10-K 1 csp_10k-093010.htm ANNUAL REPORT csp_10k-093010.htm


UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549

FORM 10-K
 
x
ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
    
For the Fiscal Year Ended September 30, 2010.
 
¨
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
    
For the transition period from            to            .
 
Commission File Number 000-10843

CSP Inc.
(Exact name of Registrant as specified in its Charter)
 
   
Massachusetts
04-2441294
(State of incorporation)
(I.R.S. Employer Identification No.)
 
43 Manning Road, Billerica, Massachusetts 01821-3901 (978) 663-7598
(Address and telephone number of principal executive offices)

 
Securities Registered Pursuant to Section 12(b) of the Act:
   
Title of Each Class
Name of Exchange of Which Registered
Common Stock, par value $0.01 per share
NASDAQ Global Market
 
Securities registered pursuant to Section 12(g) of the Act:
None

 
Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.    Yes  ¨    No  x
 
Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.    Yes  ¨    No  x
 
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    Yes  x    No  ¨.
 
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).    Yes  ¨    No  ¨.
 
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.  ¨
 
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer”, “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.
 
Large accelerated filer  ¨
Accelerated filer  ¨
Non-accelerated filer  ¨
Smaller Reporting Company  x
 
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act.    Yes  ¨    No  x
 
As of March 31, 2010, the aggregate market value of the registrant’s common stock held by non-affiliates of the registrant was $9,970,722 based on the closing sale price of $3.60 as reported on the Nasdaq Global Market.
 
As of December 17, 2010, we had outstanding 3,543,547 shares of common stock.
 
DOCUMENTS INCORPORATED BY REFERENCE
 
Certain portions of the information required in Part III of this Form 10-K are incorporated by reference from our definitive proxy statement for our 2011 annual meeting of stockholders to be filed with the Securities and Exchange Commission within 120 days after the end of our fiscal year ended September 30, 2010.
 
 
1

 
 
TABLE OF CONTENTS
 
     
   
Page
PART I. 
3
Item 1.
Business
3
Item 1A.
Risk Factors
8
Item 2.
Properties
14
Item 3.
Legal Proceedings
14
Item 4.
[Reserved]
14
   
PART II.
15
Item 5.
Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities
15
Item 7.
Management’s Discussion and Analysis of Financial Condition and Results of Operations
15
Item 8.
Financial Statements and Supplementary Data
29
Item 9.
Changes in and Disagreements with Accountants on Accounting and Financial Disclosure
30
Item 9A
Controls and Procedures
30
Item 9B.
Other Information
31
   
PART III.
32
Item 10.
Directors, Executive Officers and Corporate Governance
32
Item 11.
Executive Compensation
32
Item 12.
Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters
32
Item 13.
Certain Relationships, Related Transactions and Director Independence
33
Item 14.
Principal Accountant Fees and Services
33
   
PART IV.
34
Item 15.
Exhibits and Financial Statement Schedules
34
 
Note: Items 1B, 6 and 7A are not required for smaller reporting companies and therefore not furnished.
 
 
2

 
 
PART I
 
Item 1.
Business
 
CSP Inc. (“CSPI” or “the Company” or “we” or “our”) was incorporated in 1968 and is based in Billerica, Massachusetts, just off Route 128 in the Boston computer corridor. To meet the diverse requirements of our industrial, commercial, and defense customers worldwide, CSPI and its subsidiaries develop and market IT integration solutions and high-performance cluster computer systems.
 
Segments
 
CSPI operates in two segments, the Systems segment and the Service and System Integration segment.
 
 
The Systems segment consists primarily of CSPI’s MultiComputer Division (the “MultiComputer Division”) which designs and manufactures specialty, high-performance computer signal processing systems for the aerospace and defense markets. The MultiComputer Division’s products are known as multicomputers or cluster computers, which use multiple microprocessors linked together in a specialized network to achieve very high performance processing capabilities. Our MultiComputer systems utilize “blades” (self-contained, high-density computer boards) to achieve a high level of compute processing per-cubic-foot-per-watt. The blades and other components that make up the system are housed in a ruggedized chassis, designed to withstand physically demanding environments such as those found on board a ship or airplane. In addition, CSPI’s MultiComputer products are designed to operate in environments that have low power, cooling and space requirements. These systems are used on land and in airborne and shipboard platforms for high-speed digital signal processing (“DSP”) in radar, sonar and surveillance applications. The MultiComputer Division sells all its products through its own direct sales force in the United States and via distributors and authorized resellers in the Asia-Pacific region.
 
 
The Service and System Integration Segment consists of the computer maintenance and integration services and third-party computer hardware and software value added reseller (“VAR”) businesses of our Modcomp subsidiary (“Modcomp”). Modcomp is a wholly owned subsidiary of CSPI which operates in the United States, Germany and the United Kingdom (the “U.K.”). Modcomp markets and sells its products through its own direct sales force. Modcomp provides solutions and services for complex IT environments including storage and servers, unified communications solutions, IT security solutions and consulting services. Modcomp also provides managed IT services through its state of the art network operations center (“NOC”).
 
Financial Information about Industry Segments
 
The following table details our sales by operating segment for fiscal years ending September 30, 2010 and 2009. Additional segment and geographical information is set forth in Note 13 to our financial statements.
 
Segment
 
2010
   
%
   
2009
   
%
 
   
(Amounts in thousands)
 
Systems
  $ 8,311       9 %   $ 7,987       10 %
Service and System Integration
    86,707       91 %     75,370       90 %
Total Sales
  $ 95,018       100 %   $ 83,357       100 %
 
Systems Segment
 
Products and Services
 
The Systems segment’s MultiComputer systems utilize commodity hardware components that are compliant with industry standards and open source software and deliver a high-performance, high density and low power consuming computer solution to our customers. These systems incorporate tens to hundreds of processors, all interconnected by a very high-bandwidth network. They are specifically designed for analysis of complex signals and images in real-time or in modeling and simulations. Typical computationally intense applications requiring these products include radar, sonar, command, control, communications, computers, intelligence, surveillance and reconnaissance (“C4ISR”) within the defense market segment.
 
We utilize the most recent, currently available high performance processor technology, large memory subsystems and high-bandwidth networking components in the open hardware architecture of our MultiComputer systems. These systems are scalable and easy to upgrade, allowing for continuous insertion of the latest technologies. To meet the demands of mission-critical applications, our MultiComputer systems incorporate high-availability features to facilitate continuous operation of the system. These features include instant booting from a cold start, error-correcting memory, hot-swappable hardware, extended environmental specifications and built-in self-test. These systems ship in a variety of configurations ranging from small lab systems with as few as ten processors to multiple-chassis systems with over 400 processors.
 
 
3

 
 
Hardware Products
 
Our MultiComputer Division cluster computer systems are currently marketed under the brand name FastCluster. Introduced in 1997, the first generation of FastCluster products were referred to as the FastCluster 2000 SERIES. Based upon industry standards, the 2000 SERIES systems included a VME 6U form factor (the form factor best suited for use in rugged applications), the Motorola™ G4 PowerPC RISC processors with AltiVec™ technology, high-speed memory and Myrinet-2000™ cluster interconnect. The 2000 SERIES product line is ideally suited for use by customers in the aerospace and defense markets seeking Commercial-Off-The-Shelf (“COTS”) solutions to reduce costs and ensure widespread availability. To remain competitive, our COTS solutions incorporate the latest industry standard technologies and minimize the risks associated with proprietary solutions.
 
Our StarGate I/O blade is a 2000 SERIES board-level component designed specifically for high-speed data acquisition. The StarGate bolstered our product offerings in radar, sonar and surveillance DSP by providing the rapid execution times that are necessary for the complex signal processing demands of these applications. The StarGate I/O blade was the first 2000 SERIES product to benefit from the increased performance provided by the 1GHz Motorola 7457 PowerPC microprocessors and related technologies.
 
The FastCluster product line was enhanced with the addition of rugged system capabilities for blades and enclosures with the introduction of the FastCluster 220R to our 2000 SERIES product line. The FastCluster 220R introduced a new rugged chassis, specifically designed to meet military standard (“MIL-STD”) specifications for mission-critical, airborne defense programs. The advanced packaging maintained scalability to hundreds of processors and leveraged the latest Myrinet-2000 fiber clustering technology for multi-chassis configurations. This packaging offered better fault detection, hot-swap capability, plug-in power supply and blower assembly components for improved serviceability and addressed MIL-STD requirements for shock, vibration and EMC/EMI.
 
Building upon the momentum of the 2000 SERIES, we announced the next generation FastCluster product line, the 3000 SERIES, in fiscal 2006. The first prototype of a 3000 SERIES component was shipped to a customer for evaluation purposes in September 2007. This prototype was successfully evaluated by the customer during fiscal 2008. We received and shipped additional 3000 SERIES orders in fiscal 2010 and we expect to receive a significant order for 3000 SERIES systems in fiscal 2011. The 3000 SERIES product line is being designed to deliver performance that is superior to our predecessor products in bi-section bandwidth and processing density while preserving absolute code reuse at the application layer. The 3000 SERIES product line is targeting high performance DSP, signal intelligence (“SIGINT”), radar and sonar applications in airborne, shipboard and unmanned aerial vehicle (“UAV”) platforms where space, power and cooling are at a premium. With its built-in 10-Gigabit Ethernet technology, the 3000 SERIES supports the United States (“U.S.”) Government Department of Defense (“DOD”) vision of “systems of systems” in which embedded systems are not designed, deployed and used in isolation but rather in a cooperative way.

In fiscal 2010, we announced 3000 SERIES OpenVPXTM with Intel multi-core processors and the OpenVPXTM VITA/ANSI standard (Vita 65) to support high performance radar, sonar, C4ISR and SIGINT applications.  OpenVPXTM is the architecture framework that defines system-level interoperability for multivendor, multimode, integrated system environments. OpenVPXTM’s consideration of system-level requirements improves interoperability between computing and communications platforms and reduces customization, testing, cost and risk.
 
Also, in fiscal 2010, we announced our new 4000 SERIES ATCA products.  The 4000 SERIES is based on InfiniBand, Advanced Telecom Computing Architecture (“AdvancedTCA” or “ATCA”) & NEBS standards to deliver affordability, sustainability and high availability to manned and unmanned large mobile platforms (land, sea and air.)  ATCA was originally designed to address the high availability, robust system management and DC power distribution needs of the telecom and communications markets.  ATCA has since become attractive to the military and defense markets as well.

Military computing and communication applications share the need for increased bandwidth and reliability, extremely robust mechanical and electrical definitions, power efficiency and unprecedented processor density.  ATCA provides built-in high reliability features such as a 40 gigabit Ethernet backplane, redundant shelf managers, fail-over capability and support of live insertion of boards, power supplies and fans. These features are ideal for the DOD’s network-centric warfare initiative.
 
All of the products of the MultiComputer Division offer the user a choice in selecting the system software best suited to their application requirements. For customers wanting a lower cost solution, our cluster computer systems are available with the open-source Linux operating system and toolkit. Customer applications requiring real-time response have the option of purchasing systems with the industry standard VxWorks real-time operating system and Tornado II development tools suite.
 
All MultiComputer cluster computer systems use the best of open systems software technologies, such as message passing interface (“MPI”) software for interprocessor communications and the highly optimized industry standard math libraries: Industry Standard Signal Processing Library and Vector Signal and Image Processing Library. These libraries facilitate the development of truly portable code for seamless reuse across applications, while taking advantage of optimized performance on the PowerPC with AltiVec.
 
 
4

 
 
Markets, Marketing and Dependence on Certain Customers
 
Aerospace & Defense Market
 
We market our MultiComputer systems to the aerospace and defense markets with emphasis on applications requiring the analysis of complex signals such as sonar and radar. We distribute our products in these markets as an original equipment manufacturer (“OEM”) supplier to system integrators, distributors and value-added resellers. In these markets, the supplier/customer relationship is viewed as a long-term strategic partnership.
 
MultiComputer systems are sold primarily to prime contractors (serving as systems integrators) within the defense industry and are used in sonar, radar, C4ISR systems, simulators and signal and image analysis computers. Customers in this market segment have unique requirements. A prime contractor will typically incorporate our products into their own future product developments and, therefore, will need early access to low-level, detailed technical specifications, prototype units, form, fit and function compatibility with previous products, long term product availability and support. As a supplier in this market, we recognize that there may be a significant up-front investment of time and resources in building a business partnership. However, the result of this partnership is a strong potential for long-term revenue streams as products progress from development phases into deployment.
 
