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 to 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 corporate offices, located in Sunnyvale, California, also serve as our primary research and development, engineering, production, marketing, and administrative center. As of October 31, 2003, we leased five buildings totaling approximately 266,077 square feet under a lease that expires in March 2012.

In addition, we maintain four offices within the United States for small development, marketing, and administrative functions. We lease the following properties: 29,121 square feet of a 90,000-square-foot building in Annapolis Junction, Maryland (lease expires April 2004); 15,520 square feet of a 104,922-square-foot building in Herndon, Virginia (lease expires January 2006); 11,000 square feet of a 40,000-square-foot building in Hillsboro, Oregon (lease expires October 2004); and 14,476 square feet of a 23,300-square-foot building in Salt Lake City, Utah (lease expires April 2004).

Our business requires that we maintain a facility clearance, sponsored and approved by the United States Government, at each of our offices. This approval could be suspended or revoked if we are found not to have complied with security regulations applicable to such facilities. Any revocation or suspension of such approval that materially delayed delivery of our products to customers would materially adversely impact our ability to manufacture and sell our products and operate our business. Although we have adopted policies directed at assuring our compliance with relevant regulations, there can be no assurance that the approved status of our facilities will continue without interruption.

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.

There were no matters submitted to a vote of security holders during the fourth quarter of the fiscal year.

Our common stock was first offered to the public on March 26, 1993. Since the initial public offering, the stock has been traded on the NASDAQ National Market under the symbol "APSG." As of January 2, 2004 we had approximately 367 shareholders of record. The following table sets forth the range of high, low, and last sale prices for our common stock over the eight quarters ending October 31, 2003. The "last" price per share in the table represents the closing price on the last trading day of the quarter. The quotations represent inter-dealer quotations, without retail markups, markdowns, or commissions, and may not necessarily represent actual transactions.

In the second quarter of fiscal year 2003, the Board of Directors announced a $0.25 per share annual dividend, payable over four quarters at the rate of $0.0625 per share per quarter. Dividends of approximately $646,000, $668,000, and $673,000 were paid on May 16, 2003, August 15, 2003, and November 14, 2003, respectively, to shareholders of record at May 2, 2003, August 1, 2003, and October 31, 2003, respectively.

We paid no dividends during fiscal year 2002, and approximately $1,733,000 during fiscal year 2001.

The payment of dividends and the amount thereof will depend on a number of factors, including our financial condition, capital requirements, results of operations, future business prospects, and other factors that our Board of Directors may deem relevant.

The equity compensation plan information required to be provided in this Annual Report on Form 10-K is incorporated by reference to our proxy statement for the 2004 Annual Meeting of Shareholders to be filed with the Securities and Exchange Commission within 120 days after the end of fiscal year ended October 31, 2003.

(In thousands, except per share data)

Applied Signal Technology, Inc. provides advanced digital signal processing products, systems, and services used in reconnaissance of telecommunications signals for intelligence gathering, a process referred to as signal intelligence. Our primary customer is the United States Government.

Signal reconnaissance systems are comprised of collection and processing equipment. 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 in 1984, we focused our efforts primarily on processing equipment. Over time, we have broadened our scope to add specialized collection equipment and complete signal processing systems. Our revenues are primarily generated from sales of our products and services to two agencies of the United States Government.

Our contracts can be divided into two major types: firm fixed price and cost reimbursement. Firm-fixed-price contracts are typically characterized by negotiated prices for efforts that involve little or no development risk. Cost risks associated with building and delivering products under fixed-price contracts are borne solely by the contractor.

Cost-reimbursement types of contracts are characterized by negotiated target costs and fees, and are generally associated with engineering development work where there is a high degree of risk and uncertainty. Although risks associated with cost-reimbursement contracts are borne by the customer, we cannot exceed contract ceilings without the approval of our customer.

The following table represents the revenue concentration by contract type:

Cost-reimbursement contracts can include fixed fees, incentive fees, or award fees. In the case of cost-plus-fixed-fee contracts, the fee dollars are negotiated and fixed at the inception of the contract. Cost-plus-incentive-fee contracts include a negotiated fee that may be adjusted during the performance of the contract by a formula based on the relationship of total allowable costs to total target costs. Cost-plus-award-fee contracts can include fees consisting of a base amount that is fixed at the inception of the contract and an award amount that is earned in whole or in part during the performance of the contract based upon the evaluation of the customer.

In fiscal year 2003, we experienced significant revenue growth, which we believe was a result of increased spending by the U.S. Government on signal intelligence solutions. We believe the U.S. Government’s emphasis on protecting U.S. citizens, due to the current world state of affairs, has created a renewed emphasis upon signal intelligence gathering.

