**UNITEDSTATES**

**SECURITIESAND EXCHANGE COMMISSION**

**Washington,DC 20549-1004**

 

**Form 10-Q**

 

**(MarkOne)**

 

**ý****  Quarterly report pursuant to Section 13or 15(d) of the Securities Exchange****Act of1934**

 

**FORTHE QUARTERLY PERIOD ENDED MARCH 31, 2004**

 

**or**

 

**o****  Transition report pursuant toSection 13 or 15(d) of the Securities****Exchange Act of 1934**

 

**Forthe transition period from                 to                **

 

**CommissionFile Number 0-21681**

 

**EFJ, INC.**

(Exact name of registrant asspecified in its charter)

 

| **DELAWARE**                                                    |   | **47-0801192**                        |
|-----------------------------------------------------------------|--------|---------------------------------------|
| (State or other jurisdiction of  incorporation or organization) |   | (I.R.S. Employer Identification  No.) |

 

**4800N.W. 1st STREET**

**LINCOLN,NEBRASKA 68521**

**(402)474-4800**

(Address, including zip code, andtelephone number,

including area code, of registrant’s

principal executive office)

 

Indicate by check mark whether the Registrant (1) has filed all reportsrequired to be filed by Section 13 or 15(d) of the Securities Exchange Actof 1934 during the preceding 12 months (or for such shorter period that theRegistrant was required to file such reports), and (2) has been subject to suchfiling requirements for the past 90 days.

 

YES  ý       NOo

 

Indicate by check mark whether the registrant is an accelerated filer(as defined in Rule 12b-2 of the Exchange Act).

 

YES o          NOý

 

As of April 23, 2004, 17,589,315 shares of theRegistrant’s Common Stock were outstanding.

 

 

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**PART I.  FINANCIAL INFORMATION**

 

**ITEM 1.  FINANCIAL STATEMENTS**

 

#### **EFJ, INC. ANDSUBSIDIARIES**

**CONDENSED CONSOLIDATED BALANCE SHEETS**

March 31, 2004 and December 31, 2003

(in thousands, except share data)

 
|                                                                                                                                                                                                                                                                                                                                                                        |   | **MARCH 31,  2004** |       | **DECEMBER 31,  2003** |       |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|--------------------------|------------|-----------------------------|------------|
|                                                                                                                                                                                                                                                                                                                                                                        |   | **(unaudited)**          |       |                        |       |
| **ASSETS**                                                                                                                                                                                                                                                                                                                                                                  |   |                     |       |                        |       |
|                                                                                                                                                                                                                                                                                                                                                                        |   |                     |       |                        |       |
| Current  assets:                                                                                                                                                                                                                                                                                                                                                            |   |                     |       |                        |       |
| Cash and cash  equivalents                                                                                                                                                                                                                                                                                                                                                  |   | $                        | 12,183     |                        | $          | 4,644 |   |
| Accounts  receivable, net of allowance for returns and doubtful accounts  of $70 and $104, respectively                                                                                                                                                                                                                                                                     |   | 6,349                    |       | 19,754                      |       |
| Receivables –  other                                                                                                                                                                                                                                                                                                                                                   |   | 198                      |       | 157                         |       |
| Cost in excess  of billings on uncompleted contracts                                                                                                                                                                                                                                                                                                                        |   | 966                      |       | 869                         |       |
| Inventories                                                                                                                                                                                                                                                                                                                                                                 |   | 12,395                   |       | 18,040                      |       |
| Deferred  income taxes                                                                                                                                                                                                                                                                                                                                                      |   | 1,500                    |       | 1,500                       |       |
| Prepaid  expenses                                                                                                                                                                                                                                                                                                                                                           |   | 863                      |       | 587                         |       |
| Total current  assets                                                                                                                                                                                                                                                                                                                                                       |   | 34,454                   |       | 45,551                      |       |
|                                                                                                                                                                                                                                                                                                                                                                        |   |                     |       |                        |       |
| Property,  plant and equipment, net                                                                                                                                                                                                                                                                                                                                         |   | 3,077                    |       | 2,779                       |       |
| Deferred  income taxes                                                                                                                                                                                                                                                                                                                                                      |   | 6,500                    |       | 6,500                       |       |
| Intangible  assets, net of accumulated amortization                                                                                                                                                                                                                                                                                                                         |   | 6,751                    |       | 6,753                       |       |
| Other assets                                                                                                                                                                                                                                                                                                                                                                |   | 633                      |       | 686                         |       |
| **TOTAL ASSETS**                                                                                                                                                                                                                                                                                                                                                            |   | $                        | 51,415     |                        | $          | 62,269 |   |
|                                                                                                                                                                                                                                                                                                                                                                        |   |                     | ** ** |                        | ** ** |
| **LIABILITIES AND STOCKHOLDERS’  EQUITY**                                                                                                                                                                                                                                                                                                                              |   |                     | ** ** |                        | ** ** |
| Current  liabilities:                                                                                                                                                                                                                                                                                                                                                       |   |                     |       |                        |       |
| Revolving line  of credit                                                                                                                                                                                                                                                                                                                                                   |   | $                        | —     |                        | $          | 7,500 |   |
| Current  portion of long-term debt obligations                                                                                                                                                                                                                                                                                                                              |   | 132                      |       | 127                         |       |
| Accounts  payable                                                                                                                                                                                                                                                                                                                                                           |   | 4,157                    |       | 8,582                       |       |
| Billings in  excess of cost on uncompleted contracts                                                                                                                                                                                                                                                                                                                        |   | —                   |       | 30                          |       |
| Deferred  revenue - current                                                                                                                                                                                                                                                                                                                                                 |   | 1,022                    |       | 1,191                       |       |
| Accrued  expenses                                                                                                                                                                                                                                                                                                                                                           |   | 2,668                    |       | 3,406                       |       |
| Total current  liabilities                                                                                                                                                                                                                                                                                                                                                  |   | 7,979                    |       | 20,836                      |       |
|                                                                                                                                                                                                                                                                                                                                                                        |   |                     |       |                        |       |
| Long-term debt  obligations, net of current portion                                                                                                                                                                                                                                                                                                                         |   | 388                      |       | 426                         |       |
| Deferred  revenue, net of current portion                                                                                                                                                                                                                                                                                                                                   |   | 737                      |       | 601                         |       |
| **TOTAL LIABILITIES**                                                                                                                                                                                                                                                                                                                                                       |   | 9,104                    |       | 21,863                      |       |
|                                                                                                                                                                                                                                                                                                                                                                        |   |                     |       |                        |       |
| Stockholders’  equity:                                                                                                                                                                                                                                                                                                                                                 |   |                     |       |                        |       |
| Preferred  stock ($0.01 par value; 3,000,000 shares authorized; none issued)                                                                                                                                                                                                                                                                                                |   | —                   |       | —                      |       |
| Common stock ($0.01  par value; 25,000,000 voting shares authorized, 17,589,315 and 17,359,973  issued and outstanding as of March 31, 2004 and December 31, 2003;  600,000 non-voting shares authorized, 217,542 issued and outstanding at  December 31, 2003, which shares were converted to voting shares during  three months ended March 31, 2004) |   | 176                      |       | 176                         |       |
| Additional  paid-in capital                                                                                                                                                                                                                                                                                                                                                 |   | 99,757                   |       | 100,845                     |       |
| Accumulated  deficit                                                                                                                                                                                                                                                                                                                                                        |   | (57,622                  | )          | (60,615                     | )          |
| **TOTAL STOCKHOLDERS’  EQUITY**                                                                                                                                                                                                                                                                                                                                        |   | 42,311                   |       | 40,406                      |       |
| **TOTAL LIABILITIES  AND STOCKHOLDERS’ EQUITY**                                                                                                                                                                                                                                                                                                                        |   | $                        | 51,415     |                        | $          | 62,269 |   |

 

See accompanying notes to thecondensed consolidated financial statements.

