**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**Washington, DC20549

**FORM10-Q**
| **(Mark One)**                                                                                                                            |
|-------------------------------------------------------------------------------------------------------------------------------------------|
| ** **                                                                                                                                | ** ** |
| **x**                                                                                                                                     | **QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)  OF THE SECURITIES EXCHANGE ACT OF 1934** |
| ** **                                                                                                                                | ** ** |
| **For the  quarterly period ended June 30, 2006**                                                                                         |
| ** **                                                                                                                                | ** ** |
| **or**                                                                                                                                    |
| ** **                                                                                                                                | ** ** |
| **o**                                                                                                                                     | **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:**   000-51928**                                                                                   |

 

**CPIINTERNATIONAL, INC.**(Exact Nameof Registrant as Specified in Its Charter)

**Delaware**(Stateor Other Jurisdiction of Incorporation or Organization)

**75-3142681**(I.R.S.Employer Identification No.)

**811 Hansen WayPalo Alto, California 94303-1110(650) 846-2900**(Address of Principal Executive Offices and TelephoneNumber, Including Area Code)

Indicateby check mark whether the registrant (1) has filed all reports required to befiled by Section 13 or 15(d) of the Securities Exchange Act of 1934 duringthe preceding 12 months (or for such shorter period that the registrant wasrequired to file such reports) and (2) has been subject to such filingrequirements for the past 90 days.  Yes  x     No  o

Indicate by check mark whether the registrant is a largeaccelerated filer, an accelerated filer, or a non-accelerated filer.  See definition of “accelerated filer andlarge accelerated filer” in Rule 12b-2 of the Exchange Act. (Check one):

Large accelerated filer  o          Acceleratedfiler  o         Non-acceleratedfiler  x

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

**APPLICABLE ONLY TO CORPORATE ISSUERS:**

Indicatethe number of shares outstanding for each of the registrant’s classes of CommonStock, as of the latest practicable date: 16,032,824 shares of Common Stock,$.01 par value, at August 7, 2006.

 

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** **

**CPI International, Inc.**and Subsidiaries

**INDEX**
| **Part I:   Financial  Information** |   |                                                                                        |
|------------------------------------------------|--------|---------------------------------------------------------------------------------------------|
| Item 1.                                        |   | Financial Statements                                                                        |   |   |
|                                           |   | Unaudited Condensed Consolidated Balance Sheets                                             |   | 4 |
|                                           |   | Unaudited Condensed Consolidated Statements of  Operations and Comprehensive Income         |   | 5 |
|                                           |   | Unaudited Condensed Consolidated Statements of Cash  Flows                                  |   | 7 |
|                                           |   | Notes to Unaudited Condensed Consolidated Financial  Statements                             |   | 8 |
| Item 2.                                        |   | Management’s  Discussion and Analysis of Financial Condition and Results of Operations |   | 30 |
| Item 3.                                        |   | Quantitative  and Qualitative Disclosures About Market Risk                                 |   | 47 |
| Item 4.                                        |   | Controls and  Procedures                                                                    |   | 47 |
| **Part  II: Other Information**                |   |                                                                                        |
| Item 1.                                        |   | Legal Proceedings                                                                           |   | 48 |
| Item  1A.                                      |   | Risk  Factors                                                                               |   | 48 |
| Item 2.                                        |   | Unregistered  Sales of Equity Securities and Use of Proceeds                                |   | 49 |
| Item 3.                                        |   | Defaults Upon  Senior Securities                                                            |   | 50 |
| Item 4.                                        |   | Submission of  Matters to a Vote of Security Holders                                        |   | 50 |
| Item 5.                                        |   | Other Information                                                                           |   | 50 |
| Item  6.                                       |   | Exhibits                                                                                    |   | 50 |

 

2

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**CPI International, Inc.**and Subsidiaries

***Cautionary StatementsRegarding Forward-Looking Statements***

This document contains forward-looking statementswithin the meaning of Section 27A of the Securities Act of 1933, as amended,and Section 21E of the Securities Exchange Act of 1934, as amended, that relateto future events or our future financial performance. In some cases, readerscan identify forward-looking statements by terminology such as “may,” “will,” “should,”“expect,” “plan,” “anticipate,” “believe,” “estimate,” “predict,” “potential”or “continue,” the negative of such terms or other comparable terminology.These statements are only predictions. Actual events or results may differmaterially.

Although we believe that the expectations reflected inthe forward-looking statements are reasonable, we cannot guarantee futureresults, levels of activity, performance or achievements. Moreover, neither wenor any other person assumes responsibility for the accuracy and completenessof the forward-looking statements. Forward-looking statements are subject toknown and unknown risks and uncertainties, which could cause actual results todiffer materially from the results projected, expected or implied by theforward-looking statements. These risk factors include, without limitation,competition in our end markets; our significant amount of debt; changes orreductions in the U.S. defense budget; U.S. government contracts laws andregulations; changes in technology; the impact of unexpected costs; inabilityto obtain raw materials and components; and currency fluctuations. All writtenand oral forward-looking statements made in connection with this report thatare attributable to us or persons acting on our behalf are expressly qualifiedin their entirety by the foregoing risk factors and other cautionary statementsincluded herein and in our other filings with the Securities and ExchangeCommission (“SEC”). We are under no duty to update any of the forward-lookingstatements after the date of this report to conform such statements to actualresults or to changes in our expectations.

The information in this report is not a completedescription of our business or the risks and uncertainties associated with aninvestment in our securities. You should carefully consider the various risksand uncertainties that impact our business and the other information in thisreport and in our other filings with the SEC before you decide to invest in oursecurities or to maintain or increase your investment.

3

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**PART I: FINANCIALINFORMATION**

**Item 1. FinancialStatements**

**CPI International, Inc.**andSubsidiaries

**CONDENSEDCONSOLIDATED BALANCE SHEETS(in thousands, except share and per share data—unaudited)**
| ** **                                                                                                                           | ** ** | **June 30,** | ** ** | **September 30,** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------|------------|------------------------|------------|
| ** **                                                                                                                           | ** ** | **2006**          | ** ** | **2005**               | ** ** |
| **Assets**                                                                                                                           | ** ** | ** **        | ** ** | ** **             | ** ** |
| Current Assets:                                                                                                                      |       |              |       |                   |       |
| Cash and cash equivalents                                                                                                            |       | $                 | 12,606     |                   | $          | 26,511 |   |
| Restricted cash                                                                                                                      |       | 854               |       | 1,287                  |       |
| Accounts receivable, net                                                                                                             |       | 48,173            |       | 39,295                 |       |
| Inventories                                                                                                                          |       | 54,213            |       | 50,620                 |       |
| Deferred tax assets                                                                                                                  |       | 11,683            |       | 12,346                 |       |
| Prepaids and other current assets                                                                                                    |       | 5,137             |       | 3,981                  |       |
| Total current assets                                                                                                                 |       | 132,666           |       | 134,040                |       |
| Property, plant  and equipment, net                                                                                                  |       | 86,651            |       | 83,624                 |       |
| Deferred debt  issue costs, net                                                                                                      |       | 9,995             |       | 11,061                 |       |
| Intangible  assets, net                                                                                                              |       | 76,102            |       | 77,941                 |       |
| Goodwill                                                                                                                             |       | 145,462           |       | 145,462                |       |
| Other long-term  assets                                                                                                              |       | 2,408             |       | 2,416                  |       |
| Total assets                                                                                                                         |       | $                 | 453,284    |                   | $          | 454,544 |   |
| ** **                                                                                                                           | ** ** | ** **        | ** ** | ** **             | ** ** |
| **Liabilities  and Stockholders’ Equity**                                                                                       | ** ** | ** **        | ** ** | ** **             | ** ** |
| Current  Liabilities:                                                                                                                |       |              |       |                   |       |
| Accounts payable                                                                                                                     |       | $                 | 21,467     |                   | $          | 21,421 |   |
| Accrued expenses                                                                                                                     |       | 26,829            |       | 27,247                 |       |
| Product warranty                                                                                                                     |       | 6,295             |       | 6,359                  |       |
| Income taxes payable                                                                                                                 |       | 5,749             |       | 1,546                  |       |
| Advance payments from customers                                                                                                      |       | 5,218             |       | 12,067                 |       |
| Total current liabilities                                                                                                            |       | 65,558            |       | 68,640                 |       |
| Deferred income  taxes                                                                                                               |       | 34,024            |       | 35,556                 |       |
| Advance payments  from sale of San Carlos property                                                                                   |       | 13,450            |       | 13,450                 |       |
| Long-term debt                                                                                                                       |       | 246,768           |       | 284,231                |       |
| Other long-term  liabilities                                                                                                         |       | 31                |       | —                 |       |
| Total liabilities                                                                                                                    |       | 359,831           |       | 401,877                |       |
| Commitments and  contingencies                                                                                                       |       |              |       |                   |       |
| Stockholders’  Equity:                                                                                                          |       |              |       |                   |       |
| Common stock ($0.01 par value, 90,000,000 shares authorized;  16,030,153 and 13,078,954 shares issued and outstanding, respectively) |       | 160               |       | 131                    |       |
| Additional paid-in capital                                                                                                           |       | 65,009            |       | 34,595                 |       |
| Accumulated other comprehensive income                                                                                               |       | 936               |       | 1,621                  |       |
| Retained earnings                                                                                                                    |       | 27,348            |       | 16,320                 |       |
| Total stockholders’ equity                                                                                                      |       | 93,453            |       | 52,667                 |       |
| Total  liabilities and stockholders’ equity                                                                                     |       | $                 | 453,284    |                   | $          | 454,544 |   |

 

See accompanying notes to the condensed consolidatedfinancial statements.

4

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**CPI International, Inc.and Subsidiaries**

**CONDENSEDCONSOLIDATEDSTATEMENTS OF OPERATIONS AND COMPREHENSIVE INCOME(in thousands, except share and per share data—unaudited)**
| ** **                                             | ** ** | **Quarter Ended**      | ** ** |
|--------------------------------------------------------|------------|-----------------------------|------------|
| ** **                                             | ** ** | **June 30, 2006** | ** ** | **July 1, 2005** | ** ** |
| Sales                                                  |       | $                           | 87,761     |   | $ | 87,639 |   |
| Cost of sales                                          |       | 60,867                      |       | 57,848 |   |
| Gross profit                                           |       | 26,894                      |       | 29,791 |   |
|                                                   |       |                        |       |   |   |
| Operating costs  and expenses:                         |       |                        |       |   |   |
| Research and development                               |       | 2,515                       |       | 1,899 |   |
| Selling and marketing                                  |       | 5,248                       |       | 4,744 |   |
| General and administrative                             |       | 5,441                       |       | 5,764 |   |
| Amortization of acquisition-related intangible  assets |       | 548                         |       | 548 |   |
| Net loss on disposition of assets                      |       | 212                         |       | 25 |   |
| Total operating  costs and expenses                    |       | 13,964                      |       | 12,980 |   |
| Operating income                                       |       | 12,930                      |       | 16,811 |   |
| Interest  expense, net                                 |       | 5,945                       |       | 5,697 |   |
| Income before  income taxes                            |       | 6,985                       |       | 11,114 |   |
| Income tax  expense                                    |       | 2,517                       |       | 4,416 |   |
| Net income                                             |       | $                           | 4,468      |   | $ | 6,698 |   |
| Other  comprehensive income, net of tax                |       |                        |       |   |   |
| Net unrealized loss on cash flow hedges                |       | (196                        | )          | (711 | ) |
| Comprehensive  income                                  |       | $                           | 4,272      |   | $ | 5,987 |   |
|                                                   |       |                        |       |   |   |
| Net income per  share:                                 |       |                        |       |   |   |
| Basic                                                  |       | $                           | 0.30       |   | $ | 0.51 |   |
| Diluted                                                |       | $                           | 0.27       |   | $ | 0.48 |   |
| Shares used to  compute net income per share:          |       |                        |       |   |   |
| Basic                                                  |       | 15,039,754                  |       | 13,078,954 |   |
| Diluted                                                |       | 16,766,822                  |       | 13,978,215 |   |

 

See accompanying notes to the condensed consolidatedfinancial statements.

5

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**CPI International,Inc.and Subsidiaries**

**CONDENSEDCONSOLIDATEDSTATEMENTS OF OPERATIONS AND COMPREHENSIVE INCOME(in thousands, except share and per share data—unaudited)**
| ** **                                                                                                                       | ** ** | **Nine Months Ended** | ** ** |
|----------------------------------------------------------------------------------------------------------------------------------|------------|---------------------------------|------------|
| ** **                                                                                                                       | ** ** | **June 30, 2006**     | ** ** | **July 1, 2005** | ** ** |
| Sales                                                                                                                            |       | $                               | 257,069    |   | $ | 245,835 |   |
| Cost of sales,  including $351 of amortization of acquisition-related inventory write-up for  the nine months ended July 1, 2005 |       | 179,223                         |       | 163,263 |   |
| Gross profit                                                                                                                     |       | 77,846                          |       | 82,572 |   |
| Operating costs and  expenses:                                                                                                   |       |                            |       |   |   |
| Research and  development                                                                                                        |       | 6,366                           |       | 5,205 |   |
| Selling and  marketing                                                                                                           |       | 14,952                          |       | 13,397 |   |
| General and  administrative                                                                                                      |       | 17,419                          |       | 15,391 |   |
| Amortization of  acquisition-related intangible assets                                                                           |       | 1,642                           |       | 6,940 |   |
| Net loss on  disposition of assets                                                                                               |       | 420                             |       | 273 |   |
| Total operating costs  and expenses                                                                                              |       | 40,799                          |       | 41,206 |   |
| Operating income                                                                                                                 |       | 37,047                          |       | 41,366 |   |
| Interest expense, net                                                                                                            |       | 18,409                          |       | 14,509 |   |
| Income before income  taxes                                                                                                      |       | 18,638                          |       | 26,857 |   |
| Income tax expense                                                                                                               |       | 7,610                           |       | 10,741 |   |
| Net income                                                                                                                       |       | $                               | 11,028     |   | $ | 16,116 |   |
|                                                                                                                             |       |                            |       |   |   |
| Other comprehensive  income, net of tax                                                                                          |       |                            |       |   |   |
| Net unrealized  loss on cash flow hedges                                                                                         |       | (685                            | )          | (328 | ) |
| Comprehensive income                                                                                                             |       | $                               | 10,343     |   | $ | 15,788 |   |
|                                                                                                                             |       |                            |       |   |   |
| Net income per share:                                                                                                            |       |                            |       |   |   |
| Basic                                                                                                                            |       | $                               | 0.80       |   | $ | 1.23 |   |
| Diluted                                                                                                                          |       | $                               | 0.71       |   | $ | 1.16 |   |
| Shares used to compute  net income per share:                                                                                    |       |                            |       |   |   |
| Basic                                                                                                                            |       | 13,736,031                      |       | 13,078,954 |   |
| Diluted                                                                                                                          |       | 15,443,427                      |       | 13,851,963 |   |

 

See accompanying notes to the condensed consolidatedfinancial statements.

6

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**CPI International, Inc.and Subsidiaries**

**CONDENSEDCONSOLIDATED STATEMENTS OF CASH FLOWS(in thousands—unaudited)**
| ** **                                                 | ** ** | **Nine Months Ended** | ** ** |
|------------------------------------------------------------|------------|---------------------------------|------------|
| ** **                                                 | ** ** | **June 30,  2006**         | ** ** | **July 1,  2005** | ** ** |
| **Operating  Activities**                                  | ** ** | ** **                      | ** ** | ** ** | ** ** |
| Net cash  provided by operating activities                 |       | $                               | 1,918      |   | $ | 13,770 |   |
| ** **                                                 | ** ** | ** **                      | ** ** | ** ** | ** ** |
| **Investing  Activities**                                  | ** ** | ** **                      | ** ** | ** ** | ** ** |
| Deferred expenses relating to sale of San Carlos  property |       | (212                            | )          | (216 | ) |
| Purchase of Econco, net of cash acquired                   |       | —                          |       | (18,325 | ) |
| Capital expenditures                                       |       | (8,419                          | )          | (8,867 | ) |
| Other investing activities                                 |       | —                          |       | (16 | ) |
| Net cash used in investing activities                      |       | (8,631                          | )          | (27,424 | ) |
|                                                       |       |                            |       |   |   |
| **Financing  Activities**                                  | ** ** | ** **                      | ** ** | ** ** | ** ** |
| Proceeds from issuance of floating rate senior notes       |       | —                          |       | 79,200 |   |
| Proceeds from issuance of common stock                     |       | 52,942                          |       | — |   |
| Proceeds from senior term loan                             |       | 10,000                          |       | — |   |
| Special cash dividends                                     |       | (17,000                         | )          | (75,809 | ) |
| Repayments on senior term loan                             |       | (47,500                         | )          | (9,550 | ) |
| Payments for debt issue costs                              |       | —                          |       | (3,455 | ) |
| Payment of IPO costs                                       |       | (5,634                          | )          | — |   |
| Other financing activities                                 |       | —                          |       | (100 | ) |
| Net cash used in financing activities                      |       | (7,192                          | )          | (9,714 | ) |
| ** **                                                 |       |                            |       |   |   |
| **Net  Decrease in Cash and Cash Equivalents**             |       | (13,905                         | )          | (23,368 | ) |
| Cash and cash  equivalents at beginning of period          |       | 26,511                          |       | 40,476 |   |
| Cash and cash  equivalents at end of period                |       | $                               | 12,606     |   | $ | 17,108 |   |
| ** **                                                 | ** ** | ** **                      | ** ** | ** ** | ** ** |
| **Supplemental  Disclosures of Cash Flow Information**     | ** ** | ** **                      | ** ** | ** ** | ** ** |
| Cash paid for interest                                     |       | $                               | 13,714     |   | $ | 8,160 |   |
| Cash paid for  taxes, net of refunds                       |       | $                               | 5,205      |   | $ | 10,820 |   |

** **

See accompanying notes to the condensed consolidatedfinancial statements.

7

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**CPI International, Inc.**andSubsidiaries

**NOTES TO UNAUDITED CONDENSEDCONSOLIDATED FINANCIAL STATEMENTS**

**(All tabular dollar amounts in thousandsexcept share and per share amounts)**

**1.**                 Basisof Presentation

Unless the context otherwise requires, (1) “CPI International”means CPI International, Inc., (2) “Predecessor” means Communications &Power Industries Holding Corporation, the predecessor to CPI International, (3)“CPI” means Communications & Power Industries, Inc. and (4) “Merger” meansthe January 23, 2004 merger pursuant to which CPI International acquired thePredecessor. CPI is a direct subsidiary of CPI International. CPI Internationalis a holding company with no operations of its own. The terms “we,” “us,” “our”and the “Company” refer to CPI International, or the Predecessor, asapplicable, and its direct and indirect subsidiaries on a consolidated basis.

The accompanying condensed consolidated financial statementsrepresent the consolidated results and financial position of CPI International,a Delaware corporation, which is controlled by affiliates of The Cypress GroupL.L.C. (“Cypress”). CPI International, through its wholly owned subsidiary,CPI, develops, manufactures, and distributes microwave and power grid VacuumElectron Devices (“VEDs”), microwave amplifiers, modulators and various otherpower supply equipment and devices. The Company has two reportable segments,VED and satcom equipment.

Theaccompanying condensed consolidated financial statements have been prepared inaccordance with accounting principles generally accepted in the United Statesof America and include the accounts of the Company and its consolidatedsubsidiaries.  In the opinion of management, the accompanying unauditedcondensed consolidated financial statements contain all adjustments necessaryto present fairly the consolidated financial position of the Company and itsconsolidated results of operations and comprehensive income and cash flows.

The Company’s fiscal year is the 52 or 53-week period endingon the Friday nearest September 30. Fiscal year 2006 comprises the 52-weekperiod ending September 29, 2006, and fiscal year 2005 comprised the 52-weekperiod ended September 30, 2005. All period references are to the Company’sfiscal periods unless otherwise indicated. These interim financialstatements should be read in conjunction with the consolidated financialstatements and accompanying notes included in the Company’s Annual Report onForm 10-K for the year ended September 30, 2005. Certain amounts inprior years’ condensed consolidated financial statements have been reclassifiedto conform to the fiscal 2006 presentation. Net operating results have not beenaffected by these reclassifications.

**2.**                 SupplementalBalance Sheet Information

**Accounts receivable:**   Accounts receivable are stated net of allowances fordoubtful accounts of $0.7 million at both June 30, 2006 and September 30, 2005.

**Inventories:**   Thefollowing table provides details of inventories, net of reserves:

|                          | ** ** | **June 30,** | ** ** | **September 30,** | ** ** |
|--------------------------|------------|-------------------|------------|------------------------|------------|
| ** **               | ** ** | **2006**          | ** ** | **2005**               | ** ** |
| Raw materials  and parts |       | $                 | 35,045     |                   | $          | 29,627 |   |
| Work in process          |       | 10,580            |       | 12,540                 |       |
| Finished goods           |       | 8,588             |       | 8,453                  |       |
|                     |       | $                 | 54,213     |                   | $          | 50,620 |   |

 

8

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**Reserve for excess, slow moving and obsoleteinventory:**   

 

|                                               | ** ** | **Nine Months Ended** | ** ** |
|-----------------------------------------------|------------|---------------------------------|------------|
| ** **                                    | ** ** | **June 30,**               | ** ** | **July 1,** | ** ** |
| ** **                                    | ** ** | **2006**                        | ** ** | **2005** | ** ** |
| Beginning  balance                            |       | $                               | 8,655      |   | $ | 8,981 |   |
| Econco acquisition                            |       | —                          |       | 729 |   |
| Inventory provision, charged to cost of sales |       | 898                             |       | 661 |   |
| Inventory write-offs                          |       | (259                            | )          | (479 | ) |
| Ending balance                                |       | $                               | 9,294      |   | $ | 9,892 |   |

 

**Reserve for loss contracts and cost inexcess of market inventory:**   

 

|                                                            | ** ** | **Nine Months Ended** | ** ** |
|------------------------------------------------------------|------------|---------------------------------|------------|
| ** **                                                 | ** ** | **June 30,**               | ** ** | **July 1,** | ** ** |
| ** **                                                 | ** ** | **2006**                        | ** ** | **2005** | ** ** |
| Beginning  balance                                         |       | $                               | 1,430      |   | $ | 2,845 |   |
| Provision for loss contracts and cost in excess of  market |       |                            |       |   |   |
| inventory, charged to cost of sales                        |       | 1,350                           |       | 1,115 |   |
| Reserved inventory sold or otherwise disposed of           |       | (1,145                          | )          | (1,879 | ) |
| Ending balance                                             |       | $                               | 1,635      |   | $ | 2,081 |   |
|                                                       |       |                            |       |   |   |

 

**Intangible assets, net:**   

| June 30, 2006                            | ** ** | **Cost** | ** ** | **Accumulated  Amortization** | ** ** | **Net** | ** ** |
|----------------------------------------------------|------------|----------|------------|-------------------------------|------------|---------|------------|
| VED core  technology                               |       | $        | 30,700     |                          | $          | (1,506  | )          | $ | 29,194 |   |
| VED application  technology                        |       | 19,800   |       | (1,932                        | )          | 17,868  |       |
| X-ray generator  and satcom application technology |       | 8,000    |       | (1,306                        | )          | 6,694   |       |
| Customer backlog                                   |       | 17,450   |       | (17,450                       | )          | —  |       |
| Land lease                                         |       | 11,810   |       | (641                          | )          | 11,169  |       |
| Tradename                                          |       | 5,800    |       | —                        |       | 5,800   |       |
| Customer list  and programs                        |       | 5,700    |       | (394                          | )          | 5,306   |       |
| Noncompete  agreement                              |       | 110      |       | (39                           | )          | 71      |       |
|                                               |       | $        | 99,370     |                          | $          | (23,268 | )          | $ | 76,102 |   |

 

| September 30, 2005                       | ** ** | **Cost** | ** ** | **Accumulated  Amortization** | ** ** | **Net** | ** ** |
|----------------------------------------------------|------------|----------|------------|-------------------------------|------------|---------|------------|
| VED core  technology                               |       | $        | 30,700     |                          | $          | (1,048  | )          | $ | 29,652 |   |
| VED application  technology                        |       | 19,800   |       | (1,340                        | )          | 18,460  |       |
| X-ray generator  and satcom application technology |       | 8,000    |       | (902                          | )          | 7,098   |       |
| Customer backlog                                   |       | 17,450   |       | (17,450                       | )          | —  |       |
| Land lease                                         |       | 11,810   |       | (444                          | )          | 11,366  |       |
| Tradename                                          |       | 5,800    |       | —                        |       | 5,800   |       |
| Customer list  and programs                        |       | 5,700    |       | (224                          | )          | 5,476   |       |
| Noncompete  agreement                              |       | 110      |       | (21                           | )          | 89      |       |
|                                               |       | $        | 99,370     |                          | $          | (21,429 | )          | $ | 77,941 |   |
|                                               |       |     |       |                          |       |    |       |

 

9

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The estimated future amortization expense of purchasedamortizable intangible assets as of June 30, 2006 was as follows:

| Fiscal Year               | ** ** | ** ** | ** ** | **Amount** | ** ** |
|--------------------------------|------------|------------|------------|------------|------------|
| 2006 (remaining  three months) |       | $          | 612        |       |
| 2007                           |       | 2,451      |       |
| 2008                           |       | 2,451      |       |
| 2009                           |       | 2,432      |       |
| 2010                           |       | 2,429      |       |
| Thereafter                     |       | 59,927     |       |
| Total                          |       | $          | 70,302     |       |
|                           |       |       |       |

 

**Goodwill:**   Asof June 30, 2006 and September 30, 2005 the Company had $145.5 million ofgoodwill, $131.6 million of which has been allocated to the VED segment and$13.9 million of which has been allocated to the satcom equipment segment.There were no changes in the carrying amount of goodwill for the nine monthsended June 30, 2006.