Revenue and cost recognition. The majority of our contracts, which are with the U.S. Government, 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. These contracts are transacted using written contractual arrangements, most of which require us to design, develop, manufacture and/or modify our complex products, and perform related services according to specifications provided by the customer. 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 opera tions as incurred and recognizing contract revenues and profits by applying an estimated fee rate to actual costs on an individual contract basis. For those contracts in which all of the terms have not yet been finalized, revenue does not include an estimated fee rate on cost. 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 fee on our cost-plus-award-fee contracts is based on management’s assessment as to the likelihood that the award fee or an incremental portion of the award fee will be earned on a contract-by-contract basis. 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. Actual fees awarded are typically within management’s estimates. However, changes could arise within an award fee period causing management to either lower or raise the award fee estimate in the period in which it occurs.

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 the 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. We have determined that this estimate is the preferred practice used within our industry.

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 may utilize to absorb the variance: we can adjust some of our planned indirect spending during the year, modify our billing rates to our customers, or record adjustments to expense based on reduced estimates of future contract activities.

At the end of fiscal year 2003, there was a charge to profit of $1,107,000 for a bonus payment to our employees that was not recovered in our billing rates to our customers.

At certain points during fiscal year 2002, we determined that a portion of the indirect expenses would not be absorbed by expected contract activities. As a result, we recorded a charge to profit of approximately $1,198,000, $1,341,000, and $846,000 during the second, third, and fourth quarters, respectively. These additional charges reflect a total of approximately $3,385,000 in indirect expenses that was excluded from our indirect billing rates in fiscal year 2002. In fiscal year 2001, the charge to profit for unabsorbed indirect expenses was approximately $10,101,000.

Income taxes. Our income tax expense at interim reporting periods is based on an estimated effective tax rate. This estimated tax rate is calculated based on the projected net income at the end of the fiscal year, and is reviewed at each reporting period. At the end of the fiscal year, income tax expense is adjusted for actual results. Our effective tax rate can differ from the statutory rate. Historically, the variance from the statutory rate has been mainly due to expected benefits from R&D credits and the reversals of valuation allowances.

The following table sets forth, for the periods indicated, statements of operations data as a percentage of revenues from contracts, and, at the end of each period indicated, our backlog:

In fiscal year 2003, new orders increased approximately 61%, which created a 25% increase in revenues and a 106% increase in ending backlog, when compared to fiscal year 2002. In addition, our operating expenses grew at a lower rate than revenues. The growth in revenue, in conjunction with controlled spending, led to a 121% increase in net income during fiscal year 2003 over fiscal year 2002. We believe the increase in revenues is the result of the U.S. Government’s renewed interest in spending on signal intelligence solutions.

In fiscal year 2002, we experienced a 15% increase in orders compared to fiscal year 2001. This led to an increase in year-over-year revenues of 4% and a 32% increase in our ending backlog. As a result of the growth in revenues in fiscal year 2002, a lower operating cost structure when compared to fiscal year 2001, and the absence of our reintegrated subsidiaries, we returned to profitability in fiscal year 2002.

We experienced a significant revenue decline in fiscal year 2001. This decline was due, in part, to what we believed to be delays in the awarding of certain significant engineering development contracts and, in part, to the unanticipated contract closeout of three significant engineering development contracts for the convenience of the customer. In order to better align infrastructure costs with anticipated revenues, we reduced our consolidated workforce by 168 employees, or approximately 31% of the workforce, during 2001. As a result of staff reductions, research and development spending, overhead spending, and marketing expenditures were reduced. We amended our facilities lease and terminated the lease of two buildings and the option for a third building. The total reduction in facilities was approximately 192,379 square feet. In addition, during fiscal year 2001, we reintegrated our two subsidiaries, eNetSecure, Inc., and Transcendent Technologies, Inc., due to their inability to obtain adequate third- party financing. From their inception through the completion of the reintegration of eNetSecure and Transcendent, we invested approximately $5,000,000 and $5,400,000, respectively, plus the necessary equipment and intellectual property. Upon reintegration, we hired 7 and 11 employees from eNetSecure and Transcendent, respectively.

Revenues were approximately $95,384,000, $76,184,000, and $73,489,000 for fiscal years 2003, 2002, and 2001, respectively. Revenues increased by 25% during fiscal year 2003 over fiscal year 2002 and by 4% during fiscal year 2002 over fiscal year 2001. The increase in engineering development efforts designed to provide a variety of signal intelligence solutions to the U.S. Government was the primary reason for the significant increase in revenues during fiscal year 2003. In fiscal year 2002, we experienced an increase in our standard product sales over fiscal year 2001.

The following table identifies the source of our revenues for fiscal years 2003, 2002, and 2001 by major market:

Within the major markets, two intelligence agencies and one branch of the military represented a significant portion of revenues.

The table below identifies the revenue concentration from each significant customer.

Revenues from the U.S. Government can also be categorized as direct purchases and subcontracts, where we are the supplier to another contractor. The following table distinguishes revenue between those two categories.