Our cluster computing technologies that support “network centric warfare” and information exchange in real-time are becoming increasingly significant to twenty-first century military operations. There has been steady growth of new programs requiring signal/image processing and analysis equipment as well as upgrades to existing military programs. However, the efficiency inherent in these technologies reduces the number of systems required to achieve the same results. Both new and upgraded programs require a substantial investment in development and evaluation before products deploy into field use. The time from development to deployment varies based on the program; however, it very often extends beyond twenty-four months. Looking forward to fiscal 2011 and beyond, our focus is to build interest in our 3000 SERIES and 4000 SERIES multicomputers among our customers.
 
Competition
 
The Systems segment’s markets are very competitive. Customer requirements coupled with advances in technology drive our efforts to continuously improve existing products and develop new ones. Starting with Intel i860 microprocessors used in the SuperCards of the 1980s to the Motorola PowerPCs with AltiVec processors incorporated in the early FastCluster 2000 SERIES and later the addition of Linux open source software, we have responded with product offerings that are vital to remaining competitive. Product development efforts in fiscal year 2009 involved completing and launching new enhancements to our 3000 SERIES product line, with a focus on continuing to provide our defense customers with increased processing capabilities based on the latest industry standard technologies: VXS (VITA 41), multi-core processors, FPGAs and Myricom’s Myri-10G high speed interconnect with 10 Gigabit Ethernet support.
 
Applications expertise, product innovation, strong technical support and dedicated customer service allow us to compete favorably as a provider of high-performance cluster computer systems.
 
Our direct competitors in the aerospace and defense market are Mercury Computer Inc., AP Labs, Curtis Wright and G. E. Intelligent Platforms. Our indirect competitors are the board manufacturers that specialize in the DSP segment of this market. In the past, manufacturers such as Emerson, HP, IBM and Dell participated in the low performance segment of the general-purpose computer and single board computer market. Today, those companies manufacture general-purpose computer systems incorporating multi-core processors and have the potential to become formidable competitors in compute intensive applications, such as radar and sonar. While our products are designed to offer the best overall value in combined performance, features and price, we may not overcome the capabilities of larger companies to address the needs of the cost sensitive customer, where price, as opposed to system performance, size and specialized packaging, is the primary factor in the buying decision.
 
New companies enter the field periodically and larger companies with greater technical resources and marketing organizations could decide to compete in the future. The future growth of this market depends upon continued growth in strategic partnerships and providing high density and scalability in a compact, low power and cost effective package that can easily be integrated into OEM designs for high performance computation. Since the majority of sales are to prime contractors, the principal barrier to gaining market share is the reluctance of established users to redesign their product once it is in production. A key area of opportunity exists in design wins on new programs.
 
Manufacturing, Assembly and Testing
 
All MultiComputer systems are shipped to our customers directly from our plant in Billerica, Massachusetts. Our manufacturing activities consist mainly of final assembly and testing of printed circuit boards and systems that are designed by us and fabricated by outside vendors.
 
 
5

 
 
Upon receipt of material and components by us from outside suppliers, our quality assurance technicians inspect these products and components. During manufacture and assembly, both subassemblies and completed systems are subjected to extensive testing, including burn-in and environmental stress screening designed to minimize equipment failure at delivery and over its useful service life. We also use diagnostic programs to detect and isolate potential component failures. A comprehensive log is maintained of all past failures to monitor quality procedures and improve design standards.
 
We provide a warranty covering defects arising from products sold and service performed, which varies from 90 days to one year, depending upon the particular unit.
 
Customer Support
 
Our MultiComputer Division supports our customers with telephone assistance, on-site service, system installation, training and education. We provide product support service during the warranty period. Customers may purchase extended software and hardware maintenance and on-site service contracts for support beyond the warranty period.
 
We offer training courses at our corporate headquarters or the customer site. Field and customer service support is provided by employees located at our headquarters in Billerica, Massachusetts for Systems segment customers.
 
Sources and Availability of Raw Materials
 
Several components used in our Systems segment products are obtained from sole-source suppliers. We are dependent on key vendors like Myricom, Inc. for our high-speed interconnect components, Freescale Semiconductor, Inc. for our PowerPC processors and Wind River Systems, Inc. for VxWorks operating system software. Despite our dependence on these sole-source suppliers, we do not consider the risk of interruption of supply to be significant to meet our projected revenue requirements for the near term. Also, all components used to build our new 3000 SERIES and 4000 SERIES systems are currently available in a timely manner.
 
Research and Development
 
For the year ended September 30, 2010, our expenses for research and development were approximately $2.0 million compared to approximately $2.0 million for fiscal year 2009. Expenditures for research and development are expensed as they are incurred. Our Systems segment expects to continue to have substantial expenditures related to the development of new hardware products and the software that enables the hardware to function. Our Systems products and development currently in process are intended to extend the usefulness and marketability of existing products and introduce new products into existing market segments, including the 3000 SERIES and 4000 SERIES product lines.
 
We do not have any patents that are material to our business.
 
Backlog
 
The backlog of customer orders and contracts in the Systems segment was approximately $2.0 million at September 30, 2010 as compared to $4.1 million at September 30, 2009. Our backlog can fluctuate greatly. These fluctuations can be due to the timing of receiving large orders representing prime contractor purchases. It is expected that all of the customer orders in backlog will ship within the next twelve months.
 
Service and System Integration Segment
 
Products and Services
 
Integration Solutions
 
Over the past several years, the business of our Service and System Integration segment has evolved away from selling our proprietary process control and data acquisition (“PCDA”) computer systems, into becoming a systems integrator and VAR of integrated solutions including third-party hardware, software and technical computer-related consulting services and managed services via a state of the art NOC. Our value proposition is our ability to integrate diverse third-party components together into a complete solution and install the system at the customer site and to offer high value IT consulting services to deliver solutions.
 
Third-Party Hardware and Software
 
Modcomp sells third-party hardware and software products in the information technology market, with a strategic focus on industry standard servers and data center infrastructure solutions, midrange data storage infrastructure products, network products, unified communications and IT security hardware and software solutions. Our key offerings include products from HP, Cisco Systems, Sun Microsystems, IBM, Juniper Networks, Hitachi, QLogic, Dell, Enterasys, Citrix, APC, EMC, Intel, VMWare, Fortinet, nCirlce, Microsoft and Checkpoint. Through our supplier relationships with these vendors, we are able to offer competitively priced best-of-breed products to meet our customers’ diverse technology needs, providing procurement and engineering expertise in server infrastructure, storage, security, unified communications and networking, to the small-to-medium sized businesses (“SMBs”) and large enterprise businesses (“LEBs”) with complex IT environments. We offer our customers a single point of contact for complex multi-vendor technology purchases. Many of our SMB customers have unique technology needs and may lack technical purchasing expertise or have very limited IT engineering resources on staff. We also provide installation, integration, logistical assistance and other value-added services that customers may require. Our current customers are in web and infrastructure hosting, education, telecommunications, health services, distribution, financial services, professional services, manufacturing and entertainment industries. We target SMB and LEB customers across all industries.
 
 
6

 

Professional Services
 
We provide professional IT consulting services in the following areas:
 
 
Maintenance and technical support both for third-party products and proprietary Modcomp legacy PCDA systems—hardware and software, operating system and user support.
 
 
Implementation, integration, configuration and installation services.

 
Storage area network (“SAN”) solutions – We help our customers implement SAN solutions using products from Hitachi, EMC, HP, DataDomain and NetApp.  SANs allow system administrators to realize the benefits of SANs over conventional storage architecture.  These benefits include cost savings from better utilization of hardware and lower headcount requirements to run and maintain data storage systems, higher availability and faster data access rates resulting in increased productivity.

 
Virtualization – We implement virtualization solutions using products from companies such as VMWare. Virtualization allows one computer to do the job of multiple computers by sharing resources of a single computer across multiple environments.  With virtual servers and desktops, users can host multiple operating systems and applications, which can eliminate physical and geographical limitations. Other benefits include energy cost savings, lower capital expenditure requirements, high availability of resources, better desktop management, increased security and improved disaster recovery processes.
 
 
Enterprise security intrusion prevention, network access control and unified threat management—Using third-party products from companies like Checkpoint, Juniper Networks and Cisco Systems, our services are designed to ensure data security and integrity through the establishment of virtual private networks, firewalls and other technologies.
 
 
IT security compliance services—We provide services for IT security compliance with personal privacy laws such as HIPAA and corporate governance laws such as Sarbanes-Oxley.
 
 
Unified communications, wireless and routing and switching solutions using Cisco Systems’ products and services.
 
 
Custom software applications and solutions development and support—We develop custom applications to customer specifications using industry standard platforms such as Microsoft.Net, Sharepoint and OnBase. We are a Microsoft Gold Partner.
 
 
NOC managed IT services that include monitoring, reporting and management of alerts for the resolution and preventive general IT and IT security support tasks.
 
Markets, Marketing and Dependence on Certain Customers
 
We are an IT systems integrator and computer hardware and software VAR. We also provide technical services to achieve a value-add to our customers. We operate within the VAR sales channels of major computer hardware and software OEMs, primarily within the geographic areas of our sales offices and across the U.S. We provide innovative IT solutions, including a myriad of infrastructure products with customized integration consulting services and managed services to meet the unique requirements of our customers. We market the products we sell and services we provide through various sales offices in the U.S., Germany and the U.K. through our direct sales force (for a detailed list of our locations, see Item 2 of this Form 10-K).
 
Competition
 
The primary competition in the Service and System Integration segment are other VARs, ranging from small companies that number in the thousands, to large enterprises such as CDW, PC Connection, Insight, MoreDirect, Dimension Data, Bechtle AG and Computacenter. In addition, we compete directly with many of the companies who manufacture the third-party products that we sell including IBM, HP EMC, Hitachi and others. In the network management, security and storage systems integration services business, our competitors are extensive and vary to a certain degree in each of the geographical markets, but they include such competitors as HP/EDS, IBM and Cap Gemini.
 
 
7

 
 
Nearly all of our product offerings are available through other channels. Favorable competitive factors for the Service and System Integration segment include procurement capability, product diversity allowing for delivery of complete and custom solutions to our customers, strength of key partner relationships with the major IT OEMs, ability to supply unique and/or specialized needs of the SMB and LEB markets, strong knowledge of the IT products that we sell, ability to provide managed services through our NOC and the consulting integration services required to design and install the custom solutions that fit our customers’ IT needs. Unfavorable competitive factors include low name recognition, limited geographic coverage and pricing.
 
Backlog
 
The backlog of customer orders and contracts for the Service and System Integration segment was approximately $6.3 million at September 30, 2010, as compared to $4.8 million at September 30, 2009. Our backlog can fluctuate greatly. These fluctuations can be due to the timing of receiving large orders for third- party products and/or IT services. It is expected that all of the customer orders in backlog will ship and/or be provided within the next twelve months.
 
Significant Customers
 
See Note 13 for detailed information regarding customers which comprised 10% or more of consolidated revenues for the years ended September 30, 2010 and 2009.
 
Employees
 
On September 30, 2010, we had approximately 139 full time equivalent employees worldwide for our consolidated operations. None of our employees are represented by a labor union and we had no work stoppages. We consider relations with our employees to be good.
 
Financial Information about Geographic Areas
 
Information regarding our sales by geographic area and percentage of sales based on the location to which the products are shipped or services are rendered are in Note 13 of our consolidated financial statements.
 
Item 1A.
Risk Factors
 
Factors that may Affect Future Performance
 
This document contains forward-looking statements based on current expectations that involve a number of risks and uncertainties. Further, any forward-looking statement speaks only as of the date on which such statement is made and we undertake no obligation to update any forward-looking statement to reflect events or circumstances after the date on which such statement is made. As it is not possible to predict every new factor that may emerge, forward-looking statements should not be relied upon as a prediction of actual future financial condition or results. In response to competitive pressures or new product introductions, we may take certain pricing or marketing actions that could adversely affect our operating results. In addition, changes in the products and services mix may cause fluctuations in our gross margin. Due to the potential quarterly fluctuations in operating results, we believe that quarter-to-quarter comparisons of our results of operations are not necessarily an indicator of future performance.
 
Markets for our products and services are characterized by rapidly changing technology, new product introductions and short product life cycles. These changes can adversely affect our business and operating results. Our success will depend upon our ability to enhance our existing products and services and to develop and introduce, on a timely and cost effective basis, new products that keep pace with technological developments and address increasing customer requirements. The inability to meet these demands could adversely affect our business and operating results.
 
We Depend on a Small Number of Customers for a Significant Portion of our Revenue and Loss of any Customer Could Significantly Affect the Business
 
We are dependent on a small number of customers for a large portion of our revenues. Both the Systems and Service and System Integration segments are reliant upon a small number of significant customers, the loss of any one of which could have a material adverse effect on our business. A significant diminution in the sales to or loss of any of our major customers would have a material adverse effect on our business, financial condition and results of operations. In addition, our revenues are largely dependent upon the ability of our customers to have continued growth or need for services or to develop and sell products that incorporate our products. No assurance can be given that our customers will not experience financial or other difficulties that could adversely affect their operations and, in turn, our results of operations.
 