**Product warranty:**

 

 

|                                                          | ** ** | **Nine Months Ended** | ** ** |
|----------------------------------------------------------|------------|-----------------------|------------|
| ** **                                               | ** ** | **June 30,**     | ** ** | **July 1,** | ** ** |
| ** **                                               | ** ** | **2006**              | ** ** | **2005** | ** ** |
| Beginning  accrued warranty                              |       | $                     | 6,359      |   | $ | 6,074 |   |
| Amount acquired from Econco                              |       | —                |       | 112 |   |
| Accruals for product warranty, charged to cost of  sales |       | 4,198                 |       | 3,676 |   |
| Cost of warranty claims                                  |       | (4,262                | )          | (3,831 | ) |
| Ending balance                                           |       | $                     | 6,295      |   | $ | 6,031 |   |

** **

**3.             Long-Term Debt**

Long-term debt comprises the following:

|                                                                                                       | ** ** | **June 30,** | ** ** | **September 30,** | ** ** |
|-------------------------------------------------------------------------------------------------------|------------|-------------------|------------|------------------------|------------|
| ** **                                                                                            | ** ** | **2006**          | ** ** | **2005**               | ** ** |
| Term loan,  expiring 2010                                                                             |       | $                 | 42,500     |                   | $          | 80,000 |   |
| 8% Senior  subordinated notes due 2012                                                                |       | 125,000           |       | 125,000                |       |
| Floating rate  senior notes due 2015, net of amortized issue discount of $732 and $769,  respectively |       | 79,268            |       | 79,231                 |       |
|                                                                                                  |       | $                 | 246,768    |                   | 284,231    |   |
|                                                                                                       |            |                   |            |                        |            |  |  |

 

**Senior credit facility and term loan of CPI:**   In connection with the Merger, CPI entered into a$130.0 million credit agreement, which was amended and restated on November 29,2004, and further amended on February 16, 2005, April 13, 2005, and December15, 2005 (the “Senior Credit Facility”). The Senior Credit Facility consists ofa $40.0 million revolving commitment, with a sub-facility of $15.0 million forletters of credit and $5.0 million for swingline loans (“Revolver”), whichexpires on January 23, 2010, and a $90.0 million term loan (“Term Loan”), whichexpires on July 23, 2010. As of June 30, 2006 the Company had no outstandingborrowings under the Revolver and $42.5 million outstanding under the TermLoan, after the $47.5 million aggregate Term Loan repayments in May 2006 usingproceeds from our initial public offering of CPI International’s common stock(the “IPO”).  There are no scheduledprincipal payments due on the Term Loan during the 2006 fiscal year because ofthe optional Term Loan prepayments made by the Company in fiscal 

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year 2005. Upon certain specified conditions,including compliance on a pro forma basis with the covenants in the SeniorCredit Facility, CPI may seek commitments for a new class of term loans, not toexceed $65.0 million. The Senior Credit Facility is guaranteed by CPIInternational and all of CPI’s domestic subsidiaries and is secured bysubstantially all of their assets.

On December 15, 2005, CPI International and CPI entered intoAmendment No. 3 (the “Amendment”), to the Senior Credit Facility. The Amendmentincreased the commitments under the Term Loan by $10.0 million, and CPIborrowed an additional $10.0 million thereunder. In addition, among otherthings, the Amendment (1) permitted CPI to pay a dividend (not to exceed $20.0million) to CPI International to fund a dividend by CPI International to itsstockholders, (2) amended the definition of Excess Cash Flow in the SeniorCredit Facility to decrease Excess Cash Flow for CPI’s fiscal year 2006 by theexcess of the amount of the dividend described in clause (1) over the grossproceeds of the $10.0 million additional borrowing, and (3) permitted CPI orCPI International to use up to $70.0 million of the proceeds of the initialpublic offering of CPI International’s common stock to repurchase or redeem itsFloating Rate Senior Notes (the “FR Notes”) or CPI’s 8% Senior SubordinatedNotes due 2012 (the “8% Notes”).

Any borrowings under the Revolverwould currently bear interest at a rate equal to, at CPI’s option, LIBOR plus2.75% per annum, or the Alternate Base Rate (“ABR”) plus 1.75% per annum.Available borrowings under the Revolver are reduced by any amounts securedthrough letters of credit; at June 30, 2006, we had letters of creditcommitments for $4.2 million. The Term Loan borrowings currently bear interest ata rate equal to, at CPI’s option, LIBOR plus 2.25% per annum or the ABR plus1.25% per annum, payable quarterly. The ABR is the greater of (a) the PrimeRate and (b) the Federal Funds Rate plus 0.50%. In addition to customaryfronting and administrative fees under the Senior Credit Facility, CPI paysletter of credit participation fees equal to the applicable Revolver LIBORmargin per annum on the average daily amount of the letter of credit exposure,and a commitment fee of 0.50% per annum on the average daily unused amount ofrevolving commitment. As of June 30, 2006 (1) the Term Loan borrowing consistedof one tranche of $7.5 million and one tranche of $35.0 million with interestpayable on July 5 and July 19, 2006, at 7.38% and 7.51% per annum, respectivelyand (2) a Revolving commitment of $4.2 million for letter of credit exposure,with letter of credit participation fees and fronting fees payable quarterly ata combined interest rate of 3.0% per annum.

The Senior Credit Facility requires 1.0% of the original TermLoan amount to be repaid annually in quarterly installments of 0.25% beginningJune 30, 2004 and continuing for five years, with the remainder due in equalquarterly installments thereafter. CPI is required to prepay its outstandingloans, subject to certain exceptions and limitations, with net cash proceedsreceived from certain events, including, without limitation (1) all suchproceeds received from certain asset sales by CPI International, CPI or any ofCPI’s subsidiaries; (2) all such proceeds received from issuances of debt(other than certain specified permitted debt) or preferred stock by CPIInternational, CPI or any of CPI’s subsidiaries, (3) all such proceeds paid toCPI International, CPI or any of CPI’s subsidiaries from casualty andcondemnation events in excess of amounts applied to replace, restore orreinvest in any properties for which proceeds were paid within a specifiedperiod and (4) 50% of such proceeds received from issuances of common equityby, or equity contributions to, CPI International.

CPI is also required to make an annual prepayment within 90days after the end of each fiscal year based on a calculation of Excess CashFlow (“ECF”), as defined in the Senior Credit Facility, multiplied by a factorof 25%, 50% or 75% depending on the leverage ratio at the end of the fiscalyear, less optional prepayments made during the fiscal year. On December 30,2004, CPI made an ECF payment of $3.9 million. The ECF payment was applied prorata, in accordance with the provisions of the Senior Credit Facility, againstthe remaining scheduled installments of Term Loan principal due up to, but notincluding, the September 30, 2009 scheduled principal installment.

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CPI can make optional prepayments on the outstanding loans atany time without premium or penalty, except for customary “breakage” costs withrespect to LIBOR loans. In March 2005, CPI made an optional prepayment of $5.7million, and in May 2006, CPI made additional optional prepayments of $47.5million in the aggregate using proceeds from the IPO.  The optional prepayments were applied prorata, in accordance with the provisions of the Senior Credit Facility, againstthe remaining scheduled installments of Term Loan principal due up to June 30,2009, with the balance applied to scheduled installment amounts on or afterSeptember 30, 2009, in direct order of maturity.

The Senior Credit Facility contains a number of covenantsthat, among other things, restrict, subject to certain exceptions, the abilityof CPI International, CPI and CPI’s domestic subsidiaries to: sell assets;engage in mergers and acquisitions; pay dividends and distributions orrepurchase their capital stock; incur additional indebtedness or issue equityinterests; make investments and loans; create liens or further negative pledgeson assets; engage in certain transactions with affiliates; enter into sale andleaseback transactions; amend agreements or make prepayments relating tosubordinated indebtedness; and amend or waive provisions of charter documents ina manner materially adverse to the lenders. CPI and CPI’s subsidiaries mustcomply with: a minimum interest coverage ratio; a maximum total leverage ratio;a minimum fixed charge coverage ratio; and a maximum capital expenditureslimitation, each calculated on a consolidated basis for CPI and CPI’ssubsidiaries. CPI International must also comply with a minimum interestcoverage ratio, a minimum fixed charge coverage ratio and a maximum leverageratio, each calculated on a consolidated basis for CPI International and itssubsidiaries. As of June 30, 2006, CPI and CPI International were in compliancewith all Senior Credit Facility financial covenants.

Subject in certain cases to applicable notice provisions andgrace periods, events of default under the Senior Credit Facility include,among other things: failure to make payments when due; breaches ofrepresentations and warranties in the documents governing the Senior CreditFacility; non-compliance by CPI International, CPI and/or CPI’s subsidiarieswith certain covenants; failure by CPI International, CPI and/or CPI’ssubsidiaries to pay certain other indebtedness or to observe any othercovenants or agreements that would allow acceleration of such indebtedness,collectively in excess of $5.0 million at any time; events of bankruptcy orinsolvency of CPI International, CPI and/or CPI’s subsidiaries; certainuninsured and unstayed judgments of $5.0 million or more against CPIInternational; impairment of the security interests in the collateral or theguarantees under the Senior Credit Facility; and a change in control, asdefined in the documents governing the Senior Credit Facility.

**8% Senior subordinated notes of CPI:**   In connection with the Merger on January 23,2004, CPI issued $125.0 million in aggregate principal amount of its 8% Notes.The proceeds of the 8% Notes were used to redeem the Predecessor’s outstandingindebtedness and pay part of the Merger consideration. The 8% Notes have nosinking fund requirements.

The 8% Notes bear interest at the rate of 8.0% per year,payable on February 1 and August 1 of each year. The 8% Notes willmature on February 1, 2012. The 8% Notes are unsecured obligations,jointly and severally guaranteed by CPI International and each of CPI’sdomestic subsidiaries. The payment of all obligations relating to the 8% Notesare subordinated in right of payment to the prior payment in full in cash orcash equivalents of all senior debt (as defined in the indenture governing the8% Notes) of CPI, including debt under the Senior Credit Facility. Eachguarantee of the 8% Notes is and will be subordinated to guarantor senior debt(as defined in the indenture governing the 8% Notes) on the same basis as the8% Notes are subordinated to CPI’s senior debt.

At any time or from time to time on or after February 1,2008, CPI, at its option, may redeem the 8% Notes, in whole or in part, at theredemption prices (expressed as percentages of principal amount) set forthbelow, together with accrued and unpaid interest thereon, if any, to the redemptiondate, if redeemed during the 12-month period beginning on February 1 ofthe years indicated below:

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| Year                | ** ** | **Optional  Redemption  Price** | ** ** |
|---------------------|------------|---------------------------------|------------|
| 2008                |       | 104                             | %          |
| 2009                |       | 102                             | %          |
| 2010 and thereafter |       | 100                             | %          |

At any time or from time to time prior to February 1, 2007,and subject to certain conditions, CPI may redeem up to 35% of the aggregateprincipal amount of the 8% Notes at a redemption price equal to 108% of theprincipal amount of the 8% Notes to be redeemed, plus accrued and unpaid interestto the date of redemption, with the net cash proceeds of one or more qualifiedequity offerings. At any time on or prior to February 1, 2008, the 8%Notes may also be redeemed or purchased (by CPI or any other person) in wholebut not in part, at CPI’s option, upon the occurrence of a change of control(as defined in the indenture governing the 8% Notes) at a price equal to 100%of the principal amount of the 8% Notes, plus a “make-whole” premium (asdefined in the indenture governing the 8% Notes) to the redemption price onFebruary 1, 2008, and accrued and unpaid interest, if any, to, the date ofredemption or purchase.

Upon a change of control, CPI may be required to purchase allor any part of the 8% Notes for a cash price equal to 101% of the principalamount, plus accrued and unpaid interest thereon, if any, to the date ofpurchase.

The indenture governing the 8% Notes contains a number ofcovenants that, among other things, restrict, subject to certain exceptions,the ability of CPI and its restricted subsidiaries (as defined in the indenturegoverning the 8% Notes) to incur additional indebtedness, sell assets,consolidate or merge with or into other companies, pay dividends or repurchaseor redeem capital stock or subordinated indebtedness, make certain investments,issue capital stock of their subsidiaries, incur liens and enter into certaintypes of transactions with their affiliates.

Events of default under the indenture governing the 8% Notesinclude: failure to make payments on the 8% Notes when due; failure to complywith covenants in the indenture governing the 8% Notes; a default under certainother indebtedness of CPI or any of its restricted subsidiaries that is causedby a failure to make payments on such indebtedness or that results in theacceleration of the maturity of such indebtedness; the existence of certainfinal judgments or orders against CPI or any of the restricted subsidiaries;and the occurrence of certain insolvency or bankruptcy events.

**Floating rate senior notes of CPI International:**   On February 22, 2005, CPI International issued $80.0million in principal amount of its FR Notes. The FR Notes were issued at a 1%discount. The proceeds from the issuance of FR Notes were used to make adistribution to stockholders of CPI International of approximately $75.8million and to pay fees and expenses of approximately $3.5 million associatedwith the issuance of FR Notes. The FR Notes have no sinking fund requirements.

The FR Notes require interest payments at an annual interestrate, reset at the beginning of each semi-annual period, equal to the thensix-month LIBOR plus 5.75%, payable semiannually on February 1 and August 1 ofeach year. The interest rate on the semi-annual interest payment due August 1,2006 is approximately 10.56% per annum. CPI International may, at its option, elect to pay interest through theissuance of additional FR Notes for any interest payment date on or afterAugust 1, 2006 and on or before February 1, 2010. If CPI Internationalelects to pay interest through the issuance of additional FR Notes, the annualinterest rate on the FR Notes will increase by an additional 1% step-up, withthe step-up increasing by an additional 1% for each interest payment madethrough the issuance of additional FR Notes (up to a maximum of 4%). The FRNotes will mature on February 1, 2015.

The FR Notes are general unsecured obligations of CPIInternational. The FR Notes are not guaranteed by any of CPI International’ssubsidiaries but are structurally subordinated to all existing and futureindebtedness 

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and other liabilities of CPI International’ssubsidiaries. The FR Notes are senior in right of payment to CPI International’sexisting and future indebtedness that is expressly subordinated to the FRNotes.

Because CPI International is a holding company with nooperations of its own, CPI International relies on distributions from CPI tosatisfy its obligations under the FR Notes. The Senior Credit Facility and theindenture governing the 8% Notes restrict CPI’s ability to make distributionsto CPI International. The Senior Credit Facility prohibits CPI from makingdistributions to CPI International unless there is no default under the SeniorCredit Facility and CPI International and CPI satisfy certain leverage ratios.The indenture governing the 8% Notes prohibits CPI from making distributions toCPI International unless, among other things, there is no default under theindenture and the amount of the proposed dividend plus all previous RestrictedPayments (as defined in the indenture governing the 8% Notes) does not exceed aspecified amount.

At any time or from time to time prior to February 1, 2007,CPI International, at its option, may redeem the FR Notes in whole or in partat a “make whole” premium, plus accrued and unpaid interest to the date ofredemption. At any time or from time to time on or after February 1, 2007, CPIInternational, at its option, may redeem the Notes in whole or in part at theredemption prices (expressed as percentages of principal amount) set forthbelow, together with accrued and unpaid interest thereon, if any, to theredemption date, if redeemed during the 12-month period beginning on February 1of the years indicated below:

| Year                | ** ** | **Optional  Redemption** | ** ** |
|---------------------|------------|--------------------------|------------|
| 2007                |       | 103                      | %          |
| 2008                |       | 102                      | %          |
| 2009                |       | 101                      | %          |
| 2010 and thereafter |       | 100                      | %          |

At any time or from time to time prior to February 1, 2007,and subject to certain conditions, CPI International, at its option, may redeemup to 35% of the aggregate principal amount of the FR Notes at a redemptionprice equal to 100% of the principal amount of the FR Notes to be redeemed,plus a premium equal to the interest rate per annum on the FR Notes applicableon the date on which the notice of redemption is given, plus accrued and unpaidinterest to the date of redemption, with the net cash proceeds of one or morequalified equity offerings.

Upon a change of control, as defined in the indenturegoverning the FR Notes, CPI International may be required to purchase all orany part of the outstanding FR Notes for a cash price equal to 101% of theprincipal amount, plus accrued and unpaid interest thereon, if any, to the dateof purchase.

The indenture governing the FR Notes contains certaincovenants that, among other things, limit the ability of CPI International andits restricted subsidiaries (as defined in the indenture governing the FRNotes) to incur additional indebtedness, sell assets, consolidate or merge withor into other companies, pay dividends or repurchase or redeem capital stock orsubordinated indebtedness, make certain investments, issue capital stock oftheir subsidiaries, incur liens and enter into certain types of transactionswith their affiliates.

Events of default under the indenture governing the FR Notesinclude: failure to make payments on the FR Notes when due; failure to complywith covenants in the indenture governing the FR Notes; a default under certainother indebtedness of CPI International or any of its restricted  subsidiaries that is caused by a failure tomake payments on such indebtedness or that results in the acceleration of thematurity of such indebtedness; the existence of certain final judgments ororders against CPI International or any of the restricted subsidiaries; and theoccurrence of certain insolvency or bankruptcy events.

 

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**Debt maturities:**   As of June 30, 2006, maturities on long-term debt wereas follows (in thousands):

| Fiscal Year | ** ** | **Amount** | ** ** |
|------------------|------------|------------|------------|
| 2006             |       | $          | —     |   |
| 2007             |       | —     |       |
| 2008             |       | —     |       |
| 2009             |       | —     |       |
| 2010             |       | 42,500     |       |
| Thereafter       |       | 205,000    |       |
| Total            |       | $          | 247,500    |   |

 

**4. Stockholders’ Equity**

**Common andPreferred Stock:**  On April 7, 2006, the Company amended andrestated its certificate of incorporation. The Company’s amended and restated certificate of incorporation providesfor 90,000,000 authorized shares of Common Stock, par value $0.01 per share,and 10,000,000 authorized shares of Preferred Stock, par value $0.01 pershare.  The holder of each share of Common Stock has the right to onevote.  The board of directors has the authorityto issue the undesignated Preferred Stock in one or more series and to fix therights, preferences, privileges and restrictions thereof.    At June30, 2006 and September 30, 2005, there were no shares of Preferred Stockoutstanding.

On April 7, 2006, in connection with the amendment and restatementof its certificate of incorporation, the Company also effected a 3.059-to-1stock split of its outstanding shares of common stock as of such date. Allshare and per share amounts in the accompanying condensed financial statementsand accompanying notes have been retroactively restated to reflect the stocksplit.

On May 3, 2006 the Company completed its IPO.  The Company sold 2,941,200 shares of commonstock and the selling stockholders sold 4,117,670 shares, at an initial publicoffering price to the public of $18.00 per share, resulting in total proceedsto the Company of approximately $47.3 million, net of IPO transaction costs ofapproximately $5.6 million, which the Company used to repay $47.5 million ofthe Term Loan under the Senior Credit Facility. The underwriters for the IPO declined to exercise their option topurchase an additional 1,058,831 shares of the Company’s common stock.

**Stock Plans: **The Company has four stock plans: the 2006 Equity andPerformance Incentive Plan (the “2006 Plan”) and the 2006 Employee StockPurchase Plan (the “ESPP”), the 2004 Stock Incentive Plan (the “2004 Plan”) andthe 2000 Stock Option Plan (the “2000 Plan”).

The 2006 Plan provides for anaggregate of up to 1,400,000 shares of our common stock to be available forawards, plus the number of shares subject to awards granted under our 2004Stock Incentive Plan and our 2000 Stock Option Plan that are forfeited, expireor are cancelled after the effective date of the 2006 Plan. All of the Company’semployees (including officers), directors, and consultants are eligible forawards under the 2006 Plan. The 2006 Plan is administered by the compensationcommittee of the board of directors and awards may consist of options, stockappreciation rights, restricted stock, other stock unit awards, performanceawards, dividend equivalents or any combination of the foregoing. The exerciseprice for stock options generally cannot be less than 100% of the fair marketvalue of our shares on the date of grant. In April 2006, the compensationcommittee delegated authority to the Chief Executive Officer to grant optionsto purchase up to an aggregate 25,000 shares of common stock to employees,other than employees who are executive officers.  On April 27, 2006 we issued options to purchase297,500 shares of our common stock, at an exercise price of $18.00 per share.

