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SECURITIES AND EXCHANGE COMMISSION

FORM 10-Q

(Mark One)

or

Commission file number: 0-23576

CELERITEK, INC.

(408) 986-5060
(Registrant’s telephone number, including area code)

NOT APPLICABLE
(Former name, former address and former fiscal year, if changed since last report)

     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 in Rule 12b-2 of the Exchange Act). Yes o No x

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

     Common Stock, No Par Value: 12,458,128 shares as of January 25, 2004

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CELERITEK, INC.

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PART I FINANCIAL INFORMATION

Item 1. FINANCIAL STATEMENTS

CELERITEK, INC.
CONDENSED CONSOLIDATED BALANCE SHEETS
(In thousands)

Note:

The balance sheet at March 31, 2003 has been derived from the audited financial statements at that date but does not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements.

See accompanying notes.

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CELERITEK, INC.
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(In thousands, except per share amounts)
(Unaudited)

See accompanying notes.

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CELERITEK, INC.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(In thousands)
(Unaudited)

See accompanying notes.

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Celeritek, Inc.

Notes to Condensed Consolidated Financial Statements
(Unaudited)

December 31, 2003

1.		Basis of Presentation
		The accompanying unaudited condensed consolidated financial statements have been prepared in accordance with generally accepted accounting principles for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements. In the opinion of management, all adjustments (consisting of normal recurring adjustments) considered necessary for a fair presentation have been included.
		The Company’s reporting period consists of a thirteen-week period ending on the Sunday closest to the calendar month end. The third quarters of fiscal 2004 and fiscal 2003 ended December 28, 2003 and December 29, 2002, respectively. For convenience, the accompanying financial statements have been shown as ending on the last day of the calendar month.
		Operating results for the three and nine months ended December 31, 2003 are not necessarily indicative of the results that may be expected for the fiscal year ending March 31, 2004. This financial information should be read in conjunction with the audited consolidated financial statements and notes thereto included in the Company’s annual report on Form 10-K for the year ended March 31, 2003 as filed with the Securities and Exchange Commission.
		Certain amounts reported in previous years and interim periods have been reclassified to conform to the current year presentation.
2.		Stock Based Compensation
		The Company generally grants stock options to its employees for a fixed number of shares with an exercise price equal to the fair value of the shares on the date of grant. The Company records compensation related to employees stock awards under the intrinsic value method and accordingly, no compensation expense is recognized in the Company’s financial statements in connection with stock options granted to employees with exercise prices not less than fair value.
		Pro forma information regarding net loss and net loss per share under the fair value method is presented below (in thousands, except per share amounts):

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Pro forma information regarding net loss and net loss per share is required by Statement of Financial Accounting Standards No. 123, Accounting for Stock-based Compensation (SFAS 123), as amended by SFAS 148, and has been determined as if the Company had accounted for its stock options granted subsequent to December 31, 1994 under the fair value method of SFAS 123. The fair market value for options granted was estimated at the date of grant using the Black-Scholes option-pricing model. The Company valued its employee stock options using the following weighted-average assumptions:

		The Company granted no stock options nor Employee Stock Purchase shares during the three months ended December 31, 2003.
		The Black-Scholes option valuation model was developed for use in estimating the fair market value of traded options that have no vesting restrictions and are fully transferable. In addition, option valuation models require the input of highly subjective assumptions including the expected stock price volatility. Because the Company’s stock options have characteristics significantly different from those of traded options, and because changes in the subjective input assumptions can materially affect the fair market value estimate, in management’s opinion, the existing models do not necessarily provide a reliable measure of the fair market value of its options.
		The weighted average grant date fair value of options granted during the nine months ended December 31, 2003 was $5.12 and during the three and nine months ended December 31, 2002 was $5.00 and $5.92, respectively. The weighted average grant date fair value of Employee Stock

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		Purchases shares issued during the nine months ended December 31, 2003 and 2002 was $2.61 and $3.24, respectively.
3.		Inventories
		Inventories, stated at the lower of standard cost (which approximates actual cost on a first-in, first-out method) or market, consists of the following components (in thousands):

4.		Loss Per Share
		Basic loss per common share is computed using the weighted average common shares outstanding during the period. The effect of outstanding stock options is excluded from the calculation of diluted net loss per share, as their inclusion would be antidilutive. The common equivalent shares from stock options excluded from the three and nine month periods ended December 31, 2003 were 160,744 and 168,651, respectively. The common equivalent shares from stock options excluded from the three and nine month periods ended December 31, 2002 were 113,571 and 173,409, respectively.
		The following table sets forth the computation of basic and diluted loss per share (in thousands, except per share data):

