# CSP INC /MA/ (CSPI) FY 2021 MD&A

Verbatim Item 7 Management's Discussion and Analysis from CSP INC /MA/'s 10-K for fiscal year 2021.

SEC filing source: https://www.sec.gov/Archives/edgar/data/356037/000035603721000021/cspi-20210930x10k.htm
Accession: 0000356037-21-000021
Filing date: 2021-12-08
Report date: 2021-09-30
Extracted structurally from real Item 7 body heading to real Item 7A/8 boundary.
Confidence: high

Company profile: /company/CSPI/
All MD&A years: /company/CSPI/mda/
Next year: /company/CSPI/mda/fy2022/ (FY 2022)

Item 7.     Management’s Discussion and Analysis of Financial Condition and Results of Operations

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

Observations on effects of novel coronavirus (COVID-19)

On March 11, 2020, the World Health Organization characterized the novel coronavirus outbreak as a pandemic. The outbreak has and continues to adversely affect the economies of the U.S., U.K., and other international markets and economies in which we operate. As a result of the World Health Organization characterizing the COVID-19 outbreak as a pandemic, national, state, and local governments have and continue to take actions such as declaring states of emergency, implementing social distancing and other guidelines, and shutting down and/or limiting the opening or operation of certain businesses which are not considered essential.

In these times of pandemic, our top priorities are to protect the health, well-being, and safety of our employees and partners, while still focusing on the key drivers of our business. To that end, and to insure we continue to operate safety and cautiously while also meeting our public health responsibilities, the Company has adopted flexible business practices including allowing most employees to work remotely in all locations. Our sales decreased significantly for the year ended September 30, 2021, which we believe is primarily due to the pandemic. This is largely the result of customers reducing their budgets. The pandemic has also had an adverse effect on our ability to transact one-on-one business, which we believe is important when rolling out new IT and security products.

During fiscal year 2021 COVID-19 has adversely affected the distribution channel leading to significantly longer lead times when ordering product. Manufacturers are not producing as much product as prior to the pandemic due to disruptions, resulting in supply shortages. Additionally, recent global shipping delays have exacerbated this problem. The TS segment has many vendors it transacts with and supply shortages are pervasive with many of them. The HPP segment has also experienced shortages with their vendors as well. Related to the supply shortage and potentially inflation, we have experienced price increases for our products, which we try to pass on to the customer.

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We recognize the pandemic has created a dynamic and uncertain situation in the national economy, and we continue to closely monitor the latest information to make timely, informed business decisions and public disclosures regarding the potential impact of the pandemic on our operations. Despite reduced infection rates and ever-increasing vaccination rates in the United States, many nations and certain pockets within the United States are still battling various

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strains/variants of the novel coronavirus, creating ongoing uncertainties as to when economies will return to business as usual and what that will look like, what regulatory measures or voluntary actions will be further implemented to limit the spread of COVID-19 and its variants and the duration of any such measures. The extent, severity and impact of any further spread of COVID-19 variants or resurgence of COVID-19 in a given geographic region after it has hit its “peak,” and the extent to which herd immunity will be achieved through the vaccination process is still uncertain. In summary, the scope of this pandemic and its effects are unprecedented, and we cannot at this time make a reasonable estimate on the extent or duration of the impacts on our business.

Please refer to Item 1A Risk Factors located in Part I in this Annual Report on Form 10-K for discussion of the risks related to COVID-19 on our business, financial condition, and results of operations.

Overview of Fiscal 2021 Results of Operations

Revenue decreased by approximately $12.6 million, or 20%, to $49.2 million for the fiscal year ended September 30, 2021 versus $61.8 million for the fiscal year ended September 30, 2020.

Gross profit margin percentage increased, from 28% of revenues for the fiscal year ended September 30, 2020 to 33% for the fiscal year ended September 30, 2021.

We generated an operating loss of approximately $1.4 million for the fiscal year ended September 30, 2021 as compared to an operating loss of approximately $1.4 million for the fiscal year ended September 30, 2020.

Other income, (expense) net was $2.0 million for the fiscal year ended September 30, 2021 as compared to $0.4 million for the prior year. The increase of $1.6 million from prior year is due to a large one time gain on debt forgiveness of $2.2 million which did not occur in the prior year, partially offset by an increase in foreign exchange loss of $0.5 million and increase of interest expense of $0.1 million.

