10-Q 1 f74979e10-q.txt FORM 10-Q PERIOD ENDED JUNE 30, 2001 1 UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM 10-Q (Mark One) [X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the quarterly period ended June 30, 2001 OR [ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the transition period from _____ to _____ Commission file number 779033 ================================================================================ CONDOR SYSTEMS, INC. (Exact name of co-registrant as specified in its charter) California 94-2623793 (State or other jurisdiction of (I.R.S. Employer incorporation or organization) Identification No.) CEI SYSTEMS, INC. (Exact name of co-registrant as specified in its charter) Delaware 77-0466448 (State or other jurisdiction of (I.R.S. Employer incorporation or organization) Identification No.) 2133 Samaritan Drive San Jose, CA 95124 (Address of principal executive offices, including zip code) (408) 371-9580 (Co-registrants' telephone number, including area code) ================================================================================ INDICATE BY CHECK MARK WHETHER THE REGISTRANT (1) HAS FILED ALL REPORTS REQUIRED TO BE FILED BY SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 DURING THE PRECEDING 12 MONTHS (OR FOR SUCH SHORTER PERIOD THAT THE REGISTRANT WAS REQUIRED TO FILE SUCH REPORTS), AND (2) HAS BEEN SUBJECT TO SUCH FILING REQUIREMENTS FOR THE PAST 90 DAYS. Yes [X] No [ ] THE AGGREGATE MARKET VALUE OF THE VOTING STOCK HELD BY NON-AFFILIATES OF THE REGISTRANT AS OF JUNE 30, 2001: NOT APPLICABLE. THE NUMBER OF SHARES OR AMOUNT OUTSTANDING OF EACH OF THE ISSUER'S CLASSES OF SECURITIES AS OF JUNE 30, 2001: CLASS A COMMON STOCK, $1 PAR VALUE, ISSUED AND OUTSTANDING, 21,365,892 SHARES; CLASS B COMMON STOCK, $1 PAR VALUE, ISSUED AND OUTSTANDING, 2,551,053 SHARES; CLASS C COMMON STOCK, $1 PAR VALUE, ISSUED AND OUTSTANDING, 26,966,721 SHARES. 2 INDEX PART I. FINANCIAL INFORMATION...................................................................... 3 Item 1. Financial Statements............................................................... 4 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations......................................................................... 16 Item 3. Quantitative and Qualitative Disclosures About Market Risk......................... 30 PART II. OTHER INFORMATION......................................................................... 30 Item 1. Legal Proceedings.................................................................. 30 Item 2. Changes in Securities and Use of Proceeds.......................................... 30 Item 4. Submission of Matters to a Vote of Security Holders................................ 30 Item 5. Other Information.................................................................. 30 Item 6. Exhibits and Reports on Form 8-K................................................... 30 SIGNATURES

2 3 This Form 10-Q contains statements that, to the extent that they are not recitations of historical fact, constitute "forward looking statements" within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. The words "believe," "estimate," "anticipate, "project," "plan," " intend," "expect," or the negative of these terms and similar terminology are intended to identify forward looking statements. All forward looking statements involve risks and uncertainties, including, without limitation, statements and assumptions with respect to future revenues, program performance and cash flows, the outcome of contingencies including litigation and environmental remediation; and anticipated costs of capital investments and planned dispositions and other charges. Readers are cautioned not to place undue reliance on these forward looking statements that speak only as of the date of the Form 10-Q. Condor does not undertake any obligation to publicly release any revisions to these forward looking statements to reflect events, circumstances and changes in expectations after the date of this Form 10-Q, or to reflect the occurrence of unanticipated events. The forward looking statements in this document are intended to be subject to the safe harbor protection provided by Sections 27A of the Securities Act and 21E of the Exchange Act. For a discussion identifying some important factors that could cause actual results to vary materially from those anticipated by the forward looking statements, see "Risk Factors" on page 23. 3 4 PART I. FINANCIAL INFORMATION ITEM 1. FINANCIAL STATEMENTS. CONDOR SYSTEMS, INC. CONDENSED CONSOLIDATED BALANCE SHEETS (amounts in thousands, except per share amounts) (unaudited)

4 5 outstanding in 2001 and in 2000 22,387 22,387 Class B Shares: 10,000 designated; 2,551 issued and outstanding in 2001 and in 2000 2,551 2,551 Class C Shares: 60,000 designated; 26,967 issued and outstanding in 2001 and in 2000 26,746 26,949 Class C Common Stock warrants 2,189 2,159 Notes receivable from shareholders (1,347) (1,347) Deferred stock compensation (376) (773) Accumulated deficit (55,668) (23,149) Distribution in excess of net book value (90,115) (90,115) --------- --------- Total shareholders' deficit (93,633) (61,338) --------- --------- Total liabilities, Mandatorily Redeemable Preferred Stock and shareholders' deficit $ 73,882 $ 96,570 --------- ---------

The accompanying notes are an integral part of these condensed consolidated financial statements. 5 6 CONDOR SYSTEMS, INC. CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS (amounts in thousands) (unaudited)

The accompanying notes are an integral part of these condensed consolidated financial statements. 6 7 CONDOR SYSTEMS, INC. CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (amounts in thousands) (unaudited)

The accompanying notes are an integral part of these condensed consolidated financial statements. 7 8 CONDOR SYSTEMS, INC. NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (amounts in thousands except per share and per note amounts) (unaudited) NOTE 1 - BASIS OF PRESENTATION: The accompanying unaudited condensed consolidated financial statements have been prepared in accordance with generally accepted accounting principles for interim financial information and pursuant to the rules and regulations of the Securities and Exchange Commission. The accompanying unaudited condensed consolidated financial statements have been prepared on the same basis as and should be read in conjunction with the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 2000. In the opinion of management, these condensed consolidated financial statements reflect all adjustments, consisting only of normal recurring adjustments, necessary for a fair presentation of the financial statements for the interim periods. The interim results of operations for the three and six months ended June 30, 2001 are not necessarily indicative of the results to be expected for the full year. Certain prior year amounts have been reclassified to conform to the current year presentation. The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions. These estimates and assumptions may affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the unaudited condensed consolidated financial statements and the reported amounts of revenues and expenses during the reporting period. Estimates have been prepared on the basis of the most current and best available information. Actual results could differ from those estimates. NOTE 2 - LIQUIDITY: As of June 30, 2001 the Company was in non-compliance with certain financial ratio covenants in the revolving credit facility, largely as a result of lower than expected EBITDA due to significant program cost-to-complete growth. Estimated cost-to-complete represents future cost expenditure over the contract value and such increase must be included as a loss reserve in the current period. The Company has secured an interim waiver from the Lender Group and expects to be able to obtain additional waivers as required while discussions and planning continue. The Company remains current with respect to loan payments, fees and interest. However, given the Company's recent financial performance the Company is evaluating alternatives for restructuring its debt obligations and has engaged a financial advisor and counsel to assist in that process. No assurance can be given that future waivers will be given or that such restructuring efforts will be successful. NOTE 3 - CONTINGENCIES, RISKS AND UNCERTAINTIES: REVENUE The Company's revenue for fixed price contracts is recognized on the percentage of completion basis. Consequently, revenue and gross margin for each reporting period is determined on a contract-by-contract basis by reference to estimates of expected costs to be incurred to complete each project. These estimates include provisions for known and anticipated cost overruns, if any exist or are expected to occur. These estimates are subject to revision in the normal course of business, and such revisions may result in fluctuations in reported revenues and income/(losses). As noted above, the Company recorded significant contract revisions in the second quarter of 2001. 