Summary of ADVANCED PHOTONIX INC

Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations

Forward-Looking Statements
Certain statements contained in this Management's Discussion and Analysis (MD&A), including, without limitation, statements containing the words "may," "will," "can," "anticipate," "believe," "plan," "estimate," "continue," and similar expressions constitute "forward-looking statements." These forward-looking statements reflect our current views with respect to future events and are based on assumptions and subject to risks and uncertainties. You should not place undue reliance on these forward-looking statements. Our actual results could differ materially from those anticipated in these forward-looking statements for many reasons, including risks described in the Risk Factors sections and elsewhere in this filing. Except for our ongoing obligation to disclose material information as required by federal securities laws, we do not intend to update you concerning any future revisions to any forward-looking statements to reflect events or circumstances occurring after the date of this report. The following discussion should be read in conjunction with the Risk Factors as well as our financial statements and the related notes.

Critical Accounting Policies and Estimates The discussion and analysis of Company's financial condition and results of operations is based on its condensed consolidated financial statements, which have been prepared in conformity with accounting principles generally accepted in the United States of America. The preparation of these condensed consolidated financial statements requires us to make judgments and estimates that affect the reported amounts of assets and liabilities, disclosure of contingent assets and liabilities at the date of the financial statement and the reported amount of revenues and expenses during the reporting period. The Company bases its estimates on historical experience and on various other assumptions that it believes are reasonable under the circumstances. Actual results may differ from such estimates under different assumptions or conditions.

Application of Critical Accounting Policies Application of the Company's accounting policies requires management to make certain judgments and estimates about the amounts reflected in the financial statements. Management uses historical experience and all available information to make these estimates and judgments, although differing amounts could be reported if there are changes in the assumptions and estimates. Estimates are used for, but not limited to, the accounting for the allowance for doubtful accounts, inventory allowances, valuation of intangible assets and goodwill, depreciation and amortization, warranty costs, taxes and contingencies. Management has identified the following accounting policies as critical to an understanding of its financial statements and/or as areas most dependent on management's judgment and estimates.

Global Economic Conditions
The credit markets and the financial services industry continue to experience a period of significant disruption characterized by the bankruptcy, failure, collapse or sale of various financial institutions, increased volatility in securities prices, severely diminished liquidity and credit availability and a significant level of intervention from the United States and other governments. Continued concerns about the systemic impact of potential long-term or widespread recession, energy costs, geopolitical issues, the availability and cost of credit, the global commercial and residential real estate markets and related mortgage markets and reduced consumer confidence have contributed to increased market volatility and diminished expectations for most developed and emerging economies continuing into 2010. As a result of these market conditions, the cost and availability of credit has been and may continue to be adversely affected by illiquid credit markets and wider credit spreads. Continued turbulence in the United States and international markets and economies could restrict our ability to refinance our existing indebtedness, increase our costs of borrowing, limit our access to capital necessary to meet our liquidity needs and materially harm our operations or our ability to implement our business strategy.

Revenue Recognition
Revenue is derived principally from the sales of the Company's products. The Company recognizes revenue when the basic criteria of Staff Accounting Bulletin No. 104 are met. Specifically, the Company recognizes revenue when persuasive evidence of an arrangement exists, usually in the form of a purchase order, when shipment has occurred since its terms are FOB source, or when services have been rendered, title and risk of loss have passed to the customer, the price is fixed or determinable and collection is reasonably assured in terms of both credit worthiness of the customer and there are no post shipment obligations or uncertainties with respect to customer acceptance.

The Company sells certain of its products to customers with a product warranty that provides warranty repairs at no cost. The length of the warranty term is one year from date of shipment. The Company accrues the estimated exposure to warranty claims based upon historical claim costs. The Company's management reviews these estimates on a regular basis and adjusts the warranty provisions as actual experience differs from historical estimates or as other information becomes available.

The Company does not provide price protection or general right of return. The Company's return policy only permits product returns for warranty and non-warranty repair or replacement and requires pre-authorization by the Company prior to the return. Credit or discounts, which have been historically insignificant, may be given at the discretion of the Company and are recorded when and if determined.

The Company predominantly sells directly to original equipment manufacturers with a direct sales force. The Company sells in limited circumstances through distributors. Sales through distributors represent approximately 5% of total revenue. Significant terms and conditions of distributor agreements include FOB source, net 30 days payment terms, with no return or exchange rights, and no price protection. Since the product transfers title to the distributor at the time of shipment by the Company, the products are not considered inventory on consignment.

