Summary of HI SHEAR TECHNOLOGY CORP

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 February 28, 2009 compared with Three Months Ended February 29, 2008

Revenues recognized during the quarter ended February 28, 2009 were $5,587,000, which is a decrease of $712,000 or 11% from the revenue recognized during the same quarter last year. Revenues, which are calculated by the Company on a percentage-of-completion basis, were less than last year's third quarter because less direct efforts were expended including overtime and materials. Some customer delays in releasing their requirements to the Company drove the revenue decrease for the quarter and these delays are believed to be related to the current banking crisis. Hi-Shear's components are necessary for the successful completion of satellite launches and therefore, the Company expects these delays to be temporary. Additional labor, expended in previous quarters to meet contractual deliveries was not necessary in the current quarter and contributed to the decrease.

Cost of revenues for the quarter ended February 28, 2009 was $2,819,000, or 50% of revenues, compared to $3,675,000, or 58% of revenues, for the same quarter last year. The decrease in cost of revenues by $856,000 corresponds to the increase in manufacturing efficiencies and a decrease in overhead costs for the fiscal year resulting from cost cutting measures.

Gross margin for the quarter ended February 28, 2009 increased $144,000 to $2,768,000, and 50% of revenues, from $2,624,000, and 42% of revenues, reported for the same quarter last year. Gross margin increased due to manufacturing efficiencies, reductions in overtime and reductions in overhead expenses during the quarter.

Selling, general and administrative expenses decreased by $358,000 from $1,548,000 during the quarter ended February 29, 2008 to $1,190,000 during the quarter ended February 28, 2009. The decrease in selling, general and administrative expenses in the current quarter was due to lower litigation expense incurred.

Interest expense increased by $73,000 from $4,000 during the quarter ended February 29, 2008 to $77,000 for the quarter ended February 28, 2009. The increase in interest expense was attributed to the interest accrual for the Alliance litigation discussed in Note 8. Interest income decreased by $22,000 from $23,000 during the quarter ended February 29, 2008 to $1,000 for the quarter ended February 28, 2009. The interest income decreased due to changes in bank interest rates associated with insured bank deposit balances. The net change in interest income (expense) for the three months ended February 29, 2008 to February 28, 2009 was $95,000.

The Company realized pre-tax income of $1,502,000, or 27% of revenues, for the quarter ended February 28, 2009, compared to pre-tax income of $1,095,000, or 17% of revenues, for the same quarter last year. The $407,000 and 37% increase is the result of increases in gross margin and decreases in selling, general and administrative expenses described above.

Income tax expense for the quarter ended February 28, 2009 was $592,000 and 39% of pre-tax income, compared to $326,000 and 30% of pre-tax income for the quarter ended February 29, 2008. The $266,000 increase in income tax expense corresponds to the increase in pre-tax income, upon which reported income tax expense is principally based. The increase in the percentage of pre-tax income from 30% for the three months ended February 29, 2008 to 39% for the three months ended February 28, 2009 was due to an additional tax refund of $58,000 in the three months ended February 29, 2008 with no corresponding refund associated with the period ended February 28, 2009.

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 February 28, 2009. 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 February 28, 2009 was $910,000, or $0.13 per share, compared to net income of $769,000, or $0.11 per share, for the quarter ended February 29, 2008.

Nine Months Ended February 28, 2009 compared with Nine Months Ended February 29, 2008

Revenues recognized during the nine months ended February 28, 2009 were $18,699,000, which is an increase of $173,000 or 1% from the revenue recognized during the same nine month period last year. Revenues, which are calculated by the Company on a percentage-of-completion basis, increased slightly as efforts were expended on a wide range of customer backlog.

Cost of revenues for the nine months ended February 28, 2009 was $8,852,000 , or 47% of revenues, compared to $10,045,000 , or 54% of revenues, for the same nine months last year. The decrease in cost of revenues by $1,193,000 corresponds to an increase in manufacturing efficiencies, reductions in overtime and a decrease in overhead expenses resulting from cost cutting measures.

Gross margin for the nine months ended February 28, 2009 increased $1,366,000 to $9,847,000 , and 53% of revenues, from $8,481,000 , and 46% of revenues, reported for the same nine month period last year. Gross margin increased due to the efficiencies of manufacturing activities and lower costs during the quarter.

