SECURITIES AND EXCHANGE COMMISSION

FORM 10-Q

(Mark One)

Commission File Number 0-21074

SUPERCONDUCTOR TECHNOLOGIES INC.

460 Ward Drive,
Santa Barbara, California 93111-2356
(Address of principal executive offices & zip code)

(805) 690-4500
(Registrant’s telephone number including area code)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the
Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required
to file such reports), and (2) has been subject to such filing requirements for the past 90 days.

Yes    x   No   o

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

Yes    x   No   o

As of November 5, 2004, there were 92,111,026 shares of the Registrant’s Common Stock outstanding.

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SUPERCONDUCTOR TECHNOLOGIES INC.

INDEX TO FORM 10-Q

Three and Nine Months Ended October 2, 2004

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SPECIAL NOTE REGARDING FORWARD-LOOKING STATEMENTS

     This report contains forward-looking statements that involve risks and uncertainties. We have made these statements in reliance on the safe harbor provisions of the Private Securities Litigation Reform Act of 1995. Our forward-looking statements relate to future events or our future performance and include, but are not limited to, statements concerning our business strategy, future commercial revenues, market growth, capital requirements, new product introductions, expansion plans and our funding requirements. Other statements contained in our filings that are not historical facts are also forward-looking statements. We have tried, wherever possible, to identify forward-looking statements by terminology such as “may,” “will,” “could,” “should,” “expects,” “anticipates,” “intends,” “plans,” “believes,” “seeks,” “estimates” and other comparable terminology.

     Forward-looking statements are not guarantees of future performance and are subject to various risks, uncertainties and assumptions that are difficult to predict. Therefore, actual results may differ materially from those expressed in forward-looking statements. They can be affected by many factors, including, those discussed under the caption “Management’s Discussion and Analysis of Financial Condition and Results of Operations.” Forward-looking statements are based on information presently available to senior management, and we do not assume any duty to update our forward-looking statements.

WHERE YOU CAN FIND MORE INFORMATION

     As a public company, we are required to file annually, quarterly and special reports, proxy statements and other information with the SEC. You may read and copy any of our materials on file with the SEC at the SEC’s Public Reference Room at 450 Fifth Street, N.W., Judiciary Plaza, Washington, DC 20549, as well as at the SEC’s regional office at 5757 Wilshire Boulevard, Suite 500, Los Angeles, California 90036. Our filings are available to the public over the Internet at the SEC’s website at http:\\.www.sec.gov. Please call the SEC at 1-800-SEC-0330 for further information on the Public Reference Room. STI also provides copies of its Forms 8-K, 10-K, 10-Q, Proxy and Annual Report at no charge to investors upon request and makes electronic copies of its most recently filed reports available through its website at www.suptech.com as soon as reasonably practicable after filing such material with the SEC.

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PART I. FINANCIAL INFORMATION

Item 1. Financial Statements

SUPERCONDUCTOR TECHNOLOGIES INC.

CONSOLIDATED STATEMENT OF OPERATIONS
(Unaudited)

See accompanying notes to the condensed consolidated financial statements

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SUPERCONDUCTOR TECHNOLOGIES INC.

See accompanying notes to the condensed consolidated financial statements

Note: December 31, 2003 balances were derived from audited financial statements

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SUPERCONDUCTOR TECHNOLOGIES INC.

     See accompanying notes to the condensed consolidated financial statements.

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SUPERCONDUCTOR TECHNOLOGIES INC.

NOTES TO UNAUDITED INTERIM CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

1. General

     Superconductor Technologies Inc. was incorporated in Delaware on May 11, 1987 and maintains its headquarters in Santa Barbara, California. The Company has operated in a single industry segment, the research, development, manufacture and marketing of high-performance filters to service providers and original equipment manufacturers in the mobile wireless communications industry. The Company’s principal commercial product, the SuperLink Rx®, combines high-temperature superconductors with cryogenic cooling technology to produce a filter with significant advantages over conventional filters. From 1987 to 1997, the Company was engaged primarily in research and development and generated revenues primarily from government research contracts. The Company began full-scale commercial production of the SuperLink Rx® in 1997 and shipped 1,884 units in 2003 and 1,243 and 605 units in the nine months ended September 27, 2003 and October 2, 2004, respectively.

     The Company continues to be involved as either contractor or subcontractor on a number of contracts with the United States government. These contracts have been and continue to provide a significant source of revenues for the Company. For the nine months ended September 27, 2003 and October 2, 2004, government related contracts account for 22% and 27%, respectively, of the Company’s net revenues.

     The unaudited consolidated financial information furnished herein has been prepared in accordance with generally accepted accounting principles and reflects all adjustments, consisting only of normal recurring adjustments, which in the opinion of management, are necessary for a fair statement of the results of operations for the periods presented.

     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 the accompanying notes. Actual results could differ from those estimates and such differences may be material to the financial statements. This quarterly report on Form 10-Q should be read in conjunction with the Company’s Form 10-K for the year ended December 31, 2003. The results of operations for the three and nine months ended October 2, 2004 are not necessarily indicative of results for the entire fiscal year ending December 31, 2004.

2. Summary of Significant Accounting Policies

Basis of Presentation

     The Company’s independent registered public accounting firm has included in their audit report for 2003-year an explanatory paragraph expressing doubt about the Company’s ability to continue as a going concern due to past losses and negative cash flows. They included a similar explanatory paragraph in their audit report for 2002. In 2003, the Company incurred a net loss of $11,345,000 and negative cash flows from operations of $18,458,000. For the nine months ended October 2, 2004, the Company had a net loss of $19,949,000 and negative cash flows from operations of $16,268,000. In response during the current year, the Company adjusted its inventory build plan, reduced direct and indirect labor, cut certain fixed costs and implemented a reduced workweek. In the second quarter of 2004, the Company also began a cost restructuring program to consolidate its research and development operations in Sunnyvale into its Santa Barbara facility, eliminate an additional 50 positions and accelerate the implementation of a new lower cost wafer deposition process.

     The Company completed two financing transactions during the nine months ended October 2, 2004. First, the Company closed a transaction on April 28, 2004 to expand its credit facility. Silicon Valley Bank amended the Company’s existing line of credit to increase borrowing capacity from 80% to 95% of eligible accounts receivable. The Company concurrently secured a commitment for a $2.0 million secured bridge loan from an investor. The investor subsequently funded $1.5

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million of the bridge loan. The Company issued to the lenders warrants to purchase in the aggregate 600,000 shares of common stock at $1.85 per share. The bridge loan was subsequently paid in full on May 26, 2004. Upon repayment of the bridge loan the Silicon Valley credit facility reverted back to it original terms.

     Second, the Company completed a public offering of 23,000,000 shares of common stock at $0.80 per share during the second quarter of this year raising net proceeds of $16.7 million.

     The Company expects its existing cash resources, together with its line of credit, will be sufficient to fund planned operations into 2005. The Company expects its liquidity to reach an unacceptably low level in the second quarter of 2005 and anticipates a need for additional working capital to fund growth in the third and fourth quarters of 2005. Accordingly, the Company has concluded that it will need additional funding to provide adequate cash reserves in the event of another downturn in its business and to fund expected growth in the second half of 2005. The Company’s actual cash requirements will depend on numerous factors, including the rate of growth of sales, the timing and levels of products purchased, payment terms and credit limits from manufacturers, the timing and level of accounts receivable collections and its ability to manage the business profitability.

     The Company plans to explore various funding opportunities over the next two quarters. There is no assurance that additional financing (public or private) will be available on acceptable terms or at all. If the Company issues additional equity securities to raise funds, the ownership percentage of its existing stockholders would be reduced. New investors may demand rights, preferences or privileges senior to those of existing holders of common stock. If the Company cannot raise needed funds, it might be forced to make further substantial reductions in its operating expenses, which could adversely affect its ability to implement its current business plan and ultimately its viability as a company.

     The Company’s interim financial statements have been prepared assuming that it will continue as a going concern. The factors described above raise substantial doubt about its ability to continue as a going concern. These financial statements do not include any adjustments that might result from this uncertainty.

Principles of Consolidation

     The interim condensed consolidated financial statements include the accounts of Superconductor Technologies Inc. and its wholly owned subsidiaries (the “Company”). All significant intercompany transactions have been eliminated from the consolidated financial statements.

Cash and Cash Equivalents

     Cash and cash equivalents consist of highly liquid investments with original maturities of three months or less. Cash and cash equivalents are maintained with quality financial institutions and from time to time exceed FDIC limits.

Accounts Receivable

     The Company sells predominantly to entities in the wireless communications industry and to entities of the United States government. The Company grants uncollateralized credit to its customers. The Company performs ongoing credit evaluations of its customers before granting credit.

