**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**WASHINGTON, D.C.  20549**

 

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**FORM 10-Q**

 

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

 

**For the quarterended  September 30, 2003**

 

**Commission FileNumber 000-02324**

 

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**AEROFLEX INCORPORATED**

(Exactname of Registrant as specified 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*)*     |

 

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*Indicate by check mark whether theRegistrant (1) has filed all reports required to be filed by Section 13 or15(d) of the Securities Exchange Act of 1934 during the preceding 12 months,and (2) has been subject to such filing 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 |
|-----------------------|--------|-----------------|

 

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

 

| **November 12, 2003** |   | **66,478,917  shares  (excluding 4,388 shares held in treasury)** |
|-----------------------|--------|------------------------------------------------------------------------|
| (Date)                |   | (Number  of Shares)                                                    |

 

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

 

 

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**AEROFLEX INCORPORATED**

**AND SUBSIDIARIES**

 

**INDEX**

 
|           | **PART I:  FINANCIAL  INFORMATION** |                                                                                                                                        |
|----------------|------------------------------------------|---------------------------------------------------------------------------------------------------------------------------------------------|
|           |                                     |                                                                                                                                        |   |
| Item  1        | -                                        | CONSOLIDATED BALANCE SHEETS  September 30, 2003 and June 30, 2003                                                                           |   |
|           |                                     |                                                                                                                                        |   |
|           |                                     | CONSOLIDATED  STATEMENTS OF OPERATIONS  Three Months Ended September 30, 2003 and 2002                                                      |   |
|           |                                     |                                                                                                                                        |   |
|           |                                     | CONSOLIDATED  STATEMENTS OF CASH FLOWS  Three Months Ended September 30, 2003 and 2002                                                      |   |
|           |                                     |                                                                                                                                        |   |
|           |                                     | NOTES TO  CONSOLIDATED FINANCIAL STATEMENTS                                                                                                 |   |
|           |                                     |                                                                                                                                        |   |
| Item  2        | -                                        | MANAGEMENT’S  DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS  Three Months Ended September 30, 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 6         | -                                        | EXHIBITS AND  REPORTS ON FORM 8-K                                                                                                           |   |
|           |                                     |                                                                                                                                        |   |
| SIGNATURES     |                                     |
|           |                                     |
| CERTIFICATIONS |                                     |

 

2

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**AEROFLEX INCORPORATED**

**AND SUBSIDIARIES**

 

**CONSOLIDATED BALANCE SHEETS**

 
|                                                                                    |   | **September 30,  2003** |    | **June 30,  2003** |   |
|-----------------------------------------------------------------------------------------|--------|-------------------------|---------|--------------------|--------|
|                                                                                    |   | **(Unaudited)**         |    |               |   |
|                                                                                    |   | **(In thousands)**      |    |
|                                                                                    |   |                    |    |               |   |
| ASSETS                                                                                  |   |                    |    |               |   |
|                                                                                    |   |                    |    |               |   |
| Current assets:                                                                         |   |                    |    |               |   |
| Cash and cash equivalents                                                               |   | $                       | 10,927  |               | $      | 51,307 |   |
| Accounts receivable, less  allowance for doubtful accounts of $1,157,000 and $1,153,000 |   | 74,518                  |    | 65,243             |   |
| Inventories                                                                             |   | 94,159                  |    | 74,738             |   |
| Deferred income taxes                                                                   |   | 16,147                  |    | 14,394             |   |
| Prepaid expenses and other current  assets                                              |   | 9,883                   |    | 5,556              |   |
| Total current assets                                                                    |   | 205,634                 |    | 211,238            |   |
|                                                                                    |   |                    |    |               |   |
| Property, plant and equipment, net                                                      |   | 84,038                  |    | 66,724             |   |
| Intangible assets with definite  lives, net                                             |   | 43,644                  |    | 15,111             |   |
| Goodwill                                                                                |   | 88,589                  |    | 22,449             |   |
| Deferred income taxes                                                                   |   | —                  |    | 1,002              |   |
| Other assets                                                                            |   | 14,816                  |    | 14,092             |   |
| Total assets                                                                            |   | $                       | 436,721 |               | $      | 330,616 |   |

 

See notes to consolidated financialstatements.

 

3

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**AEROFLEX INCORPORATED**

**AND SUBSIDIARIES**

 

**CONSOLIDATED BALANCESHEETS**

**(continued)**

 
|                                                                                                            |   | **September  30,  2003** |    | **June 30,  2003** |   |
|-----------------------------------------------------------------------------------------------------------------|--------|--------------------------|---------|--------------------|--------|
|                                                                                                            |   | **(Unaudited)**          |    |               |   |
|                                                                                                            |   | **(In thousands)**       |    |
|                                                                                                            |   |                     |    |               |   |
| LIABILITIES AND STOCKHOLDERS’  EQUITY                                                                      |   |                     |    |               |   |
|                                                                                                            |   |                     |    |               |   |
| Current liabilities:                                                                                            |   |                     |    |               |   |
| Current portion of long-term debt                                                                               |   | $                        | 2,084   |               | $      | 1,879 |   |
| Accounts payable                                                                                                |   | 22,526                   |    | 19,694             |   |
| Advance payments by customers                                                                                   |   | 7,931                    |    | 2,826              |   |
| Income taxes payable                                                                                            |   | 1,235                    |    | 1,802              |   |
| Liabilities of discontinued  operations                                                                         |   | 887                      |    | 973                |   |
| Accrued expenses and other current  liabilities                                                                 |   | 41,069                   |    | 22,508             |   |
| Total current liabilities                                                                                       |   | 75,732                   |    | 49,682             |   |
|                                                                                                            |   |                     |    |               |   |
| Long-term debt                                                                                                  |   | 30,875                   |    | 10,956             |   |
| Deferred income taxes                                                                                           |   | 12,020                   |    | —             |   |
| Other long-term liabilities                                                                                     |   | 12,639                   |    | 11,563             |   |
|                                                                                                            |   |                     |    |               |   |
| Total liabilities                                                                                               |   | 131,266                  |    | 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 65,981,000 and 60,122,000 shares |   | 6,598                    |    | 6,012              |   |
| Additional paid-in capital                                                                                      |   | 268,555                  |    | 222,943            |   |
| Accumulated other comprehensive  income                                                                         |   | 4,264                    |    | 3,816              |   |
| Retained earnings                                                                                               |   | 26,052                   |    | 25,658             |   |
|                                                                                                            |   | 305,469                  |    | 258,429            |   |
|                                                                                                            |   |                     |    |               |   |
| Less: Treasury stock, at cost  (4,000 shares)                                                                   |   | 14                       |    | 14                 |   |
|                                                                                                            |   |                     |    |               |   |
| Total stockholders’ equity                                                                                 |   | 305,455                  |    | 258,415            |   |
|                                                                                                            |   |                     |    |               |   |
| Total liabilities and  stockholders’ equity                                                                |   | $                        | 436,721 |               | $      | 330,616 |   |

 

See notes to consolidated financialstatements.

