| **United States        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 May 4, 2007**

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 12 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** |

| 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 May 4, 2007, was 12,167,631. |
|----------------------------------------------------------------------------------------------------------------------------|

 

----

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

| Part    I. Financial Information |
|----------------------------------|
|                             | Item    1: Condensed Consolidated Financial Statements |
|                             |   | Condensed        Consolidated Statements of Operations (unaudited) – Three and six    months ended May 4, 2007, and April 28, 2006 |
|                             |   | Condensed          Consolidated Balance Sheets – May 4, 2007, (unaudited) and October    31, 2006 |
|                             |   | Condensed          Consolidated Statements of Cash Flows (unaudited) – Six months    ended May 4, 2007, and April 28, 2006 |
|                             |   | Notes          to Condensed Consolidated Financial Statements (unaudited) – May    4, 2007 |
|                             | 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 Consolidated Financial Statements**

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

|                                                                                 | **——— Three      Months Ended———**                                                                        | ****———**Six      Months Ended****———**                                                                      |
|--------------------------------------------------------------------------------------|-----------------------------------------------------------------------------------------------------------------------------------------------|--------------------------------------------------------------------------------------------------------------------------------------------------|
|                                                                                 | **May 4, 2007**                                                                                                                               | **April 28, 2006**                                                                                                                               | **May 4, 2007** | **April 28, 2006** |
| Revenues from contracts                                                              | $41,054                                                                                | $43,525                                                                                        | $84,598           | $77,078            |
| Operating expenses:                                                                  |                                                                                                                                          |                                                                                                                                             |   |   |
|      Contract costs                                         | 28,583                                                                                      | 29,253                                                                                         | 57,443           | 51,321           |
|      Research and development                               | 3,410                                                                                       | 4,698                                                                                          | 6,995           | 8,287           |
|      General and administrative                             | 6,585            ----------               | 6,834            ----------                  | 14,544            ----------           | 12,204            ----------            |
|           Total operating expenses | 38,578            ----------              | 40,785             ----------           | 78,982            ----------           | 71,812             ----------           |
| Operating income                                                                     | 2,476                                                                                       | 2,740                                                                                     | 5,616           | 5,266            |
| Interest income, net                                                                 | 105            ----------            | 49             ----------               | 265             ----------            | 71             ----------           |
| Income before provision for income taxes                                             | 2,581                                                                                       | 2,789                                                                                     | 5,881           | 5,337            |
| Provision for income taxes                                                           | 1,001            ----------               | 1,266             ----------            | 2,438            ----------           | 2,502             ----------           |
| Net income                                                                           | $1,580            ======             | $1,523            ======                     | $3,443            ======            | $2,835             ======            |
| Net income per common share:                                                         |                                                                                                                                          |                                                                                                                                             |   |   |
|      Basic                                                  | $0.13                                                                                       | $0.13                                                                                     | $0.29           | $0.24           |
|      Diluted                                                | $0.13                                                                                       | $0.13                                                                                          | $0.28            | $0.24           |
| Number of shares used in calculating net        income per common share:             |                                                                                                                                          |                                                                                                                                             |   |   |
|      Basic                                                  | 12,039                                                                                      | 11,712                                                                                         | 12,006            | 11,665           |
|      Diluted                                                | 12,285                                                                                      | 12,012                                                                                         | 12,228           | 11,974            |

See “Notes to CondensedConsolidated Financial Statements.”

 

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

| **Assets**                                                                                                                                                                                 | **May 4, 2007        (unaudited)**                                                                                                                                                | **October    31, 2006 †**                                                                                                                                                            |
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| Current assets:                                                                                                                                                                            |                                                                                                                                                                              |                                                                                                                                                                                        |
|      Cash and cash equivalents                                                                                                                                    | $4,991                                                                                                           | $4,194                                                                                                                |
|      Short term investments                                                                                                                                       | 23,160               -----------                | 25,651                -----------               |
|           Total cash and cash equivalents and                   short-term investments | 28,151                                                                                                           | 29,845                                                                                                                |
|      Accounts receivable:                                                                                                                                         |                                                                                                                                                                              |                                                                                                                                                                                        |
|           Billed                                                                                                                         | 20,008                                                                                                           | 20,766                                                                                                                |
|           Unbilled                                                                                                                       | 18,648               -----------                | 19,813                -----------               |
|           Total accounts receivable                                                                                                      | 38,656                                                                                                           | 40,579                                                                                                                |
| Inventory                                                                                                                                                                                  | 12,111                                                                                                           | 6,078                                                                                                                 |
| Refundable income taxes                                                                                                                                                                    | 647                                                                                                              | 647                                                                                                                   |
| Prepaid and other current assets                                                                                                                                                           | 8,587               -----------                 | 12,306                -----------               |
|      Total current assets                                                                                                                                         | 88,152                                                                                                           | 89,455                                                                                                                |
| Property and equipment, at cost:                                                                                                                                                           |                                                                                                                                                                              |                                                                                                                                                                                        |
|      Machinery and equipment                                                                                                                                      | 39,969                                                                                                      | 39,224                                                                                                                |
|      Furniture and fixtures                                                                                                                                       | 4,686                                                                                                       | 4,614                                                                                                                 |
|      Leasehold improvements                                                                                                                                       | 14,411                                                                                                           | 14,278                                                                                                                |
|      Construction in process                                                                                                                                      | 231               -----------                   | 195                -----------                  |
|                                                                                                                                                                                       | 59,297                                                                                                           | 58,311                                                                                                                |
| Accumulated depreciation and amortization                                                                                                                                                  | (43,794)              -----------                    | (41,496)               -----------                   |
|      Net property and equipment                                                                                                                                   | 15,503                                                                                                           | 16,815                                                                                                                |
| Long-term investments                                                                                                                                                                      | 5,134                                                                                                       | 2,802                                                                                                                 |
| Goodwill                                                                                                                                                                                   | 19,964                                                                                                           | 19,964                                                                                                                |
| Intangible assets, net of accumulated        amortization                                                                                                                                  | 938                                                                                                         | 1,260                                                                                                                 |
| Long-term deferred tax asset                                                                                                                                                               | 5,875                                                                                                            | 5,455                                                                                                                 |
| Other assets                                                                                                                                                                               | 850               -----------                   | 781                -----------                  |
|      Total assets                                                                                                                                                 | $136,416             =======               | $136,532                =======                 |

 

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

| **Liabilities    and Shareholders’ Equity**                                                                                                                                                                                                                                                                                                                       | **May 4, 2007        (unaudited)**                                                                                                                                               | **October    31, 2006 †**                                                                                                                                                             |
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| Current liabilities:                                                                                                                                                                                                                                                                                                                                                    |                                                                                                                                                                             |                                                                                                                                                                                         |
|      Accounts payable                                                                                                                                                                                                                                                                                                                          | $3,360                                                                                                          | $5,253                                                                                                                 |
|      Accrued payroll and related benefits                                                                                                                                                                                                                                                                                                      | 11,394                                                                                                          | 13,844                                                                                                                 |
|      Note payable                                                                                                                                                                                                                                                                                                                              | 1,429                                                                                                           | 1,429                                                                                                                  |
|      Income taxes payable                                                                                                                                                                                                                                                                                                                      | —                                                                                                         | —                                                                                                                |
|      Other accrued liabilities                                                                                                                                                                                                                                                                                                                 | 1,736               -----------                | 1,741                -----------                 |
|           Total current liabilities                                                                                                                                                                                                                                                                                   | 17,919                                                                                                          | 22,267                                                                                                                 |
| Long-term note payable                                                                                                                                                                                                                                                                                                                                                  | 5,952                                                                                                           | 6,786                                                                                                                  |
| Accrued rent                                                                                                                                                                                                                                                                                                                                                            | 1,389                                                                                                           | 1,354                                                                                                                  |
| Other long-term liabilities                                                                                                                                                                                                                                                                                                                                             | 495                                                                                                             | 495                                                                                                                    |
| Shareholder’s    equity:                                                                                                                                                                                                                                                                                                                                          | ** **                                                                                                                                                                       |                                                                                                                                                                                         |
|      Common stock and additional paid-in capital,             no par value: 20,000,000 shares authorized;             issued and outstanding shares: 12,167,631             at May 4, 2007 and 11,922,103 at              October 31, 2006 | 57,930                                                                                                          | 53,295                                                                                                                 |
|      Retained earnings                                                                                                                                                                                                                                                                                                                         | 52,677                                                                                                          | 52,272                                                                                                                 |
|      Accumulated other comprehensive income                                                                                                                                                                                                                                                                                                    | 54               -----------                   | 63                -----------                    |
| Total    shareholders’ equity                                                                                                                                                                                                                                                                                                                                     | 110,661               -----------              | 105,630                -----------               |
|      Total    liabilities and shareholders’ equity                                                                                                                                                                                                                                                                                       | 136,416               =======                  | $136,532                =======                  |

† The balance    sheet at October 31, 2006, 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.”

