**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**WASHINGTON,D.C.  20549**

 

----

 

**FORM 10-Q**

 

----

 

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

 

**For the quarter ended   December 31,2003**

 

**Commission File Number 000-02324**

 

----

 

**AEROFLEX INCORPORATED**

(Exact name of Registrant asspecified in its Charter)

 

| **DELAWARE**                                                     |   | **11-1974412**                         |
|------------------------------------------------------------------|--------|----------------------------------------|
| (State  or other jurisdiction  of incorporation or organization) |   | (I.R.S.  Employer  Identification No.) |
|                                                             |   |                                   |
| **35 South Service Road  Plainview, N.Y.**                       |   | **11803**                              |
| (Address  of principal executive offices)                        |   | (Zip  Code)                            |

 

**(516) 694-6700**

(Registrant’s telephone number, including area code)

 

----

 

 *Indicate by check mark whether the Registrant (1) has filed allreports required to be filed by Section 13 or 15(d) of the Securities ExchangeAct of 1934 during the preceding 12 months, and (2) has been subject to suchfiling requirements for the past 90 days.

 

Yes   ý          No  o

 

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

 

Yes   ý          No  o

 

  Indicatethe number of shares outstanding of each of the issuer’s classes of commonstock as of the latest practicable date.

 

| **February 17, 2004** |   | **67,095,362 shares (excluding 4,388 shares held in treasury)** |
|-----------------------|--------|-----------------------------------------------------------------|
| (Date)                |   | (Number  of Shares)                                             |

 

**NOTE:  THIS ISPAGE 1 OF A DOCUMENT CONSISTING OF 33 PAGES.**

 

 

----

 

**AEROFLEXINCORPORATED**

**AND SUBSIDIARIES**

 

**INDEX**

 
|           | **PART I:  FINANCIAL  INFORMATION**                                                                                                           |   |
|----------------|----------------------------------------------------------------------------------------------------------------------------------------------------|--------|
|           |                                                                                                                                               |   |
| Item 1 -       | CONSOLIDATED BALANCE SHEETS  December 31, 2003 and June 30, 2003                                                                                   |   |
|           |                                                                                                                                               |   |
|           | CONSOLIDATED STATEMENTS OF OPERATIONS  Six and Three Months Ended December 31, 2003 and 2002                                                       |   |
|           |                                                                                                                                               |   |
|           | CONSOLIDATED STATEMENTS OF CASH FLOWS  Six Months Ended December 31, 2003 and 2002                                                                 |   |
|           |                                                                                                                                               |   |
|           | NOTES  TO CONSOLIDATED FINANCIAL STATEMENTS                                                                                                        |   |
|           |                                                                                                                                               |   |
| Item  2 -      | MANAGEMENT’S  DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS  Six and Three Months Ended December 31, 2003 and 2002 |   |
|           |                                                                                                                                               |   |
| Item  3 -      | QUANTITIVE  AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK                                                                                          |   |
|           |                                                                                                                                               |   |
| Item  4 -      | CONTROLS  AND PROCEDURES                                                                                                                           |   |
|           |                                                                                                                                               |   |
|           | **PART II:  OTHER INFORMATION**                                                                                                               |   |
|           |                                                                                                                                               |   |
| Item 1 -       | LEGAL PROCEEDINGS                                                                                                                                  |   |
|           |                                                                                                                                               |   |
| Item 4 -       | SUBMISSION OF MATTERS TO A VOTE OF  SECURITY HOLDERS                                                                                               |   |
|           |                                                                                                                                               |   |
| Item 6 -       | EXHIBITS AND REPORTS ON FORM 8-K                                                                                                                   |   |
|           |                                                                                                                                               |   |
| SIGNATURES     |                                                                                                                                               |
|           |                                                                                                                                               |
| CERTIFICATIONS |                                                                                                                                               |
|                |                                                                                                                                                    |        |  |

 

2

----

 

**AEROFLEXINCORPORATED**

**AND SUBSIDIARIES**

 

**CONSOLIDATED BALANCE SHEETS**

 

 
|                                                                                    |   | **December 31,  2003** |       | **June 30,  2003** |   |
|-----------------------------------------------------------------------------------------|--------|------------------------|------------|--------------------|--------|
|                                                                                    |   | **(Unaudited)**        |       |               |   |
|                                                                                    |   | **(In  thousands)**    | ** ** |
|                                                                                    |   |                   |       |               |   |
| ASSETS                                                                                  |   |                   |       |               |   |
|                                                                                    |   |                   |       |               |   |
| Current assets:                                                                         |   |                   |       |               |   |
| Cash and cash equivalents                                                               |   | $                      | 9,879      |               | $      | 51,307 |   |
| Accounts receivable, less  allowance for doubtful accounts of $1,231,000 and $1,153,000 |   | 80,655                 |       | 65,243             |   |
| Inventories                                                                             |   | 100,729                |       | 74,738             |   |
| Deferred income taxes                                                                   |   | 19,529                 |       | 14,394             |   |
| Prepaid expenses and other current  assets                                              |   | 9,836                  |       | 5,556              |   |
| Total current assets                                                                    |   | 220,628                |       | 211,238            |   |
|                                                                                    |   |                   |       |               |   |
| Property, plant and equipment, net                                                      |   | 78,118                 |       | 66,724             |   |
| Intangible assets with definite  lives, net                                             |   | 43,772                 |       | 15,111             |   |
| Goodwill                                                                                |   | 91,724                 |       | 22,449             |   |
| Deferred income taxes                                                                   |   | —                 |       | 1,002              |   |
| Other assets                                                                            |   | 12,633                 |       | 14,092             |   |
| Total assets                                                                            |   | $                      | 446,875    |               | $      | 330,616 |   |

 

See notes to consolidated financialstatements.

 

3

----

 

**AEROFLEXINCORPORATED**

**AND SUBSIDIARIES**

 

**CONSOLIDATED BALANCE SHEETS**

**(continued)**

 
|                                                                                                            |   | **December 31,  2003** |       | **June 30,  2003** |   |
|-----------------------------------------------------------------------------------------------------------------|--------|------------------------|------------|--------------------|--------|
|                                                                                                            |   | **(Unaudited)**        |       |               |   |
|                                                                                                            |   | **(In  thousands)**    | ** ** |
|                                                                                                            |   |                   |       |               |   |
| LIABILITIES AND STOCKHOLDERS’  EQUITY                                                                      |   |                   |       |               |   |
|                                                                                                            |   |                   |       |               |   |
| Current liabilities:                                                                                            |   |                   |       |               |   |
| Current portion of long-term debt                                                                               |   | $                      | 4,795      |               | $      | 1,879 |   |
| Accounts payable                                                                                                |   | 23,885                 |       | 19,694             |   |
| Advance payments by customers                                                                                   |   | 10,267                 |       | 2,826              |   |
| Income taxes payable                                                                                            |   | —                 |       | 1,802              |   |
| Liabilities of discontinued  operations                                                                         |   | 794                    |       | 973                |   |
| Accrued payroll expenses                                                                                        |   | 7,471                  |       | 8,052              |   |
| Accrued expenses and other current  liabilities                                                                 |   | 33,919                 |       | 14,456             |   |
| Total current liabilities                                                                                       |   | 81,131                 |       | 49,682             |   |
|                                                                                                            |   |                   |       |               |   |
| Long-term debt                                                                                                  |   | 25,199                 |       | 10,956             |   |
| Deferred income taxes                                                                                           |   | 12,859                 |       | —             |   |
| Other long-term liabilities                                                                                     |   | 14,197                 |       | 11,563             |   |
|                                                                                                            |   |                   |       |               |   |
| Total liabilities                                                                                               |   | 133,386                |       | 72,201             |   |
|                                                                                                            |   |                   |       |               |   |
| Stockholders’ equity:                                                                                      |   |                   |       |               |   |
| Preferred Stock, par value $.10  per share; authorized 1,000,000 shares:                                        |   |                   |       |               |   |
| Series A Junior Participating  Preferred Stock, par value $.10 per share, authorized 110,000; none issued       |   | —                 |       | —             |   |
| Common Stock, par value $.10 per  share; authorized 110,000,000 shares; issued 66,843,000 and 60,122,000 shares |   | 6,684                  |       | 6,012              |   |
| Additional paid-in capital                                                                                      |   | 275,988                |       | 222,943            |   |
| Accumulated other comprehensive  income                                                                         |   | 7,169                  |       | 3,816              |   |
| Retained earnings                                                                                               |   | 23,662                 |       | 25,658             |   |
|                                                                                                            |   | 313,503                |       | 258,429            |   |
|                                                                                                            |   |                   |       |               |   |
| Less: Treasury stock, at cost  (4,000 shares)                                                                   |   | 14                     |       | 14                 |   |
|                                                                                                            |   |                   |       |               |   |
| Total stockholders’ equity                                                                                 |   | 313,489                |       | 258,415            |   |
|                                                                                                            |   |                   |       |               |   |
| Total liabilities and  stockholders’ equity                                                                |   | $                      | 446,875    |               | $      | 330,616 |   |

 

See notes to consolidated financialstatements.

 

4

----

 

**AEROFLEXINCORPORATED**

**AND SUBSIDIARIES**

 

**CONSOLIDATED STATEMENTS OF OPERATIONS**

 

(In thousands, except per sharedata)

 
|                                                          |   | **Six Months Ended  December 31,** |    |
|---------------------------------------------------------------|--------|------------------------------------|---------|
|                                                          |   | **2003**                           |    | **2002** |   |
|                                                          |   |                               |    | **(Note 3)** |   |
|                                                          |   | **(Unaudited)**                    |    |
|                                                          |   |                               |    |   |   |
| Net sales                                                     |   | $                                  | 187,446 |   | $ | 138,197 |   |
| Cost of sales                                                 |   | 105,931                            |    | 86,135 |   |
| Gross profit                                                  |   | 81,515                             |    | 52,062 |   |
| Selling, general and  administrative costs                    |   | 47,991                             |    | 32,463 |   |
| Research and development costs                                |   | 22,353                             |    | 14,994 |   |
| Impairment charge (Note 3)                                    |   | 9,100                              |    | — |   |
| Acquired in-process research and  development (Note 2)        |   | 4,220                              |    | — |   |
|                                                          |   | 83,664                             |    | 47,457 |   |
|  Operating income (loss)                                 |   | (2,149                             | )       | 4,605 |   |
|                                                          |   |                               |    |   |   |
| Other expense (income)                                        |   |                               |    |   |   |
| Interest expense                                              |   | 863                                |    | 713 |   |
| Other expense (income), net                                   |   | 202                                |    | 9 |   |
| Total other expense (income)                                  |   | 1,065                              |    | 722 |   |
| Income (loss) from continuing  operations before income taxes |   | (3,214                             | )       | 3,883 |   |
| Provision (benefit) for income  taxes                         |   | (1,218                             | )       | 1,325 |   |
| Income (loss) from continuing  operations                     |   | (1,996                             | )       | 2,558 |   |
| Discontinued operations                                       |   |                               |    |   |   |
| Loss from discontinued operations                             |   | —                             |    | 396 |   |
| Loss on abandonment of operations                             |   | —                             |    | 1,734 |   |
| Loss from discontinued operations,  net of tax                |   | —                             |    | 2,130 |   |
| Net income (loss)                                             |   | $                                  | (1,996  | ) | $ | 428 |   |
|                                                          |   |                               |    |   |   |
| Income (loss) per common share:                               |   |                               |    |   |   |
| Basic                                                         |   |                               |    |   |   |
| Continuing operations                                         |   | $                                  | (.03    | ) | $ | .04 |   |
| Discontinued operations                                       |   | —                             |    | (.03 | ) |
| Net income (loss)                                             |   | $                                  | (.03    | ) | $ | .01 |   |
|                                                          |   |                               |    |   |   |
| Diluted (1)                                                   |   |                               |    |   |   |
| Continuing operations                                         |   | $                                  | (.03    | ) | $ | .04 |   |
| Discontinued operations                                       |   | —                             |    | (.03 | ) |
| Net income (loss)                                             |   | $                                  | (.03    | ) | $ | .01 |   |
|                                                          |   |                               |    |   |   |
| Weighted average number of common  shares outstanding:        |   |                               |    |   |   |
| Basic                                                         |   | 64,258                             |    | 60,155 |   |
| Diluted (1)                                                   |   | 64,258                             |    | 60,693 |   |

 

----

(1)                                  As aresult of the loss for the six months ended December 31, 2003, all options areanti-dilutive.

