##### Table of Contents

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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549



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FORM 10-Q



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



For the quarterly period ended OCTOBER 31, 2004



OR



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



For the transition period from  to



Commission file number 0-5449



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COMARCO, INC.

(Exact name of registrant as specified in its charter)



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|                                                               |  |                                     
|-------------------------------------------------------------- |  | ------------------------------------
|California                                                     |  | 95-2088894                          
|(State or other jurisdiction of incorporation or organization) |  | (I.R.S. Employer Identification No.)



2 Cromwell, Irvine,
California 92618

(Address of principal executive offices and zip code)



(949) 599-7400

(Registrants telephone number, including area code)



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Indicate by check mark whether the registrant: (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days.    Yes  x    No ̈



Indicate by check mark whether the registrant is an accelerated
filer (as defined in Rule 12b-2 of the Exchange Act).    Yes ̈No  x



The registrant had 7,340,216 shares of common
stock outstanding as of December 10, 2004.



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##### Table of Contents

COMARCO, INC. AND SUBSIDIARIES



QUARTERLY REPORT ON FORM 10-Q

FOR THE THREE AND NINE MONTHS ENDED OCTOBER 31, 2004



TABLE OF CONTENTS



|                               |  |                                                                                                               |  |     
|------------------------------ |  | ------------------------------------------------------------------------------------------------------------- |  | ----
|                               |  |                                                                                                               |  | Page
|                               | 
|PART I  FINANCIAL INFORMATION |  |                                                                                                              
|                               |  |                                                                                                              
|ITEM 1.                        |  | FINANCIAL STATEMENTS (Unaudited)                                                                              |  |     
|                               |  |                                                                                                              
|                               |  | Condensed Consolidated Balance Sheets as of October 31, 2004 and January 31, 2004                             |  | 3   
|                               |  |                                                                                                              
|                               |  | Condensed Consolidated Statements of Operations for the Three and Nine Months Ended October 31, 2004 and 2003 |  | 4   
|                               |  |                                                                                                              
|                               |  | Condensed Consolidated Statements of Cash Flows for the Nine Months Ended October 31, 2004 and 2003           |  | 5   
|                               |  |                                                                                                              
|                               |  | Notes to Condensed Consolidated Financial Statements                                                          |  | 6   
|                               |  |                                                                                                              
|ITEM 2.                        |  | MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS                         |  | 16  
|                               |  |                                                                                                              
|ITEM 3.                        |  | QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK                                                    |  | 31  
|                               |  |                                                                                                              
|ITEM 4.                        |  | CONTROLS AND PROCEDURES                                                                                       |  | 32  
|                               | 
|PART II  OTHER INFORMATION    |  |                                                                                                              
|                               |  |                                                                                                              
|ITEM 1.                        |  | LEGAL PROCEEDINGS                                                                                             |  | 33  
|                               |  |                                                                                                              
|ITEM 2.                        |  | UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS                                                   |  | 33  
|                               |  |                                                                                                              
|ITEM 3.                        |  | DEFAULTS UPON SENIOR SECURITIES                                                                               |  | 33  
|                               |  |                                                                                                              
|ITEM 4.                        |  | SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS                                                           |  | 33  
|                               |  |                                                                                                              
|ITEM 5.                        |  | OTHER INFORMATION                                                                                             |  | 33  
|                               |  |                                                                                                              
|ITEM 6.                        |  | EXHIBITS AND REPORTS ON FORM 8-K                                                                              |  | 33  
|                               | 
|SIGNATURES                     |  | 34                                                                                                           



2



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##### Table of Contents

PART I  FINANCIAL INFORMATION



ITEM 1. FINANCIAL STATEMENTS



COMARCO, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED BALANCE SHEETS

(Unaudited)

(In thousands, except
share amounts)



|                                                                                                                                                                          |  |                 |        |                     |   |       
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------- |  | --------------- | ------ | ------------------- | - | ------
|                                                                                                                                                                          |  | October 31,2004 |        | January 31,2004 (A)
|ASSETS                                                                                                                                                                    |  |                 |        |                     |   |       
|Current Assets:                                                                                                                                                           |  |                 |        |                     |   |       
|Cash and cash equivalents                                                                                                                                                 |  | $               | 12,881 |                     | $ | 15,047
|Short-term investments                                                                                                                                                    |  |                 | 1,680  |                     |   | 2,251 
|Accounts receivable, net                                                                                                                                                  |  |                 | 5,518  |                     |   | 8,982 
|Amounts due from affiliate                                                                                                                                                |  |                 | 403    |                     |   | 2,627 
|Inventory                                                                                                                                                                 |  |                 | 7,785  |                     |   | 6,150 
|Deferred tax assets, net                                                                                                                                                  |  |                 |       |                     |   | 2,695 
|Other current assets                                                                                                                                                      |  |                 | 1,156  |                     |   | 524   
|                                                                                                                                                                          |  |                 |        |                     |   |       
|Total current assets                                                                                                                                                      |  |                 | 29,423 |                     |   | 38,276
|                                                                                                                                                                          |  |                
|Property and equipment, net                                                                                                                                               |  |                 | 2,451  |                     |   | 3,131 
|Software development costs, net                                                                                                                                           |  |                 | 4,031  |                     |   | 5,536 
|Deferred tax assets, net                                                                                                                                                  |  |                 |       |                     |   | 181   
|Goodwill                                                                                                                                                                  |  |                 | 2,394  |                     |   | 2,394 
|Acquired intangible assets, net                                                                                                                                           |  |                 | 1,312  |                     |   | 1,488 
|Other assets                                                                                                                                                              |  |                 | 1,130  |                     |   | 1,133 
|                                                                                                                                                                          |  |                 |        |                     |   |       
|                                                                                                                                                                          |  | $               | 40,741 |                     | $ | 52,139
|                                                                                                                                                                          |  |                 |        |                     |   |       
|LIABILITIES AND STOCKHOLDERS EQUITY                                                                                                                                      |  |                 |        |                     |   |       
|Current Liabilities:                                                                                                                                                      |  |                 |        |                     |   |       
|Accounts payable                                                                                                                                                          |  | $               | 209    |                     | $ | 537   
|Deferred revenue                                                                                                                                                          |  |                 | 3,499  |                     |   | 5,476 
|Deferred compensation                                                                                                                                                     |  |                 | 1,680  |                     |   | 2,251 
|Accrued liabilities                                                                                                                                                       |  |                 | 3,439  |                     |   | 4,799 
|                                                                                                                                                                          |  |                 |        |                     |   |       
|Total current liabilities                                                                                                                                                 |  |                 | 8,827  |                     |   | 13,063
|                                                                                                                                                                          |  |                
|Minority interest                                                                                                                                                         |  |                 | 77     |                     |   | 185   
|Stockholders equity:                                                                                                                                                     |  |                 |        |                     |   |       
|Preferred stock, no par value, 10,000,000 shares authorized, no shares issued or outstanding at October 31, 2004 and January 31,
2004                                     |  |                 |       |                     |   |      
|Common stock, $0.10 par value, 50,625,000 shares authorized, 7,340,216 and 7,284,374 shares issued and outstanding at October 31, 2004 and
January 31, 2004, respectively |  |                 | 734    |                     |   | 728   
|Additional paid-in capital                                                                                                                                                |  |                 | 13,478 |                     |   | 13,126
|Retained earnings                                                                                                                                                         |  |                 | 17,625 |                     |   | 25,037
|                                                                                                                                                                          |  |                 |        |                     |   |       
|Total stockholders equity                                                                                                                                                |  |                 | 31,837 |                     |   | 38,891
|                                                                                                                                                                          |  |                 |        |                     |   |       
|                                                                                                                                                                          |  | $               | 40,741 |                     | $ | 52,139
|                                                                                                                                                                          |  |                 |        |                     |   |       

---

|(A) | Derived from the audited and consolidated financial statements as of January 31, 2004.
|--- | --------------------------------------------------------------------------------------



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



3



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##### Table of Contents

COMARCO, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(Unaudited)

(In thousands, except
per share amounts)



|                                                             |  |                               |        |   |                              |   |        |      |  |   |                |   |  |   |        |  
|------------------------------------------------------------ |  | ----------------------------- | ------ | - | ---------------------------- | - | ------ | ---- |  | - | -------------- | - |  | - | ------ | -
|                                                             |  | Three Months EndedOctober 31, |        |   | Nine Months EndedOctober 31, |  
|                                                             |  | 2004                          |        |   | 2003(Restated)               |   |        | 2004 |  |   | 2003(Restated) |  
|Revenue:                                                     |  |                               |        |   |                              |   |        |      |  |   |                |   |  |   |        |  
|Products                                                     |  | $                             | 5,516  |   |                              | $ | 9,658  |      |  | $ | 18,586         |   |  | $ | 18,605 |  
|Services                                                     |  |                               | 1,199  |   |                              |   | 1,215  |      |  |   | 3,855          |   |  |   | 3,809  |  
|                                                             |  |                               |        |   |                              |   |        |      |  |   |                |   |  |   |        |  
|                                                             |  |                               | 6,715  |   |                              |   | 10,873 |      |  |   | 22,441         |   |  |   | 22,414 |  
|                                                             |  |                               |        |   |                              |   |        |      |  |   |                |   |  |   |        |  
|Cost of revenue:                                             |  |                               |        |   |                              |   |        |      |  |   |                |   |  |   |        |  
|Products                                                     |  |                               | 4,434  |   |                              |   | 5,450  |      |  |   | 13,070         |   |  |   | 12,143 |  
|Services                                                     |  |                               | 899    |   |                              |   | 777    |      |  |   | 2,548          |   |  |   | 2,397  |  
|                                                             |  |                               |        |   |                              |   |        |      |  |   |                |   |  |   |        |  
|                                                             |  |                               | 5,333  |   |                              |   | 6,227  |      |  |   | 15,618         |   |  |   | 14,540 |  
|                                                             |  |                               |        |   |                              |   |        |      |  |   |                |   |  |   |        |  
|Gross profit                                                 |  |                               | 1,382  |   |                              |   | 4,646  |      |  |   | 6,823          |   |  |   | 7,874  |  
|Selling, general and administrative expenses                 |  |                               | 1,988  |   |                              |   | 2,078  |      |  |   | 6,614          |   |  |   | 7,717  |  
|Engineering and support expenses                             |  |                               | 1,849  |   |                              |   | 1,274  |      |  |   | 5,605          |   |  |   | 4,078  |  
|                                                             |  |                               |        |   |                              |   |        |      |  |   |                |   |  |   |        |  
|Operating income (loss)                                      |  |                               | (2,455 | ) |                              |   | 1,294  |      |  |   | (5,396         | ) |  |   | (3,921 | )
|Other income, net                                            |  |                               | 57     |   |                              |   | 39     |      |  |   | 135            |   |  |   | 206    |  
|Minority interest                                            |  |                               | 17     |   |                              |   | (10    | )    |  |   | 66             |   |  |   | 40     |  
|                                                             |  |                               |        |   |                              |   |        |      |  |   |                |   |  |   |        |  
|Income (loss) from continuing operations before income taxes |  |                               | (2,381 | ) |                              |   | 1,323  |      |  |   | (5,195         | ) |  |   | (3,675 | )
|Income tax (expense) benefit                                 |  |                               | 446    |   |                              |   | (487   | )    |  |   | (2,426         | ) |  |   | 1,312  |  
|                                                             |  |                               |        |   |                              |   |        |      |  |   |                |   |  |   |        |  
|Income (loss) from continuing operations                     |  |                               | (1,935 | ) |                              |   | 836    |      |  |   | (7,621         | ) |  |   | (2,363 | )
|Discontinued operations                                      |  |                               | 222    |   |                              |   | 82     |      |  |   | 209            |   |  |   | 134    |  
|                                                             |  |                               |        |   |                              |   |        |      |  |   |                |   |  |   |        |  
|Net income (loss)                                            |  | $                             | (1,713 | ) |                              | $ | 918    |      |  | $ | (7,412         | ) |  | $ | (2,229 | )
|                                                             |  |                               |        |   |                              |   |        |      |  |   |                |   |  |   |        |  
|Earnings (loss) per share  basic and diluted:               |  |                               |        |   |                              |   |        |      |  |   |                |   |  |   |        |  
|Earnings (loss) from continuing operations                   |  | $                             | (0.26  | ) |                              | $ | 0.12   |      |  | $ | (1.04          | ) |  | $ | (0.33  | )
|                                                             |  |                               |        |   |                              |   |        |      |  |   |                |   |  |   |        |  
|Earnings from discontinued operations                        |  | $                             | 0.03   |   |                              | $ | 0.01   |      |  | $ | 0.03           |   |  | $ | 0.02   |  
|                                                             |  |                               |        |   |                              |   |        |      |  |   |                |   |  |   |        |  
|Net income (loss)                                            |  | $                             | (0.23  | ) |                              | $ | 0.13   |      |  | $ | (1.01          | ) |  | $ | (0.31  | )
|                                                             |  |                               |        |   |                              |   |        |      |  |   |                |   |  |   |        |  
|Basic weighted average common shares                         |  |                               | 7,340  |   |                              |   | 7,161  |      |  |   | 7,313          |   |  |   | 7,108  |  
|                                                             |  |                               |        |   |                              |   |        |      |  |   |                |   |  |   |        |  
|Diluted weighted average common shares                       |  |                               | 7,340  |   |                              |   | 7,191  |      |  |   | 7,313          |   |  |   | 7,108  |  
|                                                             |  |                               |        |   |                              |   |        |      |  |   |                |   |  |   |        |  



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



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##### Table of Contents

COMARCO, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(Unaudited)