 
8

 

Our largest customer for fiscal year 2010 acquired one of our largest competitors and this customer also expects a downturn in business from one of its own customers that was creating significant demand for our products.   These events could result in a significant reduction in our sales volume for fiscal 2011 and beyond.

Our largest customer for fiscal 2010 is a large hosting company that provides outsourcing of computer infrastructure, storage and communications resources. Our sales to this customer were $22.5 million for fiscal 2010, which comprised 24% of our total revenues.  Two events occurred late in our fiscal year 2010 that may have a significant impact on our sales volume for fiscal 2011 and beyond.

First, our customer expects a downturn in business from one of its own customers that was creating significant demand for our products.  This will likely have an unfavorable impact on our sales because our customer may no longer need to purchase the same volume of products from us in fiscal year 2011 as they did in fiscal year 2010.

Secondly, this customer has acquired a major competitor of ours that supplies some of the same IT networking equipment that we were supplying to them during fiscal 2010.  We believe that in the future, it is likely that this customer will procure some or most of these products from our competitor rather than purchase them from us.
 
We Depend on Defense Business for a Significant Amount of our Revenue and the Loss or Decline of Existing or Future Defense Business Could Adversely Affect our Financial Results
 
Sales of our products and services to the defense market accounted for approximately 9% and 9% of our consolidated revenues and 99% and 99% of the Systems segment sales for the fiscal years ended September 30, 2010 and 2009, respectively. Reductions in government spending on programs that incorporate our products could have a material adverse effect on our business, financial condition and results of operations. Moreover, our subcontracts are subject to special risks, such as:
 
 
delays in funding;
 
 
ability of the government agency to unilaterally terminate the prime contract;
 
 
reduction or modification in the event of changes in government policies or as the result of budgetary constraints or political changes;
 
 
increased or unexpected costs under fixed price contracts; and
 
 
other factors that are not under our control.
 
In addition, consolidation among defense industry contractors has resulted in fewer contractors with increased bargaining power relative to our bargaining power. No assurance can be given that such increased bargaining power will not adversely affect our business, financial condition or results of operations in the future.
 
Changes in government administration, as well as changes in the geo-political environment such as the current “War on Terrorism,” can have significant impact on defense spending priorities and the efficient handling of routine contractual matters. Such changes could have a negative impact on our business, financial condition, or results of operations in the future.
 
We Face Competition That Could Adversely Affect our Sales and Profitability
 
The markets for our products are highly competitive and are characterized by rapidly changing technology, frequent product performance improvements and evolving industry standards. Due to the rapidly changing nature of technology, new competitors may emerge of which we have no current awareness. Competitors may be able to offer more attractive pricing or develop products that could offer performance features that are superior to our products, resulting in reduced demand for our products. Such competitors could have a negative impact on our ability to win future business opportunities. There can be no assurance that a new competitor will not attempt to penetrate the various markets for our products and services. Their entry into markets historically targeted by us may have a material adverse effect on our business, financial condition and results of operations.
 
Slowdown in the Economy Can Affect our Revenue and Profitability
 
The uncertainty regarding the growth rate of the worldwide economies has caused companies to reduce capital investment and this may cause further reduction of demand for our products and services. These reductions have been particularly severe in the electronics and technology industries.
 
 
9

 
 
Our Operating Results May Fluctuate Significantly
 
Our operating results have fluctuated widely on a quarterly and annual basis during the last several years and we expect to experience significant fluctuations in future operating results. Many factors, some of which are beyond our control, have contributed to these fluctuations in the past and may continue to do so. Such factors include:
 
 
sales in relatively large dollar amounts to a relatively small number of customers;
 
 
competitive pricing programs and volume discounts;
 
 
loss of customers;
 
 
market acceptance of our products;
 
 
product obsolescence;
 
 
general economic conditions;
 
 
change in the mix of products sold;
 
 
obtaining or failure to obtain design wins for significant customer systems;
 
 
timing of significant orders;
 
 
delays in completion of internal product development projects;
 
 
delays in shipping our products;
 
 
delays in acceptance testing by customers;
 
 
production delays due to quality programs with outsourced components;
 
 
shortages of components;
 
 
timing of product line transitions;
 
 
declines of revenues from previous generations of products following announcement of replacement products containing more advance technology; and
 
 
fixed nature of our expenditures on personnel, facilities and marketing programs.
 
We believe that period-to-period comparisons of our results of operations will not necessarily be meaningful and should not be relied upon as indicative of our future performance. It is also possible that in some periods, our operating results may be below the expectations of securities analysts and investors. In such circumstances, the price of our common stock may decline.
 
We Rely on Single Sources for Supply of Certain Components and our Business may be Seriously Harmed if our Supply of any of These Components or Other Components is Disrupted
 
Several components used in our Systems products are currently obtained from sole-source suppliers. We are dependent on key vendors like Myricom, Inc. as well as Freescale Semiconductor, Inc. (“Freescale”) for many of our PowerPC line of processors. Generally, suppliers may terminate their purchase order with us without cause upon 30-days notice and may cease offering products to us upon 180-days notice. If Myricom or Freescale were to limit or reduce the sale of such components to us, or if these or other component suppliers to us, some of which are small companies, were to experience financial difficulties or other problems which could prevent them from supplying us with the necessary components, such events could have a material adverse effect on our business, financial condition and results of operations. These sole source and other suppliers are each subject to quality and performance issues, materials shortages, excess demand, reduction in capacity and other factors that may disrupt the flow of goods to us or our customers, which thereby may adversely affect our business and customer relationships.
 
We have no guaranteed supply arrangements with our suppliers and there can be no assurance that our suppliers will continue to meet our requirements. If our supply arrangements are interrupted, there can be no assurance that we would be able to find another supplier on a timely or satisfactory basis. Any shortage or interruption in the supply of any of the components used in our products, or the inability to procure these components from alternate sources on acceptable terms, could have a material adverse effect on our business, financial condition and results of operations. There can be no assurance that severe shortages of components will not occur in the future. Such shortages could increase the cost or delay the shipment of our products, which could have a material adverse effect on our business, financial condition and results of operations. Significant increases in the prices of these components would also materially adversely affect our financial performance since we may not be able to adjust product pricing to reflect the increase in component costs. We could incur set-up costs and delays in manufacturing should it become necessary to replace any key vendors due to work stoppages, shipping delays, financial difficulties or other factors and, under certain circumstances, these costs and delays could have a material adverse effect on our business, financial condition and results of operations.
 
 
10

 
 
We Depend on Key Personnel and Skilled Employees and Face Competition in Hiring and Retaining Qualified Employees
 
We are largely dependent upon the skills and efforts of our senior management, managerial, sales and technical employees. None of our senior management personnel except Alex Lupinetti, our Chief Executive Officer, and Victor Dellovo, Vice President and General Manager of the Modcomp Division or other key employees are subject to any employment contracts. The loss of services of any of our executives or other key personnel could have a material adverse effect on our business, financial condition and results of operations. Our future success will depend to a significant extent on our ability to attract, train, motivate and retain highly skilled technical professionals. Our ability to maintain and renew existing engagements and obtain new business depends, in large part, on our ability to hire and retain technical personnel with the skills that keep pace with continuing changes in industry standards and technologies. The inability to hire additional qualified personnel could impair our ability to satisfy our growing client base, requiring an increase in the level of responsibility for both existing and new personnel. There can be no assurance that we will be successful in retaining current or future employees.
 
Our International Operations are Subject to a Number of Risks
 
We market and sell our products in certain international markets and we have established operations in the U.K. and Germany. Foreign-based revenue is determined based on the location to which the product is shipped or services are rendered and represented 30% and 36% of our total revenue for the fiscal years ended September 30, 2010 and 2009, respectively. If revenues generated by foreign activities are not adequate to offset the expense of establishing and maintaining these foreign subsidiaries and activities, our business, financial condition and results of operations could be materially adversely affected. In addition, there are certain risks inherent in transacting business internationally, such as changes in applicable laws and regulatory requirements, export and import restrictions, export controls relating to technology, tariffs and other trade barriers, longer payment cycles, problems in collecting accounts receivable, political instability, fluctuations in currency exchange rates, expatriation controls and potential adverse tax consequences, any of which could adversely impact the success of our international activities. A portion of our revenues are from sales to foreign entities, including foreign governments, which are primarily paid in the form of foreign currencies. There can be no assurance that one or more of such factors will not have a material adverse effect on our future international activities and, consequently, on our business, financial condition or results of operations.
 
Our business could be adversely impacted if we have deficiencies in our disclosure controls and procedures or internal controls over financial reporting.
 
Effective internal control over financial reporting and disclosure controls and procedures are necessary in order for us to provide reliable financial and other reports and effectively prevent fraud. These types of controls are designed to provide reasonable assurance regarding the reliability of financial reporting and the proper preparation of our financial statements, as well as regarding the timely reporting of material information. If we cannot maintain effective internal control or disclosure controls and procedures, or provide reliable financial or Securities and Exchange Commission (“SEC”) reports or prevent fraud, investors may lose confidence in our reported financial information, our common stock could be subject to delisting on the stock exchange where it is traded, our operating results and the trading price of our common stock could suffer and we might become subject to litigation.
 
While our management will continue to review the effectiveness of our internal control over financial reporting and disclosure controls and procedures, there is no assurance that our disclosure controls and procedures or our internal control over financial reporting will be effective in accomplishing all control objectives, including the prevention and detection of fraud, all of the time.
 
To be Successful, We Must Respond to the Rapid Changes in Technology
 
Our future success will depend in part on our ability to enhance our current products and to develop new products on a timely and cost-effective basis in order to respond to technological developments and changing customer needs. The defense market, in particular, demands constant technological improvements as a means of gaining military advantage. Military planners historically have funded significantly more design projects than actual deployments of new equipment and those systems that are deployed tend to contain the components of the subcontractors selected to participate in the design process. In order to participate in the design of new defense electronics systems, we must be able to demonstrate our ability to deliver superior technological performance on a timely and cost-effective basis. There can be no assurance that we will be able to secure an adequate number of defense electronics design wins in the future, that the equipment in which our products are intended to function eventually will be deployed in the field, or that our products will be included in such equipment if it is eventually deployed.
 
 
11

 
 
The design-in process is typically lengthy and expensive and there can be no assurance that we will be able to continue to meet the product specifications of our customers in a timely and adequate manner. In addition, if we fail to anticipate or to respond adequately to changes in technology and customer preferences, or if there is any significant delay in product developments or introductions, this could have a material adverse effect on our business, financial condition and results of operations, including the risk of inventory obsolescence. Because of the complexity of our products, we have experienced delays from time to time in completing products on a timely basis. If we are unable to design, develop or introduce competitive new products on a timely basis, our future operating results would be adversely affected, particularly in our Systems segment. There can be no assurance that we will be successful in developing new products or enhancing our existing products on a timely or cost-effective basis, or that such new products or product enhancements will achieve market acceptance.
 
We Need to Continue to Expend Resources on Research and Development Efforts to Meet the Needs of our Customers
 
The industry in which our Systems segment competes is characterized by the need for continued investment in research and development. If we fail to invest sufficiently in research and development, our products could become less attractive to potential customers and our business and financial condition could be materially adversely affected. As a result of our need to maintain or increase our spending levels in this area and the difficulty in reducing costs associated with research and development, our operating results could be materially harmed if our revenues fall below expectations. In addition, as a result of CSPI’s commitment to invest in research and development, spending as a percent of revenues may fluctuate in the future.
 
We May be Unable to Successfully Integrate Acquisitions
 
In order to achieve strategic objectives to maintain and grow our market position, we may have a need to acquire or make investments in complementary companies, products or technologies. Acquisitions may pose risks to our operations, including:
 
 
problems and increased costs in connection with the integration of the personnel, operations, technologies or products of the acquired companies;
 
 
unanticipated costs;
 
 
diversion of management’s attention from our core business;
 
 
adverse effects on business relationships with suppliers and customers and those of the acquired company;
 
 
acquired assets becoming impaired as a result of technical advancements or worse-than-expected performance by the acquired company;
 
 
entering markets in which we have no, or limited, prior experience; and
 
 
potential loss of key employees, particularly those of the acquired organization.
 
In addition, in connection with any acquisitions or investments we could:
 
 
issue stock that would dilute existing shareholders’ percentage of ownership;
 
 
incur debt and assume liabilities;
 
 
obtain financing on unfavorable terms;
 
 
incur amortization expenses related to acquired intangible assets or incur large and immediate write-offs;
 
 
incur large expenditures related to office closures of the acquired companies, including costs relating to termination of employees and leasehold improvement charges relating to vacating the acquired companies’ premises; and
 
 
reduce the cash that would otherwise be available to fund operations or to use for other purposes.
 
