CSP INC /MA/ - Annual Report: 2005 (Form 10-K)

Table of Contents

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-K

ANNUAL REPORT PURSUANT TO SECTIONS 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the Fiscal Year Ended September 30, 2005.

For the transition period from                  to                .

Commission File Number 000-10843

CSP Inc.

(Exact name of Registrant as specified in its Charter)

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:

None

Securities Registered Pursuant to Section 12(g) of the Act:

Common Stock (par value $0.01 per share)

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 of 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 ¨    No x.

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. x

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act.

Large accelerated filer    ¨        Accelerated filer    ¨        Non-accelerated filer    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.

The aggregate market value of the stock held by non-affiliates of the registrant as of March 31, 2005, the last business day of the registrant’s most recently completed second fiscal quarter, (based on the closing sale price of $8.67 as quoted on the NASDAQ National Market as of that date) was approximately $31,718,319.

As of March 10, 2006, we had outstanding 3,677,671 shares of common stock.

Table of Contents

EXPLANATORY NOTE

RESTATEMENT OF CONSOLIDATED FINANCIAL STATEMENTS

Restatements

This Annual Report on Form 10-K for our fiscal year ended September 30, 2005 contains restated financial statements that reflect the errors noted below. The restatements affect our consolidated balance sheet as of September 30, 2004 and our consolidated statements of cash flows for the fiscal years ended September 30, 2004 and 2003. We intend to restate our financial statements for the fiscal 2005 and 2004 quarterly periods, in separate filings on Form 10-Q/A for the periods ended December 31, 2004, March 31, 2005 and June 30, 2005. We are not able to predict with certainty when we will make those filings.

During the fiscal 2005 year-end close process, we determined that we incorrectly classified certain highly liquid investments with maturities of three months or less as short-term investments, rather than as cash equivalents. In addition, certain investments with maturity dates of less than one year were incorrectly reported as long-term, rather than short-term. In this Form 10-K, our consolidated balance sheet as of September 30, 2004 and our consolidated statements of cash flows for the years ended September 30, 2004 and 2003 have been restated due to these classification errors.

In addition, during the preparation of our 2005 Form 10-K an error was discovered in our consolidated statements of cash flows for fiscal 2003 that led management to reanalyze the statements of cash flows for all years presented. This further analysis identified additional restatement adjustments to our consolidated statements of cash flows for the years ended September 30, 2004 and 2003 and adjustments to our consolidated statements of cash flows in our 2005 and 2004 quarterly financial statements. See Note 2, “Restatement of Financial Statements,” in the Notes to Consolidated Financial Statements in this 2005 Form 10-K for further details. The changes to the fiscal quarters will be set forth in detail in amendments to the related Quarterly Reports to be filed on Form 10-Q/A as soon as practicable.

Related Regulatory Actions

Because our 2005 Form 10-K was not timely filed, on January 23, 2006 we received a letter from the Nasdaq National Market notifying us that our common stock was subject to delisting. In accordance with Nasdaq rules, we requested and received a hearing with Nasdaq on February 16, 2006 concerning the notice of delisting. Nasdaq advised us at that time that the results of the hearing would be released to us in three to four weeks, and that the delisting action would be stayed pending that outcome. Subsequently, we did not file our Quarterly Report on Form 10-Q for the Quarter Ended December 31, 2005, and on February 22, 2006 Nasdaq again notified us that because we had not made a required filing, our common stock was subject to delisting. Nasdaq has orally advised us that the second notice of delisting is being considered concomitantly with the first, and that its decision on the hearing will govern both notices.

Table of Contents

TABLE OF CONTENTS

Table of Contents

PART I

CSP Inc. (“CSPI”) was incorporated in 1968 and is based in Billerica, Massachusetts, just off Route 128 in the Boston computer corridor. To meet the diverse requirements of our industrial, commercial, scientific and defense customers worldwide, CSPI and its subsidiaries develop and market IT integration solutions and high-performance cluster computer systems.

Restatement

During the financial reporting review process related to our 2005 annual report, certain errors in our consolidated statements of cash flows for the years ended September 30, 2004 and 2003 were discovered that resulted in our restating the consolidated statements of cash flows for these years. The changes were made to correct the reporting of the change in deferred taxes in 2003, to correct the effects of misclassifications of the foreign exchange movements on the various classifications in 2004 and 2003 and to properly classify the change in the cash surrender value of insurance policies in the cash flows statements for 2004 and 2003. Additionally, certain investments previously reported as short-term investments have been restated as cash equivalents for 2004 and 2003. This restatement has been reflected in the consolidated balance sheets and statements of cash flows for both years. A detailed discussion of the restatement is included in Note 2 to our Consolidated Financial Statements included herein.