The ESPP permits eligible employeesto purchase our stock at a discounted price. An aggregate of 760,000 shares ofour common stock is reserved for issuance under this plan. The stock purchaseplan is administered by 

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the compensation committee of the board of directors.Employees participating in the plan may purchase stock for their accountsaccording to a price formula set by the compensation committee, as administrator,before the applicable offering period, which cannot exceed 24 months. The priceper share will equal a fixed percentage (which may not be lower than 85%) ofthe fair market value of a share of our common stock on the last day of thepurchase period in the offering, or the lower of (1) a fixed percentage (not tobe less than 85%) of the fair market value of a share of our common stock onthe date of commencement of participation in the offering and (2) a fixedpercentage (not to be less than 85%) of the fair market value of a share of ourcommon stock on the date of purchase. The initial ESPP offering period for the quarter ending September 29,2006, began on July 1, 2006; the participants’ purchase price for CPIInternational, Inc. common stock will be 85% of the closing market price on thelast trading day of the quarter.

Options under the 2004 Plan vest at a rate of 20% to 25% peryear and expire 10 years after the grant date. All stock option grants underthe 2004 Plan were non-qualified stock options and were issued at exerciseprices equal to or greater than the estimated market price of the Company’scommon stock at option grant date. The Company has ceased making new grantsunder the 2004 Plan.

The 2000 Plan was established by the Predecessor, and nofurther options are available for issuance thereunder. In accordance with theterms of the stock option agreements, the unvested stock options outstandingunder the Predecessor’s 2000 Plan became fully vested at the Merger closingdate. The 2000 Plan option holders were offered the opportunity to either rollover their stock options into options to purchase common stock of CPIInternational (“Rollover Options”) or exercise their stock options. Managementelected to roll over options to purchase 912,613 shares of common stock atprices ranging from $0.20 to $0.74 per share. The Rollover Options areotherwise subject to the terms of the 2000 Plan, and, among other things, havea ten year expiration period and are subject to transferability restrictionsand continued employment.

**Stock Options: **A summary of the status of the Company’s stock optionactivity for the nine months ending June 30, 2006, is presented below:

|                                     | ** ** | **Number of  Shares (in  thousands)** | ** ** | **Weighted  Average  Exercise Price  Per Share** | ** ** | **Weighted  Average  Remaining  Contractual  Life (in years)** | ** ** | **Aggregate  Intrinsic  Value** | ** ** |
|-------------------------------------|------------|-------------------------------------------------|------------|------------------------------------------------------------|------------|--------------------------------------------------------------------------|------------|---------------------------------|------------|
| Outstanding at  beginning of period |       | 2,895.4                                         |       | $                                                          | 3.13       |                                                                     |       |                            |       |   |
| Granted                             |       | 297.5                                           |       | 18.00                                                      |       |                                                                     |       |                            |       |
| Forfeited                           |       | (8.3                                            | )          | 10.07                                                      |       |                                                                     |       |                            |       |
| Cancelled                           |       | (0.1                                            | )          | 4.32                                                       |       |                                                                     |       |                            |       |
| Outstanding at  end of period       |       | 3,184.5                                         |       | 4.50                                                       |       | 7.5                                                                      |       | $                               | 32,864     |   |
|                                |       |                                            |       |                                                       |       |                                                                     |       |                            |       |
| Exercisable at end of  period       |       | 2,365.2                                         |       | $                                                          | 2.85       |                                                                     | 7.1        |                            | $          | 27,547 |   |

 

The weighted average grant-date fair value per share was$12.67 for options granted during the third quarter and first nine months of2006.

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Changes in the company’s unvested options for the first ninemonths of 2006 are summarized as follows:

|                                 | ** ** | **Number of  Shares  (in thousands)** | ** ** | **Weighted-Average  Grant Date  Fair Value  Per Share** | ** ** |
|---------------------------------|------------|-------------------------------------------------|------------|------------------------------------------------------------------------|------------|
| Unvested at  September 30, 2005 |       | 639.0                                           |       | $                                                                      | 5.26       |   |
| Granted                         |       | 297.5                                           |       | 12.67                                                                  |       |
| Vested                          |       | (108.8                                          | )          | 5.26                                                                   |       |
| Cancelled                       |       | (8.4                                            | )          | 8.54                                                                   |       |
| Unvested at June 30,  2006      |       | 819.3                                           |       | 7.92                                                                   |       |
|                                 |            |                                                 |            |                                                                        |            |  |

 

As of June 30, 2006, there was $3.2 million of totalunrecognized compensation cost, related to unvested stock options, which isexpected to be recognized over a weighted-average period of 4.8 years.

The fair value of each option award is estimated on the dateof grant using the Black-Scholes model. Since the company’s common stock has not been publicly traded for a sufficienttime period, the expected volatility is based on expected volatilities ofsimilar companies that have a longer history of being publicly traded.  The expected life of options granted is basedon the simplified method for plain vanilla options in accordance with SEC StaffAccounting Bulletin 107.  The risk-freerates are based on the U.S. Treasury yield in effect at the time of thegrant.  Assumptions used in theBlack-Scholes model for the nine months ending June 30, 2006 are presentedbelow:

| Average expected life in  years           |   | 6.47  |   |
|-------------------------------------------|--------|-------|--------|
| Expected  volatility                      |   | 72.00 | %      |
| Weighted average  risk-free interest rate |   | 4.71  | %      |

 

The Black-Scholes option valuation model was developed foruse in estimating the fair value of traded options that have no vestingrestrictions and are fully transferable and requires the input of subjectiveassumptions, including the expected stock price volatility and estimated optionlife.  For purposes of this valuationmodel, no dividends have been assumed.

**Restricted Stock Awards: **As of June 30, 2006, there were 9,999 shares of restrictedstock outstanding.  The restricted stockawards vest over periods of one to three years and have a 10 year contractuallife.  There were no restricted stockawards in prior years.

Restricted stock activity for the first nine months of 2006is summarized as follows:

| Outstanding at beginning of  period          |   | —    |   |
|----------------------------------------------|--------|-----------|--------|
| Granted                                      |   | 10.0      |   |
| Exercised                                    |   | —    |   |
| Cancelled or  expired                        |   | —    |   |
| Outstanding at  end of period                |   | 10.0      |   |
|                                         |   |      |   |
| Aggregate  intrinsic value at end of period  |   | $         | 145    |   |
|                                         |   |      |   |
| Weighted average  remaining contractual life |   | 9.8 years |   |
|                                              |        |           |        |  |

 

The grant-date fair value per share was $18.00 for restrictedstock awards granted during the first nine months of 2006.

As of June 30, 2006, there was $161,000 of total unrecognizedcompensation cost, related to unvested restricted stock awards, which isexpected to be recognized over a weighted average vesting period of 1.9 years.

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**Stock-Based Compensation Expense: **At the beginning of fiscal year2006, the Company adopted SFAS No. 123R (“Share-Based Payments”) (“SFAS No.123R”), and Staff Accounting Bulletin No. 107, “Share-Based Payment,” forits existing stock option plans under the prospective method. Previously, theCompany applied the intrinsic value-based method of accounting prescribed byAccounting Principles Board (“APB”) Opinion No. 25, “Accounting for StockIssued to Employees,” and related interpretations. Under the intrinsicvalue-based method, compensation expense was recorded only if the market priceof the stock exceeded the stock option exercise price at the measurement date.The Company will continue to account for stock option awards outstanding atSeptember 30, 2005 using the intrinsic value-based method of measuring equityshare options.  The application of SFASNo. 123R had no impact on the Company’s cash position.

Total stock-based compensation costs for the Company’s stockplans in the third quarter and the first nine months of 2006 and 2005 comprisethe following:
| ** **                                          | ** ** | **Quarter Ended**  | ** ** | **Nine Months Ended** | ** ** |
|-----------------------------------------------------|------------|-------------------------|------------|---------------------------------|------------|
| ** **                                          | ** ** | **June 30,  2006** | ** ** | **July 1,  2005**          | ** ** | **June 30,  2006** | ** ** | **July 1,  2005** | ** ** |
|                                                |       |                    |       |                            |       |   |   |   |   |
| Stock-based  compensation expense by caption:       |       |                    |       |                            |       |   |   |   |   |
| Research and  development                           |       | $                       | 7          |                            | $          | — |   | $ | 7 |   | $ | — |   |
| Selling and  marketing                              |       | 12                      |       | —                          |       | 12 |   | — |   |
| General and  administrative                         |       | 89                      |       | 444                             |       | 90 |   | 876 |   |
|                                                |       | $                       | 108        |                            | $          | 444 |   | $ | 109 |   | $ | 876 |   |
|                                                |       |                    |       |                            |       |   |   |   |   |
| Stock-based  compensation expense by type of award: |       |                    |       |                            |       |   |   |   |   |
| Stock options                                       |       | $                       | 89         |                            | $          | 444 |   | $ | 90 |   | $ | 876 |   |
| Restricted stock                                    |       | 19                      |       | —                          |       | 19 |   | — |   |
|                                                |       | $                       | 108        |                            | $          | 444 |   | $ | 109 |   | $ | 876 |   |

 

Stock-based compensation expense of approximately $27,000 wascapitalized and remained in inventory at June 30, 2006.

**5. Derivative Financial Instruments**

The Company uses forward exchange contracts to hedge theforeign currency exposure associated with forecasted manufacturing costs inCanada.

The Company’s foreign currency forward contracts aredesignated as a cash flow hedge and are considered “highly effective,” asdefined by Statement of Financial Accounting Standards (“SFAS”) No. 133, “Accountingfor Derivative Instruments and Hedging Activities.” The unrealized gains andlosses from foreign exchange forward contracts are included in “Accumulatedother comprehensive income” in the Condensed Consolidated Balance Sheets.Realized gains and losses from foreign currency exchange contracts arerecognized in Cost of sales and General and administrative in the CondensedConsolidated Statements of Operations and Comprehensive Income. Net incomeincludes forward currency gains of $0.3 million for each of the quarters endedJune 30, 2006 and July 1, 2005, and $1.3 million and $1.0 million for the ninemonth periods ended June 30, 2006 and July 1, 2005, respectively.

In April 2005, the Company entered into an $80.0 millioninterest rate swap contract (“the Swap”) to receive variable rate 6-month LIBORinterest and pay 4.15% fixed rate interest, which when combined with the 5.75%margin, results in a fixed rate of 9.9% on the FR Notes through January 31,2008. The Swap interest payments are made semi-annually, beginning with thefirst payment on February 1, 2006. The Swap matures on January 31, 2008. TheSwap is designated as a cash flow hedge under SFAS No. 133, and the gain orloss from changes in fair value is expected to be highly effective atoffsetting the gain or loss from changes in fair value of the FR Notesattributable to changes in interest rates over the contract period. As of June30, 2006, the 

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Company had a collateral deposit of $0.5 million forthe Swap, which is included as Other long-term assets in the accompanyingCondensed Consolidated Balance Sheets. The amount of collateral fluctuatesbased on the fair value of the Swap. The unrealized gains and losses from theSwap are included in “Accumulated other comprehensive income” in the CondensedConsolidated Balance Sheets. At June 30, 2006, the fair value of the Swap was$1.7 million, and the unrealized gain was approximately $1.0 million, net ofrelated tax expense.

**6. Income Taxes**

Income tax expense for the first quarter of fiscal year 2006includes a $315,000 charge attributable to the fourth quarter of fiscal year2005, consisting of $505,000 to correct the overstatement of tax benefitsrecorded in the fourth quarter of fiscal year 2005 for stock-based compensationexpense that is not deductible for income tax purposes in a foreign taxjurisdiction, offset by reversal of a $190,000 tax contingency reserve. Incometax expense for the third quarter of fiscal year 2006 includes a discrete taxbenefit of $173,000 for true-up adjustments to fiscal year 2005 tax expenserelated to changes in estimates made as a result of filing the 2005 income taxreturns. The effective tax rates were approximately 41% and 40% for the firstnine months of fiscal years 2006 and 2005, respectively.

**7. Net IncomePer Share**

Basic net income per share is computed based on theweighted-average number of common shares outstanding during the period. Dilutednet income per share is computed based on the weighted-average number of commonshares outstanding plus the dilutive effects of stock options and restrictedstock. Potential common shares that would increase net income per share amountsor decrease loss per share amounts are antidilutive and are, therefore,excluded from net income per share calculations.  Antidilutive potential common shares thatcould dilute basic net income per share in the future were 307,499 for thethird quarter and the first nine months of fiscal year 2006, and 85,071 sharesfor the third quarter and the first nine months of fiscal year 2005.
| ** **                                   | ** ** | **Quarter Ended** | ** ** | **Nine Months Ended** | ** ** |
|----------------------------------------------|------------|------------------------|------------|---------------------------------|------------|
| ** **                                   | ** ** | **June 30,**      | ** ** | **July 1,**                | ** ** | **June 30,** | ** ** | **July 1,** | ** ** |
| ** **                                   | ** ** | **2006**               | ** ** | **2005**                        | ** ** | **2006** | ** ** | **2005** | ** ** |
| Basic weighted  average shares oustanding    |       | 15,039,754             |       | 13,078,954                      |       | 13,736,031 |   | 13,078,954 |   |
| Dilutive stock  options                      |       | 1,727,068              |       | 899,261                         |       | 1,707,396 |   | 773,009 |   |
| Diluted weighted  average shares outstanding |       | 16,766,822             |       | 13,978,215                      |       | 15,443,427 |   | 13,851,963 |   |

 

**8. Segmentsand Related Information**

In accordance with SFAS No. 131, the Company has sixdivisions that meet the criteria of an operating segment, and the Company hastwo reportable segments: VED and satcom equipment. Amounts not reported as VEDor satcom equipment are reported as other. The CEO evaluates performance andallocates resources to each of these divisions based on the Company’s principalperformance measure, earnings before interest, income taxes, depreciation andamortization (“EBITDA”).

 

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** **

Summarized financial information concerning the Company’sreportable segments is shown in the following table:
| ** **                        | ** ** | **Quarter Ended** | ** ** | **Nine Months Ended** | ** ** |
|-----------------------------------|------------|------------------------|------------|---------------------------------|------------|
| ** **                        | ** ** | **June 30,**      | ** ** | **July 1,**                | ** ** | **June 30,** | ** ** | **July 1,** | ** ** |
| ** **                        | ** ** | **2006**               | ** ** | **2005**                        | ** ** | **2006** | ** ** | **2005** | ** ** |
| Revenues from external  customers |       |                   |       |                            |       |   |   |   |   |
| VEDs                              |       | $                      | 73,050     |                            | $          | 70,363 |   | $ | 205,843 |   | $ | 200,977 |   |
| Satcom equipment                  |       | 14,711                 |       | 17,276                          |       | 51,226 |   | 44,858 |   |
| Total                             |       | $                      | 87,761     |                            | $          | 87,639 |   | $ | 257,069 |   | $ | 245,835 |   |
| Intersegment product  transfers   |       |                   |       |                            |       |   |   |   |   |
| VEDs                              |       | $                      | 5,924      |                            | $          | 6,935 |   | $ | 18,608 |   | $ | 19,719 |   |
| Satcom equipment                  |       | —                 |       | 3                               |       | 1 |   | 82 |   |
| Total                             |       | $                      | 5,924      |                            | $          | 6,938 |   | $ | 18,609 |   | $ | 19,801 |   |

 
| ** **       | ** ** | **Quarter Ended** | ** ** | **Nine Months Ended** | ** ** |
|------------------|------------|------------------------|------------|---------------------------------|------------|
| ** **       | ** ** | **June 30,**      | ** ** | **July 1,**                | ** ** | **June 30,** | ** ** | **July 1,** | ** ** |
| ** **       | ** ** | **2006**               | ** ** | **2005**                        | ** ** | **2006** | ** ** | **2005** | ** ** |
| EBITDA           |       |                   |       |                            |       |   |   |   |   |
| VEDs             |       | $                      | 19,001     |                            | $          | 20,499 |   | $ | 52,462 |   | $ | 56,386 |   |
| Satcom equipment |       | (79                    | )          | 2,415                           |       | 4,773 |   | 6,204 |   |
| Other            |       | (3,657                 | )          | (3,705                          | )          | (13,402 | ) | (9,457 | ) |
| Total            |       | $                      | 15,265     |                            | $          | 19,209 |   | $ | 43,833 |   | $ | 53,133 |   |

 

The “Other” category for EBITDA consists primarily ofcorporate operating expenses and international subsidiary sales expenses. Corporateoperating expenses include headquarters general and administrative expenses,stock-based compensation expenses, management bonuses, and purchase accountingcharges related to the Merger and Econco acquisition and certain othernon-operating expenses. Intersegment product transfers are recorded at cost.The “Other” category of EBITDA for the nine months ended June 30, 2006 includesa $3.25 million special bonus to employees and directors, and manufacturingdisruption and move related expenses of $3.8 million associated with therelocation of the San Carlos, California manufacturing division to Palo Alto,California. On December 15, 2005, CPI’s Board of Directors approved a paymentof $3.25 million in special bonuses to CPI employees and directors (other thandirectors who are employees or affiliates of Cypress), to reward them for theincrease in Company value.

For the reasons listed below, we believe that GAAP-basedfinancial information for highly leveraged businesses such as ours should besupplemented by EBITDA so that investors better understand our financialperformance in connection with their analysis of our business:

•                      EBITDA is a component of the measures used by our board ofdirectors and management team to evaluate our operating performance;

•                      the Senior Credit Facility contains covenants that require usto maintain certain interest expense coverage and leverage ratios that containEBITDA as a component, and our management team uses EBITDA to monitorcompliance with such covenants;

•                      EBITDA is a component of the measures used by our managementteam to make day-to-day operating decisions;

•                      EBITDA facilitates comparisons between our operating resultsand those of competitors with different capital structures and therefore is acomponent of the measures used by the management to facilitate internalcomparisons to competitors’ results and our industry in general; and

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•                      the payment of management bonuses is contingent upon, amongother things, the satisfaction by us of certain targets that contain EBITDA asa component.

Other companies may define EBITDA differently and, as aresult, our measure of EBITDA may not be directly comparable to EBITDA of othercompanies. Although we use EBITDA as a financial measure to assess theperformance of our business, the use of EBITDA is limited because it does notinclude certain material costs, such as interest and taxes, necessary tooperate our business. When analyzing our performance, EBITDA should beconsidered in addition to, and not as a substitute for, net income (loss), cashflows from operating activities or other statements of operations or statementsof cash flows data prepared in accordance with GAAP. The following tablereconciles net income to EBITDA:

|                                | ** ** | **Quarter ended** | ** ** | **Nine Months Ended** | ** ** |
|--------------------------------|------------|------------------------|------------|---------------------------------|------------|
| ** **                     | ** ** | **June 30,**      | ** ** | **July 1,**                | ** ** | **June 30,** | ** ** | **July 1,** | ** ** |
| ** **                     | ** ** | **2006**               | ** ** | **2005**                        | ** ** | **2006** | ** ** | **2005** | ** ** |
| Net income                     |       | $                      | 4,468      |                            | $          | 6,698 |   | $ | 11,028 |   | $ | 16,116 |   |
| Depreciation and  amortization |       | 2,335                  |       | 2,398                           |       | 6,786 |   | 11,767 |   |
| Interest  expense, net         |       | 5,945                  |       | 5,697                           |       | 18,409 |   | 14,509 |   |
| Income tax  expense            |       | 2,517                  |       | 4,416                           |       | 7,610 |   | 10,741 |   |
| EBITDA                         |       | $                      | 15,265     |                            | $          | 19,209 |   | $ | 43,833 |   | $ | 53,133 |   |

 

Geographic sales by customer location were as follows:

|                        | ** ** | **Quarter Ended** | ** ** | **Nine Months Ended** | ** ** |
|------------------------|------------|------------------------|------------|---------------------------------|------------|
| ** **             | ** ** | **June 30,**      | ** ** | **July 1,**                | ** ** | **June 30,** | ** ** | **July 1,** | ** ** |
| ** **             | ** ** | **2006**               | ** ** | **2005**                        | ** ** | **2006** | ** ** | **2005** | ** ** |
| United States          |       | $                      | 54,502     |                            | $          | 55,913 |   | $ | 162,709 |   | $ | 162,391 |   |
| All foreign  countries |       | 33,259                 |       | 31,726                          |       | 94,360 |   | 83,444 |   |
| Total sales            |       | $                      | 87,761     |                            | $          | 87,639 |   | $ | 257,069 |   | $ | 245,835 |   |

 

The United States Government is the only customer that accountedfor 10% or more of the Company’s consolidated sales. Direct sales to the UnitedStates Government were $16.5 million, and $15.5 million of the Company’sconsolidated sales for the quarters ended June 30, 2006 and July 1, 2005,respectively. Sales to this customer were $44.3 million and $45.1 million forthe nine month periods ending June 30, 2006 and July 1, 2005, respectively.

**9. San Carlos Sale Agreement**

The Company has entered into an agreement to sell the landand close its facilities located in San Carlos, California. The purchase priceis $23.8 million. Under the sale agreement, the buyer has paid the Company a$13.0 million deposit on the purchase price, which the Company used to fund thecapital expenditures and costs of moving its San Carlos operations to its PaloAlto facility and to a new location in the Palo Alto area. The $13.0 milliondeposit is nonrefundable unless the Company breaches the sale agreement. TheSan Carlos facility has preexisting soil and groundwater contamination that hasbeen the subject of some remediation and is expected to undergo additionalremediation by the purchaser after the sale closes. In connection with the saleagreement, the Company entered into an agreement regarding environmentalconditions at the property and was named as an additional insured on apollution liability insurance policy obtained by the purchaser that is intendedto fund the remediation of the contamination of the San Carlos property topermit hospital and other “unrestricted” uses under the direction of theapplicable environmental regulatory agency.

The closing of the sale is subject to a number of conditions,including the requirement that the Company vacate its facilities and obtainregulatory closure of certain permitted equipment located on the property.Although there can be no assurance that the sale of the San Carlos propertywill occur, the Company expects to close the sale of the property in calendaryear 2006.

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Pursuant to the stock sale agreement by and between VarianAssociates, Inc., the predecessor of Varian Medical Systems, Inc. (“Varian”),and the Company dated June 9, 1995, as amended, the Company agreed to certaindevelopment restrictions affecting the San Carlos property. In connection withthe San Carlos property sale agreement, Varian agreed to waive certain of thedevelopment restrictions on the San Carlos property in the event that the salecloses, subject to certain conditions, and further agreed to pay the Company$1.0 million, of which $0.5 million was paid in the fourth quarter of fiscalyear 2004. The payments from Varian are being accounted for as part of the saleof the property, with the aggregate sales price, including the $23.8 millionfrom the buyer, totaling $24.8 million. In addition, the Company has agreed torelieve Varian of certain of its indemnity obligations to the Company forcertain environmental liabilities related to the San Carlos property relatingto periods prior to August 1995 and to reimburse Varian for certain potentialenvironmental costs related to the San Carlos property that are not covered byinsurance. The Company and Varian have also agreed to certain use restrictionsand environmental cost-sharing provisions related to the Company’s property inBeverly, Massachusetts, and the Company has relinquished its right to redevelopthat property for residential or similar use.

As of June 30, 2006, the San Carlos land and building wasclassified as held for use in property, plant and equipment and the advancepayments from the sale of the property, aggregating $13.5 million, areclassified as a long-term liability in the accompanying Condensed ConsolidatedBalance Sheets. As of June 30, 2006, the Company had deferred expenses of $0.9million relating to the sale of the San Carlos property and classified theseamounts as Other long-term assets in the accompanying Condensed ConsolidatedBalance Sheets. The San Carlos land and building had a net book value of $23.4million as of June 30, 2006 and the building continues to be depreciated overits remaining useful life. Based on current projections of costs, the Companydoes not expect to recognize a loss on the sale of the San Carlos property.

