CSP INC /MA/ — Interim / Quarterly Report 2005

May 16, 2005

10-Q 1 d10q.htm FORM 10-Q Form 10-Q

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United States

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

x QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the Quarterly Period Ended March 31, 2005.

¨ 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 0-10843

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)

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 is an accelerated filer (as defined in Rule 12b-2 of the Act). Yes ¨ No x .

As of May 13, 2005, the registrant had 3,658,399 shares of common stock issued and outstanding.

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INDEX

PART I.	FINANCIAL INFORMATION	Page
Item 1.	Financial Statements
	Unaudited Consolidated Balance Sheets as of March 31, 2005 and September 30, 2004	3
	Unaudited Consolidated Statements of Operations for the three and six months ended March 31, 2005 and 2004	4
	Unaudited Consolidated Statements of Cash Flows for the six months ended March 31, 2005 and 2004	5
	Notes to Unaudited Consolidated Financial Statements	6-12
Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	13-27
Item 3.	Quantitative and Qualitative Disclosures about Market Risk	27
Item 4.	Controls and Procedures	27
PART II.	OTHER INFORMATION
Item 4.	Submission of Matters to a vote of Security Holders	28
Item 5.	Other	28
Item 6.	Exhibits	28
	Exhibit 31.1
	Exhibit 31.2
	Exhibit 32.1

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CSP INC. AND SUBSIDIARIES

UNAUDITED CONSOLIDATED BALANCE SHEETS

(Amounts in thousands, except par value)

	March 31, 2005
ASSETS
Current assets:
Cash and cash equivalents	$ 8,532	$	2,880
Short-term investments	6,598		10,015
Accounts receivable, net of allowances of $143 and $195 as of March 31, 2005 and September 30, 2004	5,654		7,292
Inventories	4,048		3,611
Refundable income taxes	25		12
Other current assets	1,306		866
Total current assets	26,163		24,676
Property, equipment and improvements, net	1,157		1,213
Other assets:
Long-term investments	695		174
Goodwill	2,996		2,996
Deferred income taxes	170		264
Cash surrender value life insurance	1,774		1,704
Other assets	139		86
Total other assets	5,774		5,224
Total assets	$ 33,094	$	31,113
LIABILITIES AND SHAREHOLDERS’ EQUITY
Current liabilities:
Accounts payable and accrued expenses	$ 8,092	$	8,185
Pension and retirement plans	389		368
Income taxes payable	991		700
Total current liabilities	9,472		9,253
Pension and retirement plans	8,224		7,717
Deferred income taxes	129		99
Other long-term liabilities	—		20
Total Liabilities	17,825		17,089
Commitments and contingencies
Shareholders’ equity:
Common stock, $.01 par; authorized, 7,500 shares; issued 4,160 and 4,140 shares as of March 31, 2005 and September 30, 2004	42		41
Additional paid-in capital	11,509		11,405
Retained earnings	10,852		9,865
Accumulated other comprehensive loss	(4,275	)	(4,428	)
	18,128		16,883
Less treasury stock, at cost, 570 shares	(2,859	)	(2,859	)
Total shareholders’ equity	15,269		14,024
Total liabilities and shareholders’ equity	$ 33,094	$	31,113

See accompanying notes to unaudited consolidated financial statements.

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CSP INC. AND SUBSIDIARIES

UNAUDITED CONSOLIDATED STATEMENTS OF OPERATIONS

(Amounts in thousands, except for per share data)

	For the three months ended — March 31, 2005	March 31, 2004	March 31, 2005		March 31, 2004
Sales:
Product	$ 15,622	$ 9,123	$	26,834	$	17,908
Services	3,339	3,043		6,501		6,058
Total sales	18,961	12,166		33,335		23,966
Cost of sales:
Product	11,657	6,470		20,024		13,593
Services	2,371	2,130		4,462		3,986
Total cost of sales	14,028	8,600		24,486		17,579
Gross profit	4,933	3,566		8,849		6,387
Operating expenses:
Engineering and development	789	661		1,653		1,351
Selling, general and administrative	3,228	2,455		5,836		4,802
Total operating expenses	4,017	3,116		7,489		6,153
Operating income	916	450		1,360		234
Other income
Foreign exchange gain (loss)	15	(12	)	(28	)	(14	)
Other income net	75	49		109		121
Total other income, net	90	37		81		107
Income before income taxes	1,006	487		1,441		341
Provision for income taxes	256	9		454		91
Net income	$ 750	$ 478	$	987	$	250
Net income per share – basic	$ 0.21	$ 0.13	$	0.28	$	0.07
Weighted average shares outstanding-basic	3,591	3,558		3,584		3,556
Net income per share-diluted	$ 0.20	$ 0.13	$	0.26	$	0.07
Weighted average shares outstanding-diluted	3,814	3,673		3,811		3,667

See accompanying notes to unaudited consolidated financial statements

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CSP INC. AND SUBSIDIARIES

UNAUDITED CONSOLIDATED STATEMENTS OF CASH FLOWS

(Amounts in thousands)

	For the six months ended — March 31, 2005	March 31, 2004
Cash flows from operating activities:
Net income	$ 987	$	250
Adjustments to reconcile net income to net cash provided by (used for) operations:
Depreciation and amortization	302		264
Loss on disposal of property, net	7		2
Loss on foreign currency transactions	28		14
Non-cash changes in accounts receivable	(49	)	(14	)
Deferred income taxes	135		(247	)
Changes in operating assets and liabilities
(Increase) decrease in accounts receivable	1,852		(1,353	)
Increase in inventories	(414	)	(563	)
(Increase) decrease in refundable income taxes	(13	)	781
(Increase) decrease in other current assets	(417	)	288
Increase in cash surrender value life insurance	(70	)	(58	)
(Increase) decrease in other assets	(53	)	29
Increase (decrease) in accounts payable and accrued expenses	(254	)	385
Increase (decrease) in pension and retirement plans	288		(34	)
Increase (decrease) in income taxes payable	285		(129	)
Decrease in other liabilities	(20	)	—
Net cash provided by (used for) operating activities	2,594		(385	)
Cash flows from investing activities:
Purchases of available-for-sale securities	(45	)	(125	)
Purchases of held-to-maturity securities	(3,439	)	(1,174	)
Sales of available-for-sale securities	45		49
Maturities of held-to-maturity securities	6,638		1,847
Proceeds from sale of property, net of expenses	—		3
Purchases of property, equipment and improvements	(252	)	(397	)
Net cash provided by investing activities	2,947		203
Cash flows from financing activities:
Proceeds from stock issued from exercise of options	61		21
Proceeds from issuance of shares under employee stock purchase plan	44		34
Net cash provided by financing activities	105		55
Effects of exchange rate on cash	6		453
Net increase in cash and cash equivalents	5,652		326
Cash and cash equivalents, beginning of period	2,880		3,129
Cash and cash equivalents, end of period	$ 8,532	$	3,455
Supplementary cash flow information:
Cash paid for income taxes	$ 37	$	162
Cash paid for interest	$ 106	$	85

See accompanying notes to unaudited consolidated financial statements.