(In thousands)



|                                                                                                   |  |                              |        |   |                 |   |         |  
|-------------------------------------------------------------------------------------------------- |  | ---------------------------- | ------ | - | --------------- | - | ------- | -
|                                                                                                   |  | Nine Months EndedOctober 31, |       
|                                                                                                   |  | 2004                         |        |   | 2003 (Restated) |  
|CASH FLOWS FROM OPERATING ACTIVITIES:                                                              |  |                              |        |   |                 |   |         |  
|Net loss                                                                                           |  | $                            | (7,412 | ) |                 | $ | (2,229  | )
|Adjustments to reconcile loss from continuing operations to net cash used in operating activities: |  |                              |        |   |                 |   |         |  
|Depreciation and amortization                                                                      |  |                              | 3,463  |   |                 |   | 3,896   |  
|Tax benefit from exercise of stock options                                                         |  |                              |       |   |                 |   | 99      |  
|Deferred income taxes                                                                              |  |                              | 2,876  |   |                 |   | (796    | )
|Loss on disposal of property and equipment                                                         |  |                              | 77     |   |                 |   | 57      |  
|Provision for doubtful accounts receivable                                                         |  |                              | (72    | ) |                 |   | 386     |  
|Provision for obsolete inventory                                                                   |  |                              | (141   | ) |                 |   | (271    | )
|Minority interest in losses of subsidiary                                                          |  |                              | (66    | ) |                 |   | (40     | )
|Net change in operating assets of discontinued operations                                          |  |                              |       |   |                 |   | 16      |  
|Changes in operating assets and liabilities:                                                       |  |                              |        |   |                 |   |         |  
|Accounts receivable                                                                                |  |                              | 3,536  |   |                 |   | (6,962  | )
|Amounts due from affiliate                                                                         |  |                              | 2,224  |   |                 |   | (556    | )
|Inventory                                                                                          |  |                              | (1,494 | ) |                 |   | (1,249  | )
|Other assets                                                                                       |  |                              | (629   | ) |                 |   | (197    | )
|Accounts payable                                                                                   |  |                              | (328   | ) |                 |   | (75     | )
|Deferred revenue                                                                                   |  |                              | (1,977 | ) |                 |   | (312    | )
|Accrued liabilities                                                                                |  |                              | (1,360 | ) |                 |   | 1,144   |  
|                                                                                                   |  |                              |        |   |                 |   |         |  
|Net cash used in operating activities                                                              |  |                              | (1,303 | ) |                 |   | (7,089  | )
|                                                                                                   |  |                              |        |   |                 |   |         |  
|CASH FLOWS FROM INVESTING ACTIVITIES:                                                              |  |                              |        |   |                 |   |         |  
|Proceeds from sales of property and equipment                                                      |  |                              | 57     |   |                 |   |        |  
|Purchases of property and equipment                                                                |  |                              | (1,009 | ) |                 |   | (1,637  | )
|Software development costs                                                                         |  |                              |       |   |                 |   | (2,540  | )
|Acquired intangible assets                                                                         |  |                              | (66    | ) |                 |   | (520    | )
|                                                                                                   |  |                              |        |   |                 |   |         |  
|Net cash used in investing activities                                                              |  |                              | (1,018 | ) |                 |   | (4,697  | )
|                                                                                                   |  |                              |        |   |                 |   |         |  
|CASH FLOWS FROM FINANCING ACTIVITIES:                                                              |  |                              |        |   |                 |   |         |  
|Net proceeds from stock option exercises                                                           |  |                              | 26     |   |                 |   |        |  
|Proceeds from issuance of subsidiary common stock                                                  |  |                              | 129    |   |                 |   | 89      |  
|Purchase and retirement of common stock                                                            |  |                              |       |   |                 |   | (195    | )
|                                                                                                   |  |                              |        |   |                 |   |         |  
|Net cash provided by (used in) financing activities                                                |  |                              | 155    |   |                 |   | (106    | )
|Net decrease in cash and cash equivalents                                                          |  |                              | (2,166 | ) |                 |   | (11,892 | )
|Cash and cash equivalents, beginning of period                                                     |  |                              | 15,047 |   |                 |   | 25,385  |  
|                                                                                                   |  |                              |        |   |                 |   |         |  
|Cash and cash equivalents, end of period                                                           |  | $                            | 12,881 |   |                 | $ | 13,493  |  
|                                                                                                   |  |                              |        |   |                 |   |         |  
|Supplemental disclosures of cash flow information:                                                 |  |                              |        |   |                 |   |         |  
|Cash paid for interest                                                                             |  | $                            | 2      |   |                 | $ |        |  
|                                                                                                   |  |                              |        |   |                 |   |         |  
|Cash paid for income taxes                                                                         |  | $                            | 109    |   |                 | $ | 2       |  
|                                                                                                   |  |                              |        |   |                 |   |         |  



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



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##### Table of Contents

COMARCO, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(UNAUDITED)



1. Organization



Comarco, Inc., through its subsidiary Comarco Wireless Technologies, Inc. (collectively, Comarco or the Company), is a leading
provider of wireless test solutions for the wireless industry. Comarco also designs and manufactures emergency call box systems and mobile power products for notebook computers, cellular telephones, PDAs, and other handheld devices. Comarco Wireless
Technologies, Inc. (CWT) was incorporated in the State of Delaware in September 1993.



2. Summary of Significant Accounting Policies



Basis of Presentation:



The interim condensed
consolidated financial statements of Comarco included herein have been prepared without audit in accordance with accounting principles generally accepted in the United States of America for interim information and with the instructions for Form 10-Q
and Article 10 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements. The Company believes that the disclosures are adequate to
make the information presented not misleading when read in conjunction with the audited consolidated financial statements included in the Companys annual report on Form 10-K for the year ended January 31, 2004. The consolidated financial
information presented herein reflects all adjustments, consisting only of normal recurring accruals, which are, in the opinion of management, necessary for a fair presentation of the results for the interim periods presented. The results for the
three months and nine months ended October 31, 2004 are not necessarily indicative of the results to be expected for the year ending January 31, 2005.



Prior Year Restatement of Quarterly Results (Fiscal 2004):



The consolidated financial statements for the three and nine months ended October 31, 2003 were restated as of January 31, 2004 for the items described
below:



| |  | Prior to the fourth quarter of fiscal 2004, the Company allocated revenue from the sales of its wireless test solutions products between the product and first year maintenance using
an estimate of the fair value of such maintenance as a percentage of the total sales price. The Company has since determined that the actual fair value of the first year maintenance as a percentage of the total sales price based on vendor specific
objective evidence was higher than the estimated percentage, 10 percent versus 5 percent. The effect of the restatement was to decrease revenue for the three and nine months ended October 31, 2003 by $57,000 and $25,000, respectively.
| | - | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | Effective the beginning of fiscal 2003 and in conjunction with the implementation of SFAS No. 142, the Company re-evaluated the useful lives of its identifiable assets, including
acquired algorithms with a net book value of $255,000 and an original historical cost basis of $1 million. Prior to the adoption of SFAS No. 142, the software algorithms were being amortized over five years. Upon the adoption of SFAS No. 142, it was
concluded that the software algorithms had an indefinite useful life and therefore, were not subject to amortization, but rather, periodic evaluation for impairment. It was subsequently concluded that the original useful life of five years should
have been applied after the adoption of SFAS No. 142. As a result, the three and nine months ended October 31, 2003 have been restated to include additional amortization expense of $0 and $55,000, reported in cost of revenue.
| | - | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | During the fourth quarter of fiscal 2003, the Company recorded estimated losses associated with the recall of its legacy ChargeSource 70-watt universal AC power adapter. Included in
the estimated loss were costs attributable to a third-party service bureau engaged to administer the Companys recall efforts. These specific costs should have been charged to expense as incurred. Accordingly, selling, general and
administrative expenses for the three and nine months ended October 31, 2003 have been increased $48,000 and $144,000, respectively, as a result of this restatement adjustment.
| | - | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



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##### Table of Contents

COMARCO, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(UNAUDITED)



| |  | As a result of the restatement adjustments, income tax benefit for the three and nine months ended October 31, 2003 has been increased by $38,000 and $82,000, respectively.
| | - | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------



The net effect of the restatement adjustments
decreased the Companys net income by $67,000 for the three months ended October 31, 2003 and decreased the net earnings per share by $0.01 for the three months ended October 31, 2003. The net effect of the restatement adjustments increased the
Companys net loss by $142,000 for the nine months ended October 31, 2003 and increased the net loss per share by $0.02. Additionally, in the fourth quarter of fiscal 2004, the Company sold the net assets of EDX Engineering (EDX)
and therefore the EDX operations have been reclassified as discontinued operations for the three and nine months ended October 31, 2003. The following table presents the impact of the restatement adjustments to amounts previously reported for fiscal
2004 (in thousands):



|                                             |  |                                     |        |   |                        |   |      |                                            |  |   |             |   |  |   |        |  
|-------------------------------------------- |  | ----------------------------------- | ------ | - | ---------------------- | - | ---- | ------------------------------------------ |  | - | ----------- | - |  | - | ------ | -
|                                             |  | Three Months Ended October 31, 2003 |       
|                                             |  | AsPreviouslyReported                |        |   | RestatementAdjustments |   |      | Reclassificationfor DiscontinuedOperations |  |   | As Restated |  
|Revenue                                      |  | $                                   | 11,222 |   |                        | $ | (57  | )                                          |  | $ | (292        | ) |  | $ | 10,873 |  
|Cost of revenue                              |  |                                     | 6,229  |   |                        |   |     |                                            |  |   | (2          | ) |  |   | 6,227  |  
|                                             |  |                                     |        |   |                        |   |      |                                            |  |   |             |   |  |   |        |  
|Gross profit                                 |  | $                                   | 4,993  |   |                        | $ | (57  | )                                          |  | $ | (290        | ) |  | $ | 4,646  |  
|                                             |  |                                     |        |   |                        |   |      |                                            |  |   |             |   |  |   |        |  
|Selling, general and administrative expenses |  | $                                   | 2,113  |   |                        | $ | 48   |                                            |  | $ | (83         | ) |  | $ | 2,078  |  
|                                             |  |                                     |        |   |                        |   |      |                                            |  |   |             |   |  |   |        |  
|Income tax expense                           |  | $                                   | 572    |   |                        | $ | (38  | )                                          |  | $ | (47         | ) |  | $ | 487    |  
|                                             |  |                                     |        |   |                        |   |      |                                            |  |   |             |   |  |   |        |  
|Income from continuing operations            |  | $                                   | 985    |   |                        | $ | (67  | )                                          |  | $ | (82         | ) |  | $ | 836    |  
|                                             |  |                                     |        |   |                        |   |      |                                            |  |   |             |   |  |   |        |  
|                                             | 
|                                             |  | Nine Months Ended October 31, 2003  |       
|                                             |  | AsPreviouslyReported                |        |   | RestatementAdjustments |   |      | Reclassificationfor DiscontinuedOperations |  |   | As Restated |  
|Revenue                                      |  | $                                   | 23,203 |   |                        | $ | (25  | )                                          |  | $ | (764        | ) |  | $ | 22,414 |  
|Cost of revenue                              |  |                                     | 14,491 |   |                        |   | 55   |                                            |  |   | (6          | ) |  |   | 14,540 |  
|                                             |  |                                     |        |   |                        |   |      |                                            |  |   |             |   |  |   |        |  
|Gross profit                                 |  | $                                   | 8,712  |   |                        | $ | (80  | )                                          |  | $ | (758        | ) |  | $ | 7,874  |  
|                                             |  |                                     |        |   |                        |   |      |                                            |  |   |             |   |  |   |        |  
|Selling, general and administrative expenses |  | $                                   | 7,870  |   |                        | $ | 144  |                                            |  | $ | (297        | ) |  | $ | 7,717  |  
|                                             |  |                                     |        |   |                        |   |      |                                            |  |   |             |   |  |   |        |  
|Income tax benefit                           |  | $                                   | (1,153 | ) |                        | $ | (82  | )                                          |  | $ | (77         | ) |  | $ | (1,312 | )
|                                             |  |                                     |        |   |                        |   |      |                                            |  |   |             |   |  |   |        |  
|Loss from continuing operations              |  | $                                   | (2,087 | ) |                        | $ | (142 | )                                          |  | $ | (134        | ) |  | $ | (2,363 | )
|                                             |  |                                     |        |   |                        |   |      |                                            |  |   |             |   |  |   |        |  



Stock-Based Compensation:



The Company grants stock options for a fixed number of
shares to employees with an exercise price equal to the fair value of the shares at the date of grant. The Company accounts for stock option grants using the intrinsic method in accordance with Accounting Principles Board (APB) Opinion
No. 25, Accounting for Stock Issued to



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##### Table of Contents

COMARCO, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(UNAUDITED)



Employees and related interpretations in accounting for its
stock-based compensation plans. The Company has adopted the disclosure-only provisions of SFAS No. 123, Accounting for Stock-Based Compensation. Accordingly, no compensation expense is recognized for the stock option grants. If
compensation cost for the Companys stock option plans was determined based on the fair value at the grant date for awards during the three and nine months ended October 31, 2004 and 2003, consistent with the provisions of SFAS No. 123, the
Companys net income (loss), basic earnings (loss) per share, and diluted earnings (loss) per share would have been reduced to the pro forma amounts as follows (in thousands, except per share amounts):



|                                                                                                                                            |  |                               |        |   |                              |   |      |      |  |   |                |   |  |   |        |  
|------------------------------------------------------------------------------------------------------------------------------------------- |  | ----------------------------- | ------ | - | ---------------------------- | - | ---- | ---- |  | - | -------------- | - |  | - | ------ | -
|                                                                                                                                            |  | Three Months EndedOctober 31, |        |   | Nine Months EndedOctober 31, |  
|                                                                                                                                            |  | 2004                          |        |   | 2003(Restated)               |   |      | 2004 |  |   | 2003(Restated) |  
|Net income (loss):                                                                                                                          |  |                               |        |   |                              |   |      |      |  |   |                |   |  |   |        |  
|As reported                                                                                                                                 |  | $                             | (1,713 | ) |                              | $ | 918  |      |  | $ | (7,412         | ) |  | $ | (2,229 | )
|Deduct: Total stock-based employee compensation expense determined under fair value based method for all awards, net of related tax
effects |  |                               | (65    | ) |                              |   | (156 | )    |  |   | (183           | ) |  |   | (470   | )
|                                                                                                                                            |  |                               |        |   |                              |   |      |      |  |   |                |   |  |   |        |  
|Pro forma                                                                                                                                   |  | $                             | (1,778 | ) |                              | $ | 762  |      |  | $ | (7,595         | ) |  | $ | (2,699 | )
|                                                                                                                                            |  |                               |        |   |                              |   |      |      |  |   |                |   |  |   |        |  
|Earnings (loss) per common share  basic:                                                                                                   |  |                               |        |   |                              |   |      |      |  |   |                |   |  |   |        |  
|As reported                                                                                                                                 |  | $                             | (0.23  | ) |                              | $ | 0.13 |      |  | $ | (1.01          | ) |  | $ | (0.31  | )
|Pro forma                                                                                                                                   |  |                               | (0.24  | ) |                              |   | 0.11 |      |  |   | (1.04          | ) |  |   | (0.38  | )
|Earnings (loss) per common share  diluted:                                                                                                 |  |                               |        |   |                              |   |      |      |  |   |                |   |  |   |        |  
|As reported                                                                                                                                 |  | $                             | (0.23  | ) |                              | $ | 0.13 |      |  | $ | (1.01          | ) |  | $ | (0.31  | )
|Pro forma                                                                                                                                   |  |                               | (0.24  | ) |                              |   | 0.11 |      |  |   | (1.04          | ) |  |   | (0.38  | )