 

**Applied Signal Technology, Inc.Statements of Cash FlowsIncrease (Decrease) in Cash and Cash Equivalents (unaudited)(in thousands)**

|                                                                                                                                                                                     | **——— Six      Months Ended****———**                                                                                                    |
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|                                                                                                                                                                                     | **May 4, 2007**                                                                                                                                                             | **April 28, 2006** |
| **Operating Activities**                                                                                                                                                                 |                                                                                                                                                                        |   |
|      Net income                                                                                                                                                 | $3,443                                                                                                     | $2,835              |
|      Adjustments to reconcile net income to             net cash used in operating activities:                                         |                                                                                                                                                                        |   |
|           Depreciation and amortization                                                                                                | 2,797                                                                                                      | 2,537              |
|           Stock-based compensation                                                                                                     | 2,222                                                                                                      | 2,266              |
|           Tax benefit related to stock plan                                                                                            | 91                                                                                                         | 304              |
|           Excess tax benefits from stock-based                  payment arrangements | (54)                                                                                                            | (159)             |
|      Changes in:                                                                                                                                                | ** **                                                                                                                                                                  |   |
|           Accounts receivable                                                                                                          | 1,923                                                                                                      | 10,981              |
|           Inventory, prepaid expenses, and other        assets                                                                         | (2,805)                                                                                                         | (8,657)             |
|           Accounts payable, taxes payable,                  and accrued liabilities  | (4,420)            ----------                  | (5,977)            ----------              |
|           Net cash provided by operating activities                                                                                    | 3,197                                                                                                      | 4,130              |
| **Investing Activities**                                                                                                                                                                 | ** **                                                                                                                                                                  |   |
|      Purchases of available-for-sale securities                                                                                                                 | (39,466)                                                                                                        | —              |
|      Maturities and sales of available-for-sale        securities                                                                                               | 39,540                                                                                                     | 5,200              |
|      Additions to property and equipment                                                                                                                        | (1,085)            ----------                  | (2,780)            ----------              |
|           Net        cash provided by (used for)          investing activities       | (1,011)                                                                                                         | 2,420              |
| **Financing Activities**                                                                                                                                                                 | ** **                                                                                                                                                                  |   |
|      Issuances of common stock                                                                                                                                  | 2,399                                                                                                      | 2,384              |
|      Excess tax benefits from stock-based              payment arrangements                                                            | 54                                                                                                         | 159              |
|      Term loan                                                                                                                                                  | (834)                                                                                                           | (715)             |
|      Dividends paid                                                                                                                                             | (3,008)            ----------                  | (2,900)            ----------              |
|      Net cash used for financing activities                                                                                                                     | (1,389)                                                                                                         | (1,072)             |
|      Net increase in cash and cash equivalents                                                                                                                  | 797                                                                                                        | 5,478              |
|      Cash and cash equivalents, beginning        of period                                                                                                      | 4,194             ----------              | 18,920             ----------              |
|      Cash and cash equivalents, end of period                                                                                                                   | $4,991             ======                 | $24,398             ======              |
| Supplemental disclosures of cash flow        information:                                                                                                                                | ** **                                                                                                                                                                  |   |
|      Interest paid                                                                                                                                              | $357                                                                                                       | $333              |
|      Income taxes paid                                                                                                                                          | $1,674                                                                                                     | $3,754              |

See “Notes to CondensedConsolidated Financial Statements.”

 

**Applied Signal Technology, Inc.Notes to Condensed Consolidated Financial Statements (unaudited)May 4, 2007**

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

**Description of Business and Basis of Presentation**

Applied Signal Technology, Inc., (AST) provides advanced digital signal processing  products, systems, and services in support of intelligence, surveillance, and  reconnaissance (ISR) for global security. We provide processing of both man-made  and naturally occurring signals. The processing of man-made signals includes  communications intelligence (COMINT) and electronic intelligence (ELINT). The  processing of natural signatures includes the use of sonar, radar, magnetic,  and chemical sensors to detect changes in the environmental phenomenology.  Our primary customer is the United States Government. We develop and manufacture  equipment for both the collection and processing of signals.

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. At inception,  our efforts were primarily focused on COMINT processing equipment. Over time,  we have broadened our scope to add specialized collection equipment and complete  signal processing systems and related services.

ELINT derives intelligence from signals associated with weapons systems. Our  investment in ELINT is 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 initiatives are new, and to date we have derived  no revenue from the sale of ELINT products or services.

Sensor signal processing observes changes in physical phenomena that can provide  an indication of activities of concern to global security. Examples of these  phenomena are detection of chemicals that might be used for explosive devices  or the detection of sub-terrain ferrous materials that might indicate an underground  facility for weapon manufacturing. Our sensor processing equipment provides  automatic detection of physical abnormalities in both marine and terrestrial  environments.

Substantially, all of our revenues were from contracts with the United States  Government, its agencies, or 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, 2006. 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 six-month periods ended May 4, 2007, are    not necessarily indicative of the results that may be expected for the year    ending October 31, 2007. The balance sheet at October 31, 2006, 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*(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).

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. 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. 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 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 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****—**—**—** | ****—**—**—**Six      Months Ended****—**—**—** |
|------------------------------|-----------------------------------------------------------------------------------|-------------------------------------------------------------------------------------|
|                         | **May 4, 2007**                                                                   | **April 28, 2006**                                                                  | **May 4, 2007** | **April 28, 2006** |
| Cost-reimbursement contracts | 70%                                                                               | 77%                                                                                 | 73% | 79% |
| Fixed-price contracts        | 15%                                                                               | 17%                                                                                 | 16% | 17% |
| Time-and-materials contracts | 15%                                                                               | 6%                                                                                  | 11% | 4% |

Five contracts represented    an aggregate of 50% and 52% of revenues for the respective three-month and    six-month periods ended May 4, 2007. Six contracts represented an aggregate    of 40% of revenues for the three-month and six-month periods ended April    28, 2006. One of the five significant contracts in fiscal year 2007 is a    time-and-materials contract. All other contracts referenced in the paragraph    are 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.

Pre-contract 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. Pre-contract costs for the periods ended May 4, 2007,  and October 31, 2006, were approximately $2,452,000 and $5,667,000, respectively.  Approximately $5,151,000 of the October 31, 2006, balance was recognized as  revenue during the six months ended May 4, 2007. At the end of the first quarter  of fiscal year 2007, approximately $569,000 that was included in pre-contract  costs was associated with an individual contract for which we had filed a formal  claim against the U.S. Government. This was a formal request for reimbursement  for work performed on this contract. During the second quarter of fiscal year  2007, the claim was rejected and we reduced pre-contract costs and operating  income by $569,000.

***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 determinable.

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 remainder of the fiscal 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 inventory.  Fee percentages on fixed-price and cost-reimbursement contracts will generally  decline as a result of any increase to indirect costs. If our rate variance  is favorable, the modification of our billing rates will decrease revenue and  operating expenses, and increase inventory. In this event, fee percentages  on fixed-price 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  allocated to the program. 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 May 4, 2007, the unfavorable rate variance was approximately $4,491,000,  and was reduced by an additional reserve of $300,000, for a net unfavorable  variance of approximately $4,191,000. The reserve was recorded as an increase  to operating expenses and a decrease to inventory, and represents the estimated  amount of profit that is not expected to be recovered through contract activities  during the remainder of the fiscal year. At April 28, 2006, the unfavorable  rate variance was approximately $3,867,000.

***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 either regularly progress  bill 90% of incurred costs or 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.

There was no charge to bad debt expense during the first six months of fiscal  year 2007 or fiscal year 2006.

***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 our products. 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 full  cost so there is limited decrement in valuation. If we determine that a product  has reached the end of its life cycle or there is no longer a need for certain  products, we dispose of the remaining inventory. Historically, we dispose inventory  at approximately the same time that the reduction to inventory is recorded  and we do not hold inventory reserves.

Disposed items included    units in various stages of completion. The charges associated with disposed    work in process and finished goods are included in contract costs in our    statement of operations. Amounts associated with disposed raw materials 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. Disposals of inventory  were not significant during the first six months of fiscal years 2007 and 2006.

**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. This estimated    tax rate is calculated based on the projected net income at the end of the    fiscal year, and is reviewed at each reporting period. At the end of the    fiscal year, income tax expense is adjusted for actual results. Our effective    tax rate can differ from the statutory rate due to the non-tax-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 six months of fiscal year 2007 or fiscal year 2006.

**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 May 4, 2007, all of our short-term    and long-term investments consist of tax-exempt securities. 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 quoted market prices for the respective  securities. Realized gains and losses on sales of available-for-sale securities  were not material for the first six months of fiscal year 2007 or fiscal year  2006. 

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

|                                                 | **—————————— May      4, 2007****——————————**                                   |
|------------------------------------------------------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|                                                      | **Amortized Cost**                                                                                                                                                                                      | **Gross Unrealized        Losses** | **Estimated Fair        Market Value** |
| Cash and cash equivalents                            | $4,991                                                                                                                       | $—                | $4,991                |
| Available-for-sale securities:                       |                                                                                                                                                                                                    |   |   |
|      Short-term, tax exempt | 23,165                                                                                                                       | (5)               | 23,160                |
|      Long-term, tax exempt  | 5,136                   ----------                | (2)              ----------                | 5,134               ----------                |
|                                                 | $33,292                     ======                | $(7)              ======                | $33,285               ======                |

  

|                                                 | **—————————— October      31, 2006****——————————**                          |
|------------------------------------------------------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|                                                      | **Amortized Cost**                                                                                                                                                                                  | **Gross Unrealized     Gains** | **Estimated Fair     Market Value** |
| Cash and cash equivalents                            | $4,194                                                                                                                   | $—                | $4,194                |
| Available-for-sale securities:                       |                                                                                                                                                                                                |   |   |
|      Short-term, tax exempt | 25,651                                                                                                                   | —                | 25,651                |
|      Long-term, tax exempt: | 2,801               ----------                | 1               ----------                | 2,802               ----------                |
|                                                 | $32,646               ======                  | $1               ======                | $32,647               ======                |

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

|                         | **May 4, 2007**                                                                                                                                       | **October 31, 2006**                                                                                                                                    |
|-------------------------|-------------------------------------------------------------------------------------------------------------------------------------------------------|---------------------------------------------------------------------------------------------------------------------------------------------------------|
| Due in one year or less | $23,160                                                                                        | $25,651                                                                                          |
| Due in one to two years | 5,134           ----------              | 2,802               ----------            |
|                    | $28,294               ======            | $28,453           ======                  |

**Restricted Cash**

 We had restricted cash balances of approximately $590,000 and $582,000 at  May 4, 2007, and at October 31, 2006, 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 $189,000 and $177,000 of contributions to disability funds  was included in prepaids and other current assets at May 4, 2007, and at October  31, 2006, respectively. Approximately $401,000 and $405,000 of contributions  to disability funds was included in other assets at May 4, 2007, and at October  31, 2006, 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 existed at May 4, 2007.

