ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

EXPLANATORY NOTE

Management's Discussion and Analysis of Results of Operations and Financial Condition ("MD&A") is provided to help provide an understanding of our business, financial condition, changes in financial condition and results of operations. The following should be read in conjunction with our unaudited Consolidated Financial Statements, the notes thereto, the other unaudited financial data included elsewhere in this Quarterly Report on Form 10-Q and our 2012 Annual Report on Form 10-K filed with the SEC on April 30, 2012. Our MD&A is organized as follows:

Overview. This section contains trend analysis, a summary of the challenges we encountered this fiscal quarter and steps we are taking to address these challenges. This section may contain forward-looking statements. These statements are based on our current expectations and actual results may materially differ from such expectations. Among the factors that could cause actual results to vary are those described in this "Overview" section and in "Item 1A. Risk Factors."

Results of Operations. This section provides an analysis of results of operations for the two fiscal quarters and two nine month fiscal periods presented in the accompanying consolidated statements of operations.

Liquidity and Capital Resources. This section provides an analysis of cash flows, a discussion of outstanding debt, working capital and capital expenditures, and commitments, both firm and contingent, that existed as of October 26, 2012, and trends, demands, events and uncertainties with respect to our ability to finance our continuing operations.

Critical Accounting Policies. This section discusses the accounting policies (i) that require us to make estimates that are highly uncertain at the time the estimate is made, (ii) for which a different estimate which could have been made would have a material impact on our consolidated financial statements, (iii) that are the most important and pervasive policies utilized, and (iv) that are the most sensitive to material change from external factors.

OVERVIEW

We design and manufacture aircraft instrumentation and sensor systems. These products are used for both primary flight data and for standby purposes in cockpits that use electronic displays for primary flight data. As cockpit panel space becomes more valuable in the new age of glass displays, we have maintained a strong position with Original Equipment Manufacturers (OEM) as a premier supplier of quality aircraft instrumentation in both the military and commercial aircraft marketplace. This allows us to offer multiple products for air data collection as well as standby displays and backup instrumentation which allow our aircraft manufacturer customers to reduce their number of suppliers. Our unique capabilities in air data collection products continue to expand with the development of multiple air data system designs for domestic and international customers, including highly advanced contour flushport systems as well as new variants of our legacy probe designs. These technologies support manned aircraft and the expanding Unmanned Aerial Vehicle (UAV) markets. During fiscal years 2013 and 2012, we were awarded development contracts to modify or extend air data capabilities for products on existing airframes using these technologies.

Building on our expertise with mechanical instrumentation, we have successfully developed and marketed digital instrumentation and displays for standby redundant systems to complement our mechanical product line.

Our current market focus has been, and will continue to be, the design, development and supply of electronic and mechanical primary and standby flight control systems components and instruments. These include altimeters, airspeed indicators, angle of attack indicators, stall warning systems, air data measurement systems and standby flight display systems. These products are critical to aircraft operation, performance and safety.

In conjunction with our development and production activities, we have developed expertise in the building, testing and validation of critical test equipment, including environmental stress screening chambers and wind tunnels. We are expanding that knowledge to offer customers the ability to order turnkey solutions for their test needs.

The trend in the aerospace industry continues toward digital cockpits and away from mechanical cockpit instrumentation that was our foundation. During the first nine months of fiscal year 2013, we continued to make progress in our ability to design and manufacture digital instrumentation that is integrated into cockpit flight management systems. We maintained and strengthened our commitment to research and development to further enhance our product line as we anticipate continued movement toward digital cockpits in the aerospace industry. Our new OASIS® multi-function standby display is being promoted in support of this trend. We plan to position ourselves such that we continue to offer both digital and mechanical instrumentation solutions to our customers. While we believe that this strategy will, over time, strengthen our position in the aerospace industry, we cannot guarantee that this strategy will be successful or that we will have access to the capital resources needed to fully support this strategy.

A significant amount of our business relates to the sale of our products, services and support to United States ("U.S.") and foreign military programs. As a consequence, our sales can fluctuate materially, either favorably or unfavorably, depending upon the level of government spending on those military programs which are a major focus of our manufacturing efforts. While we have been successful in obtaining contracts to supply military needs in recent years, sudden reductions in government spending or delays in the government contract award process could have a material unfavorable effect on our current and future military sales and related cash flow. While we cannot predict the outcome of the U.S. government contract award or budget process, we expect that the majority of the military programs that we supply will be sustained at current or near current levels. Additionally, U.S. government procurement offices often require long periods of time to issue requests for proposals and to negotiate contracts. Such lengthy contract cycle times may delay the award of certain anticipated contracts of significant value to the Company. Delays of significant contract awards may have an adverse effect on the financial results of the Company.