The fair value of
options granted under the Companys stock option plans during the nine months ended October 31, 2004 and 2003, was estimated on the date of grant using the Black-Scholes option-pricing model utilizing the following weighted average assumptions:



|                                         |  |                              |   |  |      |  
|---------------------------------------- |  | ---------------------------- | - |  | ---- | -
|                                         |  | Nine Months EndedOctober 31, |  
|                                         |  | 2004                         |   |  | 2003 |  
|Weighted average risk-free interest rate |  | 3.8                          | % |  | 3.1  | %
|Expected life (in years)                 |  | 6                            |   |  | 6    |  
|Expected stock volatility                |  | 46.2                         | % |  | 46.3 | %
|Dividend yield                           |  | None                         |   |  | None |  



Comarco, Inc. has
stock-based compensation plans under which outside directors and certain employees receive stock options. The employee stock option plans and a director stock option plan provide that officers, key employees, and directors may be granted options to
purchase shares of common stock of the Company at not less than 100 percent of the fair market value at the date of grant, unless the optionee is a 10 percent shareholder of the Company, in which case the price must not be less than 110 percent of
the fair market value. The total number of shares that may be granted under these plans is 2,704,337. Figures for these plans reflect a 3-for-2 stock split declared during the year ended January 31, 2001. The options are exercisable in installments
determined by the compensation committee of the Companys Board of Directors; however, no employee option may be exercised prior to one year following the grant of the option. The options expire as determined by the committee, but no later than
ten years and one week after the date of grant (five years for 10 percent shareholders). These plans expire through December 2010. Transactions and other information relating to these plans for the nine months ended October 31, 2004 are summarized
below:



|                            |  |                     |   |  |                                 |      
|--------------------------- |  | ------------------- | - |  | ------------------------------- | -----
|                            |  | Outstanding Options
|                            |  | Number of Shares    |   |  | Weighted-Average Exercise Price
|Balance, January 31, 2004   |  | 805,020             |   |  | $                               | 12.77
|Options granted             |  | 115,000             |   |  |                                 | 8.25 
|Options canceled or expired |  | (15,000             | ) |  |                                 | 11.04
|Options exercised           |  | (7,500              | ) |  |                                 | 3.42 
|                            |  |                     |   |  |                                 |      
|Balance, October 31, 2004   |  | 897,520             |   |  |                                 | 13.66
|                            |  |                     |   |  |                                 |      



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COMARCO, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(UNAUDITED)



The average fair value of each of the options granted
during the nine months ended October 31, 2004 totaled $8.25. The following table summarizes information about stock options outstanding at October 31, 2004:



|                         |  |                     |  |                                        |  |                             |       |                   |         |                             |   |      
|------------------------ |  | ------------------- |  | -------------------------------------- |  | --------------------------- | ----- | ----------------- | ------- | --------------------------- | - | -----
|                         |  | Options Outstanding |  | Options Exercisable                   
|Range of Exercise
Prices |  | NumberOutstanding   |  | Weighted-Avg.RemainingContractual Life |  | Weighted-Avg.Exercise Price |       | NumberExercisable |         | Weighted-Avg.Exercise Price
|$ 3.42 to 5.75           |  | 37,500              |  | 0.3 years                              |  | $                           | 5.75  |                   | 37,500  |                             | $ | 5.75 
|6.91 to 9.89             |  | 358,000             |  | 7.9                                    |  |                             | 8.08  |                   | 108,250 |                             |   | 8.37 
|10.00 to 12.41           |  | 125,145             |  | 4.8                                    |  |                             | 11.50 |                   | 94,395  |                             |   | 11.48
|13.21 to 17.50           |  | 234,375             |  | 4.4                                    |  |                             | 14.56 |                   | 216,750 |                             |   | 14.53
|19.33 to 23.67           |  | 142,500             |  | 5.6                                    |  |                             | 21.63 |                   | 142,500 |                             |   | 21.63
|                         |  |                     |  |                                        |  |                             |       |                   |         |                             |   |      
|3.42 to 23.67            |  | 897,520             |  | 5.9 years                              |  |                             | 12.30 |                   | 599,395 |                             |   | 14.08
|                         |  |                     |  |                                        |  |                             |       |                   |         |                             |   |      



Stock options
exercisable at October 31, 2004 were 605,395 at a weighted-average exercise price of $14.05. Shares available under the plans for future grants at October 31, 2004 total 101,687.



CWT also has a subsidiary stock option plan. Under this plan, officers and key employees of CWT may be granted options to
purchase up to 600,000 shares of common stock of CWT at not less than 100 percent of the fair market value at the date of grant.



As of October 31, 2004, the Company owned 3,323,000 out of the 3,353,000 outstanding shares of CWT common stock. The fair market value of the shares and
the exercise dates of the options are determined by the compensation committee of the Companys Board of Directors; however, no option may be exercised prior to one year following the grant of the option. The options expire as determined by the
compensation committee, but not later than ten years and one week after the date of grant.



In the nine months ended October 31, 2004, no options were granted. In the nine months ended October 31, 2004, 30,000 options were exercised at a weighted-average exercise price of $4.30. Stock options exercisable at
October 31, 2004 were 49,000 at a weighted-average exercise price of $12.34. Shares available under the plan for future grants at October 31, 2004 were 198,000.



9



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##### Table of Contents

COMARCO, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(UNAUDITED)



The following table summarizes information about CWT stock
options outstanding at October 31, 2004:



|                         |  |                     |  |                                        |  |                             |       |                   |        |                             |   |      
|------------------------ |  | ------------------- |  | -------------------------------------- |  | --------------------------- | ----- | ----------------- | ------ | --------------------------- | - | -----
|                         |  | Options Outstanding |  | Options Exercisable                   
|Range of Exercise
Prices |  | NumberOutstanding   |  | Weighted-Avg.RemainingContractual Life |  | Weighted-Avg.Exercise Price |       | NumberExercisable |        | Weighted-Avg.Exercise Price
|$ 11.97 to 13.22         |  | 46,000              |  | 1.2                                    |  | $                           | 12.00 |                   | 46,000 |                             | $ | 12.00
|17.62                    |  | 3,000               |  | 2.3                                    |  |                             | 17.62 |                   | 3,000  |                             |   | 17.62
|                         |  |                     |  |                                        |  |                             |       |                   |        |                             |   |      
|$ 11.97 to 17.62         |  | 49,000              |  | 1.2 years                              |  |                             | 12.34 |                   | 49,000 |                             |   | 12.34
|                         |  |                     |  |                                        |  |                             |       |                   |        |                             |   |      



Deferred Income Taxes:



Deferred income taxes, reflecting the impact of temporary
differences between assets and liabilities recognized for financial reporting purposes, are based on tax law currently enacted. The Company assesses on a periodic basis the probability that the net deferred tax assets will be recovered. If after
evaluating all of the positive and negative evidence, a conclusion is made that it is more likely than not that some portion or all of the net deferred tax assets will not be recovered, a valuation allowance is provided with a corresponding charge
to tax expense to reserve the portion of the deferred tax assets which are estimated to be more likely than not to be realized.



During the second quarter of fiscal 2005, the Company considered both positive and negative evidence in determining the need for a valuation allowance
against the net deferred tax assets. As of July 31, 2004, for the first time in recent history, the Company has incurred cumulative losses, excluding certain non-recurring items, for a three year period. This event has been determined to be a
significant element of negative evidence. While the Company expects to be profitable in the future, the projections of future profitability are based on assumptions that are not objectively verifiable. With this in mind, the negative evidence was
considered to outweigh the positive evidence and the Company concluded that its net deferred tax asset should be fully reserved at the conclusion of the second quarter of the 2005 fiscal year, and it remains fully reserved at the conclusion of the
third quarter. Accordingly, during the second quarter of fiscal 2005, a valuation allowance was established totaling approximately $2.9 million, or the entire deferred tax asset balance. Net deferred tax assets as of October 31, 2004 were zero.



Principles of Consolidation:



The condensed consolidated financial statements of the Company include the
accounts of Comarco, Inc., CWT, and wholly owned subsidiaries primarily reported as discontinued operations. All material intercompany balances, transactions, and profits have been eliminated.



Use of Estimates:



The preparation of consolidated financial statements in conformity with accounting principles generally accepted in
the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the condensed consolidated financial
statements and the reported amounts of revenue and expenses during the period reported. Actual results could differ materially from those estimates.



Certain accounting principles require subjective and complex judgments to be used in the preparation of financial statements. Accordingly, a different
financial presentation could result depending on the judgments, estimates, or assumptions that are used. Such estimates and assumptions include, but are not specifically limited to, those required in the valuation of long-lived assets, allowance for
doubtful accounts, inventory obsolescence, and valuation allowances for deferred tax assets.



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COMARCO, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(UNAUDITED)



Reclassifications:



Certain prior period balances have been reclassified to conform to the
current period presentation.



3. Stockholders Equity



During 1992, the Companys Board of Directors authorized a stock
repurchase program of up to 3.0 million shares of the Companys common stock. From program inception through October 31, 2004, the Company has repurchased approximately 2.6 million shares for an average price of $8.22 per share. During the
three and nine months ended October 31, 2004, the Company did not repurchase any shares of its common stock.



4. Earnings (Loss) Per Share



The Company calculates net earnings (loss) per share in accordance with SFAS No. 128, Earnings Per Share. Under SFAS No. 128, basic net earnings (loss) per share is calculated by dividing net income (loss) by the
weighted-average number of common shares outstanding during the reporting period. Diluted earnings (loss) per share reflects the effects of potentially dilutive securities. Since the Company incurred a net loss for the three and nine months ended
October 31, 2004 and the nine months ended October 31, 2003, basic and diluted loss per share were the same because the inclusion of potential common shares in the calculation would have been antidilutive.



Potential common shares of 3,125 and 9,431 have been excluded from diluted
weighted average common shares for the three and nine months ended October 31, 2004, as the effect would have been antidilutive. Similarly, potential common shares of 26,145 have been excluded from diluted weighted average common shares for the nine
months ended October 31, 2003, as the effect would have been antidilutive.



The following table presents reconciliations of the numerators and denominators of the basic and diluted earnings (loss) per share computations for net income (loss). In the tables below, Net income or
loss represents the numerator and Shares represents the denominator (in thousands, except per share amounts):



|                                                                         |  |                               |        |                              |                |   |       |  |   |                |   |  |   |        |  
|------------------------------------------------------------------------ |  | ----------------------------- | ------ | ---------------------------- | -------------- | - | ----- |  | - | -------------- | - |  | - | ------ | -
|                                                                         |  | Three Months EndedOctober 31, |        | Nine Months EndedOctober 31, |               
|                                                                         |  | 2004                          |        |                              | 2003(Restated) |   | 2004  |  |   | 2003(Restated) |  
|Basic:                                                                   |  |                               |        |                              |                |   |       |  |   |                |   |  |   |        |  
|                                                                         |  |                               |        |                             
|Net income (loss) from continuing operations                             |  | $                             | (1,935 | )                            |                | $ | 836   |  | $ | (7,621         | ) |  | $ | (2,363 | )
|Weighted average shares outstanding                                      |  |                               | 7,340  |                              |                |   | 7,161 |  |   | 7,313          |   |  |   | 7,108  |  
|                                                                         |  |                               |        |                              |                |   |       |  |   |                |   |  |   |        |  
|Basic and diluted earnings (loss) per share from continuing operations   |  | $                             | (0.26  | )                            |                | $ | 0.12  |  | $ | (1.04          | ) |  | $ | (0.33  | )
|                                                                         |  |                               |        |                              |                |   |       |  |   |                |   |  |   |        |  
|Discontinued operations                                                  |  | $                             | 222    |                              |                | $ | 82    |  | $ | 209            |   |  | $ | 134    |  
|Weighted average shares outstanding                                      |  |                               | 7,340  |                              |                |   | 7,161 |  |   | 7,313          |   |  |   | 7,108  |  
|                                                                         |  |                               |        |                              |                |   |       |  |   |                |   |  |   |        |  
|Basic and diluted earnings (loss) per share from discontinued operations |  | $                             | 0.03   |                              |                | $ | 0.01  |  | $ | 0.03           |   |  | $ | 0.02   |  
|                                                                         |  |                               |        |                              |                |   |       |  |   |                |   |  |   |        |  
|Net income (loss)                                                        |  | $                             | (1,713 | )                            |                | $ | 918   |  | $ | (7,412         | ) |  | $ | (2,229 | )
|Weighted average shares outstanding                                      |  |                               | 7,340  |                              |                |   | 7,161 |  |   | 7,313          |   |  |   | 7,108  |  
|                                                                         |  |                               |        |                              |                |   |       |  |   |                |   |  |   |        |  
|Basic and diluted earnings (loss) per share                              |  | $                             | (0.23  | )                            |                | $ | 0.13  |  | $ | (1.01          | ) |  | $ | (0.31  | )
|                                                                         |  |                               |        |                              |                |   |       |  |   |                |   |  |   |        |  