 

See notes to consolidated financialstatements.

 

5

----

 

**AEROFLEXINCORPORATED**

**AND SUBSIDIARIES**

 

**CONSOLIDATED STATEMENTS OFOPERATIONS**

 

(In thousands, except per share data)

 
|                                                          |   | **Three Months Ended  December 31,** |       |
|---------------------------------------------------------------|--------|--------------------------------------|------------|
|                                                          |   | **2003**                             |       | **2002** |   |
|                                                          |   | **(Unaudited)**                      | ** ** |
|                                                          |   |                                 |       |   |   |
| Net sales                                                     |   | $                                    | 105,708    |   | $ | 71,764 |   |
| Cost of sales                                                 |   | 58,952                               |       | 44,645 |   |
| Gross profit                                                  |   | 46,756                               |       | 27,119 |   |
| Selling, general and  administrative costs                    |   | 27,326                               |       | 16,937 |   |
| Research and development costs                                |   | 12,142                               |       | 7,351 |   |
| Impairment charge (Note 3)                                    |   | 9,100                                |       | — |   |
| Acquired in-process research and  development costs (Note 2)  |   | 1,100                                |       | — |   |
|                                                          |   | 49,668                               |       | 24,288 |   |
| Operating income (loss)                                       |   | (2,912                               | )          | 2,831 |   |
|                                                          |   |                                 |       |   |   |
| Other expense (income)                                        |   |                                 |       |   |   |
| Interest expense                                              |   | 468                                  |       | 362 |   |
| Other expense (income), net                                   |   | 449                                  |       | (102 | ) |
| Total other expense (income)                                  |   | 917                                  |       | 260 |   |
| Income (loss) from continuing  operations before income taxes |   | (3,829                               | )          | 2,571 |   |
| Provision (benefit) for income  taxes                         |   | (1,438                               | )          | 887 |   |
| Income (loss) from continuing  operations                     |   | (2,391                               | )          | 1,684 |   |
| Discontinued operations                                       |   |                                 |       |   |   |
| Loss from discontinued operations                             |   | —                               |       | 154 |   |
| Loss on abandonment of operations                             |   | —                               |       | 1,734 |   |
| Loss from discontinued operations,  net of tax                |   | —                               |       | 1,888 |   |
| Net income (loss)                                             |   | $                                    | (2,391     | ) | $ | (204 | ) |
|                                                          |   |                                 |       |   |   |
| Income (loss) per common share:                               |   |                                 |       |   |   |
| Basic                                                         |   |                                 |       |   |   |
| Continuing operations                                         |   | $                                    | (.04       | ) | $ | .03 |   |
| Discontinued operations                                       |   | —                               |       | (.03 | ) |
| Net income (loss)                                             |   | $                                    | (.04       | ) | $ | — |   |
|                                                          |   |                                 |       |   |   |
| Diluted (1)                                                   |   |                                 |       |   |   |
| Continuing operations                                         |   | $                                    | (.04       | ) | $ | .03 |   |
| Discontinued operations                                       |   | —                               |       | (.03 | ) |
| Net income (loss)                                             |   | $                                    | (.04       | ) | $ | — |   |
|                                                          |   |                                 |       |   |   |
| Weighted average number of common  shares outstanding:        |   |                                 |       |   |   |
| Basic                                                         |   | 66,556                               |       | 60,185 |   |
| Diluted (1)                                                   |   | 66,556                               |       | 60,764 |   |

 

----

(1)                                  As aresult of the loss for the three months ended December 31, 2003, all optionsare anti-dilutive.

 

See notes to consolidated financialstatements.

 

6

----

** **

**AEROFLEXINCORPORATED**

**AND SUBSIDIARIES**

**CONSOLIDATED STATEMENTSOF CASH FLOWS**

(In thousands)

 
|                                                                                                |   | **Six Months Ended  December 31,** |    |
|-----------------------------------------------------------------------------------------------------|--------|------------------------------------|---------|
|                                                                                                |   | **2003**                           |    | **2002** |   |
|                                                                                                |   | **(Unaudited)**                    |    |
|                                                                                                |   |                               |    |   |   |
| Cash Flows From Operating  Activities:                                                              |   |                               |    |   |   |
| Net income (loss)                                                                                   |   | $                                  | (1,996  | ) | $ | 428 |   |
| Loss from discontinued operations                                                                   |   | —                             |    | 2,130 |   |
| Income (loss) from continuing  operations                                                           |   | (1,996                             | )       | 2,558 |   |
| Adjustments to reconcile net  income (loss) to net cash provided by (used in) operating activities: |   |                               |    |   |   |
| Acquired in-process research and  development                                                       |   | 4,220                              |    | — |   |
| Depreciation and amortization                                                                       |   | 10,862                             |    | 7,536 |   |
| Impairment charge                                                                                   |   | 9,100                              |    | — |   |
| Amortization of deferred gain                                                                       |   | (100                               | )       | (99 | ) |
| Deferred income taxes                                                                               |   | (1,951                             | )       | (25 | ) |
| Other, net                                                                                          |   | 57                                 |    | 38 |   |
| Change in operating assets and  liabilities, net of effects from purchases of businesses:           |   |                               |    |   |   |
| Decrease (increase) in accounts  receivable                                                         |   | 673                                |    | 4,890 |   |
| Decrease (increase) in inventories                                                                  |   | (5,953                             | )       | (1,274 | ) |
| Decrease (increase) in prepaid  expenses and other assets                                           |   | (1,776                             | )       | (3,069 | ) |
| Increase (decrease) in accounts  payable, accrued expenses and other liabilities                    |   | (4,585                             | )       | (7,051 | ) |
|                                                                                                |   |                               |    |   |   |
| Net Cash Provided By (Used In)  Continuing Operations                                               |   | 8,551                              |    | 3,504 |   |
| Net Cash Provided By (Used In) Discontinued  Operations                                             |   | (179                               | )  | 626 |   |
| Net Cash Provided By Operating Activities                                                           |   | 8,372                              |    | 4,130 |   |
| Cash Flows From Investing Activities:                                                               |   |                               |    |   |   |
| Payment for purchase of business,  net of cash acquired                                             |   | (61,541                            | )       | (1,039 | ) |
| Capital expenditures                                                                                |   | (4,600                             | )       | (3,013 | ) |
| Other, net                                                                                          |   | 10                                 |    | 81 |   |
|                                                                                                |   |                               |    |   |   |
| Net Cash Provided By (Used In)  Continuing Operations                                               |   | (66,131                            | )       | (3,971 | ) |
| Net Cash Provided By (Used In)  Discontinued Operations                                             |   | —                             |    | (432 | ) |
| Net Cash Used In Investing Activities                                                               |   | (66,131                            | )       | (4,403 | ) |
| Cash Flows From Financing  Activities:                                                              |   |                               |    |   |   |
| Borrowings under debt agreements                                                                    |   | 26,115                             |    | — |   |
| Debt repayments                                                                                     |   | (11,887                            | )       | (842 | ) |
| Proceeds from the exercise of  stock options                                                        |   | 2,473                              |    | 392 |   |
|                                                                                                |   |                               |    |   |   |
| Net Cash Provided By (Used In)  Financing Activities                                                |   | 16,701                             |    | (450 | ) |
| Effect of Exchange Rate Changes on  Cash and Cash Equivalents                                       |   | (370                               | )       | 202 |   |
|                                                                                                |   |                               |    |   |   |
| Net  Increase (Decrease) In Cash And Cash Equivalents                                               |   | (41,428                            | )       | (521 | ) |
| Cash And Cash Equivalents At  Beginning Of Period                                                   |   | 51,307                             |    | 38,559 |   |
| Cash And Cash Equivalents At End  Of Period                                                         |   | $                                  | 9,879   |   | $ | 38,038 |   |

 

See notes to consolidated financialstatements.

 

7

----

 

**AEROFLEXINCORPORATED**

**AND SUBSIDIARIES**

 

**NOTES TOCONSOLIDATED FINANCIAL STATEMENTS**

(Unaudited)

 

1.       Basis of Presentation

 

The consolidated balance sheet ofAeroflex Incorporated and Subsidiaries (“the Company”) as of December 31, 2003,the related consolidated statements of operations for the six and three monthsended December 31, 2003 and 2002, and the consolidated statements of cash flowsfor the six months ended December 31, 2003 and 2002 have been prepared by theCompany and are unaudited.  In theopinion of management, all adjustments (which include normal recurringadjustments) necessary to present fairly the financial position, results ofoperations and cash flows at December 31, 2003 and for all periods presentedhave been made.  Certain information andfootnote disclosures normally included in financial statements prepared inaccordance with accounting principles generally accepted in the United Statesof America have been omitted.  It issuggested that these consolidated financial statements be read in conjunctionwith the financial statements and notes thereto included in the Company’s June30, 2003 annual report to shareholders. There have been no changes of significant accounting policies since June30, 2003.  Certain reclassifications havebeen made to previously reported financial statements to conform to currentclassifications.

 

Results of operations for the sixand three month periods are not necessarily indicative of results of operationsfor the corresponding years.

 

2.                     Acquisitionof Businesses and Intangible Assets

 

**Acquisition ofRacal Instruments Wireless Solutions Group**

 

On July 31, 2003, the Companyacquired the Racal Instruments Wireless Solutions Group (“RIWS”) for cash of$38 million and a deferred payment of up to $16.5 million in either cash orAeroflex common stock, at the Company’s option, depending on RIWS achievingcertain performance goals for the year ending July 31, 2004.  The Company has not included this contingentconsideration in its initial purchase price allocation as the payment of thisconsideration is not considered to be certain beyond a reasonable doubt.  As a result, the Company will adjustgoodwill for any contingent consideration in the future if and when it is earned.  RIWS develops, manufactures and integratesdigital wireless testing and measurement solutions. The addition of RIWStesting solutions products and technologies is expected to enable the Companyto provide a full spectrum of wireless testing solutions from development toproduction and services primarily for infrastructure testing and mobile handsettesting.

 

8

----

 

The Company evaluated the acquiredtangible and identifiable intangible assets to serve as a basis for allocationof the purchase price.  The Companypreliminarily allocated the purchase price, including acquisition costs ofapproximately $2.5 million, based on the estimated fair value of the assetsacquired and liabilities assumed as follows:

 
|                                             |   | **(In thousands)** |   |
|--------------------------------------------------|--------|--------------------|--------|
|                                             |   |               |   |
| Current assets (excluding cash of $5.9  million) |   | $                  | 15,769 |   |
| Property, plant and equipment                    |   | 8,672              |   |
| Developed technology                             |   | 15,600             |   |
| Customer related intangibles                     |   | 1,700              |   |
| Tradenames                                       |   | 200                |   |
| Goodwill                                         |   | 20,342             |   |
| In-process research and development              |   | 2,700              |   |
| Total  assets acquired                           |   | 64,983             |   |
| Current liabilities                              |   | (25,100            | )      |
| Deferred taxes                                   |   | (5,250             | )      |
| Total  liabilities assumed                       |   | (30,350            | )      |
| Net  assets acquired                             |   | $                  | 34,633 |   |

 

As of December 31, 2003, the Companyis completing its assessment of the fair value of certain assets and liabilitiesas of the date of acquisition which is expected to be finalized upon thereceipt and completion of additional information and analysis during the thirdquarter.

 

The developed technology, tradenamesand customer related intangibles are being amortized on a straight-line basisover a range of 1 to 8 years. Approximately $5.7 million of the goodwill isdeductible for tax purposes.  At theacquisition date, the acquired in-process research and development was notconsidered to have reached technological feasibility and had no alternativefuture uses.  Therefore, in accordancewith accounting principles generally accepted in the United States of America,the value of such has been expensed in the quarter ended September 30, 2003 inoperating costs.  At the acquisitiondate, RIWS was conducting design, development, engineering and testingactivities associated with the completion of new 2.5G and 3G protocol andconformance testers.

