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United States
Securities and Exchange Commission
Washington, D.C. 20549

Form 10-Q

(Mark One)

[X] Quarterly Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934

For the Period Ended January 31, 2003

or

[   ] 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 0-21236

 

Applied Signal Technology, Inc.
(Exact name of registrant as specified in its charter)

California
(State or other jurisdiction of incorporation or organization)

77-0015491
(I.R.S. Employer Identification No.)

400 West California Avenue, Sunnyvale, CA 94086
(408) 749-1888
(Registrant’s telephone number, including area code)

Not Applicable
(Former name, former address, and former fiscal year, if changed since last report)

 

Indicate by a check 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 periods that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.

ü    

Yes

 

No

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act).

ü    

Yes

 

No

Applicable Only to Corporate Issuers

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practical date.

Common Stock, no par value, 10,293,900 shares outstanding as of January 31, 2003.


 

Index
Applied Signal Technology, Inc.

Part I. Financial Information

Item 1: Financial Statements (Unaudited)

Consolidated Balance Sheets — January 31, 2003 and October 31, 2002

Consolidated Statements of Operations — Three months ended January 31, 2003 and February 1, 2002

Consolidated Statements of Cash Flows — Three months ended January 31, 2003 and February 1, 2002

Notes to Consolidated Financial Statements — January 31, 2003

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

Item 3: Quantitative and Qualitative Disclosures About Market Risk

Item 4: Controls and Procedures

Part II. Other Information

Item 1: Legal Proceedings

Item 2: Changes in Securities and Use of Proceeds

Item 3: Defaults Upon Senior Securities

Item 4: Submission of Matter to a Vote of Security Holders

Item 5: Other Information

Item 6: Exhibits and Reports on Form 8-K

Signatures

Certifications

Index to Exhibits


 

Part I. Financial Information

Item 1: Financial Statements

Applied Signal Technology, Inc.
Consolidated Balance Sheets
(In thousands, except share data)


Assets

January 31, 2003
(Unaudited)

 

October 31, 2002
(Note)

Current assets:

    Cash and cash equivalents

$10,174

$12,217

    Short term investments

20,557

12,710

    Accounts receivable:

        Billed

9,113

14,821

        Unbilled

9,653
__________

9,806
__________

            Total accounts receivable

18,766

24,627

Inventory

9,497

7,259

Prepaid and other current assets

1,928
__________

2,083
__________

            Total current assets

60,922

58,896

Property and equipment, at cost:

    Machinery and equipment

42,870

41,921

    Furniture and fixtures

4,956

4,956

    Leasehold improvements

10,192

10,157

    Construction in process

387
__________

412
__________

58,405

57,446

Accumulated depreciation and amortization

(44,065)
__________

(42,932)
__________

    Net property and equipment

14,340

14,514

Other assets

414
__________

414
__________

Total assets

$75,676
========

$73,824
========

 


 

Applied Signal Technology, Inc.
Consolidated Balance Sheets (continued)
(In thousands, except share data)


Liabilities and Shareholders’ Equity

January 31, 2003
(Unaudited)

 

October 31, 2002
(Note)

Current liabilities:

    Accounts payable

$1,508

$1,496

    Accrued payroll and related benefits

4,365

5,205

    Other accrued liabilities

1,927

2,004

    Income taxes payable

52
_________


_________

        Total current liabilities

7,852

8,705

Other liabilities

146

146

Shareholders’ equity:

    Common stock, no par value: 20,000,000 shares authorized; issued and outstanding: 10,293,900 at January 31, 2003 and 10,054,744 at October 31, 2002



27,455



26,565

    Retained earnings

40,128

38,343

    Accumulated comprehensive income

95
_________

65
_________

Total shareholders’ equity

67,678
_________

64,973
_________

    Total liabilities and shareholders’ equity

$75,676
=========

$73,824
=========

 

Note: The balance sheet at October 31, 2002 has been derived from the audited financial statement at that date but does not include all of the information required by accounting principles generally accepted in the United States for complete financial statements.

See Notes to Consolidated Financial Statements.


 

Applied Signal Technology, Inc.
Consolidated Statements of Operations
(Unaudited)
(In thousands, except per share data)

 
Three Months Ended
 

January 31, 2003

 

February 1, 2002

Revenues from contracts

$18,178

$16,231

Operating expenses:

    Contract costs

11,556

9,759

    Research and development

1,701

1,917

    General and administrative

2,921
________

2,700
________

        Total operating expenses

16,178
________

14,376
________

Operating income

2,000

1,855

Interest income, net

100
________

24
________

Income before provision
for income taxes


2,100


1,879

Provision for income taxes

315
________

188
________

Net income

$1,785
========

$1,691
========

Net income per common share:

    Basic

$0.17

$0.17

    Diluted

$0.17

$0.17

Number of shares used in calculating net
income per common share:

    Basic

10,216

9,732

    Diluted

10,429

9,888

 

See Notes to Consolidated Financial Statements.


 

Applied Signal Technology, Inc.
Consolidated Statements of Cash Flows
Increase (decrease) in cash and cash equivalents
(Unaudited)
(In thousands)

 
Three Months Ended
 

January 31, 2003

 

February 1, 2002

Operating Activities:

 

    Net income

$1,785

$1,691

    Adjustments to reconcile net income to net cash provided by (used in) operating activities

        Depreciation and amortization

1,173

1,286

    Changes in:

        Accounts receivable

5,861

(2,248)

        Inventory, prepaids, and other assets

(2,083)

(3,737)

        Accounts payable, taxes payable, and accrued expenses

(853)
_________

819
_________

        Net cash provided by (used in) operating activities

5,883

(2,189)

Investing Activities:

 

    Purchases of available-for-sale securities

(7,817)

    Additions to property and equipment

(999)
_________

(108)
_________

        Net cash used in investing activities

(8,816)

(108)

Financing Activities:

 

    Issuance of common stock

890
_________

680
_________

    Net cash provided by financing activities

890

680

    Net decrease in cash and cash equivalents

(2,043)

(1,617)

    Cash and cash equivalents, beginning of period

12,217
_________

9,743
_________

    Cash and cash equivalents, end of period

10,174
=========

8,126
=========

Supplemental disclosures of cash flow information:

    Interest paid

$26

$13

 

See Notes to Consolidated Financial Statements.


 

Applied Signal Technology, Inc.
Notes to Consolidated Financial Statements
(unaudited)
January 31, 2003

Note 1: Summary of Significant Accounting Policies

Description of Business and Basis of Presentation

Applied Signal Technology, Inc. was incorporated in California on January 12, 1984. We provide advanced digital signal processing products, systems, and services used in reconnaissance of foreign telecommunications signals. Our primary customers are the United States Government and its foreign allies.

The accompanying unaudited consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by accounting principles generally accepted in the United States for complete financial statements. In the opinion of management, all adjustments (consisting of normal recurring adjustments) considered necessary for a fair presentation have been included. Operating results for the three-month period ending January 31, 2003 are not necessarily indicative of the results that may be expected for the year ending October 31, 2003. For further information, refer to the consolidated financial statements and footnotes thereto included in our Annual Report on Form 10-K for the year ended October 31, 2002.

Estimates

In order for us to prepare financial statements in conformity with accounting principles generally accepted in the United States, management is required to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Actual results could differ significantly from those estimates.

Revenues and Contract Accounting

Revenues and cost recognition. The majority of our contracts are accounted for in accordance with the American Institute of Certified Public Accountants Statement of Opinion 81-1, Accounting for Performance of Construction-Type and Production-Type Contracts.

We account for cost reimbursement contracts by charging contract costs to operations as incurred and recognizing contract revenues and profits by applying an estimated fee rate to actual costs on an individual contract basis. Cost-reimbursement contracts represent approximately 73% of contract revenues in the first quarter of fiscal year 2003 (61% in the first quarter of fiscal year 2002).