In addition, our largest contract and its follow-on effort accounted for approximately 19%, 11%, and 8% of revenues in fiscal years 2003, 2002, and 2001, respectively.

Our backlog consists of anticipated revenues from new contracts and from the yet-to-be completed portions of existing contracts (excluding unexercised options). At the end of fiscal year 2003, ending backlog was approximately $87,074,000, representing a 105.9% increase from fiscal year 2002 ending backlog of approximately $42,298,000. The dramatic increase to the ending backlog balance of fiscal year 2003 was due to new orders of approximately $67,242,000 during the fourth quarter. During fiscal year 2002, backlog increased by 31.8% from fiscal year 2001 ending backlog of $32,085,000. The increase in backlog during fiscal year 2002 was primarily due to an increase in new orders generated during the year, when compared to fiscal year 2001.

Contract costs consist of direct costs incurred on contracts such as labor, materials, and manufacturing overhead costs. Contract costs were approximately $63,335,000, or 66.4% of revenues in fiscal year 2003, compared to approximately $49,067,000, or 64.4%, of revenues in fiscal year 2002, and approximately $52,199,000, or 71.0%, of revenues in fiscal year 2001. The increase in contract costs during fiscal year 2003 compared to fiscal year 2002 is a result of an increase in our cost-reimbursement contracts, since these contracts are typically negotiated for a smaller profit. Contract costs decreased during fiscal year 2002 from fiscal year 2001 due to the lower cost structure that resulted from the fiscal year 2001 restructuring activities.

Company-directed investment in research and development consists of expenditures recoverable from customers through billing rates and expenditures funded by us from operations. Research and development expenses were approximately $7,526,000, or 7.9%, of revenues in fiscal year 2003, compared to approximately $8,798,000, or 11.6%, of revenues in fiscal year 2002, and approximately $17,122,000, or 23.3%, of revenues in fiscal year 2001. The decrease in research and development costs in fiscal year 2003 is due to management’s decision to allocate labor resources to meet our contractual commitments and reduce overall R&D spending during fiscal year 2003. The decrease in spending during fiscal year 2002 compared to fiscal year 2001 was the result of management’s decision to return research and development expenses to historical levels. In addition, fiscal year 2001 costs included approximately $2,758,000 by our reintegrated sub sidiary corporations.

General and administrative expenses include administrative salaries, costs related to marketing and proposal activities, costs related to product warranties, and other administrative costs. General and administrative expenses were approximately $15,337,000, or 16.1%, of revenues in fiscal year 2003 compared to approximately $15,160,000, or 19.9%, of revenues in fiscal year 2002 and approximately $20,451,000, or 27.8%, of revenues in fiscal year 2001. In fiscal year 2003, general and administrative expenses decreased as a percentage of revenue as a result of management’s decision to hold our cost structure in place. We determined that our current cost structure could support our current revenue levels. General and administrative expenses decreased in fiscal year 2002 when compared to spending levels in fiscal year 2001 due to a lower operating cost structure.

There were no restructuring costs in fiscal years 2003 and 2002. During fiscal year 2001, we implemented cost reduction actions resulting in restructuring costs of $2,689,000. Cost reduction actions included a workforce reduction of 168 employees, which included 110 technical employees and 58 administrative employees. This represented a 31% reduction in the number of employees during fiscal year 2001. The restructuring costs included severance-related benefits of approximately $1,276,000, the write-off of leasehold improvements associated with vacated facilities of approximately $1,747,000, and other associated restructuring costs of $85,000. Restructuring costs were partially offset by the reversal of deferred rent associated with terminated facility leases of approximately $419,000. The deferred rent balance had been recorded over several years beginning with the inception of the lease term and represented the difference between amounts paid for re nt expense and the amounts recognized in the statement of operations on a straight-line basis.

Net interest income for fiscal year 2003 was approximately $510,000 compared to approximately $34,000 and $435,000 of net interest income in fiscal years 2002 and 2001, respectively. Cash and investment balances at the beginning of fiscal year 2003 were greater than at the beginning of fiscal year 2002, and therefore generated more interest income in fiscal year 2003. In addition, interest activities in fiscal year 2002 included interest payments of approximately $207,000 related to federal and state tax liabilities, which caused a decrease in net interest income from fiscal year 2001.

The effective tax rate for fiscal year 2003 is 11%, compared to a benefit rate of 23% for fiscal year 2002 and a benefit rate of 33% for fiscal year 2001. The effective tax rate at the end of fiscal year 2003 differs from the federal statutory rate and our estimated effective tax rate at the end of the third quarter, primarily due to the reduction of a valuation allowance that was originally recorded in fiscal year 2001. The valuation allowance was reduced in the fourth quarter due to the availability of potential carryback refunds for taxes paid in fiscal year 2003.

