant of product reviews. However, the endorsement from NVIDIA could help ARIA gain recognition and potentially expand its market reach. Additionally, management believes that the system could perform better if sold by a larger firm, potentially indicating the possibility of a sale. Moving forward into fiscal 2023 and beyond, ARIA's focus remains on supporting system deployments by government entities.

According to NVIDIA, ARIA's value proposition is as follows: The ARIA Zero Trust (AZT) Gateway developed by ARIA Cybersecurity is a compact, in-line, standalone network device that solves the problems of outdated and ineffective traditional cyber defense measures. It uses hardware acceleration from the NVIDIA BlueField-2 Data Processing Unit ((DPU)) for line-rate analysis to analyze each packet in real-time. The gateway creates analytics for threat analysis to enforce existing standalone protection policies and dynamically generated policies for a more effective security posture. The AZT Gateway is supported by ARIA's Advanced Detection and Response product, which uses ML and AI-driven threat models to analyze data for over 70 different types of attacks. With this solution, organizations can take automated action on alerts and deploy new security rules to prevent unwanted activities on their network, removing the need for manual human involvement.

Managed Service Provider Market at-a-Glance

Managed Service Providers (MSPs) cater to the needs of both large organizations, such as banks and governments, and small to medium-sized businesses (SMBs) by streamlining processes and reducing costs. As a result, the industry has seen a significant increase in value, leading to a surge in demand for their services. While the number of MSP companies globally reduced in 2009, it has since rebounded in recent years, currently standing at over 150,000, according to MSP Alliance. This number exemplifies the industry's resilience while also highlighting the need to stand out in the crowded market.

MSPs have experienced significant growth since 2020 due to the pandemic, which prompted many companies to shift to remote work and increase reliance on cloud services. Even before the pandemic, an estimated 90% of Fortune 1000 companies used MSPs for their IT infrastructures or services. Continued technological advancements in AI and cloud services will drive market growth, with MSPs specializing in these areas being the most successful. However, the lack of skilled labor in these cutting-edge technologies is a significant bottleneck in the industry. Companies of different sizes will require different MSP services, with larger institutions adopting AI, automation, big data, and compliance services, while SMBs focus on cloud management and cybersecurity.

The COVID-19 pandemic has accelerated the trend toward remote working and collaboration, leading to a reduced need for office space. This shift towards a tech-focused world has created an increased demand for specialized knowledge in automation, Big Data, and cloud-based services. As a result, the MSP market has thrived, with tech companies largely seeing their fortunes rise through this tumult. This trend is expected to continue, creating a steady demand for MSPs in the near term.

Primary Risks

• The Company has had to leverage its Balance Sheet to finance deals in the recent past.
• With a small company, there is a degree of concentration risk, with clients occasionally taking a large order. For example, in FY:22, a customer was 19% of the revenues, while the same customer was 7% of revenues in FY:21.

• Macro issues and IT budgets of SMBs

Valuation

CSPI, a micro-cap company, has not reported profitability in recent years and its valuation is primarily based on its sales multiple. Historically, the Company has traded at around 0.7x sales but based on the average of its peers, a multiple of 0.85x may be attainable.

Our forecast for FY:23, taking into account the majority of the backlog being cleared from the product backlog and services growing at the market rate for the MSP sector, predicts sales to be around $75M. As a result, our target price is approximately $15, representing an upside potential of ~30%.

However, if we apply the historic sales multiple of 0.7x, our target price drops to $12, resulting in a more modest upside potential of 6%.

It is important to note that these estimates have not taken into account any of the speculative catalysts. If the Company secures additional contracts with the cruise industry or secures a client for its cyber security solution, the price could have a higher upside potential.

However, we estimate the downside risk to be around 20%.

Alternatively, using the tax rate that was applied in Q1:23 for the full year, our EPS estimate for FY:23 is $1; applying the sector average of 15x P/E, we also arrive at a price target of $15.

Using a multi-stage DCF model (cost of equity at 12%) driven by the assumption that MSP growth will be at or above a forecast of 11% until 2027 and while Products growth at mid-single digit during that period, followed by a stable growth of low-mid single digit for the entire Company, we arrive at a target price of $18.

Taking an average of the low end of a multiple forecast of $12 and the high end of $18 from the DCF model - we are comfortable with a target price of $15.

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