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5.		Comprehensive Loss
		The components of comprehensive loss for the three and nine month periods ended December 31, 2003 and 2002 are as follows (in thousands):

6.		Strategic Investments
		The Company regularly reviews its investments for circumstances of other than temporary impairment and assesses the carrying value of the assets against market value. When an other than temporary impairment exists, the Company records an expense to the extent that the carrying value exceeds fair market value in the period the assessment was made. The fair value of strategic investments is dependent on the performance of the companies invested in, as well as the marketability of these investments. In assessing potential other than temporary impairment of these investments, management considers these factors as well as forecasted financial performance of the investees. If these forecasts are not met or if market conditions change, the Company may have to record additional impairment charges.
		Handset Design Company
		In December 2001, the Company invested $0.5 million in a Korean handset design company. On April 1, 2002, the Company invested an additional $2.0 million in the handset design company. The Company does not have significant influence over the management of the handset design company and accordingly has accounted for the investment on a cost basis in all reported periods. The Company reviewed the investment as of December 31, 2003 and determined no indicators of impairment were present that would indicate the current carrying value of the investment was impaired.
		GaAs Foundry
		In December 2000, the Company invested approximately $2.4 million in a GaAs foundry under construction in Taiwan in exchange for a strategic interest in the foundry. The Company does not have significant influence over the management of the GaAs foundry and accordingly has accounted for the investment on a cost basis in all reported periods.
		During the fourth quarter of fiscal 2002 and the first and fourth quarter of fiscal 2003, the Company recorded impairment charges of approximately $1.7 million, $0.3 million and $0.1 million, respectively, against its strategic investment in the Taiwanese foundry, which was deemed, in those

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		respective periods, to have an other than temporary decline in value. The Company reviewed the investment as of December 31, 2003 and determined no indicators of further impairment were present that would indicate the current carrying value of the investment was impaired.
7.		Intangible Assets
		Intangible assets consist of the following (in thousands):

		In late September 2003, the Company exited the wireless handset power amplifier market and was in final negotiations to sell certain tangible assets and all of its intangible assets. As a result, the Company reclassified certain tangible and intangible assets to be sold, as “Assets Held for Sale” as part of “prepaid expenses and other current assets” (note 8).
8.		Assets Held for Sale
		Assets held for sale as of September 30, 2003 were intangible and tangible assets actively being marketed for disposal. The assets were stated at the lower of their carrying amounts and estimated fair value, net of selling costs, and were classified as current assets. The Company completed the sale of the identified assets on October 15, 2003 for cash at the estimated fair value, net of selling costs. No gain or loss arose on the disposal in the three months ended December 31, 2003.
9.		Special Charges
		The special charges of $1.9 million recorded during the third quarter of fiscal 2004 were due to the Company’s decision to exit the wireless handset power amplifier market and included $0.7 million in employee termination expenses, $1.1 million in building consolidation costs, and $0.1 million to close the Company’s Korean subsidiary.

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		The special charges of $2.6 million recorded during the second quarter of fiscal 2004 were due to the Company’s restructuring activities at its Belfast facility in July 2003, and the Company’s decision to exit the wireless handset power amplifier market in September 2003. The special charges of $2.6 million are comprised of approximately $0.2 million of impairment charges related to the write down of carrying values for certain tangible and intangible assets to be sold, $1.8 million of equipment impairment charges related to exiting the wireless handset power amplifier market, and $0.6 million of equipment impairment charges related to restructuring at the Belfast facility.
		At March 31, 2003, the Company held an accrual for $1.2 million relating to the fiscal 2003 restructuring described above. Employee termination accruals of $0.1 million were paid out over the following six month period. Lease termination cost accruals of $1.1 million represented the present value of future minimum payments under operating leases covering unused equipment. Such amounts will be paid through to lease expiry in fiscal 2005.
		The following table summarizes the Company’s special charges activity (in thousands):

10.		Product Warranty
		The Company warrants its products against defects in design, materials, and workmanship, generally for one year from the date of shipment for all of its products. The actual term could vary depending on the specific customers. An accrual for estimated future costs relating to warranty expense is recorded, as a percentage of revenue based on prior experience, when revenue is recorded and is included in cost of goods sold. Factors that affect the Company’s warranty liability include historical and anticipated rates of warranty claims and cost per claim. The Company periodically assesses the adequacy of its recorded warranty liabilities and adjusts the amounts as necessary.
		Changes in the Company’s product liability during the three and nine months ended December 31, 2003 and 2002 were as follows (in thousands):

