**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**Washington,D.C. 20549**

----

**FORM 10-Q**

----

** **

**x**                              QUARTERLYREPORT PURSUANT TO SECTION 13 OR 15(d)OF THE SECURITIES EXCHANGE ACT OF 1934

**Forthe quarterly period ended September 30, 2006**

**OR**

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

**Forthe transition period from      to      **

**CommissionFile Number 1-6549**

**American Science and Engineering, Inc.**

(Exact name of Registrantas specified in its charter)

| **Massachusetts**                         |   | **04-2240991**       |
|-------------------------------------------|--------|----------------------|
| (State or other  jurisdiction of          |   | (I.R.S. Employer     |
|  incorporation or organization)      |   | Identification  No.) |
|                                      |   |                 |
| **829  Middlesex Turnpike**               |   | ** **           |
| **Billerica,  Massachusetts**             |   | **01821**            |
| (Address of  principal executive offices) |   | (Zip Code)           |

 

**(978) 262-8700**

(Registrant’s telephonenumber, including area code)

** **

(Former name, formeraddress and former fiscal year, if changed since last report)

Indicate by check mark whether the registrant(1) has filed all reports required to be filed by Section 13 or15(d) of the Securities Exchange Act of 1934 during the preceding12 months (or for such shorter period that the registrant was required tofile such reports), and (2) has been subject to such filing requirementsfor the past 90 days. Yes x   No o

Indicate by check mark whether the registrant is alarge accelerated filer, an accelerated filer, or a non-accelerated filer. Seedefinition of “accelerated filer and large accelerated filer” in Rule 12b-2 ofthe Exchange Act (Check one):

| Large accelerated  filer o |   | Accelerated filer x |   | Non-accelerated filer o |
|---------------------------------|--------|--------------------------|--------|------------------------------|

 

Indicate by check mark whether the Registrant is ashell company (as defined in Rule 12b-2 of the Securities Exchange Act of1934). Yes o   No x

Indicate the number of shares outstanding of each ofthe issuer’s classes of common stock, as of the latest practicable date
| Class of Common Stock | ** ** | **Outstanding at  November 6, 2006** |
|--------------------------------------|------------|-----------------------------------------------------|
| $.662¤3  par value              |       | 9,152,312                                           |

 

 

----

 

**AmericanScience and Engineering, Inc. and Subsidiary**

**Index**
| **Part 1 — Financial  Information**                                                                                              |   |   |   |
|--------------------------------------------------------------------------------------------------------------------------------------------|--------|--------|--------|
| Item 1 —  Financial Statements                                                                                                        |   | 3      |   |
| Unaudited  Condensed Consolidated Balance Sheets — September 30, 2006 and March 31, 2006                                              |   | 3      |   |
| Unaudited  Condensed Consolidated Statements of Operations - For the Three and Six  Months Ended September 30, 2006 and September 30, 2005 |   | 4      |   |
| Unaudited  Condensed Consolidated Statements of Cash Flows - For the Six Months Ended  September 30, 2006 and September 30, 2005           |   | 5      |   |
| Notes to Unaudited Condensed Consolidated Financial  Statements                                                                            |   | 6      |   |
| Item 2 — Management’s Discussion and Analysis of  Financial Condition and Results of Operations                                  |   | 11     |   |
| Item 3 — Quantitative and Qualitative Disclosure About  Market Risk                                                                   |   | 13     |   |
| Item  4 - Controls and Procedures                                                                                                          |   | 14     |   |
| **Part II  — Other Information**                                                                                                 |   | 14     |   |
| Item  1 — Legal Proceedings                                                                                                           |   | 14     |   |
| Item 4 — Submission of Matters to a Vote of Security  Holders                                                                         |   | 14     |   |
| Item 6 -  Exhibits                                                                                                                         |   | 15     |   |
| **Signatures**                                                                                                                             |   |   |   |

 

2

----

 

**PART I— FINANCIAL INFORMATION**

**Item1 — Financial Statements**

**American Science andEngineering, Inc. and SubsidiaryCondensed Consolidated Balance Sheets(Unaudited)**
| **Dollars in thousands**                                                                                                                                          | ** ** | **September 30,  2006** | ** ** | **March 31,  2006** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------------|------------|--------------------------|------------|
| **Assets**                                                                                                                                                                  | ** ** | ** **                   | ** ** | ** **               | ** ** |
| Current assets:                                                                                                                                                             |       |                         |       |                     |       |
| Cash and cash  equivalents                                                                                                                                                  |       | $                            | 28,543     |                     | $          | 50,655 |   |
| Restricted cash and  investments                                                                                                                                            |       | 14,127                       |       | 98                       |       |
| Short-term investments                                                                                                                                                      |       | 72,272                       |       | 43,117                   |       |
| Accounts receivable,  net of allowances of $404 and $345 at September 30, 2006 and March 31, 2006,  respectively                                                            |       | 27,843                       |       | 25,868                   |       |
| Unbilled costs and  fees, net of allowances of $36 and $36 at September 30, 2006 and March 31,  2006, respectively                                                          |       | 3,391                        |       | 4,057                    |       |
| Inventories                                                                                                                                                                 |       | 18,438                       |       | 16,886                   |       |
| Prepaid expense and  other current assets                                                                                                                                   |       | 3,789                        |       | 9,862                    |       |
| Deferred income taxes                                                                                                                                                       |       | 3,984                        |       | 3,381                    |       |
| **Total current assets**                                                                                                                                                    |       | 172,387                      |       | 153,924                  |       |
| Building, equipment and  leasehold improvements, net                                                                                                                        |       | 19,967                       |       | 18,717                   |       |
| Deferred income taxes                                                                                                                                                       |       | 1,160                        |       | 748                      |       |
| Other assets, net                                                                                                                                                           |       | 429                          |       | —                   |       |
| **Total assets**                                                                                                                                                            |       | $                            | 193,943    |                     | $          | 173,389 |   |
|                                                                                                                                                                        |       |                         |       |                     |       |
| **Liabilities and Stockholders’  Equity**                                                                                                                              | ** ** | ** **                   | ** ** | ** **               | ** ** |
| Current liabilities:                                                                                                                                                        |       |                         |       |                     |       |
| Accounts payable                                                                                                                                                            |       | $                            | 5,024      |                     | $          | 6,659 |   |
| Accrued salaries and  benefits                                                                                                                                              |       | 2,550                        |       | 6,554                    |       |
| Accrued warranty costs                                                                                                                                                      |       | 2,832                        |       | 3,606                    |       |
| Accrued income taxes                                                                                                                                                        |       | 782                          |       | —                   |       |
| Deferred revenue                                                                                                                                                            |       | 3,977                        |       | 3,331                    |       |
| Customer deposits                                                                                                                                                           |       | 13,887                       |       | 6,103                    |       |
| Current portion of  lease financing liability                                                                                                                               |       | 802                          |       | 787                      |       |
| Warrant liability                                                                                                                                                           |       | 565                          |       | —                   |       |
| Other current  liabilities                                                                                                                                                  |       | 2,345                        |       | 1,853                    |       |
| **Total current liabilities**                                                                                                                                               |       | 32,764                       |       | 28,893                   |       |
| Lease financing  liability, net of current portion                                                                                                                          |       | 9,232                        |       | 9,630                    |       |
| Warrant liability                                                                                                                                                           |       | —                       |       | 4,038                    |       |
| Other long term  liabilities                                                                                                                                                |       | 3,825                        |       | 630                      |       |
| **Total liabilities**                                                                                                                                                       |       | 45,821                       |       | 43,191                   |       |
|                                                                                                                                                                        |       |                         |       |                     |       |
| **Stockholders’ equity:**                                                                                                                                              | ** ** | ** **                   | ** ** | ** **               | ** ** |
| Preferred stock, no par  value Authorized — 100,000 shares; Issued - none                                                                                              |       | —                       |       | —                   |       |
| Common stock, $0.66 2/3  par value Authorized —20,000,000 shares Issued and Outstanding 9,149,378  shares at September 30, 2006 and 9,070,679 shares at March 31, 2006 |       | 6,099                        |       | 6,047                    |       |
| Capital in excess of  par value                                                                                                                                             |       | 99,332                       |       | 94,061                   |       |
| Accumulated other  comprehensive income                                                                                                                                     |       | 64                           |       | (16                      | )          |
| Unearned compensation                                                                                                                                                       |       | —                       |       | (1,773                   | )          |
| Retained earnings                                                                                                                                                           |       | 42,627                       |       | 31,879                   |       |
| **Total stockholders’ equity**                                                                                                                                         |       | 148,122                      |       | 130,198                  |       |
|                                                                                                                                                                        |       |                         |       |                     |       |
| **Total liabilities and stockholders’ equity**                                                                                                                         |       | $                            | 193,943    |                     | $          | 173,389 |   |

 

The accompanying notesare an integral part of these condensed consolidated financial statements.

