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EX-32.1 - EXHIBIT 32.1 - CSP INC /MA/cspi-20180930xex321.htm
EX-31.2 - EXHIBIT 31.2 - CSP INC /MA/cspi-20180930xex312.htm
EX-31.1 - EXHIBIT 31.1 - CSP INC /MA/cspi-20180930xex311.htm
EX-23.1 - EXHIBIT 23.1 - CSP INC /MA/consent-20180930xex231.htm
EX-21.1 - EXHIBIT 21.1 - CSP INC /MA/subsidiarylist-20180930xex.htm
                            

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
 
FORM 10-K
 
x
ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
    
EXCHANGE ACT OF 1934
 
For the Fiscal Year Ended September 30, 2018.
 
¨
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
    
EXCHANGE ACT OF 1934
 
For the transition period from             to             
 
Commission File Number 000-10843
 
CSP Inc.
(Exact name of Registrant as specified in its Charter)
 
Massachusetts
04-2441294
(State of incorporation)
(I.R.S. Employer Identification No.)
 
175 Cabot Street, Lowell, Massachusetts 01854
(Address of principal executive offices)
 
(978) 954-5038
(Registrant's telephone number including area code)
 
Securities Registered Pursuant to Section 12(b) of the Act:
 
Title of Each Class
 
Name of Exchange on Which Registered 
 
Common Stock, par value $0.01 per share
NASDAQ Global Market
 
Securities registered pursuant to Section 12(g) of the Act:
None
 
Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.
    Yes  ¨    No  x
 
Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.
Yes  ¨    No  x
 
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    Yes  x    No  ¨.
 
Indicate by check mark whether the registrant has submitted electronically every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit such files).    Yes  x    No  ¨.
 
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K(§229.405 of this chapter) is not contained herein, and will not be contained, to the best of registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.  x
 
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, a smaller reporting company, or an emerging growth company. See the definitions of “large accelerated filer”, “accelerated filer”, “smaller reporting company”, and "emerging growth company" in Rule 12b-2 of the Exchange Act.
 
Large accelerated filer  ¨
Accelerated filer  ¨
Non-accelerated filer  x
Smaller Reporting Company  x
 
Emerging Growth Company  ¨
 
If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act.  ¨

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).    Yes  ¨    No  x
 
As of March 29, 2018, the aggregate market value of the registrant's common stock held by non-affiliates of the registrant was $38,586,781 based on the closing sale price of $10.75 as reported on the Nasdaq Global Market.
 
As of December 26, 2018, we had outstanding 4,019,254 shares of common stock.
 
DOCUMENTS INCORPORATED BY REFERENCE
 
Certain portions of the information required in Part III of this Form 10-K are incorporated by reference from our definitive proxy statement for our 2019 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, 2018.


                            

TABLE OF CONTENTS
 
 
 
Page
 
 
 
 
 
 
 
 1
 9
 17
 
 
 
 
 
 18
 28
 30
 
 
 
 
 
 30
 31
 
 
 
 
 
 
 
 
Note: Items 1B, 6 and 7A are not required for Smaller Reporting Companies and therefore are not furnished.
 
 
 
 


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Special Note Regarding Forward-Looking Statements

This annual report on Form 10-K contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. This information may involve known and unknown risks, uncertainties and other factors that are difficult to predict and may cause our actual results, performance or achievements to be materially different from future results, performance or achievements expressed or implied by any forward-looking statements. The discussion below contains certain forward-looking statements related but not limited to, among others, statements concerning future revenues and future business plans. Forward-looking statements include statements in which we use words such as “expect,” “believe,” “anticipate,” “intend,” “estimate,” “should,” “could,” “may,” “plan,” “potential,” “predict,” “project,” “will,” “would” and similar expressions. Although we believe the expectations reflected in such forward-looking statements are based on reasonable assumptions, the forward-looking statements are subject to significant risks and uncertainties, and thus we cannot assure you that these expectations will prove to be correct, and actual results may vary from those contained in such forward-looking statements. We discuss many of these risks and uncertainties in Item 1A under the heading “Risk Factors” in this Annual Report.

Factors that may cause such variances include, but are not limited to, our dependence on a small number of customers for a significant portion of our revenue, our high dependence on contracts with the U.S. federal government, our reliance in certain circumstances on single sources for supply of key product components, and intense competition in the market segments in which we operate. Given these uncertainties, you should not place undue reliance on these forward-looking statements. Also, forward-looking statements represent our estimates and assumptions only as of the date of this document. We have based the forward-looking statements included in this annual report on Form 10-K on information available to us on the date of this annual report, and we assume no obligation to update any such forward-looking statements, other than as required by law.


PART I
 
Item 1.    Business

CSP Inc. ("CSPi" or "CSPI" or "the Company" or "we" or "our") was incorporated in 1968 and is based in Lowell, Massachusetts. To meet the diverse requirements of our commercial and defense customers worldwide, CSPi and its subsidiaries develop and market IT integration solutions, advanced security products, managed IT services, purpose built network adapters, and high-performance cluster computer systems.

On July 31, 2018, CSPi LTD sold all of the outstanding stock of Modcomp GmbH for $14.4 million cash, and recognized a gain of $16.8 million. The divestiture of our German operations and our increased cash position will enable us to focus time and resources on our higher-margin and greater-potential growth opportunities. We are encouraged by the traction of our managed services business in the U.S. and we intend to continue to invest and focus on our new ARIA SDS cyber security products and to capitalize on the proliferation of our wireless service business.

Segments

CSPI operates in two segments; High Performance Products ("HPP") and Technology Solutions ("TS").
    
HPP Segment

The HPP segment revenue comes from four distinct product lines: (i) a cyber security product named ARIA™ Software-Defined Security ("SDS"), which is offered to commercial, original equipment manufacturers ("OEM") and government customers; (ii) the Myricom® ARC Series of 10G Ethernet adapters for both the commercial and government customers; (iii) the Myricom nVoy Series of appliances for OEMs and end-user customers; and (iv) the Multicomputer product portfolio of computing systems for digital signal processing ("DSP") applications within the defense markets.

The ARIA SDS solution is a new portfolio of software products (an orchestrator, light-weight instances, and hosted applications) that protect an organization’s critical high-value data, such as personally identifiable information ("PII"), from breaches. Revenue from ARIA will come from the sale of the platform components, hosted software

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applications, and required support packages, all of which will be renewed on an annual basis. ARIA can be deployed on commercially available servers across an organization’s enterprise, as well as on the latest generation of Myricom adapters.

We anticipate that ARIA will be of value to regulated industries, such as financial services or healthcare, due to the rise of data privacy regulations enforced by federal, state, and industry entities. We also believe the patent-pending ARIA SDS solution will be attractive to value-added service providers and OEMs that pursue differentiated security services for their customers. While initial offerings of ARIA applications are planned for revenue shipment in fiscal year 2019, the number of applications will continue to be expanded over time.

The Myricom ARC Series of 10G network adapters are optimized for and sold into markets that require high bandwidth and low latency: (i) packet capture, (ii) financial transactions, and (iii) the storage interconnect market. Our primary customers for packet capture include government agencies that need to capture, inject, and analyze network traffic at line rate, and OEMs selling into vendors of computer security appliances. Financial institutions, such as banks, and brokerage firms use Myricom adapters to decrease transaction times. Our storage interconnect customers, primarily in the film industry, use our adapters for video capture and film editing.

The Myricom nVoy Series of appliances (Packet Recorder and Packet Broker) can be deployed as part of an organization’s data security structure as a new component to complement existing systems, and provides data breach verification and notification as well as compliance reporting. The primary customers will be OEMs and value- added services providers that are looking to expand their product and services offerings of industry regulation compliance and breach response solutions.

Multicomputer products for DSP applications are utilized by domestic and foreign government entities for existing programs. In 2016, the Company decided not to participate in the next generation of defense programs. Revenue flows come from servicing the existing product line for a modest number of existing high-value customers. Therefore, the revenue from these products, as a percentage of overall Company revenue, is expected to decline over time.

TS Segment

The TS segment consists of our wholly-owned Modcomp subsidiary, which operates in the United States and the United Kingdom.

The TS segment generates product revenues by reselling third-party computer hardware and software as a value added reseller ("VAR"). The TS segment generates service revenues by the delivery of integration services for complex IT environments, including advanced security; unified communications and collaboration; wireless and mobility; data center solutions; and network solutions as well as managed IT services ("MSP") that primarily serve the small and mid-sized business market ("SMB").

Third party products and professional services are marketed and sold through the Company's direct sales force into a variety of vertical markets, including; automotive; defense; health care; education; federal, state and local government; and maritime.

CSPi sold all of the outstanding stock of Modcomp GmbH to Reply AG on July 31, 2018 for total cash consideration of $14.4 million. CSP recognized a one-time gain of $16.8 million. The Company determined the German subsidiary met the criteria for discontinued operations under ASC 205. The Consolidated Balance Sheets and Consolidated Statements of Operations reflect the results of Modcomp GmbH classified as discontinued operations at and as of September 30, 2018 and 2017. See Note 2 to the consolidated financial statements for additional information.     

Sales Information by Industry Segment
 
The following table details our sales by operating segment for fiscal years ending September 30, 2018 and 2017. Additional segment and geographical information is set forth in Note 15 to the consolidated financial statements.
 

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Segment
 
2018
 
%
 
2017
 
%
 
 
(Dollar amounts in thousands)
HPP
 
$
10,479

 
14
%
 
$
13,844

 
16
%
TS
 
62,437

 
86
%
 
74,648

 
84
%
Total Sales
 
$
72,916

 
100
%
 
$
88,492

 
100
%
                             
HPP Segment

Products and Services

The mission of the HPP team is to deliver cyber security solutions to protect of our customers’ high-value, critical assets and improve their network intelligence capabilities.

Products

The ARIA SDS solution will give organizations an automated, central, and coordinated way to accelerate cyber threat detection and response, implement and enforce security polices, control which applications can access critical assets, and to protect applications and the associated data. The ARIA Orchestrator ("SDSo") and instances ("SDSi"), provide the foundation of the ARIA platform, so that a series of lightweight advanced security applications can be deployed, provisioned and managed uniformly across any sized organization.

These instances can be deployed in a variety of scenarios including bare metal servers, virtual machines ("VMs"), and container-based compute environments. The ARIA SDSo will automatically detect any instances and will programmatically execute the specified applications security feature set strengthening an organization's security posture.

For customers that desire a turnkey solution, a bundled offering can be created for deployment and opens the possibility for professional services offerings to our channel.

ARIA SDS APPLICATIONS

The initial rollout of ARIA SDS will consist of three applications that we believe can make the largest market impact. Additional ARIA applications will be announced in coming quarters.

1) ARIA SDS Packet Intelligence: The ARIA Packet Intelligence ("PI") application directs all of an organization’s network traffic to existing security tools like security information and event management solutions ("SIEMs"), user and entity behavior analytics ("UEBA"), and network intrusion protection systems ("NIPS"), making these tools more effective at detecting network-born threats.

The PI application will be available as licensed functionality within a low-cost high availability ("HA") probe that taps into an organization’s network infrastructure as well as the Myricom Secure Intelligent Adapter ("SIA"). The probe will be able to mine data at 10-25G line rates and perform remedial actions to stop threats on a per-traffic stream basis while minimizing impact on network traffic performance. Built-in APIs allow compatible 3rd party threat detection tools to take actions to stop detected threats. It is our belief that competing solutions currently do not provide this mix and level of capability. We will be able to provide a packaged solution by installing 3rd party IPS or IDS applications onto ARIA appliances, such as the probe, that run alongside and are fed by ARIA applications, such as Packet Intelligence. The ARIA PI application will be able to improve IPS or IDS performance by preprocessing the data feeds, allowing such solutions to run effectively at higher line rates.

2) ARIA SDS Packet Capture: Our Sniffer10G ("SNF") software is used by intelligence agencies for packet capture, network surveillance applications, and to perform detailed cyber-threat analysis. It’s a recommended solution to increase Bro IDS to support 10G line rates rather than the standard 1G. With the introduction of ARIA SDS and the Myricom SIA, SNF is being upgraded to support a 25G line-rate. When used in conjunction with the Packet Intelligence application, the SNF application can provide the details required to determine the exact type of threat and/or identify the compromised data records. This combination will improve the ability to achieve compliance with today’s new data privacy laws including the European Union’s GDPR and similar laws.

3) ARIA SDS KMS (Key Management System): The ARIA KMS application will make it easier to add encryption and decryption capabilities to applications which leverage a standards-based key management interoperability protocol

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("KMIP") client. For example, each of VMware’s vSphere and vSAN instances leverage a KMIP client to encrypt their application data output. As such, they need to be fed a KMIP compatible key to perform encryption. Depending upon the size of the environment, this could require thousands of keys. Our KMS key management server solution provides such KMIP keys securely and rapidly at scale while ensuring that the servers are highly available at all times. Our application was designed to solve the deployment complexity challenges currently associated with key management.

MYRICOM ARC SERIES

Our Myricom ARC Series product line includes a portfolio of Ethernet adapters and specialized software, which is branded as DBL for financial institutions and Sniffer10G ("SNF") for network monitoring. Both are compatible with Linux, Windows, Mac OS X, and VMware ESX. Our legacy generation of 10G ARC Series adapters are primarily used by media editors, especially those that use Avid® MediaCentral™ Platform, as stand-alone Network Interface Cards ("NIC"). Our most current ARC Series adapters, also 10G, are purpose-built for applications that require high bandwidth, low latency and line-rate packet capture such as high-frequency financial trading and network traffic analysis.
    
