e10vq

UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

Form 10-Q


þ		Quarterly Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934

For the Quarterly Period Ended July 2, 2006


o		Transition Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934

For the Transition period from to

Commission File Number 000-08193

ARGON ST, INC.

(Exact name of registrant as specified in its charter)


Delaware				38-1873250

(State or other jurisdiction of				(I.R.S. Employer
incorporation or organization)				Identification No.)

12701 Fair Lakes Circle, Suite 800, Fairfax, Virginia 22033
(Address of principal executive offices)

Registrant’s telephone number (703) 322-0881

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, and (2) has been subject to such filing requirements for the past 90 days.

Yes þ No o

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act.

Large accelerated filer o Accelerated filer þ Non-accelerated filer o

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).

Yes o No þ

As of August 3, 2006, there were 22,155,994 shares of the Registrant’s Common Stock, par value $.01 per share, outstanding.

ARGON ST, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED BALANCE SHEETS


	July 2, 2006			September 30, 2005
	(unaudited)
ASSETS
CURRENT ASSETS
Cash and cash equivalents	$	66,514,000		$	4,064,000
Accounts receivable, net		86,202,000			103,577,000
Inventory		1,779,000			1,166,000
Income taxes receivable		537,000			2,464,000
Deferred income tax asset		2,271,000			1,742,000
Prepaids and other		1,303,000			888,000

TOTAL CURRENT ASSETS		158,606,000			113,901,000
Property, equipment and software, net		15,756,000			14,896,000
Advances and cash held in escrow		—			10,900,000
Goodwill		115,135,000			107,956,000
Intangibles, net		1,851,000			1,219,000
Other assets		665,000			962,000

TOTAL ASSETS	$	292,013,000		$	249,834,000


LIABILITIES AND STOCKHOLDERS’ EQUITY
CURRENT LIABILITIES
Line of Credit	$	—		$	11,000,000
Accounts payable and accrued expenses		13,327,000			26,857,000
Accrued salaries and related expenses		12,364,000			8,848,000
Deferred revenue		3,928,000			7,139,000
Notes payable — current		—			56,000
Capital lease obligations — current		20,000			19,000
Deferred rent		360,000			61,000

TOTAL CURRENT LIABILITIES		29,999,000			53,980,000
Deferred income tax liability, long term		303,000			1,979,000
Deferred rent — net of current		1,614,000			1,799,000
Capital lease obligations — net of current		48,000			63,000
Commitments and contingencies		—			—
STOCKHOLDERS’ EQUITY
Common stock:
$.01 Par Value, 100,000,000 shares authorized, 22,260,512 and 20,153,878 shares issued at July 2, 2006 and September 30, 2005		223,000			202,000
Additional paid in capital		211,067,000			158,458,000
Treasury stock at cost, 126,245 shares		(534,000	)		(534,000	)
Retained earnings		49,293,000			34,002,000
Accumulated other comprehensive loss		—			(115,000	)

TOTAL STOCKHOLDERS’ EQUITY	$	260,049,000		$	192,013,000

TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY	$	292,013,000		$	249,834,000

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

ARGON ST, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF EARNINGS (unaudited)


	Third Quarter Ended						Nine Months Ended
	July 2, 2006			July 3, 2005			July 2, 2006			July 3, 2005
CONTRACT REVENUES	$	68,902,000		$	75,611,000		$	192,690,000		$	188,073,000

COST OF REVENUES		56,206,000			62,555,000			153,068,000			151,534,000

GENERAL AND ADMINISTRATIVE EXPENSES		4,837,000			3,474,000			15,617,000			11,305,000


INCOME FROM OPERATIONS		7,859,000			9,582,000			24,005,000			25,234,000
OTHER INCOME (EXPENSE)
Interest income		548,000			193,000			1,064,000			538,000
Interest expense		(4,000	)		(1,000	)		(165,000	)		(10,000	)

		544,000			192,000			899,000			528,000


INCOME BEFORE INCOME TAXES		8,403,000			9,774,000			24,904,000			25,762,000
PROVISION FOR INCOME TAXES		3,237,000			3,919,000			9,613,000			10,043,000

NET INCOME	$	5,166,000		$	5,855,000		$	15,291,000		$	15,719,000


EARNINGS PER SHARE (Basic)	$	0.23		$	0.30		$	0.71		$	0.80

EARNINGS PER SHARE (Diluted)	$	0.23		$	0.28		$	0.69		$	0.76


WEIGHTED-AVERAGE SHARES OUTSTANDING
Basic		22,120,000			19,830,000			21,495,000			19,665,000

Diluted		22,717,000			20,694,000			22,127,000			20,563,000

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

ARGON ST, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (unaudited)


	Nine Months Ended
	July 2, 2006			July 3, 2005
Cash flows from operating activities
Net income	$	15,291,000		$	15,719,000
Adjustments to reconcile net income to net cash provided by (used in) operating activities:
Depreciation and amortization		4,054,000			3,465,000
Deferred income tax benefit		(985,000	)		(533,000	)
Stock-based compensation		1,489,000			—
Tax benefit of stock option exercises		—			3,630,000
Change in:
Billed accounts receivable		18,329,000			3,658,000
Unbilled accounts receivable		479,000			(18,038,000	)
Inventory		(613,000	)		(287,000	)
Prepaids and other		(77,000	)		(759,000	)
Accounts payable and accrued expenses		(13,464,000	)		14,042,000
Accrued salaries and related expenses		2,734,000			(4,768,000	)
Deferred revenue		(3,211,000	)		(16,994,000	)
Income taxes receivable		1,927,000			(4,049,000	)
Deferred rent		114,000			333,000


Net cash provided by (used in) operating activities		26,067,000			(4,581,000	)

Cash flows from investing activities
Acquisitions of property, equipment and software		(2,941,000	)		(3,852,000	)
Reduction in advances and cash held in escrow		10,900,000			—
Radix Technologies, Inc. acquisition, net of cash acquired		(9,935,000	)		—
Acquisition of ProDesign Solutions, LLC net of cash acquired		(1,712,000	)		—


Net cash used in investing activities		(3,688,000	)		(3,852,000	)

Cash flows from financing activities
Repayment on line of credit, net of borrowings		(11,000,000	)		—
Payment on note payable		(56,000	)		(169,000	)
Payments on capital leases		(14,000	)		—
Tax benefit of stock option exercises		1,691,000			—
Proceeds from exercise of stock options		2,238,000			3,352,000
Proceeds from employee stock purchase plan exercises		444,000			1,170,000
Proceeds from secondary offering		46,768,000			—


Net cash provided by financing activities		40,071,000			4,353,000

Net increase (decrease) in cash and cash equivalents		62,450,000			(4,080,000	)
Cash and cash equivalents, beginning of period		4,064,000			29,732,000

Cash and cash equivalents, end of period	$	66,514,000		$	25,652,000

Supplemental disclosure
Income taxes paid	$	6,982,000		$	10,989,000

Interest expense paid	$	165,000			—

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

ARGON ST, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (unaudited)

1. BASIS OF PRESENTATION

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 period ended July 2, 2006 are not necessarily indicative of the results that may be expected for the fiscal year ending September 30, 2006. 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, 2005. Reclassifications are made to the prior year financial statements when appropriate, to conform to the current year presentation.