The failure to successfully integrate any acquisition or for acquisitions to yield expected results may negatively impact our financial condition and operating results. Any resulting impairment of goodwill would have a negative effect on results of operations.
 
Our Stock Price May Continue to be Volatile
 
Historically, the market for technology stocks has been extremely volatile. Our common stock has experienced and may continue to experience, substantial price volatility. The following factors could cause the market price of our common stock to fluctuate significantly:
 
 
loss of a major customer;
 
 
loss of a major supplier;
 
 
12

 
 
 
the addition or departure of key personnel;
 
 
variations in our quarterly operating results;
 
 
announcements by us or our competitors of significant contracts, new products or product enhancements;
 
 
acquisitions, distribution partnerships, joint ventures or capital commitments;
 
 
regulatory changes;
 
 
sales of our common stock or other securities in the future;
 
 
changes in market valuations of technology companies; and
 
 
fluctuations in stock market prices and volumes.
 
In addition, the stock market in general and the NASDAQ Global Market and technology companies in particular, have experienced extreme price and volume fluctuations that have often been unrelated or disproportionate to the operating performance of such companies. These broad market and industry factors may materially adversely affect the market price of our common stock, regardless of our actual operating performance. In the past, following periods of volatility in the market price of a company’s securities, securities class action litigation has often been instituted against such companies.
 
 
13

 
 
Item 2.
Properties
 
Listed below are our principal facilities as of September 30, 2010. Management considers all facilities listed below to be suitable for the purpose(s) for which they are used, including manufacturing, research and development, sales, marketing, service and administration.
 
Location
 
Principal Use
 
Owned or
Leased
 
Approximate
Floor Area
Systems Segment Properties:
           
             
CSP Inc.
 
Corporate Headquarters
 
Leased
 
21,500 S.F.
43 Manning Road
 
Manufacturing, Sales,
       
Billerica, MA
 
Marketing and
       
   
Administration
       
Service and Systems Integration Segment Properties:
           
             
Modcomp, Inc.
 
Division Headquarters
 
Leased
 
15,482 S.F.
1500 S. Powerline Road
 
Sales, Marketing and
       
Deerfield Beach, FL
 
Administration
       
             
Modcomp, Inc.
 
Sales, Marketing and Service
 
Leased
 
 1,356 S.F.
9155 South Dadeland Blvd, Suite 1112
           
Miami, FL
           
             
Modular Computer Systems GmbH
 
Sales, Marketing, Service
 
Leased
 
12,443 S.F.
Oskar-Jager-Strasse 50
 
and Administration
       
D-50825 Koln
           
Germany
           
             
Modcomp, Ltd.
 
Sales, Marketing and
 
Leased
 
2,490 S.F.
12a Oaklands Business Park, Fishponds Road
 
Administration
       
Wokingham Berkshire
           
United Kingdom
           
             
Modcomp Systemhaus GmbH
 
Sales, Marketing and Service
 
Leased
 
2,819 S.F.
Gartenstr. 23-27
           
D-61352 Bad Homburg
           
Germany
           
 
Item 3.
Legal Proceedings
 
We are currently not a party to any material legal proceedings.
 
Item 4.
[Reserved]
 
 
14

 
 
PART II
 
Item 5.
Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities
 
Market information.    Our common stock is traded on the Nasdaq Global Market under the symbol CSPI. The following table provides the high and low sales prices of our common stock as reported on the Nasdaq Global Market for the periods indicated.
 
   
2010
   
2009
 
Fiscal Year:
 
High
   
Low
   
High
   
Low
 
1st Quarter
  $ 4.06     $ 3.30     $ 5.27     $ 1.51  
2nd Quarter
    3.98       3.20       3.90       2.50  
3rd Quarter
    4.70       3.32       3.74       2.55  
4th Quarter
    4.65       3.85       4.25       3.38  
 
Stockholders.    We had approximately 87 holders of record of our common stock as of December 17, 2010. This number does not include stockholders for whom shares were held in a “nominee” or “street” name. We believe the number of beneficial owners of our shares of common stock (including shares held in street name) at that date was approximately 1,400.
 
Dividends.    We have never paid any cash dividends on our common stock. Our present policy is to retain earnings to finance expansion and growth and no change in the policy is anticipated.
 
Share Repurchase Plans.    The following table provides information with respect to shares of our common stock that we repurchased during the year ended September 30, 2010:
 
Month Ended
 
Total
Number
of Shares
Purchased
   
Average
Price
Paid per
Share
   
Total
Number
of Shares
Purchased
as Part of
Publicly
Announced
Plans (1)
     
Maximum
number of
Shares that
May Yet Be
Purchased
Under
the Plans
 
October 31, 2009
        $                
November 30, 2009
                         
December 31, 2009
                         
January 31, 2010
                         
February 28, 2010
    500       3.60       500          
March 31, 2010
    10,693       3.62       10,693          
April 30, 2010
    10,500       3.53       10,500          
May 31, 2010
    4,200       4.08       4,200          
June 30, 2010
    7,295       4.27       7,295          
July 31, 2010
    4,739       4.25       4,739          
August 31, 2010
    43,780       4.18       43,780          
September 30, 2010
    13,783       4.21       13,783          
                                 
Total
    95,490     $ 4.05       95,490      
                         144,556
 

(1)
All shares were purchased under publicly announced plans. For additional information about these publicly announced plans please refer to Note 12 of our financial statements.
 
Item 7.
Management’s Discussion and Analysis of Financial Condition and Results of Operations
 
The discussion below contains certain forward-looking statements related to statements concerning future revenues and future business plans. Actual results may vary from those contained in such forward-looking statements.
 
Overview of Fiscal 2011 Results of Operations
 
CSP Inc. operates in two segments:
 
 
Systems—the Systems segment consists of our MultiComputer Division which designs, develops and manufactures signal processing computer platforms that are used primarily in military applications and the process control and data acquisition (“PCDA”) proprietary hardware business of our Modcomp subsidiary.
 
 
Service and System Integration—the Service and System Integration segment includes the computer systems’ maintenance and integration services and third-party computer hardware and software products businesses of our Modcomp subsidiary.
 
 
15

 
 
Highlights include:
 
 
Revenue increased by approximately $11.7 million, or 14%, to $95 million for the year ended September 30, 2010 versus $83.4 million for the year ended September 30, 2009.
 
 
Operating income increased by approximately $6.1 million, to operating income of approximately $1.1 million for the year ended September 30, 2010 versus an operating loss of approximately $5.0 million for the year ended September 30, 2009.
 
 
Net income was approximately $0.9 million, for the year ended September 30, 2010 versus a net loss of approximately $3.8 million for the year ended September 30, 2009, an improvement of $4.7 million.
 
 
A non-cash goodwill impairment charge was taken in fiscal 2009 for $3.9 million which was the total value of goodwill on the Company’s balance sheet prior to the impairment charge. This goodwill impairment charge was a significant factor in the increase in operating income and net income for fiscal 2010 versus fiscal 2009. There was no asset impairment charges in the fiscal year ended September 30, 2010.

 
In fiscal year 2010 the Company adopted Accounting Standards Update (“ASU”) 2009-13 -  “Multiple-Deliverable Revenue Arrangements—a Consensus of the FASB Emerging Issues Task Force” (“ASU 2009-13”)  and ASU 2009-14 – “Certain Revenue Arrangements that Contain Software Elements.” (ASU 2009-14”). The impact of adopting these new standards for the year ended September 30, 2010 was an increase in revenue of $3.5 million, an increase to net income of $284 thousand and an increase of $0.08 to both basic and fully diluted earnings per share.

 
Net cash used in operating activities was approximately $1.9 million for the year ended September 30, 2010 compared to net cash provided by operating activities of $3.4 million for the year ended September 30, 2009.
 
The increase in revenues of $11.7 million was due to in large part to increased revenues in our Service and System Integration segment where revenues were up by approximately $11.3 million versus the year ended September 30, 2009.  Revenues in fiscal 2010 in the Systems segment were $8.3 million compared with $8.0 million for fiscal 2009, which is an increase of approximately $0.3 million versus the prior year.
 
Also, in fiscal 2010, we were engaged in significant research and development efforts in the Systems segment making significant progress with on-going development of our newest product lines, the Fast Cluster Series 3000 and 4000 SERIES product lines, which are designed to provide what we believe is the most advanced interconnect technology available today. The 3000 and 4000 SERIES products are expected to provide our customers with another state-of-the-art, fully ruggedized open source system, which will be essential to our future growth opportunities.
 
We do not expect that Systems segment revenues for fiscal year 2011 will show growth compared to fiscal 2010.  However we do expect to receive orders from existing programs for our 2000 SERIES products and high-margin royalties.  We also expect to receive a significant order for our 3000 SERIES product line in fiscal year 2011.
 
Revenues in the Service and System Integration segment for fiscal 2010 were $86.7 million versus fiscal 2009 revenues of $75.4 million, which was an increase of $11.3 million. The U.S. operations of this segment experienced strong sales growth in fiscal 2010 of $12.9 million, a 27% increase over fiscal year 2009. This growth was due to in large part to revenues from a large web-site hosting company, which accounted for approximately $14.3 million of the increase. Offsetting the growth in the U.S. operation, revenues declined in the European operations (Germany and the U.K.) segment for fiscal year 2010 versus fiscal 2009 by approximately $1.5 million, or 6%. The decline was due primarily to the economic recession in Europe resulting in an overall decline in large orders in fiscal 2010 compared with fiscal 2009 from the division’s largest customers.
 
Based on the current economic environment, we plan to manage the Service and System Integration segment assuming relatively weak demand in fiscal 2011. We plan to focus our attention and resources on higher-margin business and away from low margin business as we move forward. While this may put pressure on sales growth in fiscal 2011, we believe this strategy will accelerate profitable growth for the long term.

In addition, there were two significant adverse events concerning our largest customer for fiscal 2010, the web-site hosting company mentioned above. This customer provides outsourcing of computer infrastructure, storage and communications resources. Our sales to this customer were $22.5 million for fiscal 2010, which comprised 24% of our total revenues, and accounted for $14.3 million of the increase in sales for fiscal 2010 versus fiscal 2009.

First, our customer expects a downturn in business from one of its own customers that was creating significant demand for our products.  This will likely have an unfavorable impact on our sales because our customer may no longer need to purchase the same volume of products from us in fiscal year 2011 as they did in fiscal year 2010.
 
 
16

 

Secondly, this customer has acquired a major competitor of ours that supplies some of the same IT networking equipment that we were supplying to them during fiscal 2010.  We believe that in the future, it is likely that this customer will procure some or most of these products from our competitor rather than purchase them from us.
 
The following table sets forth certain information which is based on data from our Consolidated Statements of Operations:
 
     Percentage of sales     Period to Period  
     Fiscal year ended September    
   Dollar increase (decrease)
 
    2010     2009    
2010 compared to 2009  
 
    (Dollar amounts in thousands)  
Sales
    100.0 %     100.0 %   $ 11,661  
Costs and expenses:
                       
Cost of sales
    81.9 %     82.1 %     9,421  
Engineering and development
    2.1 %     2.3 %     (17 )
Selling, general and administrative
    14.8 %     16.8 %     127  
Impairment on goodwill
    %     4.7 %     (3,941 )
Total costs and expenses
    98.8 %     105.9 %     5,590  
Operating income (loss)
    1.2 %     (5.9 )%     6,071  
Other income
    %     %     34  
Income (loss) before income taxes
    1.2 %     (5.9 )%     6,105  
Income tax expense (benefit)
    0.2 %     (1.4 )%     1,408  
Net income (loss)
    1.0 %     (4.5 )%   $ 4,697  
 
Results of Operations—2010 Compared to 2009
 
For the fiscal year ended September 30, 2010, sales increased to $95.0 million, compared to $83.4 million for fiscal year ended September 30, 2009. Net income for the year ended September 30, 2010 was $0.9 million, or $0.25 per diluted share compared with a net loss of $3.8 million, or $1.05 per diluted share for fiscal year ended September 30, 2009.
 