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COMARCO, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(UNAUDITED)



|                                                                         |  |                               |        |                              |                |   |       |  |   |                |   |  |   |        |  
|------------------------------------------------------------------------ |  | ----------------------------- | ------ | ---------------------------- | -------------- | - | ----- |  | - | -------------- | - |  | - | ------ | -
|                                                                         |  | Three Months EndedOctober 31, |        | Nine Months EndedOctober 31, |               
|                                                                         |  | 2004                          |        |                              | 2003(Restated) |   | 2004  |  |   | 2003(Restated) |  
|Diluted:                                                                 |  |                               |        |                              |                |   |       |  |   |                |   |  |   |        |  
|                                                                         |  |                               |        |                             
|Net income (loss) from continuing operations                             |  | $                             | (1,935 | )                            |                | $ | 836   |  | $ | (7,621         | ) |  | $ | (2,363 | )
|Weighted average shares outstanding                                      |  |                               | 7,340  |                              |                |   | 7,191 |  |   | 7,313          |   |  |   | 7,108  |  
|                                                                         |  |                               |        |                              |                |   |       |  |   |                |   |  |   |        |  
|Basic and diluted earnings (loss) per share from continuing operations   |  | $                             | (0.26  | )                            |                | $ | 0.12  |  | $ | (1.04          | ) |  | $ | (0.33  | )
|                                                                         |  |                               |        |                              |                |   |       |  |   |                |   |  |   |        |  
|Discontinued operations                                                  |  | $                             | 222    |                              |                | $ | 82    |  | $ | 209            |   |  | $ | 134    |  
|Weighted average shares outstanding                                      |  |                               | 7,340  |                              |                |   | 7,191 |  |   | 7,313          |   |  |   | 7,108  |  
|                                                                         |  |                               |        |                              |                |   |       |  |   |                |   |  |   |        |  
|Basic and diluted earnings (loss) per share from discontinued operations |  | $                             | 0.03   |                              |                | $ | 0.01  |  | $ | 0.03           |   |  | $ | 0.02   |  
|                                                                         |  |                               |        |                              |                |   |       |  |   |                |   |  |   |        |  
|Net income (loss)                                                        |  | $                             | (1,713 | )                            |                | $ | 918   |  | $ | (7,412         | ) |  | $ | (2,229 | )
|Weighted average shares outstanding                                      |  |                               | 7,340  |                              |                |   | 7,191 |  |   | 7,313          |   |  |   | 7,108  |  
|                                                                         |  |                               |        |                              |                |   |       |  |   |                |   |  |   |        |  
|Basic and diluted earnings (loss) per share                              |  | $                             | (0.23  | )                            |                | $ | 0.13  |  | $ | (1.01          | ) |  | $ | (0.31  | )
|                                                                         |  |                               |        |                              |                |   |       |  |   |                |   |  |   |        |  



5. Inventory



Inventory consists of the following (in thousands):



|                |  |                  |       |                  |   |      
|--------------- |  | ---------------- | ----- | ---------------- | - | -----
|                |  | October 31, 2004 |       | January 31, 2004
|Raw materials   |  | $                | 4,864 |                  | $ | 4,022
|Work in process |  |                  | 553   |                  |   | 599  
|Finished goods  |  |                  | 2,368 |                  |   | 1,529
|                |  |                  |       |                  |   |      
|                |  | $                | 7,785 |                  | $ | 6,150
|                |  |                  |       |                  |   |      



6. Software Development Costs, Net



Software development costs consist of the following (in
thousands):



|                                       |  |                  |        |   |                  |   |        |  
|-------------------------------------- |  | ---------------- | ------ | - | ---------------- | - | ------ | -
|                                       |  | October 31, 2004 |        |   | January 31, 2004 |  
|Capitalized software development costs |  | $                | 8,978  |   |                  | $ | 8,978  |  
|Less: accumulated amortization         |  |                  | (4,947 | ) |                  |   | (3,442 | )
|                                       |  |                  |        |   |                  |   |        |  
|                                       |  | $                | 4,031  |   |                  | $ | 5,536  |  
|                                       |  |                  |        |   |                  |   |        |  



Amortization of
software development costs for the three months ended October 31, 2004 and 2003 totaled $488,000 and $1.0 million, respectively. For the nine months ended October 31, 2004 and 2003, amortization of software development costs totaled $1.5 million and
$2.1 million, respectively. Amortization of software development costs has been reported in cost of revenue in the accompanying condensed consolidated financial statements. The amortization period for the software costs capitalized is the shorter of
the economic life of the related product or based on expected unit sales under the sales ratio method, typically two to four years.



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COMARCO, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(UNAUDITED)



7. Goodwill and Acquired Intangible Assets, Net



Goodwill and acquired intangible assets consist of the following (in
thousands):



|                                  |  |                  |       |   |                  |   |       |  
|--------------------------------- |  | ---------------- | ----- | - | ---------------- | - | ----- | -
|                                  |  | October 31, 2004 |       |   | January 31, 2004 |  
|Goodwill                          |  | $                | 2,394 |   |                  | $ | 2,394 |  
|                                  |  |                  |       |   |                  |   |       |  
|Acquired intangible assets:       |  |                  |       |   |                  |   |       |  
|Definite-lived intangible assets: |  |                  |       |   |                  |   |       |  
|Software algorithms               |  | $                | 255   |   |                  | $ | 255   |  
|License rights                    |  |                  | 1,037 |   |                  |   | 971   |  
|Intellectual property rights      |  |                  | 950   |   |                  |   | 788   |  
|                                  |  |                  |       |   |                  |   |       |  
|                                  |  |                  | 2,242 |   |                  |   | 2,014 |  
|Less: accumulated amortization    |  |                  | (930  | ) |                  |   | (526  | )
|                                  |  |                  |       |   |                  |   |       |  
|                                  |  | $                | 1,312 |   |                  | $ | 1,488 |  
|                                  |  |                  |       |   |                  |   |       |  



The following table
presents goodwill by reportable segment (in thousands):



|                               |  |                      |     |                        |   |       |  |   |      
|------------------------------ |  | -------------------- | --- | ---------------------- | - | ----- |  | - | -----
|                               |  | WirelessApplications |     | Wireless TestSolutions |   | Total
|Balance as of October 31, 2004 |  | $                    | 496 |                        | $ | 1,898 |  | $ | 2,394
|                               |  |                      |     |                        |   |       |  |   |      
|Balance as of January 31, 2004 |  | $                    | 496 |                        | $ | 1,898 |  | $ | 2,394
|                               |  |                      |     |                        |   |       |  |   |      



The following table
presents the future expected amortization of the definite-lived intangible assets (in thousands):



|                                     |  |                     |      
|------------------------------------ |  | ------------------- | -----
|                                     |  | AmortizationExpense
|Fiscal year:                         |  |                     |      
|2005                                 |  | $                   | 104  
|2006                                 |  |                     | 378  
|2007                                 |  |                     | 317  
|2008                                 |  |                     | 149  
|2009                                 |  |                     | 136  
|Thereafter                           |  |                     | 228  
|                                     |  |                     |      
|Total estimated amortization expense |  | $                   | 1,312
|                                     |  |                     |      



Amortization of
definite-lived acquired intangible assets for the three months ended October 31, 2004 and 2003 totaled $168,000 and $64,000, respectively. For the nine months ended October 31, 2004 and 2003, amortization of definite-lived acquired intangible assets
totaled $404,000 and $195,000 respectively. The Company ceased amortizing goodwill beginning February 1, 2002 upon adoption of SFAS No. 142, (Goodwill and Other Intangible Assets.)



8. Business Segment Information



The Company has two reportable operating segments: wireless test solutions
and wireless applications. Wireless test solutions designs and manufactures hardware and software tools for use by wireless carriers, equipment vendors, and others. Radio frequency engineers, professional technicians, and others use these tools to
design, deploy, and optimize wireless networks, and to verify the performance of the wireless networks once deployed.



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##### Table of Contents

COMARCO, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(UNAUDITED)



Wireless applications designs and manufactures call box
systems and mobile power products for notebook computers, cellular telephones, PDAs, and other handheld devices. Call box systems provide emergency communication over existing wireless networks. In addition to the call box products, the Company
provides system installation and long-term maintenance services. Currently, approximately 19,000 CWT call boxes are installed, of which approximately 14,000 are serviced and maintained under long-term agreements, which expire at various times
through February 2011.



Performance measurement and resource
allocation for the reportable segments are based on many factors. The primary financial measures used are revenue and gross profit. The revenue, gross profit, gross margin, and total assets attributable to these segments are as follows (in
thousands):



|                    |  |                                     |        |   |                                     |   |       |       |  |   |                                  |   |  |                      |       |   |                 |   |        |   |  |   |        |  
|------------------- |  | ----------------------------------- | ------ | - | ----------------------------------- | - | ----- | ----- |  | - | -------------------------------- | - |  | -------------------- | ----- | - | --------------- | - | ------ | - |  | - | ------ | -
|                    |  | Three Months Ended October 31, 2004 |        |   | Three Months Ended October 31, 2003 |  
|                    |  | Wireless TestSolutions              |        |   | WirelessApplications                |   |       | Total |  |   | Wireless TestSolutions(Restated) |   |  | WirelessApplications |       |   | Total(Restated) |  
|Revenue             |  | $                                   | 4,193  |   |                                     | $ | 2,522 |       |  | $ | 6,715                            |   |  | $                    | 2,822 |   |                 | $ | 8,051  |   |  | $ | 10,873 |  
|Cost of revenue     |  |                                     | 2,334  |   |                                     |   | 2,999 |       |  |   | 5,333                            |   |  |                      | 1,979 |   |                 |   | 4,248  |   |  |   | 6,227  |  
|                    |  |                                     |        |   |                                     |   |       |       |  |   |                                  |   |  |                      |       |   |                 |   |        |   |  |   |        |  
|Gross profit (loss) |  | $                                   | 1,859  |   |                                     | $ | (477  | )     |  | $ | 1,382                            |   |  | $                    | 843   |   |                 | $ | 3,803  |   |  | $ | 4,646  |  
|                    |  |                                     |        |   |                                     |   |       |       |  |   |                                  |   |  |                      |       |   |                 |   |        |   |  |   |        |  
|Gross margin        |  |                                     | 44.3   | % |                                     |   | (18.9 | )%    |  |   | 20.6                             | % |  |                      | 29.9  | % |                 |   | 47.2   | % |  |   | 42.7   | %
|                    |  |                                     |        |   |                                     |   |       |       |  |   |                                  |   |  |                      |       |   |                 |   |        |   |  |   |        |  
|                    |  |                                    
|                    |  | Nine Months Ended October 31, 2004  |        |   | Nine Months EndedOctober 31, 2003   |  
|                    |  | Wireless TestSolutions              |        |   | WirelessApplications                |   |       | Total |  |   | Wireless TestSolutions(Restated) |   |  | WirelessApplications |       |   | Total(Restated) |  
|Revenue             |  | $                                   | 13,052 |   |                                     | $ | 9,389 |       |  | $ | 22,441                           |   |  | $                    | 6,716 |   |                 | $ | 15,698 |   |  | $ | 22,414 |  
|Cost of revenue     |  |                                     | 7,420  |   |                                     |   | 8,198 |       |  |   | 15,618                           |   |  |                      | 4,409 |   |                 |   | 10,131 |   |  |   | 14,540 |  
|                    |  |                                     |        |   |                                     |   |       |       |  |   |                                  |   |  |                      |       |   |                 |   |        |   |  |   |        |  
|Gross profit        |  | $                                   | 5,632  |   |                                     | $ | 1,191 |       |  | $ | 6,823                            |   |  | $                    | 2,307 |   |                 | $ | 5,567  |   |  | $ | 7,874  |  
|                    |  |                                     |        |   |                                     |   |       |       |  |   |                                  |   |  |                      |       |   |                 |   |        |   |  |   |        |  
|Gross margin        |  |                                     | 43.2   | % |                                     |   | 12.7  | %     |  |   | 30.4                             | % |  |                      | 34.4  | % |                 |   | 35.5   | % |  |   | 35.1   | %
|                    |  |                                     |        |   |                                     |   |       |       |  |   |                                  |   |  |                      |       |   |                 |   |        |   |  |   |        |  



|                           |  |                        |        |                      |   |           |  |       |        |  |   |       
|-------------------------- |  | ---------------------- | ------ | -------------------- | - | --------- |  | ----- | ------ |  | - | ------
|                           |  | Wireless TestSolutions |        | WirelessApplications |   | Corporate |  | Total
|Assets at October 31, 2004 |  | $                      | 13,843 |                      | $ | 5,691     |  | $     | 21,207 |  | $ | 40,741
|                           |  |                        |        |                      |   |           |  |       |        |  |   |       
|Assets at January 31, 2004 |  | $                      | 18,160 |                      | $ | 12,252    |  | $     | 21,727 |  | $ | 52,139
|                           |  |                        |        |                      |   |           |  |       |        |  |   |       



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##### Table of Contents

COMARCO, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(UNAUDITED)



Revenue by geographic area consists of the following (in
thousands):



|              |  |                                |       |                               |   |        |  |                 |        |  |   |       
|------------- |  | ------------------------------ | ----- | ----------------------------- | - | ------ |  | --------------- | ------ |  | - | ------
|              |  | Three Months Ended October 31, |       | Nine Months Ended October 31,
|              |  | 2004                           |       | 2003 (Restated)               |   | 2004   |  | 2003 (Restated)
|North America |  | $                              | 3,042 |                               | $ | 9,380  |  | $               | 11,405 |  | $ | 18,553
|Europe        |  |                                | 2,320 |                               |   | 482    |  |                 | 6,579  |  |   | 2,220 
|Asia          |  |                                |      |                               |   | 58     |  |                 | 346    |  |   | 163   
|Latin America |  |                                | 1,353 |                               |   | 953    |  |                 | 4,111  |  |   | 1,478 
|              |  |                                |       |                               |   |        |  |                 |        |  |   |       
|              |  | $                              | 6,715 |                               | $ | 10,873 |  | $               | 22,441 |  | $ | 22,414
|              |  |                                |       |                               |   |        |  |                 |        |  |   |       



9. Commitments and Contingencies



Purchase Commitments with Suppliers



The Company generally issues purchase orders to its suppliers with delivery
dates from four to six weeks from the purchase order date. In addition, the Company regularly provides significant suppliers with rolling six-month forecasts of material and finished goods requirements for planning and long-lead time parts
procurement purposes only. The Company is committed to accept delivery of materials pursuant to its purchase orders subject to various contract provisions which allows the Company to delay receipt of such orders or allows the Company to cancel
orders pursuant to certain agreed lead times. Such cancellations may or may not include cancellation costs payable by the Company. In the past, the Company has been required to take delivery of materials from its suppliers that were in excess of
Company requirements and the Company has previously recognized charges and expenses related to such excess material. If the Company is unable to adequately manage its suppliers and adjust such commitments for changes in demand, the Company may incur
additional inventory expenses related to excess and obsolete inventory. Such expenses could have a material adverse effect on the Companys business, results of operations, and financial position.