The 2002 benefit of approximately $728,000 was comprised of a federal benefit of $794,000 partially offset by a miscellaneous state income tax expense of $66,000. The 2002 effective tax rate differs from the federal statutory rate primarily due to federal and state tax credits, the usage of valuation allowance, and a benefit as result of a tax law change during fiscal year 2002, which allowed us to recover additional taxes paid in prior years.

In fiscal year 2001, we recorded an income tax benefit of approximately $6,154,000 as the result of operating losses that were carried back to recover taxes paid in prior years.

Our primary sources of liquidity during fiscal year 2003 were the cash flows generated from operations and the issuance of common stock through our employee stock purchase plans.

During the fourth quarter of fiscal year 2003, a misclassification was discovered in the previously reported October 31, 2002 balance sheet and cash flow statement. At October 31, 2002, approximately $502,000 of asset-backed securities was misclassified on the balance sheet as cash and cash equivalents instead of as short-term investments. The misclassification has no impact on our statement of operations for any period, including revenues and net income. The October 31, 2002 consolidated balance sheet and fiscal year 2002 consolidated statement of cash flows in this report have been changed to reflect the correct classification.

Cash from operating activities. Net cash from operating activities has fluctuated significantly from year to year. Net cash provided was approximately $14,859,000 in fiscal year 2003 and $15,083,000 in fiscal year 2002. For fiscal year 2001, operating activities used cash of approximately $6,357,000. The year-to-year variances are primarily the result of changes in net income (loss), accounts receivable, refundable income taxes, inventories held by us, and accounts payable and accrued liabilities.

Net income for fiscal years 2003 and 2002 was approximately $8,665,000 and $3,921,000, respectively, which contrasts to a net loss in fiscal year 2001 of approximately $12,383,000. Net income increased in fiscal year 2003 due, in part, to a significant growth in revenues, and in part, to our operating expenses experiencing proportionately less growth than revenue. The fiscal year 2002 net income was primarily due to our lower operating cost structure, which was the result of the fiscal year 2001 restructuring activities. The fiscal year 2001 net loss was due to a reduction in revenues; absorption of indirect contract costs incurred to lower our billing rates; an investment of approximately $5,805,000 in research and development, which was not reimbursed through the billing rates; the occurrence of subsidiary losses of approximately $6,712,000; and restructuring costs of approximately $2,689,000.

Accounts receivable balances increased by approximately $1,935,000 and $590,000 during fiscal years 2003 and 2002, respectively. In contrast, accounts receivable balances decreased by approximately $8,186,000 in fiscal year 2001. Our billed and unbilled receivables balances increased during fiscal year 2003, which was a result of our increase in revenues. The fluctuation of accounts receivable in fiscal year 2002 was driven primarily by two factors. First, our forward loss balance reduced by approximately $885,000, which was an element of unbilled receivables. Second, increased efficiency in our collection process led to an overall decrease of our billed receivables. The net effect created an increase in total accounts receivable. The decrease in accounts receivable in fiscal year 2001 is due, primarily, to a decline in sales of our products and services and, in part, to a $257,000 charge for doubtful accounts.

In fiscal year 2003, we collected the remaining $500,000 of a problematic accounts receivable item disclosed in fiscal year 2002. This resolved a potential reduction in operating income of up to $800,000. All amounts due under this receivable have now been collected in their entirety.

Cash provided by refundable income taxes for fiscal years 2003 and 2002 was zero and approximately $5,053,000, respectively. We received a federal tax refund in fiscal year 2002, which was recorded in fiscal year 2001.

Cash used for inventories, prepaid expenses, and other current assets was approximately $1,078,000 in fiscal year 2003. In contrast, these activities provided cash of approximately $357,000 and $4,151,000 in fiscal years 2002 and 2001, respectively. Fiscal year 2003 activities included an increase in prepaid expenses and other current assets of approximately $1,462,000, which was primarily driven by an increase to deferred tax assets of approximately $1,367,000. This increase was partially offset by a decrease in inventories of approximately $384,000. This decrease to inventory included approximately $1,145,000 in obsolete products that were scrapped. The obsolete inventory included raw materials as well as units in different stages of development. In fiscal year 2002, inventories decreased approximately $1,455,000, which was partially offset by an increase in prepaid expenses and other current assets of approximately $1,098,000. The increase in prepaid expenses and other current assets in fiscal year 200 2 included an increase to deferred tax assets of approximately $495,000 and prepaid income taxes of $263,000.

Accounts payable and accrued liabilities balances increased in fiscal years 2003 and 2002 by approximately $4,350,000 and $1,235,000, respectively. Accounts payable and accrued liabilities in fiscal year 2001 decreased by approximately $6,430,000. The increase in accounts payable and accrued liabilities during fiscal year 2003 is primarily the result of our increased contract activities during fiscal year 2003. The improvement in cash flows in fiscal year 2002 as compared to fiscal year 2001 is primarily attributed to the changes in our cost structure during the second half of fiscal year 2001 related to the reduction in staff.