Revenue
 
The following table details the Company’s sales by geographical region for fiscal years September 30, 2010 and 2009:
 
   
For the Year Ended
             
   
September 30,
2010
   
%
   
September 30,
2009
   
%
   
$ Increase/
(Decrease)
   
% Increase
(Decrease)
 
   
(Dollar amounts in thousands)
   
 
   
 
 
Americas
  $ 67,794       71 %   $ 53,748       64 %   $ 14,046       26 %
Europe
    26,118       28 %     27,387       33 %     (1,269 )     (5 )%
Asia Pacific
    1,106       1 %     2,222       3 %     (1,116 )     (50 )%
                                                 
Totals
  $ 95,018       100 %   $ 83,357       100 %   $ 11,661       14 %
 
The increase in Americas revenue for the year ended September 30, 2010 versus the year ended September 30, 2009 was primarily the result of the increase in revenues from the U.S. operations of the Service and System Integration segment which accounted for approximately $12.6 million of the increase. Additionally, sales from the Systems segment to U.S. customers increased by approximately $1.5 million, primarily resulting from an increase in  royalty income, which is part of our service revenue.  The decrease in sales in Europe was primarily the result of lower sales from the German and United Kingdom divisions of the Service and System Integration segment, where sales in Europe decreased by approximately $1.0 million and $0.6 million, respectively. The decrease in sales volume in constant U.S. dollars for the fiscal year ended September 30, 2010 versus the same year in 2009 was due to the reasons described below.  Offsetting the decreases in European sales from the German and UK divisions, sales to Europe from the U.S. division of the Service and System Integration segment increased by approximately $0.3 million.  The decrease in sales to Asia Pacific was the result of the decrease in sales into our program which supplies the Japanese defense market.
 
 
17

 
 
The following table details the Company’s sales for products and services by operating segment for the fiscal years ended September 30, 2010 and 2009:
 
   
Systems
   
Service and
System
Integration
   
Total
   
% of
Total
 
   
(Dollar amounts in thousands)
 
2010
                       
Product
  $ 4,888     $ 73,855     $ 78,743       83 %
Services
    3,423       12,852       16,275       17 %
Total
  $ 8,311     $ 86,707     $ 95,018       100 %
% of Total
    9 %     91 %     100 %        
                                 
2009
                               
Product
  $ 6,055     $ 61,182     $ 67,237       81 %
Services
    1,932       14,188       16,120       19 %
Total
  $ 7,987     $ 75,370     $ 83,357       100 %
% of Total
    10 %     90 %     100 %        
 
   
Systems
   
Service and
System
Integration
   
Total
   
%
Increase
 
   
(Dollar amounts in thousands)
 
Increase (Decrease)
                       
Product
  $ (1,167 )   $ 12,673     $ 11,506       17 %
Services
    1,491       (1,336 )     155       1 %
Total
  $ 324     $ 11,337     $ 11,661       14 %
% Increase
    4 %     15 %     14 %        
 
As shown above, total revenues increased by approximately $11.7 million, or 14%, for the year ended September 30, 2010 compared to the same period of fiscal year 2009. Revenue in the Systems segment increased for the current year versus the prior year by approximately $0.3 million, while revenues in the Service and System Integration segment increased by approximately $11.3 million, resulting in the overall increase of approximately $11.7 million.
 
Product revenues increased by approximately $11.5 million, or 17% for the year ended September 30, 2010 compared to the year ended September 30, 2009. This change in product revenues was made up of an increase in product revenues in the Service and System Integration segment of approximately $12.7 million offset by a decrease in the Systems segment of approximately $1.2 million versus the prior year.
 
The increase in the Service and System Integration segment product sales of approximately $12.7 million was due primarily to increased product sales in the U.S. division of the segment of approximately $13.0 million, offset by a decrease of approximately $0.3 million in the segment’s European divisions (Germany and the UK). The increase in the U.S. was attributable in large part to several large hardware orders which shipped to the US division’s largest customer. Sales to this customer increased by approximately $14.3 million, comparing the year ended September 30, 2010 to the year ended September 30, 2009. In addition, sales to other major customers increased by a net total of approximately $3.5 million.  Offsetting these increases, the loss of a major customer, which filed for bankruptcy protection during the prior fiscal year, resulted in a decrease in product sales of approximately $4.8 million, when comparing the years ended September 30, 2010 versus 2009.  The decrease in Europe was due primarily to weak demand caused by the overall economic and technology sector slowdown which is continuing to put downward pressure on sales volume.
 
The decrease in the Systems segment product revenues of approximately $1.2 million for the year ended September 30, 2010 versus the comparable period in fiscal 2009 was the result of a decrease in product sales into our existing program which supples the Japanese defense market.
 
As shown in the table above, service revenues increased by approximately $0.2 million, or 1% for the year ended September 30, 2010 compared to the comparable year of fiscal 2009. Service revenue in the Systems segment increased by approximately $1.5 million, while service revenue in the Service and System Integration segment decreased by approximately $1.3 million.
 
The $1.5 million increase in Systems segment service revenue was the result of an increase in royalty revenue from Lockheed Martin which was approximately $3.0 million for the year ended September 30, 2010, versus approximately $1.6 million for the year ended September 30, 2009, for a total increase of approximately $1.4 million.  In addition, service revenues to Raytheon increased by approximately $0.1 million in connection with the large product order which shipped in the second quarter of 2010, which is described above.
 
 
18

 

 The decrease in the Service and System Integration segment service revenue was driven by lower service revenues from the segment’s German and United Kingdom divisions which decreased by approximately $0.8 million, $0.5 million, respectively. These decreases in service revenue from our German and United Kingdom divisions were attributed to the unfavorable economic conditions which negatively impacted those divisions’ revenue performance.
 
Cost of Sales, Gross Profit and Gross Margins
 
The following table details our cost of sales by operating segment for fiscal years ended September 30, 2010 and 2009:
 
 
19

 
 
   
Systems
   
Service and
system
integration
   
Total
 
 
   
(Dollar amounts in thousands)
 
2010
                 
Cost of Sales:
                 
Product
  $ 2,449     $ 64,936     $ 67,385  
Services
    306       10,136       10,442  
Total
    2,755       75,072       77,827  
% of Total
    4 %     96 %     100 %
% of Sales
    33 %     86 %     82 %
Gross Profit:
                       
Product
  $ 2,439     $ 8,919     $ 11,358  
Services
    3,117       2,716       5,833  
Total
    5,556       11,635       17,191  
% of Total
    32 %     68 %     100 %
Gross Margins:
                       
Product
    50 %     12 %     14 %
Services
    91 %     21 %     36 %
Total
    67 %     13 %     18 %
2009
                       
Cost of Sales:
                       
Product
  $ 3,134     $ 53,475     $ 56,609  
Services
    143       11,654       11,797  
                         
Total
    3,277       65,129       68,406  
% of Total
    5 %     95 %     100 %
% of Sales
    41 %     86 %     82 %
Gross Profit:
                       
Product
  $ 2,921     $ 7,707     $ 10,628  
Services
    1,789       2,534       4,323  
Total
    4,710       10,241       14,951  
% of Total
    32 %     68 %     100 %
Gross Margins:
                       
Product
    48 %     13 %     16 %
Services
    93 %     18 %     27 %
Total
    59 %     14 %     18 %
Increase (Decrease)
                 
Cost of Sales:
                 
Product
  $ (685 )   $ 11,461     $ 10,776  
Services
    163       (1,518 )     (1,355 )
Total
    (522 )     9,943       9,421  
% Increase (decrease)
    (16 )%     15 %     14 %
% of Sales
    (8 )%     %     %
Gross Profit:
                       
Product
  $ (482 )   $ 1,212     $ 730  
Services
    1,328       182       1,510  
Total
    846       1,394       2,240  
% Increase
    18 %     14 %     15 %
Change in Gross Margin percentage:
                       
Product
    2 %     (1 )%     (2 )%
Services
    (2 )%     3 %     9 %
Total
    8 %     (1 )%     %
 
 
20

 
 
Total cost of sales increased by $9.4 million when comparing the year ended September 30, 2010 versus the year ended September 30, 2009, which is an increase of 14%.  The increase in costs of sales was consistent overall with the increase in sales which also increased by 14% when comparing the year ended September 30, 2010 with the year ended September 30, 2009.
 
Cost of sales in the Systems segment decreased by approximately $0.5 million comparing the current year versus the prior year despite the fact that sales in the systems segment increased by approximately $0.3 million.  This is due to two reasons. First, for the year ended September 30, 2010, substantially all of the product sales were manufactured hardware versus 3rd party parts that were resold for the year ended September 30, 2009. Manufactured products carry lower cost of sales as a percentage of selling price than do 3rd party parts. Secondly, royalty sales to Lockheed Martin for the year ended September 30, 2010 exceeded royalty sales for the year ended September 30, 2009 by approximately $1.4 million. Royalty income has no cost of sales.
 
Cost of sales in the Service and System Integration segment increased by approximately $9.9 million, which is a 15% increase in cost of sales when comparing the current year versus the prior year. This increase in cost of sales was due to the increase in Service and System Integration segment sales as described above, which also increased by 15%.
 
The overall gross margin was unchanged at 18% comparing the year ended September 30, 2010 to the same period of fiscal 2009.  While the gross margin improvement from 59% to 67% in the Systems segment was driven by the higher mix of manufactured products and royalty revenues as described above, the gross margin in the Service and System Integration segment decrease from 14% to 13% when comparing fiscal 2009 to 2010, due to lower product gross margins as shown in the table above.  The increase in gross margin in the Systems segment and the slightly lower gross margin in the Service and System Integration segment, combined to result in the overall gross margin being unchanged.

Engineering and Development Expenses
 
The following table details engineering and development expenses by operating segment for fiscal years ended September 30, 2010 and 2009:
 
   
2010
   
% of
Total
   
2009
   
% of
Total
   
$
Decrease
   
%
Decrease
 
   
(Dollar amounts in thousands)
 
By Operating Segment:
                                   
Systems
  $ 1,953       100 %   $ 1,970       100 %   $ (17 )     (1 )%
Service and System Integration
          %           %           %
Total
  $ 1,953       100 %   $ 1,970       100 %   $ (17 )     (1 )%
 
Engineering and development expenses remained virtually unchanged, for the year ended September 30, 2010 compared to the same period of fiscal 2009.
 
Selling, General and Administrative
 
The following table details selling, general and administrative (“SG&A”) expense by operating segment for fiscal years ending September 30, 2010 and 2009:
 
   
2010
   
% of
Total
   
2009
   
% of
Total
   
$ Increase
(Decrease)
   
% Increase
(Decrease)
 
   
(Dollar amounts in thousands)
 
By Operating Segment:
                                   
Systems
  $ 3,919       28 %   $ 3,367       24 %   $ 552       16 %
Service and System Integration
    10,177       72 %     10,602       76 %     (425 )     (4 )%
Total
  $ 14,096       100 %   $ 13,969       100 %   $ 127       1 %
 
Total selling, general and administrative (“SG&A”) expenses increased by $0.1 million, or 1%, for the year ended September 30, 2010 compared to the corresponding year of fiscal 2009. The Systems segment SG&A expense increased for the year ended September 30, 2010 versus the prior year by approximately $0.6 million, due primarily to higher bonus expenses of approximately $0.5 million, as a result of higher revenues and operating profits and higher retirement plan expense of approximately $0.1million, due to a higher net pension benefit calculation.  The Service and System Integration segment SG&A expense decreased for the year ended September 30, 2010 versus the prior year by approximately $0.4 million, due primarily to lower salaries of approximately $0.3 million due to headcount reductions and lower facilities expenses of approximately $0.1 million, due to reduction in facilities and lower depreciation expense.
 
 
21

 
 
Goodwill Impairment
 
The global economic downturn led to significant market volatility and a reduction in the Company’s profitability in the second half of fiscal 2009.  These changes to market and business conditions caused lower multiples and resulted in our lowering our projected forecast for 2010.  The fair value of our Systems and Solutions reporting unit declined due to these deteriorating market and business conditions, which ultimately resulted in a $3.9 million non-cash impairment charge to our goodwill as of September 30, 2009. This impairment charge of $3.9 million was equal to the carrying value of the Company’s goodwill prior to the impairment charge. There were no asset impairment charges for the year ended September 30, 2010.
 
Other Income/Expenses
 
The following table details Other Income/(Expense) for fiscal years ended September 30, 2010 and 2009:
 
   
2010
   
% of
Total
   
2009
   
% of
Total
   
$ Increase
(Decrease)
   
% Increase
(Decrease)
 
   
(Dollar amounts in thousands)
 
Interest income
  $ 61       871 %   $ 225       (833 )%   $ (164 )     (73 )%
Interest expense
    (90 )     (1,286 )%     (112 )     415 %     22       20 %
Foreign exchange loss
    (1 )     (14 )%     (104 )     385 %     103       99 %
Other income (expense), net
    37       529 %     (36 )     133 %     73       203 %
Total other income (expense), net
  $ 7       100 %   $ (27 )     100 %   $ 34       126 %
 
Total other income (expense), net, changed from other, net expense of $27 thousand to other net income of $7 thousand, resulting in a favorable change of approximately $34 thousand for the year of fiscal 2010 compared to the same year of fiscal 2009. This change was primarily due to a decrease in foreign exchange losses, which were greater in fiscal 2009 due to foreign exchange transaction losses which did not recur in fiscal 2010, and a favorable change in other, net of $73 thousand in fiscal 2010 versus 2009. These favorable variances were offset by a decrease in interest income of $164 thousand.  Interest income in fiscal year 2010 was earned primarily on money market funds as opposed to auction rate securities (“ARS”) which were held for a portion of fiscal 2009. The ARSs carried much higher interest rates than our money market funds. We divested our holdings in ARSs because of the preponderance of failed auctions in the ARS market.
 
