CSP INC /MA/ (CSPI) FY 2024 MD&A

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.

Recent trends affecting our financial performance

As of September 30, 2024, the Russian/Ukrainian military conflict and the Israeli-Hamas conflict have not had a direct significant impact on revenue as we do not have any significant recurring customers in either region. However, we do have customers and suppliers in surrounding regions which may be affected and further escalation of both conflicts and geopolitical tensions related to such conflicts could adversely affect our business, financial condition and results of operations, by among other things, cyberattacks, supply disruptions, lower consumer demand, and changes to foreign exchange rates and financial markets. It is not possible at this time to predict the size of the impact or consequences of the conflicts on the Company and our customers or suppliers.

Overview of Fiscal 2024 Results of Operations

Revenue decreased by approximately $9.4 million, or 15%, to $55.2 million for the fiscal year ended September 30, 2024 compared to $64.6 million for the fiscal year ended September 30, 2023.

Gross profit margin percentage remained consistent at 34% for the fiscal year ended September 30, 2024 and 2023.

We generated an operating loss of $(1.9) million for the fiscal year ended September 30, 2024 as compared to operating income of $1.9 million for the fiscal year ended September 30, 2023.

Other income, net was $1.5 million for the fiscal year ended September 30, 2024 as compared to $2.9 million for the prior year.

The Company recorded an income tax benefit of $(93) thousand, which reflected an effective tax rate of 22.2%, for the fiscal year ended September 30, 2024 compared to an income tax benefit of $(469) thousand, which reflected an effective tax rate of (9.9)% for the fiscal year ended September 30, 2023.

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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:

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Revenues

Revenue decreased by approximately $9.4 million, or approximately 15%, to $55.2 million for the fiscal year ended September 30, 2024 compared to $64.6 million for the fiscal year ended September 30, 2023.

TS segment revenue changes by products and services for the fiscal years ended September 30, 2024 and 2023 were as follows:

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Our TS segment revenue decreased by approximately $6.7 million consisting of a decrease of $6.6 million in our U.S. division combined with a decrease of $0.1 million in our U.K. division. The decrease in TS segment product revenue of $7.5 million during the period was the result of a $7.4 million decrease in the U.S. division combined with a decrease of $0.1 million in the U.K. division. Interest rates were relatively high compared to prior years in fiscal year 2024 along with inflation which caused economic uncertainty and some reduced customer spending on products. The decrease in our U.S. division product revenue year over year was primarily associated with several existing major customers, partially offset by an increase with several new major customers and existing customers. The decrease in the U.K. division year over year was primarily associated with two major customers. The increase in TS segment service revenue of $0.8 million as compared to the prior year was in the U.S. division. In fiscal year 2024 as compared to the prior year, the U.S. division had an increase of $1.1 million in third party maintenance revenue, an increase of $0.4 million in managed services, partially offset by a decrease of $0.7 million in internal services.

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HPP segment revenue changes by product and services for the fiscal years ended September 30, 2024 and 2023 were as follows:

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Our HPP segment revenue decreased by approximately $2.7 million or 40%. The decrease in HPP product revenue of $2.9 million in the fiscal year ended September 30, 2024 was primarily the result of two major non-recurring transactions of $1.8 million and $1.2 million in the prior year along with several other customers, partially offset  by one major AZT sale in fiscal year 2024. The increase in HPP service revenue of approximately $0.2 million for the fiscal year ended September 30, 2024 was primarily the result of a $0.5 million increase in ARIA revenue, partially offset with a decrease of $0.3 million in royalty revenues on high-speed processing boards related to the E2D program as compared to the fiscal year ended September 30, 2023.

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

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The $9.5 million decrease in the Americas revenue for the fiscal year ended September 30, 2024 as compared to the fiscal year ended September 30, 2023 was primarily due to decreased revenue by our TS-US division of $7.0 million, decreased revenue by our TS-UK division of $0.1 million, and decreased revenue by our HPP segment of $2.4 million. Sales to Europe decreased by $0.3 million primarily due to a decrease by our HPP segment of $0.3 million. Sales to Europe in the TS segment remained flat with an increase in the TS-US division of $0.1 million, offset with a decrease in the TS-UK division of $0.1 million. Sales to Asia-Pacific increased $0.4 million due to the TS-US division.