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11.		Cost Related to Shareholder and Strategic Actions
		In the fourth quarter of fiscal 2003, a group of shareholders (the “Shareholder Committee”) called a special meeting to remove the Company’s Board of Directors from office and replace them with a different slate of candidates. In May 2003 the Company’s Board of Directors entered into an agreement with the Shareholder Committee. Under the terms of the agreement, the Company has expanded its Board of Directors from six directors to seven. The new Board is now composed of three of the Company’s directors who were directors prior to the agreement, three directors nominated by the Shareholder Committee and one member who is not affiliated with either the Company or the Shareholder Committee. In the first nine months of fiscal 2004, expenses of $1.4 million related to the special meeting of shareholders and $1.7 million in investment banking fees were incurred and reported in loss from operations under the caption “Cost related to shareholder and strategic actions.”
12.		Recent Accounting Pronouncements
		In January 2003, the FASB issued Interpretation No. 46 (“FIN 46”), “Consolidation of Variable Interest Entities.” In general, a variable interest entity is a corporation, partnership, trust, or any other legal structure used for business purposes that either (a) does not have equity investors with voting rights or (b) has equity investors that do not provide sufficient financial resources for the entity to support its activities. FIN 46 requires a variable interest entity to be consolidated by a company if that company is subject to a majority of the risk of loss from the variable interest entity’s activities or entitled to receive a majority of the entity’s residual returns or both. The consolidation requirements of FIN 46 apply immediately to variable interest entities created after January 31, 2003. The consolidation requirements apply to older entities in the first fiscal year or interim period ending after December 15, 2003. Certain of the disclosure requirements apply in all financial statements issued after January 31, 2003, regardless of when the variable interest entity was established. The Company adopted FIN 46 in the third quarter of fiscal 2004 and its adoption did not have a material impact on the Company’s financial position or results of operations.
		In May 2003, the FASB issued Statement Number 150, “Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity” (SFAS 150). This Statement establishes standards for classifying and measuring as liabilities certain financial instruments that embody obligations of the issuer and have characteristics of both liabilities and equity. SFAS 150

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		generally requires liability classification for two broad classes of financial instruments: (1) instruments that represent, or are indexed to, an obligation to buy back the issuer’s shares, and (2) obligations that can be settled in shares, but are subject to certain conditions. SFAS 150 applies to all financial instruments created or modified after May 31, 2003, and to other instruments at the beginning of the first interim period beginning after July 1, 2003. As the Company has not created or modified any financial instruments since the effective date of SFAS 150, the Company does not believe this Statement will have a material impact on the Company’s financial statements.
		In November 2002, the Emerging Issues Task Force (“EITF”) reached a consensus on Issue No. 00-21 Accounting for Revenue Arrangements with Multiple Deliverables. The EITF concluded that revenue arrangements with multiple elements should be divided into separate units of accounting if the deliverables in the arrangement have value to the customer on a standalone basis, if there is objective and reliable evidence of the fair value of the undelivered elements, and as long as there are no rights of return or additional performance guarantees by the Company. The provisions of EITF Issue No. 00-21 are applicable to agreements entered into in fiscal periods beginning after June 15, 2003. Management adopted the consensus in the second quarter of fiscal 2004, and it did not have a material effect on the Company’s results of operations or financial condition.
13.		Rights Plan Termination
		On June 6, 2003, the Company amended its shareholder rights plan (the “Rights Plan”) to accelerate the final expiration date of the Preferred Share Purchase Rights issued thereunder from April 8, 2009 to June 13, 2003. The Company terminated the Rights Plan upon expiration of the purchase rights on June 13, 2003.
14.		Subsequent Events
		On January 14, 2004, the Company’s Board of Directors announced it had declared an extraordinary cash dividend of $4.50 per share to shareholders of record on February 5, 2004. The dividend will be paid on March 11, 2004 and will be recorded as a return of capital.
		As a result of the extraordinary cash dividend, the Company will violate certain lending covenants on March 11, 2004, based on current agreements in place on approximately $2.3 million in capital leases and debt. Therefore, the Company has classified the total amount of $2.3 million under current liabilities. The Company has received notice from one lender that a capital lease of $0.9 million is payable in full by March 11, 2004. The Company is in the process of renegotiating the covenants on the remaining balance of $1.4 million in debt. There can be no assurance that the Company will successfully renegotiate the covenants, in which case the $1.4 million in debt may also become due on March 11, 2004.
15.		Contingent Liability
		The Company’s sales to foreign customers are subject to export regulations, and foreign sales of some of the Company’s products require export licenses from the U.S. Department of State or the U.S. Department of Commerce. In particular, the Company has received notice from the Department of State suggesting that some products that the Company had treated as subject to the Department of Commerce’s Export Administration Regulations are in fact defense articles subject to the State Department’s International Traffic in Arms Regulations. The Company believes that this matter will be resolved without a significant adverse effect on its business. However, there is a possibility that

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the Company could be subject to substantial fines and/or other penalties that would adversely affect the Company’s results of operations.