In August 2011, the Budget Control Act (the Act) reduced the United States Department of Defense (U.S. DoD) top line budget by approximately $490 billion over 10 years starting in fiscal year 2012. In addition, barring Congressional action, further budget cuts (or Sequestration) as outlined in the Act will be implemented starting in January 2013 which would lead to additional reductions of approximately $500 billion from the defense top line budget over the next nine years, resulting in aggregate reductions of about $1 trillion through 2021. In June 2012, the Office of Management and Budget (OMB) announced that the budget for Overseas Contingency Operations and any unobligated balances in prior year funds will also be included in aggregate reductions. In September 2012, OMB provided a report to Congress stating that it was unable to determine the amount of Sequestration at the program, project, and activity level until consistent, government-wide definitions are established. OMB did, however, estimate that Sequestration would reduce non-exempt discretionary accounts in defense by about 9.4% and non-defense budgets by 8.2%. The U.S. DoD has taken the position that such reductions would generate significant operational risks and may require the termination of certain, as yet undetermined, procurement programs. Any reduction in levels of U.S. DoD spending, cancellations or delays impacting existing contracts or programs, including through Sequestration, could have a material impact on our operating results.

In September 2012, Congress passed, and the President signed, legislation making continuing appropriations from October 1, 2012 through March 27, 2013. This will enable programs to continue at the same operations rate as in 2012.

Similarly, changes in the commercial sector of the aerospace industry can have a favorable or unfavorable impact on our future business. While we have historically invested heavily in product development for both funded and unfunded programs, OEM requirements may change such that additional product development efforts will be necessary to maintain or increase our revenue in the aerospace industry. With respect to ongoing contracts, several of our commercial customers continue to operate with reduced operations and manufacturing. While this may be offset by additional increases in aftermarket support, it is likely that our business will continue to be negatively affected until the economy recovers and our customers resume prior levels of production and growth. The recession in the general aviation and business jet markets has continued longer than previously expected and significant improvement is not forecasted for at least another year.

Recognizing the risks and challenges of the current environment in both our military and commercial markets, we continue to closely monitor our operations and cost structure for opportunities to enhance our financial performance in the face of a difficult economic environment. We will continue to pursue actions we deem appropriate to counter the near-term challenges in our markets while preserving our ability to be responsive to our customers as the economy improves.

RESULTS OF OPERATIONS

Our senior management regularly reviews the performance of our operations including reviews of key performance metrics and the status of operating initiatives. We review information on the financial performance of the operations, new business opportunities, customer relationships and initiatives, independent research and development (IR&D) activities, human resources, manufacturing effectiveness, cost reduction activities, as well as other subjects. We compare performance against budget, against prior comparable periods and against our most recent internal forecasts. We do not expect the impact of inflation and changing prices on net sales and income from continuing operations to be material.

While we believe the prospects for our financial performance to be very good over the long term, we continue to work our way through short-term challenges which may cause our financial results to vary on a quarterly basis. Our backlog of firm orders, not including options, as of October 26, 2012 is $25.7 million. This represents a 1% increase of $0.2 million versus the backlog as of January 31, 2012 and a 1% increase of $0.2 million versus the backlog as of October 28, 2011.

Our ability to enhance gross profit and operating results will require that we introduce new products and grow our business while continuing to improve manufacturing throughput and delivery performance. We are well engaged in implementing lean manufacturing principles, supported by training programs, to further develop a consistent, disciplined, and innovative engineering and production culture. We complement these initiatives with a marketing and sales strategy that builds on our market presence and core competencies in sensor, air data computation, and display technologies.

We believe that our recent and planned future investments in support of our customers will produce strong returns as our markets continue their recovery. Because of our improved operating metrics, as well as direct customer feedback with respect to quality and delivery performance, we are far better positioned to win new business. We believe that our improved systems, focused value-stream teams, and growing capabilities will enable us to far more reliably fulfill commitments to our customers, suppliers, and stockholders.

Three months ended October 26, 2012 and October 28, 2011:

Net sales for the third quarter of fiscal year 2013 decreased $53,000, or 0.7%, to $7,267,000 when compared to $7,320,000 for the third quarter of fiscal year 2012. During the third quarter of fiscal year 2013, the net sales decreased from the prior year on decreased sales of mechanical products and development services, partially offset by sales of sensors, spares, and repairs. Our net sales continue to be impacted by the ongoing recession in the business jet and general aviation markets.