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CSP INC. AND SUBSIDIARIES

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

THREE AND SIX MONTH PERIODS ENDED MARCH 31, 2005 AND 2004

Organization and Business

CSP Inc. (“CSPI” or the “Company”) was founded in 1968 and is based in Billerica, Massachusetts. To meet the diverse requirements of its industrial, commercial, scientific and defense customers worldwide, CSPI and its subsidiaries develop and market IT integration solutions, messaging and image-processing software, and high-performance cluster computer systems. The Company’s wholly owned subsidiaries include MODCOMP, Inc. (“MODCOMP”), Scanalytics, Inc., and MultiComputer division.

1. Basis of Presentation

The accompanying financial statements have been prepared by the Company, without audit, and reflect all adjustments which, in the opinion of management, are necessary for a fair statement of the results of the interim periods presented. All adjustments were of a normal recurring nature. Certain information and footnote disclosures normally included in the annual financial statements, which are prepared in accordance with accounting principles generally accepted in the United States of America, have been condensed or omitted. Accordingly, the Company believes that although the disclosures are adequate to make the information presented not misleading, the financial statements should be read in conjunction with the footnotes contained in the Company’s Annual Report on Form 10-K for the fiscal year ended September 30, 2004.

In accordance with accounting principles generally accepted in the United States of America, all significant intercompany transactions and balances have been eliminated in consolidation. Accordingly, segment results reported by the Company exclude the effect of transactions between the Company’s subsidiaries.

2. Use of Estimates

The preparation of consolidated financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results may differ from those estimates under different assumptions or conditions.

3. Recent Accounting Pronouncements

In November 2004, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standard (SFAS) No. 151, “Inventory Costs” , which clarifies the accounting for abnormal amounts of idle facility expense, freight, handling costs, and wasted material. SFAS No. 151 will be effective for inventory costs incurred during fiscal years beginning after June 15, 2005. We do not believe the adoption of SFAS No. 151 will have a material impact on our consolidated financial statements or results of operations.

In December 2004, the FASB issued SFAS No. 153, “Exchanges of Nonmonetary Assets” , which eliminates the exception for nonmonetary exchanges of similar productive assets and replaces it with a general exception for exchanges of nonmonetary assets that do not have commercial substance. SFAS No. 153 will be effective for nonmonetary asset exchanges occurring in fiscal periods beginning after June 15, 2005. We do not believe the adoption of SFAS No. 153 will have a material impact on our consolidated financial statements or results of operations.

In December 2004, the FASB issued SFAS No. 123R, “Share-Based Payment”, which establishes standards for transactions in which an entity exchanges its equity instruments for goods or services. This Statement requires a public entity to measure the cost of employee services received in exchange for an award of equity instruments based on the grant-date fair value of the award. The compensation expense will be recognized over the period during which an employee is required to provide service in exchange for the award. The Statement, as issued by the FASB, was to be effective as of the beginning of the first interim or annual reporting period that begins after June 15, 2005. However, on April 15, 2005, the Securities and Exchange Commission (SEC) adopted a new rule which amends the compliance dates for revised SFAS No. 123. The rule allows implementation of the Statement at the beginning of the next fiscal year that begins after June 15, 2005. We intend to adopt the revised Statement as of October 1, 2005.

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In March 2005, the SEC issued Staff Accounting Bulletin No. 107 (SAB No. 107), which provides additional guidance to stock option expensing provisions under SFAS No. 123R. This additional guidance will be considered in establishing assumptions to value newly granted stock options under SFAS No. 123R. We are in the process of evaluating the impact of the adoption of SFAS No. 123R on our financial position and results of operations. See the pro forma disclosure in Note. 6.

4. Reclassifications

Certain amounts for prior periods in the accompanying unaudited consolidated financial statements have been reclassified to conform to current period presentations.

5. Earnings Per Share of Common Stock

Basic net income per common share is computed by dividing net income by the weighted average number of common shares outstanding for the period. Diluted net income per common share reflects the maximum dilution that would have resulted from the assumed exercise and share repurchase related to dilutive stock options and is computed by dividing net income by the assumed weighted average number of common shares outstanding.

The reconciliation of the numerators and denominators of the basic and diluted net income per share computations for the Company’s reported net income is as follows:

	For the three months ended — March 31, 2005	March 31, 2004	For the six months ended — March 31, 2005	March 31, 2004
(Amounts in thousands, except per share data)
Net income	$ 750	$ 478	$ 987	$ 250
Weighted average number of shares outstanding – basic	3,591	3,558	3,584	3,556
Incremental shares from the assumed exercise of stock options	223	115	227	111
Weighted average number of shares outstanding – dilutive	3,814	3,673	3,811	3,667
Net income per share – basic	$ 0.21	$ 0.13	$ 0.28	$ 0.07
Net income per share – diluted	$ 0.20	$ 0.13	$ 0.26	$ 0.07

SFAS No. 128 requires all anti-dilutive securities, including stock options, to be excluded from the diluted earnings per share computation. For the three and six months ended March 31, 2005 and 2004, options of 504,278 and 381,062 were included in the diluted net income per share calculation and 84,500 and 129,210 options were excluded.

6. Stock-Based Compensation

The Company accounts for its stock compensation under the provisions of SFAS No. 123, as amended by SFAS No. 148, “ Accounting for Stock-Based Compensation – Transition and Disclosure .” As permitted by SFAS No. 123, the Company measures compensation cost in accordance with Accounting Principles Board Opinion No. 25, “ Accounting for Stock Issued to Employees” and related interpretations. Accordingly, no accounting recognition is given to stock options granted at fair market value until they are exercised. Upon exercise, net proceeds, including tax benefits realized, are credited to shareholders’ equity.

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The following table illustrates the pro forma effect on net income and net income per share if the Company had applied the fair value recognition provisions of SFAS No. 123.

(Amounts in thousands, except per share data)	For the three months ended — March 31, 2005	March 31, 2004		March 31, 2005		March 31, 2004
Net income	$ 750	$	478	$	987	$	250
Deduct: Stock based employee compensation expense determined under fair value based method for all awards	(58	)	(37	)	(116	)	(73	)
Pro forma net income	$ 692	$	441	$	871	$	177
Income per share:
Basic, as reported	$ 0.21	$	0.13	$	0.28	$	0.07
Diluted, as reported	$ 0.20	$	0.13	$	0.26	$	0.07
Basic, pro forma	$ 0.19	$	0.12	$	0.24	$	0.05
Diluted, pro forma	$ 0.18	$	0.12	$	0.23	$	0.05
Weighted average shares outstanding – basic	3,591		3,558		3,584		3,556
Weighted average shares outstanding – diluted	3,814		3,673		3,811		3,667

The fair value of each stock option is estimated on the date of grant using the Black-Scholes option-pricing model with the following weighted average assumptions:

	For the three months ended — March 31, 2005	March 31, 2004	For the six months ended — March 31, 2005	March 31, 2004
Risk-free interest rate	2.72 %	2.57 %	3.50 %	2.84 %
Expected dividend yield	—	—	—	—
Expected volatility	48.44 %	48.90 %	48.44 %	48.90 %
Expected life (years)	5	5	5	5
Weighted average fair value of options granted during the period	$ 7.60	$ 6.14	$ 9.70	$ 6.70

7. Inventories

Inventories consist of the following:

	March 31, 2005	September 30, 2004
	(Amounts in thousands)
Raw materials	$ 1,066	$ 1,421
Work-in-process	753	737
Finished goods	2,229	1,453
Total	$ 4,048	$ 3,611

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8. Comprehensive Income

The components of comprehensive income are as follows:

(Amounts in thousands)	For the three months ended — March 31, 2005	March 31, 2004		March 31, 2005		March 31, 2004
Net income	$ 750	$	478	$	987	$ 250
Unrealized gain on available-for-sale securities	19		3		37	33
Effect of foreign currency translation	(111	)	(119	)	116	12
Comprehensive income	$ 658	$	362	$	1,140	$ 295

The components of Accumulated Other Comprehensive Income (Loss) are as follows:

(Amounts in thousands) — Unrealized gain on available-for-sale securities	March 31, 2005 — $ 66		September 30, 2004 — $ 29
Cumulative Effect of Foreign currency translation	(1,472	)	(1,588	)
Additional minimum pension liability	(2,869	)	(2,869	)
Accumulated Comprehensive income (loss)	$ (4,275	)	$ (4,428	)

9. Pension and Retirement Plans

In the United Kingdom and Germany, the Company provides defined benefit pension plans and defined contribution plans for the majority of its employees. Domestically, the Company also provides benefits through supplemental retirement plans to certain current and former employees. These supplemental plans provide benefits derived out of cash surrender values relating to current and former employee and officer life insurance policies, equal to the difference between the amounts that would have been payable under the defined benefit pension plans, in the absence of legislation limiting pension benefits and earnings that may be considered in calculating pension benefits, and the amounts actually payable under the defined benefit pension plans. Domestically, the Company provides for officer death benefits through the post-retirement plans to certain officers.

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 sheet.

The plan assets comprise a diversified mix of assets including corporate equities, government securities and corporate debt securities.

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The components of net periodic benefit costs related to the U.S. and foreign plans are as follows:

	For the Three Months Ended March 31 — Foreign	2005 U.S.		Total	Foreign		2004 U.S.		Total
	(Amounts in thousands)
Pension:
Service cost	$ 23	$	2	$ 25	$	28	$	17	$ 45
Interest cost	158		38	196		153		23	176
Expected return on plan assets	(93	)	—	(93	)	(84	)	—	(84	)
Amortization of:
Prior service costs/(gains)	40		15	55		43		—	43
Net transition asset	(31	)	—	(31	)	(29	)	—	(29	)
Net periodic benefit cost	$ 97	$	55	$ 152	$	111	$	40	$ 151
Post Retirement:
Service cost	$ —	$	13	$ 13	$	—	$	14	$ 14
Interest cost	—		7	7		—		2	2
Expected return on plan assets	—		—	—		—		—	—
Amortization of:
Prior service costs/(gains)	—		—	—		—		—	—
Net transition asset	—		19	19		—		—	—
Net periodic benefit cost	$ —	$	39	$ 39	$	—	$	16	$ 16
	For the Six Months Ended March 31
	Foreign	2005 U.S.		Total	Foreign		2004 U.S.		Total
	(Amounts in thousands)
Pension:
Service cost	$ 46	$	4	$ 50	$	56	$	34	$ 90
Interest cost	316		74	$ 390		311		46	357
Expected return on plan assets	(184	)	—	(184	)	(173	)	—	(173	)
Amortization of:
Prior service costs/(gains)	80		30	110		85		—	85
Net transition asset	(62	)	—	(62	)	(59	)	—	(59	)
Net periodic benefit cost	$ 196	$	108	$ 304	$	220	$	80	$ 300
Post Retirement:
Service cost	$ —	$	26	$ 26	$	—	$	28	$ 28
Interest cost	—		14	14		—		4	4
Expected return on plan assets	—		—	—		—		—	—
Amortization of:									—
Prior service costs/(gains)	—		—	—		—		—	—
Net transition asset	—		38	38		—		—	—
Net periodic benefit cost	$ —	$	78	$ 78	$	—	$	32	$ 32

There were no Company contributions for the three and six months ended March 31, 2005 and 2004.

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10. Segment and Geographical Information

Summarized financial information of the Company’s operations by operating segment is as follows:

	Systems	Service and system integration
	(Amounts in thousands)
Quarter Ended March 31, 2005
Sales:
Product	$ 3,003	$ 12,378	$	2	$	239	$	15,622
Service	62	3,018		258		1		3,339
Total sales	3,065	15,396		260		240		18,961
Profit (loss) from operations	941	(63	)	67		(29	)	916
Assets	10,814	21,281		498		501		33,094
Capital expenditures	17	63		1		11		92
Depreciation and amortization	57	92		1		3		153
Quarter Ended March 31, 2004
Sales:
Product	$ 1,912	$ 6,727	$	3	$	481	$	9,123
Service	243	2,435		345		20		3,043
Total sales	2,155	9,162		348		501		12,166
Profit (loss) from operations	516	86		(180	)	28		450
Assets	9,736	17,045		566		579		27,926
Capital expenditures	83	191		6		5		285
Depreciation and amortization	46	92		3		3		144
Six Months Ended March 31, 2005
Sales:
Product	$ 5,531	$ 20,739	$	44	$	520	$	26,834
Service	306	5,620		574		1		6,501
Total sales	5,837	26,359		618		521		33,335
Profit (loss) from operations	1,522	54		(126	)	(90	)	1,360
Assets	10,814	21,281		498		501		33,094
Capital expenditures	106	130		3		13		252
Depreciation and amortization	114	179		4		5		302
Six Months Ended March 31, 2004
Sales:
Product	$ 2,596	$ 14,451	$	82	$	779	$	17,908
Service	587	4,886		560		25		6,058
Total sales	3,183	19,337		642		804		23,966
Profit (loss) from operations	382	261		(324	)	(85	)	234
Assets	9,736	17,045		566		579		27,926
Capital expenditures	168	217		7		5		397
Depreciation and amortization	90	163		5		6		264

Profit (loss) from operations is sales less cost of sales, engineering and development, selling, general and administrative expenses but is not affected by either non-operating charges/income or by income taxes. Non-operating charges/ income consists principally of gain on sale of property, investment income and interest expense. In calculating profit (loss) from operations for individual operating segments, sales and administrative expenses incurred at the corporate level that benefit the segments are allocated to each segment based upon their relative sales levels.

All intercompany transactions have been eliminated.

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Assets, including deferred income tax assets and other financial instruments owned by the Company, common to more than one segment are allocated on a sales basis. Capital expenditures common to more than one segment are allocated on a sales basis.

For the six months ended March 31, 2005 and 2004, the Company had sales to two customers Atos Origin GmbH (a Service and system integration customer, which effective in January 2005 became the primary system integrator for E-Plus) which accounted for approximately $4.0 million (12%) and $0.0 million of consolidated sales for the six month periods ended March 31, 2005 and 2004 and E-Plus (a Service and system integration customer) which accounted for $3.2 million (10%) and $5.1 million (21%) of consolidated sales for the six month periods ended March 31, 2005 and 2004, respectively. No other customers had sales in excess of 10% of consolidated sales for the six months ended March 31, 2005 and 2004, respectively.

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Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

Forward-Looking Statements

This quarterly report on form 10-Q contains forward-looking statements based on current expectations that involve a number of risks and uncertainties. Such statements are generally identified by the use of forward-looking words and phrases, such as “intended,” “expects,” “anticipates” and “is (or are) expected (or anticipated).” Actual results may differ materially from those discussed in such forward-looking statements, and our stockholders should carefully review the cautionary statements set forth in this form 10-Q, including those set forth under the caption “Risk Factors That May Affect Future Results”. 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 our products and services mix may cause fluctuations in our gross margin. Due to the potential quarterly fluctuations in our 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 on 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.

