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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-K

For the Fiscal Year Ended September 30, 2004.

For the transition period from              to             .

Commission File Number 0-10843

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

The aggregate market value of the stock held by non-affiliates of the registrant as of March 31, 2004, the last business day of the registrant’s most recently completed second fiscal quarter, (based on the closing sale price of $6.00 as quoted on the NASDAQ National Market as of that date) was approximately $21,331,716. Outstanding shares of common stock beneficially owned by executive officers and directors of the registrant and certain related entities have been excluded from this computation because these persons may be deemed to be affiliates. The fact that these persons have been deemed affiliates for purposes of this computation should not be considered a conclusive determination for any other purpose.

As of December 31, 2004, we had outstanding 3,588,399 shares of common stock.

DOCUMENTS INCORPORATED BY REFERENCE

Certain portions of the information required for Part III of this annual report is incorporated by reference from our definitive proxy statement for our 2005 annual meeting of stockholders to be filed with the Securities and Exchange Commission within 120 days after the end of our fiscal year ended September 30, 2004.

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PART I

Item 1.    Business

(a)  General Development of Business

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 develops and markets IT integration solutions, messaging and image processing software and high-performance cluster computer systems.

CSPI operates in four segments:

Our MultiComputer Division reports its activity in the Systems segment. The MultiComputer Division helps its customers solve high-performance computing problems in the medical imaging and defense markets 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 subsidiary, MODCOMP, Inc., 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 and middleware revenue which is included in the E-business software 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 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. We also sell our products and services through distributors in the rest of the world.

We have another business operation, Scanalytics, Inc., which develops and markets imaging systems for molecular and cell biology. Its revenues are reported in the Other software segment. Scanalytics specializes in the development and marketing of highly sophisticated image capture and analysis software products used by researchers in the biological and physical sciences. By integrating these software products with a diverse group of image-capture devices, Scanalytics is able to solve application-specific problems in biotechnology and life science research, including digital microscopy, genomics, and high-throughput screening. Scanalytics sells both directly and through a network of distributors and resellers.

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Financial Information about Industry Segments

The following table details our sales by operating segment for fiscal years ending September 30, 2004, 2003 and 2002. A measure of our profits and losses and total assets by segment are listed in footnote number 14 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 receive systems based on the latest technology while reducing 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 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.

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.

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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 afford 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” fee for service 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 computers handling the coordination of 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.

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We sell all MultiComputer and related products through our own direct sales force in the U.S. and via distributors in the rest of the world.

MODCOMP also continues to offer refurbished CLASSIC (legacy computer systems) and MODACS proprietary systems as well as related parts and services from our Fort Lauderdale headquarters. The CLASSIC systems are mini and supermini computers designed specifically to support real-time applications. The legacy computer systems are generally utilized in industrial and utility plants and operate in real-time. These CLASSIC systems have been end of lifed and these products are only sold to existing customers. The MODACS and MODACSX products are data acquisition and control systems.

We continue to sell refurbished legacy systems and components, especially as the sale of such systems and components relates to servicing current customers with replacement and/or upgraded systems. The old legacy computer systems generally can be expanded without major redesign as customer requirement’s change.

Sales revenue related to legacy systems was approximately $265,000 or 1%, $199,000 or 1% and $3,037,000 or 11% of total sales for the years ended September 30, 2004, 2003 and 2002, respectively.

Service and System Integration Segment

Integration Solutions

In recent 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 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.

Computer Software and Computer Programming

Legacy computers are supported by high-level operating software, referred to as MAX, REAL/IX, REAL/IX PX and ScadaBase. This software is designed specifically for optimum real-time performance. Our software enables customers to write their own real-time application software. These applications, when combined with legacy computers or third-party computers, create systems which simultaneously perform different control functions, program tests and a batch processing operation with response and interrupt times that are required by the marketplace.

Internet Integration and Security Solutions

We also offer our own and 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 7x24 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 expands 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 product offerings include Computer Associates, IBM, Dell, HP, Citrix, ADIC, EMC, Microsoft and NetScreen.

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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.