Cost of sales for the third quarter of fiscal year 2013 decreased $1,177,000, or 22.2%, to $4,132,000 when compared to $5,309,000 for the third quarter of fiscal year 2012. Gross profit as a percentage of sales for the third quarter of fiscal year 2013 was 43.1% versus 27.5% for the third quarter of fiscal year 2012. Contributing to the three-month comparative increase in gross profit as a percent of sales was (a) an increase in repairs and spares as a percentage of the overall sales dollar volume in the period, (b) favorable pricing on certain customer orders, particularly in spares and repairs, (c) continued positive impacts of quality improvements and investments in lean activities over the past two years, and (d) the unfavorable impact in the prior year of costs associated with the transition of the Virginia repair station to our Florida facility.

Selling, general and administrative expenses for the third quarter of fiscal year 2013 were $2,370,000, an increase of $695,000 from the third quarter of fiscal year 2012 of $1,675,000. The increase was driven primarily by independent research and development costs relating to the OASIS® product.

We reported operating income during the third quarter of fiscal year 2013 of $765,000, or 10.5% of net sales, compared to operating income of $336,000, or 4.6% of net sales, in the prior year's third quarter. This increased operating income is primarily attributable to the improved gross margin percentage as described above, partially offset by the higher selling, general and administrative costs.

Interest expense, net, decreased $23,000 for the third quarter of fiscal year 2013 when compared to the third quarter of fiscal year 2012 primarily due to lower interest expense on reduced debt levels.

Income before income taxes was $698,000 in the third quarter of fiscal year 2013 versus income before income taxes of $298,000 in the third quarter of fiscal year 2012. For the quarter ended October 26, 2012, net income was $454,000 or $0.12 basic and $0.11 diluted earnings per share, versus net income of $146,000, or $0.04 basic and diluted earnings per share for the quarter ended October 28, 2011.

Nine months ended October 26, 2012 and October 28, 2011:

Net sales for the nine months ended October 26, 2012 increased $1,650,000, or 8.1%, to $22,100,000 when compared to $20,450,000 for the nine months ended October 28, 2011. During the first nine months of fiscal year 2013, the net sales increased from the first nine months of the prior fiscal year in most product groups, including sensors, spares, repairs, and development services. Net sales of mechanical products were comparable between fiscal periods. Our net sales continue to be impacted by the ongoing recession in the business jet and general aviation markets.

Cost of sales for the first nine months of fiscal year 2013 decreased ($1,457,000), or 9.5%, to $13,859,000 when compared to $15,316,000 for the first nine months of fiscal year 2012. Gross profit as a percentage of sales for the first nine months of fiscal year 2013 was 37.3% versus 25.1% for the first nine months of fiscal year 2012. The nine-month comparative increase in gross profit as a percent of sales was primarily due to (a) increased variable margin due to the higher sales volume, (b) an increase in repairs and spares as a percentage of the overall sales dollar volume in the period, (c) favorable pricing on certain customer orders, particularly in spares and repairs, (d) the positive impact of quality improvements and investments in lean activities over the past two years, and (e) the unfavorable impact in the prior year of costs associated with the transition of the Virginia repair station to our Florida facility.

Selling, general and administrative expenses for the first nine months of fiscal year 2013 were $6,916,000, an increase of $1,515,000 from the first nine months of fiscal year 2012 of $5,401,000. The increase was driven primarily by independent research and development costs relating to the OASIS® product. In addition, we incurred increased bad debt provisions as the result of the filing of a bankruptcy petition by one of our business jet customers and increased compensation costs and outside services costs, which were partially offset by lower commission expense relating to international orders, reduced travel, and reduced advertising costs.

We reported operating income during the first nine months of fiscal year 2013 of $1,325,000, or 6.0% of net sales, compared to an operating loss of ($267,000), or 1.3% of net sales, in the prior year's first nine month period. This improvement in operating income is primarily attributable to increased net sales and improved gross margin percentage as described above, partially offset by higher selling, general and administrative costs.

Interest expense, net, decreased $88,000 for the first nine months of fiscal year 2013 when compared to the first nine months of fiscal year 2012 primarily due to lower interest expense on reduced debt levels.