Additionally, the consolidated financial statements have been restated to reflect the impact of the sale of our discontinued Scanalytics subsidiary. The Company sold substantially all of the net assets of our Scanalytics subsidiary in June 2005. The assets, liabilities and operating results of Scanalytics have been segregated from continuing operations and are reported as discontinued operations in the accompanying consolidated balance sheets, statements of operations, and cash flows and the related notes to the consolidated financial statements for all periods presented.

Scanalytics was the sole constituent of the previously reported “Other Software” segment. The former “E-business” segment was no longer viewed by the Chief Operating Decision Maker as a business separate from the Service and systems integration business and, accordingly, it has been aggregated into that segment.

Segments

CSPI operates in two segments:

Our MultiComputer Division reports its activity in the Systems segment. The MultiComputer Division helps its customers solve high-performance computing problems in the defense market by supplying very dense cluster computer systems distinguished by elegant packaging and high-speed node-to-node communications in a completely integrated architecture. These systems are used in a broad array of applications, including radar, sonar and surveillance signal processing. The MultiComputer Division sells all products through its own direct sales force in the United States and via distributors in the rest of the world.

Our MODCOMP, Inc. subsidiary, is a multinational business operation that develops and markets IT solutions for complex IT environments and provides network management, storage systems and network security integration services including consulting, systems integration and outsourcing. In addition, MODCOMP develops and markets middleware software for messaging and legacy integration. Revenues from these sources are recorded in the Service and system integration segment except for sales of legacy classic systems which are included in the Systems segment. MODCOMP expanded its United States integrator operations for hardware, software and services with the acquisition of certain assets of Technisource Hardware, Inc. on May 30, 2003. The

1

Table of Contents

former Technisource business operates in the Service and system integration segment. MODCOMP sells products through our own direct sales force in the United States, Germany and United Kingdom.

Financial Information about Industry Segments

The following table details our sales by operating segment for fiscal years ending September 30, 2005, 2004 and 2003. A measure of our profits and losses and total assets by segment are listed in footnote number 15 to our financial statements.

Products and Services

Systems Segment

Our MultiComputer Division designs, manufactures, sells and services cluster computer systems and real-time embedded computer systems. These systems are characterized by high-performance, high-density, low power consumption, standards-based hardware and software components (“blades”) ideally suited for use in the aerospace and defense market and the high-end scientific/technical computing market. The incorporation of open and standard technologies ensures that customers purchase systems based on the latest technology without the risks associated with proprietary solutions.

Applications expertise, product innovation, strong technical support, and dedicated customer service make us one of the industry’s leading providers of high-performance cluster computer systems.

In fiscal year 2005, we began to recognize royalty revenues related to the production and sale of certain of our proprietary system technology by a third party. We recognize royalty revenues upon notification of shipment of the systems produced pursuant to the royalty agreement.

In fiscal year 2004, we introduced the StarGate I/O blade, which bolstered our product offerings in software-defined radio, radar, sonar and surveillance DSP by providing the high-speed data acquisition capabilities and rapid execution times necessary for the complex signal processing demands of these applications. The StarGate I/O blade was the initial product in a new generation of our MultiComputers that benefit from the exceptional performance provided by the 1GHz Motorola 7457 PowerPC microprocessors and related technologies. Customers purchasing these products have the option of selecting either an open-source Linux operating system and GNU toolkit or the industry standard VxWorks real-time operating system, coupled with the Tornado II development tools suite.

Late in fiscal year 2004, the FastCluster product line was significantly enhanced with the addition of rugged system capabilities for blades and enclosures. The new rugged chassis was specifically designed to meet MIL-STD specifications for mission-critical, airborne defense programs. The advanced packaging maintains scalability to hundreds of processors and leverages the latest Myrinet-2000 fiber clustering technology for multi chassis configurations. This packaging offers better fault detection, hot-swap capability, plug-in power supply and blower assembly components for improved serviceability, and addresses MIL-STD requirements for shock, vibration and EMC/EMI.

Along with the rugged chassis we introduced the first FastCluster rugged blade, the StarGate 2924. The StarGate 2924 was designed with enhanced environmental options to address the most demanding airborne deployment requirements for shock and vibration, and ambient thermal conditions.

2

Table of Contents

Advancements in system software included real-time enhancements to the Linux operating system environment. The Linux 2.4 kernel was upgraded to support real-time features including pre-emptive operations and low-latency.

