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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-Q

For the quarterly period ended September 26, 2004

or

For the Transition period from                      to                     

Commission File Number 0-10772

ESSEX CORPORATION

(Exact name of registrant as specified in its charter)

(301) 939-7000

(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 ¨

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

YES ¨ NO x

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

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ESSEX CORPORATION

PART I – FINANCIAL INFORMATION

INDEX

References hereinafter to the quarter(ly) and nine month periods represent the 13-week and 39-week periods, respectively, ending on the date indicated.

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CONSOLIDATED BALANCE SHEETS

The accompanying notes are an integral part of these statements.

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ESSEX CORPORATION

CONSOLIDATED BALANCE SHEETS

The accompanying notes are an integral part of these statements.

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CONSOLIDATED STATEMENTS OF OPERATIONS

UNAUDITED

The accompanying notes are an integral part of these statements.

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CONSOLIDATED STATEMENTS OF CASH FLOWS

UNAUDITED

The accompanying notes are an integral part of these statements.

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NOTES TO INTERIM UNAUDITED CONSOLIDATED FINANCIAL INFORMATION

NOTE 1: General

Fiscal Year and Presentation

These statements cover Essex Corporation (the “Company”) and its wholly-owned subsidiary, Computer Science Innovations, Inc. (“CSI”), which was acquired effective April 30, 2004. The Company is on a 52/53-week fiscal year ending the last Sunday in December. Years 2004 and 2003 are 52-week fiscal years. References to the quarter(ly) and nine month periods represent the 13-week and 39-week periods, respectively, ending on the date indicated. All material intercompany transactions have been eliminated. Certain amounts for 2003 have been reclassified to conform to the 2004 presentation.

The information furnished in the accompanying Unaudited Consolidated Balance Sheets, Unaudited Consolidated Statements of Operations and Unaudited Consolidated Statements of Cash Flows have been prepared in accordance with accounting principles generally accepted in the United States of America for interim financial information. In the opinion of management, such information contains all adjustments considered necessary for a fair presentation of such information. The operating results for the nine-month period ended September 26, 2004 may not be indicative of the results of operations for the year ending December 26, 2004, or any future period. This financial information should be read in conjunction with the Company’s 2003 audited consolidated financial statements and footnotes thereto, included in the Annual Report on Form 10-K filed with the Securities and Exchange Commission.

Use of Estimates

The preparation of the consolidated financial statements in conformity with accounting principles generally accepted in the United States of America 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 period. Estimates are used when accounting for inventory obsolescence and valuation, depreciation and amortization, intangible assets and contingencies, among others. Actual results could differ from these estimates.

Research and Development

Research and development costs are expensed as incurred. Such costs include direct labor and materials as well as a reasonable allocation of indirect costs. However, no general and administrative costs are included in research and development. Equipment which has alternative future uses is capitalized and charged to expense over its estimated useful life.

NOTE 2: Basic and Diluted Earnings Per Share

Basic earnings per common share are computed using the weighted average number of common shares outstanding during the period reduced by contingently returnable shares. Diluted earnings per common share incorporates the incremental shares issuable upon the assumed exercise of stock options and warrants. As of September 26, 2004 and September 28, 2003, the effect of the incremental shares from options, warrants and contingent shares (if applicable) of 204,500 and 2,258,800, respectively, have been excluded from diluted weighted average shares as the effect would have been antidilutive or contingencies were not resolved.

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NOTES TO INTERIM UNAUDITED CONSOLIDATED FINANCIAL INFORMATION

NOTE 3: Common Stock

The Company completed a follow-on public offering in December 2003 and issued 4,000,000 shares of common stock. The Company received net proceeds of $31.4 million. In January 2004, the underwriters exercised their over allotment option and the Company sold an additional 150,000 common shares and received net proceeds of $1.2 million.

In connection with the March 1, 2003 acquisition of Sensys Development Laboratories, Inc. (“SDL”), the Company had issued approximately 422,000 common shares into escrow. These shares were to be released to certain SDL shareholders or returned to Essex based upon certain factors, principally the future market price of the Company’s stock. During the first quarter of 2004, the 422,000 shares in escrow were returned to the Company in accordance with the terms of the purchase agreement.

NOTE 4: Stock-Based Compensation

The Company accounts for stock options granted to employees and directors using the intrinsic value based method of accounting. Under this method, the Company does not recognize compensation expenses for the stock options because the exercise price is equal to the market price of the underlying stock on the date of the grant. If the Company had used the fair value based method of accounting, net earnings and earnings per share would have been reduced to the pro forma amounts listed in the table below. The Black-Scholes option pricing model was used to calculate the pro forma stock-based compensation costs. For purposes of the pro forma disclosures, the assumed compensation expense is amortized over the option’s vesting periods. The pro forma information is consistent with assumptions used in the year end calculations. Accordingly, net income (loss) and earnings (loss) per share would be as follows:

NOTE 5: Amortization of Other Intangible Assets

In connection with the March 1, 2003 acquisition of SDL, there was $431,000 of intangible value assigned primarily to contracts. In connection with the April 30, 2004 acquisition of CSI, there was $1,279,000 of value assigned, primarily to contracts. In connection with the June 25, 2004

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NOTES TO INTERIM UNAUDITED CONSOLIDATED FINANCIAL INFORMATION

acquisition of substantially all of the assets from Performance Group, Inc., there was $1,498,000 of value assigned, primarily to contracts. (See Note 7.) Amortization of $186,000 and $348,000 was recognized in the quarter and nine months ended September 26, 2004, respectively. Amortization of $121,000 and $295,000 was recognized in the quarter and nine month periods ended September 28, 2003, respectively.

NOTE 6: Income Taxes

The Company is in a net operating loss (NOL) carryforward position for book and tax purposes.

The Company has established a valuation reserve for all of its deferred tax assets. Such tax assets are available to be recognized and benefit future periods. The evaluation of the realizability of deferred tax assets in future periods is made annually at year end based upon a variety of factors for generating future taxable income, such as historical and projected operating performance. The Company had a deferred income tax asset valuation allowance of $3.5 million at December 28, 2003.

NOTE 7: Acquisitions

In April 2004, the Company agreed to acquire 100% of the common stock of Computer Science Innovations, Inc. (“CSI”), which is headquartered in Melbourne, Florida, for approximately $8.1 million in cash. The Company incurred another $125,000 in related legal and accounting fees. CSI has proprietary techniques, algorithms and tools that are used to build custom “cognitive engines” for a broad range of intelligence, defense and commercial customers and applications. CSI had revenue of approximately $7.6 million in its fiscal year ended March 31, 2004. The Company closed this transaction effective April 30, 2004.

