10-K 1 csp_10k-093012.htm FORM 10-K csp_10k-093012.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, 2012.
 
¨
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  x    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, 2012, the aggregate market value of the registrant's common stock held by non-affiliates of the registrant was  $11,912,731 based on the closing sale price of $4.02 as reported on the Nasdaq Global Market.
 
As of November 30, 2012, we had outstanding 3,399,342 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 2013 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, 2012.
 
 
 

 
 
TABLE OF CONTENTS
 

   
Page
     
PART I.
 
     
Item 1.
Business
3
Item 1A.
Risk Factors
8
Item 2.
Properties
13
Item 3.
Legal Proceedings
14
Item 4.
Mine Safety Disclosures
15
     
PART II.
   
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
17
Item 8.
Financial Statements and Supplementary Data
29
Item 9.
Change in and Disagreements with Accountants on Accounting and Financial Disclosures
29
Item 9A.
Controls and Procedures
29
Item 9B.
Other Information
31
     
PART III.
   
Item 10.
Directors, Executive Officers and Corporate Governance
31
Item 11.
Executive Compensation
31
Item 12.
Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters
31
Item 13.
Certain Relationships, Related Transactions and Director Independence
31
Item 14.
Principal Accountant Fees and Services
32
     
PART IV.
   
Item 15.
Exhibits and Financial Statement Schedules
32
     
Note: Items 1B, 6 and 7A are not required for Smaller Reporting Companies and therefore are not furnished.
 

 
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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. 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 commercial high-performance computer signal processing systems for a variety of complex real time applications in defense and commercial markets. MultiComputer Division products are based on an architectural solution that is open, standards-based, vendor independent, scalable, easily integrated with third-party products and compatible with future product offerings. These products utilize cluster technologies, multi-core processors, and many-core General Purpose Graphics Processing Units ("GPGPUs"). MultiComputer systems consist of “blades” (self-contained, high-density computer boards) and are designed to achieve a high level of computer processing and to operate in environments with size, weight and power ("SWaP") limitations. The blades and other components that make up the system can be housed in commercially available air-cooled chassis or in ruggedized chassis, designed to withstand physically demanding environments. These systems have traditionally been utilized for sonar and radar digital signal processing (“DSP”), image recognition and simulation 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 Europe and 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, 2012 and 2011. Additional segment and geographical information is set forth in Note 12 to our financial statements.
 

Segment
 
2012
   
%
 
2011
   
%
   
(Amounts in thousands)
Systems
  $ 11,141       13 %   $ 7,822       11 %
Service and System Integration
    73,666       87 %     65,823       89 %
Total Sales
  $ 84,807       100 %   $ 73,645       100 %
 
Systems Segment
 
Products and Services
 
The Systems segment's MultiComputer products utilize commercially available hardware components that are compliant with industry standards as well as 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. CSPI's leadership in processing density, large memory subsystems, high-bandwidth networking components, optimized signal processing libraries, and specialized algorithms make these products a natural fit for applications in the commercial/industrial, medical/biotechnology, geophysics, scientific/engineering and military/defense markets.
 
 
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Hardware Products
 
Historically MultiComputer Division products have integrated industry standard software, hardware and architecture technologies to minimize the risks associated with proprietary solutions. Over the years CSPI has met customer requirements with scalable products based on cluster technologies, multi-core processors, and many-core GPGPUs.

Introduced in 1997, the first generation of MultiComputer Division cluster computer systems was 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 was ideally suited for use by customers in the aerospace, commercial and defense markets seeking Commercial-Off-The-Shelf (“COTS”) solutions to reduce costs and ensure widespread availability. To remain competitive, our COTS solutions incorporated the latest industry standard technologies and minimized the risks associated with proprietary solutions. The 2000 SERIES advanced processing capabilities coupled with the smaller footprint was also suited for exploration operations in the geophysical market.
  
In fiscal 2006, we announced the next generation FastCluster product line, the 3000 SERIES VXS. The 3000 SERIES VXS product line was designed to deliver performance that was superior to our predecessor products in interconnect bandwidth and processing density while preserving absolute code reuse at the application layer. The 3000 SERIES VXS product line targeted 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 VXS supported the most prevalent networking standard found in both business and industrial settings.

In fiscal 2010, we announced the development of the 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. Since our initial development of the first 3000 SERIES OpenVPXTM  processor blade, we have introduced several enhancements including converged fabric technology and our 3300GTX NVIDIA GPGPU coprocessor board.  The CSPI Converged Fabric integrates the Mellenox SwitchXTM Virtual Protocol Interconnect® technology - allowing Infiniband, Ethernet, and Fibre Channel traffic to exist on a single “one-wire” fabric.  The 3300GTX coprocessor enables Teraflop levels of performance for applications that require high bandwidth data streaming and can benefit from massively parallel processing. The 3000 SERIES OpenVPXTM platform with these enhancements, is currently being marketed as our TeraXP Embedded Server.  We expect significant development efforts to continue on the TeraXP platform, as we pursue initial sales opportunities for this new product line.

In fiscal 2011, we announced our new 4000 SERIES ATCA products.  The 4000 SERIES is based on InfiniBand, Advanced Telecom Computing Architecture (“AdvancedTCA” or “ATCA”) and Network Building Equipment System (“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 defense markets as well as commercial markets.

The 4000 Series ATCA products target computing and communication applications that 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. We will expend development resources we consider necessary as we pursue initial sales opportunities for the 4000 SERIES ATCA product line.
 
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 commercially available 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 open systems software technologies including message passing interface (“MPI”) software for interprocessor communications and CSPI's highly optimized industry standard math libraries. This software facilitates the development of truly portable code for seamless reuse across applications, while taking advantage of optimized performance on both PowerPC with AltiVec and Intel processors.
 
 
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Markets, Marketing and Dependence on Certain Customers
 
Aerospace & Defense Market
 
We market our MultiComputer products to defense and commercial markets with an emphasis on applications requiring the analysis of complex signals such as seismic exploration, scientific/engineering research, sonar and radar. We commercially 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.
 
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 and 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 use of high performance embedded computing technologies to support information exchange in real-time are becoming increasingly significant to twenty-first century “network centric warfare” 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 2013 and beyond, our focus is to continue to build interest in our 3000 SERIES VXS products by integrating the latest PowerPC with AltiVec processor, and to market our 4000 SERIES ATCA and TeraXP OpenVPXTM embedded server products among our existing customers as well as additional commercial application 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 2012 involved completing and launching new enhancements to our OpenVPX product line, with a focus on continuing to provide our customers with increased processing capabilities based on the latest industry standard technologies: Intel Xeon, multi-core processors, GPGPUs and the Mellanox Converged Fabric interconnect supporting fast data rate Infiniband and 10/40 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 embedded computing systems.
 