A one-time gain of $465k occurred in fiscal year 2021, which was a purchase price adjustment of a subsidiary (Modcomp GmbH) that was sold in fiscal year 2018. This is classified as discontinued operations. There are no further amounts to be received in connection with the purchase agreement from the original sale.

The Company recorded an income tax provision of approximately $444 thousand, which reflected an effective tax rate of 39%, for the year ended September 30, 2021. The provision is primarily driven by the recording of a full valuation allowance against US deferred tax assets that are not more-likely-than-not to be realized partially offset by the exclusion of income from the forgiveness of Paycheck Protection Program loans, the exclusion of the gain of the discontinued German entity under UK tax law, current year federal research and development credits, and the benefit resulting from the carryback of federal net operating losses to years in which the statutory federal tax rate was 34%.

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

[[GREPCENT_TABLE]]
[["\u200b","\u200b","\u200b","\u200b","\u200b","\u200b","\u200b","\u200b","\u200b","\u200b","\u200b","\u200b"],["\u200b","\u200b","\u200b","\u200b","\u200b","%","\u200b","\u200b","\u200b","\u200b","%"],["\u200b","","September 30, 2021","","of sales","","September 30, 2020","","of sales"],["\u200b","\u200b","(Dollar amounts in thousands)"],["Sales","\u200b","$","49,208","","100","%","$","61,793","","100","%"],["Costs and expenses:","\u200b","","","","","\u200b","","","","","\u200b"],["Cost of sales","\u200b","","33,059","","67","%","","44,626","","71","%"],["Engineering and development","\u200b","","2,887","","6","%","","2,798","","5","%"],["Selling, general and administrative","\u200b","","14,624","","30","%","","15,793","","26","%"],["Total costs and expenses","\u200b","","50,570","","103","%","","63,217","","102","%"],["Operating loss","\u200b","","(1,362)","","(3)","%","","(1,424)","","(2)","%"],["Other income, (expense) net","\u200b","","2,040","","4","%","","362","","\u2014","%"],["Income (loss) before income taxes","\u200b","","678","","1","%","","(1,062)","","(2)","%"],["Income tax expense","\u200b","","444","","1","%","","384","","\u2014","%"],["Net income (loss) from continuing operations","\u200b","\u200b","234","","\u2014","%","\u200b","(1,446)","","(2)","%"],["Gain on sale of discontinued operations","\u200b","\u200b","465","\u200b","1","%","\u200b","\u2014","","\u2014","%"],["Net income (loss)","\u200b","$","699","\u200b","1","%","$","(1,446)","\u200b","(2)","%"]]
[[/GREPCENT_TABLE]]

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Revenues

Revenue decreased by approximately $12.6 million, or 20%, to $49.2 million for the fiscal year ended September 30, 2021 versus $61.8 million for the fiscal year ended September 30, 2020. Our TS segment revenue decreased by approximately $11.3 million consisting of a decrease of $11.9 million in our U.S. division, partially offset by an increase of $0.6 million in our U.K. division. Our HPP segment revenue decreased by approximately $1.3 million, or 21%, primarily due to decreased product revenue of $0.3 million combined with decreased service revenue of $1.0 million.

TS segment revenue changes by products and services for the fiscal years ended September 30 were as follows:

[[GREPCENT_TABLE]]
[["\u200b","\u200b","\u200b","\u200b","\u200b","\u200b","\u200b","\u200b","\u200b","\u200b","\u200b","\u200b","\u200b"],["\u200b","\u200b","\u200b","\u200b","\u200b","\u200b","\u200b","\u200b","Increase (decrease)"],["\u200b","","2021","","2020","","$","","%"],["\u200b","\u200b","(Dollar amounts in thousands)","\u200b"],["Products","\u200b","$","32,100","\u200b","$","44,588","\u200b","$","(12,488)","\u200b","(28)","%"],["Services","\u200b","","12,485","\u200b","","11,329","\u200b","","1,156","\u200b","10","%"],["Total","\u200b","$","44,585","\u200b","$","55,917","\u200b","$","(11,332)","\u200b","(20)","%"]]
[[/GREPCENT_TABLE]]

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The decrease in TS segment product revenue of $12.5 million during the period was the result of a $13.1 million decrease in the U.S. division, partially offset by an increase of $0.6 million in the U.K. division. Customers’ budgets have been cut or put on hold in the short term due to the pandemic leading to significantly decreased sales. The decrease in our U.S. division product revenue year over year was primarily associated with several major customers, partially offset by a significant increase with several other customers. The increase in the U.K. division year over year was primarily associated with an increase with one major customer. The increase in TS segment service revenue of $1.2 million as compared to the prior year was due to a $1.2 million increase in the U.S. division. In fiscal year 2021 as compared to the prior year, the U.S. division had an increase of $1.4 million in third party maintenance and an increase of $0.8 million in managed services, partially offset by a decrease of $1.0 million in internal and third party services revenue.

