Overview

Giga-tronics produces instruments, subsystems and sophisticated microwave components that have broad applications in both defense electronics and wireless telecommunications. In fiscal years 2012 and 2011 Giga-tronics business consisted of two operating and reporting segments: Giga-tronics Division and Microsource.

Company business is highly dependent on government spending in the defense electronics sector and on the wireless telecommunications market. Commercial orders have declined on a year-to-date basis for fiscal 2012 versus fiscal 2011 whereas on a year-to-date basis, defense orders have improved in fiscal 2012 versus fiscal 2011.

The Company continues to monitor costs, including personnel, facilities and other expenses, to more appropriately align costs with revenues.

Results of Operations

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

             New Orders                                               % change
                                                                 2012           2011
                                                                  vs.            vs.
             (Dollars in thousands)       2012         2011      2011           2010
             Giga-tronics Division    $ 11,305     $ 14,603       (23 %)      28 %
             Microsource                 2,001        1,579        27 %      (78 %)
             Total                    $ 13,306     $ 16,182       (18 %)     (12 %)

New orders received in fiscal 2012 decreased 18% to $13,306,000 from the $16,182,000 received in fiscal 2011. New orders decreased primarily due to a decrease in commercial orders partially offset by an increase in military orders.

New orders received in fiscal 2011 decreased 12% to $16,182,000 from the $18,448,000 received in fiscal 2010. New orders decreased primarily due to a decrease in military orders partially offset by an increase in commercial orders.

In fiscal 2012, orders at Giga-tronics Division decreased primarily due to a decrease in commercial demand for its products whereas orders at Microsource increased primarily due to a shifting of military orders from fiscal 2011 to fiscal 2012.

In fiscal 2011, orders at Giga-tronics Division increased primarily due to an increase in commercial demand for its products whereas orders at Microsource decreased primarily due to a shifting of military orders from fiscal 2011 to fiscal 2012.

The following table shows order backlog and related information at fiscal year-end:

Backlog                                                                        % change
                                                                           2012               2011
                                                                            vs.                vs.
(Dollars in thousands)                      2012           2011            2011               2010
Backlog of unfilled orders            $    3,839     $    3,649               5 %          (57 %)
Backlog of unfilled orders
shippable within one year                  3,839          3,333              15 %          (56 %)
Long term backlog reclassified
during year as shippable within one
year                                       1,648          1,123              47 %          (53 %)
Net cancellations during year of
previous FYE one-year backlog                  -              -               -              -

The increase in backlog at year-end 2012 of 5% was primarily due to orders received from switch and component customers.

The decrease in backlog at year-end 2011 of 57% was primarily due to receiving only the first year order release of a four-year contract for products installed on military planes.

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

            Allocation of Net Sales                                  % change
                                                                 2012            2011
                                                                  vs.             vs.
            (Dollars in thousands)        2012         2011      2011            2010
            Commercial                $  5,673     $ 11,600       (51 %)      72 %
            Government / Defense         7,443        9,429       (21 %)     (23 %)
            Total                     $ 13,116     $ 21,029       (38 %)      10 %

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

       Allocation of Net Sales by Segment                                 % change
                                                                       2012       2011
                                                                        vs.        vs.
       (Dollars in thousands)                   2012         2011      2011       2010
       Giga-tronics Division
       Commercial                           $  5,355     $ 10,281       (48 %)     111 %
       Government / Defense                    5,148        3,665        40 %      (49 %)
       Total                                $ 10,503     $ 13,946       (25 %)      16 %

       Microsource
       Commercial                           $    318     $  1,319       (76 %)     (29 %)
       Government / Defense                    2,295        5,764       (60 %)      11 %
       Total                                $  2,613     $  7,083       (63 %)       0 %

Fiscal 2012 net sales were $13,116,000, a 38% decrease from the $21,029,000 of net sales in 2011. The decrease in sales was primarily due to a decrease in commercial shipments. Sales at Giga-tronics Division decreased 25% or $3,443,000. Microsource sales decreased by $4,470,000. The decrease in sales has two main factors: sales to a major consumer electronics manufacturer contributed heavily to total sales in fiscal year 2011; however, additional orders from that manufacturer were not received in fiscal year 2012. Secondly, there was a delay in a large defense contract for Microsource components.