The 25G Myricom ARC Series Secure Intelligent Adapter ("SIA") is our next-generation adapter and will provide additional compute capabilities and specialized hardware to run the ARIA SDS platform and applications. A 25G version of SNF is being developed to deliver higher line rates as required by enterprise and government customers. This will also let these organizations achieve lossless packet capture and packet inspection, which is required for network surveillance use cases and tools, such as lawful intercept, deep packet inspection, forensic tools, and threat detection applications. Other customers for the SIA include OEMs and MSSP partners to run their own applications upon.

Packet Broker and Packet Recorder: Also sold under the Myricom brand, the nVoy Series is comprised of a 100G Packet Broker, a 10G Packet Recorder appliance, and specialized software. These tools assist customers in the monitoring of specified critical assets and automatically verify data breaches and alert the appropriate teams, thus reducing overall breach response time. We believe that the automated breach notification capabilities found in nVoy are best suited for regulated industries such as banking, finance, healthcare, insurance, retail, and state and local government ("SLED"), all of which are under pressure to comply with data privacy regulations. The nVoy’s capabilities complement our ARIA SDS solution and can be deployed as a solution for network and/or data security forensics and regulatory compliance.

MULTICOMPUTER PRODUCTS

Our Multicomputer product portfolio includes the 2000 SERIES VME and 3000 SERIES VXS systems. The 2000 SERIES products, based on PowerPC RISC processors with AltiVec™ technology, high-speed memory, and Myrinet-2000™ cluster interconnect, are currently is use by customers in the aerospace, commercial, and defense markets. The 3000 SERIES VXS product line, incorporating the Freescale QorIQ PowerPC processors with AltiVec technology, targets high-performance DSP, signal intelligence ("SIGINT"), and radar and sonar applications in airborne, shipboard, and unmanned aerial vehicle ("UAV") platforms where space, power, and cooling are at a premium. The HPP segment continues to ship and repair existing Multicomputer products to its customer base and support an installed base of DSP systems.

Royalties

We license the design of certain 2000 SERIES computer processor boards and switch interconnect technology to third parties. In exchange for licensing this technology, we receive a royalty payment for each processor board that utilizes our design for these products.

Markets, Marketing and Dependence on Certain Customers

Aerospace & Defense Market

Our focus for fiscal 2019 and beyond is to continue our support of established Multicomputer and Myricom products allowing system deployments to be made by government entities. These programs have support requirements that often extend beyond twenty years.

Financial Transactions Market

Myricom network adapters with DBL application software address the need for the ultra-low latency required in the world of financial trading. Running DBL on the Myricom ARC Series provides acceleration for 10G Ethernet environments,

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with benchmarked application-to-application latency in the single digit microsecond range for Linux and Microsoft Windows operating systems.

Packet Capture Market

Myricom Sniffer10G, and in development, the 25G software, running on ARC Series Ethernet adapters, provides enterprise and government customers and partners the ability to capture, inject, and analyze network traffic at line rate for all Ethernet packet sizes, with low-cost CPU overhead. Sniffer10G serves the following market segments: network surveillance, monitoring and analysis, testing, measurement, and packet generation, as well as deep packet inspection ("DPI"). The ARC series is a technology component within intrusion detection systems ("IDS"), forensic tools, and threat detection and response solutions.

Storage Interconnect Market

Myricom ARC Series network adapters are used in a wide range of networked applications, including those that connect to storage subsystems using Ethernet. Many of these customers are using content-creation applications requiring high-performance networking from the storage system to video-editing workstations. We also have customers in the supercomputing market and building cable head ends for video distribution. These adapters, in conjunction with the Myri10GE software, deliver best-in-class throughput performance for Ethernet controllers.

Security Products Market

The ARIA SDS solution is targeted at organizations that need to get additional functionality out of their current cyber security solutions to find and stop intrusion threats, while also reducing their operating costs. While our ARIA SDS solutions will be offered through our direct sales channel, it is more likely that sales will come through via independent software vendor channels to the end customers.

OEMs in the applications performance management ("APM"), as well as the cyber security segments will be candidates for ARIA deployments. These vendors can benefit from integrating the ARIA applications as internal solution toolsets to allow their application to scale, add critical functionality, or solve particular problems, such as poor performance.

Another target for ARIA will be the managed security services providers, as these providers desire simple, yet differentiated, solutions that can be deployed across their customer bases. The orchestration and automation capabilities found in ARIA SDS are valuable as they allow these security service providers to scale their offerings while increasing the productivity of their security operation center staff.

It is expected that the Myricom nVoy solution will be used by information security resources who desire a new approach to quickly validate and be notified of a data breach to minimize breach impact and to meet compliance regulations. This is appealing due to the changing regulatory climate that requires response to breaches within a few days. The nVoy solution can further reduce that time and provide proof of the records breached by leveraging the ARIA applications. Value added resellers will find nVoy appealing to expand their portfolio of security products and services and replace less-effective tools and processes in their customer environments.

Competition

CSPi’s completion in the security space comes primarily from the large, traditional security vendors like Dell, IBM, and to a lesser degree, Intel. Due to the ARIA’s approach to network and data security, we also face competition from traditional security tools and best practices approaches to breaches such as threat hunting, breach detection, and breach prevention. The competition includes common firewall manufacturers such as Palo Alto or Cisco, and in the case of data packet brokers, Gigamon and Ixia. Competitors for ARIA SDS encryption include applications and appliances provided by Thales, HPE’s Voltaic group, and other smaller market players.

In the crowded security products market, our history of supporting defense and government military programs, strong security application expertise, and the ability to develop optimized products for OEMs will help set us apart. However, we must continually develop new features and solutions to stay abreast of evolving customer requirements and leverage advances in technology. One example is Intel’s chip-level roadmap that may provide additional functionality for our ARIA SDS solution but our competitors could also attempt to leverage this. Some of these competitors may also be potential go-to-market partners or OEM customers looking to integrate our capabilities within their products and solutions.


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Customers who need a combination of advanced data protection features and who require optimized application performance are best suited to the ARIA solution. Security adapter products will also leverage previous generation Myricom ARC Series network adapter capabilities that include advanced filtering, support for kernel bypass technologies, lossless packet capture, and precision time stamping. These new capabilities will offer a variety of security service combinations that our customers can put to use.

Manufacturing, Assembly and Testing

Currently, all Multicomputer products are shipped to our customers directly from our plant in Lowell, Massachusetts. Our manufacturing activities consist mainly of final assembly and testing of printed circuit boards and systems that are designed by us and fabricated by outside third-party vendors.

Upon our receipt of material and components from outside suppliers, our quality assurance technicians inspect these products and components. During manufacture and assembly, both sub-assemblies and completed systems are subjected to extensive testing, including burn-in and environmental stress screening designed to minimize equipment failure at delivery and over the useful service life of the system. We also use diagnostic programs to detect and isolate potential component failures. A comprehensive log is maintained of past failures to monitor the ongoing reliability of our products and improve design standards.

Currently, Myricom products, including the nVoy appliances and ARC Series adapters, are shipped to our customers directly from our plant in Lowell, Massachusetts. The packet recorder and packet broker appliances are sourced from third-party partners, integrated with CSPi software and resold under the CSPi brand. Our network adapters are designed in-house and fabricated by outside third party vendors. Material and components received from outside suppliers are inspected by our quality assurance technicians.

The ARIA SDS solution (platform and applications) will be downloaded and licensed from servers or content-delivery services directly controlled by CSPi. The ARIA software can be sold in conjunction with the SIA, or our appliances, which may be preloaded with the appropriate images. Licensing will be handled by the ARIA SDSo which will be accessible by CSPi’s licensing severs to allow proper flexible services feature set activation and payment.

We provide a warranty covering defects arising from the sale of Multicomputer and Myricom products, which varies from 90 days to three years, depending upon the particular unit in question.

Sources and Availability of Raw Materials

Several components used in our HPP segment products are obtained from sole-source suppliers. We are dependent on key vendors such as Xilinx or NXP for a variety of processors for certain products and Wind River Systems, Inc. for VxWorks operating system software. Despite our dependence on these sole-source suppliers, based on our current forecast and our projected sales obligations, we believe we have adequate inventory on hand and our current near-term requirements can be met in the existing supply chain.

Research and Development

For the year ended September 30, 2018, our expenses for R&D were approximately $3.3 million compared to approximately $2.4 million for fiscal year 2017. Expenditures for R&D are expensed as they are incurred. Product development efforts in fiscal year 2018 involved development of the ARIA SDS product set, and enhancements to our Myricom products, in which we expect to continue to make investments related to the development of new hardware adapter products and the ARIA SDS software that enables the hardware to meet the needs of specific applications. Our current R&D plan is intended to extend the usefulness and marketability of these products by adding features and capabilities to meet the needs of our markets.

Intellectual Property

We rely on a combination of trademark and trade secret laws in the United States and other jurisdictions, as well as confidentiality procedures and contractual provisions to protect our intellectual property rights. We have two pending patents for the ARIA software and will be pursuing additional patent rights over time.

Backlog
 

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The backlog of customer orders and contracts in the HPP segment was approximately $1.0 million at September 30, 2018 as compared to $0.8 million at September 30, 2017. Our backlog can fluctuate greatly. These possible large fluctuations can be due to the timing of receipt of large orders often for purchases from prime contractors for sales to the government. It is expected that all of the customer orders in backlog will ship within the next twelve months from September 30, 2018.

 TS Segment
 
Products and Services
 
Integration Solutions

In the TS segment, we focus on value-added reseller ("VAR") integrated solutions including third-party hardware, software and technical computer-related consulting services and managed services. Our value proposition is our ability to integrate diverse third-party components together into a complete solution to install the system at the customer site and to offer high value IT consulting services to deliver solutions.

Third-Party Hardware and Software

Our wholly-owned subsidiary, Modcomp, sells third-party hardware and software products in the information technology market, with a strategic focus on industry standard servers and data center infrastructure solutions, midrange data storage infrastructure products, network products, unified communications, and IT security hardware and software solutions. Our key offerings include products from HPE/Aruba, Cisco Systems, Palo Alto Networks, DellEMC, Juniper Networks, Citrix, Intel, VMWare, Fortinet, Microsoft and Checkpoint. Through our business relationships with these vendors, we are able to offer competitively priced robust products to meet our customers' diverse technology needs, providing procurement and engineering expertise in server infrastructure, storage, security, unified communications and networking, to the small-to-medium sized businesses ("SMBs") and large enterprise businesses ("LEBs") with complex IT environments. We offer our customers a single point of contact for complex multi-vendor technology purchases. Many of our SMB customers have unique technology needs and may lack technical purchasing expertise or have very limited IT engineering resources on staff. We also provide installation, integration, logistical assistance and other value-added services that customers may require. Our current customers are in web and infrastructure hosting, education, telecommunications, healthcare services, distribution, financial services, professional services and manufacturing. We target SMBs and LEB customers across all industries.

Professional Services

We provide professional IT consulting services in the following areas:

Implementation, integration, migration, configuration, installation services and project management.

Hyper-Converged Infrastructure ("HCI") - We assist our clients with designing and implementing HCI solutions from multiple vendors including DellEMC, Nutanix, HPE and Cisco. HCI is a software-centric architecture that tightly integrates compute, storage and virtualization resources in a single system. The benefits of an HCI solution are improved performance, scalability and flexibility all in a reduced footprint.

Virtualization - We help our customers implement virtualization solutions using products from companies such as VMWare and Citrix that allow one computer to do the job of multiple computers by sharing resources of a single computer across multiple environments. Virtualization eliminates physical and geographical limitations and enables users to host multiple operating systems and applications on fewer servers. Benefits include energy cost savings, lower capital expenditure requirements, high availability of resources, better desktop management, increased security and improved disaster recovery.

Enterprise security intrusion prevention, network access control and unified threat management. Using third-party products from companies like Palo Alto, Aruba Networks, Juniper Networks, Fortinet, Checkpoint and Cisco Systems, our services are designed to ensure data security and integrity through the establishment of virtual private networks, firewalls and other technologies.

IT security compliance services. We provide services for IT security compliance with personal privacy laws such as the Payment Card Industry Data Security Standard ("PCI DSS"), the Health Insurance Portability and Accountability Act of 1996 ("HIPAA"), and internal control regulations under the Sarbanes-Oxley Act ("SOX").


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Unified communications, wireless and routing and switching solutions using Cisco Systems and Aruba Networks products and services.

Custom software applications and solutions development and support. We develop custom applications to customer specifications using industry standard platforms such as Microsoft.Net, SharePoint and OnBase. We are a Microsoft Gold Partner.

Managed IT services that include monitoring, reporting and management of alerts for the resolution and preventive general IT and IT security support tasks.

Maintenance and technical support for third-party products including hardware and software, operating system and user support.

Managed and Cloud Services

As consumption models continue to evolve in our industry, Modcomp has developed a robust managed & cloud services offering to provide alternative solutions to traditional capital expenditure investments in IT solutions and IT operations for our clients. Our value is to provide an elastic offering that will allow the client to scale and consume these offerings with monthly billing options that help control costs and provide economies of scale.

We provide managed and cloud services in the following areas:

Proactive monitoring and remote management of IT Infrastructure that includes network (both wired and wireless), data center (which includes compute, storage and virtualization), desktops, unified communications platforms and security.

Managed Collaboration solutions (voice and video), resale of Cisco Webex Teams under annuity program.

Managed Security (firewall, endpoint protection, malware, anti-virus and SIEM).

Managed BackUp and Replication.

Cloud services that include Microsoft Office 365, Azure, Greencloud and Amazon Web Services.