Hardware Products

Our MultiComputer Division produces very dense, high-performance cluster computer systems incorporating tens to hundreds of processors, all interconnected by a very high-bandwidth network. These systems are specifically designed for analysis of complex signals and images in real-time or in modeling and simulations. Typical computationally intense applications requiring these products include RADAR, SONAR and command control and communications, computers, intelligence, surveillance, and reconnaissance (C⁴ISR) within the defense market segment.

Our MultiComputer products offer customers an open hardware platform based upon the most advanced processors, large memory subsystems and high-bandwidth networking components. These systems are scalable and easy to upgrade, allowing for continuous insertion of the latest technologies. The superior architectural design of the MultiComputer products is based on Motorola™ G4 PowerPC RISC processors with AltiVec™ technology, high-speed memory and Myrinet-2000™ cluster interconnect. These products are designed to meet the demands of mission-critical applications by incorporating high-availability features including instant booting from a cold start, error-correcting memory, hot-swappable hardware, extended environmental specifications and built-in self-test. Products ship in a variety of configurations ranging from small desktop systems to multiple-chassis systems with over 400 processors.

Supporting both open source Linux and the industry standard VxWorks™ real-time operating system, MultiComputer products offer the user a choice in selecting the software environment best suited to their application requirements.

VxWorks provides the best foundation for rapid development and execution of complex applications in real-time. This efficient real-time operating system incorporates such features as a scalable run-time kernel to conserve code space and support for many different application programming interfaces. Integrated communication routines support data transmission over the Myrinet fabric. TCP/IP is supported throughout the Myrinet network permitting standard services across heterogeneous processors.

Other applications are better served by Linux, which provides an open source UNIX like operating system environment with a POSIX implementation including true multitasking, virtual memory, shared libraries, demand loading, work load balancing and support for TCP/IP networking. The Linux operating system is easily integrated with clustering software such as message passing interface and includes a full suite of GNU compiler tools to facilitate development.

All MultiComputer systems use the best of open systems technologies incorporating message passing interface (MPI) software for interprocessor communications and the highly optimized industry standard math libraries: Industry Standard Signal Processing Library and Vector Signal and Image Processing Library. These libraries facilitate the development of truly portable code for seamless reuse across applications, while taking advantage of optimized performance on the PowerPC with AltiVec.

Legacy Products

Acknowledging the long development and deployment cycles associated with critical applications within the defense industry, our MultiComputer Division provides support for older products on an “as available” service fee basis.

Specifically, our SuperCard products, initially released more than a decade ago, are still in use on U.S. Navy programs currently in deployment. SuperCards are deployed in sonar applications handling the coordination of

3

Table of Contents

information from hydraphone sensor arrays in both ship-based and shore-based installations. The deployment phases of all programs incorporating SuperCards are completed. SuperCards are also sold to medical imaging equipment suppliers on an OEM basis. We do not anticipate any new SuperCard based programs.

MODCOMP also continues to offer refurbished CLASSIC (legacy computer systems) and MODACS proprietary systems as well as related parts and services from our Deerfield Beach, Florida headquarters. Sales revenue related to legacy systems was approximately $241,000 or 1%, $265,000 or 1% and $199,000 or 1% of total sales for the years ended September 30, 2005, 2004 and 2003, respectively.

Service and System Integration Segment

Integration Solutions

In the past three years, our product offering has shifted away from the sales of systems produced (proprietary and open architecture) hardware toward integration solutions including third-party hardware and software and special engineering. Our value proposition is integrating these third party components together into a complete solution and installing the system at the customer site. These services are offered by all MODCOMP locations. In particular, our German subsidiary has had significant successes in the telecommunication market with the recent deregulation of that industry.

Internet Integration and Security Solutions

We also offer third-party software products as well as specialized programming and engineering services to supply customers with customized legacy integration, virtual private networks and Internet security solutions.

In particular, our German subsidiary has had significant successes in the Internet security market in the telecommunications and financial services industries. The ability to offer 24 X 7 service level agreements are a critical success factor in this market.

Third-Party Offerings and Professional Services

In May of fiscal year 2003, we acquired certain assets of Technisource. This acquisition further expanded MODCOMP’s third-party offerings and professional services in the United States in the IT market with a strategic focus on storage systems, security and networking. Key third party product offerings include Computer Associates, IBM, Dell, HP, Citrix, APC, EMC, Cisco and Microsoft.