Our direct competitors in the aerospace and defense market are Mercury Computer Inc., Kontron, 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.
 
 
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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 the ongoing reliability of our products  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. and Mellanox Technologies for our high-speed interconnect components, Freescale Semiconductor, Inc. for PowerPC processors for our 2000 SERIES and our 3000 SERIES VXS products and Intel for our microprocessors for our TeraXP OpenVPXTM embedded servers 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 3000 SERIES VXS, 4000 SERIES and TeraXP OpenVPXTM products are currently available in a timely manner.
 
Research and Development
 
For the year ended September 30, 2012, our expenses for research and development were approximately $1.7 million compared to approximately $1.8 million for fiscal year 2011. 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 current development plan is intended to extend the usefulness and marketability of existing products by continuing to develop enhancements to our 3000 SERIES VXS, 4000 SERIES and TeraXP OpenVPXTM product lines and introduce new products into existing market segments.
 
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 $3.1 million at September 30, 2012 as compared to $1.4 million at September 30, 2011. 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.
 
 
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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/Oracle, IBM, Juniper Networks, Hitachi, QLogic, Dell, Enterasys, Citrix, APC, EMC, Intel, VMWare, Fortinet, nCirlce, Microsoft, Arcsight 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.

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 have advantages over conventional storage architecture.  These advantages 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 internal control regulations under the Sarbanes-Oxley Act.
 
 
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 Value Added Reseller (“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. using 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, Presidio and Computacenter AG & Co oHG. In addition, we compete directly with many of the companies who manufacture the third-party products that we sell including Cisco Systems, 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.
 
 
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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 $7.1 million at September 30, 2012, as compared to $6.7 million at September 30, 2011. 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 12 for detailed information regarding customers which comprised 10% or more of consolidated revenues for the years ended September 30, 2012 and 2011.
 
Employees
 
On September 30, 2012, we had approximately 147 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 12 of our consolidated financial statements.

Corporate By-laws

On December 13, 2012, the Company's Board of Directors approved an amendment to Section Article II, Section 3 of the Company's by-laws.  As so amended, the section reads:  “All meetings of the stockholders shall be held at the principal office of the corporation in Massachusetts, unless a different place within Massachusetts or elsewhere within the United States is designated by the Board of Directors; provided, however, that special meetings called upon stockholders' applications shall be held in the same county as the principal office of the corporation, unless some other meeting place in Massachusetts specified in the application shall be approved by the Directors.  Any adjourned session of any meeting of the stockholders shall be held at such place with Massachusetts or elsewhere within the United States as is designated in the vote of adjournment.”  The prior by-law did not by its terms limit the location of meetings to the United States, nor did it address adjournment.

Item 1A.       Risk Factors 
 
We depend on a small number of customers for a significant portion of our revenue and loss of any customer could significantly affect our 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.
 
We depend on contracts with the federal government  for a significant portion of our revenue, and our  business could be seriously harmed if the government significantly decreased or ceased doing business with us.
 
We derived 13% of our total revenue in FY2012 and 10%  of our total revenue in FY2011 from the Department of Defense ("DoD") as a subcontractor.  We expect that the DoD contracts will continue to be important to our business for the foreseeable future.  If we were suspended or debarred from contracting with the federal government generally, the General Services Administration, or any significant agency in the intelligence community or the DoD, or if our reputation or relationship with government agencies were to be impaired, or if the government otherwise ceased doing business with us or significantly decreased the amount of business it does with us, our business, prospects, financial condition and operating results could be materially and adversely affected.

Our business could be adversely affected by changes in budgetary priorities of the federal government.
 
Because we derive a significant percentage of our revenue from contracts with the federal government, changes in federal government budgetary priorities could directly affect our financial performance.  A significant decline in government expenditures, a shift of expenditures away from programs that we support or a change in federal government contracting policies could cause federal government agencies to reduce their purchases under contracts, to exercise their right to terminate contracts at any time without penalty or not to exercise options to renew contracts.
 
 
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During 2011, the federal government was unable to reach agreement on budget reduction measures required by the Budget Control Act of 2011 (Budget Act) passed by Congress.  Unless Congress and the Administration take further action, the Budget Act will trigger automatic reductions in both defense and discretionary spending in January 2013.  While the impact of sequestration is yet to be determined, automatic across-the-board budget cuts in sequestration could have significant consequences to our business and industry.
 
In years when Congress does not complete its budget process before the end of its fiscal year (September 30), government operations are funded through a continuing resolution (CR) that temporarily funds federal agencies.  Recent CRs have generally provided funding at the levels provided in the previous fiscal year and have not authorized new spending initiatives.  When the federal government operates under a CR, delays can occur in the procurement of products and services.  Historically, such delays have not had a material effect on our business; however, should funding of the federal government by CR be prolonged or extended through the entire government 2013 fiscal year, and sequestration take place in January 2013 as part of the implementation of the Budget Act, it could have significant consequences to our business and our industry.
 
Additionally, our business could be seriously affected if the demand for and priority of funding for combat operations in Afghanistan decreases which may reduce the demand for our services on contracts supporting some operations and maintenance activities in the Department of Defense or if we experience an increase in set-asides for small businesses, which could result in our inability to compete directly for prime contracts.
.
Federal government contracts contain numerous provisions that are unfavorable to us.
 
Federal government contracts contain provisions and are subject to laws and regulations that give the government rights and remedies, some of which are not typically found in commercial contracts, including allowing the government to:
 
 
cancel multi-year contracts and related orders if funds for contract performance for any subsequent year become unavailable;
 
 
 claim rights in systems and software developed by us;
 
 
 suspend or debar us from doing business with the federal government or with a governmental agency;
 
 
 impose fines and penalties and subject us to criminal prosecution; and
 
 
 control or prohibit the export of our data and technology.
 
If the government terminates a contract for convenience, we may recover only our incurred or committed costs, settlement expenses and profit on work completed prior to the termination.  If the government terminates a contract for default, we may be unable to recover even those amounts, and instead may be liable for excess costs incurred by the government in procuring undelivered items and services from another source.  Depending on the value of a contract, such termination could cause our actual results to differ materially and adversely from those anticipated.  
 
As is common with government contractors, we have experienced and continue to experience occasional performance issues under certain of our contracts.  Depending upon the value of the matters affected, a performance problem that impacts our performance of a program or contract could cause our actual results to differ materially and adversely from those anticipated.

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. and Mellanox Technologies for our high-speed interconnect components, Freescale for many of our PowerPC line of processors and Intel for our microprocessors, and Wind River Systems, Inc. for VxWorks operating system software. 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. Although we do not consider the risk of interruption of supply to be a significant risk in the near term, if in the future, 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 future 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.
 
 
9

 
 
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.

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 44% and 41% of our total revenue for the fiscal years ended September 30, 2012 and 2011, 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.