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HPP segment revenue changes by product and services for the fiscal years ended September 30 were as follows:

[[GREPCENT_TABLE]]
[["\u200b","\u200b","\u200b","\u200b","\u200b","\u200b","\u200b","\u200b","\u200b","\u200b","\u200b","\u200b","\u200b"],["\u200b","","\u200b","\u200b","\u200b","\u200b","\u200b","\u200b","Decrease"],["\u200b","\u200b","2021","","2020","","$","","%","\u200b"],["\u200b","\u200b","(Dollar amounts in thousands)","\u200b"],["Products","\u200b","$","3,126","\u200b","$","3,401","\u200b","$","(275)","\u200b","(8)","%"],["Services","\u200b","","1,497","\u200b","","2,475","\u200b","","(978)","\u200b","(40)","%"],["Total","\u200b","$","4,623","\u200b","$","5,876","\u200b","$","(1,253)","\u200b","(21)","%"]]
[[/GREPCENT_TABLE]]

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The decrease in HPP product revenue of $0.3 million in the fiscal year ended September 30, 2021 was primarily the result of an approximately $0.6 million decrease in Myricom product line shipments, partially offset with a $0.3 million increase in Multicomputer product line shipments for the fiscal year ended September 30, 2021 as compared to the fiscal year ended September 30, 2020. This is primarily due to the pandemic affecting customers’ budgets. The decrease in HPP service revenue of approximately $1.0 million for the period was primarily the result of a $0.6 million decrease in royalty revenues on high-speed processing boards related to the E2D program combined with a $0.4 million decrease of Multicomputer repairs for the fiscal year ended September 30, 2021 as compared to the fiscal year ended September 30, 2020.

Our total revenues by geographic area based on the location to which the products were shipped or services rendered were as follows:

[[GREPCENT_TABLE]]
[["\u200b","\u200b","\u200b","\u200b","\u200b","\u200b","\u200b","\u200b","\u200b","\u200b","\u200b","\u200b","\u200b","\u200b","\u200b","\u200b","\u200b"],["\u200b","\u200b","\u200b","\u200b","Increase (decrease)","\u200b"],["\u200b","","2021","","%","","2020","","%","","$","","%"],["\u200b","\u200b","(Dollar amounts in thousands)","\u200b"],["Americas","\u200b","$","45,321","","92","%","$","59,178","","95","%","$","(13,857)","\u200b","(23)","%"],["Europe","\u200b","","3,203","","7","%","","2,282","","4","%","","921","\u200b","40","%"],["Asia","\u200b","","684","","1","%","","333","","1","%","","351","\u200b","105","%"],["Totals","\u200b","$","49,208","","100","%","$","61,793","","100","%","$","(12,585)","\u200b","(20)","%"]]
[[/GREPCENT_TABLE]]

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The $13.9 million decrease in the Americas revenue for the fiscal year ended September 30, 2021 as compared to the fiscal year ended September 30, 2020 was primarily due to decreased revenue by our TS segment of approximately $12.4 million attributable to the U.S. division, combined with decreased sales by our HPP segment of approximately $1.5 million. The $0.9 million increase in Europe revenue for the fiscal year ended September 30, 2021 as compared to the prior year period was primarily due to increased sales by our TS-UK division of approximately $0.6 million combined with an increase in sales by our TS-US division of approximately $0.3 million. The $0.4 million increase in Asia revenue for the fiscal year ended September 30, 2021 as compared to the prior year period was primarily the result of increased revenue by our HPP segment of $0.2 million combined with a $0.2 million increase in our TS-U.S. division.

