ITEM 2 - MANAGEMENT DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

GENERAL

Hi-Shear Technology Corporation designs and manufactures high reliability pyrotechnic, mechanical and electronic products for the aerospace industry, national defense and other applications where pyrotechnic power is desirable. Its products are primarily used in space satellites and satellite launch vehicles, exploration missions, strategic missiles, tactical weapons, advanced fighter aircraft and military systems. Customers such as the military, satellite manufacturers, launch vehicle assemblers, U.S. Government departments and agencies (including NASA), foreign space agencies, and others in the aerospace business widely use the Company's aerospace products.

The following discussion of Hi-Shear's financial condition and results of operations should be read in conjunction with the financial statements and notes thereto included elsewhere in this report. This report, including this discussion, may contain forward-looking statements about the Company's business that involve risks and uncertainties. The Company's actual results may differ materially from those anticipated in these forward-looking statements. The statements are based on certain factors including the acceptance and pricing of the Company's new products, the development and nature of its relationships with key strategic partners, the allocation of the federal budget for government sponsored military and aerospace programs and the economy in general.

THREE MONTHS ENDED AUGUST 31, 2008 COMPARED WITH THREE MONTHS ENDED AUGUST 31, 2007

Revenues recognized during the first quarter ended August 31, 2008 were $6,044,000, which is an increase of $385,000 or 7% from the revenue recognized during the same quarter last year. Revenues, which are calculated by the Company on a percentage-of-completion basis, increased as efforts were expended on a wide range of customer backlog. Increased activity on military aircraft products accounted for the increased revenues in the quarter.

Cost of revenues for the quarter ended August 31, 2008 was $3,073,000, or 51% of revenues, compared to $2,837,000, or 50% of revenues, for the same quarter last year. The increase in cost of revenues by $236,000 corresponds to the increase in revenues between the same two quarters, as noted above. The percentage cost of revenue also increased. This slight increase is attributable to the variability in the mix of contracts serviced during the quarter.

Gross margin for the quarter ended August 31, 2008 increased $149,000 to $2,971,000, and 49% of revenues, from $2,822,000, and 50% of revenues, reported for the same quarter last year. Gross margin increased due to the increased volume of manufacturing activity during the quarter. Gross margin as a percentage of revenue was slightly less because of an increase in lower margin military aircraft components being processed during the quarter.

Selling, general and administrative expenses increased by $61,000 from $958,000 during the quarter ended August 31, 2007 to $1,019,000 during the quarter ended August 31, 2008. While selling, general and administrative expenses increased by dollars, it remained the same as a percentage of gross margin consistent with cost cutting measures for fixed administrative costs.

The Company realized pre-tax income of $1,963,000, or 32% of revenues, for the quarter ended August 31, 2008, compared to pre-tax income of $1,876,000, or 33% of revenues, for the same quarter last year. The $87,000 and 1% decrease is the result of increases in revenue and increases in cost of revenues described above.

Income tax expense for the first quarter ended August 31, 2008 was $797,000 and 41% of pre- tax income, compared to $746,000 and 40% of pre-tax income for the first quarter ended August 31, 2007. The $51,000 increase in income tax expense wholly corresponds to the increase in pre-tax income, upon which reported income tax expense is principally based.

In June 2006, the FASB issued Interpretation No. 48, "Accounting for Uncertainty in Income Taxes, an interpretation of FAS 109, Accounting for Income Taxes" ("FIN 48"), to create a single model to address accounting for uncertainty in tax positions. FIN 48 clarifies the accounting for income taxes by prescribing a minimum recognition threshold a tax position is required to meet before being recognized in the financial statements. FIN 48 also provides guidance on deregulation, measurement, classification, interest and penalties, accounting in interim periods, disclosure and transition. FIN 48 is effective for fiscal years beginning after December 15, 2006. The Company adopted the provisions of FIN 48 on June 1, 2007. The application of FIN 48 did not have a significant effect on the Company's financial position and results of operations for the quarter ended August 31, 2008. The Company's management has considered the various tax positions subject to potential examination in accordance with FIN 48, and as a result, the Company's management does not anticipate any material adjustments that may arise as the result of such examination. Accordingly, no adjustments have been made to the accompanying financial statements. The Company is currently under audit by the Internal Revenue Service for its 2006 tax return. The Company has reviewed the possible outcomes of this audit and does not believe a material adjustment will result.

Net income for the quarter ended August 31, 2008 was $1,166,000, or $0.17 per share, compared to net income of $1,130,000, or $0.17 per share, for the quarter ended August 31, 2007.

In recognition of the Company's strong operational results, a dividend in the amount of $0.50 per share was declared payable to shareholders of record as of the close of business October 24, 2008.

FINANCIAL CONDITION

Accounts receivable balances, which consist of billed and unbilled amounts, plus claims receivable, were $9,769,000 and $14,474,000 at August 31, 2008 and May 31, 2008, respectively. The billed component of the total accounts receivable balance at August 31, 2008 was $3,099,000 compared to $8,111,000 at May 31, 2008. The total accounts receivable balances at both August 31, 2008 and May 31, 2008 include $58,000 for the amount of a jury verdict in the Company's lawsuit against the United Space Alliance ("Alliance"). The Company has filed a Notice of Appeal of that jury verdict (See Note 8). The accounts receivable balances at both August 31, 2008 and May 31, 2008 were not reduced for reserves on doubtful accounts due to the Company's past experience on collecting monies due. Billed accounts receivable decreased $5,012,000 from the balance as of May 31, 2008 due to prompt cash collection.