***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 existed at May 4, 2007.

**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 isas follows (in thousands, except per-share amounts):

|                                                                      | **—**—** Three      Months Ended****—****—**                                                                      | ****—**—Six      Months Ended****—****—**                                                                     |
|---------------------------------------------------------------------------|-------------------------------------------------------------------------------------------------------------------------------------------|---------------------------------------------------------------------------------------------------------------------------------------|
|                                                                      | **May 4,        2007**                                                                                                                    | **April 28,        2006**                                                                                                             | **May 4,        2007** | **April 28,        2006** |
| **Numerator**:                                                            |                                                                                                                                      |                                                                                                                                  |   |   |
| Net income                                                                | $1,580               ======           | $1,523           ======                     | $3,443           ======           | $2,835           ======           |
| **Denominator**:                                                          |                                                                                                                                      |                                                                                                                                  |   |   |
| Shares        used to compute net income per common share – basic   | 12,039                                                                                  | 11,712                                                                                   | 12,006           | 11,665           |
| Effect of dilutive stock options                                          | 246           ----------              | 300           ----------               | 222           ----------           | 309           ----------           |
| Shares        used to compute net income per common share – diluted | 12,285           ======               | 12,012           ======           | 12,228           ======           | 11,974            ======           |
| Net    income per common share – basic                              | $0.13                                                                                        | $0.13                                                                                    | $0.29           | $0.24           |
| Net    income per common share – diluted                            | $0.13                                                                                        | $0.13                                                                                    | $0.28           | $0.24           |

 The exercise prices of approximately 919,000 and 940,000 potential common  shares for the three-month and six-month periods ended May 4, 2007, were greater  than the market value, and therefore we excluded those shares from the diluted  net income per common share computation for the respective periods, as their  effect would be antidilutive. For the same periods in fiscal year 2006, we  excluded 523,000 and 553,000 potential common shares from the diluted net income  per common share computation for the same reason as the second quarter andfirst six months of fiscal year 2007.

An additional 2,000 and 20,000 potential common shares were excluded from  the diluted net income per common share computation for the second quarter  and first six months of fiscal year 2007, as their effect would be antidilutive  under the provisions of SFAS 123 (revised 2004), *Share-Based Payment* (SFAS  123R). An additional 214,000 and 189,000 potential common shares were excluded  from the diluted net income per common share computation for the second quarter  and first six months of fiscal year 2006, for the same reason as fiscal year  2007.

**Comprehensive Income**

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

|                                 | **—**—** Three    Months Ended****—****—**                                                | **—**—** Six    Months Ended****—****—**                                                  |
|--------------------------------------|-------------------------------------------------------------------------------------------------------------------|-------------------------------------------------------------------------------------------------------------------|
|                                      | **May 4, 2007**                                                                                                   | **April 28, 2006**                                                                                                | **May 4, 2007** | **April 28, 2006** |
| Net income                           | $1,580                                                                    | $1,523                                                                    | $3,443         | $2,835         |
| Unrealized gain (loss) on securities | (3)                                                                            | 1                                                                         | (7)        | 4         |
| Derivative gain (loss), net of tax   | (27)        ----------            | 53             ----------         | (2)        ----------         | (11)        ----------         |
| Comprehensive income                 | $1,550             ======         | $1,577         ======             | 3,434         ======         | $2,828         ======         |

Accumulated other comprehensive income as of May 4, 2007, was approximately$54,000, and as of October 31, 2006, was approximately $63,000.

**Dividends**

The company currently    intends to continue the dividend at the rate of $0.50 per share per annum,    payable quarterly. Dividends were paid on February 16, 2007, and May 18,    2007, to shareholders of record on February 2, 2007, and May 4, 2007, and    are expected to be paid on August 17, 2007, and November 16,  2007, to shareholders of record on August 3, 2007, and October 31, 2007.

We paid dividends of approximately $3,008,000 during the first six months  of fiscal year 2007 and approximately $2,900,000 during the first six months  of fiscal year 2006.

At May 4, 2007, and October 31, 2006, accrued dividends of approximately $1,521,000  and $1,491,000, 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 incentive and non-statutory  stock options granted under various plans, and restricted stock awards. Stock  options are generally time based, 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 of the employee.

Prior to fiscal year 2006, we used stock options as the primary component  of our stock-based incentive plans for officers and directors. During the second  quarter of fiscal year 2006, the compensation committee elected to grant restricted  stock to our officers and directors. During the first quarter of fiscal year  2007, the compensation committee elected to grant restricted stock to our officers  as part of their annual compensation review. In addition, we granted restricted  stock to newly hired non-officer employees during the first six months of fiscal  year 2007. The restrictions will lapse in four equal annual installments, on  each anniversary of the grant date, conditioned on continued employment of  the employee. 

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 has 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 is lower than the fair market value  on the offering date, all participants are 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,  will be six months. Consequently, there will be no reset feature associated  with these offering periods. 

As of May 4, 2007, there were a total of approximately 1,332,334 shares reserved  for future issuance under the plans. This includes the addition of 600,000  shares to the ESPP that was approved by the shareholders on March 14, 2007.

In fiscal year 2006, we adopted the provisions of SFAS 123 (revised 2004), *Share-Based    Payment* (SFAS 123R), requiring us to recognize expense related to the    fair value of our stock-based compensation awards that are ultimately expected    to vest. We elected to use the modified prospective transition method as    permitted by SFAS 123R. Stock-based compensation expense for all stock-based    compensation 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, using the Black-Scholes valuation model, 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****—****—**                                                                               | **—**—** Six      Months Ended****—****—**                                                                                 |
|-------------------------------------------------------------|----------------------------------------------------------------------------------------------------------------------------------------------------|----------------------------------------------------------------------------------------------------------------------------------------------------|
|                                                        | **May 4,        2007**                                                                                                                             | **April 28,        2006**                                                                                                                          | **May 4,        2007** | **April 28,        2006** |
| Contract costs                                              | $587                                                                                        | $650                                                                                        | $1,231            | $1,343            |
| Research and development                                    | 56                                                                                          | 63                                                                                          | 110            | 138            |
| General and administrative                                  | 433            ----------            | 412            ----------            | 881            ----------            | 785            ----------            |
| Stock-based compensation expense before        income taxes | $1,076                                                                                      | $1,125                                                                                      | $2,222            | $2,266            |
| Income taxes                                                | (217)           ----------                | (166)           ----------                | (459)            ----------            | (346)           ----------            |
| Stock-based compensation expense after        income taxes  | $859                                                                                        | $959                                                                                        | $1,763            | $1,920            |
| Reduction to basic net income per share                     | $0.07                                                                                       | $0.08                                                                                       | $0.15            | $0.16            |
| Reduction to diluted net income per share                   | $0.07                                                                                       | $0.08                                                                                       | $0.14            | $0.16            |

 The fair value of options    granted and shares issued under the ESPP by the Company was estimated based    on the Black-Scholes valuation model using the following weighted averageassumptions:

|                        | **Employee Stock      Options**            | **————— Employee      Stock Purchase Plan****—****—****—****——** |
|-----------------------------|--------------------------------------------|------------------------------------------------------------------------------------------------------------------------------|
|                             | **Six Months Ended        April 28, 2006** | **Six Months Ended        May 4, 2007**                                                                                      | **Six Months Ended        April 28, 2006** |
| Risk-free interest rate     | 4.5%                                       | 4.8%                                                                                                                         | 4.4% |
| Expected life (years)       | 5.0                                        | 1.3                                                                                                                          | 1.2 |
| Expected volatility         | 50%                                        | 37%                                                                                                                          | 40% |
| Expected dividends          | 3.0%                                       | 2.8%                                                                                                                         | 2.2% |
| Weighted average fair value | $7.10                                      | $4.87                                                                                                                        | $5.86 |

There were no options granted during the first six months of fiscal year 2007. 

Our determination of the grant date fair value of stock-based compensation  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 complex and subjective variables. These factors include, but are  not limited to, our expected stock price volatility, the projected life of  the stock option, the expected dividend yield, and the risk-free interest rate.  Changes in the subjective assumptions can materially affect the estimated value  of the stock options 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 time of the option grant or  ESPP offering date.

The expected life of the options represents the period that we expect the  stock-based awards will be outstanding and is determined based on our historical  experience of similar awards, considering contractual terms, exercise patterns,  and vesting schedules. We used a five-year expected life for grants made to  our employees during fiscal year 2006, and if we had granted options to employees  during the first six months of fiscal year 2007, we would have used a five-year  expected life, as well. Although no options were granted to executives in the  first six months of fiscal year 2006 and 2007, for any such grants in the future,  we will use a six-year expected life for grants to executive officers because  we have determined that our executives, who have additional restrictions imposed  by securities regulations regarding trading of their stock options, will likely  hold their options for a longer period of time than other employees. The expected  life used for ESPP offering periods prior to June 1, 2007, is based on the  six-month purchase periods within each twenty-four-month offering period.

Our computation of expected volatility for both stock options and ESPP purchases  for the six-month periods ended May 4, 2007, and April 28, 2006, 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 the average stock price.

Stock-based compensation expense recognized in the consolidated statement  of operations in the first six months of fiscal year 2007 and 2006 reflects  estimated forfeitures, which are based on historical option forfeitures.