Item 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

Forward-Looking Statements

     This report contains forward-looking statements, which are identified by words such as “anticipate,” “believe,” “plan,” “estimate,” “expect,” “intend” and other similar expressions. In addition, forward-looking statements in this report include, but are not limited to, those regarding: focusing our resources on market areas where we believe our core competencies will allow us the greatest opportunity of success in our goal of returning to profitability; anticipated annual cost savings in the range of $9.0 to $10.0 million as a result of exiting the wireless handset power amplifier market; our future gross margins; research and development expenses; expected investment banking fees and selling, general and administrative expenses; and our belief that our cash resources after the payment of the extraordinary cash dividend will be sufficient to meet our liquidity needs through at least the next twelve months. These forward-looking statements are subject to business and economic risks and uncertainties, and our actual results of operations may differ materially from those contained in the forward-looking statements. Unless required by law, we undertake no obligation to update publicly any forward-looking statements, whether as a result of new information, future events, or otherwise. However, readers should carefully review the risk factors set forth in this Form 10-Q and other reports or documents we file from time to time with the Securities and Exchange Commission.

Critical Accounting Policies

     The preparation of financial statements in conformity with generally accepted accounting principles in the United States requires us to make estimates and assumptions that affect the reported amounts. Some of the estimation processes affect current assets and liabilities and are therefore critical in assessing our financial and operating status. These estimates involve certain assumptions that, if incorrect, could have a material adverse impact on our operations and financial position.

     We review our estimates, including, but not limited to, allowance for doubtful accounts, inventory write-downs, and impairments of long-lived assets and investments on a regular basis and make adjustments based on historical experiences and existing and expected future conditions. These evaluations are performed regularly and adjustments are made, as information is available. We believe that these estimates are reasonable; however, actual results could differ from these estimates. The following paragraphs describe the methodology we use in making some of our principal accounting estimates, in evaluating some of the uncertainties inherent in accounting estimates and in evaluating some of the ways that our estimates may impact our financial condition.

     Revenue Recognition. Revenue related to product sales is recognized when the products are shipped to the customer, title has transferred and no obligations remain. In circumstances where the collection of payment is not probable at the time of shipment, we defer recognition of the revenue until payment is collected. We provide for expected returns based on past experience as well as current customer activities. Our customers do not have rights of return outside of products returned under warranty and, to date, returns have not been material. Shipping and handling costs are included in costs of goods sold for all periods presented.

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     Allowance for Doubtful Accounts. We establish an allowance for doubtful accounts for estimated losses resulting from the inability of our customers to make required payments. We evaluate our customers’ financial position and order level to determine if an allowance should be established. Any change in the allowance from our assessment of the likelihood of receiving payment is reflected in the selling, general, and administrative costs in the period the change in assessment is made.

     Inventory Write-downs. We record inventory write-downs for estimated obsolescence or unmarketable inventory. Our write-downs for excess and obsolete inventory are primarily based upon forecasted demand and our backlog of orders for the product. Any inventory write-downs are reflected in cost of sales in the period the write-downs are made.

     Long-lived Assets and Strategic Investments. We regularly review our long-lived assets and strategic investments for indicators of impairment and assess the carrying value of the assets against market values. When impairment exists, we record an expense to the extent that the carrying value exceeds fair market value in the period the assessment is made.

     We record impairment losses on long-lived assets used in operations or expected to be disposed of when events and circumstances indicate that the undiscounted cash flow estimated to be generated by these assets is less than the carrying amounts of those assets. We consider sensitivities to capacity, utilization and technological developments in making related assumptions.

     The fair value of strategic investments is dependent on the performance of the companies in which we have invested, as well as the marketability of these investments. In assessing potential impairment of these investments, we consider these factors as well as forecasted financial performance of the investees. If these forecasts are not met or if market conditions change, we may assess the value of the strategic investment to be other than temporarily impaired and accordingly record an impairment charge.

     Intangible Assets. We recorded intangible assets at fair value. Intangible assets with finite useful lives were amortized over their estimated useful life and amortization expense was classified as part of operating expenses. To date, we have only had intangible assets with finite useful lives. We regularly performed reviews to determine if the carrying values of our intangible assets were impaired. We looked for facts, circumstances, either internal or external, that may have indicated we may not have recovered the carrying value of the assets. We recorded impairment losses based on the amount by which the carrying amounts of such assets exceeded their fair values.

