UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

(Mark One)

þ		QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended September 25, 2005

OR

o		TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

ADVANCED PHOTONIX, INC.

(Exact name of registrant as specified in its charter)

Delaware		33-0325826
(State or other jurisdiction of incorporation or organization)		(I.R.S. Employer Identification Number)

1240 Avenida Acaso
Camarillo, California 93012
(Address of principal executive offices)

(805) 987-0146
(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 þ 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 þ

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes o No þ

As of November 7, 2005, there were 18,707,924 shares of Class A Common Stock, $.001 par value, and 31,691 shares of Class B Common Stock, $.001 par value outstanding.

 

 

ADVANCED PHOTONIX, INC.

INDEX

		PAGE
PART I FINANCIAL INFORMATION
Item 1. Financial Statements (Condensed)
Condensed Consolidated Balance Sheets at September 25, 2005 and March 27, 2005.		3 - 4
Condensed Consolidated Statements of Operations for the three month and six month periods ended September 25, 2005 and September 26, 2004.		5
Condensed Consolidated Statements of Cash Flows for the three month periods and the six month periods ended September 25, 2005 and September 26, 2004.		6 - 7
Notes to Condensed Consolidated Financial Statements		8 - 24
Item 2. Management Discussion and Analysis		25 - 28
Item 3. Quantitative and Qualitative Disclosures About Market Risk		29
Item 4. Controls and Procedures		29-30
PART II OTHER INFORMATION
Item 6. Exhibits		31
Signatures		32
Certificate of Chief Executive Officer to Section 302
Certificate of Chief Financial Officer to Section 302
Certificate pursuant to 18 U.S.C. Section 1350
Certificate pursuant to 18 U.S.C. Section 1350

PART I. FINANCIAL INFORMATION

Item 1. Condensed Consolidated Financial Statements

ADVANCED PHOTONIX, INC.

CONDENSED CONSOLIDATED BALANCE SHEETS

		September 25, 2005				March 27, 2005
Assets
Current Assets:
Cash and cash equivalents		$	2,008,000			$	2,757,000
Accounts receivable, net of allowance for doubtful accounts of $56,000 and $24,000 for September 25, 2005 and March 27, 2005, respectively.			3,499,000				2,610,000
Note receivable from Picometrix			—				4,228,000
Inventory, net			4,422,000				3,644,000
Prepaid expenses and other current assets			727,000				563,000
Deferred tax asset, current portion			644,000				644,000
Total current assets			11,300,000				14,446,000
Equipment and leasehold improvements, at cost			7,732,000				5,118,000
Accumulated depreciation			(4,083,000	)			(3,719,000	)
Equipment and leasehold improvements, net			3,649,000				1,399,000
Goodwill, net of accumulated amortization of 353,000 for September 25, 2005 and March 27, 2005.			2,421,000				2,421,000
Intangibles, net of accumulated amortization of 742,000 and 181,000 for September 25, 2005 and March 27, 2005, respectively			13,907,000				481,000
Patents, net of accumulated amortization of 77,000 and 13,000 for September 25,2005 and March 27, 2005, respectively			77,000				13,000
Deposits and other assets			658,000				490,000
Deferred income taxes			4,105,000				4,105,000
Total other assets			24,817,000				8,909,000
Total assets		$	36,117,000			$	23,355,000

ADVANCED PHOTONIX, INC.

CONDENSED CONSOLIDATED BALANCE SHEETS

		September 25, 2005				March 27, 2005
Liabilities and shareholders’ equity
Current liabilities
Line of credit		$	1,000,000			$	1,000,000
Accounts payable:			1,164,000				1,053,000
Compensation and related withholdings			718,000				529,000
Customer deposits			31,000				—
Deferred income			376,000				271,000
Other accrued expenses			670,000				321,000
Current portion of Long-term debt, related party			500,000				—
Current portion of long-term debt			968,000				11,000
Total current liabilities			5,427,000				3,185,000
Long-term debt, less current portion			4,552,000				4,861,000
Long-term debt, less current portion — related party			2,401,000				—
Total liabilities			12,380,000				8,046,000
Commitments and Contingencies:
Class A Redeemable Convertible Preferred Stock, $.001 par value; 780,000 shares authorized; 2004 and 2005 — 40,000 shares issued and outstanding; liquidation preference $25,000			32,000				32,000
Shareholders’ equity:
Preferred stock, $.001 par value; 10,000,000 shares authorized; 780,000 shares designated Class A redeemable convertible; 2005 and 2004 — no shares issued and outstanding
Class A common stock, $.001 par value, 50,000,000 authorized September 25, 2005 — 17,515,981 shares issued and outstanding, March 27, 2005 — 13,512,631 shares issued and outstanding			18,000				13,000
Class B common stock, $.001 par value; 4,420,113 shares authorized; 2005 and 2004 — 31,691 issued and outstanding							—
Additional paid-in capital			37,386,000				27,995,000
Accumulated deficit			(13,699,000	)			(12,731,000	)
Total shareholders’ equity			23,737,000				15,309,000
Total liabilities and shareholders’ equity		$	36,117,000			$	23,355,000

See notes to condensed consolidated financial statements.

