Revenues and cost recognition. The majority of our contracts are accounted for in accordance with the American Institute of Certified Public Accountants Statement of Opinion 81-1, Accounting for Performance of Construction-Type and Production-Type Contracts. These contracts are executed by using written contractual arrangements, most of which require us to design, develop, manufacture, and/or modify our complex products, and perform related services according to specifications provided by the customer.

We account for cost-reimbursement contracts by charging actual labor, materials, and other direct costs, plus estimated indirect costs of operations as incurred (incurred costs). Indirect costs include overhead, research and development, and general and administrative expenses. General and administrative costs are not applied to certain subcontract costs associated with our cost-reimbursement contracts. These subcontracts must be in excess of $250,000 and must meet certain other predetermined criteria.

We recognize contract revenues and profits on cost-reimbursement contracts by applying an estimated fee rate to all incurred costs on an individual contract basis. Fee calculations are based on either negotiated fee amounts or management’s assessment of the fee amounts that are likely to be earned.

Our policy for recognizing interim award fees on our cost-plus-award-fee contracts is based on management’s assessment as to the likelihood that the award fee or an incremental portion thereof will be earned, on a contract-by-contract basis. Management’s assessments are based on numerous factors including: contract terms, nature of the work to be performed, our relationship and history with the customer, our history with similar types of projects, and our current and anticipated performance on the specific contract. No award fee is recognized in whole or in part until management determines that it is probable that the award fee or portion thereof will be earned. If management’s assessment is incorrect, the adjustment to profits resulting from such revisions may affect future period earnings.

Our engineering services contracts are typically performed on a level-of-effort basis. Revenue is recognized in accordance with our policy regarding cost-reimbursement contracts.

We account for fixed-price contracts by using the percentage-of-completion method of accounting. Under this method, labor, materials, and other direct costs, plus estimated indirect costs of operations, are charged as incurred (incurred costs). A portion of the contract revenue, based on estimated profits and the degree of completion of the contract as measured by a comparison of the actual and estimated costs, is recognized as revenue each period. Unexpected increases in the cost to develop or manufacture a product under a fixed-price contract, whether due to inaccurate estimates in the bidding process, unanticipated increases in material costs, inefficiencies, or other factors, are borne by us, and could have a material, adverse effect on our results of operations.

The following table represents the revenue concentration by contract type:

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

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

Revenues from our software licenses are accounted for under AICPA Statement of Position 97-2, Software Recognition. Revenues from our software licenses have been insignificant in all periods presented

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

Our accounting policy for recording indirect rate variances is based on management’s belief that variances accumulated during interim reporting periods will be absorbed by expected contract activities during the remainder of the year. We consider the rate variance to be unfavorable when our actual indirect rates are greater than our annual targeted rates. In contrast, a favorable rate variance occurs when our actual indirect rates are lower than our annual targeted rates. During interim reporting periods, unfavorable rate variances are recorded as reductions to operating expenses and increases to work in process inventory. Favorable rate variances are recorded as increases to operating expenses and decreases to work in process inventory. Please refer to "Notes to Condensed Financial Statements, Note 2: Inventory" for the current year inventoried indirect rate variance.

If we anticipate that actual contract activities will be different than planned levels, there are alternatives we can utilize to absorb the variance: we can adjust our planned indirect spending during the year, modify our billing rates to our customers, or record adjustments to expense based on estimates of future contract activities.

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

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

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

We excluded approximately 4,000 antidilutive potential common shares from diluted net income per common share computation for the third quarter and first nine months of fiscal year 2004, respectively. For the same periods in fiscal year 2003, we excluded approximately 50,000 and 190,000 antidilutive potential common shares from diluted net income per common share computation.

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

As of July 30, 2004, net unrealized loss on securities was approximately $22,000. As of October 31, 2003, net unrealized gain on securities was approximately $65,000.

During fiscal year 2004, we have an annual dividend of $0.50 per share, payable over four quarters at the rate of $0.125 per share per quarter. Dividends were paid on February 13, 2004, May 14, 2004, and August 13, 2004 and are payable on November 12, 2004 for shareholders of record at January 30, 2004, April 30, 2004, July 30, 2004, and October 31, 2004, respectively, and on such future dates that the Board of Directors may determine.

We paid dividends of approximately $3,420,000 and $646,000 during the first nine months of fiscal years 2004 and 2003, respectively.

At July 30, 2004 and October 31, 2003, accrued dividends of approximately $1,399,000 and $673,000, respectively, were included in other accrued liabilities in the accompanying balance sheet.