We offer competitively priced best-of-breed products from a wide variety of vendors to meet customer’s diverse systems and technology needs, providing sales and engineering expertise in storage, security and networking to the small-to-medium sized businesses. These small-to-medium sized businesses have unique technology needs, and typically lack technical purchasing expertise or have very limited engineering resources on staff. We offer small-to-medium sized businesses a single point of contact for complex multi-vendor technology purchases. We also provide installation, integration, logistical assistance and other value-added services that customers may require. Our current customers are in education, telecommunications, health services, distribution, financial, manufacturing and entertainment industries. We target the small-to-medium sized business market across all industries.

In addition, we provide Internet security consulting and implementation services for enterprise intrusion prevention and protection. Using third-party products from companies like Checkpoint and NetScreen, our services are designed to ensure data security and integrity through the establishment of virtual private networks and firewalls.

4

Table of Contents

Markets, Marketing and Dependence on Certain Customers

Systems Segment

We market our high-performance cluster computer systems into the high-end scientific/technical computing market and the aerospace and defense market with emphasis on applications requiring the analysis of complex signals. We distribute our products in these markets as an original equipment manufacturer supplier to system integrators, distributors and value added resellers. In these markets, the supplier/customer relationship is viewed as a long-term strategic partnership.

Aerospace and Defense Market

MultiComputer systems are sold primarily to prime contractors within the defense industry and are used in SONAR, RADAR, C⁴ISR systems, simulators, and signal and image analysis computers. Customers in this market segment have unique requirements. A prime contractor will be incorporating our products into their own future product developments and, therefore, will need early access to low-level, detailed technical specifications; prototype units; form, fit and function compatibility with previous products; and long term product availability and support. As a supplier in this market space, we recognize that there may be a significant up-front investment of time and resources in building a business partnership, however, the result is a strong potential for long-term revenue streams as products progress from development phases into deployment.

Our technologies that support “network centric warfare” and information exchange in real-time are becoming increasing significant to twenty-first century military operations. There has been steady growth of new programs requiring signal/image processing and analysis equipment as well as upgrades to existing military programs. However, the efficiency inherent in today’s technologies reduces the number of platforms required to achieve the same results. Both new and upgraded programs require a substantial period of development and evaluation time before products are deployed into field use. Time from development to deployment varies based on the program, however, it may extend beyond a twenty-four month time period.

This market segment represents the largest growth potential for us as the Department of Defense continues to encourage prime contractors to use commercial-off-the-shelf solutions to contain program costs and improve the time-to-deployment when inserting new technology into existing field equipment. This initiative has lead to wide spread acceptance of standard, open technology products and is now being adopted by other governmental procurement agencies around the world. Our systems have been shipped to a number of customers developing commercial-off-the-shelf based systems or evaluating systems for use in future programs.

No individual customer constituted more than 10% of total sales in the Systems segment or consolidated revenues in 2005. Systems sales to individual customers constituting 10% or more of consolidated sales in the year ended September 30, 2004 consisted of sales to Lockheed Martin, a large defense contractor, of $5.8 million (11% of consolidated sales).

High-End Scientific/Technical Computing Market

The high-end scientific/technical computing market addressed by our MultiComputer products is characterized by rapid technological change and the introduction of new products with superior capabilities at lower pricing. This market segment is driven in large part by cost sensitivity. Moreover, many of the application performance requirements can often be met with general-purpose computers. Larger companies with greater technical resources and high capacity manufacturing facilities are now providing solutions in this space. In this market, our ability to compete may be limited to the extent that we lack the high volume production capabilities of a larger company, and thus are less able to realize the cost savings associated with economies of scale.

5

Table of Contents

Service and System Integration Segment

MODCOMP supplies and integrates network management, network security and storage IT solutions. This focus as an IT solutions provider allows us to meet the needs of our customers with a variety of integration services as well as products from third-party manufacturers.

We market our products through various sales offices in the U.S., Germany and United Kingdom (for a detailed list see Item 2 of this Form 10-K). No customer of the Service and systems integrations segment constituted 10% or more of consolidated revenues in 2005. However, for the first quarter of 2005, sales continued to be made directly to E-Plus, a wireless telecommunications company in Germany. In the second quarter of 2005, E-Plus outsourced its equipment procurement function to Atos Origin GmbH (“Atos”), a systems integrator. Sales to Atos and E-Plus individually constituted less than 10% of total sales. The combined sales to Atos and E-Plus during 2005 was $8.7 million, or 15% of consolidated revenues. Sales to E-Plus and the associated percent of consolidated sales in the year ended September 30, 2004 was $11.3 million (22%).