Gross Margins

Our gross margin ("GM") decreased by $3.1 million to $18.9 million for fiscal year 2024 as compared to GM of approximately $21.9 million for fiscal year 2023. The total GM as a percentage of revenue remained flat at 34% for fiscal year 2024 and 2023.

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

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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:

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The overall TS segment GM as a percentage of revenue increased to 32% in fiscal year 2024 from 31% in fiscal year 2023. The $2.1 million product GM decrease in fiscal year 2024 as compared to the prior year resulted from a decrease in the U.S. division. Product GM as a percentage of revenue decreased 2% for fiscal year 2024 compared to the prior year due to product mix. The $0.6 million increase in our TS segment service GM in fiscal year 2024 as compared to the prior year resulted from an increase in GM in the U.S. division. Service GM as a percentage of revenue remained flat at 59% in fiscal year 2024 due to increased third party maintenance revenue, which is recorded as net sales meaning all the gross margin is recorded in the services revenue financial statement line item causing increased GM as a percentage of revenue, offset by decreased GM from internal services which have associated fixed costs which decreased the GM as a percentage of revenue.

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

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The overall HPP segment GM as a percentage of revenue increased to 65% in fiscal year 2024 from 62% in fiscal year 2023. The GM as a percentage of sales from products increased 9% primarily due to the large ARIA AZT sale which was nearly all GM. The GM as a percentage of sales from services decreased 5% primarily due to decreased Multicomputer royalty revenues, which is nearly all GM and recorded as service revenue.

Engineering and Development Expenses

Our engineering and development expenses are only in our HPP segment. These expenses decreased $0.1 million to $3.0 million for fiscal year 2024 from $3.1 million for fiscal year 2023. This was primarily due to decreased labor expenses of $0.2 million in fiscal year 2024 when compared to fiscal year 2023, partially offset by increased stock compensation of $0.1 million. Fiscal year 2024 and 2023 expenses were primarily for product engineering expenses incurred in connection with the further development of the ARIA Zero Trust (AZT) and 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, 2024 and 2023:

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The TS segment SG&A expenses increased approximately $0.1 million for the fiscal year ended September 30, 2024 when compared to the prior year. This increase was primarily due to an increase in audit and tax fees of $0.3 million, an increase in stock compensation expense of $0.2 million, an increase in actuarial fees of $0.2 million in connection to preparing to sell the pension in the TS-UK division, partially offset with decreased variable compensation of $0.3 million and decreased bonus of $0.3 million.

The HPP segment SG&A expense increase of $0.8 million for the fiscal year ended September 30, 2024 when compared to the prior year was primarily attributed to increased consulting of $0.4 million, increased professional services of $0.2 million, increased selling including travel and events of $0.2 million, increased stock compensation of $0.1 million, increased recruiting of $0.1 million, partially offset by decreased bonuses of $0.2 million.

Other Income/Expenses

The following table details our other income (expense) for the years ended September 30, 2024 and 2023:

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For the year ended September 30, 2024 the foreign exchange loss decreased $0.1 million primarily due to the U.S. dollar weakening less against the British pound in fiscal year 2024 compared to the prior year. The U.K. division has 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 gain or loss is primarily from a U.S. Dollar and Euro bank account. The U.S. Dollar bank account consists of approximately 87% of the currency held in the U.K. subsidiary after remeasurement into U.S. dollars.