Income before income taxes was $1,125,000 in the first nine months of fiscal year 2013 versus a loss before income taxes of ($575,000) in the first nine months of fiscal year 2012. For the nine months ended October 26, 2012, net income was $730,000 or $0.19 basic and $0.18 diluted earnings per share, versus a net loss of ($338,000), or ($0.09) basic and diluted loss per share for the nine months ended October 28, 2011.

LIQUIDITY AND CAPITAL RESOURCES

Our principal sources of capital have been cash flow from operations and borrowings under the Credit Facility described below. As of October 26, 2012, we had $0 in cash and cash equivalents, compared to $157,000 as of January 31, 2012. In addition, as of October 26, 2012, we had $2,960,000 available under our Credit Facility, compared to $888,000 available as of January 31, 2012.

Our cash provided by operating activities was $2,971,000 for the nine months ended October 26, 2012, an increase in cash provided of $2,372,000 compared to cash provided of $599,000 for the nine months ended October 28, 2011. This net increase in cash provided by operating activities is primarily attributable to increases in cash provided by operating activities of:

· $1,712,000 in cash advances from two customers, accounted for on the balance sheet as a liability within deferred revenue, for the near-term delivery of certain air data collection products,

· $1,380,000 from a reduction in prepaid expenses and other current assets during the nine months ended October 26, 2012 of $1,096,000, primarily attributable to the release of deferred customer-funded development contract charges, compared to an increase in prepaid expenses and other current assets of ($284,000) during the nine months ended October 28, 2011,

· $1,068,000 from a net income of $730,000 during the nine months ended October 26, 2012 compared to a net loss of ($338,000) during the nine months ended October 28, 2011,

· $743,000 from decreased accounts receivables of $1,049,000, net of a $209,000 provision for bad debts, at October 26, 2012 compared to decreased accounts receivables of $306,000, net of a $126,000 provision for bad debts, at October 28, 2011,

· $632,000 from a noncash provision for income taxes of $395,000 at October 26, 2012 compared to a noncash benefit for income taxes of ($237,000) at October 28, 2011 and

· $427,000 from an increased compensation and benefits accrual of $355,000 as of October 26, 2012 compared to a change in compensation and benefits accrual of ($72,000) at October 28, 2011;

Partially offset by increases in cash used in operating activities of:

· $1,602,000 from increased inventory of ($1,760,000) at October 26, 2012 compared to increased inventory at October 28, 2011 of ($158,000),

· $1,147,000 from decreased accrued expenses and other liabilities of ($910,000) at October 26, 2012, primarily attributable to the release of contract loss provisions related to a customer-funded development contract compared to increased accrued expenses and other liabilities of $237,000 at October 28, 2011,

· $592,000 from decreased accounts payable at October 26, 2012 of ($756,000) compared to decreased accounts payable at October 28, 2011 of ($164,000) and

· $170,000 from a decreased contract loss provision of $86,000 for the nine months ended October 26, 2012 compared to a contract loss provision of $256,000 for the nine months ended October 28, 2011.

Our cash used in investing activities decreased $281,000 for the nine months ended October 26, 2012 compared to the nine months ended October 28, 2011 due solely to capital improvements and equipment additions of $489,000 during the nine months ended October 26, 2012 compared to capital improvements and equipment additions of $770,000 during the nine months ended October 28, 2011.

Our cash used in financing activities for the nine months ended October 26, 2012 was ($2,639,000) compared to cash provided by financing activities for the nine months ended October 28, 2011 of $9,000. The change was attributable to $3,153,000 of additional payments against the Amended and Restated Revolving Credit Line Note and $95,000 of increased long-term debt repayment. These amounts are partially offset by the repayment of the Notes Payable during the first quarter ended April 29, 2011 in the amount of $600,000.

Our days sales in accounts receivable decreased to 49 days at October 26, 2012, down from 64 days at January 31, 2012, due in large part to receipt of delayed customer payments. Through cash management and purchasing practices, our outstanding account payable balances with operational and production suppliers continued to decline as days purchases in accounts payable decreased to 29 days at October 26, 2012, down from 41 days at January 31, 2012. However, due to our past payment history, we continue to be challenged to maintain favorable payment terms with certain suppliers.