Argon ST 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. 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.

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 estimates of future contract activities.

If the Company’s rate variance is unfavorable, the 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, the 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.

At July 2, 2006, the unfavorable rate variance was $1,163,000, which is materially consistent with the planned variance in our operating budget for this point in time in the fiscal year. Management anticipates that the actual rates will meet target rates by the completion of fiscal year 2006.

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 common equivalent shares outstanding during each period. The following summary is presented for the periods indicated.


	Third Quarter Ended				Nine Months Ended
	July 2, 2006		July 3, 2005		July 2, 2006		July 3, 2005
Net Income	$	5,166,000	$	5,855,000	$	15,291,000	$	15,719,000
Weighted Average Shares Outstanding — Basic		22,120,000		19,830,000		21,495,000		19,665,000

Basic Earnings Per Share	$	0.23	$	0.30	$	0.71	$	0.80
Effect of Dilutive Securities:
Net Shares Issuable Upon Exercise of Stock Options		597,000		864,000		632,000		898,000
Weighted Average Shares Outstanding — Diluted		22,717,000		20,694,000		22,127,000		20,563,000
Diluted Earnings Per Share	$	0.23	$	0.28	$	0.69	$	0.76

3. STOCK-BASED COMPENSATION

In December 2004, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 123 (revised 2004), “Share-Based Payment,” (“SFAS No. 123R”) which requires that compensation costs related to share-based payment transactions be recognized in financial statements. SFAS No. 123R requires all companies to measure compensation costs for all share-based payments at fair value, and eliminates the option of using the intrinsic method of accounting provided for in Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees,” (“APB No. 25”) which generally resulted in no compensation expense recorded in the financial statements related to the grant of stock options to employees and directors if certain conditions were met.

Effective October 1, 2005, the Company adopted SFAS No. 123R using the modified prospective method. Under this method, compensation costs for all awards granted after the date of adoption and the unvested portion of previously granted awards outstanding at the date of adoption will be measured at estimated fair value and included in operating expenses over the vesting period during which an employee provides service in exchange for the award. Accordingly, prior period amounts presented herein have not been restated to reflect the adoption of SFAS No. 123R.

Prior to the adoption of SFAS No. 123R, the Company included all tax benefits resulting from the exercise of stock options as operating cash flows in the consolidated statements of cash flows. In accordance with SFAS No. 123R, for the period beginning October 1, 2005, excess tax benefits from the exercise of stock options are presented as financing cash flows. The excess tax benefits totaled $1,691,000 for the nine months ended July 2, 2006. Such benefits were $3,630,000 for the nine months ended July 3, 2005 and are presented as a component of operating cash flows in that period.

As a result of adopting SFAS No. 123R, the Company recorded $603,000 and $1,489,000 of stock-based compensation expense, or $489,000 and $1,211,000 after tax, in its statement of earnings for the three and nine months ended July 2, 2006, respectively. This stock-based compensation expense reduced basic earnings per share by $0.02 and $0.06 respectively, for the three and nine months ended July 2, 2006, and diluted earnings per share by $0.02 and $0.05, respectively for the three and nine months ended July 2, 2006.

Fair Value Determination

The fair value concepts were not changed significantly in SFAS No. 123R; however, in adopting this Standard, companies must choose among alterative valuation models and amortization assumptions. The Company has elected to use both the Binomial option pricing model and straight-line amortization of compensation expense over the requisite service period of the grant. The Company will reconsider use of the Binomial model if additional information becomes available in the future that indicates another model would be more appropriate, or if grants issued in future periods have characteristics that cannot be reasonably estimated using this model.

The Company has 10-year options. In calculating fair value, the following weighted-average assumptions were used for option granted during the nine months ended July 2, 2006.

Expected Volatility. The expected volatility of the Company’s shares was estimated based upon the historical volatility of the Company’s share price over an historical period, as being representative of the price volatility expected in the future. This volatility is comparable to the volatilities reported by companies within our peer group. While volatility changes on a daily basis, there has been no material change in the expected rate during the nine months ended July 2, 2006 of 36%.

Risk-free Interest Rate. The Company bases the risk-free interest rate used in the Binomial valuation method on the implied yield available on a U.S. Treasury note on the applicable grant date, with a term equal to the expected term of the underlying grants. The risk-free interest rates used in valuing options granted during the nine months ended July 2, 2006 were 4.46%, 4.55% and 4.56%.

Dividend Yield. The Binomial valuation model calls for a single expected dividend yield as an input. The Company has not paid dividends in the past nor does it expect to pay dividends in the future. As such, the Company used a dividend yield percentage of zero.

Expected Term. The expected term used in the Company’s Binomial model is ten years, the contractual term of the options.

Exercise Factor. The exercise factor is the ratio by which the stock price must increase from the exercise price before the employee is expected to exercise, as estimated by management. The exercise factors used in valuing employee and director options granted during the nine months ended July 2, 2006 were 1.8817 and 4.5957, respectively.

Post-vest Percentage. The post-vest percentage is the rate at which employees are likely to exercise their options earlier than usual because they are leaving the Company, as estimated by management. Employees have 90 days and directors have 1 year to exercise upon termination of employment or resignation from the board. The post-vest percentage used in valuing options granted during the nine months ended July 2, 2006 was 3.08%. For options granted to directors, the post vest percentage was zero.

Stock Compensation Expense

The Company recorded $603,000 and $1,489,000, respectively, of stock-based compensation expense for the three and nine months ended July 2, 2006. Stock-based compensation is included in Cost of Revenues.

In prior years, while accounting for stock options under APB No. 25 and disclosing a pro forma expense calculation under SFAS No. 123, the Company did not include a forfeiture rate when calculating pro forma expense related to the options. In accordance with SFAS No. 123R, the Company estimates forfeitures and is recognizing compensation expense only for those share-based awards that are expected to vest.

As of July 2, 2006, there was $5,467,000 of total unrecognized compensation cost related to nonvested share-based compensation arrangements. This cost is expected to be fully amortized in five years, with half of the total amortization cost being recognized within the next 24 months.

Stock Option Activity

During the nine months ended July 2, 2006, the Company granted stock options to purchase 527,300 shares of common stock at a weighted-average exercise price of $29.48 per share. The Binomial weighted-average fair value of the options granted during the nine months ended July 2, 2006 was $13.28 per share. Of these options, 452,300 vest at the rate of 20% per year over five years from the date of grant and 75,000 of these options vest in full in one year after the date of grant. All of the options expire ten years from the grant date. For the nine months ended July 2, 2006, the weighted average closing price was $29.54 per share.