 

2

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** **

**EFJ, INC. AND SUBSIDIARIES**

**CONDENSED CONSOLIDATED STATEMENTS OFOPERATIONS**

For the three months endedMarch 31, 2004 and 2003

(Unaudited and in thousands,except share and per share data)

 
|                                                                                                                                                                  |   | **THREE MONTHS ENDED  MARCH 31,** |   |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|----------------------------------------|--------|
|                                                                                                                                                                  |   | **2004**                               |   | **2003** |   |
|                                                                                                                                                                  |   |                                   |   |   |   |
| Revenues                                                                                                                                                              |   | $                                      | 22,244 |   | $ | 9,001 |   |
| Cost of sales                                                                                                                                                         |   | 13,686                                 |   | 5,042 |   |
|                                                                                                                                                                  |   |                                   |   |   |   |
| Gross profit                                                                                                                                                          |   | 8,558                                  |   | 3,959 |   |
|                                                                                                                                                                  |   |                                   |   |   |   |
| Operating  expenses:                                                                                                                                                  |   |                                   |   |   |   |
| Research and  development                                                                                                                                             |   | 2,576                                  |   | 1,402 |   |
| Sales and  marketing                                                                                                                                                  |   | 2,246                                  |   | 1,311 |   |
| General and administrative,  inclusive of non-cash stockoption repricing (benefit) expense adjustment of  $(1,087)  and $446 in 2004 and 2003  (See Note 9) |   | 688                                    |   | 1,810 |   |
| Total  operating expenses                                                                                                                                             |   | 5,510                                  |   | 4,523 |   |
|                                                                                                                                                                  |   |                                   |   |   |   |
| Income (loss)  from operations                                                                                                                                        |   | 3,048                                  |   | (564 | ) |
|                                                                                                                                                                  |   |                                   |   |   |   |
| Interest  income                                                                                                                                                      |   | 11                                     |   | 12 |   |
| Interest  expense                                                                                                                                                     |   | (56                                    | )      | (39 | ) |
| Other income  (expense)                                                                                                                                               |   | (8                                     | )      | 27 |   |
|                                                                                                                                                                  |   |                                   |   |   |   |
| Income (loss)  before income taxes                                                                                                                                    |   | 2,995                                  |   | (564 | ) |
|                                                                                                                                                                  |   |                                   |   |   |   |
| Income tax  provision                                                                                                                                                 |   | —                                 |   | — |   |
|                                                                                                                                                                  |   |                                   |   |   |   |
| Net income  (loss)                                                                                                                                                    |   | $                                      | 2,995  |   | $ | (564 | ) |
|                                                                                                                                                                  |   |                                   |   |   |   |
| Net income  (loss) per share – Basic                                                                                                                             |   | $                                      | 0.17   |   | $ | (0.03 | ) |
| Net income  (loss) per share – Diluted                                                                                                                           |   | $                                      | 0.16   |   | $ | (0.03 | ) |
|                                                                                                                                                                  |   |                                   |   |   |   |
| Weighted  average common shares – Basic                                                                                                                          |   | 17,584,295                             |   | 17,577,315 |   |
| Weighted  average common shares – Diluted                                                                                                                        |   | 19,062,117                             |   | 17,577,315 |   |

 

See accompanying notes to thecondensed consolidated financial statements.

 

3

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**EFJ,INC. AND SUBSIDIARIES**

**CONSOLIDATEDSTATEMENTS OF CASH FLOWS**

Three months ended March 31,2004 and 2003

(Unaudited and in thousands, except sharedata)

 
|                                                                                      |   | **Three months ended March 31,** |   |
|-------------------------------------------------------------------------------------------|--------|---------------------------------------|--------|
|                                                                                      |   | **2004**                              |   | **2003** |   |
| Cash flows  from operating activities:                                                    |   |                                  |   |   |   |
| Net income  (loss)                                                                        |   | $                                     | 2,995  |   | $ | (564 | ) |
| Adjustments to  reconcile net income (loss) to net cash provided by operating activities: |   |                                  |   |   |   |
| Depreciation  and amortization                                                            |   | 335                                   |   | 251 |   |
| Non-cash  compensation (benefit) expense – intrinsic value of repriced options       |   | (1,087                                | )      | 446 |   |
| Gain on sale  of fixed assets                                                             |   | —                                |   | (8 | ) |
| Changes in  assets and liabilities:                                                       |   |                                  |   |   |   |
| Accounts  receivable                                                                      |   | 13,364                                |   | 3,060 |   |
| Cost in excess  of billings on uncompleted contracts                                      |   | (97                                   | )      | (14 | ) |
| Inventories                                                                               |   | 5,645                                 |   | (477 | ) |
| Prepaid expenses                                                                          |   | 19                                    |   | (149 | ) |
| Accounts  payable                                                                         |   | (4,775                                | )      | (886 | ) |
| Billings in  excess of cost on uncompleted contracts                                      |   | (30                                   | )      | (38 | ) |
| Deferred  revenues                                                                        |   | (33                                   | )      | (269 | ) |
| Accrued and  other liabilities                                                            |   | (738                                  | )      | (657 | ) |
| Total  adjustments                                                                        |   | 12,603                                |   | 1,259 |   |
| Net cash  provided by operating activities                                                |   | 15,598                                |   | 695 |   |
|                                                                                      |   |                                  |   |   |   |
| Cash flows  from investing activities:                                                    |   |                                  |   |   |   |
| Proceeds from  sale of fixed assets                                                       |   | —                                |   | 2 |   |
| Purchase of  property, plant and equipment                                                |   | (633                                  | )      | (79 | ) |
| Other assets                                                                              |   | 108                                   |   | 76 |   |
| Net cash used  in investing activities                                                    |   | (525                                  | )      | (1 | ) |
|                                                                                      |   |                                  |   |   |   |
| Cash flows  from financing activities:                                                    |   |                                  |   |   |   |
| Payments on  revolving line of credit, net                                                |   | (7,500                                | )      | — |   |
| Principal  payments on long-term debt                                                     |   | (33                                   | )      | (5 | ) |
| Other                                                                                     |   | (1                                    | )      | — |   |
| Net cash used  in financing activities                                                    |   | (7,534                                | )      | (5 | ) |
|                                                                                      |   |                                  |   |   |   |
| Net increase  in cash and cash equivalents                                                |   | 7,539                                 |   | 689 |   |
|                                                                                      |   |                                  |   |   |   |
| Cash and cash  equivalents, beginning of period                                           |   | 4,644                                 |   | 11,333 |   |
|                                                                                      |   |                                  |   |   |   |
| Cash and cash  equivalents, end of period                                                 |   | $                                     | 12,183 |   | $ | 12,022 |   |

 

**Summary of non-cashtransactions:**

 

In the three months ending March 31, 2003, the Company acquired$374 of fixed assets in exchange for long-term debt.

 

See accompanying notes to the condensed consolidated financialstatements

 

4

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**EFJ,INC. AND SUBSIDIARIES**

**NOTESTO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**

**Threemonths ended March 31, 2004 and 2003**

**(Unauditedand in thousands, except share and per share data)**

 

**1. GENERAL**

 

The condensed consolidated balance sheet of EFJ, Inc. (“EFJ” or the“Company”) at December 31, 2003, presented within this Report on Form 10-Qfiling, has been derived from audited consolidated financial statements at thatdate.  The condensed consolidatedfinancial statements as of March 31, 2004 and for the three months ended March 31,2004 and 2003 are unaudited.  Thecondensed consolidated financial statements reflect all normal and recurringaccruals and adjustments that, in the opinion of management, are necessary fora fair presentation of the financial position, operating results, and cashflows for the interim periods presented in this quarterly report.  The condensed consolidated financialstatements should be read in conjunction with the consolidated financialstatements and notes thereto, together with management’s discussion andanalysis of financial condition and results of operations, contained in theCompany’s Annual Report on Form 10-K for the year ended December 31,2003.  The results of operations andcash flows for the three months ended March 31, 2004 are not necessarilyindicative of the results for any other period or the entire fiscal year endingDecember 31, 2004.  Whereappropriate, items within the condensed consolidated financial statements havebeen reclassified from the previous period’s presentation to conform to thecurrent presentation.

 

**2.  ORGANIZATION AND CONSOLIDATION**

 

The Company is a provider of land mobile radio (“LMR”) wirelesscommunications products and systems, which are sold to: (1) domesticpublic safety / public service and other governmental users; (2) domesticcommercial users; and (3) international customers.  Through its wholly-owned subsidiaries, E.F. Johnson Company(“EFJohnson”) and Transcrypt International, Inc. (“Transcrypt”), the Company designs,develops, manufactures and / or markets:

 

•                  mobile andportable LMR radios (“subscriber units”);

 

•                  stationary LMRtransmitters / receivers (base stations or repeaters);

 

•                  LMR systems;

 

•                  informationsecurity products, based on a wide range of analog scrambling and digitalencryption technologies;

 

•                  LMR services.

 

The condensed consolidated financial statementsinclude the accounts of the Company and its wholly owned subsidiaries.  All significant intercompany accounts andtransactions have been eliminated in the consolidation.

 

**3.  NET INCOME (LOSS) PER SHARE**

 

Basic income (loss) per share (“EPS”) is calculated based upon theweighted average number of common shares outstanding during the period.  The diluted EPS calculation reflects thepotential dilution from common stock equivalents such as stock options.  For the three months ended March 31,2004 and 2003, substantially all outstanding stock options granted as of suchdates had exercise prices lower than the average market price of the commonstock for the respective periods and are, thereby, considered common stockequivalents in the calculation of the diluted weighted average commonshares.  The Company uses the treasurystock method to calculate diluted weighted average common shares, as if allsuch options were outstanding for the three-month periods presented.

 

For the three months ended March 31, 2003, the impact ofoutstanding stock options on diluted EPS was anti-dilutive as the period had anet loss; accordingly, basic EPS is used for both basic and diluted EPS for theperiod.  Had the Company not incurred anet loss for the three months ending March 31, 2003, the diluted weightedaverage common shares would have been 18,761,344.  Because of the net loss condition, the Company uses weightedaverage outstanding common shares for both the basic and diluted weightedaverage common shares, or 17,577,315 for the period ending March 31, 2003.