**10. Econco Acquisition**

On October 8, 2004, the Company purchased all of theoutstanding stock of Econco Broadcast Service, Inc. (“Econco”) of Woodland,California for cash consideration of approximately $18.3 million. Thepreliminary Econco purchase price estimate of $18.7 million was finalized andadjusted in our financial results in the third quarter of fiscal year2005.  Econco is a provider ofremanufactured high-power microwave devices, allowing broadcasters and otherusers of these critical products to extend the life of their devices at a costthat is lower than buying a new device.

The Econco acquisition was accounted for using the purchasemethod of accounting as required by Financial Accounting Standards Board (“FASB”)Statement No. 141, “Business Combinations.” Accordingly, the assets andliabilities of Econco were adjusted to their fair values, and the excess of thepurchase price over the fair value of the assets acquired was recorded asgoodwill. The allocation of the purchase price to specific assets andliabilities was based, in part, upon internal estimates of cash flow andrecoverability.

The following table summarizes the final allocation of fairvalue of the Econco assets acquired and liabilities assumed at October 8, 2004:

| Net current assets              |   | $     | 2,049  |   |
|---------------------------------|--------|-------|--------|--------|
| Property, plant  and equipment  |   | 3,239 |   |
| Identifiable  intangible assets |   | 7,210 |   |
| Goodwill                        |   | 5,848 |   |
| Total                           |   | $     | 18,346 |   |

 

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Net current assets at October 8, 2004 included $0.4 millionfor the revaluation of inventory. The following table presents details of thepurchased intangible assets acquired:

|                             | ** ** | **Weighted-  Average  Useful Life** | ** ** | **Amount** | ** ** |
|-----------------------------|------------|------------------------------------------|------------|------------|------------|
| Non-compete  agreement      |       | 5  years                                 |       | $          | 110        |   |
| Tradename                   |       | indefinite                               |       | 1,400      |       |
| Customer list  and programs |       | 25  years                                |       | 5,700      |       |
| Total                       |       |                                     |       | $          | 7,210      |   |

 

**11. Special Cash Dividends**

In December 2005, the Board of Directors declared and paid aspecial cash dividend to stockholders of $17 million. This dividend was paidusing (a) the $10 million in net proceeds obtained from the additionalborrowing under the Senior Credit Facility in connection with the December 2005amendment thereto, and (b) available cash. The cash dividend was made on thebasis of the stockholders’ relative ownership of CPI International’soutstanding common stock.

In February 2005, the Board of Directors declared and paid aspecial cash dividend to stockholders of approximately $75.8 million.  The special cash dividend was made on thebasis of the stockholders’ relative ownership of CPI International’soutstanding common stock and was paid using the net proceeds from the offeringof $80 million aggregate principal amount of the FR Notes.

**12. Recent Accounting Pronouncements**

In November 2004, the FASB issued SFAS No. 151, “InventoryCosts — an amendment of ARB No. 43, Chapter 4,” which is the result of the FASB’sproject to reduce differences between U.S. and international accountingstandards. SFAS No. 151 requires idle facility costs, abnormal freight,handling costs, and amounts of wasted materials (spoilage) to be treated ascurrent-period costs. Under this concept, if the costs associated with theactual level of spoilage or production defects are greater than the costsassociated with the range of normal spoilage or defects, then the differencewould be charged to current-period expense, and not included in inventorycosts. The Company adopted SFAS No. 151 in the beginning of fiscal year 2006and its adoption did not have a significant impact on the Company’s results ofoperations or financial condition.

In March 2005, the FASB issued Interpretation No. 47, “Accountingfor Conditional Asset Retirement Obligations,” which clarifies that an entityis required to recognize a liability for the fair value of a conditional assetretirement obligation if the fair value can be reasonably estimated even thoughuncertainty exists about the timing and/or method of settlement. The Company isrequired to adopt Interpretation No. 47 by the end of fiscal year 2006. TheCompany does not expect the implementation of Interpretation No. 47 to have asignificant impact on its results of operations or financial condition.

In May 2005, the FASB issued SFAS No. 154, “AccountingChanges and Error Corrections.” SFAS No. 154 replaces APB Opinion No. 20, “AccountingChanges,” and SFAS No. 3, “Reporting Accounting Changes in Interim FinancialStatement,” and changes the requirements for the accounting for and reportingof a change in accounting principle. The Company is required to adopt SFAS No.154 for accounting changes and error corrections in fiscal year 2007. TheCompany’s results of operations and financial condition will only be impactedby SFAS No. 154 if it implements changes in accounting principle that areaddressed by the standard or correct accounting errors in future periods.

In February 2006, the FASBissued SFAS No. 155, “Accounting for Certain Hybrid Financial Instruments.” SFASNo. 155 permits fair value remeasurement for any hybrid financial instrumentthat contains an embedded derivative that otherwise would require bifurcation.As of June 30, 2006, the Company did not 

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have any hybrid financialinstruments subject to the fair value election under SFAS No. 155. The Companyis required to adopt SFAS No. 155 at the beginning of fiscal year 2007.

In March 2006, the FASB issued SFAS No. 156, “Accounting forServicing of Financial Assets—an amendment to FASB Statement No. 140.” SFAS No.156 amends FASB Statement No. 140 “Accounting for Transfers and Servicing ofFinancial Assets,” with respect to the accounting for separately recognizedservicing assets and servicing liabilities. The Company is required to adoptSFAS No. 156 at the beginning of fiscal year 2007 and as of June 30, 2006, theCompany did not have any servicing assets or servicing liabilities.

In June 2006, the FASB issued Interpretation No. 48, “Accounting forUncertainty in Income Taxes”, which supplements SFAS No. 109, “Accounting forIncome Taxes,” by defining the confidence level that a tax position must meetin order to be recognized in the financial statements. The Interpretationrequires that the tax effects of a position be recognized only if it is “more-likely-than-not”to be sustained based solely on its technical merits as of the reporting date.The more-likely-than-not threshold represents a positive assertion bymanagement that a company is entitled to the economic benefits of a taxposition. If a tax position is not considered more-likely-than-not to besustained based solely on its technical merits, no benefits of the position areto be recognized.

Moreover, the more-likely-than-not threshold must continue to be met ineach reporting period to support continued recognition of a benefit. Atadoption, companies must adjust their financial statements to reflect onlythose tax positions that are more-likely-than-not to be sustained as of theadoption date. Any necessary adjustment would be recorded directly to retainedearnings in the period of adoption and reported as a change in accountingprinciple. This Interpretation is effective as of the beginning of the firstfiscal year beginning after December 15, 2006. We are required to adoptInterpretation No. 48 at the beginning of fiscal year 2008 and management isassessing the potential impact on our financial condition and results ofoperations.

**13. Supplemental Guarantors Condensed Consolidating FinancialInformation (Unaudited)**

On January 23, 2004, CPI issued $125.0 million of 8% Notesthat are guaranteed by CPI International and all of CPI’s domesticsubsidiaries. Separate financial statements of the guarantors are not presentedbecause (i) the guarantors are wholly-owned and have fully and unconditionallyguaranteed the 8% Notes on a joint and several basis, and (ii) the Company’smanagement has determined that such separate financial statements are notmaterial to investors. Instead, presented below are the consolidating condensedfinancial statements of: (a) the parent, CPI International, (b) the issuer,CPI, (c) the guarantor subsidiaries, the Company’s domestic subsidiaries (d)the non-guarantor subsidiaries, (e) the consolidating elimination entries, and(f) the consolidated total. The accompanying condensed consolidating financialstatements should be read in connection with the condensed consolidatedfinancial statements of the Company.

Investments in subsidiaries are accounted for on the equitymethod. The principal elimination entries eliminate investments insubsidiaries, intercompany balances, intercompany transactions and intercompanysales.

 

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** **

**CONDENSED CONSOLIDATING BALANCESHEETAs of June 30, 2006**
| ** **                                           | ** ** | ** ** | ** ** | ** ** | ** ** | **Guarantor**    | ** ** | **Non-Guarantor** | ** ** | **Consolidating** | ** ** | **Consolidated** | ** ** |
|------------------------------------------------------|------------|------------|------------|------------|------------|------------------|------------|-------------------|------------|-------------------|------------|------------------|------------|
| ** **                                           | ** ** | **Parent** | ** ** | **Issuer** | ** ** | **Subsidiaries** | ** ** | **Subsidiaries**  | ** ** | **Eliminations**  | ** ** | **Total**        | ** ** |
|                                                 |       |       |       |       |       |             |       |              |       |              |       |             |       |
| **Assets**                                           |       |       |       |       |       |             |       |              |       |              |       |             |       |
| Cash and cash  equivalents                           |       | $          | 391        |       | 9,186      |             | 668        |              | 2,361      |              | —     |             | 12,606     |   |
| Restricted cash                                      |       | —     |       | —     |       | 746              |       | 108               |       | —            |       | 854              |       |
| Accounts receivable,  net                            |       | —     |       | 26,133     |       | 9,594            |       | 12,446            |       | —            |       | 48,173           |       |
| Inventories                                          |       | —     |       | 34,278     |       | 2,030            |       | 19,009            |       | (1,104            | )          | 54,213           |       |
| Deferred tax assets                                  |       | —     |       | 11,635     |       | 7                |       | 41                |       | —            |       | 11,683           |       |
| Prepaid and other  current assets                    |       | 1,112      |       | 2,836      |       | 248              |       | 941               |       | —            |       | 5,137            |       |
| Intercompany receivable                              |       | —     |       | 30,477     |       | —           |       | —            |       | (30,477           | )          | —           |       |
| Total  current assets                                |       | 1,503      |       | 114,545    |       | 13,293           |       | 34,906            |       | (31,581           | )          | 132,666          |       |
| Property, plant and  equipment, net                  |       | —     |       | 74,120     |       | 3,041            |       | 9,490             |       | —            |       | 86,651           |       |
| Deferred debt issue  costs, net                      |       | 3,176      |       | 6,819      |       | —           |       | —            |       | —            |       | 9,995            |       |
| Intangible assets, net                               |       | —     |       | 60,301     |       | 6,777            |       | 9,024             |       | —            |       | 76,102           |       |
| Goodwill                                             |       | —     |       | 92,041     |       | 5,848            |       | 47,573            |       | —            |       | 145,462          |       |
| Other long-term assets                               |       | 1,125      |       | 1,283      |       | —           |       | —            |       | —            |       | 2,408            |       |
| Intercompany notes receivable                        |       | —     |       | 1,035      |       | —           |       | —            |       | (1,035            | )          | —           |       |
| Investment in  subsidiaries                          |       | 200,169    |       | 56,670     |       | —           |       | —            |       | (256,839          | )          | —           |       |
| Total  assets                                        |       | $          | 205,973    |       | 406,814    |             | 28,959     |              | 100,993    |              | (289,455   | )                | 453,284    |   |
|                                                 |       |       |       |       |       |             |       |              |       |              |       |             |       |
| **Liabilities and Stockholders’  Equity**       |       |       |       |       |       |             |       |              |       |              |       |             |       |
| Accounts payable                                     |       | $          | —     |       | 10,656     |             | 579        |              | 10,232     |              | —     |             | 21,467     |   |
| Accrued expenses                                     |       | 3,366      |       | 18,852     |       | 1,087            |       | 3,524             |       | —            |       | 26,829           |       |
| Product warranty                                     |       | —     |       | 3,853      |       | 192              |       | 2,250             |       | —            |       | 6,295            |       |
| Income taxes payable                                 |       | —     |       | 3,819      |       | 230              |       | 1,700             |       | —            |       | 5,749            |       |
| Advance payments from  customers                     |       | —     |       | 2,288      |       | 703              |       | 2,227             |       | —            |       | 5,218            |       |
| Intercompany payable                                 |       | 28,175     |       | —     |       | 457              |       | 1,845             |       | (30,477           | )          | —           |       |
| Total  current liabilities                           |       | 31,541     |       | 39,468     |       | 3,248            |       | 21,778            |       | (30,477           | )          | 65,558           |       |
| Deferred income taxes                                |       | 695        |       | 26,495     |       | —           |       | 6,834             |       | —            |       | 34,024           |       |
| Intercompany notes  payable                          |       | —     |       | —     |       | —           |       | 1,035             |       | (1,035            | )          | —           |       |
| Advance payments from  sale of San Carlos property   |       | —     |       | 13,450     |       | —           |       | —            |       | —            |       | 13,450           |       |
| Long-term debt                                       |       | 79,268     |       | 167,500    |       | —           |       | —            |       | —            |       | 246,768          |       |
| Other long-term  liabilities                         |       | —     |       | 31         |       | —           |       | —            |       | —            |       | 31               |       |
| Total  liabilities                                   |       | 111,504    |       | 246,944    |       | 3,248            |       | 29,647            |       | (31,512           | )          | 359,831          |       |
| Common stock                                         |       | 160        |       | —     |       | —           |       | —            |       | —            |       | 160              |       |
| Parent investment                                    |       | —     |       | 124,306    |       | 22,228           |       | 57,237            |       | (203,771          | )          | —           |       |
| Additional paid-in  capital                          |       | 65,009     |       | —     |       | —           |       | —            |       | —            |       | 65,009           |       |
| Accumulated other  comprehensive  income (loss) |       | 936        |       | (106       | )          | —           |       | (8                | )          | 114               |       | 936              |       |
| Retained earnings                                    |       | 28,364     |       | 35,670     |       | 3,483            |       | 14,117            |       | (54,286           | )          | 27,348           |       |
| Total  stockholders’ equity                     |       | 94,469     |       | 159,870    |       | 25,711           |       | 71,346            |       | (257,943          | )          | 93,453           |       |
| Total liabilities and  stockholders’ equity     |       | $          | 205,973    |       | 406,814    |             | 28,959     |              | 100,993    |              | (289,455   | )                | 453,284    |   |

** **

25

----

** **

**CONDENSED CONSOLIDATING BALANCE SHEETAs of September 30, 2005**
| ** **                                         | ** ** | ** ** | ** ** | ** ** | ** ** | **Guarantor**    | ** ** | **Non-Guarantor** | ** ** | **Consolidating** | ** ** | **Consolidated** | ** ** |
|----------------------------------------------------|------------|------------|------------|------------|------------|------------------|------------|-------------------|------------|-------------------|------------|------------------|------------|
| ** **                                         | ** ** | **Parent** | ** ** | **Issuer** | ** ** | **Subsidiaries** | ** ** | **Subsidiaries**  | ** ** | **Eliminations**  | ** ** | **Total**        | ** ** |
|                                               |       |       |       |       |       |             |       |              |       |              |       |             |       |
| **Assets**                                         |       |       |       |       |       |             |       |              |       |              |       |             |       |
| Cash and cash  equivalents                         |       | $          | 33         |       | 25,528     |             | 323        |              | 627        |              | —     |             | 26,511     |   |
| Restricted cash                                    |       | —     |       | —     |       | 1,180            |       | 107               |       | —            |       | 1,287            |       |
| Accounts  receivable, net                          |       | —     |       | 21,982     |       | 5,531            |       | 11,782            |       | —            |       | 39,295           |       |
| Inventories                                        |       | —     |       | 33,746     |       | 2,135            |       | 15,755            |       | (1,016            | )          | 50,620           |       |
| Deferred tax  assets                               |       | —     |       | 12,339     |       | 7                |       | —            |       | —            |       | 12,346           |       |
| Prepaid and  other current assets                  |       | 165        |       | 3,930      |       | 127              |       | 791               |       | (1,032            | )          | 3,981            |       |
| Intercompany  receivable                           |       | —     |       | 17,849     |       | 2,278            |       | 8,064             |       | (28,191           | )          | —           |       |
| Total current assets                               |       | 198        |       | 115,374    |       | 11,581           |       | 37,126            |       | (30,239           | )          | 134,040          |       |
| Property, plant  and equipment, net                |       | —     |       | 72,462     |       | 3,166            |       | 7,996             |       | —            |       | 83,624           |       |
| Deferred debt  issue costs, net                    |       | 3,326      |       | 7,735      |       | —           |       | —            |       | —            |       | 11,061           |       |
| Intangible  assets, net                            |       | —     |       | 61,500     |       | 6,965            |       | 9,476             |       | —            |       | 77,941           |       |
| Goodwill                                           |       | —     |       | 92,041     |       | 5,848            |       | 47,573            |       | —            |       | 145,462          |       |
| Other long-term  assets                            |       | 1,515      |       | 901        |       | —           |       | —            |       | —            |       | 2,416            |       |
| Intercompany  notes receivable                     |       | —     |       | 7,635      |       | —           |       | —            |       | (7,635            | )          | —           |       |
| Investment in  subsidiaries                        |       | 157,658    |       | 49,587     |       | —           |       | —            |       | (207,245          | )          | —           |       |
| Total assets                                       |       | $          | 162,697    |       | 407,235    |             | 27,560     |              | 102,171    |              | (245,119   | )                | 454,544    |   |
|                                               |       |       |       |       |       |             |       |              |       |              |       |             |       |
| **Liabilities  and Stockholders’ Equity**     |       |       |       |       |       |             |       |              |       |              |       |             |       |
| Accounts payable                                   |       | $          | —     |       | 13,223     |             | 368        |              | 7,830      |              | —     |             | 21,421     |   |
| Accrued expenses                                   |       | 1,320      |       | 21,610     |       | 1,078            |       | 3,239             |       | —            |       | 27,247           |       |
| Product warranty                                   |       | —     |       | 3,698      |       | 164              |       | 2,497             |       | —            |       | 6,359            |       |
| Income taxes  payable                              |       | —     |       | —     |       | 11               |       | 2,567             |       | (1,032            | )          | 1,546            |       |
| Advance payments  from customers                   |       | —     |       | 4,744      |       | 1,834            |       | 5,489             |       | —            |       | 12,067           |       |
| Intercompany  payable                              |       | 28,191     |       | —     |       | —           |       | —            |       | (28,191           | )          | —           |       |
| Total current liabilities                          |       | 29,511     |       | 43,275     |       | 3,455            |       | 21,622            |       | (29,223           | )          | 68,640           |       |
| Deferred income  taxes                             |       | 272        |       | 28,240     |       | —           |       | 7,044             |       | —            |       | 35,556           |       |
| Intercompany notes  payable                        |       | —     |       | —     |       | —           |       | 7,635             |       | (7,635            | )          | —           |       |
| Advance payments  from sale of San Carlos property |       | —     |       | 13,450     |       | —           |       | —            |       | —            |       | 13,450           |       |
| Long-term debt                                     |       | 79,231     |       | 205,000    |       | —           |       | —            |       | —            |       | 284,231          |       |
| Total liabilities                                  |       | 109,014    |       | 289,965    |       | 3,455            |       | 36,301            |       | (36,858           | )          | 401,877          |       |
| Common stock                                       |       | 131        |       | —     |       | —           |       | —            |       | —            |       | 131              |       |
| Parent  investment                                 |       | —     |       | 95,179     |       | 22,228           |       | 57,216            |       | (174,623          | )          | —           |       |
| Additional  paid-in capital                        |       | 34,595     |       | —     |       | —           |       | —            |       | —            |       | 34,595           |       |
| Accumulated  other comprehensive income            |       | 1,621      |       | 1,213      |       | —           |       | 360               |       | (1,573            | )          | 1,621            |       |
| Retained  earnings                                 |       | 17,336     |       | 20,878     |       | 1,877            |       | 8,294             |       | (32,065           | )          | 16,320           |       |
| Total stockholders’ equity                    |       | 53,683     |       | 117,270    |       | 24,105           |       | 65,870            |       | (208,261          | )          | 52,667           |       |
| Total  liabilities and stockholders’ equity   |       | $          | 162,697    |       | 407,235    |             | 27,560     |              | 102,171    |              | (245,119   | )                | 454,544    |   |

 

 

26

----

** **

**CONDENSED CONSOLIDATING STATEMENT OF OPERATIONS For the Quarter Ended June 30, 2006**
| ** **                                                                    | ** ** | ** ** | ** ** | ** ** | ** ** | **Guarantor**    | ** ** | **Non-  Guarantor** | ** ** | **Consolidating** | ** ** | **Consolidated** | ** ** |
|-------------------------------------------------------------------------------|------------|------------|------------|------------|------------|------------------|------------|---------------------|------------|-------------------|------------|------------------|------------|
| ** **                                                                    | ** ** | **Parent** | ** ** | **Issuer** | ** ** | **Subsidiaries** | ** ** | **Subsidiaries**    | ** ** | **Eliminations**  | ** ** | **Total**        | ** ** |
|  Sales                                                                   |       | $          | —     |       | 59,103     |             | 15,958     |                | 31,036     |              | (18,336    | )                | 87,761     |   |
| Cost of sales                                                                 |       | —     |       | 42,091     |       | 12,994           |       | 23,925              |       | (18,143           | )          | 60,867           |       |
| Gross profit                                                                  |       | —     |       | 17,012     |       | 2,964            |       | 7,111               |       | (193              | )          | 26,894           |       |
| Operating costs and  expenses:                                                |       |       |       |       |       |             |       |                |       |              |       |             |       |
| Research and  development                                                     |       | —     |       | 927        |       | —           |       | 1,588               |       | —            |       | 2,515            |       |
| Selling and  marketing                                                        |       | —     |       | 2,206      |       | 921              |       | 2,121               |       | —            |       | 5,248            |       |
| General and  administrative                                                   |       | —     |       | 3,841      |       | 225              |       | 1,375               |       | —            |       | 5,441            |       |
| Amortization of  acquisition-related intangible assets                        |       | —     |       | 334        |       | 63               |       | 151                 |       | —            |       | 548              |       |
| Net loss on  disposition of assets                                            |       | —     |       | 206        |       | 2                |       | 4                   |       | —            |       | 212              |       |
| Total operating costs  and expenses                                           |       | —     |       | 7,514      |       | 1,211            |       | 5,239               |       | —            |       | 13,964           |       |
| Operating income                                                              |       | —     |       | 9,498      |       | 1,753            |       | 1,872               |       | (193              | )          | 12,930           |       |
| Interest expense  (income), net                                               |       | 2,026      |       | 3,912      |       | (2               | )          | 9                   |       | —            |       | 5,945            |       |
| (Loss) income before  income tax expense and equity in income of subsidiaries |       | (2,026     | )          | 5,586      |       | 1,755            |       | 1,863               |       | (193              | )          | 6,985            |       |
| Income tax  (benefit) expense                                                 |       | (811       | )          | 2,318      |       | 504              |       | 506                 |       | —            |       | 2,517            |       |
| Equity in income  of subsidiaries                                             |       | 5,683      |       | 2,608      |       | —           |       | —              |       | (8,291            | )          | —           |       |
| Net income                                                                    |       | $          | 4,468      |       | 5,876      |             | 1,251      |                | 1,357      |              | (8,484     | )                | 4,468      |   |

