The accompanying unaudited condensed consolidated financial statements have been prepared in accordance with generally accepted accounting principles of the United States of America for interim financial information and the instructions to Form 10-Q. Accordingly, they do not include all of the information and disclosures required by generally accepted accounting principles for complete financial statements. In the opinion of management, all adjustments (consisting of normal recurring items) considered necessary for fair presentation have been included. Operating results for the three month period ended December 28, 2008January 3, 2010, are not necessarily indicative of the results that may be expected for the fiscal year ending September 30, 2009.2010. Inter-company accounts and transactions have been eliminated in consolidation. For further information, refer to the consolidated financial statements and footnotes thereto included in Argon ST, Inc.’s Annual Report on Form 10-K for the fiscal year ended September 30, 2008.2009. Reclassifications are made to the prior year financial statements when appropriate, to conform to the current year presentation.

          Argon ST, Inc. (“Argon ST” or the “Company”) maintains a September 30 fiscal year-end for annual financial reporting purposes. Argon ST presents its interim periods ending on the Sunday closest to the end of the month for each quarter consistent with labor and billing cycles. As a result, each quarter of each year may contain more or less days than other quarters of the year. Management does not believe that this practice has a material effect on quarterly results or on the comparison of such results.

          Argon ST records 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 the Company’s interim reporting periods, variances may accumulate between the actual indirect rates and the annual targeted rates.rates due to necessarily uneven rates of spending throughout the year. Timing-related indirect spending variances are not applied to contract costs, research and development, and general and administrative expenses, but are included in unbilled receivables during these interim reporting periods. These rates are reviewed regularly, and the Company records adjustments for any material, permanent variances in the period they become determinable.

          Argon ST’s accounting policy for recording indirect rate variances is based on management’s belief that variances accumulated during interim reporting periods will be absorbed by management actions to control costs during the remainder of the year. The Company considers the rate variance to be unfavorable when the actual indirect rates are greater than the Company’s annual targeted rates. During interim reporting periods, unfavorable rate variances are recorded as reductions to operating expenses and increases to unbilled receivables. Favorable rate variances are recorded as increases to operating expenses and decreases to unbilled receivables. At December 28, 2008,January 3, 2010, the unfavorable rate variance totaled $1,421,$4,611, which was approximately $750 less$774 more than the $2,171$3,837 unfavorable rate variance planned for the period. If the Company anticipates that actual contract activities will be different than planned levels, there are alternatives the Company can utilize to absorb the variance: the Company can adjust planned indirect spending during the year, modify its billing rates to its customers, or record adjustments to expense based on estimatesfor the portion of future contract activities.rate variance that is considered permanent, if any. Management expects the variance to be eliminated over the course of the fiscal year and therefore, no portion of the variance is considered permanent.

          If the Company’s rate variance is expected to be unfavorable for the entire fiscal year, any modification of the Company’s indirect rates will likely increase revenue and operating expenses. Profit percentages on fixed-price contracts will generally decline as a result of an increase to indirect costs unless compensating savings can be achieved in the direct costs to complete the projects. Profit percentages on cost reimbursement contracts will generally decline as a percentage of total costs as a result of an increase in indirect costs even if the cost increase is funded by the customer. If the Company’s rate variance is favorable, any modification of the Company’s indirect rates will decrease revenue and operating expenses. In this event, profit percentages on fixed-price contracts will generally increase. Profit 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 and anticipated performance on specific contracts.

     2. EARNINGS PER SHARE

          Basic earnings per share is computed using the weighted average number of common shares outstanding during each period. Diluted earnings per share is computed using the weighted average number of common and dilutive common equivalent shares outstanding during each period. The following summary is presented for the fiscal quartersthree months ended January 3, 2010 and December 28, 2008 and December 30, 2007:2008:

          The following table summarizes stock option activity for the three months ended January 3, 2010. On December 28, 2008. At December 26, 2008,31, 2009, the closing price of our common stock was $17.55.$21.71.

     4. ACCOUNTS RECEIVABLE

          Accounts receivable consistsconsist of the following as of:

          As of December 28, 2008,January 3, 2010, the Company has capitalized $10,893$5,301 of construction in progress primarily consisting of $9,714$4,405 of costs incurred directly associatedin connection with the construction of one asset to be used internally for test equipment, demonstration equipment and other purposes. The Company expects to place this asset into service during fiscal year 2009.2010.

     7. REVOLVING LINE OF CREDIT

          TheThrough January 3, 2010, the Company maintainsmaintained a $40,000 line of credit with Bank of America, N.A. (the “Lender”)., which was renewed on January 25, 2010, with substantially the same terms and conditions existing prior to the renewal. The credit facility will terminate no later than February 28, 2010 at which time the facility will be subject to renewal.2012. The credit facility also contains a sublimit of $15,000 to cover letters of credit. In addition, borrowings on the line of credit bear interest at LIBOR plus 150175 basis points. An unused commitment fee of 0.25% per annum, payable in arrears, is also required.