Markets, Marketing and Dependence on Certain Customers

We are an IT systems integrator and computer hardware and software VAR. We also provide technical services to achieve a value-add to our customers. We operate within the VAR sales channels of major computer hardware and software OEMs, primarily within the geographic areas of our sales offices and across the U.S. We provide innovative IT solutions, including a myriad of infrastructure products with customized integration consulting services and managed services to meet the unique requirements of our customers. We market the products and services we sell through sales offices in the U.S. and the U.K. using our direct sales force (for a list of our locations, see Item 2 of this Form 10-K).

Competition

Our primary competition in the TS segment is other VARs ranging from small companies that number in the thousands, to large enterprises such as CDW, PC Connection, Insight, Presidio, Dimension Data, Bechtle AG and Computacenter AG & Co oHG. In addition, we compete directly with many of the companies that manufacture the third-party products we sell, including Cisco Systems, IBM, Hewlett Packard (HPE), EMC (now part of Dell) and others. In the network management, security and storage systems integration services business, our competitors are extensive and vary to a certain degree in each of the geographical markets, but they also include such national competitors as HP/EDS, IBM and Cap Gemini.

Nearly all of our product offerings are available through other channels. Favorable competitive factors for the TS segment include procurement capability, product diversity which enables the delivery of complete and custom solutions to our customers and the strength of our key business relationships with the major IT OEMs. We also consider our ability to meet the unique and/or specialized needs of the SMB and LEB markets and our strong knowledge of the IT products that we sell to be a key competitive advantage. Our ability to provide managed services through our network operations center and the consulting integration services required to design and install the custom solutions that fit our customers' IT needs are distinct competitive advantages. Unfavorable competitive factors include low name recognition, limited geographic coverage and pricing.

8

                            


Backlog
 
The backlog of customer orders and contracts for the TS segment was approximately $7.2 million at September 30, 2018, as compared to $8.9 million at September 30, 2017. Our backlog can fluctuate greatly. These fluctuations can be due to the timing of receiving large orders for third-party products and/or IT services. It is expected that all of the customer orders in backlog will ship and/or be provided during fiscal year 2019.

Significant Customers
 
See Note 15 in the notes to the consolidated financial statements for detailed information regarding customers which comprised 10% or more of consolidated revenues for the years ended September 30, 2018 and 2017.
 
Employees
 
On September 30, 2018, we had approximately 124 full time equivalent employees worldwide for our consolidated operations. None of our employees are represented by a labor union and we have had no work stoppages in the last three fiscal years. We consider relations with our employees to be good.

Company Website

The Company's internet address is http://www.cspi.com. Through that address, the Company's Annual Report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and amendments to those reports are available free of charge as soon as reasonably practicable after they are filed with the United States Securities and Exchange Commission (Securities and Exchange Commission or Commission). The information contained on the Company's website is not included in, nor incorporated by reference into, this annual report on Form 10-K.
 
Financial Information about Geographic Areas
 
Information regarding our sales by geographic area and percentage of sales based on the location to which the products are shipped or services rendered are in Note 15 of the notes to the consolidated financial statements.

Item 1A.
Risk Factors
 
If any of the risks and uncertainties set forth below actually materialize, our business, financial condition and/or results of operations could be materially and adversely affected, the trading price of our common stock could decline and a stockholder could lose all or part of its, his or her investment. The risks and uncertainties set forth below are not the only ones we face. Additional risks and uncertainties not presently known to us or that we currently consider immaterial may also impair our business operations.

We depend on a small number of customers for a significant portion of our revenue and loss of any customer could significantly affect our business.

Both the HPP and TS segments are reliant upon a small number of significant customers, and the loss of or significant reduction in sales to any one of which could have a material adverse effect on our business. For the fiscal year ended September 30, 2018, one customer accounted for approximately $7.5 million in revenue, or 10% of our total revenues for the fiscal year. A significant reduction 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 continue to grow or need 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 key personnel and skilled employees and face competition in hiring and retaining qualified employees.
 
We are largely dependent upon the skills and efforts of our senior management, managerial, sales and technical employees. None of our senior management personnel or other key employees are subject to any employment contracts except Victor Dellovo, our Chief Executive Officer and President. The loss of services of any of our executives or other key personnel could have a material adverse effect on our business, financial condition and results of operations. Our future success will depend to a significant extent on our ability to attract, train, motivate and retain highly skilled technical professionals. Our ability to maintain and renew existing engagements and obtain new business depends, in large part, on our ability to hire and retain technical personnel with the skills that keep pace with continuing changes in our industry standards and technologies. The inability to hire additional qualified personnel could impair our ability to satisfy or grow our client base. There can be no assurance that we will be successful in retaining current or future employees.

Our success depends in part on our timely introduction of new products and technologies and our results can be impacted by the effectiveness of our significant investments in new products and technologies


9

                            

We make significant investments in Aria SDS cyber security products and services that may not achieve expected returns. We will continue to make significant investments in research, development, and marketing for Aria products, services, and technologies. Commercial success depends on many factors, including innovativeness, developer support, and effective distribution and marketing. If customers do not perceive our latest offerings as providing significant new functionality or other value, they may reduce their purchases of new software and hardware products or upgrades, unfavorably affecting revenue. We may not achieve significant revenue from new product, service, and distribution channel investments for several years, if at all. New products and services may not be profitable, and even if they are profitable, operating margins for some new products and businesses will not be as high as the margins we have experienced historically. Developing new technologies is complex. It can require long development and testing periods. Significant delays in new releases or significant problems in creating new products or services could adversely affect our revenue.

We depend on contracts with the federal government, primarily with the Department of Defense ("DoD"), for a significant portion of our revenue, and our business could be seriously harmed if the government significantly decreased or ceased doing business with us.
 
We derived 6% of our total revenue in fiscal year 2018 and 8% of our total revenue in fiscal year 2017 from the DoD as a subcontractor. We expect that the DoD contracts will continue to be important to our business for the foreseeable future. If we were suspended or debarred from contracting with the federal government generally, the General Services Administration, or any significant agency in the intelligence community or the DoD, if our reputation or relationship with government agencies were to be impaired, or if the government otherwise ceased doing business with us or significantly decreased the amount of business it does with us, our business, prospects, financial condition and operating results would be materially and adversely affected.

To be successful, we must respond to the rapid changes in technology. If we are unable to do so on a timely basis our business could be materially adversely affected.

Our future success will depend in large part on our ability to enhance our current products and to develop new commercial products on a timely and cost-effective basis in order to respond to technological developments and changing customer needs. The design-in process is typically lengthy and expensive and there can be no assurance that we will be able to continue to meet the product specifications of our customers in a timely and adequate manner. In addition, if we fail to anticipate or to respond adequately to changes in technology and customer preferences, or if there is any significant delay in product developments or introductions, this could have a material adverse effect on our business, financial condition and results of operations, including the risk of inventory obsolescence. Because of the complexity of our products, we have experienced delays from time to time in completing products on a timely basis. If we are unable to design, develop or introduce competitive new products on a timely basis, our future operating results would be adversely affected, particularly in our HPP segment. There can be no assurance that we will be successful in developing new products or enhancing our existing products on a timely or cost-effective basis, or that such new products or product enhancements will achieve market acceptance.

We 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 HPP products are currently obtained from sole-source suppliers. We are dependent on key vendors like Mellanox Technologies for our high-speed interconnect components. Generally, suppliers may terminate our purchase orders without cause upon 30 days' notice and may cease offering products to us upon 180 days' notice. Although we do not consider the risk of interruption of supply to be a significant risk in the near term, if in the future, Mellanox Technologies were to limit or reduce the sale of such components to us, or if these or other component suppliers, some of which are small companies, were to experience future financial difficulties or other problems which could prevent them from supplying 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 risks, materials shortages, excess demand, reduction in capacity and other factors that may disrupt the flow of goods to us or our customers, which thereby may adversely affect our business and customer relationships.
 
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

10

                            

be able to adjust product pricing to reflect the increase in component costs. We could incur set-up costs and delays in manufacturing should it become necessary to replace any key vendors due to work stoppages, shipping delays, financial difficulties or other factors and, under certain circumstances, these costs and delays could have a material adverse effect on our business, financial condition and results of operations.

Our international operation is subject to a number of risks.
We market and sell our products in certain international markets and we have established operations in the U.K. The sale of our German operation in fiscal year 2018 is treated as discontinued operations in our 2018 financial statements. Foreign-based revenue is determined based on the location to which the product is shipped or services are rendered and represented 17% and 21% of our total revenue for the fiscal years ended September 30, 2018 and 2017, respectively. If revenues generated by foreign activities are not adequate to offset the expense of establishing and maintaining these foreign activities, our business, financial condition and results of operations could be materially adversely affected. In addition, there are certain risks inherent in transacting business internationally, such as changes in applicable laws and regulatory requirements, export and import restrictions, export controls relating to technology, tariffs and other trade barriers, longer payment cycles, problems in collecting accounts receivable, political instability, fluctuations in currency exchange rates, expatriation controls and potential adverse tax consequences, any of which could adversely impact the success of our international activities. In particular, it is possible activity in the United Kingdom and the rest of Europe will be adversely impacted and that we will face increased regulatory and legal complexities, including those related to tax, trade, and employee relations as a result of Brexit. A portion of our revenues are from sales to foreign entities, including foreign governments, which are primarily paid in the form of foreign currencies. There can be no assurance that one or more of such factors will not have a material adverse effect on our future international activities and, consequently, on our business, financial condition or results of operations.

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


11

                            

Our business could be adversely affected by changes in budgetary priorities of the federal government.
 
Because we derive a significant percentage of our revenue from contracts with the federal government, changes in federal government budgetary priorities could directly affect our financial performance. A significant decline in government expenditures, a shift of expenditures away from programs that we support or a change in federal government contracting policies could cause federal government agencies to reduce their purchases under contracts, to exercise their right to terminate contracts at any time without penalty or not to exercise options to renew contracts.
 
In years when Congress does not complete its budget process before the end of its fiscal year (September 30), government operations are funded through a continuing resolution ("CR") that temporarily funds federal agencies. Recent CRs have generally provided funding at the levels provided in the previous fiscal year and have not authorized new spending initiatives. When the federal government operates under a CR, delays can occur in the procurement of products and services. Historically, such delays have not had a material effect on our business; however, should funding of the federal government by CR be prolonged or extended, and sequestration is not alleviated, it could continue to have significant consequences to our business and our industry.
 
Additionally, our business could be seriously affected if changes in DoD priorities reduces the demand for our services on contracts supporting some operations and maintenance activities or if we experience an increase in set-asides for small businesses, which could result in our inability to compete directly for contracts.

U.S. Federal government contracts contain numerous provisions that are unfavorable to us.
U.S. Federal government contracts contain provisions and are subject to laws and regulations that give the government rights and remedies, some of which are not typically found in commercial contracts, including allowing the government to:
cancel multi-year contracts and related orders if funds for contract performance for any subsequent year become unavailable;
 claim rights in systems and software developed by us;
 suspend or debar us from doing business with the federal government or with a governmental agency;
 impose fines and penalties and subject us to criminal prosecution; and
 control or prohibit the export of our data and technology.
 
If the government terminates a contract for convenience, we may recover only our incurred or committed costs, settlement expenses and profit on work completed prior to the termination. If the government terminates a contract for default, we may be unable to recover even those amounts, and instead may be liable for excess costs incurred by the government in procuring undelivered items and services from another source. Depending on the value of a contract, such termination could cause our actual results to differ materially and adversely from those anticipated.

As is common with government contractors, we have experienced and continue to experience occasional performance issues under certain of our contracts.  Depending upon the value of the matters affected, a performance problem that impacts our performance of a program or contract could cause our actual results to differ materially and adversely from those anticipated.

We may be unsuccessful in protecting our intellectual property rights which could result in the loss of a competitive advantage.

Our ability to compete effectively against other companies in our industry depends, in part, on our ability to protect our current and future proprietary technology under patent, copyright, trademark, trade secret and unfair competition laws. We cannot assure that our means of protecting our proprietary rights in the United States or abroad will be adequate, or that others will not develop technologies similar or superior to our technology or design around our proprietary rights. In addition, we may incur substantial costs in attempting to protect our proprietary rights.

Also, despite the steps taken by us to protect our proprietary rights, it may be possible for unauthorized third parties to copy or reverse-engineer aspects of our products develop similar technology independently or otherwise obtain and use information that we regard as proprietary and we may be unable to successfully identify or prosecute unauthorized uses of our technology. Furthermore, with respect to our issued patents and patent applications, we cannot assure that patents from any pending patent applications (or from any future patent applications) will be issued, that the scope of any patent protection will exclude competitors or provide competitive advantages to us, that any of our patents will be held valid if subsequently

12

                            

challenged or that others will not claim rights in or ownership of the patents (and patent applications) and other proprietary rights held by us.

If we become subject to intellectual property infringement claims, we could incur significant expenses and could be prevented from selling specific products.

We may become subject to claims that we infringe the intellectual property rights of others in the future. We cannot assure that, if made, these claims will not be successful. Any claim of infringement could cause us to incur substantial costs defending against the claim even if the claim is invalid, and could distract management from other business. Any judgment against us could require substantial payment in damages and could also include an injunction or other court order that could prevent us from offering certain products.

Our need for continued or increased investment in research and development may increase expenses and reduce our profitability.

Our industry is characterized by the need for continued investment in research and development. If we fail to invest sufficiently in research and development, our products could become less attractive to potential customers and our business and financial condition could be materially and adversely affected. As a result of the need to maintain or increase 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 research and development efforts fail to result in new products or if revenues fall below expectations. In addition, as a result of our commitment to invest in research and development, spending levels of research and development expenses as a percentage of revenues may fluctuate in the future.