Unbilled receivables represent revenues recognized from long term fixed priced contracts based upon percentage-of-completion, but in advance of completing billable events for which invoices are submitted to customers. As billing events occur for such contracts, previously unbilled receivables are converted to billed accounts receivable with the preparation and submission of invoices to customers. Unbilled receivables at August 31, 2008 were $6,670,000 compared to $6,363,000 at May 31, 2008. Unbilled accounts receivable increased $307,000; the increase is due to work completed on programs whose billing events have not yet been achieved.

The total accounts receivable balance is 46% of current assets and 41% of total assets. Other than the lawsuit regarding unpaid balances with United Space Alliance, the Company has yet to experience significant collection issues with its other customers nor has it reason to anticipate any collection issues; as a result, there are no reserves for uncollectible amounts against the total receivable balance.

Inventories, net of reserves, increased from $1,345,000 at May 31, 2008 to $2,094,000 at August 31, 2008. The $749,000 increase in net inventory balance was primarily the result of the cumulative cost of acquiring long lead time materials for contracts and performing efforts on building units in anticipation of allocation to current and future contracts. Inventory reserves in the amount of $526,000, which are established in accordance with management's estimates regarding the extent to which inventory items will ultimately be used to generate future revenues, remained unchanged at August 31, 2008 from the balance at May 31, 2008.

Trade accounts payable decreased from $740,000 at May 31, 2008 to $678,000 at August 31, 2008. There are no disputed amounts included in accounts payable at August 31, 2008.

Accrued liabilities increased by $310,000 due mostly to the increase in accrued income taxes. The accrued income taxes balance at August 31, 2008 includes the estimate of the first quarter taxes due; the balance at May 31, 2008 included only the estimated remaining payment of taxes due for fiscal year 2008.

At both August 31, 2008 and May 31, 2008 the Company did not have any bank debt on its revolving line of credit or equipment loan.

The Company has considered the implications and risks associated with the current banking financial environment and have taken steps to ensure its cash balances are protected from loss.

LIQUIDITY AND CAPITAL RESOURCES

Net cash generated by operating activities during the quarter ended August 31, 2008 was $5,292,000, compared to net cash of $1,009,000 that was provided by operating activities during the same quarter last year. The $4,283,000 increase in net operating cash flows between the two quarters is primarily the result of an increase in billings and collections from billed accounts receivable during the quarter ended August 31, 2008 compared to the same quarter last year.

To supplement cash provided by operating activities, the Company maintains a business loan agreement including a revolving line of credit with a commercial bank, for the purpose of having sufficient cash to meet its cash obligations. The Company's management believes that the current line of credit is sufficient to enable the Company to meet its projected needs for cash throughout the period of time during which the revolving line of credit is available for its use. Furthermore, Hi-Shear's management is confident that the availability of sufficient cash under a revolving line of credit will continue well beyond the maturity date of the current line of credit.

The business loan agreement contains various financial covenants that have not been modified during the current fiscal year. The Company is in compliance with all covenants as of August 31, 2008.

In its attempt to minimize interest expense associated with any outstanding balance that may exist under the revolving line of credit, the Company has arranged with its bank to maintain "zero balances" in its disbursement and depository accounts for the purpose of "sweeping" excess deposited cash to pay down any revolving line of credit balance. Consequently, the reported "cash and cash equivalents" amounts reflected on the Company's balance sheet occasionally are minimal. However, the need to "sweep" excess cash at August 31, 2008 did not exist, and therefore reported "cash and cash equivalents" at that date was $6,858,000.

Effective June 1, 2006, the Company adopted Financial Accounting Standards Board ("FASB") Statement of Financial Accounting Standards ("SFAS") No. 123 (revised 2004), Share Based Payment ("SFAS 123R"). SFAS 123R supersedes Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees ("APB 25") and related interpretations and amends SFAS No. 95, Statement of Cash Flows. SFAS 123R requires all share based payments to employees, including grants of employee stock options, restricted stock units and employee stock purchase rights, to be recognized in the financial statements based on their respective grant date fair values and does not allow the previously permitted pro forma disclosure-only method as an alternative to financial statement recognition.

The estimated value of the Company's stock based awards, less expected forfeitures, is amortized over the awards' respective vesting period on a straight-line basis. In accordance with SFAS No. 123R, net income for the three months ended August 31, 2008 was reduced by $52,000. The implementation of SFAS No. 123R did not have any impact on cash flows from financing activities during the first quarter of fiscal 2009.

The Company had a non-statutory stock option plan, which was in effect from December 23, 1993 through its termination date of December 23, 2003. Under the plan, options to purchase common stock, with a maximum term of ten years, were granted and vested as determined by the Company' Stock Option Committee. Options for up to 500,000 shares could be granted to employees or directors. Termination of the stock option plan did not nullify stock options previously granted, but not exercised. Those options continue to be exercisable through their expiration dates, which occur ten years after their grant dates.

On July 31, 2006 the Company's Board of Directors approved the 2006 Stock Award Plan, which was subsequently accepted by the Company's shareholders for adoption at the October 16, 2006 annual shareholders' meeting. Under the plan, options to purchase common stock, with a maximum term of 10 years, were granted and vested as determined by the Company's Stock Option Committee. Options for up to 500,000 shares could be granted to employees or directors. There were no options granted during the quarter ended August 31, 2008.