Significant Customers and Suppliers



The Company has historically derived a significant portion of its revenue
from a limited number of customers. For the nine months ended October 31, 2004 three customers accounted for more than 10.0 percent of the Companys revenue. SwissQual, the Companys European distributor of WTS products accounted for $6.2
million or 27.7 percent of revenue, Targus, the former distributor of ChargeSource products, accounted for $3.6 million or 16.2 percent of revenue, and TIM Celular S.A., a customer of the WTS business, accounted for $3.0 million or 13.2 percent of
revenue. For the nine months ended October 31, 2003 only one customer, Targus at 31.2 percent, accounted for in excess of 10.0 percent of the Companys revenues.



A decision by a significant customer to substantially decrease or delay purchases from the Company or the Companys
inability to collect receivables from these customers could have a material adverse effect on the Companys business, results of operations, and financial condition.



For the nine months ended October 31, 2004, the Company had two inventory suppliers that each accounted for more than 10.0
percent of the Companys inventory purchases. Nokia and Synnex, WTS vendors, accounted for 12.1 percent and 11.2 percent of inventory purchases, respectively, made during the nine months ended October 31, 2004. For the nine months ended October
31, 2003, the Company had two inventory suppliers that each accounted for more than 10 percent of the Companys inventory purchases. Future Electronics and Supercomal Advanced Cables, ChargeSource vendors, accounted for 17.4 percent and 13.7
percent of inventory purchases, respectively, made during the nine months ended October 31, 2003.



A significant suppliers inability to perform under a firm purchase order or significant delay in performance could have a material adverse effect on
the Companys business, results of operations, and financial condition.



Significant Supplier Agreements



During the
third quarter of fiscal 2005, the Company entered into a supply agreement with Kensington (the Supply Agreement), a tier-one distributor of consumer electronics, to distribute certain of our ChargeSource products to Big Box
retailers and other channels. The Supply Agreement commenced September 1, 2004 and continues for a term of eighteen (18) months and provides Kensington with channel conflict protection with respect to certain channels and ChargeSource products based
on Kensingtons performance.



During January 2004, we
entered into a supply agreement with Belkin Corporation (Belkin and the Belkin Supply Agreement) and began shipping a limited number of ChargeSource units to Belkin late in the first quarter of fiscal 2005. The subsequent
sales and marketing efforts, as well as the ramp-up of unit sales of the Belkin-branded ChargeSource products did not meet our original expectations. The Belkin Supply Agreement was terminated in conjunction with the execution of a mutual release
during the third quarter of fiscal 2005. Accordingly, during the third quarter of fiscal 2005 the Company established an inventory reserve recorded as cost of revenue totaling approximately $0.6 million to fully reserve undelivered Belkin-branded
ChargeSource products that were manufactured under non-cancelable purchase orders.



Legal Contingencies



During fiscal 2001, the
Company sold a business which, among other things, provided airport management services. During the fourth quarter of fiscal 2004, the Company was sued by a tenant at an airport where the Company provided management services pursuant to a contract
with the County of Los Angeles (prior to the sale of this business during the 2001 fiscal year). The claimant seeks damages of $2.0 million in addition to other unspecified damages. The outcome of this matter is not determinable or estimable. No
provision has been made for losses, if any, which may result from the final outcome of this matter.



The Company is from time to time involved in various legal proceedings incidental to the conduct of our business. Management of the Company believes that
the outcome of all such pending legal proceedings will not in the aggregate have a material adverse effect on the Companys consolidated results of operations, financial position or cash flows.



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##### Table of Contents

ITEM 2. MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS



The following discussion and analysis should be read in conjunction with our unaudited consolidated financial statements and the related notes and
other financial information appearing elsewhere in this quarterly report on Form 10-Q. Readers are also urged to carefully review and consider the various disclosures made by us which attempt to advise interested parties of the factors which affect
our business, including without limitation the disclosures made under the caption Managements Discussion and Analysis of Financial Condition and Results of Operations, and disclosure made in our annual report on Form 10-K for the
fiscal year ended January 31, 2004 under the caption Risk Factors, Uncertainties and Other Factors that May Affect Results of Operations and Financial Condition, as well as the audited consolidated financial statements and notes thereto
also included in our annual report on Form 10-K for the fiscal year ended January 31, 2004.



Forward-Looking Statements



Some of the statements in this report and the documents incorporated herein by reference constitute forward-looking statements within the meaning of Section 21E of the Securities Exchange Act of 1934. These statements relate to future
financial performance and involve known and unknown risks, uncertainties, and other factors that may cause our businesss or our industrys actual results, levels of activity, performance, or achievements to be materially different from
those expressed or implied by any forward-looking statements. Such statements include, in particular, statements about our plans, strategies, prospects, changes and trends in our business and the markets in which we operate as described in this
report. In some cases, you can identify forward-looking statements by terminology such as may, will, could, would, should, expect, plan, anticipate,
intend, believe, estimate, forecast, predict, propose, potential, or continue or the negative of those terms or other comparable terminology. These
statements are only predictions.



Although we believe
that the expectations reflected in the forward-looking statements are reasonable, we cannot guarantee future results, levels of activity, performance, or achievements. Moreover, neither we, nor any other person, assume responsibility for the
accuracy and completeness of the forward-looking statements. We are under no obligation to update any of the forward-looking statements after the filing of this report on Form 10-Q to conform such statements to actual results or to changes in our
expectations.



Overview



Comarco, Inc., through its subsidiary Comarco Wireless Technologies, Inc.
(collectively, we, Comarco, or the Company), is a leading provider of wireless test solutions for the wireless industry. We also design and manufacture emergency call box systems and mobile power products for
notebook computers, cellular telephones, PDAs, and other handheld devices. Our operations consist solely of the operations of Comarco Wireless Technologies, Inc. (CWT).



Our revenue is primarily derived from sales of our wireless test solutions and wireless applications products, and from
services related to the maintenance of emergency call box systems. We have two reportable operating segments: wireless test solutions (WTS) and wireless applications. See Business Segment Information in Note 9 of notes to our
unaudited condensed consolidated financial statements included in Part I, Item 1 of this report.



Critical Accounting Policies



We have identified the following as critical accounting policies to our company: revenue recognition, software development costs, accounts receivable, inventory, income taxes, valuation of goodwill, and valuation of long-lived assets.



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##### Table of Contents

Revenue Recognition



We recognize product revenue upon shipment of products provided there are no uncertainties regarding customer acceptance, persuasive evidence of an
arrangement exists, the sales price is fixed or determinable, and collectibility is probable. For our WTS products, which are integrated with embedded software, we recognize revenue using the residual method pursuant to requirements of Statement of
Position No. 97-2, Software Revenue Recognition, and other applicable revenue recognition guidance and interpretations. Under the residual method, we allocate revenue to the undelivered element, typically maintenance, based on its
respective fair value, with the fair value determined by the price charged when that element is sold separately. We amortize the revenue allocated to the maintenance element evenly over the term of the maintenance commitment made at the time of
sale. We expense as incurred the costs associated with honoring the maintenance commitment.



We recognize service revenue as the services are performed. Maintenance revenue from extended warranty sales is deferred and recognized ratably over the term of the maintenance agreement, typically 12 months.



Significant management judgments must be made and used in
connection with the revenue recognized in any accounting period. Material differences may result in the amount and timing of our revenue for any period if our management made different judgments.



Software Development Costs



We capitalize software developed for sale or lease in accordance with SFAS
No. 86, Accounting for Costs of Computer Software to be Sold, Leased, or Otherwise Marketed. Software costs incurred subsequent to the determination of the technological feasibility of the software product are capitalized. Our policy is
to capitalize the costs associated with development of new products but expense the costs associated with new releases, which consist of enhancements or increased functionality of software embedded in our existing products. Significant management
judgment is required in determining whether technological feasibility has been achieved for a particular software project. Capitalization ceases and amortization of capitalized costs begins when the software product is available for general release
to customers. Capitalized software development costs, net of related amortization, are compared to managements estimate of projected revenues quarterly to determine if any impairment in value has occurred that would require an adjustment in
the carrying value or change in expected useful lives under the guidelines established under SFAS No. 86. We also continually evaluate the recoverability of software acquired through acquisition or by direct purchase of technology.



We had $4.0 million of capitalized software as of October 31, 2004, net of
accumulated amortization of $4.9 million. Capitalized software amortization expense is included in cost of revenue. The amortization period for the software costs capitalized is the shorter of the economic life of the related product or based on
expected unit sales under the sales ratio method, typically two to four years.



Accounts Receivable



We perform ongoing credit
evaluations of our customers and adjust credit limits and related terms based upon payment history and the customers current credit worthiness. We continuously monitor collections and payments from our customers and maintain a provision for
estimated credit losses based upon our historical experience and any specific customer collection issues that we have identified. While such credit losses have historically been within our expectations and the provisions established, we cannot
guarantee that we will continue to experience the same credit loss rates that we have in the past. Since our accounts receivable are concentrated in a relatively few number of customers, a significant change in the liquidity or financial position of
any one of these customers could have a material adverse effect on the collectibility of our accounts receivable and our future operating results.



Specifically, our management must make estimates of the collectibility of our accounts receivable. Management analyzes specific customer accounts,
historical bad debt, trends, customer concentrations, customer credit-worthiness, and current economic trends when evaluating the adequacy of the allowance for doubtful accounts. Significant management judgments and estimates must be made and used
in connection with establishing the allowance for doubtful accounts in any accounting period. Material differences may result in the amount and timing of our losses for any period if management made different judgments or utilized different
estimates.



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##### Table of Contents

Inventory



We value our inventory at the lower of the actual cost to purchase and/or manufacture the inventory (calculated on average costs, which approximates
first-in, first-out basis) or market value. We regularly review inventory quantities on hand and record a write down of excess and obsolete inventory based primarily on our estimated forecast of product demand and production requirements for the
next twelve months. As demonstrated during prior periods, demand for our products can fluctuate significantly. A significant increase in the demand for our products could result in a short-term increase in the cost of inventory purchases while a
significant decrease in demand could result in an increase in the amount of excess inventory quantities on hand. In addition, our industry is characterized by rapid technological change, frequent new product development, and rapid product
obsolescence that could result in an increase in the amount of obsolete inventory quantities on hand. Additionally, our forecasts of future product demand may prove to be inaccurate, in which case we may have understated or overstated the provision
required for excess and obsolete inventory. In the future, if our inventory were determined to be overvalued, we would be required to recognize such costs in our cost of goods sold at the time of such determination. Therefore, although we make every
effort to ensure the accuracy of our forecasts of future product demand, any significant unanticipated changes in demand or technological developments could have a significant impact on the value of our inventory and our operating results.



During the third quarter of fiscal 2005, we entered into a
Mutual Release Agreement (Mutual Release) with Belkin Corporation (Belkin), a former distributor of our ChargeSource products, whereby each party released the other party of its obligations under the previously executed
Supply Agreement dated January 8, 2004 (the Supply Agreement), as well as any obligations under non-cancelable purchase orders received from Belkin. Accordingly, during the third quarter of fiscal 2005, we established an inventory
reserve totaling approximately $0.6 million to fully reserve undelivered Belkin-branded ChargeSource products that were manufactured under non-cancelable purchase orders, which we intend to destroy.



Income Taxes



As part of the process of preparing our unaudited condensed consolidated financial statements we are required to estimate
our provision for income taxes in each of the tax jurisdictions in which we conduct business. This process involves estimating our actual current tax expense in conjunction with the evaluation and measurement of temporary differences resulting from
differing treatment of certain items for tax and accounting purposes. These temporary timing differences result in the establishment of deferred tax assets and liabilities, which are recorded on a net basis and included in our consolidated balance
sheets. We then assess on a periodic basis the probability that our net deferred tax assets, if any, will be recovered. If after evaluating all of the positive and negative evidence, a conclusion is made that it is more likely than not that some
portion or all of the net deferred tax assets will not be recovered, a valuation allowance is provided with a corresponding charge to tax expense to reserve the portion of the deferred tax assets which are estimated to be more likely than not to be
realized.



Significant management judgment is required in
determining our provision for income taxes, our deferred tax assets and liabilities and any required valuation allowance. During the second quarter of fiscal 2005, we established a valuation allowance totaling approximately $2.9 million, or the
entire deferred tax asset balance. This valuation allowance was established based on managements overall assessment of risks and uncertainties related to our future ability to realize, and hence, utilize certain deferred tax assets, primarily
consisting of net operating losses, carry forward temporary differences and future tax deductions resulting from certain types of stock option exercises. Due to the losses of the current quarter, no changes to the deferred tax assets and liabilities
were made during the third quarter of fiscal 2005.



In the
third quarter of fiscal 2005, we recorded a tax benefit of $446,000 due to the generation of refund claims created upon completion of our fiscal 2004 corporate tax returns in this quarter.



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##### Table of Contents

Intangible Assets



We account for goodwill and intangible assets in accordance with SFAS No. 141, Business Combinations, and SFAS No. 142, Goodwill
and Other Intangible Assets. Accordingly, the Company no longer amortizes goodwill from acquisitions, but continues to amortize other acquisition-related intangibles and costs. As of October 31, 2004, we had $2.4 million of goodwill recorded
in our unaudited condensed consolidated balance sheet.



We
performed our annual goodwill impairment analysis at January 31, 2004 and identified no impairment. The impairment review is based on a discounted cash flow approach that uses estimates of future market share and revenue and costs for the reporting
units, as well as appropriate discount rates. The estimates used are consistent with the plans and estimates that we use to manage the underlying businesses. However, if we fail to deliver new products for these groups, if the products fail to gain
expected market acceptance, or if market conditions in the related businesses are unfavorable, revenue and cost forecasts may not be achieved, and the Company may incur charges for impairment of goodwill.