 

5

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**4.  ACCOUNTING FOR STOCK-BASED COMPENSATION**

 

The Company applies the intrinsic value-based method of accounting forstock options issued to employees.  When both the number of shares that an individual employee is entitledto receive and the option price are known at the grant date, total compensationcost for the Company’s grants of stock options is measured at the grant date(“fixed plan awards”).  However, wheneither or both of these factors are not known at the grant date, the Companyestimates total compensation cost each accounting period from the date of grantbased on the estimated fair value of the Company’s common stock at the end ofeach period (“variable plan awards”). Changes, either increases or decreases, in the estimated fair value ofthe shares between the date of grant and the final exercise or expiration ofthe options result in a change in the measure of compensation cost for variableplan awards.  Compensation cost isrecognized as expense over the periods in which the employee performs therelated services, which is generally presumed to be the vesting period.

 

Hadcompensation cost for the Company’s stock option plans been determined based onthe fair value at the grant date for awards for the three months endedMarch 31, 2004 and 2003, the Company’s pro forma net income (loss) and proforma net income (loss) per share would have been as follows:

 

 
|                                                                          |   | **Three months ended March 31,** |   |
|-------------------------------------------------------------------------------|--------|---------------------------------------|--------|
|                                                                          |   | **2004**                              |   | **2003** |   |
|                                                                          |   |                                  |   |   |   |
| Net income (loss) — as reported                                          |   | $                                     | 2,995  |   | $ | (564 | ) |
| General and administrative expenses for  management stock option compensation |   | 531                                   |   | 363 |   |
| Pro forma net income (loss)                                                   |   | $                                     | 2,464  |   | $ | (927 | ) |
|                                                                          |   |                                  |   |   |   |
| Net income (loss) per share, basic — as  reported                        |   | $                                     | 0.17   |   | $ | (0.03 | ) |
| Net income (loss) per share, diluted — as  reported                      |   | 0.16                                  |   | (0.03 | ) |
| Pro forma net income (loss) per share,  basic                                 |   | 0.14                                  |   | (0.06 | ) |
| Pro forma net income (loss) per share,  diluted                               |   | 0.13                                  |   | (0.06 | ) |

 

Theweighted average fair value per option at date of grant during the three monthsended March 31, 2004 and 2003 was $5.46 and $1.70, respectively.  The fair value of each option grant isestimated on the date of grant using the Black-Scholes option-pricing modelwith the following weighted-average assumptions for options granted:

 
|                       |   | **Three months ended March 31,** |   |
|----------------------------|--------|---------------------------------------|--------|
|                       |   | **2004**                              |   | **2003** |   |
| Expected option life       |   | 10 years                              |   | 10 years |   |
| Expected annual volatility |   | 161                                   | %      | 193 | % |
| Risk-free interest rate    |   | 3.98                                  | %      | 2.93 | % |
| Dividend yield             |   | 0                                     | %      | 0 | % |

 

**5. INVENTORIES**

 

The following is a summary of inventories:

 
|                       |   | **March 31, 2004** | ** ** | **December 31, 2003** | ** ** |
|----------------------------|--------|-------------------------|------------|----------------------------|------------|
| Raw materials and supplies |   | $                       | 7,230      |                       | $          | 8,069 |   |
| Work in progress           |   | 963                     |       | 1,350                      |       |
| Finished goods             |   | 4,914                   |       | 9,250                      |       |
|                       |   | 13,107                  |       | 18,669                     |       |
| Reserve for obsolescence   |   | 712                     |       | 629                        |       |
| Total inventories          |   | $                       | 12,395     |                       | $          | 18,040 |   |

 

6

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**6.  INTANGIBLE ASSETS**

 

As required by Statement of Financial Accounting Standards (“SFAS”) No.142, ***Goodwill and Other IntangibleAssets,*** the Company does not amortize its goodwill andtradename, both of which relate solely to the Company’s EFJohnson segment, butinstead reviews such assets for impairment, at least annually.  The Company performed fair value-basedimpairment tests, in accordance with SFAS No. 142, at December 31, 2003and 2002, concluding that no impairment of goodwill or tradename had occurredas of these dates.  No events occurredduring the three months ended March 31, 2004 and 2003 that would indicatethat an impairment of such assets had taken place as of such dates.  As of January 1, 2002, certain of theCompany’s intangible assets (primarily acquired workforce) were reclassified togoodwill, as these assets, per SFAS No. 141, ***Business Combinations,*** were not deemedseparable from goodwill.

 

Amortization expense, related to intangible assets which are subject toamortization, was $2 for the three months ended March 31, 2004 and2003.  Amortization expense ofintangible assets subject to amortization is anticipated to be $8 for 2004 andannually thereafter through 2012. Intangible assets consist of the following:

 
|                                           |   | **March 31, 2004** |   | **December 31, 2003** |   |
|------------------------------------------------|--------|-------------------------|--------|----------------------------|--------|
| Intangible assets not subject to amortization: |   |                    |   |                       |   |   |   |   |   |
| Goodwill                                       |   |                    |   | $                          | 5,126  |   |   |   | $ | 5,126 |   |
| Tradename                                      |   |                    |   | 1,564                      |   |   |   | 1,564 |   |
|                                           |   |                    |   |                       |   |   |   |   |   |
| Intangible assets subject to amortization:     |   |                    |   |                       |   |   |   |   |   |
| Proprietary and core technology                |   | 1,290                   |   |                       |   | 1,290 |   |   |   |
| Less:   accumulated amortization          |   | 1,290                   |   | —                     |   | 1,290 |   | — |   |
| Patents                                        |   | 113                     |   | 113                        |   |   |   |   |   |
| Less:   accumulated amortization          |   | 52                      |   | 61                         |   | 50 |   | 63 |   |
| Total                                          |   |                    |   | $                          | 6,751  |   |   |   | $ | 6,753 |   |

 

**7.  REVOLVING LINE OF CREDIT**

 

TheCompany has a $10.0 million secured line of credit agreement with Bank ofAmerica.  The line of credit bears interestat a rate of LIBOR plus 200 basis points, the effective rate at March 31,2004, which rate may be increased to LIBOR plus 275 basis points dependent uponcertain debt ratios. The line of credit is collateralized by substantially allthe Company’s assets.  Borrowingsavailable under the line of credit are calculated as a percentage of eligibleinventory and receivables.  Theagreement, which expires September 30, 2004, includes certain covenants,including financial covenants, with which the Company was in compliance as ofMarch 31, 2004 and December 31, 2003.  At March 31, 2004 and December 31, 2003, the Companyhad zero and $7,500, respectively, outstanding on its line of credit.  The total available credit under the line ofcredit was $6.6 million as of March 31, 2004.

 

**8.  WARRANTY COSTS**

 

The Company substantially provides a one-year warranty on its productsand estimates future warranty claims based on historical experience andanticipated costs to be incurred. Warranty expense is accrued at the time of sale with an additionalaccrual for specific items after the sale when their existence is known andamounts are determinable.  Areconciliation of changes in the Company’s accrued warranty as ofMarch 31, 2004 is as follows:

 
|                           |   | **Balance at  December 31, 2003** |       | **Charged to  Expenses** |       | **Deduction /  Expenditures** |       | **Balance at  March 31, 2004** |       |
|--------------------------------|--------|----------------------------------------|------------|--------------------------|------------|-------------------------------|------------|-------------------------------------|------------|
|                           |   |                                   | ** ** |                     | ** ** |                          | ** ** |                                | ** ** |
| Allowance for Warranty Reserve |   | $                                      | 727        |                     | 418        |                          | 253        |                                | $          | 892 |   |
|                                |        |                                        |            |                          |            |                               |            |                                     |            |  |  |

 

7

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**9.  REPRICED STOCK OPTIONS**

 

In 2000and 2001, the Company effectively cancelled and reissued stock options in orderto lower the exercise price of those options to $0.656 per share, an amountapproximating 150% of the then prevailing market value of the Company’s commonstock (the “repricing”).  The repricingof the stock options resulted in a new measurement date for accounting purposesand the reclassification of these options as variable plan awards beginning onthe date of the repricing.  The Companyhad previously accounted for these option grants as fixed plan awards.  The market value of the Company’s commonstock was $4.59 and $1.80 per share at March 31, 2004 and 2003,respectively; this compared to market values of $5.90 and $1.25 per share at December 31,2003 and 2002.  Aggregate non-cash compensationcharges, therefore, resulted to the extent that the market value at therespective period ending date exceeded the repriced exercise price of $0.656per share.  In the three months endedMarch 31, 2004 and 2003, the amounts of compensation (benefit) expenserelating to these repriced options were $(1,087) and $446, which were includedin general and administrative expenses.

 

As ofMarch 31, 2004 and 2003, respectively, approximately 867,000 and 872,000of these repriced options, in various stages of vesting, were outstanding, ofwhich 800,000 related to options issued to the Company’s Chief ExecutiveOfficer (“CEO”) and Chief Financial Officer (“CFO”).  In the first quarter of 2004, the CEO and CFO adoptedpre-arranged stock selling plans, pursuant to Rule 10b5-1 of the Securities andExchange Act of 1934, in regards to these 800,000 option shares held by themwhich are subject to variable accounting treatment.  Under the pre-arranged stock selling plans, stock options will beexercised contemporaneously with the sales of the resulting shares.  The respective selling of the stock willcommence no earlier than May 17, 2004 and will continue over a period of notless than thirteen months.  Any non-cashcompensation related to these options will become fixed at the time the optionsare exercised; prior to exercise, the options will continue to be subject tovariable accounting treatment.