3

----

 

**American Science andEngineering, Inc. and SubsidiaryCondensed Consolidated Statements of Operations(Unaudited)**
| ** **                                                                                                                                                                                                                                                    | ** ** | **Three Months Ended** | ** ** | **Six Months Ended** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|----------------------------------|------------|--------------------------------|------------|
| **Dollars and shares in thousands, except per share amounts**                                                                                                                                                         | ** ** | **Sept. 30,  2006**         | ** ** | **Sept. 30,  2005**       | ** ** | **Sept. 30,  2006** | ** ** | **Sept. 30,  2005** | ** ** |
| ** **                                                                                                                                                                                                                                                    | ** ** | ** **                       | ** ** | ** **                     | ** ** | ** ** | ** ** | ** ** | ** ** |
| Revenues:                                                                                                                                                                                                                                                     |       |                             |       |                           |       |   |   |   |   |
| Net product sales and  contract revenues                                                                                                                                                                                                                      |       | $                                | 17,038     |                           | $          | 41,979 |   | $ | 36,151 |   | $ | 71,492 |   |
| Net service revenues                                                                                                                                                                                                                                          |       | 12,550                           |       | 7,162                          |       | 23,319 |   | 12,811 |   |
| Total net revenues                                                                                                                                                                                                                                            |       | 29,588                           |       | 49,141                         |       | 59,470 |   | 84,303 |   |
|                                                                                                                                                                                                                                                          |       |                             |       |                           |       |   |   |   |   |
| Cost of sales and  contracts:                                                                                                                                                                                                                                 |       |                             |       |                           |       |   |   |   |   |
| Cost of product sales  and contracts                                                                                                                                                                                                                          |       | 9,235                            |       | 19,781                         |       | 19,976 |   | 36,808 |   |
| Cost of service revenues                                                                                                                                                                                                                                      |       | 6,824                            |       | 4,584                          |       | 12,468 |   | 8,127 |   |
| Total cost of sales and  contracts                                                                                                                                                                                                                            |       | 16,059                           |       | 24,365                         |       | 32,444 |   | 44,935 |   |
| Gross profit                                                                                                                                                                                                                                                  |       | 13,529                           |       | 24,776                         |       | 27,026 |   | 39,368 |   |
|                                                                                                                                                                                                                                                          |       |                             |       |                           |       |   |   |   |   |
| Expenses:                                                                                                                                                                                                                                                     |       |                             |       |                           |       |   |   |   |   |
| Selling, general and  administrative expenses                                                                                                                                                                                                                 |       | 5,931                            |       | 4,699                          |       | 11,626 |   | 8,837 |   |
| Research and  development                                                                                                                                                                                                                                     |       | 1,531                            |       | 2,470                          |       | 3,780 |   | 4,892 |   |
| Total expenses                                                                                                                                                                                                                                                |       | 7,462                            |       | 7,169                          |       | 15,406 |   | 13,729 |   |
|                                                                                                                                                                                                                                                          |       |                             |       |                           |       |   |   |   |   |
| Operating income                                                                                                                                                                                                                                              |       | 6,067                            |       | 17,607                         |       | 11,620 |   | 25,639 |   |
|                                                                                                                                                                                                                                                          |       |                             |       |                           |       |   |   |   |   |
| Other income (expense):                                                                                                                                                                                                                                       |       |                             |       |                           |       |   |   |   |   |
| Interest and investment  income                                                                                                                                                                                                                               |       | 1,375                            |       | 511                            |       | 2,491 |   | 872 |   |
| Interest expense                                                                                                                                                                                                                                              |       | (90                              | )          | —                         |       | (189 | ) | — |   |
| Other, net                                                                                                                                                                                                                                                    |       | 80                               |       | 11                             |       | 93 |   | 25 |   |
| Change in warrant  valuation                                                                                                                                                                                                                                  |       | 207                              |       | (3,450                         | )          | 2,339 |   | (2,917 | ) |
| Total other income  (expense)                                                                                                                                                                                                                                 |       | 1,572                            |       | (2,928                         | )          | 4,734 |   | (2,020 | ) |
|                                                                                                                                                                                                                                                          |       |                             |       |                           |       |   |   |   |   |
| Income before income  taxes                                                                                                                                                                                                                                   |       | 7,639                            |       | 14,679                         |       | 16,354 |   | 23,619 |   |
| Provision for income  taxes                                                                                                                                                                                                                                   |       | 2,886                            |       | 6,283                          |       | 5,606 |   | 8,226 |   |
|                                                                                                                                                                                                                                                          |       |                             |       |                           |       |   |   |   |   |
| Net income                                                                                                                                                                                                                                                    |       | $                                | 4,753      |                           | $          | 8,396 |   | $ | 10,748 |   | $ | 15,393 |   |
|                                                                                                                                                                                                                                                          |       |                             |       |                           |       |   |   |   |   |
| Income per share—Basic                                                                                                                                                                                                                                   |       | $                                | 0.52       |                           | $          | 0.99 |   | $ | 1.18 |   | $ | 1.83 |   |
|                                                                                                                                                                                                                                                          |       |                             |       |                           |       |   |   |   |   |
|                            —Diluted                                                                               |       | $                                | 0.49       |                           | $          | 0.93 |   | $ | 0.90 |   | $ | 1.72 |   |
|                                                                                                                                                                                                                                                          |       |                             |       |                           |       |   |   |   |   |
| Weighted average  shares—Basic                                                                                                                                                                                                                           |       | 9,094                            |       | 8,475                          |       | 9,083 |   | 8,425 |   |
|                                         —Diluted |       | 9,316                            |       | 9,003                          |       | 9,338 |   | 8,931 |   |

 

The accompanying notesare an integral part of these condensed consolidated financial statements.

4

----

 