Our engineering services contracts are typically performed on a level-of-effort basis. Revenue is calculated in accordance with our policy regarding cost-reimbursement contracts; specifically, revenue is based on a fee percentage applied to the costs incurred on these contracts.

We account for fixed-price contracts by using the percentage-of-completion method of accounting. Under this method, contract costs are charged to operations as incurred. A portion of the contract revenue, based on estimated profits and the degree of completion of the contract as measured by a comparison of the actual and estimated costs, is recognized as revenue each period. Unexpected increases in the cost to develop or manufacture a product under a fixed-price contract, whether due to inaccurate estimates in the bidding process, unanticipated increases in material costs, inefficiencies, or other factors are borne by us, and could have a material adverse effect on our results of operations. Fixed-price contracts represent approximately 27% of contract revenues in the first quarter of fiscal year 2003 (39% in the first quarter of fiscal year 2002).

Management reviews contract performance, costs incurred, and estimated completion costs regularly, and adjusts revenues and profits on contracts in the period in which changes become determinable. Anticipated losses on contracts are recorded in the period in which they become determinable.

Indirect rate variance. We record contract revenues and costs for interim reporting purposes based on annual targeted indirect rates. At year-end, the revenues and costs are adjusted for actual indirect rates. During our interim reporting periods, variances may accumulate between the actual indirect rates and the annual targeted rates. All timing-related indirect spending variances are inventoried as part of work in process during these interim reporting periods. These rates are reviewed regularly, and we record reserves for any permanent variances in the period they become known. Please refer to "Notes to Consolidated Financial Statements, Note 2: Inventory" for the current year inventoried spending variance.

Our accounting policy is based on management’s belief that such a variance will be absorbed by expected contract activities during the remainder of the year. If contract activities do not reach planned levels, there are alternatives we can utilize to absorb the variance: we can adjust downward some of our planned indirect spending during the year, increase our billing rates to our customers, or record charges to expense based on reduced estimates of future contract activities.

Award fees. Our policy for recognizing interim fees on our award fee contracts is based on management’s assessment, on a contract-by-contract basis, as to the likelihood that the award fee or an incremental portion of the award fee will be earned. Management’s assessments are based on numerous factors including: contract terms, nature of the work to be performed, our relationship and history with the customer, our history with similar types of projects, and our current and anticipated performance on the specific contract. No award fee is recognized until management determines that it is probable that an award fee or portion thereof will be earned.

Accounts receivables. Accounts receivables are segregated between billed and unbilled accounts. For cost-reimbursement contracts, we bill incurred costs and a portion of our fees on a regular basis. Under fixed-price contracts, we either regularly progress bill 90% of incurred costs or bill contract costs on a milestone or unit of delivery basis. Unbilled amounts result from recognition of contract revenue in advance of contractual billing or progress billing terms.

Cash Equivalents and Investments

We consider all highly liquid debt instruments purchased with an original maturity date of three months or less to be cash equivalents.

Short-term investments include securities that are classified as available-for-sale and are carried at fair market value. At the time of purchase, management determines the appropriate classification of these securities and re-evaluates such designation as of each balance sheet date. Unrealized gains and losses, net of tax, are reported in shareholders’ equity as part of retained earnings. The cost of securities sold is based on the specific identification method. Realized gains and losses on sales of available-for-sale securities were not material in the first three months of fiscal years 2003 and 2002.

The following tables summarize our cash, cash equivalents, and short-term securities (in thousands):

 
January 31, 2003

Amortized Cost

Gross Unrealized
Gains

Gross Unrealized Losses

Estimated Fair Market Value

Cash and cash equivalents

$10,174

$—

$—

$10,174

Short-term, available-for-sale securities:

    Asset-backed securities

2,525

10

2,535

    Corporate securities

5,318

26

(3)

5,341

    Government securities

10,139

62

10,201

    Money market securities

2,480
________


________


________

2,480
________

$30,636
========

$98
========

($3)
========

$30,731
========

 

 
October 31, 2002

Amortized Cost

Gross Unrealized
Gains

Gross Unrealized Losses

Estimated Fair Market Value

Cash and cash equivalents

$12,215

$2

$—

$12,217

Short-term, available-for-sale securities:

    Asset-backed securities

1,523

5

1,528

    Corporate securities

4,007

15

(2)

4,020

    Government securities

7,117
________

45
________


________

7,162
________

$24,862
========

$67
========

($2)
========

$24,927
========

 

The following table summarizes the maturities of our investments (in thousands):

January 31, 2003

October 31, 2002

Due in one year or less

$6,036

$1,031

Due in one to three years

14,521
________

11,679
________

$20,557
========

$12,710
========

 

Per Share Data

Basic net income per share is determined by dividing net income by the weighted average number of common shares outstanding during the period. Diluted net income per share is determined by dividing net income by the weighted average number of common shares used in the basic earnings per share calculation, plus the number of common shares that would be issued assuming conversion of all potentially dilutive securities outstanding under the treasury stock method.

The per share data is as follows (in thousands, except per share amounts):

 
Three Months Ended
 

January 31, 2003

 

February 1, 2002

Numerator:

     

    Net income

$1,785
========

$1,691
========

Denominator:

    Shares used to compute net income per common share-basic


10,216


9,732

    Effect of dilutive stock options

213
________

156
________

    Shares used to compute net income per common share-diluted


10,429
========


9,888
========

    Net income per common share – basic

$0.17

$0.17

    Net income per common share diluted

$0.17

$0.17

 

Comprehensive Income

The components of comprehensive income, net of tax are as follows (in thousands):

 
Three Months Ended
 

January 31, 2003

 

February 1, 2002

Net income

$1,785

$1,691

Unrealized gain on securities

30
________


________

Comprehensive income

$1,815
========

$1,691
========

 

As of January 31, 2003, net unrealized gain on securities was approximately $95,000. As of October 31, 2002, net unrealized gain on securities was approximately $65,000.

Note 2: Inventory

The components of inventory consist of the following (in thousands):

 

January 31, 2003

 

October 31, 2002

Raw materials

$811

$812

Work in process

8,007

5,747

Finished goods

573
________

613
________

9,391

7,172

Precontract costs

106
________

87
________

$9,497
========

$7,259
========

 

At January 31, 2003, the unfavorable inventoried indirect rate variance was approximately $1,004,000. At February 1, 2002, the unfavorable inventoried indirect rate variance was approximately $3,508,000. At October 31, 2002 and October 31, 2001, costs were recorded at actual indirect rates, and therefore the rate variance balances were zero. Management believes that the rate variance at January 31, 2003 will be absorbed by expected contract activities during the remainder of fiscal year 2003. For further information on our accounting policy for this inventoried variance, see "Notes to Consolidated Financial Statements, Note 1: Summary of Significant Accounting Policies."

Precontract costs represent costs incurred in connection with ongoing contracts for which contract modifications have not been definitized and costs incurred in anticipation of specific expected future contract awards.

 

Note 3: Recent Accounting Pronouncements

In August 2001, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standards (SFAS) No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets, which addresses financial accounting and reporting for the impairment or disposal of long-lived assets and supersedes SFAS No. 121, Accounting for the Impairment of Long-lived Assets and for Long-lived Assets to be Disposed Of, and the accounting and reporting provisions of APB Opinion No. 30, Reporting the Results of Operations, for a disposal of a segment of a business. SFAS 144 is effective for fiscal years beginning after December 15, 2001, with earlier application encouraged. We adopted SFAS 144 on October 1, 2002 and the adoption did not have a material effect on our financial position or results of operations.

