| **Securities              and Exchange Commission        Washington, D.C. 20549**

**Form              10-Q**

(Mark            One)

[X]            Quarterly Report Pursuant to Section 13 or 15(d) of the Securities            Exchange Act of 1934

**For              the Period Ended August 1, 2008**

or

[   ]            Transition Report Pursuant to Section 13 or 15(d) of the Securities            Exchange Act of 1934 for the Transition Period from ____________________to            ____________________.

Commission            file number 0-21236 |
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|

| **Applied            Signal Technology, Inc.**        (Exact name of registrant as specified in its charter)   |
|----------------------------------------------------------------------------------------------------------------|
| **California**        (State or other jurisdiction of        incorporation or organization)                    | **77-0015491**        (I.R.S. Employer        Identification No.) |
| **400            West California Avenue, Sunnyvale, CA 94086**        (Address of principal executive offices) |
| **(408)            749-1888**(Registrant’s        telephone number, including area code)                 |

| Indicate          by checkmark whether the registrant (1) has filed all reports required          to be filed by Section 13 or 15(d) of the Securities Exchange Act of          1934 during the preceding twelve months (or for such shorter periods          that the registrant was required to file such reports), and (2) has          been subject to such filing requirements for the past 90 days. |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|                                                                                                                                                                                                                                                                                                                                                                                                      | ü**Yes** | **No** |

| Indicate          by check mark whether the registrant is a large accelerated filer,          an accelerated filer, or a non-accelerated filer. See definition of “accelerated          filer and large accelerated filer” in Rule 12b-2 of the Exchange          Act (check one): |
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| **Large accelerated        filer**                                                                                                                                                                                                                                                             | ü**Accelerated            filer** | **Non-accelerated            filer** | **Smaller            reporting company** |

| Indicate          by check mark whether the registrant is a shell company (as defined          by Rule 12b-2 of the Act). |
|---------------------------------------------------------------------------------------------------------------------------|
|                                                                                                                      | **Yes** | ü**No** |

| The          number of shares of the Registrant’s common stock outstanding          as of August 1, 2008, was 12,755,815. |
|---------------------------------------------------------------------------------------------------------------------------------|

 

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**Index**Applied Signal Technology, Inc.**

| **Part    I. Financial Information** |
|--------------------------------------|
|                                 | Item    1: Condensed Consolidated Financial Statements |
|                                 |   | Condensed          Consolidated Statements of Operations (unaudited) – Three and    nine months ended August 1, 2008, and August 3, 2007 |
|                                 |   | Condensed          Consolidated Balance Sheets – August 1, 2008, (unaudited) and    October 31, 2007 |
|                                 |   | Condensed          Consolidated Statements of Cash Flows (unaudited) – Nine months    ended August 1, 2008, and August 3, 2007 |
|                                 |   | Notes          to Condensed Consolidated Financial Statements (unaudited) – August    1, 2008 |
|                                 | Item        2: Management’s Discussion and Analysis of Financial Condition    and Results of Operations |
|                                 | Item    3: Quantitative and Qualitative Disclosures about Market Risk |
|                                 | Item    4: Controls and Procedures |
| **Part    II. Other Information**    |
|                                 |   | Item 1: Legal Proceedings |
|                                 |   | Item 1A: Risk Factors |
|                                 |   | Item 2: Unregistered    Sales of Equity Securities and Use of Proceeds |
|                                 |   | Item 3: Defaults    Upon Senior Securities |
|                                 |   | Item 4: Submission    of Matters to a Vote of Security Holders |
|                                 |   | Item 5: Other Information |
|                                 |   | Item 6: Exhibits |
| **Signatures**                       |
| **Index    to Exhibits**             |

  

----

**Part I. Financial Information**

**Item 1: Condensed ConsolidatedFinancial Statements**

**Applied Signal Technology, Inc.  Statements of Operations (unaudited)**  (in thousands, except per-share data) 

|                                                                                      | **——— Three      Months Ended———**                                                                         | **——— Nine      Months Ended———**                                                                       |
|--------------------------------------------------------------------------------------|------------------------------------------------------------------------------------------------------------------------------------------------|---------------------------------------------------------------------------------------------------------------------------------------------|
|                                                                                      | **August 1, 2008**                                                                                                                             | **August 3, 2007**                                                                                                                          | **August 1, 2008** | **August 3, 2007** |
| Revenues from contracts                                                              | $49,948                                                                                      | $39,542                                                                                   | $137,957           | $124,140           |
| Operating expenses:                                                                  |                                                                                                                                           |                                                                                                                                        |   |   |
|      Contract costs                                         | 34,572                                                                                       | 27,062                                                                                    | 95,435           | 84,505           |
|      Research and development                               | 3,953                                                                                        | 3,756                                                                                     | 10,486           | 10,751           |
|      General and administrative                             | 8,205               ------------           | 7,101           ------------            | 23,603           ------------           | 21,645           ------------           |
|           Total operating expenses | 46,730           ------------              | 37,919           ------------           | 129,524           ------------           | 116,901           ------------           |
|                                                                                 |                                                                                                                                           |                                                                                                                                        |   |   |
| Operating income                                                                     | 3,218                                                                                        | 1,623                                                                                     | 8,433           | 7,239           |
| Interest income, net                                                                 | 158           ------------                 | 189           ------------              | 538           ------------           | 454           ------------           |
| Income before provision for income taxes                                             | 3,376                                                                                        | 1,812                                                                                     | 8,971           | 7,693           |
| Provision for income taxes                                                           | 1,411           ------------               | 835           ------------              | 3,503           ------------           | 3,273           ------------           |
|                                                                                 |                                                                                                                                           |                                                                                                                                        |   |   |
| Net income                                                                           | $1,965               =======               | $977           =======                  | $5,468           =======           | $4,420           =======           |
|                                                                                 |                                                                                                                                           |                                                                                                                                        |   |   |
| Net income per common share:                                                         |                                                                                                                                           |                                                                                                                                        |   |   |
|      Basic                                                  | $0.16                                                                                        | $0.08                                                                                     | $0.44           | $0.37           |
|      Diluted                                                | $0.15                                                                                        | $0.08                                                                                     | $0.43           | $0.36           |
|                                                                                 |                                                                                                                                           |                                                                                                                                        |   |   |
| Number of shares used in calculating net        income per common share:             |                                                                                                                                           |                                                                                                                                        |   |   |
|      Basic                                                  | 12,538                                                                                       | 12,171                                                                                    | 12,427           | 12,062           |
|      Diluted                                                | 12,741                                                                                       | 12,381                                                                                    | 12,616           | 12,283           |

See “Notes to CondensedConsolidated Financial Statements.”

----

**Applied Signal Technology, Inc.Balance Sheets**(in thousands, except share data)

| **Assets**                                                                                                                                                                               | **August 1, 2008        (unaudited)**                                                                                                                                | **October    31, 2007†**                                                                                                                                      |
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| Current assets:                                                                                                                                                                          |                                                                                                                                                                 |                                                                                                                                                                 |
|      Cash and cash equivalents                                                                                                                                  | $6,601                                                                                                   | $5,250                                                                                                   |
|      Short term investments                                                                                                                                     | 34,493             ------------              | 29,683             ------------              |
|           Total          cash, cash equivalents, and          short-term investments | 41,094                                                                                                   | 34,933                                                                                                   |
|      Accounts receivable:                                                                                                                                       |                                                                                                                                                                 |                                                                                                                                                                 |
|           Billed                                                                                                                       | 19,026                                                                                                   | 25,097                                                                                                   |
|           Unbilled                                                                                                                     | 23,261             ------------              | 19,379             ------------              |
|           Total accounts receivable                                                                                                    | 42,287                                                                                                   | 44,476                                                                                                   |
| Inventory                                                                                                                                                                                | 8,251                                                                                                    | 5,944                                                                                                    |
| Refundable income taxes                                                                                                                                                                  | —                                                                                                  | 647                                                                                                      |
| Prepaid and other current assets                                                                                                                                                         | 8,267             ------------               | 9,760             ------------               |
|      Total current assets                                                                                                                                       | 99,899                                                                                                   | 95,760                                                                                                   |
| Property and equipment, at cost:                                                                                                                                                         |                                                                                                                                                                 |                                                                                                                                                                 |
|      Machinery and equipment                                                                                                                                    | 42,651                                                                                                   | 41,075                                                                                                   |
|      Furniture and fixtures                                                                                                                                     | 4,751                                                                                                    | 4,676                                                                                                    |
|      Leasehold improvements                                                                                                                                     | 17,392                                                                                                   | 14,584                                                                                                   |
|      Construction in process                                                                                                                                    | 186             ------------                 | 2,230             ------------               |
|                                                                                                                                                                                     | 64,980                                                                                                   | 62,565                                                                                                   |
| Accumulated depreciation and amortization                                                                                                                                                | (49,247)            ------------             | (46,096)            ------------             |
|      Property and equipment, net                                                                                                                                | 15,733                                                                                                   | 16,469                                                                                                   |
| Long-term investments                                                                                                                                                                    | 11,729                                                                                                   | 4,114                                                                                                    |
| Goodwill                                                                                                                                                                                 | 19,964                                                                                                   | 19,964                                                                                                   |
| Intangible assets, net of accumulated        amortization                                                                                                                                | 180                                                                                                      | 616                                                                                                      |
| Long-term deferred tax asset                                                                                                                                                             | 5,788                                                                                                    | 5,021                                                                                                    |
| Other assets                                                                                                                                                                             | 828             ------------                 | 789             ------------                 |
| Total assets                                                                                                                                                                             | $154,121                 =======             | $142,733             =======                 |

 

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**Applied Signal Technology, Inc.Balance Sheets (continued)**(in thousands, except share data)

| **Liabilities    and Shareholders’ Equity**                                                                                                                                                                                                                                                                                                                            | **August 1, 2008        (unaudited)**                                                                                                                                | **October    31, 2007†**                                                                                                                                      |
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| Current liabilities:                                                                                                                                                                                                                                                                                                                                                         |                                                                                                                                                                 |                                                                                                                                                                 |
|      Accounts payable                                                                                                                                                                                                                                                                                                                               | $5,018                                                                                                   | $3,848                                                                                                   |
|      Accrued payroll and related benefits                                                                                                                                                                                                                                                                                                           | 14,653                                                                                                   | 13,135                                                                                                   |
|      Note payable                                                                                                                                                                                                                                                                                                                                   | 1,429                                                                                                    | 1,429                                                                                                    |
|      Income taxes payable                                                                                                                                                                                                                                                                                                                           | —                                                                                                  | 14                                                                                                       |
|      Other accrued liabilities                                                                                                                                                                                                                                                                                                                      | 2,298             ------------               | 1,997             ------------               |
|           Total current liabilities                                                                                                                                                                                                                                                                                        | 23,398                                                                                                   | 20,423                                                                                                   |
| Long-term note payable                                                                                                                                                                                                                                                                                                                                                       | 4,167                                                                                                    | 5,357                                                                                                    |
| Accrued rent                                                                                                                                                                                                                                                                                                                                                                 | 2,475                                                                                                    | 1,658                                                                                                    |
| Other long-term liabilities                                                                                                                                                                                                                                                                                                                                                  | 1,345                                                                                                    | 459                                                                                                      |
| Shareholders’ equity:                                                                                                                                                                                                                                                                                                                                                  | ** **                                                                                                                                                           |                                                                                                                                                                 |
|      Common          stock and additional paid-in capital,     no par value: 20,000,000 shares        authorized;           issued and outstanding shares:           12,755,815 at August 1, 2008, and           12,388,422 at October 31, 2007 | 69,044                                                                                                   | 61,849                                                                                                   |
|      Retained earnings                                                                                                                                                                                                                                                                                                                              | 53,680                                                                                                   | 52,953                                                                                                   |
|      Accumulated other comprehensive income                                                                                                                                                                                                                                                                                                         | 12             ------------                  | 34             ------------                  |
| Total    shareholders’ equity                                                                                                                                                                                                                                                                                                                                          | 122,736             ------------             | 114,836             ------------             |
|      Total    liabilities and shareholders’ equity                                                                                                                                                                                                                                                                                            | $154,121             =======                 | $142,733             =======                 |

† The balance    sheet at October 31, 2007, has been derived from the audited financial statements    at that date but does not include all of the information required by accounting    principles generally accepted in the United States for complete financialstatements.

See “Notes to CondensedConsolidated Financial Statements.”

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**Applied Signal Technology, Inc.Statements of Cash Flows (unaudited)**(in thousands) 

|                                                                                                                                                           | **——— Nine      Months Ended**———                                                                        |
|----------------------------------------------------------------------------------------------------------------------------------------------------------------|----------------------------------------------------------------------------------------------------------------------------------------------|
|                                                                                                                                                           | **August 1, 2008**                                                                                                                           | **August 3, 2007** |
| **Operating Activities**                                                                                                                                       |                                                                                                                                         |   |
|      Net income                                                                                                                       | $5,468                                                                                     | $4,420           |
|      Adjustments to reconcile net income to        net cash provided by      (used in) operating activities: |                                                                                                                                         |   |
|           Depreciation and amortization                                                                      | 4,635                                                                                      | 4,214           |
|           Stock-based compensation                                                                           | 4,037                                                                                      | 3,255           |
|           Excess tax benefits from stock-based        payment arrangements                                   | (24)                                                                                            | (54)          |
|      Changes in:                                                                                                                      | ** **                                                                                                                                   |   |
|           Accounts receivable                                                                                | 2,189                                                                                      | 1,404           |
|           Refundable income taxes                                                                            | 752                                                                                        | —           |
|           Inventory, prepaid expenses, and other        assets                                               | (1,741)                                                                                         | (3,537)          |
|           Accrued lease incentives                                                                           | 877                                                                                        | —           |
|           Accounts payable, taxes payable, and        accrued liabilities                                    | 3,502           ------------             | (3,326)          ------------           |
|           Net cash provided by operating activities                                                          | 19,695                                                                                     | 6,376           |
| **Investing Activities**                                                                                                                                       | ** **                                                                                                                                   |   |
|      Purchases of available-for-sale securities                                                                                       | (80,236)                                                                                        | (56,902)          |
|      Maturities of available-for-sale securities                                                                                      | 67,565                                                                                     | 55,790           |
|      Additions to property and equipment                                                                                              | (3,030)          ------------            | (1,524)          ------------           |
|           Net cash used in investing activities                                                              | (15,701)                                                                                        | (2,636)          |
| **Financing Activities**                                                                                                                                       | ** **                                                                                                                                   |   |
|      Issuances of common stock                                                                                                        | 3,497                                                                                      | 4,257           |
|      Shares          repurchased for tax withholding of vested     restricted stock awards                   | (279)                                                                                           | (59)          |
|      Excess tax benefits from stock-based        payment arrangements                                                                 | 24                                                                                         | 54           |
|      Term loan                                                                                                                        | (1,190)                                                                                         | (1,191)          |
|      Dividends paid                                                                                                                   | (4,695)          ------------            | (4,529)          ------------           |
|      Net cash used in financing activities                                                                                            | (2,643)                                                                                         | (1,468)          |
|      Net increase in cash and cash equivalents                                                                                        | 1,351                                                                                      | 2,272           |
|      Cash and cash equivalents, beginning        of period                                                                            | 5,250           ------------             | 4,194           ------------           |
|      Cash and cash equivalents, end of period                                                                                         | $6,601                 =======           | $6,466           =======           |
| Supplemental disclosures of cash flow        information:                                                                                                      | ** **                                                                                                                                   | ** ** |
|      Interest paid                                                                                                                    | $295                                                                                       | $428           |
|      Income taxes paid                                                                                                                | $5,700                                                                                     | $3,007           |

See “Notes to CondensedConsolidated Financial Statements.”

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**Applied Signal Technology, Inc.Notes to Condensed Consolidated Financial Statements (unaudited)August 1, 2008**

**Note 1: Summary of Significant Accounting Policies**

**Description of Business and Basis of Presentation**

 Applied Signal Technology,    Inc. (AST) provides advanced intelligence, surveillance, and reconnaissance    (ISR) products, systems, and services to enhance global security. We provide    domain knowledge in the areas of signals intelligence (SIGINT), including    communications intelligence (COMINT) and electronic intelligence (ELINT),    and measurements and signatures intelligence (MASINT) through the use of    sonar, radar, magnetic, and chemical sensors to detect changes in the environment.    We specialize in the collection, processing, and understanding of signals    for ISR missions with low size, weight, and power configurations to enable    increased deployment on unmanned platforms. We develop and manufacture sophisticated    receivers and digital signal processing equipment that use advanced software.    Our primary customers are the United States Government and industry prime  contractors for the United States Government.

The accompanying unaudited,    condensed consolidated financial statements have been prepared in accordance    with accounting principles generally accepted in the United States for interim    financial information and with the instructions to Form 10-Q and Article    10 of Regulation S-X. Accordingly, they do not include all of the information    and footnotes required by accounting principles generally accepted in the    United States for complete financial statements, and should be read in conjunction    with the financial statements and footnotes thereto included in our Annual    Report on Form 10-K for the year ended October 31, 2007. In the opinion of    management, all adjustments (consisting of normal recurring adjustments)    considered necessary for a fair presentation have been included. Operating    results for the three-month and nine-month periods ended August 1, 2008,    are not necessarily indicative of the results that may be expected for the    year ending October 31, 2008. The balance sheet at October 31, 2007,  has been derived from the audited financial statements at that date but does  not include all of the information required by accounting principles generally  accepted in the United States for complete financial statements.

**Estimates**

The preparation of consolidated financial statements in conformity with generally  accepted accounting principles requires management to make estimates and assumptions  that affect the amounts reported in the consolidated financial statements and  accompanying notes. Actual results could differ significantly from those estimates.

**Principles of Consolidation**

The financial statements include the accounts of AST and its wholly owned  subsidiary, Dynamics Technology, Inc. (DTI). All significant intercompany transactions  have been eliminated.

**Revenues and Contract Accounting**

***Revenues and cost recognition***. The majority of our  contracts are accounted for in accordance with the American Institute of Certified  Public Accountants (AICPA) Statement of Opinion 81-1, *Accounting for Performance  of Construction-Type and Production-Type Contracts.*These contracts are  executed by using written contractual arrangements, most of which require us  to design, develop, manufacture, and/or modify our complex products and perform  related services according to specifications provided by the customer. A limited  number of standalone software contracts are recognized in accordance with the  AICPA Statement of Opinion 97-2, *Software Revenue Recognition*(SOP  97-2). In accordance with SOP 97-2, we may, at times, record an amount of deferred  revenue associated with contracts that are billed and for which customers have  paid in advance of performance requirements set forth in these contracts.