Our results of operations are subject to fluctuation from period to period and may not be an accurate indication of future performance.

We have experienced fluctuations in operating results in large part due to the sale of products and services in relatively large dollar amounts to a relatively small number of customers. Customers specify delivery date requirements that coincide with their need for our products and services. Because these customers may use our products and services in connection with a variety of defense programs or other projects with different sizes and durations, a customer’s orders for one quarter generally do not indicate a trend for future orders by that customer. As such, we have not been able in the past to consistently predict when our customers will place orders and request shipments so that we cannot always accurately plan our manufacturing, inventory, and working capital requirements. As a result, if orders and shipments differ from what we predict, we may incur additional expenses and build excess inventory, which may require additional reserves and allowances and reduce our working capital and operational flexibility. Any significant change in our customers’ purchasing patterns could have a material adverse effect on our operating results and reported earnings per share for a particular quarter. Thus, results of operations in any period should not be considered indicative of the results to be expected for any future period.

High quarterly book-ship ratios may pressure inventory and cash flow management, necessitating increased inventory balances to ensure quarterly revenue attainment. Increased inventory balances tie up additional capital, limiting our operational flexibility. Some of our customers may have become conditioned to wait until the end of a quarter to place orders in the expectation of receiving a discount. Customers conditioned to seek quarter-end discounts increase risk and uncertainty in our financial forecasting and decrease our margins and profitability.

Our quarterly results may be subject to fluctuations resulting from a number of other factors, including:

delays in completion of internal product development projects;

delays in shipping hardware and software;

delays in acceptance testing by customers;

a change in the mix of products sold to our served markets;

changes in customer order patterns;

production delays due to quality problems with outsourced components;

inability to scale quick reaction capability products due to low product volume;

13

                            


shortages and costs of components;

the timing of product line transitions;

declines in quarterly revenues from previous generations of products following announcement of replacement products containing more advanced technology;

inability to realize the expected benefits from acquisitions and restructurings, or delays in realizing such benefits;

potential asset impairment, including goodwill and intangibles, or restructuring charges; and

changes in estimates of completion on fixed price service engagements.

In addition, from time to time, we have entered into contracts, referred to as development contracts, to engineer a specific solution based on modifications to standard products. Gross margins from development contract revenues are typically lower than gross margins from standard product revenues. We intend to continue to enter into development contracts and anticipate that the gross margins associated with development contract revenues will continue to be lower than gross margins from standard product sales.

Another factor contributing to fluctuations in our quarterly results is the fixed nature of expenditures on personnel, facilities and marketing programs. Expense levels for these programs are based, in significant part, on expectations of future revenues. If actual quarterly revenues are below management’s expectations, our results of operations will likely be adversely affected. Further, the preparation of financial statements in conformity with accounting principles generally accepted in the United States requires us to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the dates of the financial statements and the reported amounts of revenues and expenses during the reporting periods. Actual results could differ from those estimates, and changes in estimates in subsequent periods could cause our results of operations to fluctuate.

Changes in regulations could materially adversely affect us.

Our business, results of operations, or financial condition could be materially adversely affected if laws, regulations, or standards relating to us or our products are newly implemented or changed. In addition, our compliance with existing regulations may have a material adverse impact on us. Under applicable federal securities laws, we are required to evaluate and determine the effectiveness of our internal control structure and procedures. We determined internal controls had not been effective in fiscal year 2017 due to a material weakness described below. If we have a material weakness in our internal controls, our results of operations or financial condition may be materially adversely affected or our stock price may decline. As of September 30, 2018, we have concluded the identified material weakness in connection with controls over revenue recognition in foreign subsidiaries in the prior years had been remediated. See Item 9A "Controls and Procedures" elsewhere in this document.

If we experience a disaster or other business continuity problem, we may not be able to recover successfully, which could cause material financial loss, loss of human capital, regulatory actions, reputational harm, or legal liability.

If we experience a local or regional disaster or other business continuity problem, such as a hurricane, earthquake, terrorist attack, pandemic or other natural or man-made disaster, our continued success will depend, in part, on the availability of our personnel, our office facilities, and the proper functioning of our computer, telecommunication and other related systems and operations. As we attempt to grow our operations, the potential for particular types of natural or man-made disasters, political, economic or infrastructure instabilities, or other country- or region-specific business continuity risks increases.

If we suffer any data breaches involving the designs, schematics, or source code for our products or other sensitive information, our business and financial results could be adversely affected.

We securely store our designs, schematics, and source code for our products as they are created. A breach, whether physical, electronic or otherwise, of the systems on which this sensitive data is stored could lead to damage or piracy of our products. If we are subject to data security breaches from external sources or from an insider threat, we may have a loss in sales or increased costs arising from the restoration or implementation of additional security measures, either of which could adversely affect our business and financial results. Other potential costs could include loss of brand value, incident response costs, loss of stock market value, regulatory inquiries, litigation, and management distraction. In addition, a security breach that

14

                            

involved classified information could subject us to civil or criminal penalties, loss of a government contract, loss of access to classified information, or debarment as a government contractor. Similarly, a breach that involved loss of customer-provided data could subject us to loss of a customer, loss of a contract, litigation costs and legal damages, and reputational harm.

Our operating results may fluctuate significantly.
 
Our operating results have fluctuated widely on a quarterly and annual basis during the last several years and we expect to experience significant fluctuations in future operating results. Many factors, some of which are beyond our control, have contributed to these fluctuations in the past and may continue to do so. Such factors include:
 
sales in relatively large dollar amounts to a relatively small number of customers;
 
competitive pricing programs and volume discounts;
 
loss of customers;

market acceptance of our products;
 
product obsolescence;
 
general economic conditions;
 
change in the mix of products sold;
 
whether or not we are able to secure design wins for significant customer systems;
 
timing of significant orders;
 
delays in completion of internal product development projects or introduction of new products;
 
delays in shipping our products;
 
delays in acceptance testing by customers;
 
production delays due to quality programs with outsourced components;
 
shortages of components;
 
timing of product line transitions;

uncertainty and timing of funding of governmental programs, including defense;
 
declines of revenues from previous generations of products following announcement of replacement products containing more advanced technology; and
 
fixed nature of our expenditures on personnel, facilities and marketing programs.
 
We believe that period-to-period comparisons of our results of operations will not necessarily be meaningful and should not be relied upon as indicative of our future performance. It is also possible that in some periods, our operating results may be below the expectations of securities analysts and investors. In such circumstances, the price of our common stock may decline.
 
We need to continue to expend resources on research and development ("R&D") efforts, particularly our HPP segment, to meet the needs of our customers. If we are unable to do so, our products could become less attractive to customers and our business could be materially adversely affected.

Our industry requires a continued investment in R&D. As a result of our need to maintain or increase our spending levels for R&D in this area and the difficulty in reducing costs associated with R&D, 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 R&D, spending as a percent

15

                            

of revenues may fluctuate in the future. Further, if we fail to invest sufficiently in R&D or our R&D does not produce competitive results, our products may become less attractive to our customers or potential
customers, which could materially harm our business and results of operations.

Our business could be adversely impacted if we have deficiencies in our disclosure controls and procedures or internal controls over financial reporting.
 
Our management identified a material weakness in internal controls over financial reporting as of September 30, 2017. A material weakness is a deficiency, or combination of deficiencies, in internal control over financial reporting at our foreign subsidiaries, such that there is a reasonable possibility that a material misstatement of the Company's annual or interim financial statements will not be prevented or detected in a timely basis.

The material weakness, which was first identified in fiscal year 2015, was in connection with our controls over the revenue recognition process at our foreign subsidiary, specifically that revenue recognition criteria have been satisfied prior to recognizing revenue and the failure to sufficiently assess gross versus net revenue indicators to certain revenue transactions. We determined that controls over the revenue recognition process, primarily in Germany, were not operating effectively and the resulting control deficiency amounted to a material weakness in our internal controls over financial reporting. Management has concluded that the material weakness has been remediated making internal controls over financial reporting effective as of September 30, 2018. See Item 9A “Controls and Procedures” for details.

Effective internal control over financial reporting and disclosure controls and procedures are necessary in order for us to provide reliable financial and other reports and effectively prevent fraud. These types of controls are designed to provide reasonable assurance regarding the reliability of financial reporting and the proper preparation of our financial statements, as well as regarding the timely reporting of material information. If we cannot maintain effective internal control over financial reporting or disclosure controls and procedures, or provide reliable financial statements or SEC reports or prevent fraud, investors may lose confidence in our reported financial information, our common stock could be subject to delisting on the stock exchange where it is traded, our operating results and the trading price of our common stock could suffer and we might become subject to litigation.

While our management will continue to review the effectiveness of our internal control over financial reporting and disclosure controls and procedures, there is no assurance that our disclosure controls and procedures or our internal control over financial reporting will be effective in accomplishing all control objectives, including the prevention and detection of fraud, all of the time.

Our stock price may continue to be volatile
 
Historically, the market for technology stocks has been extremely volatile. Our common stock has experienced and may continue to experience, substantial price volatility. The following factors could cause the market price of our common stock to fluctuate significantly:
 
loss of a major customer;
 
loss of a major supplier;
 
the addition or departure of key personnel;
 
variations in our quarterly operating results;
 
announcements by us or our competitors of significant contracts, new products or product enhancements;
 
acquisitions, distribution partnerships, joint ventures or capital commitments;
 
regulatory changes;
 
sales of our common stock or other securities in the future;
 
changes in market valuations of technology companies; and
 
fluctuations in stock market prices and volumes.
 
In addition, the stock market in general and the NASDAQ Global Market and technology companies in particular, have experienced extreme price and volume fluctuations that have often been unrelated or disproportionate to the operating

16

                            

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. If any shareholders were to issue a lawsuit, we could incur substantial costs defending the lawsuit and the attention of management
could be diverted.

Item 2.
Properties
 
Listed below are our principal facilities as of September 30, 2018. 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.
Location
 
Principal Use 
 
Owned or
Leased
 
Approximate
Floor Area 
HPP Segment Properties:
 
 
 
 
 
 
CSP Inc.
 
Corporate Headquarters
 
Leased
 
13,515 S.F.
175 Cabot Street, Suite 210
 
Manufacturing, Sales,
 
 
 
 
Lowell, MA 01854
 
Marketing and
 
 
 
 
 
 
Administration
 
 
 
 
 
 
 
 
 
 
 
TS Segment Properties:
 
 
 
 
 
 
Modcomp, Inc.
 
Division Headquarters
 
Leased
 
11,815 S.F.
1182 East Newport Center Drive
 
Sales, Marketing and
 
 
 
 
Deerfield Beach, FL 33442
 
Administration
 
 
 
 
 
 
 
 
 
 
 
Modcomp, Ltd.
 
Sales, Marketing and
 
Leased
 
2,490 S.F.
12a Oaklands Business Park, Fishponds Road
 
Administration
 
 
 
 
Wokingham Berkshire
 
 
 
 
 
 
United Kingdom
 
 
 
 
 
 
 
 
 
 
 
 
 


Item 3.    Legal Proceedings

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


Item 4.    Mine Safety Disclosures

Not Applicable.


PART II
 
Item 5.    Market for Registrant's Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities

Market information.    Our common stock is traded on the Nasdaq Global Market under the symbol CSPI. The following table provides the high and low sales prices of our common stock as reported on the Nasdaq Global Market for the periods indicated.
 
 
2018
 
2017
Fiscal Year: 
High  
 
Low 
 
High 
 
Low 
1st Quarter
$
17.00

 
$
10.60

 
$
11.95

 
$
7.89

2nd Quarter
$
18.89

 
$
10.41

 
$
11.35

 
$
8.25

3rd Quarter
$
12.18

 
$
8.75

 
$
11.23

 
$
10.00

4th Quarter
$
14.87

 
$
9.71

 
$
11.20

 
$
9.61

 
Stockholders.    We had approximately 67 holders of record of our common stock as of December 26, 2018. 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 1,467.
 

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Dividends.   For the fiscal years ended September 30, 2018 and 2017, the Company declared and paid cash dividends as follows:
Fiscal Year
 
Date Declared
 
Record Date
 
Date Paid
 
Amount Paid Per Share
2017
 
1/12/2017
 
1/27/2017
 
2/8/2017
 
$0.11
2017
 
2/23/2017
 
3/3/2017
 
3/17/2017
 
$0.11
2017
 
5/24/2017
 
6/1/2017
 
6/15/2017
 
$0.11
2017
 
8/14/2017
 
8/21/2017
 
9/5/2017
 
$0.11
2018
 
12/19/2017
 
12/29/2017
 
1/16/2018
 
$0.11
2018
 
2/12/2018
 
2/28/2018
 
3/16/2018
 
$0.11
2018
 
5/9/2018
 
5/31/2018
 
6/15/2018
 
$0.11
2018
 
8/13/2018
 
8/31/2018
 
9/14/2018
 
$0.15

Item 7.
Management's Discussion and Analysis of Financial Condition and Results of Operations
 
This management’s discussion and analysis of financial condition and results of operations and other portions of this filing contain forward-looking information that involves risks and uncertainties. Our actual results could differ materially from those anticipated by the forward-looking information. You should review the “Special Note Regarding Forward Looking Statements” and “Risk Factors” sections of this annual report for a discussion of important factors that could cause actual results to differ materially from the results described in or implied by the forward-looking statements contained in the following discussion and analysis. The following discussion should be read in conjunction with our financial statements and the related notes included elsewhere in this filing.
 
