CSP (CSPI) 10-Q 2006 Q2 Quarterly report

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

x QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the Quarterly Period Ended June 30, 2006.

¨ 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 0-10843

CSP Inc.

(Exact name of Registrant as specified in its Charter)

Massachusetts	04-2441294
(State of incorporation)	(I.R.S. Employer Identification No.)

43 Manning Road

Billerica, Massachusetts 01821-3901

(978) 663-7598

(Address and telephone number of principal executive offices)

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

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

Large accelerated filer  ¨    Accelerated filer  ¨    Non-accelerated filer  x

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).    Yes  ¨    No  x

As of August 11, 2006, the registrant had 3,686,722 shares of common stock issued and outstanding.

EXPLANATORY NOTE

RESTATEMENT OF UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

This Form 10-Q includes a restatement of our unaudited consolidated statement of cash flows for the nine months ended June 30, 2005, which was originally contained in our Form 10-Q filed on August 15, 2005.

On March 15, 2006, the Company’s management and the Audit Committee of the Board of Directors determined that the Company’s unaudited consolidated balance sheet as of June 30, 2005 and unaudited consolidated statement of cash flows for the nine months ended June 30, 2005 required restatement, as described below.

During the fiscal 2005 year-end close process, we determined that we incorrectly classified certain highly liquid investments with maturities of three months or less as short-term investments, rather than as cash equivalents. In addition, certain investments with maturity dates of more than one year were incorrectly reported as short-term, rather than long-term, and we also identified other misclassifications within the cash flows statement related to tax and the foreign exchange effects on cash. These determinations led to the restatement of our consolidated balance sheets at September 30, 2004 and 2003 as well as our consolidated statements of cash flows for the fiscal years then ended, as discussed in our Form 10-K for the fiscal year ended September 30, 2005, filed March 17, 2006. In this Form 10-Q, our unaudited consolidated statement of cash flows for the nine months ended June 30, 2005 has been restated (1) due to the quarterly impact of these classification errors, (2) due to additional misclassifications that affected the net cash provided by or used in operating and investing activities, and (3) in order to correct the effects of changes in exchange rates on cash.

See “Note 2, Restatement,” in the Notes to Unaudited Consolidated Financial Statements for further details.

INDEX

		Page
PART I. FINANCIAL INFORMATION
Item 1.	Financial Statements
	Unaudited Consolidated Balance Sheets as of June 30, 2006 and September 30, 2005	3
	Unaudited Consolidated Statements of Operations for the three and nine months ended June 30, 2006 and 2005	4
	Unaudited Consolidated Statements of Cash Flows for the nine months ended June 30, 2006 and 2005 (Restated)	5
	Notes to Unaudited Consolidated Financial Statements	6-17
Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	18-29
Item 3.	Quantitative and Qualitative Disclosures about Market Risk	29
Item 4.	Controls and Procedures	30
PART II. OTHER INFORMATION
Item 1A.	Risk Factors	30
Item 6.	Exhibits	30
	Certifications

2

CSP INC. AND SUBSIDIARIES

UNAUDITED CONSOLIDATED BALANCE SHEETS

(Amounts in thousands, except par value)

	June 30, 2006			September 30, 2005
ASSETS
Current assets:
Cash and cash equivalents	$	10,811		$	9,724
Short-term investments		2,714			3,003
Accounts receivable, net of allowances of $84 in 2006 and $89 in 2005		11,492			6,891
Inventories		5,213			3,711
Refundable income taxes		41			26
Other current assets		1,419			897
Total current assets		31,690			24,252
Property, equipment and improvements, net		1,153			1,179
Other assets:
Long-term investments		—			249
Goodwill		2,779			2,779
Deferred income taxes		380			356
Cash surrender value life insurance		2,097			1,989
Other assets		338			140
Total other assets		5,594			5,513
Total assets	$	38,437		$	30,944
LIABILITIES AND SHAREHOLDERS’ EQUITY
Current liabilities:
Accounts payable and accrued expenses	$	12,062		$	6,200
Pension and retirement plans		394			438
Income taxes payable		1,118			943
Total current liabilities		13,574			7,581
Pension and retirement plans		7,684			7,129
Deferred income taxes		222			166
Total Liabilities		21,480			14,876
Commitments and contingencies
Shareholders’ equity:
Common stock, $.01 par; authorized, 7,500 shares; issued 3,687 and 3,671 shares, respectively		37			37
Additional paid-in capital		10,697			10,377
Retained earnings		9,668			9,285
Accumulated other comprehensive loss		(3,445	)		(3,631	)
Total shareholders’ equity		16,957			16,068
Total liabilities and shareholders’ equity	$	38,437		$	30,944

See accompanying notes to unaudited consolidated financial statements.

3

CSP INC. AND SUBSIDIARIES

UNAUDITED CONSOLIDATED STATEMENTS OF OPERATIONS

(Amounts in thousands, except for per share data)

	For the three months ended					For the nine months ended
	June 30, 2006			June 30, 2005		June 30, 2006			June 30, 2005
Sales:
Product	$	14,468		$	7,612	$	41,342		$	33,926
Services		4,088			3,931		9,957			10,431
Total sales		18,556			11,543		51,299			44,357
Cost of sales:
Product		12,588			5,774		33,388			25,703
Services		2,571			2,202		6,698			6,664
Total cost of sales		15,159			7,976		40,086			32,367
Gross profit		3,397			3,567		11,213			11,990
Operating expenses:
Engineering and development		500			602		1,579			2,066
Selling, general and administrative		2,983			2,771		9,244			8,299
Total operating expenses		3,483			3,373		10,823			10,365
Operating income (loss)		(86	)		194		390			1,625
Other income (expense):
Foreign exchange gain (loss)		(3	)		3		(5	)		(25	)
Other income, net		71			65		309			174
Total other income, net		68			68		304			149
Income (loss) from continuing operations before income taxes		(18	)		262		694			1,774
Provision for income taxes		26			97		251			557
Income (loss) from continuing operations		(44	)		165		443			1,217
Income (loss) from discontinued operations		—			46		—			(19	)
Net income (loss)	$	(44	)	$	211	$	443		$	1,198
Income (loss) per share from continuing operations – basic	$	(0.01	)	$	0.05	$	0.12		$	0.34
Income (loss) per share from discontinued operations – basic		—			0.01		—			(0.01	)
Net income (loss) per share – basic	$	(0.01	)	$	0.06	$	0.12		$	0.33
Weighted average shares outstanding – basic		3,685			3,634		3,682			3,600
Income (loss) per share from continuing operations – diluted	$	(0.01	)	$	0.05	$	0.12		$	0.32
Income (loss) per share from discontinued operations – diluted		—			0.01		—			(0.01	)
Net income (loss) per share – diluted	$	(0.01	)	$	0.06	$	0.12		$	0.31
Weighted average shares outstanding – diluted		3,685			3,828		3,791			3,806

See accompanying notes to unaudited consolidated financial statements

4

CSP INC. AND SUBSIDIARIES

UNAUDITED CONSOLIDATED STATEMENTS OF CASH FLOWS

(Amounts in thousands)

	For the nine months ended
	June 30, 2006			June 30, 2005 (Restated)
Cash flows from operating activities:
Net income	$	443		$	1,198
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation		410			455
Gain on foreign currency transactions		—			25
Loss on disposal of property, net		5			7
Non-cash changes in accounts receivable		56			(8	)
Non-cash compensation expense related to stock options		202			—
Deferred income taxes		53			160
Increase in cash surrender value of life insurance		(17	)		(117	)
Changes in operating assets and liabilities:
(Increase) decrease in accounts receivable		(4,340	)		1,572
Increase in inventories		(1,445	)		(583	)
Increase in refundable income taxes		(12	)		(24	)
Increase in other current assets		(473	)		(616	)
Increase in other assets		(198	)		(53	)
Increase (decrease) in accounts payable and accrued expenses		5,503			(784	)
Increase in pension and retirement plans		235			218
Increase in income taxes payable		155			342
Decrease in other liabilities		—			(20	)
Operating cash flows used in discontinued operations		—			(111	)
Net cash provided by operating activities		577			1,661
Cash flows from investing activities:
Purchases of available-for-sale securities		(31	)		(80	)
Purchases of held-to-maturity securities		(1,877	)		(3,321	)
Sales of available-for-sale securities		343			49
Maturities of held-to-maturity securities		2,073			3,280
Life insurance premiums paid		(91	)		(90	)
Proceeds from sale of property and equipment		—			472
Purchases of property, equipment and improvements		(396	)		(442	)
Investing cash flows used in discontinued operations		—			(13	)
Net cash provided by (used in) investing activities		21			(145	)
Cash flows from financing activities:
Proceeds from stock issued from exercise of options		11			436
Proceeds from issuance of stock under employee stock purchase plan		158			87
Purchase of common stock		(110	)		—
Net cash provided by financing activities		59			523
Effects of exchange rate changes on cash		430			(188	)
Net increase in cash and cash equivalents		1,087			1,851
Cash and cash equivalents, beginning of period		9,724			9,831
Cash and cash equivalents, end of period	$	10,811		$	11,682
Supplementary cash flow information:
Cash paid for income taxes	$	91		$	56
Cash paid for interest	$	89		$	107

See accompanying notes to unaudited consolidated financial statements.

5

CSP INC. AND SUBSIDIARIES

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

THREE AND NINE MONTHS ENDED JUNE 30, 2006 AND 2005

Organization and Business

CSP Inc. (CSPI or the Company) was founded in 1968 and is based in Billerica, Massachusetts. To meet the diverse requirements of its industrial, commercial, scientific and defense customers worldwide, CSPI and its subsidiaries develop and market IT integration solutions and high-performance cluster computer systems. The Company operates in two segments, its Systems segment and its Service and system integration segment.

