CSPI

CSP Inc. 10-Q Summary: Quarter Ended December 31, 2006

Business Context and Reporting Period

CSP Inc. (CSP) is a provider of IT integration solutions and high-performance cluster computer systems, operating through two segments: Systems and Service and System Integration. This report covers the quarterly period ended December 31, 2006 (Fiscal Q1 2007). The filing was submitted late; on February 16, 2007, CSP received notice from Nasdaq that its common stock was subject to delisting due to the untimely filing of this report. A hearing was held on March 1, 2007.

Key Financial Metrics

Material Changes vs. Prior Period

• Revenue Growth: Total sales increased 40% ($6.0 million) year-over-year. The Systems segment drove this growth with a 227% increase in sales, largely due to $4.9 million in shipments from a new Raytheon contract. The Service and System Integration segment grew 16%.
• Profitability Turnaround: The company moved from an operating loss of $0.5 million in Q1 2006 to an operating income of $1.8 million in Q1 2007. Net income improved from a loss of $0.55 million to $0.98 million.
• Margin Expansion: Gross margin improved from 20% to 27%, and operating margin shifted from -3% to 8%. This was driven by a favorable shift in product mix toward the higher-margin Systems segment.
• Cash Flow: Operating cash flow turned positive, generating $3.5 million compared to a $0.25 million outflow in the prior year, primarily due to collections from Raytheon and improved net income.
• Customer Concentration: Raytheon Corp. accounted for 24% of consolidated revenues ($5.0 million) in Q1 2007. Atos Origin GmbH accounted for 14% ($2.9 million).

Outlook, Risks, and Management Commentary

• Internal Control Deficiencies: Management concluded that disclosure controls and procedures were not effective as of December 31, 2006. Material weaknesses were identified regarding revenue recognition, accounts payable cutoffs, and tax provision calculations at the Modcomp Systems and Solutions Division. These issues caused delays in filing the 10-K and this 10-Q.
• Remediation Plan: CSP plans to hire a Division CFO and a Vice President of Finance/Chief Accounting Officer, and implement new IT solutions to improve financial reporting accuracy and timeliness by the end of fiscal 2007.
• Liquidity: Management believes current cash, investments ($14.5 million combined), and operating cash flow are sufficient for foreseeable working capital needs. However, the company noted that if operations do not generate sufficient cash, it may need to access bank loans or sell securities, with no assurance of favorable terms.
• Market Risks: The company faces risks related to rapidly changing technology, short product life cycles, and dependence on government and large commercial customers. A decline in the dollar against the Euro and Pound Sterling positively impacted reported revenues by approximately $0.6 million.

Investor Verification Checklist

• Delisting Status: Verify the current status of the Nasdaq delisting proceedings initiated on February 16, 2007.
• Raytheon Contract Sustainability: Assess the duration and renewal probability of the Raytheon contract, which drove 24% of quarterly revenue.
• Internal Control Remediation: Monitor progress on hiring new finance leadership and implementing IT controls to ensure timely future filings.
• Customer Concentration: Evaluate the risk associated with reliance on a few large customers (Raytheon, Atos Origin) for nearly 40% of revenue.
• Valuation Allowance Reversal: Review the $1.4 million deferred tax asset benefit recognized in the prior fiscal year's Q4 and the assumptions regarding future U.S. taxable income.