As a supplier to the United States Government, we are required to comply with  numerous regulations, including those governing security and contracting practices.  Failure to comply with these procurement regulations and practices could result  in fines being imposed against us or our suspension for a period of time from  eligibility for bidding on, or for award of, new government contracts. Among  the causes for the suspension are violations of various statutes, including  those related to procurement integrity, export control, United States Government  security regulations, employment practices, protection of the environment,  accuracy of records in the recording of costs, and foreign corruption. The  government may investigate and make inquiries of our business practices and  conduct audits of contract performance and cost accounting. The government  audits and investigations can take several years to complete. Depending on  the results of these audits and investigations, the government may make claims  against us or take exception to certain costs we determined to be recoverable.  In the period management determines recoverability is not likely, operating  income would be reduced.

We account for cost-reimbursement contracts by charging actual labor, materials,  and other direct costs, plus estimated indirect costs of operations as incurred  (incurred costs), including overhead, research and development, and general  and administrative expenses. We do not apply indirect costs to subcontract  costs that are in excess of $250,000 and meet certain other predetermined criteria.

We recognize contract    revenues and profits on cost-reimbursement contracts by applying an estimated    fee rate to all incurred costs on an individual contract basis. Fee calculations    are based on either negotiated fee amounts or management’s  assessment of the fee amounts that are likely to be earned. On cost-reimbursement  contracts, we may bear unexpected cost increases for purposes of maintaining  customer relationships. Historically, the effect on operating results and financial  condition from cost-reimbursement losses has been minimal.

Our policy for recognizing    interim award fees on our cost-plus-award-fee contracts is based on management’s assessment as to the likelihood that the award  fee or an incremental portion thereof will be earned, on a contract-by-contract  basis. Management bases its assessments on numerous factors including contract  terms, nature of the work to be performed, our relationship and history with  the customer, our history with similar types of projects, and our current and  anticipated performance on the specific contract. No award fee is recognized  in whole or in part until management determines that it is probable that the  award fee or portion thereof will be earned. Historically, management’s  estimates have generally been consistent with the actual fees awarded. However,  changes in facts and circumstances could arise within an award fee period,  causing management to either lower or raise the award fee estimate in the period  in which the changes occur.

Some of our contracts are performed under time-and-materials contracts on  a level-of-effort basis. We recognize revenue for these contracts by applying  a negotiated billing rate to the level of effort.

We account for fixed-price contracts by using the percentage-of-completion  method. Under this method, we charge labor, materials, and other direct costs,  plus estimated indirect costs of operations, as they are incurred. Each period,  we recognize as revenue a portion of the contract revenue, based on estimated  profits and the degree of completion of the contract as measured by a comparison  of the actual costs incurred and the estimated costs to complete. On fixed-price  contracts, we bear the risk of any unexpected increases in the cost to develop  or manufacture a product; whether due to inaccurate estimates in the bidding  process, unanticipated increases in material costs, inefficiencies, or other  factors, and these costs could have a materially adverse effect on our results  of operations.

The following table represents  our revenue concentration during the respective periods by contract type.

|                         | **——— Three      Months Ended **———**** | ****———**Nine      Months Ended **———**** |
|------------------------------|-----------------------------------------------------------------------------|-------------------------------------------------------------------------------|
|                         | **August 1, 2008**                                                          | **August 3, 2007**                                                            | **August 1, 2008** | **August 3, 2007** |
| Cost-reimbursement contracts | 68%                                                                         | 71%                                                                           | 70% | 73% |
| Fixed-price contracts        | 14%                                                                         | 10%                                                                           | 11% | 14% |
| Time-and-materials contracts | 18%                                                                         | 19%                                                                           | 18% | 13% |

Five contracts represented an aggregate of 62% and 60% of revenues for the  respective three-month and nine-month periods ended August 1, 2008. Three of  these contracts were indefinite-delivery-indefinite-quantity (IDIQ) contracts.  Under the terms of this type of contract, the government may issue individual  delivery orders (DOs) for goods or services that they require. Each DO is treated  as a separate contract, which may be awarded on a cost-reimbursable, fixed-price,  or time-and-materials basis. We aggregate the DOs under each IDIQ contract  for purposes of distinguishing significant revenue concentrations. Six contracts  represented an aggregate of 56% and 57% of revenues for the respective three-month  and nine-month periods ended August 3, 2007. Four of these contracts were IDIQ  contracts. In addition, one of the five contracts in each of fiscal years 2008  and 2007 was a time-and-materials contract, which significantly increased the  revenue concentration of time-and-materials contracts during fiscal years 2008and 2007. All of the other contracts referenced were cost-reimbursement contracts.

For those contracts in which all of the terms have not yet been finalized,revenue does not include an estimated fee rate on cost.

Management reviews contract performance, costs incurred, and estimated completion  costs regularly. Revenues and profits are adjusted on all contracts in the  period in which changes, including anticipated losses, become determinable.

Precontract costs represent costs incurred in anticipation of specific expected  future contract awards and costs incurred in connection with ongoing contracts  for which contract modifications have not been defined or completed at the  end of the reporting date. These costs are included in other current assets  on the balance sheet. Precontract costs for the periods ended August 1, 2008,  and October 31, 2007, were approximately $1,245,000 and $4,465,000, respectively.  Approximately $4,012,000 of the October 31, 2007, balance was recognized as  revenue during the first nine months of fiscal year 2008.

We have one licensing agreement for which we accrue royalties upon sales of  our licensed product by a third party. Since there are essentially no costs  associated with this agreement, operating income will increase by the same  amount of revenue that we recognize. Our royalties contributed approximately  $1,253,000 and $3,764,000 to revenues and operating income during the third  quarter and first nine months of fiscal year 2008, respectively. Our royalties  contributed approximately $336,000 and $955,000 to revenues and operating incomeduring the third quarter and first nine months of fiscal year 2007, respectively. 

***Indirect rate variance adjustments to operations***.  We record contract revenues and costs of operations for interim reporting purposes  based on annual targeted indirect rates. At year end, the revenues and costs  are adjusted for actual indirect rates. During our interim reporting periods,  variances may accumulate between the actual indirect rates and the annual targeted  rates. All timing-related indirect spending variances are removed from contract  costs, research and development, and general and administrative expenses, and  are included in inventory as part of work in process during these interim reporting  periods. These rates are reviewed regularly, and we record adjustments for  any material, permanent variances in the period they become estimable.

Our accounting policy    for recording indirect rate variances is based on management’s  belief that variances accumulated during interim reporting periods will be  absorbed by expected contract activities during the remainder of the year.  We consider the rate variance to be unfavorable when our actual indirect rates  are greater than our annual targeted rates. In contrast, a favorable rate variance  occurs when our actual indirect rates are lower than our annual targeted rates.  During interim reporting periods, unfavorable rate variances are recorded as  reductions to operating expenses and increases to work-in-process inventory.  Favorable rate variances are recorded as increases to operating expenses and  decreases to work-in-process inventory.

If we anticipate that actual contract activities will be different than planned  levels, there are alternatives we can utilize to absorb the variance: we can  adjust our planned indirect spending during the year, modify our billing rates  to our customers through the Defense Contract Audit Agency in accordance with  Federal Acquisition Regulations, or record adjustments to expense based on  estimates of future contract activities for the remainder of the fiscal year.

If our rate variance is unfavorable, the modification of our billing rates  will likely increase revenue and operating expenses, and decrease the unfavorable  indirect rate variance accumulated in inventory. Fee percentages on fixed-price  and time-and-materials contracts will generally decline as a result of any  increase to indirect costs. Fee percentages on active cost-reimbursable contracts  will generally be unaffected as a result of any increase to indirect costs.  Fee percentages on completed cost-reimbursable contracts will generally be  reduced. If our rate variance is favorable, the modification of our billing  rates will decrease revenue and operating expenses, and decrease the favorable  indirect rate variance accumulated in inventory. In this event, fee percentages  on fixed-price and time-and-materials contracts will generally increase. Fee  percentages on cost-reimbursable contracts will generally be unaffected as  a result of any reduction to indirect costs, due to the fact that programs  will typically expend all of the funds available. Any impact on operating income,  however, will depend on a number of other factors, including mix of contract  types, contract terms, anticipated performance on specific contracts, and anticipated  changes in inventory.

At August 1, 2008, the    unfavorable rate variance was approximately $2,177,000. Approximately $1,180,000    of unanticipated severance costs, that we are paying to our former Chief    Executive Officer, were not included in our target rates for general and    administrative expenses. Therefore, these costs contributed to the unfavorable    rate variance at August 1, 2008. Please see “Note  9: Change in Management” for further details. At August 3, 2007, the  unfavorable rate variance for the first nine months of fiscal year 2007 was  approximately $5,445,000, and was reduced by a management reserve of $1,300,000,  for a net unfavorable variance of approximately $4,145,000. We recorded $300,000  and $1,000,000 of the management reserve during the second and third quartersof fiscal year 2007, respectively.

***Accounts receivable and allowance for bad debt***.  Accounts receivable are segregated between billed and unbilled accounts. For  cost-reimbursement contracts, we bill incurred costs and a portion of our fees  on a regular basis. Under fixed-price contracts, we bill contract costs on  a milestone or unit-of-delivery basis. Unbilled amounts result from our recognition  of contract revenue in advance of contractual billing or progress billing terms.

When evaluating our need for a bad debt allowance, we consider our customer  base and their payment history. The majority of our revenues are generated  from the United States Government and therefore credit risk is minimal. We  record allowances for bad debt as a reduction to accounts receivable and an  increase to bad debt expense. These allowances are recorded in the period a  specific collection problem is identified. Once the receivable is deemed uncollectible,  the allowance is reversed and the receivable is written off to bad debt expense.

During the first nine months of fiscal year 2008 and fiscal year 2007, there  was no material charge to bad debt expense. 

***Inventory valuation and disposal***. Typical life cycles  of our equipment are eight to ten years or more. In addition, we maintain spare  parts in order to repair the equipment. We evaluate our inventory quarterly  at interim reporting periods, and assess our ability to sell our products,  which includes raw materials. Historically, we have sold our inventory at or  above cost, so there was typically no decrement in valuation. When we determine  that a product has reached the end of its life cycle or there is no longer  a need for a certain product, typically, we will dispose of any remaining inventory,  and record the associated reduction to inventory.

We recorded a write-down    of approximately $394,000 and $1,329,000 during the third quarter and first    nine months of fiscal year 2008, respectively, to reflect the estimated market    value of one inventoried product. These charges were included in contract    costs in our statement of operations. Disposals associated with our raw material    represent a minor amount, which is included in general and administrative    expenses on the statement of operations, due to the fact that raw materials    could be used in a variety of situations other than contract costs, including    R&D.    Disposals of inventory were not significant during the first nine months  of fiscal years 2008 and 2007.

**Income Taxes**

Our income tax expense    at interim reporting periods is based on our estimated annual effective tax    rate and any discrete items that occur during any interim period. We calculate    this estimated tax rate based on the projected net income at the end of the    fiscal year, and review it at each reporting period. At the end of the fiscal    year, we adjust income tax expense for actual results. Our effective tax    rate can differ from the statutory rate primarily due to the non-deductible    nature of certain types of stock-based compensation expense. Please refer    to “Note 7: Provision for Income Taxes” for  the current year effective tax rate.

**Price Redetermination**

As a government contractor, we are subject to price redetermination on certain  fixed-price contracts if it is determined that we did not price our products  and services consistent with the requirements of the Federal Acquisition Regulations.  We did not incur any price redeterminations on any of our contracts during  the first nine months of fiscal year 2008 or the full fiscal year of 2007.

**Cash Equivalents and Investments**

We consider all highly liquid debt instruments purchased with an original  maturity date of three months or less to be cash equivalents.

Our remaining securities    are classified as available for sale and are carried at fair market value    in short-term and long-term investments. At August 1, 2008, all of our short-term    and long-term investments consisted of municipal securities. Substantially    all of our investments in the municipal securities are with A-1/SP-1/AAA    (Standard & Poor’s), P-1/MIG-1/Aaa (Moody’s),  and F-1/AA/AAA (Fitch) rated issuers.

Our investment policy prohibits our investment in auction rate securities,  mortgage-backed securities, and asset-backed securities. Insured municipal  notes or bonds are also prohibited, with the exception of daily and weekly  variable rate demand notes that contain a hard put feature.

At the time of purchase,    management determines the appropriate classification of these securities    and re-evaluates such designation as of each balance sheet date. Unrealized    gains and losses, net of tax, are reported in shareholders’ equity  as part of comprehensive income. The cost of securities sold is based on the  specific identification method. The fair value of short-term and long-term  investments is determined based on market prices for the respective securities.  Realized gains and losses on sales of available-for-sale securities were not  material for the first nine months of fiscal year 2008 or fiscal year 2007.

The following tables summarize our cash, cash equivalents, short-term securities,  and long-term securities (in thousands).

|                                                | **———————————————— August      1, 2008****————————————————** |
|-----------------------------------------------------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|                                                     | **Amortized Cost**                                                                                                                                                                                                                                           | **Gross Unrealized        Gains** | **Gross Unrealized        Losses** | **Estimated Fair        Market Value** |
| Cash and cash equivalents                           | $6,601                                                                                                                                                                                           | $—             | $—             | $6,601             |
| Available-for-sale securities:                      |                                                                                                                                                                                                                                                         |   |   |   |
|      Short-term tax exempt | 34,453                                                                                                                                                                                           | 40             | —             | 34,493             |
|      Long-term tax exempt  | 11,703            ------------                                                                                                       | 28            ------------             | (2)           ------------             | 11,729            ------------             |
|                                                | $52,757            =======                                                                                                           | $68            =======             | ($2)           =======             | $52,823            =======             |

  

|                                                | **———————————————****October      31, 2007 ———————————————** |
|-----------------------------------------------------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|                                                     | **Amortized Cost**                                                                                                                                                                                                                               | **Gross Unrealized        Gains** | **Gross Unrealized        Losses** | **Estimated Fair        Market Value** |
| Cash and cash equivalents                           | $5,250                                                                                                                                                                               | $—             | $—             | $5,250             |
| Available-for-sale securities:                      |                                                                                                                                                                                                                                             |   |   |   |
|      Short-term tax exempt | 29,671                                                                                                                                                                               | 12             | —             | 29,683             |
|      Long-term tax exempt  | 4,108            ------------                                                                                            | 6            ------------             | —            ------------             | 4,114            ------------             |
|                                                | $39,029            =======                                                                                               | $18            =======             | $—            =======             | $39,047            =======             |

 

The following table summarizes the effective maturities of our available-for-sale  investments (in thousands).

|                         | **August 1, 2008**                                                                                                                                                     | **October 31, 2007**                                                                                                                                              |
|-------------------------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| Due in one year or less | $34,493                                                                                                    | $29,683                                                                                               |
| Due in one to two years | 11,729                ------------             | 4,114            ------------             |
|                    | $46,222                =======                 | $33,797            =======                |

**Restricted Cash**

We had restricted cash balances of approximately $586,000 and $562,000 at  August 1, 2008, and at October 31, 2007, respectively. These balances include  contributions made by our employees residing in California for disability funds.  These contributions were paid in lieu of participating in the state-sponsored  disability program.

Approximately $161,000 and $194,000 was included in prepaids and other current  assets at August 1, 2008, and at October 31, 2007, respectively. Approximately  $425,000 and $368,000 was included in other assets at August 1, 2008, and at  October 31, 2007, respectively.

**Property and Equipment**

Machinery and equipment, as well as furniture and fixtures, are depreciated  by using the straight-line method over the estimated useful lives of the assets,  ranging up to five years. Leasehold improvements are amortized by using the  straight-line method over the lesser of the useful life of the assets or the  lease term. Construction in process includes costs incurred to build a portion  of our leasehold improvements and test equipment.

**Goodwill and Long-Lived Asset Valuation**

***Goodwill valuation***. We test goodwill for possible  impairment on an annual basis and at any other time if events occur or circumstances  indicate that the current carrying amount of goodwill may not be recoverable.  Circumstances that could trigger an impairment test include, but are not limited  to, a significant adverse change in the business climate or legal factors,  an adverse action or assessment by a regulator, unanticipated competition,  and loss of key personnel.

To perform the goodwill    impairment test, we determine the fair value of the reporting unit and compare    the fair value to the reporting unit’s carrying  value. We believe AST is one reporting unit, and therefore, we compare the  fair value of AST to the total net asset value on our balance sheet. If our  total net asset value were to exceed our fair value, we would perform the second  step of the impairment test. In the second step, we would compare the implied  fair value of our goodwill to our carrying amount. If no impairment exists  under step one, then step two is not necessary.

No indicators of impairment were identified at August 1, 2008.

***Long-lived asset valuation (property, plant and equipment, and      intangible assets)***. We will test long-lived assets or asset      groups for recoverability when events or changes in circumstances indicate      that their carrying amount may not be recoverable. Circumstances that could      trigger a review include, but are not limited to, significant decreases      in the market price of the asset, significant adverse changes in the business      climate or legal factors, accumulation of costs significantly in excess      of the amount originally expected for the acquisition or construction of      the asset, current period cash flow or operating losses combined with a      history of losses or a forecast of continuing losses associated with the      use of the asset, and current expectation that the asset will more likely      than not be sold or disposed of significantly before the end of its estimated      useful life.

We assess recoverability based on the carrying amount of the asset and its  fair value, which is generally determined based on the sum of the undiscounted  cash flows expected to result from the use and the eventual disposal of the  asset. We recognize an impairment loss when the carrying amount is not recoverable  and exceeds fair value.

No indicators of impairment were identified at August 1, 2008.

**Net Income Per-Share Data**

Basic net income per share is determined by dividing net income by the weighted  average number of common shares outstanding during the period. Diluted net  income per share is determined by dividing net income by the weighted average  number of common shares used in the basic earnings per share calculation, plus  the number of common shares that would be issued assuming conversion of all  potentially dilutive securities outstanding under the treasury stock method.