1. Basis of Presentation

The accompanying financial statements have been prepared by the Company, without audit, and reflect all adjustments which, in the opinion of management, are necessary for a fair statement of the results of the interim periods presented. All adjustments were of a normal recurring nature. Certain information and footnote disclosures normally included in the annual financial statements, which are prepared in accordance with accounting principles generally accepted in the United States of America, have been condensed or omitted. Accordingly, the Company believes that although the disclosures are adequate to make the information presented not misleading, the financial statements should be read in conjunction with the footnotes contained in the Company’s Annual Report on Form 10-K for the fiscal year ended September 30, 2005.

2. Restatement

On March 15, 2006, the Company’s management and the Audit Committee of the Board of Directors determined that the Company’s unaudited consolidated balance sheet as of March 31, 2005 and unaudited consolidated statement of cash flows for the nine months ended June 30, 2005 required restatement, as described below.

During the fiscal 2005 year-end close process, we determined that we incorrectly classified certain highly liquid investments with maturities of three months or less as short-term investments, rather than as cash equivalents. In addition, certain investments with maturity dates of less than one year were incorrectly reported as long-term, rather than short-term, and we also identified other misclassifications within the cash flow statement related to tax and the foreign exchange effects on cash. The Company restated $3.9 million from short-term investments to cash and cash equivalents and $491 thousand from long-term investments to short-term investments as of June 30, 2005. The Company re-analyzed its unaudited consolidated statement of cash flows for the nine months ended June 30, 2005 and identified additional misclassifications. In this Form 10-Q, our unaudited consolidated statement of cash flows for the nine months ended June 30, 2005 has been restated due to these classification errors.

The restatements reflected in the table below affected the subtotals of net cash used in operating activities, net cash provided by or used in investing activities, and the effects of changes in exchange rates on cash. The changes made to the statements were made in order to (1) properly state our investing activities related to our short and long-term investments and cash equivalents, (2) correct the effects of misclassifications of the foreign exchange movements on the various classifications, and (3) properly classify the change in the cash surrender value of insurance policies.

6

The table below also reflects the impact of certain reclassifications made to the consolidated cash flows statement as required by Statement of Financial Accounting Standards No. 95, “Statements of Cash Flows,” to reflect the impact of the discontinued operation.

CSP INC. AND SUBSIDIARIES

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

THREE AND NINE MONTHS ENDED JUNE 30, 2006 AND 2005

2. Restatement, continued

	Unaudited Consolidated Statement of Cash Flows for the nine months ended June 30, 2005
	As reported			Restatement Adjustment			As Restated
	(Amounts in thousands)
Cash flows from operating activities:
Net income	$	1,217			(19	)	$	1,198
Adjustments to reconcile net income to net cash used in operating activities:
Depreciation		455						455
Loss on foreign currency transactions		25			—			25
Loss on disposal of property, net		7			—			7
Non-cash changes in accounts receivable		58			(66	)		(8	)
Deferred income taxes		(113	)		273			160
Increase in cash surrender value of life insurance		—			(117	)		(117	)
Changes in operating assets and liabilities:
Decrease in accounts receivable		1,507			65			1,572
Increase in inventories		(583	)		—			(583	)
Increase in refundable income taxes		(36	)		12			(24	)
Increase in other current assets		(206	)		(410	)		(616	)
Increase in other assets		(180	)		127			(53	)
Decrease in accounts payable and accrued expenses		(785	)		1			(784	)
Increase in pension and retirement plans		218			—			218
Increase in income taxes payable		974			(632	)		342
Decrease in other liabilities		(20	)		—			(20	)
Operating cash flows provided by discontinued operations		—			(111	)		(111	)
Net cash provided by operating activities		2,538			(877	)		1,661
Cash flows from investing activities:
Purchases of available-for-sale securities		(117	)		37			(80	)
Purchases of held-to-maturity securities		(7,231	)		3,910			(3,321	)
Sales of available-for-sale securities		114			(65	)		49
Maturities of held-to-maturity securities		10,047			(6,767	)		3,280
Life insurance premiums paid		(207	)		117			(90	)
Proceeds from the sale of property and equipment		30			442			472
Purchases of property, equipment and improvements		(442	)		—			(442	)
Investing cash flows used in discontinued operations		—			(13	)		(13	)
Net cash provided by (used in) investing activities		2,194			(2,339	)		(145	)
Cash flows from financing activities:
Proceeds from stock issued from exercise of options		436			—			436
Proceeds from issuance of stock under employee stock purchase plan		87			—			87
Net cash provided by financing activities		523			—			523
Effects of exchange rate changes on cash		(224	)		36			(188	)
Net cash used in discontinued operations		(143	)		143			—
Net increase (decrease) in cash and cash equivalents		4,888			(3,037	)		1,851
Cash and cash equivalents, beginning of period		2,880			6,951			9,831
Cash and cash equivalents, end of period	$	7,768		$	3,914		$	11,682

7

CSP INC. AND SUBSIDIARIES

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

THREE AND NINE MONTHS ENDED JUNE 30, 2006 AND 2005

3. Use of Estimates

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

4. Recent Accounting Pronouncements

In December 2004, the FASB issued SFAS No. 123R, “Share-Based Payment”, which establishes standards for transactions in which an entity exchanges its equity instruments for goods or services. This Statement requires a public entity to measure the cost of employee services received in exchange for an award of equity instruments based on the grant-date fair value of the award. The compensation expense will be recognized over the period during which an employee is required to provide service in exchange for the award. The Company adopted the statement on October 1, 2005.

In November 2005, the FASB issued FSP FAS 123(R)-3, “Transition Election Related to Accounting for the Tax Effects of Share-Based Payment Awards” (“FSP 123R-3”). FSP 123R-3 provides a simplified alternative method to calculate the beginning pool of excess tax benefits against which excess future deferred tax assets (that result when the compensation cost recognized for an award exceeds the ultimate tax deduction) could be written off under Statement 123R. The guidance in FSP 123R-3 was effective on November 10, 2005. We may make a one-time election to adopt the transition method described in FSP 123R-3 before the end of our fiscal year ending September 30, 2006. We are currently evaluating the available transition alternatives of FSP 123R-3.

In November 2005, the FASB issued staff position FAS 115-1,The Meaning of Other-Than-Temporary Impairment and its Application to Certain Investments(“FSP 115-1”). FSP 115-1 address the determination as to when an investment is considered impaired, whether that impairment is other than temporary and the measurement of an impairment loss. FSP 115-1 also includes accounting considerations subsequent to the recognition of an other-than-temporary impairment and requires certain disclosures about unrealized losses that have not been recognized as other-than-temporary impairments. The guidance in FSP 115-1 amends FASB Statements No. 115,Accounting for Certain Investments in Debt and Equity Securities, and APB Opinion No. 18,The Equity Method of Accounting for Investments in Common Stock.

FSP 115-1 replaces the impairment evaluation guidance of EITF Issue No. 03-1,The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments(“EITF 03-1”), with references to existing other-than-temporary impairment guidance. EITF 03-1’s disclosure requirements remain in effect, and are applicable for year-end reporting and for interim periods if there are significant changes from the previous year-end. FSP 115-1 also supersedes EITF Topic No. D-44,Recognition of Other-Than-Temporary Impairment upon the Planned Sale of a Security Whose Cost Exceeds Fair Value, and clarifies that an investor should recognize an impairment loss no later than when the impairment is deemed other-than-temporary, even if a decision to sell an impaired security has not been made. FSP 115-1 applies to reporting periods beginning after December 15, 2005. FSP 115-1 did not have a material impact on our results of operations, or cash flows for the three and nine months ended June 30, 2006.

In February 2006, the FASB issued SFAS No. 155, “Accounting for Certain Hybrid Instruments,” which amends SFAS Nos. 133 and 140. SFAS No. 155 allows financial instruments that have embedded derivatives to be accounted for as a whole if the holder elects to account for the whole instrument on a fair value basis. The statement is effective for all financial instruments acquired or issued after Jan. 1, 2007. The Company is in the process of evaluating the effect of the adoption and implementation of SFAS No. 155, which is not expected to have a material impact on its financial condition, results of operation or cash flows.

In June 2006, the Financial Accounting Standards Board (“FASB”) issued FASB Interpretation No. 48, “Accounting for Uncertainty in Income Taxes” (“FIN 48”), which applies to all tax positions accounted for under SFAS No. 109. FIN 48 prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. FIN 48 also provides guidance on derecognition of such tax positions, classification, interest and penalties, accounting in interim periods and disclosure. FIN 48 is applicable to the Company as of October 1, 2007, the first day of fiscal 2008. The Company is in the process of evaluating FIN 48 and the effect it will have on its financial position and results of operations.

8

CSP INC. AND SUBSIDIARIES

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

THREE AND NINE MONTHS ENDED JUNE 30, 2006 AND 2005

5. Reclassifications

Certain reclassifications were made to the 2005 financial statements to conform to the 2006 presentation.

6. Earnings Per Share of Common Stock

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

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

	For the three months ended					For the nine months ended
	Amounts in Thousands except per share data.
	June 30, 2006			June 30, 2005		June 30, 2006		June 30, 2005
Income (loss) from continuing operations	$	(44	)	$	165	$	443	$	1,217
Weighted average number of shares outstanding – basic		3,685			3,634		3,682		3,600
Incremental shares from the assumed exercise of stock options		—			194		109		206
Weighted average number of shares outstanding – dilutive		3,685			3,828		3,791		3,806
Income (loss) per share from continuing operations – basic	$	(0.01	)	$	0.05	$	0.12	$	0.34
Income (loss) per share from continuing operations – diluted	$	(0.01	)	$	0.05	$	0.12	$	0.32

SFAS No. 128 requires all anti-dilutive securities including stock options, to be excluded from the diluted earnings per share computation. For the nine months ended June 30, 2006, options of 145,000 were excluded from the diluted net income per share calculation. For the three and nine months ended June 30, 2005, 84,500 were excluded from the net income per share calculation.