Fiscal 2011 net sales were $21,029,000, a 10% increase from the $19,057,000 of net sales in 2010. The increase in sales was primarily due to an increase in commercial shipments. Sales at Giga-tronics Division increased 16% or $1,945,000. Microsource sales increased by $27,000.

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

      Allocation of Cost of Sales by Segment                                % change
                                                                         2012       2011
                                                                          vs.        vs.
      (Dollars in thousands)                      2012         2011      2011       2010
      Giga-tronics Division                    $ 6,990     $  7,734       (10 %)       8 %
      Microsource                                2,996        4,366       (31 %)      26 %
      Total                                    $ 9,986     $ 12,100       (17 %)      14 %

In fiscal 2012, cost of sales decreased 17% to $9,986,000 from $12,100,000 in fiscal 2011, driven primarily by lower sales volume at both Giga-tronics Division and Microsource, which was partially offset by increases in cost of sales at both Giga-tronics Division and Microsource from $1,549,000 in excess and obsolete inventory reserves including reserves placed on products that reached the end of their life.

In fiscal 2011, cost of sales increased 14% to $12,100,000 from $10,622,000 in fiscal 2010, driven primarily by an increase in sales.

Operating expenses were as follows for the fiscal years shown:

        Operating Expenses                                               % change
                                                                       2012      2011
                                                                        vs.       vs.
        (Dollars in thousands)                   2012        2011      2011      2010
        Engineering                           $ 2,893     $ 2,159        34 %      42 %
        Selling, general and administrative     6,085       5,927         3 %       6 %
        Total                                 $ 8,978     $ 8,086        11 %      14 %

Operating expenses increased $892,000 in fiscal 2012 over 2011 due to an increase of $734,000 in product development expenses excluding NRE costs and an increase of $158,000 in selling, general and administrative expense. The increase in product development expenses is due to a more aggressive investment in instrument products. In fiscal year 2012 Giga-tronics strengthened marketing activities with a new Vice President of Marketing along with increased travel and spending on advertising. The increase in selling, general and administrative expense is a result of higher marketing expense of $255,000, higher commission expense of $96,000 offset by lower administrative expense of $193,000. The Company recorded $289,000 of share based compensation expense in fiscal 2012.

Net interest income in 2012 was not materially different than 2011.

Net interest income in 2011 increased by $20,000 due to improved cash management procedures.

Giga-tronics recorded a pretax loss of $5,850,000 for fiscal year 2012 versus pretax income of $847,000 for the same period last year. The loss before income taxes in fiscal 2012 was primarily due to a decrease in sales volume and an increase in operating expenses primarily associated with an increase in R&D efforts in fiscal 2012. Giga-tronics recorded net loss of $5,852,000 or $1.16 per fully diluted share for fiscal 2012 versus net income of $816,000 or $0.17 per fully diluted share in fiscal 2011.

Inventories consist of the following:

               Net Inventories                                    % change
                                                                      2012
                                                                       vs.
               (Dollars in thousands)       2012        2011          2011
               Raw materials             $ 2,313     $ 3,518           (34 %)
               Work-in-progress            1,651       1,349            22 %
               Finished goods                241         134            80 %
               Demonstration inventory       495         385            29 %
               Total                     $ 4,700     $ 5,386           (13 %)

Inventories decreased by $686,000 at the end of fiscal year 2012 compared to the prior fiscal year end, primarily due to inventory reserve adjustments of $1,549,000 for excess and obsolete inventories offset by purchase of new inventory. Giga-tronics began a shift in strategy where future product offerings will not compete directly with similar product offerings from substantially larger competitor companies. To this end existing product lines were pruned and excess inventories were written off. Items deemed at end of life amounted to $150,000 at Giga-tronics and $697,000 at Microsource.