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, income taxes, deferred compensation and 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 deferred tax assets valuation allowance; inventory valuation; and goodwill impairment.

Revenue recognition

Our revenues are primarily generated from the sale of IT solutions and image processing software, third-party products, network management and storage systems integration services and high-performance cluster computer systems. In accordance with generally accepted accounting principles in the United States and when all other revenue recognition criteria have been met, we recognize revenue as follows (organized by operating segment):

Systems Revenue

Revenue from the sale of hardware products is recognized at the time of shipment and when all revenue recognition criteria have been met.

In limited circumstances, we are engaged in long-term contracts to design, develop, manufacture or modify complex equipment. For these contracts, we may recognize revenue using the percentage-of-completion method of

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contract accounting, measuring progress toward completion based on contract cost incurred to date as compared with total estimated contract costs. The use of the percentage-of-completion method of accounting requires significant judgment relative to estimating total contract costs, including assumptions relative to the length of time to complete the contract, the nature and complexity of the work to be performed, anticipated increases in wages and prices for subcontractor services and materials, and the availability of subcontractor services and materials. Our estimates are based upon the professional knowledge and experience of our engineers, program managers and other personnel who review each long-term contract monthly to assess the contract’s schedule, performance, technical matters and estimated cost at completion. When adjustments in estimated contract costs are determined, such revisions may have the effect of adjusting in the current period the earnings applicable to performance in prior periods. Anticipated losses, if any, are recognized in the period in which determined.

We also offer training, maintenance agreements and support services. We have established fair value on our training, maintenance and support services based on separate sales of these elements at prices stated in our standard price lists. These prices are not discounted. Revenue from 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. Revenue on training is recognized when the training is completed.

Service and System Integration Revenue

Our Service and Systems Integration segment includes third-party hardware and third-party software sales, which may be bundled with extended third party warranty, installation, training and support services. The third-party warranty is solely serviced by our vendors and we do not have any service obligations under these warranties. Under the support services agreements, we provide services to identify which component in the system is causing a malfunction; however, once the malfunctioning component is isolated, the customer must deal directly with the third party vendor for remediation.

The support services are always priced using a standard calculation based on estimated calls and are based on our price lists. This price is not discounted and renewals are only adjusted for standard price index increases. As a result, we believe that we have established fair market value for this element.

As a result, we recognize revenue on all elements, except for the support services, when all the products and services included in these elements have been delivered, customer acceptance has been ascertained, if and when applicable, and all other revenue recognition criteria have been meet. Revenue for the support services is recognized over the term of the contract, typically three to twelve months.

Service and systems integration also has some customized integration revenue, which may include revenue from the sale of third-party hardware, licensed software (either proprietary or third-party), consulting integration services, maintenance support, and service support. Maintenance support agreements represent fixed-fee support agreements on our delivered integration systems, while the service agreements represent time and material billings for services on an as-needed basis. These services do not provide for upgrades unless the upgrade is required to fix a functionality issue (i.e. bug fix).

We have established vendor-specific evidence of fair value on our maintenance support and service support elements.

Service support is available to customers who have not entered into a maintenance support agreement, and this service is billed on a time and material basis at our standard prices. These rates are not discounted and are provided on an as-needed basis.

As a result, revenue for all items, except for maintenance support and service support, are recognized when all the products and services included in these elements have been delivered, customer acceptance has been ascertained and all other revenue recognition criteria have been met. Maintenance support revenue is recognized over the term of the contract. Service support revenue is recognized upon performance of the services.

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For software licenses sold separately without modification and training, revenue is recognized upon delivery.

Revenue derived from consulting services rendered in connection with the integration of third-party hardware and third-party software is generally recognized when the services have been completed.

E-business Software Revenue

Our E-business Software segment includes customized integration revenue which may include revenue from the sale of third party hardware, licensed software (either proprietary or third-party), consulting integration services, maintenance support, and service support. Maintenance support agreements represent fixed fee support agreements on our delivered integration systems while the service agreements represent time and material billings for services on an as needed basis. These services do not provide for upgrades unless the upgrade is required to fix a functionality issue (i.e. bug fix).

We have not established vendor specific evidence of fair value on our third party hardware, licensed software and consulting integration services and they are recognized on a combined basis pursuant to accounting literature noted above. We have established vendor specific evidence of fair value on our maintenance support and service support elements.

Maintenance support is priced based on prices charged in separate sales to customers at prices established and published in our standard price list depending on the size of the project and the type of support requested. Renewal rates are specified in the contracts and are consistent with the initial rates. These rates will only change as a result of (i) a standard price index increase, and/or (ii) additional customization services provided (this adjustment is based on the price list renewal rate on the additional services provided). In addition, maintenance support is never discounted.

Service support is available to customers who have not entered into a maintenance support agreement and this service is billed on a time and material basis at our standard prices. These rates are never discounted and are provided on an as needed basis.

As a result, revenue for all items, except for maintenance support and service support, are recognized when all the products and services included in these elements have been delivered, customer acceptance, if any, has been ascertained and all other revenue recognition criteria have been met. Maintenance support revenue is recognized over the term of the contract. Service support revenue is recognized upon performance of the services.

Other Software Revenue

Our Other software segment sells shrink-wrapped and packaged software products. On occasion, these products are bundled with third-party hardware and installations. For all software product sales, we provide telephone support under the software agreements. We recognize software revenue when the software product, and if applicable, the hardware product and installation, has been delivered and accepted by the customer. Our revenue recognition policy follows Statement of Position 97-2 (“SOP 97-2”) paragraph 59. SOP 97-2 paragraph 59 states that post customer support revenue may be recognized together with the initial fee, on delivery of the software, if all of the following conditions are met:

• The post customer support fee is included with the initial fee;

• The post customer support included is for one year or less;

• The estimated cost of providing post customer support during the arrangement is insignificant; and

• Unspecified upgrades/enhancements offered during the post customer support arrangement historically have been and are expected to continue to be minimal and infrequent.

We generally recognize revenue from software licenses when persuasive evidence of an arrangement exists, delivery of the product has occurred, no significant obligations with regard to customization or implementation remain, the fee is fixed or determinable, and collectibility is probable. If collectibility is not considered probable, revenue is recognized when cash is collected.

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Valuation Allowances

We maintain allowances for doubtful accounts for estimated losses resulting from the inability of our customers to make required payments. If the financial condition of our customers were to deteriorate, resulting in impairment of their ability to make payments, additional allowances may be required.

We record a valuation allowance for the entire balance of deferred tax assets in the U.S. and U.K. as it is more likely than not they will not be realized due to our being in a cumulative loss position. The ultimate realization of deferred tax assets is dependent upon the generation of future taxable income during the periods in which the associated temporary differences become deductible. We consider the scheduled reversals of deferred tax liabilities and projected taxable income in making this assessment. Based on our lack of income in the U.S. and U.K. over several years and lack of significant orders, we established a valuation allowance for the entire deferred tax asset. Based upon the level of historical taxable income and projections for the future taxable income over the period in which the deferred taxes will reverse or NOLs expire, management believes it is more likely than not, that we will not realize the benefits of these deductible differences.