**CONDENSEDCONSOLIDATING STATEMENT OF OPERATIONSFor the Quarter Ended July 1, 2005**
| ** **                                                                  | ** ** | ** ** | ** ** | ** ** | ** ** | **Guarantor**    | ** ** | **Non-  Guarantor** | ** ** | **Consolidating** | ** ** | **Consolidated** | ** ** |
|-----------------------------------------------------------------------------|------------|------------|------------|------------|------------|------------------|------------|---------------------|------------|-------------------|------------|------------------|------------|
| ** **                                                                  | ** ** | **Parent** | ** ** | **Issuer** | ** ** | **Subsidiaries** | ** ** | **Subsidiaries**    | ** ** | **Eliminations**  | ** ** | **Total**        | ** ** |
| Sales                                                                       |       | $          | —     |       | 61,172     |             | 12,679     |                | 32,818     |              | (19,030    | )                | 87,639     |   |
| Cost of sales                                                               |       | —     |       | 43,244     |       | 10,214           |       | 23,420              |       | (19,030           | )          | 57,848           |       |
| Gross profit                                                                |       | —     |       | 17,928     |       | 2,465            |       | 9,398               |       | —            |       | 29,791           |       |
| Operating costs and  expenses:                                              |       |       |       |       |       |             |       |                |       |              |       |             |       |
| Research and  development                                                   |       | —     |       | 606        |       | —           |       | 1,293               |       | —            |       | 1,899            |       |
| Selling and  marketing                                                      |       | —     |       | 1,852      |       | 876              |       | 2,016               |       | —            |       | 4,744            |       |
| General and  administrative                                                 |       | —     |       | 4,125      |       | 701              |       | 938                 |       | —            |       | 5,764            |       |
| Amortization of  acquisition-related intangible assets                      |       | —     |       | 334        |       | 63               |       | 151                 |       | —            |       | 548              |       |
| Net loss on  disposition of assets                                          |       | —     |       | 21         |       | —           |       | 4                   |       | —            |       | 25               |       |
| Total operating costs  and expenses                                         |       | —     |       | 6,938      |       | 1,640            |       | 4,402               |       | —            |       | 12,980           |       |
| Operating income                                                            |       | —     |       | 10,990     |       | 825              |       | 4,996               |       | —            |       | 16,811           |       |
| Interest expense  (income), net                                             |       | 1,832      |       | 3,600      |       | (8               | )          | 273                 |       | —            |       | 5,697            |       |
| (Loss) income before  income tax expense and equity in loss of subsidiaries |       | (1,832     | )          | 7,390      |       | 833              |       | 4,723               |       | —            |       | 11,114           |       |
| Income tax (benefit)  expense                                               |       | (733       | )          | 2,820      |       | 441              |       | 1,888               |       | —            |       | 4,416            |       |
| Equity in income  of subsidiaries                                           |       | 7,797      |       | 3,227      |       | —           |       | —              |       | (11,024           | )          | —           |       |
| Net income                                                                  |       | $          | 6,698      |       | 7,797      |             | 392        |                | 2,835      |              | (11,024    | )                | 6,698      |   |

** **

27

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** **

**CONDENSED CONSOLIDATING STATEMENT OF OPERATIONSFor the Nine months Ended June 30, 2006**
| ** **                                                                    | ** ** | ** ** | ** ** | ** ** | ** ** | **Guarantor**    | ** ** | **Non-  Guarantor** | ** ** | **Consolidating** | ** ** | **Consolidated** | ** ** |
|-------------------------------------------------------------------------------|------------|------------|------------|------------|------------|------------------|------------|---------------------|------------|-------------------|------------|------------------|------------|
| ** **                                                                    | ** ** | **Parent** | ** ** | **Issuer** | ** ** | **Subsidiaries** | ** ** | **Subsidiaries**    | ** ** | **Eliminations**  | ** ** | **Total**        | ** ** |
| Sales                                                                         |       | $          | —     |       | 167,686    |             | 45,000     |                | 99,992     |              | (55,609    | )                | 257,069    |   |
| Cost of sales                                                                 |       | —     |       | 122,617    |       | 36,936           |       | 75,191              |       | (55,521           | )          | 179,223          |       |
| Gross profit                                                                  |       | —     |       | 45,069     |       | 8,064            |       | 24,801              |       | (88               | )          | 77,846           |       |
| Operating costs  and expenses:                                                |       |       |       |       |       |             |       |                |       |              |       |             |       |
| Research and development                                                      |       | —     |       | 2,613      |       | —           |       | 3,753               |       | —            |       | 6,366            |       |
| Selling and marketing                                                         |       | —     |       | 6,304      |       | 2,764            |       | 5,884               |       | —            |       | 14,952           |       |
| General and administrative                                                    |       | —     |       | 10,411     |       | 959              |       | 6,049               |       | —            |       | 17,419           |       |
| Amortization of acquisition-related intangible  assets                        |       | —     |       | 1,002      |       | 188              |       | 452                 |       | —            |       | 1,642            |       |
| Net loss on disposition of assets                                             |       | —     |       | 378        |       | 2                |       | 40                  |       | —            |       | 420              |       |
| Total operating  costs and expenses                                           |       | —     |       | 20,708     |       | 3,913            |       | 16,178              |       | —            |       | 40,799           |       |
| Operating income                                                              |       | —     |       | 24,361     |       | 4,151            |       | 8,623               |       | (88               | )          | 37,047           |       |
| Interest expense (income), net                                                |       | 6,126      |       | 12,258     |       | (11              | )          | 36                  |       | —            |       | 18,409           |       |
| (Loss) income  before income tax expense and equity in income of subsidiaries |       | (6,126     | )          | 12,103     |       | 4,162            |       | 8,587               |       | (88               | )          | 18,638           |       |
| Income tax (benefit) expense                                                  |       | (2,451     | )          | 6,097      |       | 1,200            |       | 2,764               |       | —            |       | 7,610            |       |
| Equity in income of subsidiaries                                              |       | 14,703     |       | 8,785      |       | —           |       | —              |       | (23,488           | )          | —           |       |
| Net income                                                                    |       | $          | 11,028     |       | 14,791     |             | 2,962      |                | 5,823      |              | (23,576    | )                | 11,028     |   |

**CONDENSED CONSOLIDATING STATEMENT OF OPERATIONSFor the Nine months Ended July 1, 2005**
| ** **                                                                               | ** ** | ** ** | ** ** | ** ** | ** ** | **Guarantor**    | ** ** | **Non-  Guarantor** | ** ** | **Consolidating** | ** ** | **Consolidated** | ** ** |
|------------------------------------------------------------------------------------------|------------|------------|------------|------------|------------|------------------|------------|---------------------|------------|-------------------|------------|------------------|------------|
| ** **                                                                               | ** ** | **Parent** | ** ** | **Issuer** | ** ** | **Subsidiaries** | ** ** | **Subsidiaries**    | ** ** | **Eliminations**  | ** ** | **Total**        | ** ** |
| Sales                                                                                    |       | $          | —     |       | 174,738    |             | 33,934     |                | 88,636     |              | (51,473    | )                | 245,835    |   |
| Cost of sales,  including $351 of amortization of acquisition-related inventory write-up |       | —     |       | 123,035    |       | 27,858           |       | 63,843              |       | (51,473           | )          | 163,263          |       |
| Gross profit                                                                             |       | —     |       | 51,703     |       | 6,076            |       | 24,793              |       | —            |       | 82,572           |       |
| Operating costs  and expenses:                                                           |       |       |       |       |       |             |       |                |       |              |       |             |       |
| Research and development                                                                 |       | —     |       | 1,797      |       | —           |       | 3,408               |       | —            |       | 5,205            |       |
| Selling and marketing                                                                    |       | —     |       | 5,547      |       | 2,522            |       | 5,328               |       | —            |       | 13,397           |       |
| General and administrative                                                               |       | —     |       | 10,169     |       | 1,538            |       | 3,684               |       | —            |       | 15,391           |       |
| Amortization of acquisition-related intangible  assets                                   |       | —     |       | 5,751      |       | 183              |       | 1,006               |       | —            |       | 6,940            |       |
| Net loss on disposition of assets                                                        |       | —     |       | 269        |       | —           |       | 4                   |       | —            |       | 273              |       |
| Total operating  costs and expenses                                                      |       | —     |       | 23,533     |       | 4,243            |       | 13,430              |       | —            |       | 41,206           |       |
| Operating income                                                                         |       | —     |       | 28,170     |       | 1,833            |       | 11,363              |       | —            |       | 41,366           |       |
| Interest expense (income), net                                                           |       | 2,643      |       | 11,044     |       | (23              | )          | 845                 |       | —            |       | 14,509           |       |
| (Loss) income  before income tax expense and equity in loss of subsidiaries              |       | (2,643     | )          | 17,126     |       | 1,856            |       | 10,518              |       | —            |       | 26,857           |       |
| Income tax (benefit) expense                                                             |       | (1,057     | )          | 7,151      |       | 746              |       | 3,901               |       | —            |       | 10,741           |       |
| Equity in income of subsidiaries                                                         |       | 17,702     |       | 7,727      |       | —           |       | —              |       | (25,429           | )          | —           |       |
| Net income                                                                               |       | $          | 16,116     |       | 17,702     |             | 1,110      |                | 6,617      |              | (25,429    | )                | 16,116     |   |

** **

28

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** **

**CONDENSED CONSOLIDATING STATEMENT OF CASH FLOWSFor the Nine months Ended June 30, 2006**
| ** **                                                 | ** ** | ** ** | ** ** | ** ** | ** ** | **Guarantor**    | ** ** | **Non-  Guarantor** | ** ** | **Consolidating** | ** ** | **Consolidated** | ** ** |
|------------------------------------------------------------|------------|------------|------------|------------|------------|------------------|------------|---------------------|------------|-------------------|------------|------------------|------------|
| ** **                                                 | ** ** | **Parent** | ** ** | **Issuer** | ** ** | **Subsidiaries** | ** ** | **Subsidiaries**    | ** ** | **Eliminations**  | ** ** | **Total**        | ** ** |
| **Operating  Activities**                                  |       |       |       |       |       |             |       |                |       |              |       |             |       |
| Net cash (used in) provided by operating activities        |       | $          | (3,409     | )          | 1,285      |             | 451        |                | 3,591      |              | —     |             | 1,918      |   |
| **Investing  Activities**                                  | ** ** | ** ** | ** ** | ** ** | ** ** | ** **       | ** ** | ** **          | ** ** | ** **        | ** ** | ** **       | ** ** |
| Deferred expenses relating to sale of San Carlos  property |       | —     |       | (212       | )          | —           |       | —              |       | —            |       | (212             | )          |
| Capital expenditures                                       |       | —     |       | (6,456     | )          | (106             | )          | (1,857              | )          | —            |       | (8,419           | )          |
| Investment in subsidary                                    |       | (47,500    | )          | 47,500     |       | —           |       | —              |       | —            |       | —           |       |
| Net cash (used in) investing activities                    |       | (47,500    | )          | 40,832     |       | (106             | )          | (1,857              | )          | —            |       | (8,631           | )          |
| **Financing  Activities**                                  |       |       |       |       |       |             |       |                |       |              |       |             |       |
| Proceeds from the issuance of common stock                 |       | 52,942     |       | —     |       | —           |       | —              |       | —            |       | 52,942           |       |
| Proceeds from senior term loan                             |       | —     |       | 10,000     |       | —           |       | —              |       | —            |       | 10,000           |       |
| Special cash dividends                                     |       | (17,000    | )          | —     |       | —           |       | —              |       | —            |       | (17,000          | )          |
| Repayments on senior term loan                             |       | —     |       | (47,500    | )          | —           |       | —              |       | —            |       | (47,500          | )          |
| Payment of IPO costs                                       |       | (5,634     | )          | —     |       | —           |       | —              |       | —            |       | (5,634           | )          |
| Intercompany dividends                                     |       | 20,959     |       | (20,959    | )          | —           |       | —              |       | —            |       | —           |       |
| Net cash provided by (used in) financing activities        |       | 51,267     |       | (58,459    | )          | —           |       | —              |       | —            |       | (7,192           | )          |
| **Net  (Decrease) Increase in Cash and Cash Equivalents**  |       | 358        |       | (16,342    | )          | 345              |       | 1,734               |       | —            |       | (13,905          | )          |
| Cash and cash  equivalents at beginning of period          |       | 33         |       | 25,528     |       | 323              |       | 627                 |       | —            |       | 26,511           |       |
| Cash and cash  equivalents at end of period                |       | $          | 391        |       | 9,186      |             | 668        |                | 2,361      |              | —     |             | 12,606     |   |

**CONDENSED CONSOLIDATING STATEMENT OF CASH FLOWSFor the Nine months Ended July 1, 2005**
| ** **                                                 | ** ** | ** ** | ** ** | ** ** | ** ** | **Guarantor**    | ** ** | **Non-  Guarantor** | ** ** | **Consolidating** | ** ** | **Consolidated** | ** ** |
|------------------------------------------------------------|------------|------------|------------|------------|------------|------------------|------------|---------------------|------------|-------------------|------------|------------------|------------|
| ** **                                                 | ** ** | **Parent** | ** ** | **Issuer** | ** ** | **Subsidiaries** | ** ** | **Subsidiaries**    | ** ** | **Eliminations**  | ** ** | **Total**        | ** ** |
| **Operating  Activities**                                  |       |       |       |       |       |             |       |                |       |              |       |             |       |
| Net cash provided by operating activities                  |       | $          | 97         |       | 13,006     |             | 553        |                | 114        |              | —     |             | 13,770     |   |
| **Investing  Activities**                                  | ** ** | ** ** | ** ** | ** ** | ** ** | ** **       | ** ** | ** **          | ** ** | ** **        | ** ** | ** **       | ** ** |
| Deferred expenses relating to sale of San Carlos  property |       | —     |       | (216       | )          | —           |       | —              |       | —            |       | (216             | )          |
| Purchase of Econco, net of cash acquired                   |       | —     |       | (18,325    | )          | —           |       | —              |       | —            |       | (18,325          | )          |
| Capital expenditures                                       |       | —     |       | (8,336     | )          | (132             | )          | (399                | )          | —            |       | (8,867           | )          |
| Other investing activities                                 |       | —     |       | (16        | )          | —           |       | —              |       | —            |       | (16              | )          |
| Net cash used in investing activities                      |       | —     |       | (26,893    | )          | (132             | )          | (399                | )          | —            |       | (27,424          | )          |
| **Financing  Activities**                                  |       |       |       |       |       |             |       |                |       |              |       |             |       |
| Proceeds from issuance of floating rate senior notes       |       | 79,200     |       | —     |       | —           |       | —              |       | —            |       | 79,200           |       |
| Special cash dividends                                     |       | (75,809    | )          | —     |       | —           |       | —              |       | —            |       | (75,809          | )          |
| Repayments on senior term loan                             |       | —     |       | (9,550     | )          | —           |       | —              |       | —            |       | (9,550           | )          |
| Payments for debt issue costs                              |       | (3,455     | )          | —     |       | —           |       | —              |       | —            |       | (3,455           | )          |
| Other financing activities                                 |       | —     |       | (80        | )          | (20              | )          | —              |       | —            |       | (100             | )          |
| Net cash used in financing activities                      |       | (64        | )          | (9,630     | )          | (20              | )          | —              |       | —            |       | (9,714           | )          |
| **Net  (Decrease) Increase in Cash and Cash Equivalents**  |       | 33         |       | (23,517    | )          | 401              |       | (285                | )          | —            |       | (23,368          | )          |
| Cash and cash  equivalents at beginning of period          |       | —     |       | 38,131     |       | 113              |       | 2,232               |       | —            |       | 40,476           |       |
| Cash and cash  equivalents at end of period                |       | $          | 33         |       | 14,614     |             | 514        |                | 1,947      |              | —     |             | 17,108     |   |

 

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**Item 2.**                          Management’sDiscussion and Analysis of Financial Condition and Results of Operations

*Our fiscal years are the 52- or 53-weekperiods that end on the Friday nearest September 30. Fiscal year 2006 comprisesthe 52-week period ending September 29, 2006 and fiscal year 2005 comprised the52-week period ended September 30, 2005. The following discussion should beread in conjunction with the accompanying condensed consolidated financialstatements, and the notes thereto, of CPI International, Inc.*

**Overview**

CPI International, Inc.,headquartered in Palo Alto, California, is the parent company ofCommunications & Power Industries, Inc., a leading provider of microwave,radio frequency, power and control solutions for critical defense,communications, medical, scientific and other applications.  Communications & Power Industries, Inc.develops, manufactures and distributes products used to generate, amplify andtransmit high-power/high-frequency microwave and radio frequency signals and/orprovide power and control for various applications.  End-use applications of these systems includethe transmission of radar signals for navigation and location; transmission ofdeception signals for electronic countermeasures; transmission andamplification of voice, data and video signals for broadcasting, Internet andother types of communications; providing power and control for medicaldiagnostic imaging; and generating microwave energy for radiation therapy inthe treatment of cancer and for various industrial and scientific applications.

Unless the context otherwise requires, (1) “CPI International”means CPI International, Inc., (2) “Predecessor” means Communications &Power Industries Holding Corporation, the predecessor to CPI International, (3)“CPI” means Communications & Power Industries, Inc. and (4) “Merger” meansthe January 23, 2004 merger pursuant to which CPI International acquired thePredecessor. CPI is a direct subsidiary of CPI International. CPI Internationalis a holding company with no operations of its own. The terms “we,” “us,” “our”and the “Company” refer to CPI International, or the Predecessor, asapplicable, and its direct and indirect subsidiaries on a consolidated basis.

On May 3, 2006, we completed the initial public offering ofour Common Stock, pursuant to which we sold 2,941,200 shares and sellingstockholders sold 4,117,670 shares, at an initial offering price to the publicof $18.00 per share.  For additionalinformation about the initial public offering of our common stock see “—Liquidityand Capital Resources.”

**Eimac Relocation**

We began the relocation of ourEimac division from our San Carlos, California facility to our nearby PaloAlto, California and Mountain View, California facilities during fiscal year2005.  We expect to complete the physicalrelocation and consolidation of operations by the end of calendar year2006.  As of June 30, 2006, the physicalrelocation of the Eimac division was complete. In order to realize increased efficiencies from the relocation of ourEimac division to our Palo Alto and Mountain View facilities, on June 1, 2006,we made organizational changes and consolidated the operating activities of ourEimac division into our Microwave Power Products division, which also operatesout of our Palo Alto facility.

As part of this relocation, ourEimac division has experienced planned manufacturing disruptions stemming fromthe decommissioning of our production equipment in San Carlos and the requiredreconfiguration, installation and testing of that equipment prior to productionreadiness in Palo Alto.  During the firstnine months of fiscal year 2005, in anticipation of these planned disruptions,customers accelerated the placement of orders with our Eimac division.  As we expected, this order acceleration infiscal year 2005, and the subsequent acceleration of product shipments, causeda reduction of customers’ demand requirements from our Eimac division duringthe first nine months of fiscal year 2006, particularly in our medical,communications and industrial markets. As a result, the relocation negatively impacted our orders and sales forthe first nine months of fiscal 2006 as compared to the first nine months offiscal 2005, as well as our orders and sales for these periods as compared toour average order and sales rates for the three years prior to the start of therelocation.

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Orders and sales for the Eimacdivision have begun to recover from the impact of the relocation.  Total sales for our Eimac division were $9.6million in the third quarter of fiscal year 2006, increasing from the Eimacdivision’s total sales of $7.7 million and $7.0 million in the second and firstquarters of 2006, respectively.  Weexpect sales for our Eimac division for the fourth quarter of fiscal year 2006to be similar to those in the third quarter, as we continue to integrate theoperating activities of our Eimac division into our Microwave Power Productsdivision.  We expect sales for our Eimacdivision for future quarters to be more in line with our average total quartersales of more than $10 million for that division prior to the start of therelocation.

The following table illustrates theimpact of the relocation on our Eimac division, summarizing orders and salesfor the Eimac division for the first nine months of fiscal years 2006 and 2005,as compared to the average orders and sales for our Eimac division for thethree fiscal years before the relocation began (dollars in millions): 
| ** ** | ** ** | ** **          | ** ** | ** **          | ** ** | ** **                 | ** ** | **First Nine Months**      | ** ** | **First Nine Months**       | ** ** |
|------------|------------|---------------------|------------|---------------------|------------|----------------------------|------------|--------------------------------------|------------|---------------------------------------|------------|
| ** ** | ** ** | ** **          | ** ** | ** **          | ** ** | ** **                 | ** ** | **2006 Compared to ** | ** ** | **2005 Compared to **  | ** ** |
| ** ** | ** ** | ** **          | ** ** | ** **          | ** ** | **Average**                | ** ** | **Average for First**      | ** ** | **Average for First ** | ** ** |
| ** ** | ** ** | **First Nine** | ** ** | **First Nine** | ** ** | **for First**         | ** ** | **Nine Months **           | ** ** | **Nine Months**                  | ** ** |
| ** ** | ** ** | **Months**          | ** ** | **Months**          | ** ** | **Nine Months**       | ** ** | **2002 to 2004**           | ** ** | **2002 to 2004**            | ** ** |
| ** ** | ** ** | **2006**            | ** ** | **2005**            | ** ** | **2002 to 2004** | ** ** | **Amount**                           | ** ** | **Percentage**                        | ** ** | **Amount** | ** ** | **Percentage** | ** ** |
| Orders     |       | $                   | 28.1       |                | $          | 40.2                       |       | $                                    | 32.8       |                                  | $          | (4.7 | ) | (14 | )% | $ | 7.4 |   | 23 | % |
| Sales      |       | $                   | 24.1       |                | $          | 36.4                       |       | $                                    | 32.3       |                                  | $          | (8.2 | ) | (25 | )% | $ | 4.1 |   | 13 | % |

 

The following table illustrates theimpact of the relocation on our Eimac division, summarizing our sales for theEimac division for the third quarters of fiscal years 2006 and 2005, ascompared to the average sales for our Eimac division for the third quarters ofthe three fiscal years before the relocation began (dollars in millions): 
| ** ** | ** ** | ** **  | ** ** | ** **  | ** ** | ** **                 | ** ** | **Third Quarter 2006**      | ** ** | **Third Quarter 2005**  | ** ** |
|------------|------------|-------------|------------|-------------|------------|----------------------------|------------|---------------------------------------|------------|-----------------------------------|------------|
| ** ** | ** ** | **Average** | ** ** | ** **  | ** ** | ** **                 | ** ** | **Compared to Average**     | ** ** | **Compared to Average** | ** ** |
| ** ** | ** ** | **Third**   | ** ** | **Third**   | ** ** | **for Third**         | ** ** | **for  Third Quarter** | ** ** | **for Third Quarter**   | ** ** |
| ** ** | ** ** | **Quarter** | ** ** | **Quarter** | ** ** | **Quarter**                | ** ** | **2002 to 2004 **      | ** ** | **2002 to 2004**        | ** ** |
| ** ** | ** ** | **2006**    | ** ** | **2005**    | ** ** | **2002 to 2004** | ** ** | **Amount**                            | ** ** | **Percentage**                    | ** ** | **Amount** | ** ** | **Percentage** | ** ** |
| Sales      |       | $           | 9.6        |        | $          | 14.1                       |       | $                                     | 10.6       |                              | $          | (1.0 | ) | (9 | )% | $ | 3.5 |   | 33 | % |
|            |            |             |            |             |            |                            |            |                                       |            |                                   |            |  |  |  |  |  |  |  |  |  |

 

**The followingtable summarizes the estimated unfavorable impact of the relocation on ouroperating income (dollars in millions):**
| ** **                                                                                                                                                                                 | ** ** | **Quarter Ended**  | ** ** | **Nine Months  Ended** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------------|------------|-----------------------------|------------|
| ** **                                                                                                                                                                                 | ** ** | **June 30,  2006** | ** ** | **July 1,  2005**      | ** ** | **June 30,  2006** | ** ** | **July 1,  2005** | ** ** |
| Gross profit:  additional expenses related to the relocation, overhead absorption and  manufacturing variances due to unusual sales volume, and severance expenses,  at our Eimac division |       | $                       | 1.8        |                        | $          | 0.2 |   | $ | 5.6 |   | $ | 0.3 |   |
| Selling and  marketing: severance expenses                                                                                                                                                 |       | 0.1                     |       | —                      |       | 0.1 |   | — |   |
| General and  administrative: direct expenses for the relocation                                                                                                                            |       | 0.4                     |       | 0.3                         |       | 1.0 |   | 0.6 |   |
| Net loss on  disposition of assets: disposal of equipment no longer needed                                                                                                                 |       | 0.1                     |       | —                      |       | 0.1 |   | — |   |
| Unfavorable impact to  operating income                                                                                                                                                    |       | $                       | 2.4        |                        | $          | 0.5 |   | $ | 6.8 |   | $ | 0.9 |   |

** **

**Econco Acquisition**

On October 8, 2004, we purchased all of the outstanding stockof Econco Broadcast Service, Inc. of Woodland, California for cashconsideration of approximately $18.3 million. Econco is a provider ofremanufactured high-power microwave devices, allowing broadcasters and otherusers of these critical products to extend the life of their devices at a costthat is lower than buying a new device.