Interest expense decreased $27 thousand for the year ended September 30, 2024 compared to the prior year period primarily due to less interest expense related to multi-year agreements with vendors in the TS U.S. division. Payments on these agreements contain both principal and interest expense. As principal payments are made the interest expense decreases. 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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Interest income increased $0.6 million for the year ended September 30, 2024 when compared to the prior year. Interest income from cash and cash equivalents in fiscal year 2024 increased $0.7 million from prior year due to a significantly higher average balance during fiscal year 2024 earning interest income, partially offset by decreased interest income from multi-year agreements of $0.1 million. These agreements have payment terms in excess of one year (see Note 3 Financing Receivables, net in Item 1 to this Annual Report on Form 10-K for details) and are only in the TS-US segment.

The Employee Retention Tax Credit, net of costs to collect of $2.1 million was recognized in the fourth quarter of fiscal year 2023. The Coronavirus Aid, Relief, and Economic Security Act provided an Employee Retention Credit (“ERC”) which is a refundable tax credit against certain employment taxes. The Consolidated Appropriations Act, 2021 extended and expanded the availability of the employee retention credit through December 31, 2021 including amending the employee retention credit to be equal to 70% of qualified wages paid to employees during the 2021 calendar year. Both the TS-US division and HPP segment qualified for the ERC beginning in March 2021 for qualified wages through September 2021. There are no other amounts that will be received related to this credit.

Income Taxes

The Company recorded an income tax benefit of $(93) thousand, which reflected an effective tax rate of 22.2%, for the year ended September 30, 2024. The provision is primarily driven by the benefit recognized as a result of windfalls for restricted stock awards that vested during the period, offset by the change in valuation allowance. The benefit recorded during the fiscal year was $189 thousand for the windfall on restricted stock awards vesting during the period and an expense of $180 thousand for the change in valuation allowances against deferred tax assets.

For the year ended September 30, 2023, the income tax benefit was approximately $(469) thousand, which reflected an effective tax rate of a (9.9)% benefit. The provision was primarily driven by the benefit recognized as a result of the release of the valuation allowance against the majority of the Company's deferred tax assets. The benefit recorded during the fiscal year was $1.8 million for valuation allowances released on deferred tax assets related to prior years. The Company also claimed and received the Employee Retention Credit, which resulted in a net benefit of approximately $134 thousand, after amending prior year returns.

The Company undertakes a review of its valuation allowance at each financial statement period, reviewing the positive and negative evidence to help determine whether it is more likely than not that the Company will realize the future tax benefits from its deferred tax balances. The Company has determined that it is more likely than not that substantially all of its net deferred tax assets in the U.S. jurisdiction will be utilized and that associated valuation allowances should be reversed during year ended September 30, 2024. The Company separately analyzed the realizability of its federal and state credits and determined $796 thousand (net of federal benefit) of state credits are expected to expire unutilized and kept a valuation allowance against these credits. The Company will continue to maintain a valuation allowance against certain state tax credits in the U.S. and a full valuation allowance against the net deferred tax assets in the U.K. jurisdiction.

Liquidity and Capital Resources

Cash Flows

Our primary source of liquidity and capital resources is our cash from operations and our line of credit.

Cash and cash equivalents increased by $5.4 million to $30.6 million as of September 30, 2024 from $25.2 million as of September 30, 2023.

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The following is a summary of our cash flows for the fiscal year ended September 30, 2024 and 2023:

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Operating Activities

Cash provided by operating activities was $4.2 million for the year ended September 30, 2024 compared to $3.9 million for the prior year. The increase from prior year is primarily related the change in Accounts payable and accrued expense payments of $13.0 million as a large payment run at the end of fiscal year 2023 when in fiscal year 2024 there was not and a decrease in pension and retirement plan liabilities of $0.4 million. The primary decreases include a decrease of net income (loss) change of $5.5 million, a decrease of $4.9 million in other assets, and a decrease of $2.7 million in accounts receivable.

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The remaining differences are related to timing differences in operating assets and liabilities.

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Investing Activities

Cash used in investing activities was $258 thousand for the year ended September 30, 2024 compared to $341 thousand used in investing activities for the prior year. The decrease from the prior year is primarily related to less additions of intangible assets and less purchases of property, equipment, and improvements during fiscal year 2024 when compared to the prior fiscal year.