ADVANCED PHOTONIX, INC.

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

		Three month periods ended								Six month periods ended
		September 25,				September 26,				September 25,				September 26,
		2005				2004				2005				2004
Revenue		$	5,193,000			$	3,709,000			$	10,271,000			$	6,962,000
Cost of products sold			3,077,000				2,451,000				5,999,000				4,407,000
Gross profit			2,116,000				1,258,000				4,272,000				2,555,000
Research and development expenses			802,000				37,000				1,247,000				79,000
Sales and marketing expenses			506,000				328,000				829,000				611,000
General and administrative expenses			1,456,000				654,000				2,809,000				1,272,000
Total Operating Expenses			2,764,000				1,019,000				4,885,000				1,962,000
Income (loss) from operations			(648,000	)			239,000				(613,000	)			593,000
Other income (expense):
Interest income			5,000				7,000				14,000				12,000
Interest expense			(140,000	)			(1,000	)			(262,000	)			(6,000	)
Interest expense, related party			(51,000	)			—				(100,000	)			—
Other			—				15,000				(7,000	)			9,000
Net income (loss)			($834,000	)		$	260,000				($968,000	)		$	608,000
Basic Earnings Per Share			($0.05	)		$	0.02				($0.06	)		$	0.05
Diluted Earnings Per Share			($0.05	)		$	0.02				($0.06	)		$	0.04
Weighted average shares outstanding			16,919,000				13,431,000				16,919,000				13,431,000
Weighted average diluted shares outstanding			19,450,000				14,228,600				19,450,000				14,228,600

See notes to condensed consolidated financial statements.

ADVANCED PHOTONIX, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

For the six month periods ended		September 25, 2005				September 26, 2004
CASH FLOWS FROM OPERATING ACTIVITIES
Net income (loss)		$	(968,000	)		$	608,000
Adjustments to reconcile net income (loss) to net cash provided by (used in) operating activities:
Depreciation			364,000				181,000
Amortization — intangibles/patents			593,000				39,000
Amortization — prepaid finance expense			120,000				—
Disposal of assets			—				20,000
Changes in operating assets and liabilities:
Accounts receivable			176,000				(166,000	)
Inventories			(30,000	)			(503,000	)
Prepaid expenses & other current assets			(98,000	)			(102,000	)
Other assets			81,000				16,000
Accounts payable			(154,000	)			188,000
Accrued expenses and other			(533,000	)			—
Net cash provided by (used in) operating activities			(449,000	)			281,000
CASH FLOWS FROM INVESTING ACTIVITIES
Capital expenditures			(155,000	)			(71,000	)
Patent expenditures			(66,000	)
Cash paid for Picotronix, Inc. acquisition			(3,500,000	)			—
Cash acquired through acquisition of Picotronix, Inc.			678,000				—
Cash paid for acquisition related costs			(936,000	)			—
Net cash (used in) operating activities			(3,979,000	)			(71,000	)
CASH FLOWS FROM FINANCING ACTIVITIES
Repayment of line of credit							(900,000	)
Proceeds from bank term loan			2,700,000				—
Payment of notes payable			(512,000	)			—
Proceeds from exercise of warrants			303,000				—
Proceeds from exercise of stock options			164,000				1,000
Net cash provided by (used in) financing activities			3,679,000				(899,000	)
Net decrease in cash			(749,000	)			(689,000	)
Cash at beginning of year			2,757,000				1,299,000
Cash at end of quarter		$	2,008,000			$	610,000
Supplemental disclosure of cash flow information
Cash paid for income taxes		$	—			$	—
Cash paid for interest		$	203,877			$	—

Non cash financing activities

During the Q2 2006 senior convertible note holders exercised their options to convert debt into the following number shares of the Company’s common stock:

• Holder 1		1,287,303 shares @ 1.9393 per share		$	2,496,467
• Holder 2		257,825 shares @ 1.9393 per share			500,000
• Holder 3		257,825 shares @ 1.9393 per share			500,000
Total		1,802,953		$	3,496,467

Supplemental disclosure of non cash operating, investing and financing activities:

Picometrix acquisition		May 2, 2005
Assets acquired		$	19,404,000
Liabilities assumed			(2,406,000	)
Net assets acquired			16,998,000
Cash paid			(3,500,000	)
Broker fees & other direct costs			(936,000	)
			12,562,000
Non-cash investing activities
Common stock issued			(5,433,000	)
Note payable — related party			(2,901,000	)
Picometrix note retired			(4,228,000	)
Net balance		$	—

See notes to condensed consolidated financial statements

ADVANCED PHOTONIX, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
September 25, 2005

Basis of Presentation

General – Advanced Photonix, Inc. (the “Company”), was incorporated under the laws of the State of Delaware in June 1988. The Company is engaged in the development and manufacture of optoelectronic devices and value-added sub-systems and systems. The Company serves a variety of global Original Equipment Manufacturers (OEMs), including telecommunication, military/aerospace, industrial sensing, medical and homeland security. The Company supports the customer from the initial concept and design phase of the product, through testing to full-scale production. The company has three manufacturing facilities; located in Camarillo, CA, Dodgeville, WI and Ann Arbor, MI.

The accompanying condensed consolidated financial statements include the accounts of Advanced Photonix, Inc. (“the Company”) and the Company’s wholly owned subsidiaries, Silicon Sensors Inc. (“SSI”), Texas Optoelectronics, Inc. (“TOI”), Photonic Detectors, Inc. (“PDI”) and Picometrix, LLC (“Picometrix). The consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States for interim financial information and pursuant to the rules and regulations of the Securities and Exchange Commission. All significant inter-company accounts and transactions have been eliminated in consolidation. Certain information and footnote disclosures normally included in annual financial statements prepared in accordance with accounting principles generally accepted in the United States of America have been condensed or omitted pursuant to such rules and regulations. In the opinion of management, all adjustments, consisting of normal and recurring adjustments, necessary for a fair presentation of the financial position and the results of operations for the periods presented have been included. Operating results for the three month period and the six month period ended September 25, 2005 are not necessarily indicative of the results that may be expected for the fiscal year ending March 26, 2006. For further information, refer to the financial statements and notes thereto included in the Advanced Photonix, Inc. Annual Report on Form 10-K for the fiscal year ended March 27, 2005.

Acquisition

In May 2005, the Company completed its previously disclosed acquisition of Picotronix, Inc. through the merger of Picotronix, Inc. (doing business as and referred to herein as “Picometrix”), a Michigan corporation, with and into Michigan Acquisition Sub, LLC (“Newco”), a Delaware limited liability company and a wholly-owned subsidiary of the Company, pursuant to an Agreement and Plan of Merger dated March 8, 2005 by and among the Company, Newco, Picometrix and Robin Risser and Steven Williamson, the stockholders of Picometrix. Immediately following the effective time of the merger, the name of Newco was changed to Picometrix, LLC. Pursuant to the merger between Picometrix and the Company, the Company paid consideration of approximately $17 million in the form of $3.5 million in cash, four-year API promissory notes in the aggregate principal amount of approximately $2.9 million (the “API Notes”), $5.4 million in API Class A Common Stock (2,575,000 shares valued at $2.11 per share), a loan in the amount of approximately $4.2 million to Picometrix (the “API Loan”) which was forgiven and the proceeds of which were used to prepay existing long-term indebtedness of Picometrix to a third party, and broker fees and other transaction costs directly related to the acquisition of approximately $900,000. The API Notes are payable in four annual installments with the first being a payment of $500,000, the second being a payment of $550,000, the third being a payment of $900,000 and the fourth being a payment of $950,500. The API Notes bear an interest rate of prime plus 1.0% and are secured by all of the intellectual property of Picometrix. API has the option of prepaying the API Notes without penalty. Immediately following the effective time of the transaction, the API Loan was contributed to the capital of Picometrix, LLC. In connection with the transaction, the Company recorded approximately $14 million in intangible assets (including customer list, non-compete agreement, trademarks, R & D contracts, and technology/patents) and will amortize these finite life intangible assets over their various estimated useful lives up to 15 years.

A summary of the Picotronix assets and liabilities acquired at fair value is as follows:

Assets acquired
Cash and cash equivalents		$	678,000
Accounts receivable			1,065,000
Inventories			748,000
Prepaid expenses and other current assets			98,000
Net fixed assets			2,458,000
Customer list			178,000
Non—compete agreement			122,000
Trademarks			2,128,000
R&D contracts			1,294,000
Technology/patents			10,265,000
Deposits and other assets			370,000
Total assets acquired		$	19,404,000
Liabilities assumed
Accounts payable		$	(265,000	)
Capital lease payable			(89,000	)
Other accrued expenses			(874,000	)
Notes payable			(877,000	)
Deferred revenue and deposits			(301,000	)
Total liabilities assumed			(2,406,000	)
Net assets acquired		$	16,998,000

SUMMARY COMBINED COMPANY UNAUDITED PRO FORMA CONDENSED CONSOLIDATED
STATEMENTS OF OPERATIONS

The combined company unaudited pro forma consolidated statements of operations give effect to the purchase of Picometrix as if the transaction had occurred on March 28, 2004. The combined company unaudited pro forma condensed consolidated statements of operations do not purport to represent what the results of operations actually would have been if the purchase had occurred as of such date, or what such results will be for any future periods.