8 9 The risks of performing under long-term fixed price contracts include the difficulty of accurately forecasting costs and delivery schedules for events more than a year in the future and attaining contract revenues that are related to performance in accordance with contract specifications. In addition, the possibility of material obsolescence in connection with long-term procurements often causes increased engineering costs to rectify the obsolescence. Failure to anticipate technical problems, estimate costs accurately or control costs during performance of a fixed price contract may reduce profitability or cause a loss. In addition, as Condor's business has evolved from individual products to complex systems requiring sophisticated software development, it is increasingly exposed to the risks with software development, including time delays and unplanned costs. It is not uncommon to experience increased costs involved in the test and integration phase (which occurs late in the program) during which the various hardware and software elements are first brought together to perform as a system. FINANCIAL LEVERAGE AND LIQUIDITY The Company has incurred a significant amount of debt in connection with its 1999 recapitalization. The level of indebtedness could have significant impact on how the Company operates. It requires substantial debt service requirements that limit the amount of cash flows available for other operating and investing activities, exposes the Company to interest rate fluctuations and could also limit the Company's ability to obtain additional financing. As of June 30, 2001 the company was in non-compliance with certain financial ratio covenants in the revolving credit facility, largely as a result of lower than expected EBITDA due to significant program cost-to-complete growth. Estimated cost-to-complete represents future cost expenditure over the contract value and such increase must be included as a loss reserve in the current period. The Company has secured an interim waiver from the Lender Group and expects to be able to obtain additional waivers as required while discussions and planning continue. The Company remains current with respect to loan payments, fees and interest. However, given the Company's recent financial performance the Company is evaluating alternatives for restructuring its debt obligations and has engaged a financial advisor and counsel to assist in that process. No assurance can be given that future waivers will be given or that such restructuring efforts will be successful. GOVERNMENT OVERSIGHT As a government contractor, the Company is subject to government oversight. The U.S. Government routinely audits and reviews the Company's business and accounting practices, proposals, contract performance and cost accounting. If it is determined that the Company did not comply with the U.S. Government procurement regulations and practices, the Company could be subject to claims, fines or be suspended from bidding on new government contracts. Historically, the Company has been in compliance with the U.S. Government procurement regulations and practices and has successfully defended its actions or settled any claims, fines or inquiries without material adverse effect to the Company's business and financial results or condition. As of June 30, 2001, the U.S. Government is claiming adjustments in an aggregate amount of $817 for three contracts. Condor has responded to these claims and is working with the U.S. Government to resolve these matters and believes that the resolution of these claims will not have a material adverse effect on its financial condition and results of operations. In addition, under U.S. Government purchasing regulations, some of Condor's costs, including certain financing costs, goodwill, portions of research and development costs and certain marketing expenses may not be reimbursable under U.S. Government contracts. In addition, many of Condor's products and systems require licenses from U.S. Government agencies for export from the United States, and some products are not permitted to be exported. Condor may from time to time suffer delays in obtaining awards on account of delays in obtaining an export license. CONCENTRATIONS The Company operates in a single industry segment encompassing the electronic intelligence, electronic 9 10 support measures, electronic counter measures and threat warning market niches in the electronic warfare industry. This industry is closely tied to the military defense budgets of the U.S. Government and its allies. Any significant changes in the funding of certain programs, platforms or the overall level of the military defense budgets or the programs could adversely impact the Company. In addition, the international markets are subject to additional risks including political instability, restrictive trade policies and U.S. export laws and regulations. Historically, the U.S. Government, including various agencies and the military sector, has accounted for a significant portion of Condor's contract revenues. Condor's customers include all of the U.S. intelligence agencies and military services, the major domestic prime contractors, numerous other defense contractors worldwide and many foreign governments. Condor's primary international government customers consist of various agencies within the governments of Australia, Japan, Norway, Sweden and Taiwan. Typically, revenue from contracts with government agencies in Sweden exceeds 10% of Condor's contract revenues. SOURCES AND AVAILABILITY OF RAW MATERIALS Since Condor outsources most of the manufacturing of subassemblies, in many cases the Company does not use significant amounts of raw materials. Condor purchases manufactured component parts for its assemblies from various suppliers. Condor is not dependent on any one supplier and maintains back-up suppliers for all critical components. However, any delay in Condor's ability to obtain necessary component parts may affect its ability to meet customer production needs. CONTRACT DELINQUENCIES As of June 30, 2001, Condor was delinquent with deliveries on four major domestic contracts and two major international contracts. All of Condor's customers that were affected by the delinquencies have been in discussion with Condor to negotiate delivery date changes. Condor has received no cure notices on any major contracts and all delivery extensions will either be handled with no cost contract modifications or some form of consideration for the extension which is reasonable and customary for such transactions. The impact of such delinquencies is not expected to be material. LITIGATION Condor is not a party to any material legal proceedings, other than ordinary routine litigation incidental to its business, none of which, in the opinion of management, is expected to have a material adverse effect to Condor's business results of operation or financial condition. Condor has been served a subpoena to provide information relevant to technical data supplied in response to a request for proposal from South Korea and in response to two requests for proposals from Sweden. The subpoena arises out of a grand jury proceeding that is investigating the potential violations of International Traffic and Arms Regulations ("ITAR"). Condor is fully cooperating with the applicable authorities. Condor has retained attorneys in this matter. There is significant uncertainty as to the ultimate outcome of this matter, the Management of the Company does not expect the results of this investigation to have a material adverse effect on the Company's financial position and results of operation over and above contingencies already reserved. NOTE 4 - ADDITIONAL FINANCIAL DATA: 10 11

NOTE 5 - INCOME TAXES Condor has recorded net losses during the periods ended June 30, 2001 and June 30, 2000. Based on the Company's significant operating losses in the current period and forecasts for the future, Management believes it is more likely than not that the tax assets will not be realized. Hence, the Company has recorded a full valuation allowance for the deferred tax asset in the quarter ended June 30, 2001 in the amount of $12,050. NOTE 6 - UNAUDITED CONDENSED CONSOLIDATING FINANCIAL INFORMATION: The following summarized unaudited condensed consolidating financial information segregates CEI Systems, Inc., the subsidiary which guarantees the Subordinated Notes and Senior Discount Notes (the "Guarantor"). The accompanying financial information in the "Guarantor Subsidiary" column reflects the financial position, results of operations and cash flows for the Guarantor for the periods indicated. The Guarantor is a wholly-owned subsidiary of the Company, whose guarantees are full and unconditional. Separate statements of the Guarantor are not presented because management believes that such financial statements would not be material to investors. The financial information related to the Company's one other non-guarantor subsidiary is not presented as it is immaterial. The investments in the Guarantor in the following unaudited condensed consolidating financial information are accounted for under the equity method of accounting. The consolidating eliminations include the elimination of the investment in the Guarantor and elimination of intercompany accounts. 11 12 Condor Systems, Inc. CONDENSED CONSOLIDATING BALANCE SHEETS (amounts in thousands) (unaudited)