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**Orders**

We sell our products into six end markets: radar, electronicwarfare, medical, communications, industrial and scientific.  We track our orders in each of these endmarkets on a year-to-date basis.

Our customer sales contracts are recorded as orders when weaccept written customer purchase orders or contracts.  Customer purchase orders with an undefineddelivery schedule, or blanket purchase orders, are not reported as orders untilthe delivery date is determined.  Ourgovernment sales contracts are not reported as orders until we have beennotified that the contract has been funded. Total orders for a fiscal period represent the total dollar amount ofcustomer orders recorded by us during the fiscal period, reduced by the dollaramount of any order cancellations or terminations during the fiscal period.

Our orders by market for the first nine months of fiscalyears 2006 and 2005 are summarized as follows (dollars in millions):
| ** **          | ** ** | **Nine Months Ended** | ** ** | ** **                 | ** ** | ** ** | ** ** |
|---------------------|------------|---------------------------------|------------|----------------------------|------------|------------|------------|
| ** **          | ** ** | **June 30, 2006**     | ** ** | **July 1, 2005** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **          | ** ** | ** **                      | ** ** | **Percentage**             | ** ** | ** ** | ** ** | **Percentage** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **          | ** ** | ** **                      | ** ** | **of Total**          | ** ** | ** ** | ** ** | **of Total** | ** ** | **Increase (Decrease)** | ** ** |
| ** **          | ** ** | **Amount**                      | ** ** | **Orders**                 | ** ** | **Amount** | ** ** | **Orders** | ** ** | **Amount** | ** ** | **Percentage** | ** ** |
| Radar               |       | $                               | 88.6       |                       | 36         | %          | $          | 80.9 |   | 32 | % | $ | 7.7 |   | 10 | % |
| Electronic  Warfare |       | 18.4                            |       | 7                          | %          | 22.8       |       | 9 | % | (4.4 | ) | (19) | % |
| Medical             |       | 46.9                            |       | 19                         | %          | 42.0       |       | 16 | % | 4.9 |   | 12 | % |
| Communications      |       | 71.7                            |       | 29                         | %          | 87.1       |       | 34 | % | (15.4 | ) | (18) | % |
| Industrial          |       | 16.7                            |       | 7                          | %          | 17.5       |       | 7 | % | (0.8 | ) | (5) | % |
| Scientific          |       | 3.9                             |       | 2                          | %          | 4.5        |       | 2 | % | (0.6 | ) | (13) | % |
| Total orders        |       | $                               | 246.2      |                       | 100        | %          | $          | 254.8 |   | 100 | % | $ | (8.6 | ) | (3) | % |

 

Explanations for the order increase or decrease by market forthe first nine months of fiscal year 2006 compared to the first nine months offiscal year 2005 are as follows:

·                  **Radar:**  The increase in radar orders was due to both increased orderlevels and the timing of order receipts for several programs. The increase inorder levels included increases for products that are used on the Aegisprogram, the LANTIRN navigation and targeting system and various foreignmilitary programs.  These order increaseswere partially offset by a decrease in foreign military orders for the Patriotmissile air defense system due to the timing of order receipts.

·                  **Electronic Warfare: **Thedecrease in electronic warfare orders was primarily due to the timing of orderlevels on certain programs that did not repeat in the first nine months offiscal year 2006, including a $4.5 million order recorded in the third quarterof fiscal 2005 for the Advanced Airborne Expendable Decoy, which did not repeatin the first nine months of the current fiscal year, but on which we areexpecting follow-on orders within the next six months; a $3.4 million two-yeardelivery order recorded in the first quarter of fiscal year 2005 for theALQ-187 Electronic Countermeasures System program, which did not repeat in thefirst nine months of the current fiscal year, but on which we are expectingfollow-on orders at lower levels within the next six to twelve months; andorders recorded in the second quarter of fiscal year 2005 for a prototype forthe Project Sheriff Active Denial System. The decrease in orders was partiallyoffset by an increase in orders for the ALQ-184 Electronic CountermeasuresSystem, the SONATA shipboard Electronic Countermeasures System and variousforeign military programs.

·                  **Medical:**** **There was an increase in orders for x-ray generators bothfrom U.S. and international customers in the first nine months of fiscal year2006 as compared to the first nine months of fiscal year 2005.  This increase was partially offset by a $1.3million reduction in orders for our Eimac division due to its relocation as discussedabove.  The increase in medical orderswas primarily due to the continued strong growth in orders for x-ray

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generators, control systems and power supply productsused in x-ray imaging systems.  Thegrowth in the medical imaging orders is primarily due to new productintroductions, new customers and increases in product penetration with existingcustomers, including approximately $3.0 million in one-time opportunities inRussia and South America, which may not repeat on a regular basis. In fiscalyear 2005 we received a sales contract for approximately $20 million forproducts used in radiation therapy for the treatment of cancer; approximatelyone-half of this sales contract was reported as orders in fiscal year 2005,with the balance reported as orders in the first nine months of fiscal year2006.

·                  **Communications:**** **The decrease in communications orders was primarilyattributable to the timing of order receipts. The relocation of our Eimac division caused an order acceleration ofapproximately $2.5 million in the first nine months of fiscal year 2005 and acorresponding decrease of approximately $2.5 million in the first nine monthsof fiscal year 2006.  In addition, $3.1 million in orders for aninternational customer for vacuum electron device (“VED”) products and $3.7million in orders for troposcatter communications products for an internationalcustomer were received in fiscal year 2005 but are not expected to repeat infiscal year 2006.  An $11.0 milliondecrease in orders for GenIV satcom amplifiers also impacted communications orders,as satcom amplifier orders for the GenIV amplifier, primarily for thedirect-to-home broadcast market, are cyclical. Customers in the direct-to-home broadcast market historically haveplaced large orders for satcom amplifiers when they were expanding theirbroadcast facilities and then have reduced their orders as those products aredeployed.  Therefore, we expect continueddemand for our satcom amplifiers for direct-to-home broadcast applications overtime, but we believe that orders for these products will decrease for a timebefore returning to fiscal year 2005 levels. The GenIV amplifier shortfall waspartially offset by a $1.0 million increase in new product orders for outdoorunit amplifiers and a $6.0 million increase in millimeter wave amplifiers,which are newer products that are also primarily used for direct-to-homebroadcast applications.

·                  **Industrial:****   **The decrease in industrial orders was attributable to areduction in order receipts at our Eimac division due to its relocation, pluslower demand for power supplies from semiconductor equipment companies.

·                  **Scientific:**  Orders in the scientific market, our smallestmarket, are historically one-time projects and can fluctuate significantly fromperiod to period.  The decrease inscientific orders was primarily the result of the timing of a large order thatwas booked in the first nine months of fiscal year 2005 that was not expectedto repeat in the first nine months of fiscal year 2006.

Incoming order levels fluctuate significantly on a quarterlyor annual basis, and a particular quarter or year’s order rate may not beindicative of future order levels. In addition, our sales are highly dependentupon manufacturing scheduling and performance and, accordingly, it is notpossible to accurately predict when orders will be recognized as sales.

**Backlog**

Asof June 30, 2006, we had an order backlog of $184.8 million compared to anorder backlog of $190.6 million as of July 1, 2005.   Based on our historical backlog experience,our backlog as of June 30, 2006 is at the high end of our normalized backlogrange of $175 to $185 million.  Ourbacklog as of July 1, 2005 reflected approximately $10 million for a build-upin direct-to home satcom infrastructure in the U.S. and for several othercommercial communication and medical programs, most of which have been shippedas of June 30, 2006. Because our orders for government end-use productsgenerally have much longer terms than our orders for commercial business (whichrequire quicker turn-around), our backlog is primarily composed of governmentorders.  As a result, we expect that ourtotal backlog will not generally grow at the same rate as our total sales,because the markets where we are expecting higher growth, medical andcommunications are primarily commercial rather than governmental.

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Backlog represents the cumulative balance, at a given pointin time, of recorded customer sales orders that have not yet been shipped orrecognized as sales. Backlog is increased when an order is received, andbacklog is decreased when we recognize sales. We believe backlog and ordersinformation is helpful to investors because this information may be indicativeof future sales results. Although backlog consists of firm orders for whichgoods and services are yet to be provided, customers can, and sometimes do,terminate or modify these orders. However, historically the amount ofmodifications and terminations has not been material compared to total contractvolume.

**Results of Operations**

We derive our revenue primarily from the sale of productsthat are used to generate, amplify and transmit high-power/high-frequencymicrowave and radio frequency signals and/or provide power and control forvarious applications. Our products generally have selling prices ranging from$2,000 to $100,000, with certain limited products priced up to $1,000,000.

Cost of goods sold generally includes costs for rawmaterials, manufacturing costs, including allocation of overhead and otherindirect costs, charges for reserves for excess and obsolete inventory,warranty claims and losses on fixed price contracts. Operating expensesgenerally consist of research and development, selling and marketing andgeneral and administrative expenses.

*Quarter EndedJune 30, 2006 Compared to Quarter Ended July 1, 2005*

The following table sets forth our historical results ofoperations for each of the periods indicated (dollars in millions):
| ** **                                       | ** ** | **Quarter Ended**      | ** ** |
|--------------------------------------------------|------------|-----------------------------|------------|
| ** **                                       | ** ** | **June 30, 2006** | ** ** | **July 1, 2005** | ** ** |
| ** **                                       | ** ** | ** **                  | ** ** | **Percentage** | ** ** | ** ** | ** ** | **Percentage** | ** ** |
| ** **                                       | ** ** | **Amount**                  | ** ** | **of Sales** | ** ** | **Amount** | ** ** | **of Sales** | ** ** |
| Sales                                            |       | $                           | 87.8       |   | 100.0 | % | $ | 87.6 |   | 100.0 | % |
| Cost of sales                                    |       | 60.9                        |       | 69.4 |   | 57.8 |   | 66.0 |   |
| Gross profit                                     |       | 26.9                        |       | 30.6 |   | 29.8 |   | 34.0 |   |
| Research and  development                        |       | 2.5                         |       | 2.8 |   | 1.9 |   | 2.2 |   |
| Selling and  marketing                           |       | 5.2                         |       | 5.9 |   | 4.7 |   | 5.4 |   |
| General and  administrative                      |       | 5.4                         |       | 6.2 |   | 5.8 |   | 6.6 |   |
| Amortization of  acquisition-related intangibles |       | 0.5                         |       | 0.6 |   | 0.5 |   | 0.6 |   |
| Net loss on  disposition of assets               |       | 0.2                         |       | 0.2 |   | — |   | 0.0 |   |
| Operating income                                 |       | 12.9                        |       | 14.7 |   | 16.8 |   | 19.2 |   |
| Interest  expense, net                           |       | 5.9                         |       | 6.7 |   | 5.7 |   | 6.5 |   |
| Income before  taxes                             |       | 7.0                         |       | 8.0 |   | 11.1 |   | 12.7 |   |
| Income tax  expense                              |       | 2.5                         |       | 2.8 |   | 4.4 |   | 5.0 |   |
| Net income                                       |       | $                           | 4.5        |   | 5.1 | % | $ | 6.7 |   | 7.6 | % |
| Other Data:                                      |       |                        |       |   |   |   |   |   |   |
| EBITDA (a)                                       |       | $                           | 15.3       |   | 17.4 | % | $ | 19.2 |   | 21.9 | % |

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(a)   EBITDArepresents earnings before provision for income taxes, net interest expense anddepreciation and amortization. For the reasons listed below, we believe thatGAAP-based financial information for highly leveraged businesses such as oursshould be supplemented by EBITDA so that investors better understand ourfinancial performance in connection with their analysis of our business:

•                      EBITDA is a component of the measures used by our board ofdirectors and management team to evaluate our operating performance;

•                      the Senior Credit Facility (defined below) contains covenantsthat require us to maintain certain interest expense coverage and leverageratios that contain EBITDA as a component, and our management team uses EBITDAto monitor compliance with such covenants;

•                      EBITDA is a component of the measures used by our managementteam to make day-to-day operating decisions;

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•                      EBITDA facilitates comparisons between our operating resultsand those of competitors with different capital structures and therefore is acomponent of the measures used by the management to facilitate internalcomparisons to competitors’ results and our industry in general; and

•                      the payment of management bonuses is contingent upon, amongother things, the satisfaction by us of certain targets that contain EBITDA asa component.

Other companies may define EBITDA differently and, as aresult, our measure of EBITDA may not be directly comparable to EBITDA of othercompanies. Although we use EBITDA as a financial measure to assess theperformance of our business, the use of EBITDA is limited because it does notinclude certain material costs, such as interest and taxes, necessary tooperate our business. When analyzing our performance, EBITDA should beconsidered in addition to, and not as a substitute for, net income, cash flowsfrom operating activities or other statements of operations or statements ofcash flows data prepared in accordance with GAAP.

For a reconciliation of EBITDA to Net Income, see Note8 of the Notes to Condensed Consolidated Financial Statements.

**Sales:**   Our sales bymarket for the third quarter of fiscal years 2006 and 2005 aresummarized as follows (dollars millions):
| ** **          | ** ** | **Quarter Ended**      | ** ** | ** **                 | ** ** | ** ** | ** ** |
|---------------------|------------|-----------------------------|------------|----------------------------|------------|------------|------------|
| ** **          | ** ** | **June 30, 2006** | ** ** | **July 1, 2005** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **          | ** ** | ** **                  | ** ** | **Percentage**             | ** ** | ** ** | ** ** | **Percentage** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **          | ** ** | ** **                  | ** ** | **of Total**          | ** ** | ** ** | ** ** | **of Total** | ** ** | **Increase (Decrease)** | ** ** |
| ** **          | ** ** | **Amount**                  | ** ** | **Sales**                  | ** ** | **Amount** | ** ** | **Sales** | ** ** | **Amount** | ** ** | **Percentage** | ** ** |
| Radar               |       | $                           | 32.1       |                       | 37         | %          | $          | 28.3 |   | 32 | % | $ | 3.8 |   | 13 | % |
| Electronic  Warfare |       | 7.0                         |       | 8                          | %          | 8.5        |       | 10 | % | (1.5 | ) | (18) | % |
| Medical             |       | 15.6                        |       | 18                         | %          | 13.6       |       | 15 | % | 2.0 |   | 15 | % |
| Communications      |       | 24.9                        |       | 28                         | %          | 29.4       |       | 34 | % | (4.5 | ) | (15) | % |
| Industrial          |       | 6.5                         |       | 7                          | %          | 6.2        |       | 7 | % | 0.3 |   | 5 | % |
| Scientific          |       | 1.7                         |       | 2                          | %          | 1.6        |       | 2 | % | 0.1 |   | 6 | % |
| Total sales         |       | $                           | 87.8       |                       | 100        | %          | $          | 87.6 |   | 100 | % | $ | 0.2 |   | 0 | % |

 

Sales for the third quarter of fiscal year 2006 of $87.8million were $0.2 million higher than sales of $87.6 for the third quarter offiscal year 2005.  Explanations for thesales increase or decrease by market for the third quarter of fiscal year 2006as compared to the third quarter of fiscal year 2005 are as follows:

·                  **Radar: **The increase in sales to the radarmarket was primarily due to increased shipments of products for various U.S.government and foreign military programs, including products that are used onthe TPQ-37 Firefinder Artillery Locating Radar program, FPS-26 missile-trackingradar system and the HAWK missile system.

·                  **Electronic Warfare: **The decrease in sales to the electronic warfare market was primarily dueto the timing of shipments for various foreign military programs and aprototype system for the Project Sheriff Active Denial System.  In the third quarter of fiscal year 2005, wemade $0.8 million in shipments for various foreign military programs and $0.8million in shipments for the Project Sheriff Active Denial System.  These shipments did not repeat in the thirdquarter of fiscal year 2006.

·                  **Medical:**  The increase in sales in the medical marketwas primarily due to an increase in shipments of our x-ray generators forinternational customers.  Sales of ourmedical imaging and radiation therapy products increased approximately 29% from$10.5 million in the third quarter of fiscal year 2005 to $13.6 million in thethird quarter of fiscal year 2006.   Thisincrease was partially offset by a $1.1 million reduction in shipments from ourEimac division.

·                  **Communications:**** **The decrease in sales in the communications market wasprimarily the result of a decrease in shipments of satcom amplifiers fordirect-to-home broadcast applications, partially offset by increases inshipments of satcom compact amplifiers. In

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addition, as expected, the relocation of our Eimacdivision resulted in a $2.0 million reduction in shipments of communicationsproducts.

·                  **Industrial:   **The increase in industrial sales was primarily due to anincrease in demand for amplifiers from various commercial programs and for VEDsfor various commercial applications. This increase was partially offset by a $1.3 million reduction inshipments by our Eimac division due to its relocation.

·                  **Scientific:**** **Sales in the scientific market, our smallest market, arehistorically one-time projects and can fluctuate significantly from period toperiod.

**Gross Profit:**Grossprofit of $26.9 million, or 30.6% of sales, for the third quarter of fiscalyear 2006 was $2.9 million lower than the prior year’s level of $29.8 million,or 34.0% of sales. The decrease in gross profit in the third quarter of fiscalyear 2006 as compared to the third quarter of fiscal year 2005 was primarilydue to: the relocation of our Eimac division, which negatively impacted grossmargins by $1.6 million; start-up costs for, and a shift in the mix to newer,lower margin satcom products, which negatively impacted fiscal year 2006 grossmargins as compared to fiscal year 2005 by $0.7 million; and $0.9 million dueto the impact of the weaker U.S. dollar as compared to the Canadian dollar infiscal year 2006 and the expiration of a favorable Canadian dollar hedge inMarch 2006.

After the relocation of our Eimac division iscomplete, we expect to realize operational savings from the consolidation ofproduction facilities in Palo Alto, California, which we believe will improveour gross profit percentage.

Our satcom operation has developed numerous newproducts over the past several years. A successful introduction of these newproducts has resulted in a gradual shift in our backlog to newer products. Aswe begin to ramp up production of these new products in fiscal year 2006, weare incurring start-up manufacturing costs which are contributing to lowermargins in fiscal year 2006 as compared to fiscal year 2005.

**Research and Development:****Researchand development expenses of $2.5 million, or 2.8% of sales, for the thirdquarter of fiscal year 2006 increased from $1.9 million, or 2.2% of sales, inthe third quarter of fiscal year 2005. The increase was due to increasedspending as we invest for future growth in medical diagnostic imaging productsand VED products for the radar, electronic warfare and satellite communicationmarkets.

**Selling and Marketing:** Selling and marketing expenses of$5.2 million, or 5.9% of sales, for the third quarter of fiscal year 2006increased from $4.7 million, or 5.4% of sales, for the third quarter of fiscalyear 2005. This planned increase in selling and marketing expenses in the thirdquarter of fiscal year 2006 was due to additional selling and marketingexpenses to support the growth of our business and increased commissions due toa higher mix of sales in the current quarter through third partyrepresentatives than in the prior year.

**General and Administrative:****Generaland administrative expenses of $5.4 million, or 6.2% of sales, for the thirdquarter of fiscal year 2006 were $0.4 million lower than the $5.8 million, or6.6% of sales, for the third quarter of fiscal year 2005. The third quarter offiscal year 2005 included $0.4 million higher stock-based compensation expenseand $0.3 million higher management incentive expense. The third quarter offiscal year 2006 included $0.4 million of higher unfavorable Canadian currencytranslation loss due to the weaker U.S. dollar as compared to the Canadiandollar.  The third quarter of fiscalyears 2006 and 2005 included $0.4 million and $0.3 million, respectively, formoving expenses related to the relocation of our Eimac division.

**Amortization of Acquisition-RelatedIntangibles: **Amortization of acquisition-related intangibles was $0.5million for the third quarter in both fiscal year 2006 and 2005. Amortizationof acquisition-related intangibles consists of purchase accounting charges,primarily for technology and other intangible assets. Acquisition-relatedintangible assets will continue to be amortized over periods of up to 50 years.

 

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**Interest Expense, net:**Interest expense, net of $5.9 million, or 6.7% of sales, forthe third quarter of fiscal year 2006 was $0.2 million higher than the $5.7million, or 6.5% of sales, for the third quarter of fiscal year 2005. Theincrease in interest expense in the third quarter of fiscal year 2006 wasprimarily due to higher interest rates on our variable rate Term Loan,partially offset by lower debt levels since the $47.5 million Term Loanprepayment in May 2006.

**Income Tax Expense:**We recorded income tax expense of $2.5 million for the thirdquarter of fiscal year 2006 and $4.4 million for the third quarter of 2005. Theeffective tax rates were approximately 36% and 40% for the third quarter offiscal years 2006 and 2005, respectively. Income tax expense for the thirdquarter of fiscal year 2006 includes a $0.2 million discrete tax benefit fortrue-up adjustments to fiscal year 2005 tax expense related to changes inestimates made as a result of filing the 2005 income tax returns.

**Net Income:****Netincome of $4.5 million for the third quarter of fiscal year 2006 was $2.2million lower than the third quarter of fiscal year 2005 primarily due to therelocation of our Eimac division; other contributing factors included higherplanned spending for research and development and selling and marketingexpenses in fiscal year 2006, the impact of the weaker U.S. dollar as comparedto the Canadian dollar and the expiration of a favorable Canadian currencyhedge in March 2006.  The strongerCanadian dollar and the expiration of the favorable Canadian currency hedgecaused an unfavorable after-tax impact on net income of approximately $0.9million in the third quarter of fiscal year 2006, as compared to the thirdquarter of fiscal year 2005. Net income in the third quarter of fiscal year2006 was favorably impacted by lower income tax expense, compared to the thirdquarter of fiscal year 2005.