In fiscal year 2003, accounts payable balances increased by approximately $1,526,000, due to our increased activity in contract costs. Accrued payroll and related liabilities increased approximately $2,352,000 due to an increase in the number of employees. In addition, accrued payroll liabilities included a bonus accrual of approximately $1,107,000, which was paid in December 2003.

In fiscal year 2002, accrued payroll-related liabilities increased approximately $785,000, mostly due to an increased participation in the stock purchase plan by our employees. Trade accounts payable in fiscal year 2002 increased by approximately $294,000, as a result of improved contract activities. Other immaterial liabilities increased by approximately $156,000.

In fiscal year 2001, accrued payroll liabilities decreased by approximately $2,679,000, primarily due to payment of various liabilities associated with staff reductions. Trade accounts payable balances decreased in fiscal year 2001 by approximately $1,051,000 due to a significant decline in contract activity. Income taxes payable decreased by approximately $2,506,000 due to the net loss incurred in fiscal year 2001. Other liabilities decreased by approximately $194,000.

Cash from investing activities. Net cash used in investing activities during fiscal years 2003 and 2002 was approximately $24,023,000 and $14,781,000, respectively. In fiscal year 2001, investing activities provided cash of approximately $1,249,000. In fiscal year 2003, we purchased approximately $30,489,000 in available-for-sale securities, while approximately $8,954,000 matured. In addition, fiscal year 2003 property and equipment purchases were approximately $2,488,000.

Fiscal year 2002 investing activities included purchases of available-for-sale securities of approximately $13,147,000 and property and equipment of approximately $1,634,000.

In contrast, in fiscal year 2001, maturities of available-for-sale securities provided cash of approximately $4,029,000, partially offset by additions to property and equipment of approximately $2,780,000.

Cash from financing activities. Net cash provided by financing activities was approximately $2,821,000, $1,670,000, and $373,000 during fiscal years 2003, 2002, and 2001, respectively. The sources of cash from financing activities during each of these three years were the issuance of common stock under our employee stock purchase plan and stock option plans. The increase in cash provided during fiscal year 2003 was due to an increase in stock option exercises. The fluctuation in cash provided by financing activities between fiscal year 2002 and fiscal year 2001 is due to the absence of dividend payments in fiscal year 2002.

Cash is generated primarily from operating activities, employee stock activities, and investing activities. 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.

We have a cash-secured line of credit with a bank 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 on these borrowings is payable monthly. There are no fees associated with the unused portion of the committed amount. Under this 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, and as of October 31, 2003 there were no other borrowings.

We lease facilities under non-cancelable lease agreements, which expire at various dates between fiscal years 2004 and 2012. Certain leases contain escalation clauses and requirements for the payment of property taxes, insurance, and maintenance expenses. The aggregate minimum annual lease commitments as of October 31, 2003 under long-term operating leases are as follows (in thousands):

We had outstanding letters of credit at October 31, 2003, 2002, and 2001 totaling approximately $1,218,000, $1,331,000, and $1,218,000, respectively.

In fiscal year 2002, a purchase agreement for computer equipment created a liability of approximately $291,000. As of October 31, 2003 there is approximately $146,000 outstanding, which will be paid in March 2004.

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 at 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 $185,000, $295,000, and $321,000 for fiscal years 2003, 2002, and 2001, respectively.

In July 2002, the Financial Accounting Standards Board (FASB) issued Statement of Financial Standards (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 impact on our financial position or results of operations.

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. The adoption of this accounting pronouncement did not have a material 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 was adopted during our second quarter of fiscal year 2003.

In January 2003, the FASB issued Interpretation No. 46, Consolidation of Variable Interest Entities. The Interpretation requires an investor with a majority of the variable interests in a variable interest entity to consolidate the entity and also requires majority and significant variable interest investors to provide certain disclosures. A variable interest entity is an entity in which the equity investors do not have a controlling interest or the equity investment at risk is insufficient to finance the entity’s activities without receiving additional subordinated financial support from the other parties. This pronouncement requires the consolidation of variable interest entities created after January 31, 2003. Consolidation provisions apply for periods ending after March 15, 2004 for variable interest entities, other than special purpose entities, created prior to February 1, 2003. We do not have any variable interest entities, including special purpose entities, that must be consolidated and therefore the adoption of the provision of FIN 46 will not have an impact on our financial position or results of operations.

In April 2003, the FASB issued SFAS No. 149, Amendment of Statement 133 on Derivative Instruments and Hedging Activities. SFAS 149 amends and clarifies financial accounting and reporting for derivative instruments, including certain derivative instruments embedded in other contracts and for hedging activities under SFAS 133, Accounting for Derivative Instruments and Hedging Activities. SFAS 149 is generally effective for contracts entered into or modified after June 30, 2003 and for hedging relationships designated after June 30, 2003. We currently do not have any derivative instruments under SFAS 133.