**American Science andEngineering, Inc. and SubsidiaryCondensed Consolidated Statements of Cash Flows(Unaudited)**
| ** **                                                                                | ** ** | **For the Six Months Ended** | ** ** |
|-------------------------------------------------------------------------------------------|------------|--------------------------------------------------|------------|
| **Dollars in thousands**                                                        | ** ** | **September 30,  2006**                     | ** ** | **September 30,  2005** | ** ** |
| **Cash flows from operating  activities:**                                                | ** ** | ** **                                       | ** ** | ** ** | ** ** |
| Net income                                                                                |       | $                                                | 10,748     |   | $ | 15,393 |   |
| Adjustments to  reconcile net income to net cash provided by operating activities:        |       |                                             |       |   |   |
| Depreciation and  amortization                                                            |       | 1,084                                            |       | 405 |   |
| Provisions for  contract, inventory and accounts receivable reserves                      |       | 152                                              |       | 2,168 |   |
| Amortization of bond  discount                                                            |       | (755                                             | )          | (173 | ) |
| Deferred income taxes                                                                     |       | (1,110                                           | )          | 2,284 |   |
| Reversal of deferred  tax asset valuation allowance relating to net operating losses      |       | —                                           |       | (1,593 | ) |
| Stock based compensation  expense                                                         |       | 4,665                                            |       | 157 |   |
| Change in value of  warrants                                                              |       | (2,339                                           | )          | 2,917 |   |
| Changes in assets and  liabilities:                                                       |       |                                             |       |   |   |
| Accounts  receivable                                                                      |       | (2,034                                           | )          | (16,034 | ) |
| Unbilled costs  and fees                                                                  |       | 666                                              |       | (110 | ) |
| Inventories                                                                               |       | (1,645                                           | )          | 7,848 |   |
| Prepaid expenses  and other assets                                                        |       | 3,643                                            |       | 319 |   |
| Accounts payable                                                                          |       | (1,635                                           | )          | (2,024 | ) |
| Accrued income  taxes                                                                     |       | 782                                              |       | 3,058 |   |
| Customer  deposits                                                                        |       | 7,784                                            |       | (4,460 | ) |
| Deferred revenue                                                                          |       | 3,850                                            |       | (1,357 | ) |
| Accrued expenses  and other current liabilities                                           |       | (3,934                                           | )          | 2,724 |   |
| Non-current  liabilities                                                                  |       | (9                                               | )          | (37 | ) |
| Total adjustments                                                                         |       | 9,165                                            |       | (3,908 | ) |
| Net cash provided by  operating activities                                                |       | 19,913                                           |       | 11,485 |   |
|                                                                                      |       |                                             |       |   |   |
| **Cash flows from investing  activities:**                                                | ** ** | ** **                                       | ** ** | ** ** | ** ** |
| Purchases of short-term  investments                                                      |       | (65,435                                          | )          | (25,444 | ) |
| Maturity of short-term  investments                                                       |       | 37,095                                           |       | 23,915 |   |
| Purchases of property  and equipment                                                      |       | (2,334                                           | )          | (3,522 | ) |
| Net cash used for  investing activities                                                   |       | (30,674                                          | )          | (5,051 | ) |
|                                                                                      |       |                                             |       |   |   |
| **Cash flows from financing  activities:**                                                | ** ** | ** **                                       | ** ** | ** ** | ** ** |
| Decrease (increase) in  restricted cash                                                   |       | (14,029                                          | )          | 193 |   |
| Proceeds from exercise  of warrants                                                       |       | 834                                              |       | 1,263 |   |
| Proceeds from exercise  of stock options                                                  |       | 85                                               |       | 3,154 |   |
| Proceeds from financing  of leasehold improvement                                         |       | 2,095                                            |       | 1,500 |   |
| Repayment of lease  financing                                                             |       | (383                                             | )          | — |   |
| Reduction of income  taxes paid due to the tax benefit from employee stock option expense |       | 27                                               |       | 2,277 |   |
| Net cash provided by  (used for) financing activities                                     |       | (11,371                                          | )          | 8,387 |   |
| Foreign currency  translation effect on cash                                              |       | 20                                               |       | 1 |   |
| Net increase (decrease)  in cash and cash equivalents                                     |       | (22,112                                          | )          | 14,822 |   |
| Cash and cash  equivalents at beginning of period                                         |       | 50,655                                           |       | 15,418 |   |
| Cash and cash equivalents at end of period                                                |       | $                                                | 28,543     |   | $ | 30,240 |   |

 

The accompanying notesare an integral part of these condensed consolidated financial statements.

5

----

** **

**American Science andEngineering, Inc. and SubsidiaryNotes to Unaudited Condensed Consolidated Financial Statements**

**1.****                                      General**

The condensedconsolidated financial statements include the accounts of the Company and itswholly owned subsidiary. All significant intercompany transactions and balanceshave been eliminated.

The unaudited condensedconsolidated financial statements have been prepared pursuant to the rules andregulations of the Securities and Exchange Commission. Certain information andnote disclosures normally included in annual financial statements prepared inaccordance with generally accepted accounting principles have been condensed oromitted pursuant to those rules and regulations, although the Company believesthat the disclosures made are adequate to make the information not misleading.These condensed consolidated financial statements should be read in conjunctionwith the consolidated financial statements and the notes included in theCompany’s Annual Report on Form 10-K for the fiscal year endedMarch 31, 2006.

The unaudited condensedconsolidated financial statements, in the opinion of management, include alladjustments necessary, consisting solely of normal recurring adjustments, topresent fairly the Company’s financial position, results of operations and cashflows. These quarterly results are not necessarily indicative of the results tobe expected for the entire year.

Nature of Operations

The Company is engaged inthe development and manufacture of sophisticated X-ray inspection systems forcritical detection and security screening solutions for sale primarily to U.S.and foreign government agencies. The Company has only one reporting segment,X-ray screening products.

Significant AccountingPolicies

Revenues on costreimbursable and long-term fixed price contracts are generally recorded ascosts are incurred using the percentage of completion method. For systems thatare produced in a standard manufacturing operation and have shorter order todelivery cycles, the Company recognizes sales at the time of shipment of thesystem to the customer and when other revenue recognition criteria (such astransfer of risk) are met.

The Company’s Export andSecurity Agreement with Silicon Valley Bank East requires certain cash balancesto be restricted as collateral against outstanding standby letters of credit;these are separately presented as restricted cash. (See Note 5)

The other significantaccounting policies followed by the Company and its subsidiary in preparing itsconsolidated financial statements are set forth in Note 1 to the consolidatedfinancial statements included in its Form 10-K for the year endedMarch 31, 2006. The Company has made no changes to these policies duringthe current year.

Certain amounts in theprior period financial statements have been reclassified to conform to thecurrent period presentation.

Comprehensive Income

Comprehensive income iscomprised of the following:
| ** **                                                          | ** ** | **Three months ended** | ** ** | **Six months ended** | ** ** |
|---------------------------------------------------------------------|------------|----------------------------------|------------|--------------------------------|------------|
| **(In thousands)**                                             | ** ** | **Sept. 30,  2006**         | ** ** | **Sept. 30,  2005**       | ** ** | **Sept. 30,  2006** | ** ** | **Sept. 30,  2005** | ** ** |
| Net income                                                          |       | $4,753                           |       | $8,396                         |       | $10,748 |   | $15,393 |   |
| Foreign currency  translation adjustments, net of tax               |       | 2                                |       | 12                             |       | 22 |   | 1 |   |
| Unrealized gains  and losses from marketable securities, net of tax |       | 41                               |       | (22                            | )          | 58 |   | (18 | ) |
| Comprehensive  income                                               |       | $4,796                           |       | $8,386                         |       | $10,828 |   | $15,376 |   |

 

**2.             Accounting for Stock-Based Compensation**

On April 1, 2006, theCompany adopted Statement of Financial Accounting Standards No. 123(R) (SFAS123(R)) “Accounting for Stock-Based Compensation”, which requires themeasurement and recognition of all compensation costs for all stock basedawards made to employees and the Board of Directors based upon fair value overthe requisite service period for awards expected to vest. Prior to adoption,the Company accounted for stock options under the intrinsic value method set inaccordance with Accounting Principles Board Opinion No. 25, “Accounting forStock Issued to Employees,” and related interpretations, and provided therequired pro forma disclosures prescribed by SFAS No. 123, “Accounting forShare-based Compensation”, as amended.

6

----

 

SFAS 123(R) requires theCompany to estimate the fair value of share-based awards on the date of grantusing an option pricing model. The Company adopted SFAS 123(R) using themodified prospective transition method which requires the application of theaccounting standard starting April 1, 2006, the first day of the Company’sfiscal year 2007. Prior period information will not be restated to reflect thefair value method of expensing share-based awards.

Stock- based compensationcosts recognized for the three and six month periods ended September 30, 2006,included compensation costs for awards granted prior to, but not yet vested asof April 1, 2006 (adoption date), as well as any new grants issued after April1, 2006. Total costs recognized during the three and six month periods endedSeptember 30, 2006 amounted to $2,465,000 and $4,665,000, respectively. TheCompany recognized $2,153,000 and $3,944,000 of the share-based compensationcosts in the consolidated statements of income for the three and six monthsended September 30, 2006, respectively. In the three and six months endedSeptember 30, 2006, a total $312,000 and $721,000 of compensation costs werecapitalized to inventory as such costs qualified for capitalization. Thesecosts are recognized in the income statement when the inventory is disposed ofor consumed. The income tax benefit related to such compensation for the threeand six months ended September 30, 2006 was approximately $313,000 and $618,000,respectively.