The following table summarizes the estimated fair values of the assets acquired and liabilities assumed at the date of acquisition.

Of the intangible assets of $1,279,000, there was $923,000 assigned to contracts which have an estimated overall amortization life of less than three years. The remaining balance was primarily assigned to intellectual property with an estimated overall amortization life of less than five years.

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NOTES TO INTERIM UNAUDITED CONSOLIDATED FINANCIAL INFORMATION

The following information is presented on a pro forma basis as though the business combination had been completed as of the beginning of fiscal 2004.

On June 25, 2004, the Company completed the acquisition of substantially all of the assets of Performance Group, Inc. (“PGI”) with main offices in Fredericksburg, VA. PGI provides services and systems in the areas of Geographic Information Systems (GIS), Imagery Processing and Analysis, Spatial Data Development, Environmental Consulting, Visualization, and IT Solutions to government and private sector clients. PGI had revenue of approximately $4.5 million in calendar year 2003.

The Company paid $5.8 million in cash and assumed $362,000 of liabilities. The Company also incurred $125,000 in outside expenses.

The following table summarizes the estimated fair values of the assets acquired and liabilities assumed at the date of acquisition.

Of the intangible assets of $1.5 million, there was $1.2 million assigned to contracts which have an estimated overall amortization life of less than five years. The remaining balance was primarily assigned to intellectual property with an estimated overall amortization life of less than five years.

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NOTES TO INTERIM UNAUDITED CONSOLIDATED FINANCIAL INFORMATION

The following information is presented on a pro forma basis as though the business combination had been completed as of the beginning of fiscal 2004.

NOTE 8: Statements of Cash Flows – Supplemental Disclosure

There was a $50,000 capital lease entered into in the first nine months of 2004. There were no new capital leases in the first nine months of 2003.

In connection with the acquisition of substantially all of the assets of PGI, the Company assumed approximately $362,000 of liabilities.

NOTE 9: Major Customers

Most of the Company’s revenues are derived from contracts with the U.S. Government, where the Company is either the prime contractor or a subcontractor, depending on the contract. For the nine months ended September 26, 2004 and September 28, 2003, revenues derived from U.S. Government programs were $50.2 million, or 97.5% and $11.1 million, or 98.9%, of the Company’s total revenues, respectively. For the nine months ended September 26, 2004, approximately $34.2 million or 66.5% of revenues were derived from one U.S. Government customer on one program.

NOTE 10: Commitments regarding Facility Leases

The Company entered into leases for production and office space in Maryland in connection with the work on its largest program. The leases are for seven years ending approximately April 2011 and total rent is approximately $3.5 million. The leases contain normal clauses for payment of operating, real estate and common area maintenance over base year amounts.

In connection with these leases, the Company agreed to provide an estimated $3 million to the landlord to finance special security-related leasehold improvements. The Company has recorded a note receivable in connection with the lease as the landlord will repay the funds over forty months following construction completion at 7% interest.

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NOTES TO INTERIM UNAUDITED CONSOLIDATED FINANCIAL INFORMATION

At September 26, 2004, the Company had funded $1.3 million of this commitment.

The Company has entered into a lease for replacement office space for certain of its Maryland operations, including its corporate headquarters. The lease is for a term of seven years beginning in January 2005 and total rent is approximately $6 million. The leases contain normal clauses for payment of operating, real estate and common area maintenance over base year amounts.

NOTE 11: Subsequent Event

On November 1, 2004, the Company filed a registration statement with the Securities and Exchange Commission for a proposed follow-on underwritten public offering of up to 6,000,000 shares of its common stock, including 1,000,000 shares from a selling shareholder. Since the registration statement has not yet become effective, the price per share and net proceeds to the Company have not been determined.

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Management’s Discussion and Analysis of Financial Condition and Results of Operations and other sections contain forward-looking statements that are based on management’s expectations, estimates, projections and assumptions. Words such as “expects”, “anticipates”, “plans”, “believes”, “estimates” and variations of such words and similar expressions are intended to identify such forward-looking statements that include, but are not limited to, projections of revenues, earnings, segment performance, cash flows and contract awards. Such forward-looking statements are made pursuant to the safe harbor provisions of the Private Securities Litigation Reform Act of 1995. These statements are not guarantees of future performance and involve certain risks and uncertainties that are difficult to predict. For more information on risk factors, see the Company’s Annual Report on Form 10-K for the fiscal year ended December 28, 2003. Therefore, actual future results and trends may differ materially from what is indicated in forward-looking statements due to a variety of factors. References to the quarter(ly) and nine month periods represent the 13-week and 39-week periods, respectively, ending on the date indicated. In this Form 10-Q, “we”, “us” and “our” refers to Essex Corporation, including its consolidated subsidiaries.

OVERVIEW

Essex provides advanced signal, image, and information processing solutions primarily for U.S. Government intelligence and defense customers. We create our solutions by combining our services and expertise with hardware, software, and proprietary and patented technology to meet our customers’ requirements. Within the intelligence and defense communities we have established and maintained long-standing and successful customer relationships. We are also developing next generation signal, image and information processing solutions under classified U.S. Government research and development awards. We have been able to develop our current proprietary technology using a combination of government funding and our own internal funding and we believe this combination will allow us to continue to enhance and expand our technology and services for future market needs.

Most of our revenues are derived from awards with the U.S. Government, where we are either the prime contractor or a subcontractor, depending on the award. For the nine months ended September 26, 2004 and September 28, 2003, revenues derived from U.S. Government programs were $50.2 million, or 97.5%, and $11.1 million, or 98.9%, of our total revenues, respectively.

On certain projects, our customers require us to purchase and provide the hardware portion of the total system solution, which entails our purchasing hardware from third party vendors and reselling it to our customers. We show the revenue and costs from purchased hardware separately since this revenue carries significantly lower margins than our products and services revenue. The purchased hardware revenue is highly variable from quarter to quarter.

Our most significant expenses are cost of goods sold and services provided, which consist primarily of direct labor and associated costs for program personnel and direct expenses incurred to complete projects, including the cost of materials and equipment and subcontract efforts. Our ability to accurately predict personnel requirements, salaries and other costs, as well as to manage personnel levels and successfully redeploy personnel, can have a significant impact on our cost of goods sold and services provided.