Overview of Fiscal 2018 Results of Continuing Operations

Revenue decreased by approximately $15.6 million, or 18%, to $72.9 million for the fiscal year ended September 30, 2018 versus $88.5 million for the fiscal year ended September 30, 2017.

Our gross profit margin percentage increased overall, from 24% of revenues for the fiscal year ended September 30, 2017 to 25% for the fiscal year ended September 30, 2018.

We generated an operating loss of approximately $1.6 million for fiscal year ended September 30, 2018 as compared to operating income of approximately $3.4 million for fiscal year ended September 30, 2017.

On July 31, 2018, we completed the sale of all of the outstanding stock of our Germany division of our TS segment. The one time gain recorded due to the sale of all the stock of Modcomp GmbH was approximately $16.8 million. No income taxes were provided as the transaction was a tax-free exchange in the U.K. The Modcomp GmbH's results have been recorded as discontinued operations in the accompanying consolidated balance sheets and consolidated statements of operations for all periods presented.


18

                            

The following table details our results of operations in dollars and as a percentage of sales for the fiscal years ended:

 
 
September 30, 2018
 
%
of sales
 
September 30, 2017
 
%
of sales
 
 
(Dollar amounts in thousands)
Sales
 
$
72,916

 
100
 %
 
$
88,492

 
100
%
Costs and expenses:
 
 

 
 

 
 

 
 

Cost of sales
 
54,517

 
75
 %
 
67,069

 
76
%
Engineering and development
 
3,277

 
4
 %
 
2,362

 
3
%
Selling, general and administrative
 
16,723

 
23
 %
 
15,666

 
18
%
Total costs and expenses
 
74,517

 
102
 %
 
85,097

 
96
%
Operating income (loss)
 
(1,601
)
 
(2
)%
 
3,395

 
4
%
Other income, net
 
495

 
1
 %
 
10

 
%
Income (loss) before income taxes
 
(1,106
)
 
(2
)%
 
3,405

 
4
%
Income tax expense
 
882

 
1
 %
 
1,162

 
1
%
Net income (loss) from continuing operations
 
(1,988
)
 
(3
)%
 
2,243

 
3
%
Gain on sale of discontinued operations
 
16,838

 
23
 %
 

 
%
Net income (loss) from discontinued operations
 
(410
)
 
(1
)%
 
263

 
%
Total income from discontinued operations
 
16,428

 
22
 %
 
263

 
%
Net income
 
$
14,440

 
19
 %
 
$
2,506

 
3
%

Revenues

Revenue decreased by approximately $15.6 million, or 18%, to $72.9 million for the fiscal year ended September 30, 2018 versus $88.5 million for the fiscal year ended September 30, 2017. Our HPP segment revenue decreased by approximately $3.4 million primarily due to a decline of $2.9 million in royalty revenues combined with a $1.0 million decline in Multicomputer product revenues, partially offset by $0.5 million increase in Myricom product revenues. Our TS segment revenue decreased by approximately $12.2 million from decreases of $8.8 million and $3.4 million in our U.S. and U.K. divisions, respectively.

HPP segment revenue change by product and services lines for the fiscal years ended September 30 were as follows:
(Dollar amounts in thousands)
 
 
 
 
 
Decrease
 
 
2018
 
2017
 
$
 
%
Product
 
$
7,014

 
$
7,608

 
$
(594
)
 
(8
)%
Services
 
3,465

 
6,236

 
(2,771
)
 
(44
)%
Total
 
$
10,479

 
$
13,844

 
$
(3,365
)
 
(24
)%
    
The decrease in HPP product revenues for the period of $0.6 million was primarily the result of a decrease of approximately $1.0 million in Multicomputer product line shipments, partially due to a large shipment in the prior fiscal year period, partially offset by an increase in Myricom product line shipments of approximately $0.4 million for the fiscal year ended September 30, 2018 as compared to the fiscal year ended September 30, 2017. The decrease in HPP services revenues of approximately $2.8 million for the period was primarily the result of a decrease of approximately $2.9 million in royalty revenues on high-speed processing boards related to the E2D program during the fiscal year ended September 30, 2018 as compared to the fiscal year ended September 30, 2017.
 

19

                            

TS segment revenue change by product and services lines for the fiscal years ended September 30 were as follows:
(Dollar amounts in thousands)
 
 
 
 
 
Increase (decrease)
 
 
2018
 
2017
 
$
 
%
Product
 
$
52,647

 
$
68,745

 
$
(16,098
)
 
(23
)%
Services
 
9,790

 
5,903

 
3,887

 
66
 %
Total
 
$
62,437

 
$
74,648

 
$
(12,211
)
 
(16
)%

The TS segment total revenue decreased in the U.S. and U.K. divisions as previously noted. The $16.1 million decrease in TS segment product revenue is attributed to decreases of $12.9 million and $3.2 million in our U.S. and U.K. divisions, respectively. These decreases were primarily associated with the same major customer in the U.S. and U.K. The $3.9 million service revenue increase is related to an increase in the U.S. division of $4.1 million, partially offset by a decrease in the U.K. of $0.2 million.

Our total revenues by geographic area based on the location to which the products were shipped or services rendered were as follows:
(Dollar amounts in thousands)
 
 
For the years ended September 30,
 
Decrease
 
 
2018
 
%
 
2017
 
%
 
$
 
%
Americas
 
$
60,458

 
83
%
 
$
69,982

 
79
%
 
$
(9,524
)
 
(14
)%
Europe
 
10,325

 
14
%
 
14,507

 
16
%
 
(4,182
)
 
(29
)%
Asia
 
2,133

 
3
%
 
4,003

 
5
%
 
(1,870
)
 
(47
)%
Totals
 
$
72,916

 
100
%
 
$
88,492

 
100
%
 
$
(15,576
)
 
(18
)%

The $15.6 million decrease in total revenues is primarily attributed to a $12.2 million decrease by our TS segment combined with a $3.4 million decrease by our HPP segment. The $9.5 million decrease in the Americas revenues for the fiscal year ended September 30, 2018 as compared to the fiscal year ended September 30, 2017 is primarily due to decreased revenues by our TS segment of approximately $7.5 million, combined with decreased sales by our HPP segment of approximately $1.9 million. The $4.2 million decrease in Europe revenue is primarily due to decreased sales by our TS segment UK division of approximately $3.2 million combined with a decrease by our TS segment US division of approximately $0.8 million and a decrease in our HPP segment of approximately $0.2 million. The $1.9 million decrease in Asia is primarily the result of decreased product sales by our HPP segment to a major customer of approximately $1.0 million, combined with decreased sales by our TS segment of $0.6 million.

Gross Margins

     Our gross margins ("GM") decreased by approximately $3.0 million to $18.4 million in fiscal year 2018 as compared to gross margins of $21.4 million in fiscal year 2017.

The following table summarizes GM changes by segment for fiscal years 2018 and 2017:
 
(Dollar amounts in thousands)
 
 
2018
 
2017
 
Increase (decrease)
 
 
GM$
GM%
 
GM$
GM%
 
GM$
 
GM%
HPP
 
$
6,137

59
%
 
$
9,345

68
%
 
$
(3,208
)
 
(9
)%
TS
 
12,262

20
%
 
12,078

16
%
 
184

 
4
 %
Total
 
$
18,399

25
%
 
$
21,423

24
%
 
$
(3,024
)
 
1
 %
    


20

                            

The impact of product mix on gross margins within our HPP segment for the fiscal years ended September 30 was as follows:
 
(Dollar amounts in thousands)
 
 
2018
 
2017
 
Decrease
 
 
GM$
GM%
 
GM$
GM%
 
GM$
 
GM%
Product
 
$
2,775

40
%
 
$
3,249

43
%
 
$
(474
)
 
(3
)%
Services
 
3,362

97
%
 
6,096

98
%
 
(2,734
)
 
(1
)%
Total
 
$
6,137

59
%
 
$
9,345

68
%
 
$
(3,208
)
 
(9
)%

The overall HPP segment gross margins as a percentage of sales decreased to 59% in fiscal year 2018, from 68% in fiscal year 2017. The 9% decrease in gross margin as a percentage of sales in the HPP segment was primarily attributed to the impact of a decrease of $2.9 million in high margin Multicomputer royalty revenues combined with a $1.0 million decrease in higher margin Multicomputer product sales.
 
The impact of product mix within our TS segment on gross margins for the fiscal years ended September 30 was as follows:
(Dollar amounts in thousands)
 
 
2018
 
2017
 
Increase (decrease)
 
 
GM$
GM%
 
GM$
GM%
 
GM$
 
GM%
Product
 
$
6,886

13
%
 
$
8,607

13
%
 
$
(1,721
)
 
 %
Services
 
5,376

55
%
 
3,471

59
%
 
1,905

 
(4
)%
Total
 
$
12,262

20
%
 
$
12,078

16
%
 
$
184

 
4
 %

     The overall TS segment gross margin as a percentage of sales increased 4% for the period. For fiscal year 2018 compared to fiscal year 2017, the $1.7 million decrease in our TS segment product gross margins resulted from decreased product revenues in both divisions. The $1.9 million increase in the TS segment service gross margins resulted from a combination of increased service revenues of approximately $3.9 million combined with a general decrease in overall service revenue margins.

Engineering and Development Expenses
 
The following table details our engineering and development expenses by operating segment for the fiscal years ended September 30, 2018 and 2017:
(Dollar amounts in thousands)
 
For the years ended September 30,
 
 
 
 
 
2018
 
% of
Total
 
2017
 
% of
Total
 
$ Increase
 
% Increase
By Operating Segment:
 
 
 
 
 
 
 
 
 
 
 
HPP
$
3,277

 
100
%
 
$
2,362

 
100
%
 
$
915

 
39
%
TS

 
%
 

 
%
 

 
%
Total
$
3,277

 
100
%
 
$
2,362

 
100
%
 
$
915

 
39
%
 
Engineering and development expenses increased by $0.9 million to $3.3 million for the fiscal year ended September 30, 2018 as compared to $2.4 million for the fiscal year ended September 30, 2017. The current fiscal year expenses were primarily for product engineering expenses incurred in connection with the development of the new ARIA SDS cyber security products. The increased engineering and development expenses for the fiscal year ended September 30, 2018 as compared to the fiscal year ended September 30, 2017 is primarily attributed to an increase in engineering headcount and consulting related expenses.


21

                            

Selling, General and Administrative
 
The following table details our selling, general and administrative (“SG&A”) expenses by operating segment for the years ended September 30, 2018 and 2017:
(Dollar amounts in thousands)
 
For the years ended September 30,
 
 
 
 
 
2018
 
% of
Total
 
2017
 
% of
Total
 
$ Increase
 
% Increase
By Operating Segment:
 
 
 
 
 
 
 
 
 
 
 
HPP
$
5,637

 
34
%
 
$
5,516

 
35
%
 
$
121

 
2
%
TS
11,086

 
66
%
 
10,150

 
65
%
 
936

 
9
%
Total
$
16,723

 
100
%
 
$
15,666

 
100
%
 
$
1,057

 
7
%
 
For fiscal year 2018 compared to fiscal year 2017, the HPP segment SG&A spending increase of $0.1 million is primarily attributed to increases in variable compensation costs partially offset by decreases in consulting expenses. For fiscal year 2018 compared to fiscal year 2017, the TS segment SG&A spending increase of approximately $0.9 million is substantially the result of an increase in our U.S. division of $0.6 million primarily attributed to variable selling expenses and additional engineering and sales hires. The U.K had an increase of $0.3 million primarily due to employee redundancy expenses.

Other Income/Expenses
 
The following table details our other income/expenses for the years ended September 30, 2018 and 2017:
(Dollar amounts in thousands)
 
For the years ended September 30,
 
2018
 
2017
 
Increase (decrease)
Interest expense
$
(85
)
 
$
(73
)
 
$
(12
)
Interest income
20

 
11

 
9

Foreign exchange gain (loss)
263

 
(42
)
 
305

Other income, net
297

 
114

 
183

Total other income (expense), net
$
495

 
$
10

 
$
485

    
The increase to other income (expenses) for the fiscal year ended September 30, 2018 as compared to the fiscal year ended September 30, 2017 was primarily driven by the net change of approximately $0.3 million in the foreign exchange gain (loss) on foreign currency holdings in the current period as compared to the corresponding prior year period, combined with an increase of approximately $0.2 million in other income, net.

 Income Taxes
 
     On December 22, 2017, the President of the United States signed into law the Tax Cuts and Jobs Act ("Tax Reform Act"). The legislation significantly changes U.S. tax law by, among other things, lowering corporate income tax rates, implementing a territorial tax system, expanding the tax base and imposing a tax on deemed repatriated earnings of foreign subsidiaries. The Tax Reform Act permanently reduces the U.S. corporate federal income tax rate from a maximum of 35% to a flat 21% rate, effective January 1, 2018. The Company has recognized the impact of the Tax Reform Act in these consolidated financial statements and related disclosures. Staff Accounting Bulletin No. 118 ("SAB 118") provides companies with guidance on accounting for the impact of the Tax Reform Act. Specifically, SAB 118 provides for a measurement period, not to exceed one year, that begins on the date of enactment of December 22, 2017, and ends when the Company has obtained, prepared, and analyzed information needed to complete accounting requirements which is substantially complete. In accordance with SAB 118, the recorded amounts reflecting the impact of the Tax Reform Act are reflected in these consolidated financial statements and related disclosures. As new provisions for Global Intangible Low-Tax Income ("GILTI") are effective for tax years beginning after December 31, 2017, the Company has not calculated any tax related impact for GILTI during the period.