12 13 Condor Systems, Inc. CONDENSED CONSOLIDATING BALANCE SHEETS (amounts in thousands) (unaudited)

13 14 CONDENSED CONSOLIDATING STATEMENTS OF OPERATIONS (amounts in thousands)

14 15 CONDENSED CONSOLIDATING STATEMENTS OF CASH FLOWS (amounts in thousands) (unaudited)

15 16 NOTE 7 - SENIOR DISCOUNT NOTES: On April 12, 2001, the Company issued 15% Senior Discount Notes to Donaldson, Lufkin & Jenrette Merchant Banking Partners ("DLJMB") and Behrman Capital LP ("Behrman") for gross proceeds of $10,053. The Company incurred expenses of approximately $871 in connection with this financing and the amendment to the revolving credit facility. The notes are due on April 1, 2011. Under the terms of the notes, no interest will be paid prior to April 1, 2005. The issue price is $536 for each note, before warrant fair value allocation, with a principal maturity value of $1,000. The issue price will be accreted to the principal maturity value with periodic charges to interest expense through April 1, 2005. Interest charge for the period ended June 30, 2001 amounted to $387. Interest will be paid in cash semiannually in arrears on April 1 and October 1 in each year commencing on October 1, 2005. Proceeds from the Senior Discount Notes were used to pay down the balance under the revolving credit facility. The Company may redeem the notes at any time after March 31, 2005 at 107.5% of the Accreted Value. This percentage decreases ratably until March 31, 2008. After March 31, 2008, the Company may redeem the notes at the Accreted Value. The notes may be redeemed at the option of the holder in the event of a change of control and in certain other circumstances. Repayment of the principal and interest is unconditionally guaranteed by CEI Systems, a subsidiary of the Company. In connection with the issuance of the Senior Discount Notes, the investors also received warrants to purchase 21,670 shares of Class C Common Stock at an exercise price of $.01 per share. The warrants have a term of 10 years. The estimated relative fair value of the warrants of $150 is recorded as a discount to the issue price of the Senior Discount Notes and amortized with periodic charges to interest expense over the life of the Senior Discount Notes of 10 years. The fair value of the warrants was calculated using a fair value of common stock of $0.01 per share, term of 5 years of volatility of 50%. In accordance with the provisions of the Investor's Agreement the Company also offered to the required list of management investors (not associated with Behrman or DLJ) an opportunity to purchase Sr. Discount Notes of the same expiration date and terms. None of these individuals purchased these notes and no further capital was raised. NOTE 8 - RECENT ACCOUNTING PRONOUNCEMENTS In July 2001 the Financial Accounting Standards Board ("FASB") issued Statement of Financial Accounting Standards No. 141 ("SFAS 141"), "Business Combinations". SFAS 141 requires the purchase method of accounting for business combinations initiated after June 30, 2001 and eliminates the pooling-of-interests method. The Company believes that the adoption of SFAS 141 will not have a significant impact on the Company's consolidated financial position, results of operations and cash flows. In July 2001, the FASB issued Statement of Financial Accounting Standards No. 142 ("SFAS 142"), "Goodwill and other intangible Assets", which is effective for fiscal years beginning after March 15, 2001. SFAS 142 changes the accounting for goodwill from an amortization method to an impairment only approach. In addition, the standard includes provisions, upon adoption, for the reclassification of certain existing recognized intangibles to goodwill, reassessment of the useful lives of existing recognized intangibles, reclassification of certain intangibles out of previously reported goodwill and the testing for impairment of existing goodwill and other intangibles. The Company has not yet determined the impact of SFAS 142 on the Company's consolidated financial position, results of operations and cash flows. ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS. 16 17 OVERVIEW We are a leading provider of technologically advanced signal collection and specialized electronic countermeasure products and systems in the Electronic Warfare (EW) industry. We supply a complete line of integrated systems, subsystems and products. These products are used to intercept, identify, locate and analyze radar signals for a variety of military needs, including intelligence, reconnaissance, surveillance, precision targeting, situational awareness and threat warning. Our products and systems are used on high profile airborne, shipboard and ground based platforms. We have established long-term relationships with a wide variety of customers and we supply our products and systems to most of the U.S. intelligence agencies and military services and a number of friendly foreign governments. We also supply the major prime defense contractors. Substantially all of Condor's products and systems are sold under multiple-year development and production programs. U.S. Government contracts are awarded either on a competitive bid basis or on a negotiated sole source procurement basis. Sole source basis means that Condor's customers did not obtain bids from other competitors before awarding the contract to Condor. International contracts are primarily awarded on a competitive basis. Contracts awarded on a competitive bid basis, which are typically development programs, involve several competitors bidding on the same program with the contract usually being awarded based upon such factors as price, technical performance, program management capabilities and performance. Development programs may be unprofitable or break-even after allocating overhead, administrative and other indirect costs due to increased price competition for the award and higher risk encountered in performance of the "first time" development tasks. Such development programs generally provide future opportunities for higher margin follow-on sole source business. Negotiated sole source procurement, which comprises most of Condor's domestic contracts, is used when a customer determines that Condor has developed proprietary equipment not available from other parties or where there is a very stringent delivery schedule. For production contracts Condor delivers products based on technologies and designs developed during the initial development program, which are nonetheless generally customized to customers' specifications. All of Condor's U.S. Government contracts allow the company to charge 90% of its costs to the customer as such costs are incurred and receive progress payments for those billed costs. Condor receives the remainder of its costs and all of its profit as it completes the delivery of products under the contract. With respect to international contracts, Condor typically receives one or more advance payments from international customers during the initial phase of the contract. The advance payments are recorded as liabilities on Condor's balance sheet as customer contract advances and reduced as work is performed. Condor generally provides letters of credit to guarantee its performance of the contracts. The customer may draw down on the letters of credit if Condor defaults on the contract. As Condor reaches performance-based milestones negotiated in the contracts, the letters of credit are reduced by negotiated amounts. Condor receives the remaining contract payments as it meets the remaining delivery milestones specified in the contract. Our operating cycle is long-term and involves many types of contracts with varying production delivery schedules. Accordingly, the results of a particular year, or year-to-year comparisons of recorded sales and profits, may not be indicative of future operating results. The following comparative analysis of our results of operations should be viewed in this context. 17 18