In July 2002, the FASB issued SFAS No. 146, Accounting for Costs Associated with Exit or Disposal Activities. SFAS 146 addresses the financial accounting and reporting for obligations associated with an exit activity, including restructuring, or with a disposal of long-lived assets. Exit activities include, but are not limited to, eliminating or reducing product lines, terminating employees and contracts and relocating plant facilities or personnel. SFAS 146 specifies that a company will record a liability for a cost associated with an exit or disposal activity only when that liability is incurred and can be measured at fair value. Therefore, commitment to an exit plan or a plan of disposal expresses only management’s intended future actions and does not meet the requirement for recognizing a liability and the related expense. SFAS 146 is effective prospectively for exit or disposal activities initiated after December 31, 2002, with earlier adoption encouraged. The adoption of SFAS 146 did not have an effect on our financial position or results of operations.

In December 2002, the FASB issued SFAS No. 148, Accounting for Stock-Based Compensation — Transition and Disclosure. SFAS 148 amends SFAS 123, Accounting for Stock-Based Compensation, to provide alternative methods of transition to SFAS 123’s fair value method of accounting for stock-based employee compensation. SFAS 148 also amends the disclosure provisions of SFAS 123 and APB Opinion No. 28, Interim Financial Reporting, to require disclosure in the summary of significant accounting policies of the effects of an entity’s accounting policy with respect to stock-based employee compensation on reported net income and earnings per share in annual and interim financial statements. SFAS 148’s amendment of the transition and annual disclosure requirements of SFAS 123 are effective for our fiscal year 2003. SFAS 148’s amendment of the disclosure requirements of Opinion 28 is effective for our second quarter of fiscal year 2003.

In November 2002, the FASB issued FASB Interpretation No. 45, Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others, an Interpretation of FASB Statements No. 5, 57, and 107 and Rescission of FASB Interpretation No. 34. The Interpretation elaborates on the disclosures to be made by a guarantor in its interim and annual financial statements about its obligations under certain guarantees that it has issued. It also requires a guarantor to recognize, at the inception of a guarantee, a liability for the fair value of the obligation undertaken in issuing the guarantee. The initial recognition and measurement provisions of the Interpretation apply to guarantees issued or modified after December 31, 2002. Applied Signal Technology does not expect the adoption of this accounting pronouncement to have a material effect on its consolidated financial position or results of operations.

Note 4: Line of Credit

At January 31, 2003, we had a $3,000,000 secured, revolving bank line of credit available for short-term cash requirements, which is secured by all of our assets and expires on March 15, 2003. Borrowings under the line of credit bear interest at the bank’s reference rate (4.25% at January 31, 2003) and are payable monthly. At both January 31, 2003 and October 31, 2002, this facility was unused. Under this credit facility, we are subject to certain commitment and utilization fees on the unused portion of the committed amount. Fees incurred were not material during the first quarter of fiscal year 2003 and fiscal year 2002. The line of credit agreement requires us to comply with certain financial covenants. At both January 31, 2003 and October 31, 2002, we were in compliance with all restrictions and covenants, and this facility had not been utilized. We do not plan to renew this line of credit and have canceled the outstanding letters of credit associated with this facility. In February 2003 we entered into a new cash-secured line of credit in the amount $1,500,000, which will expire on March 1, 2004. Any borrowings bear interest at the bank’s reference rate and accrued interest is payable monthly. There are no fees associated with the unused portion of the committed amount. Under this new line of credit agreement, we have one standby letter of credit outstanding in the amount of approximately $1,218,000, related to our facilities lease.

Note 5: Segment Reporting

The financial information relating to Applied Signal Technology is reviewed and evaluated by the chief operating decision-maker as a whole, and not its individual divisions. In addition, divisional financial information is not available below the gross margin level. Thus, there is only one reportable segment during the first three months of fiscal years 2003 and 2002.

Note 6: Provision for Income Taxes

Our estimated annual effective tax rate for the quarter ended January 31, 2003 was 15% compared to a 10% effective rate for the comparable period in 2002. Our projected annual effective tax rate for fiscal year 2003 is calculated based on the projected income for the year and differs from the statutory rate primarily due to a benefit of deferred tax assets for which a valuation allowance has been recorded at the end of fiscal year 2002.

Note 7: Contingencies

Product Warranties

Our products, including associated firmware and software, are warranted against defective workmanship and materials for a period of one year from the date of acceptance by the original purchaser. In addition, we offer extended warranties as a percentage of the purchase price. An additional six-month warranty may be purchased for 3% of the unit or system purchase price. Additional one-year warranty coverage is 5% of the unit or system purchase price. Warranty costs were approximately $43,000 and $83,000 for the first quarters of fiscal years 2003 and 2002, respectively.


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

The following information should be read in conjunction with the attached financial statements and notes thereto.

This quarterly report on Form 10-Q contains forward-looking statements made pursuant to the provisions of Section 21E of the Securities Exchange Act of 1934. These forward-looking statements are based on management’s current expectations and beliefs, including estimates and projections about our industry. Forward-looking statements may be identified by the use of terms such as "anticipates," "expects," "intends," "plans," "seeks," "estimates," "believes," and similar expressions, although some forward-looking statements are expressed differently. Statements concerning financial position, business strategy, and plans or objectives for future operations are forward-looking statements. These statements are not guarantees of future performance and are subject to certain risks, uncertainties, and assumptions that are difficult to predict and may cause actual results to differ materially from management’s current expectations. Such risks and uncertainties include those set forth herein under "Summary of Business Considerations and Certain Factors that May Affect Future Operating Results and/or Stock Price." The forward-looking statements in this report speak only as of the time they are made and do not necessarily reflect management’s outlook at any other point in time. We undertake no obligation to update publicly any forward-looking statements, whether as a result of new information, future events, or for any other reason. However, readers should carefully review the risk factors set forth in other reports or documents we file from time to time with the Securities and Exchange Commission (SEC). Our SEC filings, as well as our latest annual report, can be obtained through our web site. In addition, hard copies can be obtained free of charge through our investor relations department.

Description of the Business

Applied Signal Technology, Inc. provides advanced digital signal processing products, systems, and services used in reconnaissance of foreign telecommunications signals. Our primary customers are the United States Government and its foreign allies. We develop and manufacture equipment for both the collection and processing of signals. Our signal collection equipment consists of sophisticated receivers that scan through potentially thousands of cellular telephone, microwave, ship-to-shore, and military transmissions in the radio frequency (RF) spectrum with the goal of collecting certain specific signals. Our signal processing equipment uses advanced software and hardware to evaluate characteristics of the collected signals and selects those most likely to contain relevant information. At inception, our efforts were primarily focused on processing equipment. Over time, we have broadened our scope to add specialized collection equipment and complete signal processing systems.

We were incorporated in California in 1984. Our principal executive offices are located at 400 West California Ave., Sunnyvale, CA, 94086, and our telephone number is (408) 749-1888. Our web site address is www.appsig.com. Our SEC filings, as well as our latest annual report, can be obtained through our web site. In addition, hard copies can be obtained free of charge through our investor relations department.

Signal Intelligence

Accurate and comprehensive information regarding foreign affairs and developments has become increasingly important to the United States Government. The reduction of United States military tactical forces overseas; the political instability in certain regions such as the Middle East, Eastern Europe, Africa, and Central and South America; and the continued efforts against terrorism have significantly heightened the United States Government’s need to be able to monitor activities in foreign countries. In order to obtain information about activities within foreign countries, the United States Government gathers and analyzes telecommunications signals emanating from those countries.

The use of established telecommunications technologies has been supplemented, rather than replaced, by new telecommunications technologies that have been developed and commercialized. This trend has led to a significant increase in the overall volume of information communicated and an increase in the density of signals transmitted throughout the RF spectrum. This increase can be seen in the proliferation of facsimile, cellular, and digital signal telecommunications equipment and in the global information network (for example, the Internet) in recent years, resulting in a significant increase in the amount of information being communicated. Consequently, the requirement to develop signal reconnaissance equipment capable of collecting and processing an increased volume of signals, as well as new types of signals, has increased significantly.