 

**Acquisition of MCETechnologies, Inc.**

 

On September 3, 2003, the Company acquiredall of the outstanding stock of MCE Technologies, Inc. (“MCE”) forapproximately 5.8 million shares of Aeroflex common stock with a fair value ofapproximately $43.5 million.  Inaddition, the Company discharged $22.8 million of MCE outstanding bank debt,other indebtedness and preferred stock. Further, the Company issued stockoptions for 315,000 shares of Aeroflex common stock with exercise pricesranging from $2.88 to $9.59 in exchange for outstanding options of MCE.  The fair value of these options wasapproximately $2.4 million utilizing the Black-Scholes option pricing model.MCE designs, manufactures and markets a broad range of microelectronic devices,components and multi-function modules servicing wireless, broadbandinfrastructure, satellite communications and defense markets.  These product offerings complement theexisting product lines of the Company.

 

9

----

 

The Company evaluated the acquiredtangible and identifiable intangible assets to serve as a basis for allocationof the purchase price.  The Companypreliminarily allocated the purchase price, including acquisition costs ofapproximately $2.0 million, based on the estimated fair value of the assetsacquired and liabilities assumed as follows:

 
|                                             |   | **(In thousands)** |   |
|--------------------------------------------------|--------|--------------------|--------|
|                                             |   |               |   |
| Current assets (excluding cash of  $1.8 million) |   | $                  | 18,481 |   |
| Property, plant and equipment                    |   | 9,761              |   |
| Developed technology                             |   | 8,850              |   |
| Tradenames                                       |   | 1,100              |   |
| Customer related intangibles                     |   | 2,520              |   |
| Goodwill                                         |   | 48,026             |   |
| In-process research and  development             |   | 420                |   |
| Other                                            |   | 543                |   |
| Total assets acquired                            |   | 89,701             |   |
| Current liabilities                              |   | (8,272             | )      |
| Long-term debt                                   |   | (2,895             | )      |
| Deferred taxes                                   |   | (7,811             | )      |
| Other long-term liabilities                      |   | (1,835             | )      |
| Total liabilities assumed                        |   | (20,813            | )      |
| Net assets acquired                              |   | $                  | 68,888 |   |

 

As of December 31, 2003, the Companyis completing its assessment of the fair value of certain assets andliabilities as of the date of acquisition which is expected to be finalizedupon the receipt and completion of additional information and analysis duringthe third quarter.

 

The developed technology, customerrelated intangibles, and tradenames are being amortized on a straight-linebasis over a range of 1 to 15 years. The goodwill is not deductible for taxpurposes.  At the acquisition date, theacquired in-process research and development was not considered to have reachedtechnological feasibility and had no alternative future uses.  Therefore, in accordance with accountingprinciples generally accepted in the United States of America, the value ofsuch has been expensed in the quarter ended September 30, 2003 in operatingcosts.  At the acquisition date, MCE wasconducting development activities associated with the completion of certainhigh frequency component technology.

 

**Acquisition of theBusiness of Celerity Systems Inc. (CA)**

 

On October 31, 2003, the Companyacquired the business of Celerity Systems Inc. (CA) (“Celerity”) for $4.0million of cash, 428,000 shares of Aeroflex common stock with a fair marketvalue of approximately $4.2 million and a release of certain liabilitiestotaling $1.8 million.  Celeritydesigns, develops and manufactures modular digital test and measurementsolutions for the communications, satellite, wireless and broadband testmarkets, including broadband signal generators.  Celerity’s technology enhances the Company’s automatic systemscapability.

 

The Company evaluated the acquiredtangible and identifiable intangible assets to serve as a basis for allocationof the purchase price.  The Companypreliminarily allocated the purchase price, including acquisition costs ofapproximately $101,000, based on the estimated fair value of the assetsacquired and liabilities assumed as follows:

 

10

----

 
|                                 |   | **In thousands** |   |
|--------------------------------------|--------|------------------|--------|
|                                 |   |             |   |
| Current assets                       |   | $                | 3,909  |   |
| Property, plant and equipment        |   | 729              |   |
| Developed technology                 |   | 3,400            |   |
| Goodwill                             |   | 2,224            |   |
| In-process research and  development |   | 1,100            |   |
| Other                                |   | 49               |   |
| Total assets acquired                |   | 11,411           |   |
| Current liabilities assumed          |   | (1,296           | )      |
| Net assets acquired                  |   | $                | 10,115 |   |

 

As of December 31, 2003, the Companyis completing its assessment of the fair value of certain assets andliabilities as of the date of acquisition which is expected to be finalizedupon the receipt and completion of additional information and analysis duringthe third quarter.

 

The developed technology is beingamortized on a straight-line basis over 7 years.  The goodwill is fully deductible for tax purposes.  At the acquisition date, the acquired in-processresearch and development was not considered to have reached technologicalfeasibility and had no alternative future uses.  Therefore, in accordance with accounting principles generallyaccepted in the United States of America, the value of such has been expensedin the quarter ended December 31, 2003 in operating costs.  At the acquisition date, Celerity wasconducting development activities associated with the completion of its nextgeneration modular technology.

 

**Pro Forma Resultsof Operations - RIWS, MCE and Celerity**

Summarized below are the unauditedpro forma results of operations of the Company as if RIWS, MCE and Celerity hadbeen acquired at the beginning of the fiscal periods presented.  The $4.2 million write-off of in-processresearch and development has been included in the December 31, 2003 pro formaloss, but not the December 31, 2002 pro forma income in order to providecomparability to the respective historical periods.

 
|                                                |   | **Pro forma  Six Months Ended  December 31,** |       |
|-----------------------------------------------------|--------|-----------------------------------------------|------------|
|                                                |   | **2003**                                      |       | **2002** |   |
|                                                |   | **(In  thousands)**                           | ** ** |
|                                                |   |                                          |       |   |   |
| Net sales                                           |   | $                                             | 200,792    |   | $ | 202,963 |   |
| Income (loss) from continuing  operations           |   | (5,080                                        | )          | 4,269 |   |
| Income (loss) from continuing  operations per share |   |                                          |       |   |   |
| Basic                                               |   | $                                             | (.08       | ) | $ | .06 |   |
| Diluted                                             |   |                                          | *     | .06 |   |

 

----

* As a result of the loss, alloptions are anti-dilutive.

 

The pro forma financial informationpresented above is not necessarily indicative of either the results ofoperations that would have occurred had the acquisitions taken place at thebeginning of the periods presented or of future operating results of thecombined companies.  The operatingresults of RIWS, MCE and Celerity have been included in the consolidatedstatement of operations from their respective acquisition dates.  RIWS and Celerity are included in the TestSolutions segment and MCE is included in the Microelectronic Solutions segment.

 

11

----

** **

**Intangibles withDefinite Lives**

The components of amortizableintangible assets are as follows:

 
|                         |   | **As of December 31, 2003** |   |
|------------------------------|--------|-----------------------------|--------|
|                         |   | **Gross Carrying  Amount**  |   | **Accumulated  Amortization** |   | **Net Book  Value** |   |
|                         |   | **(In thousands)**          |   |
|                         |   |                        |   |   |   |   |   |
| Existing technology          |   | $                           | 50,568 |   | $ | 12,355 |   | $ | 38,213 |   |
| Tradenames                   |   | 2,300                       |   | 633 |   | 1,667 |   |
| Customer related intangibles |   | 4,220                       |   | 328 |   | 3,892 |   |
| Total                        |   | $                           | 57,088 |   | $ | 13,316 |   | $ | 43,772 |   |

 

The aggregate amortization expensefor the amortized intangible assets was $3.5 million and $1.5 million for thesix months ended December 31, 2003 and 2002, respectively.

 

The estimated aggregate amortizationexpense for each of the twelve-month periods ending December 31, is as follows:

 

|   |   | **(In thousands)** |   |
|--------|--------|--------------------|--------|
| 2004   |   | $                  | 8,103  |   |
| 2005   |   | 7,753              |   |
| 2006   |   | 7,005              |   |
| 2007   |   | 6,326              |   |
| 2008   |   | 4,702              |   |
|        |        |                    |        |  |

 

**Goodwill**

The carrying amount of goodwill isas follows:

 
|                              |   | **Balance  as of  July 1,  2003** |   | **Adjustment  (Note a)** |   | **Adjustment  (Note b)** |   | **Balance  as of  December 31,  2003** |   |
|-----------------------------------|--------|-----------------------------------|--------|--------------------------|--------|--------------------------|--------|----------------------------------------|--------|
|                              |   |                              |   | **(In thousands)**       |   |                     |   |
|                              |   |                              |   |                     |   |                     |   |                                   |   |
| Microelectronic solutions segment |   | $                                 | 5,367  |                     | $      | 48,026                   |   | $                                      | (1,317 | ) | $ | 52,076 |   |
| Test solutions segment            |   | 16,293                            |   | 22,566                   |   | —                   |   | 38,859                                 |   |
| Isolator products segment         |   | 789                               |   | —                   |   | —                   |   | 789                                    |   |
| Total                             |   | $                                 | 22,449 |                     | $      | 70,592                   |   | $                                      | (1,317 | ) | $ | 91,724 |   |

 

----

Note a  -                 Thegoodwill recorded during the period is a result of the acquisitions of MCE inthe Microelectronic Solutions segment and of RIWS and Celerity in the TestSolutions segment.

 

Note b  -                 The write-downof goodwill represents an impairment charge related to the Company’s thin filminterconnect manufacturing business (Note 3).

 

12

----

 

3.       Impairment Charge

 

In the quarter ended December 31,2003, the Company recorded a $9.1 million ($5.8 million, net of tax) impairmentcharge to write down the net assets of its thin film interconnect manufacturingoperation to estimated fair value.  Thiswrite-down was prompted by this operation’s continued operating losses.  The fair value of the net assets wasestimated using market values for the business and the building.  The charge resulted in a write-off of $1.3million of goodwill and write-downs of $6.6 million of property, plant andequipment and $1.2 million of intangibles. The total charge was allocable to the Microelectronic Solutions segment.

 

4.       Restructuring Charges

 

In fiscal 2002, the Companyinitiated strategic plans to consolidate three of its manufacturing operationsto take advantage of excess manufacturing capacity in certain of its facilitiesand reduce operating costs. The Company recorded charges to eliminate excessequipment and facility capacity, primarily in its Microelectronic Solutionssegment, for workforce reductions in both the Microelectronic Solutions andTest Solutions segments, and for the impairment of intangibles related to itsmicroelectronic fiber optic acquisition. These consolidations are substantially complete.  In connection with these restructurings, theCompany recorded charges of $5.0 million and $4.1 million during the quartersended March 31, 2002 and June 30, 2002, respectively, or $3.4 million and $2.4million, net of tax, respectively.