For intangible assets with definite useful lives, we amortize the cost over
the estimated useful lives and assess any impairment by estimating the future cash flow from the associated asset in accordance with SFAS No. 144 Accounting for the Impairment or Disposal of Long-Lived Assets. As of October 31, 2004, we
had $1.3 million of non-goodwill intangible assets recorded in intangible assets, which includes $0.5 million of software rights and $0.8 million of intellectual property rights.



Valuation of Long-Lived Assets



We evaluate long-lived assets used in operations, including purchased intangible assets, when indicators of impairment, such as reductions in demand or
significant economic slowdowns that negatively impact our customers or markets, are present. Reviews are performed to determine whether the carrying value of assets is impaired based on comparison to the undiscounted expected future cash flows. If
the comparison indicates that there is impairment, the impaired asset is written down to fair value, which is typically calculated using a weighted average of the market approach and the discounted expected future cash flows using a discount rate
based upon our cost of capital. Impairment is based on the excess of the carrying amount over the fair value of those assets. Significant management judgment is required in the forecast of future operating results that is used in the preparation of
expected discounted cash flows. It is reasonably possible that the estimates of anticipated future net revenue, the remaining estimated economic life of the products and technologies, or both, could differ from those used to assess the
recoverability of these assets. In that event, additional impairment charges or shortened useful lives of certain long-lived assets could be required.



Prior Year Restatement of Quarterly Results (Fiscal 2004):



The consolidated financial statements for the three and nine months ended October 31, 2003 were restated as of January 31, 2004 for various adjustments
that are more fully described in Note 2 of notes to our unaudited consolidated financial statements included in Part I, Item 1 of this report. The net effect of the restatement adjustments decreased the Companys third quarter net income by
$67,000 and increased the year-to-date net loss by $142,000. Additionally, in the fourth quarter of fiscal 2004, the Company sold the net assets of EDX Engineering (EDX) and therefore the EDX operations have been reclassified as
discontinued operations for fiscal 2004.



Results of Operations 
Continuing Operations



Wireless Test Solutions



Our WTS business designs and manufactures hardware and software tools for
use by wireless carriers, equipment vendors, and others. Radio frequency engineers, professional technicians, and others use these field test tools to design, deploy, and optimize wireless networks, and to verify the performance of the wireless
networks once deployed.



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##### Table of Contents

Management currently considers the following events, trends, and uncertainties to be important to
understanding our WTS business:



| |  | The wireless communications industry has historically experienced a dramatic rate of growth both in the United States and internationally. During the past several years, however,
many wireless carriers have re-evaluated their network deployment plans in response to downturns in the capital markets, changing perceptions regarding industry growth, the adoption of new wireless technologies, increasing price competition for
subscribers and a general economic slowdown in the United States and internationally. Over the last six months, it appears that some of these conditions have begun to improve.
| | - | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | During the first half of fiscal 2004, we completed the development of our Seven.Five hardware platform and various related software applications, and began shipping products to
customers in Europe, North America, and Latin America. Seven.Five is a hardware and software solution that is flexible, scalable, and modular allowing our customers to work with all 2G, 2.5G, and 3G technologies.
| | - | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | Commencing during the second half of fiscal 2004 and continuing into fiscal 2005, and in response to consumer demand for improved network coverage, quality of service, and enhanced
data services, we believe domestic wireless carriers have begun to increase capital spending on their networks. It is likely that the increase in carrier spending patterns has resulted in increased demand for our WTS products. Currently, we expect
this trend to continue at least through the remainder of fiscal 2005. However, due to the timing and size of received and expected orders for our WTS products, revenue is expected to fluctuate quarter to quarter.
| | - | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | Our European operation experienced year-over-year revenue growth primarily driven by sales of our Seven.Five product platform to European wireless carriers. We expect our European
operation to continue to experience year-over-year revenue growth at least through the remainder of fiscal 2005 based on the demand weve experienced during the nine months ending October 31, 2004, as well as planned technology deployments by
wireless carriers.
| | - | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | The European marketplace is served by our exclusive reseller, SwissQual Holding Inc. (SwissQual). All sales to SwissQual are deferred until payment is received.
| | - | ------------------------------------------------------------------------------------------------------------------------------------------------------------------



Wireless Applications



Our wireless applications business designs and manufactures emergency call
box systems and mobile power products for notebook computers, cellular telephones, PDAs, and other handheld devices. Our call box products provide emergency communication over existing wireless networks. In addition to the call box products, we
provide system installation and long-term maintenance services. Currently, we have approximately 19,000 call boxes installed, of which approximately 14,000 are serviced and maintained under long-term agreements which expire at various dates through
February 2011.



Our wireless applications business also
includes the ChargeSource family of mobile power products. Designed with the needs of the traveling professional in mind, our ChargeSource mobile power products provide a high level of functionality and compatibility in an industry-leading compact
design. Our current and planned product offering consists of universal AC/DC, AC, and DC power adapters designed for the right mix of power output and functionality for most retail, OEM, and enterprise customers. Our ChargeSource products are also
universal allowing those who use rechargeable electronic devices to carry just one power adapter. By simply changing the compact SmartTips connected to the end of the charging cable, our universal power adapters are capable of charging and powering
multiple target devices, including most notebook computers, cellular telephones, PDAs, and other handheld devices.



Management currently considers the following events, trends, and uncertainties to be important to understanding our wireless applications business:



| |  | During the third quarter of fiscal 2005, we were awarded a $2.5 million contract to upgrade the 1,600 unit San Bernardino SAFE call box system from analog to digital. We expect to
commence upgrade activities during the fourth quarter of fiscal 2005 and complete the contracted work during the third quarter of fiscal 2006. We were also awarded a five year maintenance contract valued at approximately $3.3 million, which replaces
the expiring contract to provide system maintenance services.
| | - | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



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| |  | In addition to the San Bernardino SAFE, several of our call box customers have indicated their intentions to upgrade their existing analog-based call box systems to digital or 2.5G
wireless technologies. We currently expect to be awarded additional digital upgrade contracts during the coming quarters.
| | - | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | During the third quarter of fiscal 2005, we entered into a supply agreement with Kensington, a tier-one distributor of consumer electronics, to distribute certain of our
ChargeSource products to Big Box retailers and other channels. During the third quarter we received firm orders from Kensington and began shipping a limited number of units under this supply agreement. We currently expect to continue to
ramp-up production of Kensington-branded ChargeSource products during the fourth quarter of fiscal 2005 and the first quarter of fiscal 2006.
| | - | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | During January 2004 we entered into a supply agreement with Belkin Corporation (Belkin and the Belkin Supply Agreement) and began shipping a limited number
of ChargeSource units to Belkin late in the first quarter of fiscal 2005. The subsequent sales and marketing efforts, as well as the ramp-up of unit sales of the Belkin-branded ChargeSource products did not meet our original expectations. The Belkin
Supply Agreement was terminated in conjunction with the execution of the Mutual Release during the third quarter of fiscal 2005. Due to certain terms of this recent supply agreement, our direct access to certain significant distribution channels may
be limited with respect to certain of our ChargeSource products.
| | - | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | In addition to transitioning the distribution of our ChargeSource products to Kensington, during the third quarter of fiscal 2005, we transitioned the manufacturing of our
redesigned ChargeSource product line to a contract manufacturer located in China. These distribution and manufacturing initiatives, which are expected to enhance our competitiveness in the marketplace, interrupted our business resulting in lower
revenue from the sales of our ChargeSource products. While these initiatives are underway, we expect to experience additional, yet decreasing, disruption and ramp-up delays during the fourth quarter of fiscal 2005.
| | - | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



The following table sets forth certain items as a percentage of revenue from
our unaudited condensed consolidated statements of operations for the three and nine months ended October 31, 2004 and 2003. The table and discussion that follows provides information which management believes is relevant to an assessment and
understanding of our unaudited condensed consolidated results of operations and financial condition. The discussion should be read in conjunction with the unaudited condensed consolidated financial statements and accompanying notes thereto included
elsewhere herein.



|                 |  |                                |   |  |                               |   |  |       |   |  |                 |  
|---------------- |  | ------------------------------ | - |  | ----------------------------- | - |  | ----- | - |  | --------------- | -
|                 |  | Three Months Ended October 31, |   |  | Nine Months Ended October 31, |  
|                 |  | 2004                           |   |  | 2003 (Restated)               |   |  | 2004  |   |  | 2003 (Restated) |  
|Revenue:         |  |                                |   |  |                               |   |  |       |   |  |                 |  
|Products         |  | 82.1                           | % |  | 88.8                          | % |  | 82.8  | % |  | 83.0            | %
|Services         |  | 17.9                           |   |  | 11.2                          |   |  | 17.2  |   |  | 17.0            |  
|                 |  |                                |   |  |                               |   |  |       |   |  |                 |  
|                 |  | 100.0                          |   |  | 100.0                         |   |  | 100.0 |   |  | 100.0           |  
|                 |  |                                |   |  |                               |   |  |       |   |  |                 |  
|Cost of revenue: |  |                                |   |  |                               |   |  |       |   |  |                 |  
|Products         |  | 66.0                           |   |  | 50.1                          |   |  | 58.2  |   |  | 54.2            |  
|Services         |  | 13.4                           |   |  | 7.2                           |   |  | 11.4  |   |  | 10.7            |  
|                 |  |                                |   |  |                               |   |  |       |   |  |                 |  
|                 |  | 79.4                           |   |  | 57.3                          |   |  | 69.6  |   |  | 64.9            |  
|                 |  |                                |   |  |                               |   |  |       |   |  |                 |  



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|                                                             |  |                               |    |  |                              |   |  |       |    |  |                 |   
|------------------------------------------------------------ |  | ----------------------------- | -- |  | ---------------------------- | - |  | ----- | -- |  | --------------- | --
|                                                             |  | Three Months EndedOctober 31, |    |  | Nine Months EndedOctober 31, |  
|                                                             |  | 2004                          |    |  | 2003(Restated)               |   |  | 2004  |    |  | 2003 (Restated) |   
|Gross margin:                                                |  |                               |    |  |                              |   |  |       |    |  |                 |   
|Products                                                     |  | 16.1                          |    |  | 38.7                         |   |  | 24.6  |    |  | 28.8            |   
|Services                                                     |  | 4.5                           |    |  | 4.0                          |   |  | 5.8   |    |  | 6.3             |   
|                                                             |  |                               |    |  |                              |   |  |       |    |  |                 |   
|                                                             |  | 20.6                          |    |  | 42.7                         |   |  | 30.4  |    |  | 35.1            |   
|Selling, general and administrative expenses                 |  | 29.6                          |    |  | 19.1                         |   |  | 29.5  |    |  | 34.4            |   
|Engineering and support expenses                             |  | 27.5                          |    |  | 11.7                         |   |  | 25.0  |    |  | 18.2            |   
|                                                             |  |                               |    |  |                              |   |  |       |    |  |                 |   
|Operating income (loss)                                      |  | (36.5                         | )  |  | 11.9                         |   |  | (24.1 | )  |  | (17.5           | ) 
|Other income, net                                            |  | 0.8                           |    |  | 0.4                          |   |  | 0.6   |    |  | 0.9             |   
|Minority interest                                            |  | 0.3                           |    |  | (0.1                         | ) |  | 0.3   |    |  | 0.2             |   
|                                                             |  |                               |    |  |                              |   |  |       |    |  |                 |   
|Income (loss) from continuing operations before income taxes |  | (35.4                         | )  |  | 12.2                         |   |  | (23.2 | )  |  | (16.4           | ) 
|Income tax (expense) benefit                                 |  | 6.6                           |    |  | (4.5                         | ) |  | (10.8 | )  |  | 5.9             |   
|                                                             |  |                               |    |  |                              |   |  |       |    |  |                 |   
|Income (loss) from continuing operations                     |  | (28.8                         | )% |  | 7.7                          | % |  | (34.0 | )% |  | (10.5           | )%
|                                                             |  |                               |    |  |                              |   |  |       |    |  |                 |   



Comparison of the Three Months
Ended October 31, 2004 to the Three Months Ended October 31, 2003



Consolidated



Revenue



Total revenue for the third quarter of fiscal 2005, which ended October 31,
2004, was $6.7 million compared to $10.9 million for the corresponding quarter of the prior fiscal year, a decrease of approximately $4.2 million or 38.2 percent. As discussed below, the decrease is attributable to decreased sales of our wireless
applications products, partially offset by increased sales of our WTS products.



For the third quarter of fiscal 2005 as compared to the corresponding period of the prior fiscal year, revenue from product sales decreased 42.9 percent to $5.5 million while revenue from services remained flat at
approximately $1.2 million. The decrease in product revenue is primarily attributable to decreased sales of our wireless applications products, primarily our ChargeSource mobile power products, which declined $5.0 million or 82.7 percent, partially
offset by increased sales of our WTS products.



Cost of Revenue and Gross
Margin



Total cost of revenue for the third quarter of
fiscal 2005 decreased $0.9 million or 14.4 percent to $5.3 million. As discussed below, the decrease in cost of revenue is attributable to decreased sales of our wireless applications products, primarily our ChargeSource products. As a percentage of
revenue, gross margin for the third quarter of fiscal 2005 decreased to 20.6 percent compared to 42.7 percent for the third quarter of fiscal 2004.



Selling, General and Administrative Expenses



Selling, general and administrative expenses decreased $90,000 or 4.3 percent to $2.0 million for the third quarter of fiscal 2005 in comparison to the
corresponding quarter of fiscal 2004. During the third quarter of fiscal 2005, we charged approximately $0.2 million to allowance for uncollectible accounts related to an amount due from a customer of our WTS business. In the corresponding quarter
of the prior year we charged approximately $0.4 million to allowance for uncollectible accounts related to an amount due from our former ChargeSource distributor, which was subsequently collected. This decrease is offset by increased legal and
accounting fees recorded in the third quarter of fiscal 2005.



22



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##### Table of Contents

As a percentage of revenue, selling, general and administrative expenses were 29.6 percent and 19.1
percent for the third quarters of fiscal 2005 and 2004, respectively.