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Utilizing our own employees to complete projects results in higher gross margins as compared to our enlisting subcontracted employees for the same work. As a result, we seek to maximize our internal labor content on our awards. Selling, general and administrative expenses consist primarily of costs associated with our management, finance and administrative groups and business development expenses which include bid and proposal efforts, and occupancy, travel and other corporate costs. We have revenue from some awards on which our U.S. Government customers pay us to perform research and development on their behalf. We also spend funds on internal research and development, which are separately classified as such in the financial statements. We are in a net operating loss carry forward position, and currently do not anticipate paying taxes until 2006.

On March 1, 2003, we acquired 100% of the common stock of Sensys Development Laboratories, Inc., or SDL. The assigned value of the consideration and related expenses was approximately $4.4 million. SDL provides both system and software engineering technical support to U.S. Government customers and prime contractors supporting government programs. SDL has an established workforce with specialized experience and credentials. For its fiscal year ended September 30, 2002, SDL had revenues of $3.1 million.

On April 30, 2004, we acquired 100% of the common stock of Computer Science Innovations, Inc., or CSI, which is headquartered in Melbourne, Florida, for approximately $8.1 million in cash. CSI has proprietary techniques, algorithms and tools that are used to build custom cognitive engines for a broad range of intelligence, defense and commercial customers and applications. Cognitive engines are software that includes predictive models and classifiers, and they have applications in the areas of fraud and anomaly detection, image and signal recognition, information integration, knowledge management, network information assurance, semantic processing and waveform analysis. CSI had revenue of approximately $7.6 million in its fiscal year ended March 31, 2004.

On June 25, 2004, we acquired substantially all of the assets of Performance Group, Inc., or PGI, with main offices in Fredericksburg, Virginia, for approximately $5.8 million in cash and $362,000 in assumed liabilities. PGI provides services and systems in the areas of GIS, image processing and analysis, spatial data development, environmental consulting, visualization, and IT solutions to government and private sector clients. PGI had revenue of approximately $4.5 million in calendar year 2003.

CRITICAL ACCOUNTING POLICIES AND ESTIMATES

The preparation of 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 ongoing basis, we re-evaluate our estimates, including those related to revenue recognition, research and development, intangible assets and contingencies. We base our estimates on historical experience and on various other assumptions that we believe are reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions. We believe the following critical accounting policies affect our more significant judgments and estimates used in the preparation of our financial statements.

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Revenue Recognition

We enter into three types of U.S. Government agreements:

We use historical technical performance experience where applicable to evaluate progress on fixed price and cost plus fixed fee jobs. We use historical government audit experience in the indirect cost area to evaluate the propriety and expected recovery of our indirect costs on cost plus fixed fee agreements. The following table sets forth the percentage of revenues under each type of agreement for the nine months ended September 28, 2003 and September 26, 2004:

Research and Development

Research and development costs are expensed as incurred. Such costs include direct labor and materials as well as a reasonable allocation of indirect costs. However, no selling, general, and administrative costs are included. Equipment which has alternative future uses is capitalized and charged to expense over its estimated useful life.

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Goodwill and Other Intangible Assets

Business acquisitions typically result in the recording of goodwill and other intangible assets, which affect the amount of future period amortization expense and possible impairment expense that we will incur. We have adopted Statement of Financial Accounting Standards, or SFAS, No. 142 which requires that we, on an annual basis, calculate the fair value of the reporting units that contain the goodwill and compare that to the carrying value of the reporting unit to determine if impairment exists. Impairment testing must take place more often if circumstances or events indicate a change in the impairment status. Management judgment is required in calculating the fair value of the reporting units. Because of the integral technologies and operations of the acquisitions to date, we have determined that Essex has only one corporate-wide reporting entity to which this test applies.

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RESULTS OF OPERATIONS

The following table sets forth, for each period indicated, items in the statement of our operations expressed as a percentage of total revenue.

The following table sets forth, for each component of our revenues, the related cost of goods sold and services provided expressed as a percentage of the related revenues for the periods indicated.

Revenues. Total revenues were $51.5 million and $11.2 million in the first nine months of fiscal 2004 and 2003, respectively. Total revenues were $16.7 million and $4.1 million in the third quarters of fiscal 2004 and 2003, respectively. The key factors for the higher revenue were the increased activity on the October 2003 $57.1 million multi-year award and the January 2004 $4.5 million (increased in the third quarter of 2004 to $6.2 million) two-year award for software and systems engineering and the delivery of custom systems to national priority programs. Revenues from these two awards in the first nine months of 2004 were $34.2 million and $2.4 million, respectively. Of this total $36.6 million, $13.0 million was for purchased hardware. Revenues from these two awards in the third quarter of 2004 were $9.4 million and $290,000, respectively. Of this total $9.7 million, $1.0 million was for purchased hardware. There was no comparable purchased hardware revenue in the first nine months of 2003. In addition, we had increased revenues in 2004 associated with the acquisitions described in Note 7.

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Cost of Goods Sold and Services Provided (“CGS”). Total CGS increased $34.7 million to $41.7 million for the first nine months of 2004 from $7.0 million for the comparable period in 2003. As a percentage of total revenues, total CGS was approximately 80.9% for the first nine months of 2004, compared to approximately 62.8% for the comparable period in fiscal 2003. For services and products revenue, CGS was 75.0% for the first nine months of 2004 as compared to 62.8% for the comparable period in 2003. The increase in CGS in 2004 reflects increased volume and revenue for the period. The increase in CGS as a percentage of revenue in 2004 reflects the change in the mix of work, primarily related to the two contracts awarded in October 2003 and January 2004. Specifically, upon award and ramp up, a majority of the revenues under those contracts relate to subcontracts and purchased hardware which are lower margin. Over time, we anticipate a gradual shift of a portion of this work to our staff. For the third quarter of 2004, total CGS increased $10.2 million to $12.6 million from $2.4 million for the comparable period of 2003. As a percentage of total revenues, total CGS was approximately 75.8% for the third quarter of 2004 as compared to 58.5% for the comparable period in 2003. For services and products revenue, CGS was 74.5% for the third quarter of 2004 as compared to 58.5% for the comparable period in 2003. For purchased hardware revenues, CGS was 98.3% and 97.0% in the first nine months and third quarter of 2004, respectively, and there were no comparable purchases in the first nine months and third quarter of 2003. These third quarter results also reflect the higher volume and increased subcontractor and purchased hardware components discussed above.

Overall margins increased from the end of second quarter of 2004 to the end of third quarter of 2004 from 16.7% to 19.1% due to a change in the mix of products and services provided with an increase in our higher margin services revenue relative to our purchased hardware revenue.