 

**10.  RELATED PARTY TRANSACTION**

 

In April 2002, the Company extended a loan to its CEO, Michael E.Jalbert, in the principal amount of $75. This note is due on demand and bears interest at the annual rate of6%.  Any tax obligations associated withthe loan are the sole responsibility of Mr. Jalbert.  It is anticipated that this loan will be repaid during the nextthirteen months.

 

8

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**11.  COMMITMENTS AND CONTINGENCIES**

 

On or about February 5, 2001, ASRCCommunication (“ASRC”) filed a complaint in United States District Court forthe District of Alaska, against EFJohnson seeking damages against EFJohnson onclaims arising out of EFJohnson’s sale of radio products to ASRC.  ASRC purchased, and resold to the State ofAlaska, approximately $500 of products from EFJohnson since 1999.  ASRC’s claims against EFJohnson include breachof contract, breach of express warranty, breach of implied warranty ofmerchantability, breach of implied warranty of fitness for a particularpurpose, breach of duty of good faith and fair dealing, equitable estoppel,misrepresentation, and violations of the Racketeer Influenced and CorruptOrganizations Act.  The complaintanticipated that the State of Alaska would formally prosecute itsadministrative claim under the Alaska State Procurement Code against ASRC fordamages associated with alleged malfunctions of EFJohnson manufactured radios.Under the May 21, 2003 agreement between ASRC and EFJohnson (the “ASRCAgreement”), EFJohnson agreed to defend ASRC, at EFJohnson’s expense, againstany State’s claim alleging non-performance of the EFJohnson radios.  In the event the State prevailed in itsclaim EFJohnson and ASRC agreed to allocate any award in favor of the State inaccordance with formula in the ASRC Agreement. In addition, the parties agreed to resolve any issue or disputeremaining between them after the conclusion of the State administrativeproceeding through mediation and binding arbitration.  Based upon the ASRC Agreement, ASRC and EFJohnson dismissed theclaims against each other.  On or aboutApril 6, 2004, the State of Alaska’s Department of Administration,Information Technology Group filed an administrative claim under the StateProcurement Code against ASRC for damages associated with the EFJohnsonradios.  The State of Alaska claimalleges that it has damages in excess of $900. Subsequently, ASRC has tendered, and EFJohnson has accepted, the State’sadministrative claim in accordance with the ASRC Agreement. EFJohnson willundertake to defend ASRC under the terms and conditions of the ASRC Agreement.  The Company is unable to predict thelikelihood of the outcome or potential liability that may arise from thisaction.

 

In September 2003, EFJohnson received a request for approximately$400 for third-party commissions allegedly due in conjunction with certainproduct sales to the federal government. The Company has recorded a liability of $175 at March 31, 2004relating to this matter compared with $80 as of December 31, 2003.  The Company believes that it has meritoriouscontractual defenses against such demand and intends to vigorously contest suchallegation.  However, due to the factthat the assertion is undefined, the Company is unable to predict thelikelihood of the outcome or potential liability that may arise from thisrequest for payment.

 

TheCompany is involved in certain other legal proceedings incidental to the normalconduct of its business.  The Companydoes not believe that any liabilities relating to such other legal proceedingsare likely to be, individually or in the aggregate, material to the Company’sbusiness, financial condition, results of operations, or cash flows.

 

In thenormal course of its business activities, the Company is required under acontract with various governmental authorities to provide letters of credit andbonds that may be drawn upon if the Company fails to perform under itscontracts.  The letters of credit, whichexpire on various dates in 2004, have a total undrawn balance of $455 atMarch 31, 2004.  Bonds, whichexpire on various dates, totaled $7.3 million on March 31, 2004.  As of that date, no bonds have been drawnupon.

 

9

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**12.  SEGMENT AND RELATED INFORMATION**

 

The Company operates in the following two reportingsegments, both of which operate in the LMR industry.  These segments are the Company’s two operating subsidiaries:EFJohnson and Transcrypt.  Although bothsegments have product offerings which have some market similarity, EFJohnson’soperations primarily entail the design, development, manufacture and sale ofLMR transmitters/receivers, mobile and portable LMR radios, and LMRcommunication systems, while Transcrypt’s operations primarily entail thedesign, manufacture and sale of devices that prevent the unauthorizedinterception of sensitive voice and data communication.

 

The Company evaluates segment results based on grossmargin and income from operations. Corporate expenses are allocated to the operating segments based uponestimated usage of corporate resources. The following table is a summary of the unaudited operating results forthe three months ended March 31, 2004 and 2003.

 

 
|                                   |   | **Three Months EndedMarch 31,** |       |
|----------------------------------------|--------|--------------------------------------|------------|
| **Unaudited and in thousands**         |   | **2004**                             |       | **2003** |   |
| **Revenues:**                          |   |                                 | ** ** |   | ** ** |
| EFJohnson                              |   | $                                    | 19,854     |   | $ | 7,126 |   |
| Transcrypt                             |   | 2,390                                |       | 1,875 |   |
|                                   |   | $                                    | 22,244     |   | $ | 9,001 |   |
| **Gross profit:**                      |   |                                 |       |   |   |
| EFJohnson                              |   | $                                    | 6,777      |   | $ | 2,621 |   |
| Transcrypt                             |   | 1,781                                |       | 1,338 |   |
|                                   |   | $                                    | 8,558      |   | $ | 3,959 |   |
|                                   |   |                                 |       |   |   |
| **Operating income  (loss):**          |   |                                 |       |   |   |
| EFJohnson                              |   | $                                    | 1,869      |   | $ | (1,000 | ) |
| Transcrypt                             |   | 1,179                                |       | 436 |   |
| **Income (loss) from  operations**     |   | 3,048                                |       | (564 | ) |
|                                   |   |                                 |       |   |   |
| **Other income, (expense),  net**      |   | (53                                  | )          | — |   |
|                                   |   |                                 |       |   |   |
| **Income (loss)  before income taxes** |   | $                                    | 2,995      |   | $ | (564 | ) |
|                                   |   |                                 |       |   |   |
| **Depreciation &  amortization:**  |   |                                 |       |   |   |
| EFJohnson                              |   | $                                    | 300        |   | $ | 218 |   |
| Transcrypt                             |   | 35                                   |       | 33 |   |
|                                   |   | $                                    | 335        |   | $ | 251 |   |
|                                   |   |                                 |       |   |   |
| **Assets:**                            |   |                                 |       |   |   |
| EFJohnson                              |   | $                                    | 27,838     |   | $ | 26,355 |   |
| Transcrypt                             |   | 7,525                                |       | 5,156 |   |
| Corporate                              |   | 16,052                               |       | 12,146 |   |
|                                   |   | $                                    | 51,415     |   | $ | 43,657 |   |

 

TheCompany’s sales, as per its defined customer markets, are shown below for thethree months ended March 31, 2004 and 2003.  The Company would anticipate domestic public safety / publicservice to continue to be 80% to 85% of the overall sales.

 
| **Revenues  (in ‘000’s):**     |   | **2004**   |   | **2003** |   |
|------------------------------------------|--------|------------|--------|----------|--------|
|                                     |   | **Amount** |   | **%**    |   | **Amount** |   | **%** |   |
| Domestic public safety /  public service |   | $          | 18,493 |     | 83     | % |   | $ | 6,442 |   | 72 | % |   |
| Domestic commercial                      |   | 1,130      |   | 5        |   |   | 458 |   | 5 |   |   |
| International                            |   | 2,621      |   | 12       |   |   | 2,101 |   | 23 |   |   |
|                                     |   |       |   |     |   |   |   |   |   |
| Total Sales                              |   | $          | 22,244 |     |   |   | $ | 9,001 |   |   |   |

 

10

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**13.  PLANNED MOVES OF THE COMPANY’S OPERATINGFACILITIES**

 

Transcrypt’soperations will move from its current facility in Lincoln, Nebraska to asimilar 18,000 square-foot facility located a short distance from its currentoperations.  This move is expected to becompleted in the second quarter of 2004. The Company does not expect the move to cause any disruption of thebusiness, change its employee base, or otherwise represent any otherextraordinary risk.  The Company expectsto incur approximately $150 in relation to moving of Transcrypt’s operation;such moving expenses will predominantly be incurred in the second quarter of2004.  The new facility has beenobtained pursuant to a ten-year lease with anticipated facility costsapproximating those of the departed facility. The move was precipitated by the May 31, 2004 termination of the leaseagreement on the segment’s current facility and is expected to be completed byJune 2004.

 

Additionally,on April 14, 2004, the Company announced its decision to move EFJohnson’soperations from its current facility in Waseca, Minnesota to a 40,000square-foot facility located in Irving, Texas. The Company believes that the move of EFJohnson’s operations to Irving,Texas will enable EFJohnson to access a broader talent base as it continues toevolve from a hardware manufacturer to a software-centric design and marketingorganization with its product focus on development of digital Project 25 LMRsystems infrastructure and subscriber units. The Company began to relocate its research and development and marketingdepartments to the new facility in January 2004.  The move is expected to be completed by April 2005 and isnot expected to cause any disruption of the business.  As much as 50% of EFJohnson’s workforce may be terminated inrelation to this move, which terminations are expected to occur at varioustimes from July 2004 through April 2005.  Additionally, contemporaneous with the move of the EFJohnson’soperations, the Company is evaluating the possibility of transitioning itsmanufacturing structure from in-house to a substantially outsourcedarrangement.