18 19 THREE AND SIX MONTHS PERIOD ENDED JUNE 30, 2001 COMPARED TO THREE AND SIX MONTHS PERIOD ENDED JUNE 30, 2000 (AMOUNTS IN THOUSANDS, EXCEPT AS INDICATED) CONTRACT AWARDS Contract awards for the quarter and six months ended June 30, 2001 were $22,111 and $39,626 compared to $ 28,412 and $72,735 for the quarter and six months ended June 30, 2000. For the quarter and six months ended June 30, 2001 71% and 54% of the awards were for domestic programs and 29% and 46% were for international programs. We typically are awarded a few significant contracts during the course of the year and timing of these awards can cause significant variation when making comparisons in interim periods. While we were engaged in many opportunities during the first half of 2001 we only saw one large (over $5,000) contract award in the second quarter and a total of two large awards in the first half. In comparison, the second quarter of 2000 contained one large contract and the first half of 2000 contained 6 large (over $5,000) contracts. Large contracts amounted to 70% of awards in the first half of 2000 and only 13% in the same period of 2001. Due to the sporadic nature of large contract awards, Management does not see any significant trend developing in this metric. Several contract awards anticipated in the second quarter were not realized. It is anticipated that many of these will be awarded in the second half of the year. One large international contract was not awarded to our potential customer and one large international program has moved to 2002. However, the slip in contract awards has also affected both the contract revenue and earnings. The company continues to compete for these future orders. CONTRACT REVENUES Contract revenue is lower than comparable periods in the previous year. Contract revenues for the quarter and six months ended June 30, 2001 were $17,572 and $40,026 approximately $9,240 and $8,644 (or 34% and 18%) lower than the $26,812 and $48,670 for the quarter and six months ended June 30, 2000. The revenues reflect a decrease in international business with $4,385 and $14,178 being international for the quarter and six months ended June 30, 2001 compared to $8,783 and $18,105 for the same periods in 2000. Domestic revenues reflect a decrease to $13,187 and $25,849 (75.0% and 64.6%) for the quarter and six months ended June 30, 2001 as compared to $18,030 and $30,566 (67.2% and 62.8%) for the quarter and six months ended June 30, 2000. Four and five large contracts comprised 17.5% and 35.5% of the revenue in the quarter and six months ended June 30, 2001 as compared to seven and nine significant contracts comprising 51.1% and 56.8% of the revenue in the quarter and six months ended June 30, 2000. Management does not see any significant indication from this metric at this time due to the fact that the contract losses recognized in the second quarter of 2001 contributed to this trend. In the second quarter of 2001 three major development contracts were impacted by growth in the estimated total cost of the programs. Two international programs and one domestic program experienced cost growth driven by unforeseen complexities in integration and software of systems also causing schedule delays. These cost growths were unknown during the first quarter and were revealed by the periodic update of estimates-at-completion. In percentage-of-completion accounting, a loss contract is recognized at the time it is discovered and both revenue and profit are adjusted accordingly to reflect the latest estimate. Over $8,000 of anticipated cost growth was estimated for these programs. The largest percentage of our revenue continues to come from fixed price contracts. The percentage of contract revenues coming from fixed price contracts for the quarter and six months ended June 30, 2001 was approximately 97.7%, as compared to 95.0% and 95.1% for the quarter and six months ended June 30, 2001. The percentage of sole source contract revenues for the quarter and six months ended June 30, 2001 was approximately 94% and 90.8% as compared to the quarter and six months ended June 30, 2000 which was approximately 81.8% and 76.7%. GROSS MARGIN Gross margin (loss) for the quarter and six months ended June 30, 2001 were $(3,726) and $2,530 as compared to $11,958 and $18,515 for the like periods in 2000, or $(15,684) and $15,985 lower than the like periods in 2000. This equates to a gross margin (loss) to contract revenue percentage of (21.2)% and 6.3% for the quarter and six months ended June 30, 2001 vs. 44.6% and 38.0% for the quarter and six months 19 20 ended June 30, 2000. This represents a 65.8 percentage point decline for the quarter, and a 31.7% decline for the six-month period. The decrease was caused by the significant changes in program estimates of costs to complete mentioned above and, based on recent performance, reserves for warranty repairs, obsolete inventory, and, liquidated damages were increased. Gross margin percentages fluctuate due to factors inherent in the government contracting business such as the timing of the incurrence of direct costs, leveraging of fixed overhead costs over a greater volume of contract revenues and phasing of performance on contracts with varying margin as well as changes in estimated total cost of performance of specific contracts. RESEARCH AND DEVELOPMENT The aggregate expense for research and development activities during the three months and six months ended June 30, 2001 decreased by $302 and $269 from the three months and six months ended June 30, 2000, and is summarized as follows:

Over the six months of 2001 the amount of R&D remains slightly lower in total value than in the previous year. SELLING, GENERAL AND ADMINISTRATIVE Selling and general and administrative costs for the quarter and six months ended June 30, 2001 were $6,579 or 37.4% and $11,231 or 28% of contract revenue. For the quarter and six months ending June 30, 2000 this category of cost was $5,431 or 20.3% and $9,486 or 19.5% of contract revenue. The $1,148 and $1,745 increase in the second quarter and six months ended June 30,2001 over the second quarter and six months ended June 30, 2000 last year were primarily due to increased legal and professional expenses associated with defense of the ITAR case, (See "Legal Proceedings" Section), additional amounts for foreign sales commissions and vacation liability. OTHER CHARGES 1. There were no other charges in the quarter and six months ended June 30, 2001. In the same period of 2000 a charge of $1,500 was recorded for severance. In the first quarter of 2000, the Board of Directors elected to terminate the employment agreement with the then President and Chief Executive Officer, without cause. Pursuant to the terms of the employment agreement with him, the company recognized approximately $1,500 in severance related cost to be paid out over a two-year period commencing July 1, 2000. INTEREST AND OTHER INCOME (LOSS) The interest and other income (loss) for the quarter and six months ending June 30, 2001 was $55 and $64 of income versus $(14) and $(47) of loss for the quarter and six months ending June 30, 2000. The $14 and $47 losses were comprised of $58 and $100 of interest income offset by $72 and $147 of miscellaneous expenses. INTEREST EXPENSE 20 21 The interest expense for the quarter and six months ended June 30, 2001 were $4,277 and $8,209 as compared to $4,232 and $8,112 for the quarter and six months ending June 30, 2000. The increase of $45 and $97 in the quarter and six months ended June 30, 2001 were due to increased line of credit usage and accrued interest on senior discount notes. INCOME TAXES The provision that we recognized for income taxes for the quarter and six months ended June 30, 2001 were $12,919 and $12,057 compared to a benefit of $92 and $1,440 for the quarter and six months ended June 30, 2000. Condor has recorded net losses during the periods ended June 30, 2001. Based on the Company's significant operating losses in the current period and forecasts for the future, Management believes it is more likely than not that the tax assets will not be realized. Hence, the Company has recorded a full valuation allowance for the deferred tax asset in the amount of $12,050 during the quarter ended June 30, 2001. LIQUIDITY AND CAPITAL RESOURCES Our primary sources of liquidity continue to be funds provided by external financing. In connection with our 1999 recapitalization, we issued an aggregate of $100,000 of 11 7/8% Series A Senior Subordinated Notes that are due in full in May 2009. These notes are general, unsecured obligations of the Company that are junior to the revolving credit facility and any other senior indebtedness. Interest payments are due semi-annually in May and November. During 1999, we entered into a revolving credit facility. This revolving credit facility has a total borrowing capacity of $50,000 that provides for loans and letters of credit and has a five-year term to April 2004. Through February 9, 2000, the loans under the revolving credit facility bore interest, at our option, at the prime rate plus 2.25% or LIBOR plus 3.50% while the standby and performance letter of credit fees were 3.50%, trade letter of credit fees were 1.75% and the commitment fee on the unused portion of the revolving credit facility was 1.50% per annum. On February 9, 2000, we entered into an amendment of the revolving credit facility. Pursuant to the amendment, subsequent to February 9, 2000, the applicable margins over the prime rate and LIBOR increased to 2.75% and 4.0%, respectively, while the standby letters of credit fees increased to 4.0%, trade letter of credit fees increased to 2.0% and the commitment fee on the unused portion of the revolving credit facility increased to 2.0% per annum. These increased margins and commitment fees can decrease based upon reductions in net funded indebtedness leverage ratios. In addition, we agreed