Selling, General and Administrative Expenses. Selling, general and administrative expenses (SG&A) increased $4.2 million to $7.6 million for the first nine months of 2004 from $3.4 million for the comparable period in 2003. For the third quarter of 2004, SG&A increased $1.7 million to $3.1 million from $1.4 million for the comparable period in 2003. SG&A has increased to support the higher volume of business as well as including the SG&A of the acquired businesses. SG&A has decreased as a percentage of revenues.

Research and Development Expenses. Research and development (R&D) expenses increased $333,000 to $671,000 in the first nine months of 2004 compared to $338,000 in the comparable period in 2003. For the third quarter of 2004, R&D increased $112,000 to $224,000 compared to $112,000 in the comparable period in 2003. We incurred the majority of its research and development on efforts related to optical communications technology and has incurred R&D since May 2004 in the newly-acquired CSI operation.

Amortization of Other Intangible Assets. During the nine months ended September 26, 2004, amortization of other intangible assets was $348,000, which was primarily related to the CSI and PGI acquisitions. There was $295,000 of amortization costs in the comparable period in 2003 relating to the SDL acquisition. For the third quarters of 2004 and 2003, amortization was $186,000 and $121,000, respectively. The amortization of other intangibles related to the SDL acquisition was substantially complete in the first quarter of 2004.

Net Interest Income (Expense). Net interest income was $183,000 in the first nine months of 2004 compared to net interest expense of $61,000 in the comparable period in 2003. For the third quarter of 2004, net interest income was $58,000 compared to net interest expense of $18,000 in the comparable period in 2003.

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The net interest income reflects the temporary investment of the proceeds from the stock offering.

Net Income. We recorded net income of $589,000 and $11,000 in the third quarters of 2004 and 2003, respectively. Net income was $1.4 million and $66,000 in the first nine month periods of 2004 and 2003, respectively. We are in a net operating loss carryforward position for book and tax purposes. No provision for or benefit from income taxes was recognized in the first nine months of 2004 or 2003 due to the net operating loss carryforwards. We adjusted our income tax valuation reserves accordingly during these periods.

BACKLOG

Our awards with the U.S. government generally extend over multiple years. Funded backlog generally consists of the sum of all award amounts for which funding has been approved and contracts signed, less the value of work performed under such contracts. Since the U.S. government operates under annual appropriations, our customers typically fund awards on an incremental basis, generally for periods of one year or less. In many cases, our awards include unexercised options. Accordingly, a significant amount of our backlog is “unfunded”. We include in unfunded backlog the total value of signed contracts, less funding to date. Unfunded backlog includes contract options based upon expected performance levels for those options. Unfunded backlog does not include any estimate of future potential delivery orders that might be awarded under indefinite delivery indefinite quantity contracts. We have recently revised our calculation of unfunded backlog and the amounts presented here are consistent with this definition. The effect of our change reduced backlog by $13.3 million and $19.0 million at September 26, 2004 and December 28, 2003, respectively.

As of September 26, 2004, we had total contract backlog, funded and unfunded, of approximately $73.0 million as compared with $93.8 million at December 28, 2003. Of these amounts, funded backlog was $26.2 million and unfunded backlog was $46.8 million at September 26, 2004 compared to $15.0 million and $78.8 million, respectively, at fiscal year end 2003. Unfunded backlog as of September 26, 2004 includes the remaining balance of approximately $23.5 million on our $30 million, ten-year contract through 2011 to provide communications systems support to the intelligence community. Unfunded backlog at September 26, 2004 also includes the remaining balance of approximately $11.4 million on our $57.1 million multi-year contract for software and systems engineering that we received in October 2003 but does not include the recent increase in the ceiling of that award. In October 2004, the ceiling on this award was increased to $235.6 million, subject to final price negotiations to be completed by December 31, 2004. Backlog at September 26, 2004 does not include the $178.5 million increase in the ceiling of this award.

We currently expect to recognize revenue during the last three months of fiscal 2004 from approximately 23.3% of our total backlog as of September 26, 2004. We cannot guarantee that we will recognize any revenue from our backlog. The federal government has the prerogative to cancel any contract or delivery order at any time. Backlog varies considerably from time to time as current contracts or delivery orders are executed and new contracts or delivery orders under existing contracts are won.

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FINANCIAL CONDITION – LIQUIDITY AND CAPITAL RESOURCES

Our primary liquidity and capital resource needs are to finance the costs of our operations and to make capital expenditure. Based upon our current level of operations, we expect that our cash flow from operations and amounts of cash on hand will be adequate to meet our anticipated needs for at least the next twelve months.

We evaluate our liquidity position using various factors. The following represents some of the more important factors:

During the first nine months of 2004, net cash provided by operating activities was $1.9 million. Cash provided from net income and non cash depreciation, amortization and other charges of approximately $2.2 million was offset by an increase in accounts receivable and prepaids net of the change in accounts payable and accrued items of $300,000. The increase in accounts receivable during the first nine months of 2004 was due to the increase in sales and does not reflect any significant change in payment cycle.

During the nine months ended September 26, 2004, net cash used in investing activities was $15.2 million, of which $14.1 million was for the acquisitions of CSI and substantially all of the assets of PGI. We also expended $1.0 million for property, equipment and leasehold improvements to support our growing work force. Our working capital at September 26, 2004 decreased to $22.1 million from $33.0 million at fiscal year end 2003. The decrease was primarily a result of the acquisitions of CSI and assets of PGI for cash.

During the nine months ended September 26, 2004, net cash provided by financing activities was $156,000. Cash received of $1.6 million from the sale of common stock and proceeds from

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exercises of stock options was offset by cash of $1.3 million that was provided to a landlord under an obligation to finance special facility security improvements.

The Company expects to satisfy its operating cash requirements for the remainder of 2004 from its operating cash flows and existing cash balance.

On November 1, 2004, the Company filed a registration statement with the Securities and Exchange Commission for a proposed follow-on underwritten public offering of up to 6,000,000 shares of its common stock, including 1,000,000 shares from a selling shareholder. Since the registration statement has not yet become effective, the price per share and net proceeds to the Company have not been determined.

INFLATION

Because of the Company’s substantial activities in professional services and product development, the Company is more labor intensive than firms involved primarily in industrial activities. To attract and maintain higher caliber professional staff, the Company must structure its compensation programs competitively. The wage demand effect of inflation is felt almost immediately in the Company’s costs; however, the net effect during the periods presented is minimal.

The inflation rate in the United States generally has little impact on the Company’s cost-reimbursable type contracts and other short-term contracts. For longer-term, fixed-price and time and material type contracts, the Company endeavors to protect its margins by including cost escalation provisions or other specific inflation protective terms in these contracts.