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 or other key employees are subject to any employment contracts except Victor Dellovo, our Chief Executive Officer and President.  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.

New regulations related to conflict minerals may force us to incur additional expenses, may make our supply chain more complex and may result in damage to our relationships with customers.
 
On August 22, 2012, as mandated by the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, the SEC adopted new disclosure regulations for public companies that manufacture products that contain certain minerals and their derivatives, namely tin, tantalum, tungsten or gold, known as “conflict minerals,” if these minerals are necessary to the functionality or production of the company's products.  These regulations require such issuers to report annually whether or not such minerals originate from the Democratic Republic of Congo (DRC) and adjoining countries and in some cases to perform extensive due diligence on their supply chains for such minerals.

The implementation of these new requirements could adversely affect the sourcing, availability and pricing of conflict minerals used in the manufacture of  our products.  In addition, we may incur additional costs to comply with the disclosure requirements, including costs related to determining the source of any of the relevant minerals used in our products.  Because our supply chain is complex, the due diligence procedures that we implement may not enable us to ascertain the origins for these minerals or determine that these minerals are DRC conflict-free, which may harm our reputation.  We may also face difficulties in satisfying customers who may require that our products be certified as DRC conflict-free, which could harm our relationships with these customers and lead to a loss of revenue.  These new requirements also could have the effect of limiting the pool of suppliers from which we source these minerals, and we may be unable to obtain conflict-free minerals at competitive prices, which could increase our costs and adversely affect our manufacturing operations and our profitability.
 
 
10

 
 
Systems failures may disrupt our business and have an adverse effect on our results of operations.
 
Any systems failures, including network, software or hardware failures, whether caused by us, a third party service provider, unauthorized intruders and hackers, computer viruses, natural disasters, power shortages or terrorist attacks, could cause loss of data or interruptions or delays in our business or that of our clients.  Like other companies, we have experienced cyber security threats to our data and systems, our company sensitive information, and our information technology infrastructure, including malware and computer virus attacks, unauthorized access, systems failures and temporary disruptions.  We may experience similar security threats at customer sites that we operate and manage as a contractual requirement.  Prior cyber attacks directed at us have not had a material adverse impact on our business or our financial results, and we believe that our continuing commitment toward threat detection and mitigation processes and procedures will avoid such impact in the future.  Due to the evolving nature of these security threats, however, the impact of any future incident cannot be predicted.
 
In addition, the failure or disruption of our mail, communications or utilities could cause us to interrupt or suspend our operations or otherwise harm our business.  Our property and business interruption insurance may be inadequate to compensate us for all losses that may occur as a result of any system or operational failure or disruption and, as a result, our actual results could differ materially and adversely from those anticipated.
 
The systems and networks that we maintain for our clients, although highly redundant in their design, could also fail.  If a system or network we maintain were to fail or experience service interruptions, we might experience loss of revenue or face claims for damages or contract termination.  Our errors and omissions liability insurance may be inadequate to compensate us for all the damages that we might incur and, as a result, our actual results could differ materially and adversely from those anticipated.
 
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.

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;
 
 
whether or not we are able to secure 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;
 
 
11

 
 
 
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.

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.
 
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.


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 statements or 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.
 
 
12

 
 
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.

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;
 
 
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.

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.

Item 2.         Properties
 
Listed below are our principal facilities as of September 30, 2012. 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.
 
 
13

 

Location
 
Principal Use
 
Owned or
Leased
 
Approximate
Floor Area
Systems Segment Properties:
           
CSP Inc.
 
Corporate Headquarters
 
Leased
 
11,450 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 AG
 
Sales, Marketing and Service
 
Leased
 
323 S.F.
Gartenstr. 23-27
           
D-61352 Bad Homburg
           
Germany
           


Item 3.         Legal Proceedings

On September 4, 2011, the Company's U.S. Modcomp division (“Modcomp U.S.”), which is part of the Service and System Integration segment, received a summons entitled “Complaint to Avoid Preferential and Fraudulent Transfers and to Recover Property Transferred Pursuant to 11 U.S.C.§ 550” (the “Summons”).  The Summons is in regard to a former customer of Modcomp U.S. (the “Debtor”) who commenced a chapter 11 bankruptcy case on August 14, 2009. The Summons alleged that Modcomp U.S. received approximately $1.1 million in preferential transfers and approximately $0.2 million in otherwise avoidable transfers from the Debtor, in connection with the Debtor's bankruptcy petition.
 
As of September 30, 2011, after reviewing this matter with counsel to assess the likelihood of a loss and estimate the amount of any loss, we determined that Modcomp U.S. had a strong defense against this complaint in that these payments were made to Modcomp U.S. from the Debtor in the ordinary course of business; therefore they were not in fact preferential or otherwise avoidable transfers. However, despite our strong defense, we estimated a loss contingency in connection with the Summons in the amount of approximately $0.1 million as of September 30, 2011. On June 28, 2012, we entered into a stipulation of settlement (the "Settlement") with the Debtor, and agreed to make a payment to the Debtor of approximately $0.2 million in settlement of all claims in connection with the Summons.  Accordingly, we consider this matter closed.

We are currently not a party to any other material legal proceedings.

 
14

 

Item 4.         Mine Safety Disclosures

Not Applicable.
 
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.
 

   
2012
   
2011
 
Fiscal Year:
 
High
   
Low
   
High
   
Low
 
1st Quarter
  $ 3.73     $ 3.15     $ 5.25     $ 3.61  
2nd Quarter
    4.48       3.04       4.60       3.69  
3rd Quarter
    4.53       3.82       4.95       3.94  
4th Quarter
    4.99       3.84       4.52       3.26  
 
Stockholders.    We had approximately 68 holders of record of our common stock as of December 14, 2012. 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 1,300.
 
Dividends.        On January 12, 2012, our Board of Directors declared a cash dividend of $0.10 per share which was paid on February 3, 2012 to stockholders of record as of January 27, 2012, the record date. On August 7, 2012, our board of directors declared a cash dividend of  $0.12 per share payable on August 31, 2012 to stockholders of record as of August 23, 2012, the record date.  On December 10, 2012, our board of directors declared a cash dividend of  $0.20 per share payable on December 28, 2012 to stockholders of record as of December 20, 2012, the record date.  Payment of these dividend should not be considered to mean that dividends will be paid in the future.
 
 
15

 
 
Purchases of Equity Securities by the Issuer and Affiliated Purchasers
 
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, 2012:
 
     
Period
 
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 1-31, 2011
    6,914       3.47       6,914    
November 1-30, 2011
    1,500       3.50       1,500    
December 1-31, 2011
    8,413       3.44       8,413    
January 1-31, 2012
    5,895       3.34       5,895    
February 1-29, 2012
                   
March 1-31, 2012
    700       3.84       700    
April 1-30, 2012
                   
May 1-31, 2012
    900       4.17       900    
June 1-30, 2012
    3,778       4.11       3,778    
July 1-31, 2012
    200       4.20       200    
August 1-31, 2012
                   
September 1-30, 2012
                   
Total
    28,300       3.56       28,300  
200,525
 
 

 
 
(1)
All shares were purchased under publicly announced plans. For additional information about these publicly announced plans, please refer to Note 11 of our financial statements.
 