 

TheCompany expects to incur $1,500 million in relation to this move and suchamounts will be charged to operations, as provided below.  Additionally, pursuant to SFAS No. 144, ***Accounting for the Impairment orDisposal of Long-Lived Assets***, the Company will be conducting areview of the recoverability of its long-lived assets based in Waseca,Minnesota in regards to the associated carrying values.  As a result of such review, estimated usefullives will be decreased where necessary, and depreciation expense willcorrespondingly increase.  Inasmuch asthe Company’s evaluation of the recoverability of long-lived assets is ongoingand not yet completed, such charges associated with this review cannot beestimated at this time.  The timing ofthe recognition of costs associated with this move will be determined inaccordance with SFAS No. 146, ***Accounting for Costs Associated with Exit or Disposal Activities,***and other relevant guidance,******which provide that a liability for a cost associatedwith an exit or disposal activity shall be recognized at its fair value in theperiod in which the liability is incurred.

 

**EFJohnson Facility Move Costs (in 000’s)**

 
|                                                   |   | **Total amount  expected to be  incurred** |   | **Amount incurred  in the three  months ended  March 31, 2004** |   | **Cumulative amount  incurred as of  March 31, 2004** |   | **Remaining amount  to be incurred** |   |
|--------------------------------------------------------|--------|--------------------------------------------|--------|----------------------------------------------------------------------|--------|------------------------------------------------------------|--------|--------------------------------------|--------|
|                                                   |   |                                       |   |                                                                 |   |                                                       |   |                                 |   |
| Description  of Costs                                  |   |                                       |   |                                                                 |   |                                                       |   |                                 |   |
| Employee  relocation costs                             |   | $                                          | 500    |                                                                 | $      | —                                                     |   | $                                    | — |   | $ | 500 |   |
| Employee  termination benefits                         |   | 500                                        |   | —                                                               |   | —                                                     |   | 500                                  |   |
| Employee  replacement – recruiting & training |   | 100                                        |   | —                                                               |   | —                                                     |   | 100                                  |   |
| Equipment  - disposal & relocation                 |   | 250                                        |   | —                                                               |   | —                                                     |   | 250                                  |   |
| Other                                                  |   | 150                                        |   | —                                                               |   | —                                                     |   | 150                                  |   |
|                                                   |   |                                       |   |                                                                 |   |                                                       |   |                                 |   |
| **Total**                                              |   | $                                          | 1,500  |                                                                 | $      | —                                                     |   | $                                    | — |   | $ | 1,500 |   |

 

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**ITEM 2.  MANAGEMENT’S DISCUSSION AND ANALYSIS OFFINANCIAL CONDITION**

 

**AND RESULTS****OFOPERATIONS**

 

Discussions of certain matters contained in this Quarterly Report onForm 10-Q may constitute forward-looking statements under Section 27A ofthe Securities Act of 1933, as amended (the “Securities Act”), andSection 21E of the Securities Exchange Act of 1934, as amended, (the“Exchange Act”). These forward-looking statements relate to, among otherthings, the results of the Company’s product development efforts, future salesand expense levels, the Company’s future financial condition, liquidity andbusiness prospects generally, planned relocation of operating facilities,perceived opportunities in the marketplace for the Company’s products, and theCompany’s other business plans for the future. These forward-looking statements are subject to certain risks anduncertainties that could cause the actual results, performance and outcomes todiffer materially from those expressed or implied in these forward-lookingstatements due to a number of risk factors including, but not limited to, therisks detailed in “ITEM 1. BUSINESS — Summary of Business Considerations andCertain Factors That May Affect Future Results of Operations and/or StockPrice” contained in the Company’s Annual Report on Form 10-K for the year endedDecember 31, 2003 and to any additional risks associated with theCompany’s announced decision to move EFJohnson’s operations to Irving, Texas.

 

The following discussion is intended to provide a better understandingof the significant changes in trends relating to the Company’s financialcondition and results of operations. Management’s Discussion and Analysis of Financial Condition and Resultsof Operations should be read in conjunction with the accompanying CondensedConsolidated Financial Statements and Notes thereto.

 

The following table presents certain CondensedConsolidated Statements of Operations information as a percentage of revenuesduring the periods indicated:

 
|                               |   | **Three Months Ended  March 31,** |   |
|------------------------------------|--------|----------------------------------------|--------|
|                               |   | **2004**                               |   | **2003** |   |
|                               |   |                                   |   |   |   |
| Revenues                           |   | 100.0                                  | %      | 100.0 | % |
| Cost of sales                      |   | 61.5                                   |   | 56.0 |   |
| Gross profit                       |   | 38.5                                   |   | 44.0 |   |
| Operating  expenses:               |   |                                   |   |   |   |
| Research and  development          |   | 11.6                                   |   | 15.6 |   |
| Sales and  marketing               |   | 10.1                                   |   | 14.6 |   |
| General and  administrative        |   | 3.1                                    |   | 20.1 |   |
| Total  operating expenses          |   | 24.8                                   |   | 50.3 |   |
| Income (loss)  from operations     |   | 13.7                                   |   | (6.3 | ) |
| Interest  expense - net            |   | (0.2                                   | )      | — |   |
| Other expense                      |   | —                                 |   | — |   |
| Income (loss)  before income taxes |   | 13.5                                   |   | (6.3 | ) |
| Income tax  provision              |   | —                                 |   | — |   |
| Net income  (loss)                 |   | 13.5                                   | %      | (6.3 | )% |

 

Revenues

 

Revenues increased 147% to $22.2 million in the first quarter of 2004,as compared to $9.0 million during the same period in 2003.  Of total revenues in the first quarter of2004, the wireless communication segment comprised $19.8 million, representinga 179% increase over revenues of $7.1 million during the same period in2003.  Information security segmentrevenues of $2.4 million in the first quarter of 2004 represent a 27% increaseover revenues of $1.9 million during the same period in 2003.

 

12

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The increase in EFJohnson’s revenues related primarily to a substantialincrease in sales to the federal government, $15.1 million in the first quarterof 2004 compared to $2.3 million in the same period in 2003.  This is consistent with EFJohnson’s marketstrategy to emphasize federal, state and local governmental customers.  Approximately $17.2 million of the Company’srevenues recognized in the first quarter of 2004 related to backlog orders asof December 31, 2003.  Notwithstandingthe fact that the aforementioned increase from the prior year resultedsubstantially from orders received prior to January 1, 2004, the Companyexpects this trend of higher revenues from domestic governmental customers tocontinue.

 

The increase in revenues of the information security segment during thethree months ended March 31, 2004 was primarily the result of increasedmarketing in certain parts of the world where LMR systems are primarilyanalog.  The Company expects thatTranscrypt’s revenues for the remainder of the year will be at a levelsubstantially similar to that experienced in the first quarter.

 

TheCompany decided in the fourth quarter of 2000 to substantially exit thecommercial LMR markets and focus its LMR sales on the domestic public safety /public service sector.  Consequently,the Company’s sales to the domestic public safety / public service sector havesteadily increased, and the Company’s sales to commercial users have decreasedand are expected to continue to decrease as a percentage of total sales.

 

Internationalsales relate substantially to Transcrypt, as EFJohnson’s international saleswere only $0.8 million and $0.6 million for the three months endedMarch 31, 2004 and 2003, respectively. The Company anticipates that its consolidated international sales willcontinue at a substantially similar level through the remainder of 2004.

 

GrossProfit

 

Cost of sales includes materials, labor, depreciation, and overheadcosts associated with the production of the Company’s products, as well asshipping, royalty and warranty product costs.

 

Consolidated gross profit was $8.6 million (38% gross margin) for thefirst quarter of 2004, as compared to $4.0 million (44% gross margin) for thesame period in 2003.  Gross margin forthe wireless communication segment was 34% in the first quarter of 2004 versus37% for the same period in 2003.  Grossmargin for the information security segment was 75% in the first quarter of2004 versus 71% for the same period in 2003.

 

The decrease in overall gross margin percentage relates primarily tothe lower margin wireless communication sales comprising 89% of the sales mixin 2004 as compared to 79% during the same period in 2003.  Further, $3.6 million of EFJohnson sales inthe first quarter of 2004 involved a proprietary encryption module for whichthe Company charged no mark-up over the cost of procurement due to competitivemarket reasons.  Excluding the impact ofthese proprietary modules, gross margin for the wireless communication segmentwould have been 42% in the first quarter of 2004, and the Company’sconsolidated gross margin would have been 46%. The Company does not anticipate such proprietary encryption modulefactor to recur during the rest of 2004. The increase in Transcrypt’s margins resulted primarily frommanufacturing efficiencies relating to higher sales volume.