Revenue Recognition

     Commercial revenues are principally derived from the sale of the Company’s SuperLink Rx® products and are recognized once all of the following conditions have been met: a) an authorized purchase order has been received in writing, b) customer’s credit worthiness has been established, c) shipment of the product has occurred, d) title has transferred, and e) if stipulated by the contract, customer acceptance has occurred and all significant vendor obligations, if any, have been satisfied.

     Contract revenues are principally generated under research and development contracts. Contract revenues are recognized utilizing the percentage-of-completion method measured by the relationship of costs incurred to total estimated contract costs. If the current contract estimate were to indicate a loss, utilizing the funded amount of the contract, a provision would be made for the total anticipated loss. Revenues from research related activities are derived primarily from contracts with agencies of the United States Government. Credit risk related to accounts receivable arising from such contracts is considered minimal. These contracts include cost-plus, fixed price and cost sharing arrangements and are generally short-term in nature.

     All payments to the Company for work performed on contracts with agencies of the U.S. Government are subject to adjustment upon audit by the Defense Contract Audit Agency. These audits have been completed and agreed to through 2001. Based on historical experience and review of current projects in process, management believes that the audits will not have a significant effect on the financial position, results of operations or cash flows of the Company.

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Warranties

     The Company offers warranties generally ranging from one to five years, depending on the product and negotiated terms of purchase agreements with its customers. Such warranties require the Company to repair or replace defective product returned to the Company during such warranty period at no cost to the customer. An estimate by the Company for warranty related costs is recorded by the Company at the time of sale based on its actual historical product return rates and expected repair costs. Such costs have been within management’s expectations.

Guarantees

     In connection with the sales and manufacturing of its commercial products, the Company indemnifies, without limit or term, its customers and contract manufactures against all claims, suits, demands, damages, liabilities, expenses, judgments, settlements and penalties arising from actual or alleged infringement or misappropriation of any intellectual property relating to its products or other claims arising from its products. The Company cannot reasonably develop an estimate of the maximum potential amount of payments that might be made under its guarantee because of the uncertainty as to whether a claim might arise and how much it might total.

Research and Development Costs

     Research and development costs are expensed as incurred and include salary, facility, depreciation and material expenses. Research and development costs incurred solely in connection with research and development contracts are charged to contract research and development expense. Other research and development costs are charged to other research and development expense.

Inventories

     Inventories are stated at the lower of cost or market, with costs primarily determined using standard costs, which approximate actual costs utilizing the first-in, first-out method. Provision for potentially obsolete or slow moving inventory is made based on management’s analysis of inventory levels and sales forecasts.

Property and Equipment

     Property and equipment are recorded at cost. Equipment is depreciated using the straight-line method over their estimated useful lives ranging from three to five years. Leasehold improvements and assets financed under capital leases are amortized over the shorter of their useful lives or the lease term. Furniture and fixtures are depreciated over seven years. Expenditures for additions and major improvements are capitalized. Expenditures for minor tooling, repairs and maintenance and minor improvements are charged to expense as incurred. When property or equipment is retired or otherwise disposed of, the related cost and accumulated depreciation are removed from the accounts. Gains or losses from retirements and disposals are recorded as other income or expense.

Patents, Licenses and Purchased Technology

     Patents and licenses are recorded at cost and are amortized using the straight-line method over the shorter of their estimated useful lives or approximately seventeen years. Purchased technology acquired through the acquisition of Conductus, Inc. is recorded at its estimated fair value and is amortized using the straight-line method over seven years.

Goodwill

     Goodwill represents the excess of purchase price over fair value of net assets acquired. Goodwill is tested for impairment annually in the fourth quarter after the annual planning process, or earlier if events occur which require an impairment analysis be performed. The first step of the impairment test, used to identify potential impairment, compares the fair value of a reporting unit with its carrying value, including goodwill. If the fair value of a reporting unit exceeds its carrying value, goodwill of the reporting unit is considered not impaired. If the carrying amount of a reporting unit exceeds its fair value, the second step of the goodwill impairment test shall be performed to measure the amount of impairment loss. The second step of the goodwill impairment test, used to measure the amount of impairment loss, compares the implied fair value of the reporting unit goodwill with the carrying amount of that goodwill. If the carrying amount of the reporting unit goodwill exceeds the implied fair value of

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that goodwill, an impairment loss shall be recognized in an amount equal to that excess.

Long-Lived Assets

     The realizability of long-lived assets is evaluated periodically as events or circumstances indicate a possible inability to recover the carrying amount. Such evaluation is based on various analyses, including cash flow and profitability projections. The analyses necessarily involve significant management judgment. In the event the projected undiscounted cash flows are less than net book value of the assets, the carrying value of the assets will be written down to their estimated fair value.

Restructuring Expenses

Liability for costs associated with an exit or disposal activity are recognized when the liability is incurred.

Loss Contingencies

     In the normal course of business the Company is subject to claims and litigation. Liabilities relating to these claims are recorded when it is determined that a loss is probable and the amount of the loss can be reasonably estimated. The costs of defending the Company in such matters are expensed as incurred.

     The Company is currently involved as a defendant in several lawsuits – a patent infringement case and several substantially identical securities class actions. These matters are discussed below in “Legal Proceedings.” The Company does not believe that a loss is probable or reasonably estimable in any of these cases and therefore has not recorded any liabilities relating to these proceedings. The Company periodically reassesses its potential liability as additional information becomes available. If the Company later determines that a loss is probable and the amount reasonably estimable, the Company would record a reserve for the potential loss. The ultimate amount of the loss, if any, could materially impact its results of operations, financial condition or cash flows.

Income Taxes

     The Company accounts for income taxes under the provisions of Statement of Financial Accounting Standards No. 109 (“SFAS 109”), “Accounting for Income Taxes.” SFAS 109 utilizes an asset and liability approach that requires the recognition of deferred tax assets and liabilities for the expected future tax consequences of events that have been recognized in the Company’s financial statements or tax returns. In estimating future tax consequences, SFAS 109 generally considers all expected future events other than enactments of changes in the tax laws or rates. Valuation allowances are established when necessary to reduce deferred tax assets to the amount expected to be realized.

Marketing Costs

     All costs related to marketing and advertising the Company’s products are expensed as incurred or at the time the advertising takes place. Advertising costs were not material in each of the quarters and nine months ended September 27, 2003 and October 2, 2004.

Net Loss Per Share

     Basic and diluted net loss per share is computed by dividing net loss available to common stockholders by the weighted average number of common shares outstanding in each year. Potentially dilutive shares are not included in the calculation of diluted loss per share because their effect is antidilutive.

Stock-based Compensation

     As permitted under Statement of Financial Accounting Standards No. 123 (“SFAS 123”), “Accounting for Stock-Based Compensation”, the Company has elected to follow Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees” in accounting for its stock options and other stock-based employee awards. Pro forma information regarding net loss and loss per share, as calculated under the provisions of SFAS 123, are disclosed in the notes to the financial statements. The Company accounts for equity securities issued to non-employees in accordance with the provision of SFAS 123 and Emerging Issues Task Force 96-18.

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     If the Company had elected to recognize compensation expense for employee awards based upon the fair value at the grant date consistent with the methodology prescribed by SFAS 123, the Company’s net loss and net loss per share would have been increased to the pro forma amounts indicated below:

     Due to the fact that the Company’s employee stock options have characteristics significantly different from those of traded options and any changes in the subjective input assumptions can materially affect the fair value estimates, management does not believe that the existing models provide a reliable single measure of the fair value of its employee stock options. Therefore, the Company believes that the pro forma net expense per SFAS 123 calculated above is not a reliable measure of the costs of the Company’s stock option plans.

Use of Estimates

     The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting periods. The significant estimates in the preparation of the financial statements relate to the assessment of the carrying amount of accounts receivable, inventory, intangibles, goodwill, estimated provisions for warranty costs, accruals for restructuring and lease abandonment costs, income taxes and litigation. Actual results could differ from those estimates and such differences may be material to the financial statements.

Fair Value of Financial Instruments

     The carrying amount of cash and cash equivalents, accounts receivable, accounts payable and accrued expenses approximate fair value due to the short-term nature of these instruments. The Company estimates that the carrying amount of the debt approximates fair value based on the Company’s current incremental borrowing rates for similar types of borrowing arrangements.

Comprehensive Income (Loss)

     The Company has no items of other comprehensive income (loss) in any period other than its net loss.

Segment Information

     The Company operates in a single business segment, the development, manufacture and marketing of high performance products to service providers, systems integrators and original equipment manufacturers in the commercial wireless

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telecommunications industry. The Company’s principal commercial product, the SuperLink Rx® combines high-temperature superconductors with cryogenic cooling technology to produce a filter with significant advantages over conventional filters. We currently sell most of our product directly to wireless network operators in the United States. Net revenues derived principally from government research and development contracts are presented separately on the statement of operations for all periods presented. Management views its government research and development contracts as a supplementary source of revenue to fund its development of high temperature superconducting products.