 
16

 
 
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 2012 Results of Operations
 
CSP Inc. operates in two segments:
 
 
Systems - the Systems segment consists of our MultiComputer Division which designs, commercially 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.

Highlights include:
 
 
Revenue increased by approximately $11.2 million, or 15%, to $84.8 million for the year ended September 30, 2012 versus $73.6 million for the year ended September 30, 2011.

 
For the year ended September 30, 2012, we had an operating profit of approximately $5.0 million versus an operating profit of approximately $0.8 million for the year ended September 30, 2011, for an increase of approximately $4.2 million.

 
For the year ended September 30, 2012, net income was approximately $6.6 million, which includes $1.7 million of tax benefit versus net income of approximately $0.4 million for the year ended September 30, 2011, for an increase of approximately $6.2 million.

 
Net cash provided by operating activities was approximately $6.3 million for the year ended September 30, 2012 compared to net cash provided by operating activities of $1.5 million for the year ended September 30, 2011.
 
The increase in revenues of $11.2 million referred to above resulted from significant growth in revenues from both our Systems and our Service and System Integration segments. Revenues in the Systems segment increased from $7.8 million for fiscal 2011 to $11.1 million for fiscal 2012 for an increase of approximately $3.3 million, while, in our Service and System Integration segment revenues increased by approximately $7.8 million from $65.8 million the year ended September 30, 2011  to $73.7 million for the year ended September 30, 2012.
 
The revenue increase in the Systems segment was largely driven by higher royalty revenues which were $6.4 million for fiscal 2012 versus $1.7 million in fiscal 2011.  Royalty revenues are particularly significant because there is no cost of sales associated with royalty revenues, hence the profit margin is 100% on this revenue. This $4.7 million increase in royalty revenue was partially offset by lower product revenue in fiscal 2012 versus fiscal 2011 which decreased product revenue by $1.4 million.
 
In the Service and System Integration segment we experienced significant growth in both product and service revenues. Product revenues for the segment increased by $6.3 million which was a 13% increase from $49.1 million in fiscal 2011 to $55.4 million in fiscal 2012.  Service revenue in the segment increased by $1.6 million which was a 9% increase from $16.7 million in fiscal 2011 to $18.3 million in fiscal 2012.  The product revenue increase was derived in large part from our German operation, where product sales increased by $4.1 million.  This increase was due substantially to a significant contract with a large European telecommunications customer, pursuant to which we were engaged as a significant supplier for their global IT security infrastructure build out.  The increase in services revenue in the segment was derived entirely from our German operation and was also as a result of this telecommunications customer.
 
In assessing the outlook for fiscal 2013, anticipating that we will not realize significant royalty revenue, we must assume a less optimistic view for the Systems segment for next year in comparison to the robust operating results we realized for fiscal 2012.  In addition, based on the risks associated with the economic environment within the defense market, we plan to manage the Systems segment assuming relatively weak demand for fiscal 2013. In the Service and System Integration segment, we will continue to have a cautiously optimistic outlook for fiscal 2013, in terms of revenue, where much will depend upon the level of overall growth in the private sector economy both domestically and in our European markets.   We plan to focus our attention and resources in the Service and System Integration segment on higher-margin business and away from low margin business as we move forward. While this may put pressure on sales growth in fiscal 2013, we believe this strategy will achieve profitable growth for the long term.
 
 
17

 
 
The following table details our results of operations in dollars and as a percentage of sales for the years ended September 30, 2012 and 2011:

   
September 30, 2012
   
%
of sales
   
September 30, 2011
   
%
of sales
 
   
(Dollar amounts in thousands)
 
Sales
  $ 84,807       100 %   $ 73,645       100 %
Costs and expenses:
                               
Cost of sales
    64,386       76 %     57,276       78 %
Engineering and development
    1,720       2 %     1,785       2 %
Selling, general and administrative
    15,847       19 %     13,775       19 %
Total costs and expenses
    81,953       97 %     72,836       99 %
Income from proceeds of officer life insurance settlement
    2,115       3 %            
Operating income
    4,969       6 %     809       1 %
Other expense
    (100 )           (94 )      
Income before income taxes
    4,869       6 %     715       1 %
Income tax expense (benefit)
    (1,740 )     (2 )%     346        
Net income
  $ 6,609       8 %   $ 369       1 %
 

Sales
 
The following table details our sales by operating segment for the years ended September 30, 2012 and 2011:
 
   
Systems
   
Service and
System
Integration
   
Total
   
% of
Total
 
   
(Dollar amounts in thousands)
 
For the Year Ended September 30, 2012:                                
Product
  $ 4,214     $ 55,369     $ 59,583       70 %
Services
    6,927       18,297       25,224       30 %
Total
  $ 11,141     $ 73,666     $ 84,807       100 %
% of Total
    13 %     87 %     100 %        
 

   
Systems
   
Service and
System
Integration
   
Total
   
% of
Total
 
For the Year Ended September 30, 2011:
                               
Product
  $ 5,624     $ 49,110     $ 54,734       74 %
Services
    2,198       16,713       18,911       26 %
Total
  $ 7,822     $ 65,823     $ 73,645       100 %
% of Total
    11 %     89 %     100 %        
 

   
Systems
   
Service and
System
Integration
   
Total
   
%
increase
 
Increase (Decrease)
                         
Product
  $ (1,410 )   $ 6,259     $ 4,849       9 %
Services
    4,729       1,584       6,313       33 %
Total
  $ 3,319     $ 7,843     $ 11,162       15 %
% increase
    42 %     12 %     15 %        
 
 
18

 
 
As shown above, total revenues increased by approximately $11.2 million, or 15%, for the year  ended September 30, 2012 compared to the year ended September 30, 2011.  Revenue in the Systems segment increased for the current year versus the prior year by approximately $3.3 million, while revenues in the Service and System Integration segment increased by approximately $7.8 million.
 
Product revenues increased by approximately $4.8 million, or 9%, for the year ended September 30, 2012 compared to the comparable period of the prior fiscal year. Product revenues in the Service and System Integration segment increased by approximately $6.3 million while in the Systems segment product revenue decreased by approximately $1.4 million for the year ended September 30, 2012 versus the year ended September 30, 2011.

In the US division of the Service and System Integration segment, product sales increased by approximately $0.8 million, sales in this segment’s German division increased by of approximately $4.1 million and in the UK division sales increased by approximately $1.3 million.
 