 

4

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**AEROFLEXINCORPORATED**

**AND SUBSIDIARIES**

 

**CONSOLIDATED STATEMENTS OFOPERATIONS**

 

(In thousands, except per share data)

 
|                                                   |   | **Three Months Ended  September 30,** |   |
|--------------------------------------------------------|--------|---------------------------------------|--------|
|                                                   |   | **2003**                              |   | **2002** |   |
|                                                   |   | **(Unaudited)**                       |   |
|                                                   |   |                                  |   |   |   |
| Net sales                                              |   | $                                     | 81,737 |   | $ | 66,434 |   |
| Cost of sales                                          |   | 46,979                                |   | 41,491 |   |
| Gross profit                                           |   | 34,758                                |   | 24,943 |   |
|                                                   |   |                                  |   |   |   |
| Selling, general and  administrative costs             |   | 19,232                                |   | 14,767 |   |
| Research and development costs                         |   | 10,211                                |   | 7,643 |   |
| Amortization of acquired  intangibles                  |   | 1,433                                 |   | 759 |   |
| Acquired in-process research and  development costs    |   | 3,120                                 |   | — |   |
|                                                   |   | 33,996                                |   | 23,169 |   |
| Operating income                                       |   | 762                                   |   | 1,774 |   |
|                                                   |   |                                  |   |   |   |
| Other expense (income)                                 |   |                                  |   |   |   |
| Interest expense                                       |   | 393                                   |   | 351 |   |
| Other expense (income)                                 |   | (245                                  | )      | 112 |   |
| Total other expense (income)                           |   | 148                                   |   | 463 |   |
| Income from continuing operations  before income taxes |   | 614                                   |   | 1,311 |   |
| Provision for income taxes                             |   | 220                                   |   | 437 |   |
|                                                   |   |                                  |   |   |   |
| Income from continuing operations                      |   | 394                                   |   | 874 |   |
| Loss from discontinued operations,  net of tax         |   | —                                |   | (242 | ) |
| Net income                                             |   | $                                     | 394    |   | $ | 632 |   |
|                                                   |   |                                  |   |   |   |
| Income per common share:                               |   |                                  |   |   |   |
| Basic                                                  |   |                                  |   |   |   |
| Continuing operations                                  |   | $                                     | .01    |   | $ | .01 |   |
| Discontinued operations                                |   | —                                |   | — |   |
| Net income                                             |   | $                                     | .01    |   | $ | .01 |   |
|                                                   |   |                                  |   |   |   |
| Diluted                                                |   |                                  |   |   |   |
| Continuing operations                                  |   | $                                     | .01    |   | $ | .01 |   |
| Discontinued operations                                |   | —                                |   | — |   |
| Net income                                             |   | $                                     | .01    |   | $ | .01 |   |
|                                                   |   |                                  |   |   |   |
| Weighted average number of common  shares outstanding: |   |                                  |   |   |   |
| Basic                                                  |   | 61,959                                |   | 60,125 |   |
| Diluted                                                |   | 63,197                                |   | 60,622 |   |

 

See notes to consolidated financialstatements.

 

5

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**AEROFLEXINCORPORATED**

**AND SUBSIDIARIES**

**CONSOLIDATED STATEMENTS OFCASH FLOWS**

 

(In thousands)

 
|                                                                                         |   | **Three Months Ended  September 30,** |   |
|----------------------------------------------------------------------------------------------|--------|---------------------------------------|--------|
|                                                                                         |   | **2003**                              |   | **2002** |   |
|                                                                                         |   | **(Unaudited)**                       |   |
|                                                                                         |   |                                  |   |   |   |
| Cash Flows From Operating  Activities:                                                       |   |                                  |   |   |   |
| Net income                                                                                   |   | $                                     | 394    |   | $ | 632 |   |
| Adjustments to reconcile net  income to net cash provided by (used in) operating activities: |   |                                  |   |   |   |
| Loss from discontinued operations                                                            |   | —                                |   | 242 |   |
| Acquired in-process research and  development                                                |   | 3,120                                 |   | — |   |
| Depreciation and amortization                                                                |   | 4,792                                 |   | 3,873 |   |
| Amortization of deferred gain                                                                |   | (51                                   | )      | (101 | ) |
| Deferred income taxes                                                                        |   | 431                                   |   | 796 |   |
| Other, net                                                                                   |   | 1                                     |   | 11 |   |
| Change in operating assets and  liabilities, net of effects from purchases of businesses:    |   |                                  |   |   |   |
| Decrease (increase) in accounts  receivable                                                  |   | 2,804                                 |   | 9,092 |   |
| Decrease (increase) in inventories                                                           |   | (2,915                                | )      | (1,353 | ) |
| Decrease (increase) in prepaid  expenses and other assets                                    |   | (583                                  | )      | (1,398 | ) |
| Increase (decrease) in accounts  payable, accrued expenses and other liabilities             |   | (6,351                                | )      | (6,088 | ) |
|                                                                                         |   |                                  |   |   |   |
| **Net Cash Provided  By (Used In) Operating Activities**                                     |   | 1,642                                 |   | 5,706 |   |
|                                                                                         |   |                                  |   |   |   |
| Cash Flows From Investing  Activities:                                                       |   |                                  |   |   |   |
| Payment for purchase of business,  net of cash acquired                                      |   | (57,448                               | )      | — |   |
| Capital expenditures                                                                         |   | (1,976                                | )      | (1,641 | ) |
| Cash flow provided by (used in)  discontinued operations                                     |   | —                                |   | (221 | ) |
|                                                                                         |   |                                  |   |   |   |
| **Net Cash Provided  By (Used In) Investing Activities**                                     |   | (59,424                               | )      | (1,862 | ) |
|                                                                                         |   |                                  |   |   |   |
| Cash Flows From Financing  Activities:                                                       |   |                                  |   |   |   |
| Borrowings under debt agreements                                                             |   | 19,115                                |   | — |   |
| Debt repayments                                                                              |   | (1,940                                | )      | (577 | ) |
| Proceeds from the exercise of  stock options                                                 |   | 186                                   |   | 131 |   |
|                                                                                         |   |                                  |   |   |   |
| **Net Cash Provided  By (Used****In) Financing Activities**                                  |   | 17,361                                |   | (446 | ) |
| **Effect of  Exchange Rate Changes on Cash and Cash Equivalents**                            |   | 41                                    |   | 33 |   |
|                                                                                         |   |                                  |   |   |   |
| Net Increase (Decrease) In Cash  And Cash Equivalents                                        |   | (40,380                               | )      | 3,431 |   |
| Cash And Cash Equivalents At  Beginning Of Period                                            |   | 51,307                                |   | 38,559 |   |
| Cash And Cash Equivalents At End  Of Period                                                  |   | $                                     | 10,927 |   | $ | 41,990 |   |

 

See notes to consolidated financialstatements.

 

6

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**AEROFLEXINCORPORATED**

**AND SUBSIDIARIES**

 

**NOTES TO CONSOLIDATEDFINANCIAL STATEMENTS**

(Unaudited)

 

1.       Basis ofPresentation

 

The consolidated balance sheet of AeroflexIncorporated and Subsidiaries (“the Company”) as of September 30, 2003, therelated consolidated statements of operations for the three months endedSeptember 30, 2003 and 2002, and the consolidated statements of cash flows forthe three months ended September 30, 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 September 30, 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, except as disclosed in Note 2. Certain reclassifications have been made to previously reportedfinancial statements to conform to current classifications.

 

Results of operations for the three monthperiod are not necessarily indicative of results of operations for thecorresponding years.