     Net commercial product revenues are derived from the following products:

Certain Risks and Uncertainties

     During the two year period ended December 31, 2003, the Company sold 2,811 SuperFilter® units and in the nine months ended September 27, 2003 and October 2, 2004 it sold 1,243 and 605 SuperFilter® units, respectively. The Company has continued to incur operating losses. The Company’s long-term prospects and execution of its business plan are dependent upon the continued and increased market acceptance for the product.

     The Company currently sells most of its products directly to wireless network operators in the United States and its product sales have historically been concentrated in a small number of customers. In 2002 U.S. Cellular and ALLTEL accounted for 8% and 84% of our net commercial revenues, respectively, and 19% and 24% of accounts receivable, respectively. In 2003, ALLTEL and Verizon Wireless our two largest customers accounted for 70% and 15% of our net commercial revenues, respectively, and 21% and 25% of accounts receivable, respectively. In the nine months ended October 2, 2004, ALLTEL and Verizon Wireless, our two largest customers, accounted for 63% and 23% of our net commercial revenues, respectively, and 29% and 18% of accounts receivable, respectively. The loss of, or reduction in, sales to any of these customers could have a material adverse effect on the Company’s business, financial condition, results of operations and cash flows.

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     The Company currently relies on one supplier for purchases of high quality substrates for growth of high-temperature superconductor films and a limited number of suppliers for other key components of its products.

     In connection with the sales of its commercial products, the Company indemnifies, without limit or term, its customers against all claims, suits, demands, damages, liabilities, expenses, judgments, settlements and penalties arising from actual or alleged infringement or misappropriation of any intellectual property relating to its products or other claims arising from its products. The Company cannot reasonably develop an estimate of the maximum potential amount of payments that might be made under its guarantee because of the uncertainty as to whether a claim might arise and how much it might total.

Recent Accounting Pronouncements

     In March 2004, the consensus of the Emerging Issues Task Force (EITF) Issue No. 03-06, Participating Securities and the Two-Class Method under FASB Statement 128, was published. EITF Issue No.03-06 addresses the computations of earnings per share by companies that have issued securities other than common stock that contractually entitle the holder to participate in dividends and earnings of the company. Further guidance on the application and allocations of the two-class method of calculating earnings per share is also included. The provisions of EITF Issue No. 03-06 will be effective for reporting periods beginning after March 31, 2004. The adoption of this guidance is not expected to have a significant impact on the Company’s financial results of operations and financial position.

3. Short Term Borrowings

     The Company has a line of credit with a bank. The line of credit expires March 17, 2005 and is structured as a sale of accounts receivable. The agreement provides for the sale of up to $5 million of eligible accounts receivable, with advances to the Company totaling 80% of the receivables sold. Advances under the agreement are collateralized by all the Company’s assets. Under the terms of the agreement, the Company continues to service the sold receivables and is subject to recourse provisions.If the bank determines that there is a material adverse change in the Company’s business, they can exercise all their rights and remedies under the agreement.

     Advances bear interest at the prime rate (4.75% at October 2, 2004) plus 2.50% subject to a minimum monthly charge. Outstanding amounts under this borrowing facility at October 2, 2004 totaled $669,000 and are repaid upon collection of the underlying receivables sold.

     On April 28, 2004 the Company temporarily expanded its credit facility. Silicon Valley Bank temporarily amended the Company’s existing line of credit to increase borrowing capacity from 80% to 95% of eligible accounts receivable on up to the sale of $2.5 million of eligible accounts receivable. Advances under the modified agreement bore interest at prime rate plus 5.125%. Upon repayment of the bridge loan described below this credit facility reverted back to its original terms

     The Company concurrently secured a commitment for a $2.0 million secured bridge loan from an investor. The bridge loan bore interest at 12% per annum, was due by July 31, 2004 and included penalty provisions if there were any defaults under the agreement. The investor subsequently funded $1.5 million of the bridge loan. The bridge loan was collateralized by

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all the Company’s assets and was subordinated to the Silicon Valley Bank line of credit. The bridge loan was subsequently paid in full on May 26, 2004.

     In connection with modification of the existing credit facility with Silicon Valley Bank and $2 million bridge loan, the Company issued to the bank warrants to purchase 100,000 shares of common stock at $1.85 per share and to the bridge lender warrants to purchase 500,000 shares of common stock at $1.85 per share . These warrants expire on April 28, 2011. The fair value of the warrants issued in connection with the bridge loans were estimated using the Black-Scholes option pricing method, totaled $802,000 and were accounted for as debt issuances costs and amortized over the term of the loan. Assumptions used in the calculation were: dividends of zero percent each year, expected volatilities of 112%, expected life of 7 years and risk free interest rate of 3.99%.

4. Stockholders’ Equity

Common Stock

     In the nine months ended October 2, 2004 the Company raised net proceeds of $16,699,000, net of offering costs of $1,701,000, from the public sale of 23,000,000 shares of common stock at $0.80 per share based on a negotiated discount to market.

     This transaction caused the exercise price and the number of shares of the warrants issued to the bridge lender under the 2004 Bridge Loan to be adjusted to $1.59 and 581,761, respectively. The exercise price and shares of the warrants issued in connection with the Series E convertible Preferred Stock were not affected.

Stock Options

     The following is a summary of stock option transactions under the Company’s stock option plans:

     Options for 89,777 shares of common stock were exercised for $249,600 during the period. The outstanding options expire by the end of June 2014. The exercise prices for these options range from $0.87 to $49.38 per share, for an aggregate exercise price of approximately $53.1 million. At October 2, 2004, there were 1,184,185 shares of common stock available for granting future options.

Warrants

     In connection with modification of the existing credit facility with Silicon Valley Bank and $2 million bridge loan, the Company issued to the bank warrants to purchase 100,000 shares of common stock at $1.85 per share and to the bridge lender warrants to purchase 500,000 shares of common stock at $1.85 per share . These warrants expire on April 28, 2011. The bridge lender warrants contain “weighted average” antidilution provisions which adjust the warrant exercise price and number of shares in the event the Company sells equity securities at a discount to then prevailing market prices. The amount of the adjustment depends on the size of the below-market transaction and the amount of the discount to the market price. These warrants include call, net exercise, registration rights and penalty provisions if the sale of the shares underlying the warrants were not registered within a certain timeframe or if the registration statement effectiveness is not maintained.

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     The following is a summary of outstanding warrants at October 2, 2004:

* The terms of these warrants contain net exercise provisions, wherein instead of a cash exercise investors can elect to receive common stock equal to the difference between the exercise price and the average closing sale price for common shares over 10-30 days immediately preceding the exercise date.

During the nine months ended October 2, 2004 the following warrants were exercised:

5. Legal Proceedings

     Patent Litigation

     The Company is engaged in a patent dispute with ISCO International, Inc. relating to U.S. Patent No. 6,263,215 entitled “Cryoelectronically Cooled Receiver Front End for Mobile Radio Systems.” ISCO filed a complaint on July 17, 2001 in the United States District Court for the District of Delaware against the Company and its wholly owned subsidiary, Conductus, Inc. The ISCO complaint alleged that the Company’s SuperFilter product and Conductus’ ClearSite® product infringe ISCO’s patent. The matter went to trial on March 17, 2003.

     On April 3, 2003, the jury returned a unanimous verdict that the Company’s SuperFilter III product does not infringe the patent in question, and that ISCO’s patent is invalid and unenforceable. The jury also awarded the Company $3.8 million in compensatory damages based upon a finding that ISCO engaged in unfair competition and acted in bad faith by issuing press releases and contacting our customers asserting rights under this patent.

     On April 17, 2003, the Company filed a Motion for Attorneys’ Fees and Disbursements, in which the Company asked the court to award the Company its attorneys’ fees and other litigation expenses. On the same date, ISCO filed a motion, asking the court to overturn the verdict and grant a new trial. In August 2003, the court rejected ISCO’s request to overturn the jury’s verdict that the patent is invalid and not infringed by the SuperFilter III product, and accepted the jury’s verdict that

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the patent is unenforceable because of inequitable conduct committed by one of the alleged inventors. ISCO subsequently filed a notice of appeal as to this portion of the court’s decision. The court overturned the jury’s verdict of unfair competition and bad faith on the part of ISCO and the related $3.8 million compensatory damage award to the Company, and also denied the Company request for reimbursement of its legal fees associated with the case. The Company has filed a notice of appeal as to this portion of the court’s decision.

     Litigation expenses on the ISCO matter totaled $90,000 and $4,784,000 for the three and nine month periods ended September 27, 2003, respectively, and $25,000 and $438,000 for the three and nine month periods ended October 2, 2004, respectively.