In May 2003, the FASB issued SFAS No. 150, Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity. SFAS 150 establishes standards for how a company classifies and measures certain financial instruments with characteristics of both liabilities and equity. It requires that an issuer classify certain financial instruments as a liability (or an asset in some circumstances). SFAS 150 is effective for financial instruments entered into or modified after May 31, 2003, and otherwise is effective at the beginning of the first interim period beginning after June 15, 2003. The adoption of SFAS 150 did not have a material effect on our financial position or results of operations.

The following table sets forth certain unaudited quarterly financial data for the eight quarters ending October 31, 2003. In the opinion of management, the unaudited information set forth below has been prepared on the same basis as the audited information and includes all adjustments necessary to present fairly the information set forth herein. The operating results for any quarter are not indicative of results for any future period. All data is in thousands except for common share and per common share data.

At times, we have experienced fluctuations in our quarterly results due to both seasonal and nonseasonal factors inherent in our business. These have included costs associated with uneven flows of incoming material, the level of research and development spending during any given quarter, a significant decline in fiscal year 2001 revenues that caused us to restructure our business, fee recognition on development contracts in the early phases of contract performance where the financial risk is not entirely known until the contract is further along in the development cycle, the United States Government contracting and budget cycles, and the timing of contract awards. Management believes that these fluctuations are an inherent part of the business and could continue into the future.

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

Board of Directors and Shareholders
Applied Signal Technology, Inc.

We have audited the accompanying consolidated balance sheets of Applied Signal Technology, Inc. as of October 31, 2003 and 2002, and the related consolidated statements of operations, shareholders’ equity, and cash flows for each of the three years in the period ended October 31, 2003. These financial statements are the responsibility of the company’s management. Our responsibility is to express an opinion on these financial statements based on our audits.

We conducted our audits in accordance with auditing standards generally accepted in the United States. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Applied Signal Technology, Inc. at October 31, 2003 and 2002, and the consolidated results of its operations and its cash flows for each of the three years in the period ended October 31, 2003, in conformity with accounting principles generally accepted in the United States.

San Jose, California
December 12, 2003

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 telecommunications signals for intelligence gathering, a process referred to as signal intelligence. Our primary customer is the United States Government. For each of the three years in the period ended October 31, 2003, substantially all of our revenues were from contracts with the United States Government, its agencies, or prime contractors for the United States Government.

The consolidated financial statements for fiscal year 2001 include the accounts of Applied Signal Technology, Inc. and its wholly owned subsidiaries. All significant intercompany balances and transactions have been eliminated.

The preparation of financial statements in conformity with generally accepted accounting principles requires 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 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.

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.

The following table represents the revenue concentration by contract type:

For those contracts in which all of the terms have not yet been finalized, revenue does not include an estimated fee rate on cost. 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 also recorded in the period in which they become determinable.

Revenues from our software licenses are accounted for under AICPA Statement of Position 97-2, Software Recognition. Revenues from our software licenses have been insignificant in all periods presented.

Award fee recognition. Our policy for recognizing interim fee on our award fee contracts is based on management’s assessment as to the likelihood that the award fee or an incremental portion of the award fee will be earned on a contract-by-contract basis. 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.

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 the 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 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.

In the fourth quarter of fiscal year 2003, there was a charge to profit of $1,107,000 for a bonus payment to our employees that was not recovered in our billing rates to our customers.

Accounts receivable. 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.

Income taxes. Our income tax expense at interim reporting periods is based on an estimated effective tax rate. This estimated tax rate is calculated based on the projected net income at the end of the fiscal year, and is reviewed at each reporting period. At the end of the fiscal year, income tax expense is adjusted for actual results. Our effective tax rate can differ from the statutory rate. Historically, the variance from the statutory rate has been mainly due to expected benefits from R&D credits and the reversals of valuation allowances.

As a government contractor, we are subject to price redetermination on certain fixed-price contracts if it is determined that we did not price our products and services consistent with the requirements of the Federal Acquisition Regulations. During fiscal years 2003, 2002, and 2001, we did not incur any price redeterminations on any of our contracts.

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

Historically, our debt securities were only comprised of United States Government treasury bills and notes. In order to maximize yield while maintaining safety of the principal balance, during the fourth quarter of fiscal year 2002, we expanded our investment portfolio to include a variety of low-risk investments. These securities are classified as available-for-sale and are carried at fair market value in short-term investments. 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 for the years ended October 31, 2003, 2002, and 2001.

During the fourth quarter of fiscal year 2003, a misclassification was discovered in the previously reported October 31, 2002 balance sheet and cash flow statement. At October 31, 2002, approximately $502,000 of asset-backed securities was misclassified on the balance sheet as cash and cash equivalents instead of as short-term investments. The misclassification has no impact on our statement of operations for any period, including revenues and net income. The October 31, 2002 consolidated balance sheet and fiscal year 2002 consolidated statement of cash flows in this report have been changed to reflect the correct classification.