9

CSP INC. AND SUBSIDIARIES

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

THREE AND NINE MONTHS ENDED JUNE 30, 2006 AND 2005

7. Stock Options and Awards

In 1997, the Company adopted the 1997 Stock Option Plan covering 199,650 shares. In 1991, the Company adopted the 1991 Stock Option Plan covering 332,750 shares of common stock. In 2003, the Company adopted the 2003 Stock Incentive Plan which covers 200,000 shares of common stock. The 2003 Stock Incentive Plan also provides for awards of restricted and unrestricted stock. Under all of the plans, both incentive stock options and non-qualified stock options may be granted to officers, key employees and other persons providing services to the Company. The stock option plans provide for issuances of options at their fair market value on the date of grant. Except for options granted to non-employee directors of the Company, the options vest over four years and expire ten years from the date of grant. In the 2003 Stock Incentive Plan, an annual non-discretionary grant of 2,500 options will be granted to each of the non-employee directors of the Company who are serving on the board. The options granted to non-employee directors vest after six months and expire three years from the date of grant. In 2003, the Company issued non-qualified stock options to non-officer employees hired as part of the Technisource acquisition. These options were granted at their fair value on the date of grant. These options vest over a period of four years and expire ten years from the date of grant.

On October 1, 2005, the Company adopted Statement of Financial Accounting Standards No. 123 (revised 2004), “Share-Based Payment,” (“SFAS No. 123(R)”) which requires the measurement and recognition of compensation expense for all stock-based payment awards made to employees and directors including employee stock options and employee stock purchases based on estimated fair values. In March 2005, the Securities and Exchange Commission issued Staff Accounting Bulletin No. 107 (“SAB 107”) relating to SFAS No. 123(R). The Company has applied the provisions of SAB 107 in its adoption of SFAS No. 123(R).

SFAS No. 123(R) requires companies to estimate the fair value of stock-based payment awards on the date of grant using an option-pricing model. The value of the portion of the award that is ultimately expected to vest is recognized as expense over the requisite service periods in the Company’s consolidated statement of operations. SFAS No. 123(R) supersedes the Company’s previous accounting under the provisions of SFAS No. 123, “Accounting for Stock-Based Compensation.” As permitted by SFAS No. 123, the Company measured compensation cost for options granted prior to October 1, 2005, in accordance with Accounting Principles Board Opinion (APB) No. 25, “Accounting for Stock Issued to Employees” and related interpretations. Accordingly, no accounting recognition is given to stock options granted at fair market value until they are exercised. Upon exercise, net proceeds, including tax benefits realized, are credited to equity. The Company adopted SFAS No. 123(R) using the modified prospective transition method, which requires the application of the accounting standard as of October 1, 2005, the first day of the Company’s fiscal year 2006. In accordance with the modified prospective transition method, the Company’s consolidated financial statements for prior periods have not been restated to reflect, and do not include, the impact of SFAS No. 123(R). Stock-based compensation expense recognized under SFAS No. 123(R) for the three and nine months ended June 30, 2006 consisted of stock-based compensation expense related to employee stock options and employee stock purchases of approximately $82,000 and $202,000 respectively. There was no stock-based compensation expense related to employee stock options and employee stock purchases recognized during the three and nine months ended June 30, 2005. The following table summarizes stock-based compensation expense related to employee stock options and stock purchases and nonvested shares under SFAS No. 123(R) for the three and nine months ended June 30, 2006 which was allocated as follows:

	Three months ended June 30, 2006		Nine months ended June 30, 2006
	(Amounts in thousands)
Cost of sales		—		—
Engineering and development		—		—
Selling, general and administrative	$	82	$	202
Total	$	82	$	202

10

CSP INC. AND SUBSIDIARIES

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

THREE AND SIX MONTHS ENDED JUNE 30, 2006 AND 2005

The Company uses the Black-Scholes option-pricing model to value stock options. The Black-Scholes model requires the use of employee exercise behavior data and the use of a number of assumptions including volatility of the Company’s stock price, the weighted average risk-free interest rate, and the weighted average expected life of the options. As the Company does not pay dividends, the dividend rate variable in the Black-Scholes model is zero. There were no option grants in the quarter ended December 31, 2005. On January 17, 2006 the Company granted 38,000 share options to employees. On April 19, 2006, the Company granted a total of 10,000 shares to four of the Company’s outside Directors. The table below summarizes the assumptions used to value these options:

	Three months ended June 30, 2006	Nine months ended June 30, 2006
Expected volatility	60%	60%
Expected dividend yield	—	—
Risk-free interest rate	4.87	4.28%-4.87%
Expected term (in years)	2.3	2.3-6.0

The volatility assumption is based on the historical weekly price data of the Company’s stock over a period equivalent to the weighted average expected life of the Company’s options. Management evaluated whether there were factors during that period which were unusual and which would distort the volatility figure if used to estimate future volatility and concluded that there were no such factors.

The risk-free interest rate assumption is based upon the interpolation of various U.S. Treasury rates determined at the date of option grant.

The expected life of employee stock options represents the weighted-average period that the stock options are expected to remain outstanding. It is based upon an analysis of the historical behavior of option holders during the period from September 1995 to March 31, 2006. Management believes historical data is representative of future exercise behavior.

As stock-based compensation expense recognized in the consolidated statement of operations pursuant to SFAS No. 123(R) is based on awards ultimately expected to vest, expense for grants beginning upon adoption of SFAS No. 123(R) on October 1, 2005 will be reduced for estimated forfeitures. SFAS No. 123(R) requires forfeitures to be estimated at the time of grant and revised, if necessary, in subsequent periods if actual forfeitures differ from those estimates. Forfeitures are estimated based partially on historical experience. The forfeitures rate as of June 30, 2006 was immaterial.

No cash was used to settle equity instruments granted under share-base payment arrangements in any period of 2006 or 2005.

The Company issues new shares upon the exercise of stock options. The Company does not expect to repurchase shares issued in any period following the exercise of stock options.

    The status of the plans during the nine months ended June 30, 2006 is as follows:

Stock Options	Number of shares		Weighted average exercise price
Stock options outstanding, September 30, 2005	503,657		$	5.15
Granted	48,000			6.64
Exercised	(4,000	)		2.86
Forfeited	—			—
Stock options outstanding, June 30, 2006	547,657		$	5.75

11

CSP INC. AND SUBSIDIARIES

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

THREE AND NINE MONTHS ENDED JUNE 30, 2006 AND 2005

As of June 30, 2006, unrecognized stock based compensation related to stock options was approximately $525,300. This cost is expected to be expensed over a weighted average period of 1.8 years. The aggregate intrinsic value of stock options exercised in the three and nine months ended June 30, 2006 was zero and $13,560, respectively.

	Options Outstanding				Options Exercisable
Range of exercise prices	Number of shares	Weighted average remaining contractual life	Weighted average exercise price		Number of shares	Weighted average exercise price
$ 2.64 - $ 4.60	153,221	5.8	$	3.14	132,284	$	3.22
$ 5.00 - $ 6.50	290,936	3.1	$	5.81	252,186	$	5.72
$ 7.05 - $ 7.93	23,500	9.2	$	7.41	9,375	$	7.81
$ 10.03	80,000	8.5	$	10.03	25,000	$	10.03
	547,657	4.9	$	5.75	418,845	$	5.23

	For the three months ended				For the nine months ended
	June 30, 2006		June 30, 2005		June 30, 2006		June 30, 2005
	(Amounts in thousands except for Weighted average options grants)
Weighted average of the fair value of options granted during the period	$	2.77	$	3.95	$	3.50	$	5.12
Intrinsic value of options exercised during the period	$	—	$	395.0	$	13.6	$	470.2
Total fair value of options vested during the period	$	46.5	$	11.7	$	151.8	$	100.3

As of June 30, 2006	Fully Vested and Exercisable Options
Number of options		418,845
Aggregate intrinsic value	$	658.6
Weighted average remaining contractual term		3.8 years

Pro forma Information under SFAS No. 123.

