UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-Q

QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE

SECURITIES EXCHANGE ACT OF 1934

FOR THE QUARTERLY PERIOD ENDED MARCH 31,SEPTEMBER 30, 2004

COMMISSION FILE NUMBER 0-23599

MERCURY COMPUTER SYSTEMS, INC.

(Exact name of registrant as specified in its charter)

978-256-1300

(Registrant’s telephone number, including area code)

Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    Yes  x    No  ¨

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act).    Yes  x    No  ¨

Number of shares outstanding of the issuer’s classes of common stock as of April 21,October 29, 2004:

MERCURY COMPUTER SYSTEMS, INC.

INDEX

PART I. FINANCIAL INFORMATION

ITEM 1.    FINANCIAL STATEMENTS

MERCURY COMPUTER SYSTEMS, INC.

CONSOLIDATED BALANCE SHEETS

(IN THOUSANDS, EXCEPT SHARE AMOUNTS)

The accompanying notes are an integral part of the consolidated financial statements.

MERCURY COMPUTER SYSTEMS, INC.

CONSOLIDATED STATEMENTS OF INCOME

(UNAUDITED AND IN THOUSANDS, EXCEPT PER SHARE DATA)

The accompanying notes are an integral part of the consolidated financial statements.

MERCURY COMPUTER SYSTEMS, INC.

CONSOLIDATED STATEMENTS OF CASH FLOWS

(UNAUDITED AND IN THOUSANDS)

The accompanying notes are an integral part of the consolidated financial statements.

MERCURY COMPUTER SYSTEMS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(AMOUNTS IN THOUSANDS, EXCEPT SHARE AND PER SHARE DATA)

A.    NatureDescription of the Business

Mercury Computer Systems, Inc. (the “Company” or “Mercury”) designs, manufactures and markets high-performance, real-time digital signal and image processing computer systems that transform sensor-generated data into information that can be displayed as images for human interpretation or subjected to additional computer analysis. These multicomputer systems are heterogeneous and scalable, allowing them to accommodate several different microprocessor types and to scale from a few to hundreds of microprocessors within a single system. The primary markets for the Company’s products are Defense Electronics, Medical Imaging and Visualization Solutions (IVS), and other Original Equipment Manufacturers (“OEM”)(OEM) solutions. These markets have computing needs that benefit from the unique system architecture developed by the Company.

B.    Basis of Presentation

The accompanying financial data as of March 31,September 30, 2004 and for the three months and nine months ended March 31,September 30, 2004 and March 31, 2003 have been prepared by the Company, without audit, pursuant to the rules and regulations of the Securities and Exchange Commission (“SEC”). Certain information and footnote disclosures normally included in financial statements prepared in accordance with generally accepted accounting principles have been condensed or omitted pursuant to such rules and regulations. However, the Company believes that the disclosures are adequate to make the information presented not misleading. These consolidated financial statements should be read in conjunction with the consolidated financial statements and the notes thereto included in the Company’s Annual Report on Form 10-K for the fiscal year ended June 30, 2003.2004.

In the opinion of management, all adjustments (which include only normal recurring adjustments) necessary to present a fair statement of financial position as of March 31,September 30, 2004, results of operations for the three and nine-month periodsmonths ended March 31,September 30, 2004 and 2003, and cash flows for the nine-month periodsthree months ended March 31,September 30, 2004 and 2003 have been made. The results of operations for the three and nine months ended March 31,September 30, 2004 are not necessarily indicative of the operating results for the full fiscal year or any future periods.

C.    Accounting for Stock-Based Compensation

The Company has several stock-based employee compensation plans. The Company accounts for stock-based awards to employees using the intrinsic value method as prescribed by Accounting Principles Board (“APB”) Opinion No. 25, “Accounting for Stock Issued to Employees,” and related interpretations. Accordingly, no compensation expense is recorded for options issued to employees in fixed amounts with fixed exercise prices at least equal to the fair market value of the Company’s common stock at the date of grant. The Company has adopted the provisions of SFAS No. 123, “Accounting for Stock-Based Compensation,” as amended by SFAS No. 148, “Accounting for Stock-Based Compensation-Transition and Disclosure,” through disclosure only. All stock-based awards to non-employees are accounted for at their fair value in accordance with SFAS No. 123.

MERCURY COMPUTER SYSTEMS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

The following table illustrates the effect on net income and earnings per share as if the Company had applied the fair value recognition provisions of SFAS No. 123 to stock-based employee awards.

The weighted average grant-date fair values for options granted during the three months ended March 31,September 30, 2004 and 2003 were $18.56$15.93 and $21.00, respectively, per option. The weighted average grant-date fair values for options granted during the nine months ended March 31, 2004 and 2003 were $15.62 and $13.84,$13.17, respectively, per option. The fair value of options at date of grant was estimated using the Black-Scholes option-pricing model with the following assumptions:

The weighted-average fair value of stock purchase rights granted as part of the Company’s Employee Stock Purchase Plan (“ESPP”) during the three months ended March 31,September 30, 2004 and 2003 was $5.96$5.42 and $9.50, respectively. The weighted-average fair value of stock purchase rights granted as part of the ESPP during the nine months ended March 31, 2004 and 2003 was $5.50 and $8.66,$4.85, respectively. The fair value of the employees’ stock purchase rights was estimated using the Black-Scholes option-pricing model with the following assumptions:

D.    Inventory

MERCURY COMPUTER SYSTEMS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

D.    Inventory

E.    Net Income Per Share

The following table sets forth the computation of basic and diluted net income per share:share (in thousands, except per share data):

Options to purchase 1,4311,931,375 and 1,2162,416,133 shares of common stock were not included in the calculation of diluted net income per share for the three months ended March 31,September 30, 2004 and 2003, respectively, because the option exercise prices were greater than the average market price of the Company’s common stock during those periods. Options to purchase 2,010periods and 1,989 shares of common stock were not included in the calculation of diluted net income per share for the nine months ended March 31, 2004 and 2003, respectively, because the option exercise prices were greater than the average market price of the Company’s common stock during those periods.therefore would be antidilutive.

F.    Recent Accounting Pronouncements

In April 2003,September 2004, the Financial Accounting Standards BoardFASB announced that it had reached a final consensus with respect to Emerging Issue Task Force 04-8 (“FASB”) issued Statement of Financial Accounting Standards 149 (“SFAS 149”EITF 04-08”), “Amendment“The Effect of Statement 133Contingently Convertible Debt on Derivative Instruments and Hedging Activities.Diluted Earnings per Share.” SFAS 149 amends and clarifies accounting and reportingThe FASB’s final consensus states that shares of derivative instruments, including certain derivative instruments embeddedcommon stock contingently issuable pursuant to contingent convertible securities should be included in diluted earnings per share computations (if dilutive) regardless of whether their market price triggers (or other contracts, and hedging activities under SFAS 133, “Accounting for Derivative Instruments and Hedging Activities.” This statement iscontingent features) have been met. EITF 04-8 will be effective for contracts entered into or modifiedall periods ending after June 30, 2003December 15, 2004 and will require the Company to include an additional 4,134,962 shares, using the if-converted method (under which net income would also be adjusted to exclude imputed interest expense, net of tax), in the Company’s computation of diluted earnings per share for hedging relationships designated after June 30, 2003.the three-month and six-month periods ending December 31, 2004. The Company’s adoption of SFAS 149 did not have any impact on its financial position or results of operations.

In May 2003,consensus will require the FASB issued Statement of Financial Accounting Standards 150 (“SFAS 150”), “Accounting for Certain Financial Instruments with Characteristics of Both Liabilities and Equity.” SFAS 150 establishes standards for how an issuer classifies and measures certain financial instruments with characteristics of both liabilities and equity. It requires that an issuer classify a financial instrument that is within its scope as a liability. For all financial instruments entered into or modified after May 31, 2003, SFAS 150 is effective

MERCURY COMPUTER SYSTEMS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

immediately. For all other instruments, SFAS 150 goes intoCompany to show the effect at the beginning of the first interimif-converted shares on the prior period beginning after June 15, 2003. The Company’s adoption of SFAS 150 did not have any impact on its financial position or results of operations.

In November 2002, the FASB issued Emerging Issues Task Force 00-21 (“EITF 00-21”), “Revenue Arrangements with Multiple Deliverables.” EITF 00-21 requires revenue arrangements with multiple deliverables to be divided into separate units of accounting. If the deliverables in the arrangement meet certain criteria, arrangement consideration should be allocated among the separate units of accounting based on their relative fair values. Applicable revenue recognition criteria are to be considered separatelyearnings per share for separate units of accounting. The guidance in EITF 00-21 was effective for revenue arrangements entered into in fiscal periods beginning after June 15, 2003. The Company’s adoption of EITF 00-21 did not have a material impact on its financial position or results of operations.

In January 2003, the FASB issued Interpretation (“FIN”) No. 46, “Consolidation of Variable Interest Entities” (“FIN 46”) and, in December 2003, issued a revision to that interpretation (“FIN 46R”). FIN 46R replaces FIN 46 and addresses consolidation by business enterprises of variable interest entities that possess certain characteristics. A variable interest entity (“VIE”) is defined as (a) an ownership, contractual or monetary interest in an entity where the ability to influence financial decisions is not proportional to the investment interest, or (b) an entity lacking the invested capital sufficient to fund future activities without the support of a third party. FIN 46R establishes standards for determining under what circumstances VIEs should be consolidated with their primary beneficiary, including those to which the usual condition for consolidation does not apply. The Company adopted the provisions of FIN 46R during the quarter ended December 31, 2003. The Company’s adoption of FIN 46R did not have a material effect on its financial position or results of operations.

On December 17, 2003, the Staff of the Securities and Exchange Commission (“SEC”) issued Staff Accounting Bulletin No. 104 (SAB 104), “Revenue Recognition”, which supersedes SAB 101, “Revenue Recognition in Financial Statements.” SAB 104’s primary purpose is to rescind the accounting guidance contained in SAB 101 related to multiple-element revenue arrangements that was superseded as a result of the issuance of EITF 00-21, “Accounting for Revenue Arrangements with Multiple Deliverables.” Additionally, SAB 104 rescinds the SEC’s related “Revenue Recognition in Financial Statements Frequently Asked Questions and Answers” issued with SAB 101 that had been codified in SEC Topic 13, “Revenue Recognition.” While the wording of SAB 104 has changed SAB 101 to reflect the issuance of EITF 00-21, the revenue recognition principles of SAB 101 remain largely unchanged by the issuance of SAB 104, which was effective upon issuance. The Company’s adoption of SAB 104 did not have a material effect on its financial position or results of operations.comparative purposes.

G.    Comprehensive Income

The Company’s total comprehensive income was as follows:

MERCURY COMPUTER SYSTEMS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

H.    Operating Segment Information

Operating segments are defined as components of an enterprise evaluated regularly by the Company’s senior management in deciding how to allocate resources and assess performance. The Company has three operating and reportable segments: Defense Electronics MedicalGroup, Imaging and Visualization Solutions Group and OEM Solutions.Solutions Group. These operating segments were determined based upon the nature of the products offered to customers, the market characteristics of each operating segment and the Company’s management structure.

The accounting policies of the business segments are the same as those described in “Note B: Summary of Significant Accounting Policies” in the Company’s Annual Report on Form 10-K for the fiscal year ended June 30, 2003.2004. Asset information by reportable segment is not reported because the Company does not produce such information internally.

In the first quarter of fiscal 2005, the Company began reporting its operating segment results on a fully allocated basis. Segment information for the prior period has been reclassified to conform to the current presentation. The following is a summary of the Company’s operations by reportable segment:

I.    Goodwill and Acquired Intangible Assets

As of September 30, 2004 and June 30, 2003 and March 31, 2004, goodwill of $4,225$28,963 and $29,009 was recorded, resulting from an acquisition is allocated to the Defense Electronics reportable segment.acquisitions of Myriad Logic, Inc., the TGS Group (TGS), and Advanced Radio Corporation (ARC).

At March 31, 2004, acquiredAcquired intangible assets consisted of the following:

At June 30, 2003, acquired intangible assets consisted of the following:

MERCURY COMPUTER SYSTEMS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

In September 2003, a $185 asset impairment charge was recorded in selling, general and administrative expenses related to the Company’s abandonment of the acquired licensing agreement. The impaired asset is in the Defense Electronics segment of the Company.

Amortization expense related to acquired intangible assets for the three months ended March 31,September 30, 2004 and 2003 was $194$416 and $213,$212, respectively. AmortizationEstimated future amortization expense related tofor acquired intangible assets remaining at September 30, 2004 is $1,233 for the nine months ended March 31, 2004remainder of fiscal 2005, $1,438 for fiscal 2006, $857 for fiscal 2007 and 2003 was $5822008 and $637, respectively. Estimated remaining amortization expense$728 for each fiscal year is as follows:2009.

J.    Commitments and Contingencies

LEGAL PROCEEDINGS

The Company is subject to legal proceedings and claims that arise in the ordinary course of business. The Company does not believe these actions will have a material adverse effect on its financial position, or results of operations.operations or cash flows.

K.    Stock Repurchase

On May 15, 2003,In July 2004, the Company announced that theCompany’s Board of Directors hadextended the share repurchase program through December 2005 and authorized an increase in the total authorized dollar amount for repurchase then available to approximately $25,000. In the first quarter of fiscal 2005, the Company to purchase up to $25,000purchased 300,000 shares of the Company’s common stock for a total cost of which $14,861 was$7,844. Approximately $17,156 remained available under the plan for future purchasesrepurchases as of March 31, 2004. In October 2003, the Board of Directors extended the program’s expiration date through December 31, 2004. The Company has made no stock purchases during fiscalSeptember 30, 2004.

Effective July 1, 2004, the Massachusetts Business Corporation Act eliminated the use of treasury shares by Massachusetts corporations. As a result, all of the Company’s treasury shares were automatically converted to authorized but unissued shares on July 1, 2004. All future shares repurchased by the Company under the share repurchase program will constitute authorized but unissued shares.

L.    Product Warranty Liability

The Company’s product sales generally include a one-year hardware warranty. At the time of product shipment, the Company accrues for the estimated cost to repair or replace potentially defective products. Estimated warranty costs are based upon prior actual warranty costs for substantially similar transactions. The following table presents the changes in the Company’s product warranty liability for the ninethree months ended March 31,September 30, 2004 and 2003:

MERCURY COMPUTER SYSTEMS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

M.    Workforce Reduction

In the fourth quarter of fiscal 2003, the Company recorded workforce reduction charges approximating $1,388. The accrual for severance and benefits related to workforce reductions is reflected in accrued compensation in the consolidated balance sheet. All payments to these employees have been made as of March 31, 2004. A summary of the workforce reduction accrual is outlined as follows:

N.    Subsequent Events

On April 12, 2004, the Company announced it had signed an agreement to purchase the TGS Group (“TGS”) for approximately $18.5 million, consisting of $6.0 million in Mercury common stock (approximately 258 shares) and the remainder in cash, subject to closing adjustments. The TGS Group is a leading supplier of three-dimensional (3-D) image processing and visualization software to diverse end markets including life sciences (medical imaging and biotechnology), geoscience (earth sciences including oil and gas exploration), and simulation (commercial and defense). The company is headquartered in Bordeaux, France and has operations in Berlin, Germany and San Diego, California. The acquisition, which is expected to close in the fourth quarter of fiscal 2004, is subject to certain closing conditions.

On April 21, 2004, the Company announced the pricing of a private offering of $100.0 million of convertible senior notes due 2024 (the “Notes”) to be sold to qualified institutional buyers pursuant to Rule 144A under the Securities Act of 1933, as amended. The Notes will bear interest at a rate of 2.00%. Under certain circumstances, the Notes will be convertible into the Company’s common stock at a conversion rate of 33.0797 shares per $1,000 principal amount of the Notes, subject to adjustment in certain circumstances. The conversion rate is equal to an initial conversion price of approximately $30.23 per share. Until the closing price of the stock is above the contingent conversion price of $36.28 for at least twenty trading days in a thirty consecutive day period, or upon certain other events, the shares will not be included in calculation of weighted average shares outstanding used in calculating the Company’s earnings per share. On April 23, 2004, the Company announced that the initial purchasers had exercised their over-allotment option to purchase an additional $25.0 million aggregate principal amount of the Notes. The Company has the right to redeem the Notes on or after May 1, 2009 at par plus accrued interest. Noteholders may require the Company to repurchase the Notes at par plus accrued and unpaid interest on May 1, 2009, 2014 and 2019 and upon certain other events. The sale of the Notes is expected to close on April 29, 2004, subject to the satisfaction of customary closing conditions.

ITEM 2.    MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

From time to time, information provided, statements made by our employees or information included in our filings with the Securities and Exchange Commission may contain statements whichthat are not historical facts but whichthat are “forward-looking statements” which involve risks and uncertainties. The words “may,” “will,” “expect,” “anticipate,” “continue,” “estimate,” “plan,” “project,” “intend” and similar expressions are intended to identify forward-looking statements regarding events, conditions and financial trends that may affect our future plans of operations, business strategy, results of operations and financial position. These statements are based on our current expectations and estimates as to prospective events and circumstances about which there can be no firm assurances given. Further, any forward-looking statement speaks only as of the date on which such statement is made, and we undertake no obligation to update any forward-looking statement to reflect events or circumstances after the date on which such statement is made. As it is not possible to predict every new factor that may emerge, forward-looking statements should not be relied upon as a prediction of actual future financial condition or results. Actual results, performances or achievements may differ materially from the anticipated future results, performances or achievements expressed or implied by these forward-looking statements. Important factors that may cause our actual results to differ from these forward-looking statements include, but are not limited to, those referenced in the section entitled “Factors that May Affect Future Results” in Part I—Item 2 of this Form 10-Q.

OVERVIEW

Mercury designs, manufacturesWe design, manufacture and marketsmarket high-performance, real-time digital signal and image processing computer systems that transform sensor-generated data into information which can be displayed as images for human interpretation or be subjected to additional computer analysis. These multicomputer systems are heterogeneous and scalable, allowing them to accommodate several microprocessor types and to scale from a few to hundreds of microprocessors within a single system.

During the past several years, the majority of our revenue has been generated from sales of our products to the defense electronicsDefense Electronics Group (DEG) market, generally for use in intelligence-gathering electronic warfare systems. Our activities in this area have focused on the proof of concept, development and deployment of advanced military applications in radar, sonar and airborne surveillance. Medical imagingImaging and Visualization Solutions (IVS) is another primary market that we currently serve. Our computer systems are embedded in magnetic resonance imaging (“MRI”)(MRI), computed tomography (“CT”)(CT), positron emission tomography (“PET”)(PET), and digital X-ray machines. Our remaining revenues are derived from computer systems used in such commercial OEMOriginal Equipment Manufacturers (OEM) solutions as semiconductor photomask generation, wafer inspection, baggage scanning, seismic analysis and development of new reticle inspection and wafer inspection systems.

During the first ninethree months of fiscal year 2004,2005, revenues decreasedincreased by $9.3$14.5 million compared to the same period in fiscal 2003,2004, primarily as a result of a $9.0 million increase in our OEM Solutions revenues and growth in both the anticipated lossDEG and IVS business units, as well as $1.7 million of CT revenues withinassociated with the medical imaging groupacquisition of $5.6the TGS Group (TGS). Operating expenses increased $6.0 million from the same period last year primarily due to $4.7 million of additional operating expenses associated with the acquisition of the TGS and the timing of defense electronics orders. We expect total revenues to increaseAdvanced Radio Corporation (ARC), which were completed in the fourth quarter of fiscal 2004 compared to each of the previous three quarters of fiscal 2004. Operating expenses as a percentage of revenues decreased by $3.8 millionto 50% for the ninethree months ended March 31,September 30, 2004 as compared to 53% for the same period in fiscal 2003,2004, primarily as a result of operating effectiveness initiatives which began in the fourth quarter of fiscal 2003.revenues increasing 36% from period to period. We continue to monitor key operating metrics in order to maintain an appropriate operating expense cost structure relative to our revenue growth expectations. The overall decrease in earnings per share for the nine months ended March 31, 2004 as compared to the same period last year was primarily due to the absence of significant non-operating income resulting from the sale of the Shared Storage Business Unit (“SSBU”).

On April 12, 2004, we announced we had signed an agreement to purchase the TGS Group (“TGS”) for approximately $18.5 million, consisting of $6.0 million in our common stock (approximately 258,000 shares) and the remainder in cash, subject to closing adjustments. The TGS Group is a leading supplier of three-dimensional (3-D) image processing and visualization software to diverse end markets including life sciences

(medical imaging and biotechnology), geoscience (earth sciences including oil and gas exploration), and simulation (commercial and defense). The company is headquartered in Bordeaux, France and has operations in Berlin, Germany and San Diego, California. The acquisition, which is expected to close in the fourth quarter of fiscal 2004, is subject to certain closing conditions.

Because 3-D imaging is becoming the accepted standard for many medical procedures, following the closing of the acquisition, we intend to combine our capabilities in medical imaging and visualization under a common business group called “Imaging and Visualization Solutions.” This group will replace our current Medical Imaging Business Group.

On April 21, 2004, we announced the pricing of a private offering of $100.0 million of convertible senior notes due 2024 (the “Notes”) to be sold to qualified institutional buyers pursuant to Rule 144A under the Securities Act of 1933, as amended. The Notes will bear interest at a rate of 2.00%. Under certain circumstances, the Notes will be convertible into our common stock at a conversion rate of 33.0797 shares per $1,000 principal amount of the Notes, subject to adjustment in certain circumstances. The conversion rate is equal to an initial conversion price of approximately $30.23 per share. Until the closing price of the stock is above the contingent conversion price of $36.28 for at least twenty trading days in a thirty consecutive day period, or upon certain other events, the shares will not be included in calculation of weighted average shares outstanding used in calculating our earnings per share. On April 23, 2004, we announced that the initial purchasers had exercised their over-allotment option to purchase an additional $25.0 million aggregate principal amount of the Notes. We have the right to redeem the Notes on or after May 1, 2009 at par plus accrued and unpaid interest. Noteholders may require us to repurchase the Notes at par plus accrued and unpaid interest on May 1, 2009, 2014 and 2019 and upon certain other events. The sale of the Notes is expected to close on April 29, 2004, subject to the satisfaction of customary closing conditions.

Going forward, business and market uncertainties may affect future results. For a discussion of key factors that could impact the future and must be managed by us, please refer to the discussion below.

CRITICAL ACCOUNTING POLICIES AND SIGNIFICANT JUDGMENTS AND ESTIMATES

We have identified the policies discussed below as critical to understanding our business and our results of operations. The impact and any associated risks related to these policies on our business operations are discussed throughout Management’s Discussion and Analysis of Financial Condition and Results of Operations where such policies affect our reported and expected financial results.

The preparation of consolidated financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent liabilities. On an on-going basis, we evaluate our estimates and judgments, including those related to revenue recognition, allowances for bad debts, warranties, contingencies, litigation, and the valuation of inventory, long-lived assets, goodwill, and income tax assets. We base our estimates on historical experience and on appropriate and customary assumptions that are believedwe believe to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions.

Changes in our estimates from period to period, such as changes in assumptions underlying our estimates, may have a material impact on our financial condition or results of operations. Similarly, using the ends of the range of reasonably possible amounts that we determined in formulating our estimate, rather than the reported estimate, may have a material impact on our financial condition or results of operations. However, during the past three fiscal years, such changes in our estimates, including those related to accounts receivable and inventory valuation and to warranty cost accruals, have not had a material impact on our overall financial performance or on any individual line item in our financial statements.

Revenue Recognition and Accounts Receivable

Revenue from system sales is recognized upon shipment provided that title and risk of loss have passed to the customer, there is persuasive evidence of an arrangement, the sales price is fixed or determinable, collection of the related receivable is reasonably assured, and customer acceptance criteria, if any, have been successfully demonstrated.

Certain contracts with customers require us to perform tests of our products prior to shipment to ensure their performance complies with our published product specifications and, on occasion, with additional customer-requested specifications. In these cases, we conduct such tests and, if they are completed successfully, include a written confirmation with each order shipped. As a result, at the time of each product shipment, we believe that no further customer testing requirements exist and that there is no uncertainty of non-acceptance by our customer. In the rare instance that customer payment is conditioned upon final acceptance testing by the customer at its own facility, we do not recognize any revenue until the final acceptance testing has been completed and written confirmation from the customer has been received.

We do not provide our customers with rights of product return, other than those related to warranty provisions that permit repair or replacement of defective goods. We accrue for anticipated warranty costs upon product shipment.

Installation of our products require insignificant effort that does not alter the capabilities of the products and may be performed by our customers or other vendors. If an order includes installation or training services that are undelivered at the time of product shipment, we defer revenue equal to the fair value of the installation or training obligations until such time as the services have been provided. We determine these fair values based on the price typically charged to our customers who purchase these services separately.

In limited circumstances, we engage in long-term contracts to design, develop, manufacture or modify complex equipment. For these contracts, we recognize revenue using the percentage-of-completion method of contract accounting, measuring progress towardstoward completion based on contract cost incurred to date as compared with total estimated contract costs. The use of the percentage-of-completion method of accounting requires

significant judgment relative to estimating total contract costs, including assumptions relative to the length of time to complete the contract, the nature and complexity of the work to be performed, anticipated increases in wages and prices for subcontractor services and materials, and the availability of subcontractor services and materials. Our estimates are based upon the professional knowledge and experience of our engineers, program managers and other personnel who review each long-term contract monthly to assess the contract’s schedule, performance, technical matters and estimated cost at completion. When adjustments in estimated contract costs are determined, such revisions may have the effect of adjusting in the current period the earnings applicable to performance in prior periods. Anticipated losses, if any, are recognized in the period in which determined.

For transactions involving the licensing of stand-alone software products and of software that is not incidental to the product, we recognize revenue when there is persuasive evidence of an arrangement, delivery of the software has occurred, the price is fixed or determinable and collection of the related receivable is reasonably assured. Our stand-alone software products are not deemed essential to the functionality of any hardware system and do not require installation by us or significant modification or customization of the software. The fair value of maintenance agreements related to stand-alone software products is recognized as revenue ratably over the term of each maintenance agreement.

At the time of product shipment, we assess collectibility of trade receivables based on a number of factors, including past transaction and collection history with a customer and the credit-worthiness of the customer. If we determine that collectibility of a particular sale is not reasonably assured, revenue is deferred until such time as collection becomes reasonably assured, which generally occurs upon receipt of payment from the customer. After the time of sale, we assess our exposure to changes in our customers’ abilities to pay outstanding receivables and record allowances for such potential bad debts.

Inventory

Inventory, which includes materials, labor and manufacturing overhead, is stated at the lower of cost (first-in, first-out basis) or net realizable value. On a quarterly basis, we use consistent methodologies to evaluate inventory for net-realizable value. We record a provision for excess and obsolete inventory, consisting of on-hand and non-cancelable on-order inventory in excess of estimated usage. The excess and obsolete inventory evaluation is based upon assumptions about future demand, product mix and possible alternative uses. If actual demand, product mix or possible alternative uses are less favorable than those projected by management, additional inventory write-downs may be required.

Impairment of Long-Lived Assets and Goodwill

We assess the impairment of acquired intangible assets and property and equipment whenever events or changes in circumstances indicate that the carrying value may not be recoverable. Factors we consider important that could indicate impairment include significant underperformance relative to prior operating results projections, significant changes in the manner of our use of the asset or the strategy for our overall business and significant negative industry or economic trends. When we determine that the carrying value of acquired intangible assets or property and equipment may not be recoverable based upon the existence of one or more of the above indicators of impairment, we measure any impairment based on a projected discounted cash flow method using a discount rate determined by our management to be commensurate with the risk inherent in our current business model.

Goodwill is assessed for impairment on a reporting unit basis at least annually or more frequently when events or circumstances occur indicating that the recorded goodwill may be impaired. If the book value of a reporting unit exceeds its fair value, the implied fair value of goodwill is compared to the carrying amount of goodwill. If the carrying amount of goodwill exceeds the implied fair value, an impairment loss is recorded in an amount equal to that excess.

Income Tax Assets

We evaluate the realizability of our deferred tax assets on a quarterly basis and assess the need for a valuation allowance. Realization of our net deferred tax assets is dependent on our ability to generate sufficient future taxable income. WeExcept for deferred tax assets acquired in the TGS acquisition, we believe that it is more likely than not that our net deferred tax assets will be realized based on forecasted income; however, there can be no assurance that we will be able to meet our expectations of future income.

Warranty Accrual

Our product sales include a one-year hardware warranty. At the time of product shipment, we accrue for the estimated cost to repair or replace potentially defective products. Estimated warranty costs are based upon prior actual warranty costs for substantially similar transactions.products.

RESULTSOF OPERATIONS:

The following tables set forth, for the periods indicated, certain financial data as a percentage of total revenues:

REVENUES

Total revenues decreased 7%increased by $14.5 million or $3.3 million36% to $45.4$55.0 million for the three months ended March 31,September 30, 2004 compared to $48.7$40.5 million during the same period in fiscal 2003.2004. Revenues decreased 7% or $9.3 million to $126.5 million for the nine months ended March 31, 2004 compared to $135.8 million during the same period in fiscal 2003. Revenue by segment as a percentage of total revenues isare as follows:

		Three Months Ended September 30,
		2004			2003
Defense Electronics Group		56	%		71	%
Imaging and Visualization Solutions Group		19			18
OEM Solutions Group		25			11
Total revenues		100	%		100	%

Defense electronics

DEG revenues decreased 22%increased by $2.2 million or $7.7 million8% to $26.7$31.0 million for the three months ended March 31,September 30, 2004 compared to $34.4$28.8 million during the same period in fiscal 2003. Defense electronics2004. The increase for the three months ended September 30, 2004 was primarily related to a $2.4 million increase in shipments of signal intelligence applications, and a $1.5 million increase in shipments of defense technologies applications, offset by a $1.6 million decrease in shipments for radar applications.

IVS revenues decreased 9%increased $3.3 million or $8.4 million46% to $83.2$10.4 million for the ninethree months ended March 31,September 30, 2004 compared to $91.6$7.2 million during the same period in fiscal 2003. The decrease for the three months ended March 31, 2004 as compared to the same period in fiscal 2003 was primarily related to a decrease within all defense applications, including a decrease of approximately $5.7 million in shipments of emerging markets applications, and was primarily a result of customer order patterns and program delivery dates. The decrease for the nine months ended March 31, 2004 compared to the same period in the prior year was related to decreased emerging market

applications and radar shipments of $10.7 and $6.2 million, respectively, partially offset by an increase in shipments of signals intelligence applications. We continue to experience limited visibility into the defense programs that utilize our products, and as a result, defense electronics revenues may fluctuate in future periods due to the timing of large orders.

Medical imaging revenues increased 15% or $1.2 million to $9.4 million for the three months ended March 31, 2004 compared to $8.2 million during the same period in fiscal 2003. Medical imaging revenues decreased 15% or $4.4 million to $24.0 million for the nine months ended March 31, 2004 compared to $28.4 million during the same period in fiscal 2003.2004. The increase for the three months ended March 31,September 30, 2004 as compared to the same period in fiscal 2003 was primarily the result of increased shipments of products for both digital X-ray applications and shipments of products for magnetic resonance imaging (“MRI”)(MRI) applications of $2.9 million, partially offset by a decrease in revenues of boards used in CT imaging systems of $1.8 million. The decrease in medical imaging revenues for the nine months ended March 31, 2004 compared to the same period in fiscal 2003 was primarily related to a decrease in revenues of boards used in CT imaging systems of $5.6$1.6 million, and a decrease$1.7 million of revenues associated with the acquisition of TGS, which was completed in revenuesthe fourth quarter of our MRI modality of $2.6 million, partially offset by an increase in shipments for digital X-ray applications and our PET applications.2004.

OEM solutionsSolutions Group revenues increased 53%$9.0 million or $3.2 million195% to $9.3$13.5 million for the three months ended March 31,September 30, 2004 compared to $6.1$4.6 million during the same period in fiscal 2003. OEM solutions2004. The increase in revenues increased 23% or $3.6was primarily related to a $7.6 million to $19.3 million for the nine months ended March 31, 2004 compared to $15.7 million during the same period in fiscal 2003. OEM solutions revenues increased for the three and nine months ended March 31, 2004 as compared to the same periods in fiscal 2003 primarily as a resultincrease of increased shipments of semiconductor imaging boards for developing and testing new semiconductor systems of $4.2semiconductors and a $1.4 million and $6.0 million, respectively, partially offset by a decreaseincrease in shipments of systems for inclusion in baggage scanning applications. Revenues related toShipments of semiconductor applications were 88%imaging boards represented 83% and 84%79% of OEM solutionsSolutions Group revenues for the three and nine months ended March 31,September 30, 2004 and 2003, respectively.

GROSS PPROFITROFIT

Gross profit was 66.0%64.6% for the three months ended March 31,September 30, 2004, an increase of 50 basis points from the 65.5%64.1% gross profit achieved in the same period of fiscal 2003. Gross profit was 65.5% for the first nine months of fiscal 2004, an increase of 20 basis points from the 65.3% gross profit achieved in the same period of fiscal year 2003.2004. The increase in gross profit formargin is primarily the three months ended March 31, 2004 as compared to the same period of the prior fiscal year was primarily a result of increased revenues which absorbed certain fixed manufacturing costs, partially offset by the decrease inof DEG revenues as a percentage of total revenues. DEG revenues generally carry a higher margin contribution from long-term defense electronics contracts which carry higher costs than do standard products due to the addition of third party products and direct labor. The increase in gross profit for the nine months ended March 31, 2004 as compared to the same period of the prior fiscal year was primarily a result of a favorable program mix within defense electronics revenues, which was offset by an increase in inventory provisions.our other operating segments.

SELLING, GENERALAND ADMINISTRATIVE

Selling, general and administrative expenses decreased 7%increased 25% or $0.9$3.2 million to $12.5$16.0 million for the three months ended March 31,September 30, 2004 compared to $13.4$12.8 million during the same period in fiscal 2003. Selling, general and administrative expenses decreased 5% or $1.9 million to $38.0 million for the nine months ended March 31, 2004 compared to $39.9 million during the same period in fiscal 2003.2004. The decreaseincrease in selling, general and administrative expenses for the three months ended March 31, 2004 compared to the same period in the prior fiscal year was primarily the result of a decrease in compensation expenses of $0.7 million as a result of a decrease in headcount and decreased consulting expenses of $0.5 million, offset by slight increases in accounting and legal expenses. The decreases in selling, general and administrative expenses for the nine months ended March 31, 2004 was primarily the result of an arbitration award againstadditional $2.9 million of expenses relating to the Company in a former employee matterfull quarter effect of approximately $0.8 millionthe acquisitions completed in the secondfourth quarter of fiscal 2003, as well as a decrease in compensation expense of $0.8 million as a result of a decrease in headcount and consulting expenses of $1.2 million, which were offset in part by an increase in expenses relating to compliance with the Sarbanes-Oxley Act.

RESEARCHAND DEVELOPMENT

Research and development expenses decreased 7%increased 32% or $0.7$2.8 million to $9.2$11.5 million for the three months ended March 31,September 30, 2004 compared to $9.9$8.7 million during the same period in fiscal 2003. Research and development expenses decreased 7% or $2.0 million to $26.8 million for the nine months ended March 31, 2004 compared to $28.8 million during the same period in fiscal 2003.2004. The decreaseincrease in research and development expenses for the three months ended March 31,September 30, 2004 was primarily the result of an additional $1.6 million of expenses relating to the increased utilizationfull quarter effect of research and development personnel temporarily engagedthe acquisitions completed in costthe fourth quarter of sales activities, partially offset byfiscal 2004, as well as an increase in prototype development expenses of approximately $1.0$1.4 million. The decrease in research and development expenses for the nine months ended March 31, 2004 was primarily related to the increased utilization of research and development personnel temporarily engaged in cost of sales activities, partially offset by an increase in personnel related expenses and prototype development expenses.

INTEREST INCOME (EXPENSE), NET

Interest income, net of interest expense for the three months ended March 31,September 30, 2004 remained unchanged at $0.2decreased by $0.3 million compared to the same period in fiscal 2003. Interest income,$0.1 million of net of interest expense for the nine months ended March 31, 2004 remained unchanged at $0.7 million compared to the same period in fiscal 2003.

GAINONTHE SALEOF DIVISION

For the three and nine months ended March 31, 2003, we received $2.6 million and $5.8 million, respectively, in paymentsexpense. The decrease was primarily related to the saleincreased interest associated with our issuance of the SSBU. We received the final payment due from the sale$125.0 million of convertible debt in March 2003.April 2004.

INCOME TAX PROVISION

We recorded tax provisions during the three and nine months ended March 31,September 30, 2004 reflecting a 26.6% and 29%34% effective tax rate, respectively.rate. The decreaseincrease in the effective tax rate from 31% for the six months ended December 31, 2003 to 29% for the nine monthsfiscal year ended March 31,June 30, 2004 was due to an increase in estimatedthe

expiration of the tax benefits related to foreign salescredit for research and a decrease in estimated non deductible expenses.development. The effective tax rate for all periods is less than the U.S. statutory tax rate of 35% primarily due to state research and development credits, tax-exempt interest, and the extraterritorial income (“ETI”) benefit. We expect our fiscal year 20042005 effective tax rate to be approximately 29%.30%, as a result of the tax credit legislation passed in October 2004.

SEGMENT OPERATING RESULTS

Income from operations of each reportingthe DEG segment excludes substantially all research and development expenses and other unallocated operating expenses that cannot be specifically identified with a reporting segment.

Income from operations of the defense electronics segment decreased $3.7increased $0.6 million to $13.7$5.6 million for the three months ended March 31,September 30, 2004 from $17.4$5.0 million for the same period of fiscal 2003, and decreased $4.8 million to $41.3 million for the nine months ended March 31, 2004 from $46.1 million for the same period of fiscal 2003. The decreases in income from operations of the defense electronics segment for the three and nine months ended March 31, 2004 were primarily related to the decreased revenues of $7.7 million and $8.4 million, respectively, slightly offset by increased gross profit as a result of favorable program mixes within the defense electronics business applications.

Income from operations of the medical imaging segment increased $1.0 million to $4.1 million for the three months ended March 31, 2004 from $3.1 million for the same period of fiscal 2003, and decreased $3.0 million to $9.9 million for the nine months ended March 31, 2004 from $12.9 million for the same period of fiscal 2003.2004. The increase in income from operations of the medical imagingDEG segment for the three months ended March 31, 2004 comparedwas primarily related to the same period in fiscal 2003 was primarily the result of increased revenues of $1.2 million

and increases in gross profit as a result of a favorable product mix. The decrease in income from operations of the medical imaging segment for the nine months ended March 31, 2004 compared to the same period of fiscal 2003 was primarily a result of a decreaseincrease in revenues of $4.4$2.2 million.

Income from operations of the OEM solutionsIVS segment increased $1.4$0.1 million to $3.5$0.6 million for the three months ended March 31,September 30, 2004 from $2.1$0.5 million for the same period of fiscal 2003, and2004. The increase in income from operations of the IVS segment was primarily the result of increased $1.1revenues for the period, partially offset by the impact of the TGS acquisition.

Income from operations of the OEM Solutions Group segment increased $2.8 million to $5.5$1.8 million for the ninethree months ended March 31,September 30, 2004 from $4.4a loss position of $1.0 million for the same period of fiscal 2003.2004. The increasesincrease in income from operations of the OEM solutions segment werewas primarily a result of the increase in revenues for the three and nine months ended March 31,September 30, 2004 of $3.2$9.0 million, and $3.6 million, respectively, slightly offset by a decrease in gross profit due to a changeprimarily in the product mix.semiconductor market applications.