Revenue is also derived from technology research and development contracts. We recognize revenue from these contracts as services and/or materials are provided.

Impairment of Long-Lived Assets
As of June 26, 2009 and March 31, 2009, our consolidated balance sheet included $4.6 million in goodwill. Goodwill represents the excess purchase price over amounts assigned to tangible or identifiable intangible assets acquired and liabilities assumed from our business acquisitions.

In accordance with SFAS No. 142, "Goodwill and Other Intangible Assets", goodwill and intangible assets that are not subject to amortization shall be tested for impairment annually, or more frequently if events or changes in circumstances indicate that the asset might be impaired. The impairment test shall consist of a comparison of the fair value of the asset with its carrying amount, as defined. SFAS 142 requires a two-step method for determining goodwill impairment. Step one is to compare the fair value of the reporting unit with the unit's carrying amount, including goodwill. If this test indicates that the fair value is less than the carrying value, then step two is required to compare the implied fair value of the reporting unit's goodwill with the carrying amount of the reporting unit's goodwill. If the carrying amount of the asset exceeds its fair value, an impairment loss shall be recognized in an amount equal to that excess.

We determine the fair value of our single reporting unit to be equal to our market capitalization plus a control premium. Market capitalization is determined by multiplying the shares outstanding on the assessment date by the average market price of our common stock over a 10-day period before and a 10-day period after each assessment date. We use this 20-day duration to consider inherent market fluctuations that may affect any individual closing price. We believe that our market capitalization alone does not fully capture the fair value of our business as a whole, or the substantial value that an acquirer would obtain from its ability to obtain control of our business. As such, in determining fair value, we add a control premium - which seeks to give effect to the increased consideration a potential acquirer would be required to pay in order to gain sufficient ownership to set policies, direct operations and make decisions related to our company - to our market capitalization.

The Company's evaluation as of March 31, 2009 indicated there were no impairments. As of March 31, 2009, our market capitalization calculated as described as above, had fallen to $17.1 million and our carrying value, including goodwill, had decreased to $17.9 million. We applied a 25% control premium to market capitalization to determine a fair value of $21.4 million. We believe that including a control premium at this level is supported by recent transaction data in our industry. Absent the inclusion of a control premium greater than 4% for FY 2009, our carrying value would have exceeded fair value, requiring a step two analysis which may have resulted in an impairment of goodwill.

We determined in the first quarter 2010 that there were no events or changes in circumstances since the end of fiscal year 2009 requiring an impairment test. Our stock price has fluctuated from a high of $0.73 to a low of $0.59 during the first quarter of FY 2010. The current macroeconomic environment continues to be challenging and we cannot be certain of the duration of these conditions and their potential impact on our stock price performance. If our recent stock price decline persists and our market capitalization remains below our carrying value for a sustained period, it is reasonably likely that a goodwill impairment assessment prior to the next annual review in the fourth quarter of fiscal 2010 would be necessary and an impairment of goodwill may be recorded.

In accordance with SFAS No. 144, "Accounting for the Impairment or Disposal of Long-lived Assets", the carrying value of long-lived assets, including amortizable intangibles and property and equipment, are evaluated whenever events or changes in circumstances indicate that a potential impairment has occurred relative to a given asset or assets. Impairment is deemed to have occurred if projected undiscounted cash flows associated with an asset are less than the carrying value of the asset. The estimated cash flows include management's assumptions of cash inflows and outflows directly resulting from the use of that asset in operations. The amount of the impairment loss recognized is equal to the excess of the carrying value of the asset over its then estimated fair value. The Company's evaluation for the fiscal year ended March 31, 2009, indicated there were no impairments.

Deferred Tax Asset Valuation Allowance
The Company records deferred income taxes for the future tax consequences of events that were recognized in the Company's financial statements or tax returns. The Company records a valuation allowance against deferred tax assets in accordance with SFAS 109, "Accounting for Income Taxes," when, in management's judgment, it is more likely than not that the deferred income tax assets will not be realized in the foreseeable future. Consistent with the March 31, 2009 10K, the Company has a full valuation allowance on its net Deferred Tax Assets as of June 26, 2009.