The Company recorded an income tax expense of approximately $882 thousand, which reflected an effective tax expense rate of (79.7%) for the year ended September 30, 2018. The impact of the Tax Reform Act included remeasurement of

22

                            

the Company’s U.S. deferred tax assets and liabilities to a 24.3% for current and 21% for the non-current portions resulted in a tax expense of approximately $588 thousand consisting of a reduction of the Company’s net deferred tax asset. The Company recorded tax expense of approximately $771 thousand related to the deemed repatriation tax. For the year ended September 30, 2017, the income tax expense was approximately $1.2 million, which reflected an effective tax rate of 34.1%. The lower effective tax rate for 2017 as compared to the statutory rate was due in part to a large research and development credit.

As of September 30, 2018, management assessed the positive and negative evidence in the U.S. operations, and estimated that we will have sufficient future taxable income to utilize the existing deferred tax assets. Significant objective positive evidence included the cumulative profits that we realized in recent fiscal years. This evidence enhances our ability to consider other subjective evidence such as our projections for future growth. Other factors that we considered are the likelihood for continued royalty income in future years, new product revenue from cyber security products, and our expectation that the TS segment will continue to be profitable in future years. On the basis of this evaluation, as of September 30, 2018, we have concluded that our U.S. deferred tax asset is more likely than not to be realized. It should be noted however, that the amount of the deferred tax asset realized could be adjusted in future years, if estimates of taxable income during the carryforward periods are reduced, or if there is objective negative evidence in the form of cumulative losses.

We continue to maintain a full valuation allowance against our U.K. deferred tax assets as we have experienced cumulative losses and do not have any indication that the operation will be profitable in the future to an extent that will allow us to utilize much of our net operating loss carryforwards. To the extent that actual experience deviates from our assumptions, our projections would be affected and hence our assessment of realizability of our deferred tax assets may change.

Results of Discontinued Operations

CSPi LTD, a wholly owned indirect subsidiary of the Company, sold all of the outstanding stock of Modcomp GmbH to Reply AG, an affiliate of Reply SpA, a holding company for a worldwide group of companies, on July 31, 2018 for $14.4 million cash, and recognized a gain of $16.8 million. The divestiture of CSP’s German operations and our increased cash position will enable us to focus time and resources on our higher-margin and greater-potential growth opportunities. We are encouraged by the traction of our managed services business in the U.S. and we intend to continue to invest and focus on our new ARIA SDS cyber security products and to capitalize on the proliferation of our wireless service business. This divestiture of our German operations is another positive step toward our future growth.
  
The following table is a summary of the operating results of the Germany division of our TS segment which have been reflected as discontinued operations. See Note 2 for additional information.

 
For the years ended
 
September 30, 2018
 
September 30, 2017
 
(Amounts in thousands)
Revenues
$
18,365

 
$
22,990

Income (loss) from discontinued operations, net of tax
$
(410
)
 
$
263



Liquidity and Capital Resources
 
Our primary source of liquidity is our cash and cash equivalents, which increased by approximately $14.7 million to $25.1 million as of September 30, 2018 from $10.4 million as of September 30, 2017, which was primarily due to the sale of our German operations to Reply AG on July 31, 2018 (see Note 2 in the Notes to our Consolidated Financial Statements contained in this annual report on Form 10-K). At September 30, 2018, cash equivalents totaled $0.5 million of this amount.
 
Significant sources of cash for the year ended September 30, 2018 included net income of approximately $14.4 million, a decrease in accounts receivable of approximately $5.2 million, an increase in long term liabilities of approximately $0.6 million and an increase in income taxes payable of approximately 0.5 million. Partially offsetting these sources of cash were an increase in inventories of approximately $2.6 million, a decrease in accounts payable of approximately $2.4 million, and payment of dividends of approximately $1.9 million. The significant increase in net income was primarily due to the $16.8 million gain recognized for the sale of our German operations, which included $14.4 million in cash received in the sale transaction.

Cash held by our foreign subsidiary located in the U.K. totaled approximately $9.9 million as of September 30, 2018 and $1.1 million as of September 30, 2017. This cash is included in our total cash and cash equivalents reported above.

23

                            

 
As of September 30, 2018 and September 30, 2017, the Company maintained a line of credit that allows for borrowings of up to $1.0 million. Availability under the facility is reduced by outstanding borrowings thereunder. The interest rates on outstanding borrowings is London Inter-Bank Offer Rate ("LIBOR") plus 2.5%, with a floor of 4%. Borrowings under the credit agreements are required to be repaid on demand in certain circumstances, upon termination of the agreements, or may be prepaid by the Company without penalty. The Company had no amounts outstanding under the line of credit during the fiscal years ending September 30, 2018 and 2017.

As of September 30, 2018 and September 30, 2017, the Company also maintained an inventory line of credit that may be used by the TS segment in the U.S. to purchase inventory from approved vendors with payment terms which exceed those offered by the vendors. No interest accrues under the inventory line of credit when advances are paid within terms, however, late payments are subject to an interest charge of Prime plus 5%. The credit agreement for the inventory line of credit contains financial covenants which require the Company to maintain the following TS segment-specific financial ratios: (1) a minimum current ratio of 1.2, (2) tangible net worth of no less than $4.0 million, and (3) a maximum ratio of total liabilities to total net worth of less than 5.0:1. As of September 30, 2018 and September 30, 2017, Company borrowings under the inventory line of credit, which is included as a component of accounts payable and accrued expenses on the accompanying consolidated balance sheets, were $3.2 million and $3.1 million, respectively, and the Company was in compliance with all covenants.

For more information, please refer to Note 13 - Lines of Credit, in the Notes to our Consolidated Financial Statements contained in this annual report on Form 10-K.

If cash generated from operations is insufficient to satisfy working capital requirements, we may need to access funds through bank loans, the equity markets, or other means. There is no assurance that we will be able to raise any such capital on terms acceptable to us, on a timely basis or at all. If we are unable to secure additional financing, we may not be able to complete development or enhancement of products, take advantage of future opportunities, respond to competition or continue to effectively operate our business.
 
Based on our current plans and business conditions, management believes that the Company’s available cash and cash equivalents, the cash generated from the sale of our German operations, the cash generated from operations and availability on our lines of credit will be sufficient to provide for the Company’s working capital and capital expenditure requirements for the foreseeable future.

Critical Accounting Policies
 
Our discussion and analysis of our financial condition and results of operations are based upon our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses. On an on-going basis, we evaluate our estimates, including those related to uncollectible receivables, inventory valuation, goodwill and intangibles, income taxes, deferred compensation, revenue recognition, retirement plans, restructuring costs and contingencies. We base our estimates on historical performance and on various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions.
 
We believe the following critical accounting policies affect our more significant judgments and estimates used in the preparation of our consolidated financial statements: revenue recognition; valuation allowances, specifically the allowance for doubtful accounts and net deferred tax asset valuation allowance; inventory valuation; intangibles; and pension and retirement plans.

Revenue Recognition
 
We derive revenue from the sale of integrated hardware and software, financing of hardware and software, professional services, maintenance contracts, other services, and third party service contracts. Professional services generally include implementation, installation, and training services. Other services generally include revenue generated through our royalty and extended warranty contracts. We recognize revenue when persuasive evidence of an arrangement exists, delivery of the product or service has occurred, the fee is fixed and determinable and collectability is reasonably assured. We enter into multiple element arrangements as well as standalone sales of product, professional services, and other services.

We recognize revenue from standalone product sales upon transfer of title, which is typically upon shipment, provided all other revenue recognition criteria have been met. Revenue generated from standalone professional services and

24

                            

extended warranty contracts is recognized as services are performed, provided all other revenue recognition criteria have been met. In some instances professional service contracts include a customer acceptance provision, in which case revenue is deferred until we have evidence of customer acceptance. We recognize revenue from usage based royalty contracts upon confirmation from the customer of shipment of the system produced pursuant to the royalty agreement.

We recognize revenue from multiple element arrangements in accordance with Accounting Standards Codification ("ASC") 605-25, Multiple Element Arrangements. We evaluate multiple element arrangements to determine if separate units of accounting exist, and if so, we allocate revenue to each element based upon the relative selling price of each element. ASC 605-25 establishes a hierarchy for determining the amount to allocate to each separate deliverable in an arrangement. We determine selling price using vendor specific objective evidence ("VSOE"), if it exists; or, if VSOE does not exist, third party evidence ("TPE") of fair value is applicable; otherwise, we use the best estimate of selling price ("BESP"). The objective of BESP is to determine the price at which the Company would transact if the element was sold on a standalone basis. Management’s determination of BESP involves several factors including budgeted profit margins, and cost to complete services.

We recognize revenue from third party service contracts as either gross sales or net sales in accordance with ASC 605-45, Principal Agent Considerations, which requires us to determine if the Company is acting as a principal party to the transaction or simply acting as an agent or broker. Under ASC 605-45, the assumption of the risks and rewards under the arrangement are considered indicators of principal parties to the arrangement. We record revenue as gross when it is a principal party to the arrangement and net of cost when we are acting as a broker or agent. Under gross sales recognition, the entire selling price is recorded in revenue and our cost to the third-party service provider or vendor is recorded in cost of goods sold. Under net sales recognition, the cost to the third-party service provider or vendor is recorded as a reduction to revenue resulting in net sales equal to the gross profit on the transaction.

In May 2014, the FASB issued ASU No. 2014-09, Revenue from Contracts with Customers, which requires an entity to recognize the amount of revenue to which it expects to be entitled for the transfer of promised goods or services to customers. The standard outlines a five-step model whereby revenue is recognized as performance obligations within a contract are satisfied. The standard also requires new, expanded disclosures regarding revenue recognition. The ASU replaces most existing revenue recognition guidance in GAAP. The new standard was adopted by the Company effective October 1, 2018 using the modified retrospective approach. The effects of adoption did not have a material impact on October 1, 2018.
 
The following policies are applicable to our major categories of segment revenue transactions:

HPP Segment Revenue

HPP segment revenue is derived from the sale of integrated hardware and software, maintenance, and other services through the Multicomputer and Myricom product lines. Multicomputer product revenue is generally recognized when product is shipped, provided that all revenue recognition criteria are met. Service revenue consists principally of warranty and royalty revenue. Revenue generated from extended warranty contracts is recognized as services are performed over the term of the contract, provided all other revenue recognition criteria have been met We recognize revenue from usage based royalty contracts upon confirmation from the customer of shipment of the system produced pursuant to the royalty agreement.

Myricom revenue is derived from the sale of products, which are comprised of both hardware and embedded software which is essential to the products functionality, and post contract maintenance and support. Revenue from multiple element arrangements is recognized in accordance with ASC 605-25. We evaluate multiple element arrangements to determine if separate units of accounting exist, and if so, we allocate revenue to each element based upon the relative selling price of each element. We determine selling price using BESP. Management’s determination of BESP is based on several factors, including, but not limited to, internal costs and gross margin objectives. Accordingly, revenue for post contract maintenance and support is recognized over the implied maintenance period of one to three years, and revenue for product sales is recognized upon delivery assuming all other revenue recognition criteria have been met.

TS Segment Revenue

TS Segment revenue is derived from the sale of hardware, software, financing of hardware and software, professional services, maintenance contracts and third party service contracts. TS product revenue is generally recognized when product is shipped, provided that all revenue recognition criteria are met. Service revenue consists of professional services which generally include implementation, installation, and training services. Revenue generated from standalone professional services is recognized as the services are completed, provided all other revenue recognition criteria have been

25

                            

met. Our standard sales agreements generally do not include customer acceptance provisions. However, in certain instances when arrangements include a customer acceptance provision or there is uncertainty about customer acceptance, revenue is deferred until we have evidence of customer acceptance.

Revenue derived from the sale of products, which are comprised of both hardware and software, and professional services is recognized in accordance with ASC 605-25. We evaluate multiple element arrangements to determine if separate units of accounting exist, and if so, we allocate revenue to each element based upon the relative selling price of each element. We determine selling price using BESP. Management’s determination of BESP is based on several factors, including, but not limited to, internal costs and gross margin objectives. Accordingly revenue for professional services is recognized as services are completed, and revenue for product sales is recognized upon delivery assuming all other revenue recognition criteria have been met.

We also recognize TS segment revenue from certain third party service contracts, which are evaluated to determine whether such service revenue should be recorded as gross sales or net sales in accordance with ASC 605-45. We evaluate all third party service contracts to determine whether we act as a principal in the transaction and assume the risks and rewards of ownership or if we are simply acting as an agent or broker. Under gross sales recognition, the entire selling price is recorded in sales and our cost to the third-party service provider or vendor is recorded in cost of goods sold. Under net sales recognition, the cost to the third-party service provider or vendor is recorded as a reduction to sales resulting in net sales equal to the gross profit on the transaction and there are no costs of goods sold. We use the net sales recognition method for the third party service contracts that we sell when we are not the primary obligor on the contract. We use the gross sales recognition for the third party service contracts that we sell when we act as principal and are the primary obligor.

Product Warranty Accrual
 
Our product sales generally include a 90-day to three-year hardware warranty. At time of product shipment, we accrue for the estimated cost to repair or replace potentially defective products. Estimated warranty costs are based upon prior actual warranty costs for substantially similar products.
 
Engineering and Development Expenses
 
Engineering and development expenses include payroll, employee benefits, stock-based compensation and other headcount-related expenses associated with product development. Engineering and development expenses also include third-party development and programming costs. We consider technological feasibility for our software products to be reached upon the release of the software, accordingly, no internal software development costs have been capitalized.