 Net cash proceeds from the exercise of stock options were approximately $594,000  for the six-month period ended May 4, 2007, and approximately $794,000 for  the six-month period ended April 28, 2006. The net cash proceeds associated  with our ESPP were $1,805,000 for the six-month period ended May 4, 2007, and  $1,590,000 for the six-month period ended April 28, 2006. The income tax benefit  realized from stock option exercises during the first six months of fiscal  year 2007 was approximately $91,000 and $304,000 during the same period of  fiscal year 2006. In accordance with SFAS 123R, we present excess tax benefits  from the exercise of stock options, if any, as financing cash flows rather  than operating cash flows.

Stock option activity for the six months ended May 4, 2007 is as follows: 

|                                 | **Shares**                                                                                | **Weighted Average Exercise Price**                                                                                      |
|---------------------------------|-------------------------------------------------------------------------------------------|--------------------------------------------------------------------------------------------------------------------------|
| Outstanding at October 31, 2006 | 1,547,779                                                   | $17.83                    |
| Grants                          | —                                                     |                                                                                                                     |
| Exercised                       | (62,914)                                                         | $9.75                     |
| Forfeitures or expirations      | (30,958)          ----------       | $18.78                    |
| Outstanding at May 4, 2007      | 1,453,907                                                   | $18.16                    |
| Exercisable at May 4, 2007      | 919,844                                                     | $16.07                    |

As of May 4, 2007, approximately $5,021,000 of total unrecognized compensation  expense related to unvested stock options is expected to be recognized overa weighted average period of 2.95 years. 

Unrecognized compensation expense associated with our ESPP as of May 4, 2007,  is approximately $2,016,000 and is expected to be recognized over a weighted  average period of 1.58 years.

The following table summarizes  our restricted stock activity for the six months ended May 4, 2007.

| **Nonvested Shares**          | **Shares**                                                                                                                         | **Weighted Average Grant Date Fair Value        Per Share**                                                              |
|-------------------------------|------------------------------------------------------------------------------------------------------------------------------------|--------------------------------------------------------------------------------------------------------------------------|
| Nonvested at October 31, 2006 | 61,875                                                                                | $19.58                    |
| Grants                        | 51,750                                                                                | $15.81                    |
| Vested                        | (15,472)                                                                                   | $19.58                    |
| Forfeitures                   | —              ----------          |                                                                                                                     |
| Nonvested at May 4, 2007      | 98,153                                                                                | $17.59                    |

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 $1,571,000, and is expected to be recognized over a weightedaverage period of 3.27 years.

**Recent Accounting Pronouncements**

In June 2005, the FASB issued SFAS 154, *Accounting Changes and Error Corrections*,  a replacement of APB Opinion No. 20, *Accounting Changes*, and Statement  No. 3, *Reporting Accounting Changes in Interim Financial Statements*.  SFAS 154 changes the requirements for the accounting for and reporting of a  change in accounting principle. Previously, most voluntary changes in accounting  principles were required to be recognized through a cumulative effect adjustment  within net income of the period of the change. SFAS 154 requires retrospective  application to prior periods’ financial statements, unless it is impracticable  to determine either the period-specific effect or the cumulative effect of  the change. We adopted SFAS 154 at the beginning of fiscal year 2007. The adoption  of SFAS 154 did not have a material impact on our financial statements.

In May 2006, the FASB issued SFAS 155, *Accounting for Certain Hybrid Instruments*,  which amends SFAS 133, *Accounting for Derivative Instruments and Hedging  Activities*, and SFAS 140, *Accounting for Transfers and Servicing of  Financial Assets and Extinguishments of Liabilities*. SFAS 155 allows financial  instruments that have embedded derivatives to be accounted for as a whole (eliminating  the need to bifurcate the derivative from its host) if the holder elects to  account for the whole instrument on a fair value basis. We adopted SFAS 155  at the beginning of fiscal year 2007. The adoption of SFAS 155 did not have  a material impact on our financial statements. 

In September 2006, the SEC released Staff Accounting Bulletin No. 108, *Considering    the Effects of Prior Year Misstatements when Quantifying Misstatements in    Current Year Financial Statements* (SAB 108). SAB 108 provides guidance    on the SEC’s views regarding quantifying the materiality of financial    statement misstatements, including misstatements that were not material to    prior years’ financial statements. We adopted SAB 108 at the beginning    of fiscal year 2007. The adoption of SAB 108 did not have a material impact    on our financial statements. 

In June 2006, the FASB issued FASB Interpretation Number 48, *Accounting    for Uncertainty in Income Taxes – an Interpretation of FASB Statement    No. 109* (FIN 48). The interpretation clarifies the accounting for uncertainty    in income taxes and utilizes a two-step approach. 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, with the presumption that the    position will be examined. The second step is to measure the amount of benefit    to recognize in the financial statements. The tax position is measured at    the largest amount of benefit that is greater than 50% likely of being realized    upon ultimate settlement. The provisions are effective for us for our fiscal    year beginning November 1, 2007. We are evaluating the impact this interpretation    will have on our financial statements.

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.

On February 15, 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 is effective as of    the beginning of the first fiscal year beginning after November 15, 2007.    Earlier application is permitted provided the company also applies the provisions    of Statement 157. We are evaluating the impact adopting SFAS 159 will have    on our financial statements.

**Note 2: Inventory and Pre-contract Costs**

Inventories are stated at cost and consisted of the following (in thousands):

|            | **May 4, 2007**                                                                                                                                                   | **October 31, 2006**                                                                                                                                          |
|-----------------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------|---------------------------------------------------------------------------------------------------------------------------------------------------------------|
| Raw materials   | $920                                                                                                  | $768                                                                                              |
| Work in process | 10,863                                                                                                | 5,060                                                                                             |
| Finished goods  | 328                ----------             | 250            ----------             |
|            | $12,111                                                                                               | $6,078                                                                                            |

At May 4, 2007, the unfavorable inventoried rate variance increased work in  process by approximately $4,491,000, and was reduced by an additional reserve  of $300,000, for a net increase to work in process of approximately $4,191,000.  At April 28, 2006, the unfavorable inventoried indirect rate variance increasedwork in process by approximately $3,867,000.

Activity associated with actual production increased work in process by approximately  $1,612,000 and $1,712,000 during the first six months of fiscal years 2007  and 2006, respectively.

Disposal activities were not significant during the first six months of fiscal    years 2007 and 2006.

Pre-contract costs are classified on the balance sheets as other current assets  for all periods presented. Pre-contract 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. Pre-contract costs for the periods  ended May 4, 2007, and October 31, 2006, were approximately $2,452,000 and  $5,667,000, respectively. At the end of the first quarter of fiscal year 2007,  approximately $569,000 that was included in pre-contract costs was associated  with an individual contract for which we had filed a formal claim against the  U.S. Government. This was a formal request for reimbursement for work performed  on this contract. During the second quarter of fiscal year 2007, the claim  was rejected and we reduced pre-contract costs and operating income by $569,000.

**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 six months    of fiscal year 2007.

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

|                                                                    |            | **——————————— May      4, 2007****———————————** |
|-------------------------------------------------------------------------|-----------------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|                                                                         | **Useful Life** | **Gross Carrying Amount**                                                                                                                                                           | **Accumulated Amortization** | **Net Carrying Amount** |
| Identifiable intangible assets that are subject        to amortization: |            |                                                                                                                                                                                |   |   |
|      Customer relationships                    | 3 years         | $1,720                                                                                                                  | $(1,051)            | $669             |
|      Existing technology                       | 5 years         | 340                                                                                                                     | (125)            | 215             |
|      Non-compete agreements                    | 1 year          | 60                                                                                                                      | (60)            | —             |
|      Patent                                    | 18 years        | 60                                                                                                                      | (6)            | 54             |
|      Trade name                                | 1 year          | 90                ----------                                | (90)           ----------             | —            ----------             |
|           Total       |            | $2,270                                                                                                                  | $(1,332)            | $938             |

All of our acquired identifiable intangible assets are subject to amortizationand have originally estimated useful lives as noted in the table above.

As of May 4, 2007, the estimated future amortization expense for acquired  identifiable intangible assets is as follows (in thousands):

| **Fiscal Years**  |                                                                        |
|-------------------|-----------------------------------------------------------------------------|
| Remainder of 2007 | $323                                               |
| 2008              | 453                                                |
| 2009              | 71                                                 |
| 2010              | 49                                                 |
| 2011–2023   | 42         ---------      |
| Total             | $938                                               |

The goodwill and identifiable intangible assets are related to our July 2005  acquisition of Dynamics Technology, Inc. (DTI) for a purchase price of approximately$31.4 million. 

**Note 4: Borrowing Arrangements**

***Revolving line of credit***. At May 4, 2007, we had  a revolving line of credit (Line of Credit) under which Wells Fargo Bank, National  Association (the Bank), will advance funds to us from time to time up to and  including March 1, 2008, not to exceed at any time the maximum principal amount  of $3 million. 

At May 4, 2007, we had two standby letters of credit under the Line of Credit  totaling approximately $1,370,000. One letter of credit, related to our Sunnyvale,  California facilities lease, had a committed balance of approximately $1,220,000  at May 4, 2007. The second letter of credit is a requirement of our workers  compensation insurance, and had a committed balance of approximately $150,000  at May 4, 2007. 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 $1,630,000.    No fees or interest were associated with this unused portion. Borrowings    under the Line of Credit bear interest at the Bank’s  reference rate (8.25% at May 4, 2007), and interest on those borrowings are  payable monthly. As security for our indebtedness under the Line of Credit,  we have granted to the Bank a security interest in our cash and marketable  securities maintained with an affiliate of the Bank.