In the US division, product sales were bolstered by sales to several new customers in both the IT Infrastructure, Higher Education and Healthcare industry verticals. While we did experience decreases in sales to some of our prior year large customers across several industry verticals, the acquisition of new customers was enough to overcome the decreases in product sales to previously acquired customers. Therefore, while we experienced significant customer turnover, the pipeline for sales to new customers more than made up for the turnover.

In Germany, the $4.1 million increase was net of an unfavorable foreign currency impact of approximately $1.3 million, which means on a volume basis in constant dollars the increase was approximately $5.4 million.  This sales volume increase was driven by increased sales to the division’s largest customer, a large UK-based wireless carrier, of approximately $4.6 million, and sales to a newly acquired customer of $5.7 million.  There can be no assurance that there will be significant sales to either or both of these customers in the future.  These increases were offset by decreases to two of the divisions long-term customers.  The aggregate decrease in sales volume to these two customers amounted to approximately $3.3 million. Additionally, sales to all other customers in the German division decreased by an aggregate of approximately $1.6 million.

The increase in sales in the UK division was the result of increased third party product sales versus the prior year.  This was the result of the Company's efforts to start up a third-party reseller business, offering a wider array of third-party technology products within the UK operation.
 
The decrease in product revenues in the Systems segment of approximately $1.4 million was due to a decrease in sales to our Japanese defense department customer of approximately $0.2 million, and a decrease of $1.2 million in sales of parts, components and spares to existing US defense department customers.
 
As shown in the table above, service revenues increased by approximately $6.3 million, or 33%.  This increase was made up of an increase in the Systems segment of $4.7 million and an increase in the Service and System Integration segment of approximately $1.6 million. The increase in the Systems segment service revenue was due to higher royalty income recorded in the year ended September 30, 2012 which was approximately $6.4 million versus $1.7 million for the year ended September 30, 2011. The increase in service revenues in the Service and System Integration segment was primarily from the German division, where service revenue increased by approximately $1.7 million.  In Germany, there was an unfavorable currency fluctuation impact to service revenues of approximately $1.0 million, which means sales volume in constant dollars increased by approximately $2.7 million.  This increase in sales volume was driven by increased service revenues to the German division's largest customer, a UK-based wireless carrier, of approximately $2.8 million, offset by decreases in service revenues of approximately $0.1 million of all other customers combined.
 
Our sales by geographic area, based on the location to which the products were shipped or services rendered, are as follows:

   
For the Year ended,
           
   
September 30,
2012
    %    
September 30,
2011
    %    
$ Increase
(Decrease)
   
% Increase
(Decrease)
 
   
(Dollar amounts in thousands)
 
Americas
  $ 47,163       56 %   $ 43,528       59 %   $ 3,635       8 %
Europe
    34,053       40 %     26,273       36 %     7,780       30 %
Asia
    3,591       4 %     3,844       5 %     (253 )     (7 )%
Totals
  $ 84,807       100 %   $ 73,645       100 %   $ 11,162       15 %
 
The increase in Americas revenue for the year ended September 30, 2012 versus the year ended September 30, 2011 was primarily the result of the fluctuations described above in the Systems segment where combined product and service sales to US customers increased by an aggregate $3.6 million.
 
The increase in sales in Europe was primarily the result of the higher sales described above from the German and UK divisions of the Service and System Integration segment. The decrease in Asia sales was the result of the decrease in sales to our existing customer that supplies a large Japanese defense program (see discussion above).
 
 
19

 
 
Cost of Sales, Gross Profit and Gross Margins

The following table details our cost of sales, gross profit and gross margins by operating segment for the fiscal years ended September 30, 2012 and 2011:

    Systems     Service and
System
Integration
    Total     % of
Total
 
    (Dollar amounts in thousands)  
For the Year Ended September 30, 2012:
                               
Cost of Sales:
                               
Product
  $ 2,508     $ 47,718     $ 50,226       78 %
Services
    283       13,877       14,160       22 %
Total
  $ 2,791     $ 61,595     $ 64,386       100 %
% of Total
    4 %     96 %     100 %        
% of Sales
    25 %     84 %     76 %        
Gross Profit:
                               
Product
  $ 1,706     $ 7,651     $ 9,357       46 %
Services
    6,644       4,420       11,064       54 %
Total
  $ 8,350     $ 12,071     $ 20,421       100 %
% of Total
    41 %     59 %     100 %        
Gross Margins:
                               
Product
    40 %     14 %     16 %        
Services
    96 %     24 %     44 %        
Total
    75 %     16 %     24 %        
                                 
For the Year Ended September 30, 2011:
                               
Cost of Sales:
                               
Product
  $ 2,391     $ 42,419     $ 44,810       78 %
Services
    330       12,136       12,466       22 %
Total
  $ 2,721     $ 54,555     $ 57,276       100 %
% of Total
    5 %     95 %     100 %        
% of Sales
    35 %     83 %     78 %        
Gross Profit:
                               
Product
  $ 3,233     $ 6,691     $ 9,924       61 %
Services
    1,868       4,577       6,445       39 %
Total
  $ 5,101     $ 11,268     $ 16,369       100 %
% of Total
    31 %     69 %     100 %        
Gross Margins:
                               
Product
    57 %     14 %     18 %        
Services
    85 %     27 %     34 %        
Total
    65 %     17 %     22 %        
                                 
Increase (decrease)
                               
Cost of Sales:
                               
Product
  $ 117     $ 5,299     $ 5,416       12 %
Services
    (47 )     1,741       1,694       14 %
Total
  $ 70     $ 7,040     $ 7,110       12 %
% Increase (decrease)
    3 %     13 %     12 %        
% of Sales
    (10 )%     1 %     (2 )%        
Gross Profit:
                               
Product
  $ (1,527 )   $ 960     $ (567 )     (6 )%
Services
    4,776       (157 )     4,619       72 %
Total
  $ 3,249     $ 803     $ 4,052       25 %
% increase (decrease)
    64 %     7 %     25 %        
Change in Gross Margin percentage:
                               
Product
    (17 )%           (2 )%        
Services
    11 %     (3 )%     10 %        
Total
    10 %     (1 )%     2 %        
 
 
20

 
 
Total cost of sales increased by approximately $7.1 million when comparing the year ended September 30, 2012 versus the year ended September 30, 2011.   This increase in cost of sales of 12% overall is consistent with the increase in sales of 15% overall as described previously.  The resulting higher gross profit margin ("GPM") of 24% for the year ended September 30, 2012 versus 22% for 2011 was due to several factors which are discussed below.
 
In the Service and System Integration segment, the overall GPM was 16% for the year ended September 30, 2012 versus 17% for the prior year.  Product GPM in the segment remained unchanged at 14% when comparing the year ended September 30, 2012 to the year ended September 30, 2011, while the segment’s service GPM decreased from 27% to 24%.  This decrease in service GPM was attributable primarily to increased costs of training new billable service engineer employees due to significant employee turnover in the German division of the segment.  Additionally, we experienced greater use of contractors versus in-house resources to provide billable  services in Germany.
 