Financing Activities

Cash provided by financing activities was $1.4 million for the year ended September 30, 2024 compared to $2.4 million used in financing activities for the prior year. The primary difference was the timing in the net borrowing on the line-of-credit, which for the year ended September 30, 2024 we had a net borrowing of $2.7 million compared to a net payment of $1.6 million in the prior year. Additionally, in fiscal year 2024 there were increased cash dividends paid by $0.4 million and increased treasury stock repurchases of $0.1 million compared to the prior fiscal year.

Other Liquidity and Capital Resources Items

Our cash held by our foreign subsidiary in the United Kingdom totaled the equivalent of approximately $5.4 million as of September 30, 2024, which consisted of 0.4 million Euros, 0.3 million British Pounds, and 4.7 million U.S. Dollars. This cash is included in our total cash and cash equivalents reported within our financial statements. Due to the pension obligation in the U.K., we maintain a large balance of cash in the U.K. Subsequent to September 30, 2024, the U.K. pension assets, excluding cash, were all converted into cash to sell the U.K. pension obligation. As of the date of this filing, there is an agreement to sell the pension obligation in full. This agreement has many contingencies and the expected timeframe of the sale occurring is 4 to 16 months from the date of this filing.

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As of September 30, 2024 and September 30, 2023, 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. Amounts of $10.2 million and $13.5 million were available as of September 30, 2024 and September 30, 2023, respectively. As of September 30, 2024 and September 30, 2023 there were

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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.

The last note payable was paid in full in fiscal year 2024 of $0.4 million and no notes remain outstanding as of September 30, 2024. There is a total of $3.8 million due to vendors with financing agreements outstanding as of September 30, 2024, including $2.3 million payments to be made that are current. Each vendor financing agreement was related to a sale and has a related financing receivable. There is a total of $7.3 million due to the Company of customer financing agreements outstanding as of September 30, 2024, including $4.3 million to be received that are current.

A subsequent review of qualified wages for the Employee Retention Credit was performed during the preparation of the tax provision for fiscal year 2023 and it was determined $0.6 million of the money received did not qualify and was paid back to the Internal Revenue Service (IRS) except for $11k, which is still owed to the IRS as of September 30, 2024. This $0.6 million was included in Cash and cash equivalents as of September 30, 2023. However, this amount was not recognized in net income in the Consolidated statements of operations for the fiscal year ended September 30, 2023. The Company may be subject to interest and penalties related to this cash.

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 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 the inventory valuation, income taxes, deferred compensation, revenue recognition, retirement plans, 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 net deferred tax asset valuation allowance, inventory valuation, 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 the principal party to the transaction or acting as an agent or broker based on control and timing. We are the principal if we control the good or service before that good or service is transferred to the customer. For each identified performance obligation in a transaction, we evaluate the facts and circumstances present to determine whether or not we control the specified good or service prior to transfer to the customer. This evaluation includes, but is not limited to, assessing indicators such as whether: (i) we are primarily responsible for fulfilling the promise to provide the specified goods or service, (ii) we have inventory risk before the specified good or service has been transferred to a customer and (iii) we have discretion in establishing the price for the specified good or service. When the evaluation indicates we control the specified good or service prior to transfer to the customer, we are acting as a principal. When the evaluation indicates we do not control the specified good or service prior to transfer to the customer, we are acting as an agent.

We record revenue as gross when we are the 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 includes critical updates. When CSPi sells goods and services with a financing component the strongest indicator is whether the Company has discretion in selling price as many of the agreements are brought to us at predetermined price by the manufacturer.

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

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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.

Inventories

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

Pension and Retirement Plans

The funded status of pension and other post-retirement benefit plans is recognized prospectively on the consolidated balance sheet. Gains and losses, prior service costs and credits and any remaining transition amounts that have not yet been recognized through pension expense will be recognized in accumulated other comprehensive 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, 2024. 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, 2024. 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

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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.