UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended: January 30, 2011

[ ] 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 0-5411

HERLEY INDUSTRIES, INC.

(Exact name of registrant as specified in its charter)

DELAWARE 23-2413500

(State or other jurisdiction of incorporation or organization) (I.R.S. Employer Identification Number)

3061 Industry Drive, Lancaster, Pennsylvania 17603

(Address of Principal Executive Offices) (Zip Code)

Registrant's Telephone Number, including Area Code: (717) 397-2777

_________________________________________ _________________

(Former name, former address and former fiscal year (Zip Code)

if changed since last report)

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. X Yes __ No

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes No

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definition of “large accelerated filer” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.

[ ] Large accelerated filer [X] Accelerated filer

[ ] Non-accelerated filer [ ] Smaller reporting company

(Do not check if a smaller reporting company)

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes X No

As of February 28, 2011, there were 14,097,904 shares of Common Stock outstanding.

HERLEY INDUSTRIES, INC. AND SUBSIDIARIES

INDEX TO FORM 10-Q

	PART I - FINANCIAL INFORMATION	PAGE

Item 1 -	Financial Statements:

	Condensed Consolidated Balance Sheets -
	January 30, 2011 (Unaudited) and August 1, 2010	2

	Condensed Consolidated Statements of Income (Unaudited) - for the thirteen and twenty-six weeks ended January 30, 2011 and January 31, 2010	3

	Condensed Consolidated Statements of Cash Flows (Unaudited) – for the twenty-six weeks ended January 30, 2011 and January 31, 2010	4

	Notes to Condensed Consolidated Financial Statements (Unaudited)	5

Item 2 -	Management’s Discussion and Analysis of Financial Condition and Results of Operations	12

Item 3 -	Quantitative and Qualitative Disclosures About Market Risk	17

Item 4 -	Controls and Procedures	17

	PART II - OTHER INFORMATION

Item 1 -	Legal Proceedings	18

Item 1A -	Risk Factors	18

Item 2 -	Unregistered Sales of Equity Securities and Use of Proceeds	19

Item 3 -	Defaults upon Senior Securities	19

Item 4 -	Removed and Reserved	19

Item 5 -	Other Information	19

Item 6 -	Exhibits	20

Signature		20

Part I - Financial Information
Item I - Financial Statements

HERLEY INDUSTRIES, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED BALANCE SHEETS
(In thousands, except share data)

	January 30, 2011			August 1, 2010
	(Unaudited)

ASSETS
Current Assets:
Cash and cash equivalents	$	26,374		$	25,690
Trade accounts receivable, net		28,903			28,705
Costs incurred and income recognized in excess
of billings on uncompleted contracts		11,734			9,334
Inventories, net		50,769			51,453
Deferred income taxes		15,963			15,726
Other current assets		4,368			3,875
Total Current Assets		138,111			134,783
Property, plant and equipment, net		31,656			32,441
Goodwill		43,722			43,722
Intangibles, net		7,696			8,197
Deferred income taxes		5,391			7,045
Other assets		392			426
Total Assets	$	226,968		$	226,614
LIABILITIES AND SHAREHOLDERS' EQUITY
Current Liabilities:
Current portion of long-term debt	$	1,330		$	1,321
Current portion of employment settlement agreements		1,405			1,331
Accounts payable and accrued expenses		21,316			31,335
Income taxes payable		834			539
Billings in excess of costs incurred and
income recognized on uncompleted contracts		1,004			648
Accrual for contract losses		2,514			2,080
Advance payments on contracts		9,317			9,922
Total Current Liabilities		37,720			47,176
Long-term debt, net of current portion		10,107			10,881
Long-term portion of employment settlement agreements		694			1,437
Other long-term liabilities		8,458			8,136
Total Liabilities		56,979			67,630
Commitments and Contingencies
Shareholders' Equity:
Common stock, $.10 par value; authorized 20,000,000 shares;
issued and outstanding 14,060,404 at January 30, 2011
and 13,774,394 at August 1, 2010		1,406			1,377
Additional paid-in capital		105,378			103,029
Retained earnings		63,593			54,896
Accumulated other comprehensive loss		(388	)		(318	)
Total Shareholders' Equity		169,989			158,984
Total Liabilities and Shareholders' Equity	$	226,968		$	226,614

See notes to condensed consolidated financial statements.

HERLEY INDUSTRIES, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF INCOME (UNAUDITED)
(In thousands, except per share data)


	Thirteen weeks ended							Twenty-six weeks ended
	January 30, 2011			January 31, 2010				January 30, 2011			January 31, 2010

Net sales	$	50,659			$	46,609		$	99,580			$	94,288
Cost and expenses:
Cost of products sold		34,249				33,752			67,412				68,144
Selling and administrative expenses		8,958				7,746			17,149				15,427
Litigation settlement		-				-			1,100				-
Litigation costs, net of recovery settlement		120				(1,224	)		940				(684	)
Employment settlement costs		-				900			-				900
		43,327				41,174			86,601				83,787

Operating income		7,332				5,435			12,979				10,501
Other (expense) income:
Interest income		82				9			90				20
Interest expense		(112	)			(165	)		(134	)			(330	)
Foreign exchange transaction gains (losses)		90				(122	)		22				(164	)
		60				(278	)		(22	)			(474	)

Income before income taxes		7,392				5,157			12,957				10,027
Provision for income taxes		2,192				1,367			4,259				2,686

Net income	$	5,200			$	3,790		$	8,698			$	7,341

Earnings per common share - Basic	$	.37			$	.28		$	.63			$	.54

Basic weighted average shares		14,004				13,687			13,898				13,695

Earnings per common share - Diluted	$	.37			$	.27		$	.62			$	.53

Diluted weighted average shares		14,132				13,853			14,112				13,865

See notes to condensed consolidated financial statements.

HERLEY INDUSTRIES, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED)
(In thousands)
	Twenty-six weeks ended
	January 30,			January 31,
	2011			2010
Cash flows from operating activities:
Net income	$	8,698		$	7,341
Adjustments to reconcile net income to
net cash (used in) provided by operating activities:
Depreciation and amortization		3,399			3,633
Stock-based compensation costs		768			240
Excess tax benefit from exercises of stock options		(1,609	)		-
Imputed interest on employment and litigation settlement liabilities		35			88
Inventory valuation reserve charges		557			619
Warranty reserve charges		580			842
Deferred tax provision		1,741			5,990
Changes in operating assets and liabilities:
Trade accounts receivable		(195	)		(1,630	)
Income taxes receivable		224			(3,735	)
Income taxes payable		1,904			312
Costs incurred and income recognized in excess
of billings on uncompleted contracts		(2,349	)		5,969
Inventories, net		136			1,111
Other current assets		(708	)		(2,531	)
Accounts payable and accrued expenses		(604	)		(5,186	)
Billings in excess of costs incurred and
income recognized on uncompleted contracts		344			161
Accrual for contract losses		434			(1,172	)
Employment settlement payments		(704	)		(7,769	)
Litigation settlement payments		(12,075	)		(2,000	)
Advance payments on contracts		(606	)		(557	)
Other, net		10			(80	)
Total adjustments		(8,718	)		(5,695	)
Net cash (used in) provided by operating activities		(20	)		1,646
Cash flows from investing activities:
Proceeds from sale of fixed assets		44			-
Capital expenditures		(2,145	)		(2,738	)
Net cash used in investing activities		(2,101	)		(2,738	)
Cash flows from financing activities:
Merger agreement fee		2,000			-
Proceeds from exercise of stock options		1			-
Excess tax benefit from exercises of stock options		1,609			-
Payments of long-term debt		(729	)		(1,005	)
Purchase of treasury stock		-			(588	)
Net cash provided by (used in) financing activities		2,881			(1,593	)
Effect of exchange rate changes on cash		(76	)		(1	)
Net increase (decrease) in cash and cash equivalents		684			(2,686	)
Cash and cash equivalents at beginning of period		25,690			14,820
Cash and cash equivalents at end of period	$	26,374		$	12,134
See notes to condensed consolidated financial statements

HERLEY INDUSTRIES, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

1.	Principles of Consolidation and Basis of Presentation

The unaudited Condensed Consolidated Financial Statements include the accounts of Herley Industries, Inc. (“Herley”), a Delaware corporation, and its wholly-owned subsidiaries (collectively the “Company”), which are engaged in the design, development and manufacture of microwave technology solutions for the defense, aerospace and medical industries worldwide with four domestic and three foreign manufacturing facilities and two engineering offices in the U.S. Herley’s corporate office is in Lancaster, Pennsylvania. Herley’s primary facilities include: Herley Lancaster; Herley New England; Herley Israel; Micro Systems, Inc. (“MSI”); Herley-CTI; Herley-GMI Eyal (“Eyal”); and EW Simulation Technology (“EWST”). All significant intercompany accounts and transactions have been eliminated.

The accompanying unaudited Condensed Consolidated Financial Statements have been prepared in accordance with instructions to Form 10-Q and Article 10 of Regulation S-X and do not include all of the information and disclosures normally included in annual financial statements as required by accounting principles generally accepted in the United States of America (“U.S. GAAP”) for complete financial statements. In the opinion of management, all adjustments considered necessary for a fair presentation have been included in the accompanying Condensed Consolidated Financial Statements. Operating results for this quarter are not necessarily indicative of the results of operations that may be expected for any other interim period or for the full fiscal year. These statements should be read in conjunction with the consolidated financial statements and notes thereto, and the Company’s description of critical accounting policies included in the Company’s 2010 Annual Report on Form 10-K for the fiscal year ended August 1, 2010 as filed with the Securities and Exchange Commission (“SEC”) on October 14, 2010. The accounting policies used in preparing these unaudited condensed consolidated interim financial statements are consistent with those described in the August 1, 2010 audited financial statements. The Condensed Consolidated Balance Sheet at August 1, 2010 has been derived from the audited consolidated financial statements at that date but does not include all of the information and footnotes required by U.S. GAAP for complete financial statements. Certain prior-period balances have been reclassified to conform to the current period’s financial statement presentation.

The preparation of financial statements in conformity with U.S. GAAP requires that management of the Company make certain estimates and assumptions that affect the reported amounts of assets, liabilities and disclosures of contingent assets and liabilities at the date of the financial statements and reported amounts of revenues and expenses during the reporting periods. These judgments can be subjective and complex, and consequently actual results could differ from those estimates and assumptions. The most significant estimates include: valuation and recoverability of goodwill and long-lived assets; income taxes; recognition of revenue and costs on production contracts; the valuation of inventory; accrual of litigation settlements and other contingencies; and stock-based compensation costs. Each of these areas requires the Company to make use of reasoned estimates including estimating the cost to complete a contract and loss accruals, forecasted cash flows and the net realizable value of its inventory. Changes in estimates can have a material impact on the Company’s financial position and results of operations.

2.	Goodwill and Intangibles, net

The changes in Goodwill and Intangibles, net during the twenty-six weeks ended January 30, 2011 is as follows (in thousands):

	Goodwill		Intangibles
Balance at August 1, 2010	$	43,722	$	8,197
Add: Translation gain		-		7
Less: amortization		-		(508	)
Balance at January 30, 2011	$	43,722	$	7,696

Amortization expense related to intangibles subject to amortization was $251,000 and $423,000 for the thirteen weeks ended January 30, 2011 and January 31, 2010, respectively, and $508,000 and $875,000, for the twenty-six weeks ended January 30, 2011 and January 31, 2010, respectively.

The Company performs an evaluation of its goodwill and intangible assets with indefinite lives for impairment on an annual basis during the fourth quarter of its fiscal year and on an interim basis if there has been a triggering event or other indication that impairment has occurred. There have been no triggering events or indicators of impairment that have occurred during the thirteen and twenty-six weeks ended January 30, 2011 that would require additional impairment testing of goodwill or long-lived intangible assets.

3. Inventories, net

The major components of inventories, net are as follows (in thousands):

	January 30,		August 1,
	2011		2010
Purchased parts and raw materials	$	31,450	$	33,026
Work in process		25,365		24,623
Finished products		2,885		2,612
		59,700		60,261
Less:
Allowance for obsolete and slow moving inventory		7,910		7,373
Unliquidated progress payments		1,021		1,435
	$	50,769	$	51,453

4. Income Taxes

The Company files income tax returns in the U.S. federal jurisdiction and various state and foreign jurisdictions. The Company is no longer subject to income tax examinations by U.S. federal and state taxing authorities for years before fiscal 2006 and foreign taxing authorities before fiscal 2003. There are no audit examinations currently in process by any income taxing authority.

The provision for income taxes for the twenty-six weeks ended January 30, 2011 was $4,259,000 as compared to $2,686,000 for the twenty-six weeks ended January 31, 2010. The estimated annual effective tax rate for fiscal 2011, before consideration of discrete items, is approximately 32%. This rate is lower than the statutory U.S. federal tax rate of 35%, primarily due to the Company’s foreign earnings attributable to its Israeli and United Kingdom subsidiaries which are taxed at estimated rates of 14% and 27%, respectively.

Gross unrecognized tax benefits, excluding interest and penalties, were approximately $5,941,000 at January 30, 2011 of which $363,000 would impact the annual effective tax rate in accordance with deferred tax accounting standards. Management does not anticipate that it is reasonably possible that the amount of unrecognized tax benefits will significantly increase or decrease in the next twelve months.

The Company recognizes accrued interest and penalties related to unrecognized tax benefits in income tax expense. The Company recognized $296,000 of accrued interest and $79,000 of accrued penalties related to unrecognized tax benefits in the Condensed Consolidated Statement of Income, on a gross basis, for the twenty-six weeks ended January 30, 2011; the balances of accrued interest and accrued penalties were $488,000 and $79,000, respectively, in the Condensed Consolidated Balance Sheet on a gross basis at such date. Unrecognized tax benefits and the corresponding accrued interest and accrued penalty amounts are included as “Other long-term liabilities” in the Condensed Consolidated Balance Sheets.

5.	Product Warranties

The Company warrants its products for a period of one year. Product warranty costs are accrued based on historical claims expense, and are included in “Accounts payable and accrued expenses” on the Condensed Consolidated Balance Sheets. The reserve for warranty costs is reduced as warranty repair costs are incurred. The following table presents the change in the accrual for product warranty costs for the thirteen and twenty-six weeks ended January 30, 2011 and January 31, 2010, respectively (in thousands):


	Thirteen weeks ended						Twenty-six weeks ended
	January 30,			January 31,			January 30,			January 31,
	2011			2010			2011			2010
Balance at beginning of period	$	1,052		$	1,028		$	1,039		$	938
Provision for warranty obligations		350			334			580			913
Warranty costs charged to the reserve		(160	)		(326	)		(377	)		(815	)
Balance at end of period	$	1,242		$	1,036		$	1,242		$	1,036

6. Litigation

As previously reported in the Company’s Quarterly Report Form 10-Q for the period ended October 31, 2010, and in accordance with accounting standards related to contingencies, the Company recorded a charge of $1,100,000 during the quarter ended October 31, 2010 relating to litigation brought against the Company by a competitor in October 2009. On December 14, 2010 the parties reached an agreement to settle this action and on December 15, 2010 the Company paid $1,100,000 which is consistent with the charge recorded by the Company for the quarter ended October 31, 2010. The Company does not anticipate any additional charges relating to this litigation.

In July 2010, the Company reached an agreement to settle all securities class actions originally filed in 2006, and subsequently consolidated under the caption: In re Herley Industries, Inc. Securities Litigation, Docket No. 06-CV-2596 (JRS). As previously disclosed, between June 2006 and August 2006, the Company and certain of its current and former officers and directors (the “Individual Defendants”) were named as defendants in five related class actions alleging violations of the federal securities laws. Those cases were subsequently consolidated into one class action on behalf of a purported class of all persons who purchased or otherwise acquired shares of our stock during the period October 1, 2001 through June 14, 2006 (the “Class”). At all times during the pendency of the litigation, the Company and the Individual Defendants steadfastly maintained that the claims raised in the securities class action were without merit, and vigorously contested those allegations. As part of the settlement, the Company and the Individual Defendants continue to deny any liability or wrongdoing under the securities laws. The terms of the settlement provided for, in part, the dismissal of the litigation against the Company and all of the Individual Defendants, and the creation by the Company of a $10 million settlement fund. The fund will be allocated, after deduction of court-ordered expenses, such as attorneys’ fees and expenses, settlement administration costs and any applicable taxes, among members of the settlement class who submit valid proofs of claim. Upon final approval of the settlement by the Court, in August 2010 the Company paid $10 million out of existing cash reserves to create the settlement fund.

In May, 2010 the Company reached an agreement to settle all stockholder derivative actions originally filed in 2006 in the United States District Court for the Eastern District of Pennsylvania at Docket No. 06-CV-2964 (JRS). The consolidated derivative complaint, filed on January 12, 2007, alleged that current and former directors violated their fiduciary obligations in connection with certain actions or decisions in their capacities as officers or directors of the Company. All of the defendants previously denied any wrongdoing and, under the settlement agreement, the Company and the other defendants continue to deny any breach of fiduciary duties or any other improper actions. Under the terms of the settlement, as approved by the Court, the Company agreed to institute certain corporate governance practices relating to the Board of Directors structure, directors’ independence, and nomination and election procedures for directors, related party transactions, director stock ownership, and oversight policies. The Company’s Board is committed to the implementation of best practices in the area of corporate governance and believes that the agreed upon practices are consistent with that commitment. In addition, the Court awarded plaintiffs’ counsel the sum of $975,000 for fees and costs in pursuit of the consolidated derivative action. The Company paid this award in August 2010.

The Company is involved in various other legal proceedings and claims which arise in the ordinary course of its business. While any litigation contains an element of uncertainty, management believes that the outcome of such other litigation will not have a material adverse effect on the Company’s financial position or results of operations.

7.	Line of Credit, Long-Term Debt and Stand-by Letters of Credit

We have a $40,000,000 Revolving Credit Loan Agreement (“Agreement”) with two banks on an unsecured basis, which may be used for general corporate purposes, including business acquisitions and stand-by letters of credit. The Agreement requires the payment of interest only on a monthly basis and payment of the outstanding principal balance on March 31, 2012. The Company may elect to borrow with interest at (A) the bank’s prime rate of interest minus 0.50% or (B) the greater of (i) LIBOR plus a margin of 2.50% or (ii) 3.50%. There is a fee of 25 basis points per annum on the unused portion of the credit facility payable quarterly and a fee of 1.50% per annum on outstanding stand-by letters of credit. The Agreement contains various financial covenants, including minimum tangible net worth, total liabilities to tangible net worth, debt service coverage and restrictions on other borrowings. The Company was in compliance with all of its financial covenants at January 30, 2011.

We had no loans outstanding under our credit facility during the quarter ended January 30, 2011. Stand-by letters of credit in the amount of approximately $7,539,000, of which $5,545,000 reduces the amount of credit available under the credit line, were outstanding at January 30, 2011. We had approximately $34,455,000 available under our line at January 30, 2011.

On September 16, 2008, the Company entered into a ten-year term loan with a bank in Israel in the amount of $10,000,000 in connection with the acquisition of Eyal. The loan is payable in quarterly installments of $250,000 plus interest at LIBOR plus a margin of 1.5%. The loan agreement contains various financial covenants which have been met at January 30, 2011, including minimum net equity, as defined.

8.	Stock Buyback Program

In October 2007, the Company’s Board of Directors approved an expansion of its existing stock buyback program to make additional purchases of up to 1,000,000 shares of its common stock in the open market or in private transactions, in accordance with applicable SEC rules for an aggregate of 3,000,000 shares. As of August 1, 2010, the Company had repurchased and retired approximately 2,460,000 shares under the program. There were no stock repurchases during the twenty-six weeks ended January 30, 2011. During the thirteen and twenty-six weeks ended January 31, 2010, the Company repurchased and retired 11,730 and 47,632 shares of its common stock, respectively, pursuant to this program at an aggregate cost of approximately $147,000 and $588,000, respectively, including transaction costs. Funds to acquire the shares came from excess cash reserves. The timing, actual number and value of any additional shares that may be repurchased under this program will depend on a number of factors, including the Company’s future financial performance, the Company’s available cash resources and competing uses for the cash, prevailing market prices of the Company’s common stock and the number of shares that become available for sale at prices that the Company believes are attractive. As of January 30, 2011, approximately 540,000 shares were eligible for future purchase under the Company’s buyback program.

9.	Comprehensive Income

Comprehensive income for the periods presented is as follows (in thousands):


	Thirteen weeks ended						Twenty-six weeks ended
	January 30,			January 31,			January 30,			January 31,
	2011			2010			2011			2010
Net income	$	5,200		$	3,790		$	8,698		$	7,341
Unrealized gain on interest rate swap		11			5			22			9
Translation of foreign financial statements		(91	)		(19	)		(93	)		(16	)
Comprehensive income	$	5,120		$	3,776		$	8,627		$	7,334

The foreign currency translation gain (loss) relates to the Company’s investment in its U.K. subsidiary and fluctuations in exchange rates between its local currency and the U.S. dollar.

The components of accumulated other comprehensive loss was as follows (in thousands):

	January 30,			August 1,
	2011			2010
Unrealized loss on interest rate swap, net of tax	$	(29	)	$	(51	)
Translation of foreign financial statements		(359	)		(267	)
Accumulated other comprehensive loss	$	(388	)	$	(318	)

10.	Share-Based Compensation

The Company has various stock option plans which are described in Note O of its August 1, 2010 Annual Report on Form 10-K that provide for the grant of stock options and restricted stock to eligible employees and directors.

The Company recorded total share-based costs related to stock option and restricted stock awards, included as compensation costs in operating expenses, of approximately $429,500 and $116,000 for the thirteen weeks ended January 30, 2011 and January 31, 2010, respectively, and $767,500 and $240,000 for the twenty-six weeks ended January 30, 2011 and January 31, 2010, respectively.

As of January 30, 2011, there were 1,555,750 stock options outstanding. During the first quarter of fiscal 2011, options for 42,250 shares of common stock at an exercise price of $16.13 per share and 16,467 shares of restricted stock were granted to certain management employees and directors with a fair value of approximately $681,000 and $255,000, respectively. During the second quarter of fiscal 2011, options for 2,500 shares of common stock at an exercise price of $17.59 and 16,520 shares of restricted stock were granted to a management employee and directors with a fair value of approximately $44,000 and $282,000, respectively. The aggregate value of unvested options as of January 30, 2011, as determined using a Black-Scholes option valuation model, was approximately $332,700 (net of estimated forfeitures), which is expected to be recognized over a weighted-average period of 1.1 years. The aggregate value of unvested restricted stock as of January 30, 2011 was approximately $1,180,000 net of estimated forfeitures which are expected to be recognized over a weighted-average period of 3.6 years.

Options for 800,000 and 810,000 shares of common stock were exercised on a non-cash swap basis during the thirteen and twenty-six weeks, respectively, ended January 30, 2011. The exercise prices averaged $11.33 and $11.35 per share during the thirteen and twenty-six weeks, respectively, ended January 30, 2011. Options for 8,500 and 17,600 shares of common stock expired during the thirteen and twenty-six weeks, respectively, ended January 30, 2011. No options were exercised during the twenty-six weeks ended January 31, 2010 and options for 64,000 and 82,800 shares of common stock expired or were forfeited during the thirteen and twenty-six week period ended January 31, 2010.

There were 1,418,002 vested stock options outstanding as of January 30, 2011 at a weighted average exercise price of $17.80. Included in the vested stock options outstanding were 1,079,800 options with exercise prices greater than the closing stock price of $16.57 as of January 30, 2011.

11. Earnings per Common Share (“EPS”)

The following table shows the components used in the calculation of basic and diluted earnings per common share (in thousands):


	Thirteen weeks ended				Twenty-six weeks ended
	January 30,		January 31,		January 30,		January 31,
	2011		2010		2011		2010
Numerator:
Net income	$	5,200	$	3,790	$	8,698	$	7,341
Denominator:
Basic weighted-average shares		14,004		13,687		13,898		13,695
Effect of dilutive securities:
Employee stock options		128		166		214		170
Diluted weighted-average shares		14,132		13,853		14,112		13,865

Stock options not included in computation		1,146		2,373		1,150		2,388

Exercise price range of options excluded	$	16.13 - $21.18	$	12.45 - $21.18	$	16.13 - $21.18	$	12.45 - $21.18

Certain options outstanding as of January 30, 2011 are excluded from the computation as noted in the table above because their effect is anti-dilutive. Such options expire at various dates through June 8, 2017.

12. Geographic Information and Major Customers

Net sales directly to the U.S. Government for the thirteen weeks ended January 30, 2011 and January 31, 2010 were approximately 12.0% and 15.6% of consolidated net sales from continuing operations, respectively, and in the twenty-six weeks ended January 30, 2011 and January 31, 2010 were approximately 12.7% and 16.0%, respectively.

Northrop Grumman Corporation and Lockheed Martin Corporation accounted for approximately 20.6% and 12.3%, respectively, of consolidated net sales for the thirteen weeks ended January 30, 2011, and approximately 20.0% and 12.6%, respectively, for the twenty-six weeks ended January 30, 2011. Northrop Grumman and Lockheed Martin each accounted for approximately 20.5% and 9.5%, respectively, of net sales in the thirteen weeks ended January 31, 2010, and approximately 18.5% and 10.9%, respectively, for the twenty-six weeks ended January 31, 2010. No other customer accounted for 10% or more of consolidated net sales in the periods presented. Foreign sales amounted to approximately $17,561,000 (35%) and $17,233,000 (37%) for the thirteen weeks ended January 30, 2011 and January 31, 2010, respectively, and approximately $33,531,000 (34%) and $34,156,000 (36%) for the twenty-six weeks ended January 30, 2011 and January 31, 2010, respectively.

Geographic net sales from continuing operations for the second fiscal quarter and year to date based on place of contract performance were as follows (in thousands):


	Thirteen weeks ended				Twenty-six weeks ended
	January 30,		January 31,		January 30,		January 31,
	2011		2010		2011		2010

United States	$	37,146	$	34,813	$	72,696	$	69,873
Israel		10,756		10,913		22,670		22,261
England		2,757		883		4,214		2,154
	$	50,659	$	46,609	$	99,580	$	94,288

Net property, plant and equipment by geographic area were as follows (in thousands):

		January 30,		August 1,
		2011		2010

United States	$	23,990	$	24,856
Israel		7,337		7,382
England		329		203
	$	31,656	$	32,441

13. Supplemental Cash Flow information is as follows (in thousands):

	Twenty-six weeks ended
	January 30, 2011		January 31, 2010
Net cash paid during the period for:
Interest	$	141	$	290
Income taxes	$	437	$	136

Non-cash financing transactions:
Retirement of 47,632 shares of treasury stock	$	-	$	588

14.	New Accounting Pronouncements

Newly issued effective accounting pronouncements:

In April 2010, the Financial Accounting Standards Board issued ASU 2010-17, “Revenue Recognition — Milestone Method.” The amended guidance provides the criteria that should be met for determining whether the milestone method of revenue recognition is appropriate for research and development transactions. The amended guidance is currently effective for milestones achieved in the Company’s fiscal period ended January 30, 2011 and did not have any impact on the Company’s financial position, results of operations, or cash flows.

In October 2009, the Financial Accounting Standards Board issued ASU 2009-13, “Multiple Deliverable Revenue Arrangements.” This amended guidance enables companies to account for products or services (deliverables) separately rather than as a combined unit in certain circumstances. The amended guidance is currently effective for revenue arrangements entered into or materially modified in the Company’s fiscal period ended January 30, 2011 and did not have a significant impact on the Company’s financial position, results of operations, or cash flows.

15.	Related Party Transaction

Prior to the acquisition of MSI, MSI had leased one of its two buildings in Fort Walton Beach, Florida from MSI Investments, a Florida LLC. Owners of MSI Investments include two current employees of MSI and one who serves as a consultant. Lease expense for the thirteen and twenty-six weeks ended January 30, 2011 was approximately $74,000 and $148,000, respectively; and approximately $74,000 and $148,000, respectively, for the thirteen and twenty-six weeks ended January 31, 2010.

On August 24, 2005, the Company amended the lease agreements for its manufacturing facility in Farmingdale, New York with a partnership owned by the wife of the Company’s current Chairman (and children of the Company’s former Chairman) and the children of the Company’s former Chief Executive Officer to incorporate two individual leases into a single lease and extended the term of the initial leases to August 31, 2010. The Company incurred rent expense of approximately $430,000, $494,000, and $478,000 in fiscal 2010, 2009 and 2008, respectively, under the leases. During the fourth quarter of fiscal 2008, the Company decided to close its manufacturing facility in Farmingdale, New York and transfer its contracts and assets to its other facilities in Whippany, New Jersey, Woburn, Massachusetts, Lancaster, Pennsylvania and Jerusalem, Israel. On January 25, 2009, the Company entered into a modification of the lease to reduce the amount of space it was leasing and reduce the annual rental payments remaining under the lease to approximately $430,000 annually through August 2010.

The Company entered into a new three year lease agreement commencing September 1, 2010 with a partnership owned by the wife of the Company’s current Chairman (and children of the Company’s former Chairman) relocating its Farmingdale, New York office to a new location having approximately 4,000 square feet at an annual cost of $72,000, subject to escalation of 3% per annum.

16.	Subsequent Event

On February 7, 2011, the Company entered into an Agreement and Plan of Merger (the “Merger Agreement”) with Kratos Defense & Security Solutions, Inc., a Delaware corporation (“Kratos”), and Lanza Acquisition Co., a Delaware corporation and an indirect, wholly-owned subsidiary of Kratos (“Lanza”). The definitive agreement was unanimously approved by the Company’s Board of Directors and was the result of the Board of Directors’ evaluation of various strategic alternatives to maximize stockholder value.

Pursuant to the terms and conditions of the Merger Agreement:

			· Lanza commenced a tender offer (the “Offer”) on February 25, 2011 to acquire all of the outstanding shares of common stock, $0.10 par value per share, of the Company at a purchase price of $19.00 per share net to the holders thereof in cash, without interest, subject to applicable withholding taxes; and
			· as soon as practicable after the consummation of the Offer and subject to the satisfaction or waiver of certain conditions set forth in the Merger Agreement, Lanza will merge with and into the Company with the Company continuing as the surviving corporation and an indirect wholly-owned subsidiary of Kratos.

The Offer will remain open for 20 business days, subject to periods of extension through June 30, 2011 if the conditions to the Offer have not been satisfied at the end of any Offer period (subject to the parties’ termination rights under the Merger Agreement).

Each share of Company common stock remaining outstanding following the consummation of the Offer, other than shares of Company common stock held by stockholders who have validly exercised their appraisal rights under Delaware law, will be converted into the right to receive cash in an amount equal to $19.00 per share net to the holders thereof.

The parties have agreed that if, following completion of the Offer, Lanza owns at least 90% of the then outstanding shares of the Company’s common stock, the Merger will be completed without a meeting of Company stockholders pursuant to Delaware’s “short form” merger statute. Lanza may, but is not required to, provide for a “subsequent offering period” in accordance with applicable law following the consummation of the Offer in order to seek additional shares of Company common stock to facilitate the consummation of the Merger using such short form merger procedures. In the event that Lanza does not hold at least 90% of the outstanding shares of Company common stock following the consummation of the Offer (including the “subsequent offering period” provided by Lanza, if any), the Company must obtain the approval of the Company’s stockholders to consummate the Merger. In this event, the Company will call and convene a stockholder meeting to obtain this approval, and Kratos and Lanza will vote all shares of Company common stock acquired by them pursuant to the Offer in favor of the adoption of the Merger Agreement and the consummation of the Merger, thereby assuring approval of the Merger.

The obligation of Lanza to accept for payment and pay for all shares of Company common stock tendered in the Offer is subject to the satisfaction or waiver of a number of conditions set forth in the Merger Agreement, including: (i) at least a majority of the shares of common stock then outstanding, on a fully diluted basis, having been validly tendered in (and not withdrawn from) the Offer, (ii) the expiration or termination of applicable waiting periods under the Hart-Scott-Rodino Antitrust Improvements Act of 1976, as amended, and, subject to the terms of the Merger Agreement, other applicable competition laws, (iii) the absence of a material adverse effect on the Company and its subsidiaries, and (iv) other customary conditions. The completion of the Offer is not contingent upon the receipt of financing by Kratos or Lanza.

The Merger Agreement includes customary representations, warranties and covenants of the Company, Kratos and Lanza. The Company has agreed to operate its business in the ordinary course until the Offer is consummated. Under the terms of the Merger Agreement, the Company has also agreed to certain covenants prohibiting the Company from soliciting, or providing information or entering into discussions concerning proposals relating to alternative business combination transactions, except in limited circumstances relating to unsolicited proposals that are, or may reasonably be expected to become, a Superior Proposal (as defined in the Merger Agreement).

The Merger Agreement also includes customary termination provisions for both the Company and Kratos. In order for the Company to accept a Superior Proposal or in connection with the termination of the Merger Agreement under specified circumstances, the Company will be required to pay Kratos a termination fee of approximately $9.4 million.

In connection with the execution by the Company and Kratos of an Exclusivity Agreement on January 19, 2011, Kratos paid the Company an exclusivity fee of $2.0 million. In the Merger Agreement, the Company has agreed to repay the exclusivity fee to Kratos on the earlier of (i) the date of the acceptance of the tendered shares by Kratos, or (ii) the termination of the Merger Agreement under certain circumstances.

The Merger Agreement also contains customary representations and warranties that the Company, on one hand, and Kratos and Lanza, on the other hand, made to each other as of specific dates. The assertions embodied in those representations and warranties were made solely for purposes of the contract among the Company, Kratos and Lanza and may be subject to important qualifications and limitations agreed to by the Company, Kratos and Lanza in connection with the negotiated terms, including, but not limited to, information in confidential disclosure schedules provided by the Company in connection with the signing of the Merger Agreement. These disclosure schedules contain information that modifies, qualifies and creates exceptions to the representations and warranties set forth in the Merger Agreement. Moreover, some of those representations and warranties may not be accurate or complete as of any specified date, may be subject to a contractual standard of materiality different from those generally applicable to shareholders or may have been used for purposes of allocating risk among the Company, Kratos and Lanza rather than establishing matters as facts.

Further details with respect to the Merger Agreement can be found in other filings with the U.S. Securities and Exchange Commission made by the Company, including, but not limited to, the Solicitation / Recommendation Statement on Schedule 14D-9 filed by the Company with the SEC on February 25, 2011.

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

Safe Harbor Statement under the Private Securities Litigation Reform Act of 1995

All statements other than statements of historical fact included in ‘Management's Discussion and Analysis of Financial Condition and Results of Operations’ which follow are forward-looking statements. Forward-looking statements involve various important assumptions, risks, uncertainties and other factors which could cause our actual results to differ materially from those expressed in such forward-looking statements. Forward-looking statements in this discussion can be identified by words such as "anticipate," "believe," "could," "estimate," "expect," "plan," "intend," "may," "should" or the negative of these terms or similar expressions. Although we believe that the expectations reflected in the forward-looking statements are reasonable, we cannot guarantee future results, performance or achievement. Actual results could differ materially from those contemplated by the forward-looking statements as a result of certain factors including, but not limited to, competitive factors and pricing pressures, changes in legal and regulatory requirements, cancellation or deferral of customer orders, technological change or difficulties, difficulties in the timely development of new products, difficulties in manufacturing, commercialization and trade difficulties and general economic conditions, as well as the factors set forth in our public filings with the Securities and Exchange Commission including the risk factors identified in Item 1A of the Company’s Annual Report on Form 10-K for the fiscal year ended August 1, 2010 filed with the Securities and Exchange Commission on October 14, 2010.

You are cautioned not to place undue reliance on the forward-looking statements, which speak only as of the date of this Quarterly Report or the date of any document incorporated by reference in this Quarterly Report. We are under no obligation, and expressly disclaim any obligation, to update or alter any forward-looking statements, whether as a result of new information, future events or otherwise.

For these forward-looking statements, we claim the protection of the safe harbor for forward-looking statements contained in Section 21E of the Securities Exchange Act of 1934.

Explanatory Note

We begin Management’s Discussion and Analysis of Financial Condition and Results of Operations (“MD&A”) of Herley Industries, Inc. with an overview. The overview includes a discussion of our business and a discussion of the critical accounting estimates that we believe are important to understanding the assumptions and judgments underlying our reported financial results, which we discuss under “Results of Operations.” We then provide an analysis of cash flows under “Liquidity and Capital Resources.” This MD&A should be read in conjunction with our unaudited Condensed Consolidated Financial Statements, the notes thereto, the other unaudited financial data included elsewhere in this Quarterly Report on Form 10-Q and our 2010 Annual Report on Form 10-K filed with the SEC on October 14, 2010.

Overview

This Overview is intended to provide a context for Management’s Discussion and Analysis of Financial Condition and Results of Operations which should be read in conjunction with our unaudited Condensed Consolidated Financial Statements and Notes thereto, included in Item 1 of this Quarterly Report on Form 10-Q. We have attempted to identify the most important matters on which our management focuses in evaluating our financial condition and operating performance and the short-term and long-term opportunities, challenges and risks (including material trends and uncertainties) which we face. We also discuss the actions we are taking to address these opportunities, challenges and risks. The Overview is not intended as a summary of, or a substitute for review of, Management’s Discussion and Analysis of Financial Condition and Results of Operations.

Our Business

We are a leading supplier of microwave products and systems primarily for use in flight instrumentation, weapons sensors, electronic warfare systems and command and control systems. To a lesser extent, we also provide power amplifiers for use in nuclear magnetic resonance and magnetic resonance imaging systems for scientific and medical use. We operate in a single business segment consisting of research, engineering, product development, and the manufacturing of complex microwave radio frequency (RF) and millimeter wave components and subsystems, supplying products for defense and space customers worldwide. We employ approximately 1,000 people and operate seven manufacturing facilities, four in the U.S., one in the United Kingdom and two in Israel.

Our primary customers include large defense prime contractors including Northrop Grumman Corporation, Lockheed Martin Corporation, Raytheon Company, The Boeing Company, BAE Systems and Harris Corporation, as well as the U.S. Government (including the Department of Defense, NASA and other U.S. Government agencies) and international customers (including the Israeli, Egyptian, German, Japanese, Taiwanese, Spanish, Australian and South Korean militaries and suppliers to international militaries). The U.S. Government is our single largest customer (including direct sales of 15% of our net sales in fiscal 2010) with approximately 62% of our annual net sales tied, either directly or indirectly, to government contracts, including shipments from our Israeli operations. Any increase or cut in defense appropriations could have a significant impact on our net sales. Moreover, our contracts are highly concentrated, with our top 5 customers (in addition to direct sales to the U.S. Government) accounting for approximately 47% of our net sales in fiscal 2010 and approximately 56% for the first half of fiscal 2011.

Our goal is to continue to leverage our proprietary technology, microwave expertise and manufacturing capabilities to further expand our penetration in our market by:

* increasing levels of component integration and value added content;

* maintaining leadership in microwave technology;

* strengthening and expanding customer relationships;

* capitalizing on outsourcing dynamics in the aerospace and defense industry;

* pursuing strategic acquisitions; and

* enhancing manufacturing capabilities.

We believe our competitive strengths include:

* our technical expertise;

* our high proportion of longer-term sole-provider production programs;

* a diverse customer base;

* long-standing industry relationships;

* a successful acquisition track record;

* our emphasis on research and development; and

* our experienced management team.

Significant Event

See Notes to Condensed Consolidated Financial Statements in Note 16 for a discussion of the Agreement and Plan of Merger (the “Merger Agreement”) entered into on February 7, 2011 with Kratos Defense & Security Solutions, Inc., a Delaware corporation (“Kratos”), and Lanza Acquisition Co., a Delaware corporation and an indirect, wholly-owned subsidiary of Kratos (“Lanza”).

Critical Accounting Policies and Estimates

Our significant accounting policies are described in Note A of the Notes to Consolidated Financial Statements included in our Annual Report on Form 10-K for the fiscal year ended August 1, 2010 (the “Report”) filed with the SEC on October 14, 2010, and a discussion of these critical accounting policies and estimates are included in Management’s Discussion and Analysis of Results of Operations and Financial Condition of that Report. We continually evaluate the appropriateness of our accounting methods as new events occur. We believe that our policies are applied in a manner that is intended to provide the user of our financial statements with a current, accurate and complete presentation of information in accordance with accounting principles generally accepted in the United States of America. Important accounting practices that require the use of assumptions and judgments are outlined therein. Management has discussed the development and selection of these policies with the Audit Committee of the Company’s Board of Directors, and the Audit Committee of the Board of Directors has reviewed the Company’s disclosures of these policies. There have been no material changes to the critical accounting policies or estimates reported in Management’s Discussion and Analysis section of the Report as filed with the SEC.

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 operations, new business development, customer relationships, product development activities, human resources, manufacturing effectiveness and cost reduction activities. We compare performance against budget, prior comparable periods and our most recent internal forecasts. The following table presents a financial summary comparison (in thousands) of operating results and certain key performance indicators.

	Thirteen weeks ended			Twenty-six weeks ended
	January 30,	January 31,		January 30,	January 31,
	2011	2010	% Change	2011	2010	% Change

Net sales	$50,659	$46,609	9 %	$99,580	$94,288	6 %
Gross profit	$16,410	$12,857	28 %	$32,168	$26,144	23 %
Gross profit percentage	32.4%	27.6%		32.3%	27.7%
Operating income	$7,332	$5,435	35 %	$12,979	$10,501	24 %
Bookings	$45,681	$43,980	4 %	$80,876	$78,953	2 %
Backlog (end of period)	$166,972	$168,372	(1)%	$166,972	$168,372	(1)%

Thirteen weeks ended January 30, 2011 and January 31, 2010

Net sales for the second quarter of fiscal 2011 were approximately $50.7 million compared to $46.6 million in fiscal 2010, an increase of $4.1 million, or approximately 9%. The increase in net sales was primarily related to increased deliveries under major production programs particularly under the EA-18G program, Trident program, and other increases attributable to improvement in manufacturing throughput, and to revenue recognized under certain percentage-of-completion contracts.

Domestic and foreign sales were 65% and 35%, respectively, of net sales for the quarter compared to 63% and 37%, respectively, in the prior-year quarter.

Gross profit in the quarter was $16.4 million (32.4% gross profit margin) compared to $12.9 million (27.6% gross profit margin) in the second quarter last year, an increase of $3.5 million. The increase in gross profit and gross profit margin during the second quarter of fiscal 2011 was principally related to the following:

· An increase in gross profit of $1.6 million associated with favorable product mix and improved productivity, with

programs providing positive performance including Trident, EA-18G, AFSAT, QF16, and programs using standard

catalog components. Costs of products sold for the second quarter fiscal 2010 included the impact of cost overruns on a

major contract, and lower margins on certain development programs;

· An increase in gross profit of $1.2 million related to increased sales volumes and an increase of revenue recognition on

percentage of completion contracts for the quarter for programs that included EA-18G, AFSAT, Navy GRDCS, ICAP,

F16, SPEWS and various Electronic Warfare Simulation Systems sold on a global basis; and

· The balance of favorable gross profit impact was related to reduced contract loss provisions and lower return/repair

requirements.

Selling and administrative (“S&A”) expenses for the quarter were $9.0 million, or 17.7% of net sales, compared to $7.7 million, or 16.6% of net sales, in the prior-year quarter. The $1.3 million increase in S&A expenses was primarily attributable to increased stock compensation cost and audit and tax professional fees; partially offset by reduced employee incentive payments and lower commission expense.

Income from operations during the quarter was $7.3 million compared to $5.4 million in the same quarter last year, which reflects the increased sales volume and gross margin improvements discussed above. The second quarter of fiscal 2010 included a recognized net benefit of $1.2 million litigation cost resulting from a recognized insurance settlement under our Director and Officers (“D&O”) insurance policy, in which we received a final settlement payment of $1.7 million in February 2010. For the second quarter of fiscal 2010 additional cost associated with an employment settlement charge of $.9 million was recognized in connection with the resignation of a former director and Chairman of the Board of Directors of the Company.

The provision for income taxes for the thirteen weeks ended January 30, 2011 was $2.2 million as compared to $1.4 million for the thirteen weeks ended January 31, 2010. The estimated annual effective tax rate for fiscal 2011, before consideration of discrete items, is approximately 32%. This rate is lower than the statutory U.S. federal tax rate of 35%, primarily due to the Company’s foreign earnings attributable to its Israeli and United Kingdom operations which are taxed at estimated rates of 14% and 27%, respectively.

The Company estimates that its annual effective tax rate, including discrete items, for fiscal 2011 will be 33%. This rate may change from quarter to quarter due to both recurring factors, such as the geographic mix of income, and items discrete to the quarter, such as adjustments to deferred tax asset and liability balances and the accrual of interest on unrecognized tax benefits.

As of August 1, 2010, the Company had available net operating loss carry-forwards for state and U.S. federal income tax purposes of approximately $32.5 million and $17.4 million, respectively, with expiration dates through 2028. Unused U.S federal research and development credits of approximately $2.1 million, with expiration dates through 2029, are available for U.S. federal income tax purposes, as well as a U.S. federal alternative minimum tax credit of $43,000.

Basic and diluted earnings per common share for the quarter were $.37, as compared to $.28 per basic and $.27 per diluted common share for the prior-year quarter.

Twenty-six weeks ended January 30, 2011 and January 31, 2010

Net sales for the twenty-six weeks ended January 30, 2011 were $99.6 million compared to $94.3 million in the first twenty-six weeks of fiscal 2010, an increase of $5.3 million, or approximately 6%. The increase in net sales was primarily related to deliveries under major production programs that include EA-18G, Trident, Euro Fighter, Navy GRDCS, QF-16, and AFSAT, in addition to increased activity under certain percentage of completion contracts providing for increased revenue for the period.

Domestic and foreign sales were 66% and 34%, of net sales, respectively, in the twenty-six weeks ended January 30, 2011 compared to 64% and 36%, respectively, for the twenty-six weeks ended January 31, 2010. Bookings were approximately $81 million, of which 63% were domestic and 37% were foreign. This level of bookings compares to bookings of approximately $79 million in the prior twenty-six weeks ended January 31, 2010 of which 61% were domestic and 39% foreign. Bookings improved over last quarter resulting in a positive increase over last year for the first six months of the fiscal year. Notable bookings for the first half of the current year included various parts for the U.S. Navy Electronic Attack Aircraft, IFF Shipboard Interrogators for the Republic of Korea Navy, Tactical Landing Systems for the E-2D Navy aircraft, with additional international contract awards for the Electronic Warfare Simulator Systems.

Gross profit in the twenty-six weeks ended January 30, 2011 was $32.1 million (32% of net sales) compared to $26.1 million (28% of net sales) in the first half of fiscal 2010, an increase of $6.0 million. The increase in gross profit and gross profit margin during fiscal 2010 was principally related to the following:

· An increase in gross profit of $3.6 million associated with favorable product mix and improved productivity, with

programs providing positive performance including Trident, EA-18G, AFSAT, and programs using standard catalog

components. Costs of products sold for the second half of fiscal 2010 included the impact of cost overruns on a major

contract, and lower margins on certain development programs;

· An increase in gross profit of $1.9 million related to increased sales volumes and improved revenue recognition for our

percentage of completion contracts for the quarter for programs that included Trident, EA-18G, AFSAT, Navy GRDCS,

QF-16, F16, SPEWS and various Electronic Warfare Simulation Systems sold on a global basis; and

· The balance of favorable gross profit impact was related to reduced contract loss provisions, and lower return/repair

requirements.

S&A expenses for the twenty-six weeks ended January 30, 2011 were $17.1 million, or 17.2% of sales, compared to $15.4 million, or 16.4% of sales, for the same period in fiscal 2010. The $1.7 million increase over prior year included an increase in stock compensation costs, additional audit and tax service costs, and increased legal expense, partially offset by lower sales commissions for the period.

For the twenty-six weeks ended January 31, 2010, we recognized a net benefit of $.7 million in litigation costs resulting from a $4 million settlement of litigation under our D&O insurance policy, and received a payment of $1.7 million in February 2010, net of $2.3 million that had been previously advanced, for the recovery of previously-expensed litigation costs. Also, in connection with the resignation of a former director and Chairman of the Board of Directors of the Company, we entered into an employment settlement agreement in January 2010 under which he received a payment in the amount of $.9 million.

Other (expense) income for the twenty-six weeks ended January 30, 2011 provided for a positive variance of $.5 million in comparison to the same period in fiscal 2010, with a decrease of $.2 million in interest expense due to the reduction of debt during the current-year period in combination with lower effective loan rates. A positive variance for our currency exchange transaction was related to our UK division with a stronger GBP over US dollar for this period.

Income before income taxes for the twenty-six weeks ended January 30, 2011 was $13 million compared to $10 million for the twenty-six weeks ended January 31, 2010, an improvement of $3.0 million. The major positive impact for the first half of 2011 was the increase in gross profit for the period of $6.0 million associated with improved sales volumes, manufacturing efficiencies and pricing. Included within the results for first quarter of fiscal 2011 was the $1.1 million legal settlement claim, which was recognized in the first quarter in accordance with Generally Accepted Accounting Principles but was settled and paid within the second quarter of the same fiscal period. The results for the second quarter of fiscal 2010 included a recognized net benefit of $.7 million litigation cost resulting from a recognized insurance settlement under our Director and Officers (“D&O”) insurance policy, in which we received a final settlement payment of $1.7 million in February 2010. For the second quarter of fiscal 2010 additional cost associated with an employment settlement charge of $.9 million was recognized in connection with the resignation of a former director and Chairman of the Board of Directors of the Company.

The income tax expense related to continuing operations in the first half of fiscal 2011 was $4.3 million compared to $2.7 million in the prior year’s first half. The estimated effective tax rate for fiscal year 2011, before consideration of discrete items, is approximately 32.5%, which is less than the statutory rate of 35.0%, primarily due to foreign earnings attributable to our Israeli and United Kingdom subsidiaries which are taxed at estimated rates of 14% and 27%, respectively.

Basic and diluted earnings per common share for the twenty-six weeks ended January 30, 2011 were $.63 and $.62 per common share, respectively, compared to basic and diluted earnings per common share of $.54 and $.53 for the twenty-six weeks ended January 31, 2010, respectively.

Liquidity and Capital Resources

We believe that anticipated cash flows from operations, together with existing cash and cash equivalents and our bank line availability, will be adequate to finance presently anticipated working capital, capital expenditure requirements and other contractual obligations and to repay our long-term debt as it matures. A significant portion of our revenue for fiscal 2011 is expected to be generated from our existing backlog of sales orders. The funded backlog of orders at August 1, 2010 was approximately $187 million, of which approximately 85% is expected to ship in fiscal 2011. The funded backlog of orders at January 30, 2011 was approximately $167 million. All orders included in this backlog are covered by signed contracts or purchase orders. Nevertheless, contracts involving government programs may be terminated at the discretion of the government. In the event of the cancellation of a significant amount of government contracts included in our backlog, we would be required to rely more heavily on cash balances and our existing credit facility to fund our operations. We are not aware of any events which are reasonably likely to result in any cancellation of our government contracts, nor does our historical experience with the government indicate any reasonable likelihood of such cancellations.

A small number of customers accounted for a substantial portion of historical net sales and we expect that a limited number of customers will continue to represent a substantial portion of sales for the foreseeable future. Approximately 20% and 13% of total net sales from continuing operations for the first half of fiscal 2011 were made to Northrop Grumman Corporation and to Lockheed Martin Corporation, respectively. Future operating results will continue to substantially depend on the success of our largest customers and our relationship with them. Orders from these customers are subject to fluctuation and may be reduced materially. The loss of all or a portion of the sales volume from any one of these customers would have an adverse effect on our liquidity and operations.

As is customary in the defense industry, inventory is partially financed by progress payments. In addition, it is customary for us to receive advanced payments from customers on major contracts at the time a contract is entered into. The unliquidated balance of progress payments was approximately $1.0 million at January 30, 2011 and $1.4 million at August 1, 2010. The balance of advanced payments was approximately $9.3 million at January 30, 2011 and $9.9 million at August 1, 2010. The fiscal 2011 decrease relates to the timing of payments pursuant to the terms of various contracts.

As of January 30, 2011, we had approximately $26.4 million in cash and cash equivalents and approximately $34.5 million available under our bank credit facility, net of specific outstanding stand-by letters of credit of $5.5 million. As of January 30, 2011 and August 1, 2010, working capital was $100.4 million and $87.6 million, respectively, and the ratio of current assets to current liabilities was 3.7 to 1 and 2.9 to 1, respectively.

For the first six months of the fiscal year there was no measureable operating cash impact as compared to net cash provided by operating activities of $1.6 million in the prior year, a net operating cash flow decrease of approximately $1.6 million.

Significant approximate changes from prior year results in net cash from operating activities and non-cash items during the first half of fiscal 2011 include:

·	an increase in litigation settlement payments providing additional cash used in operations of $10.1 million;

·	an increase in costs incurred and income recognized in excess of billings on uncompleted contracts providing for additional cash used in operations of $8.3 million;

·	excess tax benefits from the exercise of stock options for cash used of $1.6 million;

·	a decrease in employment settlement payments providing an increase in operating cash of $7.0 million;

·	a decrease in income taxes receivable providing for an increase in operating cash of $4.0 million;

·	an increase in accounts payable and accrued expenses providing for an increase in operating cash of $5.9 million;

·	an increase in income taxes payable providing for an increase in operating cash of $1.6 million;

·	a reduction in trade accounts receivable providing for an increase in operating cash of $1.4 million; and

·	an increase in net income adjusted for depreciation and amortization providing an increase in operating cash of $1.1 million.

Net cash used in investing activities of approximately $2.1 million relates to capital expenditures net of fixed asset sales proceeds.

Net cash provided in financing activities of approximately $2.9 million relates to the receipt of a merger exclusivity agreement fee of $2.0 million, positive impact of the tax benefit from the exercise of stock options of $1.6 million, partially offset by payments of approximately $.7 million of long-term debt, including payments of approximately $.5 million on the term loan in Israel. The merger exclusivity agreement is described in Note 16 “Subsequent Event” of the Notes to Condensed Consolidated Financial Statements. The Company has agreed to repay this fee to Kratos on the earlier of (1) the date of the acceptance of the tendered shares by Kratos, or (2) the termination of the Merger Agreement under certain circumstances.

Bank Line of Credit

We have a $40 million Revolving Credit Loan Agreement (“Agreement”) with two banks on an unsecured basis, as modified in February 2010, which may be used for general corporate purposes, including business acquisitions and stand-by letters of credit. The Agreement requires the payment of interest only on a monthly basis and payment of the outstanding principal balance on March 31, 2012. We may elect to borrow with interest at (A) the bank’s prime rate of interest minus 0.50%; or (B) the greater of (i) LIBOR plus a margin of 2.50% or (ii) 3.50%. There is a fee of 25 basis points per annum on the unused portion of the credit facility payable quarterly and a fee of 1.5% per annum on outstanding stand-by letters of credit. The Agreement contains various financial covenants, including minimum tangible net worth, total liabilities to tangible net worth, debt service coverage and restrictions on other borrowings. We were in compliance with all financial covenants at January 30, 2011.

We had no loans outstanding under our credit facility at January 30, 2011, August 1, 2010 or at August 2, 2009. Stand-by letters of credit in the amount of approximately $7.5 million, of which $5.5 million reduces the amount of credit available under the credit line, were outstanding at January 30, 2011. We had approximately $34.5 million available under our line at January 30, 2011.

Stock Buyback Program

In October 2007, our Board of Directors approved an expansion of our existing stock buyback program to make additional purchases of up to 1,000,000 shares of our common stock in the open market or in private transactions, in accordance with applicable SEC rules, for an aggregate of 3,000,000 shares under the program. As of August 1, 2010, we had repurchased and retired approximately 2,460,000 shares under the program. There were no stock repurchases during the thirteen weeks ended January 30, 2011. During the twenty-six weeks ended January 31, 2010, the Company repurchased and retired 47,632 shares of its common stock pursuant to this program at an aggregate cost of approximately $588,000. Funds to acquire shares came from excess cash reserves. The timing, actual number and value of any additional shares that may be repurchased under this program will depend on a number of factors, including our future financial performance, our available cash resources and competing uses for the cash, prevailing market prices of our common stock and the number of shares that become available for sale at prices that we believe are attractive. As of January 30, 2011, approximately 540,000 shares were eligible for future purchase under the buyback program.

Dividend Policy

We have not paid cash dividends in the Company’s history. Our Board of Directors evaluates our dividend policy based on our financial condition, profitability, cash flow, capital requirements, and the outlook of our business. We currently intend to retain any earnings for use in the business, including for investment in acquisitions, and consequently we do not anticipate paying any cash dividends on our common stock in the foreseeable future.

Contractual Financial Obligations, Commitments and Off-Balance Sheet Arrangements

Our financial obligations and commitments to make future payments under contracts include purchase orders, debt and lease agreements and contingent commitments, such as stand-by letters of credit. These financial obligations are recorded in accordance with accounting rules applicable to the underlying transaction, with the result that some are recorded as liabilities on the Condensed Consolidated Balance Sheet, while others are required to be disclosed in the Notes to Condensed Consolidated Financial Statements and Management’s Discussion and Analysis of Financial Condition and Results of Operations. The Company’s contractual financial obligations and other contingent commitments are disclosed in our Annual Report on Form 10-K for the fiscal year ended August 1, 2010 under Management’s Discussion and Analysis of Financial Condition and Results of Operations.

Recent Accounting Pronouncements

The Financial Accounting Standards Board issues, from time to time, new accounting standards updates. See Notes to Condensed Consolidated Financial Statements in Note 14 for a discussion of these updates.

Item 3. Quantitative and Qualitative Disclosures About Market Risk

The Company’s exposures to market risk have not changed significantly since August 1, 2010. For information regarding the Company's market risk, refer to the Company's Annual Report on Form 10-K for the fiscal year ended August 1, 2010.

Item 4. Controls and Procedures

(a)

Evaluation of disclosure controls and procedures. The term “disclosure controls and procedures” are defined in Rules 13a-15(e) and 15d-15(e) of the Securities Exchange Act of 1934, as amended (the “Exchange Act”). These rules refer to the controls and other procedures of a company that are designed to ensure that information required to be disclosed by the Company in the reports that it files under the Exchange Act is recorded, processed, summarized and reported within the required time periods. The Company’s Chief Executive Officer and Chief Financial Officer, with participation of the Company’s management, have evaluated the design, operation and effectiveness of the Company’s disclosure controls and procedures and have concluded, based on such evaluation, that such controls and procedures were effective at providing reasonable assurance that required information will be disclosed in the Company’s reports filed under the Exchange Act as of January 30, 2011.

(b)

Changes in internal controls. There were no changes in the Company’s internal controls over financial reporting (as such term is defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act) during the fiscal quarter ended January 30, 2011 that have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting.

PART II - OTHER INFORMATION

Item 1. Legal Proceedings

See Note 6 to Condensed Consolidated Financial Statements (Unaudited) in Part I - Item 1 for a discussion of Legal Proceedings.

Item 1A. Risk Factors

There have been no material changes to the risk factors disclosed in “Item 1A. Risk Factors” in our Annual Report on Form 10-K for the year ended August 1, 2010, except for the risk factors described below:

The announcement and pendency of our agreement to be acquired by Kratos Defense & Security Solutions, Inc. and the transactions contemplated thereby could adversely affect our business, financial results and operations.

As a result of the execution of the Agreement and Plan of Merger (the “Merger Agreement”) with Kratos Defense & Security Solutions, Inc. (“Kratos”), and irrespective of whether or not the offer (the “Offer”) and the merger (the “Merger”) proposed therein (collectively, the “Transactions”) are completed, the uncertainty of the Transactions could cause disruptions in our business, which could have an adverse effect on our businesses and financial results including, but not limited to, the following:

·	Effects on Employees: Current and prospective employees of the Company may experience uncertainty about their future roles with the combined company, which might adversely affect our ability to retain or attract key managers and other employees;

Effects on Customers and Other Third Parties: New or existing customers may prefer to enter into agreements with our competitors who have not expressed an intention to sell their business because customers may perceive that such new relationships are likely to be more stable. As a result of our execution of the Merger Agreement and the announcement of the Transactions, other third parties may be unwilling to enter into material agreements with us. If we fail to complete the Transactions, the failure to maintain existing business relationships or enter into new ones could adversely affect our business, results of operations and financial condition.

·	Diversion of Management’s Attention: The attention of our management may be diverted from the operation of the businesses toward the completion of the proposed Transactions.

There is no assurance that the Transactions will be completed.

We cannot assure you that the proposed Transactions will be consummated in the expected time frame or at all. The consummation of the Transactions are subject to the satisfaction or waiver of a number of conditions which have not yet been satisfied as of this date, including, with respect to the Offer, the tendering by the Company’s stockholders of over 50% of the outstanding shares of the Company’s common stock. No assurance can be given that the remaining required conditions to closing will be satisfied. In addition, Kratos may terminate the Merger Agreement if there is a material adverse effect on the business as defined in the Merger Agreement.

If the proposed Transactions, or a similar transaction, are not completed, the share price of our common stock may change to the extent that the current market price of our common stock reflects an assumption that a transaction will be completed. We also will have incurred significant costs, including the diversion of management resources, for which we will have received little or no benefit. In addition, if the Transactions are not consummated, we may not be able to develop and implement a strategy for the future growth and development of the Company’s business that would generate a return similar to or better than the return which would be generated by the Transactions.

The Merger Agreement imposes restrictions on our ability to operate the Company, which may delay or prevent us from undertaking business opportunities that may be beneficial to the Company, pending completion of the Transactions.

The Merger Agreement contains restrictions on our ability to operate the Company prior to the closing. These restrictions could harm us by, among other things, prohibiting, limiting or restricting our ability to take advantage of mergers, acquisitions and other corporate opportunities or to take certain actions that management may deem to be necessary or desirable to operate or grow the Company or to increase its profitability.

If sufficient stockholders fail to tender their shares in response to the Offer, we may not receive an offer from another potential acquirer of the Company on satisfactory terms or at all.

If sufficient stockholders fail to tender their shares in response to the tender offer and the Merger Agreement is subsequently terminated, we may decide to seek another strategic transaction with respect to the Company. However, we may not be able to find a potential acquirer of the Company willing to pay an equivalent or more attractive price than that which would be paid pursuant to the Offer, and in fact any purchase price that we do find may be less.

We are not permitted to terminate the Merger Agreement except in limited circumstances, and we may be required to pay a substantial termination fee to Kratos if the Merger Agreement is terminated.

The Merger Agreement does not generally allow us to terminate it, except in certain limited circumstances. If the Merger Agreement is terminated under certain circumstances for specified reasons, we would be obligated to pay a termination fee of approximately $9.4 million.

In addition to the other information set forth in this report, you should carefully consider the risk factors disclosed under Part 1 –“Item 1A. Risk Factors” in our Annual Report on Form 10-K for the year ended August 1, 2010, which could materially adversely affect our business, financial condition, operating results and cash flows. The risks and uncertainties described in our Form 10-K for the year ended August 1, 2010 are not the only ones we face. Risks and uncertainties not currently known to us or that we currently deem immaterial also may materially adversely affect our business, financial condition, operating results or cash flows.

Item 2. Unregistered Sales of Equity Securities and Use of Proceeds

(a) None

(b) None

We have a stock repurchase program that was initially instituted in October 2002, as further modified, for the purchase of up to 3 million shares of our common stock. As of January 30, 2011, we had acquired an aggregate of approximately 2.5 million shares in the open market under the program, all of which have been previously retired. The timing and amount of share repurchases, if any, will depend on business and market conditions, as well as legal and regulatory considerations, among other things. There were no stock repurchases under the program during the first half of fiscal period ended January 30, 2011.

Item 3. Defaults Upon Senior Securities

None

Item 4. Removed and Reserved

Item 5. Other Information

None

Item 6. Exhibits

31 Certifications pursuant to Rules 13a-14(a) as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002

32	Certifications pursuant to 18 U.S.C. Section 1350 as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002

SIGNATURE

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.

HERLEY INDUSTRIES, INC.

BY: /s/ Anello C. Garefino

Anello C. Garefino, Chief Financial Officer

(Principal Financial Officer)

Date: March 2, 2011

HERLEY INDUSTRIES INC /NEW 10-Q