E-Business Software Segment

ViewMax^® is a middleware development environment software that allows us to rapidly re-engineer and integrate legacy systems such as mainframe, midrange and other diverse host systems with Internet technology. Using ViewMax^® technology, we create solutions that extend corporate data to a much wider audience via a corporate Intranet, Extranet, or the Internet. ViewMax^® is also used to develop solutions that can also integrate electronic commerce transactions with existing legacy systems. Our current ViewMax^® customers are in the travel, insurance, financial, health services, education, government, manufacturing and distribution markets.

We have the relevant expertise in enterprise level messaging solutions and the intellectual property for the core-messaging server called Xport. This product has advanced gateway functionality for handling high throughput messages between host business systems such as IBM mainframes and client devices—fax, email, telex, EDI.

In fiscal year 2004, our strategic investments in E-business software research and develop was OpenXport, the next generation of the successful Xport software platform. Xport currently is used by some of the major players in the financial services industry, including J.P. Morgan Chase and Barclays. In developing OpenXport, we leveraged our expertise in building customized communication software solutions using message-oriented middleware with Dresdner Kleinwort Wassersteins’ open source messaging adaptor technology for the rigorous performance and reliability requirements of the financial services industry. OpenXport is a Java/XML-based enterprise level server that allows for rapid business systems integration with little or no custom programming and seamlessly interfaces a wide range of major software platforms.

Other Software Segment

Our Scanalytics Division gives “sight” to computers by creating software that captures images from digital cameras and scanners and extracts information from those images. We integrate those software products with off-the-shelf hardware components to create high-performance vision systems that support scientific researchers in the biological and the physical sciences. During 2004, our Other software segment focused our efforts in three applications areas of biotechnology and life science research: digital microscopy, genomics, and high throughput screening.

Digital Microscopy

IPLab is a general-purpose image analysis software package. Add-on modules for IPLab, called Extensions, provide application-specific functionality, making IPLab extremely adaptable for a wide variety of customers and industries. Extensions can easily be written by IPLab customers and third-party developers, as well as by our staff. We make and market individual Extensions for multi-fluorescence microscopy, calcium-ratio imaging, 3-D image visualization, time lapse studies, and microscope automation.

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Genomics

We offer several software products oriented towards the genomics imaging market. The 1Dscan EX is used in biomedical research labs for documentation and analysis of electrophoretic gels. We recently forged a distribution agreement for 1Dscan EX with Ultra-Lum, Inc., of Claremont, California. 1Dscan EX will be integral in providing image capture and analysis capabilities in Ultra-Lum’s new line of gel imaging systems. Additional products include GeneProfiler which is a sophisticated tool for DNA fingerprinting and GelLab II+ which is used for 2D-gel analysis.

High Throughput Screening

High Throughput Screening systems are characterized by a high density of samples automated analysis and experimental repeatability. MicroArray Suite is an extension to IPLab that was developed by and licensed from the National Center for Human Genome Research at the National Institutes of Health. This software package assists researchers in analyzing microarrays, which are devices that let researchers evaluate potential drug candidates by simultaneously testing them against thousands of DNA fragments.

We are continuing development of the ELISpot Imager in collaboration with the Navy Medical Research Center. This system of software and hardware is used for immunological assays. (ELISpot stands for Enzyme Linked Immuno-Spot).

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

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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.

Systems sales to individual customers constituting 10% or more of total sales consisted of sales to Lockheed Martin, a large defense contractor, of $5.8 million (11%) in the year ended September 30, 2004.

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.

Service and System Integration Segment

MODCOMP supplies and integrates network management, network security and storage IT solutions as well as high-speed mini-computers worldwide principally for use in real-time applications. These computer systems are used in operations involving process measurement and control, power production and distribution, manufacturing test and inspection, scientific data collection and monitoring. We have expanded this product line by including third-party equipment in our sales and servicing offerings. This new 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., Canada, Germany and United Kingdom (for a detailed list see Item 2 of this Form 10-K). Throughout the remainder of the world, these offices coordinate the activities of independent distributors and manufacturers’ representatives who represent other companies’ product lines not competitive with ours and are either paid a commission on units sold or are permitted to buy units for resale at a discount.

Service and system integration sales to individual customers constituting 10% or more of total sales consisted of sales to E-Plus, a wireless telecommunications company in Germany, of $11.3 million (21%), $10.3 million (32%) and $5.6 million (20%) in the years ended September 30, 2004, 2003 and 2002.