Income Taxes
 
We use the asset and liability method of accounting for income taxes whereby deferred tax assets and liabilities are recognized for the estimated future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using enacted tax rates in effect for the year in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date. We also reduce deferred tax assets by a valuation allowance if, based on the weight of available evidence, it is more likely than not that some portion or all of the recorded deferred tax assets will not be realized in future periods. This methodology requires estimates and judgments in the determination of the recoverability of deferred tax assets and in the calculation of certain tax liabilities. Valuation allowances are recorded against the gross deferred tax assets that management believes, after considering all available positive and negative objective evidence, historical and prospective, with greater weight given to historical evidence, that it is more likely than not that these assets will not be realized.
 
In addition, we are required to recognize in the consolidated financial statements, those tax positions determined to be more-likely-than-not of being sustained upon examination, based on the technical merits of the positions as of the reporting date. If a tax position is not considered more-likely-than-not to be sustained based solely on its technical merits, no benefits of the position are recognized.
 
In addition, the calculation of the Company's tax liabilities involves dealing with uncertainties in the application of complex tax regulations in a multitude of jurisdictions. The Company records liabilities for estimated tax obligations in the U.S. and other tax jurisdictions. These estimated tax liabilities include the provision for taxes that may become payable in the future.


26

                            

Intangible Assets
 
Intangible assets that are not subject to amortization are also required to be tested annually, or more frequently if events or circumstances indicate that the asset may be impaired. We did not have intangible assets with indefinite lives at any time during the two years ended September 30, 2018. Intangible assets subject to amortization are amortized over their estimated useful lives, generally three to ten years, and are carried at net book value. The remaining useful lives of intangible assets are evaluated on an annual basis. Intangible assets subject to amortization are also tested for recoverability whenever events or changes in circumstances indicate that their carrying amount may not be recoverable. If the fair value of an intangible asset subject to amortization is determined to be less than its carrying value, then an impairment charge is recorded to write down that asset to its fair value.
 
Inventories
 
Inventories are stated at the lower of cost or market, with cost determined using the first-in, first-out method. The recoverability of inventories is based upon the types and levels of inventories held, forecasted demand, pricing, competition and changes in technology. We write down our inventory for estimated obsolescence or unmarketable inventory equal to the difference between the cost of inventory and the estimated market value based upon assumptions about future demand and market conditions. If actual market conditions are less favorable than those projected by management, additional inventory write-downs may be required.

Pension and Retirement Plans
 
The funded status of pension and other post-retirement benefit plans is recognized prospectively on the consolidated balance sheet. Gains and losses, prior service costs and credits and any remaining transition amounts that have not yet been recognized through pension expense will be recognized in accumulated other comprehensive income, net of tax, until they are amortized as a component of net periodic pension/post-retirement benefits expense. Additionally, plan assets and obligations are measured as of our fiscal year-end balance sheet date (September 30).

We have defined benefit and defined contribution plans in the U.K. and in the U.S. In the U.K., the Company provides defined benefit pension plans for certain employees and former employees and defined contribution plans for the majority of the employees. The defined benefit plans in the U.K. are closed to newly hired employees and have been for the two years ended September 30, 2018. In the U.S., the Company provides defined contribution plans that cover most employees and supplementary retirement plans to certain employees and former employees who are now retired. These supplementary retirement plans are also closed to newly hired employees and have been for the two years ended September 30, 2018. These supplementary plans are funded through whole life insurance policies. The Company expects to recover all insurance premiums paid under these policies in the future, through the cash surrender value of the policies and any death benefits or portions thereof to be paid upon the death of the participant. These whole life insurance policies are carried on the balance sheet at their cash surrender values as they are owned by the Company and not assets of the defined benefit plans. In the U.S., the Company also provides for officer death benefits and post-retirement health insurance benefits through supplemental post-retirement plans to certain officers. The Company also funds these supplemental plans' obligations through whole life insurance policies on the officers.
 
Pension expense is based on an actuarial computation of current future benefits using estimates for expected return on assets, expected compensation increases and applicable discount rates. Management has reviewed the discount rates and rates of return with our consulting actuaries and investment advisers and concluded they were reasonable. A decrease in the expected return on pension assets would increase pension expense. Expected compensation increases are estimated based on historical and expected increases in the future. Increases in estimated compensation increases would result in higher pension expense while decreases would lower pension expense. Discount rates are selected based upon rates of return on high quality fixed income investments currently available and expected to be available during the period to maturity of the pension benefit. A decrease in the discount rate would result in greater pension expense while an increase in the discount rate would decrease pension expense.
 
The Company funds its pension plans in amounts sufficient to meet the requirements set forth in applicable employee benefits laws and local tax laws. Liabilities for amounts in excess of these funding levels are accrued and reported in the consolidated balance sheets.

Inflation and Changing Prices
 
Management does not believe that inflation and changing prices had significant impact on sales, revenues or income during fiscal years 2018 or 2017. There is no assurance that the Company's business will not be materially and adversely affected by inflation and changing prices in the future.

27

                            


Item 8.
Financial Statements and Supplementary Data
 
The consolidated financial statements are included herein.
 

Item 9.    Changes in and Disagreements with Accountants on Accounting and Financial Disclosures
None.

Item 9A.    Controls and Procedures

 Evaluation of Controls and Procedures

Disclosure Controls and Procedures. The Company evaluated the effectiveness of the design and operation of our disclosure controls and procedures as of September 30, 2018. Our Chief Executive Officer, our Chief Financial Officer and other members of our senior management team supervised and participated in this evaluation. The term “disclosure controls and procedures,” as defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act, means controls and other procedures of a company that are designed to ensure that information required to be disclosed by a company in the reports that it files or

28

                            

submits under the Exchange Act is recorded, processed, summarized and reported, within the time periods specified in the Securities and Exchange Commission's ("SEC") rules and forms. Disclosure controls and procedures include, without limitation, controls and procedures designed to ensure that information required to be disclosed by a company in the reports that it files or submits under the Exchange Act is accumulated and communicated to the company's management, including its principal executive and principal financial officers, as appropriate to allow timely decisions regarding required disclosure. Management recognizes that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving their objectives and management necessarily applies its judgment in evaluating the cost-benefit relationship of possible controls and procedures. Based on the evaluation of our disclosure controls and procedures as of September 30, 2018, the Company’s Chief Executive Officer and Chief Financial Officer concluded that, as of such date, our disclosure controls and procedures were effective. As discussed below, we concluded the prior year’s material weakness described in this Item 9A has been remediated by the changes we made in fiscal year 2018 in response to that material weakness.

Management's Report on Internal Control over Financial Reporting.

The Company's management is responsible for establishing and maintaining adequate internal control over financial reporting. As defined in Rule 13a-15(f) under the Exchange Act, internal control over financial reporting is a process designed by or under the supervision of a company's principal executive and principal financial officers and effected by a company's board of directors, management and other personnel, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with accounting principles generally accepted in the United States of America. It includes those policies and procedures that:

pertain to the maintenance of records that in reasonable detail accurately and fairly reflect the transactions and dispositions of the assets of a company;

provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles and that receipts and expenditures of a company are being made only in accordance with authorizations of management and the board of directors of a company; and

provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use or disposition of a company's assets that could have a material effect on its financial statements.

Management has assessed the effectiveness of the Company's internal control over financial reporting as of September 30, 2018. In making its assessment of internal control, management used the criteria described in “Internal Control-Integrated Framework” issued by the Committee of Sponsoring Organizations ("COSO") of the Treadway Commission. As a result of its assessment, management has concluded that the Company's internal control over financial reporting was effective as of September 30, 2018.

As of September 30, 2017, management had identified a material weakness. A material weakness is a deficiency, or combination of deficiencies, in internal control over financial reporting, such that there is a reasonable possibility that a material misstatement of the Company's annual or interim financial statements will not be prevented or detected in a timely basis.

The material weakness was in connection with our controls over the revenue recognition process at our foreign subsidiaries, specifically whether revenue recognition criteria have been satisfied prior to recognizing revenue and the failure to sufficiently assess gross versus net revenue indicators to certain revenue transactions. We determined that controls over the revenue recognition process, primarily in Germany, were not operating effectively and the resulting control deficiency amounted to a material weakness in our controls over financial reporting. As a result, we have concluded that the Company’s internal control over financial reporting was not effective as of September 30, 2017.

During the periods following our initial identification of the material weakness referred to above, management assessed various alternatives to remediate this material weakness and we implemented additional changes to our system of internal controls, which included the implementation of enhanced internal auditing procedures, whereby a comprehensive review form is prepared for all new revenue transactions. Our review process has been expanded to include corporate and TS accounting personnel reviews to ensure the correct accounting methodology is applied to all revenue transactions. We also created new revenue reports from the German ERP system to assist in the revenue transaction review process. During the twelve months ended September 30, 2017, management took additional actions to upgrade our international accounting staff with the hiring of a new controller at the beginning of fiscal year 2018 and added consultants to assist in the revenue transaction processing which improved accounting operations in our European divisions during fiscal year 2018.

29

                            


During the first three quarters of fiscal year 2018, we did not identify any deficiencies in the revenue recognition control process. In addition, on July 31, 2018 the German operations were sold. As a result, management has concluded the material weakness was remediated and that the Company's internal control over financial reporting was effective as of September 30, 2018.

Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

This Annual Report on Form 10-K does not include an attestation report of the Company's independent registered public accounting firm regarding internal control over financial reporting. Management's assessment of the effectiveness of the Company's internal control over financial reporting as of September 30, 2018 was not subject to attestation by the Company's independent registered public accounting firm pursuant to rules of the SEC that call for the Company to provide only management's report in this Annual Report on Form 10-K.

Changes in Internal Control over Financial Reporting.                    

During the quarter ended September 30, 2018, there were no changes in our internal control over financial reporting that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.


Item 9B.    Other Information
None.


PART III

Item 10.
Directors, Executive Officers and Corporate Governance
 
We incorporate the information required by this item by reference to the sections captioned “Nominees for Election”, “Our Board of Directors”, “Our Executive Officers”, “Section 16(a) Beneficial Ownership Reporting Compliance” and “Corporate Governance” in our Schedule 14A Proxy Statement for our 2019 Annual Meeting of Stockholders, to be filed with the SEC within 120 days after the end of our fiscal year ended September 30, 2018.

Item 11.
Executive Compensation
 
We incorporate the information required by this item by reference to the sections captioned “Compensation of Executive Officers” and “Compensation of Non-Employee Directors” in our Schedule 14A Proxy Statement for our 2019 Annual Meeting of Stockholders to be filed with the SEC within 120 days after the end of our fiscal year ended September 30, 2018.

Item 12.
Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters
 
Securities Authorized for Issuance Under Equity Compensation Plans.
 
The equity compensation plans approved by our stockholders consist of the CSP, Inc. 1997 Incentive Stock Option Plan, the 2003 Stock Incentive Plan, the 2007 Stock Incentive Plan, the 2014 Employee Stock Purchase Plan (the "ESPP") and the 2015 Stock Incentive Plan . In fiscal 2018 and 2017, the Company granted to certain key employees, certain officers including its Chief Executive Officer and non-employee directors shares of non-vested common stock instead of stock options. The vesting periods for the key employees', officers', the Chief Executive Officer's and the non-employee directors' non-vested stock awards are four years, three years and one year, respectively. The following table sets forth information as of September 30, 2018 regarding the total number of securities outstanding under these equity compensation plans.
 
 
(a) (1)(2)
 
(b)
 
(c) 
Plan Category
 
 
Number of securities to be
issued upon exercise of
outstanding options, warrants and rights  
 
Weighted-average
exercise price of outstanding
stock options, warrants and rights
 
Number of securities
remaining available for future
issuance under equity
compensation plans (excluding
securities reflected in column
(a))(3)
Equity compensation plans approved by security holders
 
157,852

 
$
3.42

 
252,156

 
(1)
Includes 154,352 non-vested shares issued.

30

                            

(2)
Does not include purchase rights under the ESPP, as the purchase price and number of shares to be purchased under the ESPP are not determined until the end of the relevant purchase period.
(3)
Includes 125,965 shares available for future issuance under the stock incentive and stock option plans and 126,191 under the ESPP.
  
We incorporate additional information required by this Item by reference to the section captioned “Security Ownership of Certain Beneficial Owners and Management” in our Schedule 14A Proxy Statement for our 2019 Annual Meeting of Stockholders to be filed with the SEC within 120 days after the end of our fiscal year ended September 30, 2018.

Item 13.
Certain Relationships and Related Transactions and Director Independence
 
We incorporate the information required by this item by reference to the section captioned “Corporate Governance” in our Schedule 14A Proxy Statement for our 2019 Annual Meeting of Stockholders to be filed with the SEC within 120 days after the end of our fiscal year ended September 30, 2018.

Item 14.
Principal Accountant Fees and Services
 
We incorporate the information required by this item by reference to the sections captioned “Fees for Professional Services” and “Pre-approval Policies and Procedures” in our Schedule 14A Proxy Statement for our 2019 Annual Meeting of Stockholders to be filed with the SEC within 120 days after the end of our fiscal year ended September 30, 2018.


PART IV

Item 15.
Exhibits and Financial Statement Schedules
 
(a)   (1)   Financial statements filed as part of this report:
 
Consolidated Balance Sheets as of September 30, 2018 and 2017
 
Consolidated Statements of Operations for the years ended September 30, 2018 and 2017

Consolidated Statements of Comprehensive Income for the years ended September 30, 2018 and 2017
 
Consolidated Statements of Shareholders' Equity for the years ended September 30, 2018 and 2017
 
Consolidated Statements of Cash Flows for the years ended September 30, 2018 and 2017
 
Notes to Consolidated Financial Statements
 
(2)   Financial statement schedules
 
All other financial statements and schedules not listed have been omitted since the required information is included in the consolidated financial statements or the notes thereto included in Item 8, or is not applicable, material or required.