We devote significant resources toward understanding the United States Government’s signal reconnaissance goals, capabilities, and perceived future needs. We obtain information about these signal reconnaissance needs through frequent marketing contact between our employees and technical and contracting officials of the United States Government. In addition, we invest in research and development (R&D) activities that we anticipate will enable us to develop signal reconnaissance equipment that meets future needs of the United States Government. We believe that we invest a greater percentage of our revenues in R&D than is typical among our competitors. (See "Research and Development.")

Our signal reconnaissance products can be used, with or without further modification, to satisfy requirements of a variety of customers. Our products can be deployed readily in a wide variety of circumstances to meet current United States Government signal reconnaissance requirements.

The United States Government is beginning to provide increased funding for counterterrorism. Counterterrorism focuses on individuals and groups of individuals, and relies heavily on human intelligence (HUMINT) gathering. HUMINT refers to all National Security information obtained directly from human resources. It includes a wide range of activities from direct reconnaissance and observation to the use of informants and spies. Signal intelligence (SIGINT) is an adjunct of HUMINT. SIGINT refers to all National Security information derived from intercepting and analyzing foreign instrumentation, communications, or electronic signals, many of which are protected by codes and other complex countermeasures. We believe we are a pre-eminent resource for SIGINT capabilities, providing products, systems, and services.

Strategy

Our objective is to anticipate the needs of the signal reconnaissance marketplace and to invest in research and development in an effort to provide solutions before our competitors. In some cases, this involves the development of equipment or services to address new telecommunications technologies. In other cases, it involves the development of equipment that offers smaller size, lower power consumption, and lower cost than potentially competitive products. Our strategy to accomplish these objectives focuses on the following elements.

Anticipate marketplace needs. We devote significant resources in order to anticipate future telecommunications processing needs. We monitor technological and commercial advances in telecommunications to identify what we believe are new opportunities for the development of our products. We obtain information about marketplace needs through frequent contact with technical and contracting officials of pertinent government agencies within the intelligence community.

Many times, the United States Government grants sole-source contracts when a single contractor is deemed to have expertise or technology that is superior to that of competing contractors. Since our inception, a significant portion of our revenues has been from sole-source contracts. Although we believe that the large number of sole-source contracts we obtain demonstrates that we often correctly anticipate marketplace needs, we cannot be sure that we will continue to correctly anticipate the marketplace needs in the future.

Invest in research and development. We invest in research and development that we believe will enable us to develop equipment and services that will satisfy the future signal reconnaissance needs of our customers. We believe that we invest a greater percentage of our revenues in R&D than is typical among our competitors, which, in turn, often enables us to introduce products that meet marketplace demands before our competitors.

Develop flexible products. We develop products that can be used as originally designed, or with further customization, to satisfy the needs of a variety of customers. We use prior product development efforts to offer customers cost-effective solutions and to offer these solutions promptly. We believe that custom equipment developed by many of our competitors generally cannot be deployed as readily in as wide a variety of circumstances as our products.

Develop highly integrated products. We design our products to use advanced circuitry and highly integrated components. This enables us to offer products that are smaller, consume less power, and cost customers less when multiple units are built than equipment of similar functionality that uses fewer advanced designs and materials. The lower cost of many of our products appeals to customers with budget constraints, and the small size and low power consumption of many of our products appeal to customers with physical installation constraints.

Focus on signal processing. Since inception, we have focused much of our attention on developing signal processing equipment and services. We believe that there have been and will continue to be opportunities to develop specialized signal processing equipment and services to satisfy emerging technological requirements.

Increase penetration and broaden customer base. We believe that our current customers offer opportunities for sales growth, both in terms of additional units of developed products and the development of new products and, accordingly, direct much of our marketing efforts toward these customers in order to increase our penetration of these markets. Additionally, we continue to try to broaden our customer base by increasing marketing efforts toward military signal reconnaissance and by evaluating law enforcement opportunities.

Critical Accounting Policies and Estimates

General. Our discussion and analysis of our financial condition and results of operations are based upon our consolidated financial statements. These financial statements are prepared in accordance with accounting principles generally accepted in the United States, which require management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Actual results could differ significantly from those estimates. We believe that the estimates, assumptions, and judgments involved in the accounting policies described below have the greatest potential impact on our financial statements and, therefore, consider these to be critical accounting policies. See Note 1 to consolidated financial statements included elsewhere in this report for more information about these critical accounting policies, as well as descriptions of other significant accounting policies.

Revenue and cost recognition. The majority of our contracts are accounted for in accordance with the American Institute of Certified Public Accountants Statement of Opinion 81-1, Accounting for Performance of Construction-Type and Production-Type Contracts. We account for fixed-price contracts by using the percentage-of-completion method of accounting. Under this method, contract costs are charged to operations as incurred. A portion of the contract revenue, based on estimated profits and the degree of completion of the contract as measured by a comparison of the actual and estimated costs, is recognized as revenue each period. We account for cost-reimbursement contracts by charging contract costs to operations as incurred and recognizing contract revenues and profits by applying an estimated fee rate to actual costs on an individual contract basis. Management reviews contract performance, costs incurred, and estimated completion costs regularly and adjusts revenues and profits on contracts in the period in which changes become determinable.

Our engineering services contracts are typically performed on a level-of-effort basis. Revenue is calculated in accordance with our policy regarding cost-reimbursement contracts; specifically, revenue is based on a fee percentage applied to the costs incurred on these contracts.

Anticipated losses on cost-reimbursement and fixed-price contracts are also recorded in the period in which they become determinable. Unexpected increases in the cost to develop or manufacture a product, whether due to inaccurate estimates in the bidding process, unanticipated increases in material costs, inefficiencies, or other factors are borne by us on fixed-price contracts, and could have a material adverse effect on results of operations and financial condition. Unexpected cost increases in cost-reimbursement contracts may be borne by us for purposes of maintaining customer relationships. Historically, the effect on operating results and financial condition from cost-reimbursement losses has been minimal.

Award fee recognition. Our policy for recognizing interim fees on our award fee contracts is based on management’s assessment, on a contract-by-contract basis, as to the likelihood that the award fee or an incremental portion of the award fee will be earned. Management’s assessments are based on numerous factors including: contract terms, nature of the work to be performed, our relationship and history with the customer, our history with similar types of projects, and our current and anticipated performance on the specific contract. No award fee is recognized until management determines that it is probable that an award fee or a portion thereof will be earned.

Indirect rate variance. We record contract revenues and costs for interim reporting purposes based on annual targeted indirect rates. At year-end, the revenues and costs are adjusted for actual indirect rates. During our interim reporting periods, variances may accumulate between the actual indirect rates and the annual targeted rates. All timing-related indirect spending variances are inventoried as part of work in process during these interim reporting periods. These rates are reviewed regularly, and we record reserves for any permanent variances in the period they become known.

Our accounting policy is based on management’s belief that such interim variances, if deemed recoverable, will be absorbed by expected contract activities during the remainder of the year. If contract activities do not reach planned levels, there are alternatives we can utilize to absorb the variance: we can adjust downward some of our planned indirect spending during the year, increase our billing rates to our customers, or record charges to expense based on reduced estimates of future contract activities.

At January 31, 2003, the unfavorable inventoried indirect rate variance was approximately, $1,004,000. At February 1, 2002, the inventoried rate variance was approximately $3,508,000. Management currently anticipates that the rate variance recorded at the end of the first quarter of fiscal year 2003 will be absorbed by expected contract activities.

Three Months Ended January 31, 2003 Compared to Three Months Ended February 1, 2002

Revenues and backlog. Revenues for the first quarter of fiscal year 2003 were approximately $18,178,000, a 12% increase from revenues of approximately $16,231,000, recorded in the first quarter of fiscal year 2002. The increase in revenues in the first quarter of fiscal year 2003 when compared to the first quarter of fiscal year 2002 was due to increased revenues generated by our engineering development programs. The revenues generated by these programs were primarily a result of orders received during the third and fourth quarters of fiscal year 2002.