Class Action Lawsuits

     The Company has been named as a defendant in several substantially identical class action lawsuits filed in the United States District Court for the Central District of California in April 2004. The cases were consolidated in August 2004, and the plaintiffs filed an amended consolidated complaint in October 2004. The plaintiffs allege securities law violations by the Company and certain of its officers and directors under SEC Rule 10b-5 and Sections 10(b) and 20(a) of the Securities Exchange Act of 1934, as amended. The complaint was filed on behalf of a purported class of people who purchased our stock during the period between January 9, 2004 and March 1, 2004. The plaintiffs base their allegations primarily on the fact that the Company did not achieve our forecasted revenue guidance of $10 to $13 million for the first quarter of 2004. The complaint seeks unspecified damages.

6. Earnings Per Share

     The computation of per share amounts for the three and nine month periods ended September 27, 2003 and October 2, 2004 is based on the average number of common shares outstanding for the period. Options and warrants to purchase 18,664,666 and 15,691,015 shares of common stock during the three and nine months periods ended September 27, 2003 and October 2, 2004, respectively, were not considered in the computation of diluted earnings per share because their inclusion would be anti-dilutive.

7. Commitments and Contingencies

Operating Leases

     The Company leases its offices and production facilities under non-cancelable operating leases that expire at various times over the next seven years. Generally leases contain escalation clauses for increases in annual renewal options and require the Company to pay utilities, insurance, taxes and other operating expenses.

     For the three and nine months ended September 27, 2003, rent expense was $299,000 and $922,000, respectively. For the three and nine months ended October 2, 2004, rent expense was $298,000 and $944,000, respectively.

Capital Leases

     The Company leases certain property and equipment under capital lease arrangements that expire at various dates through 2007. The leases bear interest at various rates ranging from 8.56% to 14.95%.

Patents and Licenses

     The Company has entered into various licensing agreements requiring royalty payments ranging from 0.13% to 2.5% of specified product sales. Certain of these agreements contain provisions for the payment of guaranteed or minimum royalty

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amounts. In the event that the Company fails to pay minimum annual royalties, these licenses may automatically become non-exclusive or be terminated. These royalty obligations terminate in 2009 to 2020. Royalty expenses totaled $179,000 in 2001, $294,000 in 2002 and $572,000 in 2003. For the three and nine months ended September 27, 2003, royalty expense totaled $141,000 and $386,000, respectively. For the three and nine months ended October 2, 2004, royalty expense totaled $94,000 and $370,000, respectively. Under the terms of certain royalty agreements, royalty payments made may be subject to audit. There have been no audits to date and the Company does not expect any possible future audit adjustments to be significant.

The minimum lease payments under operating and capital leases and license obligations are as follows:

     In connection with the acquisition of Conductus, Inc. as of December 31, 2002 operating leases with remaining commitments totaling $2,044,000 and $1,758,000 have been abandoned or are considered unfavorable, respectively. A liability totaling $1,995,000 representing the present value of the minimum lease payments and executory costs was recorded at December 18, 2002 relating to the abandoned leases. A liability totaling $1,140,000 representing the present value of the difference between the fair market rental and lease commitment was recorded at December 31, 2002 relating to unfavorable leases.

     As discussed further in the Restructuring Expenses footnote 9, during the quarter ended October 2, 2004, the Company completed closure of its Sunnyvale facility. A liability totaling $279,000 was recognized representing the present value of the remainder of the lease commitment was recorded. In connection with the closure of this facility, the remaining unfavorable lease commitment of $558,000 recorded in connection with the acquisition of Conductus, Inc. was transferred to lease abandonment costs.

     As of October 2, 2004, the remaining minimum lease commitments on these operating leases totaled $1,593,000 and are included in the above commitment table.At October 2, 2004, the present value of the remaining liability related to the abandoned leases totaled $1,657,000. These amounts are included in accrued liabilities.

Note 8 — Contractual Guarantees and Indemnities

Warranties

     The Company establishes reserves for future product warranty costs that are expected to be incurred pursuant to specific warranty provisions with its customers. The Company’s warranty reserves are established at the time of sale and updated

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throughout the warranty period based upon numerous factors including historical warranty return rates and expenses over various warranty periods.

     During its normal course of business, the Company makes certain contractual guarantees and indemnities pursuant to which the Company may be required to make future payments under specific circumstances. The Company has not recorded any liability for these contractual guarantees and indemnities in the accompanying consolidated financial statements. A description of significant contractual guarantees and indemnities existing as of October 2, 2004 is included below:

Intellectual Property Indemnities

     The Company indemnifies certain customers and its contract manufacturers against liability arising from third-party claims of intellectual property rights infringement related to the Company’s products. These indemnities appear in development and supply agreements with our customers as well as manufacturing service agreements with our contract manufacturers, are not limited in amount or duration and generally survive the expiration of the contract. Given that the amount of any potential liabilities related to such indemnities cannot be determined until an infringement claim has been made, the Company is unable to determine the maximum amount of losses that it could incur related to such indemnifications.

Director and Officer Indemnities and Contractual Guarantees

     The Company has entered into indemnification agreements with its directors and executive officers which require the Company to indemnify such individuals to the fullest extent permitted by Delaware law. The Company’s indemnification obligations under such agreements are not limited in amount or duration. Certain costs incurred in connection with such indemnifications may be recovered under certain circumstances under various insurance policies. Given that the amount of any potential liabilities related to such indemnities cannot be determined until a lawsuit has been filed against a director or executive officer, the Company is unable to determine the maximum amount of losses that it could incur relating to such indemnifications. Historically, any amounts payable pursuant to such director and officer indemnifications have not had a material negative effect on the Company’s business, financial condition or results of operations.

     The Company has also entered into severance and change in control agreements with certain of its executives. These agreements provide for the payment of specific compensation benefits to such executives upon the termination of their employment with the Company.

     General Contractual Indemnities/Products Liability

     In connection with the sales of its commercial products, the Company indemnifies, without limit or term, its customers against all claims, suits, demands, damages, liabilities, expenses, judgments, settlements and penalties arising from actual or alleged infringement or misappropriation of any intellectual property relating to its products or other claims arising from its products. The Company cannot reasonably develop an estimate of the maximum potential amount of payments that might be made under its guarantee because of the uncertainty as to whether a claim might arise and how much it might total.

     Short Term Borrowings

     Advances under the agreement are collateralized by all the Company’s assets. Under the terms of the agreement, the Company continues to service the sold receivables and is subject to recourse provisions. Under the terms of the agreement, if the bank determines that there is a material adverse change in the Company’s business, they can exercise all their rights and remedies under the agreement.

9. Restructuring Expenses

     During the quarter ended July 3, 2004, the Company announced the implementation of a restructuring program to streamline its operations and reduce its cost structure. In connection with this during the quarter ended July 3, 2004 the Company recorded cash and non-cash restructuring charges of $2.5 million. The Company consolidated its research and

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development operations in Sunnyvale into its Santa Barbara facility. Also, the Company reduced its workforce by approximately 50 positions. The workforce reduction included reductions associated with the Sunnyvale facilities consolidation, as well as other strategic reductions in the organization. In addition, as part of the consolidation the Company accelerated the implementation of a new, lower cost wafer deposition process called Reactive Co-Evaporation.

     In connection with this program in the quarter ended October 2, 2004 the Company incurred additional period expenses of $722,000 to relocate machinery and equipment and employees and lease abandonment costs relating to its Sunnyvale facility closed in July.

     As a result of all cost reduction initiatives, the Company saved approximately $2.3 million in the quarter ended October 2, 2004, as compared to the first quarter of 2004.

     During the quarter ended October 2, 2004, the Company further reduced its workforce primarily associated with its manufacturing operations and recognized an additional $63,000 in severance benefits expenses.

     A summary of the restructuring charges for the quarter and nine months ended October 2, 2004 and estimated charges for subsequent quarters is as follows:

10. Details of Certain Financial Statement Components and Supplemental Disclosures of Cash Flow Information and Non-Cash Activities

Balance Sheet Data:

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     At December 31, 2003 and October 2, 2004, equipment includes $237,000 of assets financed under capital lease arrangements, net of $91,000 and $145,000 of accumulated amortization, respectively. Depreciation expense amounted to $628,000 and $1,769,000 for the three and nine month periods ended September 27, 2003, respectively and $729,000 and $2,063,000 for the three and nine month periods ended October 2, 2004, respectively. In connection with a restructuring of the Company’s operations and other abandonments in the second quarter of 2004, $1,526,000 of property and equipment cost and $723,000 of related accumulated depreciation was written off in the quarter ended July 3, 2004.

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     Amortization expense related to these items totaled $191,000 and $570,000 for the three and nine month periods ended September 27, 2003, respectively and $155,000 and $562,000 for the three and nine months ended October 2, 2004, respectively. In connection with a restructuring of the Company’s operations in the second quarter of 2004, $1,338,000 of purchased technology cost and $287,000 of related accumulated amortization was written off. Amortization expenses are expected to total $160,000 for the remainder of 2004, $500,000 in 2005 and $450,000 in each of the years 2006, 2007 and 2008.