Engineering and Support Expenses



The Company
capitalizes costs incurred for the development of software embedded in our WTS products subsequent to establishing technological feasibility. These capitalized costs are subject to an ongoing assessment of recoverability based on anticipated future
revenue and changes in hardware and software technologies. Costs that are capitalized include direct labor and related overhead. Engineering and support expenses for the third quarter of fiscal 2005 and 2004 are as follows:



|                                       |  |                                |       |      |   |       |  
|-------------------------------------- |  | ------------------------------ | ----- | ---- | - | ----- | -
|                                       |  | Three Months Ended October 31, |      
|                                       |  | 2004                           |       | 2003 |  
|                                       |  | (In thousands)                 |      
|Engineering                            |  | $                              | 1,273 |      | $ | 1,760 |  
|Less: Capitalized software development |  |                                |      |      |   | (811  | )
|Support expenses                       |  |                                | 576   |      |   | 325   |  
|                                       |  |                                |       |      |   |       |  
|                                       |  | $                              | 1,849 |      | $ | 1,274 |  
|                                       |  |                                |       |      |   |       |  



Engineering and
support expenses, net of capitalized software development costs, for the third quarter of fiscal 2005 were $1.8 million compared to $1.3 million for the corresponding quarter of the prior fiscal year, an increase of approximately $0.5 million. Gross
engineering, before reduction for capitalized software development costs, decreased $0.5 million in comparison to fiscal 2004 costs. The development of our Seven.Five product platform was substantially completed during fiscal 2004 and staffing and
consulting costs related to WTS engineering decreased accordingly. Additionally, because the primary development of the Seven.Five software is complete, we no longer incur engineering costs that qualify to be capitalized. This has resulted in an
increase in engineering and support expenses, net of capitalized software development costs, for the three months ended October 31, 2004. The increase in product support costs for the third quarter of fiscal 2005 is consistent with increased sales
of our recently developed WTS Seven.Five product platform.



Other Income,
net



Other income, net, which consists primarily of
interest income, increased approximately $18,000 to $57,000 for the three months ended October 31, 2004 compared to the same period of the prior fiscal year.



Income Taxes



During the third quarter of fiscal 2005, we recorded an income tax benefit, totaling $0.4 million, for net operating loss carry backs recovering income
taxes paid in prior years, compared to an income tax expense of $0.5 million for the third quarter of fiscal 2004. As we have incurred losses for a period in excess of three years, no additional income tax provision was required for the third
quarter of fiscal 2005. During the second quarter of fiscal 2005, we established a valuation allowance totaling approximately $2.9, or the entire deferred tax asset balance. This valuation allowance was established based on managements overall
assessment of risks and uncertainties related to our future ability to realize, and hence, utilize certain deferred tax assets, primarily consisting of net operating losses, carry forward temporary differences and future tax deductions resulting
from certain types of stock option exercises. See Note 2 of notes to our unaudited condensed consolidated financial statements included in Part I, Item 1 of this report for discussion of the valuation allowance.



23



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##### Table of Contents

Wireless Test Solutions



|                |  |                                |       |   |                |   |       |  
|--------------- |  | ------------------------------ | ----- | - | -------------- | - | ----- | -
|                |  | Three Months Ended October 31, |      
|                |  | 2004                           |       |   | 2003(Restated) |  
|                |  | (In thousands)                 |      
|Revenue         |  | $                              | 4,193 |   |                | $ | 2,822 |  
|Cost of revenue |  |                                | 2,334 |   |                |   | 1,979 |  
|                |  |                                |       |   |                |   |       |  
|Gross profit    |  | $                              | 1,859 |   |                | $ | 843   |  
|                |  |                                |       |   |                |   |       |  
|Gross margin    |  |                                | 44.3  | % |                |   | 29.9  | %
|                |  |                                |       |   |                |   |       |  



Revenue



Wireless test solutions revenue for the third quarter of fiscal 2005 was
$4.2 million compared to $2.8 million for the corresponding quarter of the prior fiscal year, an increase of $1.4 million or 48.6 percent. This increase was due to sales of our Seven.Five product platform, which was released during the first half of
fiscal 2004, and reflects the impact of payments from our resellers, sales through resellers are typically recorded as revenue when payment from the reseller is received by the Company.



The European marketplace for our WTS products is served by our exclusive reseller SwissQual AG (SwissQual). All
sales to SwissQual are deferred until payment is received. For the third quarter of fiscal 2005, we received payments of $2.4 million from SwissQual and recorded the corresponding revenue (excluding maintenance) totaling $2.2 million. Additionally,
as of October 31, 2004, approximately $0.4 million of sales to SwissQual has been deferred pending cash collections, which we expect to receive during the fourth quarter of fiscal 2005 and thereafter.



Cost of Revenue and Gross Margin



Wireless test solutions cost of revenue for the third quarter of fiscal 2005
was $2.3 million compared to $2.0 million for the corresponding quarter of the prior fiscal year, an increase of approximately $0.3 million or 17.9 percent. Gross margin for the third quarter of fiscal 2005 increased to 44.3 percent from 29.9
percent for the third quarter of fiscal 2004. The increase in gross margin is attributable to decreased amortization of software development costs recorded as cost of revenue for the third quarter of fiscal 2005 compared to the corresponding period
of the prior fiscal year, as well as increased absorption of fixed manufacturing costs due to increased WTS product sales. Amortization of capitalized software development costs totaled $0.5 million and $1.0 million for the three month periods
ending October 31, 2004 and 2003, respectively. Excluding such amortization and as a percentage of revenue, gross margin for the third quarter of fiscal 2005 decreased to 56.3 percent from 65.3 percent for the third quarter of fiscal 2004.



24



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##### Table of Contents

Wireless Applications



|                    |  |                               |       |    |      |   |       |  
|------------------- |  | ----------------------------- | ----- | -- | ---- | - | ----- | -
|                    |  | Three Months EndedOctober 31, |      
|                    |  | 2004                          |       |    | 2003 |  
|                    |  | (In thousands)                |      
|Revenue             |  | $                             | 2,522 |    |      | $ | 8,051 |  
|Cost of revenue     |  |                               | 2,999 |    |      |   | 4,248 |  
|                    |  |                               |       |    |      |   |       |  
|Gross profit (loss) |  | $                             | (477  | )  |      | $ | 3,803 |  
|                    |  |                               |       |    |      |   |       |  
|Gross margin        |  |                               | (18.9 | )% |      |   | 47.2  | %
|                    |  |                               |       |    |      |   |       |  



Revenue



Wireless applications revenue for the third quarter of fiscal 2005 was $2.5
million compared to $8.1 million for the third quarter of 2004, a decrease of approximately $5.5 million or 68.7 percent. This decrease was due to a $5.0 million decrease in sales of our ChargeSource products and a $0.5 million decrease in sales of
our call box products and services. Revenue recorded in the third quarter of fiscal 2004 includes $1.1 million relating to our former ChargeSource distributors unused recall credit.



During the third quarter of fiscal 2005, we transitioned the manufacturing of our redesigned ChargeSource product line to a
contract manufacturer located in China. Additionally and as discussed above, we also transitioned the distribution of these products to Kensington. These strategic initiatives, which are expected to enhance our competiveness in the marketplace,
interrupted our business resulting in lower revenue from the sales of our ChargeSource products. While these initiatives are underway, we expect to experience additional, yet decreasing, disruption and ramp-up delays during the fourth quarter of
fiscal 2005.



For the third quarter of fiscal 2005 and 2004,
call box revenue generated from product sales and maintenance services totaled $1.5 million and $2.0 million, respectively. Revenue attributable to sales of call box products or upgrades to existing call box systems tend to fluctuate
quarter-to-quarter while revenue from maintenance services provided under long-term contracts remain relatively comparable quarter-to-quarter.



Cost of Revenue and Gross Margin



Wireless applications cost of revenue for the third quarter of fiscal 2005 was $3.0 million compared to $4.2 million for the third quarter of fiscal 2004,
a decrease of $1.2 million or 29.4 percent. Cost of revenue for the third quarter of fiscal 2005 exceeded revenue resulting in a gross loss of $0.5 million as compared to gross profit of $3.8 million for the corresponding quarter of the prior fiscal
year.



Gross margin for our wireless applications business
decreased in the third quarter of fiscal 2005 compared to the corresponding period of the prior fiscal year because of decreased sales of our ChargeSource products and the related decrease in absorption of manufacturing overhead. The decrease in
gross margin for the third quarter of fiscal 2005 is also partially attributable to an inventory reserve recorded as cost of revenue totaling approximately $0.6 million to fully reserve undelivered Belkin-branded ChargeSource products that were
manufactured under non-cancelable purchase orders, which we intend to destroy. We did not experience similar type costs during the corresponding period of the prior fiscal period.



Discontinued Operations



On January 6, 2004, we sold the net assets of the EDX reporting unit and the EDX operations have been reclassified as discontinued operations. This
reporting unit was formerly reported as a component of the WTS segment.



Additionally, during fiscal 2001, the Company sold its defense and commercial staffing businesses (the non-wireless businesses.)



25



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##### Table of Contents

Net income from discontinued operations was $222,000 for the third quarter of fiscal 2005, $95,000
related to a reduction of an indemnification liability and $127,000 related to a reduction in the bad debt reserve recorded in conjunction with the sales of our non-wireless businesses. Net income from discontinued operations for the third quarter
of fiscal 2004 was $82,000, with the related revenue attributable to EDX totaling $292,000.



Comparison of the Nine Months Ended October 31, 2004 to the Nine Months Ended October 31, 2003



Consolidated



Revenue



Total revenue
for the nine months ended October 31, 2004, remained flat at $22.4 million compared to the nine months ended October 31, 2003. As discussed below, current year revenue includes a $6.3 million increase in sales of our WTS products offset by a $6.3
million decrease in sales of our wireless applications products.



For the nine months ended October 31, 2004 as compared to the corresponding period of the prior fiscal year, revenue from product sales and services remained flat at $18.6 million and $3.8 million, respectively.



Cost of Revenue and Gross Margin



Total cost of revenue for the nine months ended October 31, 2004, was $15.6
million compared to $14.5 million for the corresponding period of fiscal 2004, an increase of approximately $1.1 million or 7.4 percent. As a percentage of revenue, gross margin was 30.4 percent and 35.1 percent for the nine months ended October 31,
2004 and 2003, respectively. As discussed below, the decrease in gross margin is primarily attributable to decreased sales of our ChargeSource products and a $0.6 million increase in inventory reserves related to our ChargeSource products.



Selling, General and Administrative Expenses



Selling, general and administrative expenses for the nine months ended
October 31, 2004, decreased $1.1 million or 14.3 percent to $6.6 million. Selling, general and administrative expenses for the nine months ended October 31, 2004 includes a $0.4 million charge recorded for settling a dispute with a significant WTS
customer based in Latin America. Additionally, selling, general and administrative expenses for the nine months ended October 31, 2004 excludes approximately $2.0 million in legal, settlement, and related costs incurred during the corresponding
period of fiscal 2004.



As a percentage of revenue, selling,
general and administrative expenses were 29.5 percent and 34.4 percent for the nine months ended October 31, 2004 and 2003, respectively. Excluding both charges discussed above, selling, general and administrative expenses as a percentage of revenue
were 27.7 percent and 25.5 percent for the nine months ended October 31, 2004 and 2003, respectively.



Engineering and Support Expenses



The Company capitalizes costs incurred for the development of software embedded in our WTS products subsequent to establishing technological feasibility. These capitalized costs are subject to an ongoing assessment of
recoverability based on anticipated future revenue and changes in hardware and software technologies. Costs that are capitalized include direct labor and related overhead. Engineering and support expenses for the nine months ended October 31, 2004
and 2003, are as follows (in thousands):



|                                             |  |                              |       |      |   |        |  
|-------------------------------------------- |  | ---------------------------- | ----- | ---- | - | ------ | -
|                                             |  | Nine Months EndedOctober 31, |      
|                                             |  | 2004                         |       | 2003 |  
|                                             |  | (In thousands)               |      
|Engineering                                  |  | $                            | 3,908 |      | $ | 5,553  |  
|Less: Capitalized software development costs |  |                              |      |      |   | (2,538 | )
|Support expenses                             |  |                              | 1,697 |      |   | 1,063  |  
|                                             |  |                              |       |      |   |        |  
|                                             |  | $                            | 5,605 |      | $ | 4,078  |  
|                                             |  |                              |       |      |   |        |  



26



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##### Table of Contents

Engineering and support expenses, net of capitalized software development costs, for the nine months
ended October 31, 2004 were $5.6 million compared to $4.1 million for the corresponding period of the prior fiscal year, an increase of approximately $1.5 million. Gross engineering and support expenses, before reduction for capitalized software
development costs, decreased $1.0 million in comparison to the corresponding period of fiscal 2004. The development of our Seven.Five product platform was substantially completed during fiscal 2004 and staffing and consulting costs related to WTS
engineering decreased accordingly. Additionally, because the primary development of the Seven.Five software is complete, we no longer incur engineering costs that qualify to be capitalized. This has resulted in an increase in our engineering and
support expenses, net of capitalized software development costs, for the nine months ended October 31, 2004. The increase in product support costs for the nine months ended October 31, 2004 is consistent with increased sales of our recently
developed Seven.Five product platform.



Other Income, net



Other income, net, consisting primarily of interest income, decreased
approximately $71,000 to $135,000 for the nine months ended October 31, 2004 compared to the same period of the prior fiscal year. This decrease was primarily due to lower invested cash balances and reduced interest rates earned on invested cash
balances.



Income Taxes



Our effective income tax rate for the nine months ended October 31, 2004
exceeded federal and state statutory rates as income tax expense for the nine month period includes the $2.9 million valuation allowance recorded during the second quarter of fiscal 2005 attributable to the deferred tax assets. See Note 2 of notes
to unaudited condensed consolidated financial statements included in Part I, Item 1 of this report for discussion of the valuation allowance. Our effective income tax rate for the nine months ended October 31, 2003 was 35.7 percent, consistent with
the federal and state statutory rates reduced by approximately 3.0 percent for eligible research and experimentation credits.