The combined company unaudited pro forma consolidated statements of operations are derived from the historical financial statements of API and Picometrix and the assumptions and adjustments described in the accompanying notes. The pro forma adjustments are based on preliminary estimates and assumptions that API and Picometrix believe are reasonable under the circumstances. The combined company unaudited pro forma financial information should be read in conjunction with the historical financial statements and the accompanying notes thereto of API and Picometrix. The combined company unaudited pro forma consolidated statements of operations do not reflect any cost savings or other economic efficiencies which will result from the purchase.

ADVANCED PHOTONIX, INC. AND SUBSIDIARIES
UNAUDITED PRO FORMA CONDENSED CONSOLIDATED BALANCE SHEET
MARCH 27, 2005

		3/27/2005				3/31/2005
		API				PICO				ADJUSTMENTS				NOTE				PROFORMA
CURRENT ASSETS
Cash and cash equivalents		$	1,503,000			$	1,222,303				($4,291,471	)			3				($1,566,168	)
											2,700,000				6				2,700,000
											1,254,000				8				1,254,000
Restricted cash			1,254,000								(1,254,000	)			8				—
Repurchase of Class A common Stock Options											(509,545	)			9				(509,545	)
Total cash and cash equivalents			2,757,000				1,222,303				(2,101,016	)							1,878,287
Accounts receivable, net			2,610,000				988,506												3,598,506
Note receivable from Picometrix, Inc.			4,228,000								(4,228,000	)			7				—
Inventory			3,644,000				723,233												4,367,233
Deferred tax asset, current portion			644,000																644,000
Prepaid expenses and other current assets			563,000				122,204												685,204
Total Current Assets			14,446,000				3,056,246				(6,329,016	)							11,173,230
Fixed assets, net of depreciation			1,399,000				1,872,799				595,163				2				3,866,962
OTHER ASSETS
Deferred tax assets, net			4,105,000																4,105,000
Goodwill, net			2,421,000																2,421,000
Intangible assets			494,000				467,142				12,486,926				2				13,448,068
Prepaid capital finance expenses, net			315,000																315,000
Security deposits and other assets			175,000				370,226												545,226
Total Other Assets			7,510,000				837,368				12,486,926								20,834,294
TOTAL ASSETS		$	23,355,000			$	5,766,413				$6,753,073							$	35,874,486
CURRENT LIABILITIES
Accounts payable and accrued expenses		$	2,185,000			$	703,584											$	2,888,584
Income taxes payable							16,725												16,725

		3/27/2005				3/31/2005
		API				PICO				ADJUSTMENTS				NOTE				PROFORMA
Deferred revenue																			—
Current portion of long-term debt		$	1,000,000			$	4,349,681			$	(3,328,000	)			6,7			$	2,021,681
Total Current Liabilities			3,185,000				5,069,990				(3,328,000	)							4,926,990
LONG-TERM LIABILITIES
Long-term debt			4,859,000				1,153,291												6,012,291
											2,900,500				4				2,900,500
											1,800,000				6				1,800,000
Capital lease payable			2,000																2,000
Total Long-Term Liabilities			4,861,000				1,153,291				4,700,500								10,714,791
COMMITMENTS AND CONTINGENCIES																			—
Class A redeemable convertible preferred stock			32,000				—												32,000
Total Commitments and Contingencies			32,000				—				—								32,000
TOTAL LIABILITIES		$	8,078,000			$	6,223,281			$	1,372,500							$	15,673,781
SHAREHOLDERS’ EQUITY
Common stock			13,000				22,440				(22,440	)			1				13,000
											2,575				5				2,575
Additional paid-in capital			27,995,000								5,430,675				5				33,425,675
Accumulated deficit			(12,731,000	)			(479,308	)			479,308				1				(12,731,000	)
Option repurchase											(509,545	)							(509,545	)
Total Shareholders’ Equity			15,277,000				(456,868	)			5,380,573								20,200,705
TOTAL LIABILITIES AND SHAREHOLDERS’ EQUITY		$	23,355,000			$	5,766,413			$	6,753,073							$	35,874,486

SEE NOTES TO PRO FORMA CONDENSED CONSOLIDATED FINANCIAL STATEMENTS.