The per-share data is as follows (in thousands, except per-share amounts):

|                                                                       | **——— Three      Months Ended ———**                                                                                         | **——— Nine      Months Ended ———**                                                                                          |
|-----------------------------------------------------------------------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------|
|                                                                       | **August 1,        2008**                                                                                                                                       | **August 3,        2007**                                                                                                                                       | **August 1,        2008** | **August 3,        2007** |
| **Numerator**:                                                        |                                                                                                                                                            |                                                                                                                                                            |   |   |
| Net income                                                            | $1,965                                                                                              | $977                                                                                                | $5,468             | $4,420             |
| **Denominator**:                                                      |                                                                                                                                                            |                                                                                                                                                            |   |   |
| Shares    used to compute net income per common share – basic   | 12,538                                                                                              | 12,171                                                                                              | 12,427             | 12,062             |
| Effect of dilutive stock options and awards                           | 203            ------------             | 210            ------------             | 189            ------------             | 221            ------------             |
| Shares    used to compute net income per common share – diluted | 12,741            =======               | 12,381            =======               | 12,616            =======             | 12,283            =======             |
|                                                                  |                                                                                                                                                            |                                                                                                                                                            |   |   |
| Net    income per common share – basic                          | $0.16                                                                                                                                                           | $0.08                                                                                                                                                           | $0.44 | $0.37 |
| Net    income per common share – diluted                        | $0.15                                                                                                                                                           | $0.08                                                                                                                                                           | $0.43 | $0.36 |

We excluded approximately 882,000 and 926,000 potential common shares for  the three-month and nine-month periods ended August 1, 2008, respectively,  from the diluted net income per common share computation, as their effect would  be antidilutive. For the same periods in fiscal year 2007, we excluded 1,023,000  and 964,000 potential common shares, respectively, from the diluted net incomeper common share computation for the same reason.

**Comprehensive Income**

The components of comprehensive income, net of tax, are as follows (in thousands):

|                                      | **——— Three      Months Ended ———**                                                                                        | **——— Nine      Months Ended ———**                                                                                      |
|--------------------------------------|----------------------------------------------------------------------------------------------------------------------------------------------------------------|-------------------------------------------------------------------------------------------------------------------------------------------------------------|
|                                      | **August 1, 2008**                                                                                                                                             | **August 3, 2007**                                                                                                                                          | **August 1, 2008** | **August 3, 2007** |
| Net income                           | $1,965                                                                                             | $977                                                                                            | $5,468             | $4,420             |
| Unrealized gain (loss) on securities | 3                                                                                                  | 3                                                                                               | 48             | (4)            |
| Derivative gain (loss)               | 17            ------------             | (4)           ------------               | (70)           ------------             | (6)           ------------             |
| Comprehensive income                 | $1,985            =======              | $976            =======             | $5,446            =======             | $4,410            =======             |

The accumulated other comprehensive income balance as of August 1, 2008, was  a gain of approximately $12,000, and as of October 31, 2007, was a gain ofapproximately $34,000.

**Dividends**

We have paid dividends    at the rate of $0.50 per share per annum, payable quarterly, since fiscal    year 2004. However, the dividend is subject to approval by the Board of Directors    and is reviewed quarterly. Dividends were paid on February 15, 2008, May    16, 2008, and August 15, 2008, to shareholders of record at February 1, 2008,  May 2, 2008, and August 1, 2008. We paid dividends of approximately $4,695,000 during the first nine months  of fiscal year 2008 and approximately $ 4,529,000 during the first nine months  of fiscal year 2007.

At August 1, 2008, and October 31, 2007, accrued dividends of approximately  $1,594,000 and $1,549,000, respectively, were included in other accrued liabilities  on the accompanying balance sheet.

**Stock-Based Compensation**

We have stock-based compensation programs that enable our Board of Directors  to award employee equity incentives. These programs include restricted stock  awards and incentive and non-statutory stock options granted under various  plans. Restrictions on the restricted stock awards typically lapse in four  equal annual installments, on each anniversary of the grant date, conditioned  on continued employment. The restrictions for the majority of the fiscal year  2007 awards to non-employee directors will lapse in three equal annual installments.  Stock options granted in 2006 and prior years are generally time based, typically  vesting 20% on each anniversary of the grant date over five years, and expiring  eight or ten years from the grant date, conditioned on continued employment.

Additionally, we have    an Employee Stock Purchase Plan (ESPP) that allows employees to purchase    shares of common stock at 85% of the fair market value at the lower of either    the date of enrollment or the date of purchase. For offering periods beginning    prior to June 1, 2007, our ESPP had a twenty-four-month offering period with    four six-month purchase periods within each offering period. If the fair    market value on the purchase date was lower than the fair market value on    the offering date, all participants were withdrawn from the offering period    and re-enrolled into a new offering period. Effective, May 31, 2007, we modified    our ESPP such that the length of all offering periods, beginning June 1,    2007, is six months. Consequently, there is no reset feature associated with    the new offering periods. As a result of the modification to the ESPP, the    December 1, 2006, offering period, originally scheduled to end on November    30, 2008, was the final twenty-four-month offering. On August 20, 2008, the    Board of Directors increased the purchase price and eliminated the look-back    provision for offering periods beginning on or after December 1, 2008. The    purchase price for participants will be 95% of the fair market value on the    date of purchase, and therefore, will be prospectively non-compensatory under    the provisions of SFAS 123R. For offering periods beginning prior to December 1, 2008,  we are required to recognized stock compensation expense in accordance with  SFAS 123R. Our closing stock price on the November 30, 2007, ESPP purchase  date was lower than the closing stock price on the December 1, 2006, offering  date. Therefore, 361 participants were re-enrolled from the original twenty-four-  month offering period ending on November 30, 2008, into a new six-month offering  period, beginning December 1, 2007, and ending May 31, 2008. This re-enrollment  effectively canceled the final six-month purchase period of the original twenty-four-month  offering. Therefore, the remaining unamortized compensation amount associated  with this final purchase period, approximately $382,000, was immediately recognized  on December 1, 2007. In addition, as a result of the modification, approximately  $89,000 of incremental compensation cost was generated at December 1, 2007,  of which we recognized $13,000 during the third quarter and $89,000 duringthe first nine months of fiscal year 2008.

On November 15, 2007, one of our non-employee directors retired. Immediately  prior to his retirement, we accelerated the vesting of all unvested shares  of his restricted stock and stock option awards. In addition, we extended the  remaining exercise period of all vested and unexercised options from ninety  days to one year. As a result, our stock compensation expense associated with  these modified equity awards was approximately $80,000 higher than it would  have been had the awards not been modified.

In addition, we recorded    additional stock based compensation expense during the third quarter of fiscal    year 2008, associated with the acceleration of unvested stock options and    restricted stock for our former Chief Executive Officer. For further information  please see “ Note 9: Change in Management.”

As of August 1, 2008, there were a total of approximately 989,896 shares reserved  for future issuance under the equity incentive and ESPP plans.

We adopted the provisions of SFAS 123 (revised 2004), *Share-Based Payment* (SFAS  123R), in fiscal year 2006, using the modified prospective transition method.  Stock-based compensation expense for awards granted subsequent to November  1, 2005, was based on the grant-date fair value estimated in accordance with  the provisions of SFAS 123R. For awards granted prior to, but not yet vested,  as of November 1, 2005, stock-based compensation expense was based on the grant-date  fair value previously estimated in accordance with the original provisions  of SFAS 123. We recognize the stock compensation expense on a straight-line  basis over the requisite service period of the award, which generally equals  the vesting period of each grant.

The following table sets forth the total stock-based compensation expense    resulting from the grant of stock options, restricted stock awards, and purchases    under ESPP included in our condensed consolidated statements of operations  (in thousands, except share data).

|                                                        | **—— Three      Months Ended**    ——                                                                                                    | **—— Nine      Months Ended ——**                                                                                                        |
|-------------------------------------------------------------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------|
|                                                             | **August 1,    2008**                                                                                                                                           | **August 3,    2007**                                                                                                                                           | **August 1,    2008** | **August 3,        2007** |
| Contract costs                                              | $557                                                                                                | $620                                                                                                | $2,242             | $1,852             |
| Research and development                                    | 41                                                                                                  | 46                                                                                                  | 153             | 155             |
| General and administrative                                  | 633            ------------             | 367            ------------             | 1,642            ------------             | 1,248            ------------             |
| Stock-based compensation expense before        income taxes | $1,231                                                                                              | $1,033                                                                                              | $4,037             | $3,255             |
| Income taxes                                                | (368)           ------------                 | (223)           ------------                 | (860)           ------------             | (682)           ------------             |
| Stock-based compensation expense        after income taxes  | $863                                                                                                | $810                                                                                                | $3,177             | $2,573             |
| Reduction to basic net income per share                     | $0.07                                                                                                                                                           | $0.07                                                                                                                                                           | $0.26 | $0.21 |
| Reduction to diluted net income per share                   | $0.07                                                                                                                                                           | $0.07                                                                                                                                                           | $0.25 | $0.21 |

 The fair value of offering periods for future purchases under the ESPP was  estimated based on the Black-Scholes valuation model by using the followingweighted average assumptions:

|                        | **——— Employee      Stock Purchase Plan**——— |
|-----------------------------|----------------------------------------------------------------------------------|
|                        | **Nine Months Ended        August 1, 2008**                                      | **Nine Months Ended        August 3, 2007** |
| Risk-free interest rate     | 2.0%                                                                             | 4.6% |
| Expected life (years)       | 0.5                                                                              | 1.9 |
| Expected volatility         | 39%                                                                              | 39% |
| Expected dividends          | 3.9%                                                                             | 2.5% |
| Weighted average fair value | $3.79                                                                            | $5.59 |

Our determination of the    grant date fair value of our ESPP using an option-pricing model and the resulting    compensation expense that is recognized are affected by our stock price as    well as assumptions regarding a number of variables. These factors include,    but are not limited to, our expected stock price volatility, the projected    life, the expected dividend yield, and the risk-free interest rate. Changes    in the assumptions can materially affect the estimated fair value and the    expense recognized. The risk-free interest rate is based on the Federal Reserve    Bank’s constant maturities daily interest rate in effect at the  ESPP offering date. For our ESPP offering periods beginning prior to June 1,  2007, the expected life was based on the six-month purchase periods within  each twenty-four-month offering period. Offering periods beginning after that  date have a single six-month purchase period and we use an expected life of  six months. Our computation of expected volatility reflects a combination of  historical and market-based implied volatility consistent with SFAS 123R and  Staff Accounting Bulletin 107. We determined that the combination of historical  and market-based implied volatility provides a more accurate reflection of  our market conditions and is more representative of future stock price trends  than employing solely historical volatility. The expected dividend yield is  calculated by taking the total expected annual dividend payout divided by theaverage stock price.

Stock-based compensation expense recognized in the consolidated statement  of operations in the first nine months of fiscal years 2008 and 2007 reflects  estimated forfeitures, which are based on historical option forfeitures. 

 The net cash proceeds associated with our ESPP were $3,195,000 for the nine-month  period ended August 1, 2008, and $3,531,000 for the nine-month period ended  August 3, 2007. Unrecognized compensation cost associated with our ESPP as  of August 1, 2008, is approximately $305,000 and is expected to be recognized  over a weighted average period of 0.33 years.

Stock option activity for the nine months ended August 1, 2008, is as follows:

|                            | **Shares**                                                                                    | **Weighted Average Exercise Price**                                                                    |
|---------------------------------|-----------------------------------------------------------------------------------------------|--------------------------------------------------------------------------------------------------------|
| Outstanding at October 31, 2007 | 1,409,724               | $18.33                 |
| Grants                          | —                 |                                                                                                   |
| Exercised                       | (30,907)                     | $9.75                  |
| Forfeitures or expirations      | (64,136)                     | $23.62                 |
| Outstanding at August 1, 2008   | 1,314,681               | $18.28                 |
| Exercisable at August 1, 2008   | 1,075,576               | $17.72                 |

Net cash proceeds from    the exercise of stock options were approximately $301,000 for the nine-month    period ended August 1, 2008, and approximately $ 726,000 for the nine-month    period ended August 3, 2007. Unrecognized compensation cost associated with    unvested stock options as of August 1, 2008, is approximately $1,900,000,    and is expected to be recognized over a weighted average period of 2.16 years.

The following table summarizes our restricted stock grant activity for the  nine months ended August 1, 2008.

| **Nonvested Shares**          | **Shares**                                                                                  | **Weighted Average Grant Date Fair Value        Per Share** |
|-------------------------------|---------------------------------------------------------------------------------------------|-------------------------------------------------------------|
| Nonvested at October 31, 2007 | 163,266               | $17.35                                                      |
| Grants                        | 75,000                | $14.79                                                      |
| Vested                        | (67,253)                   | $16.84                                                      |
| Forfeitures                   | (12,796)                   | $17.53                                                      |
| Nonvested at August 1, 2008   | 158,217               | $16.07                                                      |

The fair value of our restricted stock is based on our closing stock price  on the date of grant. Our unrecognized compensation cost related to nonvested  (restricted) stock is $2,067,000, and is expected to be recognized over a weightedaverage period of 3.44 years.

 We realized an income tax deficiency from stock options exercised and restricted  stock vested of approximately $59,000 during the first nine months of fiscal  year 2008. We realized a tax benefit of approximately $55,000 during the same  period of fiscal year 2007. In accordance with SFAS 123R, we present excess  tax benefits from the exercise of stock options and the vesting of restricted  stock, if any, as financing cash flows rather than operating cash flows.

**Recent Accounting Pronouncements**

In September 2006, the Financial Accounting Standards Board (FASB) issued  SFAS 157, *Fair Value Measurement*. SFAS 157 defines fair value, establishes  a framework for measuring fair value, and enhances disclosures about fair value  measurements. The statement will be effective for our fiscal year beginning  November 1, 2008. We are evaluating the impact adopting SFAS 157 will have  on our financial statements. 

In February 2007, the FASB issued SFAS 159, *The Fair Value Option for    Financial Assets and Financial Liabilities*. SFAS 159 provides companies    with an option to report selected financial assets and liabilities at fair    value. It also establishes presentation and disclosure requirements to facilitate    comparisons between companies using different measurement attributes for    similar types of assets and liabilities. The statement will be effective    for our fiscal year beginning November 1, 2008. We are evaluating the impact    adopting SFAS 159 will have on our financial statements. 

In June 2007, the FASB    ratified Emerging Issues Task Force (EITF) Issue  No. 07-3, Accounting for Nonrefundable Advance Payments for Goods or Services  to Be Used in Future Research and Development Activities (EITF 07-3). EITF  07-3 requires non-refundable advance payments for goods and services to be  used in future research and development activities to be recorded as an asset,  with the payments expensed when the research and development activities are  performed. EITF 07-3 applies to new contractual arrangements entered into in  fiscal years beginning after December 15, 2007. We believe that adoption  of EITF 07-3 will not have a material effect on our financial position, results  of operations, or cash flows.

In December 2007, the FASB issued SFAS 141R, *Business Combinations*.  SFAS 141R replaces SFAS 141. The statement retains the purchase method of accounting  for acquisitions, but requires a number of changes, including changes in the  way assets and liabilities are recognized in the purchase accounting. It changes  the recognition of assets acquired and liabilities assumed arising from contingencies,  requires the capitalization of in-process research and development at fair  value, and requires the expensing of acquisition-related costs as incurred.  The statement will apply prospectively to business combinations occurring in  our fiscal year beginning November 1, 2009. We do not expect any impact onour financial statements as a result of adopting SFAS 141R.

In March 2008, the    FASB issued SFAS 161*, Disclosures about Derivative    Instruments and Hedging Activities—an amendment of FASB Statement No. 133*.    SFAS 161 requires enhanced disclosures about derivatives on a quarterly basis,    including qualitative disclosures about objectives and strategies for using    derivatives, and quantitative disclosures about the fair value of derivatives,    as well as gains and losses on derivative instruments. It also requires disclosures    about the volume of derivative activity and credit-risk-related contingent    features in derivative agreements. SFAS 161 does not change the accounting    treatment for derivative instruments, and therefore, the adoption will not    have any impact on our financial position, results of operations, or cash    flows. SFAS 161 is effective for fiscal years and interim periods beginning    after November 15, 2008.

**Note 2: Inventory**

Inventories are stated at the lower of average cost or market and consisted  of the following (in thousands):

|            | **August          1,    2008**                                                                                                                                                  | **October          31,    2007**                                                                                                                                            |
|-----------------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| Raw materials   | $810                                                                                                           | $904                                                                                                       |
| Work in process | 6,876                                                                                                          | 4,597                                                                                                      |
| Finished goods  | 565                 ------------              | 443             ------------              |
|            | $8,251                                                                                                         | $5,944                                                                                                     |

At August 1, 2008, the    unfavorable indirect rate variance included in work in process was approximately    $2,177,000. Approximately $1,180,000 of unanticipated severance costs, that    we are paying to our former Chief Executive Officer, were not included in    our target rates for general and administrative expenses. Therefore, these    costs contributed to the unfavorable rate variance at August 1, 2008. Please    see “Note 9: Change in Management” forfurther details.

Inventory activity included write-downs of work-in-process inventory of approximately  $394,000 and $1,329,000, during the third quarter and first nine months of  fiscal year 2008. Disposal activities were not significant during the first  nine months of fiscal years 2008 and 2007.

**Note 3: Goodwill and Intangible Assets**

***Goodwill***. Under SFAS 142, *Goodwill and Other    Intangible Assets*, goodwill is not subject to amortization. Rather,    we evaluate goodwill for impairment at least annually or more frequently    if events and changes in circumstances suggest that the carrying amount may    not be recoverable. No impairment was recognized in the first nine months    of fiscal year 2008.

******

***Intangible assets***.    Information on our identifiable intangible assets that are subject to amortization  is presented in the table below (in thousands).

|                                                                    |            | **——————————— August      1, 2008 ———————————**    |
|-------------------------------------------------------------------------|-----------------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|                                                                    | **Useful Life** | **Gross Carrying Amount**                                                                                                                                                              | **Accumulated Amortization** | **Net Carrying Amount** |
| Identifiable intangible assets that are subject        to amortization: |            |                                                                                                                                                                                   |   |   |
|      Customer    relationships                 | 3 years         | $1,720                                                                                                           | ($1,720)              | $0               |
|      Existing technology                       | 5 years         | 340                                                                                                              | (210)              | 130               |
|      Patent                                    | 18 years        | 60              ------------               | (10)             ------------               | 50                  ------------               |
|           Total       |            | $2,120                                                                                                           | ($1,940)              | $180               |

All of our acquired identifiable intangible assets are subject to amortization  and have originally estimated useful lives as noted in the table above. Amortization  expense associated with our intangible assets was approximately $113,000 and  $436,000 for the third quarter and first nine months of fiscal year 2008, respectively,and $161,000 and $483,000, for the same periods in fiscal year 2007, respectively.