Overview

     In late September 2003, we exited the wireless handset power amplifier market. This decision was the result of severe pricing pressure and other adverse market conditions in the wireless handset industry that we believe would have prevented our handset related business from achieving acceptable gross margins. Our exit from the wireless handset power amplifier market will allow us to focus our resources on market areas where we believe our core competencies will provide us the greatest opportunity of success in our goal of returning to profitability. As a result of this action, we face increased reliance on the sales of our defense products and semiconductor products for commercial communications, both of which markets may have lower growth potential than the wireless handset market.

     As a result of this action, we incurred $2.6 million in special charges in the second quarter of fiscal 2004 for fixed and intangible asset impairment charges. The special charges of $2.6 million are comprised of approximately $0.2 million of impairment charges related to the reassessment of carrying values for certain tangible and intangible assets to be sold, $1.8 million of equipment impairment charges related to exiting the

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wireless handset power amplifier market, and $0.6 million of equipment impairment charges related to restructuring at the Belfast facility.

     In October 2003, we sold all the intangible and certain tangible assets related to the wireless handset power amplifier market for $1.0 million to Anadigics, Inc. We also terminated 42 employees in early October 2003. In December 2003, we consolidated our Santa Clara operations into one building and closed our Korean office. As a result of these activities, we incurred special charges of approximately $1.9 million in the third quarter of fiscal 2004 related to employee termination expenses, a building lease termination charge and facilities consolidation costs.

     We anticipate realizing annual cost savings in the range of $9.0 to $10.0 million compared to our expense rate before these actions were taken.

Result of Operations – Third Quarter of Fiscal 2004 Compared to Third Quarter of Fiscal 2003:

     Total net sales were $7.7 million for the third quarter of fiscal 2004, compared to $10.5 million for the third quarter of fiscal 2003, a decrease of 27%.

     Semiconductor sales were $3.0 million in the third quarter of fiscal 2004, compared to $5.5 million in the third quarter of fiscal 2003, a decrease of 45%. Semiconductor sales, excluding sales related to power amplifier modules for handsets and a milestone achievement in a development contract, were approximately $2.0 million in the third quarter of fiscal 2004. Comparatively, semiconductor sales, excluding power amplifier modules for handsets were approximately $2.0 million in the third quarter of fiscal 2003. Due to our decision to exit the wireless handset market, we do not expect any future sales for handset related products. Subsystem sales in the third quarter of fiscal 2004 were $4.7 million, compared to $4.9 million in the second quarter of fiscal 2003, a decrease of 4%. The decrease in sales of subsystems products to defense customers is primarily the result of many defense customers making purchases for specific programs, and therefore product demand fluctuates from quarter to quarter.

     Gross margin was 34% of net sales in the third quarter of fiscal 2004, compared to 18% of net sales in the third quarter of fiscal 2003. The increase in gross margin was primarily due to the unanticipated sale of approximately $0.7 million of power amplifier modules for handsets where the corresponding costs were written off in prior periods as obsolete inventory and $0.4 million of sales for a milestone achievement in a contract to develop power amplifier modules for satellite handsets with the corresponding costs recorded in research and development expense. The increased revenue without a corresponding cost of sales contributed 10% to the gross margin improvement. The remaining improvement in gross margin is due to reduced overhead expenses, which are the result of headcount reductions and asset and lease impairments. We do not expect significant improvement in gross margin until sales volumes increase because of fixed costs related to our fabrication facility.

     Research and development expenses were $1.9 million, or 24% of net sales, in the third quarter of fiscal 2004, compared to $2.5 million, or 24% of net sales, in the third quarter of fiscal 2003, a decrease of 26%. Research and development expenses decreased from the prior year due to our decision to exit the wireless handset market and the closure of our Lincoln design facility. A significant part of our research and development efforts were focused on developing wireless handset power amplifier products for the market in South Korea. These decreases in spending were somewhat offset by increased spending on the development of defense products.

     Selling, general and administrative expenses were $1.9 million, or 25% of net sales, in the third quarter of fiscal 2004, compared to $2.3 million, or 22% of net sales, in the third quarter of fiscal 2003, a decrease of

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16%. The decrease was primarily due to lower personnel costs associated with reduced headcount related to our cost reduction measures.

     The $0.3 million in costs related to shareholder and strategic actions in the third quarter of fiscal 2004 was primarily for investment banking fees. The $0.2 million in costs related to shareholder actions in the third quarter of fiscal 2003 was primarily for investment advisors in response to an unsolicited offer from Anaren Microwave, Inc. We expect to incur additional investment banking fees of at least $0.3 million through March 2004.