Competition

Systems Segment

The MultiComputer systems market is very competitive. Customer requirements coupled with advancements 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 1980’s to the Motorola PowerPC’s with AltiVec incorporated in the 2000 SERIES and the addition of Linux open source software on the FastCluster product line, we have responded with product offerings vital to remaining competitive. Product development efforts in fiscal year 2005 were focused on providing our defense customers with increased capabilities for both blades and enclosures intended for deployment under rigorous environmental conditions. Blade product enhancements ranged from increased memory to an improved board layout designed to withstand harsher shock, vibration and thermal conditions. Rugged packaging options for chassis products addressed MIL-STD requirements while enhancing the serviceability of the enclosures.

Aerospace & Defense Market

Our direct competitors in the aerospace and defense market are Mercury Computer Inc., Curtis Wright with their acquisition of DY4 and Synergy, Thales Computers and Transtech. Our indirect competitors are the board manufacturers that specialize in the DSP segment of this market. In the low performance segment of the general-purpose computer and single board computer market, manufacturers such as Motorola, Force, Hewlett Packard, IBM and Dell may compete. 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 the 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 be easily integrated into OEM designs for high performance computation. Since the majority of sales are to OEMs, 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.

High-End Scientific/Technical Computing Market

Competitors in the high-end scientific/technical cluster computing market include general-purpose computer and single board computer manufacturers such as IBM, Motorola, Force, Hewlett Packard and Dell. Companies manufacturing general-purpose computer systems incorporating multiple processors will be the principal competitors in this market. While our products 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, not system size/packaging, is the primary factor in the buying decision.

6

Table of Contents

Service and System Integration Segment

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 EDS, IBM and Sun Microsystems.

Competitors in the third-party offerings and professional services business range from catalog houses such as CDW, PC Connection, Insite, More Direct, and MicroWarehouse, to customers buying directly from the manufacturers with solutions services such as IBM, Unisys, iData, Foresyth, Dell, and HP. Nearly all of our product offerings are available through other channels. For this reason the combination of personalized attention, technical expertise, add-on services and competitive pricing have been the key to our current success.

Manufacturing, Assembly and Testing

All of our MultiComputer systems manufacturing is performed at our plant in Billerica, Massachusetts. The primary manufacturing process is the assembly and testing of printed circuit boards and systems, designed by us and fabricated by other vendors. We offer products in a variety of standard formats and primarily build products based on customer orders. A varying percentage of sales reflect products customized to a particular customer’s specification, and even these products are easily reconfigurable should the customer cancel the order for any reason.

Upon receipt of material by us from outside suppliers, our QC/QA technicians inspect products and components. During manufacture and assembly, both subassemblies and completed systems are subjected to extensive testing, including burn-in and environmental stress screening designed to minimize equipment failure at delivery and over its useful service life. We also use diagnostic programs to detect and isolate potential component failures. A comprehensive log is maintained of all past failures to monitor quality procedures and improve design standards.

SuperCard products were designed using the Intel i860 RISC microprocessor. Intel discontinued production of the i860 at the end of the 1998 calendar year. We have made provisions to accommodate the future needs of all of our SuperCard customers for this product. No new application development programs will be initiated incorporating SuperCard products, however, SuperCard products will continue to be shipped into existing programs that have committed to the SuperCard end-of-life plan.

We do not consider the risk of interruption of supply to be significant to meet our projected revenue requirements for the immediate future.

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. In the past, warranties of substantially greater scope have been extended to certain major customers for financial and other considerations.

Customer Support

Our MultiComputer Division and MODCOMP subsidiary support our customers with telephone assistance, on-site service, system installation, and 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 either corporate headquarters or the customer site. Field and customer service support is provided through our headquarters in Billerica, Massachusetts for Systems customers. Support for our Service and system integration segment is provided through our offices in the United States, United Kingdom and Germany.

7

Table of Contents

Support for legacy systems is delivered in a number of ways including telephone assistance, on-site service, installations of systems, training and education. Service and parts warranty, generally of 90 days duration, is provided on all products. In addition, we sell maintenance service contracts to customers. We also conduct customer training courses of one to three weeks’ duration on a fee basis either at the customer’s location or ours.

Research and Development

During fiscal year 2005, our expenses for engineering and were approximately $2.7 million (5% of sales) compared to approximately $2.5 million (5% of sales) and $3.0 million (10% of sales) in fiscal years 2004 and 2003, respectively. Expenditures for engineering and development are expensed as they are incurred. Our Systems segment expects to continue to have substantial expenditures related to the development of our next generation of hardware products and the software which enables the hardware to function. Our Systems products and development currently in process are intended to extend the usefulness and marketability of existing products and introduce new products into existing market segments.

We do not have any patents that are material to our business.