 

The following table sets forth thecharges and payments related to the restructuring reserve for the six monthsended December 31, 2003:

 
|                |   | **Balance  July 1,  2003**        |   | **Six Months Ended  December 31, 2003**    |   | **Balance  December 31,  2003** |   |
|---------------------|--------|-----------------------------------|--------|--------------------------------------------|--------|---------------------------------|--------|
|                |   | **Restructuring    Reserve** |   | **Adjustments to  Restructuring  Reserve** |   | **Cash  Payments**              |   | **Restructuring  Reserve** |   |
|                |   |                              |   | **(In thousands)**                         |   |                            |   |
|                |   |                              |   |                                       |   |                            |   |   |   |
| Workforce reduction |   | $                                 | 91     |                                       | $      | —                          |   | $ | (83 | ) | $ | 8 |   |
|                |   |                              |   |                                       |   |                            |   |   |   |
| Lease payments      |   | 101                               |   | —                                     |   | (81                             | )      | 20 |   |
|                |   |                              |   |                                       |   |                            |   |   |   |
| Plant shutdown      |   | 123                               |   | 75                                         |   | —                          |   | 198 |   |
|                |   |                              |   |                                       |   |                            |   |   |   |
|                |   | $                                 | 315    |                                       | $      | 75                              |   | $ | (164 | ) | $ | 226 |   |

 

 

5.       EarningsPer Share

In accordance with SFAS No. 128“Earnings Per Share,” net income per common share (“Basic EPS”) is computed bydividing net income by the weighted average common shares outstanding.  Net income per common share, assumingdilution (“Diluted EPS”) is computed by dividing net income by the weightedaverage common shares outstanding plus potential dilution from the exercise ofstock options. A reconciliation of the numerators and denominators of the BasicEPS and Diluted EPS calculations is as follows:

 
|                                                                                                            |   | **Six Months  Ended December 31,**        |   |
|-----------------------------------------------------------------------------------------------------------------|--------|-------------------------------------------|--------|
|                                                                                                            |   | **2003**                                  |   | **2002** |   |
|                                                                                                            |   | **(In thousands, except per share data)** |   |
|                                                                                                            |   |                                      |   |   |   |
| Income (loss) from continuing  operations                                                                       |   | $                                         | (1,996 | ) | $ | 2,558 |   |
|                                                                                                            |   |                                      |   |   |   |
| Computation of adjusted weighted  average shares outstanding:                                                   |   |                                      |   |   |   |
| Weighted average shares  outstanding                                                                            |   | 64,258                                    |   | 60,155 |   |
| Add: Effect of dilutive options  outstanding (1)                                                                |   | —                                    |   | 538 |   |
| Weighted average shares and common  share equivalents used for computation of diluted earnings per common share |   | 64,258                                    |   | 60,693 |   |
|                                                                                                            |   |                                      |   |   |   |
| Income (loss) from continuing  operations per share:                                                            |   |                                      |   |   |   |
| • Basic                                                                                                    |   | $                                         | (.03   | ) | $ | .04 |   |
| • Diluted  (1)                                                                                             |   | $                                         | (.03   | ) | $ | .04 |   |

 

13

----

 
|                                                                                                            |   | **Three Months  Ended December 31,**      |   |
|-----------------------------------------------------------------------------------------------------------------|--------|-------------------------------------------|--------|
|                                                                                                            |   | **2003**                                  |   | **2002** |   |
|                                                                                                            |   | **(In thousands, except per share data)** |   |
|                                                                                                            |   |                                      |   |   |   |
| Income (loss) from continuing  operations                                                                       |   | $                                         | (2,391 | ) | $ | 1,684 |   |
|                                                                                                            |   |                                      |   |   |   |
| Computation of adjusted weighted  average shares outstanding:                                                   |   |                                      |   |   |   |
| Weighted average shares  outstanding                                                                            |   | 66,556                                    |   | 60,185 |   |
| Add: Effect of dilutive options  outstanding (1)                                                                |   | —                                    |   | 579 |   |
| Weighted average shares and common  share equivalents used for computation of diluted earnings per common share |   | 66,556                                    |   | 60,764 |   |
|                                                                                                            |   |                                      |   |   |   |
| Income (loss) from continuing  operations per share:                                                            |   |                                      |   |   |   |
| • Basic                                                                                                    |   | $                                         | (.04   | ) | $ | .03 |   |
| • Diluted  (1)                                                                                             |   | $                                         | (.04   | ) | $ | .03 |   |

 

----

(1)                 As aresult of the loss for the three and six months ended December 31, 2003, alloptions are anti-dilutive.  Options topurchase 15.5 million shares at exercise prices ranging between $1.67 and$34.41 per share were outstanding as of December 31, 2003.

 

6.       Accountingfor Stock-Based Compensation

 

The Company records compensationexpense for employee and director stock options only if the current marketprice of the underlying stock exceeds the exercise price on the date of thegrant.  The Company has chosen not toimplement the fair value based accounting method for employee and directorstock options, but has elected to disclose the pro forma income and income pershare as if such method had been used to account for stock-based compensation costsas described in SFAS No. 123.

 

The per share weighted average fairvalue of stock options granted during the six months ended December 31, 2003was $6.59 on the date of grant.  Thefair value was determined using the Black Scholes option-pricing model with thefollowing weighted average assumptions: expected dividend yield of 0%, riskfree interest rate of 4.4%, expected volatility of 84%, and an expected life of5.1 years.  The per share weightedaverage fair value of stock options granted during the six months endedDecember 31, 2002 was $5.18 on the date of grant.  The fair value was determined using the Black Scholesoption-pricing model with the following weighted average assumptions: expecteddividend yield of 0%, risk free interest rate of 4.1%, expected volatility of112% and an expected life of 3.0 years. The Company’s net income (loss) and netincome (loss) per share using the pro forma fair value compensation cost methodwould have been:

 

14

----

 
|                                                                                                                          |   | **Six Months Ended  December 31,**        |   | **Three Months Ended  December 31,** |   |
|-------------------------------------------------------------------------------------------------------------------------------|--------|-------------------------------------------|--------|--------------------------------------|--------|
|                                                                                                                          |   | **2003**                                  |   | **2002**                             |   | **2003** |   | **2002** |   |
|                                                                                                                          |   | **(In thousands, except per share data)** |   |
|                                                                                                                          |   |                                      |   |                                 |   |   |   |   |   |
| Income (loss) from continuing  operations                                                                                     |   | $                                         | (1,996 | )                                    | $      | 2,558 |   | $ | (2,391 | ) | $ | 1,684 |   |
|                                                                                                                          |   |                                      |   |                                 |   |   |   |   |   |
| Deduct: Total stock-based employee  compensation expense determined under fair value based method for all grants,  net of tax |   | (5,298                                    | )      | (17,239                              | )      | (2,950 | ) | (8,010 | ) |
|                                                                                                                          |   |                                      |   |                                 |   |   |   |   |   |
| Pro forma income (loss) from  continuing operations                                                                           |   | $                                         | (7,294 | )                                    | $      | (14,681 | ) | $ | (5,341 | ) | $ | (6,326 | ) |
|                                                                                                                          |   |                                      |   |                                 |   |   |   |   |   |
| Earnings (loss) per share:                                                                                                    |   |                                      |   |                                 |   |   |   |   |   |
| Basic - as reported                                                                                                           |   | $                                         | (.03   | )                                    | $      | .04 |   | $ | (.04 | ) | $ | .03 |   |
| Basic - pro forma                                                                                                             |   | $                                         | (.11   | )                                    | $      | (.24 | ) | $ | (.08 | ) | $ | (.11 | ) |
|                                                                                                                          |   |                                      |   |                                 |   |   |   |   |   |
| Diluted - as reported                                                                                                         |   |                                      | *      | $                                    | .04    |   |   | * | $ | .03 |   |
| Diluted - pro forma                                                                                                           |   |                                      | *      |                                 | *      |   | * |   | * |

 

----

* As a result of the loss, all options areanti-dilutive.

 

 

7.       ComprehensiveIncome

The components of comprehensiveincome are as follows:

 
|                                                                 |   | **Six Months Ended  December 31,** |   |
|----------------------------------------------------------------------|--------|------------------------------------|--------|
|                                                                 |   | **2003**                           |   | **2002** |   |
|                                                                 |   | **(In thousands)**                 |   |
|                                                                 |   |                               |   |   |   |
| Net income (loss)                                                    |   | $                                  | (1,996 | ) | $ | 428 |   |
|                                                                 |   |                               |   |   |   |
| Unrealized gain (loss) on interest  rate swap agreements, net of tax |   | 78                                 |   | (104 | ) |
|                                                                 |   |                               |   |   |   |
| Foreign currency translation  adjustment                             |   | 3,275                              |   | 1,685 |   |
|                                                                 |   |                               |   |   |   |
| Total comprehensive income                                           |   | $                                  | 1,357  |   | $ | 2,009 |   |

 

15

----

 
|                                                                 |   | **Three Months Ended  December 31,** |   |
|----------------------------------------------------------------------|--------|--------------------------------------|--------|
|                                                                 |   | **2003**                             |   | **2002** |   |
|                                                                 |   | **(In thousands)**                   |   |
|                                                                 |   |                                 |   |   |   |
| Net income (loss)                                                    |   | $                                    | (2,391 | ) | $ | (204 | ) |
|                                                                 |   |                                 |   |   |   |
| Unrealized gain (loss) on interest  rate swap agreements, net of tax |   | 35                                   |   | 1 |   |
|                                                                 |   |                                 |   |   |   |
| Foreign currency translation  adjustment                             |   | 2,870                                |   | 1,224 |   |
|                                                                 |   |                                 |   |   |   |
| Total comprehensive income                                           |   | $                                    | 514    |   | $ | 1,021 |   |

 

Accumulated other comprehensiveincome (loss) is as follows:

 
|                       |   | **Unrealized  Gain (Loss)  on Interest  Rate Swap  Agreements  (net of tax)** |   | **Minimum  Pension  Liability  Adjustment  (net of tax)** |   | **Foreign  Currency  Translation  Adjustment** |   | **Total  (net of tax)** |   |
|----------------------------|--------|-------------------------------------------------------------------------------|--------|-----------------------------------------------------------|--------|------------------------------------------------|--------|-------------------------|--------|
|                       |   | **(In thousands)**                                                            |   |
|                       |   |                                                                          |   |                                                      |   |                                           |   |                    |   |
| Balance, June 30, 2003     |   | $                                                                             | (268   | )                                                         | $      | (2,445                                         | )      | $                       | 6,529  |   | $ | 3,816 |   |
| Six months activity        |   | 78                                                                            |   | —                                                    |   | 3,275                                          |   | 3,353                   |   |
| Balance, December 31, 2003 |   | $                                                                             | (190   | )                                                         | $      | (2,445                                         | )      | $                       | 9,804  |   | $ | 7,169 |   |

 

8.                     Bank LoanAgreements

On February 14, 2003, the Companyexecuted an amended and restated revolving credit and security agreement withtwo banks which replaced a previous loan agreement. The amended and restatedloan agreement increased the line of credit to $50 million through February2007, continued the mortgage on the Company’s Plainview property for $3.3million and is secured by the pledge of the stock of certain of the Company’ssubsidiaries.  The interest rate onrevolving credit borrowings under this agreement is at various rates dependingupon certain financial ratios, with the current rate substantially equivalentto the LIBOR (1.2% at December 31, 2003) plus 150 basis points.  The Company paid a facility fee of $125,000and is required to pay a commitment fee of .25% per annum of the average unusedportion of the credit line.

 

The mortgage is payable in monthlyinstallments of approximately $26,000 through March 2008 and a balloon paymentof $1.6 million in April 2008.  TheCompany has entered into interest rate swap agreements for the outstandingamount under the mortgage agreement at approximately 7.6% in order to reducethe interest rate risk associated with these borrowings.  The fair market value of the interest rateswap agreements was $287,000 as of December 31, 2003 in favor of the banks.

 

16

----

 

The terms of the loan agreementrequire compliance with certain covenants including minimum consolidatedtangible net worth and pretax earnings, maintenance of certain financialratios, limitations on indebtedness and prohibition of the payment of cashdividends. At December 31, 2003, the Company was not in compliance with twocovenants of the agreement due to the loss for the quarter and six monthscaused by the impairment charge of the Company’s thin film interconnectoperation.  The banks have waived thisnon-compliance.  In connection with thepurchase of certain materials for use in manufacturing, the Company has aletter of credit of $2.0 million.  AtDecember 31, 2003, the Company’s available unused line of credit wasapproximately $29.7 million after consideration of this and other letters ofcredit.

 

9.       Inventories

Inventories consist of thefollowing:

 

|            |   | **December 31,  2003** |    | **June 30,********2003** |   |
|-----------------|--------|------------------------|---------|--------------------------|--------|
|            |   |                   |    |
|            |   | **(In thousands)**     |    |
| Raw materials   |   | $                      | 36,300  |                     | $      | 33,952 |   |
| Work in process |   | 41,376                 |    | 25,675                   |   |
| Finished goods  |   | 23,053                 |    | 15,111                   |   |
|            |   | $                      | 100,729 |                     | $      | 74,738 |   |

 

10.   Product Warranty

The Company warrants its productsagainst defects in design, materials and workmanship, generally for one yearfrom their date of shipment.  Aprovision for estimated future costs relating to these warranties is recordedwhen revenue is recorded and is included in cost of goods sold.