The following table illustrates the pro forma effect on net income and net income per share if the Company had applied the fair value recognition provisions of SFAS No. 123 for the three and nine months ended June 30, 2005:

Amounts	For the three Months ended June 30, 2005			For the nine months ended June 30, 2005
Net income	$	211		$	1,198
Deduct: Stock based employee compensation expense determined under fair value based method for all awards		(60	)		(176	)
Add: Total stock-based employee compensation expense included in reported net income		—			—
Pro forma net income	$	151		$	1,022
Net income per share:
Basic, as reported	$	0.06		$	0.33
Diluted, as reported	$	0.06		$	0.31
Basic, pro forma	$	0.04		$	0.28
Diluted, pro forma	$	0.04		$	0.27
Weighted average shares outstanding – basic		3,634			3,600
Weighted average shares outstanding – diluted		3,828			3,806

12

CSP INC. AND SUBSIDIARIES

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

THREE AND NINE MONTHS ENDED JUNE 30, 2006 AND 2005

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

	For the three months ended June 30, 2005			For the nine months ended June 30, 2005
Risk-free interest rate		4.1	%		3.6	%
Expected dividend yield		—			—
Expected volatility		48.4	%		48.4	%
Expected life (years)		5			5
Weighted average value of options granted during the period	$	3.32		$	6.23

8. Inventories

Inventories consist of the following:

	June 30, 2006		September 30, 2005
	(Amounts in thousands)
Raw materials	$	1,619	$	993
Work-in-progress		1,993		571
Finished goods		1,601		2,147
Total	$	5,213	$	3,711

9. Comprehensive Income (loss)

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

	For the three months ended						For the nine months ended
	June 30, 2006			June 30, 2005			June 30, 2006			June 30, 2005
Net income (loss)	$	(44	)	$	211		$	443		$	1,198
Unrealized gain (loss) on available-for-sale securities		—			(26	)		(45	)		11
Effect of foreign currency translation		311			(191	)		231			(75	)
Comprehensive income (loss)	$	267		$	(6	)	$	629		$	1,134

13

CSP INC. AND SUBSIDIARIES

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

THREE AND NINE MONTHS ENDED JUNE 30, 2006 AND 2005

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

	June 30, 2006			September 30, 2005
	(Amounts in thousands)
Unrealized gain on available-for-sale securities	$	—		$	45
Cumulative effect of foreign currency translation		(1,441	)		(1,759	)
Additional minimum pension liability		(2,004	)		(1,917	)
Accumulated Comprehensive loss	$	(3,445	)	$	(3,631	)

10. Pension and Retirement Plans

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

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

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

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

	For the Three Months Ended June 30,
	2006								2005
	Foreign			U.S.		Total			Foreign			U.S.		Total
				(Amounts in thousands)
Pension:
Service cost	$	29		$	2	$	31		$	22		$	2	$	24
Interest cost		142			36		178			157			37		194
Expected return on plan assets		(99	)		—		(99	)		(92	)		—		(92	)
Amortization of:
Prior service costs/(gains)		8			22		30			40			15		55
Net transition asset		(25	)		—		(25	)		(31	)		—		(31	)
Net periodic benefit cost	$	55		$	60	$	115		$	96		$	54	$	150
	For the Three Months Ended June 30,
	2006								2005
	Foreign			U.S.		Total			Foreign			U.S.		Total
				(Amounts in thousands)
Post Retirement:
Service cost	$	—		$	14	$	14		$	—		$	13	$	13
Interest cost		—			9		9			—			7		7
Expected return on plan assets		—			—		—			—			—		—
Amortization of:										—			—		—
Prior service costs/(gains)		—			15		15			—			18		18
Net transition asset		—			—		—			—			—		—
Net periodic benefit cost	$	—		$	38	$	38		$	—		$	38	$	38
	For the nine Months Ended June 30,
	2006								2005
	Foreign			U.S.		Total			Foreign			U.S.		Total
				(Amounts in thousands)
Pension:
Service cost	$	86		$	5	$	91		$	68		$	6	$	74
Interest cost		421			107		528			473			111		584
Expected return on plan assets		(294	)		—		(294	)		(276	)		—		(276	)
Amortization of:
Prior service costs		35			65		100			120			45		165
Net transition asset		(85	)		—		(85	)		(93	)		—		(93	)
Net periodic benefit cost	$	163		$	177	$	340		$	292		$	162	$	454
Post Retirement:
Service cost	$	—		$	41	$	41		$	—		$	39	$	39
Interest cost		—			26		26			—			21		21
Expected return on plan assets		—			—		—			—			—		—
Amortization of:										—			—		—
Prior service costs		—			44		44			—			56		56
Net transition asset		—			—		—			—			—		—
Net periodic benefit cost	$	—		$	111	$	111		$	—		$	116	$	116

15

CSP INC. AND SUBSIDIARIES

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

THREE AND NINE MONTHS ENDED JUNE 30, 2006 AND 2005

11. Segment Information

The following table presents certain operating segment information.

	Systems			Service and system integration			Consolidated Total
	(Amounts in thousands)
Three Months Ended June 30, 2006
Sales:
Product	$	282		$	14,186		$	14,468
Services		1,250			2,838			4,088
Total sales	$	1,532		$	17,024		$	18,556
Profit (loss) from operations	$	(72	)	$	(14	)	$	(86	)
Assets	$	11,779		$	26,658		$	38,437
Capital expenditures	$	97		$	91		$	188
Depreciation	$	52		$	94		$	146
	(Amounts in thousands)
Three Months Ended June 30, 2005
Sales:
Product	$	1,348		$	6,264		$	7,612
Services		901			3,030			3,931
Total sales	$	2,249		$	9,294		$	11,543
Profit (loss) from operations	$	(16	)	$	210		$	194
Assets	$	11,844		$	20,487		$	32,331
Capital expenditures	$	63		$	140		$	203
Depreciation	$	64		$	94		$	158
	Systems			Service and system integration			Consolidated Total
	(Amounts in thousands)
Nine Months Ended June 30, 2006
Sales:
Product	$	5,302		$	36,040		$	41,342
Services		1,754			8,203			9,957
Total sales	$	7,056		$	44,243		$	51,299
Profit (loss) from operations	$	(181	)	$	571		$	390
Assets	$	11,779		$	26,658		$	38,437
Capital expenditures	$	144		$	252		$	396
Depreciation	$	156		$	254		$	410
	(Amounts in thousands)
Nine Months Ended June 30, 2005
Sales:
Product	$	6,907		$	27,019		$	33,926
Services		1,207			9,224			10,431
Total sales	$	8,114		$	36,243		$	44,357
Profit from operations	$	549		$	1,076		$	1,625
Assets	$	11,844		$	20,487		$	32,331
Capital expenditures	$	170		$	272		$	442
Depreciation	$	178		$	277		$	455

16

CSP INC. AND SUBSIDIARIES

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

THREE AND NINE MONTHS ENDED JUNE 30, 2006 AND 2005

Profit (loss) from operations is sales less cost of sales, engineering and development, selling, general and administrative expenses but is not affected by either non-operating charges/income or by income taxes. Non-operating charges/ income consists principally of gain on sale of property, investment income and interest expense. The information for the three and nine months ended June 30, 2005 has been reclassified to conform to the segment presentation as disclosed in 2005 Form 10-K.

All intercompany transactions have been eliminated.

Assets include deferred income tax assets and other financial instruments owned by the Company.

For the three months ended June 30, 2006, the Company generated approximately 22% of its overall sales from tranactions with Atos Origin GmbH, a systems integrator located in Germany. No other customer provided 10% or greater revenues during the quarter. For the nine months ended June 30, 2006, approximately 15% of revenues were attributable to Atos Origin GmbH, and approximately 12% of revenues were attributable to Kable Deutchland, also located in Germany. No other customers accounted for 10% or more in revenues for the nine month period.

12. Restructuring

Early in the third quarter of 2006,Vodaphone, an integration services customer of our German subsidiary significantly reduced their contract service levels in order to reduce costs. The Company, in response to this reduction in revenues, initiated a staff reduction of three engineers. In connection with this initiative, the Company accrued a restructuring charge of $243 thousand in the third quarter of fiscal 2006, which was charged to service cost of sales.This amount consists of termination payments to the affected engineers. The Company is still evaluating if further reductions in staffing levels may be required and may incur additional severance charges in the fourth quarter of fiscal 2006.

13. Subsequent Event

On August 8, 2006, the Company reported a contract award from Raytheon Company that will provide revenues of between $17 and $18 million for the sale of FastCluster 220R systems. Initial deliveries will begin in late fiscal 2006 and continue into the following year.

17

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

Forward-Looking Statements

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

Restatement

As discussed in Note 2 to our consolidated financial statements included herein, we have restated our consolidated statement of cash flows for the nine months ended June 30, 2005 to correct certain misclassifications. The restatement had no effect on our reported operating results for the three or nine months ended June 30, 2005. The following discussion has been adjusted, where applicable, for the restatement of our unaudited consolidated statement of cash flows.

Risk factors

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

Critical Accounting Policies

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

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

Revenue recognition

Our revenues are primarily generated from the sale of IT solutions, third-party products, network management and storage systems integration services and high-performance cluster computer systems. CSPI recognizes revenues in accordance with generally accepted accounting principles in the United States. Specifically, we follow the requirements of SAB 104 and EITF 00-21. The manner in which we apply these standards to our revenue recognition is as follows:

Systems Revenue

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

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

During fiscal 2005, the Company began to recognize royalty revenues related to the production and sale of certain of the Company’s proprietary system technology by a third party. The Company recognizes royalty revenues upon notification

18

of shipment of the systems produced pursuant to the royalty agreement. This is the point as defined in the contract that payment of the royalty is committed and the Company has no further performance obligations and the earnings process is complete.

Service and System Integration Revenue

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

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

After persuasive evidence of an arrangement exists, the Company recognizes revenue on all elements, except for the support services, when all the products and services included in these elements have been delivered, customer acceptance has been ascertained, if and when applicable, and all other revenue recognition criteria have been met. Revenue for the support services is recognized over the term of the contract, typically three to twelve months.

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

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

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

Valuation Allowances

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

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

In assessing the realizability of our deferred tax assets, we consider and rely upon projections of future income. The key assumptions in our projections include sales growth rates, including potential contract wins, and expected levels of operating expenditures in addition to factors discussed in the section “Risk Factors That May Affect Future Results”. See the discussion of risk factors in our 2005 Form 10-K. These assumptions are subject to variation based upon both internal and external factors, many of which are beyond our control. To the extent that actual experience deviates from our assumptions, our projections would be affected and hence our assessment of realizability of our deferred tax asset may change. If we are awarded a significant contract our projections will be impacted and this impact may affect the valuation allowance against the deferred tax asset.