The following table summarizes stock option activity for the nine months ended July 2, 2006:


						Aggregate
						Intrinsic
	Number			Weighted-Average		Value
	of Shares			Exercise Price		(in thousands)
Shares under option, September 30, 2005		1,741,127		$	8.75
Options granted		527,300		$	29.48
Options exercised		(340,559	)	$	6.57	$	7,920
Options cancelled and expired		(57,310	)	$	21.66


Shares under option, July 2, 2006		1,870,558		$	14.60	$	27,946

Options exercisable at July 2, 2006		819,812		$	11.39	$	14,880

Shares reserved for equity awards at July 2, 2006		1,011,472

Information with respect to stock options outstanding and stock options exercisable at July 2, 2006 was as follows:


			Weighted-Average
	Options		Remaining			Weighted-Average
Range of Exercise Price	Outstanding		Contractual Life			Exercise Price
$ 0.10 — $ 0.90		229,828		4.8	years	$	0.65
$ 2.25 — $ 4.63		330,560		5.9			4.05
$ 5.00 — $ 6.88		292,320		7.3			5.70
$ 7.54 — $17.63		220,500		6.8			12.64
$20.40 — $29.87		797,350		8.6			26.80

		1,870,558


			Weighted-Average
	Options		Remaining			Weighted-Average
Range of Exercise Price	Exercisable		Contractual Life			Exercise Price
$ 0.10 — $ 0.90		153,308		4.7	years	$	0.52
$ 2.25 — $ 4.63		115,824		5.1			3.94
$ 5.00 — $ 6.88		79,680		7.1			5.74
$ 7.54 — $17.63		220,500		6.8			12.64
$20.40 — $29.87		250,500		7.4			22.71

		819,812

Pro Forma Disclosures

Under the modified prospective method, results for the nine months ended July 3, 2005 were not restated to include stock option expense. The previously disclosed pro forma effects of recognizing the estimated fair value of stock-based employee compensation, which historically was calculated using the Black-Scholes pricing model, for the three and nine months ended July 3, 2005 are presented below.


	Third Quarter Ended		Nine Months Ended
	July 3, 2005		July 3, 2005
Net Income	$	5,855,000	$	15,719,000
Add: Stock-based employee compensation expense included		—		—
In reported net income, net of related tax effects

Less: Total stock-based employee compensation expense determined under fair value method of all awards, net of related tax effects		327,000		1,012,000


Pro forma net income	$	5,528,000	$	14,707,000


Earnings per share:
Basic — as reported	$	0.30	$	0.80
Basic — pro forma	$	0.28	$	0.75
Earnings per share:
Diluted — as reported	$	0.28	$	0.76
Diluted — pro forma	$	0.27	$	0.72

4. REVOLVING LINE OF CREDIT

The Company’s $15,000,000 line of credit with Bank of America, N.A. (the “Lender”) expired on February 28, 2006, and was replaced by a revolving credit agreement, also with the Lender. The new credit facility will terminate no later than February 28, 2008. The terms and conditions are substantially similar to the credit facility it replaced, except that the facility was increased to $40,000,000 and the facility contains a sublimit of $15,000,000 to cover letters of credit. In addition, borrowings on the line of credit will bear reduced interest at the LIBOR rate plus 150 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 its primary accounts with the Lender. 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 July 2, 2006, the Company was in compliance with these covenants and the financial ratio.

At July 2, 2006, there were no borrowings outstanding against the line of credit. Letters of credit outstanding at July 2, 2006 amounted to $1,898,000, leaving $37,576,000 available on the line of credit.

5. ACQUISITIONS

Radix Technologies, Inc.

Effective October 1, 2005, the Company acquired 100% of the voting equity of Radix Technologies, Inc. (‘Radix’) through the merger of a wholly-owned subsidiary of Argon ST with and into Radix. Radix is based in Mountain View, California, and designs and produces signal processing systems and equipment for military, intelligence and commercial applications.

The Company paid $10,900,000 in cash at closing for the Radix stock, and the transaction provides for additional consideration in a maximum aggregate amount of $1,500,000 to be paid upon the achievement of certain performance targets during the fifteen month period following the closing. In addition to the purchase price, direct expenses of $143,000 consisting of legal, accounting and other fees were incurred in connection with the acquisition. Management believes that Radix’s complementary capabilities and its customer relationships will create significant new business opportunities for the Company. Radix operates as a wholly owned subsidiary of the Company. The results of Radix’s operations are included in the consolidated financial statements beginning as of October 1, 2005.

Of the purchase price, $1,066,000 was allocated to intangibles related to customer relationships and will be amortized over three years. In addition, $6,348,000 was allocated to goodwill, none of which is deductible for tax purposes. Pursuant to the requirements of SFAS No. 141, management has determined that this acquisition is not material to the financial statements, therefore, pro forma disclosures are not presented.

ProDesign Solutions, LLC

On February 13, 2006, the Company acquired certain assets of ProDesign Solutions, LLC (“ProDesign”). ProDesign, based in Sarasota, Florida, provides a wide array of industrial design services including ruggedized electronic enclosures, electro-mechanical engineering, software/firmware engineering, and rapid prototyping, with extensive experience in working with composite materials for weight savings. The Company paid $1,750,000 in cash and assumed liabilities of $66,000 related to a note payable and a capital lease. Of the purchase price, $434,000 was allocated to intangibles related to technology and processes that will be amortized over three years. In addition, $831,000 was allocated to goodwill, all of which is deductible for tax purposes over a 15 year amortization period. The results of ProDesign’s operations are included in the consolidated financial statements as of February 14, 2006. Pursuant to the requirements of SFAS No. 141, management has determined that this acquisition is not material to the financial statements, therefore, pro forma disclosures are not presented.

6. RELATED PARTY TRANSACTIONS

At July 2, 2006, the Company had $170,000 on deposit at James Monroe Bank, the bank operating subsidiary of James Monroe Bancorp, Inc. (“James Monroe”). An individual who is a director, executive officer and significant shareholder of Argon ST is a director and significant shareholder of James Monroe. Another director of Argon ST is a director and significant shareholder of James Monroe. James Monroe Bancorp, Inc. was acquired by Mercantile Bankshares Corporation on July 17, 2006. The Board of Directors of James Monroe was dissolved on July 11, 2006 by the vote of James Monroe shareholders and the two current directors of Argon ST did not join the Mercantile Bankshares Corporation Board of Directors.

7. SECONDARY OFFERING

On December 16, 2005, the Company completed a public offering of common stock at $29.00 per share. In the offering, the Company sold 1,725,000 shares. Selling stockholders sold an additional 920,000 shares, including 345,000 shares sold pursuant to an over-allotment option exercised by the underwriters. Proceeds to the Company from the offering were $46,768,000, net of underwriting fees, legal, accounting and other fees associated with the offering and paid by the Company of $3,257,000. The Company did not receive any proceeds from the shares sold by the selling stockholders. Selling stockholders paid a portion of the expenses related to their shares sold.

8. COMMITMENTS AND CONTINGENCIES

On June 6, 2006, the Company entered into an agreement with the Pennsylvania Industrial Development Authority (PIDA) to guarantee PIDA’s loan to WSW Holding, the lessor of the Company’s testing and engineering center in Lemont Furnace, PA. The loan is for $477,000, with a stated fixed interest rate of 2.75% and is payable monthly over ten years. In the event of default by the lessor, rent payments made by the Company will be collected by PIDA and applied to the loan arrearages. The Company is in the process of determining the fair value of this guarantee but does not believe it will have a material impact on its financial statements.