In assessing the realizability of our deferred tax assets, we consider and rely upon projections of future income. The key assumptions in our projections include sales growth rates, including potential contract wins, and expected levels of operating expenditures in addition to factors discussed in the section “Risk Factors That May Affect Future Results”. These assumptions are subject to variation based upon both internal and external factors, many of which are beyond our control. To the extent that actual experience deviates from our assumptions, our projections would be affected and hence our assessment of realizability of our deferred tax asset may change. If we are awarded a significant contract our projections will be impacted and we may reverse the valuation allowance against the deferred tax asset.

Inventory Valuation

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-down may be required.

Goodwill Impairment

We adopted SFAS No. 142, “Goodwill and Other Intangible Assets” on October 1, 2002. This standard requires that goodwill no longer be amortized, and instead, be tested for impairment at least annually and whenever events or changes in circumstances indicate that the carrying value may not be recoverable. Factors we consider important that could indicate impairment include significant under performance relative to prior operating results, change in projections, significant changes in the manner of our use of assets or the strategy for our overall business, and significant negative industry or economic trends. At March 31, 2005 and 2004, we had $2,779,000 in Goodwill. We had no impairment charge during the year ended September 30, 2004, but we did have an impairment charge of $365,000 recorded during the year ended September 30, 2003. In evaluating the impairment of goodwill, we consider a number of analyses such as discounted cash flow projections and market capitalization value. The process of evaluating the potential impairment of goodwill is highly subjective and requires significant judgment at many points during the analysis. In estimating fair value of the businesses with goodwill for the purposes of our annual or periodic analyses, we make estimates and judgments about the future cash flows of these businesses. Our cash flow forecasts are based on assumptions that are consistent with the plans and estimates we are using to manage the underlying businesses. In addition, we make certain judgments about assets such as accounts receivable and inventory to the estimated balance sheet for those businesses. We also consider our market capitalization (adjusted for unallocated monetary assets such as cash, marketable debt securities and debt) on the date we perform the analysis. Our key assumptions include sales growth and expected levels of operating expenditures, which are subject to variation based on both internal and external factors. To the extent that actual experience deviates from the projections, our assessment regarding impairment may change. Such a change could have a material adverse affect on the statement of operations.

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Pension and Retirement Plans

In the United Kingdom and Germany, we provide defined benefit pension plans and defined contribution plans for the majority of the employees. In the U.S., we also provide benefits through supplementary retirement plans to employees. These supplemental plans are funded from cash surrender values from life insurance policies. The plan assumptions in the U.S. include a discount rate of 6.0% and the plan assumptions in the U.K. and Germany include a discount rate of 5.0%. In addition, in the U.S., we provide for officer death benefits through the post-retirement plans to certain officers. In calculation of the deferred compensation and retirement plans net liabilities, we make assumptions regarding expected discount rates, rates of return on assets and compensation increase rates. If activities differ from the assumptions, deferred compensation and retirement plans net liabilities may require significant adjustments. We fund the 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 sheet.

Results of Operations

The following table details our results of operations in dollars and as a percentage of sales for the three and six months ended March 31, 2005 and 2004:

	March 31, 2005	% of sales	March 31, 2004	% of sales	March 31, 2005	% of sales	March 31, 2004	% of sales
Sales	$ 18,961	100 %	$ 12,166	100 %	$ 33,335	100 %	$ 23,966	100 %
Costs and expenses:
Cost of sales	14,028	74 %	8,600	71 %	24,486	74 %	17,579	73 %
Engineering and development	789	4 %	661	5 %	1,653	5 %	1,351	6 %
Selling, general and administrative	3,228	17 %	2,455	20 %	5,836	17 %	4,802	20 %
Total costs and expenses	18,045	95 %	11,716	96 %	31,975	96 %	23,732	99 %
Operating income	916	5 %	450	4 %	1,360	4 %	234	1 %
Other income	90	— %	37	— %	81	— %	107	— %
Income before income taxes	1,006	5 %	487	4 %	1,441	4 %	341	1 %
Provision for income taxes	256	1 %	9	— %	454	1 %	91	— %
Net income	$ 750	4 %	$ 478	4 %	$ 987	3 %	$ 250	1 %

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Sales

The following table details our sales by operating segment for the three and six month periods ended March 31, 2005 and 2004:

By Operating Segment:	March 31, 2005	% of Total	March 31, 2004	% of Total	$ Increase		% Increase
		(Amounts in thousands)
For the Three Months Ended:
Systems	$ 3,065	16 %	$ 2,155	18 %	$ 910		42	%
Service and system integration	15,397	81 %	9,162	75 %	6,235		68	%
E-business software	259	2 %	348	3 %	(89	)	(25	)%
Other software	240	1 %	501	4 %	(261	)	(52	)%
Total	$ 18,961	100 %	$ 12,166	100 %	$ 6,795		56	%
For the Six Months Ended:
Systems	$ 5,837	17 %	$ 3,183	13 %	$ 2,654		83	%
Service and system integration	26,359	79 %	19,337	81 %	7,022		36	%
E-business software	618	2 %	642	3 %	(24	)	(4	%)
Other software	521	2 %	804	3 %	(283	)	(35	)%
Total	$ 33,335	100 %	$ 23,966	100 %	$ 9,369		39	%

The Systems segment revenue increased by $0.9 million (42%) and $2.7 million (83%) for the three and six months ended March 31, 2005, respectively. This increase was primarily due to sales to defense contractors for two programs, one in the U.S., which represented 4% and 27% of the segment sales for the three and six months ended March 31, 2005, and one in Japan which represented 44% and 23% of segment sales for the three and six month periods ended March 31, 2005. We expect there to be approximately $1.2 million additional sales from the U.S. program that will be shipped in our third quarter of fiscal 2005. The Service and system integration segment sales increased by $6.2 million (68%) and $7.0 million (36%) for the three and six months ended March 31, 2005, respectively. This increase for the six month period ended March 31, 2005 compared to the same period of fiscal 2004 was primarily due to an increase of $6.9 million (78%) in sales by our German subsidiary for a number of large systems integration projects which included the sale of equipment and services.

Our sales by geographic area, based on the location of where the products were shipped or services rendered, are as follows:

	2005	%	2004	%	$ Increase		% Increase
		(Amounts in thousands)
For the Three Months Ended March 31:
Europe	$ 10,441	55 %	$ 4,902	40 %	$ 5,539		113	%
North America	6,684	35 %	7,062	58 %	(378	)	(5	)%
Asia and the rest of the world	1,836	10 %	202	2 %	1,634		809	%
Totals	$ 18,961	100 %	$ 12,166	100 %	$ 6,795		56	%
For the Six Months Ended:
Europe	$ 17,233	52 %	$ 10,195	42 %	$ 7,038		69	%
North America	13,548	40 %	13,367	56 %	181		1	%
Asia and the rest of the world	2,554	8 %	404	2 %	2,150		532	%
Totals	$ 33,335	100 %	$ 23,966	100 %	$ 9,369		39	%

The European sales increase was due to the increase in Service and systems integration revenue primarily in Germany and the U.K. Sales in Asia were primarily from the Systems segment to a defense contractor for a program in Japan.

