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United States

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

For the Quarterly Period Ended December 31, 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)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    Yes  x    No  ¨.

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Act).    Yes  ¨    No  x.

As of February 16, 2005, the registrant had 3,591,399 shares of common stock issued and outstanding.

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INDEX

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CSP INC. AND SUBSIDIARIES

UNAUDITED CONSOLIDATED BALANCE SHEETS

(Amounts in thousands, except par value)

See accompanying notes to unaudited consolidated financial statements.

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CSP INC. AND SUBSIDIARIES

UNAUDITED CONSOLIDATED STATEMENTS OF OPERATIONS

(Amounts in thousands, except for per share data)

See accompanying notes to unaudited consolidated financial statements

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CSP INC. AND SUBSIDIARIES

UNAUDITED CONSOLIDATED STATEMENTS OF CASH FLOWS

(Amounts in thousands)

See accompanying notes to unaudited consolidated financial statements.

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CSP INC. AND SUBSIDIARIES

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

THREE MONTH PERIODS ENDED DECEMBER 31, 2004 AND 2003

Organization and Business

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

1. Basis of Presentation

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

2. Use of Estimates

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

3. Recent Accounting Pronouncements

In December 2004, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standard No. 123R (SFAS 123R), a revision of SFAS No. 123 (SFAS 123), “Accounting for Stock-Based Compensation.” This statement requires an entity to measure the cost of employee services received in exchange for an award of equity instruments based on the grant-date fair value of the award. The compensation expense will be recognized over the period during which an employee is required to provide service in exchange for the award. SFAS 123R is effective for annual and interim periods beginning after June 15, 2005. The adoption of SFAS 123R will require us to record compensation expense beginning in the fourth quarter of the current year for the unvested fair value of our equity instruments given to our employees. We are in the process of evaluating the impact of the adoption of SFAS 123R on our financial position and results of operations. See the proforma disclosure in Note 6.

4. Reclassifications

Certain reclassifications were made to the 2004 financial statements to conform to the 2005 presentation.

5. Earnings Per Share of Common Stock

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

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

SFAS No. 128 requires all anti-dilutive securities, including stock options, to be excluded from the diluted earnings per share computation. For the three months ended December 31, 2003, due to our net loss, all of our outstanding options of 516,344 were excluded from the diluted loss per share calculation because their inclusion would have been anti-dilutive. For the three months ended December 31, 2004, options of 578,165 were included in the diluted net income per share calculation and 3,000 options were excluded.

6. Stock-Based Compensation

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

The following table illustrates the pro forma effect on net income/ (loss) and net income/ (loss) per share if the Company had applied the fair value recognition provisions of SFAS 123.

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

7. Inventories

Inventories consist of the following:

8. Comprehensive Income (Loss)

The components of comprehensive income (loss) are as follows:

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

9. Pension and Retirement Plans

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

The Company funds its pension plans in amounts sufficient to meet the requirements set forth in applicable employee benefits laws and local tax laws. Liabilities for amounts in excess of these funding levels are accrued and reported in the consolidated balance sheet.

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

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

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The Company contributions were $60,000 and $37,000 for three month period ended December 31, 2004 and 2003.

10. Segment and Geographical Information

The following table presents certain operating segment information.

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

All intercompany transactions have been eliminated.

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

For the three months ended December 31, 2004 and 2003, the Company had sales to one customer (E-Plus, a Service and system integration customer) which accounted for approximately $3.1 million (22%) and $3.2 million (27%) of consolidated sales, respectively. No other customers had sales in excess of 10% of consolidated sales for the three months ended December 31, 2004 and 2003, respectively.

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

Forward-Looking Statements

This quarterly report on form 10-Q contains forward-looking statements based on current expectations that involve a number of risks and uncertainties. Such statements are generally identified by the use of forward-looking words and phrases, such as “intended,” “expects,” “anticipates” and “is (or are) expected (or anticipated).” Actual results may differ materially from those discussed in such forward-looking statements, and our stockholders should carefully review the cautionary statements set forth in this form 10-Q, including those set forth under the caption “Risk Factors That May Affect Future Results”. Any forward-looking statement speaks only as of the date on which such statement is made, and we undertake no obligation to update any forward-looking statement to reflect events or circumstances after the date on which such statement is made. As it is not possible to predict every new factor that may emerge, forward-looking statements should not be relied upon as a prediction of actual future financial condition or results. In response to competitive pressures or new product introductions, we may take certain pricing or marketing actions that could adversely affect our operating results. In addition, changes in our products and services mix may cause fluctuations in our gross margin. Due to the potential quarterly fluctuations in our operating results, we believe that quarter-to-quarter comparisons of our results of operations are not necessarily an indicator of future performance.

Markets for our products and services are characterized by rapidly changing technology, new product introductions and short product life cycles. These changes can adversely affect our business and operating results. Our success will depend on our ability to enhance our existing products and services and to develop and introduce, on a timely and cost effective basis, new products that keep pace with technological developments and address increasing customer requirements. The inability to meet these demands could adversely affect our business and operating results.

Critical Accounting Policies

Our discussion and analysis of our financial condition and results of operations are based upon our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted

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in the United States. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses. On an on-going basis, we evaluate our estimates, including those related to uncollectible receivables, inventory valuation, goodwill, income taxes, deferred compensation and retirement plans, restructuring costs and contingencies. We base our estimates on historical performance and on various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions.