Income Taxes
 
For the year ended September 30, 2010, the Company recorded an income tax provision of $0.2 million reflecting an effective income tax rate of 20% compared to an income tax benefit of $1.2 million for the fiscal year ended September 30, 2009, which reflected an effective tax benefit rate of 24%.  The effective tax rate for the year ended September 30, 2010, was impacted favorably by the de-recognition of a liability of approximately $334 thousand for an unrecognized tax benefit, which the company had recorded pursuant to accounting principles regarding uncertain tax positions.  This de-recognition was the result of the lapsing of the statute of limitations and the completion of an audit by the Internal Revenue Service, which did not result in any adjustment related to the uncertain tax position.  The lower than statutory tax benefit rate for the fiscal year ended September 30, 2009 was due primarily to a valuation allowance established for a substantial portion of the deferred tax asset related to the goodwill impairment charge.
 
In assessing the realizability of deferred tax assets, we considered our taxable future earnings and the expected timing of the reversal of temporary differences. Accordingly, we have recorded a valuation allowance which reduces the gross deferred tax asset to an amount which we believe will more likely than not be realized. Our inability to project future profitability beyond fiscal year 2011 in the U.S. and cumulative losses incurred in recent years in the United Kingdom represent sufficient negative evidence to record a valuation allowance against certain deferred tax assets. We maintained a substantial valuation allowance against our United Kingdom deferred tax assets as we have experienced cumulative losses and do not have any indication that the operation will be profitable in the future to an extent that will allow us to utilize much of our net operating loss carryforwards. To the extent that actual experience deviates from our assumptions, our projections would be affected and hence our assessment of realizability of our deferred tax asset may change.  Our German subsidiary has no valuation  allowance recorded against their gross deferred tax assets since they have projected sufficient future income that we believe it is more likely than not to be realized.
 
Liquidity and Capital Resources
 
Our primary source of liquidity is our cash and cash equivalents, which decreased by approximately $3.4 million to $15.5 million as of September 30, 2010.  This compares to $18.9 million as of September 30, 2009.  At September 30, 2010, the Company’s cash equivalents of $3.5 million were held in money market funds.
 
 
22

 
 
The significant uses of cash during the period were an increase in accounts receivable of approximately $4.9 million, decrease in deferred taxes of approximately $0.4 million, purchases of property and equipment of approximately $0.5 million, re-purchase of the Company’s common stock of approximately $0.4 million and an unfavorable foreign exchange impact of $0.6 million.  Significant sources of cash included net income of $0.9 million, an increase in deferred revenue of approximately $1.1 million, a decrease in refundable income taxes of approximately $0.4 million, an increase in income taxes payable of approximately $0.4 million, depreciation and amortization expense of approximately $0.5 million and equity plan compensation of $0.2 million.
 
If cash generated from operations is insufficient to satisfy working capital requirements, we may need to access funds through bank loans or other means. There is no assurance that we will be able to raise any such capital on terms acceptable to us, on a timely basis or at all. If we are unable to secure additional financing, we may not be able to complete development or enhancement of products, take advantage of future opportunities, respond to competition or continue to effectively operate our business.
 
Based on our current plans and business conditions, management believes that the Company’s available cash and cash equivalents and cash generated from operations and investments will be sufficient to provide for the Company’s working capital and capital expenditure requirements for the foreseeable future.
 
 
23

 
 
Critical Accounting Policies
 
Our discussion and analysis of our financial condition and results of operations are based upon our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses. On an on-going basis, we evaluate our estimates, including those related to uncollectible receivables, inventory valuation, goodwill and intangibles, income taxes, deferred compensation, revenue recognition, retirement plans, restructuring costs and contingencies. We base our estimates on historical performance and on various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions.
 
We believe the following critical accounting policies affect our more significant judgments and estimates used in the preparation of our consolidated financial statements: revenue recognition; valuation allowances, specifically the allowance for doubtful accounts and net deferred tax asset valuation allowance; inventory valuation; goodwill and intangibles; and pension and retirement plans.
 
Revenue recognition
 
The Company recognizes product revenue from customers at the time of transfer of title and risk of loss which is generally at the time of shipment, provided that persuasive evidence of an arrangement exists, the price is fixed or determinable and collectability of sales proceeds is reasonably assured. We include freight billed to our customers as sales and the related freight costs as cost of sales. The Company reduces revenue for estimated customer returns.
 
The Company recognizes revenue from software licenses when persuasive evidence of an arrangement exists, delivery of the product has occurred and the fee is fixed or determinable and collectability is probable. When delivery of services accompany software sales, and vendor specific objective evidence does not exist, and the only undelivered element is services that do not involve significant modification, or customization, of software, then the entire fee is recognized as the services are performed.  If no pattern of performance is discernable, the fee is recognized straight line over the service period.
 
The Company also offers training, maintenance agreements and support services. The Company has established fair value on its training, maintenance and support services based on prices charged in separate sales to customers at prices established and published in its standard price lists. These prices are not discounted. Revenue from these service obligations under maintenance contracts is deferred and recognized on a straight-line basis over the contractual period, which is typically three to twelve months, if all other revenue recognition criteria have been met. Support services provided on a time and material basis are recognized as provided if all of the revenue recognition criteria have been met for that element and the support services have been provided. Training revenue is recognized when performed.
 
In certain multiple-element revenue arrangements, the Company is obligated to deliver to its customers multiple products and/or services (“multiple elements”). In these transactions, the Company allocates the total revenue to be earned under the arrangement among the various elements based on the Company’s best estimate of the standalone selling price. The allocation is based on vendor specific objective evidence, third party evidence or estimated selling price when that element is sold separately. The Company recognizes revenue related to the delivered products or services only if the above revenue recognition criteria are met and the delivered element has standalone value.
 
In October 2009, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) 2009-13 -  “Multiple-Deliverable Revenue Arrangements—a Consensus of the FASB Emerging Issues Task Force” (“ASU 2009-13”)  and ASU 2009-14 – “Certain Revenue Arrangements that Contain Software Elements.” (‘ASU 2009-14”).  ASU 2009-13 amends existing revenue recognition accounting principles regarding multiple-deliverable revenue arrangements. The consensus provides accounting principles and application guidance on whether multiple deliverables exist, how the arrangement should be separated, and how the consideration should be allocated. This guidance eliminates the requirement to establish verifiable, objective evidence of the fair value of undelivered products and services and also eliminates the residual method of allocating arrangement consideration. The new guidance provides for separate revenue recognition based upon management’s estimate of the selling price for an undelivered item when there is no other means to determine the fair value of that undelivered item. Under the previous guidance, if the fair value of all of the elements in the arrangement was not determinable, then revenue was deferred until all of the items were delivered or fair value was determined. This pronouncement is effective prospectively for revenue arrangements entered into or materially modified in fiscal years beginning on or after June 15, 2010, with early adoption permitted.
 
ASU 2009-14 removes the sale of tangible products containing software components and non-software components that function together to deliver the tangible product’s essential functionality from the scope of software revenue recognition guidance.
 
 
24

 
 
Adoption of the new revenue recognition guidance has had an impact on the pattern and timing of revenue recognition.  In some cases, revenue that would have been deferred pursuant to the previously existing multiple-element revenue recognition guidance, has been recognized pursuant to the newly issued guidance.  This is because in some cases we are not able to determine VSOE or third-party evidence of the service element in our arrangements. Under the new guidance, because the requirement to determine fair value of undelivered elements has been eliminated, and we may use estimated selling price to allocate revenue to elements in an arrangement, we are now more likely to be able to separate arrangements into separate units of accounting, and thereby recognize the delivered elements (typically product revenue) without having delivered the other elements in the arrangements (typically services).   The impact of adopting this new accounting guidance on revenue for year ended September 30, 2010 was that $3.5 million in additional revenue was recognized under the newly adopted guidance that wouldn’t have been recognized had we not adopted the new standards. The impact of adopting this new accounting guidance on net income and EPS was an increase to net income of $284 thousand for the year ended September 30, 2010,  and an increase of $0.08,  to both basic and fully diluted earnings per share for the year ended September 30, 2010.
 
The Company has adopted these standards as of October 1, 2009.
 
Description of multiple-deliverable arrangements and Software Elements
 
In many cases, our multiple-deliverable arrangements involve initial shipment of hardware (including tangible products that include software and non-software elements), software products and subsequent delivery of services which add value to the products that have been shipped.  In some instances, services are performed prior to product shipment, but more typically services are performed subsequent to shipment of the hardware products. The timing of the delivery and performance of deliverables may vary case-by-case.  We evaluate whether we can determine vendor-specific objective evidence (“VSOE”) or third-party evidence to allocate revenue among the various elements in an arrangement. When VSOE or third-party evidence cannot be determined, we use estimated selling prices to allocate revenue to the various elements.  Estimated selling prices are determined using the targeted gross margin for each element and calculating the gross revenue for each element that would have been required to achieve the targeted gross margin, and allocating revenue to each element based on those relative values.
 
Typically, product revenue, which may consist of hardware (including tangible products that include software and non-software elements) and/or software elements, are recognized upon shipment, or when risk of loss passes to the customer.  Services elements are typically recognized upon completion for fixed-price service arrangements, and as services are performed for time and materials service arrangements. For software elements that include services that do not involve significant production, modification or customization, and VSOE does not exist, the entire fee allocable to that element is recognized as the services are performed. If no pattern of performance is discernable, the fee is recognized straight line over the service period.  The period over which services are delivered typically ranges from approximately sixty to ninety days, or longer in some cases.
 
For tangible products containing software components and non-software components, we determine whether these elements function together to deliver the tangible product essential functionality.  If the software and non-software components of the tangible product function together to deliver the tangible product’s essential functionality, software revenue recognition guidance is not applied, but rather other appropriate revenue recognition guidance as described above.
 
The following policies are applicable to the Company’s major categories of segment revenue transactions:
 
Systems Segment Revenue
 
Revenue in the Systems Segment consists of product and service revenue. Generally, product revenue is recognized when product is shipped, provided that all revenue recognition criteria are met. Service revenue consists principally of royalty revenue related to the licensing of certain of the Company’s proprietary system technology and repair services. The Company recognizes royalty revenues upon notification by the customer of shipment of the systems produced pursuant to the royalty agreement. Repair service revenue is generally based upon a fixed price and is recognized upon completion of the repair.
 
From time to time we enter into multiple element arrangements in the Systems Segment. We follow the accounting policies described above for such arrangements.
 
The Company’s standard sales agreements generally do not include customer acceptance provisions. However, in certain instances when arrangements include a customer acceptance provision or there is uncertainty about customer acceptance, revenue is deferred until the Company has evidence of customer acceptance. Customers generally do not have the right of return, once customer acceptance has occurred.
 
  Service and System Integration Segment Revenue
 
Revenue in the Service and System Integration Segment consists of product and service revenue.
 
Revenue from the sale of third-party hardware and third-party software is recognized when the revenue recognition criteria are met. The Company’s standard sales agreements generally do not include customer acceptance provisions. However, in certain instances when arrangements include a customer acceptance provision or there is uncertainty about customer acceptance, revenue is deferred until the Company has evidence of customer acceptance. Customers do not have the right of return.
 
 
25

 
 
Service revenue is comprised of information technology consulting development, installation, implementation and maintenance services. We follow the accounting policies described above for service transactions. For arrangements that include a customer acceptance provision, or if there is uncertainty about customer acceptance of services rendered, revenue is deferred until the Company has evidence of customer acceptance.
 
 For sales that are financed by customers through leases with a third party when risk of loss does not pass to the customer until the lease is executed, revenue is recognized upon cash receipt and execution of the lease.
 
We sell certain third party service contracts, which are evaluated to determine whether the sale of such service revenue should be recorded as gross sales or net sales in accordance with the sales recognition criteria as required by U.S. Generally Accepted Accounting Principles (“GAAP”). We must determine whether we act as a principal in the transaction and assume the risks and reward of ownership or if we are simply acting as an agent or broker. Under gross sales recognition, the entire selling price is recorded in sales and our cost to the third-party service provider or vendor is recorded in cost of goods sold. Under net sales recognition, the cost to the third-party service provider or vendor is recorded as a reduction to sales resulting in net sales equal to the gross profit on the transaction and there are no costs of goods sold. We use the gross sales recognition method for the third party service contracts that we sell, as we have determined that we act as a principal in these sales transactions.
 