 

Changes in the Company’s productwarranty liability during the six months ended December 31, 2003 were asfollows:

 

|                               |   | **Six Months Ended  December 31,** |   |
|------------------------------------|--------|------------------------------------|--------|
|                               |   | **2003**                           |   | **2002** |   |
|                               |   | **(In thousands)**                 |   |
|                               |   |                               |   |   |   |
| Balance at beginning of period     |   | $                                  | 1,340  |   | $ | 1,500 |   |
| Provision for warranty obligations |   | 648                                |   | 816 |   |
| Charges incurred                   |   | (612                               | )      | (891 | ) |
| Acquired warranty obligations      |   | 197                                |   | — |   |
|                               |   |                               |   |   |   |
| Balance at end of period           |   | $                                  | 1,573  |   | $ | 1,425 |   |

 

11.     Income Taxes

The Company recorded credits of $1.1million and $64,000 to additional paid-in capital during the six months endedDecember 31, 2003 and 2002, respectively, in connection with the tax benefitrelated to compensation deductions on the exercise of stock options.

 

12.     Contingencies

The Company is involved in variousroutine legal matters.  Managementbelieves the outcome of these matters will not have a materially adverse effecton the Company’s consolidated financial statements.

 

13.     Business Segments

The Company’s business segments andmajor products included in each segment, are as follows:

 

17

----

 
|   | **Microelectronic Solutions:**            |   | **Test Solutions:**       |
|--------|-------------------------------------------|--------|---------------------------|
|   | a)Microelectronic  Modules and Components |   | a)Instrument  Products    |
|   | b)Thin  Film Interconnects                |   | b)Motion  Control Systems |
|   | c)Integrated  Circuits                    |   |                      |
|   |                                      |   |                      |
|   | **Isolator Products**                     |   |                      |
|   | a)Commercial  Spring and Rubber Isolators |   |                      |
|   | b)Industrial  Spring and Rubber Isolators |   |                      |
|   | c)Military  Wire-Rope Isolators           |   |                      |

 
|                                                          |   | **For The Six Months Ended  December 31,** |       |
|---------------------------------------------------------------|--------|--------------------------------------------|------------|
|                                                          |   | **2003**                                   |       | **2002** |   |
|                                                          |   | **(In thousands)**                         |       |
| **Business Segment  Data:**                                   |   |                                       | ** ** |   | ** ** |
|                                                          |   |                                       |       |   |   |
| Net sales:                                                    |   |                                       |       |   |   |
| Microelectronic solutions                                     |   | $                                          | 72,828     |   | $ | 49,858 |   |
| Test solutions                                                |   | 106,956                                    |       | 80,682 |   |
| Isolator products                                             |   | 7,662                                      |       | 7,657 |   |
| Net sales                                                     |   | $                                          | 187,446    |   | $ | 138,197 |   |
|                                                          |   |                                       |       |   |   |
| Segment adjusted operating income:                            |   |                                       |       |   |   |
| Microelectronic solutions                                     |   | $                                          | 13,548     |   | $ | 6,253 |   |
| Test solutions                                                |   | 1,807                                      |       | 1,020 |   |
| Isolator products                                             |   | 477                                        |       | 220 |   |
| General corporate expenses                                    |   | (4,661                                     | )          | (2,888 | ) |
|                                                          |   | 11,171                                     |       | 4,605 |   |
| Acquired in-process research and  development (1)             |   | (4,220                                     | )          | — |   |
| Impairment charge (2)                                         |   | (9,100                                     | )          | — |   |
| Interest expense                                              |   | (863                                       | )          | (713 | ) |
| Other income (expense), net                                   |   | (202                                       | )          | (9 | ) |
| Income (loss) from continuing  operations before income taxes |   | $                                          | (3,214     | ) | $ | 3,883 |   |

 
|                                                          |   | **For The Three Months  Ended  December 31,** |    |
|---------------------------------------------------------------|--------|-----------------------------------------------|---------|
|                                                          |   | **2003**                                      |    | **2002** |   |
|                                                          |   | **(In thousands****)**                        |    |
| **Business Segment  Data:**                                   |   |                                          |    |   |   |
|                                                          |   |                                          |    |   |   |
| Net sales:                                                    |   |                                          |    |   |   |
| Microelectronic solutions                                     |   | $                                             | 43,781  |   | $ | 26,096 |   |
| Test solutions                                                |   | 57,897                                        |    | 41,713 |   |
| Isolator products                                             |   | 4,030                                         |    | 3,955 |   |
| Net sales                                                     |   | $                                             | 105,708 |   | $ | 71,764 |   |
|                                                          |   |                                          |    |   |   |
| Segment adjusted operating income:                            |   |                                          |    |   |   |
| Microelectronic solutions                                     |   | $                                             | 8,612   |   | $ | 4,013 |   |
| Test solutions                                                |   | 1,168                                         |    | 659 |   |
| Isolator products                                             |   | 368                                           |    | (40 | ) |
| General corporate expenses                                    |   | (2,860                                        | )       | (1,801 | ) |
|                                                          |   | 7,288                                         |    | 2,831 |   |
| Acquired in-process research and  development (1)             |   | (1,100                                        | )       | — |   |
| Impairment charge (2)                                         |   | (9,100                                        | )       | — |   |
| Interest expense                                              |   | (468                                          | )       | (362 | ) |
| Other income (expense), net                                   |   | (449                                          | )       | 102 |   |
| Income (loss) from continuing  operations before income taxes |   | $                                             | (3,829  | ) | $ | 2,571 |   |

 

Management evaluates theoperating results of the three segments based upon reported operating income,less costs related to impairments, restructurings, and in process research anddevelopment charges.

 

18

----

 

----

(1)                          For thesix months ended December 31, 2003, the charges for the write-off of in-processresearch and development acquired in the purchase of RIWS ($2.7 million) andCelerity ($1.1 million) are allocable to the Test Solutions segment and thecharge for MCE ($420,000) is allocable to the Microelectronic Solutionssegment.  For the three months endedDecember 31, 2003, the charge for Celerity ($1.1 million) is allocable to theTest Solutions segment.

 

(2)                          For thesix and three months ended December 31, 2003, the impairment charge of $9.1million to adjust the net assets of the Company’s thin film interconnectmanufacturing subsidiary to estimated fair value is allocable to theMicroelectronic Solutions segment.

 

Revenues, based on the customers’locations, attributed to the United States and other regions are as follows:

 
|                     |   | **For the Six Months Ended  December 31,** |    |
|--------------------------|--------|--------------------------------------------|---------|
|                     |   | **2003**                                   |    | **2002** |   |
|                     |   | **(In thousands)**                         |    |
|                     |   |                                       |    |   |   |
| United States of America |   | $                                          | 123,470 |   | $ | 89,493 |   |
| Europe and Middle East   |   | 47,951                                     |    | 37,390 |   |
| Asia and Australia       |   | 13,715                                     |    | 9,619 |   |
| Rest of World            |   | 2,310                                      |    | 1,695 |   |
|                     |   | $                                          | 187,446 |   | $ | 138,197 |   |

 

**14.****                      ****Subsequent Events**

 

Discontinued Operation

In February 2004, the Board ofDirectors of the Company approved a plan to divest the Company’s thin filminterconnect manufacturing operation and to seek a strategic buyer.  In the quarter ended December 31, 2003, theCompany recorded a $9.1 million ($5.8 million, net of tax) impairment charge towrite down the net assets of this business to its estimated net fair value.

 

Beginning with the quarter endingMarch 31, 2004, in accordance with SFAS 144, the Company will report theresults of operations of this business as income (loss) from discontinuedoperations and all prior periods will be restated in order to conform to thispresentation.  As a result, the assetsand liabilities of the discontinued operation will be reclassified on thebalance sheet from the historical classifications and presented under thecaptions “assets of discontinued operations” and “liabilities of discontinuedoperations,” respectively.

 

19

----

 

**ITEM 2** - **MANAGEMENT’SDISCUSSION AND ANALYSIS OF FINANCIAL CONDITION****AND RESULTS OF OPERATIONS**

 

We use our advanced design,engineering and manufacturing abilities to produce microelectronic and testingsolutions.  We have built our businessesthrough acquisitions and internal product development.  Our products are used in the aerospace,defense, wireless and satellite communications markets.  We also design and manufacture motioncontrol systems and shock and vibration isolation systems which are used forcommercial, industrial and defense applications.  Our operations are grouped into three segments:

 

•                 AeroflexMicroelectronic Solutions (“AMS”)

•                 AeroflexTest Solutions (“ATS”)

•                 AeroflexIsolator Products (“AIP”)

 

Our consolidated financialstatements include the accounts of Aeroflex Incorporated and all of oursubsidiaries.  All of our subsidiariesare wholly-owned.

 

Our microelectronic solutionssegment has been designing, manufacturing and selling state-of-the-artmicroelectronics for the electronics industry since 1974.  We built this segment’s business primarilythrough various acquisitions, as follows:

 

•                                                  In January1994, we acquired substantially all of the net operating assets of themicroelectronics division of Marconi Circuit Technology Corporation, whichmanufactures a wide variety of microelectronic assemblies.

 

•                                                  InFebruary 1999, we acquired all of the outstanding stock of UTMC MicroelectronicSystems, Inc. (now Aeroflex Colorado Springs, Inc.), consisting of UTMC’sintegrated circuit business.  Thatoperation designs and supplies radiation tolerant integrated circuits fordefense and satellite communications.

 

•                                                  InSeptember 2000, we acquired all of the operating assets of AmpliComm, Inc.(merged into Aeroflex Plainview, Inc.), which designs and develops amplifiersused by aerospace/defense and communications systems manufacturers.

 

•                                                  InSeptember 2003, we acquired MCE Technologies, Inc.  MCE designs, manufactures and markets a broad range of devices,components and subsystems that are used in defense related applications, aswell as throughout mobile and fixed wireless infrastructure equipment andrelated test equipment applications. MCE’s products are also used in wireless broadband access, cable head-endsystems, fiber optic networking, and satellite applications.

 

Ourtest solutions segment consists of two divisions: (1) instruments and (2)motion control products, including the following product lines:

 

•                                                  Comstron,a leader in radio frequency and microwave technology used in the manufacture offast switching frequency signal generators and components, which we acquired inNovember 1989.  Comstron is currently anoperating division of Aeroflex Plainview, Inc., one of our wholly-ownedsubsidiaries.

 

•                                                  Lintek(now Aeroflex Powell, Inc.), a leader in high speed synthetic instrumentationantenna measurement systems, radar systems, transmit/receive module testsystems and satellite test systems, which we acquired in January 1995.

 

20

----

 

•                                                  Europtest,S.A. (France), which we acquired in September 1998.  Europtest develops and sells specialized software-driven testequipment used primarily in cellular, satellite and other communicationsapplications.

 

•                                                  Altair, whichwe merged with in October 2000 in a pooling-of-interest businesscombination.  Altair (merged intoAeroflex Powell, Inc.) designs and develops advanced object-oriented controlsystems software based upon a proprietary software engine.

 

•                                                  RDL, whichwe acquired in October 2000.  RDL(merged into Aeroflex Plainview, Inc.) designs, develops and manufacturesadvanced commercial communications test and measurement products and defensesubsystems.

 

•                                                  IFR, whichwe acquired in May 2002.  IFR (nowAeroflex Wichita, Inc. and Aeroflex International Ltd.) designs andmanufactures advanced test solutions for communications, avionics and generaltest and measurement applications.

 

•                                                  RacalInstrument Wireless Solutions Group, which we acquired in July 2003.  RIWS is a leading developer, manufacturerand integrator of digital wireless testing and measurement solutions.  Its products address two primary wirelessapplications - infrastructure testing and mobile handset testing.

 

•                                                  In October2003, Aeroflex Powell acquired the business of Celerity Systems Inc. (CA), acompany engaged in the development, manufacture and sale of test andmeasurement systems.