The following tablesummarizes share-based compensation costs included in the Company’sconsolidated statement of income:
| ** **                                         | ** ** | **Three Months Ended  September 30, 2006** | ** ** | **Six Months Ended  September 30, 2006** | ** ** |
|----------------------------------------------------|------------|----------------------------------------------------------------|------------|--------------------------------------------------------------|------------|
| Cost of revenues                                   |       | $                                                              | 832        |                                                         | $          | 1,514 |   |
| Selling, general  and administrative               |       | 1,321                                                          |       | 2,430                                                        |       |
| Total  share-based compensation expense before tax |       | $                                                              | 2,153      |                                                         | $          | 3,944 |   |

 

The Company hadpreviously adopted the provisions of SFAS No. 123, “Accounting forShare-based Compensation,” as amended by SFAS No. 148, “Accounting forShare-based Compensation—Transition and Disclosure,” through disclosure only.The following table illustrates the effect on net income and earnings per sharefor the three and six months ended September 30, 2005 as if the Companyhad applied the fair value recognition provisions of SFAS No. 123 toshare-based employee awards.
| **(In thousands except per share amounts)**   | ** ** | **Three months ended  Sept. 30,  2005** | ** ** | **Six months ended  Sept. 30,  2005** | ** ** |
|------------------------------------------------------------------------|------------|--------------------------------------------------------|------------|------------------------------------------------------|------------|
| Net income                                                             |       |                                                   |       |                                                 |       |
| As reported                                                            |       | $                                                      | 8,396      |                                                 | $          | 15,393 |   |
| Add: Stock based  compensation included in net income as reported      |       | 106                                                    |       | 157                                                  |       |
| Less: Stock  based compensation using fair value method for all awards |       | (879                                                   | )          | (4,904                                               | )          |
| Pro forma net  income                                                  |       | 7,623                                                  |       | $                                                    | 10,646     |   |
| Income per share  —Basic:                                         |       |                                                   |       |                                                 |       |
| As reported                                                            |       | $                                                      | 0.99       |                                                 | $          | 1.83 |   |
| Pro forma                                                              |       | $                                                      | 0.90       |                                                 | $          | 1.26 |   |
| Income per share  —Diluted:                                       |       |                                                   |       |                                                 |       |
| As reported                                                            |       | $                                                      | 0.93       |                                                 | $          | 1.72 |   |
| Pro forma                                                              |       | $                                                      | 0.85       |                                                 | $          | 1.20 |   |

 

Upon adoption of SFAS123(R), in accordance with Staff Accounting Bulletin No. 107, the Companyselected the Black-Scholes option pricing model as the most appropriate methodfor determining the estimated fair value for the stock awards. TheBlack-Scholes method of valuation requires several assumptions: (1) theexpected term of the stock award, (2) the expected future stock volatility overthe expected term and (3) risk-free interest rate. The expected term representsthe expected period of time the Company believes the options will beoutstanding based on historical information. Estimates of expected future stockprice volatility are based on the historic volatility of the Company’s commonstock and the risk free interest rate is based on the U.S. Zero-Bond rate. Thefair value of options at date of grant was estimated with the followingassumptions:
| ** **               | ** ** | **Six Months Ended**   | ** ** |
|--------------------------|------------|----------------------------------|------------|
| ** **               | ** ** | **September 30, 2006** | ** ** | **September 30, 2005** | ** ** |
| **Assumptions:**         | ** ** | ** **                       | ** ** | ** ** | ** ** |
| Option life              |       | 3 years                          |       | 3-5 years |   |
| Risk-free  interest rate |       | 4.77                             | %          | 3.40 | % |
| Stock volatility         |       | 56                               | %          | 62 | % |
| Dividend yield           |       | 0                                | %          | 0 | % |

 

7

----

 

**Stock Option and OtherCompensation Plans:**

Effective April 1, 2006,the Company adopted SFAS 123(R) using the modified prospective method toaccount for share-based payments to employees and the Company’s Board ofDirectors. The primary types of share-based payments currently utilized by theCompany are stock options, restricted stock and restricted stock units.

The Company has variousstock option and other compensation plans for directors, officers, andemployees. The Company had the following stock option plans outstanding as ofSeptember 30, 2006: the 1995 Combination Plan, the 1996 Plan for Non-EmployeeDirectors, the 1997 Non-Qualified Option Plan, the 1998 Non-Qualified OptionPlan, the 1999 Combination Plan, the 2000 Combination Plan, the 2002Combination Plan, the 2003 Stock Plan for Non-Employee Directors and the 2005Equity and Incentive Plan. There are 3,780,000 shares authorized under theseplans. Vesting periods are at the discretion of the Board of Directors andtypically range between one and three years. Options under these plans aregranted at fair market value and have a term of five or ten years from the dateof grant.

***Stockoptions***

Thefollowing tables summarize stock option activity during the first six months offiscal year 2007:
| ** **                             | ** ** | **Options Outstanding** | ** ** |
|----------------------------------------|------------|------------------------------|------------|
| ** **                             | ** ** | **Number of  Shares**   | ** ** | **Weighted  Average  Exercise  Price** | ** ** | **Weighted  Average  Contractual   Life** | ** ** | **Aggregate  Intrinsic  Value** | ** ** |
| **Outstanding  at March 31, 2006**     |       | 878,470                      |       | $ | 36.79 |   |   |   |   |   |
| Grants                                 |       | 60,670                       |       |   |   |   |   |   |   |
| Exercises                              |       | (3,400                       | )          |   |   |   |   | $ | 100,000 |   |
| Cancellations                          |       | (13,037                      | )          |   |   |   |   |   |   |
| **Outstanding  at September 30, 2006** |       | 922,703                      |       | $ | 37.38 |   | 7.99 |   |   |   |
| **Exercisable at September 30,  2006** |       | 384,212                      |       | $ | 25.15 |   |   |   | $ | 13,007,000 |   |

 

Information related tothe stock options outstanding as of September 30, 2006 is as follows:
| **Range of Exercise Prices** | ** ** | **Number  of Shares** | ** ** | **Weighted-Average  Remaining  Contractual  Life (years)** | ** ** | **Weighted-Average  Exercise Price** | ** ** | **Exercisable  Number of  Shares** | ** ** | **Exercisable  Weighted-  Average  Exercise  Price** | ** ** |
|---------------------------------------------|------------|----------------------------|------------|-----------------------------------------------------------------|------------|-------------------------------------------|------------|-----------------------------------------|------------|------------------------------------------------------|------------|
| $6.50 - $20.00                              |       | 258,470                    |       | 6.27                                                            |       | $                                         | 11.77      |                                    | 203,670    |                                                 | $          | 11.43 |   |
| $20.01 - $30.00                             |       | 114,150                    |       | 7.89                                                            |       | 27.21                                     |       | 105,100                                 |       | 27.77                                                |       |
| $30.01 - $40.00                             |       | 73,041                     |       | 8.19                                                            |       | 38.95                                     |       | 7,375                                   |       | 37.96                                                |       |
| $40.01 - $50.00                             |       | 140,199                    |       | 9.02                                                            |       | 45.84                                     |       | 17,667                                  |       | 44.62                                                |       |
| $50.01 - $60.00                             |       | 240,443                    |       | 8.79                                                            |       | 53.63                                     |       | —                                  |       | —                                               |       |
| $60.01 - $83.02                             |       | 96,400                     |       | 9.11                                                            |       | 64.04                                     |       | 50,400                                  |       | 66.45                                                |       |
| $6.50 - $83.02                              |       | 922,703                    |       | 7.99                                                            |       | $                                         | 37.38      |                                    | 384,212    |                                                 | $          | 25.15 |   |

The weighted average fair value of options granted in the six monthsended September 30, 2006 was $20.09. As of September 30, 2006, there was$5,751,000 of total unrecognized compensation cost related to nonvested stockoptions granted and outstanding; that cost is expected to be recognized over a3 year period. Nonvested common stock options are subject to the risk offorfeiture until the fulfillment of specified conditions.

***RestrictedStock and Restricted Stock Units***

During fiscal 2006, theCompany instituted a long term incentive plan for certain key employees. Theplan calls for the issuance of restricted stock and options which vest upon theachievement of certain performance based goals as well as service timeincurred. Restricted stock and restricted stock units granted to otheremployees have vesting periods that range from one to three years. Annually onJanuary 10th, theBoard of Directors is granted restricted stock. The stock vests pro-rata basedon service time incurred in the upcoming calendar year. The fair values ofthese restricted stock awards are equal to the market price per share of theCompany’s common stock on the date of grant.