to additional restrictions on the utilization of the revolving credit facility for acquisition financing and to limit the availability of loans under the revolving credit facility to a borrowing base. Loans outstanding under the revolving credit facility aggregated to $18,900 at June 30, 2001 and $17,500 at December 31, 2000. We had additional loan availability of approximately $0 and $4,141 at June 30, 2001 and 2000, respectively. Letters of credit outstanding under the revolving credit facility aggregated to $31,077 at June 30, 2001 and $24,429 at June 30, 2000. In connection with the amendment of our revolving credit facility on February 9, 2000, we, Donaldson, Lufkin & Jenrette Merchant Banking Partners ("DLJMB") and Behrman Capital L.P. ("Behrman") entered into a subscription agreement for the purchase of preferred stock. Under the terms of this subscription agreement, DLJMB and Behrman invested an additional $10,000 through the purchase of Series A1 Preferred Stock. In addition, we received $377 from the sale of the Series A1 Preferred Stock to other existing shareholders. The Series A1 Preferred Stock was converted into the Series A2 mandatory redeemable preferred stock in 2001. The Series A2 Preferred Stock is non-voting, cumulative and accretes dividends at an annual rate of 15%. Dividends will accrete to the liquidation value until 2005, subject to the right of a majority of holders of the Series A2 Preferred Stock to 21 22 elect that dividends to paid in additional shares of Preferred Stock. After 2005, Condor will be required to pay such dividends in cash. We were required to utilize the $10,000 in proceeds from the issuance of Series A1 Preferred Stock to pay down the loans outstanding under the revolving credit facility. The obligations under the revolving credit facility are guaranteed by all of the Company's existing and future domestic subsidiaries. They are also secured by substantially all of our assets. We are required to maintain certain financial leverage and interest coverage ratios, as well as comply with certain other covenants. These covenants include restrictions on additional borrowings and operating leases, certain stock transactions and dividends, as well as capital expenditures. We were not in compliance with certain financial leverage covenants of the revolving credit facility as of December 31, 2000 and obtained a waiver from the bank in an amendment to the credit facility effective April 12, 2001 for such non-compliance. Effective April 12, 2001, we renegotiated the covenants for future periods. Starting fiscal quarter ended March 31, 2001, the existing financial leverage covenants under the facility were relaxed and additional financial covenants were added. In addition we raised gross proceeds of $10,053 in April 2001 from an offering of 15% Senior Discount Notes to our principal shareholders. We incurred expenses of approximately $871 in connection with this financing and the amendment to the revolving credit facility. The notes are due on April 1, 2011. Under the terms of the notes, no interest will be paid prior to April 1, 2005. From April 12, 2001 through April 1, 2005, interest will accrue at a compounded rate of 15% per year and will be paid at maturity. Interest will be paid in cash semiannually in arrears on April 1 and October 1 in each year commencing on October 1, 2005. Proceeds from the Senior Discount Notes were used to pay down the balance under the revolving credit facility. As of June 30, 2001 the Company was in non-compliance with certain financial ratio covenants in the revolving credit facility, largely as a result of lower than expected EBITDA due to significant program cost-to-complete growth. Estimated cost-to-complete represents future cost expenditure over the contract value and such increase must be included as a loss reserve in the current period. The Company has secured an interim waiver from the Lender Group and expects to be able to obtain additional waivers as required while discussions and planning continue. The Company remains current with respect to loan payments, fees and interest. However, given the company's recent financial performance the Company is evaluating alternatives for restructuring its debt obligations and has engaged a financial advisor and counsel to assist in that process. No assurance can be given that future waivers will be given or that such restructuring efforts will be successful. Cash flows used in operating activities were $(14,456) for the six months ended June 30, 2001 as compared to $(4,493) for the six months ended June 30, 2000. The fluctuations in our operating cash flows are primarily the result of changes in the levels of our contract receivables, advances and inventories. Cash flows utilized in investing activities were $(467) for the six months ended June 30, 2001 compared to $(5,898) for the six months ended June 30, 2000. These investing activities primarily related to capital expenditures and an acquisition in 2000. At June 30, 2001 The only major capital commitments were associated with the move of the facility to Morgan Hill expected to be completed in October of 2001 . The revolving credit facility contains restrictions on our ability to make capital expenditures. We continually monitor our capital spending in relation to current and anticipated business needs. Our operations typically do not require large capital expenditures and we anticipate that capital spending will remain relatively consistent. 22 23 There was $11,453 cash provided by financing activities for the six month period ended June 30, 2001 compared to $8,822 for the six month period ended June 30, 2000. The funds provided by financing transaction in the second quarter of 2001 were related to the proceeds from the Senior Discount Notes along with additional borrowings on the line of credit. The cash provided by our financing transactions in the first quarter of 2000 was primarily related to the proceeds from the Series A1 preferred stock offering. This source of financing was primarily offset by the repurchase of common stock and the pay down of our bank borrowings. EFFECT OF INFLATION; SEASONALITY We do not believe that inflation has had a material impact on our financial position or results of operations. Our operating performance frequently varies significantly from period to period, depending on the contract type, export sales and, in particular, the award or expiration of one or more contracts and the timing of manufacturing and delivery of products under such contracts. As a result, period-to-period comparisons may show substantial increases and decreases in contract revenues that are not necessarily representative of the underlying business activity and results for any given period, and may not be indicative of longer term results. Our business is seasonal, in part, as a result of U.S. Government spending patterns, with most U.S. Government contract awards being received in the third and fourth quarters. The timing of the receipt of domestic awards has a corresponding impact on the timing of contract performance and contract revenues. During 2000, 50% of contract revenues and 17% of EBITDA was generated in the third and fourth quarters. By comparison, during 1999 and 1998, an average of 60% of contract revenues and 61% of EBITDA was generated in the third and fourth quarters, in each case with significantly greater portions in the fourth quarter. RECENT ACCOUNTING PRONOUNCEMENTS In July 2001 the Financial Accounting Standards Board ("FASB") issued Statement of Financial Accounting Standards No. 141 ("SFAS 141"), "Business Combinations". SFAS 141 requires the purchase method of accounting for business combinations initiated after June 30, 2001 and eliminates the pooling-of-interests method. The Company believes that the adoption of SFAS 141 will not have a significant impact on the Company's consolidated financial position, results of operations and cash flows. In July 2001, the FASB issued Statement of Financial Accounting Standards No. 142 ("SFAS 142"), "Goodwill and other intangible Assets", which is effective for fiscal years beginning after March 15, 2001. SFAS 142 changes the accounting for goodwill from an amortization method to an impairment only approach. In addition, the standard includes provisions, upon adoption, for the reclassification of certain existing recognized intangibles to goodwill, reassessment of the useful lives of existing recognized intangibles, reclassification of certain intangibles out of previously reported goodwill and the testing for impairment of existing goodwill and other intangibles. The Company has not yet determined the impact of SFAS 142 on the Company's consolidated financial position, results of operations and cash flows. RISK FACTORS In addition to the other matters described in this report for the period ended June 30, 2001, you should carefully consider the following ongoing risks relating to Condor's business. RISKS RELATING TO OUR DEBT WE HAVE A SIGNIFICANT AMOUNT OF DEBT, WHICH COULD LIMIT OUR GROWTH AND OUR ABILITY TO RESPOND TO CHANGING CONDITIONS. 