The preceding paragraphs discussing the Company’s financial condition contain forward-looking statements. The factors affecting the ability of the Company to meet its funding requirements and manage its cash resources include, among other things, the amount and timing of product sales, inventory turnover, the magnitude of fixed costs, sales growth and the ability to obtain working capital, all of which involve risks and uncertainties that are difficult to predict.

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The Company had no variable rate debt outstanding as of September 26, 2004.

Our exposure to market risk relates to changes in interest rates on short-term investment of the remaining proceeds of our stock offerings. Presently, such investments earn approximately 1%. Based upon our investments during the first nine months of 2004, a hypothetical 1% increase in interest rates would have increased income by about $10,000 for every $1 million invested and would have increased our annual cash flow and interest income by a comparable amount.

Based on their most recent evaluation, Leonard E. Moodispaw, the Company’s Chief Executive Officer and Lisa G. Jacobson, the Company’s Chief Financial Officer, have concluded that the Company’s disclosure controls and procedures (as defined in Exchange Act Rules 13a-14 and 15d-14) as of the end of the period covered by this report are effective to ensure that information required to be disclosed by the Company in this report is accumulated and communicated to the Company’s management, including its principal executive officer and principal financial officer, as appropriate, to be recorded, processed, summarized and reported within the time periods specified by the Securities and Exchange Commission’s rules and forms.

There were no significant changes in the Company’s internal controls or other factors that materially affected, or are reasonably likely to materially affect, these controls subsequent to the date of their evaluation and there were no corrective actions with regard to significant deficiencies and material weaknesses.

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PART II – OTHER INFORMATION

The 2004 Annual Meeting of Shareholders of the Company (the “Meeting”) was held on July 21, 2004. The total number of outstanding shares entitled to vote at the meeting was 15,098,929 and there were present at the Meeting in person or by proxy 14,478,163 shares, which number constituted a quorum for the Meeting, and were entitled to vote and acted as follows with respect to the following proposals:

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RISK FACTORS

Our business, results of operations and financial condition may be materially and adversely affected due to any of the following risks. The risks described below are not the only ones we face. Additional risks that we are not presently aware of or that we currently believe are immaterial may also impair our business operations.

Risks Related to Our Business

We currently rely on sales to U.S. Government entities, particularly in the intelligence and defense areas, and the loss of certain of our awards with the U.S. Government could have an adverse impact on our operating results.

We depend on sales to the U.S. Government. For fiscal years 2003 and 2002, awards from the U.S. intelligence and defense communities and other departments and agencies of the Department of Defense accounted for approximately $15.9 million, or 98% of our revenues, and $4.4 million, or 97% of our revenues, respectively. For the nine months ended September 26, 2004, these contracts accounted for approximately $50.2 million, or 98% of our revenues.

For fiscal 2003 and 2002, our top three customer programs accounted for approximately $8.5 million, or 52% of our revenues, and $3.5 million, or 78% of our revenues, respectively. For the nine months ended September 26, 2004, our top three customers accounted for approximately $39.7 million, or 77% of our revenues. For fiscal years 2003 and 2002, our award with the Missile Defense Agency accounted for approximately $3.3 million, or 21% of our revenues, and $2.1 million, or 46% of our revenues, respectively. For the nine months ended September 26, 2004, our largest award with the National Security Agency accounted for approximately $34.2 million, or 67% of our revenues. The loss or significant reduction in government funding of a program for which we are the contractor or in which we participate could reduce our revenue and cash flows and have an adverse effect on our operating results.

We depend on U.S. Government awards which are only partially funded; the U.S. Government has no obligation to fully fund our awards.

Budget decisions made by the U.S. Government are outside of our control and have significant consequences for our business. Funding for U.S. Government awards is subject to Congressional appropriations. Although multi-year awards may be planned or authorized in connection with major procurements, Congress generally appropriates funds on a fiscal year basis even though a program may be expected to continue for several years. Consequently, awards often initially receive only partial funding, and additional funds are committed only as Congress makes further appropriations. The termination of funding for one of our U.S. Government awards would result in a loss of anticipated future revenues attributable to that program which could have an adverse impact on our operations and increase our overall costs of doing business.

Our backlog was approximately $73.0 million as of September 26, 2004, of which approximately $26.2 million was funded. Our backlog includes orders under awards that in some cases extend for several years, with the latest expiring in 2011. Our estimate of the portion of the backlog as

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of September 26, 2004 from which we expect to recognize revenue in the remainder of fiscal 2004 may not be precise because the receipt and timing of any revenue is subject to various contingencies, many of which are beyond our control. The U.S. Government’s ability to select multiple winners under multiple award schedule contracts, government-wide acquisition contracts, blanket purchase agreements and other indefinite delivery, indefinite quantity, or IDIQ, contracts, as well as its right to award subsequent task orders among such multiple winners, means that there is no assurance that unfunded contract backlog will result in actual orders. The actual receipt of revenues on awards included in backlog may never occur or may change because a program schedule could change or the program could be canceled, or a contract could be reduced, modified, or terminated early. Moreover, under IDIQ contracts, the U.S. Government is not obligated to order more than a minimum quantity of goods or services. If we fail to realize revenue from engagements included in our backlog as of September 26, 2004, our revenue and operating results for fiscal 2004, as well as future reporting periods, may be materially harmed.

U.S. Government awards are subject to immediate termination and are heavily regulated.

Our U.S. Government awards can be terminated by the U.S. Government either at its convenience or if we default. If the U.S. Government terminates one of our awards, we are entitled to payment of compensation only for work done and commitments made at the time of termination. If our U.S. Government awards are terminated for default, we would be obligated to pay the excess costs incurred by the U.S. Government in procuring undelivered items from another source. If any or all of our U.S. Government awards are terminated under either of these circumstances, we may be unable to procure new awards to offset the lost revenues.

In addition, supplying defense-related services and equipment to U.S. Government agencies subjects us to risks specific to the defense industry, including the ability of the U.S. Government to unilaterally:

Because a significant portion of our revenues are dependent on our procurement, performance and payment under our U.S. Government awards, the loss of one or more large awards would have an adverse impact on our financial condition.

A key part of our strategy involves pursuing acquisitions; however, acquisitions may not achieve intended results.

A key part of our strategy is to selectively pursue acquisitions. We acquired Sensys Development Laboratories, Inc., or SDL, in March 2003; Computer Science Innovations, Inc., or CSI, in April 2004; and substantially all of the assets of Performance Group, Inc., or PGI, in June 2004.