     The special charges of $1.9 million in the third quarter of fiscal 2004 are comprised of approximately $0.9 million of building lease termination costs, $0.2 million of facilities consolidation costs, approximately $0.7 million in employee termination expense and $0.1 million to close our Korean sales office.

     Amortization of intangibles was zero in the third quarter of fiscal 2004, compared to $0.1 million in the third quarter of fiscal 2003. The assets that were acquired as part of the Tavanza acquisition were sold in October 2003; therefore no amortization expense will be recorded in future periods.

     Interest income and other, net was $0.3 million in the third quarters of both fiscal 2004 and 2003.

Result of Operations – First Nine Months of Fiscal 2004 Compared to the First Nine Months of Fiscal 2003:

     Total net sales were $21.4 million for the first nine months of fiscal 2004, compared to $41.3 million for the first nine months of fiscal 2003, a decrease of 48%.

     Semiconductor sales were $6.7 million in the first nine months of fiscal 2004, compared to $26.3 million in the first nine months of fiscal 2003, a decrease of 75%. Semiconductor sales, excluding sales related to power amplifier modules for handsets and a milestone achievement in a development contract, were approximately $5.7 million for the first nine months of fiscal 2004. Comparatively, semiconductor sales, excluding power amplifier modules for handsets, were approximately $4.4 million for the first nine months of fiscal 2003. Due to our decision to exit the wireless handset market, we do not expect any future sales for handset related products. Subsystem sales in the first nine months of fiscal 2004 were $14.7 million, compared to $15.0 million in the first nine months of fiscal 2003, a decrease of 2%. The decrease in sales of subsystems products to defense customers is primarily the result of many defense customers making purchases for specific programs, and therefore product demand fluctuates.

     Gross margin was 21% of net sales in the first nine months of fiscal 2004, compared to 24% of net sales in the first nine months of fiscal 2003. The decrease in gross margin was primarily due to decreased semiconductor sales volume. During the third quarter of fiscal 2004, we sold approximately $0.7 million of power amplifier modules for handsets where the corresponding costs were written off in prior periods as obsolete inventory and $0.4 million of revenue for a milestone achievement in a contract to develop power amplifier modules for satellite handsets with the corresponding costs recorded in research and development expense. The increase in revenue without a corresponding cost of sales contributed 4% to the gross margin. We do not expect significant improvement in gross margin until sales volumes increase because of fixed costs related to our fabrication facility.

     Research and development expenses were $7.7 million, or 36% of net sales, in the first nine months of fiscal 2004, compared to $8.0 million, or 19% of net sales, in the first nine months of fiscal 2003, a decrease of 4%. Research and development expenses decreased due to the closure of our Lincoln design center partially offset by the increased expense related to the Tavanza acquisition. A significant part of our research

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and development efforts were focused on developing wireless handset power amplifier products for the market in South Korea.

     Selling, general and administrative expenses were $6.3 million, or 30% of net sales, in the first nine months of fiscal 2004, compared to $7.2 million, or 17% of net sales, in the first nine months of fiscal 2003, a decrease of 12%. The decrease was primarily due to lower selling costs driven by the decrease in revenues and lower personnel costs. In addition, we incurred management information systems consulting costs of approximately $0.2 million in the first nine months of fiscal 2003, which were not incurred in the first nine months of fiscal 2004.

     The $3.0 million in costs related to shareholder and strategic actions in the first nine months of fiscal 2004 consisted of approximately $1.4 million in expense related to the special meeting of shareholders and $1.6 million in investment banking fees. The $0.7 million in costs related to shareholder actions in the first nine months of fiscal 2003 was for legal and investment advisors in response to an unsolicited offer from Anaren Microwave, Inc. We expect to incur additional investment banking fees of at least $0.3 million through March 2004.

     The special charges of $4.5 million are comprised of approximately $0.2 million of impairment charges related to the reassessment of carrying values for certain tangible and intangible assets to be sold, $1.8 million of equipment impairment charges related to exiting the wireless handset power amplifier market, $0.6 million of equipment impairment charges related to restructuring at the Belfast facility, $0.7 million in employee termination charges, $0.9 million for building lease termination costs, $0.2 million of facilities consolidation costs, and $0.1 million to close our Korean sales office.

     At March 31, 2003, the Company held an accrual for $1.2 million relating to the fiscal 2003 restructuring described above. Employee termination accruals of $0.1 million were paid out over the following six month period. Lease termination cost accruals of $1.1 million represented the present value of future minimum payments under operating leases covering unused equipment. Such amounts will be paid through to lease expiry in fiscal 2005.