23 24 Our substantial indebtedness could limit our growth and our ability to respond to changing conditions. We have incurred a significant amount of indebtedness in connection with the recapitalization of our company. The level of our indebtedness could have important consequences, including: o limiting cash flow available for general corporate purposes, including acquisitions, because a substantial portion of our cash flow from operations must be dedicated to servicing our debt o limiting our ability to obtain additional debt financing in the future for working capital, capital expenditures or acquisitions o limiting our flexibility in reacting to competitive and other changes in our industry and economic conditions generally restricting our ability to obtain letters of credit which are necessary to support our international business o otherwise impairing our ability to obtain contract awards from customers concerned about our leverage As of June 30, 2001, we had: (a) total consolidated indebtedness of approximately $129,194 and (b) $31,077 in standby letters of credit, subject to customary conditions. Our ability to make interest and principal payments on our indebtedness and borrow additional funds will depend upon our future operating performance, which will be affected by general economic, financial, competitive, legislative, regulatory, business and other factors beyond our control. As of June 30, 2001 the Company was in non-compliance with certain financial ratio covenants in the revolving credit facility, largely as a result of lower than expected EBITDA due to significant program cost-to-complete growth. Estimated cost-to-complete represents future cost expenditure over the contract value and such increase must be included as a loss reserve in the current period. The Company has secured an interim waiver from the Lender Group and expects to be able to obtain additional waivers as required while discussions and planning continue. The Company remains current with respect to loan payments, fees and interest. However, given the Company's recent financial performance the Company is evaluating alternatives for restructuring its debt obligations and has engaged a financial advisor and counsel to assist in that process. No assurance can be given that future waivers will be given or that such restructuring efforts will be successful. In addition, subject to the restrictions and limitations contained in our debt agreements, we may incur significant additional indebtedness to finance future acquisitions, which could adversely affect our operating cash flows and our ability to service indebtedness. Restrictive covenants in our indenture and credit facility may adversely affect us by limiting the types of transactions we can enter into and potentially leading to a default and an acceleration of our indebtedness. The indenture governing the notes contains various covenants that limit our ability to engage in many types of transactions, including mergers, asset sales and the incurrence of additional indebtedness. In addition, our credit facility contains other and more restrictive covenants and prohibits us from prepaying our subordinated indebtedness. Our credit facility also requires us to maintain specified financial ratios and satisfy other financial condition tests. Our ability to meet those financial ratios and tests can be affected by events beyond our control, and we cannot assure you that we will meet those tests. A breach of any of these covenants could result in a default under our credit facility and other outstanding indebtedness. Upon the occurrence of an event of default under our credit facility, the lenders could elect to declare all amounts outstanding under our credit facility to be immediately due and payable, terminate all commitments to extend further credit and require us to cash collateralize outstanding letters of credit. If we were unable to repay those amounts, the lenders could proceed against the collateral granted to them to secure that indebtedness. We have pledged substantially all of our assets, other than assets of our foreign subsidiaries, as security under our credit facility. If the lenders under our credit facility accelerate the repayment of borrowings, we cannot assure you that 24 25 we will have sufficient assets to repay our credit facility and our other indebtedness, including our senior and subordinate notes. In the event of default on the credit facility we could be judged by the US Government as a "non-responsible" contractor making additional new US Government funded orders difficult if not impossible to attain. RISKS RELATING TO DEBT RESTRUCTURE Restructure of the debt could cause certain international customers to terminate their contracts for default and call the standby letters of credit. In such circumstances the company could also be liable for reprocurement cost for the hardware from another source. Such cost could include the excess price paid to another contractor for the equipment over and above the negotiated contract price with Condor as well as administrative costs. Further, should the US Government judge that the Company is a "non-responsible" contractor, the government may then stop all new awards to the Company until an affirmative judgment of fiscal responsibility is made. Additionally, progress payments on US Government contracts could be scaled back or stopped entirely. RISKS RELATING TO THE LEVEL OF GOVERNMENT BUSINESS FURTHER REDUCTIONS OR CHANGES IN MILITARY EXPENDITURES MAY ADVERSELY AFFECT OUR ABILITY TO OBTAIN NEW CONTRACTS. The U.S. defense budget has declined significantly in the 1990s, resulting in reduced revenues, increased pressure on operating margins and, in some cases, net losses for many defense-related contractors. During this period, our contract revenues from agencies of, and contractors to, the U.S. Government have increased. Approximately 56% of our contract revenues in the year ended December 31, 2000 (66% in 1999) were from the U.S. Government or from prime contractors that identified the U.S. Government as the ultimate purchaser. For the year ended December 31, 2000, our largest program represented approximately 8.8% of contract revenues and no other program represented more than 6.8% of contract revenues for this period. Our largest program contributed approximately 10.3% of contract revenues for the year ended December 31, 1999, and no other program represented more than 8.2% of contract revenues for this period. We believe our continued development and success in the future will depend, in part, upon the continued willingness of the U.S. Government to commit substantial resources to military spending and, in particular, upon continued purchases of our products. A significant decline in U.S. military expenditures generally, the loss or significant cutback of a large program in which we participate, or a change in focus of defense spending that de-emphasizes electronic warfare could materially adversely affect our future contract revenues and earnings and thus our ability to meet our financial obligations. RISKS RELATING TO OUR GOVERNMENT CONTRACTS OUR CONTRACTS MAY BE TERMINATED OR ADJUSTED BY THE U.S. GOVERNMENT. Companies engaged primarily in supplying defense-related equipment and services to government agencies are subject to business risks peculiar to the defense industry. These risks include the ability of the U.S. Government to: 25 26 o insist on strict compliance with the contract terms o prosecute us for knowing failures to comply with contract terms or procurement laws and regulations o obtain treble damages and penalties for knowing or reckless failures to comply with contract terms or procurement laws and regulations o suspend us from receiving new contracts pending resolution of alleged violations of procurement laws or regulations o terminate existing contracts o audit our contract-related costs and fees, including allocated indirect costs Contracts with the U.S. Government are subject to a complex set of regulations and laws and the U.S. Government has available a wide variety of criminal penalties, treble damage remedies and civil penalties to enforce those requirements. The U.S. Government may challenge positions we have taken with respect to those regulations. If the U.S. Government finds that we have violated any of its requirements, our contracts may be terminated or adjusted or we may be subject to criminal investigation and prosecution and may face civil damages provisions and penalties. All of our contracts involving U.S. Government programs, including contracts involving sales to prime contractors or subcontractors, can be terminated by the U.S. Government either for its convenience or if we default. Termination for convenience provisions provide only for our recovery of costs incurred or committed, settlement expenses and profit on work completed prior to termination. Termination for default provisions require return of unliquidated progress payments for unaccepted work and provide that we would be liable for excess costs incurred by the U.S. Government in procuring undelivered