Gross Margins

Our gross margin ("GM") decreased by approximately $1.1 million to $16.1 million for fiscal year 2021 as compared to GM of approximately $17.2 million for fiscal year 2020. The GM as a percentage of revenue increased to 33% for fiscal year 2021 from 28% for fiscal year 2020. The increase in GM as a percentage of revenue was primarily attributed to a higher percentage of service revenue relative to product revenue in the TS segment and a significant increase in TS segment product GM as a percentage of revenue. Additionally, the product mix, amount of net revenue recorded, and overall margin in products contributed to this increase from prior year. The improved product GM margin as a percentage of revenue has been a focus in fiscal year 2021, particularly in the TS segment.

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The following table summarizes GM changes by segment for fiscal years ended September 30:

[[GREPCENT_TABLE]]
[["\u200b","\u200b","\u200b","\u200b","\u200b","\u200b","\u200b","\u200b","\u200b","\u200b","\u200b","\u200b","\u200b","\u200b","\u200b","\u200b","\u200b"],["\u200b","\u200b","2021","\u200b","2020","\u200b","Increase (Decrease)"],["\u200b","\u200b","(Dollar amounts in thousands)","\u200b"],["\u200b","","GM$","","GM%","","GM$","","GM%","","GM$","","GM%"],["TS","\u200b","$","13,405","","30","%","$","13,553","","24","%","$","(148)","","6","%"],["HPP","\u200b","","2,744","","59","%","","3,614","","62","%","","(870)","","(3)","%"],["Total","\u200b","$","16,149","","33","%","$","17,167","","28","%","$","(1,018)","","5","%"]]
[[/GREPCENT_TABLE]]

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The impact of product mix within our TS segment on gross margins for the fiscal years ended September 30 was as follows:

[[GREPCENT_TABLE]]
[["\u200b","\u200b","\u200b","\u200b","\u200b","\u200b","\u200b","\u200b","\u200b","\u200b","\u200b","\u200b","\u200b","\u200b","\u200b","\u200b","\u200b"],["\u200b","\u200b","2021","\u200b","2020","\u200b","Increase (decrease)"],["\u200b","","GM$","","GM%","","GM$","","GM%","","GM$","","GM%"],["\u200b","\u200b","(Dollar amounts in thousands)","\u200b"],["Products","\u200b","$","5,898","","18","%","$","6,842","","15","%","$","(944)","","3","%"],["Services","\u200b","","7,507","","60","%","","6,711","","59","%","","796","","1","%"],["Total","\u200b","$","13,405","","30","%","$","13,553","","24","%","$","(148)","","6","%"]]
[[/GREPCENT_TABLE]]

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The overall TS segment GM as a percentage of revenue increased to 30% in fiscal year 2021 from 24% in fiscal year 2020. The increase in GM as a percentage of revenue was primarily attributed to a large relative decrease in TS segment product revenue compared to a significant increase in service revenue in fiscal year 2020 from the prior year. Additionally, both product and service GM as a percentage of revenue increased from prior year. The $0.9 million decrease in our TS segment product GM in fiscal year 2021 as compared to the prior year resulted from a decrease in GM in the U.S. division of $0.8 million combined with a decrease in the U.K division of $0.1 million. The $0.8 million increase in the TS segment service GM in fiscal year 2021 as compared to the prior year primarily resulted from increased service revenue as well as a slight increase in GM as a percentage of revenue in the U.S. division.

The impact of product mix on gross margins within our HPP segment for the fiscal years ended September 30 was as follows:

[[GREPCENT_TABLE]]
[["\u200b","\u200b","\u200b","\u200b","\u200b","\u200b","\u200b","\u200b","\u200b","\u200b","\u200b","\u200b","\u200b","\u200b","\u200b","\u200b","\u200b"],["\u200b","\u200b","2021","\u200b","2020","\u200b","Increase (Decrease)"],["\u200b","\u200b","(Dollar amounts in thousands)","\u200b"],["\u200b","","GM$","","GM%","","GM$","","GM%","","GM$","","GM%"],["Products","\u200b","$","1,304","","42","%","$","1,240","","36","%","$","64","","6","%"],["Services","\u200b","","1,440","","96","%","","2,374","","96","%","","(934)","","\u2014","%"],["Total","\u200b","$","2,744","","59","%","$","3,614","","62","%","$","(870)","","(3)","%"]]
[[/GREPCENT_TABLE]]

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The overall HPP segment GM as a percentage of revenue decreased to 59% in fiscal year 2021 from 62% in fiscal year 2020. The 3% decrease in GM as a percentage of sales in the HPP segment was primarily attributed to the impact of a decrease of $0.6 million in high margin Multicomputer royalty revenues, which is all GM. The GM as a percentage of sales from products increased primarily due to product mix in fiscal year 2021 as compared to the prior year.