***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 the Bank in the principal amount of $10 million, plus interest, the  proceeds of which were used for acquisition financing (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) (5.32% during the April 2007 calculation period).  Our Term Loan is for a seven-year term ending on July 1, 2012. Payment terms  of the loan agreement include monthly payments of principal and interest.

As security for our indebtedness under the Term Loan, we have granted to the  Bank 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 May 4, 2007, 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 derivatives and other strategies.  The derivative instrument employed, an interest rate swap, is considered a  cash flow hedge and accounted for under FASB SFAS 133, *Accounting for Derivative  Instruments and Hedging Activities*(SFAS 133). A derivative contract references  an underlying variable, such as an interest rate index, a foreign currency  exchange rate, or a commodity value. The payment, or settlement, obligation  arising from a derivative is calculated by applying the terms of the contract  to changes in the value of the reference variable during a calculation period.  Derivatives may trade on exchanges, such as most common stock options, or may  be private (over the counter) arrangements between two parties.

We entered into an over the counter interest rate swap contract with Wells  Fargo Bank designed to operate as a cash flow hedge for our Term Loan. Effectively,  the swap converts the floating interest rate of the Term Loan into a predicable  fixed rate. The use of an interest rate swap in this situation locks the variable  interest expense associated with the debt and results in a fixed interest expense  that is typically immune from subsequent market rate fluctuations. Since there  is a high correlation between the hedged instrument (the swap) and the underlying  interest variable, gains and losses on the interest exposure are usually eliminated  by offsetting changes in the swap, making it a highly effective instrument  in hedging variability.

At May 4, 2007, we had one interest rate swap agreement outstanding with Wells  Fargo Bank designated as a cash flow hedge under SFAS 133 related to our Term  Loan. No losses on the agreement due to counterparty credit issues are anticipated.  Under this swap, we pay a fixed interest rate of 4.33% 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 May 4, 2007, the effective portion of the  hedge was a deferred gain of approximately $60,000, net of taxes**.**Over  the next twelve months, we expect to reclassify approximately $56,000 of the  gain to interest expense as principle 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 May 4, 2007.

**Note 5: Contractual Obligations**

The following table sets forth our contractual obligations as of May 4, 2007  (in thousands).

|                                  | **——————————— Payments      Due by Period****———————————** |
|---------------------------------------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|                                       | **Total**                                                                                                                                                                                      | **Less than        1 Year** | **1–3        Years** | **3–5        Years** | **More than        5 Years** |
| Operating lease obligations           | $47,875                                                                                                                                                     | $7,267        | $15,125        | $13,674        | $11,809        |
| Loan    obligations – principal | 7,381                                                                                                                                                       | 1,429        | 2,857        | 2,857        | 238        |
| Purchase obligations                  | 4,223           ----------                                                                                               | 4,223       ----------        | —       ----------        | —       ----------        | —       ----------        |
|      Total   | $59,479             ======                                                                                               | $12,919       ======        | $17,982       ======        | $16,531       ======        | $12,047       ======        |

Our operating lease obligations    consist of non-cancelable lease agreements for our facilities, which expire    at various dates between fiscal years 2007 and 2016. Certain leases contain    escalation clauses and requirements for the payment of property taxes, insurance,    and maintenance expenses. During the first six months of fiscal year 2007,    we entered into a new operating lease agreement with a total lease obligation    of approximately $3,817,000 for our new facility in Torrance, California.    In addition, we amended our operating lease agreement for our facility in    Anaheim, California. This amendment increased our total lease obligation    by approximately $93,000.

**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 U.S. 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**

Our provision for income taxes for the second quarter and first six months  of fiscal year 2007 was approximately $1,001,000 and $2,438,000, respectively,  with an estimated annual effective tax rate of 44%. Our provision for income  taxes for the second quarter and first six months of fiscal year 2006 was approximately  $1,266,000 and $2,502,000, respectively, with an estimated annual effective  tax rate of 47%. During the first six months of fiscal year 2007, we reduced  our income tax expense by approximately $163,000, primarily due to the benefit  of releasing a reserve associated with our California research and development  tax refund of approximately $126,000.

**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 second quarter  and first six months of fiscal year 2007 were approximately $64,000 and $146,000,  respectively. For the same periods of fiscal year 2006 warranty costs were  approximately $54,000 and $141,000, 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 indemnification 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 May 4, 2007, or October 31, 2006.

***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 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 and entered judgment in defendants’ favor. Plaintiffs  appealed the judgment of dismissal on March 23, 2006; 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.

**Item 2: Management’sDiscussion 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, 2006.

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 digital signal processing  products, systems, and services in support of intelligence, surveillance, and  reconnaissance (ISR) for global security. We provide processing of both man-made  and naturally occurring signals. The processing of man-made signals includes  communications intelligence (COMINT) and electronic intelligence (ELINT). The  processing of natural signatures includes the use of sonar, radar, magnetic  and chemical sensors to detect changes in the environmental phenomenology.  Our primary customer is the United States Government. We develop and manufacture  equipment for both the collection and processing of signals.

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. At inception,  our efforts were primarily focused on COMINT processing equipment. Over time,  we have broadened our scope to add specialized collection equipment and complete  signal processing systems and related services.

ELINT derives intelligence from signals associated with weapons systems. Our  investment in ELINT is 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 initiatives are new, and to date we have derived  no revenue from the sale of ELINT products or services.

Sensor signal processing observes changes in physical phenomena that can provide  an indication of activities of concern to global security. Examples of these  phenomena are detection of chemicals that might be used for explosive devices  or the detection of sub-terrain ferrous materials that might indicate an underground  facility for weapon manufacturing. Our sensor processing equipment provides  automatic detection of physical abnormalities in both marine and terrestrial  environments.

Substantially, all of our revenues were from contracts with the United States  Government, its agencies, or 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 with the United States Government, its agencies, or prime contractors  with the United States Government 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). 

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, which we began recognizing in fiscal    year 2006, 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  condition 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.

Pre-contract 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.    Pre-contract costs for the periods ended May 4, 2007, and October 31, 2006,    were approximately $2,452,000 and $5,667,000, respectively. Approximately    $5,151,000 of the October 31, 2006, balance was recognized as revenue during    the first six months of fiscal year 2007. At the end of the first quarter    of fiscal year 2007, approximately $569,000 that was included in pre-contract    costs was associated with an individual contract for which we had filed a    formal claim against the U.S. Government. This was a formal request for reimbursement    for work performed on this contract. During the second quarter of fiscal    year 2007, the claim was rejected and we reduced pre-contract costs and operating  income by $569,000.

***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 determinable. We  believe that this estimate is the preferred practice used within our industry.  At year-end, the revenues and costs are adjusted 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, 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 reduce the variance: we can  adjust some of our planned indirect spending during the remainder of the fiscal  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 inventory.  Fee percentages on fixed-price and cost-reimbursement contracts will generally  decline as a result of any increase to indirect costs. If our rate variance  is favorable, the modification of our billing rates will decrease revenue and  operating expenses, and increase inventory. In this event, fee percentages  on fixed-price 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, depends on a number of  other factors, including mix of contract types, contract terms, anticipated  performance on specific contracts, and anticipated changes in inventory.

At May 4, 2007, the unfavorable rate variance was approximately $4,491,000,  and was reduced by an additional reserve of $300,000, for a net unfavorable  variance of approximately $4,191,000. The reserve was recorded as an increase  to operating expenses and a decrease to inventory, and represents the estimated  amount of profit that is not expected to be recovered through contract activities  during the remainder of the fiscal year. At April 28, 2006, the unfavorable  rate variance was approximately $3,867,000.

***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 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. 

There was no charge to bad debt expense during the first six months of fiscal  years 2007 or fiscal year 2006.

***Inventory valuation and disposal***. We provide advanced  digital signal processing products and systems to the U.S. 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 full cost so there is limited decrement in valuation. If it is determined  that a product has reached the end of its life cycle or there is no longer  a need for certain equipment, the remaining inventory is disposed. Historically,  we dispose of inventory at approximately the same time that the reduction to  inventory is recorded and we do not hold inventory reserves.

Disposed items typically    include units in various stages of completion. The charges associated with    disposed work in process and finished goods are included in contract costs    in our statement of operations. Amounts associated with disposed raw materials    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. Disposals of inventory  were not significant during the first six months of fiscal years 2007 and 2006,  respectively.

***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  six months of fiscal years 2007 and 2006, 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 existed at May 4, 2007.

***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 existed at May 4, 2007.

***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 as permitted  by SFAS 123R .Stock-based compensation expense for all stock-based compensation  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, using  the Black-Scholes valuation model, 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.

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. For the  first six months of fiscal year 2007 and 2006, 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 stock options  granted in the first six months of fiscal year 2006, we are using  a six-year expected life for executives and five years for employees. We estimated  the expected life of the options based on historical observations of our stock,  considering the average years of options actually exercised, vested and cancelled  options, and outstanding and exercisable options. Due to our executives having  additional restrictions on when they can trade their stock options, we believe  they will likely hold their options for a longer period. At least once a year,  we will assess the exercise behavior and determine if our current expected  life assumptions need to change. The expected life used for our ESPP is based  on the six-month purchase periods within each twenty-four-month offering period.  The risk-free interest rate is based on the Federal Reserve Bank’s constant  maturities daily interest rate in effect at the time of the option grant or  ESPP offering date.The expected dividend yield for both stock  options and purchases under the ESPP is calculated by taking the total expected  annual dividend payout divided by the average stock price per share.

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

**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 in fiscal year 2007.

At the beginning of fiscal year 2006, we adopted the provisions of SFAS 123R  requiring us to recognize expense related to the fair value of our stock-based  compensation awards that are ultimately expected to vest.