9. SUBSEQUENT EVENTS

San Diego Research Center Incorporated

Effective July 3, 2006, the Company completed the acquisition of 100% of the stock of San Diego Research Center Incorporated (“SDRC”) through a merger of a wholly-owned subsidiary of the Company with and into SDRC. SDRC is based in San Diego, California, and has established itself as a leader in defense wireless communications by inventing, implementing, and integrating complete systems suited for the most challenging military environments. SDRC has utilized its competencies in systems engineering, waveforms, networks and management to build areas of expertise encompassing advanced modems, innovative networking, and systems solutions. Management believes that the combination of the two companies will provide customers additional opportunities to leverage the complementary technologies to support real time tactical operations required in today’s environment. The Company paid $41,000,000 in cash for SDRC. The acquisition calls for additional payments to certain key employees of $4,000,000 to be paid over four years. These payments will be treated as compensation expense over the four year vesting period. In addition to the purchase price, direct expenses for legal, accounting and other fees were incurred in connection with the acquisition. The Company is currently in the process of valuing the tangible and intangible assets of SDRC. The results of SDRC’s operations will be included in the consolidated financial statements effective during the fourth quarter of fiscal year 2006.

The Company is following the guidance of SFAS No. 141 to record the purchase. The Company is in the process of valuing the assets and liabilities of SDRC. The purchase price allocation has not been finalized, the following table summarizes the preliminary estimated fair value of assets acquired and liabilities assumed at the date of acquisition:


Current Assets	$	2,053,000
Property, plant and equipment		973,000
Other assets		139,000
Goodwill		39,088,000


Total assets acquired		42,253,000

Liabilities assumed		(1,253,000	)


Purchase price	$	41,000,000

In accordance with SFAS No. 142 “Goodwill and Other Intangible Assets,” goodwill will be reviewed at least annually to determine if its value has been impaired.

Innovative Research, Ideas and Services Corporation

Effective July 31, 2006, the Company completed the acquisition of Innovative Research, Ideas and Services Corporation (“IRIS”). IRIS is based in Ann Arbor, MI and has developed an emerging standard for sensor and data characterization and exchange, enabling data fusion and facilitating operability of diverse sensor systems. Management believes that this technology complements the existing multi-INT capabilities of Argon ST, and will strengthen the Company’s offerings to current and future customers. The Company paid $2,000,000 in cash for the stock of IRIS plus an additional $800,000 to payoff existing debt. The acquisition provides for additional future payments of $2,850,000 if certain performance targets are met through fiscal year ending September 30, 2007. In addition, the purchase agreement set forth certain contracts in which former IRIS shareholders will share in the contract proceeds. We have not yet allocated the purchase price to specific assets. The results of IRIS’s operations will be included in the consolidated financial statements effective during the fourth quarter of fiscal year 2006.

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

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, 2005.

Forward-looking Statements

Statements in this filing which are not historical facts are forward-looking statements under the provision of the Private Securities Litigation Reform Act of 1955. Such forward-looking statements include, without limitation, statements with respect to total estimated remaining contract values and the Company’s expectations regarding the U.S. government’s procurement activities. 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 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, 2005), such risks and uncertainties include, but are not limited to: the availability of U.S. and international government funding for our products and services; changes in the U.S. federal government procurement laws, regulations, policies and budgets (including changes to respond to budgetary constraints and cost-cutting initiatives); 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; the timing of Congressional funding on our contracts; any government delay or termination of our contracts and programs; difficulties in developing and producing operationally advanced technology systems; 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; 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, except as provided by law.

Overview

General

We are a leading systems engineering and development company providing full-service C4ISR (command, control, communications, computers, intelligence, surveillance and reconnaissance) systems to a wide range of defense and intelligence customers. 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.

Revenues

Our revenues are primarily generated from the design, development, installation and support of complex sensor systems under contracts primarily with the U.S. Government and major domestic prime contractors, as well as with foreign governments, agencies and defense contractors.

Our government contracts can be divided into three major types: cost reimbursable, 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. Development activities similar to activities performed under previous contacts are also usually covered by fixed-price contracts, due to the low risk involved. 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 approved labor rates, plus other costs incurred and allocated.

The following table represents our revenue concentration by contract type for the periods indicated:


	Third Quarter Ended						Nine Months Ended
Contract Type	July 2, 2006			July 3, 2005			July 2, 2006			July 3, 2005
Cost reimbursable contracts		22	%		16	%		23	%		16	%

Fixed-price contracts		68	%		79	%		67	%		79	%

Time and material contracts		10	%		5	%		10	%		5	%

Generally, we experience revenue growth when systems move from the development stage to the production stage due to increases in sales volumes from production of multiple systems, and when we add new customers or are successful in selling new systems to existing customers. Our current production work has been derived from programs for which we have performed the initial development work. These programs are next generation systems replacing existing, obsolete systems that were developed by other companies. We were able to displace these companies primarily on the basis of technological capability. We believe that the current state of world affairs and the U.S. government’s emphasis on protecting U.S. citizens will cause funding of these programs to continue. The recent increase in cost reimbursable and time and materials contracts is indicative of our participation in development initiatives which have the potential to lead to the production of systems that may be accepted into service use.

Backlog

We define backlog as the funded and unfunded amount provided in our contracts less previously recognized revenue and excludes all unexercised options on contracts. Some contracts where work has been authorized carry a funding ceiling that does not allow us to continue work on the contract once the customer obligations have reached the funding ceiling. In such cases, we are required to stop work until additional funding is added to the contract. Our experience in such cases are very rare and therefore we generally carry the entire amount that the customer intends to execute as backlog when we are confident that the customer has access to the required funding for the contract.

In general, most of our backlog results in sales in subsequent fiscal years, as we maintain very minimal inventory and therefore the lead time on ordering and receiving material and increasing staff to execute programs has a lag time of several months from the receipt of order.

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, 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 and cancellations of orders, backlog at any particular date is not necessarily representative of actual sales to be expected for any succeeding period, and actual sales for the year may not meet or exceed the backlog represented. We may experience significant contract cancellations that were previously booked and included in backlog.

Our backlog at the dates shown was as follows:


	July 2, 2006		July 3, 2005
Funded	$	194,980,000	$	198,811,000
Unfunded		40,454,000		69,577,000

*Total*	$	235,434,000	$	268,388,000

Cost of Revenues

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 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 government approves the planned indirect rates as provisional billing rates near the beginning of each fiscal year. See also “- Critical Accounting Practices and Estimates – Revenue and Cost Recognition – Indirect Rate Variances” below.

Stock-Based Compensation Expense

Effective October 1, 2005, we adopted SFAS No. 123R using the modified prospective method. Under this method, compensation costs for all awards granted after the date of adoption and the unvested portion of previously granted awards outstanding at the date of adoption will be measured at estimated fair value and included in operating expenses over the vesting period during which an employee or director provides service in exchange for the award. Accordingly, prior period amounts presented herein have not been restated to reflect the adoption of SFAS No. 123R.