E-business Software Segment

We market solutions incorporating OpenXport and ViewMax directly to end-users. The market is cross industry, to companies of substantial size, and is not dependent on the fluctuations of any particular business segment. ViewMax^® is positioned primarily as an integration solution with a strong focus on electronic commerce, Intranet and Extranet implementations. In the United States, United Kingdom and Germany, a wide range of companies from a broad spectrum of industries have adopted ViewMax. The product is sold primarily to the financial services market. Any fluctuations in this market could adversely affect our position.

Other Software Segment

Other software segment products are primarily used to support scientific researchers in the biological and the physical sciences. These products are sold through two channels: directly to researchers via our own sales force and through a network of international and domestic dealers, OEMs and VARs. Any fluctuations in the biotechnology and life sciences research markets could adversely affect our position.

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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 2004 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., Sky Computers, Inc., DY4, Synergy, Thales Computers and DNA Computing. 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.

Legacy Market

MODCOMP’s systems competition crosses product line boundaries. Competition in our proprietary product line is with third-party companies that have developed technical expertise with the CLASSIC computer system family. Direct competitors include Accurate Computers, Queue Systems, Protostar, and Electronic Visions.

Competitors for both our proprietary and open systems product lines also include systems integrators with process control skills in markets such as primary metals, oil and gas, power, rubber and plastics, pharmaceuticals, chemicals, pulp and paper, and food and beverages. These competitors offer open systems hardware platforms and industry-specific tailored application software packages.

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.

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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, expertise, add-on services and competitive pricing have been the key to our current success.

E-Business Software Segment

Our principal, direct competitors to ViewMax in the Legacy Extension market space are IBM, Jacada, Attachmate, Clientsoft, Intelligent Environments and Micro Focus. Companies such as Jacada, Attachmate and IBM have greater technical and marketing resources than we do. Additionally, in the Internet Security Services area, the principal direct competitors are ISS, Enterasys, VeriSign, Computer Associates, IBM, HP and TruSecure. These companies have greater financial, technical and marketing resources that could adversely affect our position.

Competitors of OpenXport include Topcall and Progress Software as well as EDS, IBM Global Services and Ernst & Young, who provide custom message integration solutions for the banking industry using products like IBM MQ Series and TIBCO.

Other Software Segment

In the Digital Microscopy market, our major competitors are Media Cybernetics, Universal Imaging, and ImproVision. Other competitors include Compact, Carl Zeiss, Intelligent Imaging and QED Imaging. In the Genomics market, major competitors include Genomic Solutions, Media Cybernetics, BioRad and Alpha Innotech. In the High Throughput Screening market, the only other software company that competes directly with us is BioDiscovery. Competitors in all of these markets range from small, single product companies to large, multinational instrument companies. We maintain our competitive advantage by offering high-value solutions.

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.

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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.

Other software products and manuals are shipped from our Fairfax, Virginia facility. We also perform system integration of computer equipment with various image capture devices, such as microscopes or digital cameras, at our facilities in Virginia before installation at the customer site.

MODCOMP’s refurbished system configurations can include a wide selection of peripheral subsystems built or purchased under the original equipment manufacturer agreements. The legacy system manufacturing facility is located in Fort Lauderdale, Florida. The assembly cycle of an individual system generally takes between 30 and 45 days, depending on its complexity. These products have been end of lifed and are only sold to existing customers and therefore are manufactured on a limited basis.

Customer Support

Our MultiComputer Division and Scanalytics Division 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 and E-business software segment is provided through our offices in the United States, United Kingdom and Germany. Other software support is provided through our Fairfax, Virginia headquarters.

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 2004, CSPI’s expenses for engineering and development were approximately $2.9 million (6% of sales) compared to approximately $3.5 million (11% of sales) and $3.7 million (13% of sales) in fiscal years 2003 and 2002, 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 will continue to expand our product offerings in our Other software segment with our various products in gel and cell analysis for life sciences and complete new releases of the PC version of the IP Lab software product, however these expenditures will be nominal. Our E-business software segment middleware development will continue for OpenXport.

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

Backlog

Our backlog of customer orders and contracts was approximately $7,879,000 at September 30, 2004 as compared to $3,790,000 at September 30, 2003. 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.