          All borrowings under the line of credit are collateralized by all tangible assets of the Company. The line of credit agreement includes customary restrictions regarding additional indebtedness, business operations, permitted acquisitions, liens, guarantees, transfers and sales of assets, and maintaining the Company’s primary accounts with the Lender. Borrowing availability under the line of credit is equal to the product of 1.5 and the Company’s earnings before interest expense, taxes, depreciation and amortization (EBITDA) for the trailing 12 months, calculated as of the end of each fiscal quarter. For the fiscal quarter ending December 28, 2008,January 3, 2010, EBITDA, on a trailing 12 month basis, was $41,715,$44,941, and as such, the borrowing availability was $40,000. The agreement requires the Company to comply with a specific EBITDA to Funded Debt ratio, and contains customary events of default, including the failure to make timely payments and the failure to satisfy covenants, which would permit the Lender to accelerate repayment of borrowings under the agreement if not cured within the applicable grace period. As of December 28, 2008,January 3, 2010, the Company was in compliance with these covenants and the financial ratio.

          We areThe Company is subject to litigation from time to time, in the ordinary course of business including, but not limited to, allegations of wrongful termination or discrimination. The Company believes the outcome of such matters will not have a material adverse effect on our results of operations, financial position or cash flows.

     10.11. RELATED PARTY TRANSACTIONS

          In December 2007,June 2009, the FASB issued Statementan amendment which requires entities to provide more information about the sale of Financial Accounting Standards No. 141R,Business Combinations(“SFAS No. 141R”), which replaces SFAS No. 141Business Combinations. SFAS No. 141R establishes principles and requirements for determining how an enterprise recognizes and measures the fair value of certainsecuritized financial assets and liabilities acquiredsimilar transactions in a business combination, including noncontrolling interest, contingent consideration, and certain acquired contingencies. SFAS No. 141R also requires acquisition-related transaction expenses and restructuring cost be expensed as incurred rather than capitalized a component of the business combination. SFAS No. 141R will be applicable prospectively to business combinations for which the acquisition dateentity retains some risk related to the assets. This amendment is on oreffective for fiscal years beginning after the beginning of the first annual reporting period beginning on or after DecemberNovember 15, 2008. SFAS No. 141R would have an impact on accounting for any business combinations occurring after our fiscal year ending September 30, 2009. The Company is currently assessingdoes not believe the impact, if any,adoption of this statementamendment will have a material impact on its consolidated financial position, results of operations, or cash flows.

          In April 2008,June 2009, the FASB issued FASB Staff Position No. FAS 142-3, “Determinationan amendment, which changes how a company determines when an entity that is insufficiently capitalized or is not controlled through voting (or similar rights) should be consolidated. Under this guidance, determining whether a company is required to consolidate an entity will be based on, among other things, an entity’s purpose and design and a company’s ability to direct the activities of the Useful Life of Intangible Assets”(“FSP No. FAS 142-3”). FSP No. FAS 142-3 requires companies estimatingentity that most significantly impact the useful life of a recognized intangible asset to consider their historical experience in renewing or extending similar arrangements or, in the absence of historical experience, to consider assumptions that market participants would use about renewal or extension as adjusted for entity-specific factors. FSP No. FAS 142-3entity’s economic performance. This amendment is effective for fiscal years beginning after DecemberNovember 15, 2008.2009. The Company does not believe that the adoption of EITF 07-3 will have anya material effectimpact on ourits consolidated financial position, results of operations, or cash flows.

     Duringprice, (3) eliminates the first quarteruse of fiscal 2009, the Company adopted Statement of Financial Accounting Standards No. 157,Fair Value Measurements,which defines fair value, provides a frameworkresidual method for measuring fair value,allocation, and (4) expands the disclosures requiredongoing disclosure requirements. This guidance is effective for fair value measurements. The adoption of this Standard did not have a material effect on our consolidated financial position, results of operations, or cash flows. In February 2008, the FASB issued FASB Staff Position (“FSP”) No. FAS 157-2, Effective Date of FASB Statement No. 157. FSP 157-2 delays the effective date of SFAS No. 157 to fiscal years beginning after November 15, 2008 for all non-financial assets and non-financial liabilities, except for items that are recognized or disclosed at fair value in the financial statements on a recurring basis (at least annually) and will be adopted by the Company beginning in the first quarter of fiscal 2010. Although theOctober 1, 2010 and can be applied prospectively or retrospectively. The Company will continue to evaluate the application of FSP 157-2, management does not currently believe the adoption will have a material impact on the Company’sits consolidated financial position, results of operations, or cash flows.

          The following discussion provides information which management believes is relevant to an assessment and an understanding of the Company’s operations and financial condition. This discussion should be read in conjunction with the attached unaudited condensed consolidated financial statements and accompanying notes as well as our annual report on Form 10-K for the fiscal year ended September 30, 2008.2009.

          Statements in this filing which are not historical facts are forward-looking statements under the provision of the Private Securities Litigation Reform Act of 1995. These statements may contain words such as “expects”, “could”, “believes”, “estimates”, “intends”, “may”, “envisions”, “targets” or other similar words. Forward-looking statements are not guarantees of future performance and are based upon numerous assumptions about future conditions that could prove not to be accurate. Forward-looking statements are subject to numerous risks and uncertainties, and our actual results could differ materially as a result of such risks and other factors. In addition to those risks and uncertainties specifically mentioned in this report and in the other reports filed by the Company with the Securities and Exchange Commission (including our Form 10-K for the fiscal year ended September 30, 2008)2009), such risks and uncertainties include, but are not limited to: the availability of U.S. and international government and commercial funding for our products and services, including without limitation, statements with respect to total estimated remaining contract values and the Company’s expectations regarding the U.S. government’s procurement activities related thereto; changes in the U.S. federal government procurement laws, regulations, policies and budgets (including changes to respond to budgetary constraints and cost-cutting initiatives)initiatives as well as changes increasing internal costs for monitoring, audit and reporting activity); changes in appropriations types and amounts due to the expenditures priorities of the new Administration in Washington; the future impact of any acquisitions, reorganizations or divestitures we may make; the government’s ability to hire and retain contracting personnel; the number and type of contracts and task orders awarded to us; the exercise by the U.S. government of options to extend our contracts; our ability to retain contracts during any rebidding process; decisions by government agencies on the methods of seeking contractor support; the timing of Congressional funding on our contracts; any delay or termination of our contracts and programs; difficulties in developing and producing operationally advanced technology systems; our ability to secure business with government prime contractors; our ability to maintain adequate and unbroken supplier performance; the timing and customer acceptance of contract deliverables; our ability to attract and retain qualified personnel, including technical personnel and personnel with required security clearances; charges from any future impairment reviews; the future impact of any acquisitions or divestitures we may make; the competitive environment for defense and intelligence information technology products and services; the ability, because of the global economy and issues in the banking industry, to secure financing when and if needed; the financial health and business plans of our commercial customers; general economic, business and political conditions domestically and internationally; and other factors affecting our business that are beyond our control. All of the forward-looking statements should be considered in light of these factors. You should not put undue reliance on any forward-looking statements. We undertake no obligation to update these forward-looking statements to reflect new information, future events or otherwise.

          We are a leading systems engineering and development company providing full-service C5ISR (command, control, communications, computers, combat systems, intelligence, surveillance and reconnaissance) systems in several markets, including without limitation maritime defense, airborne reconnaissance, ground systems, tactical communications and network systems. These systems and services are provided to a wide range of defense and intelligence customers, including commercial enterprises. Our systems provide communications intelligence, electromagnetic intelligence, electronic warfare and information operations capabilities that enable our defense and intelligence customers to detect, evaluate and respond to potential threats. These systems are deployed on a range of military and strategic platforms including surface ships, submarines, unmanned underwater vehicles (UUV), aircraft, unmanned aerial vehicles (UAV), land mobile vehicles, fixed site installations and re-locatable land sites.

          Given the dramatic dislocations in the financial community, a worldwide recession, a very large federal deficit, and a new Executive Branch with an agenda that may or may not differ than the previous administration’s, we may see significant impacts on our results of operations as a result of pressure on the defense and intelligence budgets. However, we beganduring fiscal year 2009 withand continuing to impact our business in the early parts of 2010, we have seen delays in the government procurement and contract administration cycles, which has resulted in lower than anticipated bookings. We continue to see opportunities across a solid backlog. While we understand that there will be significant pressure on the defense and intelligence budgets, we believe that given the current status of global security, the productionbroad spectrum of our systems, which include critical collection of intelligencetechnology and the maintenance of persistent surveillance, are important to our success and will require continued demand of our products and services from our customers.capability offerings.

          Our revenues are primarily generated from the entire life cycle of complex sensor systems under contracts primarily with the U.S. Governmentgovernment and major domestic prime contractors, as well asbut also with foreign governments, agencies and defense contractors. This life cycle spans across the design, development, production, installation and support of the system.

          Our government contracts can be divided into three major types: cost reimbursable, contracts, fixed-price, and time and materials. Cost reimbursable contracts are primarily used for system design and development activities involving considerable risks to the contractor, including risks related to cost estimates on complex systems, performance risks associated with real time signal processing, embedded software, high performance hardware, and requirements that are not fully understood by the customer or us, the development of technology that has never been used, and interfaces with other systems that are in development or are obsolete without adequate documentation. Fees under these contracts are usually fixed at the time of negotiation; however, in some cases the fee is an incentive or award fee based on cost, schedule, and performance or a combination of those factors. Although the U.S. government customer assumes the cost risk on these contracts, the contractor is not allowed to exceed the cost ceiling on the contract without the approval of the customer.

          Fixed-price contracts are typically used for the production of systems. DevelopmentLower risk development activities similar to activities performed under previous contacts are also usually covered by fixed-price contracts, due to the lower risk involved.contracts. In these contracts, cost risks are borne entirely by the contractor. Some fixed-price contracts include an award fee or an incentive fee as well as the negotiated profit. Most foreign customers, and some U.S. customers, use fixed-price contracts for design and development work even when the work is considered high risk.

          Time and material contracts are based on hours worked, multiplied by approvedpre-negotiated labor rates, plus other costs incurred, allocated and allocated.approved.

          The following table represents our revenue concentration by contract type for the three months ended January 3, 2010 and December 28, 20082008:

          Our primary business model is to capture the full life cycle of a system beginning with concept development and December 30, 2007:

In all three of these programs we have either completed or are near completion of the test and integration phases. We believe we will receive production orders during the coming fiscal years. These production orders could cause a significant impact to continue. The increaseour mix of contract types and may result in fixed-pricelarger percentages of more desirable and potentially higher margin fixed price work although the capture of new development work on cost-type contracts may keep our mix closer to current levels and provide opportunity for future production contracts. Further, and as specific to the decrease in fixed price work in fiscal 2010, the ORBCOMM Generation Two Payload (“OG2”) development which is a total percentagefixed price contract entered the final testing phases in late 2009 and early 2010. During these final testing phases, the level of our revenueeffort of both labor and materials are much less than the large level of efforts needed during the development work which continued in the first quarter of fiscal 2009, as compared toyear 2009. We believe the first quartermaturing of fiscal 2008, is primarily due to a significant amount of work performed on athe fixed price subcontract to Sierra Nevada for the buildwork on OG2 will be replaced with newer fixed price work during fiscal 2010, such as our production of the ORBCOMM Generation Two payload, which was awarded in the third quarter of fiscal 2008 and a decreased amount of work performed on our cost-reimbursable type maritime development programs, as these programs entered the integration and test stages of their life cycle.multiple ground surveillance systems.

          We define backlog as the funded and unfunded amount provided in our contracts, less previously recognized revenue. Contract options are estimated separately and not included in backlog until they are exercised and funded. Backlog does not include the value of a contract where the customer has given permission to begin or continue working, but where a formal contract or contract extension has not yet been signed.

          Our funded backlog does not include the full value of our contracts, because Congress often appropriates funds for a particular program or contract on a yearly or quarterly basis, or less, even though the contract may call for performance that is expected to take a number of years.

          From time to time, we will exclude from backlog portions of contract values of very long or complex contracts where we judge revenue could be jeopardized by a change in U.S. government policy. Because of possible future changes in delivery schedules andand/or cancellations of orders, backlog at any particular date is not necessarily representative of actual revenuesales to be expected for any succeedingfuture period, and actual revenuesales for the year may not meet or exceed the backlog represented. We may experience significant contract cancellations or reductions that were previously booked and included in backlog.

Our backlog at the dates shown was as follows (in thousands):

          Cost of revenues consist of direct costs incurred on contracts such as labor, materials, travel, subcontracts and other direct costs and indirect costs associated with overhead expenses such as facilities, fringe benefits and other costs that are not directly related to the execution of a specific contract. We plan our spending of indirect costs on an annual basis and on cost reimbursable contracts, we receive government approval to bill those costs as a percentage of our direct labor, other direct costs and direct materials as we execute our contracts. The U.S. government approves the planned indirect rates as provisional billing rates near the beginning of each fiscal year.

          Our general and administrative expenses include administrative salaries, costs related to proposal activities and other administrative costs.

          We conduct internally funded research and development into complex signal processing, system and software architectures, and other technologies that are important to continued advancement of our systems and are of interest to our current and prospective customers. The variance from year to year in internal research and development is caused by the status of our product cycles and the level of complementary U.S. government funded research and development. For the three months ended January 3, 2010, internally funded research and development expenditures were $2.4 million, representing approximately 3% of revenues in the period. For the three months ended December 28, 2008, internally funded research and development expenditures were $1.8 million, representing 2.1%2% of revenues in the period. For the three months ended December 30, 2007 internally funded research and development expenditures were $1.7 million, respectively, representing 2.3% of revenues, respectively.