8

----

 

Nonvested restrictedstock and stock unit awards are subject to the risk of forfeiture until thefulfillment of specified conditions. As of September 30, 2006, there was$2,321,000 of total unrecognized compensation cost related to nonvestedrestricted stock and stock unit awards granted under the Company’s stock plans.This cost is expected to be recognized over a 3 year period.

The following tablesummarizes the status of the Company’s nonvested restricted stock and stockunit awards since March 31, 2006:
| ** **                             | ** ** | **Nonvested Restricted Stock and Stock Unit Awards** | ** ** |
|----------------------------------------|------------|------------------------------------------------------------------------------------|------------|
| ** **                             | ** ** | **Number of  Shares**                                                         | ** ** | **Weighted Average  Grant Date  Fair Value** | ** ** |
| **Outstanding  at March 31, 2006**     |       | 23,125                                                                             | ** ** | $ | 54.92 | ** ** |
| Granted                                |       | 36,494                                                                             |       |   |   |
| Vested                                 |       | (1,707                                                                             | )          |   |   |
| Forfeited                              |       | —                                                                             |       |   |   |
| **Outstanding at September 30,  2006** |       | 57,912                                                                             | ** ** | $ | 53.25 | ** ** |

 

**3.             Inventories**
| **(Dollars in thousands)**                      | ** ** | **Sept 30, 2006** | ** ** | **March 31, 2006** | ** ** |
|-----------------------------------------------------------|------------|-----------------------------|------------|------------------------------|------------|
| Inventories  consisted of:                                |       |                        |       |                         |       |
| Raw materials,  completed sub-assemblies, and spare parts |       | $                           | 8,052      |                         | $          | 6,856 |   |
| Work-in-process                                           |       | 6,196                       |       | 6,325                        |       |
| Finished goods                                            |       | 4,190                       |       | 3,705                        |       |
| Total                                                     |       | $                           | 18,438     |                         | $          | 16,886 |   |

 

**4.****                                      Incomeper Common and Common Equivalent Share**

Basic earnings per commonshare is computed by dividing net income available to common stockholders bythe weighted average number of shares of common stock outstanding during theperiod. Diluted earnings per share include the dilutive impact of options andwarrants using the average share price of the Company’s common stock for theperiod. For the quarters ended September 30, 2006 and September 30, 2005,common stock equivalents of 392,000 and 177,000 respectively, are excluded fromdiluted earnings per share, as their effect is anti-dilutive. For the sixmonths ended September 30, 2006 and September 30, 2005, common stockequivalents of 96,000 and 179,000 respectively, are excluded from dilutedearnings per share, as their effect is anti-dilutive.
| ** **                                                                               | ** ** | **Three Months Ended** | ** ** | **Six Months ended** | ** ** |
|------------------------------------------------------------------------------------------|------------|----------------------------------|------------|--------------------------------|------------|
| **(In thousands except per share amounts)**                     | ** ** | **Sept. 30,  2006**         | ** ** | **Sept. 30,  2005**       | ** ** | **Sept. 30,  2006** | ** ** | **Sept. 30,  2005** | ** ** |
| **Income  Per Share**                                                                    | ** ** | ** **                       | ** ** | ** **                     | ** ** | ** ** | ** ** | ** ** | ** ** |
| **Basic:**                                                                               | ** ** | ** **                       | ** ** | ** **                     | ** ** | ** ** | ** ** | ** ** | ** ** |
| Net income                                                                               |       | $                                | 4,753      |                           | $          | 8,396 |   | $ | 10,748 |   | $ | 15,393 |   |
| Weighted average  number of common shares outstanding —basic                        |       | 9,094                            |       | 8,475                          |       | 9,083 |   | 8,425 |   |
| Net income per  share —basic                                                        |       | $                                | 0.52       |                           | $          | 0.99 |   | $ | 1.18 |   | $ | 1.83 |   |
| **Diluted:**                                                                             | ** ** | ** **                       | ** ** | ** **                     | ** ** | ** ** | ** ** | ** ** | ** ** |
| Net income                                                                               |       | $                                | 4,753      |                           | $          | 8,396 |   | $ | 10,748 |   | $ | 15,393 |   |
| Adjustment to  net income for change in warrant valuation                                |       | (207                             | )          | —                         |       | (2,339 | ) | — |   |
| Adjusted net  income                                                                     |       | $                                | 4,546      |                           | $          | 8,396 |   | $ | 8,409 |   | $ | 15,393 |   |
| Weighted average  number of common shares outstanding                                    |       | 9,094                            |       | 8,475                          |       | 9,083 |   | 8,425 |   |
| Assumed exercise  of stock options and warrants, using the treasury stock method         |       | 222                              |       | 528                            |       | 255 |   | 506 |   |
| Weighted average  number of common and potential common shares outstanding —diluted |       | 9,316                            |       | 9,003                          |       | 9,338 |   | 8,931 |   |
| Net income per share  —diluted                                                      |       | $                                | 0.49       |                           | $          | 0.93 |   | $ | 0.90 |   | $ | 1.72 |   |

 

**5.             Borrowings**

On November 30,2004, the Company modified its two credit agreements with Silicon Valley BankEast. The modifications extended the credit facilities which expired onNovember 30, 2004 through November 29, 2006 and reduced the exportloan and security facility, guaranteed by the Export-Import Bank of the UnitedStates, from $20.0 million to $10.0 million. The domestic facility is a 

9

----

 

$5.0 milliondomestic loan and security agreement to support the Company’s routine workingcapital needs. Maximum borrowings for this facility are set at the lower of(a) the sum of 80% of eligible domestic accounts receivable plus 10% offinished goods inventory up to $750,000, or (b) $5.0 million. TheCompany is currently finalizing a new agreement with Silicon Valley Bank whichwill commence at the expiration of the current facility.

The credit facilitiesbear an interest rate of the greater of 4.0% or the Silicon Valley Bank primerate (8.25% at September 30, 2006). The credit agreements are collateralized bycertain assets of the Company and contain certain restrictions, includinglimitations on the amount of distributions that can be made to stockholders,and the disposition or encumbrances of assets, and require the maintenance ofcertain financial covenants.

At September 30, 2006,there were no borrowings outstanding against these credit facilities. TheCompany had outstanding $2,160,000 in stand-by letters of credit against thedomestic facility and no stand-by letters of credit against the exportfacility. Of the outstanding letters of credit, $1,250,000 relates to aperformance bond on an ongoing international project, $300,000 relates to theCompany’s building lease and the remainder is guaranteeing performance oncertain international projects. No amounts have been drawn against theseletters of credit. In addition, at September 30, 2006, the Company had arestricted cash balance of $14,127,000. Of the restricted cash, $12,500,000related to an advance payment guarantee associated with an ongoing internationalproject and the remainder related to certain bank required deposits related tooutstanding letters of credits, bid bonds, and other bank-related fees.

**6.             Warrant Liability**

On May 28, 2002, theCompany closed on a private placement offering of common stock and warrants. Atotal of 1,115,000 shares were sold to accredited investors at a price of$17.64 per share. In addition, warrants to purchase an additional 295,475shares of common stock at an exercise price of $23.52 per share were issued. Thewarrants were immediately vested and have a five-year life expiring inMay of 2007.

At September 30, 2006,21,625 warrants remain outstanding. Due to certain conversion features of thesewarrants that provide that the holder may opt for a cash settlement in certaininstances, including a merger, a sale of all or substantially all of theCompany’s assets, or a tender offer or exchange offer of shares of the Company’sstock, a liability equal to the fair value of the warrants at the deal closingdate was recorded on the Company’s balance sheet. This liability is remeasuredeach quarter and marked to market. The “mark to market” change in the warrantsvaluation of $207,000 and $(3,450,000) was recorded as other income (expense)for the three months ended September 30, 2006 and September 30, 2005,respectively. The “mark to market” change in the warrants valuation of$2,339,000 and $(2,917,000) was recorded as other income(expense) for the sixmonths ended September 30, 2006 and September 30, 2005, respectively. The liabilityof $565,000 and $4,038,000 representing the fair market value of outstandingwarrants at period end is recorded as a current liability at September 30, 2006and as a non-current liability as of March 31, 2006, respectively. Thefair market value of the warrants was determined using the Black-Scholespricing model with an assumed volatility of 65% and 49% at September 30, 2006and March 31, 2006, respectively, an interest rate of 4.98% and 4.60% atSeptember 30, 2006 and March 31, 2006, respectively and a life equal to theremaining term of the warrants at each period end.