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Employees

On September 30, 2004, we had 153 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 14 of our financial statements.

Risk Factors That May Affect Future Results

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 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. E-Plus, a wireless telecommunications company in Germany, accounted for 21%, 32% and 20% of sales in fiscal years ended September 30, 2004, 2003 and 2002, respectively. Lockheed-Martin, a large defense contractor, accounted for 11% of our sales in fiscal year 2004. 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%, 16% and 16% of our revenues and 97%, 95% and 60% of the Systems segment sales for the fiscal years ended September 30, 2004, 2003 and 2002, 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:

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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 all lines of our business in fiscal 2004 but we cannot predict if this trend will continue.

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:

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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 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

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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 46%, 61% and 64% of our total revenue for the fiscal years ended September 30, 2004, 2003 and 2002, 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.

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.

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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 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:

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:

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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.

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Item 2.    Properties

Listed below are our principal facilities as of September 30, 2004. 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 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, 2004.

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PART II

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

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 96 holders of record of our common stock as of December 14, 2004. 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.

Item 6.    Selected Financial Data

CSP INC. AND SUBSIDIARIES

SELECTED FINANCIAL DATA

(Amounts in thousands, except per share data)

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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.

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, CSPI recognizes revenue as follows:

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 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.

The Company also offers training, maintenance agreements and support services. The Company has established fair value on its training, maintenance and support services based on separate sales of these elements

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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, the Company recognizes 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 not established vendor-specific evidence of fair value (VSOE) on our third-party hardware, licensed software and consulting integration services; however, we have established VSOE 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 using rates in separate sales priced at prices included in our standard price lists. 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.

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.

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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 (VSOE) 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 VSOE 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 its 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 using rates included in our standard price lists. 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 50 states that post customer support (PCS) revenue may be recognized together with the initial fee, on delivery of the software, if all of the following conditions are met:

The Company generally recognizes revenue from software licenses when persuasive evidence of an arrangement exists, delivery of the product has occurred, no significant Company 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 the lack of income in the U.S. and U.K. over the 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 the Company 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 “Factors That May Affect Future Performance”. These assumptions are subject to variation based upon both internal and external factors, many of which are beyond the control of the Company. 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 the Company is awarded a significant contract the Company projections will be impacted and the Company 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 Statement of Financial Accounting Standards No. 142 (SFAS 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 the Company considers important that could indicate impairment include significant under performance relative to prior operating results, change in projections, significant changes in the manner of the Company’s use of assets or the strategy for the Company’s overall business, and significant negative industry or economic trends. At September 30, 2004 and 2003 we had $2,996,000 in Goodwill compared to $592,000 in September 30, 2002. 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

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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.

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 the employees. In the U.S., the Company also provides 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% and the plan assumptions in the U.K. and Germany include a discount rate of 5.5%. In addition, in the U.S., the Company provides for officer death benefits through the post-retirement plans to certain officers. In calculation of the deferred compensation and retirement plans net liabilities, the Company makes 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. The Company funds 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.

Overview of Fiscal 2004 Results of Operations

Highlights include:

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

For fiscal year 2004, our primary goals were to drive sales growth from our products and services, return to profitability, and to monitor the integration of the MODCOMP Systems and Solutions Division. We made considerable progress toward our goals as we returned to profitability for the first time in three years and had sales growth of 62%.

The Company has been focusing our management efforts on achieving profitability and growth in revenue. We have taken actions in the prior two fiscal years, 2003 and 2002, to resize the business and reduce our overhead costs.

Results of Operations—2004 Compared to 2003

For the fiscal year ended September 30, 2004, sales increased to $52.8 million, compared to $32.5 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:

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The Company’s sales by geographic area based on the location of where the products were shipped or services rendered are as follows:

The increase in revenue during the fiscal year ended September 30, 2004, as compared to the prior year, was primarily due to a full year of sales from the acquisition of Technisource and growth in the European sales for the service and systems integration and increased systems sales for the advanced E-2C Hawkeye contract. The Technisource acquisition accounted for 62% of the total increase in sales. We purchased Technisource on May 30, 2003 so there were only four months of Technisource revenue reflected in fiscal year 2003. The increase in European sales represented 20% of the total increase for the year. European sales increases were primarily due to the additional sales of our German operations, which accounted for 45% of the increased sales. The increased sales were due to additional product and service sales to our largest customer (E-Plus, a wireless communications company in Germany), additional business in the integration and security area, and the benefit from the foreign exchange rate with approximately a 6% increase in the Euro to the U.S. dollar.