Prior to the adoption of SFAS No. 123R, we included all tax benefits resulting from the exercise of stock options as operating cash flows in the consolidated statements of cash flows. In accordance with SFAS No. 123R, for the period beginning October 1, 2005, excess tax benefits from the exercise of stock options are presented as financing cash flows. The excess tax benefits totaled $1,691,000 for the nine months ended July 2, 2006. Such benefits were $3,630,000 for the nine months ended July 3, 2005 and are presented as a component of operating cash flows in that period.

As a result of adopting SFAS No. 123R, we recorded $603,000 and $1,489,000 of stock-based compensation expense, or $489,000 and $1,211,000 after tax, in our statement of earnings for the three and nine months ended July 2, 2006, respectively. This stock-based compensation expense reduced basic earnings per share by $0.02 and $0.06, respectively, for the three and nine months ended July 2, 2006, and diluted earnings per share by $0.02 and $0.05, respectively for the three and nine months ended July 2, 2006.

General and Administrative Expenses

Our general and administrative expenses include administrative salaries, costs related to proposal activities, internally funded research and development, and other administrative costs.

Interest Income and Expense

Interest income is derived solely from interest earned on cash reserves maintained in short term investment accounts and are therefore subject to short-term interest rates that have minimal risk.

Interest expense relates to interest charged on borrowings against our line of credit and capital leases.

Research and Development

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. In the nine months ending July 2, 2006 and July 3, 2005, internal research and development expenditures (“IRAD”) were $4,599,000 and $4,034,000, respectively, representing 2.4% and 2.1% respectively, of revenues in each period.

Internal research and development is a small portion of our overall research and development, as government funded research and development constitutes the majority of our activities in this area.

Deferred Revenue

Many of our fixed-price contracts contain provisions under which our customers are required to make payments when we achieve certain milestones. In many instances, these milestone payments occur before we have incurred the associated costs to which the payments will be applied. For example, under certain of our production contracts, our order of materials constitutes a milestone for which we receive a significant payment, but we do not pay the materials vendors until the materials are received and placed into production. We recognize deferred revenue when we receive milestone payments for which we have not yet incurred the applicable costs. As costs are incurred and revenue recognition criteria are met, we recognize revenue.

As the time lag between our receipt of a milestone payment and our incurrence of associated costs under the contract can be several months, milestone payments under fixed-price contracts can significantly affect our cash position at any given time. The receipt of milestone payments will temporarily increase our cash on hand and our deferred revenue. As costs are incurred under the contract and contract revenue is recognized, cash and deferred revenue associated with the payment will decrease.

We expect that fluctuations in deferred revenue will occur based on the particular timing of milestone payments under our fixed-price contracts and our subsequent incurrence of costs under the contracts. Due to these fluctuations, our cash position at the end of any fiscal quarter or year may not be indicative of our cash position at the end of subsequent fiscal quarters or years.

Critical Accounting Practices and Estimates

General

Our discussion and analysis of our financial condition and results of operations are based upon our financial statements. These financial statements are prepared in accordance with accounting principles generally accepted in the United States, which require management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Actual results could differ significantly from those estimates. We believe that the estimates, assumptions, and judgments involved in the accounting practices described below have the greatest potential impact on our financial statements and, therefore, consider these to be critical accounting practices.

Revenue and Cost Recognition

General

The majority of our contracts, which are with the U.S. government, are accounted for in accordance with the American Institute of Certified Public Accountants Statement of Position 81-1, Accounting for Performance of Construction-Type and Production-Type Contracts. These contracts are transacted using written contractual arrangements, most of which require us to design, develop, manufacture and/or modify complex products and systems, and perform related services according to specifications provided by the customer. We account for fixed-price contracts by using the percentage-of-completion method of accounting. Under this method, contract costs are charged to operations as incurred. 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. In the case of contracts with materials requirements, revenue is recognized as those materials are applied to the production process in satisfaction of the contracts’ end objectives. We account for cost reimbursable contracts by charging contract costs to operations as incurred and recognizing contract revenues and profits by applying the negotiated fee rate to actual costs on an individual contract basis. Management reviews contract performance, costs incurred, and estimated completion costs regularly and adjusts revenues and profits on contracts in the period in which changes become determinable.

Anticipated losses on contracts are also recorded in the period in which they become determinable. Unexpected increases in the cost to develop or manufacture a product, whether due to inaccurate estimates in the bidding process, unanticipated increases in material costs, inefficiencies, or other factors are borne by us on fixed-price contracts, and could have a material adverse effect on results of operations and financial condition. Unexpected cost increases in cost reimbursable contracts may be borne by us for purposes of maintaining customer relationships. If the customer agrees to fund cost increases on cost type contracts, the additional cost generally does not bear any profit and therefore dilutes margin.

Indirect rate variance

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. 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 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 management actions to control costs during the remainder of the year. We consider the rate variance to be unfavorable when the actual indirect rates are greater than our 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.

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 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 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 our rate variance is favorable, the modification of our 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.

At July 2, 2006, the unfavorable rate variance was $1,163,000, which is materially consistent with the planned variance in our operating budget for this point in time in the fiscal year. We anticipate that the actual rates will meet target rates by the completion of fiscal year 2006.

Award Fee Recognition

Our practice for recognizing interim fee on our cost-plus-award-fee contracts is based on management’s assessment as to the likelihood that the award fee or an incremental portion of the award fee will be earned on a contract-by-contract basis. Management’s assessments are based on numerous factors including contract terms, nature of the work performed, our relationship and history with the customer, our history with similar types of projects, and our current and anticipated performance on the specific contract. No award fee is recognized until management determines that it is probable that an award fee or portion thereof will be earned. Actual fees awarded are typically within management’s estimates. However, changes could arise within an award fee period causing management to either lower or raise the award fee estimate in the period in which it occurs.

Goodwill

Costs in excess of the fair value of tangible and identifiable intangible assets acquired and liabilities assumed in a business combination are recorded as goodwill. In accordance with SFAS No. 142, “Goodwill and Other Intangible Assets”, companies no longer amortize goodwill, but instead test for impairment at least annually using a two-step approach. Impairment of goodwill is tested at the reporting unit level by comparing the reporting unit’s carrying amount, including goodwill, to the fair value of the reporting unit. The fair values of the reporting units are estimated using a combination of the income, or discounted cash flows approach and the market approach, which utilizes comparable companies’ data. If the carrying amount of the unit exceeds its fair value, goodwill is considered impaired and a second step is performed to measure the amount of impairment loss, if any. We perform preliminary impairment testing quarterly, and engage an independent third party specialist to perform a formal impairment test annually during the fourth fiscal quarter.

Stock-based Compensation

We account for stock-based compensation in accordance with SFAS No. 123(R), Share-Based Payment. Under the fair value recognition provisions of this statement, share-based compensation cost is measured at the grant date based on the value of the award and is recognized as expense over the vesting period. Determining the fair value of share-based awards at the grant date requires judgment, including estimating expected volatility, dividend yield, expected term and estimated forfeitures of the options granted.