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Cost of Sales

The following table details our sales, cost of sales and gross margin by operating segment for the three and six months ended March 31, 2005 and 2004:

	Systems	Service and system integration				Other Software		Total
		(Amounts in thousands)
For the Three Months Ended March 31:
2005
Sales	$ 3,065	$ 15,397	$	259		$ 240		$ 18,961
Cost of sales	1,000	12,893		105		30		14,028
Gross margin $	$ 2,065	$ 2,504	$	154		$ 210		$ 4,933
Gross margin %	67 %	16	%	60	%	88	%	26	%
2004
Sales	$ 2,155	$ 9,162	$	348		$ 501		$ 12,166
Cost of sales	804	7,429		189		178		8,600
Gross margin $	$ 1,351	$ 1,733	$	159		$ 323		$ 3,566
Gross margin %	63 %	19	%	46	%	65	%	29	%
Increase (decrease)
Sales - $ Increase (decrease)	$ 910	$ 6,235	$	(89	)	$ (261	)	$ 6,795
% Increase (decrease)	42 %	68	%	(25	)%	(52	)%	56	%
Cost of sales- $ Increase (decrease)	$ 196	$ 5,464	$	(84	)	$ (148	)	$ 5,428
% Increase (decrease)	24 %	74	%	(44	)%	(83	)%	63	%
Gross margin- $ Increase (decrease)	$ 714	$ 771	$	(5	)	$ (113	)	$ 1,367
Gross margin % - Increase (decrease)	4 %	(3	)%	14	%	23	%	(3	)%
For the Six Months Ended March 31:
2005
Sales	$ 5,837	$ 26,359	$	618		$ 521		$ 33,335
Cost of sales	2,184	21,941		266		95		24,486
Gross margin $	$ 3,653	$ 4,418	$	352		426		$ 8,849
Gross margin %	63 %	17	%	57	%	82	%	27	%
2004
Sales	$ 3,183	$ 19,337	$	642		$ 804		$ 23,966
Cost of sales	1,306	15,750		271		252		17,579
Gross margin $	$ 1,877	$ 3,587	$	371		$ 552		$ 6,387
Gross margin %	59 %	19	%	58	%	69	%	27	%
Increase (decrease)
Sales - $ Increase (decrease)	$ 2,654	$ 7,022	$	(24	)	$ (283	)	$ 9,369
% Increase (decrease)	83 %	36	%	(4	)%	(35	)%	39	%
Cost of sales - $ Increase (decrease)	$ 878	$ 6,191	$	(5	)	$ (157	)	$ 6,907
% Increase (decrease)	67 %	39	%	(2	)%	(62	)%	39	%
Gross margin - $ Increase (decrease)	$ 1,776	$ 830	$	(19	)	$ (125	)	$ 2,462
Gross margin % - Increase (decrease)	4 %	(2	)%	(1	)%	13	%	—	%

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Cost of sales as a percentage of sales was 73% for the six months ended March 31, 2005, which is consistent with the same period of the prior fiscal year. The cost of sales for the three month period increased by 3% to 74% due primarily to the increased sales of third party products including hardware and software products and the decline in the legacy service contracts in the Service and systems integration.

Engineering and Development Expenses

The following table details our engineering and development expenses by operating segment for the three and six months ended March 31, 2005 and 2004:

By Operating Segment:	2005	% of Total	2004	% of Total	$ Increase (Decrease)		% Increase (Decrease)
		(Amounts in thousands)
For the Three Months Ended March 31:
Systems	$ 482	61 %	$ 333	50 %	$ 149		45	%
Service and system integration	134	17 %	56	9 %	78		139	%
E-business software	79	10 %	167	25 %	(88	)	(53	)%
Other software	94	12 %	105	16 %	(11	)	(11	)%
Total	$ 789	100 %	$ 661	100 %	$ 128		19	%
For the Six Months Ended March 31:
Systems	$ 997	60 %	$ 652	48 %	$ 345		53	%
Service and system integration	247	15 %	142	11 %	105		74	%
E-business software	220	13 %	328	24 %	(108	)	(33	)%
Other software	189	12 %	229	17 %	(40	)	(18	)%
Total	$ 1,653	100 %	$ 1,351	100 %	$ 302		22	%

The increase in engineering and development expense was primarily due to the hiring of three new employees in the Systems segment needed to meet the requirements of our product development schedule. The decrease in expenses in the E-business software segment was due primarily to a reduction in the engineering and labor expense for the redeployment of resources to activities and customers projects which are either classified as cost of sales or inventory for uncompleted projects where we have not recognized the revenue.

Selling, General and Administrative

The following table details our selling, general and administrative expense by operating segment for the three and six months ended March 31, 2005 and 2004:

By Operating Segment:	2005	% of Total	2004	% of Total	$ Increase (Decrease)		% Increase (Decrease)
		(Amounts in thousands)
For the Three Months Ended March 31:
Systems	$ 642	20 %	$ 502	20 %	$ 140		28	%
Service and system integration	2,433	75 %	1,591	65 %	842		53	%
E-business software	8	— %	172	7 %	(164	)	(95	)%
Other software	145	5 %	190	8 %	(45	)	(24	)%
Total	$ 3,228	100 %	$ 2,455	100 %	$ 773		32	%
For the Six Months Ended March 31:
Systems	$ 1,134	19 %	$ 843	18 %	$ 291		34	%
Service and system integration	4,117	71 %	3,184	66 %	933		29	%
E-business software	258	4 %	367	8 %	(109	)	(30	)%
Other software	327	6 %	408	8 %	(81	)	(20	)%
Total	$ 5,836	100 %	$ 4,802	100 %	$ 1,034		22	%

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Selling, general and administrative expense increased by $0.8 million and $1.0 million for the three and six months ended March 31, 2005 compared to the same periods of the prior fiscal year. This increase was primarily due to increased audit, legal, outside consultants and advisors fees related to new regulatory requirements created by the Sarbanes-Oxley Act of 2002, all of which were offset by some of the benefits of the cost cutting and containment programs. The increase in this expense represented approximately $0.1 million and $0.4 million for the three and six months ended March 31, 2005 compared the three and six months ended March 31, 2004. Other expenses that increased were sales commission expense, executive bonuses, retirement expense, labor expense due to hiring of three new employees, and insurance expense which includes the cost of directors and officer liability premiums. These expenses represented $0.5 million and $0.7 million of the increase for the three and six month periods.

Other Income/Expenses

The following table details our other income/expenses for three and six months ended March 31, 2005 and 2004:

	2005		2004		$ Increase (Decrease)
	(Amounts in thousands)
For the Three Months Ended March 31:
Interest expense	$ (34	)	$ (25	)	$ (9	)
Interest income	83		78		5
Dividend income	—		1		(1	)
Foreign exchange gain (loss)	15		(12	)	27
Other income (expense), net	26		(5	)	31
Total other income (expense), net	$ 90		$ 37		$ 53
For the Six Months Ended March 31:
Interest expense	$ (62	)	$ (52	)	$ (10	)
Interest income	135		119		16
Dividend income	2		2		—
Foreign exchange gain (loss)	(28	)	(14	)	(14	)
Other income (expense), net	34		52		(18	)
Total other income (expense), net	$ 81		$ 107		$ (26	)

We had a foreign exchange loss related to the cash in U.S. dollars that the U.K. subsidiary has in its account. We have taken steps to convert the balance to local currency.

Income Taxes

We recorded a provision for income tax expense of $0.5 million for the six months ended March 31, 2005 compared to $0.1 million for the six months ended March 31, 2004. The tax expense recorded in the six month periods is primarily due to the income generated by our foreign subsidiary in Germany, U.K. income not offset by carryforward losses, and U.S. state tax expense. In fiscal year 2002, we began to record a valuation allowance for our deferred tax assets. This valuation allowance was determined in accordance with the provisions of SFAS No. 109 (SFAS 109), “Accounting for Income Taxes” which requires an assessment of both positive and negative evidence when determining whether it is more likely than not that deferred tax assets are realizable. Such assessment is required on a jurisdiction-by-jurisdiction basis. Cumulative losses incurred in recent years represented sufficient negative evidence under SFAS 109 to record a valuation allowance against the deferred tax assets in the U.S. and the U.K. Our U.S. tax expense for fiscal year 2005 and 2004 has been reduced by decreasing our valuation allowance.