 

Our motion control products divisionhas been engaged in the development and manufacture of electro-optical scanningdevices used in infra-red night vision systems since 1975.  Additionally, it is engaged in the design,development and production of stabilization tracking devices and systems andmagnetic motors used in satellites and other high reliability applications.

 

Our isolator products segment hasbeen designing, developing, manufacturing and selling severe service shock andvibration isolation systems since 1961. These devices are primarily used in defense applications.  In October 1983, we acquired Vibration Mountings& Controls, Inc., which manufactures a line of off-the-shelf rubber andspring shock, vibration and structure borne noise control devices used incommercial and industrial applications. In December 1986, we acquired the operating assets of Korfund DynamicsCorporation, a manufacturer of an industrial line of heavy duty spring andrubber shock mounts.

 

In addition, our Aeroflex PearlRiver subsidiary designs, develops, manufactures and markets microelectronicproducts in the form of passive thin film circuits and interconnects.  As a result of continued operating losses,in the quarter ended December 31, 2003, we recorded a $9.1 million ($5.8million, net of tax) impairment charge to write down the net assets of thisbusiness to its estimated fair value. The charge resulted in a writeoff of $1.3 million of goodwill andwrite-downs of $6.6 million of property, plant and equipment and $1.2 millionof intangibles.

 

In February 2004, our Board ofDirectors approved a plan to divest our thin film interconnect manufacturingoperation and to seek a strategic buyer. Beginning with the quarter ending March 31, 2004, in accordance withSFAS 144, we will report the results of operations of this business as income(loss) from discontinued operations and all prior periods will be restated inorder to conform to this presentation.

 

21

----

 

In December 2002, our Board ofDirectors approved a formal plan to discontinue our fiber optic lithium niobatemodulator operation.  The plan calledfor an immediate cessation of operations and disposal of existing assets.  The abandonment of the operation resulted ina charge of $2.6 million ($1.7 million, net of tax) in the quarter ended December31, 2002.  The charge included a cash requirementof $1.4 million, primarily for equipment leases and payroll costs, and anon-cash charge of $1.2 million, primarily for the write-off of ownedequipment.  In accordance with SFAS No.144, the abandonment has been reported as a discontinued operation and,accordingly, losses from operations and the loss on abandonment have beenreported separately from continuing operations.

 

Approximately 34% of our sales forthe six months ended December 31, 2003, 37% of our sales for fiscal 2003 and43% of our sales for fiscal 2002 were to agencies of the United Statesgovernment or to prime defense contractors or subcontractors of the UnitedStates government.

 

As used in this report, “we,” “us”and “our” mean Aeroflex Incorporated and its subsidiaries (unless the contentindicates otherwise).

 

**Six Months EndedDecember 31, 2003 Compared to Six Months Ended December 31, 2002**

 

*Net Sales.*  Net sales increased 36% to $187.4 millionfor the six months ended December 31, 2003 from $138.2 million for the sixmonths ended December 31, 2002.  Netsales in the microelectronic solutions (“AMS”) segment increased 46% to $72.8million for the six months ended December 31, 2003 from $49.9 million for thesix months ended December 31, 2002 due primarily to the acquisition of MCE inSeptember 2003.  Net sales in the testsolutions (“ATS”) segment increased 33% to $107.0 million for the six monthsended December 31, 2003 from $80.7 million for the six months ended December31, 2002 due primarily to the acquisition of RIWS in July 2003 and increasedsales in our communication test products business. Net sales in the isolatorproducts (“AIP”) segment was $7.7 million for the six months ended December 31,2003 and $7.7 million for the six months ended December 31, 2002.

 

*Gross Profit.*  Cost of sales includes materials, directlabor and overhead expenses such as engineering labor, fringe benefits,allocable occupancy costs, depreciation and manufacturing supplies.

 
| **Six Months  Ended  December 31,** |   | **AMS** |   | **% of  sales** |   | **ATS** |   | **% of  sales** |   | **AIP** |   | **% of  sales** |   | **Total** |   | **% of  sales** |   |
|-------------------------------------|--------|---------|--------|-----------------|--------|---------|--------|-----------------|--------|---------|--------|-----------------|--------|-----------|--------|-----------------|--------|
|                                |   |    |   |            |   |    |   |            |   |    |   |            |   |      |   |            |   |
| 2003                                |   | $       | 33,963 |            | 47%    |    | $      | 45,481          |   | 43%     |   | $               | 2,071  |      | 27%    |            | $      | 81,515 |   | 43% |   |
| 2002                                |   | 21,095  |   | 42%             |   | 28,935  |   | 36%             |   | 2,032   |   | 27%             |   | 52,062    |   | 38%             |   |
|                                     |        |         |        |                 |        |         |        |                 |        |         |        |                 |        |           |        |                 |        |  |  |  |  |

 

Gross profit increased $12.9million, or 61%, in the AMS segment primarily as a result of the effect of theacquisition of MCE in September 2003 and increased margins in our integratedcircuits business due to a favorable sales mix which included more high marginstandard products.  Gross profitincreased $16.5 million, or 57%, in the ATS segment primarily as a result ofthe effect of the acquisition of RIWS in July 2003 and increased sales andmargins in our communications test products business.

 

*Selling, Generaland Administrative Costs.* Selling, general and administrative costs include office and managementsalaries, fringe benefits, amortization and commissions.

 
| **Six Months  Ended  December 31,** |   | **AMS** |   | **% of  sales** |   | **ATS**      |   | **% of  sales** |   | **AIP** |   | **% of  sales** |   | **Corporate** |   | **Total** |   | **% of  sales** |   |
|-------------------------------------|--------|---------|--------|-----------------|--------|--------------|--------|-----------------|--------|---------|--------|-----------------|--------|---------------|--------|-----------|--------|-----------------|--------|
|                                |   |    |   |            |   |         |   |            |   |    |   |            |   |          |   |      |   |            |   |
| 2003                                |   | $       | 13,165 |            | 18%    |         | $      | 28,571     |   | 27%     |   | $               | 1,594  |          | 21%    |      | $      | 4,661           |   | $ | 47,991 |   | 26% |   |
| 2002                                |   | 8,072   |   | 16%             |   | 19,690  |   | 24%             |   | 1,813   |   | 24%             |   | 2,888         |   | 32,463    |   | 23%             |   |
|                                     |        |         |        |                 |        |              |        |                 |        |         |        |                 |        |               |        |           |        |                 |        |  |  |  |  |  |

 

22

----

 

Selling, general and administrativecosts increased $5.1 million, or 63%, in the AMS segment due primarily to theaddition of the expenses of MCE. Selling, general and administrative costs increased $8.9 million, or 45%in the ATS segment due primarily to the addition of the expenses of RIWS.  Selling, general and administrative costsdecreased $219,000 in the AIP segment due primarily to lower commissions due toproduct mix.  Corporate selling, generaland administrative expenses increased $1.8 million due primarily to increased compensationexpense, professional fees and insurance expense.

 

*Research andDevelopment Costs.* Research and development costs include material, engineering labor andallocated overhead.

 
| **Six Months  Ended  December 31,** |   | **AMS** |   | **% of  sales** |   | **ATS** |   | **% of  sales** |   | **AIP** |   | **% of  sales** |   | **Total** |   | **% of  sales** |   |
|-------------------------------------|--------|---------|--------|-----------------|--------|---------|--------|-----------------|--------|---------|--------|-----------------|--------|-----------|--------|-----------------|--------|
|                                |   |    |   |            |   |    |   |            |   |    |   |            |   |      |   |            |   |
| 2003                                |   | $       | 7,250  |            | 10%    |    | $      | 15,103          |   | 14%     |   | $               | 0      |      | 0%     |            | $      | 22,353 |   | 12% |   |
| 2002                                |   | 6,769   |   | 14%             |   | 8,225   |   | 10%             |   | 0       |   | 0%              |   | 14,994    |   | 11%             |   |
|                                     |        |         |        |                 |        |         |        |                 |        |         |        |                 |        |           |        |                 |        |  |  |  |  |

 

Self-funded research and developmentcosts increased $481,000, or 7%, in the AMS segment primarily due to theaddition of the expenses of MCE offset, in part, by reduced expenses in ourmicroelectronic modules and semiconductor businesses.  Research and development costs increased $6.9 million, or 84%, inthe ATS segment primarily due to the addition of the expenses of RIWS.

 

*Impairment Charge.*  As a result of continued operating losses,in December 2003, we recorded a $9.1 million impairment charge to write-downthe net asset value of our thin film interconnect manufacturing business toestimated fair value.  Based on this operation’scontinued operating losses and considering our strategic direction of moving tohigher value-added products, we have determined to divest this business.  This charge consists of $6.6 million inproperty, plant and equipment, $1.2 million in intangible assets and $1.3million in goodwill.

 

*AcquiredIn-Process Research and Development.* In connection with the acquisition of Celerity, we allocated $1.1million of the purchase price to incomplete research and developmentprojects.  In connection with theacquisition of RIWS, we allocated $2.7 million of the purchase price toincomplete research and development projects. In connection with the acquisition of MCE, we allocated $420,000 of thepurchase price to incomplete research and development projects.  These allocations represent the estimatedfair value of such incomplete research and development based on future cashflows that have been adjusted by the respective projects’ completionpercentage.  At the respectiveacquisition dates, the development of these projects had not yet reachedtechnological feasibility and the research and development in progress had noalternative future uses.  Accordingly,we expensed these costs as of the respective acquisition dates in accordancewith accounting principles generally accepted in the United States of America.

 

*Other Expense(Income).*  Interest expense was$863,000 for the six months ended December 31, 2003 and $713,000 for the sixmonths ended December 31, 2002.  Otherexpense of $202,000 for the six months ended December 31, 2003 consistsprimarily of $351,000 of foreign currency transaction losses, a $356,000 chargeto adjust the fair value of property held for sale to its fair value partiallyoffset by $182,000 of income on investments, a $143,000 increase in the fairvalue of our interest rate swap agreements and $120,000 of interestincome.  Other expense of $9,000 for thesix months ended December 31, 2002 consisted of foreign currency transactionlosses of $464,000 and a $185,000 decrease in the fair value of our interestrate swap agreements partially offset by $428,000 of interest income.  Interest income decreased primarily due tolower levels of cash and marketable securities, which were used to acquire MCEand RIWS, and lower market interest rates.

 

23

----

 

*Provision forIncome Taxes.* The income tax benefit was $1.2 million(an effective income tax rate of 38%) for the six months ended December 31,2003 and the income tax provision was $1.3 million (an effective income taxrate of 34%) for the six months ended December 31, 2002. The effective incometax rate for the two periods differed from the amount computed by applying theU.S. Federal income tax rate to income before income taxes primarily due to foreign,state and local income taxes and research and development credits and, for thesix months ended December 31, 2003, non-deductible in-process research anddevelopment costs.

 

*Income FromContinuing Operations.* The loss from continuing operations for the six months ended December31, 2003 was $2.0 million or $.03 per share, versus income from continuingoperations of $2.6 million, or $.04 per diluted share, for the six months endedDecember 31, 2002.

 

**Three Months EndedDecember 31, 2003 Compared to Three Months Ended December 31, 2002**

 

*Net Sales.*  Net sales increased 47% to $105.7 millionfor the three months ended December 31, 2003 from $71.8 million for the threemonths ended December 31, 2002.  Netsales in the microelectronic solutions (“AMS”) segment increased 68% to $43.8million for the three months ended December 31, 2003 from $26.1 million for thethree months ended December 31, 2002 due primarily to the acquisition of MCE inSeptember 2003.  Net sales in the testsolutions (“ATS”) segment increased 39% to $57.9 million for the three monthsended December 31, 2003 from $41.7 million for the three months ended December31, 2002 due primarily to the acquisition of RIWS in July 2003 and increasedsales in our communication test products business. Net sales in the isolatorproducts (“AIP”) segment was $4.0 million for the three months ended December31, 2003 and $4.0 million for the three months ended December 31, 2002.