In the Systems segment, the overall GPM increased from 65% to 75% as shown in the table above.  This was because in the current year period, royalty revenue, which carries a 100% GPM, made up a much greater percentage of total Systems segment revenue (57%), versus the prior year royalty revenue which was 21% of total Systems segment revenue.  Offsetting the favorable GPM impact of the greater royalty revenue in the current year however, was the impact of significantly lower product GPM in the current year versus the prior year.  As shown in the table above, the GPM on product sales was  40% for the current  year versus the prior year product GPM of 57%.  This is due to the current year lower volume of production and product sales resulting in proportionately lower absorption of fixed factory overhead, therefore these fixed costs were proportionately higher versus production and sales volume, which resulted in the low GPM on product sales in the current year. In addition, we incurred significantly higher nonrecurring engineering charges for re-tooling and other services from our outside fabrication houses for the year ended September 30, 2012 versus the prior year.

 
21

 

Engineering and Development Expenses
 
The following table details our engineering and development expenses by operating segment for the year ended September 30, 2012 and 2011:
 
 
   
For the Year ended,
             
   
September 30,
2012
   
% of
Total
   
September 30,
2011
   
% of
Total
   
$ Decrease
   
% Decrease
 
   
(Dollar amounts in thousands)
 
By Operating Segment:                                    
Systems
  $ 1,720       100 %   $ 1,785       100 %   $ (65 )     (4 )%
Service and System Integration
                                   
Total
  $ 1,720       100 %   $ 1,785       100 %   $ (65 )     (4 )%
 
The $0.1 million decrease in engineering and development expenses displayed above was due to lower engineering consulting expenditures in connection with the development of the next generation of MultiComputer products in the Systems segment.
 
Selling, General and Administrative
 
The following table details our selling, general and administrative (“SG&A”) expense by operating segment for the years ended September 30, 2012 and 2011:
 

   
For the Year ended,
         
   
September 30,
2012
    % of
Total
   
September 30,
2011
   
% of
Total
   
$ Increase
   
% Increase
 
   
(Dollar amounts in thousands)
 
By Operating Segment:
                       
Systems
  $ 5,515       35 %   $ 3,908       28 %   $ 1,607       41 %
Service and System Integration
    10,332       65 %     9,867       72 %     465       5 %
Total
  $ 15,847       100 %   $ 13,775       100 %   $ 2,072       15 %
 
The increase in SG&A expense in the Systems segment was was due in part to approximately $0.7 million in higher incentive compensation expense resulting from the higher revenues, gross profit and operating results for the year ended September 30, 2012, versus the prior year and a decrease in the cash surrender value of officer life insurance policies of approximately $1.0 million, related to a policy on our former chief executive, who became deceased in fiscal 2012.  The increase in the Service & System Integration segment was due to an increase in incentive compensation expense from the more favorable revenue, gross profit and overall operating results for the year ended September 30, 2012 versus the comparable period in the prior year.

Proceeds from officer life insurance settlement

We recognized approximately $2.1 million for the settlement from a life insurance policy for our former chief executive officer, who died during fiscal 2012.  We received the cash proceeds from this settlement subsequent to year end, in October 2012.

 
22

 
 
Other Income/Expenses
 
The following table details our other income/expenses for the years ended September 30, 2012 and 2011:
 
 
   
For the Year ended,
         
   
September 30,
2012
   
September 30,
2011
   
Increase
(Decrease)
 
   
(Amounts in thousands)
 
Interest expense
 
$
(85
)
 
$
(86
)
 
$
1
 
Interest income
   
44
     
44
     
 
Foreign exchange gain (loss)
   
(60
)
   
(16
)
   
(44
)
Other income (expense), net
   
1
     
(36
)
   
37
 
Total other expense, net
 
$
(100
)
 
$
(94
)
 
$
(6
)
 
Other income (expense), net, for the years ended September 30, 2012 and 2011was not significant nor was the change from the prior year period to that of the current year.
 
Income Taxes
 
The Company recorded an income tax benefit of approximately $1.7 million, which reflected an effective tax benefit rate of (36)% for the year ended September 30, 2012, compared to income tax expense of approximately $0.3 million for the year ended September 30, 2011, which reflected an effective tax rate of 48%.
 
We realized a tax benefit for the year ended September 30, 2012, despite the fact that we had positive earnings before taxes for the year.  This was because we reduced the valuation allowance on our deferred tax assets, which had been accumulated over the past several years.  The recording and ultimate reversal of valuation allowances for our deferred tax asset requires significant judgment associated with past and projected performance.  In assessing the realizability of deferred tax assets, we consider our taxable future earnings and the expected timing of the reversal of temporary differences. In prior years, we recorded a valuation allowance which reduced the gross deferred tax asset to an amount that we believed was more likely than not to be realized because our inability to project future profitability beyond fiscal year 2012 in the U.S. and cumulative losses incurred in recent years in the United Kingdom represented sufficient negative evidence to record a valuation allowance against certain deferred tax assets.

As of September 30, 2012, management assessed the positive and negative evidence in the U.S operations, and estimated we will have sufficient future taxable income to utilize the existing deferred tax assets. Significant objective positive evidence included the cumulative profits that we realized over the most recent years.  This evidence enhances our ability to consider other subjective evidence such as our projections for future growth. Other factors we considered are the likelihood for continued royalty income in future years, and our expectation that the Service and Systems Integration segment will continue to be profitable in future years. On the basis of this evaluation, as of September 30, 2012, we have concluded that our US deferred tax asset is more likely than not to be realized. Therefore, we reversed the U.S. valuation allowance of $3.0 million, resulting in an overall tax benefit for the year ended September 30, 2012.  It should be noted however, that the amount of the deferred tax asset realized could be adjusted in future years, if estimates of taxable income during the carryforward periods are reduced, or if objective negative evidence in the form of cumulative losses is present.

We continue to  maintain a full 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 assets may change.

Liquidity and Capital Resources
 
Our primary source of liquidity is our cash and cash equivalents, which increased by approximately $4.6 million to $20.5 million as of September 30, 2012 from $15.9 million as of September 30, 2011. At September 30, 2012, cash equivalents consisted of money market funds which totaled $3.5 million.
 
 
23

 
 
Significant sources of cash for the year ended September 30, 2012 included net income of approximately $6.6 million, an increase in A/P and accrued expenses of approximately $1.6 million,  an increase in deferred revenue of approximately $0.8 million, a decrease in inventories of approximately $0.5 million, a decrease in accounts receivable of approximately $0.8 million, a decrease in cash surrender value of officers' life insurance of approximately $0.9 million and depreciation and amortization of approximately $0.4 million.  Offsetting these sources of cash, significant uses of cash were an increase in officer life insurance settlement receivable of approximately $2.2 million, a decrease in deferred tax assets of approximately $2.9 million, an increase in other assets of approximately $0.7 million, purchases of property and equipment of $0.6 million and payment of dividends of approximately $0.8 million.
 