As of August 1, 2008, the estimated future amortization expense for acquired  identifiable intangible assets is as follows (in thousands):

| **Fiscal Years**                    |                         |
|-------------------------------------|------------------------------|
| Remainder of 2008                   | 18       |
| 2009                                | 71       |
| 2010                                | 49       |
| 2011–2023                     | 42       |
|      Total | $180     |

The goodwill and identifiable intangible assets are related to our July 2005acquisition of Dynamics Technology, Inc. (DTI).

**Note 4: Borrowing Arrangements**

***Revolving line of credit***. At August 1, 2008, we  had a revolving line of credit (Line of Credit) under which Wells Fargo Bank  (Wells Fargo), could advance funds to us, up to a maximum principal amount  of $3 million. The Line of Credit was renewed on February 21, 2008, and it  will expire on March 1, 2009.

At August 1, 2008, we had two standby letters of credit under the Line of  Credit totaling approximately $1,371,000. One letter of credit, related to  our Sunnyvale, California, facilities lease, had a committed balance of approximately  $1,221,000 at August 1, 2008. The third letter of credit was a requirement  of our workers compensation insurance, and had a committed balance of approximately  $150,000 at August 1, 2008. We do not pay interest on the amounts associated  with the standby letters of credit.

As a result of the committed    but unused funds associated with the two letters of credit, the total amount    under the Line of Credit available for borrowing was approximately $1,629,000.    No fees or interest were associated with this unused portion. Borrowings    under the Line of Credit bear interest at Wells Fargo’s reference rate    (5% at August 1, 2008), and interest on those borrowings is payable monthly.    As security for our indebtedness under the Line of Credit, we have granted    to Wells Fargo a security interest in our cash and marketable securities  maintained with an affiliate of Wells Fargo.

***Term loan        and interest rate swap***. Effective July  1, 2005, and in connection with the acquisition of DTI, we entered into a term  loan with Wells Fargo in the principal amount of $10 million, plus interest,  the proceeds of which were used for acquisition financing (the Term Loan).  The Term Loan bears interest at a fixed rate per annum equal to 1.750% above  the London Inter-Bank Offered Rate (LIBOR) (2.46% at August 1, 2008). Our  Term Loan is for a seven-year term ending on July 1, 2012, with monthly payments  of principal and interest.

As security for our indebtedness under the Term Loan, we have granted to Wells  Fargo a security interest in our accounts receivable, general intangibles,  inventory, and equipment.

We are required to maintain certain financial covenants setting forth minimum  ratios for quick ratio and fixed charge coverage and maximum ratios for total  liabilities to tangible net worth. As of August 1, 2008, we were in compliance  with these covenants.

We are exposed to market risk from changes in interest rates on the Term Loan,  and manage this exposure through the use of an interest rate swap agreement  with Wells Fargo. By locking in a fixed rate for the entire term of the loan,  this strategy decreases the variability of earnings and cash flows resulting  from interest rate fluctuations and lowers the overall borrowing costs should  interest rates rise. The interest rate swap is designated as a cash flow hedge  and is accounted for under SFAS 133, *Accounting for Derivative Instruments  and Hedging Activities* (SFAS 133). No losses on the agreement due to counterparty  credit issues are anticipated. Under this swap, we pay an interest rate of  4.33%, per annum, over the seven-year term of the loan and receive an average  floating rate of LIBOR on the notional amount of the loan. Thus, we exchanged  a variable rate obligation for a fixed interest obligation, resulting in an  effective interest rate of 6.08%.

The effective portion of the cash flow hedge is reported as other comprehensive  income and reclassified into earnings in the same period during which the hedged  transaction affects earnings. At August 1, 2008, the effective portion of the  cash flow hedge was a deferred net loss of approximately $54,000, net of taxes.  Over the next twelve months, we expect to reclassify approximately $76,000  of the loss to interest expense as principal on the Term Loan is repaid and  the related swap-instrument notional amount is reduced.

We assess effectiveness of the hedge instrument regularly. The ineffective  portion of the gain or loss, if there is one, would impact earnings as it occurs.  There is no ineffective portion of the outstanding swap as of August 1, 2008.

**Note 5: Contractual Obligations**

The following table sets    forth our contractual obligations, excluding interest payments on our debt,  as of August 1, 2008, (in thousands).

|                                  | **———————————————— Payments      Due by Period****———————————————** |
|---------------------------------------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|                                  | **Total**                                                                                                                                                                                                                                                     | **Less than        1 Year** | **1–3        Years** | **3–5        Years** | **More than        5 Years** |
| Operating lease obligations           | $37,954                                                                                                                                                                                                     | $7,569           | $14,271           | $8,636           | $7,478           |
| Loan    obligations – principal | 5,595                                                                                                                                                                                                       | 1,429           | 2,857           | 1,309           | —           |
| Purchase obligations                  | 6,078           ------------                                                                                                                              | 6,078           ------------           | —           ------------           | —           ------------           | —               ------------           |
|      Total   | $49,627                 =======                                                                                                                           | $15,076           =======           | $17,128           =======           | $9,945           =======           | $7,478           =======           |

Our operating lease obligations consist of non-cancelable lease agreements  for our facilities, which expire at various dates between fiscal years 2009  and 2016. Certain leases contain escalation clauses and requirements for the  payment of property taxes, insurance, and maintenance expenses. During the  first nine months of fiscal year 2008, approximately $998,000 of the cost for  our leasehold improvements was funded by the landlord of our new facility in  Torrance, California. This was determined to be a lease incentive. This lease  incentive reduces our rent expense and will be amortized on a straight-line  basis over the remaining period of our operating lease that ends in fiscal  year 2015. This reduction to rent expense is generally equal to the increasedamortization expense of the associated leasehold improvements.

**Note 6: Segment Reporting**

We have reviewed our business operations and determined that we operate in  a single homogeneous business segment. Each of our divisions sells similar  products and services with similar economic characteristics to similar classes  of customers, primarily to the United States Government, its agencies, or prime  contractors for the United States Government. The technologies and the operations  of our divisions are highly integrated. Revenues and costs are reviewed monthly  by management on an individual contract basis as a single business segment.

**Note 7: Provision for Income Taxes**

 We adopted FASB Interpretation Number 48, *Accounting      for Uncertainty in Income Taxes – an Interpretation of FASB Statement      No. 109* (FIN    48) effective November 1, 2007. FIN 48 describes a two-step approach to recognizing    and measuring uncertain tax positions. The first step is to determine whether    it is more likely than not that a tax position accounted for under SFAS 109    will be sustained upon examination. The second step is to measure and recognize    the largest amount of benefit that is greater than 50% likely of being realized    upon ultimate settlement. We determined that there were no unrecognized tax    benefits to be recorded upon adoption of FIN 48. 

 During the third quarter of fiscal year 2008, we recorded an unrecognized  tax benefit of approximately $128,000 and a corresponding increase to income  tax expense of $117,000. The filing of our federal and state income tax returns  in the current quarter resulted in a prior year true-up and the corresponding  unrecognized tax benefit. We do not expect the amount of unrecognized tax benefits  to change materially in the next twelve months.

We record interest or penalties related to income taxes as a component of  income tax expense in our financial statements. The amount of net interest  recognized during the nine months ended August 1, 2008, and August 3, 2007,  was not material. No penalties were recorded in those periods.

In general, our income tax returns are subject to examination by U.S. federal  and state tax authorities for fiscal years 2004 and forward.

Our provision for income    taxes for the third quarter and first nine months of fiscal year 2008 was    approximately $1,411,000 and $3,503,000, respectively, with an estimated    annual effective tax rate of 45.9%. We reduced our income tax expense by    approximately $616,000 during the first nine months of fiscal year 2008.    This reduction included the filing of an Application for Change in Accounting    Method with the Internal Revenue Service (IRS) under the automatic-consent  provisions, during the second quarter of fiscal year 2008. Based upon the change  in method filed with the IRS, we re-measured our deferred tax asset balance  related to the determination of tax basis depreciation on certain property  and equipment assets as of October 31, 2006. This led to a tax benefit of approximately  $333,000, which was recorded as a discrete item during the second quarter of  fiscal year 2008. During the third quarter of fiscal year 2008, we recorded  additional discrete tax benefit items, which led to a net reduction to income  tax expense of approximately $176,000. These additional discrete items included  a reduction to income tax expense of approximately $303,000, associated with  research and development credits; offset by an increase to tax expense of approximately  $108,000 associated with a reduction to tax-exempt interest taken on our income  tax returns for fiscal year 2007.

Our provision for income taxes for the third quarter and first nine months  of fiscal year 2007 was approximately $ 835,000 and $ 3,273,000, respectively,  representing an estimated annual effective tax rate of 45.0%. During the same  period of fiscal year 2007, we recorded a reduction to income tax expense for  discrete items of approximately $183,000, primarily associated with the benefit  of our research and development tax refund from the state of California.

**Note 8: Contingencies**

***Product warranties***. Our products are warranted against  defective workmanship and materials for a period of one year from the date  of acceptance by the original purchaser. Warranty costs in the third quarter  and first nine months of fiscal year 2008 were approximately $44,000 and $157,000,  respectively. For the same periods of fiscal year 2007 warranty costs were  approximately $60,000 and $206,000, respectively.

***Guarantees***. From time to time, we enter into certain  types of contracts that contingently require us to indemnify parties against  third-party claims. These contracts primarily relate to (i) certain real estate  leases, under which we may be required to indemnify property owners for environmental  and other liabilities, and other claims arising from our use of the applicable  premises; and (ii) certain agreements with our officers, directors, and employees  under which we may be required to indemnify such persons for liabilities arising  out of their employment relationship. The terms of such obligations vary. Generally,  a maximum obligation is not explicitly stated. Because the obligated amounts  of these types of agreements often are not explicitly stated, the overall maximum  amount of the obligations cannot be reasonably estimated. Historically, we  have not been obligated to make significant payments for these obligations,  and no liabilities have been recorded for these obligations on the balance  sheets as of August 1, 2008, or October 31, 2007.

***Legal proceedings***. On March 11 and July 19, 2005,  purported securities class action complaints were filed in the United States  District Court, Northern District of California. The cases were considered  as*In re Applied Signal Technology Inc. Securities Litigation*, Master  File No. 4:05-cv-1027 (SBA). The amended consolidated complaint is brought  on behalf of a putative class of persons who purchased our Company’s  securities during a class period of August 24, 2004, through February 22, 2005.  The complaints name us, our former Chief Executive Officer, and our Chief Financial  Officer as defendants, and allege that false and misleading statements regarding  us were issued during the class period. On February 8, 2006, the Court dismissed  the case with prejudice. On June 5, 2008, the Ninth Circuit reversed the dismissal  and remanded to the District Court. We intend to contest this litigation vigorously.  Any future unfavorable outcome of the litigation could have an adverse impact  on our business, financial condition, and results of operation. At this time,  we cannot estimate the amount of possible loss or range of loss that might  be incurred as a result of this proceeding. 

On August 12, 2008, a purported shareholder derivative action was filed in  the Superior Court, State of California. *Shoemaker v. Devine et al.*,  No. 1:08-CV-119810. It is brought on purported behalf of the Company, against  current and former members of the Board of Directors, our Chief Financial Officer,  and our former Chief Executive Officer, asserting that these individuals breached  their fiduciary duties, based on essentially the same allegations as the class  action case. No damages are specified. As the case is brought on purported  behalf of the Company, there is no possible loss that might be incurred as  a result of this proceeding.

**Note 9: Change in Management**

During the second quarter    of fiscal year 2008, Mr. Gary L. Yancey, our former Chairman and Chief Executive    Officer, resigned as an executive officer and as a member of the Board of    Directors. His final date of employment with us was May 30, 2008. Upon Mr.    Yancey’s resignation, Mr. John P. Devine,  a director since 1995, was named non-executive Chairman of the Board of Directors  and Mr. William Van Vleet III, our Chief Operating Officer, was appointed as  Acting Chief Executive Officer. In connection with his departure, on May 23,  2008, we entered into a Severance Agreement and General Release of Claims with  Mr. Yancey, under which, we are providing to Mr. Yancey certain separation  benefits. These benefits are payable to Mr. Yancey pursuant to his participation  in the Company’s Executive Retention and Severance Plan of August 19,  2004, and as a result of which, we are paying to Mr. Yancey in monthly installments  an amount equal to 24 months of his base salary and 100% of his annual bonus.  The bonus was determined as the aggregate amount that would be earned by him  during fiscal year 2008 if all applicable performance goals were achieved.  We will also continue health and other similar benefits until Mr. Yancey reaches  age 65.

As a result, we recognized accrued severance of approximately $1,180,000 during  the second quarter of fiscal year 2008. In addition, management believes that  severance expense is recoverable through our indirect rates, and therefore,  we increased our indirect rate variance included in inventory by approximately  $1,180,000.

In addition, all outstanding    but unvested options to purchase Company common stock and all unvested restricted    stock awards held by Mr. Yancey vested in full as of May 30, 2008. We also    extended the period of exercisability of any vested stock options held by    Mr. Yancey to two years from the date of termination of employment or expiration    of the individual option grant, whichever occurs first. We recognized stock-based    compensation expense of approximately $304,000 during the third quarter of    fiscal year 2008, associated with the modifications to Mr. Yancey’s  equity awards.

On August 20, 2008, Mr. Van Vleet was appointed as President, Chief Executive  Officer, and a Class I member of the Board of Directors.

**Item      2: Management’s  Discussion and Analysis of Financial Condition and Results of Operations**

The following information should be read in conjunction with the attached  condensed financial statements and notes thereto, as well as our Annual Report  on Form 10-K for the year ended October 31, 2007.

This quarterly report    on Form 10-Q contains forward-looking statements made pursuant to the provisions    of Section 21E of the Securities Exchange Act of 1934. These forward-looking    statements are based on management’s current  expectations and beliefs, including estimates and projections about our industry.  Forward-looking statements may be identified by the use of terms such as “anticipates,” “expects,” “intends,” “plans,” “seeks,” “estimates,” “believes,” and  similar expressions, although some forward-looking statements are expressed  differently. Statements concerning financial position, business strategy, and  plans or objectives for future operations are forward-looking statements. These  statements are not guarantees of future performance and are subject to certain  risks, uncertainties, and assumptions that are difficult to predict and may  cause actual results to differ materially from management’s current expectations.  Such risks and uncertainties include those set forth in this document under “Item  1A, Risk Factors.” The forward-looking statements in this report speak  only as of the time they are made and do not necessarily reflect management’s  outlook at any other point in time. We undertake no obligation to update publicly  any forward-looking statements, whether as a result of new information, future  events, or for any other reason. However, readers should carefully review the  risk factors set forth in other reports or documents we file from time to time  with the Securities and Exchange Commission (SEC).

**Description of Business**

 Applied Signal Technology,    Inc. (AST) provides advanced intelligence, surveillance, and reconnaissance    (ISR) products, systems, and services to enhance global security. We provide    domain knowledge in the areas of signals intelligence (SIGINT), including    communications intelligence (COMINT) and electronic intelligence (ELINT),    and measurements and signatures intelligence (MASINT) through the use of    sonar, radar, magnetic, and chemical sensors to detect changes in the environment.    We specialize in the collection, processing, and understanding of signals    for ISR missions with low size, weight, and power configurations to enable    increased deployment on unmanned platforms. We develop and manufacture sophisticated  receivers and digital signal processing equipment that use advanced software. 

 COMINT derives intelligence from telecommunications signals. Our COMINT signal  collection equipment consists of sophisticated receivers that scan through  potentially thousands of cellular telephone, microwave, ship-to-shore, and  military transmissions in the radio frequency (RF) spectrum with the goal of  collecting certain specific signals. Our COMINT signal processing equipment  uses advanced software and hardware to evaluate characteristics of the collected  signals and selects those most likely to contain relevant information. 

 ELINT derives intelligence from signals associated with weapons systems.  Our ELINT solutions are directed toward the development of equipment for the  collection and processing of weapons systems signals. This equipment will be  able to scan the radar bands associated with weapons systems and determine  the type of system and its precise location for battlefield characterization  and force protection. The equipment will also analyze the command and control  signals associated with these weapons systems to provide information about  battlefield readiness. Our ELINT offering is new and to date we have derived  no revenue from the sale of ELINT products or services. 

 Sensor signature processing observes changes in the environment that can  provide an indication of activities of concern to global security. Sensor signatures  addressed by AST include the use of sound, such as in sonar or radar, to detect  mines or submarines; detection of chemicals to expose explosive devices; and  detection of magnetic materials that might indicate the presence of buried  mines or an underground weapons facility. Our sensor processing equipment provides  automatic detection and classification of threatening objects in both marine  and terrestrial environments. 

 Our primary customers are the United States Government and industry prime  contractors for the United States Government. 

**Critical Accounting Policies and Estimates**

***General***.    Our discussion and analysis of our financial condition and results of operations    are based upon our condensed consolidated financial statements. These condensed    consolidated financial statements are prepared in accordance with accounting    principles generally accepted in the United States, which require management    to make estimates and assumptions that affect the amounts reported in the    financial statements and accompanying notes. Actual results could differ    materially from those estimates. We believe that the estimates, assumptions,    and judgments involved in the accounting policies described below have the    greatest potential impact on our condensed consolidated financial statements    and, therefore, consider these to be critical accounting policies. See “Notes to Condensed Consolidated Financial Statements,  Note 1: Summary of Significant Accounting Policies,” included elsewhere  in this report for more information about these critical accounting policies,  as well as descriptions of other significant accounting policies.

***Revenue and cost recognition***. The majority of our  contracts are accounted for in accordance with the AICPA Statement of Opinion  81-1, *Accounting for Performance of Construction-Type and Production-Type  Contracts* (SOP 81-1). These contracts are executed by using written contractual  arrangements, most of which require us to design, develop, manufacture, and/or  modify our complex products, and perform related services according to specifications  provided by the customer. A limited number of standalone software contracts  are recognized in accordance with the AICPA Statement of Opinion 97-2, *Software  Revenue Recognition* (SOP 97-2). In accordance with SOP 97-2, we may, at  times, record an amount of deferred revenue associated with contracts that  are billed and for which customers have paid in advance of performance requirements  set forth in these contracts. 