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We intend to continue to pursue acquisition opportunities in the future. If we do identify an appropriate acquisition candidate, we may not be able to successfully negotiate the terms of the acquisition. We may use all or a substantive portion of our cash on one or more acquisitions, although we currently have no commitments or agreements and are not involved in any negotiations with respect to any specific acquisitions. In addition, in connection with an acquisition, we may incur significant amortization expenses related to intangible assets. We also may incur significant write-offs of goodwill associated with companies, businesses or technologies that we acquire.

Acquisitions and strategic investments may involve a number of other risks, including:

We face intense competition from a number of competitors that have greater resources than we do, which could result in price reductions, reduced profitability and loss of market share.

We operate in highly competitive markets and may encounter intense competition to win U.S. Government awards. If we are unable to successfully compete for new business, our revenue growth may decline. Many of our competitors are larger and have greater financial, technical, marketing and public relations resources than we do. Larger competitors include Lockheed Martin Corporation and divisions of large defense contractors such as Boeing Support Services. These competitors may be able to compete more effectively for very large scale government awards. These competitors also may be able to provide customers with different or greater capabilities or benefits than we can provide in areas such as technical qualification, past performance on larger scale contracts, geographic presence, price, and the availability of key professional personnel. Our competitors also have established or may establish relationships among themselves or with third parties, including through mergers and acquisitions, to increase their ability to address customers’ needs. Accordingly, it is possible that new competitors or alliances among competitors may emerge against whom it will be difficult for us to compete.

In addition, competition in the commercial market for network communications equipment is intense. This market has historically been dominated by such large companies as Alcatel, Ciena, Cisco Systems, JDS Uniphase, Lucent Technologies, NEC and Nortel Networks. Some of these companies, as well as emerging companies, are currently developing products that may compete in the areas that our technology is designed to address. We also may face competition from other large communications companies who may enter our markets. Many of these possible competitors have longer operating histories, greater name recognition, larger customer bases and greater financial, technical and business development resources than we do and may be able to undertake more extensive marketing efforts and adopt more aggressive pricing policies than we

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can. In addition, additional competitors with significant market presence and financial resources may enter our markets, which are rapidly evolving, further intensifying competition.

Unfavorable government audit results could force us to adjust previously reported operating results and could subject us to a variety of penalties and sanctions.

The federal government audits and reviews our performance on awards, pricing practices, cost structure, and compliance with applicable laws, regulations, and standards. Like most large government vendors, our awards are audited and reviewed on a continual basis by federal agencies, including the Defense Contract Management Agency and the Defense Contract Audit Agency. An audit of our work, including an audit of work performed by companies we have acquired or may acquire or subcontractors we have hired or may hire, could result in a substantial adjustment in the current period operating results. For example, any costs which were originally reimbursed could subsequently be disallowed. In this case, cash we have already collected may need to be refunded and our operating margins may be reduced.

If a government audit uncovers improper or illegal activities, we may be subject to civil and criminal penalties and administrative sanctions, including termination of contracts, forfeiture of profits, suspension of payments, fines and suspension or debarment from doing business with U.S. Government agencies. In addition, we could suffer serious harm to our reputation if allegations of impropriety were made against us, even if the allegations were not true. Audits for costs incurred on work performed after fiscal 2001 for Essex, CSI and SDL, and after 1994 for PGI have not yet been completed.

If we were suspended or debarred from contracting with the U.S. Government generally, or any specific agency, if our reputation or relationship with U.S. Government agencies were impaired, or if the government otherwise ceased doing business with us or significantly decreased the amount of business it does with us, our revenue and operating results would be materially harmed.

If we are unable to manage our growth, our business could be adversely affected.

Achieving our plans for growth will place significant demands on our management, as well as on our administrative, operational and financial resources. For us to successfully manage our growth, we must continue to improve our operational, financial and management information systems and expand, motivate and manage our workforce. If we are unable to successfully manage our growth without compromising the quality of our services, we could lose existing customers and our ability to attract new customers could be adversely affected.

Our success depends largely on our ability to attract and retain key personnel.

Our success has historically depended in large part on our ability to attract and retain highly skilled technical, managerial and operational personnel, particularly those knowledgeable about the U.S. Government intelligence and defense agencies, those with security clearances and those skilled in optoelectronics and optical communications equipment. In addition, the relationships and reputation that many members of our senior management team have established and maintain with government personnel contribute to our ability to maintain good customer relationships and to identify new business opportunities. The loss of key personnel may impair our ability to obtain new U.S. Government awards or adequately perform under our current U.S. Government awards.

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We also rely on the skills and expertise of our senior technical development personnel, the loss of any of whom could prevent us from completing current development projects and restrict new development projects. We currently do not maintain “key man” insurance on any of our executives or key employees.

We have a history of net losses and we may not achieve or sustain profitability.

Although we had net income of $139,000 for fiscal 2003, we incurred a net loss for each of our fiscal years 2002, 2001, and 2000. As of September 26, 2004, we had an accumulated deficit of approximately $12.9 million. If revenues do not meet our expectations, or if our expenses exceed our expectations, we may incur substantial operating losses in the future, in which case the price of our common stock may decline.

We enter into fixed price arrangements that could subject us to losses in the event costs exceed our expectations.

We provide some of our services and products through fixed price arrangements. For the nine months ended September 26, 2004, fixed price arrangements accounted for 3% of our revenues. Fixed price arrangements accounted for 16% and 28% of our revenues for fiscal 2003 and 2002, respectively. In a fixed price award, the price is not subject to adjustment based on cost incurred to perform the required work under the award. Therefore, we fully absorb cost overruns on fixed price awards.

Cost overruns reduce our profit margin on the contract and may result in a loss. Additionally, we estimate sales and costs that are related to performance in accordance with award specifications and the possibility of obsolescence in connection with long-term procurements. Failure to anticipate technical problems, estimate costs accurately or control costs during performance of a fixed price award may reduce our profit, result in significant losses or cause a loss on the award.

Our quarterly operating results may vary widely.

Our quarterly revenues and operating results have fluctuated significantly in the past, and may fluctuate in the future. A number of factors can cause our revenue, cash flow and operating results to vary from quarter to quarter, including:

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Changes in the number of projects commenced, completed or terminated during any quarter may cause significant variations in our cash flow from operations because a relatively large amount of our expenses is fixed. We may incur significant operating expenses during the start-up and early stages of an award and typically do not receive corresponding payments until subsequent quarters. We also may incur significant or unanticipated expenses when awards expire or are terminated. In addition, payments due to us from U.S. Government agencies may be delayed due to customer payment cycles or as a result of the failure of Congress and the President to approve budgets in a timely manner.