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

|                                                          | **—**—** Three        Months Ended****—****—**                                                  | **—**—** Six        Months Ended****—****—**                                                    |
|---------------------------------------------------------------|-------------------------------------------------------------------------------------------------------------------------|-------------------------------------------------------------------------------------------------------------------------|
|                                                          | **May            4,        2007**                                                                                       | **April            28,        2006**                                                                                    | **May            4,        2007** | **April            28,        2006** |
| Contract          costs                                       | $587                                                                            | $650                                                                            | $1,231         | $1,343         |
| Research          and development                             | 56                                                                              | 63                                                                              | 110         | 138         |
| General          and administrative                           | 433                 ----------          | 412                 ----------          | 881                 ----------         | 785                 ----------         |
| Stock-based          compensation expense before income taxes | $1,076                                                                          | $1,125                                                                          | $2,222         | $2,266         |
| Income          taxes                                         | (217)                ----------         | (166)                ----------         | (459)                ----------         | (346)                ----------         |
| Stock-based          compensation expense after income taxes  | $859                                                                            | $959                                                                            | $1,763         | $1,920         |
| Reduction          to basic net income per share              | $0.07                                                                           | $0.08                                                                           | $0.15         | $0.16         |
| Reduction          to diluted net income per share            | $0.07                                                                           | $0.08                                                                           | $0.14         | $0.16         |

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

**Three and Six MonthsEnded May 4, 2007, Compared to Three and Six Months Ended April 28, 2006**

***Revenues and backlog***.    Revenues for the second quarter of fiscal year 2007 were approximately $41,054,000,    a 5.7%decrease from revenues of approximately $43,525,000 recorded in the    same period of fiscal year 2006. Revenues for the first six months of fiscal    year 2007 were approximately $84,598,000, a 9.8% increase from revenues of    approximately $77,078,000 recognized during the same period of fiscal year    2006. The decrease for the second quarter of fiscal year 2007 compared to    the second quarter of 2006 is due to fewer product sales of approximately    $1,557,000 and reduced revenues generated from engineering development contracts    of approximately $913,000. The increase in revenues during the first six    months of fiscal year 2007 is primarily due to our ability to recognize approximately    $5,151,000 of pre-contract costs incurred during the fourth quarter of fiscal  2006.

New orders received during the second quarter of fiscal year 2007 were approximately  $37,631,000, an increase of 54.7% from approximately $24,332,000 in new orders  received during the same period of fiscal year 2006. New orders received during  the first six months of fiscal year 2007 were approximately $76,780,000, an  increase of 34.1% from approximately $57,238,000 in new orders received during  the same period of fiscal year 2006. Our backlog consists of the uncompleted  portions of existing contracts (excluding unexercised contract options). At  May 4, 2007, ending backlog was approximately $98,690,000, representing a 6.0%  decrease from ending backlog of approximately $104,952,000 at October 31, 2006.  Reported backlog includes both funded and unfunded portions of contract values.  There is no assurance or customer 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.

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  by applying a negotiated billing rate to the level-of-effort. Historically,  we have achieved greater profit margins from our fixed-price contracts than  from our cost-reimbursement and time-and-materials contracts. In recent years,  our significant contracts have been predominantly cost-reimbursement contracts. 

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

|                                  | **—**—**—Three        Months Ended****—**—**—** | ****—**—**—**Six        Months Ended****—**—**—** |
|---------------------------------------|-------------------------------------------------------------------------------------|---------------------------------------------------------------------------------------|
|                                  | **May              4, 2007**                                                        | **April              28, 2006**                                                       | **May              4, 2007** | **April              28, 2006** |
| Cost-reimbursement          contracts | 70%                                                                                 | 77%                                                                                   | 73% | 79% |
| Fixed-price          contracts        | 15%                                                                                 | 17%                                                                                   | 16% | 17% |
| Time-and-materials          contracts | 15%                                                                                 | 6%                                                                                    | 11% | 4% |

Five contracts represented an aggregate of 50% and 52% of revenues      for the respective three-month and six-month periods ended May 4, 2007.      Six contracts represented      an aggregate of 40% of revenues for the three-month and six-month periods      ended April 28, 2006. One of the five significant contracts in fiscal year      2007 is a time-and-materials contract. All other contracts referenced inthis paragraph are 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 $28,583,000, or 69.6% of revenues, for the second    quarter of fiscal year 2007 compared to approximately $29,253,000, or 67.2%    of revenues, for the same period of fiscal year 2006. Contract costs were    approximately $57,443,000, or 67.9% of revenues, for the first six months    of fiscal year 2007 compared to approximately $51,321,000, or 66.6% of revenues,    for the same period of fiscal year 2006. Contract costs decreased in absolute    dollars during the second quarter of fiscal year 2007 compared to the same    period of fiscal year 2006 primarily due to a decline in product sales. Contract    costs increased during the first six months of fiscal year 2007 primarily    due to a 29.8% increase in our first quarter revenues. The increase in revenues    during our first quarter was due to our ability to recognize pre-contract    costs incurred during the fourth quarter of fiscal 2006, increased revenue    generation from our engineering development programs, and increased product  sales. 

***Research and        development (R&D)***. Company-directed  investment in research and development consists of expenditures recoverable  from customers through our billing rates. For interim reporting periods, R&D  expenses include labor, materials, and estimated overhead costs. R&D expenses  were approximately $3,410,000, or 8.3% of revenues, for the second quarter  of fiscal year 2007 compared to approximately $4,698,000, or 10.8% of revenues  , for the same period of fiscal year 2006. During the first six months of fiscal  year 2007, R&D expenses were approximately $6,995,000, or 8.3% of revenues,  compared to approximately $8,287,000, or 10.8% of revenues, during the first  six months of fiscal year 2006. R&D expenses were lower in absolute dollars  and as a percentage of revenues during the second quarter and first six months  of fiscal year 2007 due to a planned reduction in R&D activities.

***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 $6,585,000, or 16.0*%* of revenues,  for the second quarter of fiscal year 2007 compared to approximately $6,834,000,  or 15.7% of revenues, for the same period of fiscal year 2006. G&A expenses  incurred during the first six months of fiscal year 2007 were approximately  $14,544,000, or 17.2% of revenues, compared to approximately $12,204,000, or  15.8%, of revenues, incurred during the same period of fiscal year 2006. G&A  expenses were higher in absolute dollars and as a percentage of revenues during  the first six months of fiscal year 2007 compared to the first six months of  fiscal year 2006, due to an overall increase in contract and bid and proposal  activities during the first six months of fiscal year 2007. In addition, we  were able to recognize approximately $1,587,000 of G&A related pre-contract  costs during the first six months of fiscal year 2007 that were incurred during  the fourth quarter of fiscal year 2006. 

***Interest income and other, net***. Net interest income  for the second quarter of fiscal year 2007 was approximately $289,000 compared  to net interest income of approximately $229,000 for the same period of fiscal  year 2006. Interest income recognized during the first six months of fiscal  year 2007 was approximately $622,000 compared to interest income of approximately  $405,000 during the first six months of fiscal year 2006. Interest income increased  due to higher yields within our investment portfolio. 

***Interest expense***. Interest expense for the second  quarter of fiscal year 2007 was approximately $184,000 compared to approximately  $180,000 of interest expense in the same period of fiscal year 2006. Interest  expense incurred during the first six months of fiscal year 2007 was approximately  $357,000 compared to interest expense of approximately $334,000 during the  first six months of fiscal year 2006.

***Provision for income taxes***.    Our provision for income taxes for the second quarter and first six months    of fiscal year 2007 was approximately $1,001,000 and $2,438,000, respectively,    with an estimated annual effective tax rate of 44%. Our provision for income    taxes for the second quarter and first six months of fiscal year 2006 was    approximately $1,266,000 and $2,502,000, respectively, with an estimated    annual effective tax rate of 47%. The difference in our estimated annual    effective tax rate at May 4, 2007, from our estimated effective tax rate    at April 28, 2006, was primarily due to a projected  increase in our tax-exempt interest related to certain short-term and long-term  investments. In addition, we recorded discrete items of approximately $163,000  during the first six months of fiscal year 2007. These discrete items included  the benefit of our research and development tax refund from the state of California  of approximately $126,000.

**Analysis of Liquidity and Capital Resources**

Our primary sources of liquidity during the first three months of fiscal year  2007 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.

***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 $3,197,000 and approximately $4,130,000 during  the first six months of fiscal years 2007 and 2006, respectively. Net income  for the first six months of fiscal year 2007 was approximately $3,443,000  compared to net income of approximately $2,835,000 for the comparable period  of fiscal year 2006. 

Accounts receivables provided cash of approximately $1,923,000 during the  first six months of fiscal year 2007, and approximately $10,981,000 during  the same period in fiscal year 2006. During the first six months of fiscal  year 2007, we generated revenues of approximately $84,598,000 and collected  approximately $86,521,000. During the first six months of fiscal year 2006,  we generated revenues of approximately $77,078,000 and collected approximately  $88,059,000. During the first six months of fiscal year 2006, our collections  were significantly higher than the revenue generated due to our ability to  collect billings recorded prior to October 31, 2005.

Cash used for inventory, prepaid expenses, and other assets during the first  six months of fiscal year 2007 was approximately $2,805,000 and approximately  $8,657,000 during the first six months of fiscal year 2006. During the first  six months of fiscal year 2007, cash used for inventory was approximately $6,033,000,  which included approximately $4,191,000, associated with our inventoried indirect  rate variance. The inventory activity was offset by a decrease in pre-contract  costs of approximately $3,215,000. During the first six months of fiscal year  2006, cash used for inventory was approximately $5,667,000, which included  approximately $3,867,000, associated with our inventoried indirect rate variance.  Cash used for prepaid expenses during the first six months of fiscal year 2006  was approximately $2,561,000, which included payments associated with our annual  insurance renewals, equipment repair and maintenance contracts, and prepaid  income taxes. 