Engineering and Development Expenses
 
Engineering and development expenses include payroll, employee benefits, stock-based compensation and other headcount-related expenses associated with product development. Engineering and development expenses also include third-party development and programming costs. We consider technological feasibility for our software products is reached upon the release of the software and, accordingly, no internal software development costs have been capitalized.
 
Product Warranty Accrual
 
Our product sales generally include a 90-day to one-year hardware warranty. At time of product shipment, we accrue for the estimated cost to repair or replace potentially defective products. Estimated warranty costs are based upon prior actual warranty costs for substantially similar products.
 
Income Taxes
 
We use the asset and liability method of accounting for income taxes whereby deferred tax assets and liabilities are recognized for the estimated future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using enacted tax rates in effect for the year in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date. We also reduce deferred tax assets by a valuation allowance if, based on the weight of available evidence, it is more likely than not that some portion or all of the recorded deferred tax assets will not be realized in future periods. This methodology requires estimates and judgments in the determination of the recoverability of deferred tax assets and in the calculation of certain tax liabilities. Valuation allowances are recorded against the gross deferred tax assets that management believes, after considering all available positive and negative objective evidence, historical and prospective, with greater weight given to historical evidence, that it is more likely than not that these assets will not be realized.
 
 
26

 
 
In addition, we are required to recognize in the consolidated financial statements, those tax positions determined to be more-likely-than-not of being sustained upon examination, based on the technical merits of the positions as of the reporting date. If a tax position is not considered more-likely-than-not to be sustained based solely on its technical merits, no benefits of the position are recognized. This is a different standard for recognition than was previously required. The more-likely-than-not threshold must continue to be met in each reporting period to support continued recognition of a benefit. Upon adoption of this standard on October 1, 2007, we were required to adjust our financial statements to reflect only those tax positions that are more-likely-than-not to be sustained. Any necessary adjustment was recorded directly to opening retained earnings in the period of adoption.
 
In addition, the calculation of the Company’s tax liabilities involves dealing with uncertainties in the application of complex tax regulations in a multitude of jurisdictions. The Company records liabilities for estimated tax obligations in the U.S. and other tax jurisdictions. These estimated tax liabilities include the provision for taxes that may become payable in the future.
 
Inventory
 
Inventories are stated at the lower of cost or market, with cost determined using the first-in, first-out method. The recoverability of inventories is based upon the types and levels of inventories held, forecasted demand, pricing, competition and changes in technology. We write down our inventory for estimated obsolescence or unmarketable inventory equal to the difference between the cost of inventory and the estimated market value based upon assumptions about future demand and market conditions. If actual market conditions are less favorable than those projected by management, additional inventory write-downs may be required.
 
Trade Accounts Receivable and Allowance for Doubtful Accounts
 
Trade accounts receivable are stated at amounts that have been billed to customers less an allowance for doubtful accounts. Allowances for doubtful accounts are recorded for the estimated losses resulting from the inability of our customers to make required payments. The estimates for allowance for doubtful accounts are based on the length of time the receivables are past due, current business environment and our historical experience. If the financial condition of our customers were to deteriorate, resulting in impairment of their ability to make payments, additional allowances may be required.
 
Goodwill and Intangible Assets
 
We test goodwill annually for impairment and more frequently if events and circumstances indicate that the asset might be impaired. We recognize impairment losses to the extent that the carrying amount of goodwill exceeds its fair value. The impairment determination is made at the reporting unit level and consists of two steps. First, the Company determines the fair value of the reporting unit and compares it to its carrying amount. Second, if the carrying amount of the reporting unit exceeds its fair value, an impairment loss is recognized for any excess of the carrying amount of the reporting unit’s goodwill over the implied fair value of that goodwill. The implied fair value of goodwill is determined by allocating the fair value of the reporting unit in a manner similar to a purchase price allocation. The residual fair value after this allocation is the implied fair value of the reporting unit goodwill. The Company’s policy is to perform its annual impairment testing for all reporting units as of the end of each fiscal year. For the year ended September 30, 2009, we recorded a goodwill impairment charge for approximately $3.9 million. There was no impairment of goodwill for the year ended September 30, 2010. All goodwill was written off in the prior year.
 
Intangible assets other than goodwill that are not subject to amortization are also required to be tested annually, or more frequently if events or circumstances indicate that the asset may be impaired. We did not have intangible assets with indefinite lives other than goodwill at any time during the two years ended September 30, 2010. Intangible assets subject to amortization are amortized over their estimated useful lives, generally three to ten years, and are carried at cost, less accumulated amortization. The remaining useful lives of intangible assets are evaluated on an annual basis. Intangible assets subject to amortization are also tested for recoverability whenever events or changes in circumstances indicate that their carrying amount may not be recoverable. If the fair value of an intangible asset subject to amortization is determined to be less than its carrying value, then an impairment charge is recorded to write down that asset to its fair value.
 
Pension and Retirement Plans
 
The funded status of pension and other postretirement benefit plans is recognized prospectively on the balance sheet. Gains and losses, prior service costs and credits and any remaining transition amounts that have not yet been recognized through pension expense will be recognized in accumulated other comprehensive income, net of tax, until they are amortized as a component of net periodic pension/postretirement benefits expense. Additionally, plan assets and obligations are measured as of our fiscal year-end balance sheet date (September 30).
 
 
27

 
 
We have defined benefit and defined contribution plans in the U.K., Germany and in the U.S. In the U.K. and Germany, the Company provides defined benefit pension plans for certain employees and former employees and defined contribution plans for the majority of the employees. The defined benefit plans in both the U.K. and Germany are closed to newly hired employees and have been for the two years ended September 30, 2010. In the U.S., the Company also provides defined contribution plans that cover most employees and supplementary retirement plans to certain employees and former employees who are now retired. These supplementary retirement plans are also closed to newly hired employees and have been for the two years ended September 30, 2010. These supplemental plans are funded through whole life insurance policies. The Company expects to recover all insurance premiums paid under these policies in the future, through the cash surrender value of the policies and any death benefits or portions thereof to be paid upon the death of the participant. These whole life insurance policies are carried on the balance sheet at their cash surrender values as they are owned by the Company and are not assets of the defined benefit plans. In the U.S., the Company also provides for officer death benefits and post-retirement health insurance benefits through supplemental post-retirement plans to certain officers. The Company also funds these supplemental plans’ obligations through whole life insurance policies on the officers.
 
Pension expense is based on an actuarial computation of current future benefits using estimates for expected return on assets, expected compensation increases and applicable discount rates. Management has reviewed the discount rates with our consulting actuary and investment advisor and concluded they were reasonable. A decrease in the expected return on pension assets would increase pension expense. Expected compensation increases are estimated based on historical and expected increases in the future. Increases in estimated compensation increases would result in higher pension expense while decreases would lower pension expense. Discount rates are selected based upon rates of return on high quality fixed income investments currently available and expected to be available during the period to maturity of the pension benefit. A decrease in the discount rate would result in greater pension expense while an increase in the discount rate would decrease pension expense.
 
The Company funds its pension plans in amounts sufficient to meet the requirements set forth in applicable employee benefits laws and local tax laws. Liabilities for amounts in excess of these funding levels are accrued and reported in the consolidated balance sheets.
 
In December 2008, the FASB issued new accounting guidance entitled, “Employers’ Disclosures about Postretirement Benefit Plan Assets”. The new guidance requires additional disclosures about plan assets for sponsors of defined benefit pension and postretirement plans including expanded information regarding investment strategies, major categories of plan assets, and concentrations of risk within plan assets. Additionally, this guidance requires disclosures similar to those required under the fair value accounting principles with respect to the fair value of plan assets such as the inputs and valuation techniques used to measure fair value and information with respect to classification of plan assets in terms of the hierarchy of the source of information used to determine their value.  These disclosures are required for the period covered by this report and are included in Note 10.
 
Recent Accounting Pronouncements
 
In April 2010, the FASB codified the consensus reached in Emerging Issues Task Force Issue No. 08-09, “Milestone Method of Revenue Recognition.” FASB ASU No. 2010-17 provides guidance on defining a milestone and determining when it may be appropriate to apply the milestone method of revenue recognition for research and development transactions. FASB ASU No. 2010-17 is effective for fiscal years beginning on or after June 15, 2010 (Fiscal year ending September 30, 2011 for the Company), and is effective on a prospective basis for milestones achieved after the adoption date. The Company does not expect this ASU will have a material impact on its financial position or results of operations when it adopts this update on October 1, 2010.

Management does not anticipate that other recently issued accounting pronouncements will have a material impact on the Company’s financial statements.
 
Inflation and Changing Prices
 
Management does not believe that inflation and changing prices had significant impact on sales, revenues or income (loss) during fiscal 2010 or 2009. There is no assurance that the Company’s business will not be materially and adversely affected by inflation and changing prices in the future.
 
 
28

 
 
Item 8.
Financial Statements and Supplementary Data
 
The consolidated financial statements are included herein.
 
 
Page
Report of Independent Registered Public Accounting Firm
38
   
Consolidated Balance Sheets as of September 30, 2010 and 2009
39
   
Consolidated Statements of Operations for the years ended September 30, 2010 and 2009
40
   
Consolidated Statements of Shareholders’ Equity and Comprehensive income (loss) for the years ended September 30, 2010 and 2009
41
   
Consolidated Statements of Cash Flows for the years ended September 30, 2010 and 2009
42
   
Notes to Consolidated Financial Statements
43
 
 
29

 
 
Item 9.
Changes in and Disagreements with Accountants on Accounting and Financial Disclosure
 
None.
 
Item 9A.
Controls and Procedures
 
Evaluation of Controls and Procedures
 
Disclosure Controls and Procedures.    The Company evaluated the effectiveness of the design and operation of our disclosure controls and procedures as of September 30, 2010. Our chief executive officer, our chief financial officer and other members of our senior management team supervised and participated in this evaluation. The term “disclosure controls and procedures,” as defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act, means controls and other procedures of a company that are designed to ensure that information required to be disclosed by a company in the reports that it files or submits under the Exchange Act is recorded, processed, summarized and reported, within the time periods specified in the SEC’s rules and forms. Disclosure controls and procedures include, without limitation, controls and procedures designed to ensure that information required to be disclosed by a company in the reports that it files or submits under the Exchange Act is accumulated and communicated to the company’s management, including its principal executive and principal financial officers, as appropriate to allow timely decisions regarding required disclosure. Management recognizes that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving their objectives and management necessarily applies its judgment in evaluating the cost-benefit relationship of possible controls and procedures. Based on the evaluation of our disclosure controls and procedures as of September 30, 2010, the Company’s chief executive officer and chief financial officer concluded that, as of such date, our disclosure controls and procedures were effective.
 
Management’s Report on Internal Control over Financial Reporting.    The Company’s management is responsible for establishing and maintaining adequate internal control over financial reporting. As defined in Rule 13a-15(f) under the Exchange Act, internal control over financial reporting is a process designed by or under the supervision of a company’s principal executive and principal financial officers and effected by a company’s board of directors, management and other personnel, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with accounting principles generally accepted in the United States of America. It includes those policies and procedures that:
 
 
pertain to the maintenance of records that in reasonable detail accurately and fairly reflect the transactions and dispositions of the assets of a company;
 
 
provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles and that receipts and expenditures of a company are being made only in accordance with authorizations of management and the board of directors of a company; and
 
 
provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use or disposition of a company’s assets that could have a material effect on its financial statements.
 
Management has assessed the effectiveness of the Company’s internal control over financial reporting as of September 30, 2010. In making its assessment of internal control, management used the criteria described in “Internal Control—Integrated Framework” issued by the Committee of Sponsoring Organizations (“COSO”) of the Treadway Commission.
 
As a result of its assessment, management has concluded that the Company’s internal control over financial reporting was effective as of September 30, 2010.
 
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
 
This Annual Report on Form 10-K does not include an attestation report of the Company’s independent registered public accounting firm regarding internal control over financial reporting. Management’s assessment of the effectiveness of the Company’s internal control over financial reporting as of September 30, 2010 was not subject to attestation by the Company’s independent registered public accounting firm pursuant to rules of the SEC that call for the Company to provide only management’s report in this Annual Report on Form 10-K.
 
 
30

 
 
Changes in Internal Control over Financial Reporting.
 
During the quarter ended September 30, 2010, there were no changes in our internal control over financial reporting that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting other than those discussed above.
 
Item 9B.
Other Information
 
None.
 
 
31

 
 
PART III
 
Item 10.
Directors, Executive Officers and Corporate Governance
 
We incorporate the information required by this item by reference to the sections captioned “Nominees for Election”, “Our Board of Directors”, “Our Executive Officers”, “Section 16(a) Beneficial Ownership Reporting Compliance” and “Corporate Governance” in our Schedule 14A Proxy Statement for our 2011 Annual Meeting of Stockholders, to be filed with the SEC within 120 days after the end of our fiscal year ended September 30, 2010.
 