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

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

Machinery and equipment as well as furniture and fixtures are depreciated by using the straight-line method over the estimated useful lives of the assets, ranging up to five years. Leasehold improvements are amortized by using the straight-line method over the lesser of the useful life of the assets or the lease term. Construction in process included costs incurred to build a portion of our leasehold improvements and test equipment.

Basic net income (loss) per share is determined by dividing net income (loss) 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):

Approximately 53,000 potential common shares were excluded from the number of shares used to compute diluted net loss per common share for the year ended October 31, 2001, as their effect would be antidilutive.

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

Accumulated comprehensive income on securities was approximately $65,000, $65,000, and zero as of October 31, 2003, 2002, and 2001, respectively.

We apply Accounting Principles Board Opinion No. 25 and related Interpretations in accounting for our stock option plans. We have opted, under SFAS No. 123, Accounting for Stock-Based Compensation, to disclose our stock-based compensation with no financial statement effect. Had compensation expense for our stock option plans been determined based upon the fair value at the grant date for awards under these plans consistent with the methodology prescribed under SFAS 123, our pro forma net income (loss) and net income (loss) per share would have been as follows (in thousands, except per share data):

The weighted average fair value at the date of grant for options granted during fiscal years 2003, 2002, and 2001 was $13.46, $8.71, and $3.35 per option, respectively. The weighted average fair value for shares purchased through the employee stock purchase plans during fiscal years 2003, 2002, and 2001 was $5.68, $3.44, and $2.65 per share, respectively.

The fair value of options at the date of grant was estimated by using the Black Scholes valuation model with the following weighted average assumptions:

Recent Accounting Pronouncements

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 e arlier adoption encouraged. The adoption of SFAS 146 did not have an impact on our financial position or results of operations.

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. The adoption of this accounting pronouncement did not have a material 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 was adopted during our second quarter of fiscal year 2003.

In January 2003, the FASB issued Interpretation No. 46, Consolidation of Variable Interest Entities. The Interpretation requires an investor with a majority of the variable interests in a variable interest entity to consolidate the entity and also requires majority and significant variable interest investors to provide certain disclosures. A variable interest entity is an entity in which the equity investors do not have a controlling interest or the equity investment at risk is insufficient to finance the entity’s activities without receiving additional subordinated financial support from the other parties. This pronouncement requires the consolidation of variable interest entities created after January 31, 2003. Consolidation provisions apply for periods ending after March 15, 2004 for variable interest entities, other than special purpose entities, created prior to February 1, 2003. We do not have any variable interest entities, including special purpose entities, that must be consolidated and therefore the adoption of the provision of FIN 46 will not have an impact on our financial position or results of operations.

In April 2003, the FASB issued SFAS No. 149, Amendment of Statement 133 on Derivative Instruments and Hedging Activities. SFAS 149 amends and clarifies financial accounting and reporting for derivative instruments, including certain derivative instruments embedded in other contracts and for hedging activities under SFAS 133, Accounting for Derivative Instruments and Hedging Activities. SFAS 149 is generally effective for contracts entered into or modified after June 30, 2003 and for hedging relationships designated after June 30, 2003. We currently do not have any derivative instruments under SFAS 133.

In May 2003, the FASB issued SFAS No. 150, Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity. SFAS 150 establishes standards for how a company classifies and measures certain financial instruments with characteristics of both liabilities and equity. It requires that an issuer classify certain financial instruments as a liability (or an asset in some circumstances). SFAS 150 is effective for financial instruments entered into or modified after May 31, 2003, and otherwise is effective at the beginning of the first interim period beginning after June 15, 2003. The adoption of SFAS 150 did not have a material effect on our financial position or results of operations.

The following table identifies the source of our revenues for fiscal years 2003, 2002, and 2001 by major market:

Within the major markets, two intelligence agencies and one branch of the military represented a significant portion of revenues.

The table below identifies the revenue concentration from each significant customer.

Revenues from the U.S. Government can also be categorized as direct purchases and subcontracts, where we are the supplier to another contractor. The following table distinguishes revenue between those two categories.

We regard the credit risk of our business to be minimal. At October 31, 2003, 2002, and 2001, the allowance for doubtful accounts balance was zero, $26,000, and $283,000, respectively. During fiscal year 2003, approximately $154,000 was deemed uncollectible and charged to bad debt expense. The fiscal year 2002 allowance reduction of $257,000 was due to the write off of an uncollectible balance of one customer.

Inventories are stated at the lower of average cost or market and consisted of the following (in thousands):

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.

The reduction to inventory in fiscal year 2003 included the scrapping of approximately $1,145,000 in obsolete products. The obsolete inventory included raw materials as well as units in different stages of development.