As a supplier to the United States Government, we are required to comply with  numerous regulations, including those governing security and contracting practices.  Failure to comply with these procurement regulations and practices could result  in fines being imposed against us or our suspension for a period of time from  eligibility for bidding on, or for award of, new government contracts. Among  the causes for the suspension are violations of various statutes, including  those related to procurement integrity, export control, United States Government  security regulations, employment practices, protection of the environment,  accuracy of records in the recording of costs, and foreign corruption. The  government may investigate and make inquiries of our business practices and  conduct audits of contract performance and cost accounting. The government  audits and investigations can take several years to complete. Depending on  the results of these audits and investigations, the government may make claims  against us or take exception to certain costs we determined to be recoverable.  In the period management determines recoverability is not likely, operating  income would be reduced.

We account for cost-reimbursement contracts by charging actual labor, materials,  and other direct costs, plus estimated indirect costs of operations as incurred  (incurred costs). Indirect costs include overhead, research and development,  and general and administrative expenses. Stock compensation expense is generally  not reimbursable under these contracts. We do not apply indirect costs to subcontract  costs that are in excess of $250,000 and that meet certain other predetermined  criteria.

We recognize contract    revenues and profits on cost-reimbursement contracts by applying an estimated    fee rate to all incurred costs on an individual contract basis. Fee calculations    are based on either negotiated fee amounts or management’s  assessment of the fee amounts that are likely to be earned. On cost-reimbursement  contracts, we may bear unexpected cost increases for purposes of maintaining  customer relationships. Historically, the effect on operating results and financial  position from cost-reimbursement losses has been minimal.

 Our policy for recognizing    interim fees on our cost-plus-award-fee contracts is based on management’s assessment as to the likelihood that the award  fee or an incremental portion of the award fee will be earned, on a contract-by-contract  basis. Management bases its assessments on numerous factors, including contract  terms, nature of the work to be performed, our relationship and history with  the customer, our history with similar types of projects, and our current and  anticipated performance on the specific contract. No award fee is recognized  until management determines that it is probable that an award fee or a portion  thereof will be earned. Historically, management’s estimates have generally  been consistent with the actual fees awarded. However, changes in facts and  circumstances could arise within an award fee period, causing management to  either lower or raise the award fee estimate in the period in which the changes  occur. 

Some of our engineering services are performed under time-and-materials contracts  on a level-of-effort basis. We recognize revenue for these contracts by applying  a negotiated billing rate to the level of effort.

We account for fixed-price contracts by using the percentage-of-completion  method. Under this method, we charge labor, materials, and other direct costs,  plus estimated indirect costs of operations, as they are incurred (incurred  costs). Each period, we recognize as revenue a portion of the contract revenue,  based on estimated profits and the degree of completion of the contract as  measured by a comparison of the actual costs incurred and the estimated total  costs to complete. On fixed-price contracts, we bear any unexpected increases  in the cost to develop or manufacture a product, whether due to inaccurate  estimates in the bidding process, unanticipated increases in material costs,  inefficiencies, or other factors, and these costs could have a materially adverse  effect on results of operations and financial condition.

For those contracts in which all of the terms have not yet been finalized,  revenue does not include an estimated fee rate on cost.

Management reviews contract performance, costs incurred, and estimated completion  costs regularly. We adjust revenues and profits on all contracts in the period  in which changes, including anticipated losses, become determinable.

Precontract costs represent costs incurred in anticipation of specific expected  future contract awards and costs incurred in connection with ongoing contracts  for which contract modifications have not been defined or completed at the  end of the reporting date. These costs are included in other current assets  on the balance sheet. Precontract costs for the periods ended August 1, 2008,  and October 31, 2007, were approximately $1,245,000 and $4,465,000, respectively.  Approximately $4,012,000 of the October 31, 2007, balance was recognized as  revenue during the first nine months of fiscal year 2008.

We have one licensing agreement for which we accrue royalties upon sales of  our licensed product by a third party. Since there are essentially no costs  associated with this agreement, operating income will increase by the same  amount of revenue that we recognize. Our royalties contributed approximately  $1,253,000 and $3,764,000 to revenues and operating income during the third  quarter and first nine months of fiscal year 2008, respectively. Our royalties  contributed approximately $336,000 and $955,000 to revenues and operating incomeduring the third quarter and first nine months of fiscal year 2007, respectively. 

***Indirect rate variance adjustment to operations***.  We record contract revenues and costs of operations for interim reporting purposes  based on annual targeted indirect rates. During our interim reporting periods,  variances may accumulate between the actual indirect rates and the annual targeted  rates. Timing-related indirect spending variances are removed from contract  costs, research and development, and general and administrative expenses, and  are included in inventory as part of work in process during these interim reporting  periods. These rates are reviewed regularly, and we record adjustments for  any material, permanent variances in the period they become estimable. We believe  that this method is the preferred practice used within our industry. At year-end,  we adjust the revenues and costs for actual indirect rates.

Our accounting policy    for recording the indirect rate variance is based on management’s belief    that variances accumulated during interim reporting periods will be absorbed    by expected contract activities during the remainder of the year. We consider    the rate variance to be unfavorable when our actual indirect rates are greater    than our annual targeted rates. In contrast, a favorable rate variance occurs    when our actual indirect rates are lower than our annual targeted rates.    During interim reporting periods, we record unfavorable rate variances as    reductions to operating expenses and increases to work-in-process inventory.    We record favorable rate variances as increases to operating expenses and  decreases to work-in-process inventory.

If we anticipate that actual contract activities will be different than planned  levels, there are alternatives we can utilize to reduce the variance: we can  adjust some of our planned indirect spending during the year, request a modification  of our billing rates to our customers through the Defense Contract Audit Agency  any time during the fiscal year in accordance with Federal Acquisition Regulations,  or record adjustments to expense based on estimates of future contract activities  for the remainder of the fiscal year.

If our rate variance is unfavorable, the modification of our billing rates  will likely increase revenue and operating expenses, and decrease the unfavorable  indirect rate variance accumulated in inventory. Fee percentages on fixed-price  and time-and-materials contracts will generally decline as a result of any  increase to indirect costs. Fee percentages on active cost-reimbursable contracts  will generally be unaffected as a result of any increase to indirect costs.  Fee percentages on completed cost-reimbursable contracts will generally be  reduced. If our rate variance is favorable, the modification of our billing  rates will decrease revenue and operating expenses, and decrease the favorable  indirect rate variance accumulated in inventory. In this event, fee percentages  on fixed-price and time-and-materials contracts will generally increase. Fee  percentages on cost-reimbursable contracts will generally be unaffected as  a result of any reduction to indirect costs, due to the fact that programs  will typically expend all of the funds available. Any impact on operating income,  however, will depend on a number of other factors, including mix of contract  types, contract terms, anticipated performance on specific contracts, and anticipated  changes in inventory.

At August 1, 2008, the    unfavorable inventoried indirect variance was approximately $2,177,000. Approximately    $1,180,000 of unanticipated severance costs, that we are paying to our former    Chief Executive Officer, were not included in our target rates for general    and administrative expenses. Therefore, these costs contributed to the unfavorable    rate variance at August 1, 2008. Please see “Note  9: Change in Management” for further details. At August 3, 2007, the  unfavorable rate variance for the first nine months of fiscal year 2007 was  approximately $5,445,000, and was reduced by a management reserve of $1,300,000,  for a net unfavorable variance of approximately $4,145,000. We recorded $300,000  and $1,000,000 of the management reserve during the second and third quartersof fiscal year 2007, respectively. 

***Income taxes***.    Our income tax expense at interim reporting periods is based on our estimated    annual effective tax rate and any discrete items that occur during any interim    period. We calculate this estimated tax rate based on the projected net income    at the end of the fiscal year, and review it at each reporting period. At    the end of the fiscal year, we adjust income tax expense for actual results.    Our effective tax rate can differ from the statutory rate primarily due to    the non-tax-deductible nature of certain types of stock-based compensation    expense. Please refer to “Notes to  Condensed Consolidated Financial Statements, Note 7: Provision for Income Taxes” for  the current year effective tax rate.

***Allowance for bad debt***. Since the majority of our  revenues are generated from the United States Government, its agencies, or  prime contractors for the United States Government, we regard the credit risk  of our business to be minimal. We record allowances for bad debt as a reduction  to accounts receivable and an increase to bad debt expense. These allowances  are recorded in the period a specific collection problem is identified. Once  the receivable is deemed uncollectible, the allowance is reversed and the receivable  is written off.

During the first nine months of fiscal year 2008 and fiscal year 2007, there  was no material charge to bad debt expense. 

***Inventory valuation and disposal***. We provide advanced  digital signal processing products and systems to the United States Government.  Typical life cycles of our equipment are eight to ten years or more. In addition,  we maintain spare parts in order to repair the equipment. We evaluate our inventory  quarterly, at interim reporting periods, and assess our ability to sell our  equipment, which includes raw materials. Historically, we have sold our inventory  at or above cost, so there was typically no decrement in valuation. When we  determine that a product has reached the end of its life cycle or there is  no longer a need for a certain product, typically, we will dispose of any remaining  inventory, and record the associated reduction to inventory. 

We recorded a write-down    of approximately $394,000 and $1,329,000 during the third quarter and first    nine months of fiscal year 2008, respectively, to reflect the estimated market    value of one inventoried product; these charges were included in contract    costs in our statement of operations. Disposals associated with our raw materials    represent a minor amount and are included in general and administrative expenses    on the statement of operations due to the fact that raw materials could be  used in a variety of situations other than contract costs, including R&D.

Disposal activities were not significant during the first nine months of fiscal  years 2008 and 2007.

***Price redetermination***. As a government contractor,  we are subject to price redetermination on certain fixed-price contracts if  it is determined that we did not price our products and services consistent  with the requirements of the Federal Acquisition Regulations. During the first  nine months of fiscal years 2008 and 2007, we did not incur any price redeterminations  on any of our contracts. 

***Goodwill valuation***. We test goodwill for possible  impairment on an annual basis and at any other time if events occur or circumstances  indicate that the current carrying amount of goodwill may not be recoverable.  Circumstances that could trigger an impairment test include, but are not limited  to, a significant adverse change in the business climate or legal factors,  an adverse action or assessment by a regulator, unanticipated competition,  and loss of key personnel.

The determination as to whether a write down of goodwill is necessary involves  significant judgment based on the short-term and long-term projections of the  future performance as well as estimating discount rates.

To perform the goodwill    impairment test, we determine the fair value of the reporting unit and compare    the fair value to the reporting unit’s carrying  value. We believe AST is one reporting unit, and therefore, we compare the  fair value of AST to the total net asset value on our balance sheet. If our  total net asset value were to exceed our fair value, we would perform the second  step of the impairment test. In the second step, we would compare the implied  fair value of our goodwill to our carrying amount. If no impairment exists  under step one, then step two is not necessary.

No indicators of impairment were identified at August 1, 2008.

***Long-lived asset valuation (property, plant and equipment, and      intangible assets)***. We will test long-lived assets or asset      groups for recoverability when events or changes in circumstances indicate      that their carrying amount may not be recoverable. Circumstances that could      trigger a review include, but are not limited to, significant decreases      in the market price of the asset, significant adverse changes in the business      climate or legal factors, accumulation of costs significantly in excess      of the amount originally expected for the acquisition or construction of      the asset, current period cash flow or operating losses combined with a      history of losses or a forecast of continuing losses associated with the      use of the asset, and current expectation that the asset will more likely      than not be sold or disposed of significantly before the end of its estimated      useful life.

We assess recoverability based on the carrying amount of the asset and its  fair value, which is generally determined based on the sum of the undiscounted  cash flows expected to result from the use and the eventual disposal of the  asset. We recognize an impairment loss when the carrying amount is not recoverable  and exceeds fair value.

No indicators of impairment were identified at August 1, 2008.

***Share-based payment***. We adopted SFAS 123 (revised  2004), *Share-Based Payment* (SFAS 123R), at the beginning of fiscal  year 2006. Applying this complex standard to value equity-based compensation  requires us to use significant judgment and to make estimates, particularly  for the assumptions used in the Black-Scholes valuation model, such as stock  price volatility and expected option lives, as well as for the expected option  forfeiture rates.

We elected to use the modified prospective transition method. Stock-based  compensation expense for awards granted subsequent to November 1, 2005, was  based on the grant-date fair value estimated in accordance with the provisions  of SFAS 123R. For awards granted prior to, but not yet vested, as of November  1, 2005, stock-based compensation expense was based on the grant-date fair  value previously estimated in accordance with the original provisions of SFAS  123. We recognize the stock compensation expense over the requisite service  period of the award, which generally equals the vesting period of each grant.

We have an Employee Stock    Purchase Plan (ESPP) that allows employees to purchase shares of common stock    at 85% of the fair market value at the lower of either the date of enrollment    or the date of purchase. For offering periods beginning prior to June 1,    2007, our ESPP had a twenty-four month offering period with four six-month    purchase periods within each offering period. If the fair market value on    the purchase date was lower than the fair market value on the offering date,    all participants were withdrawn from the offering period and re-enrolled    into a new offering period. Effective May 31, 2007, we modified our ESPP    such that the length of all offering periods, beginning June 1, 2007, is    six months. Consequently, there is no reset feature associated with the new    offering periods. As a result of the modification to the ESPP, the December    1, 2006 offering period, ending on November 30, 2008, was the final twenty-four month offering.  On August 20, 2008, the Board of Directors increased the purchase price and  eliminated the look-back provision for offering periods beginning on or after  December 1, 2008. The purchase price for participants will be 95% of the fair  market value on the date of purchase, and therefore, will be prospectively  non-compensatory under the provisions of SFAS 123R. For offering periods  beginning prior to December 1, 2008, we are required to recognized stock compensationexpense in accordance with SFAS 123R. 

Our closing stock price    on the November 30, 2007, ESPP purchase date was lower than the closing stock    price on the December 1, 2006, offering date. Therefore, 361 participants    were re-enrolled from the original twenty-four-month offering period ending    on November 30, 2008, into a new six-month offering period, beginning December 1,    2007, and ending May 31, 2008. This re-enrollment effectively canceled the    final six-month purchase period of the original twenty-four-month offering.    Therefore, the remaining unamortized compensation amount associated with    this final purchase period, approximately $382,000, was immediately recognized  on December 1, 2007. In addition, as a result of the modification, approximately  $89,000 of incremental compensation expense was generated at December 1, 2007,  of which we recognized $13,000 during the third quarter and $89,000 during  the first nine months of fiscal year 2008. 

On November 15, 2007, one of our non-employee directors retired. Immediately  prior to his retirement, we accelerated the vesting of all unvested shares  of his restricted stock and stock option awards. In addition, we extended the  remaining exercise period of all vested and unexercised options from ninety  days to one year. As a result, our stock compensation expense associated with  these modified equity awards, was approximately $80,000 higher than it would  have been had the awards not been modified upon retirement.

The following table sets forth the total stock-based compensation expense  resulting from stock options, restricted stock, and ESPP activity included  in our condensed consolidated statements of operations (in thousands, except  share data).

|                                                        | **——— Three      Months Ended ———**                                                                                             | **——— Nine      Months Ended ———**                                                                                          |
|-------------------------------------------------------------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------|
|                                                        | **August 1,        2008**                                                                                                                                           | **August 3,        2007**                                                                                                                                       | **August 1,        2008** | **August 3,        2007** |
| Contract costs                                              | $557                                                                                                    | $620                                                                                                | $2,242             | 1,852             |
| Research and development                                    | 41                                                                                                      | 46                                                                                                  | 153             | 155             |
| General and administrative                                  | 633                ------------             | 367            ------------             | 1,642            ------------             | 1,248            ------------             |
| Stock-based compensation expense before        income taxes | $1,231                                                                                                  | $1,033                                                                                              | $4,037             | $3,255             |
| Income taxes                                                | (368)           ------------                     | (223)           ------------                 | (860)           ------------             | (682)           ------------             |
| Stock-based compensation expense        after income taxes  | $863                                                                                                    | $810                                                                                                | $3,177             | $2,573             |
| Reduction to basic net income per share                     | $0.07                                                                                                                                                               | $0.07                                                                                                                                                           | $0.26 | $0.21 |
| Reduction to diluted net income per share                   | $0.07                                                                                                                                                               | $0.07                                                                                                                                                           | $0.25 | $0.21 |

Assumptions used in the    Black-Scholes model are the expected stock price volatility over the expected    life of the awards, the projected employee stock option’s  life, the expected dividend yield, and the risk-free interest rate. Changes  in the subjective assumptions can materially affect the estimated value of  the stock awards. Historical volatility, market-based implied volatility, or  a combination of both will be considered when projecting the expected stock  price volatility for both stock options and purchases under our ESPP. We determined  that the combination of historical and market-based implied volatility provides  a more accurate reflection of our market conditions and is more representative  of future stock price trends than employing solely historical volatility. For  our ESPP offering periods beginning prior to June 1, 2007, the expected life  was based on the six-month purchase periods within each twenty-four-month offering  period. Offering periods beginning after that date have a single six-month  purchase period and we use an expected life of six months. The risk-free interest  rate is based on the Federal Reserve Bank’s constant maturities daily  interest rate in effect at the ESPP offering date. The expected dividend yield  is calculated by taking the total expected annual dividend payout divided bythe average stock price per share.

The fair value of our restricted stock is based on our closing stock price  on the date of grant.

Please refer to “Notes to Condensed Consolidated Financial Statements,  Note 1: Summary of Significant Accounting Policies, Stock-Based Compensation” for  additional information.

**Overview**

We believe that there continues to be an interest in ISR by the United States  Government to respond to the threat of terrorist activities and the war against  terrorism, and that we are well positioned to benefit from the spending that  might result. We believe that our COMINT and sensor processing markets have  strong growth potential and that our move into the ELINT marketplace provides  us an opportunity to diversify into a complementary business. As a result of  this anticipated growth, we expect to make additional investments of capital  and management resources, including additional personnel and facilities.

We continue to focus our operations on assuring program performance, meeting  staffing requirements, maintaining a competitive cost structure, and diversifying  our marketplace. Our customers continue to come to us with new requirements  for ISR solutions, weighted heavily toward new developments. A significant  portion of our revenue continues to be generated by cost-reimbursable contracts  that tend to be developmental in nature, and require highly specialized, technical  skill sets. We believe that this trend will continue through the remainder  of fiscal year 2008.