Our liquidity will depend on our ability to achieve budgeted operating results and to renew our Bank Notes and Amended and Restated Revolving Credit Line Note when they mature on May 1, 2013 and June 27, 2013, respectively. Sufficient liquidity is necessary to, among other things, (i) satisfy working capital requirements, (ii) fulfill necessary capital spending, and (iii) meet our debt obligations in fiscal year 2013 and beyond. Although our nine months ended October 26, 2012 cash flow from operations improved over the prior year, we continue to carefully monitor our liquidity in anticipation of possible earnings volatility, and in light of continued demand for capital additions and investment in new product development programs during fiscal year 2013 when compared to fiscal year 2012. Our failure to improve our operating results could have a material adverse effect on our liquidity and could require the implementation of curative measures, including raising capital, deferring planned capital expenditures and research and development efforts, reductions in force, reducing discretionary spending, and selling assets. There can be no assurance that our proposed plans and actions will be successful or that unforeseen circumstances will not require us to seek additional funding sources in the future or effectuate additional plans to conserve liquidity. In addition, there can be no assurance that in the event additional sources of funds are needed, they will be available on acceptable terms, if at all.

Working Capital and Capital Expenditures

Our working capital at October 26, 2012 was $3,092,000 compared to $6,184,000 at January 31, 2012. This decrease in working capital of $3,092,000 as of October 26, 2012 relates, in part, to (a) a second quarter reclassification of $3,465,000 of long-term debt from non-current liabilities to current liabilities as the Bank Notes mature on May 1, 2013, less third quarter principal payments of $152,000, (b) an increase in deferred revenue of $1,712,000 of cash advances from two customers, accounted for on the balance sheet as a liability within deferred revenue, for the near-term delivery of certain air data collection products, (c) a reduction in accounts receivable of $1,258,000 and (d) a decrease in prepaid expenses and other current assets of $1,096,000 due primarily to the release of deferred charges related to a customer-funded development contract. These decreases to working capital are offset, in part, by
(a) the pay down of the Amended and Restated Revolving Credit Line Note of $2,072,000, using primarily cash flow from operations and customer cash advances, (b) an increase in inventory of $1,627,000, due primarily to altimeter demand in raw materials inventory and (c) the pay down of accounts payable of $756,000.

The collection of our accounts receivable is the primary source of cash used to fund our operations. Our banking line of credit is used as an additional source of cash as necessary from time to time, and we sweep any excess cash back against the line of credit on a daily basis to minimize interest expense. We believe that cash collected from our accounts receivable, as further supplemented by advances under our Credit Facility, are adequate to fund our ongoing operations for the next twelve months. Prior to maturity on June 27, 2012, we renewed the Amended and Restated Revolving Credit Line Note, which now matures on June 27, 2013, with BMO Harris Bank. However, there can be no assurance that we will achieve our expected operating results and/or have access to and/or renew or refinance our Credit Facility, or that unforeseen circumstances will not require us to seek additional funding sources in the future. In addition, there can be no assurance that in the event additional sources of funds are needed, they will be available on acceptable terms, if at all.

Management believes the sale of the Earlysville, Virginia facility is probable within one year. However, we have presented the property held for sale as a non-current asset as we anticipate that the terms of a sale will likely contain cash escrow provisions relating to the contamination treatment costs, thereby precluding the full conversion of the asset to cash within one year.

Our future capital requirements depend on numerous factors, including research and development, expansion of product lines and other factors. Furthermore, we may need to develop and introduce new or enhanced products, respond to competitive pressures, invest or acquire businesses or technologies or respond to unanticipated requirements or developments, which would require additional resources. Currently, our cash flow from operations alone may not be sufficient to meet these challenges.

Our capital expenditures for the first nine months ended October 26, 2012 were $489,000, compared to $770,000 for the first nine months ended October 28, 2011. Capital expenditures for the first nine months ended October 26, 2012 consisted of $250,000 for operating and test equipment, $87,000 for purchased software and $152,000 for self-constructed assets. Historically, our capital budget wasintended to replace fixed asset equipment as needed and to take advantage of technological improvements that would improve productivity. We continue to replace certain critical fixtures, environmental test chambers and testing equipment that we lost in the August, 2008 fire during fiscal years 2013 and 2012. Additionally, we renovated and reconfigured our Florida production facility in those years to accommodate equipment previously located in ourbuilding destroyed in the fire.

Notes Payable and Credit Facility

On May 14, 2009, we entered into unsecured notes payable arrangements with three investors allowing us to borrow up to an aggregate of $2,000,000. We completed repayment of the outstanding balance of these notes payable in the first quarter of fiscal year 2012. See Note 6 of "Notes to Consolidated Financial Statements (Unaudited)."

We are party to a Loan Agreement (the "Loan Agreement") with BMO Harris Bank (the "Lender") with a maximum amount of credit facilities (the "Credit Facility") available to us of $10,100,000. The Loan Agreement provides for (a) a . . .