Historical Operating Results

Fiscal quarter ended July 2, 2006 compared to fiscal quarter ended July 3, 2005

The following table sets forth certain items, including consolidated contract revenues, cost of revenues, general and administrative expenses, interest income and interest expense, provision for income taxes and net income, and the changes in these items for the fiscal quarters ended July 2, 2006 and July 3, 2005:


	Third Quarter Ended				Increase (Decrease)
	July 2, 2006		July 3, 2005		2006 Compared To 2005
Contract revenues	$	68,902,000	$	75,611,000	$	(6,709,000	)
Cost of revenues	$	56,206,000	$	62,555,000	$	(6,349,000	)
General and administrative expenses	$	4,837,000	$	3,474,000	$	1,363,000
Interest income and interest expense	$	544,000	$	192,000	$	352,000
Provision for income taxes	$	3,237,000	$	3,919,000	$	(682,000	)
Net income	$	5,166,000	$	5,855,000	$	(689,000	)

Contract Revenues:

Revenues decreased approximately 9% for the fiscal quarter ended July 2, 2006, as compared to the fiscal quarter ended July 3, 2005. During the period, a lower number of submarine systems were delivered, in addition to the revenue lost due to the terminated ACS contract. During the second quarter, we announced the receipt of a follow on order for the next phase of production on the surface ship program. That program has been ramping up and contributed approximately 15% of revenue for the fiscal quarter ended July 2, 2006.

Cost of Revenues:

Cost of revenues decreased approximately 10% for the fiscal quarter ended July 2, 2006 as compared to the fiscal quarter ended July 3, 2005. We have continued to add staff to meet the requirements of our development programs, which has resulted in higher labor costs as well as related fringe benefits and facilities costs. Direct labor increased to $9,242,000 for the fiscal quarter ended July 2, 2006 as compared to $7,852,000 for the fiscal quarter ended July 3, 2005, while material costs decreased to $29,506,000 for the fiscal quarter ended July 2, 2006 compared to the $40,870,000 for the same prior year quarter. Cost of revenues as a percentage of revenues decreased to 82% from 83%, respectively, for the fiscal quarters ended July 2, 2006 and July 3, 2005.

General and Administrative Expenses:

General and administrative expenses increased approximately 39% for the fiscal quarter ended July 2, 2006, as compared to the fiscal quarter ended July 3, 2005. The increase was due primarily to an increase in general and administrative labor of $300,000 and an increase in internal research and development cost of $632,000. Internal research and development cost increased as we invested in technologies aimed at differentiating us in the competitive market place.

Interest Income and Interest Expense:

Interest income increased approximately $355,000 for the fiscal quarter ended July 2, 2006, as compared to the fiscal quarter ended July 3, 2005. This increase was a result of higher average cash balances as a result of the secondary offering and improved accounts receivable management, as well as higher short-term interest rates. During the quarters ended July 2, 2006 and July 3, 2005, there were no borrowings under the line.

Provision for Income Taxes:

Our effective income tax rate decreased to 38.6% for the fiscal quarter ended July 2, 2006, compared to an effective rate of 40.1% for the fiscal quarter ended July 3, 2005. The decrease is due to an increase in tax exempt interest, the production tax deduction which was available this period, and an increase in the R&D tax credit.

Net Income:

Net income decreased approximately $689,000, or 12%, for the fiscal quarter ended July 2, 2006 compared to the fiscal quarter ended July 3, 2005. This was partly the result of the revenue decrease described above, and partly caused by a shift in fixed price contract work from 79% of revenues in the quarter ended July 3, 2005 to 68% of revenues in the quarter ended July 2, 2006.

In addition, stock-based compensation expense, net of tax, incurred during the three months ended July 2, 2006 was $489,000. During the prior year quarter, no stock-based compensation expense was recognized. Also, we have had to lower the profit expectations on one of our larger fixed price programs as a result of unanticipated technical difficulties causing a delay in program completion.

Nine Months Ended July 2, 2006 compared to Nine Months Ended July 3, 2005


	Nine Months Ended				Increase 2006
	July 2, 2006		July 3, 2005		Compared to 2005
Contract revenues	$	192,690,000	$	188,073,000	$	4,617,000
Cost of revenues		153,068,000		151,534,000		1,534,000
General and administrative expenses		15,617,000		11,305,000		4,312,000
Interest income and interest expense		899,000		528,000		371,000
Provision for income taxes		9,613,000		10,043,000		(430,000	)
Net income		15,291,000		15,719,000		(428,000	)

Contract Revenues:

Revenues increased approximately 2% for the nine months ended July 2, 2006, as compared to the nine months ended July 3, 2005, however, without the additional revenue generated by Radix, we would have reported a decrease in revenue for this period. As we stated in the quarterly results, although we have seen increased revenue from a number of new programs, including the new surface ship initiatives, these increases have been largely offset by fewer submarine systems delivered, and as a result of the revenue lost from the ACS contract termination. During the current nine month period, our revenue was spread over a larger number of development and production efforts, rather than being concentrated in a few large production programs.

Cost of Revenues:

Cost of revenues increased approximately 1% for the nine months ended July 2, 2006 as compared to the nine months ended July 3, 2005. The increase was comprised primarily of increase in direct labor, subcontracts and other direct costs of $5,248,000, $1,994,000 and $6,272,000, respectively. These increases were offset by a decrease in material costs of $19,231,000 due to our nearing completion of two significant production programs. Compensated leave increased $1,066,000, 401k contributions increased $388,000, group insurance increased $541,000 and other fringe benefits increased $3,891,000. Business development and facilities costs increased $748,000 and $631,000 respectively, when compared to the nine months ended July 3, 2005. The increase in fringe benefits and facilities costs are related to an increase in employee population, while the increase in business development costs is consistent with our emphasis on penetrating new markets. Cost of revenues as a percentage of revenue decreased to 79% for the nine month period ended July 2, 2006 from 81% for the nine months ended July 3, 2005.

General and Administrative Expenses:

General and administrative expenses increased approximately 38% for the nine months ended July 2, 2006, as compared to the nine months ended July 3, 2005. The increase was due primarily to a significant increase in bid and proposal costs of $1,846,000 resulting from our pursuit of a major competitive program, an increase in salaries expense of $1,003,000 as a result of increased staff, increased internal research and development expenses of $565,000, and an increase in accounting related expenses of $308,000.

Interest Income and Interest Expense:

Interest income increased approximately $526,000 for the nine months ended July 2, 2006, as compared to the nine months ended July 3, 2005. This increase was a result of significantly higher average cash balances due to proceeds from our secondary stock offering in December 2005, improved accounts receivable collections, and higher short-term interest rates during the nine months ended July 2, 2006 compared to the nine months ended July 3, 2005. Interest expense increased by $155,000 for the nine months ended July 2, 2006 compared to the nine months ended July 3, 2005 due to borrowings on the line of credit during the first quarter.

Provision for Income Taxes:

Our effective income tax rate decreased to 38.6% for the nine months ended July 2, 2006, compared to 39.0% for the nine months ended July 3, 2005. This slight decrease is related to an increase in tax exempt interest, the production tax deduction which was available this period, and an increase in the R&D tax credit.

Net Income:

Net income decreased approximately $428,000, or 3%, for the nine months ended July 2, 2006 compared to the nine months ended July 3, 2005. This decrease in net income reflects the shift in fixed price contract work from 79% of revenues during the nine months ended July 3, 2005 to 67% of revenues during the nine months ended July 2, 2006. The profitability of the increase in revenues was offset by stock compensation expense, net of tax, of $1,211,000 for the nine months ended July 2, 2006. During the prior year nine months period, no stock-based compensation was recognized. In addition, we have had to lower the profit expectations on one of our larger fixed price programs as a result of unanticipated technical difficulties causing a delay in program completion.

Analysis of Liquidity and Capital Resources

Cash

At July 2, 2006, we had cash of $66,514,000 compared to cash of $4,064,000 on September 30, 2005. This increase in cash of $62,450,000 was primarily the result of the net proceeds from our secondary stock offering of $46,768,000, and a decrease in billed and unbilled receivables of $18,808,000 offset by the net repayment of the line of credit of $11,000,000. As stated in Note 9 to the consolidated financial statements, we acquired San Diego Research Center, Inc. on July 3, 2006 for $41,000,000 in cash and Innovative Research, Ideas and Services Corporation on July 31, 2006 for $2,800,000 in cash.

Line of Credit

On March 31, 2006, we replaced our $15,000,000 line of credit with Bank of America with a $40,000,000 line of credit also with Bank of America, which will terminate no later than February 28, 2008. The line of credit agreement also contains a $15,000,000 sublimit to cover letters of credit. Total letters of credit at July 2, 2006 were $1,898,000. The line of credit is available to finance the performance of government contracts, to support the issuance of stand-by letters of credit, and for short-term working capital purposes.

At July 2, 2006, there were no borrowings under the line of credit. The line of credit less the letters of credit provided loan availability of $37,576,000 at July 2, 2006. Based on current backlog, planned contract revenue, and planned capital expenditures, we do not anticipate the need for any cash other than cash generated from operations during the next twelve months. This planning does not assume any acquisitions that would require cash.

The bank agreement establishes the interest rate at the LIBOR plus 150 basis points. Unused commitment fees of one quarter of one percent per annum are required. All borrowings under the line of credit are collateralized by all of our tangible personal property. The agreement contains a specific EBITDA to Funded Debt ratio and contains customary events of default, including 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 July 2, 2006, we are in compliance with these covenants and the financial ratio.

Cash Flows

Net cash provided by operating activities was $26,067,000 for the nine months ending July 2, 2006, compared to net cash used in operating activities of $4,581,000 for the nine months ending July 3, 2005. The increase in changes in net cash from operating activities for the nine months ending July 2, 2006 period compared to the nine months ending July 3, 2005 was primarily caused by a decrease in billed and unbilled accounts receivable of $33,188,000, a decrease in income taxes receivable of $5,976,000, a decrease in deferred revenue of $13,783,000 and an increase in accrued salaries and related expenses of $7,502,000 partially offset by a decrease in accounts payable and accrued expenses of $27,506,000. The decrease in billed and unbilled receivables resulted from improved collection processes, and the achievement of contractual milestones. The decrease in deferred revenue resulted from our recognition of revenue during the nine months ended July 2, 2006, related to milestone payments received during the fourth fiscal quarter of 2004 and the first fiscal quarter of 2005. See “ — Overview — Deferred Revenue” above.

Net cash used in investing activities was $3,688,000 for the nine months ended July 2, 2006, compared to net cash used in investing activities of $3,852,000 for the nine months ended July 3, 2005. The decrease is due primarily to a decrease in the acquisition of property, equipment and software.

Net cash provided by financing activities was $40,071,000 for the nine months ended July 2, 2006 compared to $4,353,000 for the nine months ended July 3, 2005. The increase in net cash provided by financing activities was primarily due to the net proceeds from our secondary stock offering of $46,768,000, partially offset by the repayment of the line of credit of $11,000,000 and a decrease of proceeds from exercise of stock options of $1,114,000.

Contractual Obligations and Commitments

As of July 2, 2006, our contractual cash obligations were as follows:


			Due in		Due in		Due in		Due in		Due in
	Total		2006		2007		2008		2009		2010		Thereafter
Capital leases	$	67,000	$	5,000	$	20,000	$	20,000	$	20,000	$	2,000		—
Operating leases		24,853,000		1,518,000		6,190,000		6,242,000		4,034,000		1,887,000		4,982,000


Total	$	24,920,000	$	1,523,000	$	6,210,000	$	6,262,000	$	4,054,000	$	1,889,000	$	4,982,000

As of July 2, 2006, other commercial commitments were as follows:


	Total		Less Than 1 Year		1-3 Years
Letters of credit	$	1,898,000	$	1,898,000		—

We have no long-term debt obligations, capital lease obligations, other operating lease obligations, contractual purchase obligations, or other long-term liabilities other than those shown above. We also have no off-balance sheet arrangements of any kind.

Market Risks

In addition to the risks inherent in our operations, we are exposed to financial, market, political and economic risks. The following discussion provides additional detail regarding our exposure to credit, interest rates and foreign exchange rates.

Cash and Cash Equivalents:

All unrestricted, highly liquid investments purchased with a remaining maturity of three months or less are considered to be cash equivalents. We maintain cash and cash equivalents with various financial institutions in excess of the amount insured by the Federal Deposit Insurance Corporation. We believe that any credit risk related to these cash and cash equivalents is minimal.

Interest Rates:

Our line of credit financing provides available borrowing to us at a variable interest rate tied to LIBOR or the bank’s basic interest rate. There were no outstanding borrowings under this line of credit at July 2, 2006. Accordingly, we do not believe that any movement in interest rates would have a material impact on future earnings or cash flows.

Foreign Currency:

We have contracts to provide services to certain foreign countries approved by the U.S. government. Our foreign sales contracts require payment in U.S. dollars, and therefore are not affected by foreign currency fluctuations. We occasionally issue orders or subcontracts to foreign companies in local currency. The current obligations to foreign companies are of an immaterial amount and we believe the associated currency risk is also immaterial.

ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISKS

The information called for by this item is provided under Item 2 — “Management’s Discussion and Analysis of Financial Condition and Results of Operations.”

ITEM 4. CONTROLS AND PROCEDURES

	(a)		Our management has evaluated, with the participation of our Chief Executive Officer and Chief Financial Officer, the effectiveness of our disclosure controls and procedures as of the end of the period covered by this Quarterly Report on Form 10-Q. Based on this evaluation, our Chief Executive Officer and Chief Financial Officer have concluded that our disclosure controls and procedures are effective to ensure that information we are required to disclose in reports that we file or submit under the Securities Exchange Act of 1934, as amended, is recorded, processed, summarized and reported within the time periods specified in Securities and Exchange Commission rules and forms.

	(b)		During the last quarter, there were no significant changes in our internal controls over financial reporting (as defined in Rule 13a-15(f) and 15d-15(f) under the Securities Exchange Act of 1934, as amended) that have materially affected these controls, or are reasonably likely to materially affect these controls subsequent to the evaluation of these controls.

PART II — OTHER INFORMATION

ITEM 5. OTHER INFORMATION

None.

ITEM 6. EXHIBITS


Exhibit
Number		Description of Exhibit
2.1		Agreement and Plan of Merger dated as of June 7, 2004, by and between Sensytech, Inc. and Argon Engineering Associates, Inc. (incorporated by reference to Exhibit 2.1 of the Company’s Registration Statement on Form S-4 filed on July 16, 2004, Registration Statement No. 333-117430)

3.1		Amended and Restated Certificate of Incorporation of the Company (incorporated by reference to Exhibit 3.1 of the Company’s Registration Statement on Form S-1(Registration Statement No. 333-98757) filed on August 26, 2002)


Exhibit
Number		Description of Exhibit
3.1.1		Amendment to the Company’s Amended and Restated Certificate of Incorporation (incorporated by reference to Exhibit 3.1 the Company’s Current Report on Form 8-K filed October 5, 2004 covering Items 2.01, 5.01, 5.02, 8.01 and 9.01 of Form 8-K)

3.1.2		Amendment, dated March 15, 2005 to the Company’s Amended and Restated Certificate of Incorporation (incorporated by reference to Exhibit 3.1.2 to the Company’s Quarterly Report on Form 10-Q for the quarterly period ended July 5, 2005, filed May 11, 2005)

3.2		Amended and Restated Bylaws of the Company (incorporated by reference to Exhibit 13(a)(i) of the Company’s Annual Report on Form 10-KSB for the fiscal year ended September 30, 2001)

4.1		Form of Common Stock Certificate (incorporated by reference to Exhibit 4.3 to the Company’s Registration Statement on Form S-3 (Registration Statement No. 333-128211) filed on September 9, 2005)

10.1		Amended and Restated Line of Credit Agreement with Bank of America (incorporated by reference to Exhibit 10.1 of the Company’s Registration Statement on Form S-1 (Registration Statement No. 333-98757) filed on August 26, 2002

10.1.1		Fifth Amendment to Second Amended and Restated Financing and Security Agreement (incorporated by reference to Exhibit 10.1 of the Company’s Current Report on Form 8-K dated March 31, 2006 and filed July 6, 2006

10.2+		Argon ST, Inc. 2002 Stock Incentive Plan (incorporated by reference to Appendix A to the Company’s Definitive Proxy Statement on Schedule 14A filed January 27, 2006)

10.2.1		Form of Stock Option Agreement under Argon ST 2002 Stock Incentive Plan (incorporated by reference to Exhibit 10.2.1 to the Company’s Annual Report on Form 10-K for fiscal year ended September 30, 2005, filed December 14, 2005)

10.3+		Argon Engineering Associates, Inc. Stock Plan (incorporated by reference to Exhibit 10.3 to the Company’s Annual Report on Form 10-K for the fiscal year ended September 30, 2004, filed December 14, 2004)

10.5+		Retention Agreement dated February 17, 2004, by and between the Company and S. Kent Rockwell (incorporated by reference to Exhibit 10.4 of the Company’s Registration Statement on Form S-4 (Registration Statement No. 333-117430) filed on July 16, 2004)

16.1		Letter of PricewaterhouseCoopers LLP regarding change in certifying accountant (incorporated by reference to Exhibit 16.1 to the Company’s Current Report on Form 8-K covering Items 4.01 and 9.01 of Form 8-K, filed October 5, 2004)

16.2		Letter of Watkins, Meegan, Drury & Company, L.L.C. regarding change in certifying accountant (incorporated by reference to Exhibit 16.2 to the Company’s Current Report on Form 8-K covering Items 4.01 and 9.01 of Form 8-K, filed October 5, 2004)

31.1*		Certification of the Company’s Chief Executive Officer pursuant to Rule 13a-14(a)/15d-14(a) under the Securities Exchange Act

31.2*		Certification of the Company’s Chief Financial Officer pursuant to Rule 13a-14(a)/15d-14(a) under the Securities Exchange Act

32.1**		Certification pursuant to Rule 13a-14(b)/15d-14(b) under the Securities Exchange Act and Section 1350 of Chapter 63 of Title 8 of the United States Code


*		Filed herewith

**		Furnished herewith

+		Indicates management contract or compensatory plan or arrangement


PART I. FINANCIAL INFORMATION

Item 1. Financial Statements (Unaudited)

Condensed Consolidated Balance Sheets at July 2, 2006 and September 30, 2005			3

Condensed Consolidated Statements of Earnings for the three and nine months ended July 2, 2006 and July 3, 2005			4

Condensed Consolidated Statements of Cash Flows for the nine months ended July 2, 2006 and July 3, 2005			5

Notes to Condensed Consolidated Financial Statements			6-12

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations			13-23

Item 3. Quantitative and Qualitative Disclosures about Market Risks			23

Item 4. Controls and Procedures			23

PART II. OTHER INFORMATION

Item 5. Other Information			23

Item 6. Exhibits			23

Signatures			25

Exhibits			26-28


	ARGON ST, INC. (Registrant)
	By:	/s/ Terry L. Collins
	Terry L. Collins, Ph.D.
	Chairman, Chief Executive Officer and President


	By:	/s/ Victor F. Sellier
	Victor F. Sellier
	Vice President - Business Operations, Chief Financial Officer, Secretary and Treasurer

	a.		Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared;

	b.		Designed such internal control over financial reporting or caused such internal control over financial reporting to be designed under our supervision, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles;

	c.		Evaluated the effectiveness of the registrant’s disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and

	d.		Disclosed in this report any change in the registrant’s internal control over financial reporting that occurred during the registrant’s third fiscal quarter that has materially affected, or is reasonably likely to materially affect, the registrant’s internal control over financial reporting; and

	a.		All significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant’s ability to record, process, summarize and report financial information; and

	b.		Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant’s internal control over financial reporting.

	a.		Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared;

	b.		Designed such internal control over financial reporting or caused such internal control over financial reporting to be designed under our supervision, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles;

	c.		Evaluated the effectiveness of the registrant’s disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and

	d.		Disclosed in this report any change in the registrant’s internal control over financial reporting that occurred during the registrant’s third fiscal quarter that has materially affected, or is reasonably likely to materially affect, the registrant’s internal control over financial reporting; and

1.		I have reviewed this quarterly report on Form 10-Q of Argon ST, Inc.;

2.		Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report;

3.		Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations, and cash flows of the registrant as of, and for, the periods presented in this report;

4.		The registrant’s other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) and internal control over financial reporting (as defined in Exchange Act Rules 13a-15(f) and 15d-15(f)) for the registrant and have:


/s/ Terry L. Collins
Terry L. Collins Chief Executive Officer


/s/ Victor F. Sellier
Victor F. Sellier
Chief Financial Officer


/s/ Victor F. Sellier
Victor F. Sellier Chief Financial Officer