During the second quarter    of fiscal year 2008, Mr. Gary L. Yancey, our former Chairman and Chief Executive    Officer, resigned as an executive officer and as a member of the Board of    Directors. His final date of employment with us was May 30, 2008. Upon Mr.    Yancey’s resignation, Mr. John P. Devine,  a director since 1995, was named non-executive Chairman of the Board of Directors  and Mr. William Van Vleet III, our Chief Operating Officer, was appointed as  Acting Chief Executive Officer. In connection with his departure, on May 23,  2008, we entered into a Severance Agreement and General Release of Claims with  Mr. Yancey, under which, we are providing to Mr. Yancey certain separation  benefits. These benefits are payable to Mr. Yancey pursuant to his participation  in the Company’s Executive Retention and Severance Plan of August 19,  2004, and as a result of which, we are paying to Mr. Yancey in monthly installments  an amount equal to 24 months of his base salary and 100% of his annual bonus.  The bonus was determined as the aggregate amount that would be earned by him  during fiscal year 2008 if all applicable performance goals were achieved.  We will also continue health and other similar benefits until Mr. Yancey reaches  age 65.

As a result, we recognized accrued severance of approximately $1,180,000 during  the second quarter of fiscal year 2008. In addition, management believes that  severance expense is recoverable through our indirect rates, and therefore  we increased our indirect rate variance included in inventory by approximately  $1,180,000.

In addition, all outstanding    but unvested options to purchase Company common stock and all unvested restricted    stock awards held by Mr. Yancey vested in full as of May 30, 2008. We also    extended the period of exercisability of any vested stock options held by    Mr. Yancey to two years from the date of termination of employment or expiration    of the individual option grant, whichever occurs first. We recognized stock-based    compensation expense of approximately $304,000 during the third quarter of    fiscal year 2008, associated with the modifications to Mr. Yancey’s  equity awards.

On August 20, 2008, Mr. Van Vleet was appointed as President, Chief Executive  Officer, and a Class I member of the Board of Directors.

**Three and Nine Months Ended August 1, 2008, Compared to Three Months and  Nine Months Ended August 3, 2007**

***Revenues and backlog***. Revenues for the third quarter  of fiscal year 2008 were approximately $49,948,000, a 26.3% increase from revenues  of approximately $ 39,542,000 recorded in the third quarter of fiscal year  2007. Revenues for the first nine months of fiscal year 2008 were approximately  $137,957,000, an 11.1% increase from revenues of approximately $124,140,000  recognized during the same period of fiscal year 2007. Revenues generated by  our development programs increased by approximately $7,076,000 and $15,845,000  during the third quarter and first nine months of fiscal year 2008, respectively,  compared to the same periods in fiscal year 2007. This increase included revenues  recognized from pre-contract costs of approximately $1,912,000 and $4,012,000  during the third quarter and first nine months of fiscal year 2008, respectively. 

 Product sales increased by approximately $2,413,000 during the third quarter  of fiscal year 2008, and decreased by approximately $4,836,000 during first  nine months of fiscal year 2008, compared to the same periods of fiscal year  2007. 

We have one licensing agreement for which we accrue royalties upon sales of  our licensed product by a third-party. Since there are essentially no costs  associated with this agreement, operating income will increase by the same  amount of revenue that we recognize. We recorded royalty income of approximately  $1,253,000 during the third quarter of fiscal year 2008, compared to approximately  $336,000 during the same period of fiscal year 2007. Royalty income for the  first nine months of fiscal year 2008 was approximately $3,764,000, compared  to approximately $955,000 during the same period of fiscal year 2007.

New orders received during the third quarter of fiscal year 2008 were approximately  $70,275,000, a decrease of 5.1% from approximately $ 74,081,000 in new orders  received during the same period of fiscal year 2007. New orders received during  the first nine months of fiscal year 2008 were approximately $ 145,314,000,  a decrease of 3.7% from approximately $ 150,861,000 in new orders received  during the same period of fiscal year 2007. Our backlog consists of the uncompleted  portions of existing contracts (excluding unexercised contract options). At  August 1, 2008, ending backlog was approximately $133,333,000, representing  a 5.2% increase from ending backlog of approximately $126,708,000 at October  31, 2007. Reported backlog includes both funded and unfunded portions of contract  values. There is no assurance or obligation that contracts will be fully funded.  To the extent that contracts are not fully funded, there will be a reduction  to backlog in a future period. We recently received a termination for the convenience  of the government related to several delivery orders. New orders and backlog  are expected to be reduced by approximately $2 to $4 million when we complete  settlement of the terminated efforts.

Our contracts can be fixed-price contracts, where we agree to deliver equipment  for a fixed price and assume the risk of cost overruns; cost-reimbursement  contracts, where we are reimbursed for our direct and indirect costs and paid  a negotiated profit; or time-and-materials contracts, where we recognize revenue  for these contracts by applying a negotiated billing rate to the level-of-effort.  Cost-reimbursement and time-and-materials contracts typically do not return  as high a profit margin as fixed-price contracts, and accordingly, our profit  margin will be affected by the mix of our orders by contract type.

The following table represents our revenue concentration during the respective  periods by contract type.

|                         | **——— Three      Months Ended ———** | **——— Nine      Months Ended ———** |
|------------------------------|-------------------------------------------------------------------------|------------------------------------------------------------------------|
|                         | **August          1,    2008**                                          | **August 3,     2007**                                                 | **August          1,    2008** | **August 3,     2007** |
| Cost-reimbursement contracts | 68%                                                                     | 71%                                                                    | 70% | 73% |
| Fixed-price contracts        | 14%                                                                     | 10%                                                                    | 11% | 14% |
| Time-and-materials contracts | 18%                                                                     | 19%                                                                    | 18% | 13% |

Five contracts represented an aggregate of 62% and 60% of revenues for the  respective three-month and nine-month periods ended August 1, 2008. Three of  these contracts were indefinite-delivery-indefinite-quantity (IDIQ) contracts.  Under the terms of this type of contract, the government may issue individual  delivery orders (DOs) for goods or services that they require. Each DO is treated  as a separate contract, which may be awarded on a cost-reimbursable, fixed-price,  or time-and-materials basis. We aggregate the DOs under each IDIQ contract  for purposes of distinguishing significant revenue concentrations. Six contracts  represented an aggregate of 56% and 57% of revenues for the respective three-month  and nine-month periods ended August 3, 2007. Four of these contracts were IDIQ  contracts. In addition, one of the five contracts in each of fiscal years 2008  and 2007 was a time-and-materials contract, which significantly increased the  revenue concentration of time-and-materials contracts during fiscal year 2008and 2007. All of the other contracts referenced were cost-reimbursement contracts.

***Contract costs***. Contract costs consist of direct  costs incurred in the performance of the contract, including labor, materials,  and estimated overhead costs. Contract costs were approximately $34,572,000,  or 69.2 % of revenues, for the third quarter of fiscal year 2008 compared to  approximately $27,062,000, or 68.4% of revenues, for the same period of fiscal  year 2007. Contract costs were approximately $95,435,000, or 69.2% of revenues,  for the first nine months of fiscal year 2008 compared to approximately $ 84,505,000,  or 68.1% of revenues, for the same period of fiscal year 2007. Contract costs  increased in absolute dollars and as a percentage of revenues during the third  quarter and first nine months of fiscal year of fiscal year 2008 compared to  the same periods of fiscal year 2007 primarily due to increased activity with  development programs. In addition, we recorded an inventory write-down during  the second and third quarters of fiscal year 2008, which increased contract  costs by approximately $394,000 and $1,329,000 for the third quarter and first  nine months of fiscal year 2008, respectively. 

***Research and        development (R&D)***. Company-directed  investment in research and development consists of expenditures recoverable  from customers through our billing rates and expenditures funded by us from  operations. For interim reporting periods, R&D expenses include labor,  materials, and estimated overhead costs. R&D expenses were approximately  $3,953,000, or 7.9 % of revenues, for the third quarter of fiscal year 2008  compared to approximately $3,756,000, or 9.5% of revenues, for the same period  of fiscal year 2007. During the first nine months of fiscal year 2008, R&D  expenses were approximately $10,486,000, or 7.6% of revenues, compared to approximately  $ 10,751,000, or 8.7% of revenues, during the first nine months of 2007. R&D  expenses decreased in absolute dollars and as a percentage of revenues during  the first nine months of fiscal year 2008 primarily due to directing our efforts  toward meeting our contractual obligations.

***General and        administrative (G&A)***. General and  administrative expenses include administrative salaries, costs related to marketing  and proposal activities, costs associated with product warranties, and other  administrative costs. We record G&A expenses based on annual targeted indirect  rates applied to our quarterly revenue base, for interim reporting periods.  G&A expenses were approximately $8,205,000, or 16.4 % of revenues, for  the third quarter of fiscal year 2008, compared to approximately $ 7,101,000,  or 18.0% of revenues, for the same period of fiscal year 2007. During the first  nine months of fiscal year 2008, G&A expenses were approximately $23,603,000,  or 17.1 % of revenues, compared to approximately $ 21,645,000, or 17.4% of  revenues, during the first nine months of 2007. G&A expenses increased  in absolute dollars during the first nine months of fiscal year 2008 primarily  due to the applied target G&A rate on an increased contract base.

***Interest income and other, net***. Net interest income  for the third quarter of fiscal year 2008 was approximately $285,000, representing  an immaterial difference to net interest income of approximately $347,000 for  the third quarter of fiscal year 2007. Interest income recognized during the  first nine months of fiscal year 2008 was approximately $950,000 compared to  interest income of approximately $ 969,000 during the first nine months of  2007.

***Interest expense***. Interest expense for the third  quarter of fiscal year 2008 was approximately $127,000 compared to approximately  $158,000 of interest expense in the third quarter of fiscal year 2007. Interest  expense incurred during the first nine months of fiscal year 2008 was approximately  $412,000 compared to interest expense of approximately $ 515,000 during the  first nine months of fiscal year 2007. Interest expense decreased during the  third quarter and first nine months of fiscal year 2008 primarily due to the  reduction of the balance of our Term Loan with Wells Fargo. 

***Provision for income taxes***. Our provision for income  taxes for the third quarter and first nine months of fiscal year 2008 was approximately  $1,411,000 and $3,503,000, respectively, representing an estimated 45.9% annual  effective tax rate. Our provision for income taxes for the third quarter and  first nine months of fiscal year 2007 was approximately $835,000 and $3,273,000,  respectively, representing an estimated 45% annual effective tax rate. The  difference in our estimated annual effective tax rate at August 1, 2008, from  our effective tax rate at August 3, 2007, was primarily due to a projected  decrease in our tax-exempt interest. 

During the first nine    months of fiscal year 2008, we reduced our income tax expense by approximately    $616,000. This reduction included the filing of an Application for Change    in Accounting Method with the Internal Revenue Service (IRS) under the automatic-consent    provisions, during the second quarter of fiscal year 2008. Based upon the    change in method filed with the IRS, we re-measured our deferred tax asset    balance related to the determination of tax basis depreciation on certain    property and equipment assets as of October 31, 2006. This led to a tax benefit    of approximately $333,000, which was recorded as a discrete item during the    second quarter of fiscal year 2008. During the third quarter of fiscal year    2008, we recorded additional discrete tax benefit items, which led to a net    reduction to income tax expense of approximately $176,000. These additional    discrete items included a reduction to income tax expense of approximately  $303,000, associated with research and development credits; offset by an increase  to tax expense of approximately $108,000 associated with a reduction to tax-exempt  interest taken on our income tax returns for fiscal year 2007. During the first  nine months of fiscal year 2007, we recorded a reduction to income tax expense  for discrete items of approximately $183,000, primarily associated with the  benefit of our research and development tax refund from the state of California.

**Analysis of Liquidity and Capital Resources**

Our primary sources of    liquidity during the first nine months of fiscal year 2008 were cash flows    generated from operations, the issuance of common stock through exercise    of options granted under our employee stock option plans, and stock purchases    under our ESPP. We have reduced option grants in favor of restricted stock    awards and have modified our ESPP. We are unable to estimate the impact on  liquidity, associated with the issuance of common stock, on future periods.

***Net cash from operating activities***. Net cash from  operating activities has varied significantly from quarter to quarter. These  quarter-to-quarter variances are primarily the result of changes in net income  and operating assets and liabilities. Operating activities provided cash of  approximately $19,695,000 and $6,376,000 during the first nine months of fiscal  years 2008 and 2007, respectively. Net income for the first nine months of  fiscal year 2008 was approximately $5,468,000 compared to net income of approximately  $4,420,000 for the comparable period of fiscal year 2007.

Accounts receivable balances decreased during the first nine months of fiscal  year 2008 by approximately $2,189,000 and by approximately $ 1,404,000 during  the same period in fiscal year 2007. During the first nine months of fiscal  year 2008, we generated revenues of approximately $137,957,000 and collected  approximately $140,146,000. During the first nine months of fiscal year 2007,  we generated revenues of approximately $124,140,000 and collected approximately  $125,544,000.

Inventory, prepaid expenses, and other assets increased during the first nine  months of fiscal year 2008 by approximately $1,741,000 and by approximately  $3,537,000 during the same period of fiscal year 2007. Inventory balances increased  by approximately $2,307,000 during the first nine months of fiscal year 2008.  The increase in inventory included an increase to the indirect rate variance  of approximately $2,177,000, an increase to work-in-process inventory of approximately  $1,431,000, and a reduction due to an inventory write-down of approximately  $1,329,000. During the first nine months of fiscal year 2008, precontract costs  decreased other current assets by approximately $3,220,000, while prepaid expenses  increased other current assets by approximately $1,831,000. During the first  nine months of fiscal year 2007, precontract costs decreased other current  assets by approximately $3,137,000, the indirect rate variance included in  inventory increased by approximately $4,145,000, and work-in-process inventory  increased by approximately $2,109,000. 

During the first nine months of fiscal year 2008, we received a payment of  approximately $877,000 for lease incentives associated with our facility in  Torrance, California.

Accounts payable, taxes payable, accrued payroll liabilities, and other accrued  liabilities balances increased by approximately $3,502,000 during the first  nine months of fiscal year 2008 and decreased by approximately $3,326,000 during  the first nine months of fiscal year 2007. The increase during the first nine  months of fiscal year 2008 included accrued severance for our former Chief  Executive Officer of approximately $1,135,000. In addition, accounts payable  and other accrued liabilities increased by approximately $1,998,000 during  the first nine months of fiscal year 2008.

During the same period in fiscal year 2007, accounts payable and other accrued  liabilities balances decreased by approximately $2,366,000, primarily due to  decreased outstanding procurements, and accrued payroll liabilities decreased  by approximately $960,000.

***Net cash from investing activities***. Investing activities  used cash of approximately $15,701,000 during the first nine months of fiscal  year 2008. During the same period of fiscal year 2007, investing activities  used cash of approximately $2,636,000. During the first nine months of fiscal  year 2008, we purchased approximately $80,236,000 of investment securities  and approximately $67,565,000 matured. During the same period of fiscal year  2007, we purchased approximately $56,902,000 of investment securities and approximately  $55,790,000 matured.

***Net cash from financing activities***. Financing activities  used cash of approximately $2,643,000 during the first nine months of fiscal  year 2008 and used cash of approximately $1,468,000 during the same period  in fiscal year 2007. The difference in financing activities between the first  nine months of fiscal years 2008 and 2007 is due to a decrease in the amount  of proceeds from our employee stock purchase plan and fewer option exercises  during the first nine months of fiscal year 2008. In addition, we paid dividends  of approximately $4,695,000 and $4,529,000 during the first nine months of  fiscal years 2008 and 2007, respectively.

Cash is generated primarily    from operating activities, employee stock activities, and investing activities.    At August 1, 2008, we held in our investment portfolio approximately $46,222,000    of short-term and long-term municipal securities. Substantially all of our    investments in the municipal securities are with A-1/SP-1/AAA (Standard & Poor’s), P-1/MIG-1/Aaa (Moody’s),  and F-1/AA/AAA (Fitch) rated issuers.

Our investment policy prohibits our investment in auction rate securities,  mortgage-backed securities, and asset-backed securities. Insured municipal  notes or bonds are also prohibited, with the exception of daily and weekly  variable rate demand notes that contain a hard put feature.

Based on our ability to liquidate our investment portfolio and our expected  operating cash flows, we do not anticipate any liquidity constraints as a result  of the current credit environment.

We believe the primary risk to liquidity is the potential decrease in demand  for our products and services. Historically, this demand has been influenced  by the ISR needs of the United States Government.

We believe that the funds generated from operations, existing working capital,  and the amount available under our existing line of credit will be sufficient  to meet our cash needs for the next twelve months.

**Borrowing Arrangements**

***Revolving line of credit***. At August 1, 2008, we  had a revolving line of credit (Line of Credit) under which Wells Fargo Bank  (Wells Fargo), could advance funds to us, up to a maximum principal amount  of $3 million. The Line of Credit was renewed on February 21, 2008, and it  will expire on March 1, 2009.

At August 1, 2008, we had two standby letters of credit under the Line of  Credit totaling approximately $1,371,000. One letter of credit, related to  our Sunnyvale, California facilities lease, had a committed balance of approximately  $1,221,000 at August 1, 2008. The third letter of credit was a requirement  of our workers compensation insurance, and had a committed balance of approximately  $150,000 at August 1, 2008. We do not pay interest on the amount associated  with the standby letters of credit.

As a result of the committed    but unused funds associated the two letters of credit, the total amount under    the Line of Credit available for borrowing was approximately $1,629,000.    No fees or interest were associated with this unused portion. Borrowings    under the Line of Credit bear interest at Wells Fargo’s  reference rate (5% at August 1, 2008), and interest on those borrowings are  payable monthly. As security for our indebtedness under the Line of Credit,  we have granted to Wells Fargo a security interest in our cash and marketable  securities maintained with an affiliate of Wells Fargo.

***Term loan and interest rate swap***. Effective July  1, 2005, and in connection with the acquisition of DTI, we entered into a Term  Loan with Wells Fargo, in the principal amount of $10 million, plus interest,  the proceeds of which were used for acquisition financing (the Term Loan).  The Term Loan bears interest at a fixed rate per annum equal to 1.750% above  the London Inter-Bank Offered Rate (LIBOR) (2.46% at August 1, 2008). Our Term  Loan is for a seven-year term ending on July 1, 2012, with monthly payments  of principal and interest.

As security for our indebtedness under the Term Loan, we have granted to Wells  Fargo a security interest in our accounts receivable, general intangibles,  inventory, and equipment.