We have maintained the valuation allowances for the deferred tax assets for our U.S. and U.K. operations due to the losses sustained over the last three years. Management believes that it is more likely than not the deferred tax assets will not be realized.

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Liquidity and Capital Resources

Our primary source of liquidity is our cash and cash equivalents and short-term investments, which increased by $2.2 million to $15.1 million as of March 31, 2005, as compared to $12.9 million as of September 30, 2004. In the six month period ended March 31, 2005, we generated approximately $2.6 million of cash in operating activities, compared to $0.4 million used by operating activities in the same period of the prior fiscal year. The significant change in net cash provided by operating activities was primarily due to net income of $1.0 million versus $0.3 million for the prior comparable period and to the decrease in accounts receivable which was offset by increases in inventory and other current assets. The decrease in accounts receivable was due to the timing of cash receipts. The increase in inventory was due to longer lead times to procure critical parts and the need to meet the requirements of our customers.

Approximately $2.9 million of net cash was provided by investing activities for the six months ended March 31, 2005 compared to $0.2 million during the prior comparable period. During the six month period ended March 31, 2005, our investing activities consisted of purchases, sales and maturities of marketable securities providing net cash of $3.2 million from the net sales of investments and the use of ($0.3) million for the purchases of property equipment and improvements.

Financing activities generated approximately $0.1 million of cash during the six month period ended March 31, 2005. This cash was provided from the proceeds of stock issued from the exercise of stock options and from the issuance of shares under our employee stock purchase plan.

If cash generated from operations is insufficient to satisfy working capital requirements, we may need to access funds through bank loans, sale of securities 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.

The following is a schedule of our contractual obligations at March 31, 2005:

	Total	One year or less	2-3 Years	4-5 Years	Thereafter
		(Amounts in thousands)
Operating leases	$ 2,526	$ 1,553	$ 640	$ 234	$ 99
Retirement Obligations	8,613	389	1,115	1,227	5,882
	$ 11,139	$ 1,942	$ 1,755	$ 1,461	$ 5,981

Based on our current plans and business conditions management believes that our available cash and cash generated from operations and investments will be sufficient to provide for our working capital and capital expenditure requirements for the foreseeable future.

Inflation and Changing Prices

Management does not believe that inflation and changing prices had significant impact on sales, revenues or net income during the three and six month periods ended March 31, 2005 and 2004. There is no assurance that our business will not be materially and adversely affected by inflation and changing prices in the future.

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Risk Factors That May Affect Future Results

We Depend on a Small Number of Customers for a Significant Portion of our Revenue and Loss of any Customer Could Significantly Affect the Business

We are dependent on a small number of customers for a large portion of our revenues. The Company had sales to two customers Atos Origin GmbH (a Service and system integration customer, which effective in January 2005 became the primary system integrator for E-Plus) which accounted for approximately 12% consolidated sales and E-Plus (a Service and system integration customer) which accounted for 21% of consolidated sales, respectively. 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 Defense Business for a Significant Amount of our Revenue and the Loss or Decline of Existing or Future Defense Business Could Adversely Affect our Financial Results

Sales of our systems to the defense market accounted for approximately 17% and 13% of our revenues and 98%, and 95% of the Systems segment sales for the six months ended March 31, 2005 and 2004, respectively. Reductions in government spending on programs that incorporate our products could have a material adverse effect on our business, financial condition and results of operations. Moreover, our subcontracts are subject to special risks, such as:

• delays in funding;

• ability of the government agency to unilaterally terminate the prime contract;

• reduction or modification in the event of changes in government policies or as the result of budgetary constraints or political changes;

• increased or unexpected costs under fixed price contracts; and

• other factors that are not under our control.

In addition, consolidation among defense industry contractors has resulted in fewer contractors with increased bargaining power relative to our bargaining power. No assurance can be given that such increased bargaining power will not adversely affect our business, financial condition or results of operations in the future.

Changes in government administration, as well as changes in the geo-political environment such as the current “War on Terrorism,” can have significant impact on defense spending priorities and the efficient handling of routine contractual matters. Such changes could have a negative impact on our business, financial condition, or results of operations in the future.

We Face Competition That Could Adversely Affect our Sales and Profitability

The markets for our products are highly competitive and are characterized by rapidly changing technology, frequent product performance improvements and evolving industry standards. Due to the rapidly changing nature of technology, new competitors may emerge of which we have no current awareness. Competitors may be able to offer more attractive pricing or develop products that could offer performance features that are superior to our products, resulting in reduced demand for our products. Such competitors could have a negative impact on our ability to win future business opportunities. There can be no assurance that a new competitor will not attempt to penetrate the various markets for our products and services. Their entry into markets historically targeted by us may have a material adverse effect on our business, financial condition and results of operations.

Slowdown in the Economy Can Affect our Revenue and Profitability

Our business was negatively impacted by the slowdown in the economies of the United States, Europe and elsewhere that began during fiscal years 2002 and continued through 2003. The uncertainty regarding the growth rate of the worldwide economies had caused companies to reduce capital investment and this may cause further reduction of such investments. These reductions have been particularly severe in the electronics and technology industries. We have experienced good growth in the majority of the lines of our business in the first six months of fiscal 2005 but we cannot predict if this trend will continue.

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Our Operating Results May Fluctuate Significantly

Our operating results have fluctuated widely on a quarterly and annual basis during the last several years, and we expect to experience significant fluctuations in future operating results. Many factors, some of which are beyond our control, have contributed to these fluctuations in the past and may continue to do so. Such factors include:

• sales in relatively large dollar amounts to a relatively small number of customers;

• competitive pricing programs and volume discounts;

• loss of customers;

• market acceptance of our products;

• product obsolescence;

• general economic conditions;

• change in the mix of products sold;

• obtaining or failure to obtain design wins for significant customer systems;

• timing of significant orders;

• delays in completion of internal product development projects;

• delays in shipping our products;

• delays in acceptance testing by customers;

• production delays due to quality programs with outsourced components;

• shortages of components;

• timing of product line transitions;

• declines of revenues from previous generations of products following announcement of replacement products containing more advanced technology; and

• fixed nature of our expenditures on personnel, facilities and marketing programs.

We believe that period-to-period comparisons of our results of operations will not necessarily be meaningful and should not be relied upon as indicative of our future performance. It is also possible that in some periods, our operating results may be below the expectations of securities analysts and investors. In such circumstances, the price of our common stock may decline.