**EBITDA:******EBITDA for the third quarter of fiscal year 2006 was $15.3million, a decrease of $3.9 million compared to $19.2 million for the thirdquarter of fiscal year 2005. The decrease in EBITDA from the third quarter offiscal year 2005 to the third quarter of 2006 was primarily due to therelocation of our Eimac division; other contributing factors included higherplanned spending for research and development and selling and marketingexpenses in fiscal year 2006, the impact of the weaker U.S. dollar as comparedto the Canadian dollar and the expiration of a favorable Canadian currencyhedge in March 2006.The total negative impact of the stronger Canadian dollar andthe expiration of the favorable Canadian currency hedge, was approximately $1.5million on the third quarter of fiscal year 2006 as compared to the thirdquarter of fiscal year 2005, with $0.9 million reflected in gross profit, $0.2million in research and development and selling and marketing expenses, and$0.4 million in general and administrative.

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***Ninemonths Ended June 30, 2006 Compared to Nine months Ended July 1, 2005***

The following table sets forth our historical results ofoperations for each of the periods indicated (dollars in millions):
| ** **                                       | ** ** | **Nine Months Ended** | ** ** |
|--------------------------------------------------|------------|---------------------------------|------------|
| ** **                                       | ** ** | **June 30, 2006**     | ** ** | **July 1, 2005** | ** ** |
| ** **                                       | ** ** | **Amount**                      | ** ** | **Percentage  of Sales** | ** ** | **Amount** | ** ** | **Percentage  of Sales** | ** ** |
| Sales                                            |       | $                               | 257.1      |   | 100.0 | % | $ | 245.8 |   | 100.0 | % |
| Cost of sales  (a)                               |       | 179.2                           |       | 69.7 |   | 163.3 |   | 66.4 |   |
| Gross profit                                     |       | 77.8                            |       | 30.3 |   | 82.6 |   | 33.6 |   |
| Research and  development                        |       | 6.4                             |       | 2.5 |   | 5.2 |   | 2.1 |   |
| Selling and  marketing (a)                       |       | 15.0                            |       | 5.8 |   | 13.4 |   | 5.5 |   |
| General and  administrative (a)                  |       | 17.4                            |       | 6.8 |   | 15.4 |   | 6.3 |   |
| Amortization of  acquisition-related intangibles |       | 1.6                             |       | 0.6 |   | 6.9 |   | 2.8 |   |
| Net loss on  disposition of assets               |       | 0.4                             |       | 0.2 |   | 0.3 |   | 0.1 |   |
| Operating income                                 |       | 37.0                            |       | 14.4 |   | 41.4 |   | 16.8 |   |
| Interest  expense, net                           |       | 18.4                            |       | 7.2 |   | 14.5 |   | 5.9 |   |
| Income before  taxes                             |       | 18.6                            |       | 7.2 |   | 26.9 |   | 10.9 |   |
| Income tax  expense                              |       | 7.6                             |       | 3.0 |   | 10.7 |   | 4.4 |   |
| Net income                                       |       | $                               | 11.0       |   | 4.3 | % | $ | 16.1 |   | 6.6 | % |
| Other Data:                                      |       |                            |       |   |   |   |   |   |   |
| EBITDA (b)                                       |       | $                               | 43.8       |   | 17.0 | % | $ | 53.1 |   | 21.6 | % |

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(a)   The firstnine months of fiscal year 2006 include a special bonus expense (see “SpecialBonus” below) of $3.25 million, allocated as follows: $0.3 million for cost ofsales, $0.2 million for selling and marketing and $2.75 million for general andadministrative.

(b)   EBITDArepresents earnings before provision for income taxes, net interest expense anddepreciation and amortization. For the reasons listed below, we believe thatGAAP-based financial information for highly leveraged businesses such as oursshould be supplemented by EBITDA so that investors better understand ourfinancial performance in connection with their analysis of our business:

•                      EBITDA is a component of the measures used by our board ofdirectors and management team to evaluate our operating performance;

•                      the Senior Credit Facility contains covenants that require usto maintain certain interest expense coverage and leverage ratios that containEBITDA as a component, and our management team uses EBITDA to monitorcompliance with such covenants;

•                      EBITDA is a component of the measures used by our managementteam to make day-to-day operating decisions;

•                      EBITDA facilitates comparisons between our operating resultsand those of competitors with different capital structures and therefore is acomponent of the measures used by the management to facilitate internalcomparisons to competitors’ results and our industry in general; and

•                      the payment of management bonuses is contingent upon, amongother things, the satisfaction by us of certain targets that contain EBITDA asa component.

Other companies may define EBITDA differently and, as aresult, our measure of EBITDA may not be directly comparable to EBITDA of othercompanies. Although we use EBITDA as a financial measure to assess theperformance of our business, the use of EBITDA is limited because it does notinclude certain material costs, such as interest and taxes, necessary tooperate our business. When analyzing our performance, EBITDA should beconsidered in addition to, and not as a substitute for, net income, cash flowsfrom operating activities or other statements of operations or statements ofcash flows data prepared in accordance with GAAP.

For a reconciliation of EBITDA to Net Income, see Note8 of the Notes to Condensed Consolidated Financial Statements.

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**Sales:**   The following table comparestotal sales by market for the nine months ended June 30, 2006 to the nine monthsended July 1, 2005 (dollars in millions):
| ** **          | ** ** | **Nine Months Ended** | ** ** | ** **                 | ** ** | ** ** | ** ** |
|---------------------|------------|---------------------------------|------------|----------------------------|------------|------------|------------|
| ** **          | ** ** | **June 30, 2006**     | ** ** | **July 1, 2005** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **          | ** ** | ** **                      | ** ** | **Percentage**             | ** ** | ** ** | ** ** | **Percentage** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **          | ** ** | ** **                      | ** ** | **of Total**          | ** ** | ** ** | ** ** | **of Total** | ** ** | **Increase (Decrease)** | ** ** |
| ** **          | ** ** | **Amount**                      | ** ** | **Sales**                  | ** ** | **Amount** | ** ** | **Sales** | ** ** | **Amount** | ** ** | **Percentage** | ** ** |
| Radar               |       | $                               | 90.2       |                       | 35         | %          | $          | 83.9 |   | 34 | % | $ | 6.3 |   | 8 | % |
| Electronic  Warfare |       | 20.0                            |       | 8                          | %          | 21.3       |       | 9 | % | (1.3 | ) | (6) | % |
| Medical             |       | 42.8                            |       | 17                         | %          | 39.3       |       | 16 | % | 3.5 |   | 9 | % |
| Communications      |       | 83.6                            |       | 32                         | %          | 76.8       |       | 31 | % | 6.8 |   | 9 | % |
| Industrial          |       | 16.2                            |       | 6                          | %          | 18.0       |       | 7 | % | (1.8 | ) | (10) | % |
| Scientific          |       | 4.3                             |       | 2                          | %          | 6.5        |       | 3 | % | (2.2 | ) | (34) | % |
| Total sales         |       | $                               | 257.1      |                       | 100        | %          | $          | 245.8 |   | 100 | % | $ | 11.3 |   | 5 | % |

 

Sales for the first nine months of fiscal year 2006 of $257.1million were $11.3 million, or 5%, higher than the comparable period of fiscalyear 2005.  Explanations for the salesincrease or decrease by market for the first nine months of fiscal year 2006 ascompared to the first nine months of fiscal year 2005 are as follows:

·                  **Radar:**  The increase in sales to the radar market wasprimarily due to increased shipments of products for various U.S. governmentand foreign military programs, including products that are used on the TPQ-37Firefinder Artillery Radar program and the FPS-26 missile-tracking radarsystem.

·                  **Electronic Warfare:**  The decrease in salesto the electronic warfare market was primarily due to $1.6 million of sales fora prototype system in the first nine months of fiscal year 2005 for the ProjectSheriff Active Denial System, which did not repeat in the first nine months offiscal year 2006.

·                  **Medical:**  The increase in sales to the medical marketwas primarily due to an increase in shipments of our x-ray generators for U.S.and international customers.  Sales ofour medical imaging and radiation therapy products increased approximately 23%from $30.9 million in the first nine months of fiscal year 2005 to $38.1million in the first nine months of fiscal year 2006.  This increase was partially offset by a $3.6million reduction in shipments from our Eimac division.

·                  **Communications:**  The increase in salesto the communications market was primarily the result of an increase inshipments of VEDs for military satellite communications uplink, troposcattercommunications products, satellite communications products for foreigncustomers and commercial millimeter wave amplifiers for direct-to-homebroadcast applications.  Our millimeterwave amplifiers are a newer product line, and we are expecting initially lowerprofit margins on these newer products in comparison to our more establishedsatcom amplifiers for direct-to-home broadcast applications.  Offsetting the sales increase for the firstnine months of fiscal year 2006, was a $5.2 million reduction in shipments ofcommunications products due to the relocation of the Eimac facility.

·                  **Industrial:**     The decrease in sales to the industrialmarket was primarily due to a $3.3 million reduction in shipments by our Eimacdivision due to its relocation.

·                  **Scientific:**  The decrease in sales to the scientificmarket, our smallest market, was primarily due to the product deliveries onprograms for a European laboratory and the Spallation Neutron Source atOakridge National Laboratory in the first nine months of fiscal year 2005 thatdid not repeat in the first nine months of 2006.  Sales in the scientific market arehistorically one-time projects.

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**Gross Profit:** Gross profitof $77.8 million, or 30.3% of sales, for the first nine months of fiscal year2006 was $4.8 million lower than the prior year’s level of $82.6 million, or33.6% of sales. The decrease in gross profit for the first nine months offiscal year 2006 as compared to the first nine months of fiscal year 2005 wasprimarily due to: the relocation of our Eimac division, which negativelyimpacted gross margins by $5.3 million; start-up costs for, and a shift in themix to newer, lower margin satcom products, which negatively impacted fiscalyear 2006 gross margins as compared to fiscal year 2005 by $1.8 million; and$1.1 million due to the impact of the weaker U.S. dollar as compared to theCanadian dollar in fiscal year 2006 and the expiration of a favorable Canadiandollar hedge in March 2006. Offsetting the aforementioned unfavorable impact togross margin was approximately $3.8 million higher gross margin relatedprimarily to $11.3 million higher sales in the first nine months of fiscal year2006 as compared to the first nine months of fiscal year 2005.

After the relocation of our Eimac division iscomplete, we expect to realize operational savings from the consolidation ofproduction facilities in Palo Alto, California, which we believe will improveour gross profit percentage.

Our satcom operation has developed numerous newproducts over the past several years. A successful introduction of these newproducts has resulted in a gradual shift in our backlog to newer products. Aswe begin to ramp up production of these new products in fiscal year 2006, weare incurring start-up manufacturing costs which are contributing to lowermargins in fiscal year 2006 as compared to fiscal year 2005.

**Research and Development:**Research and development expensesof $6.4 million, or 2.5% of sales, for the first nine months of fiscal year2006 increased from $5.2 million, or 2.1% of sales, in the first nine months offiscal year 2005. The increase was due to increased spending as we invest forfuture growth in medical diagnostic imaging products and VED products for theradar, electronic warfare and satellite communication markets. Total spendingon research and development, including company-sponsored amounts charged toresearch and development and customer-sponsored amounts charged to cost ofsales, increased from $9.9 million, or 4.0% of sales, in the first nine monthsof fiscal year 2005 to $10.7 million, or 4.2% of sales, in the first ninemonths of fiscal year 2006.

**Selling and Marketing:**Selling and marketing expenses of$15.0 million, or 5.8% of sales, for the first nine months of fiscal year 2006increased from $13.4 million, or 5.5% of sales, for the first nine months offiscal year 2005. This planned increase in selling and marketing expenses in thefirst nine months of fiscal year 2006 was primarily due to additional sellingand marketing expenses to support the growth of our business, and $0.2 millionfor the special bonus, described below.

**General and Administrative:**General and administrative expenses of $17.4 million, or 6.8%of sales, for the first nine months of the fiscal year 2006 were $2.0 millionhigher than the $15.4 million, or 6.3% of sales, for the first nine months offiscal year 2005. The first nine months of fiscal year 2006 included $2.75million for the special bonus, described below, partially offset by $0.8million lower stock-based compensation and $0.7 million lower managementincentive expenses.  Moving expensesrelated to the Eimac relocation were $1.0 million and $0.6 million in fiscalyears 2006 and 2005, respectively.

**Special Bonus:**On December 15, 2005, our board of directors approved thepayment of $3.25 million in bonuses to our employees and directors (other thandirectors who are employees or affiliates of Cypress) to reward them for theincrease in company value. The special bonus was charged to the CondensedConsolidated Statement of Operations and Comprehensive Income in the same linesas cash compensation paid to those employees and directors, as follows: $0.3 millionto cost of sales, $0.2 million to selling and marketing and $2.75 million togeneral and administrative.

**Amortization of Acquisition-RelatedIntangibles:**Amortization ofacquisition-related intangibles of $1.6 million for the first nine months ofthe fiscal year 2006 was $5.3 million lower than the first nine months offiscal year 2005. Amortization of acquisition-related intangibles consists ofpurchase accounting charges, primarily for customer backlog, technology andother intangible assets. The first nine months of fiscal year 2005 included$5.3 million for the amortization of customer backlog, which was fullyamortized

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in January 2005. Acquisition-related intangible assetswill continue to be amortized over periods of up to 50 years.

**Interest Expense, net:**Interest expense, net of $18.4 million, or 7.2% of sales, forthe first nine months of fiscal year 2006 was $3.9 million higher than the$14.5 million, or 5.9% of sales, for the first nine months of fiscal year 2005.The increase in interest expense for the first nine months of fiscal year 2006was primarily due to additional interest expense for the $80 million aggregateprincipal amount of CPI International’s Floating Rate Senior Notes (“FR Notes”)issued in February 2005 and higher interest rates on our variable rate TermLoan.

**Income Tax Expense:**We recorded income tax expense of $7.6 million for the firstnine months of fiscal year 2006 and $10.7 million for the first nine months offiscal year 2005. The effective tax rates were approximately 41% and 40% forthe first nine months of fiscal years 2006 and 2005, respectively. Income taxexpense for the first nine months of fiscal year 2006 includes a $0.3 millioncharge attributable to the fourth quarter of fiscal year 2005, consisting of$0.5 million to correct the overstatement of tax benefits recorded in thefourth quarter of fiscal year 2005 for stock-based compensation expense that isnot deductible for income tax purposes in a foreign tax jurisdiction, offset byreversal of a $0.2 million tax contingency reserve that is no longer considerednecessary.  Income tax expense for thefirst nine months of fiscal year 2006 also includes a $0.2 million discrete taxbenefit for true-up adjustments to fiscal year 2005 tax expense related tochanges in estimates made as a result of filing the 2005 income tax returns.

**Net Income:**Netincome of $11.0 million for the first nine months of fiscal year 2006 was $5.1million lower than the first nine months of fiscal year 2005 primarily due tothe impact of the Eimac relocation; other contributing factors included higherinterest expense related to higher debt levels and higher interest rates on ourTerm Loan, the $3.25 million special bonus described above, higher plannedspending for research and development and selling and marketing expenses infiscal year 2006, the impact of the weaker U.S. dollar as compared to theCanadian dollar and the expiration of a favorable Canadian hedge contract inMarch 2006. The stronger Canadian dollar and the expiration of the favorableCanadian currency hedge caused an unfavorable after-tax impact on net income ofapproximately $0.9 million for the first nine months of fiscal year 2006 ascompared to the first nine months of fiscal year 2005. Net income for the firstnine months of fiscal year 2006 was favorably impacted by lower amortization ofacquisition-related intangibles and the lower income tax expense, compared tothe first nine months of fiscal year 2005.

**EBITDA:**EBITDAfor the first nine months of fiscal year 2006 was $43.8 million, a decrease of$9.3 million compared to $53.1 million for the first nine months of fiscal year2005. The decrease in EBITDA from the first nine months of fiscal year 2005compared to the first nine months of 2006 resulted primarily from the impact ofthe Eimac relocation; other contributing factors included the $3.25 millionspecial bonus described above, higher planned spending for research anddevelopment and selling and marketing expenses in fiscal year 2006, the impactof the weaker U.S. dollar as compared to the Canadian dollar and the expirationof the favorable Canadian currency hedge in March 2006. The total negativeimpact of the stronger Canadian dollar and the expiration of the favorableCanadian currency hedge, was approximately $1.5 million on the first ninemonths of fiscal year 2006 as compared to the first nine months of fiscal year2005, with $1.1 million reflected in gross profit, $0.2 million in research anddevelopment and selling and marketing expenses, and $0.2 million in general andadministrative.

**Liquidityand Capital Resources**

***Overview***

Our liquidity is affected by many factors, some of which arebased on normal ongoing operations of our business and others that are relatedto uncertainties in the markets in which we compete and other global economicfactors. We have historically financed, and intend to continue to finance, ourcapital and working capital requirements including debt service and internalgrowth, through a combination of cash flows from our operations and borrowingsunder CPI’s senior credit agreement (the “Senior Credit Facility”), whichconsists of a $40.0 million revolving commitment, with a sub-facility of $15.0million for letters of credit

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and $5.0 million for swingline loans (“Revolver”), anda $90.0 million term loan (the “Term Loan”). Our primary uses of cash are costof sales, operating expenses, debt service and capital expenditures.

As of June 30, 2006, we had no borrowings outstanding and borrowingavailability of $35.8 million under the Revolver and $42.5 million outstandingunder the Term Loan, after the $47.5 million aggregate Term Loan repayments inMay 2006 using proceeds from our initial public offering of CPI International’scommon stock (the “IPO”).  Upon certainspecified conditions, including compliance on a pro forma basis with thecovenants in the Senior Credit Facility, CPI may seek commitments for a newclass of term loans, not to exceed $65.0 million. We believe that cash and cashequivalents on hand and cash expected to be generated from operations will besufficient to meet our currently anticipated cash requirements for theremainder of this fiscal year. Thereafter, our ability to fund our cashrequirements and to comply with the financial covenants under our debtagreements will depend on our results of future operations, performance andcash flows and will be subject to uncertainties in the markets in which wecompete and other factors, many of which are beyond our control.

As of June 30, 2006, we had cash and equivalents of $12.6million compared to $26.5 million as of September 30, 2005. Cash balances inexcess of operating requirements are invested daily in overnight U.S.Government securities.

***Operating, Investing and FinancingActivities***

*Operating Activities:*Operatingactivities provided cash of approximately $1.9 million in the first nine monthsof 2006, which was attributable to net income of $11.0 million, depreciation,amortization and other non-cash charges of $7.7 million; partially offset by$16.8 million used by net operating assets and liabilities. The principal usesof net operating assets and liabilities in the first nine months of 2006 wereincreases in accounts receivable of $8.9 million, inventories of $3.6 millionand decreases in advance payments from customers of $6.8 million, partiallyoffset by a $4.2 million increase in income taxes payable.  Operating activities provided cash ofapproximately $13.8 million in the first nine months of 2005, which wasattributable to net income of $16.1 million, depreciation, amortization andother non-cash charges of $10.4 million; partially offset by $12.7 million usedby net operating assets and liabilities. The principal uses of net operating assets and liabilities in the firstnine months of 2005 were increases in accounts receivable of $11.2 million andinventories of $7.5 million and decreases in advance payments from customers of$4.0 million partially offset by increases in accrued expenses of $5.4 millionand income tax payable of $4.2 million.

*Investing Activities:*   Net cash used in investing activities was $8.6 millionfor the first nine months of 2006, consisting primarily of $8.4 million forcapital expenditures, including $4.4 million for capital equipment, buildingand land lease improvements in Palo Alto, California related to the relocationof our Eimac division and $1.2 million for a building expansion project at ourCanadian facility. Net cash used in investing activities was $27.4 million forthe first nine months of 2005, consisting primarily $18.3 million for thepurchase price of Econco, $8.9 million for capital expenditures, including $6.8million for capital equipment, building and land lease improvements related tothe Eimac relocation.

*Financing Activities:*   Net cash used in financing activities was $7.2 millionfor the first nine months of fiscal year 2006, consisting primarily of $37.5million in net repayments on the Term Loan and a $17.0 million special cashdividend to the holders of CPI International’s common stock in December 2005,partially offset by $47.3 million of net proceeds from our initial publicoffering of common stock (the “IPO”), after deduction of IPO expenses of $5.6million.  Net cash used in financingactivities was $9.7 million for the first nine months of fiscal year 2005,consisting primarily of a $75.8 million special cash dividend to holders of CPIInternational’s common stock, $9.6 million repayments on the Term Loan, and$3.4 million of debt issue costs incurred to issue the FR Notes, partiallyoffset by $79.2 million of proceeds from the issuance of FR Notes. The TermLoan repayments in the first nine months of fiscal year 2005 included $3.9million of required annual prepayment and an optional prepayment of $5.7million.

The Senior Credit Facility requires an annual prepayment tobe made within 90 days after the end of the fiscal year based on a calculationof excess cash flow (“ECF”), as defined in the Senior Credit Facility,

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multiplied by a factor of 25%, 50% or 75% depending onthe leverage ratio at the end of the fiscal year, less any optional prepaymentsmade during the fiscal year. There was no ECF payment due in the first ninemonths of fiscal year 2006.

***Amendment toSenior Credit Facility***

On December 15, 2005, CPI International and CPI entered intoAmendment No. 3 (the “Amendment”), to the Senior Credit Facility. The Amendmentincreased the commitments under the Term Loan by $10 million, and CPI borrowedan additional $10 million thereunder. In addition, among other things, theAmendment (1) permitted CPI to pay a dividend (not to exceed $20 million) toCPI International to fund a dividend by CPI International to its stockholders,(2) amended the definition of Excess Cash Flow in the Senior Credit Facility todecrease Excess Cash Flow for CPI’s fiscal year 2006 by the excess of theamount of the dividend described in clause (1) over the gross proceeds of the$10 million additional borrowing, and (3) permitted CPI or CPI International touse up to $70 million of the proceeds of the IPO to repurchase or redeem the FRNotes or CPI’s 8% Senior Subordinated Notes due 2012 (the “8% Notes”).

***San Carlos SaleAgreement***

In February 2003, we entered into an agreement to sell theland and close our facilities located in San Carlos, California. The purchaseprice is $23.8 million. Under the sale agreement, the buyer has paid us a $13.0million deposit on the purchase price, which was used to fund the capitalexpenditures and costs of moving our San Carlos operations to our Palo Altofacility and Mountain View facilities. The $13.0 million deposit isnonrefundable unless we breach the sale agreement.

The closing of the sale is subject to a number of conditions,including the requirement that we vacate our facilities and obtain regulatoryclosure of certain permitted equipment located on the property. Although therecan be no assurance that the sale of the San Carlos property will occur, weexpect to close the sale of the property in calendar year 2006.

Pursuant to the stock sale agreement by and between VarianAssociates, Inc., the predecessor of Varian Medical Systems, Inc. (“Varian”),and the Company dated June 9, 1995, as amended, the Company  agreed to certain development restrictionsaffecting the San Carlos property. In connection with the San Carlos propertysale agreement, Varian agreed to waive certain of the development restrictionson the San Carlos property in the event that the sale closes, subject tocertain conditions, and further agreed to pay the Company $1.0 million, ofwhich $0.5 million was paid in the fourth quarter of fiscal year 2004. Thepayments from Varian are being accounted for as part of the sale of theproperty, with the aggregate sales price, including the $23.8 million from thebuyer, totaling $24.8 million.