We are required to maintain certain financial covenants setting forth minimum  ratios for quick ratio and fixed charge coverage and maximum ratios for total  liabilities to tangible net worth. As of August 1, 2008, we were in compliance  with these covenants.

We are exposed to market risk from changes in interest rates on the Term Loan,  and manage this exposure through the use of an interest rate swap agreement  with Wells Fargo. By locking in a fixed rate for the entire term of the loan,  this strategy decreases the variability of earnings and cash flows resulting  from interest rate fluctuations and lowers the overall borrowing costs should  interest rates rise. The interest rate swap is designated as a cash flow hedge  and is accounted for under SFAS 133, *Accounting for Derivative Instruments  and Hedging Activities* (SFAS 133). No losses on the agreement due to counterparty  credit issues are anticipated. Under this swap, we pay an interest rate of  4.33%, per annum, over the seven-year term of the loan and receive an average  floating rate of LIBOR on the notional amount of the loan. Thus, we exchanged  a variable rate obligation for a fixed interest obligation, resulting in an  effective interest rate of 6.08%.

The effective portion of the cash flow hedge is reported as other comprehensive  income and reclassified into earnings in the same period during which the hedged  transaction affects earnings. At August 1, 2008, the effective portion of the  cash flow hedge was a deferred net loss of approximately $54,000, net of taxes.  Over the next twelve months, we expect to reclassify approximately $76,000  of the loss to interest expense as principal on the Term Loan is repaid and  the related swap-instrument notional amount is reduced.

We assess effectiveness of the hedge instrument regularly. The ineffective  portion of the gain or loss, if there is one, would impact earnings as it occurs.  There is no ineffective portion of the outstanding swap as of August 1, 2008.

**Contractual Obligations**

The following table sets forth our contractual obligations as of August 1,  2008, (in thousands).

|                                  | **———————————————— Payments    Due by Period****———————————————** |
|---------------------------------------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|                                  | **Total**                                                                                                                                                                                                                                                   | **Less than        1 Year** | **1–3        Years** | **3–5        Years** | **More than        5 Years** |
| Operating lease obligations           | $37,954                                                                                                                                                                                                   | $7,569           | $14,271           | $8,636           | $7,478           |
| Loan    obligations – principal | 5,595                                                                                                                                                                                                     | 1,429           | 2,857           | 1,309           | 0           |
| Loan    obligations – interest  | 691                                                                                                                                                                                                       | 306           | 344           | 41           | 0           |
| Purchase obligations                  | 6,078              ------------                                                                                                                         | 6,078          ------------           | 0          ------------           | 0          ------------           | 0          ------------           |
|      Total   | $50,318              =======                                                                                                                            | $15,382          =======           | $17,472          =======           | $9,986          =======           | $7,478          =======           |

Our operating lease obligations consist of non-cancelable lease agreements  for our facilities, which expire at various dates between fiscal years 2009  and 2016. Certain leases contain escalation clauses and requirements for the  payment of property taxes, insurance, and maintenance expenses. During the  first quarter of fiscal year 2008, approximately $998,000 of the cost for our  leasehold improvements was funded by the landlord of our new facility in Torrance,  California. This was determined to be a lease incentive. This lease incentive  reduces our rent expense and will be amortized on a straight-line basis over  the remaining period of our operating lease that ends in fiscal year 2015.  This reduction to rent expense is generally equal to the increased amortizationexpense of the associated leasehold improvements.

We do not have any off-balance sheet arrangements with unconsolidated entities  or related parties, and, accordingly, our liquidity and capital resources are  not subject to off-balance sheet risks from unconsolidated entities.

**Recent Accounting Pronouncements**

In September 2006, the FASB issued SFAS 157, *Fair Value Measurement*.  SFAS 157 defines fair value, establishes a framework for measuring fair value,  and enhances disclosures about fair value measurements. The statement will  be effective for our fiscal year beginning November 1, 2008. We are evaluating  the impact adopting SFAS 157 will have on our financial statements.

In February 2007, the FASB issued SFAS 159, *The Fair Value Option for    Financial Assets and Financial Liabilities.*SFAS 159 provides companies    with an option to report selected financial assets and liabilities at fair    value. It also establishes presentation and disclosure requirements to facilitate    comparisons between companies using different measurement attributes for    similar types of assets and liabilities. The statement will be effective    for our fiscal year beginning November 1, 2008. We are evaluating the impact    on the adoption of SFAS 159 will have on our financial statements.

In June 2007, the FASB    ratified Emerging Issues Task Force (EITF) Issue  No. 07-3, Accounting for Nonrefundable Advance Payments for Goods or Services  to Be Used in Future Research and Development Activities (EITF 07-3). EITF  07-3 requires non-refundable advance payments for goods and services to be  used in future research and development activities to be recorded as an asset,  with the payments expensed when the research and development activities are  performed. EITF 07-3 applies to new contractual arrangements entered into in  fiscal years beginning after December 15, 2007. We currently record a  prepaid asset for any non-refundable advance payments and recognize the expense  when the activities are performed. We believe that adoption of EITF 07-3 will  not have a material effect on our financial position, results of operations,  or cash flows.

In December 2007, the FASB issued SFAS 141R, *Business Combinations*.  SFAS 141R replaces SFAS 141. The statement retains the purchase method of accounting  for acquisitions, but requires a number of changes, including changes in the  way assets and liabilities are recognized in the purchase accounting. It changes  the recognition of assets acquired and liabilities assumed arising from contingencies,  requires the capitalization of in-process research and development at fair  value, and requires the expensing of acquisition-related costs as incurred.  We do not  expect any impact on our financial statements as a result  of adopting SFAS 141R.

In March 2008, the FASB issued SFAS 161*,      Disclosures about Derivative Instruments and Hedging Activities—an amendment of FASB Statement No. 133*.    SFAS 161 requires enhanced disclosures about derivatives on a quarterly basis,    including qualitative disclosures about objectives and strategies for using    derivatives, and quantitative disclosures about the fair value of derivatives,    as well as gains and losses on derivative instruments. It also requires disclosures    about the volume of derivative activity and credit-risk-related contingent    features in derivative agreements. SFAS 161 does not change the accounting    treatment for derivative instruments, and therefore, the adoption will not    have any impact on our financial position, results of operations, or cash    flows. SFAS 161 is effective for fiscal years and interim periods beginning    after November 15, 2008.

**Item 3: Quantitative and  Qualitative Disclosures about Market Risk**

***Interest rate risk***.    Our interest income is sensitive to changes in the general level of United    States interest rates. At August 1, 2008, our short-term and long-term securities    consisted of municipal securities. Substantially all of our investments in    the municipal securities are with A-1/SP-1/AAA (Standard & Poor’s), P-1/MIG-1/Aaa (Moody’s),    and F-1/AA/AAA (Fitch) rated issuers. Our investment policy prohibits our    investment in auction rate securities, mortgage-backed securities, and asset-backed    securities. Insured municipal notes or bonds are also prohibited, with the    exception of daily and weekly variable rate demand notes that contain a hard  put feature.

The average days to maturity of our investment portfolio is 160 days as of  August 1, 2008. Due to the short-term nature of these cash investments and  the ability to liquidate our investment portfolio, we do not believe that there  is a material interest rate risk associated with the current credit environment.  As of August 1, 2008, our total cash and investments balance that was sensitive  to interest rate risk was approximately $ 52,823,000. As a measurement of the  sensitivity of our portfolio, if yields were to fluctuate by 100 basis points,  the total effect to the investment portfolio balance would be approximately  $217,000.

The following table summarizes our cash, cash equivalents, and short-term  securities, at fair value, that are sensitive to interest rate risk (in thousands).

|                                                | **August          1,    2008**                                                                                                             | **October          31,    2007**                                                                                                          |
|-----------------------------------------------------|--------------------------------------------------------------------------------------------------------------------------------------------|-------------------------------------------------------------------------------------------------------------------------------------------|
| Cash and cash equivalents                           | $6,601                                                                                   | $5,250                                                                                  |
| Available-for-sale securities:                      |                                                                                                                                       |                                                                                                                                      |
|      Short-term tax exempt | 34,493                                                                                   | 29,683                                                                                  |
|      Long-term tax exempt  | 11,729          ------------           | 4,114          ------------           |
|                                                | $52,823          =======               | $39,047          =======              |

***Term loan        and interest rate swap***. Effective July  1, 2005, and in connection with the acquisition of DTI, we entered into a Term  Loan agreement in the principal amount of $10 million with Wells Fargo Bank,  the proceeds of which were used for acquisition financing. The Term Loan bears  interest at an annual rate of 1.75% above LIBOR (2.46% at August 1, 2008).

We manage potential market risk from changes in interest rates on the Term  Loan through the use of an interest rate swap agreement designated as a cash  flow hedge. By locking in a fixed rate for the entire term of the loan, this  strategy decreases the variability of earnings and cash flows resulting from  interest rate fluctuations and lowers our overall borrowing costs should interest  rates rise.

Coincident with the Term Loan transaction, we also entered into an interest  rate swap agreement with Wells Fargo whereby we pay interest to Wells Fargo  at a fixed rate of 4.33% and Wells Fargo pays interest to us at a floating  rate tied to the LIBOR index. The combined interest amounts on the Term Loan  and the swap reflect our total monthly interest obligation, which is locked  in at 6.08%.

**Item 4: Controls and Procedures**

***Conclusions regarding disclosure controls and procedure***.  Under the supervision and with the participation of our management, including  our Chief Executive Officer and our Chief Financial Officer, we evaluated the  effectiveness of our disclosure controls and procedures, as such term is defined  under Rule 13a-15(e) promulgated under the Securities Exchange Act of  1934, as amended. Based upon that evaluation, our Chief Executive Officer and  Chief Financial Officer concluded that our disclosure controls and procedures  were effective as of the end of the period covered by this quarterly report.

***Changes in internal control over financial reporting***.  T here have been no changes in our internal control over financial reporting  during the quarter ended August 1, 2008, that have materially affected, or  are reasonably likely to materially affect, our internal control over financial  reporting. 

***Limitations of the effectiveness of internal control***.  A control system, no matter how well conceived and operated, can provide only  reasonable, not absolute, assurance that the objectives of the internal control  system are met. Because of the inherent limitations of any internal control  system, no evaluation of controls can provide absolute assurance that all control  issues, if any, within a company have been detected. Notwithstanding these  limitations, our disclosure controls and procedures are designed to provide  reasonable assurance of achieving their objectives. Our Chief Executive Officer  and Chief Financial Officer have concluded that our disclosure controls and  procedures are, in fact, effective at the “reasonable assurance” level. 

**Part II. Other Information**

**Item 1: Legal Proceedings**

We are subject to litigation, from time to time, in the ordinary course of  business including, but not limited to, allegations of wrongful termination  or discrimination, or governmental agency investigations. As a government contractor,  we may also be subject to investigations by the United States Government for  alleged violations of procurement or other federal laws. Under present government  procurement regulations, if judged in violation of procurement or other federal  civil laws, we could be suspended or barred from eligibility for awards of  new government contracts.

On March 11 and July 19,    2005, purported securities class action complaints were filed in the United    States District Court, Northern District of California. The cases were considered    as*In re Applied Signal Technology Inc. Securities  Litigation*, Master File No. 4:05-cv-1027 (SBA). The amended consolidated  complaint is brought on behalf of a putative class of persons who purchased  our Company’s securities during a class period of August 24, 2004, through  February 22, 2005. The complaints name us, our former Chief Executive Officer,  and our Chief Financial Officer as defendants, and allege that false and misleading  statements regarding us were issued during the class period. On February 8,  2006, the Court dismissed the case with prejudice. On June 5, 2008, the Ninth  Circuit reversed the dismissal and remanded to the District Court. We intend  to contest this litigation vigorously. Any future unfavorable outcome of the  litigation could have an adverse impact on our business, financial condition,  and results of operation. At this time, we cannot estimate the amount of possible  loss or range of loss that might be incurred as a result of this proceeding. 

On August 12, 2008, a    purported shareholder derivative action was filed in the Superior Court,    State of California. *Shoemaker v. Devine et al.*,  No. 1:08-CV-119810. It is brought on purported behalf of the Company, against  current and former members of the Board of Directors, our Chief Financial Officer,  and our former Chief Executive Officer, asserting that these individuals breached  their fiduciary duties, based on essentially the same allegations as the class    action case. No damages are specified. As the case is brought on purported    behalf of the Company, there is no possible loss that might be incurred as    a result of this proceeding.

****

**Item 1A: Risk Factors**

Our future performance is subject to a variety of risks. If any of the following    risks actually occurs, our business could be harmed and the trading price of    our common stock could decline. In addition to the following disclosures, please    refer to the other information contained in this report, including consolidated  financial statements and the related notes.

***We may not be successful in our expansion of our products and        markets, and may not realize the benefits of our investments in these new        markets***. Over the last several years, we have made investments        in other areas complementary to our historic COMINT offerings. As a result        of these investments, including our acquisition of Dynamics Technology,        Inc. (DTI) in July 2005, and our research and development into the ELINT        market, we have expanded our product offerings, approached new customers,        and entered into new markets for advanced digital signal processing products,        systems, and services in support of intelligence, surveillance, and reconnaissance        (ISR) for global security. Our operations during fiscal year 2008 have        been, and are expected to continue to be, substantially influenced by the        operations of the businesses we acquired from DTI as well as from our continued        investment in products and markets complementary to our existing and new        businesses. Our entry into new markets, and introduction of new products,      subject us to a number of risks and uncertainties, including the following:

- We are entering markets in which we have no or limited prior experience, and        are marketing to new customers in addition to our historic customer relationships.        We may not be successful in these markets, and we may be unable to successfully        enter into contracts with new or existing customers for these new business        lines. We may not achieve the strategic objectives and other anticipated potential        benefits of the acquisition of DTI or the investment in other products and        complementary technologies. Our failure to achieve these strategic objectives      could have a material, adverse effect on our ability to grow our business.
- As a result of the acquisition of DTI, we incurred debt in the amount of $10        million, of which $5.6 million remains outstanding as of August 1, 2008. Our        failure to repay this debt when due would materially, adversely affect our      financial condition and results of operations.
- Our diversification into        ELINT, and into new signal processing capabilities, requires us to invest        additional capital, open new facilities, and incur additional R&D expenditures. In addition, diversification results in diversion of        management’s attention from our historic business. Although we believe        that entering into these new business areas will be important to remaining        competitive in the defense electronics marketplace, there can be no assurance        that we will derive benefits from this diversification, our core business        could suffer, and we could incur significant unanticipated costs, which could      have a material impact on our results of operations.

***Any decrease in expected product sales during a period could adversely        impact our revenues, results of operations, and financial condition***.        From time to time, we have derived a significant portion of our revenue        from product sales. In recent periods, however, we have been focusing on        sales of systems and software, and targeting larger programs. In addition,        we have experienced some seasonality in product sales to the United States        Government, with more product sales occurring in the second half of the        fiscal year than in the first. The amount and timing of Government purchases        of products is unpredictable, and fluctuates significantly from period        to period, making it difficult for us to predict the amount of revenue        we will generate from product sales in any particular period, and causing        our revenues to fluctuate from period to period. If we are not able to        generate revenues from product sales as expected in a particular period,        we may fail to meet our revenue expectations and the expectations of industry      analysts and investors, which could cause our stock price to decline.

***If we are unable to recruit, train, and retain key personnel with        required security clearances, our ability to develop, introduce, and sell        our products may be adversely impacted***. Our ability to execute        our business plan is contingent upon successfully attracting and retaining        qualified employees who obtain, or are able to obtain and retain, necessary        government security clearances. If we fail to attract and retain qualified        employees who can obtain the necessary security clearances, our business        could be significantly harmed. The loss of the services of our qualified        employees, the inability to attract or retain qualified personnel in the        future, or delays in hiring required personnel could negatively impact        our ability to develop, introduce, and sell our products. In addition,      employees may leave us and subsequently compete against us.

Many of the personnel we hire will need United States Government security    clearances in order to perform tasks required on our government contracts,    and without such clearances, employees cannot work on the majority of our projects.    We have found that there is a shortage of qualified personnel possessing the    necessary clearances, and new security clearances are taking longer to be granted.    If we are not able to obtain security clearances for our personnel where required,    they will be unable to perform tasks requiring clearances, and we may be unable    to satisfy the terms of our contracts, resulting in customer dissatisfaction  and possible loss of current or future contracts.

***Stop-work orders could negatively impact our operating results        and financial condition***. Almost all of our contracts contain        stop-work clauses that permit the Government or other contracting party,        at any time, by written order, to stop work on all or any part of the work        called for by the contract for a period of ninety days. Within the ninety-day        period, the other contracting party may cancel the stop-work order and        resume work or terminate all or part of the work covered by the stop-work        order. There can be no assurance that stop-work orders will not be received        in future periods. If we receive stop work orders, our orders and backlog      may be reduced, and we may fail to achieve anticipated revenues.

***Any reduction in government spending on ISR could materially adversely        impact our revenues, results of operations, and financial condition***.        Historically, defense and intelligence agencies of the United States Government        have accounted for almost all of our revenues. There are risks associated        with programs that are subject to appropriation by Congress, which could        be potential targets for reductions in funding to pay for other programs.        Future reductions in United States Government spending on global security        or future changes in the kind of products or services required by the United        States Government agencies could limit demand for our products and services,        which could result in failure to achieve anticipated revenues, resulting      in a materially adverse effect on our operating results and financial condition.

In the event there are shifts in responsibilities and functions among the    government agencies responsible for United States defense and intelligence,    it could result in a reduction of orders for global security by the defense    and intelligence agencies that have historically been our major customers.    Our relationships with other Government agencies to which responsibilities    and functions for our contracts have shifted may not be as strong as our relationships    with current customer agencies. Accordingly, a reduction in contracts from    our customer agencies may not be offset by contracts from other United States    Government agencies. Even if other agencies increase spending for global security,    we may not secure the same amount of work from these agencies. As a result,    demand for our products and services could decline, resulting in a decrease    in revenues, and could adversely affect our operating results and financial  condition materially.