 

Management intends to make adjustments to its product offerings, wheredeemed appropriate, to include elimination of marginally profitable productsand product lines.  Management is alsocontinuing to review its manufacturing procedures to create furtherefficiencies.  While managementcontinues to review pricing and product strategy, gross margins for bothindustry segments are likely to vary in the future, based primarily upon themix of products and the amount of revenues recognized in the respectiveperiods; however, the Company believes that consolidated gross marginpercentage for the year ended December 31, 2004 will be similar to thepercentages experienced in 2003 and 2002.

 

Researchand Development

 

Research and development expenses consist primarily of the costsassociated with research and development personnel, materials, and thedepreciation of research and development equipment and facilities.

 

13

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Research and development expenses increased to $2.6 million in thefirst quarter of 2004 (11.6% of revenues) from $1.4 million in the firstquarter of 2003 (16% of revenues).  Theincrease related primarily to Project 25 LMR infrastructure development atEFJohnson, along with the Company’s development efforts towards new digitalsubscriber units, upon which the Company’s 2004 research and developmentefforts will be substantially concentrated.

 

The Company expects its future research and development coststhroughout 2004 to continue at a level similar to that experienced in the firstquarter of 2004.  Certain of theCompany’s anticipated future sales are dependent upon successful and timelycompletion of its on-going research and development projects.

 

Salesand Marketing

 

Sales and marketing expenses consist primarily of salaries and relatedcosts of sales personnel, including sales commissions and travel expenses, andcosts of advertising, public relations, and trade show participation.

 

Sales and marketing expenses were $2.2 million in the first quarter of2004 (10% of revenues) as compared to $1.3 million incurred in the firstquarter of 2003 (15% of revenues).  Thedecrease in the expenditure level, as a percentage of revenues, resulted fromthe higher sales volume in 2004.

 

The Company anticipates that sales and marketing expenses, as apercentage of revenues, during 2004 will be substantially similar to thatrealized for 2003.

 

Generaland Administrative

 

General and administrative expenses consist primarily of salaries andother expenses associated with the Company’s management, finance, accounting,and administration.

 

General and administrative expenses decreased to $0.7 million in thefirst quarter of 2004 (3% of revenues) from $1.8 million in the first quarterof 2003 (20% of revenues).  Thisdecrease relates substantially to the material difference in amount of non-cashcompensation (benefit) expense related to the repricing of its stock optionsrecorded in the respective periods. This non-cash compensation (benefit) expense varies according to themarket value of the Company’s common stock, as explained in Note 8 of theaccompanying Notes to Condensed Consolidated Financial Statements.  The Company recorded non-cash compensationbenefit of $1.1 million in the first quarter of 2004 as compared to an expenseof $0.4 million in the same period in 2003. When accounting for this non-cash compensation difference, general andadministrative expenses only increased $0.4 million in 2004 as compared to2003, an amount relating to approximately 3% of the respective increase insales.

 

Going forward, the Company’s general and administrative expenses willinclude costs related to the Company’s planned move of its operatingfacilities, as described in Note 12 to the accompanying Notes to CondensedConsolidated Financial Statements.  TheCompany anticipates incurring approximately $0.8 million during the remainderof 2004 related to these operating facility moves.  Otherwise, the Company anticipates general and administrativeexpenses for the remainder of 2004 to be similar to the level experiencedduring the first quarter of 2004, excluding any impact from non-cashcompensation relating to the repriced stock options.

 

Other Income (Expense)

 

Other expense, net for the three months ended March 31, 2004 was$8,000, as compared to other income, net of $27,000 for the three months endedMarch 31, 2003.  The Company wouldexpect other income (expense) to remain at an insignificant level during theremainder of 2004.

 

14

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Interest Income / Interest Expense

 

Interestincome consists of interest income earned on cash and invested funds; interestexpense related to the Company’s loans and bank line of credit.  Interest income and interest expense were$11,000 and $56,000, respectively, for the three months ended March 31,2004, as compared to $12,000 and $39,000 in the same period in 2003.  Interest income and expense vary based onthe relative interest rates earned or incurred, and the relative cash and loanbalances.  The Company expects interestincome for the remainder of the fiscal year to remain similar to the levelexperienced in the first quarter of 2004. The Company’s interest expense in 2004, which includes monthly expenseof $12,000 related to amortization of loan fees and bank line of creditavailability fees, is also expected to remain similar to the level experiencedin the first quarter of 2004.  However,interest income and expense will vary according to the Company’s use of cash,interest rates, and operating results over the remainder of 2004.

 

Provision / Benefit for Income Taxes

 

The Company did not record a tax provision or benefit in either thefirst quarter of 2004 or 2003.  As ofMarch 31, 2004, the Company had approximately $25.3 million in deferredtax assets primarily comprised of net operating loss carryforwards, which assetwas reduced by a valuation allowance of $17.3 million.  This reserve is based upon management’sexpectation that its tax assets will actually be realized, such expectationbased upon management’s estimates of future operating results and otherfactors.

 

The Company’s tax asset is chiefly composed of net operating losscarryforwards (“NOL’s”).  These NOL’stotal approximately $57.9 million at March 31, 2004 and do not begin toexpire until 2011.  The Company’sdeferred tax asset of $8.0 million is approximately comprised of the followingcomponents at March 31, 2004:

 

 

| **Tax asset components (in millions):** |   | **March 31, 2004** |   | **December 31, 2003** |   |
|-----------------------------------------|--------|-------------------------|--------|----------------------------|--------|
|                                    |   |                    |   |                       |   |
| Net operating loss carryforwards        |   | $                       | 19.6   |                       | $      | 20.4 |   |
| Timing differences – book to tax   |   | 3.3                     |   | 3.3                        |   |
| General business tax credits            |   | 2.4                     |   | 2.4                        |   |
|                                    |   | 25.3                    |   | 26.1                       |   |
| Less: valuation allowance               |   | 17.3                    |   | 18.1                       |   |
|                                    |   | $                       | 8.0    |                       | $      | 8.0 |   |

 

The Company cannot presently estimate what changes to the deferred taxasset valuation allowance may be deemed appropriate in 2004 and to what extentthe Company may record a tax benefit (expense) during the remainder of 2004.  However, as management presently anticipatesthat the Company will continue its recent trend of profitability in 2004, someportion, if not all, of the deferred tax asset valuation allowance may continueto be reduced in 2004, and a net tax benefit may subsequently be recorded.  Conversely, if the Company incurs futurelosses or management revises its forecasted income downward, it may benecessary to write off some or all of the $8.0 million deferred tax assetrecorded at March 31, 2004.

 

Net Income (Loss)

 

The Company had a net income of $3.0 million during the first quarterof 2004, as compared to a net loss of $0.6 million during the first quarter of2003.  Operating results for bothperiods do not include any tax provision or benefit.  However, in both the three months ending March 31, 2004 and2003, the Company’s net income (loss) was affected by non-cash compensationresulting from variable accounting treatment required for certain of theCompany’s stock options repriced in the fourth quarter of 2000 and the firstquarter of 2001.  The amounts of suchnon-cash compensation (benefit) expense, included in general and administrativeexpenses, were $(1,087,000) and $446,000 for the three months endingMarch 31, 2004 and 2003, respectively.

 

The table below illustrates the operating results for the three monthsending 2004 and 2003, adjusting for the stock option repricing effect discussedabove.  The Company believes that suchpresentation offers a more comparative measurement of the Company’s operatingresults.

 

15

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| **Operating Results (in millions)**                             |   | **2004** |   | **2003** |   |
|-----------------------------------------------------------------|--------|----------|--------|----------|--------|
|                                                            |   |     |   |     |   |
| Net income (loss)                                               |   | $        | 3.0    |     | $      | (0.6 | ) |
|                                                            |   |     |   |     |   |
| Stock option repricing non-cash compensation  (benefit) expense |   | (1.1     | )      | 0.5      |   |
|                                                            |   |     |   |     |   |
| Proforma income (loss) – comparative basis                 |   | $        | 1.9    |     | $      | (0.1 | ) |
|                                                            |   |     |   |     |   |
| Proforma income (loss) as a percentage of total  revenues       |   | 8.6      | %      | (0.1     | )%     |

 

Liquidityand Capital Resources

 

Since January 1, 1997, the Company has financed its operations andmet its capital requirements primarily through short-term borrowings, long-termdebt, and stock offerings completed on January 22, 1997 andOctober 15, 1997.  However, theCompany’s operations have provided positive cash since the second quarter of2001, and operations provided positive cash for the three months endedMarch 31, 2004 and 2003.

 

The Company’s operating activities provided cash of$15.6 million and $0.7 million in the three months ended March 31, 2004and 2003, respectively.  Cash providedby operating activities in the first quarter of 2004 consisted primarily of:net income of $3.0 million; depreciation and amortization expenses of $0.3million; non-cash compensation of $(1.1) million; and a net change in thevarious components of working capital of $13.3 million, which change wasprimarily effected by the $13.4 million cash provided by the decrease inreceivables.  The decrease inreceivables resulted from the high receivable balance at December 31, 2003coupled with timing of revenues in the first quarter of 2004 that permittedfirst quarter revenues to be substantially collected prior to March 31,2004.  Cash provided by operatingactivities in the first quarter of 2003 consisted primarily of: net loss of$(0.6) million; depreciation and amortization expenses of $0.3 million;non-cash compensation of $0.4 million; and a net change in the variouscomponents of working capital of $0.6 million primarily related to prepaidroyalty fees.