ADVANCED PHOTONIX, INC. AND SUBSIDIARIES
UNAUDITED PRO FORMA CONDENSED CONSOLIDATED STATEMENT OF OPERATIONS
FOR THE YEAR ENDED MARCH 27, 2005

		API				PICOMETRIX
		Historical				Historical				ADJUSTMENTS				NOTE				PROFORMA
REVENUES
Revenues		$	14,803,000			$	7,473,404											$	22,276,404
COST OF SALES			10,071,000				2,311,104				62619				8				12,444,723
GROSS PROFIT (LOSS)			4,732,000				5,162,300				(62,619	)							9,831,681
OPERATING EXPENSES
Research and development expense			146,000				2,574,997				399,376				8				3,120,373
Selling, General and administrative expense			3,920,000				1,703,389				47,550				8				5,670,939
Depreciation											119,033				1				119,033
Amortization			—				—				1,186,017				2				1,186,017
Total Operating Expenses			4,066,000				4,278,386				1,751,976								10,096,362
INCOME (LOSS) FROM OPERATIONS			666,000				883,914				(1,814,595	)							(264,681	)
OTHER (INCOME) EXPENSE
Interest income			(43,000	)			(6,990	)											(49,990	)
Interest expense			154,000				304,784				167,752				3				626,536
											(392,771	)			4				(392,771	)
											62,045				5				62,045
Other, net			35,000				42,040				(1,950,000	)			7				(1,872,960	)
Total Other (Income) Expense			146,000				339,834				(2,112,974	)							(1,627,140	)
NET INCOME (LOSS) BEFORE PROVISION FOR INCOME TAXES			520,000				544,080				298,379								1,362,459
PROVISION FOR INCOME TAXES
Provision for income taxes — current			18,000				5,889								6				23,889
Provision for income taxes — deferred			(4,752,000	)			(349,979	)											(5,101,979	)
Total Provision For Income Taxes			(4,734,000	)			(344,090	)			—								(5,078,090	)
NET INCOME (LOSS)		$	5,254,000			$	888,170			$	298,379							$	6,440,549

Summary of Significant Accounting Policies

Cash and Cash Equivalents: The Company considers all highly liquid investments, with an original maturity of three months or less when purchased, to be cash equivalents.

Concentration of Credit Risk: Financial instruments, which potentially subject the Company to concentrations of credit risk, consist principally of cash equivalents and trade accounts receivable. The Company places its temporary cash investments in certificates of deposit in excess of FDIC insurance limits, principally at a regional bank. At September 25, 2005 substantially all cash and cash equivalents were on deposit at five financial institutions, with these institutions having FDIC or SIPC insurance less than the amounts on deposit.

At September 25, 2005, no single customer accounted for more than 10 % of our total accounts receivable.

At September 25, 2005, no single customer accounted for more than 10 % of Consolidated Revenue.

The Company performs ongoing credit evaluations of its customers and normally does not require collateral to support accounts receivable.

The Company does not apply interest charges to past due accounts receivable.

Shipping and Handling Costs: The Company’s policy is to classify shipping and handling costs as a component of Costs of Goods Sold in the Consolidated Statement of Operations.

Net Income (Loss) Per Share: Net income (loss) per share is calculated in accordance with Statement of Financial Accounting Standards (“SFAS”) No. 128, “Earnings per Share” (“SFAS 128”). Accordingly, basic net income (loss) per share is computed by dividing net income (loss) by the weighted average number of shares outstanding for the period. Such weighted average shares were approximately 16,919,000 at September 25, 2005 and 13,431,000 at September 26, 2004. The pro-forma impact of Statement 128 on the calculation of earnings per share is as follows:

		Six Months Ended				Six Months Ended
		September 25, 2005				September 26, 2004
BASIC
Weighted average shares outstanding			16,919,000				13,431,000
Net income (loss)			(968,000	)			608,000
Basic income per share			($0.06	)			$0.05

		Six Months Ended				Six Months Ended
		September 25, 2005				September 26, 2004
DILUTED
Weighted average shares outstanding			16,919,000				13,431,000
Net effect of dilutive stock options and warrants based on the treasury stock method using average market price			1,283,000				796,000
Net effect of shares issuable pursuant to terms of convertible note, based on the “if converted” method			1,248,000				—
Total shares			19,450,000				14,227,000
Net income (Loss) adjusted for interest expense on convertible note			(823,000	)			608,000
Diluted earnings per share		anti-dilutive					$0.04
Average market price of common stock			$3.19				$2.17
Ending Market price of common stock			$3.11				$1.80

The following stock options granted to Company employees, directors, and former owners were excluded from the calculation of diluted earnings per share in the financial statements because they were anti-dilutive for the periods reported:

Six Months Ended September 25, 2005						Six Months Ended September 26, 2004
No. of Shares		Exercise Price Per				No. of Shares Underlying				Exercise Price Per
Underlying Options		Share				Options				Share
1,000			3.0940				27,700				2.5000
350,000			3.1875				1,000				3.0940
50,000			5.3440				350,000				3.1875
							50,000				5.3440
401,000							428,700

Inventory

Inventories, which include material, labor and manufacturing overhead, are stated at standard cost (which approximates the first-in, first-out method) or market.