Backlog

Our backlog of customer orders and contracts was approximately $6.9 million at September 30, 2005 as compared to $7.8 million at September 30, 2004. Our backlog can fluctuate greatly. These fluctuations can be due to the timing of receiving large orders for integration services and OEM purchases. All of the customer orders in backlog will be shipped within the next twelve months.

Employees

On September 30, 2005, we had 147 employees. 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 Foreign and Domestic Operations and Export Sales

Our sales and percentage of sales by geographic area based on the location to which the products are shipped or services are rendered are in footnote number 15 of our financial statements.

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 effect basis, new products that keep pace with technological developments

8

Table of Contents

and address increasing customer requirements. The inability to meet these demands could adversely affect our business and operating results.

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

We are dependent on a small number of customers for a large portion of our revenues. Sales to E-Plus, a wireless telecommunications company in Germany, and those to E-Plus through its system integrator, Atos, accounted for 15%, 22% and 33% of sales in fiscal years ended September 30, 2005, 2004 and 2003, respectively. Lockheed-Martin, a large defense contractor, accounted for 5% of our sales in 2005 and 11% and 3% of our sales in fiscal years 2004 and 2003, 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 16%, 18% and 18% of our consolidated revenues and 97%, 97% and 95% of the Systems segment sales for the fiscal years ended September 30, 2005, 2004 and 2003, 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:

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

9

Table of Contents

penetrate the various markets for our products and services. Their entry into markets historically targeted by us may have a material adverse effect on our business, financial condition and results of operations.

Slowdown in the Economy Can Affect our Revenue and Profitability

The uncertainty regarding the growth rate of the worldwide economies has caused companies to reduce capital investment and this may cause further reduction of demand for our products and services. These reductions have been particularly severe in the electronics and technology industries. Growth in our European markets may be adversely affected by continued weakness in the German economy in 2006.

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:

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.

10

Table of Contents

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 Freescale for many of our PowerPC line of processors. Generally, suppliers may terminate their purchase order with us without cause upon 30-days notice and may cease offering products to us upon 180-days notice. If 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 may adversely affect our business and customer relationships. We have no guaranteed supply arrangements with our suppliers and there can be no assurance that our suppliers will continue to meet our requirements. If our supply arrangements are interrupted, there can be no assurance that we would be able to find another supplier on a timely or satisfactory basis. Any shortage or interruption in the supply of any of the components used in our products, or the inability to procure these components from alternate sources on acceptable terms could have a material adverse effect on our business, financial condition and results of operations. There can be no assurance that severe shortages of components will not occur in the future. Such shortages could increase the cost or delay the shipment of our products, which could have a material adverse effect on our business, financial condition and results of operations. Significant increases in the prices of these components would also materially adversely affect our financial performance since we may not be able to adjust product pricing to reflect the increase in component costs. We could incur set-up costs and delays in manufacturing should it become necessary to replace any key vendors due to work stoppages, shipping delays, financial difficulties or other factors and, under certain circumstances, these costs and delays could have a material adverse effect on our business, financial condition and results of operations.

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 50%, 46% and 62% of our total revenue for the fiscal years ended September 30, 2005, 2004 and 2003, 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,

11

Table of Contents

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 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 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

The industry in which our Systems segment competes is characterized by the need for continued investment in research and development. If we fail to invest sufficiently in research and development, our products could become less attractive to potential customers, and our business and financial condition could be materially adversely affected. As a result of our need to maintain or increase our spending levels in this area and the difficulty in reducing costs associated with research and development, our operating results could be materially harmed if our revenues fall below expectations. In addition, as a result of CSPI’s commitment to invest in research and development, spending as a percent of revenues may fluctuate in the future.

We May be Unable to Successfully Integrate Acquisitions

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

12

Table of Contents

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

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

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:

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 1B.    Unresolved Staff Comments

None.

13

Table of Contents

Item 2.    Properties

Listed below are our principal facilities as of September 30, 2005. 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.

Item 3.    Legal Proceedings

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

Item 4.    Submission of Matters to a Vote of Security Holders

No matters were submitted for a vote of security holders during our fiscal quarter ended September 30, 2005.

14

Table of Contents

PART II

Item 5.    Market for Registrant’s Common Equity and Related Stockholder Matters and Issuer Purchases of

                   Equity Securities

Market information.    Our common stock is traded on the NASDAQ National Market System under the symbol CSPI. The following table provides the high and low sales prices of our common stock as reported on the NASDAQ National Market for the periods indicated.