New orders received for the first quarter of fiscal year 2003 were approximately $12,044,000, down 9% from approximately $13,162,000 received in the first quarter of fiscal year 2002. The decline in new order levels is due to what management believes to be the typical fluctuations experienced in the U.S. Government procurement process.

Our backlog consists of anticipated revenues from new contracts and from the uncompleted portions of existing contracts (excluding unexercised options). At January 31, 2003, ending backlog was approximately $36,151,000, representing a 25% increase from ending backlog of approximately $29,016,000 at February 1, 2002. The increase in backlog at the end of the first quarter of fiscal year 2003, when compared to the same period in fiscal year 2002, is primarily due to the new orders received during the third and fourth quarters of fiscal year 2002. Our backlog balance at October 31, 2002 was approximately $42,298,000. New order levels were lower than the revenues generated in the first quarter of fiscal year 2003, which decreased backlog by approximately $6,147,000, or 15%. New order levels were lower than revenues due, primarily, to the delay in the awarding of certain contracts, which we expect to be awarded in the second quarter of fiscal year 2003. Additionally, our contract bookings during the first quarter are typically lower than the order levels during the fourth quarter due to the U.S. Government’s annual procurement cycle.

Cost-reimbursement contracts typically do not return as high a profit margin as fixed price contracts. The following table represents the revenue concentration by contract type:

 

Q1 FY03

 

FY02

 

FY01

 

FY00

Cost-reimbursement contracts

73%

 

59%

 

68%

 

59%

Fixed price contracts

27%

 

41%

 

32%

 

41%

 

We currently anticipate that the mix of contract types for fiscal year 2003 will be similar to that experienced in fiscal year 2001.

Contract costs. Contract costs consist of direct costs on contract, including materials, labor, and manufacturing overhead costs. Contract costs were approximately $11,556,000, or 63.6%, of revenues for the first quarter of fiscal year 2003 compared to approximately $9,759,000, or 60.1%, of revenues for the same period of fiscal year 2002. The increase in contracts costs in the first quarter in fiscal year 2003 is primarily due to an increase in direct labor. The direct labor growth is the result of increased activity in our engineering development contracts, which are typically more labor-intensive than our standard product orders.

Research and development (R&D). Company-directed investment in research and development consists of expenditures recoverable from customers through our billing rates and expenditures funded from earnings. We record R&D expenses based on annual targeted indirect rates, for interim reporting periods. (See "Notes to Consolidated Financial Statements, Note 1: Summary of Significant Accounting Policies.") Research and development expenses were approximately $1,701,0000, or 9.4%, of revenues for the first quarter of fiscal year 2003 compared to approximately $1,917,000, or 11.8%, of revenues for the same period of fiscal year 2002. R&D expenses in the first quarter of fiscal year 2003 were lower than the first quarter of fiscal year 2002 as a result of management’s decision to decrease R&D spending for fiscal year 2003.

General and administrative. General and administrative expenses include administrative salaries, costs related to marketing and proposal activities, costs associated with product warranties, and other administrative costs. We record general and administrative expenses based on annual targeted indirect rates, for interim reporting periods. (See "Notes to Consolidated Financial Statements, Note 1: Summary of Significant Accounting Policies.") General and administrative expenses were approximately $2,921,000, or 16.1%, of revenues for the first quarter of fiscal year 2003 compared to approximately $2,700,000, or 16.6%, of revenues for the same period of fiscal year 2002. General and administrative expenses were higher during the first quarter fiscal year of 2003 primarily because our targeted indirect rates were applied to a larger cost base. The increase in our cost base is the result of more contract revenues generated in the first quarter of fiscal year 2003 when compared to the first quarter of fiscal year 2002.

Interest income (expense), net. Net interest income for the first quarter of fiscal year 2003 was approximately $100,000 compared to net interest income of approximately $24,000 for the first quarter of fiscal year 2002. Interest income increased during the first quarter of fiscal year 2003 as a result of higher cash and investment balances at the beginning of fiscal year 2003 when compared to the beginning of fiscal year 2002.

Provision for income taxes. Our estimated annual effective tax rate for the quarter ended January 31, 2003 was 15% compared to a 10% effective rate for the comparable period in 2002. Our projected annual effective tax rate for fiscal year 2003 is calculated based on the projected income for the year and differs from the statutory rate primarily due to a benefit of deferred tax assets for which a valuation allowance has been recorded at the end of fiscal year 2002.

Product warranties. Our products, including associated firmware and software, are warranted against defective workmanship and materials for a period of one year from the date of acceptance by the original purchaser. In addition, we offer extended warranties as a percentage of the purchase price. An additional six-month warranty may be purchased for 3% of the unit or system purchase price. Additional one-year warranty coverage is 5% of the unit or system purchase price. Warranty costs were approximately $43,000 and $83,000 for the first quarters of fiscal years 2003 and 2002, respectively.

Analysis of Liquidity and Capital Resources

Our primary sources of liquidity during the first three months of fiscal year 2003 were the cash flows generated from net income, accounts receivable, and the issuance of common stock through our employee stock purchase plans.

We have a $3,000,000 secured, revolving bank line of credit available for short-term cash requirements, which is secured by all of our assets and expires on March 15, 2003. Borrowings under the line of credit bear interest at the bank’s reference rate (4.25% at January 31, 2003) and are payable monthly. At both January 31, 2003 and October 31, 2002, this facility was unused. Under this credit facility, we are subject to certain commitment and utilization fees on the unused portion of the committed amount. Fees incurred were not material during the first quarter of fiscal year 2003 and fiscal year 2002. The line of credit agreement requires us to comply with certain financial covenants. At both January 31, 2003 and October 31, 2002, we were in compliance with all restrictions and covenants, and this facility had not been utilized. We do not plan to renew this line of credit and have canceled the outstanding letters of credit associated with this facility. In February 2003 we entered into a new cash-secured line of credit in the amount $1,500,000, which will expire on March 1, 2004. Any borrowings bear interest at the bank’s reference rate and accrued interest is payable monthly. There are no fees associated with the unused portion of the committed amount. Under this credit facility, we have one standby letter of credit outstanding in the amount of approximately $1,218,000, related to our facilities lease.

Net cash from operating activities. Net cash provided by (used in) operating activities has varied significantly from quarter to quarter. These quarter-to-quarter variances are primarily the result of changes in net income and operating assets and liabilities. During the first three months of fiscal year 2003, approximately $5,883,000 was provided by operating activities compared to approximately $2,189,000 used in operating activities during the comparable period of fiscal year 2002. Net income for the first quarter of fiscal year 2003 was approximately $1,785,000 compared to a net income of approximately $1,691,000 for the comparable period of fiscal year 2002. This increase in net income is primarily due to the growth in revenues during the first quarter of fiscal year 2003 when compared to the first quarter of fiscal year 2002.

Cash provided by accounts receivable during the first three months of fiscal year 2003 was approximately $5,861,000, whereas during the comparable period of fiscal year 2002 accounts receivable activities used cash of approximately $2,248,000. The primary factor in the comparison of accounts receivable activities is that increased revenues during the fourth quarter of fiscal year 2002 when compared to fiscal year 2001 led to a significant increase in cash received during the first quarter of fiscal year 2003 when compared to the same period in fiscal year 2002.

Although we have experienced an increase in the efficiency of collecting our billed receivables, we are currently pursuing a problematic receivable item. We expect to collect this item in fiscal year 2003 and have not recorded any reserve for doubtful accounts at this time. However, in the event we do not collect this receivable, our fiscal year 2003 revenue and operating income could be reduced by approximately $800,000.

Cash used to support inventory, prepaid expenses, and other assets was approximately $2,083,000 and $3,737,000 during the first quarters of fiscal years 2003 and 2002, respectively. The decrease in cash used during the first quarter of fiscal year 2003 is predominantly due to a lower inventoried rate variance than in the first quarter of fiscal year 2002.