items from another source. The U.S. Government may review Condor's costs and performance on contracts, as well as Condor's accounting and general business practices. Under the Truth in Negotiations Act, for any contract in excess of $500, the U.S. Government may reduce the contract price by the amount by which it was overstated as a result of not providing current, accurate or complete cost or pricing data. As of June 30, 2001, the U.S. Government is claiming adjustments in an aggregate amount of $817 for 3 contracts. Condor has responded to these claims and is working with the U.S. Government to resolve these matters and believes that the resolution of these claims will not have a material adverse effect on its financial condition and results of operations. Under U.S. Government purchasing regulations, some of Condor's costs, including certain financing costs, goodwill, portions of research and development costs and certain marketing expenses may not be reimbursable under U.S. Government contracts. The electronic warfare industry is closely tied to the military defense budgets of the U.S. Government and its allies. Condor's continued development and success in the future will depend, in part, upon the continued willingness of the U.S. Government to commit substantial resources to military spending and, in particular, upon continued purchases of Condor's products. A significant decline in U.S. military expenditures generally, the loss or significant cutback of a large program in which Condor participates, or a change in focus of defense spending that de-emphasizes electronic warfare could materially adversely affect Condor's future contract revenues and earnings. U.S. Government related contracts in the year ended December 31, 2000 accounted for approximately 65% of Condor's revenue. RISKS RELATED TO THE WAY WE OBTAIN OUR MILITARY CONTRACTS COULD AFFECT OUR ABILITY TO OBTAIN NEW CONTRACTS AND AFFECT THE PROFITABILITY OF THOSE CONTRACTS. We obtain military contracts through the process of competitive bidding and through sole source negotiations. While most of our historical contract revenues have been derived from sole source negotiations, as our international business increases we expect to derive a greater portion of our contract revenues through competitive bidding. In addition, while our domestic production programs are predominately sole source, some of 26 27 our development programs are competitively bid. We cannot assure you that we will continue to be successful in having our bids accepted or, if accepted, that awarded contracts will generate sufficient contract revenues to result in profitability. In particular, we often aggressively compete on development programs by pursuing a low price bidding strategy. Accordingly, such development programs are typically unprofitable or break-even after allocating overhead, administrative and other indirect costs. Although we pursue such development programs because we expect to profit from the follow-on sole source business, we cannot assure you that we will obtain such follow-on business. Also, the U.S. Government may in the future determine to shift programs historically awarded to us on a sole source basis to a competitive bidding process. This may reduce the profit margin on these contracts. We are also subject to risks associated with the military procurement and development process which affect the profitability of our contracts. These risks include: o the frequent need to bid on programs in advance of the completion of their design, which may result in unforeseen software development or other technological difficulties and/or cost overruns o the substantial time and effort required for relatively unproductive design and development o design complexity and obsolescence o the constant need for design improvement RISKS RELATED TO OUR INDUSTRY WE OPERATE IN A COMPETITIVE INDUSTRY AND MANY OF OUR COMPETITORS HAVE GREATER RESOURCES THAN WE DO. The electronic warfare industry is highly competitive. The defense industry in general has experienced substantial consolidation due to declining defense budgets and increasing pressures for cost reductions. Many of our competitors are larger than us and have substantially greater financial and other resources than we have, including Lockheed Martin, Raytheon and Boeing. Our ability to compete for electronic warfare contracts largely depends on the following factors: o the effectiveness and innovations of our research and development programs o our ability to offer better performance than our competitors at a lower cost o the readiness of our facilities, equipment and personnel to undertake the programs for which we compete RISKS RELATED TO EXPORT OF OUR PRODUCTS THE U.S. GOVERNMENT MAY ALTER EXPORT POLICIES OR DENY LICENSES TO EXPORT OUR PRODUCTS. Many of our products and systems require licenses from U.S. Government agencies for export from the United States, and some of our products are not permitted to be exported. We cannot be sure of our ability to gain any licenses required to export our products, and failure to receive required licenses could materially reduce our ability to sell our products outside the United States. Similar to other defense contractors, we have been receiving increased scrutiny and experiencing delays in the processing of our export license requests by U.S. government agencies. These delays and additional inquiries could cause delays in new contract awards and may impact the timing of our contract performance. RISK RELATED TO OUR OWNERSHIP THE DEPARTMENT OF DEFENSE MAY WITHDRAW ITS DECISION THAT WE ARE NOT UNDER FOREIGN OWNERSHIP. 27 28 Since we perform work on classified U.S. Government contracts, we had to submit the structure of our ownership to review by the Department of Defense. DLJ Merchant Banking Partners II, L.P., one of our equity investors, is indirectly majority owned by a holding company incorporated in Switzerland (CS First Boston). Previously, when DLJ Merchant Banking Partners II, L.P. was indirectly owned by a holding company incorporated in France, we received a decision from the Department of Defense that we were not be under foreign ownership, control or influence as a result of the acquisition. However, we cannot assure you that this determination will not be subsequently withdrawn by the Department of Defense in the event that it concludes that we were or came under foreign ownership, control or influence because of DLJ Merchant Banking's equity ownership in us. Should the Department of Defense ever reach such a conclusion, in order for us to maintain our ability to perform work on classified U.S. Government contracts, we may be required to implement methods to mitigate such foreign ownership, control or influence. These mitigating methods may include placing control of our board of directors in the hands of independent outside directors with no relationship to any of our shareholders, eliminating or modifying some of the approval rights that DLJ Merchant Banking will have over actions by our board of directors or implementing prior approval requirements regarding communications between us and DLJ Merchant Banking. RISK RELATED TO OUR TECHNOLOGY OUR OPERATIONS INVOLVE KEEPING UP WITH TECHNOLOGICAL CHANGE AND THE FAILURE TO DO SO COULD LIMIT OUR ABILITY TO OBTAIN FUTURE CONTRACTS. If we fail to keep up with technological changes, our profitability and ability to obtain new contracts may be affected. Changes in technology are a key feature of the electronic warfare industry. To succeed in the future, we will need to design, develop, manufacture, assemble, test, market and support new products and enhancements on a timely and cost-effective basis. Historically, our technology has been developed through research and development incurred in connection with long-term development contracts, a substantial portion of which was effectively funded by our customers, as well as through acquisitions and from internally funded research and development. We cannot assure you that we will be able to maintain the same level of customer funding for research and development incurred in connection with long-term development contracts in the future. In addition, when we work on such a contract, we seek to protect our proprietary technologies by taking steps to maintain ownership of data rights for our "core" technologies, source codes and other developments. We keep records of our data rights in order to claim these rights as our proprietary technology, but generally we do not make specific delineations in our government contracts of ideas which we developed under these rights prior to entering into such contracts. We cannot assure you that our customers will not challenge our data rights as technology that was developed with government funds or in the performance of their contracts. RISKS RELATED TO INTERNATIONAL CONTRACTS OUR INTERNATIONAL CONTRACTS REQUIRE LETTERS OF CREDIT AND, IN SOME CASES, LIQUIDATED DAMAGE PROVISIONS IN THE CONTRACTS. FAILURE TO PERFORM MAY CAUSE SIGNIFICANT LOSS. We cannot assure you that we will be able to compete successfully in international