The change in accounts payable, taxes payable, and accrued liabilities balances  resulted in a net decrease of approximately $4,420,000 and approximately $5,977,000  during the first six months of fiscal years 2007 and 2006, respectively. Accounts  payable and other accrued liabilities decreased approximately $1,970,000 during  the first six months of fiscal year 2007 and decreased approximately $4,797,000  during the same period in fiscal year 2006. The primary difference between  accounts payable activities during the first six months of fiscal years 2007  and 2006 is due to first quarter fiscal year 2007 payments for accruals from  the previous fiscal year-end being lower than those payments made in the same  period of fiscal year 2006.

Accrued payroll liabilities    decreased by approximately $2,450,000 during the first six months of fiscal    year 2007, and decreased by approximately $853,000 during the same period    in fiscal year 2006. Accrued salaries declined during the first six months    of fiscal year 2007 by approximately $1,919,000 compared to a decrease during    the same period of fiscal year 2006 by approximately $360,000. The difference    in activities for accrued salaries was due to the timing of our bi-weekly    payroll.

***Net cash from investing activities***. Investing activities  used cash of approximately $1,011,000 and provided cash of approximately $2,420,000  during the first six months of fiscal years 2007 and 2006, respectively. The  primary difference between investing activities is that during fiscal year  2007, we increased our investment in securities that were classified as short-term  or long-term investments. During the same period of fiscal year 2006, the majority  of our investments were classified as cash equivalents. In addition, property  and equipment purchases declined by approximately $1,695,000 during the first  six months of fiscal year 2007 compared to the same period of fiscal year 2006. 

***Net cash from financing activities***. Financing activities  used cash of approximately $1,389,000 during the first six months of fiscal  year 2007 and approximately $1,072,000 during the same period in fiscal year  2006. The increase in cash used is due to increases in payments of principal  on our term loan and the amount of dividends paid, offset by the change in  cash provided from the excess tax benefits associated with our stock-based  payment arrangements.

Cash is generated primarily from operating activities, employee stock activities,  and investing activities. Our investment portfolio includes a variety of low-risk  investments. 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 U.S. 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 May 4, 2007, we had  a revolving line of credit (Line of Credit) under which Wells Fargo Bank, National  Association (the Bank), will advance funds to us from time to time up to and  including March 1, 2008, not to exceed at any time the maximum principal amount  of $3 million. 

At May 4, 2007, we had two standby letters of credit under the Line of Credit  totaling approximately $1,370,000. One letter of credit, related to our Sunnyvale,  California facilities lease, had a committed balance of approximately $1,220,000  at May 4, 2007. The second letter of credit was a requirement of our workers  compensation insurance, and had a committed balance of approximately $150,000  at May 4, 2007. 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 $1,630,000.    No fees or interest were associated with this unused portion. Borrowings    under the Line of Credit bear interest at the Bank’s  reference rate (8.25% at May 4, 2007), and interest on those borrowings are  payable monthly. As security for our indebtedness under the Line of Credit,  we have granted to the Bank a security interest in our cash and marketable  securities maintained with an affiliate of the Bank.

***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 the Bank, in the principal amount of $10 million, plus interest,  the proceeds of which were used for acquisition financing (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) (5.32% at May 4, 2007). Our Term Loan  is for a seven-year term ending on July 1, 2012. Payment terms of the loan  agreement include monthly payments of principal and interest. 

As security for our indebtedness under the Term Loan, we have granted to the  Bank 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 May 4, 2007, 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 the Bank. 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 considered a cash flow hedge  and is accounted for under by SFAS 133, *Accounting for Derivative Instruments  and Hedging Activities* (SFAS 133).

At May 4, 2007, we had one interest rate swap agreement outstanding with the  Bank related to our $10 million Term Loan. No losses on the agreement due to  counterparty credit issues are anticipated. Under this swap, we pay a fixed  interest rate of 4.33% over the seven-year term of the loan and receive an  average floating rate of LIBOR on the notional amount of the loan. The combined  interest amounts on the Term Loan and the swap reflect our total monthly interest  obligation, which is fixed at 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 May 4, 2007, the effective portion of the  cash flow hedge was a deferred gain of approximately $60,000, net of taxes.  Over the next twelve months, we expect to reclassify approximately $56,000  of the gain to interest expense as principle on the Term Loan is repaid and  the related swap-instrument notional amount is reduced. 

The ineffective portion of the gain or loss, if there is one, impacts earnings  as it occurs. There is no ineffective portion of the outstanding swap as of  May 4, 2007.

**Contractual Obligations**

The following table sets forth our contractual obligations as of May 4, 2007  (in thousands).

|                                        | **——————————— Payments        Due by Period****———————————** |
|---------------------------------------------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|                                             | **Total**                                                                                                                                                                                        | **Less            than        1 Year** | **1–3        Years** | **3–5        Years** | **More            than        5 Years** |
| Operating          lease obligations        | $47,875                                                                                                                                                       | $7,267        | $15,125        | $13,674        | $11,809        |
| Loan          obligations – principal | 7,381                                                                                                                                                         | 1,429        | 2,857        | 2,857        | 238        |
| Loan obligations – interest           | 1,197                                                                                                                                                         | 416        | 567        | 212        | 2        |
| Purchase          obligations               | 4,223               ----------                                                                                             | 4,223               ----------        | —               ----------        | —               ----------        | —               ----------        |
|      Total         | $60,676               ======                                                                                               | $13,335               ======        | $18,549               ======        | $16,743               ======        | $12,049               ======        |

Our operating lease obligations consist of non-cancelable lease agreements  for our facilities, which expire at various dates between fiscal years 2007  and 2016. Certain leases contain escalation clauses and requirements for the  payment of property taxes, insurance, and maintenance expenses. During the  first six months of fiscal year 2007, we entered into a new operating lease  agreement with a total lease obligation of approximately $3,817,000 for our  new facility in Torrance, California. In addition, we amended our operating  lease agreement for our facility in Anaheim, California. This amendment increasedour lease obligation by approximately $93,000.

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 June 2005, the FASB issued SFAS 154, *Accounting Changes and Error Corrections*,  a replacement of APB Opinion No. 20, *Accounting Changes*, and Statement  No. 3, *Reporting Accounting Changes in Interim Financial Statements*.  SFAS 154 changes the requirements for the accounting for and reporting of a  change in accounting principle. Previously, most voluntary changes in accounting  principles were required to be recognized through a cumulative effect adjustment  within net income of the period of the change. SFAS 154 requires retrospective  application to prior periods’ financial statements, unless it is impracticable  to determine either the period-specific effect or the cumulative effect of  the change. We adopted SFAS 154 at the beginning of fiscal year 2007. The adoption  of SFAS 154 did not have a material impact on our financial statements. 

In May 2006, the FASB issued SFAS 155, *Accounting for Certain Hybrid Instruments*,  which amends SFAS 133, *Accounting for Derivative Instruments and Hedging  Activities*, and SFAS 140, *Accounting for Transfers and Servicing of  Financial Assets and Extinguishments of Liabilities*. SFAS 155 allows financial  instruments that have embedded derivatives to be accounted for as a whole (eliminating  the need to bifurcate the derivative from its host) if the holder elects to  account for the whole instrument on a fair value basis. We adopted SFAS 155  at the beginning of fiscal year 2007. The adoption of SFAS 155 did not have  a material impact on our financial statements. 

In September 2006, the SEC released Staff Accounting Bulletin No. 108, *Considering    the Effects of Prior Year Misstatements when Quantifying Misstatements in    Current Year Financial Statements* (SAB 108). SAB 108 provides guidance    on the SEC’s views regarding quantifying the materiality of financial    statement misstatements, including misstatements that were not material to    prior years’ financial statements. We adopted SAB 108 at the beginning    of fiscal year 2007. The adoption of SAB 108 did not have a material impact    on our financial statements. 

In June 2006, the FASB issued FASB Interpretation Number 48, *Accounting    for Uncertainty in Income Taxes – an interpretation of FASB Statement    No. 109* (FIN 48). The interpretation clarifies the accounting for uncertainty    in income taxes and utilizes a two-step approach. 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, with the presumption that the    position will be examined. The second step is to measure the amount of benefit    to recognize in the financial statements. The tax position is measured at    the largest amount of benefit that is greater than 50% likely of being realized    upon ultimate settlement. The provisions are effective for us for our fiscal    year beginning November 1, 2007. We are evaluating the impact this interpretation    will have on our financial statements.

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.

On February 15, 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 is effective as of    the beginning of the first fiscal year beginning after November 15, 2007.    Earlier application is permitted provided the company also applies the provisions    of Statement 157. We are evaluating the impact adopting SFAS 159 will have    on our financial statements.

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

***Interest rate risk***. Our interest income is sensitive  to changes in the general level of U.S. interest rates. The average maturity  of our investment portfolio is 124 days as of May 4, 2007. Due to the short-term  nature of our cash equivalents and investments, we do not believe that there  is a material interest rate risk. As of May 4, 2007, our total cash and investments  balance that was sensitive to interest rate risk was approximately $33,285,000.  The sensitivity of our portfolio is: if yields were to fluctuate by 100 basis  points, the total effect to the investment portfolio balance would be approximately  $103,000.