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

General

     We develop, manufacture and market high performance products used in cellular base stations to maximize the performance of wireless telecommunications networks by improving the quality of uplink signals from mobile wireless devices. Our solutions leverage our expertise in high-temperature superconducting filters to “hear” wireless devices with the best possible clarity while rejecting interfering signals. We believe that this combination of interference rejection and receiver sensitivity is only possible using HTS technology. We sell our products directly to wireless carriers in the Americas, and we have plans to expand internationally. Our customers to date include ALLTEL, AT&T Wireless, U.S. Cellular, and Verizon Wireless.

     We derive our commercial revenues from three product lines:

	•		SuperLink Rx. In order to receive uplink signals from wireless handsets, base stations require a wireless filter system to eliminate, or filter out, out-of-band interference. To address this need, we offer the SuperLink Rx product line for the receiver front-end of base stations. These products combine specialized filters using HTS technology with a proprietary cryogenic cooler and a cryogenically cooled low-noise amplifier. The result is a highly compact and reliable cryogenic receiver front-end that can simultaneously deliver both high selectivity (interference rejection) and high sensitivity (detection of low level signals). SuperLink Rx products thereby offer significant advantages over conventional filter systems.
	•		AmpLink Rx. The recently introduced AmpLink Rx is our lower-cost receiver front-end product designed specifically to address the sensitivity requirements of wireless base stations. The AmpLink Rx is a ground-mounted unit which includes a high-performance amplifier and up to six dual duplexers. The enhanced uplink provided by AmpLink Rx 1900 improves PCS network coverage immediately and avoids the installation and maintenance costs associated with tower mounted amplifiers. As network interference increases, the AmpLink Rx 1900 is easily upgradeable to include a SuperLink Rx front-end, which uses HTS technology to maintain the same sensitivity improvement while eliminating the effects of increasing interference.
	•		SuperPlex. SuperPlex, our antenna sharing solution is a line of multiplexers that provides extremely low insertion loss and excellent cross-band isolation. Products in our SuperPlex line of high-performance multiplexers are designed to eliminate the need for additional base station antennas and reduce infrastructure costs. Relative to competing technologies, these products offer increased transmit power delivered to the base station antenna, higher sensitivity to subscriber handset signals, fast and cost-effective network overlays. The SuperPlex product family offers network performance benefits synergistic with SuperLink Rx.

     We began commercial production of the SuperFilter (the precursor to the SuperLink Rx) in 1997. Our initial commercial sales of our SuperLink products were to small rural providers who had the most immediate need for range extension and coverage enhancement. We sold our first systems in the fourth quarter of 1997. We sold 83 more systems in 1998, 123 systems in 1999, 393 systems in 2000, 438 systems in 2001, 927 systems in 2002, 1,884 systems in 2003 and 1,243

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and 605 units in the nine months ended September 27, 2003 and October 2, 2004. In 2001, U.S. Cellular accounted for 12% of our net commercial revenues and ALLTEL accounted for 73% of our net commercial revenues. In 2002, U.S. Cellular accounted for 8% of our net commercial revenues and ALLTEL for 84% of our net commercial revenues. In 2003, ALLTEL accounted for 70% of our net commercial revenues and Verizon accounted for 15% of our net commercial revenues. In the nine months ended October 2, 2004, ALLTEL accounted for 63% of our net commercial revenues and Verizon accounted for 23% of our net commercial revenues.

     In our business model, we use government contracts as a source of funds for our commercial technology development. We typically own the intellectual property developed under these contracts, and the Federal Government receives a royalty-free, non-exclusive and nontransferable license to use the intellectual property for the United States. We acquired Conductus, Inc. on December 18, 2002. Conductus was a competing supplier of high-temperature superconducting technology for wireless networks. The acquisition of Conductus contributed $4.6 million to our government revenues in 2003.

     During 2002 and 2003, we were marketing a power amplifier product called the SuperLink Tx manufactured by another company. The SuperLink Tx was for wireless networks that suffer from insufficient transmit power on the downlink signal path. A competitor acquired our supplier for this product in November 2003. We have not had significant sales of the SuperLink Tx product to date. We are evaluating alternative sources of power amplifiers for our customers.

Critical Accounting Policies and Estimates

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

     We believe the following critical accounting policies affect our more significant judgments and estimates used in the preparation of the financial statements. We maintain allowances for doubtful accounts for estimated losses resulting from the inability of our customers to make required payments. If the financial condition of our customers were to deteriorate, resulting in an impairment of their ability to make payments, additional allowances may be required. We write down our inventory for estimated obsolescence or unmarketable inventory equal to the difference between the cost of inventory and the estimated market value based upon assumptions about future demand and market conditions. If actual market conditions are less favorable than those projected by management, additional inventory write-downs may be required.

     Our net sales consist of revenue from sales of products net of trade discounts and allowances. We recognize revenue when evidence of an arrangement exists, contractual obligations have been satisfied, title and risk of loss have been transferred to the customer and collection of the resulting receivable is reasonably assured. At the time revenue is recognized, we provide for the estimated cost of product warranties if allowed for under contractual arrangements. Our warranty obligation is effected by product failure rates and service delivery costs incurred in correcting a product failure. Should such failure rates or costs differ from these estimates, accrued warranty costs would be adjusted.

     In connection with the sales and manufacture of its commercial products, the Company indemnifies, without limit or term, its customers and contract manufactures against all claims, suits, demands, damages, liabilities, expenses, judgments, settlements and penalties arising from actual or alleged infringement or misappropriation of any intellectual property relating to its products or other claims arising from its products. The Company cannot reasonably develop an estimate of the maximum potential amount of payments that might be made under its guarantee because of the uncertainty as to whether a claim might arise and how much it might total.

     Contract revenues are principally generated under research and development contracts. Contract revenues are recognized utilizing the percentage-of-completion method measured by the relationship of costs incurred to total estimated contract costs. If the current contract estimate were to indicate a loss, utilizing the funded amount of the contract, a provision would be made for the total anticipated loss. Revenues from research related activities are derived primarily from contracts with agencies of the United States Government. Credit risk related to accounts receivable arising from such contracts is considered minimal. These contracts include cost-plus, fixed price and cost sharing arrangements and are generally short-term in nature.

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     All payments to the Company for work performed on contracts with agencies of the U.S. Government are subject to adjustment upon audit by the Defense Contract Audit Agency. Based on historical experience and review of current projects in process, management believes that the audits will not have a significant effect on the financial position, results of operations or cash flows of the Company.

     We recognized $20 million of goodwill in connection with the acquisition of Conductus, Inc. in December 2002. During the third quarter of 2003 we tested the goodwill for possible impairment and determined that there was no impairment. This goodwill will again be tested for impairment in the fourth quarter of 2004. If the carrying amount exceeds its implied fair value, an impairment loss will be recognized equal to the excess.

     We also review the recoverability of the carrying value of identified intangibles and other long lived assets on an annual basis or whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. Recoverability of these assets is determined based upon the forecasted undiscounted future net cash flows from the operations to which the assets relate, utilizing our best estimates, appropriate assumptions and projections at the time. These projected future cash flows may vary significantly over time as a result of increased competition, changes in technology, fluctuations in demand, consolidation of our customers and reductions in average selling prices. If the carrying value is determined not to be recoverable from future operating cash flows, the asset is deemed impaired and an impairment loss is recognized to the extent the carrying value exceeded the estimated fair market value of the asset.

     We account for employee stock-based compensation under the “intrinsic value” method prescribed in Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees (“APB 25”), as opposed to the “fair value” method prescribed by Statement of Financial Accounting Standards No. 123, Accounting for Stock-Based Compensation (“SFAS 123”). Pursuant to the provisions of APB 25, we generally do not record an expense for the value of stock-based awards granted to employees. If the Financial Accounting Standards Board Proposed Statement of Financial Accounting Standard, “Share-Based Payment, an amendment of FASB Statements No. 123 and 95” is issued, we may be required to treat the value of stock-based awards granted to employees as compensation expense in the future, which could have a material adverse effect on our reported operating results and could negatively affect the price of our Common Stock. If this proposal is issued, we could decide to reduce the number of stock-based awards granted to employees in the future, which could adversely impact our ability to attract qualified candidates or retain existing employees without increasing their cash compensation and, therefore, have a material adverse effect on our business, results of operations and financial condition.

     As permitted under No. 123, the Company has elected to follow Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees” in accounting for its stock options and other stock-based employee awards. Pro forma information regarding net loss and loss per share, as calculated under the provisions of SFAS 123, are disclosed in the notes to the financial statements. The Company accounts for equity securities issued to non-employees in accordance with the provision of SFAS 123 and Emerging Issues Task Force 96-18.