Inventory Valuation

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

19

Goodwill Impairment

We follow the requirements of Statement of Financial Accounting Standards No. 142 (SFAS 142), “Goodwill and Other Intangible Assets”, and test for impairment at least annually and whenever events or changes in circumstances indicated that the carrying value may not be recoverable. Factors we consider important that could indicate impairment include significant under performance relative to prior operating results, change in projections, significant changes in the manner of our use of assets or the strategy for our overall business, and significant negative industry or economic trends. At June 30, 2006 and September 30, 2005, we had $2,779,000 in Goodwill. In evaluating the impairment of goodwill, we consider a number of analyses such as discounted cash flow projections and market capitalization value. The process of evaluating the potential impairment of goodwill is highly subjective and requires significant judgment at many points during the analysis. In estimating fair value of the businesses with goodwill for the purposes of our annual or periodic analyses, we make estimates and judgments about the future cash flows of these businesses. Our cash flow forecasts are based on assumptions that are consistent with the plans and estimates we are using to manage the underlying businesses. In addition, we make certain judgments about assets such as accounts receivable and inventory to the estimated balance sheet for those businesses. We also consider our market capitalization (adjusted for unallocated monetary assets such as cash, marketable debt securities and debt) on the date we perform the analysis. Our key assumptions include sales growth and expected levels of operating expenditures, which are subject to variation based on both internal and external factors. To the extent that actual experience deviates from the projections, our assessment regarding impairment may change. Such a change could have a material adverse affect on the statement of operations. Goodwill is tested at the lowest level within the consolidated group for which identifiable cash flows that are largely independent on the cash flows of other assets and liabilities. For testing conducted at September 30, 2005, the testing was conducted at the level of the division within the service and systems integration segment which comprises the business acquired from Technisource in 2003.

Pension and Retirement Plans

In the United Kingdom and Germany, the Company provides defined benefit pension plans and defined contribution plans for the majority of the employees. Pension expense is based on actuarial computation of current and future benefits using estimates for expected return on assets, expected compensation increases and applicable discount rates. The Company estimates return on assets using historical market data for the investment classes of assets held by the Plans, adjusted for the current economic environment. 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 debt securities currently available and expected to be available during the period to maturity of the pension benefits. A decrease in the discount rate would result in greater pension expense and projected benefit obligation while an increase in the discount rate would decrease pension expense and projected benefit obligation. In accordance with Financial Accounting Standards No. 87 “Employee Accounting for Pensions”, actual results that differ from the actuarial assumptions are accumulated and, if outside a certain corridor, amortized over future periods and therefore, generally affect recognized expense and the recorded obligation in future periods.

Stock-Based Compensation Expense

On October 1, 2005, the Company adopted Statement of Financial Accounting Standards No. 123 (revised 2004), “Share-Based Payment,” (“SFAS No. 123(R)”) which requires the measurement and recognition of compensation expense for all stock-based payment awards made to employees and directors including employee stock options and employee stock purchases based on estimated fair values. In March 2005, the Securities and Exchange Commission issued Staff Accounting Bulletin No. 107 (“SAB 107”) relating to SFAS No. 123(R). The Company has applied the provisions of SAB 107 in its adoption of SFAS No. 123(R).

SFAS No. 123(R) requires companies to estimate the fair value of stock-based payment awards on the date of grant using an option-pricing model. The value of the portion of the award that is ultimately expected to vest is recognized as expense over the requisite service periods in the Company’s consolidated statement of operations. SFAS No. 123(R) supersedes the Company’s previous accounting under the provisions of SFAS No. 123, “Accounting for Stock-Based Compensation.” As permitted by SFAS No. 123, the Company measured compensation cost for options granted prior to October 1, 2005, in accordance with Accounting Principles Board Opinion (APB) No. 25, “Accounting for Stock Issued to Employees” and related interpretations. Accordingly, no accounting recognition is given to stock options granted at fair market value until they are exercised. Upon exercise, net proceeds, including tax benefits realized, are credited to equity.

20

The Company adopted SFAS No. 123(R) using the modified prospective transition method, which requires the application of the accounting standard as of October 1, 2005, the first day of the Company’s fiscal year 2006. In accordance with the modified prospective transition method, the Company’s consolidated financial statements for prior periods have not been restated to reflect, and do not include, the impact of SFAS No. 123(R). Stock-based compensation expense recognized under SFAS No. 123(R) for the three and nine months ended June 30, 2006 consisted of stock-based compensation expense related to employee stock options and employee stock purchases of approximately $82,000 and $202,000, respectively. There was no stock-based compensation expense related to employee stock options and employee stock purchases recognized during the three and nine months ended June 30, 2005.

Stock-based compensation expense recognized during the period is based on the value of the portion of stock-based payment awards that is ultimately expected to vest during the period. Stock-based compensation expense recognized in the Company’s unaudited consolidated statement of operations for the three and nine months ended June 30, 2006 included compensation expense for stock-based payment awards granted prior to, but not yet vested as of September 30, 2005 based on the grant date fair value estimated in accordance with the pro forma provisions of SFAS No. 123. Compensation expense for the stock-based payment awards granted subsequent to September 30, 2005 was $32,400, $53,300 for the three and nine months ended June 30, 2006 related to 48,000 options granted in 2006.

Upon adoption of SFAS No. 123(R), the Company also continued the use of the Black-Scholes option pricing method that it had used to establish fair value of options granted prior to October 1, 2005. The Company’s determination of fair value of stock-based payment awards on the date of grant using an option-pricing model is affected by the Company’s stock price as well as assumptions regarding a number of highly complex and subjective variables. These variables include, but are not limited to the Company’s expected stock price volatility over the term of the awards, and actual and projected employee stock option exercise behaviors. Any changes in these assumptions may materially affect the estimated fair value of the stock-based award.

In November 2005, the FASB issued FSP FAS 123(R)-3, “Transition Election Related to Accounting for the Tax Effects of Share-Based Payment Awards” (“FSP 123R-3”). FSP 123R-3 provides a simplified alternative method to calculate the beginning pool of excess tax benefits against which excess future deferred tax assets (that result when the compensation cost recognized for an award exceeds the ultimate tax deduction) could be written off under Statement 123R. The guidance in FSP 123R-3 was effective on November 10, 2005. We may make a one-time election to adopt the transition method described in FSP 123R-3 before the end of our fiscal year ending September 30, 2006. We are currently evaluating the available transition alternatives of FSP 123R-3.

Results of Operations

Overview of the nine months ended June 30, 2006 Results of Operations

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

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

CSP Inc. operates in two segments:

• Systems, which include manufactured hardware products:

• Service and systems integration, which includes maintenance and integration and sale of third-party hardware products and services and software application development.

Highlights include:

• Revenue decline in service sales offset by growth in product sales for nine month period.

• Operating income declined 76%, from $1.6 million in the first nine months of 2005 to $0.4 million in the first nine months of 2006

• Loss of service contracts in Germany caused an $829 thousand decline in service revenues in the first nine months of 2006 compared to 2005.

• Results include $243 thousand of restructuring costs and $179 thousand in idle capacity costs related to our German division, included in services cost of sales.

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Results for 2006 include $202 thousand in compensation expense related to stock options. Results for 2005 do not include any expense related to stock options.

The following table details our results of operation in dollars and as a percentage of sales for the nine months ended June 30, 2006 and 2005:

	June 30, 2006		% of sales		June 30, 2005			% of sales
Sales	$	51,299	100.0	%	$	44,357		100.0	%
Costs and expenses:
Cost of sales		40,086	78.1	%		32,367		73.0	%
Engineering and development		1,579	3.1	%		2,066		4.6	%
Selling, general and administrative		9,244	18.0	%		8,299		18.7	%
Total costs and expenses		50,909	99.2	%		42,732		96.3	%
Operating income		390	0.8	%		1,625		3.7	%
Other income		304	0.6	%		149		0.3	%
Income from continuing operations before income taxes		694	1.4	%		1,774		4.0	%
Provision for income taxes		251	0.5	%		557		1.3	%
Income from continuing operations		443	0.9	%		1,217		2.7	%
Loss from discontinued operations		—	—			(19	)	0.0	%
Net income	$	443	0.9	%	$	1,198		2.7	%

Sales

The following table details our sales by operating segment for the nine months ended June 30, 2006 and 2005:

	For the Nine Months Ended								$ Increase/ (Decrease)			% Increase/ (Decrease)
	June 30, 2006		% of Total		June 30, 2005		% of Total
	(Amounts in thousands)
Operating Segment:
Systems	$	7,056	14	%	$	8,114	18	%	$	(1,058	)	(13	)%
Service and system integration		44,243	86	%		36,243	82	%		8,000		22	%
Total	$	51,299	100	%	$	44,357	100	%	$	6,942		16	%

Overall product sales increased by approximately $7.4 million, or 22%, in the nine months ended June 30, 2006 compared to the same period of 2005. Foreign currency effects reduced the increase in revenue growth by approximately $1.2 million dollars due to a weakening in the euro and the pound sterling with respect to the US dollar in the first nine months of 2006 relative to the same period of 2005.

Product sales in the Systems segment declined approximately $1.6 million, or 23%, while overall Service and systems integration product revenues increased approximately $9.0 million, or 33%. Within the Service and systems integration segment, product revenues at our German subsidiary increased approximately $3.0 million, or 23%, on increased sales activity with Atos Origin GmbH, a systems integrator in Germany, increased activity with Arcor, and a new customer, Primacon, a TV cable provider in East Germany. Our Florida division of the Service and systems segment increased product sales by approximately $6.0 million, or 45%, by generating approximately $2.1 million in revenues to new customers and by significantly increasing sales to existing customers, such as General Dynamics, Rackspace, Raydon, and BrightStar.