Inventories
The Company's inventories are stated at the lower of standard cost (which approximates actual cost under the first-in, first-out method) or market. Slow moving and obsolete inventories are reviewed throughout the year. To calculate a reserve for obsolescence, we begin with a review of our slow moving inventory. Any inventory, which has been slow moving within the past 12 months, is evaluated and reserved if deemed appropriate. In addition, any residual inventory, which is customer specific and remaining on hand at the time of contract completion, is reserved for at the standard unit cost. The complete list of slow moving and obsolete inventory is then reviewed by the production, engineering and/or purchasing departments to identify items that can be utilized in the near future. These items are then excluded from the analysis and the remaining amount of slow-moving and obsolete inventory is then reserved for. Additionally, non-cancelable open purchase orders for parts we are obligated to purchase where demand has been reduced may be reserved. Reserves for open purchase orders where the market price is lower than the purchase order price are also established. If a product that had previously been reserved for is subsequently sold, the amount of reserve specific to that item is then reversed.

RESULTS OF OPERATIONS

Revenues
The Company predominantly operates in one industry segment, consisting of light
and radiation detection devices. The Company sells its products to multiple
markets including telecommunications, industrial sensing/non destructive testing
(NDT), military-aerospace, medical, and homeland security.

Revenues by market consisted of the following (dollars in thousands):

                                                Three months ended
                Revenues                 June 26, 2009      June 27, 2008
                Telecommunications     $  1,701      29%  $  2,199      28%
                Industrial Sensing/NDT    2,126      36%     3,211      41%
                Military/Aerospace        1,937      32%     1,763      23%
                Medical                     122       2%       500       7%
                Homeland Security            48       1%        97       1%
                    Total Revenues     $  5,934     100%  $  7,770     100%

The Company's revenues for the quarter ended June 26, 2009 were $5.9 million, a decrease of 24% (or $1.8 million) over revenues of $7.8 million for the quarter ended June 27, 2008. The Company had growth in only one of the five markets for the quarter ending June 26, 2009.

Military/Aerospace market revenues in Q1 2010 were $1.9 million, an increase of 10% (or $174,000) from the comparable prior period revenues of $1.8 million. The increases were attributable primarily to an increase in Terahertz contracts. The Company expects military revenues to be up for the year compared to the prior year.

Industrial Sensing/NDT market revenues decreased to $2.1 million in Q1 2010, a decrease of 34% (or $1.1 million) from the comparable prior year period. The Company's Industrial Sensing/NDT revenue in the first quarter continued to experience a slow down as our customers responded to reduced demand as the result of the recession and our customers delayed capital expenditures which delayed purchases of our terahertz products. The Company expects Industrial Sensing/NDT revenues to improve in the second half of the year as the economy begins its anticipated climb out of the recession; however, we expect an overall decline in the Industrial Sensing/NDT market for fiscal year compared to the prior year.

Homeland Security revenues in Q1 2010 were $48,000 compared to $97,000 in the same quarter of the prior year. The sales in the current fiscal year are attributable to a THz development contract for the nuclear gauge replacement from the Department of Homeland Security. The Company expects Homeland Security revenues for the remainder of the year to be down significantly as compared to the prior year as a result of the terahertz development contract ending in September 2009.

Telecommunications market revenues of $1.7 million for Q1 2010 were approximately 23% lower (or $498,000) than the same quarter of the prior year. The Company's telecommunications revenues for the first half of the first quarter continued to experience a slow down as our customers responded to the recession by implementing inventory reduction programs and delaying second source initiatives for the 40G line side products. Based on customer guidance, the reduced demand was not the result of changing underlying market demand for 40G infrastructure capacity expansion. Consistent with this guidance, most of their inventory reduction programs were completed in the first quarter of FY 2010 as evidenced by a 147% growth in our Telecommunications market revenues in Q1 2010 compared to Q4 2009. We expect a return to more normal growth for the balance of the fiscal year.

Medical market revenues for Q1 2010 were $122,000, a decrease of 76% (or $378,000) from Q1 2009. This decrease was primarily a result of the Company's decision to eliminate business at a customer that did not meet its profitability criteria. The Company expects Medical market revenues to be slightly lower for the year as compared the prior year.