Inventories consisted of the following:

		September 25, 2005				March 27, 2005
Raw Material		$	4,081,000			$	3,129,000
Work-in-process			1,212,000				1,245,000
Finished Goods			330,000				302,000
Total inventories			5,623,000				4,676,000
Less inventory reserves			(1,201,000	)			(1,032,000	)
Inventories, net		$	4,422,000			$	3,644,000
Accounts Receivable
Accounts receivable consisted of the following:
		September 25, 2005				March 27, 2005
Trade receivables, net		$	3,193,000			$	2,555,000
Unbilled receivables (represents certain contracts that are not billed until month end)			306,000				55,000
Total		$	3,499,000			$	2,610,000

Application of Critical Accounting Policies

Application of our accounting policies requires management to make judgments and estimates about the amounts reflected in the financial statements. Management uses historical experience and all available information to make these estimates and judgments, although differing amounts could be reported if there are changes in the assumptions and estimates. Estimates are used for, but not limited to, the accounting for the allowance for doubtful accounts, inventory allowances, restructuring costs, impairment costs, depreciation and amortization, Sales discounts and returns, warranty costs, taxes and contingencies. Management has identified the following accounting policies as critical to an understanding of our financial statements and/or as areas most dependent on management’s judgment and estimates.

Revenue Recognition

In accordance with Staff Accounting Bulletin No 104, we recognize revenue from the sale of products when the products are shipped to the customer. Revenues from the sale of services consist of non-recurring engineering charges, which are recognized when the services have been rendered. One of the subsidiaries will accrue for revenues (progress billings) to government agencies for those months when the required billing date falls after the financial closing date. An unbilled receivable is recorded and then reversed when the actual charges are invoiced. Historically, sales returns have amounted to less than 1% of net income and all Revenues are recorded net of returns and discounts.

Impairment of Long-Lived Assets

We continually review the recoverability of the carrying value of long-lived assets using the methodology prescribed in Statement of Financial Accounting Standards (SFAS) 144, “Accounting for the Impairment and Disposal of Long-Lived Assets.” We also review long-lived assets and the related intangible assets for impairment whenever events or changes in circumstances indicate that the carrying value of such assets may not be recoverable. Upon such an occurrence, recoverability of these assets is determined by comparing the forecasted undiscounted net cash flows to which the assets relate, to the carrying amount. If the asset is determined to be unable to recover its carrying value, then intangible assets, if any, are written down first, followed by the other long-lived assets to fair value. Fair value is determined based on discounted cash flows, appraised values or management’s estimates, depending on the nature of the assets.

Deferred Tax Asset Valuation Allowance

We record a deferred tax asset in jurisdictions where we generate a loss for income tax purposes. For all years prior to fiscal 2005, due to our history of operating losses, we had recorded a full valuation allowance against these deferred tax assets in accordance with SFAS 109, “Accounting for Income Taxes,” because, in management’s judgment, the deferred tax assets would not be realized in the foreseeable future. In fiscal years 2004 and 2005, the Company returned to a position of profitability Based on our profit history in FY 2005 and on anticipated future profits resulting from the Company’s acquisition and merger with Picometrix, Inc. in May 2005, we reversed a portion of the valuation allowance for the year ended March 27, 2005, because, in our estimation, we believe that at least 50% of the deferred tax assets will be realized. The ultimate realization of deferred tax assets is dependent upon the generation of future taxable income during the periods in which those temporary differences become deductible, and no assurance can be given that the Company will, in fact, generate future taxable income in amounts sufficient to fully realize the asset. We have considered the scheduled reversal of deferred tax liabilities, projected future taxable income and tax planning strategies in making our assessment. The deferred tax assets are evaluated annually and the valuation allowance may be adjusted again in the future years if it is determined that any additional portion of the assets will or will not be realized.