Accounts payable, taxes payable, and accrued liabilities activities used cash of approximately $853,000 during the first three months of fiscal year 2003 and provided cash of approximately $819,000 during the same period in fiscal year 2002. The increased use of cash related to these activities during the first quarter of fiscal year 2003 when compared to the first quarter of fiscal year 2002 is driven primarily by two factors. First, accounts payable disbursements in the first quarter of fiscal year 2003 were larger than in the same period of fiscal year 2002 due to increased contract activities. Second, the first quarter of fiscal year 2002 included an increase to our accrued employee bonus liability, which is a non-cash transaction during the period. The first quarter of fiscal year 2003 did not include any accrued employee bonus amounts.

Net cash from investing activities. Cash used in investing activities during the first three months of fiscal years 2003 and 2002 were approximately $8,816,000 and $108,000, respectively. The difference in cash used between the first quarters of fiscal years 2003 and 2002 is essentially driven by our purchases of available-for-sale securities of approximately $7,817,000 in the first three months of fiscal year 2003. There were no such purchases during the first three months of fiscal year 2002. Additions to property and equipment were approximately $999,000 and $108,000 during the first three months of fiscal years 2003 and 2002, respectively. Fiscal year 2003 activities included computer equipment purchases of approximately $855,000.

Net cash from financing activities. Financing activities provided cash of approximately $890,000 during the first quarter of fiscal year 2003 and approximately $680,000 during the same period in fiscal year 2002. The source of cash provided by financing activities in both periods was the issuance of common stock under our employee stock purchase plan and stock option plans.

Cash is generated primarily from operating activities, employee stock activities, and investing activities. Our investment portfolio includes a variety of low-risk investments. We believe the primary risk to liquidity is the potential decrease in demand for our products and services. Historically, this demand has been influenced by the needs of the United States intelligence community.

We believe that the funds generated from operations, existing working capital, and the amount available under our existing line of credit will be sufficient to meet our cash needs for the next twelve months.

Summary of Business Considerations and Certain Factors That May Affect Future Results of Operations and/or Stock Price

Our future performance is subject to a variety of risks. If any of the following risks actually occurs, our business could be harmed and the trading price of our common stock could decline. In addition to the following disclosures, please refer to the other information contained in this report, including consolidated financial statements and the related notes.

Any reduction in government spending on signal reconnaissance could materially adversely impact our revenues, results of operations, and financial condition. Historically, defense and intelligence agencies of the United States Government have accounted for almost all of our revenues. There are risks associated with programs that are subject to appropriation by Congress, which could be potential targets for reductions of their funding to pay for other programs. Future reductions in United States Government spending on signal reconnaissance or future changes in the kind of signal reconnaissance products or services required by the United States Government agencies could limit demand for our products and services, which would have a material adverse effect on our operating results and financial condition.

Also, potential shifts in responsibilities and functions within the defense and intelligence communities could result in a reduction of spending on signal reconnaissance by the defense and intelligence agencies that have historically been our major customers. We believe that the United States Government may compensate for reductions in spending by these agencies with increases in spending for signal reconnaissance by other Government agencies. However, our relationships with other Government agencies are not as strong as they are with the agencies with which we have historically dealt. A reduction in spending by the agencies with which we have historically dealt may not be offset by spending by other United States Government agencies. Even if other agencies increase spending for signal reconnaissance, we may not secure the same amount of work from such other agencies. As a result, demand for our products and services could decline, resulting in a decrease in revenues, and could materially adversely affect our operating results and financial condition.

If we are unable to comply with complex government regulations governing security and contracting practices, we could be disqualified as a supplier to the United States Government. As a supplier to United States Government defense and intelligence agencies, we must comply with numerous regulations, including regulations governing security and contracting practices. Failure to comply with these procurement regulations and practices could result in fines being imposed against us, or our suspension for a period of time from eligibility for bidding on, or for award of, new government contracts. If we are disqualified as a supplier to government agencies, we will lose most, if not all, of our customers, revenues from sales of our products would decline significantly, and our ability to continue operations would be seriously jeopardized. The government may investigate and make inquiries of our business practices and conduct audits of contract performance and cost accounting. Depending on the results of these audits and investigations, the government may make claims against us.

We depend on revenues from a few significant contracts, and any loss, cancellation, reduction, or delay in these contracts could harm our business. From time to time, including recent periods, we have derived a material portion of our revenue from one or more individual contracts that could be terminated by the customer at the customer’s discretion. For example, a single contract and its follow-on effort accounted for 19% and 6% of revenues for the first three months of fiscal years 2003 and 2002, respectively. We expect that in future periods we may again enter into individual contracts with significant revenue concentrations. If such contracts were terminated, revenues and net income would significantly decline. Our success will depend on our continued ability to develop and manage relationships with significant customers. Although we are attempting to expand our customer base, we expect that our customer concentration will not change significantly in the near future. The markets in which we sell our products are dominated by a relatively small number of governmental agencies and allies of the United States Government, thereby limiting the number of potential customers. Our dependence on large orders from a relatively small number of customers makes our relationship with each customer critical to our business. We cannot be sure that we will be able to retain our largest customers, that we will be able to attract additional customers, or that our customers will continue to buy our products in the same amounts as in prior years. The loss of one or more of our largest customers, any reduction or delay in sales to these customers, our inability to successfully develop relationships with additional customers, or future price concessions that we may have to make could significantly harm our business.

Continued competition in our markets may lead to a reduction in our revenues and market share. The signal reconnaissance market is highly competitive and we expect that competition will increase in the future. Our current competitors include L-3 Communications Corporation, Boeing-North America, Raytheon Corporation, General Dynamics Corporation, Harris Corporation, Lockheed Martin Corporation, and Northrop Grumman, Inc., and have significantly greater technical, manufacturing, financial, and marketing resources than we do. We expect that more companies will enter the market for SIGINT. We may not be able to compete successfully against either current or future competitors. Increased competition could result in reduced revenue, lower margins, or loss of market share, any of which could significantly harm our business. Our competitors may introduce improved products with lower prices, and we will have to do the same to remain competitive.

If we are unable to recruit, train, and retain key personnel, our ability to develop, introduce, and sell our products may be adversely impacted. Our ability to execute our business plan is contingent upon successfully attracting and retaining qualified employees. In California, it has not been as difficult to recruit new staff capable of obtaining the necessary security clearances in fiscal years 2003 and 2002 as in prior years. If we fail to attract and retain qualified employees who can obtain the necessary security clearances, our business could be significantly harmed. We maintain offices in Herndon, Virginia; Annapolis Junction, Maryland; Salt Lake City, Utah; and Hillsboro, Oregon, providing us the ability to attract and retain qualified personnel in areas outside of California. Management believes that it continues to be difficult to attract and hire qualified candidates who hold the necessary security clearances in the Annapolis Junction, Maryland office due to current labor market conditions. The loss of the services of any of our qualified employees, the inability to attract or retain qualified personnel in the future, or delays in hiring required personnel could negatively impact our ability to develop, introduce, and sell our products. In addition, employees may leave us and subsequently compete against us.

Unexpected increases in the cost to develop or manufacture our products under fixed-price contracts may cause us to experience unreimbursed cost overruns. A significant portion of our revenue is derived from fixed-price contracts. Under fixed-price contracts, unexpected increases in the cost to develop or manufacture a product, whether due to inaccurate estimates in the bidding process, unanticipated increases in materials costs, inefficiencies, or other factors, are borne by us. We have experienced cost overruns in the past that have resulted in losses on certain contracts, and may experience additional cost overruns in the future. Such cost overruns would increase our operating expenses, reduce our net income and earnings per share, and have a materially adverse effect on our future results of operations and financial condition.