Engineering and Development Expenses

Our engineering and development expenses are only in our HPP segment. These expenses had a slight increase of $0.1 million from $2.8 million in fiscal year 2020 to $2.9 million for fiscal year 2021. Fiscal year 2021 and 2020 expenses were primarily for product engineering expenses incurred in connection with the development of the ARIA SDS cyber security products.

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Selling, General and Administrative

The following table details our selling, general and administrative (“SG&A”) expenses by operating segment for the years ended September 30, 2021 and 2020:

[[GREPCENT_TABLE]]
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[[/GREPCENT_TABLE]]

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For fiscal year 2021 compared to fiscal year 2020, the TS segment SG&A spending decrease of approximately $1.0 million was primarily due to a decrease in variable compensation and salaries of $1.0 million and a decrease of $0.1 million for travel expense.

For fiscal year 2021 compared to fiscal year 2020, the HPP segment SG&A spending decrease of $0.1 million was primarily attributed to decreased headcount in the sales department.

Other Income/Expenses

The following table details our other income (expenses) for the years ended September 30, 2021 and 2020:

[[GREPCENT_TABLE]]
[["\u200b","\u200b","\u200b","\u200b","\u200b","\u200b","\u200b","\u200b","\u200b","\u200b","\u200b"],["\u200b","\u200b","For the year ended","\u200b","\u200b","\u200b","\u200b"],["\u200b","\u200b","\u200b","\u200b","\u200b","\u200b","\u200b","\u200b","$ Increase","\u200b"],["\u200b","","September 30, 2021","","September 30, 2020","","(Decrease)","\u200b"],["\u200b","\u200b","(Amounts in thousands)","\u200b"],["Interest expense","\u200b","$","(350)","\u200b","$","(228)","\u200b","$","(122)","\u200b"],["Interest income","\u200b","","575","\u200b","","582","\u200b","","(7)","\u200b"],["Foreign exchange (loss) gain","\u200b","","(488)","\u200b","","(2)","\u200b","","(486)","\u200b"],["Gain on debt forgiveness","\u200b","\u200b","2,196","\u200b","\u200b","\u2014","\u200b","\u200b","2,196","\u200b"],["Other income, net","\u200b","","107","\u200b","","10","\u200b","","97","\u200b"],["Total other income (expense), net","\u200b","$","2,040","\u200b","$","362","\u200b","$","1,678","\u200b"]]
[[/GREPCENT_TABLE]]

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The $1.7 million increase to total other income (expense), net for the year ended September 30, 2021 as compared to the prior year period is primarily driven by a gain on debt forgiveness of $2.2 million, partially offset by an increase in foreign exchange loss of $0.5 million. The U.K. division has significant bank accounts with U.S. dollars and Euros. In consolidation, U.S. dollars and Euros are remeasured into the functional currency, British Pounds, of our U.K. subsidiary. This non-cash remeasurement is included in foreign exchange gain or loss on the income statement and the foreign exchange loss is primarily from a U.S. Dollar and Euro bank account. The US dollar and Euro weakened relative to the British Pound when comparing the exchange rate as of September 30, 2021 to September 30, 2020, which caused the foreign exchange loss.

Interest income is primarily related to agreements that have payment terms in excess of one year (see Note 3 Accounts and Long-Term Receivable in Item 1 to this Annual Report on Form 10-K for details) from the TS-US segment as interest income recognized in each agreement decreases as principal payments are made.

The interest expense increase of $122 thousand for the year ended September 30, 2021 as compared to the prior year period is related to three new multi-year agreements with vendors in the TS U.S. division in fiscal year 2021. Payments on these agreements contain both principal and interest expense. See Note 9 Accounts payable and accrued expenses, and Other noncurrent liabilities in Item 1 to this Annual Report on Form 10-K.

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The other income increase of $97 thousand for the year ended September 30, 2021 as compared to the prior year period is primarily related to a nonrecurring rebate we received that originated several years ago, which we did not anticipate receiving.