Inventories

Our inventories are stated at standard cost (which approximates the first-in, first-out method) or market. Slow moving and obsolete inventories are analyzed quarterly. To calculate a reserve for obsolescence, we begin with a review of our slow moving inventory. Any inventory which has not moved within the past 24 months is reserved for at 100% of book value; inventory which has not moved within the past 12 months is reserved for at 40%. The percentages applied to the reserve calculation are based on historical usage analyses. In addition, any residual inventory which is customer specific and remaining on hand at the time of contract completion is reserved for at the standard unit cost. The complete list of slow moving and obsolete inventory is then reviewed by the production, engineering and/or purchasing departments to identify items that can be utilized in the near future. These items are then excluded from the analysis and the remaining amount of slow-moving and obsolete inventory is then reserved for. Additionally, non-cancelable open purchase orders for parts we are obligated to purchase where demand has been reduced may be reserved. Reserves for open purchase orders where the market price is lower than the purchase order price are also established. If a product which had previously been reserved for is subsequently sold, the amount of reserve specific to that item is then reversed.

Accounts Receivable and Allowance for Doubtful Accounts

The Allowance for Doubtful Accounts is established by analyzing each account that has a balance over 90 days past due. Each account is individually assigned a probability of collection. The total amount determined to be uncollectible in the 90-days-past-due category is then reserved fully. The percentage of this reserve to the 90-days-past-due total is then established as a guideline and applied to the rest of the non-current accounts receivable balance where appropriate. When other circumstances suggest that a receivable may not be collectible, it is immediately reserved for, even if the receivable is not yet in the 90-days-past-due category.

Goodwill and Other Intangible Assets

In accordance with SFAS No. 142, “Goodwill and other Intangible Assets” (SFAS 142), goodwill and intangibles with indefinite lives are subject to periodic impairment testing but are not amortized, and intangibles with definite lives are separately classified and are amortized. SFAS 142 requires testing goodwill for impairment on an annual basis and on an interim basis if an event occurs or circumstance change that may reduce the fair value of a reporting unit below its carrying value. We performed our most recent impairment testing at the end of fiscal 2005, and concluded that there was no impairment losses related to goodwill.

Intangible assets that have definite lives consist of the following (in thousands):

		Sept. 25, 2005																March 27, 2005
		Weighted
		Average				Carrying				Accumulated				Intangibles				Carrying				Accumulated				Intangibles
		Lives				Value				Amortization				Net				Value				Amortization				Net
Non-Compete agreement			15			$	347			$	228			$	119			$	150			$	150			$	0
Customer list			15				812				100				712				512				31				481
Trademarks			15				2,128				55				2,073				—				—				—
R&D contracts			15				1,294				34				1,260				—				—				—
Technology			10				10,395				452				9,943				64				51				13
Total Intangibles						$	14,976			$	869			$	14,107			$	726			$	232			$	494

Amortization expense for the six months ended September 25, 2005 was approximately $593,000.
Balances for September 25, 2005 reflect the reclassification of intangibles from current asset accounts to intangible accounts for Non Compete agreement of $75K and Customer list of 122K

At September 25, 2005, estimated future amortization expense is as follows (in thousands):

		Amortization
Fiscal Year		Expense
Balance of 2005		$	702
2006			1,404
2007			1,404
2008			1,378
2009			1,275
2010			1,275
2011 & thereafter			6,669
Total		$	14,107

Stock Based Compensation

The Company has four stock option plans: The 1990 Incentive Stock Option and Non-Qualified Stock Option Plan, the 1991 Directors’ Stock Option Plan (“The Directors’ Plan”), the 1997 Employee Stock Option Plan and the 2000 Stock Option Plan. The company measures compensation for these plans under APB Opinion No. 25. No compensation cost has been recognized as all options were granted at the fair market value or greater than fair market value of the underlying stock at the date of grant. Had compensation expense for these plans been determined consistent with SFAS No. 123, the Company’s net income (loss) and net income (loss) per share would be as follows:

		Three months ended								Six months ended
		Sept. 25, 2005				Sept.26, 2004				Sept. 25, 2005				Sept.26, 2004
Net (loss) earnings as reported			($834,000	)		$	260,000				($968,000	)		$	608,000
Deduct: Stock based employee compensation expense determined under the fair value-based method for all awards, net of related tax effects			(106,000	)			—				(153,000	)
Pro forma net (loss) earnings			($940,000	)		$	260,000				($1,121,000	)		$	608,000
(Loss) earnings per common share
As reported			($0.05	)		$	0.02				($0.06	)			$0.05
Pro forma			($0.06	)		$	0.02				($0.07	)			$0.05
Diluted (loss) earnings per share
As reported			($0.04	)		$	0.02				($0.05	)			$0.04
Pro forma			($0.05	)		$	0.02				($0.06	)			$0.04
Shares — Basic			16,919,000				13,431,000				16,919,000				13,431,000
Shares — Diluted			19,450,000				14,228,600				19,450,000				14,228,600

The fair value of each option grant is estimated on the date of grant using the Black-Scholes option pricing model with the following weighted-average assumptions used for grants in 2005, 2004 and 2003, respectively: risk-free interest rates of, 4%, 5% and 9%, expected volatility of 1% and 5% expected lives of 10 years in all periods. No dividends were assumed in the calculations.