We Rely on Single Sources for Supply of Certain Components and our Business may be Seriously Harmed if our Supply of any of These Components or Other Components is Disrupted

Several components used in our Systems products are currently obtained from sole-source suppliers. We are dependent on key vendors like Myricom as well as Motorola for many of our PowerPC line of processors. Generally, suppliers may terminate their purchase order with us without cause upon 30-days notice and may cease offering products to us upon 180-days notice. If Motorola was to limit or reduce the sale of such components to us, or if these or other component suppliers to us, some of which are small companies, were to experience financial difficulties or other problems which prevented 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; thereby adversely affecting our business and customer

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relationships. We have no guaranteed supply arrangements with our suppliers and there can be no assurance that our suppliers will continue to meet our requirements. If our supply arrangements are interrupted, there can be no assurance that we would be able to find another supplier on a timely or satisfactory basis. Any shortage or interruption in the supply of any of the components used in our products, or the inability to procure these components from alternate sources on acceptable terms could have a material adverse effect on our business, financial condition and results of operations. There can be no assurance that severe shortages of components will not occur in the future. Such shortages could increase the cost or delay the shipment of our products, which could have a material adverse effect on our business, financial condition and results of operations. Significant increases in the prices of these components would also materially adversely affect our financial performance since we may not be able to adjust product pricing to reflect the increase in component costs. We could incur set-up costs and delays in manufacturing should it become necessary to replace any key vendors due to work stoppages, shipping delays, financial difficulties or other factors and, under certain circumstances, these costs and delays could have a material adverse effect on our business, financial condition and results of operations.

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 or other key employees are subject to any employment contract which require services for a period of time. The loss of services of any of our executives or other key personnel could have a material adverse effect on our business, financial condition and results of operations. Our future success will depend to a significant extent on our ability to attract, train, motivate and retain highly skilled technical professionals. Our ability to maintain and renew existing engagements and obtain new business depends, in large part, on our ability to hire and retain technical personnel with the skills that keep pace with continuing changes in industry standards and technologies. The inability to hire additional qualified personnel could impair our ability to satisfy our growing client base, requiring an increase in the level of responsibility for both existing and new personnel. There can be no assurance that we will be successful in retaining current or future employees.

Our International Operations are Subject to a Number of Risks

We market and sell our products in certain international markets, and we have established subsidiaries in the United Kingdom and Germany. Foreign-based revenue is determined based on the location to which the product is shipped or services are rendered, and represented 51% and 42% of our total revenue for the six months ended March 31, 2005 and 2004, 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, less favorable operations, 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. In the recent past, the financial markets in Asia have experienced significant turmoil. A portion of our revenues are from sales to foreign entities, including foreign governments, which are primarily 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.

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 its 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.

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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 OEM 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 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. 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 Maintain our Research and Development Effort to Meet the Needs of our Customers

Our industry is characterized by the need for continued investment in research and development. If we failed 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 our commitment to invest in research and development, spending as a percent of revenues may fluctuate in the future.

We May be Unable to Successfully Integrate Acquisitions

We may in the future acquire or make investments in complementary companies, products or technologies. Acquisitions may pose risks to our operations, including:

• problems and increased costs in connection with the integration of the personnel, operations, technologies or products of the acquired companies;

• unanticipated costs;

• diversion of management’s attention from our core business;

• adverse effects on business relationships with suppliers and customers and those of the acquired company;

• acquired assets becoming impaired as a result of technical advancements or worse-than-expected performance by the acquired company;

• entering markets in which we have no, or limited, prior experience; and

• potential loss of key employees, particularly those of the acquired organization.

In addition, in connection with any acquisitions or investments we could:

• issue stock that would dilute existing shareholders’ percentage of ownership;

• incur debt and assume liabilities;

• obtain financing on unfavorable terms;

• incur amortization expenses related to acquired intangible assets or incur large and immediate write-offs;

• incur large expenditures related to office closures of the acquired companies, including costs relating to termination of employees and leasehold improvement charges relating to vacating the acquired companies’ premises; and

• reduce the cash that would otherwise be available to fund operations or to use for other purposes.

The failure to successfully integrate any acquisition or for acquisitions to yield expected results may negatively impact our financial condition and operating results.

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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:

• our loss of a major customer;

• 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 National 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.

Item 3. Quantitative and Qualitative Disclosures about Market Risk

There was no material change in our exposure to market risk during the three and six months ended March 31, 2005.

Item 4. Controls and Procedures

Our chief executive officer, chief financial officer, and other members of our senior management team believe that the procedures followed by the Company provide reasonable assurance that the identified weaknesses noted by our independent auditors KPMG, LLP in the course of auditing the Company’s fiscal 2004 financial statements, the need for additional staff in its financial group, did not lead to material misstatements in the Company’s consolidated financial statements. We recognize the need to improve and enhance our internal control and financial reporting system. To address the weaknesses noted by the auditors, we have hired a Director of Accounting and Financial Reporting and he started in late April 2005 and we have extended an offer to a senior accountant at our MODCOMP subsidiary in Florida. The offer was accepted and the individual is scheduled to start in the middle of May 2005. Moreover, if greater or additional resources are needed to meet the requirements necessary to handle the complexities of our operations, management has stated that they will authorize the hiring of additional personnel as well.

The effectiveness of a system of disclosure controls and procedures is subject to various inherent limitations, including cost limitations, judgments used in decision making, assumptions about the likelihood of future events, the soundness of internal controls, and fraud. Due to such inherent limitations, there can be no assurance that any system of disclosure controls and procedures will be successful in preventing all errors or fraud, or in making all material information known in a timely manner to the appropriate levels of management.

During the first and second quarters of fiscal 2005, 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 with the exception of our hiring a Director of Accounting and Financial Reporting as discussed above.

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PART II. OTHER INFORMATION

Item 4. Submissions of Matters to a vote of Security Holders

The Company held its Annual Meeting of Stockholders on Tuesday, April 26, 2005. The following matter was approved by the shareholders:

C. Shelton James and Alexander R. Lupinetti were elected as Class III directors for a term of three years with 3,059,793 shares voting for them and 9,116 against.

Item 5. Other Information

None

Item 6. Exhibits

(a) Exhibits

Number	Description
3.1	Articles of Organization and amendments thereto (incorporated by reference to Exhibit 3.1 to our Form 10-K for the year ended August 31, 1990)
3.2	By-Laws, as amended (incorporated by reference to Exhibit 3.2 to our Form 10-K for the year ended August 25, 1995)
31.1	Certification of Chief Executive Officer Pursuant Section 302 of the Sarbanes-Oxley Act of 2002
31.2	Certification of Chief Financial Officer Pursuant Section 302 of the Sarbanes-Oxley Act of 2002
32.1	Certification of Chief Executive Officer and Chief Financial Officer Pursuant Section 906 of the Sarbanes-Oxley Act of 2002

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SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, as amended, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

Date: May 16, 2005	CSP INC. — By:	/s/ ALEXANDER R. LUPINETTI
		Alexander R. Lupinetti
		Chief Executive Officer,
		President and Chairman
Date: May 16, 2005	By:	/s/ GARY W. LEVINE
		Gary W. Levine
		V.P. of Finance and
		Chief Financial Officer

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Exhibit Index

Number	Description
3.1	Articles of Organization and amendments thereto (incorporated by reference to Exhibit 3.1 to our Form 10-K for the year ended August 31, 1990)
3.2	By-Laws, as amended (incorporated by reference to Exhibit 3.2 to our Form 10-K for the year ended August 25, 1995)
31.1	Certification of Chief Executive Officer Pursuant Section 302 of the Sarbanes-Oxley Act of 2002
31.2	Certification of Chief Financial Officer Pursuant Section 302 of the Sarbanes-Oxley Act of 2002
32.1	Certification of Chief Executive Officer and Chief Financial Officer Pursuant Section 906 of the Sarbanes-Oxley Act of 2002

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