If we are unable to protect our intellectual property effectively, we may be unable to prevent third parties from using our technologies, which would impair our competitive advantage.

We rely on a combination of patent, copyright, trademark and trade secret laws and restrictions on disclosure to protect our intellectual property rights. We also enter into confidentiality or license agreements with our key employees and consultants and control access to and distribution of our software, documentation and other proprietary information. We believe that our patents and patent applications provide us with a competitive advantage and, therefore, patent protection is important to our business. However, our patent and other intellectual property protection may not adequately protect our rights or permit us to gain or keep any competitive advantage. For instance, unauthorized parties may attempt to copy, reverse engineer or otherwise obtain and use our patented products or technology without our permission, eroding or eliminating the competitive advantage we hope to gain though the exclusive rights provided by patent protection. Moreover, our existing patents and pending patent applications, if granted, may not protect us against competitors that independently develop proprietary technologies that are substantially equivalent or superior to our technologies, or design around our patents. The competitive advantage provided by patenting our technology may erode if we do not upgrade, enhance and improve our technology on an ongoing basis to meet competitive challenges.

In addition, we conduct research and development under projects with the U.S. Government. In general, our rights to technologies we develop under those projects are subject to the U.S. Government’s non-exclusive, non-royalty bearing, world-wide license to use those technologies. In the case of SBIR awards, the U.S. Government has limited rights to the delivered data for five years after project completion, and unlimited rights after five years. Our rights to license and protect our technology are unaffected by the U.S. Government’s rights to SBIR technical data.

Monitoring unauthorized use of our technology is difficult, and we cannot be certain that the steps we have taken will prevent unauthorized use of our technology, particularly in foreign countries where the laws may not protect our proprietary rights as fully as in the United States.

There is a risk that some of our patent applications will not be granted.

Although we have received our first hyperfine WDM and VLI patents, we have filed several other applications for U.S. and International patents relating to our hyperfine WDM, VLI and OPERA^™ technologies, and there is a risk that some or all of the pending applications will not be

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granted. Although we believe our patent applications are valid, the failure of our pending applications to be granted would affect the competitive advantage we hope to gain by obtaining patent protection and could have a material adverse effect upon our business and results of operations.

We may become involved in intellectual property disputes, which could subject us to significant liability, divert the time and attention of our management and prevent us from selling our products.

We or our customers may be a party to litigation in the future to protect our intellectual property or to respond to allegations that we infringe on others’ intellectual property. We have not performed any patent infringement clearance searches and are not in a position to assess the likelihood that any claims would be asserted. If any parties assert that our products infringe upon their proprietary rights, we would be forced to defend ourselves and possibly our customers against the alleged infringement. If we are unsuccessful in any intellectual property litigation, we could be subject to significant liability for damages and loss of our proprietary rights. Intellectual property litigation, regardless of its success, would likely be time consuming and expensive to resolve and would divert management’s time and attention. In addition, we could be forced to do one or more of the following:

If we are forced to take any of these actions, our business could be seriously harmed.

Because we currently are developing our optoelectronic products for the commercial market, it is difficult to evaluate our future business and prospects in this market.

We traditionally have derived our revenues from awards from the U.S. Government. While we intend to enhance and expand our government business, we are continuing our work to develop new optoelectronic commercial products, including products based on our hyperfine WDM fiber optic communications technology, such as our optical encryptor. Because we have not begun significant commercial sales of these products, our commercial revenue and profit potential is unproven and our limited history in the commercial market makes it difficult to evaluate our business and prospects. We cannot accurately forecast our commercial revenue and we have limited historical financial data upon which to base production budgets. You should consider our business and prospects in light of the heightened risks and unexpected expenses and problems we may face as a company developing new commercial products for a rapidly changing industry.

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Our ability to expand into the commercial optical networking market may be adversely affected by unfavorable and uncertain conditions in the communications industry and the economy in general.

One element of our strategy is to develop products targeted at the commercial optical networking market. The market for communications equipment, including optical components, has suffered a severe and prolonged downturn. Many of our potential customers in this market have experienced significant financial distress, and some have gone out of business. This has resulted in a significant consolidation in the commercial communications equipment industry, combined with a substantial reduction in overall demand. In addition, most of the potential customers we would like to reach have become more conservative about their future purchases, which has made our commercial business slow to materialize.

We expect the following factors to affect our ability to expand our commercial market business for an indeterminate period:

The result of any one or a combination of these factors could eliminate or reduce our ability to successfully enter and compete in this market.

Our optoelectronic products are complex, operate in demanding environments and have not yet been widely deployed. If our products contain defects that are undiscovered until full deployment we may incur significant and unexpected expenses, losses of sales and harm to our reputation.

Optoelectronic products are complex and are designed to be deployed across complex networks. Because of the nature of the products, they can only be fully tested when completely deployed in large networks with high amounts of traffic. Our products have not yet been deployed and tested in a commercial environment, and when they are, customers may discover errors or defects in the hardware or the software, or products we develop may not operate as expected. If we are unable to fix defects or other problems that may be identified in full deployment, we would likely experience:

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Defects, integration issues or other performance problems could result in financial or other damages to our customers or could negatively affect market acceptance for the products we develop. Our customers could also seek damages for losses from us, which, if they were successful, could adversely affect our cash flow from operations. A product liability claim brought against us, even if unsuccessful, would likely be time consuming and costly and would put a strain on our management and resources.

If necessary licenses of third-party technology are not available to us or are very expensive, we may not be able to sell products of the same quality, and our cost of operations could increase.

From time to time we may be required to license technology from third parties to sell or develop our products and product enhancements. These third-party licenses may not be available to us on commercially reasonable terms, if at all. Our inability to maintain or obtain any third-party license required to sell or develop our products and product enhancements could require us to obtain substitute technology of lower quality or performance standards or at greater cost. If we were required to use technology with lower performance standards or quality, customers may stop buying our products and this would cause our revenues to decline. Similarly, if our costs rise significantly, customers may choose less expensive alternative products, which would cause our revenues to decline.

Changes in stock option accounting rules may adversely impact our operating results.

Technology companies like ours have a history of using broad based employee stock option programs to hire, incentivize and retain our workforce in a competitive marketplace. Statement of Financial Accounting Standards No. 123, “Accounting for Stock-Based Compensation,” allows companies the choice of either using a fair value method of accounting for options which would result in expense recognition for all options granted, or using an intrinsic value method, as prescribed by Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees,” or APB 25, with a pro forma disclosure of the impact on net income (loss) of using the fair value option expense recognition method. We have elected to apply APB 25 and accordingly we generally do not recognize any expense with respect to employee stock options as long as such options are granted at exercise prices equal to the fair value of our common stock on the date of grant.