The Company’s various stock option plans provide for the granting of non-qualified and incentive stock options to purchase up to 3,700,000 shares of common stock for periods not to exceed 10 years. Options typically vest at the rate of 25% per year over four years, except for options granted under the Directors’ Plan, which typically vest at the rate of 50% per year over two years. Under these plans, the option exercise price equals the stock’s market price on the date of grant. Options may be granted to employees, officers, directors and consultants. The Company has also granted options, under similar terms as above, under no specific shareholder approved plan.

Stock option transactions for September 25, 2005 and June 26, 2005.

		Shares				Weighted Average
		(000)				Exercise Price
Outstanding, March 27, 2005			2,355			$	1.47
Granted			616			$	2.19
Exercised			(30	)		$	0.80
Expired			—
Outstanding, June 26, 2005			2,941			$	1.63
Exercisable, June 26, 2005			1,897			$	1.49
Outstanding, June 26, 2005			2,941			$	1.63
Granted			215			$	2.36
Exercised			(136	)		$	0.88
Expired			—
Outstanding, September 25, 2005			3,020			$	1.71
Exercisable, September 25, 2005			1,813			$	1.52

Line of Credit/Term Debt

The Company maintains a revolving line of credit with a regional bank which provides for borrowings up to $3,000,000, based on 80% of the Company’s eligible accounts receivable and 40% of the Company’s eligible inventory, subject to certain limitations as defined by the agreement. At September 25, 2005, the outstanding balance on the line was $1,000,000. The line is secured by all business assets of the Company. As most recently amended, repayment is interest only monthly, with principal due at maturity date on November 3, 2006. Interest is computed at the Wall Street Journal Prime plus 1/2% with a floor of 6.5%. The prime interest rate was 6.25% at September 25, 2005

In May 2005, the Company borrowed $2,700,000 from a regional bank. The loan is guaranteed by all of the Company’s subsidiaries. Repayment is principal of $75,000 per month, plus interest, until maturity on May 2, 2008. Interest is computed at the Wall Street Journal Prime plus 1% with a ceiling of 7.75% and a floor of 6%. The prime interest rate was 6.25% at September 25, 2005

In October 2004, the Company entered into a definitive agreement for the private placement to four institutional investors of $5 million aggregate principal amount of its senior convertible notes. The original Securities Purchase Agreement was filed with the Securities and Exchange Commission on October 12, 2004. The notes are convertible at the option of the holder under certain circumstances into shares of the Company’s Class A Common Stock at an initial conversion price of $1.9393 per share. The notes pay interest at an annual rate of prime plus 1% and shall not be less than 6.5% at any time and will mature on October 12, 2007. In addition, the investors in the private placement subordinated their principal and interest payments on the Notes to the “Permitted Bank Debt” (as such term is defined in the letters of agreement) and (ii) their liens on the Company’s assets to any lien granted by the Company as security for the “Permitted Bank Debt”.

In connection with the transaction, the Company issued to the investors five-year warrants to purchase 850,822 shares of the Company’s Class A Common Stock at an exercise price of $1.78 per share, subject to adjustment. The Company has registered the shares of common stock issuable upon conversion of the notes and upon exercise of the warrants for resale under the Securities Act of 1933. The investors have the option for a period of one year following effectiveness of the registration statement (April 6, 2005) to acquire an additional $5 million aggregate principal amount of the notes with an initial conversion price of $2.1156 per share and five-year warrants to purchase an additional 850,822 shares of Company’s Class A Common Stock at $1.78 per share.

In accordance with APB 14, the Company has recorded a discount to the note of $141,000 to account for the fair value associated with the note’s detachable warrants. Upon any exercise of the conversion feature, the notes will then be converted from debt to equity. A copy of the original agreement and all related documents were filed with the Securities and Exchange Commission on October 12, 2004 on Form 8-K, and the foregoing summary is qualified in its entirety by reference thereto.

During Q2 06, $3,496,467 of the senior convertible notes were converted into 1,802,953 shares of the Company’s Class A Common Stock at $1.9393 per share. The investors exercised their option and provided an additional $1,000,000 of senior convertible notes in September, 2005 that can be converted into 472,678 shares at 2.1156 per share and received warrants to purchase 170,164 shares of Class A Common Stock at $1.78 per share (see ‘Subsequent Events’ note). At the end of Q2 06, the outstanding senior convertible notes totaled $2,503,503 that can be converted into 1,247,975 shares of Class A Common Stock and their were outstanding detachable warrants to purchase 850,822 shares of Class A Common Stock at $1.78 per share.

Notes payable to Related Parties