Overall service revenues declined approximately $474 thousand, or 5%, in the nine months ended June 30, 2006 compared to the same period of 2005. Service revenues in the Systems segment increased approximately $547 thousand, or 45%, offset by a decline in service revenues in the Service and systems integration segment of $1.0 million, or 11%. The decline in service revenues in this segment was due primarily to the loss of a service contract with E-Plus in January 2006 and with the modification of a contract with Vodaphone in April 2006, both of which are customers of our Germany subsidiary.

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The decline in year-to-date product sales in the Systems segment reflects approximately $1.0 million lower levels of sales of the FastCluster 2000 SERIES product in 2006. Service revenue in the Systems segment increased approximately $0.9 million due to the receipt of approximately $1.5 million in royalty revenues related to the E-2 Hawkeye program in 2006, compared to $0.6 million received the previous year, offset by declines of approximately $0.4 million related to engineering and project management contract revenue.

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

	For the Nine Months Ended								$ Increase/ (Decrease)			% Increase (Decrease)
	(Amounts in thousands)
	June 30, 2006		%		June 30, 2005		%
North America	$	26,720	52	%	$	20,842	47	%	$	5,878		28	%
Europe		22,853	45	%		20,972	47	%		1,881		9	%
Asia		1,726	3	%		2,543	6	%		(817	)	(32	)%
Totals	$	51,299	100	%	$	44,357	100	%	$	6,942		16	%

North American revenues increased 28% for the first nine months of 2006 relative to the same period of fiscal 2005 due to increased sales activity at the Systems and solutions division in Florida, offset by a decline in revenues at the Multicomputer division. European revenues increased 9% due to a $2.2 million increase experienced at our German subsidiary, offset by reduced revenues at the UK division of the service and systems integration segment. Sales to Asia declined in the first nine months of 2006 due to lower sales activity in Japan for defense related programs.

Cost of Sales and Gross Margins

The following table details our sales, cost of sales and gross margin by operating segment for the nine months ended June 30, 2006 and 2005:

	Systems			Service and system integration			Total
Nine Months Ended June 30, 2006
Sales	$	7,056			44,243		$	51,299
Cost of sales		2,335			37,751			40,086
Gross margin $	$	4,721		$	6,492		$	11,213
Gross margin %		67	%		15	%		22	%
Nine Months Ended June 30, 2005
Sales	$	8,114			36,243		$	44,357
Cost of sales		2,946			29,421			32,367
Gross margin $	$	5,168			6,822		$	11,990
Gross margin %		64	%		19	%		27	%
Sales - $ Increase (decrease)	$	(1,058	)		8,000		$	6,942
% Increase (decrease)		(13	)%		22	%		16	%
Cost of sales - $ Increase (decrease)	$	(611	)		8,330		$	7,719
% Increase (decrease)		(21	)%		28	%		24	%
Gross margin - $ Decrease	$	(447	)		(330	)	$	(777	)
Gross margin % - Increase (decrease)		3	%		(4	)%		(5	)%

The overall cost of sales as a percentage of sales increased from 73% in the nine months ended June 30, 2005 to 78% in the comparable period of 2006.

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The gross margin percentage on total sales in the Service and systems integration segment declined from 19% in the 2005 period to 15% in 2006. Despite increasing product revenues of approximately $9.0 million, the cost of sales percentage on product sales within the segment increased by 1.6% due to continuing pricing pressure experienced at our Florida, and to a lesser extent, our German subsidiaries. Gross margins on service sales within the segment declined from 30% in 2005 to 21% in 2006, primarily due to the loss of $829 thousand of service revenues at our German subsidiary without any reduction in the cost of sales expenses. Cost of sales for the service segment is primarily for labor and associated expenses for the staff. In the third quarter of 2006, the German subsidiary had a reduction in force of three engineers, which resulted in severance expense of $243 thousand being recorded in the cost of sales.

Offsetting the decline in gross margins in the Service and systems integration segment was the increase in gross margins in the Systems segment, which rose from 64% in the 2005 period to 67% in 2006. Product sales in the Systems segment declined $1.6 million, though effect on gross margins on segment product sales was to reduce product gross margins from 61% in 2005 to 60% in 2006. Systems segment service revenues included royalty revenues of approximately $1.5 million in 2006, compared to $576 thousand in 2005, which was the primary cause of the overall margin improvement in the Systems segment.

Engineering and Development Expenses

The following table details our engineering and development expenses by operating segment for the nine months ended June 30, 2006 and 2005:

	For the Nine months ended								$ Increase (Decrease)			% Increase (Decrease)
	June 30, 2006		% of Total		June 30, 2005		% of Total
	(Amounts in thousands)
By Operating Segment:
Systems	$	1,541	98	%	$	1,516	73	%	$	25		2	%
Service and system integration		38	2	%		550	27	%		(512	)	(93	)%
Total	$	1,579	100	%	$	2,066	100	%	$	(487	)	(24	)%

Engineering and development expenses decreased overall by $487,000, or 24%, in the first nine months of 2006 compared to the first nine months of 2005. The decrease was primarily due to the re-deployment of engineers in the Systems and service integration segment to customer projects, and therefore charged to cost of sales. Engineering costs in our MultiComputer division within the Systems segment increased by 2% due to addition of an engineer and salary increases.

Selling, General and Administrative

The following table details our selling, general and administrative expense by operating segment for the nine months ended June 30, 2006 and 2005:

	For the Nine Months Ended								$ Increase		% Increase
	June 30, 2006		% of Total		June 30, 2005		% of Total
	(Amounts in thousands)
By Operating Segment:
Systems	$	3,361	36	%	$	3,104	37	%	$	257	8	%
Service and system integration		5,883	64	%		5,195	63	%		688	13	%
Total	$	9,244	100	%	$	8,299	100	%	$	945	11	%

Overall selling, general and administrative costs increased by $945,000, or 11%, in the first nine months of 2006 compared to the corresponding period of 2005. Approximately $708,000 of the increase was due to increased selling and marketing expenses. Our Florida-based service and system integration business increased selling and marketing costs by approximately $703,000 due to higher commission on higher levels of sales as well as an increase in sales related headcount. MultiComputer division in the Systems segment increased $60,000 in the first nine months of 2006 compared to the first nine months of 2005 related to increased consulting costs to assist in our sales efforts.

24

General and administrative costs increased $237,000 in the first nine months of 2006 compared to the first nine months of 2005. Overall, general and administrative expenses increased due to increased staffing in the finance departments for both segments. The Company recorded compensation expense of $202,000 in connection with the initial adoption of SFAS 123(R) Share Based Payment for employee and directors stock options and employee stock purchase plan. The Company incurred higher costs associated with officers life insurance, audits and financial reviews, and legal fees. The cost in professional fees of the restatement of prior year financial statements was $384,000, included in the first half of 2006. Offsetting these increases are reduced occupancy costs related to the corporate headquarters due to a newly negotiated rent agreement and the Florida operations related to the move to a smaller facility, both concluded late in 2005, a reduction in bonus expense, and reduction in consulting fees due to the delay in effective date of certain provisions of the Sarbanes-Oxley Act of 2002.

Other Income/Expenses

The following table details our other income/expenses for the nine months ended June 30, 2006 and 2005:

	For the Nine Months Ended						$ Increase (Decrease)
	June 30, 2006			June 30, 2005
	(Amounts in thousands)
Interest expense	$	(73	)	$	(88	)	$	15
Interest income		282			234			48
Dividend income		2			5			(3	)
Foreign exchange gain (loss)		(5	)		(25	)		20
Insurance settlement		60			—			60
Realized gain on investments		65			—			65
Other income (expense), net		(27	)		23			(50	)
Total other income (expense), net	$	304		$	149		$	155

Increases in interest income and expense are due primarily to the general increase in interest rates in effect over the first nine months of 2006 compared to the comparable period of 2005. The Company received reimbursement of $60,000 in the first nine months of 2006 from its business interruption insurance provider for lost profits at its Florida division due to the effects of Hurricane Wilma that occurred in the autumn of 2005. The realized gain on investments was related to the sale of investments held by a trust that was liquidated during the second quarter of 2006.

Overview of the three months ended June 30, 2006 Results of Operations

Highlights include:

• Product revenue growth in our German subsidiary increased $5.1 million, or 357% compared to third quarter of 2005 but cost of sales increased $4.6 million, or 384%.

• Loss and modification of service contracts in Germany lead to a $105 thousand decline in third quarter 2006 service revenues compared to 2005.

• Product revenue in the Florida division of the Service and Systems integration segment increased $2.9 million, or 61%, compared to third quarter of 2005.

• Competitive pressure on margins continue to be experienced at both the German and Florida operations of the Service and systems integration segment from 22% in 2005 to 13% in 2006.

• Operating income declines from $194 thousand in the third quarter of 2005 to an operating loss of $86 thousand in the third quarter of 2006, due to lower margins realized on product sales and increased selling, general and administrative expenses in the Service and systems integration segment.

• Restructuring charge of $243 thousand recorded in the Germany division within the Service and systems integration segment. The charge is classified as services cost of sales.