As of June 30, 2006, the San Carlos land and building wasclassified as held for use in property, plant and equipment, and the advancepayments from the sale of the property, aggregating $13.5 million, areclassified as a long-term liability in the accompanying Condensed ConsolidatedBalance Sheets. As of June 30, 2006, we had capitalized recoverable sellingcosts of $0.9 million relating to the sale of the San Carlos property andclassified these amounts as Other long-term assets in the CondensedConsolidated Balance Sheets. As of June 30, 2006, the San Carlos land andbuilding had a net book value of $23.4 million and the building continues to bedepreciated over its remaining useful life. Based on current projections, we donot expect to recognize a loss on the sale of the San Carlos property.

***Capital Expenditures***

Our continuing operations typically do not have largerecurring capital expenditure requirements. Capital expenditures are generallymade to replace existing assets, increase productivity, facilitate costreductions or meet regulatory requirements. We expect the relocation of the SanCarlos operations to be completed in the fourth quarter of fiscal year 2006.Total capital expenditures for fiscal year 2006 are expected to beapproximately $13 million, including approximately $5 million for the relocationof the San Carlos operations, $4 million for the expansion of the Canadianfacility to accommodate its expected growth and $4 million for ongoing capitalexpenditures. In fiscal year 2007, ongoing capital expenditures,

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excluding expenditures of approximately $3 million forcompletion of the Canadian facility expansion, are expected to be approximately$5 million.

**Recent Accounting Pronouncements**

In November 2004, the Financial Accounting Standards Board (“FASB”)issued Statement of Financial Accountings Standards (“SFAS”) No. 151, “InventoryCosts — an amendment of ARB No. 43, Chapter 4”, which is the result of the FASB’sproject to reduce differences between U.S. and international accountingstandards. SFAS No. 151 requires idle facility costs, abnormal freight,handling costs, and amounts of wasted materials (spoilage) to be treated ascurrent-period costs. Under this concept, if the costs associated with theactual level of spoilage or production defects are greater than the costsassociated with the range of normal spoilage or defects, then the differencewould be charged to current-period expense, and not included in inventorycosts. We adopted SFAS No. 151 in the beginning of fiscal year 2006 and itsadoption did not have a significant impact on our results of operations orfinancial condition.

In March 2005, the FASB issued Interpretation No. 47, “Accountingfor Conditional Asset Retirement Obligations,” which clarifies that an entityis required to recognize a liability for the fair value of a conditional assetretirement obligation if the fair value can be reasonably estimated even thoughuncertainty exists about the timing and (or) method of settlement. We arerequired to adopt Interpretation No. 47 by the end of fiscal year 2006. We donot expect the implementation of Interpretation No. 47 to have a significantimpact on our results of operations or financial condition.

In May 2005, the FASB issued SFAS No. 154, “AccountingChanges and Error Corrections.” SFAS No. 154 replaces APB Opinion No. 20, “AccountingChanges,” and SFAS No. 3, “Reporting Accounting Changes in Interim FinancialStatement,” and changes the requirements for the accounting for and reportingof a change in accounting principle. We are required to adopt SFAS No. 154 foraccounting changes and error corrections in fiscal year 2007. Our results ofoperations and financial condition will only be impacted by SFAS No. 154 if weimplement changes in accounting principle that are addressed by the standard orcorrect accounting errors in future periods.

In February 2006, the FASBissued SFAS No. 155, “Accounting for Certain Hybrid Financial Instruments.”SFAS No. 155 permits fair value remeasurement for any hybrid financialinstrument that contains an embedded derivative that otherwise would requirebifurcation. As of June 30, 2006, we did not have any hybrid financialinstruments subject to the fair value election under SFAS No. 155. We arerequired to adopt SFAS No. 155 at the beginning of fiscal year 2007.

In March 2006, the FASBissued SFAS No. 156, “Accounting for Servicing of Financial Assets—an amendmentto FASB Statement No. 140.” SFAS No. 156 amends FASB Statement No. 140 “Accountingfor Transfers and Servicing of Financial Assets,” with respect to theaccounting for separately recognized servicing assets and servicingliabilities. We are required to adopt SFAS No. 156 at the beginning of fiscalyear 2007 andas of June30, 2006, we did not have any servicing assets or servicing liabilities.

In June 2006, the FASB issued Interpretation No. 48, “Accounting forUncertainty in Income Taxes”, which supplements SFAS No. 109, “Accounting forIncome Taxes,” by defining the confidence level that a tax position must meetin order to be recognized in the financial statements. The Interpretationrequires that the tax effects of a position be recognized only if it is “more-likely-than-not”to be sustained based solely on its technical merits as of the reporting date.The more-likely-than-not threshold represents a positive assertion by managementthat a company is entitled to the economic benefits of a tax position. If a taxposition is not considered more-likely-than-not to be sustained based solely onits technical merits, no benefits of the position are to be recognized.

Moreover, the more-likely-than-not threshold must continue to be met ineach reporting period to support continued recognition of a benefit. Atadoption, companies must adjust their financial statements to reflect onlythose tax positions that are more-likely-than-not to be sustained as of theadoption date. Any necessary adjustment would be recorded directly to retainedearnings in the period of adoption and reported as a change in accountingprinciple. This Interpretation is effective as of the beginning of the firstfiscal year

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beginning after December 15, 2006. We are required toadopt Interpretation No. 48 at the beginning of fiscal year 2008 and managementis assessing the potential impact on our financial condition and results ofoperations.

**Critical Accounting Policies**

Our Condensed Consolidated Financial Statements are based onthe selection and application of significant accounting policies. Thepreparation of these financial statements and application of these policiesrequires management to make estimates and assumptions that affect the reportedamounts of assets and liabilities and the disclosure of contingent assets andliabilities at the date of the financial statements, as well as the reportedamounts of revenues and expenses during the reporting period. Actual resultscould differ from these estimates. However, we are not currently aware of anyreasonably likely events or circumstances that would result in materiallydifferent results from current estimates.

We believe the following critical accounting policies are themost significant to the presentation of our financial statements and requirethe most subjective and complex judgments. These matters, and the judgments anduncertainties affecting them, are also essential to understanding our reportedand future operating results. For a more comprehensive discussion of oursignificant accounting policies, see Note 2 to the Company’s Annual Report onForm 10-K for the year ended September 30, 2005.

***Revenue recognition:***   We generally recognize revenue upon shipment ofproduct, following receipt of written purchase orders, when the price is fixedor determinable, title has transferred, and collectibility is reasonablyassured. Approximately 1% of our sales during fiscal year 2005 were based onthe percentage of completion method of accounting, and we expect a similarportion in fiscal year 2006. Sales on percentage of completion contracts aredetermined on the basis of costs incurred and estimates of costs at completion,which require management estimates of future costs. Changes in estimated costsat completion over time could have a material impact on our operating results.

***Inventory reserves:***   We assess the valuation of inventory and periodicallywrite down the value for estimated excess and obsolete inventory based uponactual usage and estimates about future demand. The excess balance determinedby this analysis becomes the basis for our excess inventory charge. Managementpersonnel play a key role in our excess inventory review process by providingupdated sales forecasts, managing product rollovers and working withmanufacturing to maximize recovery of excess inventory. If our estimates regardingdemand are inaccurate or changes in technology affect demand for certainproducts in an unforeseen manner, we may incur losses or gains in excess of ourestablished markdown reserve that could be material.

Management also reviews the carrying value of inventory forlower of cost or market on an individual product or contract basis. A lossreserve is charged to cost of sales if the estimated product cost or thecontract cost at completion is in excess of net realizable value (selling priceless estimated cost of disposal). If the actual contract cost at completion isdifferent than originally estimated, then a loss or gain provision adjustmentwould be recorded that could have a material impact on our operating results.

***Product warranty:***   Our products are generally warranted for a variety ofperiods, typically one to three years or a predetermined product usage life. Aprovision for estimated future costs of repair, replacement or customeraccommodations is reflected in the accompanying consolidated financialstatements. We assess the adequacy of our preexisting warranty liabilities andadjust the balance based on actual experience and changes in futureexpectations. The determination of product warranty reserves requires us tomake estimates of product return rates and expected cost to repair or replacethe products under warranty. If actual repair and replacement costs differsignificantly from our estimates, then adjustments to recognize additional costof sales may be required.

***Business combination:****  *InJanuary 2004, as a result of the Merger, assets acquired and liabilitiesassumed by the successor company were adjusted to reflect fair value, and theexcess of the purchase price over the fair value was recorded as goodwill. Werecorded goodwill of $140 million as a result of the Merger. Accounting forbusiness combinations requires the allocation of purchase price to identifiable

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tangible and intangible assets and liabilities basedupon their fair value. The allocation of purchase price is a matter of judgmentand requires the use of estimates and fair value assumptions. The allocation ofpurchase price to finite-lived assets can have a significant impact onoperating results because finite-lived assets are depreciated or amortized overtheir remaining useful lives.

***Recoverability oflong-lived assets:***   Weassess the recoverability of the carrying value of goodwill and otherintangible assets with indefinite useful lives at least annually or wheneverevents or changes in circumstances indicate that the carrying amount of theasset may not be fully recoverable. Recoverability of goodwill is measured atthe reporting unit level (our six divisions) based on a two-step approach.First, the carrying amount of the reporting unit is compared to the fair valueas estimated by the future net discounted cash flows expected to be generatedby the reporting unit. To the extent that the carrying value of the reportingunit exceeds the fair value of the reporting unit, a second step is performed,wherein the reporting unit’s assets and liabilities are valued. The impliedfair value of goodwill is calculated as the fair value of the reporting unit inexcess of the fair value of all non-goodwill assets and liabilities allocatedto the reporting unit. To the extent the reporting unit’s carrying value ofgoodwill exceeds its implied fair value, impairment exists and must berecognized. This process requires the use of discounted cash flow models thatutilize estimates of future revenue and expenses as well as the selection ofappropriate discount rates. There is inherent uncertainty in these estimates,and changes in these factors over time could result in an impairment charge.

At June 30, 2006, the carrying amount of goodwill and otherintangible assets, net was approximately $222 million and no significantchanges in the underlying business assumptions or circumstances that drive theimpairment analysis led us to believe that goodwill might have beenimpaired.  We will continue to evaluatethe need for impairment if changes in circumstances or available informationindicate that impairment may have occurred, and at least annually in the fourthquarter.

At June 30, 2006, the carrying amount of property, plant andequipment was approximately $87 million. We assess the recoverability of property, plant and equipment to be heldand used by a comparison of the carrying amount of an asset or group of assetsto the future net undiscounted cash flows expected to be generated by the assetor group of assets.  If such assets areconsidered impaired, then the impairment recognized is measured as the amountby which the carrying amount of the assets exceeds the fair value of theassets.  This process requires the use ofcash flow models that utilize estimates of future revenue and expenses.  There is inherent uncertainty in theseestimates, and changes in these factors over time could result in an impairmentcharge.

A prolonged general economic downturn and, specifically, aprolonged downturn in the defense, communications or medical markets, ortechnological changes, as well as other market factors could intensifycompetitive pricing pressure, create an imbalance of industry supply anddemand, or otherwise diminish volumes or profits. Such events, combined withchanges in interest rates, could adversely affect our estimates of future netcash flows to be generated by our long-lived assets. Consequently, it ispossible that our future operating results could be materially and adverselyaffected by additional impairment charges related to the recoverability of ourlong-lived assets.

***Accounting for stock-based compensation:***    At the beginning of fiscal year 2006, we adopted SFASNo. 123(R) using the prospective application method and beganaccounting for its stock-based compensation using a fair-value basedrecognition method. Under the provisions of SFAS No. 123(R), stock-basedcompensation cost is estimated at the grant date based on the fair-value of theaward and is recognized as expense ratably over the requisite service period ofthe award. Determining the appropriate fair-value model and calculating thefair value of stock-based awards at the grant date requires considerablejudgment, including estimating stock price volatility, expected option life andforfeiture rates. We develop our estimates based on historical data and marketinformation which can change significantly over time. A small change in theestimates used can have a relatively large change in the estimated valuation.

We use the Black-Scholesoption valuation model to value employee stock awards. Since our common stockhas not been publicly traded for a sufficient time period, we estimate stockprice volatility based on 

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the expected volatilities of similar companies thathave a longer history of being publicly traded. The expected life of options granted is based on the simplified methodfor plain vanilla options in accordance with SEC Staff Accounting Bulletin 107.The estimated forfeiture rate assumptions are based on historical data. Forstock based compensation awards with graded vesting that were granted afterfiscal year 2005, we recognizes compensation expense using the straight-lineamortization method.

**Item 3. Quantitative and Qualitative Disclosures About Market Risk**

We do not enter into derivative financial instruments fortrading or speculative purposes.

***Interest Rate Risk:***   Our exposure to market risk for changes in interestrates relates primarily to our long-term debt and our investment in overnightgovernment securities.

We have variable rate debt that comprises a $90.0 millionterm loan due in 2010 under our Senior Credit Facility and $80.0 million in FRNotes. Our variable rate debt is subject to changes in the prime rate and theLIBOR rate. We entered into an interest rate swap contract (the “Swap”) with anotional amount of $80 million to effectively convert the FR Notes to a fixedrate of 9.9% through the Swap maturity date in January 2008. We also have$125.0 million of fixed rate 8% Notes. At June 30, 2006, the fair value of the unrealized gain on the Swap was$1.7 million.

***Foreign Currency ExchangeRate Risk*****:**   Although the majority of ourrevenue and expense activities are transacted in U.S. dollars, we do transactbusiness in foreign countries. Our primary foreign currency cash flows are inCanada and several European countries. We have limited market risk exposurefrom foreign currency financial instruments. As of June 30, 2006, we hadentered into Canadian dollar forward contracts for approximately $19.5 million(Canadian dollars), or 50% of estimated Canadian dollar denominated expensesover the next nine months, at an average rate of approximately $0.90 U.S.dollar to Canadian dollar. We estimate the impact of a one cent change in theU.S. dollar to Canadian dollar exchange rate to be approximately $0.5 millionannually to operating income.

In an effort to reduce our foreign currency exposure toCanadian dollar denominated expenses, we enter into Canadian dollar forwardcontracts to hedge the Canadian dollar denominated costs for our manufacturingoperation in Canada. Net income includes recognized gains from foreign currencyforward contracts of $0.3 million for the third quarter in both fiscal year2006 and 2005. Net income includes recognized gains from foreign currencyforward contracts of $1.2 million and $1.0 million for the first nine months offiscal years 2006 and 2005, respectively.

**Item 4.  Controlsand Procedures**

Management, including our principal executive officer andprincipal financial officer, has evaluated, as of the end of the period coveredby this report, the effectiveness of the design and operation of our disclosurecontrols and procedures with respect to the information generated for use inthis report. Based upon, and as of the date of that evaluation, the principalexecutive officer and principal financial officer concluded that the disclosurecontrols and procedures were effective to provide reasonable assurances thatinformation required to be disclosed in the reports filed or submitted underthe Securities Exchange Act of 1934, as amended, is recorded, processed,summarized and reported within the time periods specified in the Securities andExchange Commission’s rules and forms.

There have been no changes in our internal control overfinancial reporting that occurred during the most recent fiscal quarter thathave materially affected, or are reasonably likely to materially affect, ourinternal control over financial reporting.

 

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**Part II: OTHERINFORMATION**

**Item 1.**                          LegalProceedings

None.

**Item 1A.**                 Risk Factors

TheCompany’s Annual Report on Form 10-K for the fiscal year ended September 30,2005 includes a detailed discussion of our risk factors. The informationpresented below updates and should be read in conjunction with the risk factorsand information disclosed in that Form 10-K. We have not made any material changes in the risk factors previouslydisclosed in our quarterly report on Form 10-Q for the quarter ended March 31,2006.

** **

**Our anti-takeover provisions could prevent or delay a change in controlof our company, even if such change of control would be beneficial to ourstockholders.**

 

Provisions of our amended and restated certificate of incorporation andamended and restated bylaws as well as provisions of Delaware law coulddiscourage, delay or prevent a merger, acquisition or other change in controlof our company. These provisions include:

 

·                  aboard of directors that is classified such that only one-third of directors areelected each year;

·                  authorizingthe issuance of “blank check” preferred stock that could be issued by our boardof directors to increase the number of outstanding shares and thwart a takeoverattempt;

·                  limitationson the ability of stockholders to call special meetings of stockholders;

·                  prohibitingstockholder action by written consent and requiring all stockholder actions tobe taken at a meeting of our stockholders;

·                  establishingadvance notice requirements for nominations for election to the board ofdirectors or for proposing matters that can be acted upon by stockholders atstockholder meetings; and

·                  requiringthat the affirmative vote of the holders of at least two thirds (66 2/3%) ofthe voting power of our issued and outstanding capital stock entitled to votein the election of directors be obtained to amend certain provisions of ouramended and restated certificate of incorporation.

 

In addition, Section 203 of the Delaware General Corporation Law, whichwill apply to us after Cypress ceases to own at least 15% of the total votingpower of our common stock, limits business combination transactions with 15%stockholders that have not been approved by the board of directors. Theseprovisions and other similar provisions make it more difficult for a thirdparty to acquire us without negotiation. These provisions may apply even if thetransaction may be considered beneficial by some stockholders.

** **

**The controlling position of Cypress will limit your ability toinfluence corporate matters.**

 

As of August 7, 2006, entities affiliatedwith The Cypress Group collectively own over 55% of our outstanding shares ofcommon stock. Accordingly, the entities affiliated with Cypress havesignificant influence over our management and affairs and over most matters requiringstockholder approval, including the election of directors and the approval ofsignificant corporate transactions. The entities affiliated with Cypress willalso be able to deter any attempted change of control. This concentratedcontrol will limit your ability to influence corporate matters and, as aresult, we may take actions that some of our stockholders do not view asbeneficial. Accordingly, the market price of our common stock could beadversely affected.

 

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**Item 2.**                          UnregisteredSales of Equity Securities and Use of Proceeds

On May 3, 2006, the Company issued a total of 9,999 shares of theCompany’s Common Stock, par value $0.01 per share, to certain of its directors,as set forth below.  Such shares ofCommon Stock were issued to such persons in connection with and inconsideration for their service as directors of the Company in a transactionthat did not involve any public offering and was exempt from the registrationrequirements of the Securities Act of 1933, as amended, pursuant to Section4(2) of the Securities Act of 1933.

| Name of Director | ** ** | ** ** | ** ** | **Number of Shares Issued** | ** ** |
|----------------------------|------------|------------|------------|--------------------------------------------|------------|
|                       |       |       |       |
| Michael F.  Finley         |       | 3,333      |       |
|                       |       |       |       |
| Jeffrey P.  Hughes         |       | 1,111      |       |
|                       |       |       |       |
| Michael Targoff            |       | 2,222      |       |
|                       |       |       |       |
| Chris Toffales             |       | 1,111      |       |
|                       |       |       |       |
| William P. Rutledge        |       | 2,222      |       |

 

The Company’s Registration Statement on Form S-1 (Commission File No333-130662) relating to the sale of up to 8,117,701 shares of the Company’sCommon Stock, par value $0.01 per share, by the Company and certain sellingstockholders in the initial public offering of the Company’s Common Stock wasdeclared effective by the Securities and Exchange Commission on April 27,2006.  The aggregate price of theoffering amount registered was $146,118,618 based on an $18.00 per share price.

 

The offering of the Company’s Common Stock commenced on April 27, 2006and the offering of 7,058,870 shares was completed on May 3, 2006.  The initial offering price was $18.00 pershare and the price received by the Company and selling stockholders was $16.74per share, after deducting commissions (but not other expenses).  UBS Investment Bank, Bear, Stearns & CoInc., Wachovia Securities and Banc of America Securities LLC served asunderwriters of the offering. Of the total shares sold on May 3, 2006: (i)4,117,670 shares were sold on behalf of the selling stockholders, for anaggregate offering price of $74,118,060 (before deducting underwritingdiscounts and commissions); and (ii) 2,941,200 shares were sold on theCompany’s behalf, for an aggregate offering price of $52,941,600 (beforededucting underwriting discounts and commissions).

 

Costs incurred by the Company in connection with the issuance anddistribution of securities registered were as follows:

 

·                  Underwriting discounts andcommissions—approximately $3.7 million

·                  Other expenses—approximately $1.9 million

·                  Total expenses— approximately $5.6 million

 

None of theexpenses, discounts or commissions described above were paid (directly orindirectly) to directors or officers of the Company or their associates or topersons owning 10% or more of any class of equity securities of the Company orto any of the Company’s affiliates.  Thenet offering proceeds to the Company after deducting the total expensesdescribed above were approximately $47.3 million.

 

TheCompany used all of the net proceeds from the initial public offering to repayamounts outstanding under the term loan under the Company’s senior creditfacility. None of the net proceeds received by the Company were paid (directlyor indirectly) to directors or officers of the Company or their associates orto persons owning 10% or more of any class of equity securities of the Companyor to any of the Company’s affiliates.

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**Item 3.**                          DefaultsUpon Senior Securities

None.

**Item 4.**                          Submissionof Matters to a Vote of Security Holders

Prior to the completion of the Company’s initial public offering, theCompany submitted to its stockholders for approval by written consent (1) theAmended and Restated Certificate of Incorporation of the Company, (2) theAmended and Restated Bylaws of the Company, (3) the Company’s 2006 Equity andPerformance Incentive Plan and (4) the Company’s 2006 Employee Stock PurchasePlan.  The Company received writtenconsents approving the foregoing matters from the holders of 4,275,566 shares ofcommon stock of the Company (representing all of the outstanding shares ofcommon stock as of the date of submission of such matters to the stockholdersfor approval prior to giving effect to the 3.059 to 1 common stock split onApril 7, 2006), and such matters were approved on April 6, 2006.

**Item 5.**                          OtherInformation

None.

**Item 6.**                          Exhibits
| **No.** |   | **Description**                                                                                                                                              |
|---------|--------|--------------------------------------------------------------------------------------------------------------------------------------------------------------|
|    |   |                                                                                                                                                         |
| 31.1    |   | Certification of Chief Executive Officer pursuant to  Rule 13a-15(e) and Rule 15d-15(e), promulgated under the Securities Exchange  Act of 1934, as amended. |
|    |   |                                                                                                                                                         |
| 31.2    |   | Certification of Chief Financial Officer pursuant to  Rule 13a-15(e) and Rule 15d-15(e), promulgated under the Securities Exchange  Act of 1934, as amended. |
|    |   |                                                                                                                                                         |
| 32.1    |   | Certifications of Chief Executive Officer, pursuant  to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the  Sarbanes-Oxley Act of 2002.       |
|    |   |                                                                                                                                                         |
| 32.2    |   | Certifications of Chief Financial Officer, pursuant  to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the  Sarbanes-Oxley Act of 2002.       |

** **

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** **

**SIGNATURES**

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

 
|                              |   | CPI INTERNATIONAL, INC.                                           |
|------------------------------|--------|-------------------------------------------------------------------|
|                         |   |                                                              |
|                         |   |                                                              |
|                         |   |                                                              |
| Dated: August 14, 2006  |   | /s/ O. Joe Caldarelli                                        |   |
|                         |   | O. Joe Caldarelli  Chief Executive Officer                        |
|                         |   |                                                              |
|                         |   |                                                              |
| Dated: August  14, 2006 |   | /s/ Joel A. Littman                                          |   |
|                         |   | Joel A. Littman  Chief Financial Officer, Treasurer and Secretary |
|                         |   | (Principal Financial and Accounting Officer)                      |

** **

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