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

|                                                      | **May 4, 2007**                                                                                                                            | **October 31, 2006**                                                                                                                   |
|------------------------------------------------------|--------------------------------------------------------------------------------------------------------------------------------------------|----------------------------------------------------------------------------------------------------------------------------------------|
| Cash and cash equivalents                            | $4,991                                                                                   | $4,194                                                                               |
| Available-for-sale securities:                       |                                                                                                                                       |                                                                                                                                   |
|      Short-term, tax exempt | 23,160                                                                                   | 25,651                                                                               |
|      Long-term, tax exempt  | 5,134              ---------           | 2,802          ---------           |
|                                                 | $33,285              ======            | $32,647          ======            |

***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,  National Association (the Bank), the proceeds of which were used for acquisition  financing. The Term Loan bears interest at an annual rate of 1.75% above LIBOR(5.32% at May 4, 2007).

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 the Bank whereby we pay interest to the Bank at a  fixed rate of 4.33% and the Bank pays interest to the Company 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 May 4, 2007, 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.

***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 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 and entered judgment in defendants’ favor. Plaintiffs  appealed the judgment of dismissal on March 23, 2006; 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.

**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. There have been no material changes in our risk factors    from those disclosed in Part I, Item 1A to our Annual  Report on Form 10-K for the fiscal year ended October 31, 2006, which  are set forth below. In addition to the following disclosures, please refer  to the other information contained in this report, including the financial  statements and 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***. We are subject to a number of special risks as a      result of our acquisition of Dynamics Technology, Inc. (DTI). On July 1,      2005, we acquired DTI for approximately $30.1 million, plus estimated transaction      costs. As a result of this acquisition, together with investments we are      making in other areas complementary to our historic COMINT offerings, we      are expanding our products, approaching new customers, and entering 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 2007 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. This expansionsubjects us to a number of risks and uncertainties, including:

- We are entering markets in which we have no or limited prior experience.    We may not be successful in these markets, and we may be unable to enter    into new contracts for these new business lines or grow the combined business.    We may not achieve the strategic objectives and other anticipated potential    benefits of the acquisition of DTI or the investment in other products. Our    failure to achieve these strategic objectives could have a material, adverse    effect on our revenues, expenses, and operating results.
- As a result of the acquisition of DTI, we incurred debt in the amount of    $10 million, of which $7.4 million remains outstanding as of May 4, 2007,    and our failure to repay this debt when due would materially, adversely affect    our financial condition and results of operations.
- We may also be assuming unknown liabilities, risk the incurrence of expenses    related to the future impairment of goodwill, or the incurrence of other    large write-offs immediately or in the future.

***We may not achieve the anticipated benefits of our investments      in new business opportunities and any such investments could have a negative,      material impact on our operating results and financial condition***.      We have expanded our historical COMINT business into ELINT, and have expanded      our signal processing capabilities as a result of our acquisition of DTI.      This diversification 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 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 additional 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. Depending on the results of these audits      and investigations, the government may make claims against us, and if it      prevails, certain incurred costs would not be recoverable. 

***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 May 4, 2007, was approximately $98.7 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; however, we received no such notifications in fiscal years 2007      or 2006.

***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. 

***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. 

***Our headquarters and most of our operations are located in California      where natural disasters may occur, resulting in disruption to our business***.      Our corporate headquarters, including most of our research and development      operations and production facilities, are located in the Silicon Valley      area of Northern California, a region known for being vulnerable to natural      disasters and other risks, such as earthquakes, fires, and floods, which      at times have disrupted the local economy and posed physical risks to our      property. A significant earthquake could materially affect operating results.      We are not insured for most losses and business interruptions of this kind,      and do not presently have redundant, multiple site capacity in the event      of a natural disaster. In the event of such disaster, our business would      suffer. 

***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, four 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.

***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.

***Continued compliance with new regulatory and accounting requirements      will be challenging and may cause our general and administrative expenses      to increase and impact our future financial position and results of operations***.      As a result of compliance with the Sarbanes-Oxley Act of 2002, as well      as changes to listing standards adopted by the Nasdaq Stock Market, and      the attestation and accounting changes required by the SEC, we are required      to implement additional internal controls, to improve our existing internal      controls, and to comprehensively document and test our internal controls.      Although we successfully met our compliance with internal control evaluation      and attestation at the end of fiscal year 2006, we continue to remain subject      to these requirements, and as a result, expect to continue to obtain outside      legal, accounting, and advisory services, all of which may add to our general      and administrative costs. In addition, changes in the accounting rules,      including legislative and other requirements to account for employee stock      options as a compensation expense among others, could materially increase      the expenses that we report under generally accepted accounting principles,      which may adversely affect our operating results.

***Changes in stock option accounting rules have adversely impacted      our operating results prepared in accordance with generally accepted accounting      principles***. We have historically used broad-based employee      stock option programs to hire, incentivize, and retain our workforce in      a competitive marketplace. In December 2004, the FASB issued SFAS      123R, *Share-Based Payment*, which requires all companies to measure      compensation cost for all share-based payments, including employee stock      options, at fair value. We adopted Statement 123R beginning with the first      quarter of our 2006 fiscal year, and implemented the new standard on a      prospective basis. We have incurred approximately $2,222,000 in stock compensation      expense during the first six months of fiscal year 2007. We expect to continue      to incur compensation expense in the future. Please refer to “Notes      to Consolidated Financial Statements, Note 1: Summary of Significant Accounting      Policies, Stock-Based Compensation.” 

***We face litigation        risks as a result      of our stock option review and restatement of our financial statements***.      In our annual report on Form 10-K for the year ended October 31, 2006,      we restated the consolidated balance sheet as of October 31, 2005, and      the statements of operations, shareholders’ equity, and cash flows      for fiscal year 2004, as well as the statements of shareholder’s      equity for fiscal year 2005 and our statements of operations, shareholders’ equity,      and cash flows for the year ended October 31, 2004, and the changes to      the financial statements for the years ended October 31, 2000, October      31, 2001, October 31, 2002, October 31, 2003, and October 31, 2004. This      restatement was the result of our review of our historic stock option grant      practices and procedures and related accounting. As a result of our review,      we concluded that we had not properly measured compensation cost for an      annual option grant to non-officer employees on November 18, 1999, because      the number of shares certain non-officer individual employees were entitled      to receive was not determined until after the original measurement date.      We also concluded that we used improper measurement dates for certain grants      to newly hired non-officer employees because the measurement date utilized      predated the actual commencement of employment. This restatement of our      prior financial statements could impose upon us additional risks, including      the risk that derivative actions are filed against us or certain current      and former directors and officers based on allegations relating to our      historical stock option practices. Litigation may be time consuming, expensive      and distracting for management from the conduct of our business. The adverse      resolution of any lawsuit could have a material adverse effect on our business,      financial condition and results of operations. We cannot assure that any      future litigation relating to our historical stock option practices will      result in the same conclusions reached by us. Furthermore, if we are subject      to adverse findings in any of these matters, we could be required to pay      damages or penalties or have other remedies imposed upon us, which could      adversely affect our business, results of operations, or financial condition.

We may in the future be subject to regulatory proceedings or actions arising  in relation to our historical stock option practices and the restatement of  our prior period financial statements. Any potential regulatory proceeding  or action may be time consuming, expensive and distracting for management from  the conduct of our business. The adverse resolution of any potential regulatory  proceeding or action could adversely affect our business, results of operations,  or financial condition. We cannot assure that any future regulatory action  relating to our historical stock option practices will result in the same conclusions  reached by us. Furthermore, if we are subject to adverse findings in any of  these matters, we could be required to pay damages or penalties or have other  remedies imposed upon us, including criminal penalties, which could adversely  affect our business, results of operations, or financial condition.

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

None.

**Item 3: Defaults Upon Senior Securities**

None.

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

At the annual meeting of our shareholders held on March 14, 2007, the following  matters were considered and voted upon.

The following nominees    were elected as Class I directors to serve on  our Board of Directors for a two-year term expiring at the 2009 annual meeting  of shareholders or until their successors are duly elected and qualified. The  number of shares voted and withheld for such nominees were as follows:

| **Name**          | **For**                | **Withheld**          |
|-------------------|------------------------|-----------------------|
| John P. Devine    | 10,406,003   | 525,837     |
| David Elliman     | 10,162,877   | 768,963     |
| Robert Richardson | 10,657,493   | 274,347     |
| Gary L. Yancey    | 9,590,471    | 1,341,369   |

The appointment of Ernst & Young    LLP as our independent registered public accounting firm for the fiscal year    ending October 31, 2007, was approved and ratified. The number of sharesvoted for and against the appointment were as follows:

| **For**    | **Against** | **Abstain** |
|------------|-------------|-------------|
| 10,434,544 | 492,754     | 4,542       |

A proposal to amend the    Company’s    1993 Employee Stock Purchase Plan to increase by 600,000 shares the maximum    number of shares of common stock that may be issued under this plan was approved.The number of shares voted for and against the amendment were as follows:

| **For**   | **Against** | **Abstain** | **Broker Non-Vote** |
|-----------|-------------|-------------|---------------------|
| 8,224,293 | 519,320     | 416,906     | 1,771,321           |

**Item 5: Other Information**

None.

**Item 6: Exhibits**

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

**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/    -------------------------------------------------------           | June 11, 2007      ---------------------------- |
|----------------------------------------------------------------------------------------------------------------------|-------------------------------------------------|
| James E. Doyle        Vice President and Chief Financial Officer        (Principal Financial and Accounting Officer) |                                            |

  

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

| **Exhibit     Number** | **Description of Document**                                                                                                                                 |
|------------------------|-------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 3.1                    | Second Amended and Restated Articles of Incorporation                                                                                                       |
| 3.2                    | Amended and Restated Bylaws                                                                                                                                 |
| 4.1                    | Specimen Common Stock Certificate                                                                                                                           |
| 10.58                  | Amendment to Line of Credit Agreement, dated    March 1, 2007, with Wells Fargo Bank, National Association                                                  |
| 10.59                  | Amendment to 1993 Employee Stock Purchase    Plan, dated May 31, 2007                                                                                       |
| 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 |