31

                            

(3)   Exhibits
 
Exhibit
No.
 
Description 
 
Filed with
this Form
10-K
 
Incorporated by Reference
 
Form
 
Filing Date
 
Exhibit
No.
 
 
 
 
 
 
 
 
 
 
 
3.1
 
Articles of Organization and amendments thereto
 
 
 
10-K
 
December 26, 2007
 
3.1

3.2
 
By-laws, as amended December 13, 2012
 
 
 
10-K
 
December 20, 2012
 
3.1

10.1
 
Form of Employee Invention and Non-Disclosure Agreement
 
 
 
10-K
 
November 22, 1996
 
10.3

10.2
 
CSPI Supplemental Retirement Income Plan
 
 
 
10-K
 
December 29, 2008
 
10.2

10.3*
 
2007 Stock Incentive Plan
 
 
 
DEF 14A
 
March 30, 2007
 
B

10.4*
 
2014 Variable Compensation (Executive Bonus) and Base Programs dated November 12, 2013
 
 
 
10-K
 
December 23, 2014
 
10.10

10.5*
 
Death Benefit and Retirement Benefit Agreement between the Company and Victor Dellovo dated September 13, 2013
 
 
 
10-K
 
December 24, 2013
 
10.11

10.6*
 
Form of Change of Control Agreement with Gary W. Levine and William E. Bent Jr. each dated January 11, 2008
 
 
 
10-K
 
December 22, 2009
 
10.11

10.7*
 
2014 Employee Stock Purchase Plan
 
 
 
DEF 14A
 
January 6, 2014
 
A

10.8*
 
2015 Stock Incentive Plan
 
 
 
DEF 14A
 
January 5, 2015
 
A

10.9
 
2015 Lowell, MA Lease
 
 
 
10-K
 
December 24, 2015
 
10.21

10.10
 
2015 Deerfield Beach, FL Lease
 
 
 
10-K
 
December 24, 2015
 
10.20

10.11*
 
Executive Retention and Service Agreement with Victor Dellovo, dated September 4, 2012
 
 
 
10-Q
 
February 14, 2018
 
10.1

10.12*
 
Forms of Employee Restricted Stock Award Agreement
 
 
 
10-Q
 
February 14, 2018
 
10.2

10.13
 
Share Purchase and Assignment Agreement
 
 
 
8-K
 
June 27, 2018
 
2.1

 
Subsidiaries
 
X
 
 
 
 
 
 

 
Consent of RSM LLP, Independent Registered Public Accounting Firm
 
X
 
 
 
 
 
 

 
Certification of Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
 
X
 
 
 
 
 
 

 
Certification of Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
 
X
 
 
 
 
 
 

 
Certification of Chief Executive Officer and Chief Financial Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
 
X
 
 
 
 
 
 

101.INS
 
XBRL Instance
 
 
 
 
 
 
 
 
101.SCH
 
XBRL Taxonomy Schema
 
 
 
 
 
 
 
 
101.CAL
 
XBRL Taxonomy Extension Calculation
 
 
 
 
 
 
 
 
101.DEF
 
XBRL Taxonomy Extension Definition
 
 
 
 
 
 
 
 
101.LAB
 
XBRL Taxonomy Extension Labels
 
 
 
 
 
 
 
 
101.PRE
 
XBRL Taxonomy Extension Presentation
 
 
 
 
 
 
 
 
*
Management contract or compensatory plan.


Item 16.
Form 10-K Summary

None.

32

                            

SIGNATURES
 
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
 
 
 
 
CSP INC.
By:
/s/ Victor Dellovo
 
Victor Dellovo
Chief Executive Officer and President
 
Date: December 27, 2018
 
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated.
 
Name
 
 Title 
 
 Date 
  /s/ Victor Dellovo
 
Chief Executive Officer, President and Director
 
December 27, 2018
Victor Dellovo
 
 
 
/s/ Gary W. Levine
 
Chief Financial Officer
(Principal Financial Officer)
 
December 27, 2018
Gary W. Levine
 
 
 
/s/ Mike Newbanks
 
Vice President of Finance
(Chief Accounting Officer)
 
December 27, 2018
Mike Newbanks
 
 
 
/s/ C. Shelton James
 
Director
 
December 27, 2018
C. Shelton James
 
 
 
 
/s/ Raymond Charles Blackmon
 
Director
 
December 27, 2018
Raymond Charles Blackmon
 
 
 
 
/s/ Marilyn T. Smith
 
Director
 
December 27, 2018
Marilyn T. Smith
 
 
 
 
/s/ Izzy Azeri
 
Director
 
December 27, 2018
Izzy Azeri
 
 
 
 






33

                            





Report of Independent Registered Public Accounting Firm
 
 
To the Shareholders and the Board of Directors of CSP Inc. and Subsidiaries
 
Opinion on the Financial Statements
We have audited the accompanying consolidated balance sheets of CSP Inc. and Subsidiaries (the “Company”) as of September 30, 2018 and 2017, the related consolidated statements of operations, comprehensive income, shareholders' equity and cash flows for the years then ended, and the related notes to the consolidated financial statements (collectively, the financial statements). In our opinion, the financial statements present fairly, in all material respects, the financial position of the Company as of September 30, 2018 and 2017, and the results of its operations and its cash flows for the years then ended, in conformity with accounting principles generally accepted in the United States of America.

Basis for Opinion
These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on the Company’s financial statements based on our audits. We are a public accounting firm registered with the Public Company Accounting Oversight Board (United States) (PCAOB) and are required to be independent with respect to the Company in accordance with U.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB.
 
We conducted our audits in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement, whether due to error or fraud. The Company is not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting. As part of our audits we are required to obtain an understanding of internal control over financial reporting but not for the purpose of expressing an opinion on the effectiveness of the Company's internal control over financial reporting. Accordingly, we express no such opinion.
 
Our audits included performing procedures to assess the risks of material misstatement of the financial statements, whether due to error or fraud, and performing procedures that respond to those risks. Such procedures included examining, on a test basis, evidence regarding the amounts and disclosures in the financial statements. Our audits also included evaluating the accounting principles used and significant estimates made by management, as well as evaluating the overall presentation of the financial statements. We believe that our audits provide a reasonable basis for our opinion.
 
/s/ RSM US LLP

We have served as the Company’s auditor since 2007.
 
Boston, Massachusetts
December 27, 2018


34

                            

CSP INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(Amounts in thousands, except par value)
 
September 30,
2018
 
September 30,
2017
ASSETS
 
 
 
Current assets:
 
 
 
Cash and cash equivalents
$
25,107

 
$
10,421

Accounts receivable, net of allowances of $87 and $120
11,980

 
17,673

Unbilled accounts receivable
1,166

 
703

Investment in lease, net-current portion
246

 

Inventories
7,558

 
5,567

Deferred costs

 
19

Refundable income taxes
480

 

Other current assets
1,878

 
1,076

Current assets of discontinued operations

 
14,867

Total current assets
48,415

 
50,326

Property, equipment and improvements, net
847

 
919

 
 
 
 
Other assets:
 

 
 

Intangibles, net
48

 
167

Investment in lease, net-less current portion
564

 

Deferred income taxes
1,895

 
1,963

Cash surrender value of life insurance
3,441

 
3,300

Other assets
65

 
65

Noncurrent assets of discontinued operations

 
2,188

Total other assets
6,013

 
7,683

Total assets
$
55,275

 
$
58,928

 
 
 
 
LIABILITIES AND SHAREHOLDERS’ EQUITY
 
 
 
Current liabilities:
 
 
 
Accounts payable and accrued expenses
$
12,524

 
$
14,895

Deferred revenue
1,197

 
938

Pension and retirement plans
340

 
325

Income taxes payable

 
138

Current liabilities of discontinued operations

 
9,727

Total current liabilities
14,061

 
26,023

Pension and retirement plans
6,168

 
6,653

Income taxes payable non-current
709

 

Other long term liabilities
535

 
29

Noncurrent liabilities of discontinued operations

 
5,222

Total liabilities
21,473

 
37,927

 
 
 
 
Commitments and contingencies


 


 
 
 
 
Shareholders’ equity:
 
 
 
Common stock, $.01 par value per share; authorized, 7,500 shares; issued and outstanding 4,017 and 3,935 shares, respectively
40

 
40

Additional paid-in capital
14,661

 
13,717

Retained earnings
29,926

 
17,407

Accumulated other comprehensive loss
(10,825
)
 
(10,163
)
Total shareholders’ equity
33,802

 
21,001

Total liabilities and shareholders’ equity
$
55,275

 
$
58,928

 
See accompanying notes to consolidated financial statements.

35

                            

CSP INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
(Amounts in thousands, except for per share data)

 
For the years ended
 
September 30,
2018
 
September 30,
2017
Sales:
 
 
 
Product
$
59,661

 
$
76,353

Services
13,255

 
12,139

Total sales
72,916

 
88,492

 
 
 
 
Cost of sales:
 
 
 
Product
50,000

 
64,497

Services
4,517

 
2,572

Total cost of sales
54,517

 
67,069

 
 
 
 
Gross profit
18,399

 
21,423

 
 
 
 
Operating expenses:
 
 
 
Engineering and development
3,277

 
2,362

Selling, general and administrative
16,723

 
15,666

Total operating expenses
20,000

 
18,028

Operating income (loss)
(1,601
)
 
3,395

 
 
 
 
Other income (expense):
 
 
 
Foreign exchange gain (loss)
263

 
(42
)
Other income, net
232

 
52

Total other income, net
495

 
10

Income (loss) before income taxes and discontinued operations
(1,106
)
 
3,405

Income tax expense
882

 
1,162

Net income (loss) from continuing operations
(1,988
)
 
2,243

Discontinued operations:
 
 
 
Gain from sale of discontinued operations
16,838

 

Income (loss) from discontinued operations
(410
)
 
263

Net income from discontinued operations
16,428

 
263

Net income
$
14,440

 
$
2,506

Net income attributable to common shareholders
$
13,842

 
$
2,398

 
 
 
 
Net income (loss) per share from continuing operations - basic
$
(0.52
)
 
$
0.57

Gain per share from sale of discontinued operations - basic
$
4.41

 
$

Income (loss) per share of discontinued operations - basic
(0.11
)
 
0.07

Total income per share of discontinued operations - basic
$
4.30

 
$
0.07

Net income per share – basic
$
3.62

 
$
0.64

Weighted average shares outstanding – basic
3,822

 
3,723

 
 
 
 
Net income (loss) per share from continuing operations - diluted
$
(0.52
)
 
$
0.56

Gain per share from sale of discontinued operations - diluted
$
4.32

 
$

Income (loss) per share of discontinued operations - diluted
(0.11
)
 
0.07

Total income per share of discontinued operations - diluted
$
4.21

 
$
0.07

Net income per share – diluted
$
3.55

 
$
0.63

Weighted average shares outstanding – diluted
3,901

 
3,817

 
See accompanying notes to consolidated financial statements.

36

                            

CSP INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
(Amounts in thousands)

 
 
For the years ended
 
 
September 30,
2018
 
September 30,
2017
 
 
 
 
 
Net income
 
$
14,440

 
$
2,506

Other comprehensive income (loss):
 
 
 
 
Unrealized actuarial gain on minimum pension liability, net of tax effect
 
470

 
2,175

Foreign currency translation loss
 
(1,132
)
 
(407
)
Other comprehensive gain (loss)
 
(662
)
 
1,768

Total comprehensive income
 
$
13,778

 
$
4,274


See accompanying notes to consolidated financial statements.


37

                            

CSP INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENT OF SHAREHOLDERS’ EQUITY
For the Year Ended September 30, 2018:
(Amounts in thousands)
 
Shares
 
Amount
 
Additional
Paid-in
Capital
 
Retained
Earnings
 
Accumulated
other
comprehensive
loss
 
Total
Shareholders’
Equity
Balance as of September 30, 2016
3,821

 
$
39

 
$
12,924

 
$
16,623

 
$
(11,931
)
 
$
17,655

Comprehensive income:
 
 
 
 
 
 
 
 
 
 
 
Net income

 

 

 
2,506

 

 
2,506

Other comprehensive income

 

 

 

 
1,768

 
1,768

Stock-based compensation

 

 
577

 

 

 
577

Restricted stock issuance
86

 
1

 

 

 

 
1

Issuance of shares under employee stock purchase plan
23

 

 
201

 

 

 
201

Exercise of stock options
5

 
 
 
15

 

 

 
15

Cash dividends on common stock ($0.44 per share)

 

 

 
(1,722
)
 

 
(1,722
)
Balance as of September 30, 2017
3,935

 
40

 
13,717

 
17,407

 
(10,163
)
 
21,001

Comprehensive income:
 
 
 
 
 
 
 
 
 
 
 
Net income

 

 

 
14,440

 

 
14,440

Other comprehensive loss

 

 

 

 
(662
)
 
(662
)
Stock-based compensation

 

 
691

 

 

 
691

Restricted stock issuance
54

 

 

 

 

 

Issuance of shares under employee stock purchase plan
23

 

 
231

 

 

 
231

Exercise of stock options
5

 

 
22

 

 

 
22

Cash dividends on common stock ($0.48 per share)

 

 

 
(1,921
)
 

 
(1,921
)
Balance as of September 30, 2018
4,017