Unexpected contract terminations could negatively impact our operating results and financial condition. Almost all of our contracts contain termination clauses that permit contract termination upon our default or for the convenience of the other contracting party. In either case, termination could adversely affect our operating results and financial condition. For example, in fiscal year 2001, we received unanticipated contract closeout notifications on three significant engineering contracts for the convenience of the other contracting party. These closeouts contributed, in part, to our need to reduce our cost structure during fiscal year 2001. There were no such notifications during the first quarter of fiscal year 2003 or fiscal year 2002. There can be no assurance that such terminations will not occur in the future.

Our future revenues are inherently unpredictable, our operating results are likely to fluctuate from period to period, and if we fail to meet the expectations of securities analysts or investors, our stock price could decline significantly. Our quarterly and annual operating results have fluctuated in the past and are likely to fluctuate significantly in the future due to a variety of factors, some of which are outside our control. Accordingly, we believe that period-to-period comparisons of our results of operations are not meaningful and should not be relied upon as indications of future performance. Some of the factors that could cause our quarterly or annual operating results to fluctuate include conditions inherent in government contracting and our business such as the timing of cost and expense recognition for contracts, the United States Government contracting and budget cycles, and contract closeouts. Because we base our operating expenses on anticipated revenue trends and a high percentage of our expenses are fixed in the short term, any delay in generating or recognizing forecasted revenues could significantly harm our business. Fluctuations in quarterly results, shortfalls in revenues or earnings from levels forecast by securities analysts, changes in estimates by analysts, competition, or announcements of extraordinary events such as acquisitions or litigation may cause revenues to fall below the expectations of securities analysts and investors. In this event, the trading price of our common stock would significantly decline. In addition, there can be no assurance that an active trading market will be sustained for our common stock. The stock market in recent years has experienced extreme price and volume fluctuations that have particularly affected the market prices of many technology companies and that have been unrelated or disproportionately related to the operating performance of such companies. These fluctuations, as well as general economic and market conditions, may adversely affect the future market price of our common stock.

Our market is subject to rapid technological change, and to compete effectively, we must continually introduce new products or enhancements that achieve market acceptance. The market for our products is characterized by rapidly changing technology, frequent new product introductions, changes in customer requirements, and evolving industry standards. We believe that we have been successful to date in identifying certain signal reconnaissance needs early, investing in research and development to meet these needs, and delivering products before our competitors. We believe that our future success will depend upon continuing to develop and introduce, in a timely manner, products capable of collecting or processing new types of telecommunications signals. However, we expect that new technologies will continue to emerge. Our future performance will depend on the successful development, introduction, and market acceptance of new and enhanced products that address these changes as well as current and potential customer requirements. The introduction of new and enhanced products may cause our customers to defer or cancel orders for existing products. There can be no assurance that we will be able to develop and market new products successfully in the future or respond effectively to technological changes, such as data encryption technology and others, or that new products introduced by others will not render our products or technologies noncompetitive or obsolete.

We also may not be able to develop the underlying core technologies necessary to create new products and enhancements or to license these technologies from third parties. Product development delays may result from numerous factors, including:

The development of new, technologically advanced products is a complex and uncertain process requiring high levels of innovation and highly skilled engineering and development personnel, as well as the accurate anticipation of technological and market trends. We cannot ensure that we will be able to identify, develop, manufacture, market, or support new or enhanced products successfully, if at all, or on a timely basis. Further, we cannot ensure that our new products will gain market acceptance or that we will be able to respond effectively to product announcements by competitors, technological changes, or emerging industry standards. Any failure to respond to technological change would significantly harm our business.

We may lose sales if our suppliers fail to meet our needs. Although we procure most of our parts and components from multiple sources or believe that these components are readily available from numerous other sources, certain components are available only from sole sources or from a limited number of sources. While we believe that substitute components or assemblies could be obtained, use of substitutes would require development of new suppliers or would require us to re-engineer our products, or both, which could delay shipment of our products and could have a material adverse effect on our operating results and financial condition.

Our headquarters and most of our manufacturing operations are located in California where natural disasters may occur, resulting in disruption to our business. Our corporate headquarters, including most of our research and development operations and production facilities, are located in the Silicon Valley area of Northern California, a region known for being vulnerable to natural disasters and other risks, such as earthquakes, fires, and floods, which at times have disrupted the local economy and posed physical risks to our property. A significant earthquake could materially affect operating results. We are not insured for most losses and business interruptions of this kind, and do not presently have redundant, multiple site capacity in the event of a natural disaster. In the event of such disaster, our business would suffer.

Delays in the receipt of engineering contracts could negatively impact our business. During our history, we have experienced delays in the receipt of certain engineering development contracts. While we work closely with our customers to try and capture what we believe to be sole-source orders, delays in the receipt of such orders could result in revenues falling short of estimates. In addition, gross margins and net income will decrease if we elect to hold our cost structure in place while awaiting the award of delayed contracts.

Our failure to protect our intellectual property may significantly harm our business. Our success and ability to compete is dependent in part on our proprietary technology. We rely on a combination of patent, copyright, trademark, and trade secret laws, as well as confidentiality agreements to establish and protect our proprietary rights. We license certain of our proprietary technology to customers, and we rely largely on provisions of our licensing agreements to protect our intellectual property rights in this technology. To date, we have relied primarily on proprietary processes and know-how to protect our intellectual property. Although we have filed applications for several patents, two of which we currently hold, we cannot ensure that any patents will be issued as a result of pending patent applications or that our issued patents will be upheld. Any infringement of our proprietary rights could result in significant litigation costs, and any failure to adequately protect our proprietary rights could result in our competitors offering similar products, potentially resulting in loss of a competitive advantage and decreased revenues. Despite our efforts to protect our proprietary rights, existing patent, copyright, trademark, and trade secret laws afford only limited protection. In addition, the laws of some foreign countries do not protect our proprietary rights to the same extent as do the laws of the United States. Attempts may be made to copy or reverse engineer aspects of our products or to obtain and use information that we regard as proprietary. Accordingly, we may not be able to prevent misappropriation of our technology or deter others from developing similar technology. Furthermore, policing the unauthorized use of our products is difficult. Litigation may be necessary in the future to enforce our intellectual property rights or to determine the validity and scope of the proprietary rights of others. This litigation could result in substantial costs and diversion of resources and could significantly harm our business.

Claims that we infringe third-party intellectual property rights could result in significant expenses or restrictions on our ability to sell our products. It is possible that from time to time, other parties may assert patent, copyright, trademark, and other intellectual property rights to technologies and in various jurisdictions that are important to our business. Any claims asserting that our products infringe or may infringe proprietary rights of third parties, if determined adverse to us, could significantly harm our business. Any claims, with or without merit, could result in costly litigation, divert the efforts of our technical and management personnel, cause product shipment delays, or require us to enter into royalty or licensing agreements, any of which could significantly harm our business. Royalty or licensing agreements, if required, may not be available on terms acceptable to us, if at all. In addition, our agreements with our customers typically require us to indemnify our customers from any expense or liability resulting from claimed infringement of third party intellectual property rights. In the event a claim against us was successful and we could not obtain a license to the relevant technology on acceptable terms, license a substitute technology, or redesign our products to avoid infringement, our business would be significantly harmed.


 

Item 3: Quantitative and Qualitative Disclosures About Market Risk

Interest rate risk. Our interest income is sensitive to changes in the general level of U.S. interest rates, particularly since the majority of our investments are in short-term instruments. The average days to maturity of our investment portfolio is 333 days. Due to the short-term nature of these cash investments, we do not believe that there is a material interest rate risk. As of January 31, 2003, our total cash and investments balance that was sensitive to interest rate risk was approximately $30,731,000. The sensitivity of our portfolio is: if yields were to fluctuate by 100 basis points, the total effect to the investment portfolio balance would be approximately $262,000.