Cash held by our foreign subsidiaries located in Germany and the United Kingdom totaled approximately $9.8 million as of September 30, 2012 and $5.6 million as of September 30, 2011. This cash is included in our total cash and cash equivalents reported above. We consider this cash to be permanently reinvested into these foreign locations because repatriating it would result in unfavorable tax consequences.  Consequently, it is not available for activities that would require it to be repatriated to the U.S.
 
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, the cash generated from operations and availability on our lines of credit will be sufficient to provide for the Company’s working capital and capital expenditure requirements for the foreseeable future.
 
 
24

 
 
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; 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 discernible, 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 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 amended previously 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 was 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.  The Company adopted these standards as of October 1, 2009.
 
 
25

 
 
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 vendor-specific objective evidence (“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).
 
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 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 discernible, 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.
 
 
26

 
 
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 accounting principles generally accepted in the U.S. We must determine whether we act as a principal in the transaction and assume the risks and rewards 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 net sales recognition method for the third party service contracts that we sell when we are not the primary obligor on the contract. We use the gross sales recognition for the third party service contracts that we sell when we act as principal and are the primary obligor.

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.
 
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 to be reached upon the release of the software, accordingly, no internal software development costs have been capitalized.

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.
 
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.
 
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.

 Intangible Assets
 
Intangible assets 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, 2012. 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.
 
 
27

 
 
Inventories
 
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.

Pension and Retirement Plans
 
The funded status of pension and other post-retirement 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/post-retirement benefits expense. Additionally, plan assets and obligations are measured as of our fiscal year-end balance sheet date (September 30).
 
We have defined benefit and defined contribution plans in the United Kingdom (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, 2012. 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, 2012. These supplementary 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 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 and rates of return with our consulting actuaries 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.
 
 
New Accounting Pronouncements
 
In June 2011, the FASB issued Accounting Standards Update 2011-05, Comprehensive Income (Topic 220) - Presentation of Comprehensive Income (“ASU 2011-05”), which requires all non-owner changes in stockholders' equity to be presented either in a single continuous statement of comprehensive income or in two separate but consecutive statements.  ASU 2011-05 is effective for fiscal years and interim periods within those years beginning after December 15, 2011.
 
Inflation and Changing Prices
 
Management does not believe that inflation and changing prices had significant impact on sales, revenues or income (loss) during fiscal 2012 or 2011. 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
35
 
   
Consolidated Balance Sheets as of September 30, 2012 and 2011
36
 
   
Consolidated Statements of Operations for the years ended September 30, 2012 and 2011
37
 
   
Consolidated Statements of Shareholders' Equity and Comprehensive income (loss) for the years ended September 30, 2012 and 2011
38
 
   
Consolidated Statements of Cash Flows for the years ended September 30, 2012 and 2011
39
 
   
Notes to Consolidated Financial Statements
40
 
 
Item 9.          Changes in and Disagreements with Accountants on Accounting and Financial Disclosures
 
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, 2012. 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, 2012, 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, 2012. 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, 2012.
 
 
29

 
 
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, 2012 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.

Changes in Internal Control over Financial Reporting.
 
During the quarter ended September 30, 2012, 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.
 
 
30

 
 
Item 9B.       Other Information
 
None.

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 2013 Annual Meeting of Stockholders, to be filed with the SEC within 120 days after the end of our fiscal year ended September 30, 2012.


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 2013 Annual Meeting of Stockholders to be filed with the SEC within 120 days after the end of our fiscal year ended September 30, 2012.


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 and 2007 Stock Incentive Plan.  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 2012 and 2011, 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, 2012 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)
 
306,392
   
$
5.37
   
141,283
 
Equity compensation plans not approved by security holders
 
40,000
   
$
2.70
   
 
Total
 
346,392
   
$
5.06
   
141,283
 
 
(1)
Includes  99,967 non-vested shares issued.
  
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 2013 Annual Meeting of Stockholders to be filed with the SEC within 120 days after the end of our fiscal year ended September 30, 2012.

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 2013 Annual Meeting of Stockholders to be filed with the SEC within 120 days after the end of our fiscal year ended September 30, 2012.
 
 
31

 
 
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 2013 Annual Meeting of Stockholders to be filed with the SEC within 120 days after the end of our fiscal year ended September 30, 2012.
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, 2012 and 2011
 
Consolidated Statements of Operations for the years ended September 30, 2012 and 2011
 
Consolidated Statements of Shareholders' Equity and Comprehensive income (loss) for the years ended September 30, 2012 and 2011
 
Consolidated Statements of Cash Flows for the years ended September 30, 2012 and 2011
 
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.
 
 
32

 
 
(3)   Exhibits
 
           
Incorporated by Reference
Exhibit
No.
  Description   Filed with
this Form
10-K
 
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 December 13, 2012
 
X
             
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
 
10.6*
 
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*
 
2012 Variable Compensation (Executive Bonus) and Base Programs dated November 8, 2011
 
X
             
10.12*
 
Form of Change of Control Agreement with Gary W. Levine, Walter Pastucha and William E. Bent Jr. each dated January 11, 2008
     
10-K
 
December 22, 2009
 
10.11
 
10.13*
 
Form of Change of Control Agreement with Robert A. Stellato, Andrew Shieh, Robert Gove, Joseph Parent, William M. Newbanks, Ronald Cook, Michael Schumacher, Peter Haebler, Kevin Magee and Stephen Pfeil each dated January 11, 2008
     
10-K
 
December 22, 2009
 
10.11
 
10.14*
 
Employment Agreement with Victor Dellovo dated April 11, 2003
     
10-K
 
December 22, 2009
 
10.11
 
21.1
 
Subsidiaries
 
X
             
23.1
 
Consent of McGladrey 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  and Chief Financial Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
 
X
             
101.INS**
 
XBRL Instance
                 
101.SCH**
 
XBRL Taxonomy Schema
                 
101.CAL**
 
XBRL Taxonomy Extension Calculation
                 
101.DEF**
 
XBRL Taxonomy Extension Definition
                 
101.LAB**
 
XBRL Taxonomy Extension Labels
                 
101.PRE**
 
XBRL Taxonomy Extension Presentation
                 
*
Management contract or compensatory plan.
 
**
XBRL information is furnished and not filed or a part of a registration statement or prospectus for purposes of sections 11 or 12 or the Securities Act of 1933, as amended, is deemed not filed for purposes of section 18 of the Securities Exchange Act of 1934, as amended, and otherwise is not subject to liability under these sections.
 