**7.             Income Taxes**

The Company accounts forincome taxes in accordance with SFAS No. 109, “Accounting for IncomeTaxes.” Accordingly, the Company recognizes deferred income taxes based on theexpected future tax consequences of differences between the financial statementbasis and the tax basis of assets and liabilities, calculated using enacted taxrates in effect for the year in which the differences are expected to bereflected in the tax return. The Company evaluates the need for a valuationallowance against its net deferred tax assets at year end based upon its threeyear cumulative income and its projections of future income, and records avaluation allowance against any net deferred tax assets if it is more likelythan not that they will not be realized.

On November 10, 2005, theFinancial Accounting Standards board (“FASB”) issued FASB Staff Position No.FAS 123(R) “Transition Election Related to Accounting for Tax Effects of Share-BasedPayment Awards” that allows for a simplified or Long-Haul Method to establishthe beginning balance of the additional paid-in-capital pool (“APIC pool”)related to the tax effects of employee stock-based compensation, and todetermine the subsequent impact on the APIC pool and Consolidated Statements ofCash Flows of the tax effects of employee stock-based compensation awards thatare outstanding upon adoptions of SFAS 123(R). The Company has elected to usethe Long-Haul Method of calculating the APIC pool.

**8.             Guarantees**

Certain of the Company’sproducts carry a one-year warranty, the costs of which are accrued for at timeof shipment or delivery. Accrual rates are based upon historical experienceover the preceding twelve months and management’s judgment of future exposure. Warrantyexperience for the three and six months ended September 30, 2006 and September30, 2005 is as follows:
| ** **                                        | ** ** | **Three Months Ended** | ** ** | **Six Months Ended** | ** ** |
|---------------------------------------------------|------------|----------------------------------|------------|--------------------------------|------------|
| **(In thousands)**                           | ** ** | **Sept. 30,  2006**         | ** ** | **Sept. 30,  2005**       | ** ** | **Sept. 30,  2006** | ** ** | **Sept. 30,  2005** | ** ** |
| Warranty accrual  - beginning of period           |       | $                                | 3,210      |                           | $          | 2,768 |   | $ | 3,606 |   | $ | 2,322 |   |
| Accruals for  warranties issued during the period |       | 465                              |       | 1,412                          |       | 1,054 |   | 2,499 |   |
| Adjustment of  preexisting accrual estimates      |       | (451                             | )          | (85                            | )          | (981 | ) | (358 | ) |
| Warranty costs  incurred during the period        |       | (392                             | )          | (344                           | )          | (847 | ) | (712 | ) |
| Warranty accrual — end  of period            |       | $                                | 2,832      |                           | $          | 3,751 |   | $ | 2,832 |   | $ | 3,751 |   |

 

10

----

 

In conjunction with thesale of certain assets and contracts of the Company’s High Energy SystemsDivision in January of 2005, the lease for the California operations ofthe High Energy Systems Division was assigned to Accuray, Inc. The Companyremains secondarily liable for the remaining lease payments in the event ofdefault by Accuray, Inc. during the lease term which expires inFebruary 2011. Total remaining lease payments at September 30, 2006totaled $1,647,000. No accrual for this contingent liability has been recordedat September 30, 2006 as payment of this liability is considered remote.

**9.             Lease Commitments**

In March 2005, theCompany renewed its lease agreement for its corporate headquarters andmanufacturing facilities in Billerica, Massachusetts. As part of the leaseagreement, the Company’s landlord agreed to certain renovations to theBillerica facility including the construction of additional high baymanufacturing space. The Company was responsible for a portion of theconstruction costs and was deemed to be the owner of the building during theconstruction period under EITF 97-10, “The Effect of Lessee Involvement inAsset Construction”. During the year ended March 31, 2006, the Companycapitalized $5,153,000 to record the facility on its books with an offsettingcredit to the lease financing liability. In addition, amounts paid forconstruction were recorded as construction in progress and the landlordconstruction allowances of $5,642,000 (of which $208,000 was a receivable atSeptember 30, 2006) were recorded as additional lease financing liability.

At the completion of theconstruction in February 2006, the lease was reviewed for potentialsale-leaseback treatment in accordance with SFAS No. 98. Based on thisreview, it was determined that the lease did not qualify for sale-leasebacktreatment. As a result, building and tenant improvements and associated leasefinancing liabilities remain on the Company’s books. The lease financingliability is being amortized over the lease term based on the paymentsdesignated in the agreement and the building and tenant improvement assets arebeing depreciated on a straight line basis over their useful lives.

**Item2 — Management’s Discussion and Analysis of Financial Condition and Results ofOperations**

Results of Operations 

Net revenues for thequarter ended September 30, 2006 decreased by $19,553,000 to $29,588,000compared to the corresponding period a year ago. This decrease is attributableprimarily to a decrease of $24,941,000 in product sales, $16,869,000 whichrelates to decreased shipments of Z Backscatter systems. In addition, there wasa $4,066,000 decrease in sales of aftermarket parts from the prior year due toa one-time large order fulfilled last year, a decrease of $2,771,000 inCargoSearch system revenues due primarily to the completion of two largeCargoSearch projects which were ongoing last fiscal year and a decrease of$1,176,000 in ParcelSearch system revenues attributable to lower unit sales inthe current year. Service revenues increased by $5,388,000 to $12,550,000compared to the second quarter of fiscal 2006 due primarily to an increase inthe number of systems under service contracts as the warranties on systems soldin prior years expired and were replaced with service contracts and additionalextended warranties sold with international systems.

Net revenues for the sixmonths ended September 30, 2006 decreased by $24,833,000 to $59,470,000compared to the corresponding period a year ago. This decrease is attributableprimarily to a decrease of $35,341,000 in product sales, $22,494,000 whichrelates to decreased shipments of Z Backscatter systems. In addition, there wasa $4,249,000 decrease in sales of aftermarket parts from the prior year dueprimarily to a large order fulfilled last year, a decrease of $4,946,000 inCargoSearch system revenues due primarily to the completion of two largeCargoSearch projects which were ongoing last fiscal year and a decrease of$3,116,000 in ParcelSearch system revenues attributable to lower unit sales inthe current year. Service revenues increased by $10,508,000 to $23,319,000compared to the first six months of fiscal 2006 due primarily to an increase inthe number of systems under service contracts as the warranties on systems soldin prior years expired and were replaced with service contracts and additionalextended warranties sold with international systems.

Total cost of sales andcontracts for the quarter ended September 30, 2006 decreased by $8,306,000 to$16,059,000 as compared to the corresponding period a year ago. Cost of salesand contracts related to product revenues decreased by $10,546,000 to$9,235,000 as compared to the corresponding period a year ago. Cost of productsales and contract revenues represented 54% of revenues versus 47% of revenue,for the corresponding period last year. This decrease in gross margin is dueprimarily to $832,000 of stock-based compensation recorded as a result ofadopting SFAS 123(R) and a decrease in the volume of shipments of higher marginZ Backscatter systems. The cost of service revenues for the quarter endedSeptember 30, 2006 increased by $2,240,000 to $6,824,000 as 

11

----

 

compared to thecorresponding period a year ago. Cost of service revenues represented 54% ofrevenues versus 64% for the corresponding period last year. This marginimprovement is due primarily to the revenue increases noted above and increasedmargins on extended warranty related contracts.

Total cost of sales andcontracts for the six months ended September 30, 2006 decreased by $12,491,000to $32,444,000 as compared to the corresponding period a year ago. Cost ofsales and contracts related to product revenues decreased by $16,832,000 to$19,976,000 as compared to the corresponding period a year ago. Cost of productsales and contract revenues represented 55% of revenues versus 51% of revenue,for the corresponding period last year. This decrease in gross margin is dueprimarily to $1,514,000 of stock-based compensation recorded as a result ofadopting SFAS 123(R) and a decrease in the volume of shipments of higher marginZ Backscatter systems in the period. The cost of service revenues for the sixmonths ended September 30, 2006 increased by $4,341,000 to $12,468,000 ascompared to the corresponding period a year ago. Cost of service revenuesrepresented 53% of revenues versus 63% for the corresponding period last year. Thismargin improvement is due primarily to the revenue increases noted above andincreased margins on extended warranty related contracts.