Gross Profit
Gross Profit for Q1 2010 was $3.0 million compared to Q1 2009 of $3.8 million, or a decrease of $759,000 on lower revenue volume of $1.8 million. Gross profit margins increased slightly to 51% for Q1 2010 compared to 48% of sales for the comparable prior year. The improvement in gross profit margin was due primarily to favorable product mix and cost reductions now being realized through our prior years' facilities consolidation activities.

Operating Expenses
Total operating expenses were $3.2 million during Q1 2010 as compared to $3.5 million in Q1 2009. This decrease was primarily driven by lower sales and marketing expenses of $169,000 related to the decrease in revenue and our cost reduction program, decreased R&D expenses of $65,000 and lower spending on the Wafer Fabrication consolidation of $120,000 as a result of the completion of this consolidation during Q1 2010. These decreases were partially offset by an increase in G&A expenses of $90,000.

Research, development and engineering (RD&E) expenses decreased by $65,000 in Q1 2010 compared to Q1 2009, primarily due to lower spending on development programs in our high speed optical receiver (HSOR) product platform, offset by increased spending in our Terahertz product platform. The Company expects to continue to increase investment in the next generation 40G/100G HSOR products and THz applications in FY 2010 in order to gain HSOR market share and move THz from the laboratory to the factory floor.

Sales and marketing expenses decreased $169,000 (or 27%) to $451,000 in Q1 2010, as compared to $620,000 for Q1 2009. The decrease was primarily attributable to lower compensation expenses driven by the Company's cost saving measures implemented in response to the recession and lower sales volume.

The Company has and will continue to focus its sales and marketing activity for the growing Telecom and Industrial/NDT markets. However, sales and marketing expenses are expected to decrease during the balance of FY 2010.

Total general and administrative expenses (G&A) increased by $90,000 (8%), to approximately $1.2 million (20% of sales) in Q1 2010 as compared to Q1 2009. This increase was primarily attributable to increased depreciation associated with the implementation of the company wide Enterprise Resource Planning system and increased cost associated with Section 404 Sarbanes-Oxley Act compliance.

The Company expects G&A expenses to remain relatively constant for the balance of the year with planned cost reductions offset by increased expenses relating to Section 404 of the Sarbanes-Oxley Act. Currently, the Company is required to be compliant with the external reporting requirements of Section 404 by the end of fiscal year 2010. External costs required to be in compliance will materially increase in fiscal year 2010.

Amortization expense decreased by 2% to $515,000 in Q1 2010 compared to $528,000 in Q1 2009 due to the Company's utilization of the cash flow amortization method on the majority of its intangible assets.

The non-cash expensing of stock option and restricted stock grants included in cost of products sold and operating expenses was $95,000 for the three months period ended June 26, 2009 compared to $34,000 for the three months ended June 27, 2008, an increase of $61,000.

Other operating expense incurred was related to the previously announced wafer fabrication consolidation to the Company's Ann Arbor facility, which amounted to $40,000 in Q1 2010, compared to $160,000 in Q1 2009. Wafer fabrication consolidation was completed in the first quarter of 2010.

Other Income (Expense), net
Interest income decreased in Q1 2010 by $15,000 from Q1 2009, due primarily to lower interest rates and lower bank balances for short term investments.

Interest expense in Q1 2010 was $81,000 compared to $108,000 in Q1 2009, a decrease of $27,000. The Company incurred lower interest expense to banks and related parties primarily due to the combination of lower debt obligations and lower interest rates.

As discussed in Note 7 to the Condensed Consolidated Financial Statements, the adoption of EITF 07-5 on April 1, 2009 requires our standing warrants be recorded as a liability at fair value with subsequent changes in fair value recorded in earnings. The fair value of the warrant is determined using a Black-Scholes option pricing model, and is affected by changes in inputs to that model including our stock price, expected stock price volatility and contractual term. To the extent that the fair value of the warrant liability increases or decreases, we record a loss or income in our statements of income. The income of $39,000 on change in fair value of the warrant liability in the first quarter of FY 2010 is primarily due to the change in the current expected stock price, volatility, interest rates and contractual life of the warrants which are the primary assumptions applied to the Black-Scholes model which we have used to calculate the fair value of the warrants.

The Company incurred a net loss for Q1 2010 of $296,000 ($0.01 per share), as compared to a net profit of $147,000 ($0.01 per share) in Q1 2009, for an increase in losses of approximately $443,000.