Wireless Test Solutions



|                |  |                              |        |   |                |   |       |  
|--------------- |  | ---------------------------- | ------ | - | -------------- | - | ----- | -
|                |  | Nine Months EndedOctober 31, |       
|                |  | 2004                         |        |   | 2003(Restated) |  
|                |  | (In thousands)               |       
|Revenue         |  | $                            | 13,052 |   |                | $ | 6,716 |  
|Cost of revenue |  |                              | 7,420  |   |                |   | 4,409 |  
|                |  |                              |        |   |                |   |       |  
|Gross profit    |  | $                            | 5,632  |   |                | $ | 2,307 |  
|                |  |                              |        |   |                |   |       |  
|Gross margin    |  |                              | 43.2   | % |                |   | 34.4  | %
|                |  |                              |        |   |                |   |       |  



Revenue



Revenue from our wireless test solutions segment for the nine months ended
October 31, 2004 was $13.1 million compared to $6.7 million for the nine months ended October 31, 2003, an increase of 94.3 percent. This revenue increase is attributable to increased sales of our Seven.Five product platform during the nine month
period ended October 31, 2004. Seven.Five was released during the first half of fiscal 2004 and only available for sale during a portion of the nine month period ended October 31, 2003.



27



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##### Table of Contents

Cost of Revenue and Gross Margin



Cost of revenue from our wireless test solutions for the nine months ended October 31, 2004, was $7.4 million compared to
$4.4 million for the nine months ended October 31, 2003, an increase of approximately $3.0 million or 68.3 percent. The increase in cost of revenue for the nine months ended October 31, 2004 was primarily the result of increased sales of our
Seven.Five product platform. Gross margin for the nine months ended October 31, 2004 increased to 43.2 percent from 34.4 percent for the corresponding period of the prior fiscal year. The increase in gross margin is attributable to decreased
amortization of software development costs recorded for the nine months ended October 31, 2004 compared to the corresponding period of the prior fiscal year, as well as increased absorption of fixed manufacturing costs due to increased WTS product
sales. Amortization of capitalized software development costs totaled $1.5 million and $2.1 million for the nine month period ending October 31, 2004 and 2003, respectively. Excluding such amortization and as a percentage of revenue, gross margin
for the nine month period ending October 31, 2004 decreased to 54.6 percent from 65.6 percent for the corresponding period of the prior fiscal year.



Wireless Applications



|                |  |                               |       |   |      |   |        |  
|--------------- |  | ----------------------------- | ----- | - | ---- | - | ------ | -
|                |  | Nine Months Ended October 31, |      
|                |  | 2004                          |       |   | 2003 |  
|                |  | (In thousands)                |      
|Revenue         |  | $                             | 9,389 |   |      | $ | 15,698 |  
|Cost of revenue |  |                               | 8,198 |   |      |   | 10,131 |  
|                |  |                               |       |   |      |   |        |  
|Gross profit    |  | $                             | 1,191 |   |      | $ | 5,567  |  
|                |  |                               |       |   |      |   |        |  
|Gross margin    |  |                               | 12.7  | % |      |   | 35.5   | %
|                |  |                               |       |   |      |   |        |  



Revenue



Wireless applications revenue for the nine months ended October 31, 2004 was
$9.4 million compared to $15.7 million for the nine months ended October 31, 2003, a decrease of approximately $6.3 million or 40.2 percent. This decrease was due to a $5.9 million decrease in sales of our ChargeSource products and a $0.4 million
decrease in sales of our call box products and services.



During January 2004 we entered into a supply agreement with Belkin and began shipping a limited number of ChargeSource units to Belkin late in the first quarter of fiscal 2005. The subsequent sales and marketing efforts, as well as the
ramp-up of unit sales of the Belkin-branded ChargeSource products, did not meet our original expectations and was the primary cause of the decrease in sales of our ChargeSource products during the nine months ended October 31, 2004. Accordingly and
subsequent to the second quarter of fiscal 2005, we entered into a supply agreement with Kensington, a tier-one distributor of consumer electronics, to distribute certain of our ChargeSource products to Big Box retailers and other
channels. During the third quarter of fiscal 2005, we have received firm orders from Kensington and began shipping a limited number of units under this supply agreement.



In addition to transitioning the distribution to Kensington, during the third quarter of fiscal 2005, we transitioned the
manufacturing of our redesigned ChargeSource product line to a contract manufacturer located in China. These strategic initiatives, which are expected to enhance our competitiveness in the marketplace, interrupted our business resulting in lower
revenue from the sales of our ChargeSource products. While these initiatives are underway, we expect to experience additional, yet decreasing, disruption and ramp-up delays during the fourth quarter of fiscal 2005.



For the nine months ended October 31, 2004 and October 31, 2003, call box
revenue generated from product sales and maintenance services totaled $5.0 million and $5.4 million, respectively. Revenue attributable to sales of call box products or upgrades to existing call box systems tend to fluctuate quarter-to-quarter while
revenue from maintenance services provided under long-term contracts remain relatively comparable quarter-to-quarter.



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Cost of Revenue and Gross Margin



Wireless applications cost of revenue for the nine months ended October 31, 2004 was $8.2 million compared to $10.1 million
for the nine months ended October 31, 2003, a decrease of $1.9 million or 19.1 percent. As a percentage of revenue, gross margin decreased to 12.7 percent from 35.5 percent for the nine months ended October 31, 2003. The decrease in gross margin for
the nine months ended October 31, 2004 is partially attributable to an inventory reserve recorded as cost of revenue totaling approximately $0.6 million to fully reserve undelivered Belkin-branded ChargeSource products that were manufactured under
non-cancelable purchase orders, which we intend to destroy. We did not experience similar type costs during the corresponding period of the prior fiscal period. Additionally, due to decreased sales of our ChargeSource products during the nine months
ended October 31, 2004 and the related decrease in absorption of manufacturing overhead, the gross margin for our wireless applications business decreased compared to the corresponding period of the prior fiscal year.



Discontinued Operations



On January 6, 2004, Comarco sold the net assets of the EDX reporting unit and the EDX operations have been reclassified as
discontinued operations. This reporting unit was formerly included in the WTS segment.



Additionally, during fiscal 2001, the Company sold its non-wireless businesses.



Net income from discontinued operations was $209,000 for the nine months ended October 31, 2004, related primarily to a reduction of an indemnification
liability and bad debt expense recorded in conjunction with the sales of our non-wireless businesses. Net income from discontinued operations for the nine months ended October 31, 2003 was $134,000, with the related revenue attributable to EDX
totaling $763,000.



Liquidity and Capital Resources



The Company has cash and cash equivalents of $12.9 million as of October 31,
2004 and no outstanding debt.



Cash Flows from Operating Activities



Net cash used in operating activities was $1.3 million
for the nine months ended July 31, 2004 compared to $7.1 million for the corresponding period of the prior fiscal year. Our net loss for the nine months ended October 31, 2004 was $7.4 million and was offset by cash collections that reduced accounts
receivable by $3.5 million as well as depreciation and amortization expense of $3.5 million and the non-cash valuation allowance recorded to fully reserve our net deferred tax asset totaling $2.9 million at July 31, 2004. Inventory levels during the
nine month period increased by $1.5 million as we purchased additional raw materials required for customer purchase orders that are scheduled to be delivered during the fourth quarter of fiscal 2005. Additionally, accounts payable and accrued
liabilities decreased by $0.3 million and $1.4 million, respectively, as we paid suppliers and others for accrued inventory and other expenses incurred as of the end of fiscal 2004.



Cash Flows from Investing Activities



Net cash used in investing activities was $1.0 million for the nine months ended October 31, 2004 compared to $4.7 million for the corresponding period of
the prior fiscal year. For the nine months ended October 31, 2004, capital expenditures for property and equipment constituted substantially all of our cash used in investing activities. For the corresponding period of the prior fiscal year and in
addition to the $1.6 million expended for property and equipment, we invested $2.5 million in the development of software, which is critical to our WTS products. As previously discussed, we have completed the development of our Seven.Five hardware
and software product platform and have entered the maintenance and enhancement phase of this products life cycle. Accordingly, no amounts related to the development of software have been capitalized during fiscal 2005. We currently have no
specific plans that would require us to capitalize software development costs during the balance of fiscal 2005.



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We believe that our existing cash and cash equivalent balances will provide us sufficient funds to
satisfy our cash requirements for at least the next twelve months. In addition to our cash and cash equivalent balances, we expect to derive a portion of our liquidity from our cash flows from operations. As discussed above, certain factors and
events could negatively affect our cash flows from operations, including:



| |  | Due to the uncertainties associated with the spending patterns of our customers and the corresponding demand for our wireless test solutions products, we have experienced and expect
to continue to experience significant fluctuations in demand. Such fluctuations have caused and may continue to cause significant reductions in revenue and operating results,
| | - | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | In the event the distributors of our ChargeSource products are unable to perform under their non-cancelable commitments due to their inability to take delivery of the products
and/or pay for such products in a timely manner, we would be required to establish alternative distribution channels.
| | - | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



We are focused on preserving our cash balances by continuously monitoring expenses, identifying cost savings, and investing only in those development
programs and products most likely to contribute to our profitability.



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ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK



Currency Risk



From
time to time, we may be exposed to the risk of changes in currency exchange rates. As of October 31, 2004, we had no material accounts receivable denominated in foreign currencies. Our standard terms require customers to pay for our products and
services in U.S. dollars. For those orders denominated in foreign currencies, we may limit our exposure to losses from foreign currency transactions through forward foreign exchange contracts. To date, sales denominated in foreign currencies have
not been significant and we have not entered into any foreign exchange contracts.



Interest Rate Sensitivity



The primary
objective of our investment activities is to preserve principal while at the same time maximizing the income we receive from our investments without significantly increasing risk. Some of the securities that we have invested in may be subject to
market risk. This means that a change in prevailing interest rates may cause the principal amount of the investment to fluctuate. For example, if we hold a security that was issued with a fixed interest rate at the then-prevailing rate and the
prevailing interest rate later rises, the principal amount of our investment will probably decline in value. To minimize this risk, we maintain a significant portion of our cash balances in money market funds. In general, money market funds are not
subject to interest rate risk because the interest paid on such funds fluctuates with the prevailing interest rate.



We do not hold any derivative financial instruments.



Our cash and cash equivalents have maturities dates of three months or less and the fair value approximates the carrying value in our financial
statements.



Equity Price Risk



Our short-term investments consist primarily of balances maintained in a
non-qualified deferred compensation plan funded by our executives and directors. We value these investments using the closing market value for the last day of each month. These investments are subject to market price volatility. We reflect these
investments and the related liability to the executives and directors on our balance sheet at market value, with the unrealized gains and losses excluded from reported operations. We have also invested in equity instruments of SwissQual, a privately
held company. We evaluate whether any decline in value of certain public and non-public equity investments is other than temporary.



Due to the inherent risk associated with some of our investments, and in light of current stock market conditions, we may incur future losses on the
sales, write-downs, or write-offs of our investments. We do not currently hedge against equity price changes.



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ITEM 4. CONTROLS AND PROCEDURES



| | (a) | Evaluation of disclosure controls and procedures
| | --- | ------------------------------------------------



As of the end of the period covered by this report, an evaluation was performed, under the supervision and with the participation of our
management, including our Chief Executive Officer and Chief Financial Officer, of the effectiveness of our disclosure controls and procedures, as of the end of the period covered by this report, pursuant to the Securities Exchange Act of 1934, as
amended, Rule 13a-15b. Based upon that evaluation, our Chief Executive Officer and Chief Financial Officer concluded that, as of the end of the period covered by this report, our disclosure controls and procedures are effective.



| | (b) | Changes in internal controls over financial reporting
| | --- | -----------------------------------------------------



During the period covered by this report, there was no change in our internal control over financial reporting that has materially
affected, or is reasonably likely to materially affect, our internal control over financial reporting.



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PART II  OTHER INFORMATION



ITEM 1. LEGAL PROCEEDINGS



Pulsar v. Comarco, Inc., et al,



Case
No. BC30638, Superior Court of California County of Los Angeles-Central District



During fiscal 2001, the Company sold a business which, among other things, provided airport management services. During the fourth quarter of fiscal 2004, the Company was sued by a tenant at an airport where the
Company provided management services pursuant to a contract with the County of Los Angeles (prior to the sale of this business during the 2001 fiscal year). The claimant seeks damages of $2.0 million in addition to other unspecified damages. The
outcome of this matter is not determinable or estimable. No provision has been made for losses, if any, which may result from the final outcome of this matter.



The Company is from time to time involved in various legal proceedings incidental to the conduct of our business. We believe that the outcome of all
such pending legal proceedings will not in the aggregate have a material adverse effect on our results of operations and financial position.



ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS



None.



ITEM 3. DEFAULTS UPON SENIOR SECURITIES



None.



ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS



None.



ITEM 5. OTHER INFORMATION



None.



ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K



| | (a) | Exhibits:
| | --- | ---------



|     |  |                                                                                                   
|---- |  | --------------------------------------------------------------------------------------------------
|31.1 |  | Certification of Chief Executive Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
|     | 
|31.2 |  | Certification of Chief Financial Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
|     | 
|32.1 |  | Certification of Chief Executive Officer Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
|     | 
|32.2 |  | Certification of Chief Financial Officer Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002

|
|



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SIGNATURES



Pursuant to the
requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this Report to be signed on its behalf by the undersigned, thereunto duly authorized.



|                        |  |                                           
|----------------------- |  | ------------------------------------------
|                        |  | COMARCO, INC.                             
|                        | 
|Date: December 14, 2004 |  | /s/ Thomas A. Franza                      
|                        |  | Thomas A. Franza                          
|                        |  | President and Chief Executive Officer     
|                        | 
|Date: December 14, 2004 |  | /s/ Daniel R. Lutz                        
|                        |  | Daniel R. Lutz                            
|                        |  | Vice President and Chief Financial Officer



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EXHIBIT INDEX



|     |  |                                                                                                   
|---- |  | --------------------------------------------------------------------------------------------------
|31.1 |  | Certification of Chief Executive Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
|     | 
|31.2 |  | Certification of Chief Financial Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
|     | 
|32.1 |  | Certification of Chief Executive Officer Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
|     | 
|32.2 |  | Certification of Chief Financial Officer Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002



35