Stockholders.    We had approximately 93 holders of record of our common stock as of December 20, 2005. This number does not include stockholders for whom shares were held in a “nominee” or “street” name. We believe the number of beneficial owners of our shares of common stock (including shares held in street name) at that date was approximately 1,400.

Dividends.    We have never paid any cash dividends on our common stock. Our present policy is to retain earnings to finance expansion and growth, and no change in the policy is anticipated.

Issuer Purchases of Equity Securities

Item 6.    Selected Financial Data

The following table sets forth selected consolidated financial information of the Company for the five years ended September 30, 2005. The following selected consolidated financial data should be read in conjunction with “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and the Company’s consolidated financial statements and notes to those statements included elsewhere or incorporated by reference in this report. The following consolidated financial data includes the results of operations (from date of acquisition) of certain assets of Technisource Hardware since May 30, 2003. For all periods presented, the results of operations of our Scanalytics subsidiary have been accounted for within discontinued operations. A description of the Company’s recent discontinued operations and divestiture activities is set forth in Note 3 of the Notes to Consolidated Financial Statements. The historical results presented herein are not necessarily indicative of future results.

15

Table of Contents

CSP INC. AND SUBSIDIARIES

SELECTED FINANCIAL DATA

(Amounts in thousands, except per share data)

Item 7.    Management’s Discussion and Analysis of Financial Condition and Results of Operations

The discussion below contains certain forward-looking statements related to, among others, but not limited to, statements concerning future revenues and future business plans. Actual results may vary from those contained in such forward-looking statements.

As discussed in the Note 2 to our consolidated financial statements included herein, we have restated our consolidated statements of cash flows for the years ended September 30, 2004 and 2003 to correct certain misclassifications. Additionally, the restatement includes the restatement of certain short-term investments to cash and cash equivalents at September 30, 2004 and 2003. The restatement had no effect on our reported operating results for any period presented. However, the following discussion and the selected financial data above have been adjusted, where applicable, for the restated cash flow, investments and cash and cash equivalents data.

Overview of Fiscal 2005 Results of Operations

The Company sold substantially all of the net assets of its Scanalytics subsidiary in June 2005. The assets, liabilities and operating results of Scanalytics have been segregated from continuing operations and are reported as discontinued operations in the accompanying consolidated balance sheets, statements of operations, and cash flows and the related notes to the consolidated financial statements for all periods presented.

16

Table of Contents

Scanalytics was the sole constituent of the previously reported “Other Software” segment. The former “E-business” segment was no longer viewed by the Chief Operating Decision Maker as a business separate from the Service and systems integration business and, accordingly, it has been aggregated into that segment.

CSPI operates in two segments:

Highlights include:

The following table sets forth certain information which is based on Operations Statement Data:

For fiscal year 2005, our primary goals were to drive sales growth from our products and services, to improve profitability, and to monitor the integration of the MODCOMP Systems and Solutions Division which was purchased from Technisource in 2003.

Results of Operations—2005 Compared to 2004

For the fiscal year ended September 30, 2005, sales increased to $57.5 million, compared to $51.4 million for fiscal year ended September 30, 2004. Net income for the year ended September 30, 2005 was $0.8 million or $0.20 per share—diluted compared with $1.2 million or $.32 per share—diluted for fiscal year ended September 30, 2004.

17

Table of Contents

Revenue

The following table details the Company’s sales by operating segment and geography for fiscal years September 30, 2005 and 2004:

The Company’s sales by geographic area are based upon the location to which the products were shipped or services rendered.

Of the $6.1 million increase in revenues in 2005 compared to 2004, $3.7 million was attributable to increased product and service sales in our German subsidiary within the Service and systems integration segment. During 2004, approximately $11.3 million in revenues in Germany were attributable to the relationship with the German wireless communications company, E-Plus. During 2005, E-Plus designated Atos Origin GmbH, a systems integrator in Germany, as the procurement agent for E-Plus. While sales to E-Plus through Atos remained Germany’s largest single customer in 2005, sales volume declined to approximately $8.7 million. This decline was more than offset by several new integration projects undertaken by our German subsidiary with other customers. Foreign exchange effects of the euro and the pound sterling against the dollar contributed to approximately $270,000 of overall increase in revenues in 2005 compared to 2004.

Systems sales increased approximately $ 411,000 in 2005 compared to the prior year. We recognized approximately $702,000 of royalty revenue related to our contract with Lockheed Martin for the Hawkeye E-2D program. The Company expects to receive approximately $2.6 million in incremental royalty revenue from this contract through fiscal 2006. Offsetting the increase in royalty revenue was a slight decline in product sales from our Multi-computer division, reflecting a reduced level of contract activity in that division. Management believes there is a reasonable potential of increased contract activity for systems products in mid-2006.