Selling, general and administrativeexpenses for the quarter ended September 30, 2006 of $5,931,000 were $1,232,000higher than the corresponding period a year ago. Selling, general andadministrative expenses represented 20% of revenues in the current period ascompared to 10% for the corresponding period last year. The increase in costswas primarily the result of $1,321,000 of stock-based compensation expenserecorded in accordance with SFAS 123(R) and a $278,000 increase in bid andproposal related costs.

Selling, general and administrativeexpenses for the six months ended September 30, 2006 of $11,626,000 were$2,789,000 higher than the corresponding period a year ago. Selling, generaland administrative expenses represented 20% of revenues in the current periodas compared to 10% for the corresponding period last year. The increase incosts was primarily the result of $2,430,000 of stock-based compensationexpense recorded in accordance with SFAS 123(R) and a $576,000 increase in bidand proposal related costs.

Company funded researchand development expenses of $1,531,000 for the quarter ended September 30, 2006decreased by $939,000 compared to the corresponding period last year. Researchand development expenses represented 5% of revenues in both periods reported. Theseexpenditures decreased as the Company’s engineering efforts focused on revenueproducing programs, bid and proposal activities and product maintenance duringthe quarter.

Company funded researchand development expenses of $3,780,000 for the six months ended September 30,2006 decreased by $1,112,000 compared to the corresponding period last year. Researchand development expenses represented 6% of revenues in both periods reported.These expenditures decreased as the Company’s engineering efforts focused on revenueproducing programs, bid and proposal activities and product maintenance duringthe quarter.

Other income was$1,572,000 in income for the quarter ended September 30, 2006 as compared to$2,928,000 in expense for the corresponding period a year ago. Other income forthe quarter ended September 30, 2006 and September 30, 2005 includes $207,000and $(3,450,000), respectively of warrant income (expense) due to the changesin the warrant liability as a result of stock price volatility. In addition, inthe quarter ended September 30, 2006, the Company earned $1,375,000 in incomeon investments held as compared to $511,000 in the quarter ended September 30,2005 due to increases in the Company’s cash and investments balances, and a 30%increase in the average interest rate when compared to the prior year.

Other income was$4,734,000 in income for the six months ended September 30, 2006 as compared to$2,020,000 in expense for the corresponding period a year ago. Other income forthe six months ended September 30, 2006 and September 30, 2005 include$2,339,000 and $(2,917,000), respectively of warrant income (expense) due tothe changes in the warrant liability as a result of stock price volatility. Inaddition, in the six months ended September 30, 2006, the Company earned$2,491,000 in income on investments held as compared to $872,000 in the sixmonths ended September 30, 2005 due to increases in the Company’s cash andinvestments balances, and an increase in the average interest rate whencompared to the prior year.

As a result of the above,the Company reported pre-tax income of $7,639,000 in the quarter endedSeptember 30, 2006 as compared to pre-tax income of $14,679,000 in thecorresponding period a year ago. The Company reported pre-tax income of $16,354,000in the six months ended September 30, 2006 as compared to pre-tax income of$23,619,000 in the corresponding period a year ago.

The Company’s projectedeffective tax rate, excluding the income tax effect of the warrants which is apermanent item, for fiscal year 2007 increased to 40.0% from 30.8% for the yearended March 31, 2006. This increase is due to the Company recognition of taxcarryforward benefits during fiscal 2006 which reduced taxable income as wellas changes in other permanent tax items.

The Company had netincome of $4,753,000 during the quarter ended September 30, 2006 as compared tonet income of $8,396,000 in the second quarter of fiscal 2006. For the sixmonths ended September 30, 2006, the Company had net income of $10,748,000 ascompared to $15,393,000 for the six months ended September 30, 2005. Thesignificant factors contributing to these results are noted in the abovesections.

12

----

 

Liquidity and CapitalResources

Cash and cash equivalentsdecreased by $22,112,000 to $28,543,000 at September 30, 2006 compared to$50,655,000 at March 31, 2006. This decrease in cash and cash equivalentsis due primarily to $28,340,000 of net purchases of short term investments, a$14,029,000 increase in restricted cash related primarily to one largeinternational contract and $2,334,000 in capital expenditures related primarilyto the Company’s ongoing ERP system implementation and other leaseholdimprovements. These decreases are offset by $19,913,000 in cash provided byoperating activities comprised mainly of $10,748,000 of net income earnedduring the period adjusted for non-cash related items related to stockcompensation and warrants, and increases in customer deposits ($7,784,000) anddeferred revenue ($3,850,000).

On November 30,2004, the Company modified its two credit agreements with Silicon Valley BankEast. The modifications extended the credit facilities which expired onNovember 30, 2004 through November 29, 2006 and reduced the exportloan and security facility, guaranteed by the Export-Import Bank of the UnitedStates, from $20.0 million to $10.0 million. The domestic facility is a$5.0 million domestic loan and security agreement to support the Company’sroutine working capital needs. Maximum borrowings for this facility are set atthe lower of (a) the sum of 80% of eligible domestic accounts receivableplus 10% of finished goods inventory up to $750,000, or(b) $5 million. The Company is currently finalizing a new agreementwith Silicon Valley Bank which will commence at the expiration of the currentfacility.

The credit facilitiesbear an interest rate of the greater of 4.0% or the Silicon Valley Bank primerate (8.25% at September 30, 2006). The credit agreements are collateralized bycertain assets of the Company and contain certain restrictions, includinglimitations on the amount of distributions that can be made to stockholders,and the disposition or encumbrances of assets, and require the maintenance ofcertain financial covenants.

At September 30, 2006,there were no borrowings outstanding against these credit facilities. TheCompany had outstanding $2,160,000 in stand-by letters of credit against thedomestic facility and no stand-by letters of credit against the exportfacility. Of the outstanding letters of credit, $1,250,000 relates to aperformance bond on an ongoing international project, $300,000 relates to theCompany’s building lease and the remainder is guaranteeing performance oncertain international projects. No amounts have been drawn against theseletters of credit. In addition, at September 30, 2006, the Company had arestricted cash balance of $14,127,000. Of the restricted cash, $12,500,000related to an advance payment guarantee associated with an ongoinginternational project and the remainder related to certain bank requireddeposits related to outstanding letters of credits, bid bonds, and otherbank-related fees.

**NewAccounting Pronouncements:**

In December 2004,the FASB issued a FASB Staff Position (FSP) 109-1 Application of FASB 109 tothe Tax Deduction on Qualified Production Activities provided by the AmericanJobs Creation Act of 2004. The new act provides for a special tax deduction onqualified production activities income that effectively reduces the Company’stax rate. The FASB has decided that these amounts should be recorded as aspecial deduction, and recorded in the year earned. The Company does notbelieve that the adoption of this FSP statement will have a material impact onthe Company’s consolidated financial statements.

In July 2006, the FASBissued FASB Interpretation No. 48 “Accounting for Uncertainty in Income Taxes”(“FIN48”). FIN 48 is an interpretation of FASB Statement No. 109. “Accountingfor Income Taxes,” and it seeks to reduce the diversity in practice associatedwith certain aspects of measurement and recognition in accounting for incometaxes. In addition, FIN 48 requires expanded disclosure with respect to theuncertainty in income taxes and is required to be adopted for fiscal yearsbeginning after December 15, 2006. The Company is currently evaluating theimpact, if any, that FIN 48 will have on its financial statements.

In September 2006, the FASB issued Statement of Financial AccountingStandards No. 157 “Fair Value Measurements”, (“FAS 157”). FAS 157 defines fairvalue, establishes a framework for measuring fair value, and expands disclosurerequirements regarding fair value measurement. FAS 157 is effective for theCompany beginning April 1, 2008. The Company is currently reviewing theStatement to determine the impact and materiality of its adoption to theCompany.