 

*Gross Profit.*

 
| **Three Months  Ended  December 31,** |   | **AMS**      |         | **% of  sales** |   | **ATS** |   | **% of  sales** |   | **AIP** |   | **% of  sales** |   | **Total** |   | **% of  sales** |   |
|---------------------------------------|--------|--------------|--------------|-----------------|--------|---------|--------|-----------------|--------|---------|--------|-----------------|--------|-----------|--------|-----------------|--------|
|                                  |   |         |         |            |   |    |   |            |   |    |   |            |   |      |   |            |   |
| 2003                                  |   | $            | 20,733  |            | 47%    |    | $      | 24,871          |   | 43%     |   | $               | 1,152  |      | 29%    |            | $      | 46,756 |   | 44% |   |
| 2002                                  |   | 11,292  |         | 43%             |   | 14,813  |   | 36%             |   | 1,014   |   | 26%             |   | 27,119    |   | 38%             |   |
|                                       |        |              |              |                 |        |         |        |                 |        |         |        |                 |        |           |        |                 |        |  |  |  |  |

 

Gross profit increased $9.4 million,or 84%, in the AMS segment due primarily to the acquisition of MCE in September2003 and increased margins in the integrated circuits business due to afavorable sales mix which included more high margin standard products.  In the ATS segment, gross profit increased$10.0 million, or 68%, due primarily to the acquisition of RIWS in June 2003and increased sales and margins in our communications test products business.

 

*Selling, Generaland Administrative Costs.*

 
| **Three Months  Ended  December 31,** |   | **AMS** |   | **% of  sales** |   | **ATS**      |   | **% of  sales** |   | **AIP** |   | **% of  sales** |   | **Corporate** |   | **Total** |   | **% of  sales** |   |
|---------------------------------------|--------|---------|--------|-----------------|--------|--------------|--------|-----------------|--------|---------|--------|-----------------|--------|---------------|--------|-----------|--------|-----------------|--------|
|                                  |   |    |   |            |   |         |   |            |   |    |   |            |   |          |   |      |   |            |   |
| 2003                                  |   | $       | 7,966  |            | 18%    |         | $      | 15,716     |   | 27%     |   | $               | 784    |          | 19%    |      | $      | 2,860           |   | $ | 27,326 |   | 26% |   |
| 2002                                  |   | 3,904   |   | 15%             |   | 10,178  |   | 24%             |   | 1,054   |   | 27%             |   | 1,801         |   | 16,937    |   | 24%             |   |
|                                       |        |         |        |                 |        |              |        |                 |        |         |        |                 |        |               |        |           |        |                 |        |  |  |  |  |  |

 

24

----

 

Selling, general and administrativeexpenses in the AMS segment increased $4.1 million, or 104%, due primarily tothe addition of the expenses of MCE. Selling, general and administrative expenses increased by $5.5 million,or 54%, in the ATS segment due primarily to the addition of the expenses atRIWS.  Selling, general andadministrative expenses decreased $270,000 or 26% in the AIP segment dueprimarily to lower commissions due to product mix.  Corporate selling, general and administrative expenses increased$1.1 million, or 59%, due primarily to increased compensation expense,professional fees and insurance expense.

 

*Research andDevelopment Costs.*

 
| **Three Months  Ended  December 31,** |   | **AMS** |   | **% of  sales** |       | **ATS** |   | **% of  sales** |   | **AIP** |   | **% of  sales** |   | **Total** |   | **% of  sales** |   |
|---------------------------------------|--------|---------|--------|-----------------|------------|---------|--------|-----------------|--------|---------|--------|-----------------|--------|-----------|--------|-----------------|--------|
|                                  |   |    |   |            |       |    |   |            |   |    |   |            |   |      |   |            |   |
| 2003                                  |   | $       | 4,155  |            |    9% |    | $      | 7,987           |   | 14%     |   | $               | 0      |      | 0%     |            | $      | 12,142 |   | 11% |   |
| 2002                                  |   | 3,375   |   | 13%             |       | 3,976   |   | 10%             |   | 0       |   | 0%              |   | 7,351     |   | 10%             |   |
|                                       |        |         |        |                 |            |         |        |                 |        |         |        |                 |        |           |        |                 |        |  |  |  |  |

 

Our self-funded research anddevelopment costs increased $780,000, or 23%, in the AMS segment primarily dueto the addition of the expenses of MCE, partially offset by reduced expenses atour microelectronic modules and semiconductor businesses.  Research and development costs increased$4.0 million, or 101%, in the ATS segment due primarily to the addition of theexpenses of RIWS.

 

*Impairment Charge.* As aresult of continued operating losses, in December 2003, we recorded a $9.1million impairment charge to write-down the net asset value of our thin filminterconnect manufacturing business to estimated fair value.  Based on this operation’s continuedoperating losses and considering our strategic direction of moving to highervalue-added products, we have determined to divest this business.  This charge consists of $6.6 million inproperty, plant and equipment, $1.2 million in intangible assets and $1.3million in goodwill.

 

*AcquiredIn-Process Research and Development.* In connection with the acquisition of Celerity, we allocated $1.1million of the purchase price to incomplete research and development projects.

 

*Other Expense(Income).*  Interest expense was$468,000 for the three months ended December 31, 2003 and $362,000 for thethree months ended December 31, 2002. Other expense of $449,000 for the three months ended December 31, 2003consists primarily of $354,000 of foreign currency transaction losses, a$356,000 charge to adjust the fair value of property held for sale to its fairvalue partially offset by $84,000 of income on investments, a $67,000 increasein the fair value of our interest rate swap agreements and $81,000 of interestincome.  Other income of $102,000 forthe three months ended December 31, 2002 consisted of $123,000 of interestincome, $88,000 from the sale of a product line and other miscellaneous incomepartially offset by foreign currency transaction losses of $218,000.  Interest income decreased primarily due tolower levels of cash and marketable securities, which were used to acquire MCEand RIWS, and lower market interest rates.

 

*Provision forIncome Taxes.* The income tax benefit was $1.4 million(an effective income tax rate of 38%) for the three months ended December 31,2003 and the income tax provision was $887,000 (an effective income tax rate of35%) for the three months ended December 31, 2002. The effective income taxrate for the two periods differed from the amount computed by applying the U.S.Federal income tax rate to income before income taxes primarily due to foreign,state and local income taxes and research and development credits and, for thethree months ended December 31, 2003, non-deductible in-process research anddevelopment costs.

 

25

----

 

*Income FromContinuing Operations.* Loss from continuing operations for the three months ended December 31,2003 was $2.4 million or $.04 per share, versus income from continuingoperations of $1.7 million, or $.03 per diluted share, for the three monthsended December 31, 2002.

 

**Off-Balance SheetArrangements**

 

We are not a party to anyoff-balance sheet arrangements.

 

**Liquidity andCapital Resources**

 

As of December 31, 2003, we had$139.5 million in working capital.  Ourcurrent ratio was 2.7 to 1 at December 31, 2003. On February 14, 2003, weexecuted an amended and restated revolving credit and security agreement withtwo banks which replaced a previous loan agreement. The amended and restatedloan agreement increased the line of credit to $50 million through February2007, continued the mortgage on our Plainview property for $3.3 million and issecured by the pledge of the stock of certain of our subsidiaries.  The interest rate on revolving creditborrowings under this agreement is at various rates depending upon certainfinancial ratios, with the current rate substantially equivalent to LIBOR (1.2%at December 31, 2003) plus 150 basis points. The mortgage is payable in monthly installments of approximately $26,000through March 2008 and a balloon payment of $1.6 million in April 2008.  We have entered into interest rate swapagreements for the outstanding amount under the mortgage agreement atapproximately 7.6% in order to reduce the interest rate risk associated withthese borrowings.

 

The terms of the loan agreementrequire compliance with certain covenants including minimum consolidatedtangible net worth and pretax earnings, maintenance of certain financialratios, limitations on indebtedness and prohibition of the payment of cashdividends. In connection with the purchase of certain materials for use inmanufacturing, we have a letter of credit of $2.0 million.

 

We are currently in full compliancewith all of the covenants contained in our loan agreement, as amended to date.At December 31, 2003, we were not in compliance with two covenants of theagreement due to our loss for the quarter and six months caused by theimpairment charge of our thin film interconnect operation.  The banks have waived this non-compliance.We expect to be in compliance with all covenants for the foreseeable future.

 

For the six months ended December31, 2003, our operations provided cash of $8.4 million.  For the six months ended December 31, 2003,our investing activities used cash of $66.1 million, primarily for theacquisitions of MCE, RIWS and Celerity. For the six months ended December 31, 2003, our financing activitiesprovided cash of $16.7 million, primarily from borrowings under our revolvingcredit agreement offset, in part, by debt payments.

 

On July 31, 2003, we acquired RIWSfor cash of $38 million and a deferred payment of up to $16.5 million in eithercash or Aeroflex common stock, at our option, depending on RIWS achievingcertain performance goals for the year ending July 31, 2004.

 

On September 3, 2003, we acquiredMCE for approximately 5.8 million shares of Aeroflex common stock.  In addition, we discharged $22.8 million ofMCE outstanding bank debt, other indebtedness and preferred stock and issuedstock options for 315,000 shares of Aeroflex common stock with exercise pricesranging from $2.88 to $9.59 in exchange for outstanding options of MCE.

 

On October 31, 2003, we acquired thebusiness of Celerity for approximately $4.0 million in cash, 428,000 shares ofAeroflex common stock and release of certain liabilities totaling $1.8 million.

 

26

----

 

We believe that existing cash andcash equivalents coupled with internally generated funds and available lines ofcredit will be sufficient for our working capital requirements, capitalexpenditure needs and the servicing of our debt for the foreseeable future.  Our cash and cash equivalents, coupled withour available lines of credit, are available to fund acquisitions and otherpotential large cash needs that may arise. At December 31, 2003, our available unused line of credit was $29.7million after consideration of letters of credit.

 

The following table summarizes, asof December 31, 2003, our obligations and commitments to make future paymentsunder debt and operating leases:

 
|             |   | **Payments due by period** |   |
|------------------|--------|----------------------------|--------|
|             |   | **Total**                  |   | **Less Than  1 Year** |   | **1-3 Years** |   | **4-5 Years** |   | **After  5 Years** |   |
|             |   | **(In thousands)**         |   |
|             |   |                       |   |   |   |   |   |   |   |   |   |
| Long-term debt   |   | $                          | 29,994 |   | $ | 4,795 |   | $ | 2,602 |   | $ | 17,609 |   | $ | 4,988 |   |
| Operating leases |   | 48,379                     |   | 9,300 |   | 14,211 |   | 8,293 |   | 16,575 |   |
| Total            |   | $                          | 78,373 |   | $ | 14,095 |   | $ | 16,813 |   | $ | 25,902 |   | $ | 21,563 |   |

 

The operating lease commitmentsshown in the above table have not been reduced by future minimum sub-leaserentals of $17.2 million.

 

In the normal course of business, weroutinely enter into binding and non-binding purchase obligations primarilycovering anticipated purchases of inventory and equipment.  None of these obligations are individuallysignificant.  We do not expect thatthese commitments as of December 31, 2003 will materially adversely affect ourliquidity.

 

**Accounting PoliciesInvolving Significant Estimates**

 

The preparation of financialstatements and related disclosures in conformity with accounting principlesgenerally accepted in the United States of America requires us to makeestimates and assumptions that affect the reported amounts of assets andliabilities, the disclosure of contingent assets and liabilities at the date ofthe financial statements and the recognition of revenue and expenses during theperiod reported.  The followingaccounting policies require us to make estimates and assumptions based on thecircumstances, information available and our experience and judgment.  These estimates and assumptions are reviewedperiodically and the effects of revisions are reflected in the period that theyare determined to be necessary.  Ifactual results differ significantly from our estimates, our financialstatements could be materially impacted.