We believe the following critical accounting policies affect our more significant judgments and estimates used in the preparation of our consolidated financial statements: revenue recognition; valuation allowances, specifically the allowance for doubtful accounts and deferred tax assets valuation allowance; inventory valuation; and goodwill impairment.

Revenue recognition

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

Systems Revenue

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

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

We also offer training, maintenance agreements and support services. We have established fair value on our training, maintenance and support services based on separate sales of these elements at prices stated in our standard price lists. These prices are not discounted. Revenue from service obligations under maintenance contracts is deferred and recognized on a straight-line basis over the contractual period, which is typically three to twelve months, if all other revenue recognition criteria have been met. Support services provided on a time and material basis are recognized as provided if all of the revenue recognition criteria have been met for that element and the support services have been provided. Revenue on training is recognized when the training is completed.

Service and System Integration Revenue

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

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

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

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

We have established vendor-specific evidence of fair value on our maintenance support and service support elements, however we have not established vendor-specific evidence of fair value on our third-party hardware, licensed software and consulting integration services.

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

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

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

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

E-business Software Revenue

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

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

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

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

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

Other Software Revenue

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

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

Valuation Allowances

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

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

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

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Inventory Valuation

The recoverability of inventories is based upon the types and levels of inventories held, forecasted demand, pricing, competition and changes in technology. We write down our inventory for estimated obsolescence or unmarketable inventory equal to the difference between the cost of inventory and the estimated market value based upon assumptions about future demand and market conditions. If actual market conditions are less favorable than those projected by management, additional inventory write-down may be required.

Goodwill Impairment

We adopted SFAS No. 142, “Goodwill and Other Intangible Assets” on October 1, 2002. This standard requires that goodwill no longer be amortized, and instead, be tested for impairment at least annually and whenever events or changes in circumstances indicate that the carrying value may not be recoverable. Factors we consider important that could indicate impairment include significant under performance relative to prior operating results, change in projections, significant changes in the manner of our use of assets or the strategy for our overall business, and significant negative industry or economic trends. At December 31, 2004 and 2003, we had $2,996,000 in Goodwill. We had no impairment charge during the year ended September 30, 2004, but we did have an impairment charge of $365,000 recorded during the year ended September 30, 2003. In evaluating the impairment of goodwill, we consider a number of analyses such as discounted cash flow projections and market capitalization value. The process of evaluating the potential impairment of goodwill is highly subjective and requires significant judgment at many points during the analysis. In estimating fair value of the businesses with goodwill for the purposes of our annual or periodic analyses, we make estimates and judgments about the future cash flows of these businesses. Our cash flow forecasts are based on assumptions that are consistent with the plans and estimates we are using to manage the underlying businesses. In addition, we make certain judgments about assets such as accounts receivable and inventory to the estimated balance sheet for those businesses. We also consider our market capitalization (adjusted for unallocated monetary assets such as cash, marketable debt securities and debt) on the date we perform the analysis. Our key assumptions include sales growth and expected levels of operating expenditures, which are subject to variation based on both internal and external factors. To the extent that actual experience deviates from the projections, our assessment regarding impairment may change. Such a change could have a material adverse affect on the statement of operations.

Pension and Retirement Plans

In the United Kingdom and Germany, we provide defined benefit pension plans and defined contribution plans for the majority of the employees. In the U.S., we also provide benefits through supplementary retirement plans to employees. These supplemental plans are funded from cash surrender values from life insurance policies. The plan assumptions in the U.S. include a discount rate of 6% and the plan assumptions in the U.K. and Germany include a discount rate of 5.5%. In addition, in the U.S., we provide for officer death benefits through the post-retirement plans to certain officers. In calculation of the deferred compensation and retirement plans net liabilities, we make assumptions regarding expected discount rates, rates of return on assets and compensation increase rates. If activities differ from the assumptions, deferred compensation and retirement plans net liabilities may require significant adjustments. We fund the pension plans in amounts sufficient to meet the requirements set forth in applicable employee benefits laws and local tax laws. Liabilities for amounts in excess of these funding levels are accrued and reported in the consolidated balance sheet.

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Results of Operations

The following table details our results of operations in dollars and as a percentage of sales for the three months ended December 31, 2004 and 2003:

For the three months ended December 31, 2004, sales increased to $14.4 million, compared to $11.8 million for the three months ended December 31, 2003. Net income for the three months ended December 31, 2004 was $0.2 million or $0.06 per share – diluted compared with a net loss of $(0.2) million or $(0.06) per share - diluted for the three months ended December 31, 2003.

Sales

The following table details our sales by operating segment for the three month periods ended December 31, 2004 and 2003:

The Systems segment revenue increased by $1.7 million primarily due to sales to a defense contractor for an unspecified program which represented 47% of the segment sales for the quarter ended December 31, 2004. The program represented 94% of the sales increase in the quarter ended December 31, 2004 compared to the same period of the prior year. We expect there to be approximately $1.0 million additional sales from this program that will be shipped in our second and third quarter of fiscal 2005. The Service and system integration segment sales increased by 8% primarily due to an increase of 20% in sales by our German subsidiary. The largest portion of the increase was for the sale of third-party products.

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