***If we are unable to comply with complex government regulations        governing security and contracting practices, we could be disqualified        as a supplier to the United States Government***. As a supplier        to United States Government defense and intelligence agencies, we must        comply with numerous regulations, including those governing security and        contracting practices. Failure to comply with these procurement regulations        and practices could result in fines being imposed against us or our suspension        for a period of time from eligibility for bidding on, or for award of,        new government contracts. If we are disqualified as a supplier to government        agencies, we will lose most, if not all, of our customers, revenues from        sales of our products would decline significantly, and our ability to continue        operations would be seriously jeopardized. Among the causes for disqualification        are violations of various statutes, including those related to procurement        integrity, export control, United States Government security regulations,        employment practices, protection of the environment, accuracy of records      in the recording of costs, and foreign corruption.

***The government may investigate and make inquiries of our business        practices and conduct audits of contract performance and cost accounting.*** The        government audits and investigations can take several years to complete.        Depending on the results of these audits and investigations, the government        may make claims against us or take exception to certain costs we determined        to be recoverable. In the period management determines recoverability is      not likely, operating income would be reduced.

***We depend on revenues from a few significant contracts, and any            loss, cancellation, reduction, or delay in these contracts could harm our            business***. From time to time, including recent periods,            we have derived a material portion of our revenue from one or more            individual contracts that could be terminated by the customer in            full or in part at the customer’s discretion. We have in the            past experienced a significant reduction of, and stop work order            on, one of our largest contracts. We expect that in future periods            we may again enter into individual contracts with significant revenue            concentrations. In addition, the majority of our contracts are with            a limited number of government agencies. If our individually large            contracts were terminated or substantially reduced, we could fail      to achieve expected revenues and net income.

United States Government contracts are generally not fully funded at inception    and funding may be terminated or reduced at any time. We act as a prime contractor    or subcontractor for many different United States Government programs. Department    of Defense and intelligence contracts typically involve long lead times for    design and development and are subject to significant changes in contract scheduling.    Programs can be partially funded initially, and additional funds may or may    not be allocated. The termination or reduction of funding for a government    program would result in a loss of anticipated future revenues attributable  to that program.

Our backlog as of August 1, 2008, was approximately $133.3 million, and includes    orders under awards that in some cases extend several years. The actual receipt    of revenues on awards included in backlog may never occur or may change because    a program schedule could change or the program could be canceled, or a contract  could be reduced, modified, or terminated early.

***Our business depends upon our relationships with, and the performance            of, our prime contractors***. We expect to continue to            depend on relationships with other contractors for a substantial            portion of our revenues in the foreseeable future. Our business,            prospects, financial condition, or operating results could be adversely            affected if other contractors terminate or reduce their subcontracts            or relationships with us, either because they choose to establish            relationships with our competitors or because they choose to directly            offer services that compete with our business. Our business also            suffers if the prime contractor fails to win the contract, or if            the Government terminates or reduces these other contractors’ programs      or does not award them new or additional contracts.

In addition, on those    contracts for which we are not the prime contractor, the United States Government    could terminate a prime contract under which we are subcontractor, regardless    of the quality of our performance as a subcontractor. A prime contractor’s    performance deficiencies could adversely affect our status as a subcontractor    on the program, jeopardize our ability to collect award or incentive fees,  cause customers to delay payments, and result in contract terminations.

***We depend on revenues from a few significant customers; the loss        of any significant customer could have an adverse effect on our business***.        Our success will depend on our continued ability to develop and manage        relationships with significant customers. The markets in which we sell        our products are dominated by a relatively small number of governmental        agencies and allies of the United States Government, thereby limiting the        number of potential customers. Our dependence on large orders from a relatively        small number of customers makes our relationship with each customer critical        to our business. We cannot be sure that we will be able to retain our largest        customers, that we will be able to attract additional customers, or that        our customers will continue to buy our products and services in the same        amounts as in prior years. The loss of one or more of our largest customers,        any reduction or delay in sales to these customers, our inability to successfully        develop relationships with additional customers, or future price concessions      that we may have to make could significantly harm our business.

***Continued competition in ISR may lead to a reduction in our revenues        and market share***. The global security market is highly competitive        and we expect that competition will continue to increase in the future.        Our current competitors have significantly greater technical, manufacturing,        financial, and marketing resources than we do. We expect that more companies        will enter the market for global security, possibly resulting in pricing        pressures on our products and services. We may not be able to compete successfully        against either current or future competitors. Increased competition could        result in reduced revenue, lower margins, or loss of market share, any        of which could significantly harm our business. Our competitors may introduce        improved products with lower prices, and we would have to do the same to      remain competitive.

Unexpected increases in the cost to develop or manufacture our products under    fixed-price contracts may cause us to experience unreimbursed cost overruns    resulting in reduced profit margins or increased loss provisions. A significant    portion of our revenue is derived from fixed-price contracts. Under fixed-price    contracts, unexpected increases in the cost to develop or manufacture a product,    whether due to inaccurate estimates in the bidding process, unanticipated increases    in materials costs, unfavorable indirect rate variances, inefficiencies, or    other factors, are borne by us. We have experienced cost overruns in the past    that have resulted in losses on certain contracts, and may experience additional    cost overruns in the future. Such cost overruns would increase our operating    expenses, reduce our net income and earnings per share, and could have a material,  adverse effect on our future results of operations and financial condition.

Fixed price contracts use percentage-of-completion accounting to determine    profit margins. Under generally accepted accounting principles unexpected cost    over-runs can change the percentage completion estimates and result in reduced    profit margins and the reversal of previously recognized profits in addition    to reducing future period profits. Although we believe that our profit margins    are fairly stated and that adequate provisions for losses for our fixed-price    contracts are recorded in our financial statements as required under accounting    principles generally accepted within the United States, there can be no assurance    that our contract profit margins will not decrease or our loss provision will  not increase in the future.

***Unexpected contract terminations could negatively impact our operating        results and financial condition***. Almost all of our contracts        contain termination clauses that permit contract termination upon our default        or for the convenience of the other contracting party. In either case,        termination could adversely affect our operating results and financial        condition. We recently received a termination for the convenience of the        government related to several delivery orders. New orders and backlog are        expected to be reduced by approximately $2 to $4 million when we complete        settlement of the terminated efforts. We received no such terminations      in fiscal year 2007.

***Our future revenues are inherently unpredictable, our operating        results are likely to fluctuate from period to period, and if we fail to        meet the expectations of securities analysts or investors, our stock price        could decline significantly***. Our quarterly and annual operating        results have fluctuated in the past and are likely to fluctuate significantly        in the future due to a variety of factors, some of which are outside our        control. Accordingly, we believe that period-to-period comparisons of our        results of operations are not meaningful and should not be relied upon        as indications of future performance. Some of the factors that could cause        our quarterly or annual operating results to fluctuate include conditions        inherent in government contracting and our business such as the timing        of cost and expense recognition for contracts, the United States Government        contracting and budget cycles, and contract closeouts. Because we base        our operating expenses on anticipated revenue trends and a high percentage        of our expenses are fixed in the short term, any delay in generating or        recognizing forecasted revenues could significantly harm our business.        Fluctuations in quarterly results, competition, or announcements of extraordinary        events such as acquisitions or litigation may cause earnings to fall below        the expectations of securities analysts and investors. In this event, the        trading price of our common stock could significantly decline. In addition,        there can be no assurance that an active trading market will be sustained        for our common stock. The stock market in recent years has experienced        extreme price and volume fluctuations that have particularly affected the        market prices of many technology companies. These fluctuations, as well        as general economic and market conditions, may adversely affect the future      market price of our common stock.

***We have been named as a party to securities class action and derivative        action lawsuits, which may require significant management time and attention        and legal expense, and may result in an unfavorable outcome which could        have a material adverse effect on our business, financial condition, results        of operations and cash flows.*** Applied Signal and one officer        and one former officer have been named in a purported securities class        action complaint filed in the United States District Court, Northern District        of California in *In re Applied Signal Technology Inc. Securities Litigation*,        Master File No. 4:05-cv-1027 (SBA). The amended consolidated complaint        is brought on behalf of a putative class of persons who purchased our securities        during a class period of August 24, 2004, through February 22, 2005. The        complaint alleges that false and misleading statements regarding us were        issued during the class period. In addition, we have been named as a nominal        defendant in a purported shareholder derivative action filed in the Superior        Court, State of California as *Shoemaker v. Devine et al.*,        No. 1:08-CV-119810. It is brought on purported behalf of the Company,        against current and former members of the Board of Directors, our Chief        Financial Officer, and our former Chief Executive Officer, asserting        that these individuals breached their fiduciary duties, based on essentially        the same allegations as the class action case. We cannot predict whether        these actions are likely to result in any material recovery by or expense        to AST, and any future unfavorable outcome of either of these proceedings        could have an adverse impact on our business, financial condition, and        results of operation. At this time, we cannot estimate the amount of        possible loss or range of loss that might be incurred as a result of        either of these proceedings. We expect to continue to incur legal fees        in responding to these lawsuits, including expenses for the reimbursement        of legal fees of present and former officers and directors under indemnification        obligations. The expense of defending such litigation may be significant.        The amount of time to resolve this and any additional lawsuits is unpredictable        and these actions may divert management’s attention from the day-to-day        operations of our business, which could adversely affect our business,      results of operations, and cash flows.

***Our market is subject to rapid technological change, and to compete        effectively, we must continually introduce new signal processing solutions        that achieve market acceptance***. The market for our products        is characterized by rapidly changing technology, frequent new product introductions,        changes in customer requirements, and evolving industry standards. We believe        that we have been successful to date in identifying certain global security        needs early, investing in research and development to meet these needs,        and delivering products before our competitors. We believe that our future        success will depend upon continued development and timely introduction        of products capable of satisfying emerging global security needs. However,        we expect that new requirements will continue to emerge. Our future performance        will depend on the successful development, introduction, and market acceptance        of new and enhanced products that address these new requirements. The introduction        of new and enhanced products may cause our customers to defer or cancel        orders for existing products. There can be no assurance that we will be        able to develop and market new products successfully in the future or respond        effectively to new requirements, or that new products introduced by others      will not render our products or technologies noncompetitive or obsolete.

We also may not be able to develop the underlying core technologies necessary    to create new products and enhancements or to license these technologies from    third parties. Product development delays may result from numerous factors,  including:

- Changing product specifications and customer requirements
- Difficulties in hiring and retaining necessary technical personnel
- Difficulties in reallocating engineering resources and overcoming resource      limitations
- Difficulties with contract manufacturers
- Changing market or competitive product requirements
- Unanticipated engineering complexities

The development of new, technologically advanced products is a complex and    uncertain process requiring high levels of innovation and highly skilled engineering    and development personnel, as well as the accurate anticipation of technological    and market trends. We cannot ensure that we will be able to identify, develop,    manufacture, market, or support new or enhanced products successfully, or on    a timely basis, if at all. Further, we cannot ensure that our new products    will gain market acceptance or that we will be able to respond effectively    to product announcements by competitors, technological changes, or emerging    industry standards. Any failure to respond to technological change would significantly  harm our business.

***Our results of operations could be negatively impacted if we are        required to write off inventory deemed not saleable or usable***.        Some of our products or raw materials may become obsolete or unusable while        in inventory. This could be due to changing customer specifications, decreases        in demand for existing products, or changes in government spending on signal        intelligence. Work in process deemed not saleable is written off to contract        costs in our statement of operations, while unusable raw materials are      written off to general and administrative expenses.

***We may lose sales if our suppliers fail to meet our needs***.    Although we procure most of our parts and components from multiple sources    or believe that these components are readily available from numerous sources,    certain components are available only from sole sources or from a limited number    of sources. While we believe that substitute components or assemblies could    be obtained, use of substitutes would require development of new suppliers    or would require us to re-engineer our products, or both, which could delay    shipment of our products and could have a materially adverse effect on our  operating results and financial condition.

***Delays in the receipt of contracts could negatively impact our        business***. During our history, the receipt of certain final        contracts has periodically been delayed to periods later than originally        expected. Delays in the receipt of such orders could result in revenues        falling short of estimates. On some of these contracts, we will make expenditures        in advance of receipt of the final contract in anticipation of meeting        the expected timetables, and will from time to time hire personnel in anticipation        of receipt of the contract. If the contract is delayed, these costs are        not covered. In addition, gross margins and net income will decrease if        we elect to hold our cost structure in place while awaiting the award of      delayed contracts.

***Our failure to protect our intellectual property may significantly        harm our business***. Our success and ability to compete is        dependent in part on our proprietary technology. We rely on a combination        of patent, copyright, trademark, and trade secret laws, as well as confidentiality        agreements to establish and protect our proprietary rights. We license        certain of our proprietary technology to customers, and we rely largely        on provisions of our licensing agreements to protect our intellectual property        rights in this technology. To date, we have relied primarily on proprietary        processes and know-how to protect our intellectual property. Although we        have filed applications for several patents, five of which we currently        hold, we cannot ensure that any patents will be issued as a result of pending        patent applications or that our issued patents will be upheld. Any infringement        of our proprietary rights could result in significant litigation costs,        and any failure to adequately protect our proprietary rights could result        in our competitors offering similar products, potentially resulting in        loss of a competitive advantage and decreased revenues. Despite our efforts        to protect our proprietary rights, existing patent, copyright, trademark,        and trade secret laws afford only limited protection. In addition, the        laws of some foreign countries do not protect our proprietary rights to        the same extent as do the laws of the United States. Attempts may be made        to copy or reverse engineer aspects of our products or to obtain and use        information that we regard as proprietary. Accordingly, we may not be able        to prevent misappropriation of our technology or deter others from developing        similar technology. Furthermore, policing the unauthorized use of our products        is difficult. Litigation may be necessary in the future to enforce our        intellectual property rights or to determine the validity and scope of        the proprietary rights of others. This litigation could result in substantial      costs and diversion of resources, and could significantly harm our business.

***The United States Government has rights to our technology that        limits our intellectual property rights***. Although we seek        to protect the competitive benefits we derive from our patents, proprietary        information, and other intellectual property, we do not have the right        to prohibit the United States Government from using certain technologies        developed or acquired by us or to prohibit third-party companies, including        our competitors, from using those technologies in providing products and        services to the United States Government. The United States Government        has the right to royalty-free use of technologies that we have developed        under United States Government contracts. We may commercially exploit those        government-funded technologies and may assert our intellectual property        rights against other non-government users of technology developed by us,      but we may not be successful in our efforts to do so.

***Claims that we infringe third-party intellectual property rights        could result in significant expenses or restrictions on our ability to        sell our products***. It is possible that from time to time,        other parties may assert patent, copyright, trademark, and other intellectual        property rights to technologies and in various jurisdictions that are important        to our business. Any claims asserting that our products infringe or may        infringe proprietary rights of third parties, if determined adverse to        us, could significantly harm our business. Any claims, with or without        merit, could result in costly litigation, divert the efforts of our technical        and management personnel, cause product shipment delays, or require us        to enter into royalty or licensing agreements, any of which could significantly        harm our business. Royalty or licensing agreements, if required, may not        be available on terms acceptable to us, if at all. In addition, our agreements        with our customers typically require us to indemnify our customers from        any expense or liability resulting from claimed infringement of third-party        intellectual property rights. In the event a claim against us was successful        and we could not obtain a license to the relevant technology on acceptable        terms, license a substitute technology, or redesign our products to avoid      infringement, our business would be significantly harmed.

***We derive revenue from royalty payments, the timing of receipt        of which can be difficult to predict and which may be difficult to expand***.        We derive royalty income from the sale of products licensed to other third        parties for sale, and expect to continue to derive royalty income in the        future. Revenue derived from royalty payments provides greater profitability        to us than revenue from sale of our products and services, accordingly,        our operating income and earnings per share will be impacted by the comparative        mix of revenue from our digital signal processing products, systems, and        services and revenue derived from royalty income. Although we have licensed        one of our products for sale by a third party, and expect to increase our        efforts in future periods, we have not historically devoted significant        resources to licensing our technologies. Our future ability to generate      royalty income depends upon:

- Our ability to secure patent coverage for our technologies and enter into      license agreements with potential licensees
- The ability of our licensees to develop and commercialize successful products      that incorporate our technologies
- The rate of adoption of our technologies by, and the incorporation of our      technologies into products of, other parties

In addition, royalty-based income is subject to the willingness and ability    of licensees to design and assemble products using our technology, the pricing    and demand for products incorporating our technology, and our ability to negotiate    and enforce agreements for the determination and payment of royalties. It is    difficult to predict when we will enter into additional license agreements,    if at all. The timing of our receipt of royalty payments, including payments    from our existing royalty-based arrangement, is also difficult to predict,    and may fluctuate from period to period, causing our revenues to fluctuate    from period to period, which may significantly impact our quarterly or annual    operating results. If we are not able to generate royalty income as expected    in a particular period, we may fail to meet our revenue expectations, our operating    income may decline disproportionately, and we may fail to meet the expectations  of industry analysts and investors, which could cause our stock price to decline.

**Item 2: Unregistered Sales  of Equity Securities and Use of Proceeds**

None.

**Item 3: Defaults UponSenior Securities**

None.

**Item 4: Submission ofMatters to a Vote of Security Holders**

None.

**Item 5: Other Information**

None.

**Item 6: Exhibits**

***Exhibits***. See Index to Exhibits.

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**Signatures**

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

| Applied Signal Technology, Inc./James E. Doyle/-------------------------------------------------------------         | September 8, 2008---------------------------- |
|----------------------------------------------------------------------------------------------------------------------|-----------------------------------------------|
| James E. Doyle        Vice President and Chief Financial Officer        (Principal Financial and Accounting Officer) |                                          |

  

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**Applied Signal Technology, Inc.  Index to Exhibits**

| **Exhibit Number** | **Description of Document**                                                                                                                                                     |
|--------------------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 3.1                | Third Amended and Restated Articles of Incorporation                                                                                                                            |
| 3.2                | Amended and Restated Bylaws                                                                                                                                                     |
| 4.1                | Specimen Common Stock Certificate                                                                                                                                               |
| 10.62              | Third Amendment to Lease Agreement Between        1555 Wilson Boulevard Limited Partnership and Applied Signal Technology,        Inc., dated July 25, 2008                     |
| 31.1               | Certification of Chief Executive Officer        Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002                                                                       |
| 31.2               | Certification of Chief Financial Officer        Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002                                                                       |
| 32.1               | Certification          of Chief Executive Officer Pursuant to 18 U.S.C. Section 1350, As Adopted          Pursuant to Section 906        of the Sarbanes-Oxley Act of 2002 |
| 32.2               | Certification          of Chief Financial Officer Pursuant to 18 U.S.C. Section 1350, As Adopted          Pursuant to Section 906        of the Sarbanes-Oxley Act of 2002 |