Income Taxes

The Company recorded an income tax provision of approximately $444 thousand, which reflected an effective tax rate of 39%, for the year ended September 30, 2021. The provision is primarily driven by the recording of a full valuation allowance against US deferred tax assets that are not more-likely-than-not to be realized partially offset by the exclusion of income from the forgiveness of Paycheck Protection Program loans, the exclusion of the gain of the discontinued German entity under UK tax law, and current year federal R&D credits and the benefit resulting from the carryback of federal net operating losses to years in which the statutory federal tax rate was 34%.

For the year ended September 30, 2020, the income tax provision was approximately $384 thousand, which reflected an effective tax rate of 36%. The provision is primarily driven by the recording of a partial valuation allowance against US deferred tax assets that are not more-likely-than-not to be realized partially offset by current year federal R&D credits and the benefit resulting from the carryback of federal net operating losses to years in which the statutory federal tax rate was 34%.

During the period ended September 30, 2021, management assessed the positive and negative evidence in the U.S. operations, and concluded that it is more likely than not that the deferred tax assets as of September 30, 2021 will not be realized in light of recent results, the ongoing impacts of COVID-19, and the resulting economic fallout. In assessing the realizability of deferred tax assets, we consider taxable income in prior carryback years, as permitted under the tax law, our forecasted taxable earnings, tax planning strategies, and the expected timing of the reversal of temporary differences. This determination requires significant judgment, including assumptions about future taxable income that are based on historical and projected information and is performed on a jurisdiction-by-jurisdiction basis.

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

Gain on Discontinued Operations

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CSPi sold all stock of Modcomp GmbH to Reply AG on July 31, 2018 for $14.4 million cash and a gain of $18.1 million. This sale was recorded in fiscal year 2018. An additional €400 thousand was included in escrow as part of the Share Purchase and Assignment Agreement to potentially be received later as a purchase price adjustment in fiscal year 2021. This amount was received in July 2021 and recorded as a gain from discontinued operations in the Consolidated Statements of Operations. No income taxes were provided as the transaction was a tax-free exchange in the U.K. There are no other amounts that will be received as part of the agreement.

Liquidity and Capital Resources

Our primary source of liquidity is our cash and cash equivalents, which increased by approximately $0.7 million to $20.0 million as of September 30, 2021 from $19.3 million as of September 30, 2020.

Our significant sources of cash for the year ended September 30, 2021 are primarily related to the $1.5 million net change between a increase in accounts receivable and long-term receivable of $9.3 million netted with an increase of $10.8 million in accounts payable and accrued expenses, and other-long-term liabilities. We have multi-year agreements on both the receivables (including long-term) and payables (long-term portion in other long-term liabilities). During fiscal year 2021 we entered into agreements with customers, which contained a significant financing component totaling payments of $16.7 million including interest due to the Company over the next four years. It was determined we were acting as the agent in the transactions and recorded net revenue of approximately $0.9 million during fiscal year 2021

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from these contracts. For some of these agreements, we entered into agreements with vendors to pay for product over the next 4 years. These payments totaled $9.2 million including interest. Additionally, deferred revenue increased $0.9 million primarily due to a large upfront payment we received for one managed services contract.

Our significant uses of cash for the year ended September 30, 2021 included repayments on debt of $0.8 million, net payments under the line-of-credit agreement of $0.6 million, and principal payments on finance leases of $0.3 million.

Our cash held by our foreign subsidiary in the United Kingdom totaled approximately $10.0 million as of September 30, 2021, which consisted of 0.5 million Euros, 0.2 million British Pounds, and 9.2 million U.S. Dollars. This cash is included in our total cash and cash equivalents reported within our financial statements. Due to the large pension obligation in the U.K., we maintain a large balance of cash in the U.K., most of the cash is from the sale of Modcomp GmbH in fiscal year 2018.

As of September 30, 2021 and September 30, 2020, the Company maintained a line of credit with a capacity of up to $15.0 million for inventory accessible to both the HPP and TS segments. This line of credit also includes availability of a limited cash withdrawal of up to $1.0 million. An amount of $14.1 million and $13.4 million were available as of September 30, 2021 and September 30, 2020, respectively. As of September 30, 2021 and September 30, 2020 there were no cash withdrawals outstanding. For a further discussion of the Company’s line of credit, including its financial covenants, see Item 1, Note 12 Line of Credit.