     If the Company had elected to recognize compensation expense for employee awards based upon the fair value at the grant date consistent with the methodology prescribed by SFAS 123, the Company’s net loss and net loss per share would have been increased to the pro forma amounts indicated below:

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     Our valuation allowance against the deferred tax assets is based on our assessments of historical losses and projected operating results in future periods. If and when we generate future taxable income in the U.S. against which these tax assets may be applied, some portion or all of the valuation allowance would be reversed and an increase in net income would consequently be reported in future years.

     We are currently involved as a defendant in several lawsuits – a patent infringement case and several substantially identical securities class actions. These matters are discussed below in “Legal Proceedings.” We do not believe that a loss is probable or reasonably estimable in any of these cases and therefore have not recorded any liabilities relating to these proceedings. We periodically reassess our potential liability as additional information becomes available. If we later determine that a loss is probable and the amount reasonably estimable, we would record a reserve for the potential loss. The ultimate amount of the loss, if any, could materially impact our results of operations, financial condition or cash flows.

Backlog

     Our commercial backlog consists of accepted product purchase orders scheduled for delivery within 24 months and consists of purchase orders for both dollar and unit purchase commitments. The exact dollar commitment for unit commitments may vary depending on the exact units purchased. Based on past purchasing patterns and expected purchasing trends of customers with unit commitments, we estimate our backlog at October 2, 2004 to be $380,000, as compared to $250,000 at December 31, 2003.

Results of Operations

Trends for 2004

     We are a manufacturer of equipment to a relatively small number of customers and are highly sensitive to any changes experienced by our customers. We are currently experiencing the downside of such changes with two customers that we consider important for our revenues in 2004. One of our customers was recently acquired. We believe that this customer has suspended work temporarily on certain infrastructure projects because of the acquisition. Some of these projects involved our products. We also believe that another customer has decided to greatly accelerate a project to roll out a new third generation technology that has diverted their human resources. This is delaying some projects to deploy our product for improvements to their existing network. We believe these are temporary impediments but cannot be certain of their duration. We are also aggressively pursuing efforts to have our product incorporated into our customers’ new third generation wireless networks. We believe our product sales will, in the long run, continue to be driven by the need for efficient capital spending and improved network performance of both the existing wireless technologies and the new third generation wireless technologies such as 1X-EVDO, EDGE and W-CDMA.

     We compete directly with venders of other interference solutions such as tower mount amplifiers and conventional filters. This creates customer pressure on our product pricing to match the lower prices of these other vendors.. Our product pricing has always been influenced by this competition, and we have responded by continually and substantially reducing our product costs. We have reduced our product costs in the first nine months of 2004 and expect further product cost reductions over the next 12 months, but we cannot predict whether our costs will decline at a rate sufficient to keep pace with the competitive pricing pressure.

Quarter and nine months ended October 2, 2004 as compared to the quarter and nine months ended September 27, 2003.

     Total net revenue decreased by $6.9 million, or 48%, from $14.2 million in third quarter of 2003 to $7.3 million in the third quarter of 2004. Total net revenues decreased by $13.9 million, or 42%, from $33.0 million in the first nine months of 2003 to $19.1 million in the same period this year. Total revenues primarily consist of commercial revenue and government contract revenue.

     Net commercial product revenues in the third quarter of 2004 decreased to $6.1 million from $11.6 million in the same period last year, a decrease of $5.5 million, or 48%. For the first nine months of 2004, net commercial product revenues decreased to $13.8 million from $25.6 million in the same period last year, a decrease of 46%. The decrease in the third quarter of 2004 as compared to the prior year period is primarily the result of lower unit sales of our SuperLink Rx products of $5.6 million. The decrease in the first nine months of 2004 as compared to the prior year period is primarily the result of lower unit sales of our SuperLink Rx products of $11.8 million. The average selling price of our SuperLink Rx product is comparable

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between the periods. Our two largest customers accounted for 89% of our net commercial revenues in the nine months ended September 27, 2003 and 86% in the nine months ended October 2, 2004.

     Government contract revenues decreased by $1.3 million, or 52%, from $2.6 million in the third quarter of 2003 to $1.2 million in the same quarter of 2004. For the first nine months of 2003, government contract revenues decreased to $5.2 million from $7.3 million in the same period last year, a decrease of $2.1 million, or 29%. This decrease is primarily attributable to the completion of contracts in 2003 and 2004 that have not been replaced.

     Cost of commercial product revenue includes all direct costs and manufacturing overhead. The cost of commercial product revenue totaled $6.0 million for the third quarter ended October 2, 2004 and $8.2 million for the third quarter ended September 27, 2003. The cost of commercial product revenue totaled $14.8 million for the nine months ended October 2, 2004 and $19.5 million for the nine months ended September 27, 2003. Decreased costs result primarily from decreased unit shipments partially offset by increased provision for inventory reserves in both periods of approximately $350,000. Inventory reserves were increased to align inventory carrying costs with their market value.

     Our cost of sales includes both variable and fixed cost components. The variable components consist primarily of materials, assembly and test labor, overhead, which includes equipment and facility depreciation, transportation costs and warranty costs. Components of our fixed cost structure include test equipment and facility depreciation, purchasing and procurement expenses and quality assurance costs. Given the fixed nature of such costs, the absorption of our production overhead costs into inventory decreases and the amount of production overhead variances expensed to cost of sales increases as production volumes decline since we have fewer units to absorb our overhead costs against. Conversely, the absorption of our production overhead costs into inventory increases and the amount of production overhead variances expensed to cost of sales decreases as production volumes increase since we have more units to absorb our overhead costs against. As a result, our gross profit margins generally decrease as revenue and production volumes decline due to lower sales volume and higher amounts of production overhead variances expensed to cost of sales; and our gross profit margins generally increase as our revenue and production volumes increase due to higher sales volume and lower amounts of production overhead variances expensed to cost of sales.

     The following is an analysis of our gross profit and margins:

     For the third quarter ended October 2, 2004 we had positive gross profit of $39,000 from sale of our commercial products as compared to positive gross profit of $3.4 million in our third quarter of 2003. For the nine months ended October 2, 2004 we had negative gross profit of $1.0 million from sale of our commercial products as compared to positive gross profit of $6.2 million in the nine months ended September 27, 2003. We experienced negative gross profits because the reduced level of commercial sales was insufficient to cover our fixed manufacturing overhead costs.

     Contract research and development expenses totaled $860,000 in the third quarter of 2004 and $1.7 million in the third quarter of 2003. These expenses totaled $3.5 million in the first nine months of 2004 and $4.7 million in the first nine months of 2003. These decreases were the result of lower expenses associated with performing a fewer number of government contracts.

     Other research and development expenses relate to development of our commercial products. These expenses totaled $1.3 million in the third quarter of 2004, as compared to $985,000 in the same period last year. These expenses increased in the current year quarter as compared to the prior year due to increased commercial research and development efforts. These expenses totaled $3.8 million in the first nine months of 2004 and $4.3 million in the first nine months of 2003. The decline is due to lower commercial product development efforts for the year to date period.

     Selling, general and administrative expenses totaled $3.5 million in the third quarter of 2004 as compared to $4.1 million in the same period last year. In the first nine months of 2004 these expenses totaled $12.4 million as compared to $16.6 million in the same period last year. This decrease in the third quarter of 2004 as compared to the same quarter in the prior year is primarily due to lower expenses resulting from the closure of our Sunnyvale facility. The decrease in the first nine months of

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2004 as compared to the prior year results primarily from lower ISCO litigation expenses and the closure of our Sunnyvale facility. In the third quarter of 2004 ISCO litigation expenses totaled $25,000 as compared to $90,000 in the third quarter of 2003. In the first nine months of 2004 these expenses totaled $438,000 as compared to $4.8 million in the same period last year. These decreases were partially offset by higher sales and marketing expenses.

     During the quarter ended July 3, 2004, we announced the implementation of a restructuring program to streamline our operations and reduce its cost structure. In connection with this during the quarter ended July 3, 2004 we recorded cash and non-cash restructuring charges of $2.5 million. We consolidated our research and development operations in Sunnyvale into our Santa Barbara facility. We reduced our workforce by approximately 50 positions. The workforce reduction included reductions associated with the Sunnyvale facility consolidation, as well as other strategic reductions in the organization. In addition, as part of the consolidation we accelerated the implementation of a new, lower cost wafer deposition process called Reactive Co-Evaporation. In connection with this program, in the quarter ended October 2, 2004 we incurred additional period expenses of $722,000 to relocate machinery and equipment and employees and lease abandonment costs relating to the closure of our Sunnyvale facility. In the fourth quarter of 2004, we expect additional restructuring expenses to relocate machinery and employees to total $240,000.

     During the quarter ended October 2, 2004, we further reduced our workforce primarily associated with its manufacturing operations and recognized an additional $63,000 in severance benefit expenses.

     As a result of all cost reduction initiatives, the Company saved approximately $2.3 million in the quarter ended October 2, 2004 as compared to the first quarter of 2004.