We have a cash-secured line of credit with a bank in the amount of $1,500,000, which will expire on March 1, 2004. Any borrowings bear interest at the bank’s reference rate (4.0% at October 31, 2003) and accrued interest on these borrowings is payable monthly. There are no fees associated with the unused portion of the committed amount. Under this line of credit agreement, we have one standby letter of credit outstanding related to our facilities lease, and as of October 31, 2003 there were no other borrowings.

We lease facilities under non-cancelable lease agreements, which expire at various dates between fiscal years 2004 and 2012. Certain leases contain escalation clauses and requirements for the payment of property taxes, insurance, and maintenance expenses. The aggregate minimum annual lease commitments as of October 31, 2003 under long-term operating leases are as follows (in thousands):

Rent expense under operating leases was $4,228,000, $4,219,000, and $4,847,000 in fiscal years 2003, 2002, and 2001, respectively.

We had outstanding letters of credit at October 31, 2003, 2002, and 2001 totaling approximately $1,218,000, $1,331,000, and $1,218,000, respectively. These letters of credit were for our facilities located in Sunnyvale, California as part of our lease agreement.

In fiscal year 2002, we entered into a purchase agreement for computer equipment of approximately $291,000. As of October 31, 2003 there is approximately $146,000 outstanding, which will be paid by March 2004.

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 at 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 $185,000, $295,000, and $321,000 for fiscal years 2003, 2002, and 2001, respectively.

In the second quarter of fiscal year 2003, the Board of Directors announced a $0.25 per share annual dividend, payable over four quarters at the rate of $0.0625 per share per quarter. Dividends of approximately $646,000, $668,000, and $673,000 were paid on May 16, 2003, August 15, 2003, and November 14, 2003, respectively, to shareholders of record at May 2, 2003, August 1, 2003, and October 31, 2003, respectively.

At October 31, 2003 accrued dividends of approximately $673,000 were included in other accrued liabilities in the accompanying balance sheet.

We paid no dividends during fiscal year 2002, and approximately $1,733,000 during fiscal year 2001.

We maintain our 1993 Employee Stock Purchase Plan ("1993 Plan"), and have reserved 4,300,000 shares of common stock for issuance to employees under the 1993 Plan. The 1993 Plan was adopted by the Board of Directors on January 22, 1993 and approved by the shareholders on February 22, 1993. Under this plan, eligible employees purchase common stock through payroll deductions (which cannot exceed 10% of any employee’s compensation) at 85% of the lower of its fair market value at the beginning of a twenty-four-month offering period, or the end of each six-month purchase period. As of October 31, 2003, 940,441 shares remain reserved for issuance and eligible for purchase under the 1993 Plan.

Our 1991 Stock Option Plan ("1991 Plan") provides for the granting of incentive stock options and non-qualified stock options to our employees, directors, and consultants at exercise prices ranging from 85% to 110% (depending on the type of grant) of the fair market value of the common stock on the date of grant. Some options are exercisable only at the end of a two-year vesting period and some options are exercisable at the rate of 20% per year over five years. The 1991 Plan expired on January 19, 2001 and all remaining shares reserved for issuance expired. Options to purchase an aggregate of 534,186 shares of our common stock remain outstanding under the 1991 Plan, as of October 31, 2003.

Our 2000 Stock Option Plan ("2000 Plan") was adopted by the Board of Directors on May 11, 2000, and provides for the granting of non-qualified stock options to our employees and consultants at exercise prices ranging from 85% to 100% of the fair market value of the common stock on the date of grant. Options generally vest over five years, at the rate of 20%, one year after the date of grant and in equal monthly installments over the remaining 48 months, and have a maximum term of 10 years. Options to purchase an aggregate of 326,348 shares of our common stock remain outstanding under the 2000 Plan, as of October 31, 2003.

Our 2001 Stock Option Plan ("2001 Plan") was adopted by the Board of Directors on November 16, 2000 and approved by the shareholders on March 15, 2001. The 2001 Plan provides for the granting of incentive stock options and non-qualified stock options to our employees, directors, and consultants at exercise prices ranging from 85% to 100% of the fair market value of the common stock on the date of grant. Options generally vest over five years, at the rate of 20%, one year after the date of grant and in equal monthly installments over the remaining 48 months, and have a maximum term of 10 years. Options to purchase an aggregate of 434,403 shares of our common stock remain outstanding under the 2001 Plan, as of October 31, 2003.

A summary of the option activity under all stock option plans is as follows:

The following table summarizes information about options outstanding for all option plans as of October 31, 2003:

The number of shares exercisable at October 31, 2002 and October 31, 2001 were 589,649 and 326,454, respectively.

The provision (benefit) for income taxes for the years ended October 31, 2003, 2002, and 2001 consists of the following (in thousands):

The provision (benefit) for income taxes differs from the amount computed by applying the statutory federal income tax rate of 34% to income (loss) before provision (benefit) for income taxes as follows (in thousands):