markets or that our international sales will be profitable. Substantially all of our contract revenues are denominated in U.S. dollars, and we intend to continue to predominately enter into U.S. dollar-denominated contracts. Accordingly, we do not, and believe that in the future we will not, have significant exposure to fluctuations in currency. Nevertheless, fluctuations in currency could adversely affect our customers, which may lead to delays in the timing and execution of contract awards. We typically receive one or more advance payments from our international customers during the initial phase of the contract, which advances range from approximately 19% to 60% of the total contract value. We generally provide letters of credit to guarantee our performance of the contract. Our capability to provide these standby letters of credit is limited by revolving credit facility. If capacity does not exist under the credit facility the company would not receive down payments on schedule until credit capacity was available thus delaying cash flow. The customer may draw down on the letters of credit if we default under the contract. A number of our foreign contracts also give our customers the right to receive liquidated damages ranging from 5% to 15% of the aggregate value of the items not delivered or 28 29 performed on schedule. As of June 30, 2001, our performance continues to be delayed on two of our international contracts, which have an aggregate contract value of approximately $25 million. Performance delays constitute defaults under those contracts. However, none of our customers has invoked the default provisions because of performance delays. In addition, none of our customers has attempted to draw down on our letters of credit or sought liquidated damages in any material amount, although we may incur additional costs as we work with our customers to revise their contract schedules. RISK RELATED TO OUR FIXED PRICE CONTRACTS FAILURE TO CONTROL COSTS IN CONNECTION WITH FIXED PRICE CONTRACTS MAY RESULT IN REDUCED PROFITS OR EVEN LOSSES. The risks of performing under long-term fixed price contracts include the difficulty of accurately forecasting costs and delivery schedules for events more than a year in the future and attaining contract revenues that are related to performance in accordance with contract specifications. In addition, the possibility of material obsolescence in connection with long-term procurements often causes increased engineering costs to rectify the obsolescence. Failure to anticipate technical problems, estimate costs accurately or control costs during performance of a fixed price contract may reduce profitability or cause a loss. Because we assume the risk of performing our firm fixed price contracts at a set price, the failure to accurately estimate the ultimate costs of the contracts or to control the costs during the performance of the work could result in, and sometimes has resulted, in reduced profits or losses for such contracts. While we are focused on preventing this occurrence, depending on the scope and scale of such an occurrence, the impact may or may not be material to the results of our operations. RISK RELATED TO OUR DEPENDENCE ON KEY PERSONNEL WE ARE DEPENDENT ON KEY PERSONNEL TO IMPLEMENT OUR BUSINESS STRATEGY. Our success depends to a significant extent on the continued services of our senior management and other members of management because our growth strategy will require substantial management expertise to implement successfully. Our senior management has extensive expertise in the electronic warfare industry. We could be adversely affected if any of our current management were unwilling or unable to continue in our employ. We have taken steps to minimize these risks by executing employment agreements with key executive officers. RISKS RELATED TO OUR INTELLECTUAL PROPERTY OUR INTELLECTUAL PROPERTY IS IMPORTANT TO OUR BUSINESS AND MAY NOT BE SUFFICIENTLY PROTECTED. Our ability to compete for new contracts will depend, in part, on our ability to obtain and enforce intellectual property protection for our technology in the United States and internationally. The failure to protect our intellectual property could have a material adverse on our financial condition and results of operations. Although we hold several U.S. patents, we currently rely primarily on a combination of trade secret and trademark laws and employee and third-party nondisclosure agreements. We also limit access to and distribution of proprietary information. Although these patents and licenses are, in the aggregate, important to the operation of our business, no existing patent, license or other such right is of such importance that its loss or termination would, in the opinion of management, materially affect our business. Trade secret laws, however, afford limited protection because they cannot be used to prevent third parties from reverse engineering and reproducing our products. We cannot assure you that our methods for protecting proprietary information will be adequate to prevent misappropriation of our technology or to preclude competitors from independently developing such technology. We cannot assure you that the obligations to maintain the confidentiality of our proprietary technology will prevent disclosure of such information. In addition, trade secret protection of our proprietary technology may be unavailable or limited in some foreign countries. Litigation may be necessary for us to defend against claims of infringement or to protect our proprietary technology. 29 30 Additionally, we cannot assure you that third parties will not assert infringement claims against us or, as described above, that our customers will not challenge our data rights in our proprietary technology as constituting technology that was developed in the performance of their contracts. ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK. Condor has financial instruments that are subject to interest rate risk, principally short- term investments and debt obligations issued at a fixed rate. Historically, we have not experienced material gains or losses due to interest rate changes when selling short-term investments. Based on the current holdings of short-term investments at June 30, 2001, the exposure to interest rate risk is not material. The fixed rate debt obligations issued by Condor are generally not callable until maturity. Condor is also subject to foreign currency exchange rate risk relating to receipts from customer and payments to suppliers in foreign currencies. As of June 30, 2001, the amount of receipts and expenditures that are contracted in foreign currencies, and market risk exposure relating to currency exchange, was not material. PART II. OTHER INFORMATION ITEM 1. LEGAL PROCEEDINGS. Condor is not a party to any material legal proceedings, other than ordinary routine litigation incidental to its business, none of which, in the opinion of management, is expected to have a material adverse effect to Condor's business results of operation or financial condition. Condor has been served a subpoena to provide information relevant to technical data supplied in response to a request for proposal from South Korea and in response to two requests for proposals from Sweden. The subpoena arises out of a grand jury proceeding which is investigating the potential violations of International Traffic and Arms Regulations. Condor is fully cooperating with the applicable authorities. Condor has retained attorneys in this matter. While there is significant uncertainty as to the ultimate outcome of this matter, Condor's management does not expect that the results of this investigation will have a material adverse effect on Condor's financial position and results of operation over and above contingencys already reserved. ITEM 2. CHANGES IN SECURITIES AND USE OF PROCEEDS. None in this quarter ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS. None in this quarter ITEM 5. OTHER INFORMATION On June 15, 2001, the Company terminated Vernon A. Dale, former Vice President, Electronic Warfare Systems and Vice President of Business Development. Mr. Klingler has assumed responsibility as Vice President of Marketing. Mr. Dale has retained counsel, who has demanded, among other items, that the Company pay to Mr. Dale the full amount of severance set forth in his employment agreement, which equals $500. The Company believes that Mr. Dale is not entitled to such amount pursuant to the terms of Mr. Dale's employment agreement. ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K. (a) Exhibits: Exhibits are numbered in accordance with the Exhibit Table of Item 601 of Regulation S-K: Exhibit 10.1 Waiver of Default Dated Aug. 3, 2001 (b) Reports on Form 8-K: Condor did not file any reports on Form 8-K in the first quarter of 2001. SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. CONDOR SYSTEMS, INC. By: /s/ FREDERIC B. BASSETT ------------------------------------ 30 31 Frederic B. Bassett Secretary and Chief Financial Officer Date: Aug. 14, 2001 31 32 EXHIBIT INDEX

CONDOR SYSTEMS INC 10-Q