Fluctuation in Operating Results
The Company's operating results may fluctuate from period to period and will depend on numerous factors, including, but not limited to, customer demand and market acceptance of the Company's products, new product introductions, product obsolescence, component price fluctuation, varying product mix, and other factors. If demand does not meet the Company's expectations in any given quarter, the sales shortfall may result in an increased impact on operating results due to the Company's inability to adjust operating expenditures quickly enough to compensate for such shortfall. The Company's results of operations could be materially adversely affected by changes in economic conditions, governmental or customer spending patterns for the markets it serves. The current turbulence in the global financial markets and its potential impact on global demand for our customers' products and their ability to finance capital expenditures could materially affect the Company's operating results. In addition, any significant reduction in defense spending as a result of a change in governmental spending patterns could reduce demand for the Company's product sold into the military market.

Liquidity and Capital Resources
At June 26, 2009, the Company had cash and cash equivalents of $1.8 million, a decrease of $312,000 from the March 31, 2009 balance of $2.1 million. The lower balance is attributable to a decrease of cash from operating activities of $48,000, a decrease in investing activities of $156,000, and a decrease in cash of $108,000 from financing activities.

Operating Activities
The decrease of $48,000 in cash resulting from operating activities was primarily attributable to net cash generated from operations of $569,000 offset by net reduction in operating assets and liabilities of $617,000. This net reduction was primarily the result of an increase in accounts receivable of $597,000, inventory of $165,000 and prepaid/other assets of $118,000 offset by an increase in accounts payable and other accruals of $263,000. Cash generated from operations of $569,000 included a loss from operations of $296,000, income of $39,000 to record a change in fair value of warrants and $904,000 in non-cash depreciation, amortization, and stock-based compensation expenses.

Investing Activities
The Company used $156,000 in investing activities for capital expenditures of $81,000 (which includes $40,000 to complete the conversion of the California clean room to hybrid assembly manufacturing space) and patent expenditures of $75,000.

Financing Activities
For the quarter ended June 26, 2009, the Company used $108,000 in net cash from financing activities to pay down on the bank term loan.

On May 29, 2009, the Company amended its credit facility with The PrivateBank and Trust Company, headquartered in Chicago, IL effective March 31, 2009. As part of this amendment, the Company continued its three year Line of Credit of $3.0 million, with a minimum compensating balance requirement of $500,000. The borrowings are based on 80% of the Company's eligible accounts receivable and 50% of the Company's eligible inventory, subject to certain limitations as defined by the agreement. The line of credit is guaranteed by each of API's wholly-owned subsidiaries and the loan is secured by a Security Agreement among API, its subsidiaries and The PrivateBank, pursuant to which API and its subsidiaries granted to The PrivateBank a first-priority security interest in certain described assets. All business assets of the Company secure the line other than the intellectual property of the Company's Picometrix subsidiary. The amended loan agreement contains customary representations, warranties and financial covenants including minimum debt service coverage ratio, Adjusted EBITDA level, and Net Worth Requirements (as defined in the agreement). According to the terms of the amended loan agreement, the Adjusted EBITDA level is measured on a year to date basis for the June 26, 2009, September 25, 2009, December 25, 2009 and March 31, 2010 test dates and thereafter on a trailing four quarter basis. In addition, the Debt Service Coverage ratio and the Net Worth covenants were amended. The amended minimum Debt Service Coverage ratio is 1.0 to 1.0 for the first quarter, 1.25 to 1.0 for the second quarter and 1.5 to 1.0 thereafter. The amended minimum Net Worth covenant is $15.5 million and will increase by 10% of Net Income for each fiscal year that the Company reports net income.

At June 26, 2009, the Company was in compliance with the financial covenants. The interest rate is variable at a prime rate plus 1.0% and is adjusted quarterly. Interest is payable monthly, with principal due at maturity date on September 25, 2011. The prime interest rate was 3.25% at June 26, 2009. At June 26, 2009, the outstanding balance on the line was $1.4 million.

The Company identifies and discloses all significant off balance sheet arrangements and related party transactions. API does not utilize special purpose entities or have any known financial relationships with other companies' special purpose entities.

Operating Leases
The Company enters into operating leases where the economic climate is favorable. The liquidity impact of operating leases is not material.

Purchase Commitments
The Company has purchase commitments for materials, supplies, services, and . . .