 
33

 
 
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.
   
 
By:
/s/ Victor Dellovo
   
Victor Dellovo
    Chief Executive Officer and President
 
Date: December 20, 2012
 
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/ Victor Dellovo
 
Chief Executive Officer,
 
December 20, 2012
Victor Dellovo
  President and Director    
         
         
/s/ Gary W. Levine
 
Chief Financial Officer
 
December 20, 2012
Gary W. Levine
 
(Principal Financial Officer)
   
         
         
/s/Robert A. Stellato
 
Vice President of Finance
 
December 20, 2012
Robert A. Stellato
 
(Chief Accounting Officer)
   
         
         
/s/ J. David Lyons
 
Director
 
December 20, 2012
J. David Lyons
       
         
         
/s/ C. Shelton James
 
Director
 
December 20, 2012
C. Shelton James
       
         
         
/s/ Robert M. Williams
 
Director
 
December 20, 2012
Robert M. Williams
       
         
         
/s/ Christopher J. Hall
 
Director
 
December 20, 2012
Christopher J. Hall
       

 
34

 
 
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, 2012 and 2011, and the related consolidated statements of operations, other comprehensive income (loss), shareholders' equity, 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 audits 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, 2012 and 2011, and the results of their operations and their cash flows for the years then ended in conformity with U.S. generally accepted accounting principles.

 
/s/ McGladrey LLP

Boston, Massachusetts
December 20, 2012
 
 
35

 
 
CSP INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(Amounts in thousands, except par value)

   
September 30,
2012
   
September 30,
2011
 
ASSETS
           
Current assets:
           
Cash and cash equivalents
  $ 20,493     $ 15,874  
Accounts receivable, net of allowances of $243 and $302
    12,145       13,148  
Officer life insurance settlement receivable
    2,172        
Inventories
    6,276       6,777  
Refundable income taxes
    121       231  
Deferred income taxes
    1,284       158  
Other current assets
    2,215       1,690  
Total current assets
    44,706       37,878  
Property, equipment and improvements, net
    991       833  
                 
Other assets:
               
Intangibles, net
    492       574  
Deferred income taxes
    2,373       663  
Cash surrender value of life insurance
    2,181       2,918  
Other assets
    323       242  
Total other assets
    5,369       4,397  
Total assets
  $ 51,066     $ 43,108  
                 
LIABILITIES AND SHAREHOLDERS’ EQUITY
               
Current liabilities:
               
Accounts payable and accrued expenses
  $ 13,574     $ 12,103  
Deferred revenue
    3,693       2,937  
Pension and retirement plans
    717       709  
Income taxes payable
    184       121  
Total current liabilities
    18,168       15,870  
Pension and retirement plans
    9,431       9,056  
Other long term liabilities
    426       286  
Total liabilities
    28,025       25,212  
                 
Commitments and contingencies
               
                 
Shareholders’ equity:
               
Common stock, $.01 par value per share; authorized, 7,500 shares; issued and outstanding 3,399 and 3,417 shares, respectively
    34       34  
Additional paid-in capital
    10,875       10,880  
Retained earnings
    18,744       12,885  
Accumulated other comprehensive loss
    (6,612 )     (5,903 )
Total shareholders’ equity
    23,041       17,896  
Total liabilities and shareholders’ equity
  $ 51,066     $ 43,108  
 
See accompanying notes to consolidated financial statements.
 
 
36

 
 
CSP INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
(Amounts in thousands, except for per share data)
 
   
For the Year ended
 
   
September 30,
2012
   
September 30,
2011
 
Sales:
           
Product
  $ 59,583     $ 54,734  
Services
    25,224       18,911  
Total sales
    84,807       73,645  
                 
Cost of sales:
               
Product
    50,226       44,810  
Services
    14,160       12,466  
Total cost of sales
    64,386       57,276  
                 
Gross profit
    20,421       16,369  
                 
Operating expenses:
               
Engineering and development
    1,720       1,785  
Selling, general and administrative
    15,847       13,775  
Total operating expenses
    17,567       15,560  
Income from proceeds of officer life insurance settlement
    2,115        
Operating income
    4,969       809  
                 
Other (expense):
               
Foreign exchange (loss)
    (59 )     (16 )
Other (expense), net
    (41 )     (78 )
Total other (expense), net
    (100 )     (94 )
Income before income taxes
    4,869       715  
Income tax expense (benefit)
    (1,740 )     346  
Net income
  $ 6,609     $ 369  
Net income attributable to common stockholders
  $ 6,496     $ 363  
Net income per share – basic
  $ 1.93     $ 0.11  
Weighted average shares outstanding – basic
    3,362       3,439  
Net income per share – diluted
  $ 1.91     $ 0.10  
Weighted average shares outstanding – diluted
    3,405       3,482  
 
See accompanying notes to consolidated financial statements.
 
 
37

 
 
CSP INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENT OF SHAREHOLDERS’ EQUITY
For the Year Ended September 30, 2012:
(Amounts in thousands)

   
Shares
   
Amount
   
Additional
Paid-in
Capital
   
Retained
Earnings
   
Accumulated
other
comprehensive
loss
   
Total
Shareholders’
Equity
   
Comprehensive
Income
 
Balance September 30, 2010
    3,520     $ 35     $ 11,280     $ 12,516     $ (5,352 )   $ 18,479        
Comprehensive loss:
                                                     
Net income
                      369             369     $ 369  
Other comprehensive losses from:
                                                       
Effect of foreign currency translation
                            (95 )     (95 )     (95 )
Increase in minimum pension liability
                                    (456 )     (456 )     (456 )
Total comprehensive loss
                                                  $ (182 )
Stock-based compensation
                68                   68          
Issuance of shares under employee stock purchase plan
    25             75                   75          
Restricted stock shares issued
    37       1       100                       101          
Purchase of common stock
    (165 )     (2 )     (643 )                     (645 )        
Balance as of September 30, 2011
    3,417       34       10,880       12,885       (5,903 )     17,896          
Comprehensive income (loss):
                                                       
Net income
                      6,609             6,609     $ 6,609  
Other comprehensive losses from:
                                                       
Effect of foreign currency translation
                            (45 )     (45 )     (45 )
Increase in minimum pension liability
                            (664 )     (664 )     (664 )
Total comprehensive income
                                                  $ 5,900  
Stock-based compensation
                17                   17          
Purchase of common stock
    (28 )           (97 )                 (97 )        
Restricted stock issuance
    10             75                   75          
Cash dividends on common stock ($0.22 per share)
                      (750 )           (750 )        
Balance as of September 30, 2012
    3,399     $ 34     $ 10,875     $ 18,744     $ (6,612 )   $ 23,041          
 
See accompanying notes to consolidated financial statements.
 
 
38

 
 
CSP INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(Amounts in thousands)

   
For the Year ended