 

Cash used by investing activities was $0.5 million for the firstquarter of 2004; this compared to cash used by investing activities of lessthan $0.1 million for the same period in 2003. The difference between 2004 and 2003 related primarily to cash flowsused in the purchase of property.  Totalcapital expenditures in 2004 were $0.6 million, as compared to $0.3 million ofcapital expenditures in 2003. Additionally, capital expenditures in 2003 were substantially acquiredthrough the exchange of debt and are, thus, excluded from the Statement of CashFlows.

 

The line of credit balance of $7.5 million at December 31, 2003was paid off during the three months ended March 31, 2004, and the line ofcredit balance was zero at March 31, 2004.  In the previous year, the line balance remained unchanged atMarch 31, 2003 as compared to December 31, 2002.

 

The Company’s cash availability position and overall working capitalposition were significantly improved as of March 31, 2004, as compared toDecember 31, 2003.  This was theresult of cash collection of December 31, 2003 accounts receivable, aswell as revenues recognized in the first quarter of 2004.  Further, the Company had zero borrowingsunder its $10.0 million secured line of credit with Bank of America as ofMarch 31, 2004.  Accordingly, atMarch 31, 2004, the Company had unrestricted cash of $12.2 million and anadditional $6.6 million available credit under its line of credit.

 

In the normal course of its business activities, the Company isrequired under contracts with various government authorities to provide lettersof credit or bonds that may be drawn upon if the Company fails to perform underits contracts.  The Company’s currentbonding arrangement calls for zero-collateral bonding, with a single bondlimitation of $2.0 million.  The Companyhas approximately $6.2 million of bonding availability under its currentbonding agreement.  The Company believesits present bonding arrangements provide it with sufficient bondingavailability through 2004; however, the Company continues to seek improvedbonding alternatives with increased limits.

 

The Company’s backlog of unfilled orders at March 31, 2004 was$10.1 million, compared to a backlog of $22.2 million at December 31, 2003and $5.7 million at March 31, 2003. Due to the unpredictable timing of major domestic governmental orders,the Company does not believe that its backlog figures, and variations fromperiod to period therein, are necessarily indicative of sales of products infuture periods.

 

The Company does not anticipate paying cash dividends in theforeseeable future.

 

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**Critical AccountingPolicies**

 

The preparation of theCompany’s consolidated financial statements in conformity with accountingprinciples generally accepted in the United States (“USGAAP”) requiresmanagement to make judgments, estimates and assumptions in certaincircumstances that affect the amounts reported in the consolidated financialstatements and related footnotes.  TheCompany regularly evaluates the accounting policies and estimates used toprepare its financial statements. Estimates are used for, but not limited to: the accounting for allowancefor doubtful accounts and sales returns; application of the percentage ofcompletion accounting for long-term contract revenues, inventory reserves,income taxes, long-lived assets, and contingencies.  These estimates are based on historical experience and variousassumptions that the Company believes to be reasonable under the particularapplicable facts and circumstances. Actual results could differ from those estimates.

 

The Company considers its critical accounting policies to be those that(i) involve significant judgments and uncertainties, (ii) require estimatesthat are more difficult for management to determine and (iii) have thepotential to result in materially different outcomes under varying assumptionsand conditions.  The application ofUSGAAP may require management to make estimates and assumptions that affect theamounts reported in the financial statements and accompanying results.  Listed below are those policies the Companybelieves are critical and require the use of complex judgment in theirapplication.

 

*Revenue*

 

The Company’s revenue recognition policy is in accordance with thecriteria put forth in Staff Accounting Bulletins 101 and 104.  Revenues are recognized when the earningsprocess is complete, less an estimate for an allowance for returns, ifapplicable, and collection is reasonably assured.  The earnings process is generally complete when the product isshipped, or received by the customer, depending upon whether the title to thegoods, as well as the risks and benefits of ownership, are transferred to thecustomer at point of shipment or point of delivery.  For sales where collection is not reasonably assured, the Companyrecognizes revenue as cash is received. If collection is contingent on a future event, the Company recognizesrevenue when the contingency lapses, generally upon cash collection.

 

System sales under long-term contracts are accounted for under thepercentage-of-completion method.  Underthis method, revenues are recognized as work on a contract progresses.  The recognized revenue is that percentage ofestimated total revenue that incurred costs to date bear to estimated totalcosts to complete the contract. Revisions in cost and profit estimates are made when conditionsrequiring such revisions become known. Anticipated losses on contracts are recognized in operations as soon assuch losses are determined to be probable and reasonably estimable.

 

Deferred revenue includes unearned services provided under systemsmaintenance contracts and unearned warranty fees on extended product warrantycontracts sold to customers.  TheCompany recognizes the fees based upon a straight-line method over the life ofthe contract.

 

The Company periodically reviews its revenue recognition procedures toassure that such procedures are in accordance with the provisions of StaffAccounting Bulletins 101 and 104.

 

*Inventory*

 

Inventory is recorded at the lower of cost or market with cost determinedby the first-in, first-out (FIFO) method. The Company periodically assesses its inventory for potentialobsolescence and lower-of-cost-or-market issues.  The Company makes estimates of inventory obsolescence, providingreserves when necessary, based on, among other factors, demand for inventorybased on backlog, product pricing, the ability to liquidate or sell olderinventory, and the impact of introducing new products.  Charges associated with providing for inventoryobsolescence, or revisions to related reserves, have historically correlatedwith selling activity and have had a consistent impact on the Company’s grossmargins over the last three fiscal years.

 

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*Goodwill*

 

SFAS No. 142 requires that goodwill and other indefinite-livedintangible assets no longer be amortized to earnings, but instead be reviewedfor impairment, on at least an annual basis, by applying a fair value-basedtest.  The Company adopted theprovisions SFAS No. 142 effective January 1, 2002.  At least annually, the Company assesses itsgoodwill and tradename, using a fair value-based test, consistent with SFAS No.142.  If the carrying amounts exceed thecomputed fair values, goodwill and/or tradename, as appropriate, is consideredto be impaired.  In evaluatingimpairment, the Company estimates the sum of the expected future cash flowsderived from its goodwill and tradename. Such evaluations for impairment are significantly impacted by estimatesof future revenues, costs and expenses and other factors.  The estimates use assumptions about theCompany’s market segment share in the future and about future expenditures bygovernment entities for wireless communications products.  The Company continually evaluates whetherevents and circumstances have occurred that indicate the remaining carryingvalues of goodwill and tradename may not be recoverable.  If the Company fails to deliver newproducts, if the products fail to gain expected market acceptance, or if theCompany fails to achieve assumed revenue growth rates or assumed gross margin,the Company may incur charges for impairment of goodwill and/or tradename inthe future.

 

# ***Income Taxes***

# ** **

The Company accounts for income taxes using the asset and liabilitymethod.  Deferred tax assets andliabilities are recognized for the future tax consequences attributable todifferences between the financial statement carrying amounts of existing assetsand liabilities and their respective tax bases.  Deferred tax assets and liabilities are measured using currentenacted tax rates.  The effect ondeferred tax assets and liabilities of a change in tax rates is recognized inthe results of operations in the period that includes the enactment date.  Valuation allowances are provided to theextent that recoverability of tax assets is not considered likely.  In determining whether a tax asset isrecoverable, the Company considers estimates of future revenues, costs andexpenses and other factors.  If theCompany fails to achieve revenue growth rates or gross margins assumed in thecalculation of the deferred tax asset, the Company may be required to reduceits deferred tax assets in the future.

 

*Long-Lived Assets*

 

In accordance with SFAS No. 144, ***Accounting for the Impairment or Disposal of Long-Lived Assets****,*theCompany reviews its long-lived assets, to include intangible assets subject toamortization, for recoverability whenever events or changes in circumstancesindicate that the carrying amount of such long-lived asset or group oflong-lived assets (collectively referred to as “the asset”) may not berecoverable.  Such circumstancesinclude, but are not limited to:

 

•                  significantdecrease in the market price of the asset;

 

•                  significantchange in the extent or manner in which the asset is being used;

 

•                  significantchange in the business climate that could affect the value of the asset;

 

•                  current periodlosses combined with projection of continuing losses associated with the use ofthe asset;

 

•                  currentexpectation that, more likely than not, the asset will be sold or otherwisedisposed of before the end of its previously estimated useful life.

 

The Company continually evaluates whether events and circumstances haveoccurred.  When such events orcircumstances exist, the recoverability of the asset’s carrying value shall bedetermined by estimating the undiscounted future cash flows (cash inflows lessassociated cash outflows) that are directly associated with and that areexpected to arise as a direct result of the use and eventual disposition of theasset.  To date, no such impairment hasoccurred.  To the extent such events orcircumstances occur that could affect the recoverability of the Company’slong-lived assets, the Company may incur charges for impairment in the future.