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The following table details our results of operations in dollars and as a percentage of sales for the three months June 30, 2006 and 2005:

	June 30, 2006			% of sales		June 30, 2005		% of sales
	(Amounts in thousands)
Sales	$	18,556		100.0	%	$	11,543	100.0	%
Costs and expenses:
Cost of sales		15,159		81.7	%		7,976	69.1	%
Engineering and development		500		2.7	%		602	5.2	%
Selling, general and administrative		2,983		16.1	%		2,771	24.0	%
Total costs and expenses		18,642		100.5	%		11,349	98.3	%
Operating income (loss)		(86	)	(0.5	)%		194	1.7	%
Other income		68		0.4	%		68	0.6	%
Income (loss) from continuing operations before income taxes		(18	)	(0.1	)%		262	2.3	%
Provision for income taxes		26		0.1	%		97	0.9	%
Income (loss) from continuing operations		(44	)	(0.2	)%		165	1.4	%
Income from discontinued operations		—		—			46	0.4	%
Net income (loss)	$	(44	)	(0.2	)%	$	211	1.8	%

For the three months ended June 30, 2006, sales increased to $18.6 million, compared to $11.5 million for the three months ended June 30, 2005. The net loss for the three months ended June 30, 2006 was $44 thousand or $(0.01) per share – diluted, compared with a net income of $211 thousand or $0.06 per share – diluted, for the three months ended June 30, 2005.

Sales

The following table details our sales by operating segment for the three months ended June 30, 2006 and 2005:

	For the Three Months Ended								$ Increase/ (Decrease)			% Increase/ (Decrease)
	June 30, 2006		% of Total		June 30, 2005		% of Total
	(Amounts in thousands)
Operating Segment:
Systems	$	1,532	8	%	$	2,249	19	%	$	(717	)	(32	)%
Service and system integration		17,024	92	%		9,294	81	%		7,730		83	%
Total	$	18,556	100	%	$	11,543	100	%	$	7,013		61	%

Total revenues increased by approximately $7.0 million, or 61%, in the third quarter of 2006 compared to the corresponding quarter of 2005. Foreign currency effects contributed approximately $310 thousand to the increase in revenue growth to a strengthening of the euro and the pound sterling with respect to the US dollar in the third quarter of 2006 relative to the same period of 2005. The Systems segment revenues decreased $717 thousand, or 32%, due to lower product sales in the MultiComputer division partly offset by an increase in service revenues from royalties.

Service and system integration segment revenues increased $7.7 million, or 83%, during the third quarter compared to the corresponding quarter of 2005. Product revenues increased substantially at our German and Florida divisions. Product revenue growth in German subsidiary increased $5.1 million, or 357% compared to third quarter of 2005. Product revenue in the Florida division increased $2.9 million, or 61%, compared to third quarter of 2005.

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

	For the Three Months Ended								$ Increase		% Increase
	(Amounts in thousands)
	June 30, 2006		%		June 30, 2005		%
North America	$	9,781	53	%	$	7,603	66	%	$	2,178	29	%
Europe		8,649	47	%		3,844	33	%		4,805	125	%
Asia		126	—	%		96	1	%		30	31	%
Totals	$	18,556	100	%	$	11,543	100	%	$	7,013	61	%

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North American revenue increased in the third quarter of 2006 were primarily driven by the increased product sales experienced at our Florida-based service and systems integration operation offset by a decline in revenues experienced at our MultiComputer division within the Systems segment. European sales increases were due largely to increased product sales at our German subsidiary within the Service and system integration business. The major portion of the increase was related sales to Atos Origin GmbH and an initial order to Primacon, a TV cable provider in East Germany.

Cost of Sales and Gross Margins

The following table details our sales, cost of sales and gross margin by operating segment for the three months ended June 30, 2006 and 2005:

	Systems			Service and system integration			Total
	(Amounts in thousands)
Three Months Ended June 30, 2006
Sales	$	1,532		$	17,024		$	18,556
Cost of sales		364			14,795			15,159
Gross margin $	$	1,168		$	2,229		$	3,397
Gross margin %		76	%		13	%		18	%
Three Months Ended June 30, 2005
Sales	$	2,249			9,294		$	11,543
Cost of sales		750			7,226			7,976
Gross margin $	$	1,499			2,068		$	3,567
Gross margin %		67	%		22	%		31	%
Sales - $ Increase (decrease)	$	(717	)		7,730		$	7,013
% Increase (decrease)		(32	)%		83	%		61	%
Cost of sales - $ Increase (decrease)	$	(386	)		7,569		$	7,183
% Increase (decrease)		(52	)%		105	%		90	%
Gross margin - $ Decrease	$	(331	)		161		$	(170	)
Gross margin % - Increase (decrease)		9	%		(9	)%		(13	)%

The overall cost of sales as a percentage of sales increased from 69% in the quarter ended June 30, 2005 to 82% in the comparable period of 2006.

The gross margin percentage on total sales in the Service and systems integration segment declined from 22% in the 2005 period to 13% in 2006. Despite increasing product revenues of $7.9 million, the cost of sales percentage on product sales within the segment increased by approximately 4.8% due to continuing pricing pressure experienced at our Florida and German subsidiaries. Cost of sales on service sales within the segment increased from 68% in 2005 to 86% in 2006, primarily due to the loss of $105 thousand of service revenues at our German subsidiary without any reduction in the cost of sales expenses which is primarily the labor cost and associated expense. In the third quarter of 2006, the German subsidiary had a reduction in force of three engineers, which resulted in severance expense of $243 thousand recorded in the cost of sales.

Offsetting the decline in gross margins in the Service and systems integration segment was the increase in gross margins in the Systems segment, which rose from 67% in the 2005 period to 76% in 2006. Although product sales in the Systems segment declined $1.1 million, which caused the Systems segment product gross margin to decrease from 54% in 2005 to 18% in 2006 due to the fixed expenses of the production operation on very low sales . Systems segment service revenues included royalty revenues of approximately $1.2 million in the third quarter of 2006, compared to none recorded in the third quarter of 2005 which caused the service gross margin to increase from 85% to 89% thus causing overall margin improvement.

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Engineering and Development Expenses

The following table details our engineering and development expenses by operating segment for the three months ended June 30, 2006 and 2005:

	For the Three Months Ended								$ Increase (Decrease)			% Increase (Decrease)
	June 30, 2006		% of Total		June 30, 2005		% of Total
	(Amounts in thousands)
By Operating Segment:
Systems	$	492	98	%	$	520	86	%	$	(28	)	(5	)%
Service and system integration		8	2	%		82	14	%		(74	)	(90	)%
Total	$	500	100	%	$	602	100	%	$	(102	)	(17	)%

Engineering and development expenses decreased overall by $102,000, or 17%, in the third quarter of 2006 compared to the third quarter of 2005. The decrease was primarily due to the re-deployment of engineers in the Systems and service integration segment to customer projects, and therefore charged to cost of sales. The decrease in engineering and development expenses in the Systems segment was due to reduced reliance on outside consulting services in the current period.

Selling, General and Administrative

The following table details our selling, general and administrative expense by operating segment for the three months ended June 30, 2006 and 2005:

	For the Three Months Ended								$ Increase (Decrease)			% Increase
	June 30, 2006		% of Total		June 30, 2005		% of Total
	(Amounts in thousands)
By Operating Segment:
Systems	$	748	25	%	$	995	36	%	$	(247	)	(25	)%
Service and system integration		2,235	75	%		1,776	64	%		459		26	%
Total	$	2,983	100	%	$	2,771	100	%	$	212		8	%

Overall selling, general and administrative costs in the third quarter of 2006 increased 8%, or $212 thousand compared to the third quarter of 2005. Our Florida-based service and system integration business increased selling and marketing costs due to higher commission on higher levels of sales, costs associated with an increase in sales related headcount, and stock options expense of $22 thousand in the third quarter of 2006.

The Company recorded compensation expense of $82,000 during the quarter in connection with the initial adoption of SFAS 123(R) Share Based Payment for employee and directors stock options and employee stock purchase plan in the third quarter of 2006. No expenses related to stock options were recorded in the third quarter of 2005. The Company incurred higher costs associated with officers life insurance, audits and financial reviews. Offsetting these increases are reduced occupancy costs related to the corporate headquarters due to a newly negotiated rent agreement and the Florida operations related to the move to a smaller facility, both concluded late in 2005, and lower bonus costs.

Other Income/Expenses

The following table details our other income/expenses for the three months ended June 30, 2006 and 2005:

	For the Three Months Ended						$ Increase (Decrease)
	June 30, 2006			June 30, 2005
	(Amounts in thousands)
Interest expense	$	(23	)	$	(26	)	$	3
Interest income		105			99			6
Dividend income		—			2			(2	)
Foreign exchange gain (loss)		(3	)		3			(6	)
Other income (expense), net		(11	)		(10	)		(1	)
Total other income (expense), net	$	68		$	68		$	—

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Increases in interest income and expense are due primarily to the general increase in interest rates in effect over the second quarter of 2006 compared to the comparable period of 2005.

Income Taxes

We recorded an income tax expense of $26,000 and $251,000 for the three and nine months ended June 30, 2006, respectively, compared to $97,000 and $557,000 of income tax expense for the three and nine months ended June 30, 2005. The tax expense in these periods was primarily due to the income generated by our foreign subsidiaries in Europe, as well as for a deferred tax liability related to goodwill, which is not amortizable for financial statement purposes, state tax and U.S. Alternative Minimum Tax (AMT).

We recorded a valuation allowance for the deferred tax assets for our U.S. and U.K. operations due to the consistent trend of losses sustained during a number of the quarters during the last three years. Management believes that it is more likely than not the deferred tax assets will not be realized. This valuation allowance was determined in accordance with the provisions of SFAS No. 109 (SFAS 109), “Accounting for Income Taxes” which requires an assessment of both positive and negative evidence when determining whether it is more likely than not that deferred tax assets are realizable. Such assessment is required on a jurisdiction-by-jurisdiction basis. Cumulative losses incurred in recent years represented sufficient negative evidence under SFAS 109 to record a valuation allowance against the deferred tax assets in the U.S. and the U.K.