Financial Condition and Liquidity

As of March 31, 2012, Giga-tronics had $2,365,000 in cash and cash-equivalents, compared to $1,408,000 as of March 26, 2011.

Working capital at the end of fiscal year 2012 is $6,568,000 as compared to $10,142,000 at the end of fiscal year 2011. The current ratio (current assets divided by current liabilities) at March 31, 2012 is 4.14 as compared to 4.75 at March 26, 2011. The decrease in working capital was due primarily to operating losses for fiscal year 2012, with the cash received from collection of accounts receivable funding operating expenses and the volume of sales not sufficient to replenish accounts receivable balances. While overall working capital decreased, cash and cash equivalents at year end increased $957,000 from the prior year. The increase in cash is largely due to investment in the Company by Alara Capital.

Cash used in operations amounted to $806,000 in 2012 and $1,503,000 in 2011. Cash used in fiscal year 2012 operations is primarily attributed to the loss for the year. Cash used in fiscal year 2011 operations is primarily attributed to the increase in accounts receivable and a reduction in deferred revenue.

Additions to property and equipment were $214,000 in 2012 compared to $368,000 in 2011 Capital equipment spending in fiscal 2012 and 2011included upgraded computer network infrastructure and electronic document scanning equipment. .

Other cash inflows in fiscal year 2012 are due to the $1.997 million investment by Alara Capital in exchange for convertible preferred stock shares and from the sale of common stock in connection with the exercise of stock options. In fiscal year 2011 other cash inflow was mainly from the sale of common stock in connection with the exercise of stock options.

We believe the funds generated by the collection of our accounts receivable, the anticipated revenues of our operations and reductions in operating expenses, continued management of our supply chain, and potential funds available to us through debt or equity financing, are adequate to fund our anticipated cash needs through the next twelve months. Although our line of credit expires in September 2012, we expect to renew the line of credit at maturity. Additionally, we do not have any outstanding balances on the line of credit. We anticipate that we will retain all earnings, if any, to fund future growth in the business. We believe we have effectively implemented cash management controls to meet ongoing obligations and as such believe that we will have sufficient liquidity to continue to operate over the next twelve months.

Should unforeseen circumstances occur, there are no assurances that we will not be required to seek additional working capital through debt or equity offerings. If such additional working capital is required, there are no assurances that such financing will be available on favorable terms to the Company, if at all, though we have been successful in the past in obtaining the levels of capital needed to continue operations and believe that we would be able to do so if necessary for the foreseeable future

Contractual Obligations

The Company leases various facilities under operating leases that expire through December 2016. Total future minimum lease payments under these leases amount to approximately $3,550,000.

The Company leases equipment under capital leases that expire through July 2014. The future minimum lease payments under these leases amount to approximately $26,000.

The Company is committed to purchase certain inventory under non-cancelable purchase orders. As of March 31, 2012, total non-cancelable purchase orders were approximately $887,000 through fiscal 2013 and are scheduled to be delivered to the Company at various dates through January 2013.

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, allowance for doubtful accounts, valuation of inventories, valuation allowance on deferred tax assets, product development costs 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.

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

Accounts receivable are stated at their net realizable value. 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, and the Company's historical collection experience.

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 income.

Product Development Costs

The Company incurs pre-production costs on certain long-term supply arrangements. The costs, which represent non-recurring engineering and tooling costs, are capitalized as other assets and amortized over their useful lives when reimbursable by the customer. All other pre-production and product development costs are expensed as incurred.

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 using a Black-Scholes-Merton option pricing model and records the fair value of 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.

Management believes that the Company has adequate resources to meet its anticipated operating and capital expenditure needs for the foreseeable future. Giga-tronics intends to maintain research and development expenditures for the purpose of broadening its product base. From time to time, Giga-tronics considers a variety of acquisition opportunities to also broaden its product lines and expand its markets. Such acquisition activity could also increase the Company's operating expenses and require the additional use of capital resources.