     Interest income decreased in the third quarter and first nine months of 2004 as compared to the same periods in the prior year because we had less cash available for investment.

     Interest expense in the quarter ended October 2, 2004 is comparable to the same period in the prior year. For the nine months ended October 2, 2004 interest expense totaled $1.2 million as compared to $374,000 in the nine months ended September 27, 2003. This increase is related primarily to an $802,000 non-cash charge relating to warrants issued in connection with the Bridge Loans entered into in April 2004.

     We had a net loss of $5.2 million for the quarter ended October 2, 2004 as compared to $851,000 in the same period last year. For the nine months ended October 2, 2004 our net loss totaled $19.9 million as compared to $12.3 million in the same period last year.

     The net loss available to common shareholders totaled $0.06 per common share in the current quarter, as compared to $0.01 per common share, in the same period last year. The net loss available to common shareholders totaled $0.25 per common share in the nine months ended October 2, 2004, as compared to $0.20 per common share, in the same period last year.

Liquidity and Capital Resources

     We have historically financed our operations through a combination of cash on hand, cash provided from operations, equipment lease financings, available borrowings under bank lines of credit and both private and public equity offerings. We have effective registration statements on file with the SEC covering the public resale by investors of all the common stock issued in our private placements, as well as any common stock acquired upon exercise of their warrants. Our principal sources of liquidity consist of existing cash balances and funds expected to be generated from future operations. As of October 2, 2004, we had working capital of $15.5 million, including $7.1 million in cash and cash equivalents, as compared to working capital of $15.6 million at December 31, 2003, which included $11.1 million in cash and cash equivalents. We currently invest our excess cash in short-term, investment-grade, money-market instruments with maturities of three months or less. We typically hold such investments until maturity and then reinvest the proceeds in similar money market instruments. We believe that all of our cash investments would be readily available to us should the need arise.

     Cash and cash equivalents decreased by $4.0 million from $11.1 million at December 31, 2003 to $7.1 million at October 2, 2004. Cash was used in operations, for the purchase of property and equipment and for the payment of short and long-term borrowings and was partially offset by cash received from the sale of common stock in a public offering during the second quarter of 2004. Cash and cash equivalents decreased by $5.1 million from $18.2 million at December 31, 2002 to $13.1 million at September 27, 2003. Cash used in operations and investing activities during the first nine months of 2003 was partially offset by cash received from the sale of common stock and warrants in a private placement during the second quarter.

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     Cash used in operations totaled $16.3 million in the first nine months of 2004. We used $13.9 million to fund the cash portion of our net losses. We also used cash to fund a $9.0 million increase in inventory, prepaid expenses and other current assets, patents and licenses and accounts payable payments. Inventory increased during the first nine months of 2004 due to lower than expected sales. These uses were partially offset by cash generated from the collection of accounts receivable of $6.6 million. Cash used in operations totaled $13.4 million in the first nine months of 2003. We used $9.6 million to fund the cash portion of our net losses. We also used cash to fund a $4.3 million increase in accounts receivable, inventory, patents and licenses and other assets. Cash generated from the increase in accounts payable and other accrued expenses totaled $589,000.

     Net cash used to purchase manufacturing related equipment and tenant improvements totaled $1.7 million in the first nine months of 2004 and $2.4 million the same period last year.

     Net cash provided by financing activities totaled $13.9 million in the first nine months of 2004. Cash received from the sale of common stock and exercise of options and warrants totaled $17.2 million and borrowings against our credit and bridge loan facilities totaled $5.3 million. These sources of cash were partially offset by payments against our credit and bridge loan facilities totaling $7.9 million and payments against our long-term debt totaling $627,000. Net cash provided by financing activities totaled $10.7 million in the first nine months of 2003. Cash received from the sale of common stock and warrants totaled $10.1 million and net borrowings against our credit facility totaled $1.6 million and was partially offset by the reduction in long-term borrowings of $948,000.

     We have a line of credit from a bank. It is a material source of funds for our business. The line of credit expires March 17, 2005 and is structured as a sale of our accounts receivable. The bank agreement provides for the sale of up to $5.0 million of eligible accounts receivable, with advances to us totaling 80% of the receivables sold. Advances bear interest at the prime rate (4.75% at October 2, 2004) plus 2.50% subject to a minimum monthly charge. Outstanding amounts under this borrowing facility at October 2, 2004 totaled $669,000. The amount outstanding is repaid upon collection of the underlying accounts receivable. Advances are collateralized by a lien on all of our assets. Under the terms of the agreement, we continue to service the sold receivables and are subject to recourse provisions.

     At October 2, 2004, we had the following cash commitments:

     There were no material changes to commitments outside the ordinary course of business.

     We plan to invest approximately $150,000 to $250,000 in fixed assets during the remainder of 2004 to continue to expand manufacturing capacity if there is sufficient market demand for our products.

     Our independent registered public accounting firm has included in their audit report for 2003-year an explanatory paragraph expressing doubt about our ability to continue as a going concern due to past losses and negative cash flows. They included a similar explanatory paragraph in their audit report for 2002. In 2003, we incurred a net loss of $11,345,000 and had negative cash flows from operations of $18,458,000. For the nine months ended October 2, 2004, we had a net loss of $19.9 million and negative cash flows from operations of $16.3 million. In response during the current year, we adjusted our inventory build plan, reduced direct and indirect labor, cut certain fixed costs and implemented a reduced workweek. We also began a cost restructuring program to consolidated our research and development operations in Sunnyvale

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into our Santa Barbara facility, eliminate an additional 50 positions and accelerate the implementation of a new lower cost wafer deposition process.

     We completed two financing transactions during the nine months ended October 2, 2004. First, we closed a transaction on April 25, 2004 to temporarily expand our credit facility. Silicon Valley Bank amended our existing line of credit to increase borrowing capacity from 80% to 95% of eligible accounts receivable. We concurrently secured a commitment for a $2.0 million secured bridge loan from an investor. The investor subsequently funded $1.5 million of the bridge loan. We issued to the lenders warrants to purchase in the aggregate 600,000 shares of common stock at $1.85 per share. The bridge loan was subsequently paid in full on May 26, 2004. Upon repayment of the bridge loan the Silicon Valley credit facility reverted back to it original terms.

     Second, we completed a public offering of 23,000,000 shares of common stock at $0.80 per share during the quarter raising net proceeds of $16.7 million.

     We expect our existing cash resources, together with our line of credit, will be sufficient to fund our planned operations into 2005. We expect our liquidity to reach an unacceptably low level in the second quarter of 2005 and anticipate a need for additional working capital to fund growth in the third and fourth quarters of 2005. Accordingly, we have concluded that the company will need additional funding to provide adequate cash reserves in the event of another downturn in our business and to fund expected growth in the second half of 2005. Our actual cash requirements will depend on numerous factors, including the rate of growth of our sales, the timing and levels of products purchased, payment terms and credit limits from manufacturers, the timing and level of our accounts receivable collections and our ability to manage the business profitability.

     We plan to explore various funding opportunities over the next two quarters. We cannot assure you that additional financing (public or private) will be available on acceptable terms or at all. If we issue additional equity securities to raise funds, the ownership percentage of our existing stockholders would be reduced. New investors may demand rights, preferences or privileges senior to those of existing holders of common stock. If we cannot raise any needed funds, we would also be forced to make further substantial reductions in our operating expenses, which could adversely affect our ability to implement our current business plan and ultimately our viability as a company.

     In the last several years, we have raised money from investors to cover our operating losses through public and private offerings. Our ability to continue to raise funds using these methods may be adversely impacted by any future NASDAQ listing issues. Our continued NASDAQ listing requires us to maintain a minimum of $1 share price. Our stock has traded at less than $1 per share recently. Although NASDAQ de-listing would not be immediate, our lower share price could make capital raising more difficult.

     Our interim financial statements have been prepared assuming that the Company will continue as a going concern. The factors described above raise substantial doubt about our ability to continue as a going concern. Our financial statements do not include any adjustments that might result from this uncertainty.

Net Operating Loss Carryforward

     As of December 31, 2003, the Company has net operating loss carryforwards for federal income tax purposes of approximately $215.1 million and for state income tax purposes of $90.6 million which expire in the years 2004 through 2023. Of these amounts $93.9 million and $30.2 million, respectively resulted from the acquisition of Conductus. Included in the net operating loss carryforwards are deductions related to stock options of approximately $24.0 million and $13.0 million for federal and California income tax purposes. To the extent net operating loss carryforwards are recognized for accounting purposes the resulting benefits related to the stock options will be credited to stockholders’ equity. In addition, the Company has research and development and other tax credits for federal and state income tax purposes of approximately $2.6 million and $2.3 million, respectively, which expire in the years 2004 through 2023. Of these amounts $972,000 and $736,000, respectively resulted from the acquisition of Conductus.