**Item3 - Quantitative and Qualitative Disclosures about Market Risk**

The cash accounts for theCompany’s operations in Singapore, Hong Kong, England, and Abu Dhabi aremaintained in Singapore dollars, Hong Kong dollars, pounds sterling and dirham,respectively. Foreign currency accounts are marked to market at current ratesthat resulted in immaterial translation adjustments to stockholders’ equity.The gains and losses from foreign currency transactions are included in thestatements of operations for the period and were also immaterial. Ahypothetical 10% change in foreign currency rates would not have a materialimpact on the Company’s results of operations or financial position.

As of September 30, 2006,the Company held short-term investments consisting of money market funds andU.S. government and government agency bonds. The Company’s primary objectivewith its investment portfolio is to invest available cash while preservingprincipal and meeting liquidity needs. These investments had an averageinterest rate of approximately 5.03% and are subject to interest rate risk. Asa result of the average maturity and conservative nature of the investmentportfolio, a sudden change in interest rates would not have a material adverseeffect on the value of these investments.

13

----

 

In fiscal 2003, theCompany issued 295,475 warrants in connection with a private placement offeringof common stock. As of September 30, 2006, 21,625 of these warrants remainoutstanding. These warrants can be exchanged for cash under certaincircumstances including a merger, sale or tender offer of the Company, and assuch a liability equal to the fair value of the warrants is recorded on thebalance sheet. Changes in the fair value of the warrants are recorded as otherincome (expense). The Black-Scholes value of these warrants can fluctuatesignificantly based on the current fair market value of the Company’s commonstock. A 10% change in the fair market value of the Company’s common stock,holding other assumptions constant, would have approximately a$100,000 positive or negative impact on earnings.

**Item4 - Controls and Procedures**

a)             Evaluation of disclosure controls and procedures.

As of the end of theperiod covered by this report, under the supervision and with the participationof our management, including our Chief Executive Officer and Chief FinancialOfficer, the Company reviewed and evaluated the effectiveness of the Company’sdisclosure controls and procedures pursuant to Rule 13a-15(e) and15d-15(e) of the Securities Exchange Act of 1934 as amended (the “ExchangeAct”). Based upon their evaluation, our Chief Executive Officer and our ChiefFinancial Officer concluded that our disclosure controls and procedures wereeffective to provide reasonable assurance that information required to bedisclosed by the Company in the reports filed and submitted by it under theExchange Act is recorded, processed, summarized and reported within the timeperiod specified in the Securities and Exchange Commission’s rules andforms, and to provide reasonable assurance that information required to bedisclosed by the Company in such reports is accumulated and communicated to theCompany’s management, including its Chief Executive Officer and Chief FinancialOfficer, as appropriate to allow timely decisions regarding requireddisclosure.

b)            Changesin internal controls

There have been nochanges in our internal controls over financial reporting as such term isdefined in Rule 13a-15(f) and 15d-15(f) of the SecuritiesExchange Act of 1934 during the period covered by this report that havematerially affected, or are reasonably likely to materially affect, the Company’sinternal controls over financial reporting.

**PART II— OTHER INFORMATION**

**Item1- Legal Proceedings**

SinceFebruary 2004, the Company and L-3 Communications, Inc. had been engaged inlitigation in the United States District Court for the District ofMassachusetts in Boston over two of the Company’s patents — United StatesPatent No. 6,292,533 and No. 5,903,623. In August 2006, the parties enteredinto a Settlement Agreement that resulted in the dismissal of the underlyingsuit. This settlement had no material effect on the Company, the value of itsintellectual property or the development and sale of any of its products.

TheCompany is also subject to various legal proceedings and claims that arise inthe ordinary course of business. At the present time, it is not possible topredict the outcome of these matters; however, the Company currently believesthat resolving these matters will not have a material adverse impact o itsfinancial condition, results of operations or cash flows.

**Item4 - Submission of Matters to a Vote of Security Holders**

At the annual meeting ofStockholders of the Company held on September 14, 2006, the stockholdersof the Company (1) elected William E. Odom, Denis R. Brown, Roger P. Heinisch,Hamilton W. Helmer, Ernest J. Moniz, Carl W. Vogt and Anthony R. Fabiano asdirectors of the Company to hold office for a one-year term and no othernominations were made; and (2) ratified the appointment of Vitale, Caturano andCompany, Ltd., independent registered public accountants, as our independentauditors for the fiscal year ending March 31, 2007. The votes were asfollows:
|                                                                                 | ** ** | **Votes For** | ** ** | **Votes  Withheld or  Opposed** | ** ** | **Abstentions** | ** ** |
|---------------------------------------------------------------------------------|------------|--------------------|------------|--------------------------------------|------------|-----------------|------------|
|                                                                            |       |               |       |                                 |       |            |       |
| (1) Election of Directors:                                                      |       |               |       |                                 |       |            |       |
| William E. Odom                                                                 |       | 7,836,383          |       | 309,969                              |       | —          |       |
| Denis R. Brown                                                                  |       | 7,821,344          |       | 325,008                              |       | —          |       |
| Roger P. Heinisch                                                               |       | 6,899,076          |       | 1,247,276                            |       | —          |       |
| Hamilton W. Helmer                                                              |       | 7,758,340          |       | 388,012                              |       | —          |       |
| Ernest J. Moniz                                                                 |       | 7,841,237          |       | 305,115                              |       | —          |       |
| Mark Thompson                                                                   |       | 7,845,117          |       | 301,235                              |       | —          |       |
| Carl W. Vogt                                                                    |       | 7,819,781          |       | 326,571                              |       | —          |       |
| Anthony R. Fabiano                                                              |       | 7,749,517          |       | 396,835                              |       | —          |       |
| (2) Ratification  of Vitale, Caturano and Company, Ltd. as independent auditors |       | 8,072,792          |       | 39,931                               |       | 33,629          |       |

 

14

----

 

**Item6 - Exhibits**

| (a)    | ** ** | **Exhibits**                                                                                                                                                  | ** ** |
|--------|------------|---------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|
|   |       |                                                                                                                                                          |       |
| 31.1   |       | Certification by Chief  Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of  2002                                                     |       |
|   |       |                                                                                                                                                          |       |
| 31.2   |       | Certification by Chief  Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of  2002                                                     |       |
|   |       |                                                                                                                                                          |       |
| 32.1   |       | Certification of Chief  Executive Officer pursuant to 18 U.S.C. Section 1350, as adopted  pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 |       |
|   |       |                                                                                                                                                          |       |
| 32.2   |       | Certification of Chief  Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted  pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 |       |

 

The information requiredby Exhibit Item 11 (Statement re: Computation of Income per Common andCommon Equivalent Share) may be found in Footnote No. 4.

15

----

 

**SIGNATURES**

Pursuant to the requirementsof the Securities Exchange Act of 1934, the Registrant has duly caused thisReport to be signed on its behalf by the undersigned hereunto duly authorized.
|                             | AMERICAN SCIENCE AND ENGINEERING, INC. |
|-----------------------------|----------------------------------------|
|                        |                                   |
|                        |                                   |
| Date  November 9, 2006 | /s/ Kenneth J. Galaznik                |
|                        | Kenneth J. Galaznik                    |
|                        | Chief Financial Officer and Treasurer  |

 

*SafeHarbor Statement*

*Theforegoing 10-Q contains statements concerning the Company’s financialperformance and business operations, which may be considered “forward-looking”under applicable securities laws.*

*TheCompany wishes to caution readers of this Form 10-Q that actual resultsmight differ materially from those projected in any forward-looking statements.*

*Factorswhich might cause actual results to differ materially from those projected inthe forward-looking statements contained herein include the following:significant reductions or delays in procurements of the Company’s systems bythe United States and other governments; disruption in the supply of any sourcecomponent incorporated into AS&E’s products; litigation seeking to restrictthe use of intellectual property used by the Company; potential productliability claims against the Company; global political trends and events whichaffect public perception of the threat presented by drugs, explosives and othercontraband; global economic developments and the ability of governments andprivate organizations to fund purchases of the Company’s products to addresssuch threats; and the potential insufficiency of Company resources, includinghuman resources, capital, plant and equipment and management systems, toaccommodate any future growth and any future delays in federal funding. Theseand certain other factors which might cause actual results to differ materiallyfrom those projected are more fully set forth in the Company’s Annual Report onForm 10-K for the fiscal year ended March 31, 2006 under Item 1A “Risk Factors.”Please also refer to our other filings with the Securities and ExchangeCommission.*

16

----