 

2.                     RecentAccounting Pronouncements

 

In November 2002, the FASB issuedInterpretation No. 45, “Guarantor’s Accounting and Disclosure Requirements forGuarantees, Including Indirect Guarantees of Indebtedness of Others” (“FIN45”).  FIN 45 requires certainguarantees to be recorded at fair value regardless of the probability of theloss.  FIN 45 has been adoptedprospectively by the Company as of January 1, 2003.  The adoption resulted in additional disclosure in theconsolidated financial statements (see Note 10).

 

In November 2002, the Emerging Issues TaskForce (“EITF”) finalized EITF Issue 00-21, “Revenue Arrangements with MultipleDeliverables”, which provides guidance on the timing and method of revenuerecognition for sales arrangements that include the delivery of more than oneproduct or service.  EITF Issue 00-21 iseffective prospectively for arrangements entered into in fiscal periods beginningafter June 15, 2003.  Such adoption didnot have any impact on the Company’s consolidated financial statements.

 

In December 2002, the FASB issued SFAS No.148, “Accounting for Stock-Based Compensation - Transition andDisclosure.”  SFAS No. 148 providesalternative methods of transition for a voluntary change to the fair valuemethod of accounting for stock-based employee compensation as originallyprovided by SFAS No. 123 “Accounting for Stock-Based Compensation.”  Additionally, SFAS No. 148 amends thedisclosure requirements of SFAS No. 123 in both annual and interim financialstatements.  The Company has adopted thedisclosure portion of this statement for the fiscal year ended June 30,2003.  The adoption did not have anyimpact on the Company’s consolidated financial statements.

 

7

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In April 2003, the FASB issued SFAS No.149, “Amendment of Statement 133 on Derivative Instruments and HedgingActivities,” which amends and clarifies accounting for derivative instruments,including certain derivative instruments embedded in other contracts, and forhedging activities under SFAS No. 133. The statement is effective (with certain exceptions) for contractsentered into or modified after June 30, 2003. The adoption did not have any impact on the Company’s consolidatedfinancial statements.

 

In May 2003, the FASB issued SFAS No. 150, *“*Accounting for Certain FinancialInstruments with Characteristics of both Liabilities and Equity*.”* The statement establishes standards for how an issuer classifies andmeasures certain financial instruments with characteristics of both liabilitiesand equity.  It requires that an issuerclassify a financial instrument that is within its scope as a liability (or anasset in some circumstances).  It iseffective for financial instruments entered into or modified after May 31,2003, and otherwise is effective at the beginning of the first interim periodbeginning after June 15, 2003.  Theadoption of this statement did not have any impact on the Company’sconsolidated financial statements.

 

In July 2003, the EITF reached a consensuson Issue 03-5, “Applicability of AICPA Statement of Position 97-2 (“SOP 97-2”)to Non-Software Deliverables” (“EITF 03-5”). The consensus was reached that SOP 97-2 is applicable to non-softwaredeliverables if they are included in an arrangement that contains software thatis essential to the non-software deliverables’ functionality.  This consensus is to be applied to fiscalperiods beginning after August 13, 2003. The Company is currently analyzing the impact of this consensus on itsconsolidated financial statements.

 

3.       Acquisition of Businesses andIntangible Assets

 

**Acquisition of RacalInstruments Wireless Solutions Group**

 

On July 31, 2003, the Company acquired theRacal Instruments Wireless Solutions Group (“RIWS”) for cash of $38 million anda deferred payment of up to $16.5 million in either cash or Aeroflex commonstock, at the Company’s option, depending on RIWS achieving certain performancegoals for the year ending July 31, 2004. The Company has not included this contingent consideration in itsinitial purchase price allocation as the payment of this consideration is notconsidered to be certain beyond a reasonable doubt.  As a result, the Company will adjust goodwill for any contingentconsideration in the future if and when it is earned.  RIWS develops, manufactures and integrates digital wirelesstesting and measurement solutions. The addition of RIWS testing solutionsproducts and technologies is expected to enable the Company to provide a fullspectrum of wireless testing solutions from development to production andservices primarily for infrastructure testing and mobile handset testing.

 

The Company evaluated the acquired tangibleand identifiable intangible assets to serve as a basis for allocation of thepurchase price.  The Companypreliminarily allocated the purchase price, including acquisition costs ofapproximately $2.4 million, based on the estimated fair value of the assets acquiredand liabilities assumed as follows:

 

8

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|                                             |   | **(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                                         |   | 18,102             |   |
| In-process research and  development             |   | 2,700              |   |
| Total assets acquired                            |   | 62,743             |   |
| Current liabilities                              |   | (22,995            | )      |
| Deferred taxes                                   |   | (5,250             | )      |
| Total liabilities assumed                        |   | (28,245            | )      |
| Net assets acquired                              |   | $                  | 34,498 |   |

 

As of September 30, 2003, the Company is completing its assessment ofthe fair value of certain assets and liabilities as of the date of acquisitionwhich is expected to be finalized upon the receipt and completion of additionalinformation and analysis during the second quarter.

 

The developed technology, tradenames andcustomer related intangibles are being amortized on a straight-line basis overa 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.

 

Summarized below are the unaudited proforma results of operations of the Company as if RIWS had been acquired at thebeginning of the fiscal periods presented. The $2.7 million write-off has been included in the September 30, 2003pro forma loss, but not the September 30, 2002 pro forma income in order toprovide comparability to the respective historical periods.

 
|                                                |   | **Pro forma  Three Months Ended  September 30,** |   |
|-----------------------------------------------------|--------|--------------------------------------------------|--------|
|                                                |   | **2003**                                         |   | **2002** |   |
|                                                |   | **(In thousands)**                               |   |
|                                                |   |                                             |   |   |   |
| Net sales                                           |   | $                                                | 83,689 |   | $ | 80,054 |   |
| Income (loss) from continuing  operations           |   | (2,322                                           | )      | 1,638 |   |
| Income (loss) from continuing  operations per share |   |                                             |   |   |   |
| Basic                                               |   | $                                                | (0.04  | ) | $ | .03 |   |
| Diluted                                             |   |                                             | *      | .03 |   |

 

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

 

The pro forma financial informationpresented above is not necessarily indicative of either the results ofoperations that would have occurred had the acquisition taken place at thebeginning of the periods presented or of future operating results of thecombined companies.  The operatingresults of RIWS have been included in the consolidated statement of operationsfrom the acquisition date and are included in the Test Solutions segment.

 

9

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**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 ourexisting product lines.

 

The Company evaluated the acquired tangibleand identifiable intangible assets to serve as a basis for allocation of thepurchase 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  $1,803) |   | $                  | 18,481 |   |
| Property, plant and equipment              |   | 9,761              |   |
| Developed technology                       |   | 8,850              |   |
| Tradenames                                 |   | 1,100              |   |
| Customer related intangibles               |   | 2,520              |   |
| Goodwill                                   |   | 48,038             |   |
| In-process research and  development       |   | 420                |   |
| Other                                      |   | 543                |   |
| Total assets acquired                      |   | 89,713             |   |
| 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                        |   | $                  | 68,900 |   |

 

As of September 30, 2003, the Company is completing its assessment ofthe fair value of certain assets and liabilities as of the date of acquisitionwhich is expected to be finalized upon the receipt and completion of additionalinformation and analysis during the second quarter.

 

The developed technology, customer relatedintangibles, and tradenames are being amortized on a straight-line basis over arange of 1 to 15 years. The goodwill is not deductible for tax purposes.  At the acquisition date, the acquiredin-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.

 

Summarized below are the unaudited proforma results of operations of the Company as if MCE had been acquired at thebeginning of the fiscal periods presented. The $420,000 write-off has been included in the September 30, 2003 proforma income, but not the September 30, 2002 pro forma income in order toprovide comparability to the respective historical periods.

 

10

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|                                         |   | **Pro forma  Three Months Ended  September 30,** |   |
|----------------------------------------------|--------|--------------------------------------------------|--------|
|                                         |   | **2003**                                         |   | **2002** |   |
|                                         |   | **(In thousands)**                               |   |
|                                         |   |                                             |   |   |   |
| Net sales                                    |   | $                                                | 91,352 |   | $ | 81,863 |   |
| Income from continuing operations            |   | 267                                              |   | 911 |   |
| Income from continuing operations  per share |   |                                             |   |   |   |
| Basic                                        |   | $                                                | — |   | $ | 0.01 |   |
| Diluted                                      |   | —                                           |   | 0.01 |   |

 

The pro forma financial informationpresented above is not necessarily indicative of either the results ofoperations that would have occurred had the acquisition taken place at thebeginning of the periods presented or of future operating results of thecombined companies.  The operatingresults of MCE have been included in the consolidated statement of operationsfrom the acquisition date and are included in the Microelectronic Solutionssegment.

 

**Intangibles with DefiniteLives**

The components of amortizable intangibleassets are as follows:

 
|                         |   | **As of September 30, 2003** |   |
|------------------------------|--------|------------------------------|--------|
|                         |   | **Gross Carrying  Amount**   |   | **Accumulated  Amortization** |   | **Net Book  Value** |   |
|                         |   | **(In thousands)**           |   |
|                         |   |                         |   |   |   |   |   |
| Existing technology          |   | $                            | 48,351 |   | $ | 10,610 |   | $ | 37,741 |   |
| Tradenames                   |   | 2,300                        |   | 500 |   | 1,800 |   |
| Customer related intangibles |   | 4,220                        |   | 117 |   | 4,103 |   |
| Total                        |   | $                            | 54,871 |   | $ | 11,227 |   | $ | 43,644 |   |

 

The aggregate amortization expense for theamortized intangible assets was $1.4 million and $759,000 for the three monthsended September 30, 2003 and 2002, respectively.

 

The estimated aggregate amortizationexpense for each of the twelve-month periods ending September 30, is as follows:

 

|   |   | **(In thousands)** |   |
|--------|--------|--------------------|--------|
| 2004   |   | $                  | 7,778  |   |
| 2005   |   | 7,252              |   |
| 2006   |   | 7,122              |   |
| 2007   |   | 6,285              |   |
| 2008   |   | 5,199              |   |
|        |        |                    |        |  |

 

11

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**Goodwill**

The carrying amount of goodwill is asfollows:

 
|                              |   | **Balance  as of  July 1,  2003** |   | **Adjustment  (Note a)** |   | **Balance  as of  September 30,  2003** |   |
|-----------------------------------|--------|-----------------------------------|--------|--------------------------|--------|-----------------------------------------|--------|
|                              |   | **(In thousands)**                |   |
|                              |   |                              |   |                     |   |                                    |   |
| Microelectronic solutions segment |   | $                                 | 5,367  |                     | $      | 48,038                                  |   | $ | 53,405 |   |
| Test solutions segment            |   | 16,293                            |   | 18,102                   |   | 34,395                                  |   |
| Isolator products segment         |   | 789                               |   | —                   |   | 789                                     |   |
| Total                             |   | $                                 | 22,449 |                     | $      | 66,140                                  |   | $ | 88,589 |   |

 

Note a -     The goodwill recorded during the period is a result of theacquisitions of RIWS and MCE.

 

4.       Restructuring Charges

 

In fiscal 2002, the Company initiatedstrategic plans to consolidate three of its manufacturing operations to takeadvantage of excess manufacturing capacity in certain of its facilities andreduce operating costs. The Company recorded charges to eliminate excessequipment and facility capacity, primarily in its microelectronics segment, forworkforce reductions in both the microelectronic and test solutions segments,and for the impairment of intangibles related to its microelectronic fiberoptic acquisition.  These consolidationsare substantially complete.  Inconnection with these restructurings, the Company recorded charges of $5.0million and $4.1 million during the quarters ended March 31, 2002 and June 30,2002, respectively, or $3.4 million and $2.4 million, net of tax, respectively.

 

The following table sets forth the chargesand payments related to the restructuring reserve for the three months endedSeptember 30, 2003:

 
|                |   | **Balance  July 1,  2003** |   | **Three Months Ended  September 30, 2003** |   | **Balance  September 30,  2003** |   |
|---------------------|--------|----------------------------|--------|--------------------------------------------|--------|----------------------------------|--------|
|                |   | **Restructuring  Reserve** |   | **Adjustments to  Restructuring  Reserve** |   | **Cash  Payments**               |   | **Restructuring  Reserve** |   |
|                |   | **(In thousands)**         |   |
|                |   |                       |   |                                       |   |                             |   |   |   |
| Workforce reduction |   | $                          | 91     |                                       | $      | —                           |   | $ | (54 | ) | $ | 37 |   |
|                |   |                       |   |                                       |   |                             |   |   |   |
| Lease payments      |   | 101                        |   | —                                     |   | (66                              | )      | 35 |   |
|                |   |                       |   |                                       |   |                             |   |   |   |
| Plant shutdown      |   | 123                        |   | —                                     |   | —                           |   | 123 |   |
|                |   |                       |   |                                       |   |                             |   |   |   |
|                |   | $                          | 315    |                                       | $      | —                           |   | $ | (120 | ) | $ | 195 |   |

 

12

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5.       Earnings Per Share

In accordance with SFAS No. 128 “EarningsPer Share,” net income per common share (“Basic EPS”) is computed by dividingnet 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:

 
|                                                                                                            |   | **Three Months  Ended September 30,**     |   |
|-----------------------------------------------------------------------------------------------------------------|--------|-------------------------------------------|--------|
|                                                                                                            |   | **2003**                                  |   | **2002** |   |
|                                                                                                            |   | **(In thousands, except per share data)** |   |
|                                                                                                            |   |                                      |   |   |   |
| Income from continuing operations                                                                               |   | $                                         | 394    |   | $ | 874 |   |
|                                                                                                            |   |                                      |   |   |   |
| Computation of adjusted weighted  average shares outstanding:                                                   |   |                                      |   |   |   |
| Weighted average shares  outstanding                                                                            |   | 61,959                                    |   | 60,125 |   |
| Add: Effect of dilutive options  outstanding                                                                    |   | 1,238                                     |   | 497 |   |
| Weighted average shares and common  share equivalents used for computation of diluted earnings per common share |   | 63,197                                    |   | 60,622 |   |
|                                                                                                            |   |                                      |   |   |   |
| Income from continuing operations  per share:                                                                   |   |                                      |   |   |   |
| • Basic                                                                                                    |   | $                                         | .01    |   | $ | .01 |   |
| • Diluted                                                                                                  |   | $                                         | .01    |   | $ | .01 |   |

 

Options to purchase 8.6 million shares atexercise prices ranging between $9.05 and $34.41 per share were outstanding asof September 30, 2003 but were not included in the computation of diluted EPSbecause the exercise prices of these options were greater than the averagemarket price of the common shares.

 

6.       Accounting for Stock-BasedCompensation

 

The Company records compensation expensefor employee and director stock options only if the current market price of theunderlying stock exceeds the exercise price on the date of the grant.  The Company has chosen not to implement thefair value based accounting method for employee and director stock options, buthas elected to disclose the pro forma income and income per share as if suchmethod had been used to account for stock-based compensation costs as describedin SFAS No. 123.

 

The per share weighted average fair valueof stock options granted during the quarter ended September 30, 2003 was $6.11on the date of grant.  The fair valuewas determined using the Black Scholes option-pricing model with the followingweighted average assumptions: expected dividend yield of 0%, risk free interestrate of 4.4%, expected volatility of 108%, and an expected life of 3.6years.  No options were granted duringthe quarter ended September 30, 2002. The Company’s net income (loss) and net income (loss) per share usingthe pro forma fair value compensation cost method would have been:

 

13

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|                                                                                                                          |   | **Three Months Ended  September 30,** |   |
|-------------------------------------------------------------------------------------------------------------------------------|--------|---------------------------------------|--------|
|                                                                                                                          |   | **2003**                              |   | **2002** |   |
|                                                                                                                          |   | **(In thousands)**                    |   |
|                                                                                                                          |   |                                  |   |   |   |
| Income from continuing operations                                                                                             |   | $                                     | 394    |   | $ | 874 |   |
|                                                                                                                          |   |                                  |   |   |   |
| Deduct: Total stock-based employee  compensation expense determined under fair value based method for all grants,  net of tax |   | (2,348                                | )      | (9,229 | ) |
|                                                                                                                          |   |                                  |   |   |   |
| Pro forma income from continuing  operations                                                                                  |   | $                                     | (1,954 | ) | $ | (8,355 | ) |
|                                                                                                                          |   |                                  |   |   |   |
| Earnings per share:                                                                                                           |   |                                  |   |   |   |
| Basic - as reported                                                                                                           |   | $                                     | 0.01   |   | $ | 0.01 |   |
| Basic - pro forma                                                                                                             |   | $                                     | (0.03  | ) | $ | (0.14 | ) |
|                                                                                                                          |   |                                  |   |   |   |
| Diluted - as reported                                                                                                         |   | $                                     | 0.01   |   | $ | 0.01 |   |
| Diluted - pro forma                                                                                                           |   |                                  | *      |   | * |

 

----

* As aresult of the loss, all options are anti-dilutive.

 

7.       Comprehensive Income

The components of comprehensive income areas follows:

 
|                                                                 |   | **Three Months Ended  September 30,** |   |
|----------------------------------------------------------------------|--------|---------------------------------------|--------|
|                                                                 |   | **2003**                              |   | **2002** |   |
|                                                                 |   | **(In thousands)**                    |   |
|                                                                 |   |                                  |   |   |   |
| Net income                                                           |   | $                                     | 394    |   | $ | 632 |   |
|                                                                 |   |                                  |   |   |   |
| Unrealized gain (loss) on interest  rate swap agreements, net of tax |   | 43                                    |   | (105 | ) |
|                                                                 |   |                                  |   |   |   |
| Foreign currency translation  adjustment                             |   | 405                                   |   | 461 |   |
| Total comprehensive income                                           |   | $                                     | 842    |   | $ | 988 |   |

 

8.       Bank Loan Agreements

On February 14, 2003, the Company executedan amended and restated revolving credit and security agreement with two bankswhich replaced a previous loan agreement. The amended and restated loanagreement increased the line of credit to $50 million through February 2007,continues the mortgage on the Company’s Plainview property for $3.3 million andis 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 prime rate (4.0% at September 30, 2003).  The Company paid a facility fee of $125,000 and is required topay a commitment fee of .25% per annum of the average unused portion of thecredit line.

 

14

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The mortgage is payable in monthly installmentsof approximately $26,000 through March 2008 and a balloon payment of $1.6million in April 2008.  The Company hasentered into interest rate swap agreements for the outstanding amount under themortgage agreement at approximately 7.6% in order to reduce the interest raterisk associated with these borrowings. The fair market value of the interest rate swap agreements was $340,000as of September 30, 2003 in favor of the banks.

 

The terms of the loan agreement requirecompliance with certain covenants including minimum consolidated tangible networth and pretax earnings, maintenance of certain financial ratios, limitationson indebtedness and prohibition of the payment of cash dividends. In connectionwith the purchase of certain materials for use in manufacturing, the Companyhas a letter of credit of $2.0 million. At September 30, 2003, the Company’s available unused line of credit wasapproximately $28.1 million after consideration of this and other letters ofcredit.

 

9.       Inventories

Inventories consist of the following:

 
|            |   | **September  30,****2003** |   | **June 30,****2003** |   |
|-----------------|--------|----------------------------|--------|----------------------|--------|
|            |   | **(In thousands)**         |   |
| Raw materials   |   | $                          | 37,594 |                 | $      | 33,952 |   |
| Work in process |   | 35,910                     |   | 25,675               |   |
| Finished goods  |   | 20,655                     |   | 15,111               |   |
|            |   | $                          | 94,159 |                 | $      | 74,738 |   |

 

10.     Product Warranty

The Company warrants its products againstdefects in design, materials and workmanship, generally for one year from theirdate of shipment.  A provision forestimated future costs relating to these warranties is recorded when revenue isrecorded and is included in cost of goods sold.

 

Changes in the Company’s product warrantyliability during the three months ended September 30, 2003 were as follows:

 
|                               |   | **Three Months Ended  September 30,** |   |
|------------------------------------|--------|---------------------------------------|--------|
|                               |   | **2003**                              |   | **2002** |   |
|                               |   | **(In thousands)**                    |   |
|                               |   |                                  |   |   |   |
| Balance at beginning of period     |   | $                                     | 1,340  |   | $ | 1,654 |   |
| Provision for warranty obligations |   | 330                                   |   | 405 |   |
| Charges incurred                   |   | (257                                  | )      | (495 | ) |
| Acquired warranty obligations      |   | 156                                   |   | — |   |
|                               |   |                                  |   |   |   |
| Balance at end of period           |   | $                                     | 1,569  |   | $ | 1,564 |   |

 

11.     Income Taxes

The Company recorded credits of $61,000 and$8,000 to additional paid-in capital during the three months ended September30, 2003 and 2002, respectively, in connection with the tax benefit related tocompensation deductions on the exercise of stock options.

 

12.     Contingencies

The Company is involved in various routinelegal matters.  Management believes theoutcome of these matters will not have a materially adverse effect on theCompany’s consolidated financial statements.

 

15

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13.     Business Segments

The Company’s business segments and majorproducts included in each segment, are as follows:

 

**MicroelectronicSolutions:**

a)Microelectronic Modules andComponents

b)Thin Film Interconnects

c)Integrated Circuits

 

**Test Solutions:**

a)Instrument Products

b)Motion Control Systems

 

**Isolator Products**

a)Commercial Spring and RubberIsolators

b)Industrial Spring and RubberIsolators

c)Military Wire-Rope Isolators

 
|                                                   |   | **For The Three Months Ended  September 30,** |   |
|--------------------------------------------------------|--------|-----------------------------------------------|--------|
|                                                   |   | **2003**                                      |   | **2002** |   |
|                                                   |   | **(In thousands)**                            |   |
| **Business Segment  Data:**                            |   |                                          |   |   |   |
|                                                   |   |                                          |   |   |   |
| Net sales:                                             |   |                                          |   |   |   |
| Microelectronic solutions                              |   | $                                             | 29,047 |   | $ | 23,762 |   |
| Test solutions                                         |   | 49,059                                        |   | 38,969 |   |
| Isolator products                                      |   | 3,631                                         |   | 3,703 |   |
| Net sales                                              |   | $                                             | 81,737 |   | $ | 66,434 |   |
|                                                   |   |                                          |   |   |   |
| Segment operating income:                              |   |                                          |   |   |   |
| Microelectronic solutions                              |   | $                                             | 4,935  |   | $ | 2,240 |   |
| Test solutions                                         |   | 639                                           |   | 361 |   |
| Isolator products                                      |   | 108                                           |   | 260 |   |
| General corporate expenses                             |   | (1,800                                        | )      | (1,087 | ) |
|                                                   |   | 3,882                                         |   | 1,774 |   |
| Acquired in-process research and  development(1)       |   | (3,120                                        | )      | — |   |
| Interest expense                                       |   | (393                                          | )      | (351 | ) |
| Other income (expense), net                            |   | 245                                           |   | (112 | ) |
| Income from continuing operations  before income taxes |   | $                                             | 614    |   | $ | 1,311 |   |

 

----

(1)                For thethree months ended September 30, 2003, the charges for the write-off ofin-process research and development acquired in the purchase of RIWS ($2.7million) and MCE ($420,000) are allocable to the Test Solutions andMicroelectronic Solutions segments, respectively.

 

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

 
|                     |   | **For the Three Months Ended  September 30,** |   |
|--------------------------|--------|-----------------------------------------------|--------|
|                     |   | **2003**                                      |   | **2002** |   |
|                     |   | **(In thousands)**                            |   |
|                     |   |                                          |   |   |   |
| United States of America |   | $                                             | 53,271 |   | $ | 44,254 |   |
| Europe and Middle East   |   | 20,927                                        |   | 16,655 |   |
| Asia and Australia       |   | 6,463                                         |   | 4,724 |   |
| Rest of World            |   | 1,076                                         |   | 801 |   |
|                     |   | $                                             | 81,737 |   | $ | 66,434 |   |

 

16

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**14.    Subsequent Events**

 

Acquisition of Celerity SystemsIncorporated

On October 31, 2003, the Company acquiredthe business of Celerity Systems Inc. (CA) (“Celerity”) from L-3 CommunicationsCorp. for approximately $10.1 million, consisting of cash, Aeroflex commonshares and a release of certain liabilities. Celerity designs, develops and manufactures modular digital test andmeasurement solutions for the communications, satellite,wireless and broadbandtest markets, including broadband signal generators.  On a pro forma basis, had the Celerity acquisition taken place asof the beginning of the periods presented, results of operations for thoseperiods would not have been materially affected.

 

17

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**ITEM 2** - **MANAGEMENT’S DISCUSSION 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:

 

•                                          microelectronicsolutions

•                                          testsolutions

•                                          isolatorproducts

 

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:

 

•                                          InJanuary 1994, we acquired substantially all of the net operating assets of themicroelectronics division of Marconi Circuit Technology Corporation, which manufacturesa wide variety of microelectronic assemblies.

 

•                                          InMarch 1996, we acquired MIC Technology Corporation (now Aeroflex Pearl River,Inc.) which designs, develops, manufactures and markets microelectronicproducts in the form of passive thin film circuits and interconnects.  Effective July 1, 1997, Aeroflex PearlRiver, Inc. acquired certain equipment, inventory, licenses for technology andpatents of two of Lucent Technologies’ telecommunications component units -multi-chip modules and film integrated circuits.  These units manufacture microelectronic modules and interconnectproducts.

 

•                                          InFebruary 1999, we acquired all of the outstanding stock of UTMC MicroelectronicSystems, Inc. (now Aeroflex Colorado Springs, Inc.), consisting of UTMC’s integratedcircuit business.  That operationdesigns and supplies radiation tolerant integrated circuits for defense andsatellite 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, manufacturers 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, cablehead-end systems, fiber optic networking, and satellite applications.

 

Our test solutions segment consists of twodivisions: (1) instruments and (2) motion control products, including thefollowing 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.

 

18

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•                                          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.

 

•                                          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,which we 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.) designs and manufactures advanced test solutions forcommunications, avionics and general test 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 VibrationMountings & Controls, Inc., which manufactures a line of off-the-shelfrubber and spring shock, vibration and structure borne noise control devicesused in commercial and industrial applications.  In December 1986, we acquired the operating assets of KorfundDynamics Corporation, a manufacturer of an industrial line of heavy duty springand rubber shock mounts.

 

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 endedDecember 31, 2002.  The charge includeda cash requirement of $1.4 million, primarily for equipment leases and payrollcosts, and a non-cash charge of $1.2 million, primarily for the write-off ofowned equipment.  In accordance withSFAS No. 144, the abandonment has been reported as a discontinued operationand, accordingly, losses from operations and the loss on abandonment have beenreported separately from continuing operations.

 

Approximately 35% of our sales forthe three months ended September 30, 2003, 37% of our sales for fiscal 2003 and43% of our sales for fiscal 2002 were to agencies of the United States governmentor to prime defense contractors or subcontractors of the United Statesgovernment.

 

19

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

 

**Three Months Ended September 30, 2003 Compared to ThreeMonths Ended September 30, 2002**

 

*Net Sales.*  Net sales increased 23% to $81.7 million forthe three months ended September 30, 2003 from $66.4 million for the threemonths ended September 30, 2002.  Netsales in the microelectronic solutions segment increased 22% to $29.0 millionfor the three months ended September 30, 2003 from $23.8 million for the threemonths ended September 30, 2002 due primarily to the acquisition of MCE inSeptember 2003.  Net sales in the testsolutions segment increased 26% to $49.1 million for the three months endedSeptember 30, 2003 from $39.0 million for the three months ended September 30,2002 due primarily to the acquisition of RIWS in July 2003. Net sales in theisolator products segment was $3.6 million for the three months ended September30, 2003 and $3.7 million for the three months ended September 30, 2002.

 

*Gross Profit.*   Gross profit increased 39% to $34.8 million(42.5% of net sales) for the three months ended September 30, 2003 from $24.9million (37.5% of net sales) for the three months ended September 30,2002.  The increases were primarily aresult of the effect of the acquisitions of MCE and RIWS, which have highergross margins than our historical average.

 

*Selling, Generaland Administrative Costs.* Selling, general and administrative costs increased 30% to $19.2 million(23.5% of net sales) for the three months ended September 30, 2003 from $14.8million (22.2% of net sales) for the three months ended September 30,2002.  The increase in such expenses wasdue primarily to the addition of the expenses of MCE and RIWS.

 

*Research andDevelopment Costs.* Our self-funded research and development costs increased 34% to $10.2million (12.5% of net sales) for the three months ended September 30, 2003 from$7.6 million (11.5% of net sales) for the three months ended September 30,2002. The increase was primarily due to the addition of the expenses of MCE andRIWS.

 

*Amortization ofAcquired Intangibles.* Amortization of acquired intangibles increased 89% to $1.4 million (1.8%of net sales) for the three months ended September 30, 2003 from $759,000 (1.1%of net sales) for the three months ended September 30, 2002.  The increase was due primarily to theaddition of amortization of the MCE and RIWS acquired intangibles.

 

*AcquiredIn-Process Research and Development.* In connection with the acquisition of RIWS, we allocated $2.7 million ofthe purchase price to incomplete research and development projects.  In connection with the acquisition of MCE,we allocated $420,000 of the purchase price to incomplete research anddevelopment projects.  These allocationsrepresent the estimated fair value of such incomplete research and developmentbased on future cash flows that have been adjusted by the respective projects’completion percentage.  At therespective acquisition dates, the development of these projects had not yetreached technological feasibility and the research and development in progresshad no alternative future uses. Accordingly, we expensed these costs as of the respective acquisitiondates in accordance with accounting principles generally accepted in the UnitedStates of America.

 

20

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*Other Expense(Income).*  Interest expense was$393,000 for the three months ended September 30, 2003 and $351,000 for thethree months ended September 30, 2002. Other income of $245,000 for the three months ended September 30, 2003consists primarily of $98,000 of income on investments, $75,000 increase in thefair value of our interest rate swap agreements and $40,000 of interestincome.  Other expense of $112,000 forthe three months ended September 30, 2002 consisted of foreign currencytransaction losses of $246,000 and a $185,000 decrease in the fair value of ourinterest rate swap agreements partially offset by $305,000 of interestincome.  Interest income decreasedprimarily due to lower levels of cash and marketable securities, which wereused to acquire MCE and RIWS, and lower market interest rates.

 

*Provision forIncome Taxes.* The income tax provision was $220,000 (aneffective income tax rate of 35.8%) for the three months ended September 30,2003 and $437,000 (an effective income tax rate of 33.3%) for the three monthsended September 30, 2002. The income tax provision for the two periods differedfrom the amount computed by applying the U.S. Federal income tax rate to incomebefore income taxes primarily due to foreign, state and local income taxes andresearch and development credits.

 

*Income FromContinuing Operations.* Income from continuing operations for the three months ended September30, 2003 was $394,000 or $.01 per diluted share, versus $874,000, or $.01 pershare, for the three months ended September 30, 2002.

 

**Off-Balance Sheet Arrangements**

 

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

 

**Liquidity and Capital Resources**

 

As of September 30, 2003, we had$129.9 million in working capital.  Ourcurrent ratio was 2.7 to 1 at September 30, 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, continues 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 prime (4.0%at September 30, 2003).  The mortgage ispayable in monthly installments of approximately $26,000 through March 2008 anda balloon payment of $1.6 million in April 2008.  We have entered into interest rate swap agreements for theoutstanding amount under the mortgage agreement at approximately 7.6% in orderto reduce the interest rate risk associated with these 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.

 

For the three months ended September30, 2003, our operations provided cash of $1.6 million.  For the three months ended September 30,2003, our investing activities used cash of $59.4 million, primarily for theacquisition of MCE and RIWS.  For thethree months ended September 30, 2003, our financing activities provided cashof $17.4 million, primarily from borrowings under our revolving creditagreement offset, in part, by debt payments.

 

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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.

 

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 foreseeablefuture.  Our cash and cash equivalents,coupled with our available lines of credit, are available to fund acquisitionsand other potential large cash needs that may arise.  At September 30, 2003, our available unused line of credit was$28.1 million after consideration of letters of credit.

 

The following table summarizes, asof September 30, 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   |   | $                          | 32,959 |   | $ | 2,084 |   | $ | 5,692 |   | $ | 20,191 |   | $ | 4,992 |   |
|             |   |                       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Operating leases |   | 48,517                     |   | 8,790 |   | 13,563 |   | 9,403 |   | 16,761 |   |
|             |   |                       |   |   |   |   |   |   |   |   |   |
| Total            |   | $                          | 81,476 |   | $ | 10,874 |   | $ | 19,255 |   | $ | 29,594 |   | $ | 21,753 |   |

 

The operating lease commitmentsshown in the above table have not been reduced by future minimum sub-leaserentals of $16.5 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 September 30, 2003 will materially adversely affect ourliquidity.

 

**Accounting Policies Involving 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.

 

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Revenueand Cost Recognition Under Long-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 the percentage-of-completionmethod, whereby revenues and associated costs are recognized as work on acontract progresses.  We measure theextent of progress toward completion generally based upon one of the following(based upon an assessment of which method most closely aligns to the underlyingearnings process): (i) the units-of-delivery method, (ii) the cost-to-costmethod, using the ratio of contract costs incurred as a percentage of totalestimated costs at contract completion (based upon engineering and productionestimates), or (iii) the achievement of contractual milestones.  Provisions for anticipated losses orrevisions in estimated profits on contracts-in-process are recorded in theperiod in which such anticipated losses or revisions become evident.

 

Inventories

 

Inventories are stated at the lower ofcost (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 market analysis,forecasted sales requirements and forecasted warranty requirements.  After taking these and other factors intoconsideration, such as technological changes, age and physical condition,appropriate adjustments are recorded to the inventory balance.  If actual conditions differ from ourexpectations, then inventory balances may be over or under valued, which couldhave a material effect on our results of operations and financial condition.

 

Recoverabilityof Long-Lived and Intangible 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, thevalue of these assets may be over or under stated, which in turn could have amaterial effect 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).  Suchestimations are inherently subjective, and subject to change in future periods.

 

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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.

 

RestructuringCharges

 

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.

 

IncomeTaxes

 

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.

 

**Recent Accounting Pronouncements**

 

In November 2002, the FASB issuedInterpretation No. 45, “Guarantor’s Accounting and Disclosure Requirements forGuarantees, Including Indirect Guarantees of Indebtedness of Others” (“FIN 45”).  Fin 45 requires certain guarantees to berecorded at fair value regardless of the probability of the loss.  FIN 45 has been adopted prospectively by usas of January 1, 2003.  The adoptionresulted in additional disclosure in the consolidated financial statements.

 

In November 2002, the EmergingIssues Task Force (“EITF”) finalized EITF Issue 00-21, “Revenue Arrangementswith Multiple Deliverables”, which provides guidance on the timing and methodof revenue recognition for sales arrangements that include the delivery of morethan one product or service.  EITF Issue00-21 is effective prospectively for arrangements entered into in fiscalperiods beginning after June 15, 2003. Such adoption did not have any impact on our consolidated financialstatements.

 

In December 2002, the FASB issuedSFAS No. 148, “Accounting for Stock-Based Compensation - Transition andDisclosure.”  SFAS No. 148 providesalternative methods of transition for a voluntary change to the fair valuemethod of accounting for stock-based employee compensation as originallyprovided by SFAS No. 123 “Accounting for Stock-Based Compensation.”  Additionally, SFAS No. 148 amends thedisclosure requirements of SFAS No. 123 in both annual and interim financialstatements.  We have adopted the disclosureportion of this statement for the fiscal year ended June 30, 2003.  The adoption did not have any impact on ourconsolidated financial statements.

 

In April 2003, the FASB issued SFASNo. 149, “Amendment of Statement 133 on Derivative Instruments and HedgingActivities,”**which amends andclarifies accounting for derivative instruments, including certain derivativeinstruments embedded in other contracts, and for hedging activities under SFASNo. 133.  The statement is effective(with certain exceptions) for contracts entered into or modified after June 30,2003.  The adoption did not have anyimpact on our consolidated financial statements.

 

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In May 2003, the FASB issued SFASNo. 150,**“Accounting for CertainFinancial Instruments with Characteristics of both Liabilities andEquity.”  The statement establishesstandards for how an issuer classifies and measures certain financialinstruments with characteristics of both liabilities and equity.  It requires that an issuer classify afinancial instrument that is within its scope as a liability (or an asset insome circumstances).  It is effectivefor financial instruments entered into or modified after May 31, 2003, andotherwise is effective at the beginning of the first interim period beginningafter June 15, 2003.  The adoption ofthis statement did not have any impact on our consolidated financialstatements.

 

In July 2003, the EITF reached aconsensus on Issue 03-5, “Applicability of AICPA Statement of Position 97-2(“SOP 97-2”) to Non-Software Deliverables” (“EITF 03-5”).  The consensus was reached that SOP 97-2 isapplicable to non-software deliverables if they are included in an arrangementthat contains software that is essential to the non-software deliverables’functionality.  This consensus is to beapplied to fiscal periods beginning after August 13, 2003.  We are currently analyzing the impact ofthis consensus on our consolidated financial statements.

 

**Forward-Looking Statements**

 

Allstatements other than statements of historical fact included in this Report onForm 10-Q, including without limitation, statements under “Management’sDiscussion and Analysis of Financial Condition and Results of Operations”regarding our financial position, business outlook, business strategy and plansand objectives of our management for future operations, are forward-lookingstatements.  When used in this Report onForm 10-Q, words such as “anticipate,” “believe,” “estimate,” “expect,”“intend” and similar expressions, as they relate to us or our management,identify forward-looking statements. Such forward-looking statements are based on the current beliefs of ourmanagement, as well as assumptions made by and information currently availableto our management.  Actual results coulddiffer materially from those contemplated by the forward-looking statements, asa result of certain factors, including but not limited to, competitive factorsand pricing pressures, the integration of the business of each of MCE, RIWS andCelerity, 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 atSeptember 30, 2003, the effect on our net income would be a reduction ofapproximately $35,000 per year.  Most ofour invested cash and cash equivalents are at variable rates of interest.  If market interest rates decrease by 10 percentfrom levels at September 30, 2003, the effect on our net income would be a decreaseof approximately $8,000 per year.  Weoperate businesses that are located outside of the United States, which exposesus to the fluctuation of foreign currency exchange rates (primarily the BritishPound and the Euro).  If foreigncurrency exchange rates change by 10% from levels at September 30, 2003, theeffect on our other comprehensive income would be approximately $7.4 million.

 

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**ITEM 4** - **EVALUATIONAND DISCLOSURE CONTROLS AND PROCEDURES**

 

Based on their evaluation as ofOctober 30, 2003, a date within 90 days of the filing of this Form 10-Q, ourmanagement, with the participation of our Chief Executive Officer and ChiefFinancial Officer, conducted an evaluation of the effectiveness of the designand operation of our disclosure controls and procedures, as required byExchange Act Rule 13a-15.  Based on thatevaluation, the Chief Executive Officer and Chief Financial Officer haveconcluded that our disclosure controls and procedures were effective to ensurethat information required to be disclosed by us in the reports that we file orsubmit under the Exchange Act is recorded, processed, summarized and reportedwith the time periods specified by the SEC’s rules and forms.

 

**Changes in Internal Controls**

 

There were no significant changes inour internal controls over financial reporting that occurred during the quarterended September 30, 2003 that have materially affected, or are reasonablylikely to materially affect, our internal control over financial reporting.

 

**Limitations on the Effectiveness 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.

 

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**PART II - OTHER INFORMATION**

 

Item1.             Legal Proceedings

 

Weare involved in various routine legal matters. We believe the outcome of these matters will not have a material effecton us.

 

Item 2.             Changes inSecurities

 

None

 

Item 3.             Defaultsupon Senior Securities

 

None

 

Item 4.             Submissionof Matters to a Vote of Security Holders

 

None

 

Item 5.             OtherInformation

 

None

 

Item 6.             Exhibits and Reports on Form 8-K

 

(a)           Exhibits

 

10.1                           StockPurchase Agreement dated as of July 31, 2003, by and among Racal InstrumentsGroup Limited, Registrant and IFR Systems Limited, a wholly-owned subsidiary ofRegistrant (incorporated by reference to Exhibit 99.1 of Report on Form 8-Kfiled August 5, 2003).

 

10.2                           AssetPurchase Agreement dated as of July 31, 2003, by and between Racal Instruments,Inc. and Registrant (incorporated by reference to Exhibit 99.2 of Report onForm 8-K filed August 5, 2003).

 

10.3                           AssetPurchase Agreement dated as of July 31, 2003, by and among Racal InstrumentsGroup Limited and Registrant (incorporated by reference to Exhibit 99.3 ofReport on Form 8-K filed August 5, 2003).

 

31.1                           Certificationof Chief Executive Officer pursuant to Section 302 of Sarbanes-Oxley Act of2002.

 

31.2                           Certificationof Chief Financial Officer pursuant to Section 302 of Sarbanes-Oxley Act of2002.

 

32.1                           Certificationof Chief Executive Officer pursuant to Section 906 of Sarbanes-Oxley Act of2002.

 

32.2                           Certificationof Chief Financial Officer pursuant to Section 906 of Sarbanes-Oxley Act of2002.

 

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(b)           Reports onForm 8-K

 

Reporton Form 8-K filed on July 2, 2003 - Item 5 - Merger Agreement with MCETechnologies, Inc.

 

Reporton Form 8-K filed on July 21, 2003 - Item 5 and 7 - In connection withdiscontinuance of lithium niobate fiber optic modulator operations - FinancialStatements and Schedules Comprising Item 8 of Annual Report on Form 10-K as ofand for the years ended June 30, 2002, 2001 and 2000.

 

Reporton Form 8-K filed on August 5, 2003 - Item 5 - Acquisition of Racal InstrumentsWireless Solutions Group.

 

Reporton Form 8-K furnished on August 13, 2003 - Items 7 and 9 - release of financialresults for the fourth fiscal quarter ended June 30, 2003.

 

Reporton Form 8-K filed on September 8, 2003 - Item 2 - Acquisition of MCETechnologies, Inc.

 

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SIGNATURES

 

Pursuantto the requirements of the Securities Exchange Act of 1934, the Registrant hasduly caused this report to be signed on its behalf by the undersigned thereuntoduly authorized.

 

 
|               | AEROFLEX INCORPORATED              |             |
|--------------------|------------------------------------|------------------|
|               | (REGISTRANT)                       |             |
|               |                               |             |   |
|               |                               |             |   |
| November  14, 2003 | By:                                | /s/Michael Gorin |   |
|               |                               | Michael Gorin    |   |
|               | President, Chief Financial Officer |             |
|               | and Principal Accounting Officer   |             |

 

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