     The following table summarizes our special charges activity (in thousands):

     Amortization of intangibles was $0.3 million during the first nine months of fiscal 2004, compared to $0.1 million in the first nine months of fiscal 2003. The assets that were acquired as part of the Tavanza acquisition were sold in October 2003; therefore no amortization expense will be recorded in future periods.

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     The $0.3 million impairment of strategic investment included in the first quarter of fiscal 2003 was the result of a further impairment of our investment in a Taiwanese foundry. The additional impairment charge was determined after analysis of changes in the market values of public companies in the GaAs market from March 2002 to June 2002. We reviewed the investment as of December 31, 2003 and determined no indicators of further impairment were present that would indicate the current carrying value of the investment was impaired.

     Interest income and other, net was $1.5 million in the first nine months of fiscal 2004 compared to $1.2 million in the first nine months of fiscal 2003. The increase in interest income and other, net, was due to the collection of a customer’s order cancellation charge of $0.8 million in September 2003, offset by lower interest rates on lower cash balances.

     Liquidity and Capital Resources

     We have funded our operations to date primarily through cash flows from operations and sales of equity securities. As of December 31, 2003, we had $12.4 million in cash and cash equivalents, $71.2 million in short-term investments and $81.2 million in working capital.

     Net cash used by operating activities was $9.1 million in the first nine months of fiscal 2004 and was due primarily to the quarterly net losses partially offset by non-cash impairment charges and depreciation charges. Net cash provided by operating activities was $7.0 million in the first nine months of fiscal 2003 and was due primarily to decreases in accounts receivable and inventory and increases in accounts payable and other current liabilities. The net cash provided by changes in operating assets and liabilities was significantly higher in the first nine months of fiscal 2003 as compared to the first nine months of fiscal 2004. The decrease in accounts receivables and inventory during the first nine months of fiscal 2003 was due to a significant decline in our business levels and revenues. In addition, our accounts payable and accrued liabilities also increased during the first nine months of fiscal 2003 because of accrued costs related to our Tavanza acquisition and operating lease impairment charges.

     Net cash used by investing activities was $5.3 million in the first nine months of fiscal 2004 and was due to the net purchases, sales and maturities of short-term investments of approximately $4.5 million and the purchase of property and equipment of approximately $0.7 million. Net cash provided by investing activities was $7.0 million in the first nine months of fiscal 2003 and was due to the net purchases, sales and maturities of short-term investments of approximately $11.3 million, offset by the purchase of property and equipment of approximately $2.3 million, and further investment of approximately $2.0 million in a Korean handset design company.

     Net cash used by financing activities was $2.1 million in the first nine months of fiscal 2004 and was due to principal payments on long-term debt of approximately $2.0 million and payments on capital leases of approximately $0.5 million offset by cash proceeds of $0.4 million from the issuance of common stock. Net cash used by financing activities was approximately $1.8 million in the first nine months of fiscal 2003 and was due to principal payments on long-term debt of approximately $1.7 million and payments on capital leases of approximately $0.5 million off set by cash proceeds of $0.5 million from the issuance of common stock. As of December 31, 2003, we had $0.5 million in outstanding letters of credit, which are secured by certificates of deposits. Given our cash position, we currently do not have a line of credit.

     On January 14, 2004, we announced our intention to pay an extraordinary cash dividend of $4.50 per share to shareholders of record as of February 5, 2004, payable on March 11, 2004. We expect the total dividend to be approximately $56.0 million.

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     As a result of the extraordinary cash dividend, the Company will violate certain lending covenants on March 11, 2004, based on current agreements in place on approximately $2.3 million in capital leases and debt. Therefore, the Company has classified the total amount of $2.3 million under current liabilities. The Company has received notice from one lender that a capital lease of $0.9 million is payable in full by March 11, 2004. The Company is in the process of renegotiating the covenants on the remaining balance of $1.4 million in debt. There can be no assurance that the Company will successfully renegotiate the covenants, in which case the $1.4 million in debt may also become due on March 11, 2004.

     We believe that our cash resources after the payment of the extraordinary cash dividend and $2.3 million in capital leases and debt, will be sufficient to meet our liquidity requirements through at least the next twelve months.

Commitments

     We do not have any special purpose entities. We have no commercial commitments with related parties, except for employee loans. We have outstanding loans to certain current and former employees totaling approximately $1.4 million at December 31, 2003. The notes are relocation loans collateralized by certain real property assets, bear no interest and have maturities through 2019. The principal will be repaid at various dates. If an employee voluntarily ceases being employed by us, the principal outstanding will be due and payable within 90 days.