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In October 2004, the Financial Accounting Standards Board, or FASB, proposed that Statement 123R, “Share Based Payment,” which would require all companies to measure compensation cost for all share-based payments, including employee stock options, at fair value, would be effective for public companies for interim or annual periods beginning after June 15, 2005. We are currently evaluating the effect that the adoption of Statement 123R will have on our financial position and results of operations, but it is possible that our adoption of this standard may adversely affect our operating results in future periods.

We may lose our ability to benefit from government programs aimed at small businesses.

We currently participate in certain government programs under the regulations promulgated by the U.S. Small Business Administration, or SBA, such as the Small Business Innovative Research, or SBIR, program and small business set-aside contracts and preferences. Qualification as a small business is determined under the criteria set forth in the SBA Small Business Size Standards regulation. These criteria include the classification of the product or service in the North American Industry Classification System, trailing three year averages of the number of employees or annual receipts, affiliates, and other applicable factors. The restriction of a particular project or program under small business limited competition rules is a unilateral decision that is made at the time of procurement by the responsible agency procurement authority. The restriction of a particular project or program to small businesses, as a small business set-aside, in one procurement cycle does not assure that it will be similarly restricted in follow-on or related procurements.

A significant portion of our revenue historically has resulted from our participation in these small business set-aside programs, and our award from the National Security Agency, which accounted for 67% of our revenues for the nine months ended September 26, 2004, is under the NSA Set-aside for Small Business, or NSETS, Program.

We anticipate that, in the future, due to the increases in the levels of our revenues and number of employees, we may begin to lose our ability to participate in some or all of these programs, including receiving new awards under the programs. We also anticipate that some follow-on or related procurements for programs that were originally awarded to us as small business set-asides may not be issued under the small business limited competition rules of the SBA.

The failure by Congress to timely approve budgets for the federal agencies we support could delay or reduce spending and cause us to lose revenue.

On an annual basis, Congress must approve budgets that govern spending by each of the federal agencies we support. When Congress is unable to agree on budget priorities, and thus is unable to pass the annual budget on a timely basis, then Congress typically enacts a continuing resolution. A continuing resolution allows government agencies to operate at spending levels approved in the previous budget cycle. When government agencies must operate on the basis of a continuing resolution it may delay funding we expect to receive from clients on work we are already performing and would result in any new initiatives being delayed, and in some cases being cancelled.

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BUSINESS

Overview

Essex provides advanced signal, image, and information processing solutions primarily for U.S. Government intelligence and defense customers. We create our solutions by combining our services and expertise with hardware, software, and proprietary and patented technology to meet our customers’ requirements. Within the intelligence and defense communities we have established and maintained long-standing and successful customer relationships. We are also developing next generation signal, image and information processing solutions under classified U.S. Government research and development contracts. We have been able to develop our current proprietary technology using a combination of government funding and our own internal funding and we believe this combination will allow us to continue to enhance and expand our technology and services for future market needs.

While we have primarily marketed our services and products to the intelligence and defense markets, we believe we are also well positioned to apply our solutions to growth areas within the commercial market. Historically, our proprietary technology and products, although critical to our solutions offerings, have not accounted for a significant portion of our revenues on a standalone basis.

Achieving information superiority, or the ability to collect, process and disseminate information while denying our adversaries capabilities to do the same, is a primary objective for the intelligence and defense communities. Our services and products facilitate the technology transformation necessary for our intelligence and defense customers to achieve information superiority. We provide advanced processing solutions using optical, optoelectronic, and software technology within the following three business areas:

Signal Processing.

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Image Processing.

Information Processing.

Our current customers include the National Security Agency, the National Reconnaissance Office, the National Geospatial-Intelligence Agency, other intelligence agencies, the Missile Defense Agency, the Defense Advanced Research Project Agency, the U.S. Army, Navy, and Air Force and other defense elements. Many of our advanced processing solutions are used in critical national defense programs. Of our 246 employees, 164 have government security clearances, with 127 holding Top Secret/Sensitive Compartmented Information clearances, or TS/SCI, which are security clearances at the highest levels.

We have enhanced our internally developed, core optoelectronic processing technology and solutions with selective acquisitions of complementary technologies and capabilities. We acquired Sensys Development Laboratories, Inc., or SDL, in March 2003; Computer Science Innovations, Inc., or CSI, in April 2004; and substantially all of the assets of Performance Group, Inc., or PGI, in June 2004. SDL’s systems and software engineering capabilities, combined with our core capabilities, enabled us to win a $57.1 million, 4.3-year award with the National Security Agency in October 2003. In September 2004, 18 months after closing the SDL acquisition, we opened a 50,000-square foot leased secure facility in Annapolis Junction, Maryland related to on-going work on this award. In October 2004, we signed an expansion of this award to a new ceiling of $235.6 million subject to final price negotiations to be completed by December 31, 2004. We believe CSI and PGI bring highly complementary capabilities and technology to our core signal, image, and information processing business areas.

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For fiscal 2002 and 2003, we generated revenue of $4.5 and $16.3 million respectively. For the nine months ended September 26, 2004, we generated revenues of $51.5 million. Over 97% of our revenue in each of these periods was derived from our customers in the intelligence and defense community.

Industry Overview

While we primarily serve the intelligence and defense markets, we also believe significant opportunities exist for us to expand into commercial markets.

Intelligence and Defense Market.

The total defense budget, as submitted in the President’s 2005 Budget to Congress, is projected to grow from $375.3 billion in government fiscal year 2004 to $487.7 billion in government fiscal year 2009. The President’s 2005 Budget submission supports the defense transformation process, in which information superiority is a primary objective, by including nearly $75 billion for procurement and nearly $70 billion for research, development, test and evaluation. The intelligence budget has been classified except for government fiscal years 1997 and 1998. According to the Congressional Research Service, the intelligence budget for those two years was $26.6 and $26.7 billion, respectively. Since then, the global threat of terrorism, wars in Iraq and Afghanistan, the demands of homeland security, the needs of the intelligence community and renewed focus on modernizing Department of Defense infrastructures under the information superiority transformation program have led to increased spending.

The U.S. Government is one of the largest purchasers of optoelectronic, signal processing and other information technology services and products. We believe we are well positioned within the intelligence and defense market to capitalize on the following trends: