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GIGA TRONICS INC - 10-K - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITIONS AND RESULTS OF OPERATIONS

June 24, 2014

Overview

Giga-tronics produces instruments, subsystems and sophisticated microwave components that have broad applications in both defense electronics and wireless telecommunications. The Company has two reporting segments: Giga-tronics Division and Microsource.

The Giga-tronics Division produces signal sources, generators, power measurement and amplification instruments for use in the microwave and radio frequency (RF) range (10 kilohertz (kHz) to 50 gigahertz (GHz)). Within each product line are a number of different models and options allowing customers to select frequency range and specialized capabilities, features and functions. The end-user markets for these products can be divided into three broad segments: electronic warfare, radar and commercial telecommunications. These instruments are used in the design, production, repair and maintenance and calibration of other manufacturers' products, from discrete components to complex systems.

The Giga-tronics Division also produces switching systems that operate with a bandwidth from direct current (DC) to optical frequencies. These switch systems may be incorporated in customers' automated test equipment. The end-user markets for these products are primarily related to defense, aeronautics, communications, satellite and electronic warfare, commercial aviation and semiconductors.

The Microsource segment develops and manufactures a broad line of YIG tuned oscillators, filters, filter components, and microwave synthesizers, which are used by its customers in operational applications and in manufacturing a wide variety of microwave instruments or devices. The end-user markets for these products are primarily related to defense and commercial aerospace.

In fiscal 2014 and fiscal 2013 almost all of the sales for Microsource were to one large aerospace customer associated with programs for retrofitting radar filter components on existing military aircraft, and radar filter components for new military aircraft being manufactured. The timing of orders and the contractual shipment schedule associated with this customer cause significant differences in orders, sales, deferred revenue, inventory and cash flow when comparing one fiscal period to another.

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A second large aerospace company has engaged Microsource for design services and a production bid associated with a similar radar filter program. On August 13, 2013 Microsource received an initial order for $733,000, on May 6, 2014 a follow on order of $659,000 was received, and then on May 20, 2014 the complete order for an additional $5.5 million was received. The total orders for the design and production bid for the associated program is $6.9 million. The Company anticipates the associated multi-year production agreement to be for approximately $10.0 million and for it to finalize in calendar 2014. No assurances can be given that the parties will agree on the final multi-year production agreement, or what the actual terms will be. (see Note 20, Subsequent Events)

In fiscal 2014 the Company saw a continuation of substantial losses as legacy Giga-tronics Division products sales and gross margins decreased, while the Company continued to invest heavily in the development of a new Giga-tronics Division product platform. The Company anticipates long-term revenue growth and improved gross margins from the new product platform, but delays in completing it have contributed to the existence of substantial doubt about the Company's ability to continue as a going concern.

In fiscal 2014 the Microsource business unit completed its move from Santa Rosa, California, to the Company's headquarters in San Ramon, California. Microsource maintained all defense and manufacturing related certifications during the move and increased revenue shipments by 25% in fiscal 2014 when compared to fiscal 2013. Microsource also started working with a second large aerospace company on another radar filter program, and finalized the total $6.9 million design and production bid on May 20, 2014. (see Note 20, Subsequent Events)

Since March 2013 the Company has raised additional capital and generated liquidity to support the ongoing development of a new Giga-tronics Division product platform by selling a product line, issuing equity in the Company, increasing its debt, and cutting costs. The Company's management will continue to look at all these strategies in fiscal 2015 in order to complete development of the new product design, market introduction and volume production.

Results of Operations



New orders by reporting segment are as follows for the fiscal years ended:

NEW ORDERS % change 2014 2013 vs. vs.



(Dollars in thousands) 2014 2013 2013 2012 Giga-tronics Division $ 8,684$ 9,013 (4.0% ) (20.0% ) Microsource

4,947 8,679 (43.0% ) 334.0 % Total $ 13,631$ 17,692 (23.0% ) 33.0 %



New orders received in fiscal 2014 decreased 23% to $13.6 million from the $17.7 million received in fiscal 2013. The decrease in orders was primarily due to Microsource's receipt in fiscal 2013 of $8.2 million in long term contracts from a large aerospace company. In fiscal 2014 Microsource received annual extensions of these contracts totaling $4.0 million, and an initial $733,000 order from a second large aerospace company for design services and a production bid associated with a similar radar filter program. The decrease in new orders for the Giga-tronics Division in fiscal 2014 was primarily due to the sale of the SCPM product line to Teradyne in April 2013 (see Note 6, Gain on Sale of Product).

New orders received in fiscal 2013 increased 33% to $17.7 million from the $13.3 million received in fiscal 2012. The increase was primarily due to Microsource's receipt in fiscal 2013 of $8.2 million in long term contracts from a large aerospace company compared to $1.6 million in fiscal 2012. This was partially offset by a $2.2 million decrease in Giga-tronics Division defense orders, primarily from a decrease of switch modules associated with the older SCPM product line that was sold to Teradyne in April 2013 (see Note 6, Gain on Sale of Product).

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The following table shows order backlog and related information at fiscal year-end: Backlog % change 2014 2013 vs. vs. (Dollars in thousands) 2014 2013 2013 2012 Backlog of unfilled orders $ 6,669$ 7,344 (9% ) 91 % Backlog of unfilled orders shippable within one year 5,438 6,706 (19% ) 75 % Long term backlog reclassified during year as shippable within one year 931 2,162 (57% ) 31 %



The decreases in backlog at the end of fiscal 2014 when compared to fiscal 2013 are primarily due to the Microsource business unit's fulfilling $6.1 million of scheduled shipments over the past year attributable to long term contracts awarded in fiscal 2013. This was partially offset by the Microsource business unit's receipt in fiscal 2014 of $4.0 million follow on orders, and an initial order of design services and a production bid for $733,000 from a second aerospace company for radar filters.

The increase in backlog at year-end 2013 of 91% was primarily due to the Microsource business unit's receipt of long term contracts from a large aerospace company.

The allocation of net sales by reporting segment was as follows for the fiscal years shown:

Allocation of Net Sales % change 2014 2013 vs. vs.



(Dollars in thousands) 2014 2013 2013 2012 Giga-tronics Division $ 7,290$ 9,385 (22% ) (11% ) Microsource

6,019 4,802 25 % 84 % Total $ 13,309$ 14,187 (6% ) 8 %



Net sales in fiscal 2014 were $13.3 million, a 6% decrease from $14.2 million in fiscal 2013. Sales for the Giga-tronics Division decreased 22%, or $2.1 million, primarily due to a decrease in SCPM switch product sales as a result of the sale of this product line during fiscal 2014 (see Note 6, Gain on Sale of Product). Sales for the Microsource business unit increased 25%, or $1.2 million, largely due to the contractual timing of shipments associated with long-term contracts from a large aerospace company.

Net sales in fiscal 2013 were $14.2 million, an 8% increase from $13.1 million in fiscal 2012. The Microsource business unit's sales increased 84%, or $2.2 million, primarily due to increased defense sales caused by the fulfillment of radar filter component orders. Sales at Giga-tronics Division decreased 11%, or $1.1 million, primarily due to lower defense sales caused by the SG VXI product end of life program in fiscal 2012.

The allocation of cost of sales by reporting segment was as follows for the fiscal years shown: Cost of Sales % change 2014 2013 vs. vs. (Dollars in thousands) 2014 2013 2013 2012 Giga-tronics Division $ 5,093$ 5,727 (11 %) (18 %) Microsource 3,718 2,983 25 % 0 % Total $ 8,811$ 8,710 1 % (13 %)



Cost of sales as a percentage of sales increased in fiscal 2014 to 66.2%, compared to 61.4% for fiscal 2013. The increase in fiscal 2014 was primarily due to the change in product mix of Giga-tronics Division, which saw an increase in the sales of lower margin legacy products in fiscal 2014 when compared to fiscal 2013.

In fiscal 2013 cost of sales as a percentage of sales decreased to 61.4%, compared to 76.2% for fiscal 2012. The decrease is primarily due to a $1.5 million excess and obsolete inventory reserve charge in fiscal 2012.

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Operating expenses were as follows for the fiscal years shown:

Operating Expenses % change 2014 2013 vs. vs. (Dollars in thousands) 2014 2013 2013 2012 Engineering $ 3,897$ 4,282 (9 %) 48 % Selling, general and administrative 4,809 4,976 (3 %) (18 %) Restructuring 331 418 (21 %) 1248 % Total $ 9,037$ 9,676 (7 %) 8 %



Operating expenses decreased 7%, or $639,000, in fiscal 2014 compared to fiscal 2013. Engineering expenses decreased $385,000 during fiscal 2014 when compared to fiscal 2013, the decrease is primarily due to some engineers being assigned to a Microsource nonrecurring engineering project that is recorded as cost of sales. Selling, general and administrative expenses decreased $167,000 in fiscal 2014 when compared to fiscal 2013, primarily due to reductions in personnel. Restructuring expenses decreased $87,000 in fiscal 2014 when compared to fiscal 2013, primarily due to the Company's completion of its closure of the Santa Rosa facility in May 2013.

The Company is currently spending approximately $1.0 million to $1.1 million in research and development per quarter. The majority of these expenses are associated with the development of the new product platform that experienced delays and is currently forecasted to begin shipping in the second quarter of fiscal 2015. Expenses associated with the development of the new product platform have significantly contributed to the losses in fiscal 2014 and fiscal 2013.

In order to reduce its manufacturing and facilities costs, Giga-tronics made the decision during the fourth quarter of fiscal 2012 to consolidate its Santa Rosa, CA operations with those of its facility in San Ramon, CA. The Company announced its intentions to employees in February 2012, and entered into employment agreements with all key Santa Rosa employees to retain the talent needed to continue shipments during the transition and to help ensure the new operation in San Ramon would run smoothly.

The major types of costs associated with this move and estimates of their respective totals were as follows:

Type of cost (In thousands) Retention agreements for employees $ 542 Preparation of San Ramon facility 59 Training of San Ramon employees 4 Moving expenses 24 Clean-up of Santa Rosa facility 151 Total $ 780



Of the total estimated expense of $780,000, $331,000 was expensed during fiscal 2014; $418,000 was expensed during fiscal 2013; and $31,000 was expensed during fiscal 2012. The Company vacated its Santa Rosa facility on May 31, 2013 and does not anticipate any additional expenses.

Gain on the Sale of Product Line

On March 18, 2013, the Company entered into an Asset Purchase Agreement with Teradyne, whereby Teradyne agreed to purchase the Giga-tronics Division product line known as SCPM for $1.0 million, resulting in a net gain of $913,000. In April 2013 the Company received $800,000 in proceeds at the closing of the transaction upon delivery of electronic data associated with the purchase. The Company also earned an additional $50,000 associated with training of Teradyne employees, which was offset by $34,000 of associated costs. The balance of the consideration ($150,000) was subject to a hold back arrangement until December 31, 2013 to cover certain contingencies and the requirement to deliver certain inventory. During fiscal 2014, the Company delivered to Teradyne all of the associated inventory, totaling $53,000. On December 6, 2013, the Company received the remaining $150,000 along with confirmation from Teradyne that the holdback provisions were removed. Net sales for the SCPM product line during fiscal 2014 and fiscal 2013 were $265,000 and $1.7 million, respectively.

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Net Interest Expense



Net interest expense in fiscal 2014 was $106,000, an increase of $90,000 over fiscal 2013 and was primarily due to borrowings under the SVB line of credit. In order to support operations during the last seven months of fiscal 2014 the Company borrowed on substantially all eligible receivables under the Line of Credit.

Giga-tronics recorded a pre-tax loss of $3.7 million for fiscal 2014 versus pre-tax loss of $4.2 million for fiscal 2013. The lower pre-tax loss in fiscal 2014 compared to fiscal 2013 was primarily due to lower operating expenses and the gain on the sale of the SCPM product line discussed above, which was partially offset by a decline in gross margin.

Net Inventories



Inventories consisted of the following:

Net Inventories % change 2014 March 29, March 30, vs.

(Dollars in thousands) 2014 2013 2013 Raw materials $ 1,501$ 2,157 (30 %) Work-in-progress 1,400 2,049 (32 %) Finished goods 353 50 606 % Demonstration inventory 67 304 (78 %) Total $ 3,321$ 4,560 (27 %)



Net inventories decreased by $1.2 million from March 30, 2013 to March 29, 2014. The decrease was primarily due to the sale of lower margin legacy products, or demonstration inventory, and a reduction of raw materials on hand supporting the Giga-tronics manufacturing production line.

Financial Condition and Liquidity

As of March 29, 2014, Giga-tronics had $1.1 million in cash and cash-equivalents, compared to $1.9 million as of March 30, 2013.

Working capital at the end of fiscal year 2014 was $1.0 million as compared to $3.2 million at the end of fiscal year 2013.

The current ratio (current assets divided by current liabilities) at March 29, 2014 was 1.17 as compared to 1.60 at March 30, 2013. The decrease in working capital was primarily attributable to the net loss of $3.7 million for fiscal 2014, which was partially offset by $817,000 of cash proceeds from the issuance of preferred stock.

Cash used in operating activities amounted to $2.5 million in fiscal 2014 and $1.6 million in fiscal 2013. Cash used in fiscal year 2014 operating activities was primarily attributed to the net loss of $3.7 million for the year, which was partially offset by a $1.2 million decrease in inventories. Cash used in fiscal year 2013 operating activities was primarily attributed to the net loss of $4.2 million for the year, which was partially offset by a $2.3 million increase in deferred revenue associated with progress billings for completed contract milestones prior to final delivery of the finished product.

Additions to property and equipment were $482,000 in fiscal 2014, of which $254,000 were related to capital lease obligations, compared to $349,000 in fiscal 2013, of which $170,000 were related to capital lease obligations. The increase in property and equipment in fiscal 2014 was primarily attributable to leasehold improvements associated with the move of the Microsource business unit's manufacturing to the San Ramon facility. The increase in property and equipment in fiscal 2013 was primarily attributable to test equipment needed to prepare a manufacturing line for the new Giga-tronics product platform.

Cash provided by financing activities in fiscal year 2014 was $2.1 million, primarily due to $1.0 million in proceeds from a term loan with Partners For Growth IV, L.P. ("PFG"), $817,000 in net proceeds from the issuance of Series D convertible preferred stock, and $308,000 of net proceeds from the Company's line of credit with Silicon Valley Bank ("SVB"). Cash provided by financing activities in fiscal year 2013 of $1.3 million was primarily due to $857,000 in net proceeds from the Company's line of credit with SVB, and $457,000 in net proceeds from the issuance of Series C convertible preferred stock.

On March 13, 2014 the Company entered into a three year, $2.0 million term loan agreement with PFG under which the Company received $1.0 million on March 14, 2014. Pursuant to the agreement, the Company may borrow an additional $1.0 million following the Company's achievement of certain performance milestones which includes achieving $7.5 million in net sales during the first half of fiscal 2015 and two consecutive quarters of net income greater than zero during fiscal 2015. The PFG loan agreement provides for a fixed interest rate of 9.75% and requires monthly interest only payments during the first six months of the agreement followed by monthly principal and interest payments over the remaining thirty months. The Company may prepay the loan at any time prior to maturity by paying all future scheduled principal and interest payments. The PFG Loan is secured by all of the assets of the Company under a lien that is junior to the SVB position described in Note 15, and limits borrowing under the SVB credit line limit to $3.0 million. The loan agreement contains financial covenants associated with the Company achieving minimum quarterly net sales and maintaining a minimum monthly shareholders' equity. In the event of default by the Company, all or any part of the Company's obligation to PFG could become immediately due.

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The loan agreement also provided for the issuance of warrants convertible into 300,000 shares of the Company's common stock, of which 180,000 were exercisable upon receipt of the First Draw and 120,000 would be exercisable if the Second Draw is funded. Each warrant issued under the loan agreement has a term of five years and an exercise price of $1.42 which is equal to the average NASDAQ closing price of the Company's common stock for the ten trading days prior to the First Draw. The number of shares exercisable under the warrant agreements is subject to downward adjustment from 180,000 to 155,000 and from 120,000 to 95,000 if the Company achieves in fiscal 2015 net sales of at least $18.0 million and net income of at least $1.0 million.

In the event of any acquisition or other change in control of the Company, future public issuance of Company securities, liquidation (or substantially similar event) of the Company, or expiration of the warrants, the warrants associated with the First Draw can be exchanged for $150,000 in cash and the warrants associated with the Second Draw can be exchanged for $100,000 in cash. The Company has no plans for public offering, so the cash out date is estimated to be the expiration date unless warrants are exercised before then. Due to the fixed payment amount on the expiration date, the warrant structure in substance is a debt arrangement (Warrant Debt) with a zero interest rate, a fixed maturity date and a feature that makes the debt convertible to common stock. For accounting purposes, the conversion feature is bifurcated and accounted for separately from the host debt instrument as a derivative liability measured at fair value which resulted in an initial carrying value of $128,000.

The proceeds from the First Draw were allocated between the PFG Debt and the Warrant Debt (inclusive of its conversion feature) based on their relative fair values on the date of issuance which resulted in initial carrying values of $822,000 and $178,000, respectively. The conversion feature is bifurcated from the Warrant Debt and recorded at fair value resulting in a remaining carrying value of $50,000 associated with the Warrant Debt. The resulting discounts of $178,000 and $100,000, respectively, will be accreted to interest expense under the effective interest method over the three-year term of the PFG Debt and the five-year term of the Warrant Debt. (See Note 16, Term Loan).

On June 11, 2013 the Company entered into an amendment to the Second Amended Credit Facility (the "New Amended Credit Facility") with SVB. The New Amended Credit Facility amended the Second Amended Credit Facility by expanding the definition of eligible accounts, increasing the maximum limit, and extending the maturity date. The New Amended Credit Facility, which expires on April 15, 2015, is secured by all assets of the Company and provides for a borrowing capacity equal to 80% of eligible accounts receivable (70% of eligible foreign accounts receivable) on an aggregate basis, up to a maximum $3.0 million, provided the Company maintains borrowing base eligibility, that is, a minimum of $750,000 of cash in excess of its line of credit liability.

As of March 29, 2014, the Company's outstanding borrowings under the New Amended Credit Facility were $1.2 million. Management intends to draw upon the New Amended Credit Facility throughout fiscal 2015 to meet projected cash requirements. As of March 29, 2014, the line of credit was at its maximum borrowing capacity. SVB may terminate or suspend advances under the line of credit if SVB determines there has been a material adverse change in the Company's general affairs, financial forecasts or general ability to repay.

The Company has incurred net losses of $3.7 million in fiscal 2014, and $4.2 million in fiscal 2013. These losses have contributed to an accumulated deficit of $18.3 million at March 29, 2014, and have resulted in the Company using cash in its operations of $2.5 million in fiscal 2014.

In fiscal 2014 and 2013 the Company invested heavily in the development of a new Giga-tronics Division product platform. The Company anticipates long-term revenue growth and improved gross margins from the new product platform, but delays in completing it have contributed significantly to the losses of the Company. The new product platform is forecasted to start shipping in the second quarter of fiscal 2015, but further delays could cause additional losses.

To help fund operations, the Company relies on advances under the line of credit with Silicon Valley Bank. However the Bank may terminate or suspend advances under the line of credit if the Bank determines there has been a material adverse change in the Company's general affairs, financial forecasts or general ability to repay. (see Note 15, Line of Credit). As of March 29, 2014, the line of credit was at its maximum borrowing capacity.

These matters, along with recurring losses in prior years, raise substantial doubt as to the ability of the Company to continue as a going concern.

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To address this matter, the Company's management has taken several actions to provide additional liquidity during fiscal 2014, and reduce costs and expenses going forward. These actions are described in the following paragraph.

? On March 13, 2014 the Company entered into a three year, $2.0 million term loan agreement with PFG under which the Company received $1.0 million on March 14, 2014. Pursuant to the agreement, the Company may borrow an additional $1.0 million following the Company's achievement of certain performance milestones which includes achieving $7.5 million in net sales during the first half of fiscal 2015 and two consecutive quarters of net income greater than zero during fiscal 2015. The PFG loan agreement provides for a fixed interest rate of 9.75% and requires monthly interest only payments during the first six months of the agreement followed by monthly principal and interest payments over the remaining thirty months. The Company may prepay the loan at any time prior to maturity by paying all future scheduled principal and interest payments. The PFG Loan is secured by all of the assets of the Company under a lien that is junior to the SVB position described in Note 15, and limits borrowing under the SVB credit line limit to $3.0 million. The loan agreement contains financial covenants associated with the Company achieving minimum quarterly net sales and maintaining a minimum monthly shareholders' equity. In the event of default by the Company, all or any part of the Company's obligation to PFG could become immediately due. (see Note 16, Term Loan). On June 16, 2014 the Company amended the term loan agreement with PFG creating a $500,000 revolving line of credit that the Company drew $500,000. (see note 20, Subsequent Events). ? On July 8, 2013 the Company received $817,000 in net cash proceeds from Alara Capital AVI II, LLC, a Delaware limited liability company (the "Investor"). Under a Securities Purchase Agreement ("SPA"), the Company sold to the Investor 5,111.86 shares of a new Series D Convertible Voting Perpetual Preferred Stock and warrants to purchase up to 511,186 additional shares of common stock at the price of $1.43 per share. (see Note 19, Series D Convertible Voting Perpetual Preferred Stock and Warrants). ? To assist with the upfront purchases of inventory required for future product deliveries, the Company entered into an advance payment arrangements with a large customer, whereby the customer reimburses the Company for raw material purchases prior to the shipment of the finished products. In fiscal 2014 the Company entered into advance payment arrangements totaling $1.3 million, and will seek similar terms in future agreements with this customer, and other customers. ? A second large aerospace company has engaged Microsource for design services and a production bid associated with a similar radar filter program. On August 13, 2013 Microsource received an initial order for $733,000, on May 6, 2014 a follow on order of $659,000 was received, and then on May 20, 2014 the complete order for an additional $5.5 million was received. The total orders for the design and production bid for the associated program is $6.9 million. The Company anticipates the associated multi-year production agreement to be for approximately $10.0 million and for it to finalize in calendar 2014. No assurances can be given that the parties will agree on the final multi-year production agreement, or what the actual terms will be. (see Note 20, Subsequent Events)



Management also plans to further improve asset management by continuing to reduce product inventories that are on hand at March 29, 2014. In addition, management will continue to review all aspects of the business in an effort to improve cash flow and reduce costs and expenses, while continuing to invest, to the extent possible, in new product development for future revenue streams.

Management will also continue to seek additional working capital through debt, equity financing or possible product line sales, but there are no assurances that such financings or sales will be available at all, or on terms acceptable to the Company.

The current year losses and the impacts of recurring losses in prior years have had a significant negative impact on the financial condition of the Company and raise substantial doubt about the Company's ability to continue as a going concern. Management believes that through the actions to date and possible future actions described above, the Company should have the necessary liquidity to continue its operations at least for the next twelve months, though no assurances can be made in this regard based on uncertainties with respect to the continued development, manufacturing and marketing efforts of the Company's new product platform and the material adverse change clause in the Company's line of credit agreement discussed above. The Consolidated Financial Statements have been prepared assuming the Company will continue as a going concern and do not include any adjustments that might result if the Company were unable to do so.

Contractual Obligations



The Company leases its facility under an operating lease that expires in December 2016 and leases certain equipment under operating leases. Total future minimum lease payments under these leases amount to approximately $2.0 million.

The Company leases equipment under capital leases that expire through September 2018. The future minimum lease payments under these leases are approximately $245,000.

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The Company is committed to pay the PFG loan with a maturity date of March 2017. Future payments under this loan consist of $1.0 million in principal and $175,000 in interest.

The Company is committed to purchase certain inventory under non-cancelable purchase orders. As of March 29, 2014, total non-cancelable purchase orders were approximately $2.1 million through fiscal 2015 and are scheduled to be delivered to the Company at various dates through March 2015.

Critical Accounting Policies



The Company's discussion and analysis of its financial condition and the results of operations are based upon the consolidated financial statements included in this report and the data used to prepare them. The consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America and management is required to make judgments, estimates and assumptions in the course of such preparation. The Summary of Significant Accounting Policies included with the consolidated financial statements describes the significant accounting policies and methods used in the preparation of the consolidated financial statements. On an ongoing basis, the Company re-evaluates its judgments, estimates and assumptions, including those related to revenue recognition, product warranties, accounts receivable and allowance for doubtful accounts, valuation of inventories, income taxes and valuation allowance on deferred tax assets, and share based compensation. The Company bases its judgment and estimates on historical experience, knowledge of current conditions, and its beliefs of what could occur in the future considering available information. Actual results may differ from these estimates under different assumptions or conditions. Management of Giga-tronics has identified the following as the Company's critical accounting policies:

Revenue Recognition



Revenues are recognized when there is evidence of an arrangement, delivery has occurred, the price is fixed or determinable, and collectability is reasonably assured. This generally occurs when products are shipped and the risk of loss has passed. Revenue related to products shipped subject to customers' evaluation is recognized upon final acceptance. Revenue recognized under the milestone method is recognized once milestones are met. Determining whether a milestone is substantive is a matter of judgment and that assessment is performed only at the inception of the arrangement. The consideration earned from the achievement of a milestone must meet all of the following for the milestone to be considered substantive:

a. It is commensurate with either of the following:

1. The Company's performance to achieve the milestone

2. The enhancement of the value of the delivered item or items as a result of a specific outcome resulting from the Company's performance to achieve the milestone.

b. It relates solely to past performance.

c. It is reasonable relative to all of the deliverables and payment terms (including other potential milestone consideration) within the arrangement.

Milestones for revenue recognition are agreed upon with the customer prior to the start of the contract and some milestones will be tied to product shipping while others will be tied to design review.

On certain contracts with one of the Company's significant customers the Company receives payments in advance of manufacturing. Advanced payments are recorded as deferred revenue until the revenue recognition criteria described above has been met.

Product Warranties



The Company's warranty policy generally provides one to three years of coverage depending on the product. The Company records a liability for estimated warranty obligations at the date products are sold. The estimated cost of warranty coverage is based on the Company's actual historical experience with its current products or similar products. For new products, the required reserve is based on historical experience of similar products until sufficient historical data has been collected on the new product. Adjustments are made as new information becomes available.

Accounts Receivable and Allowance for Doubtful Accounts

Accounts receivable are stated at their net realizable values. The Company has estimated an allowance for uncollectible accounts based on analysis of specifically identified problem accounts, outstanding receivables, consideration of the age of those receivables, the Company's historical collection experience, and adjustments for other factors management believes are necessary based on perceived credit risk.

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Inventory



Inventories are stated at the lower of cost or market. Cost is determined on a first-in, first-out basis. The Company periodically reviews inventory on hand to identify and write down excess and obsolete inventory based on estimated product demand.

Income Taxes



Income taxes are accounted for using the asset and liability method. Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases and operating loss and tax credit carryforwards. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date. Future tax benefits are subject to a valuation allowance when management is unable to conclude that its deferred tax assets will more likely than not be realized. The ultimate realization of deferred tax assets is dependent upon generation of future taxable income during the periods in which those temporary differences become deductible. Management considers both positive and negative evidence and tax planning strategies in making this assessment.

The Company considers all tax positions recognized in the consolidated financial statements for the likelihood of realization. When tax returns are filed, it is highly certain that some positions taken would be sustained upon examination by the taxing authorities, while others are subject to uncertainty about the merits of the positions taken or the amounts of the positions that would be ultimately sustained. The benefit of a tax position is recognized in the financial statements in the period during which, based on all available evidence, management believes it is more likely than not that the position will be sustained upon examination, including the resolution of appeals or litigation processes, if any. Tax positions that meet the more-likely-than-not recognition threshold are measured as the largest amount of tax benefit that is more than 50 percent likely of being realized upon settlement with the applicable taxing authority. The portion of the benefits associated with tax positions taken that exceeds the amount measured as described above, if any, would be reflected as unrecognized tax benefits, as applicable, in the accompanying consolidated balance sheets along with any associated interest and penalties that would be payable to the taxing authorities upon examination. The Company recognizes accrued interest and penalties, if any, related to unrecognized tax benefits as a component of the provision for income taxes in the consolidated statements of operations.

Share Based Compensation



The Company has a stock incentive plan that provides for the issuance of stock options and restricted stock to employees and directors. The Company calculates share based compensation expense for stock options using a Black-Scholes-Merton option pricing model and records the fair value of stock option and restricted stock awards expected to vest over the requisite service period. In so doing, the Company makes certain key assumptions in making estimates used in the model. The Company believes the estimates used, which are presented in Note 1 of Notes to Consolidated Financial Statements, are appropriate and reasonable.

Off-Balance-Sheet Arrangements

The Company has no other off-balance-sheet arrangements (including standby letters of credit, guaranties, contingent interests in transferred assets, contingent obligations indexed to its own stock or any obligation arising out of a variable interest in an unconsolidated entity that provides credit or other support to the Company), that have or are likely to have a material effect on its financial conditions, changes in financial conditions, revenue, expense, results of operations, liquidity, capital expenditures or capital resources.


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