We apply Accounting Principles Board Opinion No. 25 and related Interpretations in accounting for our stock option plans. We have opted, under SFAS No. 123, Accounting for Stock-Based Compensation, as amended by SFAS 148, to disclose our stock-based compensation with no financial statement effect. Under APB 25, no stock-based compensation expense is charged for options granted at an exercise price equal to the fair market value of the underlying common stock on the date of grant. Had compensation expense for our stock plans been determined based upon the fair value at the grant date for awards under these plans consistent with the methodology prescribed under SFAS 123, our pro forma net income and net income per share would have been as follows (in thousands, except per share data):

Note 2: Inventory

The components of inventory consist of the following (in thousands):

The following information should be read in conjunction with the attached condensed financial statements and notes thereto, as well as our Annual Report on Form 10-K for the year ended October 31, 2003.

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

Description of the Business

We were incorporated in California in 1984. Our principal executive offices are located at 400 West California Ave., Sunnyvale, CA, 94086, and our telephone number is (408) 749-1888. Our web site address is www.appsig.com. The information posted on our web site is not incorporated into this quarterly report. However, investors can obtain a copy of this report, previous quarterly reports on Form 10-Q, our latest Annual Report on Form 10-K, current reports on Form 8-K, and amendments to such reports filed or furnished with the SEC on our web site free of charge. In addition, hard copies can be obtained free of charge through our investor relations department.

Overview

Three and Nine Months Ended July 30, 2004 Compared to Three and Nine Months Ended August 1, 2003

Revenues and backlog. Revenues for the third quarter of fiscal year 2004 were approximately $38,275,000, a 47.2% increase from revenues of approximately $26,002,000 recorded in the third quarter of fiscal year 2003. Revenues for the first nine months of fiscal year 2004 were approximately $103,380,000, a 56.0% increase from revenues of approximately $66,261,000 recognized during the first nine months of fiscal year 2003. It is our belief that the increase in revenues recorded during the third quarter and first nine months of fiscal year 2004, when compared to the same periods in fiscal year 2003, is due to an increase in new orders and backlog.

New orders received for the third quarter 2004 were approximately $35,417,000, down 13.7% compared to new orders of approximately $41,031,000 received during the third quarter of fiscal year 2003. We believe the decline in new orders is due to the typical fluctuations experienced in the U.S. Government procurement process. New orders received during the first nine months of fiscal year 2004 were approximately $128,602,000, compared to approximately $72,554,000 received during the same period in fiscal year 2003. We believe the increase in new orders during the first nine months of fiscal year 2004, when compared to the first nine months of fiscal year 2003, is due to the U.S. Government’s emphasis on intelligence.

Our backlog consists of the uncompleted portions of existing contracts (excluding unexercised options). At July 30, 2004, ending backlog was approximately $110,755,000, representing a 27.2% increase from ending backlog of approximately $87,074,000 at October 31, 2003. During June 2004, we received a stop-work order instructing us to stop work on a portion of our largest single contract. In accordance with the instructions received from the other contracting party, we prepared a proposal that detailed the tasks that were stopped and estimated the reduction in contract costs. If all the stopped tasks are terminated, the result could be a significant reduction in orders and backlog in the period in which it occurs. If such a reduction occurs, we believe it could happen sometime during the next three to six months and could result in orders and backlog reduction in the range of $10 million to $15 million. This potential reduction primarily impacts our fiscal 2005 anticipated revenues. We believe the government initiated this stop-work order to mitigate risk on the program in an attempt to meet certain key milestones. Although not stated in writing, the other contracting party has informed us that the stopped tasks could be deferred to later periods after successful completion of these key milestones.

Cost-reimbursement contracts typically do not return as high a profit margin as fixed-price contracts, and accordingly, our profit margin will be affected by the mix of our orders by contract type. The following table represents the revenue concentration by contract type:

Product warranties. Our products, including associated firmware and software, are warranted against defective workmanship and materials for a period of one year from the date of acceptance by the original purchaser. In addition, we offer extended warranties at a percentage of the purchase price. An additional six-month warranty may be purchased for 3% of the unit or system purchase price. Alternatively, one-year warranty coverage may be purchased 5% of the unit or system purchase price. Warranty costs were approximately $45,000 and $117,000 for the third quarter and first nine months of fiscal year 2004, respectively. Fiscal year 2003 warranty costs were approximately $56,000 and $144,000 during the third quarter and first nine months, respectively.