     We have various equipment notes outstanding with lenders, which are secured by the equipment. Several of these notes have covenants pertaining to liquidity levels and minimum tangible net worth. As a result of the extraordinary cash dividend, we will violate certain lending covenants on March 11, 2004, based on current agreements in place on approximately $2.3 million in capital leases and debt. Therefore, we have classified the total amount of $2.3 million under current liabilities. We have received notice from one lender that a capital lease of $0.9 million is payable in full by March 11, 2004. We are in the process of renegotiating the covenants on the remaining balance of $1.4 million in debt. There can be no assurance that we will successfully renegotiate the covenants, in which case the $1.4 million in debt may also become due on March 11, 2004.

     We have contractual obligations in the form of operating and capital leases, debt and purchase order commitments. The following table sets forth our future contractual obligations as of December 31, 2003 (in thousands):

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Contractual Obligations

     The table records cash obligations, including future interest repayments, and includes operating lease obligations for equipment that no longer has economic value for us, for which a special charge of $1.3 million was recorded in the third quarter of fiscal 2003 in the statement of operations and includes an operating lease obligation for a building that is no longer in use, for which a special charge of $0.9 million was recorded in the third quarter of fiscal 2004.

     In addition, we have contractual commitments as of December 31, 2003, relating to our engagement of financial advisory firms pursuant to which we will be required to incur aggregate minimum future costs of approximately $0.3 million through March 2004. However, as is customary for contracts of this type, these commitments may increase above the minimum depending on the value of any strategic transaction we may complete, or the value of our common stock in the event that there is no strategic transaction.

     We have outstanding letters of credit, secured by certificates of deposits, of approximately $0.5 million as security for equipment leases.

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RISK FACTORS

     You should carefully consider the risks described below. The risks and uncertainties described below are not the only ones facing us. Additional risks and uncertainties not presently known to us or that we currently deem immaterial may also impair our business operations. If any of the following risks actually occur, our business, results of operations or cash flows could be adversely affected. In those cases, the trading price of our common stock could decline, and you may lose all or part of your investment.

Because many of our expenses are fixed, we will not achieve profitability until our revenues significantly increase.

     Our business requires us to maintain manufacturing equipment and related support infrastructure that we must pay for regardless of our level of sales. To support our manufacturing capacity we also incur costs for maintenance and repairs and employ personnel for manufacturing and process engineering functions. These expenses, along with depreciation costs, are fixed and do not vary greatly, if at all, when our net sales decrease. In addition, the lead time for developing and manufacturing our products often requires us to invest in manufacturing capacity in anticipation of future demand. The recent decline in market demand has resulted in infrastructure costs in excess of current needs and has resulted in lower earnings. Although we recently exited the wireless handset power amplifier market — which we believe will result in reduced expenses — we are nevertheless still relying on increased sales to manufacturers of commercial communications equipment and defense contractors in order to realize a significant increase in revenues. If these sales do not materialize, and if our revenues do not significantly increase to a level commensurate with our installed capacity, we will be unable to achieve profitability.

As a result of our recent exit from the wireless handset power amplifier business, we face risks relating to our increased reliance on sales of our defense products and semiconductor products for commercial communications.

     In late September 2003, we exited the wireless handset power amplifier business in order to focus our resources on market areas where we believe our core competencies will allow us the greatest opportunity of success in our goal of returning to profitability. There is, however, no guarantee that our exit from the wireless handset power amplifier business will enable us to reach profitability on a more expedited basis, or at all. In particular, we now face increased reliance on the sales of our defense products and semiconductor products for commercial communications, both of which markets may have lower growth potential than the wireless handset market. In addition, we may fail to manage successfully our exit from the wireless handset power amplifier business. If we do not properly manage our exit from the handset business, or if our projections with respect to the sales of our defense products and semiconductors products for commercial communications are incorrect, we may fail to achieve profitability and our business may suffer.

Our operating results have fluctuated significantly in the past, and we expect these fluctuations to continue. If our results are worse than expected, our stock price could fall.

     Our operating results have fluctuated in the past, and may continue to fluctuate in the future. These fluctuations may cause our stock price to decline. Some of the factors that may cause our operating results to fluctuate include:

	•		the timing, cancellation or delay of customer orders or shipments, particularly from our largest customers;
	•		fluctuating demand from our defense customers;
	•		the timing of our introduction of new products and the introduction of new products by our competitors;
	•		variations in average selling prices of our products;

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	•		the mix of products that we sell;
	•		our ability to secure manufacturing capacity and effectively utilize the capacity;
	•		the availability and cost of components;
	•		GaAs semiconductor component and GaAs-based subsystem failures and associated support costs;
	•		variations in our manufacturing yields related to our GaAs semiconductor components;
	•		market acceptance of our products; and
	•		changes in our inventory levels.