On April 17, 2020, the Company and Modcomp, Inc., its wholly owned subsidiary each received a loan (“SBA Loans”) in the form of a promissory note from Paragon Bank in the amounts of $827,000 and $1,353,600, respectively under the Paycheck Protection Program, which was established under the recently enacted Coronavirus Aid, Relief, and Economic Security Act (“CARES Act”) administered by the U.S. Small Business Administration. The SBA loans had a two-year term and carried an annual fixed interest rate of 1%. The SBA Loans were forgiven in full by the SBA in the first quarter of fiscal year 2021.

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If cash generated from operations is insufficient to satisfy working capital requirements, we may need to access funds through bank loans or other means. 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, retain key employees, or continue to effectively operate our business.

Based on our current plans and business conditions, management believes that the Company’s available cash and cash equivalents, the cash received from the SBA loans, the cash generated from operations, and availability on our line of credit will be sufficient to provide for the Company’s working capital and capital expenditure requirements for at least 12 months from the date of this filing.

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Critical Accounting Estimates and Policies

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

We believe the following critical accounting policies affect our more significant judgments and estimates used in the preparation of our consolidated financial statements: revenue recognition, valuation allowances, specifically the

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allowance for doubtful accounts and net deferred tax asset valuation allowance, inventory valuation, intangibles, and pension and retirement plans.

Revenue Recognition

See Note 1 Summary of Significant Accounting Policies, in the Consolidated Financial Statements for additional information regarding our revenue recognition policies. The following areas involve significant judgment and estimates:

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Allocating transaction price with agreements with multiple components including leasing and/or a financing component

A financing component exists when at contract inception the period between the transfer of a promised good and/or service to the customer differs from when the customer pays for the good and/or service. As a practical expedient, we have elected not to adjust the amount of consideration for effects of a significant financing component when it is anticipated the promised good or service will be transferred and the subsequent payment will be one year or less.

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Certain contracts contain a financing component including managed services contracts with financing of hardware and software. The interest rate used reflects the approximate interest rate consistent with a separate financing transaction with the customer at the inception of the agreement. Revenues from arrangements which include financing are allocated considering relative standalone selling prices of lease and non-lease components within the agreement. The lease component includes hardware, which is subject to ASC 842, Leases. The non-lease components are subject to ASC 606, Revenue from Contracts with Customers.

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When product and non-managed services are sold together, the allocation of the transaction price to each performance obligation is calculated based on the estimated relative selling price or a budgeted cost-plus margin approach, as appropriate. Due to the complex nature of these contracts, there is significant judgment in allocating the transaction price. These estimates are periodically reviewed by project managers, engineers, and other staff involved to ensure estimates remain appropriate. For items sold separately, including hardware, software, professional services, maintenance contracts, other services, and third-party service contracts, there is no allocation as there is one performance obligation.

Professional Services Sold Without Products

The input method using labor hours expended relative to the total expected hours is used to recognize revenue for professional services. Only the hours that depict our performance toward satisfying a performance obligation are used to measure progress. An estimate of hours for each professional service agreement is made at the beginning of each contract based on prior experience and monitored throughout the performance of the services. This method is most appropriate as it depicts the measure of progress towards satisfaction of the performance obligation.

Gross versus Net Revenue

We recognize revenue from third-party service contracts as either gross sales or net sales depending on whether we are acting as a principal party to the transaction or acting as an agent or broker based on control and timing. We are a principal if we control the good or service before that good or service is transferred to the customer. We record revenue as gross when we are a principal party to the arrangement and net of cost when we are acting as a broker or agent for a third party. Under gross sales recognition, the entire selling price is recorded in revenue and our cost to the third-party service provider or vendor is recorded in cost of sales. Under net sales recognition, the cost to the third-party service provider or vendor is recorded as a reduction to revenue resulting in net sales equal to the gross profit on the transaction. Third-party service contracts are sold in different combinations with hardware, software, and services. When we are an agent, revenue is typically recorded at a point in time. When we are the principal, revenue is recognized over the contract term. We have concluded we are the agent in sales of third-party maintenance, software or hardware support, and certain security software that is sold with integral third-party delivered software maintenance that include critical updates.

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Product Warranty Accrual

Our product sales generally include a 90-day to three-year hardware warranty. At time of product shipment, we accrue for the estimated cost to repair or replace potentially defective products. Estimated warranty costs are based upon prior actual warranty costs for substantially similar products.

Engineering and Development Expenses

Engineering and development expenses include payroll, employee benefits, stock-based compensation and other headcount-related expenses associated with product development. Engineering and development expenses also include third-party development and programming costs. We consider technological feasibility for our software products to be reached upon the release of the software, accordingly, no internal software development costs have been capitalized.