 

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**ITEM 3.  QUANTITATIVE AND QUALITATIVE DISCLOSURESABOUT MARKET RISK**

 

Although all of the Company’s sales are denominated in U.S. dollars,fluctuations in the value of international currencies relative to the U.S.dollar may affect the price, competitiveness and profitability of the Company’sproducts sold in international markets. Furthermore, the uncertainty of monetary exchange values has caused, andmay in the future cause, some foreign customers to delay new orders or delaypayment for existing orders. Additionally, troubled economic conditions, such as that recentlyexperienced in Asia and in Latin America, could result in lower revenues forthe Company.  While most internationalsales are supported by letters of credit, the purchase of Company products byinternational customers presents increased risks, which include:

 

•                  unexpectedchanges in regulatory requirements;

•                  tariffs andother trade barriers;

•                  political andeconomic instability in foreign markets;

•                  difficulties inestablishing foreign distribution channels;

•                  longer paymentcycles;

•                  uncertainty inthe collection of accounts receivable;

•                  increased costsassociated with maintaining international marketing efforts;

•                  difficulties inprotecting intellectual property; and

•                  susceptibilityto orders being cancelled as a result of foreign currency fluctuations (sinceall the Company quotations and invoices are denominated in U.S. dollars).

 

Some of the Company’s information security products are subject toexport controls under U.S. law, which in most cases requires the approval ofthe Department of Commerce in order to ship internationally. The Company cannotassure that such approvals will be available to it or its products in thefuture in a timely manner or at all or that the federal government will notrevise its export policies or the list of products and countries for whichexport approval is required. The Company’s inability to obtain required exportapprovals would adversely affect the Company’s international sales, which wouldhave a material adverse effect on the Company. In addition, foreign companiesnot subject to United States export restrictions may have a competitiveadvantage in the international information security market. The Company cannotpredict the impact of these factors on the international market for itsproducts.

 

**ITEM 4. CONTROLS ANDPROCEDURES**

 

In accordance with Rule 13a-15(b) of the Securities Exchange Act of1934 (“Exchange Act”), the Company evaluated the effectiveness of the designand operation of its disclosure controls and procedures as defined in Rule13a-15(e) and 15d-15(e) under the Exchange Act (“Disclosure Controls”) as ofthe three months ended March 31, 2004. This evaluation (the “Controls Evaluation”) was done under thesupervision and with the participation of management, including the Company’sChief Executive Officer (“CEO”) and Chief Financial Officer (“CFO”).  The effectiveness of the Company’sDisclosure Controls, as determined by this evaluation, is disclosed in theChief Executive Officer’s Certification of Report on Form 10-Q for the QuarterEnding March 31, 2004 and the Chief Financial Officer’s Certification ofReport on Form 10-Q for the Quarter Ending March 31, 2004 (together,“Certifications”).

 

Disclosure Controls are procedures that are designed with the objectiveof ensuring that information required to be disclosed in the Company’s reportsfiled under the Exchange Act, such as this Quarterly Report, is recorded,processed, summarized and reported within the time periods specified in theSecurities and Exchange Commission’s (“SEC”) rules and forms.  Disclosure Controls are also designed withthe objective of ensuring that such information is accumulated and communicatedto management, including the CEO and CFO, as appropriate to allow timelydecisions regarding required disclosure.

 

A control system, no matter how well conceived and operated, canprovide only reasonable, not absolute, assurance that the objectives of thecontrol system are met. Further, the design of a control system must reflectthe fact that there are resource constraints, and the benefits of controls mustbe considered relative to their costs. Because of the inherent limitations in all control systems, noevaluation of controls can provide absolute assurance that all control issuesand instances of fraud, if any, within the Company have been detected.  These inherent limitations include therealities that judgments in decision-making can be faulty, and that breakdownscan occur because of simple error or mistake. Additionally, controls can be circumvented by the individual acts ofsome

 

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persons, by collusion of two or more people, or by management overrideof the control.  The design of anysystem of controls also is based in part upon certain assumptions about thelikelihood of future events, and there can be no assurance that any design willsucceed in achieving its stated goals under all potential future conditions;over time, control may become inadequate because of changes in conditions, orthe degree of compliance with the policies or procedures may deteriorate.  Because of the inherent limitations in acost-effective control system, misstatements due to error or fraud may occurand not be detected, and, thus, the Company’s management cannot provideabsolute assurance that the Company’s Disclosure Controls will prevent allerrors and all fraud.

 

The Company’s Disclosure Controls are also evaluated on an ongoingbasis by its Finance organization.  Theoverall goals of these various evaluation activities are to monitor theCompany’s Disclosure Controls and to make modifications as necessary.  The Company’s intent in this regard is thatthe Disclosure Controls will be maintained as dynamic systems that change(including with improvements and corrections) as conditions warrant.

 

Based upon the Controls Evaluation, the Company’s CEO and CFO haveconcluded that, subject to the limitations noted above, the Company’sDisclosure Controls are effective as of the three months ended March 31,2004 to ensure that material information relating to the Company and itsconsolidated subsidiaries was made known to management, including the CEO andCFO, particularly during the period when periodic reports are being prepared,and that the Company’s Disclosure Controls are effective to provide reasonableassurance that its financial statements are fairly presented in conformity withUSGAAP.

 

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**PART II.  OTHER INFORMATION**

 

**ITEMS 1.  LEGAL PROCEEDINGS**

 

On or about February 5, 2001, ASRCCommunication (“ASRC”) filed a complaint in United States District Court forthe District of Alaska, against EFJohnson seeking damages against EF Johnson onclaims arising out of EF Johnson’s sale of radio products to ASRC.  ASRC purchased, and resold to the State ofAlaska, approximately $500,000 of products from EFJohnson since 1999.  ASRC’s claims against EFJohnson includebreach of contract, breach of express warranty, breach of implied warranty ofmerchantability, breach of implied warranty of fitness for a particularpurpose, breach of duty of good faith and fair dealing, equitable estoppel,misrepresentation, and violations of the Racketeer Influenced and CorruptOrganizations Act.  The complaintanticipated that the State of Alaska would formally prosecute itsadministrative claim under the Alaska State Procurement Code against ASRC fordamages associated with alleged malfunctions of EFJohnson manufactured radios.Under the May 21, 2003 agreement between ASRC and EFJohnson (the “ASRCAgreement”), EFJohnson agreed to defend ASRC, at EFJohnson’s expense, againstany State’s claim alleging non-performance of the EFJohnson radios.  In the event the State prevailed in itsclaim EF Johnson and ASRC agreed to allocate any award in favor of the State inaccordance with formula in the ASRC Agreement.   In addition, the parties agreed to resolve any issue or disputeremaining between them after the conclusion of the State administrative proceedingthrough mediation and binding arbitration. Based upon the ASRC Agreement, ASRC and EFJohnson dismissed the claimsagainst each other.

 

On about April 6, 2004, the State ofAlaska’s Department of Administration, Information Technology Group filed anadministrative claim under the State Procurement Code against ASRC for damagesassociated with the EFJohnson radios. The State of Alaska claim alleges that it has damages in excess of$900,000.  Subsequently, ASRC hastendered, and EFJohnson has accepted, the State’s administrative claim inaccordance with the ASRC Agreement. EFJohnson will undertake to defend ASRC under the terms and conditionsof the ASRC Agreement.  The Company isunable to predict the likelihood of the outcome or potential liability that mayarise from this action.

 

**ITEMS 2 – 5.**

 

**ITEM 6.  EXHIBITS AND REPORTS ON FORM 8-K**

 

(a)  Exhibits

 

The following exhibits are filed herewith:

 
| **Exhibit No.** |   | **Description**                                                                                                                                     |
|-----------------|--------|-----------------------------------------------------------------------------------------------------------------------------------------------------|
|            |   |                                                                                                                                                |
| 11.1            |   | Computation of income (loss) per share                                                                                                              |
|            |   |                                                                                                                                                |
| 31.1            |   | Chief Executive Officer’s Certification of Report on Form 10-Q  For the Quarter Ending March 31, 2004                                     |
|            |   |                                                                                                                                                |
| 31.2            |   | Chief Financial Officer’s Certification of Report on Form 10-Q  For the Quarter Ending March 31, 2004                                     |
|            |   |                                                                                                                                                |
| 32.0            |   | Written certification of Chief Executive Officer and Chief Financial  Officer,  dated April 30, 2004, pursuant to 18 U.S.C. Section 1350. |
|            |   |                                                                                                                                                |
| 99.0            |   | EFJ, Inc. Business Code of Ethics                                                                                                                   |

 

(b)  Reports on Form 8-K:

 

The Company filed its press release announcing financial results for2003 and providing performance

 

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guidance for 2004 as a report on Form 8-K, under Items 5 and 7, onMarch 04, 2004.

 

The Company filed itspress release announcing that its stock would commence trading on the NASDAQNational Market (“NASDAQ”) on February 19, 2004 under the Company’scurrent symbol “EFJI” as a report on Form 8-K, under Items 5 and 7, onFebruary 18, 2004.

 

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**SIGNATURE**

 

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

 
|                                             | EFJ, INC. |
|--------------------------------------------------|-----------|
|                                             |      |
|                                             |      |
| Date:    April 30, 2004 | By:       |  /s/ Massoud Safavi |   |
|                                             |      |   |
|                                             |      | Massoud Safavi |
|                                             |      | Senior Vice President and |
|                                             |      | Chief Financial Officer |
|                                             |      | (Principal Financial and Accounting |
|                                             |      | Officer) |

 

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