Selling, general and administrative expenses decreased by $161,000 from $3,395,000 during the nine months ended February 29, 2008 to $3,234,000 during the nine months ended February 28, 2009. Selling, general and administrative expenses decreased compared to last years activity consistent with cost reduction measures for fixed administrative costs.

Interest expense increased by $140,000 from $16,000 during the nine months ended February 29, 2008 to $156,000 for the nine months ended February 28, 2009. The increase in interest expense was attributed to the interest accrual for the Alliance litigation discussed in Note 8. Interest income decreased by $29,000 from $55,000 for the nine months ended February 29, 2008 to $26,000 for the nine months ended February 28, 2009. The interest income decreased due to changes in bank interest rates associated with insured bank deposit balances. The net change in interest income (expense) for the nine months ended February 29, 2008 to February 28, 2009 was $169,000.

The Company realized pre-tax income of $6,483,000, or 35% of revenues, for the nine months ended February 28, 2009, compared to pre-tax income of $5,125,000, or 28% of revenues, for the same nine months last year. The $1,358,000 and 26% increase is the result of decreases in cost of revenues and selling, general and administrative expenses described above.

Income tax expense for the nine months ended February 28, 2009 was $2,567,000 and 40% of pre-tax income, compared to $1,900,000 and 37% of pre-tax income for the nine months ended February 29, 2008. The $667,000 increase in income tax expense corresponds to the increase in pre-tax income, upon which reported income tax expense is principally based. The income tax provision for the nine months ended February 28, 2009 did not include the impact of an additional tax refund similar to the refund included in the income tax provision for the nine months ended February 29, 2008. This additional refund attributed to a lower effective tax rate for that period.

Net income for the nine months ended February 28, 2009 was $3,916,000, or $0.57 per share, compared to net income of $3,225,000, or $0.47 per share, for the nine months ended February 29, 2008. The net income growth of $0.10 per share was the result of gross margin improvement and lower general and administrative expense during the nine-month period.

Financial Condition

Accounts receivable balances, which consist of billed and unbilled amounts, were $11,668,000 and $14,474,000 at February 28, 2009 and May 31, 2008, respectively. The billed component of the total accounts receivable balance at February 28, 2009 was $4,662,000 compared to $8,111,000 at May 31, 2008. The total accounts receivable balances at both February 28, 2009 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 accounts receivable balances at both February 28, 2009 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 $3,449,000 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 February 28, 2009 were $7,006,000 compared to $6,363,000 at May 31, 2008. Unbilled accounts receivable increased $643,000; the increase is due to work completed on programs whose billing events have not yet been achieved.

The total accounts receivable balance is 59% of current assets and 52% 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 $2,446,000 at February 28, 2009. The $1,101,000 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 February 28, 2009 from the balance at May 31, 2008.

Trade accounts payable increased from $740,000 at May 31, 2008 to $875,000 at February 28, 2009. There are no disputed amounts included in accounts payable at February 28, 2009.

Accrued liabilities decreased by $176,000 due to changes in accrued vacation, accrued commissions, accrued income taxes and accrued Alliance litigation. Accrued vacation decreased resulting from pay-downs in vacation balances that have occurred since May 31, 2008. Accrued commissions decreased with the completion of international contracts; as some international contracts are completed, billed and collected, commissions owed to representatives are paid. Accrued income taxes decreased because cumulative estimated tax payments for fiscal year 2009 resulted in a pre-paid (asset) tax payment position. These decreases were partially offset by an increase in accrued interest expense associated with the Alliance litigation costs as discussed in Note 8.

At both February 28, 2009 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 provided by operating activities during the nine months ended February 28, 2009 was $4,741,000, compared to net cash of $3,587,000 provided by operating activities during the same nine month period last year. The $1,154,000 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 nine month period ended February 28, 2009 compared to the same nine month period last year. "Cash and cash equivalents" at February 29, 2008 were $2,644,000.

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 February 28, 2009.

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 nine months ended February 28, 2009 was reduced by $177,000 compared to $32,000 for the nine months ended February 29, 2008. The implementation of SFAS No. 123R did not have any impact on cash flows from financing activities during the first nine months of fiscal 2009 and 2008.

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 issued during the quarter ended February 28, 2009; there were 8,860 grants issued during the quarter ended February 28, 2009.