Liquidity and Capital Resources

Our primary source of liquidity is our cash and cash equivalents and short-term investments, which rose to $13.5 million as of June 30, 2006 as compared to $12.7 million as of September 30, 2005. In the nine months ended June 30, 2006, we generated approximately $577 thousand of cash in operating activities compared to $1.7 million in the same period of the prior fiscal year. The significant change in net cash provided by operating activities was primarily due to net income of $443 thousand in the nine months of 2006 versus net income of $1.2 million for the first nine months of 2005. Working capital items which drove the most significant changes in operating cash flows were accounts payable and accrued expenses and accounts receivable primarily due to timing differences of transactions.

Approximately $21 thousand of net cash was provided by investing activities for the nine months ended June 30, 2006 compared to $145 thousand used during the prior comparable period. During the nine months ended June 30, 2006, our investing activities consisted of purchases, sales and maturities of marketable securities generating net cash of $508 thousand and the use of $396 thousand for the purchases of property, equipment and improvements and the use of $91 thousand to pay life insurance premiums.

Financing activities generated approximately $59 thousand of cash during the nine months ended June 30, 2006 compared to $523 thousand during the prior comparable period. The cash provided in the first nine months of 2006 was mainly from the proceeds of stock issued under our employee stock purchase plan and the exercise of stock options off set by the repurchase of Company common stock.

If cash generated from operations is insufficient to satisfy working capital requirements, we may need to access funds through bank loans, sale of securities 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 our available cash and investments and cash generated from operations will be sufficient to provide for our working capital and capital expenditure requirements for the foreseeable future.

Inflation and Changing Prices

Management does not believe that inflation and changing prices had significant impact on sales, revenues or income from continued operations during the three and nine month periods ended June 30, 2006 and 2005. There is no assurance that our business will not be materially and adversely affected by inflation and changing prices in the future.

Item 3. Quantitative and Qualitative Disclosures about Market Risk

There was no material change in our exposure to market risk during the quarter ended June 30, 2006.

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Item 4. Controls and Procedures

We evaluated the effectiveness of the design and operation of our disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) as of June 30, 2006. Our chief executive officer, our chief financial officer, and other members of our senior management team supervised and participated in this evaluation. Based on the evaluation, we did not maintain effective controls over the preparation and disclosure of our consolidated financial statements. These control deficiencies led to (1) the delay in the filing of our 2005 Annual Report on Form 10-K, (2) the delay in the filing of our Form 10-Q for the Quarter Ended December 31, 2005, and (3) restatements of the consolidated balance sheets as of September 30, 2004 and 2003 and statements of cash flows for the years then ended as detailed in our 2005 Form 10-K as well as restatement of our unaudited consolidated statement of cash flows for the nine months ended June 30, 2005, as described below.

We incorrectly classified certain highly liquid investments with maturities of three months or less as short-term investments, rather than as cash equivalents. In addition, certain investments with maturity dates of less than one year were incorrectly reported as long-term, rather than short-term. Our unaudited consolidated statement of cash flows for the nine months ended June 30, 2005 has been restated due to these classification errors.

In addition, during the preparation of our 2005 Form 10-K an error was discovered in our consolidated statement of cash flows for fiscal 2003 that led management to re-analyze the statements of cash flows for all years presented. This control deficiency resulted in additional restatement adjustments to our consolidated statement of cash flows for the nine months ended June 30, 2005.

Accordingly, management determined that these restatements are indicative of control deficiencies that constitute a material weakness in our internal control over financial reporting. A material weakness is a control deficiency or a combination of control deficiencies that results in more than a remote likelihood that a material misstatement of the annual or interim consolidated financial statements will not be prevented or detected.

In the course of their audit of our fiscal 2004 financial statements, our independent auditors advised us that they considered the following to constitute material weaknesses in internal control and operations: We did not have adequate staffing in our finance group with the appropriate level of experience to effectively control the increased level of transaction activity, address non-routine accounting matters, and manage the increased financial reporting complexities resulting from the acquisition of Technisource and associated integration activities.

In April 2005, we hired a Director of Accounting and Financial Reporting with 20 years of experience to oversee the financial reporting preparation process to address the weaknesses. We also hired a senior accountant at our MODCOMP subsidiary in Florida, who commenced employment in July 2005. As acknowledged by us and our independent auditors, we continued to experience material internal control weaknesses in 2005 but as these new personnel become fully familiar with our reporting structure we anticipate improvement. We will continue to evaluate our finance staff resources in response to the concerns about our controls and procedures that arose in connection with the audit of our fiscal 2005 and 2004 financial statements. If greater or additional resources are needed to meet the requirements necessary to handle the complexities of our operations, management will authorize the hiring of additional personnel. The Audit Committee has reviewed all of the matters discussed above and have been actively assessing the plan to improve our controls and procedures. The Committee will continue to monitor the situation and expects to take such further actions as are needed.

The effectiveness of a system of disclosure controls and procedures is subject to various inherent limitations, including cost limitations, judgments used in decision making, assumptions about the likelihood of future events, the soundness of internal controls, and fraud. Due to such inherent limitations, there can be no assurance that any system of disclosure controls and procedures will be successful in preventing all errors or fraud, or in making all material information known in a timely manner to appropriate levels of management.

During the third quarter of fiscal 2006, there were no changes in our internal controls over financial reporting that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

PART II. OTHER INFORMATION

Item 1A. Risk Factors.

We are updating the following two risk factors from our Annual Report on Form 10-K for the fiscal year ended September 30, 2005. The update reflects the contract with Raytheon Company that we announced August 8, 2006.

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

We are dependent on a small number of customers for a large portion of our revenues. Sales to E-Plus, a wireless telecommunications company in Germany, and those to E-Plus through its system integrator, Atos, accounted for 15%, 22% and 33% of sales in fiscal years ended September 30, 2005, 2004 and 2003, respectively. Lockheed-Martin, a large defense contractor, accounted for 5% of our sales in 2005 and 11% and 3% of our sales in fiscal years 2004 and 2003, respectively. On August 8, 2006, we announced that we had entered into a major contract with Raytheon, another major defense contractor, for approximately $17-$18 million, which is expected to be filled over the next year. A significant diminution in the sales to or loss of any of our major customers would have a material adverse effect on our business, financial condition and results of operations. In addition, our revenues are largely dependent upon the ability of our customers to have continued growth or need for services or to develop and sell products that incorporate our products. No assurance can be given that our customers will not experience financial or other difficulties that could adversely affect their operations and, in turn, our results of operations.

We Depend on Defense Business for a Significant Amount of our Revenue and the Loss or Decline of Existing or Future Defense Business Could Adversely Affect our Financial Results

Sales of our systems to the defense market accounted for approximately 16%, 18% and 18% of our consolidated revenues and 97%, 97% and 95% of the Systems segment sales for the fiscal years ended September 30, 2005, 2004 and 2003, respectively. On August 8, 2006, we announced that we had entered into a major contract with Raytheon, another major defense contractor, for approximately $17-$18 million, which is expected to be filled over the next year. Reductions in government spending on programs that incorporate our products could have a material adverse effect on our business, financial condition and results of operations. Moreover, our subcontracts are subject to special risks, such as:

• delays in funding;

• ability of the government agency to unilaterally terminate the prime contract;

• reduction or modification in the event of changes in government policies or as the result of budgetary constraints or political changes;

• increased or unexpected costs under fixed price contracts; and

• other factors that are not under our control.

In addition, consolidation among defense industry contractors has resulted in fewer contractors with increased bargaining power relative to our bargaining power. No assurance can be given that such increased bargaining power will not adversely affect our business, financial condition or results of operations in the future.

Changes in government administration, as well as changes in the geo-political environment such as the current “War on Terrorism,” can have significant impact on defense spending priorities and the efficient handling of routine contractual matters. Such changes could have a negative impact on our business, financial condition, or results of operations in the future.

Item 6. Exhibits

(a) Exhibits

Number	Description
3.1	Articles of Organization and amendments thereto (incorporated by reference to Exhibit 3.1 to our Form 10-K for the year ended August 31, 1990)
3.2	By-Laws, as amended (incorporated by reference to Exhibit 3.2 to our Form 10-K for the year ended August 25, 1995)
31.1	Certification of Chief Executive Officer Pursuant Section 302 of the Sarbanes-Oxley Act of 2002
31.2	Certification of Chief Financial Officer Pursuant Section 302 of the Sarbanes-Oxley Act of 2002
32.1	Certification of Chief Executive Officer and Chief Financial Officer Pursuant Section 906 of the Sarbanes-Oxley Act of 2002

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SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, as amended, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

	CSP INC.
Date: August 14, 2006	By:	/s/ ALEXANDER R. LUPINETTI
		Alexander R. Lupinetti
		Chief Executive Officer, President and Chairman
Date: August 14, 2006	By:	/s/ GARY W. LEVINE
		Gary W. Levine
		V.P. of Finance and Chief Financial Officer

Exhibit Index

Number	Description
3.1	Articles of Organization and amendments thereto (incorporated by reference to Exhibit 3.1 to our Form 10-K for the year ended August 31, 1990)
3.2	By-Laws, as amended (incorporated by reference to Exhibit 3.2 to our Form 10-K for the year ended August 25, 1995)
31.1	Certification of Chief Executive Officer Pursuant Section 302 of the Sarbanes-Oxley Act of 2002
31.2	Certification of Chief Financial Officer Pursuant Section 302 of the Sarbanes-Oxley Act of 2002
32.1	Certification of Chief Executive Officer and Chief Financial Officer Pursuant Section 906 of the Sarbanes-Oxley Act of 2002

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