     Due to the uncertainty surrounding their realization, the Company has recorded a full valuation allowance against its net deferred tax assets. Accordingly, no deferred tax asset has been recorded in the accompanying balance sheet.

     Section 382 of the Internal Revenue Code imposes an annual limitation on the utilization of net operating loss carryforwards based on a statutory rate of return (usually the “applicable federal funds rate”, as defined in the Internal Revenue Code) and the value of the corporation at the time of a “change of ownership” as defined by Section 382. Recently, the Company completed an analysis of its equity transactions and determined that it had a change in ownership in August 1999 and December 2002. Therefore, the ability to utilize net operating loss carryforwards incurred prior to the change of ownership totaling $101.6 million will be subject in future periods to an annual limitation of $1.3 million. In addition, the Company acquired the right to Conductus’ net operating losses, which are also subject to the limitations imposed by Section 382. Conductus underwent three ownership changes, which occurred in February 1999, February 2001 and December 2002. Therefore, the ability to utilize Conductus’ net operating loss carryforwards of $93.9 million incurred prior to the ownership

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changes will be subject in future periods to annual limitation of $700,000. Net operating losses incurred by the Company subsequent to the ownership changes totaled $19.5 million and are not subject to this limitation.

Future Accounting Requirements

     In March 2004, the consensus of the Emerging Issues Task Force (EITF) Issue No. 03-06, Participating Securities and the Two-Class Method under FASB Statement 128, was published. EITF Issue No.03-06 addresses the computations of earnings per share by companies that have issued securities other than common stock that contractually entitle the holder to participate in dividends and earnings of the company. Further guidance on the application and allocations of the two-class method of calculating earnings per share is also included. The provisions of EITF Issue No. 03-06 will be effective for reporting periods beginning after March 31, 2004. The adoption of this guidance is not expected to have a significant impact on the Company’s financial results of operations and financial position.

Forward-Looking Statements

     This report contains forward-looking statements that involve risks and uncertainties. We have made these statements in reliance on the safe harbor provisions of the Private Securities Litigation Reform Act of 1995. Our forward-looking statements relate to future events or our future performance and include, but are not limited to, statements concerning our business strategy, future commercial revenues, market growth, capital requirements, new product introductions, expansion plans and the adequacy of our funding. Other statements contained in this report that are not historical facts are also forward-looking statements. We have tried, wherever possible, to identify forward-looking statements by terminology such as “may,” “will,” “could,” “should,” “expects,” “anticipates,” “intends,” “plans,” “believes,” “seeks,” “estimates” and other comparable terminology.

     Forward-looking statements are not guarantees of future performance and are subject to various risks, uncertainties and assumptions that are difficult to predict. Therefore, actual results may differ materially from those expressed in forward-looking statements. They can be affected by many factors, including, but not limited to the following:

	•		fluctuations in product demand,
	•		the impact of competitive filter products, technologies and pricing,
	•		manufacturing capacity constraints and difficulties,
	•		market acceptance risks, and
	•		general economic conditions.

     Please read Exhibit 99 to our report on Form 10-K for the year ended December 31, 2003 entitled “Disclosure Regarding Forward-Looking Statements” for a description of additional uncertainties and factors that may affect our forward-looking statements. Forward-looking statements are based on information presently available to senior management, and we do not assume any duty to update our forward-looking statements.

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Item 3. Quantitative and Qualitative Disclosures About Market Risk

     There was no material change in our exposure to market risk at October 2, 2004 as compared with our market risk exposure on December 31, 2003. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations – Market Risk” in our 2003 Annual Report on Form 10K.

Item 4. Disclosure Controls and Procedures.

     Evaluation of Disclosure Controls and Procedures

     The Company maintains disclosure controls and procedures that are designed to ensure that information required to be disclosed in the Company’s reports under the Securities Exchange Act of 1934, as amended (the “Exchange Act”), is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms, and that such information is accumulated and communicated to the Company’s management, including its Chief Executive Officer and Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosure. In designing and evaluating the disclosure controls and procedures, management recognized that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives, and management necessarily was required to apply its judgment in evaluating the cost-benefit relationship of possible controls and procedures.

     We carried out an evaluation, under the supervision and with the participation of our management, including our Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of our disclosure controls and procedures pursuant to Exchange Act Rules 13a-15(e) as of the end of the period covered by this report (the “Evaluation Date”). Based on that evaluation, our Chief Executive Officer and Chief Financial Officer have concluded that our disclosure controls and procedures are effective in timely alerting them to material information relating to the Company that as of the Evaluation Date is required to be included in our periodic SEC filings.

     Changes in Internal Controls

     There has been no change in our internal control over financial reporting (as defined in Exchange Act Rules 13a-15(f) and 15(d) – 15(f)) during the third quarter of 2004 that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

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PART II. OTHER INFORMATION

Item 1. Legal Proceedings

Patent Litigation

     We are engaged in a patent dispute with ISCO International, Inc. relating to U.S. Patent No. 6,263,215 entitled “Cryoelectronically Cooled Receiver Front End for Mobile Radio Systems.” ISCO filed a complaint on July 17, 2001 in the United States District Court for the District of Delaware against us and our wholly owned subsidiary, Conductus, Inc. The ISCO complaint alleged that our SuperFilter product and Conductus’ ClearSite® product infringe ISCO’s patent. The matter went to trial on March 17, 2003.

     On April 3, 2003, the jury returned a unanimous verdict that our SuperFilter III product does not infringe the patent in question, and that ISCO’s patent is invalid and unenforceable. The jury also awarded us $3.8 million in compensatory damages based upon a finding that ISCO engaged in unfair competition and acted in bad faith by issuing press releases and contacting our customers asserting rights under this patent.

     On April 17, 2003, we filed a Motion for Attorneys’ Fees and Disbursements, in which we asked the court to award us our attorneys’ fees and other litigation expenses. On the same date, ISCO filed a motion, asking the court to overturn the verdict and grant a new trial. In August 2003, the court rejected ISCO’s request to overturn the jury’s verdict that the patent is invalid and not infringed by the SuperFilter III product, and accepted the jury’s verdict that the patent is unenforceable because of inequitable conduct committed by one of the alleged inventors. ISCO subsequently filed a notice of appeal as to this portion of the court’s decision. The court overturned the jury’s verdict of unfair competition and bad faith on the part of ISCO and the related $3.8 million compensatory damage award to us, and also denied our request for reimbursement of our legal fees associated with the case. We have filed a notice of appeal as to this portion of the court’s decision.

     If the appellate court overturns the jury’s verdict and grants ISCO a new trial, there is a risk that we may not prevail in a second trial. If this should happen, we could be subject to significant liabilities and be required to cease using key technology. In any case, the cost of defending continued litigation by ISCO, or any other intellectual property lawsuit, could constitute a major financial burden and materially and adversely affect our results of operations, balance sheet and cash flows.

Class Action Lawsuits

     We were named as a defendant in several substantially identical class action lawsuits filed in the United States District Court for the Central District of California in April 2004. The cases were consolidated in August 2004, and the plaintiffs filed an amended consolidated complaint in October 2004. The plaintiffs allege securities law violations by us and certain of our officers and directors under Rule 10b-5 and Sections 10(b) and 20(a) of the Securities Exchange Act of 1934, as amended. The complaint was filed on behalf of a purported class of people who purchased our stock during the period between January 9, 2004 and March 1, 2004 and seeks unspecified damages. The plaintiffs base their allegations primarily on the fact that we did not achieve our forecasted revenue guidance of $10 to $13 million for the first quarter of 2004. We believe the complaint is without merit and intend to defend this action vigorously. However, we cannot assure you that we will prevail in such litigation and, if the outcome is unfavorable to us, our reputation, profitability, balance sheet, cash flow and share price could be adversely affected.

Item 5. Other Information

(a) Additional Disclosures

     Consulting Agreement. We entered into a consulting agreement with Charles Shalvoy, a director, on November 4, 2004. Under the agreement, we may retain his services from time to time as a consultant on strategic planning matters at the rate

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of $3,000 per day plus reasonable out-of-pocket and travel expenses. As additional consideration, we agreed to continue his health benefits and grant him an option to purchase 100,000 shares of common stock.

     Amendment to Change In Control Agreement. We amended the existing Change in Control Agreement between the company and Mr. Peter Thomas, our President and CEO, on November 4, 2004. The original Change in Control Agreement granted Mr. Thomas certain severance benefits in the event we terminate him in connection with a change in control of the company (as defined in the agreement). The amendment increases the amount of his severance benefits under the agreement from two times his base salary to three times his base salary.

(b) Stockholder Nominations

     There have been no material changes to the procedures by which stockholders may recommend nominees to our board of directors. Please see the discussion of our procedures under the heading “Board Meetings and Committees” on pages 4 and 5 of our 2004 Proxy Statement available online at www.sec.gov.

Item 6. Exhibits

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**

Confidential treatment requested for certain portions of these exhibits.

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.

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