The following table summarizes our cash, cash equivalents, and short-term securities, at fair value, that are sensitive to interest rate risk (in thousands):

January 31, 2003

October 31, 2002

Cash and cash equivalents

$10,174

$12,217

Short-term, available-for-sale securities:

     

    Asset-backed securities

2,535

1,528

    Corporate securities

5,341

4,020

    Government securities

10,201

7,162

    Money market securities

2,480
________


________

$30,731
========

$24,927
========

 


 

Item 4: Controls and Procedures

Evaluation of disclosure controls and procedures. Under the supervision and with the participation of our management, including our Chief Executive Officer and Chief Financial Officer, we conducted an evaluation of our disclosure controls and procedures, as such term is defined under Rule 13a-14(c) promulgated under the Securities Exchange Act of 1934, as amended (the "Exchange Act"), within 90 days prior to the filing date of this report (the "Evaluation Date"). Based on this evaluation, our Chief Executive Officer and Chief Financial Officer concluded that, as of the Evaluation Date, to their knowledge and belief, our disclosure controls and procedures were effective.

Changes in internal controls. Since the Evaluation Date referred to above, there have not been any significant changes in internal controls or, to the Chief Executive Officer and Chief Financial Officer’s knowledge, in other factors that could significantly affect such controls.


 

Part II. Other Information

Item 1: Legal Proceedings

We are subject to litigation, from time to time, in the ordinary course of business including, but not limited to, allegations of wrongful termination or discrimination or governmental agency investigations. Although the amount of any liability with respect to such litigation cannot currently be determined, we are not party to any pending legal proceedings, which, in the opinion of management, are material to our business or financial condition. As a government contractor, we may also be subject to investigations by the United States Government for alleged violations of procurement or other federal laws. Under present government procurement regulations, if judged in violation of procurement or other federal civil laws, we could be suspended or barred from eligibility for awards of new government contracts.

Item 2: Changes in Securities and Use of Proceeds

None.

Item 3: Defaults Upon Senior Securities

None.

Item 4: Submission of Matter to a Vote of Security Holders

None.

Item 5: Other Information

None.

Item 6: Exhibits and Reports on Form 8-K

Exhibits – See Index to Exhibits

Reports on Form 8-K We did not file any reports on Form 8-K during the three months ended January 31, 2003.


 

Signatures

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

Applied Signal Technology, Inc.

/James E. Doyle/

 

March 14, 2003

James E. Doyle
Vice President and Chief Financial Officer
(Principal Financial and Accounting Officer)

   

 


 

Certifications

I, Gary Yancey, Chief Executive Officer of the registrant, certify that:

1. I have reviewed this quarterly report on Form 10-Q of Applied Signal Technology, Inc.;

2. Based on my knowledge, this quarterly report does not contain any untrue statement of a material fact or omit to state a material fact necessary in order to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this quarterly report;

3. Based on my knowledge, the financial statements and other financial information included in this quarterly report fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this quarterly report;

4. The registrant’s other certifying officers and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have:

(a) designed such disclosure controls and procedures to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this quarterly report is being prepared;

(b) evaluated the effectiveness of the registrant’s disclosure controls and procedures as of a date within 90 days prior to the filing date of this quarterly report (the "Evaluation Date"); and

(c) presented in this quarterly report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation Date;

5. The registrant’s other certifying officers and I have disclosed, based on our most recent evaluation, to the registrant’s auditors and the audit committee of the registrant’s board of directors (or persons performing the equivalent function):

(a) all significant deficiencies in the design or operation of internal controls which could adversely affect the registrant’s ability to record, process, summarize and report financial data and have identified for the registrant’s auditors any material weaknesses in internal controls; and

(b) any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant’s internal controls; and

6. The registrant’s other certifying officers and I have indicated in this quarterly report whether or not there were significant changes in internal controls or in other factors that could significantly affect the internal controls subsequent to the date of our most recent evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses.

 

/s/ Gary L. Yancey

   

Gary L. Yancey, Chief Executive Officer

 

March 14, 2003

 


 

I, James Doyle, Chief Financial Officer of the registrant, certify that:

1. I have reviewed this quarterly report on Form 10-Q of Applied Signal Technology, Inc.;

2. Based on my knowledge, this quarterly report does not contain any untrue statement of a material fact or omit to state a material fact necessary in order to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this quarterly report;

3. Based on my knowledge, the financial statements and other financial information included in this quarterly report fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this quarterly report;

4. The registrant’s other certifying officers and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have:

(a) designed such disclosure controls and procedures to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this quarterly report is being prepared;

(b) evaluated the effectiveness of the registrant’s disclosure controls and procedures as of a date within 90 days prior to the filing date of this quarterly report (the "Evaluation Date"); and

(c) presented in this quarterly report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation Date;

5. The registrant’s other certifying officers and I have disclosed, based on our most recent evaluation, to the registrant’s auditors and the audit committee of the registrant’s board of directors (or persons performing the equivalent function):

(a) all significant deficiencies in the design or operation of internal controls which could adversely affect the registrant’s ability to record, process, summarize and report financial data and have identified for the registrant’s auditors any material weaknesses in internal controls; and

(b) any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant’s internal controls; and

6. The registrant’s other certifying officers and I have indicated in this quarterly report whether or not there were significant changes in internal controls or in other factors that could significantly affect the internal controls subsequent to the date of our most recent evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses.

 

/s/ James E. Doyle

   

James E. Doyle, Chief Financial Officer

 

March 14, 2003

 


 

Applied Signal Technology, Inc.
Index to Exhibits

 

3.1†

Second Amended and Restated Articles of Incorporation

3.2†

Amended and Restated Bylaws

4.1†

Specimen Common Stock Certificate

10.20

Amendment to the 2001 Stock Option Plan

10.21

Line of Credit Agreement dated January 27, 2003 with Wells Fargo Bank

10.22

Security Agreement dated January 27, 2003 with Wells Fargo Bank

99.1

Certification of Chief Executive Officer Pursuant to 18 U.S.C. Section 1350, As Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002

99.2

Certification of Chief Financial Officer Pursuant to 18 U.S.C. Section 1350, As Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002

†Incorporated by reference to corresponding Exhibit filed as an Exhibit to Registrant's Registration Statement on Form S-1 filed January 28, 1993 (File No. 33-581168).

 


 

Applied Signal Technology, Inc.
Exhibit 99.1

Certification of Chief Executive Officer Pursuant to
18 U.S.C. Section 1350,
As Adopted Pursuant to
Section 906 of the Sarbanes-Oxley Act of 2002

I, Gary L. Yancey, certify that:

1. I have reviewed this quarterly report on Form 10-Q of Applied Signal Technology, Inc.;

2. Based on my knowledge, this quarterly report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this quarterly report; and

3. Based on my knowledge, the financial statements and other financial information included in this quarterly report fairly present in all material respects the financial condition, results of operations, and cash flows of the registrant as of, and for, the periods presented in this quarterly report.

 

Date: March 14, 2003

 

/s/ Gary L. Yancey

   

Gary L. Yancey
President and Chief Executive Officer

 

***********************************************

Applied Signal Technology, Inc.
Exhibit 99.2

Certification of Chief Executive Officer Pursuant to
18 U.S.C. Section 1350,
As Adopted Pursuant to
Section 906 of the Sarbanes-Oxley Act of 2002

I, James E. Doyle, certify that:

1. I have reviewed this quarterly report on Form 10-Q of Applied Signal Technology, Inc.;

2. Based on my knowledge, this quarterly report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this quarterly report; and

3. Based on my knowledge, the financial statements and other financial information included in this quarterly report fairly present in all material respects the financial condition, results of operations, and cash flows of the registrant as of, and for, the periods presented in this quarterly report.

 

Date: March 14, 2003

 

/s/ James E. Doyle

   

James E. Doyle
Vice President and Chief Financial Officer