Income Taxes

We use the asset and liability method of accounting for income taxes whereby deferred tax assets and liabilities are recognized for the estimated future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using enacted tax rates in effect for the year in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date. We also reduce deferred tax assets by a valuation allowance if, based on the weight of available evidence, it is more likely than not that some portion or all of the recorded deferred tax assets will not be realized in future periods. This methodology requires estimates and judgments in the determination of the recoverability of deferred tax assets and in the calculation of certain tax liabilities. Valuation allowances are recorded against the gross deferred tax assets that management believes, after considering all available positive and negative objective evidence, historical and prospective, with greater weight given to historical evidence, that it is more likely than not that these assets will not be realized.

In addition, we are required to recognize in the consolidated financial statements, those tax positions determined to be more-likely-than-not of being sustained upon examination, based on the technical merits of the positions as of the reporting date. If a tax position is not considered more-likely-than-not to be sustained based solely on its technical merits, no benefits of the position are recognized.

In addition, the calculation of the Company’s tax liabilities involves dealing with uncertainties in the application of complex tax regulations in a multitude of jurisdictions. The Company records liabilities for estimated tax obligations in the U.S. and other tax jurisdictions. These estimated tax liabilities include the provision for taxes that may become payable in the future.

Intangible Assets

Intangible assets that are not subject to amortization are also required to be tested annually, or more frequently if events or circumstances indicate that the asset may be impaired. We did not have intangible assets with indefinite lives at any time during the two years ended September 30, 2021. Intangible assets subject to amortization are amortized over their estimated useful lives, generally three to ten years, and are carried at net book value. The remaining useful lives of intangible assets are evaluated on an annual basis. Intangible assets subject to amortization are also tested for recoverability whenever events or changes in circumstances indicate that their carrying amount may not be recoverable. If the fair value of an intangible asset subject to amortization is determined to be less than its carrying value, then an impairment charge is recorded to write down that asset to its fair value.

Inventories

Inventories are stated at the lower of cost or market, with cost determined using the first-in, first-out method. The recoverability of inventories is based upon the types and levels of inventories held, forecasted demand, pricing,

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

Pension and Retirement Plans

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

We have defined benefit and defined contribution plans in the U.K. and in the U.S. In the U.K., the Company provides defined benefit pension plans for certain employees and former employees and defined contribution plans for the majority of the employees. The defined benefit plans in the U.K. are closed to newly hired employees and have been for the two years ended September 30, 2021. In the U.S., the Company provides defined contribution plans that cover most employees and supplementary retirement plans to certain employees and former employees who are now retired. These supplementary retirement plans are also closed to newly hired employees and have been for the two years ended September 30, 2021. These supplementary plans are funded through whole life insurance policies. The Company expects to recover all insurance premiums paid under these policies in the future, through the cash surrender value of the policies and any death benefits or portions thereof to be paid upon the death of the participant. These whole life insurance policies are carried on the balance sheet at their cash surrender values as they are owned by the Company and not assets of the defined benefit plans. In the U.S., the Company also provides for officer death benefits and post-retirement health insurance benefits through supplemental post-retirement plans to certain officers. The Company also funds these supplemental plans’ obligations through whole life insurance policies on the officers.

Pension expense is based on an actuarial computation of current future benefits using estimates for expected return on assets, expected compensation increases and applicable discount rates. Management has reviewed the discount rates and rates of return with our consulting actuaries and investment advisers and concluded they were reasonable. A decrease in the expected return on pension assets would increase pension expense. Expected compensation increases are estimated based on historical and expected increases in the future. Increases in estimated compensation increases would result in higher pension expense while decreases would lower pension expense. Discount rates are selected based upon rates of return on high quality fixed income investments currently available and expected to be available during the period to maturity of the pension benefit. A decrease in the discount rate would result in greater pension expense while an increase in the discount rate would decrease pension expense.

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

Inflation and Changing Prices

Management does not believe that inflation and changing prices had significant impact on sales, revenues or income during fiscal years 2021 or 2020. However, we have seen a trend of significantly increasing prices, specifically with integrated circuit vendors. We try to pass these price increases to our customers, but certain economic factors and technological advances have placed downward pressure on pricing. There is no assurance that the Company’s business will not be materially and adversely affected by inflation and changing prices in the future.

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