 

Revenue and Cost Recognition UnderLong-Term Contracts

 

We recognize revenue when persuasiveevidence of an arrangement exists, delivery has occurred or services have beenrendered, the selling price is fixed or determinable and collectibility of theresulting receivable is reasonably assured. For arrangements other than certain long-term contracts, revenue(including shipping and handling fees) is recognized when products are shippedand title is passed to the customer. Revenues associated with certain long-term contracts are recognized inaccordance with Statement of Position No. 81-1 “Accounting for Performance ofConstruction-Type and Certain Production-Type Contracts” (“SOP 81-1”).  Under SOP 81-1, we use thepercentage-of-completion method, whereby revenues and associated costs arerecognized as work on a contract progresses. We measure the extent of progress toward completion generally based uponone of the following (based upon an assessment of which method most closelyaligns to the underlying earnings process): (i) the units-of-delivery method,(ii) the cost-to-cost method, using the ratio of contract costs incurred as apercentage of total estimated costs at contract completion (based uponengineering and production estimates), or (iii) the achievement of contractualmilestones.  Provisions for anticipatedlosses or revisions in estimated profits on contracts-in-process are recordedin the period in which such anticipated losses or revisions become evident.

 

27

----

 

 

Inventories

 

Inventories are stated at the lowerof cost (first-in, first-out) or market. Inventory levels are maintained in relation to the expected salesvolume.  We periodically evaluate thenet realizable value of our inventory. Numerous analyses are applied including lower of cost or marketanalysis, forecasted sales requirements and forecasted warrantyrequirements.  After taking these andother factors into consideration, such as technological changes, age andphysical condition, appropriate adjustments are recorded to the inventorybalance.  If actual conditions differfrom our expectations, then inventory balances may be over or under valued,which could have a material effect on our results of operations and financialcondition.

 

Recoverability of Long-Lived andIntangible Assets

 

Property, plant and equipment arestated at cost less accumulated depreciation computed on a straight-line basisover the estimated useful lives of the related assets.  Leasehold improvements are amortized overthe life of the lease or the estimated life of the asset, whichever isshorter.  Changes in circumstances suchas technological advances or changes to our business model can result in theactual useful lives differing from our estimates.  To the extent the estimated useful lives are incorrect, the valueof these assets may be over or under stated, which in turn could have a materialeffect on our results of operations and financial condition.

 

Long-lived assets other thangoodwill, are reviewed for impairment not less than annually and wheneverevents or changes in circumstances indicate that the carrying value of any suchasset may be impaired.  We evaluate therecoverability of such assets by estimating future cash flows.  If the sum of the undiscounted cash flowsexpected to result from the use of the assets and their eventual disposition isless than the carrying amount of the assets, we will recognize an impairmentloss to the extent of the excess of the carrying amount of the assets over thediscounted cash flow.

 

SFAS No. 142 requires that weperform an assessment of whether goodwill is impaired on an annual basis unlessevents or circumstances warrant a more frequent assessment.  The impairment assessment involves, amongother things, an estimation of the fair value of each of our reporting units(as defined in SFAS No. 142).  Such estimationsare inherently subjective, and subject to change in future periods.

 

If the impairment review ofgoodwill, intangible assets and other long-lived assets differ significantlyfrom actual results, it could have a material effect on our results ofoperations and financial condition.

 

Restructuring Charges

 

When circumstances warrant arestructuring charge, we estimate and record all appropriate expenses.  These expenses include severance, retentionbonuses, fringe benefits, asset impairment, buyout of leases and inventorywrite-downs.  To the extent that ourestimates differ from actual expenses, there could be significant additionalexpenses or reversals of previously recorded charges in the future.

 

28

----

 

Income Taxes

 

The carrying value of our netdeferred tax assets assumes that we will be able to generate sufficient futuretaxable income in certain tax jurisdictions. If this assumption changes in the future, we may be required to recordadditional valuation allowances against our deferred tax assets resulting inadditional income tax expense in our consolidated statement of operations.  We evaluate the realizability of thedeferred tax assets and assess the adequacy of the valuation allowancequarterly.

 

**Forward-LookingStatements**

 

All statements other than statementsof historical fact included in this Report on Form 10-Q, including withoutlimitation, statements under “Management’s Discussion and Analysis of FinancialCondition and Results of Operations” regarding our financial position, businessoutlook, business strategy and plans and objectives of our management forfuture operations, are forward-looking statements.  When used in this Report on Form 10-Q, words such as“anticipate,” “believe,” “estimate,” “expect,” “intend” and similar expressions,as they relate to us or our management, identify forward-lookingstatements.  Such forward-lookingstatements are based on the current beliefs of our management, as well asassumptions made by and information currently available to our management.  Actual results could differ materially fromthose contemplated by the forward-looking statements, as a result of certainfactors, including but not limited to, competitive factors and pricingpressures, the divestiture of the thin film interconnect manufacturingbusiness, the integration of the business of each of MCE, RIWS and Celerity,changes in legal and regulatory requirements, technological change ordifficulties, product development risks, commercialization difficulties andgeneral economic conditions.  Suchstatements reflect our current views with respect to the future and are subjectto these and other risks, uncertainties and assumptions relating to ourfinancial condition, results of operations, growth strategy and liquidity.  We undertake no obligation to update suchforward-looking statements which are made as of the date of this Report.

 

**ITEM 3** - **QUANTITIVEAND QUALITATIVE DISCLOSURES ABOUT MARKET RISK**

 

We are exposed to market riskrelated to changes in interest rates and to foreign currency exchangerates.  Some of our debt is at fixedrates of interest or at a variable rate with an interest rate swap agreementwhich effectively converts the variable rate debt into fixed rate debt.Therefore, if market interest rates increase by 10 percent from levels atDecember 31, 2003, the effect on our net income would be a reduction ofapproximately $51,000 per year.  Most ofour invested cash and cash equivalents are at variable rates of interest.  If market interest rates decrease by 10percent from levels at December 31, 2003, the effect on our net income would bea decrease of approximately $7,000 per year. We operate businesses that are located outside of the United States,which exposes us to the fluctuation of foreign currency exchange rates (primarilythe British Pound and the Euro).  Ifforeign currency exchange rates change by 10% from levels at December 31, 2003,the effect on our other comprehensive income would be approximately $7.5million.

 

29

----

 

**ITEM 4** -**CONTROLSAND PROCEDURES**

 

Based on their evaluation as of adate within 90 days of the filing of this Form 10-Q, our management, with theparticipation of our Chief Executive Officer and Chief Financial Officer,conducted an evaluation of the effectiveness of the design and operation of ourdisclosure controls and procedures, as required by Exchange Act Rule13a-15.  Based on that evaluation, theChief Executive Officer and Chief Financial Officer have concluded that ourdisclosure controls and procedures were effective to ensure that informationrequired to be disclosed by us in the reports that we file or submit under theExchange Act is recorded, processed, summarized and reported with the timeperiods specified by the SEC’s rules and forms.

 

**Changes in InternalControls**

 

There were no significant changes inour internal controls over financial reporting that occurred during the quarterended December 31, 2003 that have materially affected, or are reasonably likelyto materially affect, our internal control over financial reporting.

 

**Limitations on theEffectiveness of Controls**

 

We believe that a control system, nomatter how well designed and operated, cannot provide absolute assurance thatthe objectives of the control system are met, and no evaluation of controls canprovide absolute assurance that all control issues and instances of fraud, ifany, within a company have been detected.

 

30

----

 

**AEROFLEXINCORPORATED**

**AND SUBSIDIARIES**

**PART II - OTHER INFORMATION**

 
| Item 1.  |   | Legal  Proceedings                                                                                                                                                                                                                    |   |   |
|----------|--------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|--------|
|     |   |                                                                                                                                                                                                                                  |   |   |
|     |   | We  are involved in various routine legal matters.  We believe the outcome of these matters will not have a  material effect on us.                                                                                              |
|     |   |                                                                                                                                                                                                                                  |   |   |
| Item  2. |   | Changes  in Securities                                                                                                                                                                                                                |   |   |
|     |   |                                                                                                                                                                                                                                  |   |   |
|     |   | None                                                                                                                                                                                                                                  |   |   |
|     |   |                                                                                                                                                                                                                                  |   |   |
| Item  3. |   | Defaults  upon Senior Securities                                                                                                                                                                                                      |   |   |
|     |   |                                                                                                                                                                                                                                  |   |   |
|     |   | None                                                                                                                                                                                                                                  |   |   |
|     |   |                                                                                                                                                                                                                                  |   |   |
| Item 4.  |   | Submission  of Matters to a Vote of Security Holders                                                                                                                                                                                  |
|     |   |                                                                                                                                                                                                                                  |   |   |
|     |   | (a)  The Registrant held its Annual Meeting of Stockholders on November 6, 2003.                                                                                                                                                      |
|     |   |                                                                                                                                                                                                                                  |   |   |
|     |   | (b)  Not applicable.                                                                                                                                                                                                                  |   |   |
|     |   |                                                                                                                                                                                                                                  |   |   |
|     |   | (c)  Four directors were elected at the Annual Meeting to serve until the Annual  Meeting of Stockholders in 2006.  The  names of these directors and votes cast in favor of their election and shares  withheld are as follows: |

 
| **Name**                 |   | **Votes For** |   | **Votes Withheld** |   |
|--------------------------|--------|---------------|--------|--------------------|--------|
|                     |   |          |   |               |   |
| Harvey R. Blau           |   | 56,386,069    |   | 1,688,565          |   |
| Ernest E. Courchene, Jr. |   | 55,449,823    |   | 2,624,811          |   |
| Joseph E. Pompeo         |   | 57,638,817    |   | 435,817            |   |
| Michael Nelson           |   | 57,637,693    |   | 436,941            |   |

 
| Item  5. |   | Other  Information                |
|----------|--------|-----------------------------------|
|     |   |                              |
|     |   | None                              |
|     |   |                              |
| Item 6.  |   | Exhibits  and Reports on Form 8-K |
|     |   |                              |   |   |
|     |   | (a)                               | Exhibits |
|     |   |                              |   |   |
|     |   |                              |   3.1 | Amended  and Restated By-Laws. |
|     |   |                              |   |   |
|     |   |                              | 10.1 | Employment  Agreement dated November 6, 2003 between the Company and Charles Badlato. |
|     |   |                              |   |   |
|     |   |                              | 10.2 | Employment  Agreement dated November 6, 2003 between the Company and Carl Caruso. |
|     |   |                              |   |   |
|     |   |                              | 31.1 | Certification  of Chief Executive Officer pursuant to Section 302 of Sarbanes-Oxley Act of  2002. |
|     |   |                              |   |   |
|     |   |                              | 31.2 | Certification  of Chief Financial Officer pursuant to Section 302 of Sarbanes-Oxley Act of  2002. |
|          |        |                                   |  |  |  |

 

31

----

 
|   |   |   | 31.3                 | Certification  of Chief Operating Officer pursuant to Section 302 of Sarbanes-Oxley Act of  2002.                                                        |
|--------|--------|--------|----------------------|----------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |   |                 |                                                                                                                                                     |
|   |   |   | 32.1                 | Certification  of Chief Executive Officer and of Chief Financial Officer pursuant to Section  906 of Sarbanes-Oxley Act of 2002.                         |
|   |   |   |                 |                                                                                                                                                     |
|   |   | (b)    | Reports  on Form 8-K |
|   |   |   |                 |                                                                                                                                                     |
|   |   |   |                 | Report  on Form 8-K furnished on November 6, 2003 - Items 7 and 9 - release of  financial results for the first fiscal quarter ended September 30, 2003. |
|   |   |   |                 |                                                                                                                                                     |
|   |   |   |                 | Report  on Form 8-K/A filed on November 17, 2003 - Item 7 - financial statements  required in connection with acquisition of MCE Technologies, Inc.      |

 

32

----

 

SIGNATURES

 

Pursuant to the requirements of theSecurities Exchange Act of 1934, the Registrant has duly caused this report tobe signed on its behalf by the undersigned thereunto duly authorized.

 

 
|               | AEROFLEX INCORPORATED |                                                                       |
|--------------------|-----------------------|----------------------------------------------------------------------------|
|               | (REGISTRANT)          |                                                                       |
|               |                  |                                                                       |
| February  17, 2004 | By:                   |                                                                       | /s/Michael  Gorin |   |
|               |                  |           Michael  Gorin |
|               |                  | Vice  Chairman, Chief Financial Officer                                    |
|               |                  |    and  Principal Accounting Officer                        |
|                    |                       |                                                                            |  |  |  |  |

 

33

----