Our systems sales increased by $3.5 million or 64%, due primarily to the advanced E-2C Hawkeye aircraft contract with Lockheed Martin, which represented 65% of the total systems sales for the year.

On September 23, 2003 we were awarded a contract with Lockheed Martin to provide advanced 2000 SERIES MultiComputer products and technology for use in the next generation radar in the U.S. Navy’s advanced E-2C Hawkeye aircraft. The System Development and Demonstration (SD &D) contract value is approximately $6 million. Lockheed Martin will license technology from the Company for a ruggedized version of the CSPI 2000 SERIES product. The E-2C Hawkeye is slated to replace the current AN/APS-145 airborne radar system by 2010. In the SD &D phase Lockheed Martin is scheduled to produce five radar systems for qualification, testing and reliability checking by the Navy and we fulfilled most of the deliverables requirements under the contract as of September 30, 2004. A full-scale production program to outfit all 75 aircraft in the E2-C fleet by 2020 is possible according to Lockheed Martin.

Other software had increased shipments during the year with the sale and delivery of three systems to screen for potential drugs.

North American sales increases were also attributable to the Technisource acquisition. This acquired division sells primarily in the U.S. and accounted for $17.5 million of total sales for the fiscal year ended September 30, 2004, compared to $4.8 million for the prior fiscal year. In addition, sales of the Systems segment increased approximately $3.5 million due to the sales to Lockheed Martin for the advance E-2C Hawkeye. Sales of the Systems segment are primarily made in the U.S. and Japan. The Company expects that the trend toward increased North American sales will continue in the future, but with nominal increases. This will change from our historic results, where previously more than 60% of the revenue of the Company had come from international markets.

European sales increased $4.1 million or 23%. This increase was primarily from our subsidiaries in Germany.

Sales in Asia increased $0.3 million which was primarily for Systems sales for defense-based projects in Japan.

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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, 2004 and 2003:

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 cost of sales decreased as a percentage of sales to 71% from 72% in the prior year. The improvement was due to the increased sales in the Systems segment, which improved our overall manufacturing efficiencies with the increased volume. There was also a decrease in the cost of sales for service and systems integration, due in part to price benefits from manufacturers such as HP in Europe, and increased service revenue, which has a lower cost of sales. The Other software segment had an increased cost of goods, which was due to increased hardware sales for the drug screen systems.

Engineering and Development Expenses

The following table details engineering and development expenses by operating segment for fiscal years ending September 30, 2004 and 2003:

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Engineering and development expense decreases were due primarily to the reduction and redeployment of staff in the Service and system integration segment and Other software segment made in the prior fiscal years. We had staff reductions of 3 employees last fiscal year in the Service and system integration and we also re-deployed personnel from development activities to assist in expanding our services activities to enhance our revenue. The related expenses were accordingly shifted to cost of sales. We reduced our staff by two in Other software in an effort to control costs.

Selling, General and Administrative

The following table details selling, general and administrative expense by operating segment for fiscal years ending September 30, 2004 and 2003:

Selling, general and administrative expenses increased by $2.6 million due to the Technisource acquisition, executive bonuses, increased audit and other expenses related to new regulatory requirements created by the Sarbanes-Oxley legislation, all of which was offset by some of the benefits of the cost cutting and containment programs. The Technisource acquisition accounted for $1.6 million of the increased expenses. The Company exceeded its projections for the fiscal year in both sales and profitability, which increased the executive bonuses that are based on meeting the financial goals of the Company. If the Company exceeds the goals, the bonus calculation increases. The increased bonus expense represented 29% of the total increase. The Company had a significant increase in the cost of meeting the requirements of the new regulations with our auditors, lawyers, outside consultants and advisors. The increase represented 22% of the increased expenses.

Other Income/Expenses

The following table details Other Income/Expenses for fiscal years ending September 30, 2004 and 2003: