Group CEO's Operating Review

Summary
Segment Analysis
Wireless Infrastrucutre
Compound Semiconductors
Defence Electronics
Central Research & Development
Business Disposals
Finance
Capital Expenditure
Employees
Outlook

Summary
This year has been one of considerable change as I have sought to complete the financial restructuring initiated in September 2004 and to revitalise the market’s appreciation of the value inherent in the group.

The Handset Products division was sold in September 2005 to Pulse Electronics (Singapore) PTE Ltd, a subsidiary of Technitrol Inc. (“Pulse”) for a total consideration of £56.7m, including the earn-out consideration of £11.3m due in August 2006. The initial consideration of £45.4m was used to repay the £44.0m term loan from Barclays and ABN AMRO, which had been rescheduled over a five year term with revised financial covenants in July 2005.

Defence Electronics opened its new manufacturing site in New Hampshire, USA in September 2005, partly to support the supply of subsystems to ITT. The UK continued its activities across a range of programmes including the supply of subsystem assemblies for the Eurofighter Defensive Aids system to Elettronica of Italy and EADS of Germany.

Compound Semiconductors continued to experience growing demand for its products, so we decided in the first half of the year to increase capacity as its financial performance was on target.

In January 2006, the Board also asked me to move from being Chairman to take the role of Group Chief Executive on John Roulston’s resignation. I undertook to carry out the role for a twelve to eighteen month period with the specific aims of providing leadership to the Wireless Infrastructure division following the retirement of its previous Managing Director, Alan Needle, in December 2005, and to support Iain Gibson in setting the direction for the next steps in the growth of the Compound Semiconductor and Defence Electronics activities within the Integrated Products division.

On appointment, I secured the management team of the Wireless Infrastructure division by ensuring the retention of Geoff Fletcher as Managing Director of the division. Subsequently, after a review of the group’s strategic options, the Board agreed that the majority of the activities in the Wireless Infrastructure business, covering transmit receive modules, integrated power amplifiers and remote radio head products, would be acquired by Powerwave.

We have subsequently continued to benefit from strengthening growth for the Wireless Infrastructure division arising from operators outside North America commissioning systems from OEMs.

The outlook for the businesses within the group is set out at the end of this report.

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The segmental analysis of the operating results is as follows:

The business segments were redefined with effect from 1 June 2005. The business segment results for the comparative period have been re-analysed to be consistent with the current period.

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Wireless Infrastructure
Wireless Infrastructure designs and manufactures the transmit/receive modules, power amplifiers and remote radio heads for mobile base stations, and point to point backhaul radio products that are primarily used to support mobile phone networks. During the year, the activities generated revenues of £172.7m (2005 £177.7m). The core business maintained its market leading position supplying all Western OEMs, and reflected a static market awaiting the placing of certain large contracts in India, China and the US that have started to be placed during the current year.

The operating profit was £5.5m (2005 £17.5m), reflecting principally pricing pressure that was not able to be fully compensated by product redesign, and a slower than planned move of production on high volume product lines from Finland to Hungary and from the US to China. We closed our Australian operations in August 2005 at a total cost of £1.1m, which is included in this result. During the second half of the financial year, the business suffered unseasonally low demand during the third quarter and the activity for the fourth quarter included the negative impact of the announcement made on 5 May 2006 of discussions with Powerwave. Provision was also made in the second half of the financial year for the finalisation of a commercial agreement in respect of a product liability issue with a customer.

The power amplifier products were manufactured in production quantities for one customer, and we undertook product development for another customer on a product scheduled to start production in the second half of the financial year ending 31 May 2007.

The principal products for the point to point backhaul radio products are radio transceivers assembled in the UK, which use integrated circuits produced by Compound Semiconductors, along with diplex filters which are manufactured in the UK and Hungary. Its customers are leading OEMs in the sector for whom several new products have entered production during the year. Further new designs are in qualification using our more complex multifunction integrated circuits.

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Compound Semiconductors
In the past twelve months, the Compound Semiconductors facility at Newton Aycliffe has been undergoing a transition from its prior position as a modest producer of Gallium Arsenide (GaAs) pHEMT wafers to being a volume producer of these products. They are used mainly in switches in mobile telephones, but also have applications in communication equipment and defence applications. While the majority of recent growth stems from expansion in the mobile telephone sector, it has also been pleasing that the year has seen initial volume production orders from Selex as they achieve success with E-Scan radar sales. While there was some disappointment in sales of merchant semiconductors, to a large extent this has been caused by the priority of meeting steep customer demand for switches. One benefit of the additional capacity to be created in the future is to allow Compound Semiconductors to establish a stronger presence in the merchant semiconductors sector.

The global mobile handset market is continuing its growth with approximately 815 million handsets sold in 2005, and forecast to be over 1 billion handsets sold in 2008. Use of GaAs switches is now specified for most new handset designs, and 80% of handsets manufactured in 2008 are expected to be of a design which contains this type of switch. This switch has the advantage that it consumes less power than alternative products for complex switches, and meets demanding low-loss and linearity requirements. Competition is from older technologies that use 3 way pin diode or GaAs switches combined with band defining filters. Furthermore, handsets are becoming more complex with increasing switching requirements offering the possibility that the quantity of GaAs used per handset will increase further over the next two to three years.

Revenue in the year grew 142% (2005 £8.6m to 2006 £20.8m) and the sequential growth rate in revenue comparing half year on half year during the financial year was 45%. Operating losses reduced from £11.7m in 2005 to £5.1m in 2006, including closure costs of our USA West Coast sales office of £0.4m which were incurred in the first half of the year.

It was pleasing that Compound Semiconductors reached its targeted financial performance of an operating break even run rate over the fourth quarter of the financial year to 31 May 2006. This was after absorbing the cost increases associated with commissioning a further capacity in the second half of the year. This was before the recognition of the release of £2.7m of deferred income in the period arising from the renegotiation of arrangements on past government grants. On the basis of this performance and the demand growth mentioned above, the Board has planned further expansion in the capacity of Compound Semiconductors in the coming financial year.

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Defence Electronics
For over 25 years Filtronic has supplied complex electromagnetic components and subsystems, most notably for use in the field of electronic warfare, to defence equipment prime contractors around the world. Although the Defence Electronics activities are divided between the UK and the US, the two parts of the company, which are managed as separate entities, operate in similar market sectors, reflecting the original technology base of the UK company.

The UK business (FCL) currently has manufacturing sites in Shipley and at Newton Aycliffe and a small research group in Australia. The past financial year has seen one of FCL’s larger contracts, for the supply of subsystems for the Eurofighter project, draw to a close. Consequently, additional focus has been applied to securing new business for future years.

Following a review of the future opportunities for the company in the US defence market, the past year has seen a significant consolidation of the US business. In order to achieve better leverage of the company’s competencies and to lay a solid growth path for the company in the US defence market, the Sage manufacturing operation and the Sigtek design centre were combined into a new business, Filtronic Signal Solutions (FSS). A new manufacturing site was opened in Hudson, New Hampshire in September 2005, which consolidated the two previous manufacturing operations in the US, supporting the contract with ITT, following which the management team has been progressively strengthened. A major review of the business following these changes resulted in an inventory write down of £1.5m, which was made in the interim results for the six months to 30 November 2005.

Revenue in the year grew 2% (2005 £31.6m to 2006 £32.1m) and operating profit before the inventory write down of £1.5m in 2006 was £2.1m (2005 £3.1m).

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Central Research and Development
Central Research and Development has supported the development of a new power amplifier product for a new customer, based on LDMOS technology, that is scheduled to start production in October 2006. It has also undertaken development work on remote radio heads for 3G and WiMAX applications in support of the Wireless Infrastructure division.

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Business disposals
This has been a year of major change in the structure of the group with the sale of the Handset Products division in September 2005, and agreement for the sale of the Wireless Infrastructure business (transmit/receive modules, power amplifiers and remote radio heads activities of the Wireless Infrastructure division).

The Handset Products division is treated as a discontinued operation. The Handset Products division was a market leader in the provision of internal antennas for mobile handsets and was sold to Pulse in September 2005. For the period from 1 June 2005 to the date of its sale on 8 September 2005, it generated revenue of £13.6m and an operating profit of £0.2m. The total consideration, including the earn-out due in August 2006, was £56.7m, resulting in a profit on disposal of £14.1m.

Finance
The group rescheduled its bank facilities with Barclays and ABN AMRO in July 2005 to be a term loan of £44m repayable over five years and an overdraft of £9m. The term loan was repaid on completion of the sale of the Handset Products division in September 2005 and the group’s facilities became a revolving credit facility of £18m available until August 2008 and an overdraft of £2m. In May 2006, the group secured an additional facility of £15m from its bankers until 30 November 2006 to fund the expansion of the Compound Semiconductors facility at Newton Aycliffe.

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Capital expenditure
The group’s capital expenditure for the continuing operations was £13.4m (2005 £8.5m). The capital expenditure was incurred principally to increase capacity in Compound Semiconductors in the light of continued growth in customer demand, and the completion of the move to the new manufacturing facility in the US for Defence Electronics. Capital expenditure in the discontinued Handset Products operation was £1.0m (2005 £4.5m) in the period before disposal. This was for the start-up of the manufacturing facility in Hungary and capacity expansion in China.

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Employees
At 31 May 2006, the group employed 3,353 people in its continuing operations, an increase of 20% since May 2005, primarily in Wireless Infrastructure’s manufacturing operations in China and Hungary.

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Outlook
Wireless Infrastructure
The Wireless Infrastructure division has experienced continuing strengthened demand in its market, that has been reflected in the order book in June being extended out from its usual period of around two weeks to twelve weeks and this has been accompanied by increased visibility in the forecasts received from customers for later in the financial year.

As a result, production capacity has been increased with output for the largest volume product being doubled since January and manufacturing operations in Finland have been restarted to meet demand for a specific product. In addition, demand for point to point backhaul radios has doubled year on year.

With this increase in demand, pricing has been agreed for a longer period than usual with a key customer.

It is also well positioned to support Long Term Evolution GSM with its core OEM customers. This outlook for this division is focused on growth from its traditional customer base.

The planned financial performance for the Wireless Infrastructure division is therefore that revenue for the first half of the current financial year is expected to increase by more than 25% compared with the preceding half year and, with the strength of the current market, customer demand extends well into the second half of the current financial year, supporting expected continued growth going forward.

Compound Semiconductors
For Compound Semiconductors, we are now providing some 20% of the overall mobile handset market with 4-way and above mobile phone pHEMT switches, which is around an 80% share of the addressable market. Continued market adoption of our type of switches is expected to reach 80% of overall mobile phone market over the coming three years.

As a result of a detailed assessment of future wafer requirements, we have phased our plans for capacity increase and we are currently undertaking this expansion in line with forecast demand for the current financial year.

Therefore our financing plan for the growth of Compound Semiconductors requires less than £15m of additional cash for this financial year, after which the business is targeted to be self-financing.

With the profile of capacity deployment, revenue growth of over 25% is therefore expected per sequential half year for the current financial year including initial growth in merchant semiconductors and non-switch volume products and growth in demand to support filter and backhaul radio products.

Defence Electronics
With its three major contracts substantially complete in the financial year ended 31 May 2006, the focus in Defence Electronics is to secure new business which will mostly generate replacement revenues over the financial year and provide a platform for future growth. In both the UK and US, opportunities have been identified and are being supported by appropriate product development activities.

Pension Scheme
We are expecting to implement changes to the group’s final salary pension scheme at the end of the consultation period on 31 July 2006 to have benefits based on career average revalued earnings.

As part of this change to the scheme, the company has agreed to provide additional funding of £4.6m on implementation of the changes to the scheme to fund the actuarial deficit at the date of change. The existing contribution arrangements remain in place which require that any increases in contribution rates over current levels that are required to fund deficits would be made two thirds by employee members and one third by the company.

Professor J David Rhodes CBE FRS FREng
Group CEO
31 July 2006

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