Item 11.
Executive Compensation
 
We incorporate the information required by this item by reference to the sections captioned “Compensation of Executive Officers” and “Compensation of Non-Employee Directors” in our Schedule 14A Proxy Statement for our 2011 Annual Meeting of Stockholders to be filed with the SEC within 120 days after the end of our fiscal year ended September 30, 2010.
 
Item 12.
Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters
 
Securities Authorized for Issuance Under Equity Compensation Plans.
 
The equity compensation plans approved by our stockholders consist of the CSP, Inc. 1991 Incentive Stock Option Plan, 1997 Incentive Stock Option Plan, 2003 Stock Incentive Plan, 2007 Stock Incentive Plan and 1997 Employee Stock Purchase Plan (the “ESPP”). The equity compensation plan not approved by our stockholders is a stock option plan for certain employees of Modcomp. Stock options issued under this plan were granted at the fair market value of our common stock on the date of grant, have a term of ten years and vest at the rate of 25% per year starting one year from the date of grant. In fiscal 2009 and 2010, the Company granted certain officers including its Chief Executive Officer and non-employee directors shares of non-vested common stock instead of stock options. The vesting periods for the officers’, the Chief Executive Officer’s and the directors’ non-vested stock awards are four years, three years and one year, respectively. The following table sets forth information as of September 30, 2010 regarding the total number of securities outstanding under these stock option and stock purchase plans.
 
   
(a)
   
(b)
   
(c)
 
Plan Category
 
Number of
securities to
be issued upon
exercise of
outstanding
options,
warrants
and rights, and
non-vested
shares issued
   
Weighted-average
exercise price
of outstanding
options, warrants
and rights
   
Number of
securities
remaining
available
for future
issuance
under equity
compensation
plans (excluding
securities reflected
in column
(a))
 
Equity compensation plans
     approved by security holders
    (1)(2) 289,075     $ 7.67       191,954 (3)
Equity compensation plans not
     approved by security holders
    40,000     $ 2.70        
Total
    329,075     $ 6.95       191,954  

(1)  
Does not include purchase rights under the ESPP, as the purchase price and number of shares to be purchased under the ESPP are not determined until the end of the relevant purchase period.

(2)  
 Includes 54,300 non-vested shares issued.
 
(3)  
Includes 167,950 shares available for future issuance under the incentive stock and stock option plans and 24,044 under the ESPP.
 
We incorporate additional information required by this Item by reference to the section captioned “Security Ownership of Certain Beneficial Owners and Management” in our Schedule 14A Proxy Statement for our 2011 Annual Meeting of Stockholders to be filed with the SEC within 120 days after the end of our fiscal year ended September 30, 2010.
 
 
32

 
 
Item 13.
Certain Relationships and Related Transactions and Director Independence
 
We incorporate the information required by this item by reference to the section captioned “Corporate Governance” in our Schedule 14A Proxy Statement for our 2011 Annual Meeting of Stockholders to be filed with the SEC within 120 days after the end of our fiscal year ended September 30, 2010.
 
Item 14.
Principal Accountant Fees and Services
 
We incorporate the information required by this item by reference to the section captioned “Fees for Professional Services” and “Pre-approval Policies and Procedures” in our Schedule 14A Proxy Statement for our 2011 Annual Meeting of Stockholders to be filed with the SEC within 120 days after the end of our fiscal year ended September 30, 2010.
 
 
33

 
 
PART IV
 
Item 15.
Exhibits and Financial Statement Schedules
 
(a)   (1)   Financial statements filed as part of this report:
 
Consolidated Balance Sheets as of September 30, 2010 and 2009
 
Consolidated Statements of Operations for the years ended September 30, 2010 and 2009
 
Consolidated Statements of Shareholders’ Equity and Comprehensive income (loss) for the years ended September 30, 2010 and 2009
 
Consolidated Statements of Cash Flows for the years ended September 30, 2010 and 2009
 
Notes to Consolidated Financial Statements
 
(2)   Financial Statement Schedules
 
All other financial statements and schedules not listed have been omitted since the required information is included in the consolidated financial statements or the notes thereto included in Item 8, or is not applicable, material or required.
 
 
34

 
 
(3)   Exhibits
 
Exhibit
No.
Description
Filed with
this Form
10-K
Incorporated by Reference
Form
Filing Date
Exhibit
No.
3.1
Articles of Organization and amendments thereto
 
10-K
December 26, 2007
3.1
           
3.2
By-laws, as amended January 8, 1998
 
10-K
December 26, 2007
3.2
           
10.1
Form of Employee Invention and Non-Disclosure Agreement
 
10-K
November 22, 1996
10.3
           
10.2
CSPI Supplemental Retirement Income Plan
 
10-K
December 29, 2008
10.2
           
10.4*
1991 Incentive Stock Option Plan
 
10-K
December 29, 2008
10.4
           
10.5*
Employment Agreement with Alexander R. Lupinetti dated September 12, 1996
 
10-K
November 27, 1996
10.14
           
10.6*
1997 Incentive Stock Option Plan, as amended
 
DEF 14A
December 1, 1997
A
           
10.7*
1997 Employee Stock Purchase Plan
 
DEF 14A
December 1, 1997
B
           
10.8*
2003 Stock Incentive Plan
 
DEF 14A
December 23, 2003
B
           
10.9*
2007 Stock Incentive Plan
 
DEF 14A
March 30, 2007
B
           
10.10*
2011 Variable Compensation (Executive Bonus) and Base Programs dated November 9, 2010
X
     
           
10.11*
Form of Change of Control Agreement with Alexander R. Lupinetti dated January 11, 2008
X
     
           
10.12*
Form of Change of Control Agreement with Gary W. Levine and  William E. Bent Jr. each dated January 11, 2008
       
           
10.13*
Form of Change of Control Agreement with Robert A. Stellato dated January 11, 2008
X
     
           
  10.14*
Employment Agreement with Victor Dellovo dated April 11, 2003
X
     
           
21.1
Subsidiaries
X
     
           
23.1
Consent of McGladrey & Pullen, LLP, Independent Registered Public Accounting Firm
X
     
           
31.1
Certification of Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
X
     
           
31.2
Certification of Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
X
     
           
32.1
Certification of Chief Executive Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
X
     
           
32.2
Certification of Chief Financial Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
X
     

*
Management contract or compensatory plan.
 
 
35

 
 
SIGNATURES
 
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
 
 
CSP INC.
 
       
Date: December 22, 2010
By:
/s/ ALEXANDER R. LUPINETTI      
   
Alexander R. Lupinetti
Chief Executive Officer, President and Chairman
 
 
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated.
 
Name
 
Title 
 
Date 
         
/s/ ALEXANDER R. LUPINETTI
 
Chief Executive Officer,
 
December  22, 2010
Alexander R. Lupinetti   President and Chairman    
         
/s/ GARY W. LEVINE
 
Chief Financial Officer
 
December 22, 2010
Gary W. Levine   (Principal Financial Officer)    
         
/s/ ROBERT A. STELLATO
 
Vice President of Finance
 
December 22, 2010
Robert A. Stellato   (Chief Accounting Officer)    
         
/s/ J. DAVID LYONS
 
Director
 
December 22, 2010
J. David Lyons        
         
/s/ C. SHELTON JAMES        
 
Director
 
December 22, 2010
C. Shelton James        
         
/s/ ROBERT M. WILLIAMS
 
Director
 
December 22, 2010
Robert M. Williams        
         
/s/ CHRISTOPHER J. HALL        
 
Director
 
December 22, 2010
Christopher J. Hall        
 
 
36

 
 
CSP INC.
 
ANNUAL REPORT ON FORM 10-K
 
 
Item 8
Financial Statements
Years Ended September 30, 2010 and 2009
 
 
37

 
 
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
 
To the Board of Directors and Shareholders
CSP Inc.
 
We have audited the accompanying consolidated balance sheets of CSP, Inc. and subsidiaries as of September 30, 2010 and 2009, and the related consolidated statements of operations, shareholders’ equity and comprehensive income (loss), and cash flows for the years then ended.  These financial statements are the responsibility of the Company's management.  Our responsibility is to express an opinion on these financial statements based on our audits.

We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States).  Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement.  The Company is not required to have, nor were we engaged to perform an audit of its internal control over financial reporting.  Our audit included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company’s internal control over financial reporting.  Accordingly, we express no such opinion.  An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation.  We believe that our audits provide a reasonable basis for our opinion.

In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of CSP, Inc. and subsidiaries as of September 30, 2010 and 2009, and the results of their operations and their cash flows for the years then ended in conformity with U.S. generally accepted accounting principles.

As discussed in Note 1 to the financial statements, CSP, Inc. and subsidiaries has changed its method of recognizing certain revenues  in 2010 due to the adoption of  Accounting Standards Update (“ASU”) 2009-13 – Multiple-Deliverable Revenue Arrangements-a Consensus of the FASB Emerging Issues Task Force and ASU 2009-14 – Certain Revenue Arrangements that Contain Software Elements.
 
 
/s/ McGladrey & Pullen, LLP
Boston, Massachusetts
December 22, 2010 
 
 
38

 
 
CSP INC. AND SUBSIDIARIES
 
CONSOLIDATED BALANCE SHEETS
(Amounts in thousands, except par value)
 
   
September 30,
2010
   
September 30,
2009
 
ASSETS
           
Current assets:
           
Cash and cash equivalents
  $ 15,531     $ 18,904  
Accounts receivable, net of allowance for doubtful accounts
     of $288 in 2010 and $298 in 2009
    12,190       7,410  
Inventories
    5,862       5,935  
Refundable income taxes
    721       1,160  
Deferred income taxes
    124       633  
Other current assets
    1,523       1,824  
                 
Total current assets
    35,951       35,866  
                 
Property, equipment and improvements, net
    873       832  
                 
Other assets:
               
Intangibles, net
    687       800  
Deferred income taxes
    880       275  
Cash surrender value of life insurance
    2,689       2,460  
Other assets
    299       253  
                 
Total other assets
    4,555       3,788  
                 
Total assets
  $ 41,379     $ 40,486  
                 
LIABILITIES AND SHAREHOLDERS’ EQUITY
               
Current liabilities:
               
Accounts payable and accrued expenses
  $ 10,049     $ 10,530  
Deferred revenue
    3,078       2,059  
Pension and retirement plans
    441       447  
Deferred income taxes
          96  
Income taxes payable
    380       25  
                 
Total current liabilities
    13,948       13,157  
Pension and retirement plans
    8,928       8,120  
Deferred income taxes
          146  
Capital lease obligation
    24       48  
Other long term liabilities
          320  
                 
Total liabilities
    22,900       21,791  
                 
Commitments and contingencies
               
Shareholders’ equity:
               
Common stock, $.01 par; authorized, 7,500 shares; issued and
     outstanding 3,520 and 3,542 shares, respectively
    35       36  
Additional paid-in capital
    11,280       11,325  
Retained earnings
    12,516       11,602  
Accumulated other comprehensive loss
    (5,352 )     (4,268 )
                 
Total shareholders’ equity
    18,479       18,695  
                 
Total liabilities and shareholders’ equity
  $ 41,379     $ 40,486  
 
See accompanying notes to consolidated financial statements.
 
 
39

 
 
CSP INC. AND SUBSIDIARIES
 
CONSOLIDATED STATEMENTS OF OPERATIONS
(Amounts in thousands, except for per share data)
 
   
Years ended September 30,
 
   
2010
   
2009
 
Sales:
           
Product
  $ 78,743     $ 67,237  
Services
    16,275       16,120  
                 
Total sales
    95,018       83,357  
                 
Cost of sales:
               
Product
    67,385       56,609  
Services
    10,442       11,797  
                 
Total cost of sales
    77,827       68,406  
                 
Gross profit
    17,191       14,951  
                 
Operating expenses:
               
Engineering and development
    1,953       1,970  
Selling, general and administrative
    14,096       13,969  
Goodwill impairment
          3,941  
                 
Total operating expenses
    16,049       19,880  
                 
Operating income (loss)
    1,142       (4,929 )
                 
Other income (expense):
               
Interest income
    61       225  
Interest expense
    (90 )     (112 )
Foreign exchange loss
    (1 )     (104 )
Other income (expense), net
    37       (36 )
                 
Total other income (expense), net
    7       (27 )
                 
Income (loss) before income tax
    1,149       (4,956 )
Income tax expense (benefit)
    235       (1,173 )
                 
Net income (loss)
  $ 914     $ (3,783 )
                 
       Net income (loss) attributable to common stockholders
  $ 905     $ (3,765 )
                 
Net income (loss) per share-basic
  $ 0.26     $ (1.05 )