Analysis of Liquidity and Capital Resource

The change in accounts payable, taxes payable, and accrued liabilities balances resulted in a net increase of approximately $2,668,000 and $1,727,000 during the first nine months of fiscal years 2004 and 2003, respectively. Income taxes payable increased approximately $918,000 during the first nine months of fiscal year 2004, compared to no change during the first nine months of fiscal year 2003. The difference in the income taxes payable activities between fiscal years 2004 and 2003 is the difference in our estimated effective tax rate (31.2% at July 30, 2004 and 15% at August 1, 2003). Accrued payroll liabilities increased approximately $1,634,000 during the first nine months of fiscal year 2004, and decreased approximately $578,000 during the same period of fiscal year 2003. Accrued payroll liabilities increased during the first nine months of fiscal year 2004 due to an increase of approximately $2,041,000 in accrued bonus expense and a significant increase to our staff, when compared to the same period in fiscal year 2003. Payroll liabilities decreased during the first nine months of fiscal year 2003 due to the issuance of common stock under our employee stock purchase plan. Accounts payable and other accrued liabilities increased approximately $116,000 and $2,305,000 during the first nine months of fiscal years 2004 and 2003, respectively. The primary difference between accounts payable activities during the first nine months of fiscal years 2004 and 2003 is due to approximately $1,594,000 in subcontract costs accrued at the end of the third quarter of fiscal year 2003, which were paid during the fourth quarter of fiscal year 2003.

Net cash from financing activities. Financing activities provided cash of approximately $1,636,000 during the first nine months of fiscal year 2004 and approximately $2,759,000 during the same period in fiscal year 2003. The source of cash provided by financing activities in both periods was the issuance of common stock under our employee stock purchase plan and stock option plans. Cash from our stock option exercises increased during the first nine months of fiscal year 2004, when compared to fiscal year 2003, by approximately $1,307,000. We believe our employees exercised more options during the first nine months of fiscal year 2004 due to the increase in market value of our common stock. However, cash from the issuance of common stock was offset by dividend payments of $3,420,000 and $646,000 in the first nine months of fiscal years 2004 and 2003, respectively.

Cash is generated primarily from operating activities, employee stock activities, and investing activities. Our investment portfolio includes a variety of low-risk investments. We believe the primary risk to liquidity is the potential decrease in demand for our products and services. Historically, this demand has been influenced by the intelligence needs of the U.S. Government.

At July 30, 2004, we had a cash-secured line of credit with a bank in the amount of $2,000,000. Borrowings under the line of credit bear interest at the bank’s reference rate (4.25% at July 30, 2004) and accrued interest on those borrowings were payable monthly. No fees were associated with the unused portion of the committed amount. This line of credit will expire on March 1, 2005.

Under the line of credit, we had two standby letters of credit totaling approximately $1,370,000. One letter of credit, related to our facilities lease, was approximately $1,220,000 and $1,218,000 at July 30, 2004 and October 31, 2003, respectively. The second letter of credit was obtained during the first quarter of fiscal year 2004 as a requirement of our workers compensation insurance, and was approximately $150,000 at July 30, 2004. At both July 30, 2004 and October 31, 2003, there were no other borrowings.

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

Summary of Business Considerations and Certain Factors That May Affect Future Results of Operations and/or Stock Price

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

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

Also, potential shifts in responsibilities and functions within the defense and intelligence communities could result in a reduction of orders for signal intelligence by the defense and intelligence agencies that have historically been our major customers. We believe that the United States Government may compensate for reduced order flow by these agencies with increases in spending for signal intelligence by other Government agencies. However, our relationships with other Government agencies are not as strong as our relationships with current customer agencies. A reduction in contracts from our customer agencies may not be offset by contracts from other United States Government agencies. Even if other agencies increase spending for signal intelligence, we may not secure the same amount of work from such other agencies. As a result, demand for our products and services could decline, resulting in a decrease in revenues, and could adversely affect our operating results and financial condition materially.

We depend on revenues from a few significant contracts, and any loss, cancellation, reduction, or delay in these contracts could harm our business. From time to time, including recent periods, we have derived a material portion of our revenue from one or more individual contracts that could be terminated by the customer at the customer’s discretion. We expect that in future periods we may again enter into individual contracts with significant revenue concentrations. If such contracts were terminated, revenues and net income would significantly decline. Our success will depend on our continued ability to develop and manage relationships with significant customers. Although we are attempting to expand our customer base, we expect that our customer concentration will not change significantly in the near future. The markets in which we sell our products are dominated by a relatively small number of governmental agencies and allies of the United States Government, thereby limiting the number of potential customers. Our dependence on large orders from a relatively small number of customers makes our relationship with each customer critical to our business. We cannot be sure that we will be able to retain our largest customers, that we will be able to attract additional customers, or that our customers will continue to buy our products in the same amounts as in prior years. The loss of one or more of our largest customers, any reduction or delay in sales to these customers, our inability to successfully develop relationships with additional customers, or future price concessions that we may have to make could significantly harm our business.