18

Table of Contents

Cost of Sales

The following table details the Company’s sales, cost of sales and gross margin by operating segment for fiscal years ended September 30, 2005 and 2004:

Cost of sales consists primarily of expenses related to the cost of products, either purchased in the Service and systems integration segment or manufactured for the Systems segment for sale, as well as the salaries, benefits expenses, consultants, facilities and other operating costs. The Company’s overall cost of sales as a percentage of sales increased from 73% to 75% in 2005 compared to 2004. The cost of sales percentage of sales in the Systems segment declined from 41% to 39% in 2005 compared to the prior year due to the effects of royalty revenues, which have no associated cost of sales, offset by decreased absorption of overhead costs of $290,000 in the third and fourth quarters of 2005 due to a reduction in product sales, write-down of inventory due to obsolescence of $70,000, and the addition of a Quality Manager and a Systems Engineer of $ 133,000. Cost of sales as a percentage of sales in the Service and systems integration segment increased from 79% in 2004 to 82% in 2005. This increase is attributable to higher costs incurred in transactions involving the sale of third party products and to the reduction of a favorable pricing program conducted by HP in Europe compared to pricing obtained in 2004.

Engineering and Development Expenses

The following table details engineering and development expenses by operating segment for fiscal years ended September 30, 2005 and 2004:

19

Table of Contents

Engineering and development expenses increased overall by $126,000, or 5%, in 2005 compared to 2004. The Service and systems integration segment experienced a decline of approximately $288,000 in engineering expense due to reduced development efforts as engineers were re-deployed on customer projects, and therefore charged to cost of sales. The Systems segment experienced a $414,000, or 26% increase in engineering costs. Our Multi-computer division added two engineers to its staff during 2005. General salary increases accounted for the remainder of the increase.

Selling, General and Administrative

The following table details selling, general and administrative expense by operating segment for fiscal years ending September 30, 2005 and 2004:

Selling, general and administrative expenses increased $896,000, or 9%, in 2005 compared to 2004. Approximately $225,000 of the overall increase is attributable to costs associated with compliance with the provisions of the Sarbanes-Oxley Act.

The $856,000 increase in the Service and systems integration segment was due to increased salaries and commissions expense at the Deerfield Beach, Florida location as the sales staff was increased from 12 to 16 people in 2005. Costs associated with the move of the corporate offices of MODCOMP in Florida to Deerfield Beach also contributed to the increase over 2004. Offsetting the increase in selling and marketing costs in Florida was a decrease in sales and marketing costs in the UK due primarily to the retirement of the general manager. Increased costs associated with the UK pension and audit fees increased UK general and administrative costs.

Selling, general, and administrative expenses in the Systems division increased $40,000 due primarily to increased costs associated the additions to the finance group staffing, increased directors’ fees, and higher Directors and Officer’s insurance premiums.

Other Income/Expenses

The following table details Other Income/Expenses for fiscal years ended September 30, 2005 and 2004:

20

Table of Contents

Increases in interest expense and interest income are due to the general rise in interest rates during 2005 compared to 2004. The foreign currency loss in 2005 reflects the general decline of the Euro and the Pound Sterling with respect to the US Dollar in 2005 compared to 2004.

Income Taxes

The Company recorded a provision for income tax expense of $517,000 for fiscal year 2005 compared to tax expense of $540,000 for fiscal year 2004. The tax expense in fiscal year 2005 and 2004 is primarily due to the income generated by our foreign subsidiaries. In fiscal year 2002, we began to record a valuation allowance for our deferred tax assets. The valuation allowance was determined in accordance with the provisions of “SFAS No. 109 Accounting for Income Taxes” (SFAS 109) 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 UK. Our U.S. tax expense for fiscal years 2005 and 2004 has been reduced by decreasing our valuation allowance, thus reducing the U.S. tax expense to the Company, to reflect the portion of fully reserved net operating losses that we were able to use during these years.

Results of Operations—2004 Compared to 2003

For the fiscal year ended September 30, 2004, sales increased to $51.4 million, compared to $31.2 million for fiscal year ended September 30, 2003. Net income for the year ended September 30, 2004 was $1.2 million or $0.32 per share—diluted compared with a net loss of $(1.4) million or $(0.39) per share—diluted for fiscal year ended September 30, 2003.

Revenue

The following table details the Company’s sales by operating segment for fiscal years September 30, 2004 and 2003. The Company’s sales by geographic area based on the location to which the products were shipped or services rendered are as follows: