Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations Restatement As discussed in the Explanatory Note and Note 3 to this Amended Filing, we are amending and restating our unaudited consolidated condensed financial statements and related disclosures for all periods presented in this Amended Filing. The following discussion and analysis of our financial condition and results of operations incorporates the restated amounts. For this reason, the data set forth in this section may not be comparable to discussion and data in our previously filed Quarterly Report on Form 10-Q for the quarter ended September 30, 2010. Overview We were incorporated in 1989 and are a regenerative medicine company focused on the development of innovative cell therapies to repair or regenerate damaged or diseased tissues. We are currently focused on developing autologous cell therapies for the treatment of severe, chronic cardiovascular diseases. Using our proprietary technology, we are able to expand the number of stem and early progenitor cells from a small amount of bone marrow (approximately 50 ml) collected from the patient. Preclinical and interim clinical data suggest that our cell therapy is effective in treating patients with critical limb ischemia (CLI). We are currently investigating the effectiveness of our therapy in other severe, chronic cardiovascular diseases, such as dilated cardiomyopathy (DCM). Nearly 200 patients have been treated in recent clinical trials using our current cell therapy (over 400 patients safely treated since our inception) with no treatment related adverse events or safety issues. Our technology is an autologous, expanded cellular therapy developed, using our proprietary, automated cell processing system, which utilizes “single-pass perfusion” to produce human cell products for clinical use. Single-pass perfusion is our patented manufacturing technology for growing large numbers of human cells. The production of our cell therapy products is done under current Good Manufacturing Practices (cGMP) guidelines required by the U.S. Food and Drug Administration (FDA). Our therapies begin with a small amount of the patient’s own bone marrow to produce large numbers of stem and early progenitor cells, many times more than what is found in the patient’s bone marrow. Our proprietary mixture of cell types may be capable of developing into cardiovascular and other tissues as well as stimulating a patient’s own existing repair mechanisms. Our cellular therapies have several features that we believe are critical for success in treating patients with severe, chronic cardiovascular diseases: Safe — our bone marrow derived, expanded, autologous cellular therapy leverages decades of scientific and medical experience, as bone marrow and bone marrow-like therapies have been used safely and efficaciously in medicine for decades. Autologous — we start with the patient’s own cells, which are accepted by the patient’s immune system allowing the cells to differentiate and integrate into existing functional tissues, and may provide long-term engraftment and repair. Expanded — we begin with a small amount of bone marrow from a patient (approximately 50 ml) and significantly expand the number of stem and progenitor cells to more than are present in the patient’s own bone marrow. A mixed population of cells — we believe our proprietary mixture of cell populations contains the cell types required for tissue regeneration, which are also found in natural bone marrow, though in smaller quantities. Minimally invasive — our procedure for taking bone marrow (an “aspirate”) can be performed in an out-patient setting and takes approximately 15 minutes. For diseases such as CLI, the administration of our therapy can be performed in an out-patient setting in a short procedure. We are pursuing a minimally invasive approach to cell delivery in diseases such as DCM. Our cell therapies are produced at our cell manufacturing facility in the United States, located at our headquarters in Ann Arbor, Michigan. Our clinical development programs are focused on advancing therapies for unmet medical needs in cardiovascular diseases. Our CLI program is currently in phase 2b clinical development, and we expect it to advance to Phase 3 development in 2011. Our DCM program is in early Phase 2 clinical development and is focused on achieving proof of concept in this indication. Results to date in our clinical trials may not be indicative of results obtained from subsequent patients enrolled in those trials or from future clinical trials. Further, our future clinical trials may not be successful or we may not be able to obtain the required Biologic License Application (BLA) registration in the United States for our products in a timely fashion, or at all. Critical Limb Ischemia CLI is the most serious and advanced stage of peripheral arterial disease (PAD). PAD is a chronic disease that progressively restricts blood flow in the limbs and can lead to serious medical complications. This disease is often associated with other clinical conditions including hypertension, cardiovascular disease, hyperlipidemia, diabetes, obesity and stroke. CLI is used to describe patients with the most severe forms of PAD: those with chronic ischemia-induced pain (even at rest), ulcers, tissue loss or gangrene in the limbs, often leading to amputation and death. CLI leads to more than 160,000 amputations per year. The one-year and four-year mortality rates for no-option CLI patients that progress to amputation are approximately 25% and 80%, respectively. Our technology has shown promise in the treatment of CLI. In June 2010, we reported results from the planned interim analysis of our multi-center, randomized, double-blind, placebo controlled U.S. Phase 2b RESTORE-CLI clinical trial. This clinical trial is designed to evaluate the safety and efficacy of our therapy in the treatment of patients with CLI. It is the largest multi-center, randomized, double-blind, placebo-controlled cellular therapy study ever conducted in CLI patients. We completed enrollment of this trial in February 2010 with a total of 86 patients at 18 sites across the United States. These patients are being followed for a period of 12 months following treatment. In addition to assessing the safety of our product, efficacy endpoints include amputation-free survival, time to first occurrence of treatment failure (defined as major amputation, all-cause mortality, doubling in wound size and de novo gangrene), major amputation rates, level of amputation, complete wound healing, patient quality of life, and pain scores. Results from the RESTORE-CLI interim analysis were presented at the Society of Vascular Surgery Meeting in June 2010. The results included the finding that amputation free survival — defined as time to major amputation or death — was statistically significant in favor of our therapy (p=0.038). Additionally, statistical analysis revealed a significant increase in time to treatment failure (e.g., major amputation, doubling in wound size de novo gangrene, and death) (log-rank test, p=0.0053). Other endpoints measured (e.g., major amputation rate, complete wound healing, change in Wagner wound scale) showed encouraging trends, but had not yet reached statistical significance at the interim analysis. The primary purpose of the interim analysis was to assess performance of our therapy and, if positive, to help plan the Phase 3 program. Discussions held with the FDA in June 2010 confirmed the appropriateness of using amputation free survival as the primary endpoint for the Phase 3 program. The last patient enrolled in this trial was treated in March 2010 and we expect to present six-month data on all patients in this study later this year. We continue to make progress towards the Phase 3 clinical development program in CLI. In October, we announced that the FDA had granted fast track designation for the use of our cellular therapy for the CLI indication. The fast track program is designed to facilitate the development and expedite the review of new drugs and biologics intended to treat serious or life-threatening conditions and that demonstrate the potential to address unmet medical needs. At the June FDA meeting, Aastrom was encouraged to use the Special Protocol Assessment (SPA) process for the Phase 3 program. The SPA’s supporting the Phase 3 program were submitted in October of 2010. Dilated Cardiomyopathy In February 2007, the FDA granted Orphan Drug Designation to our investigational therapy involving the use of our therapy in the treatment of DCM. DCM is a severe, chronic cardiovascular disease that leads to enlargement of the heart, reducing the pumping function of the heart to the point that blood circulation is impaired. Patients with DCM typically present with symptoms of congestive heart failure, including limitations in physical activity and shortness of breath. There are two types of DCM: ischemic and non-ischemic. Ischemic DCM, the most common form, is associated with atherosclerotic cardiovascular disease. Among other causes, non-ischemic DCM can be triggered by toxin exposure, virus or genetic diseases. Patient prognosis depends on the stage of the disease but is typically characterized by a high mortality rate. Other than heart transplantation or ventricular assist devices, there are currently no effective treatment options for end-stage patients with this disease. According to the book, Heart Failure: A Combined Medical and Surgical Approach (2007), DCM affects 200,000-400,000 patients in the United States alone. Our DCM development program is currently in Phase 2 and we have two ongoing U.S. Phase 2 trials investigating surgical and catheter-based delivery for our product in the treatment of DCM. In May 2008, the FDA activated our IND application for surgical delivery of our therapy. The 40-patient U.S. IMPACT-DCM clinical trial began with the treatment of the first patient in November 2008. This multi-center, randomized, controlled, prospective, open-label, Phase 2 study was designed to include 20 patients with ischemic DCM and 20 patients with non-ischemic DCM. We completed enrollment of the 40 patients in the IMPACT-DCM clinical trial in January 2010 and the final patient was treated in March 2010. We expect to report interim results of all patients who have completed six months of follow-up during fiscal year 2011. Participants in the IMPACT-DCM clinical trial were required to have New York Heart Association (NYHA) functional class III or IV heart failure, a left ventricular ejection fraction (LVEF) of less than or equal to 30% (60-75% is typical for a healthy person), and meet other eligibility criteria, including optimized medical therapy. Patients were randomized in an approximate 3:1 ratio of treatment to control group. Patients in the treatment group received our therapy through direct injection into the heart muscle during minimally invasive-surgery (involving a chest incision of approximately 2 inches). The primary objective of this study is to assess the safety of our therapy in patients with DCM. Efficacy measures include cardiac dimensions and tissue mass, cardiac function (e.g. cardiac output, LVEF, cardiopulmonary exercise testing parameters), cardiac perfusion and viability, as well as other efficacy endpoints. NYHA functional class and quality of life are also assessed. Patients will be followed for 12 months post-treatment. In November 2009, the FDA activated our second IND application to allow for the evaluation of our therapy delivered by a percutaneous catheter as opposed to surgically. The Catheter-DCM clinical trial is designed to explore catheter-based delivery of our therapy to treat DCM patients. This multi-center, randomized, controlled, prospective, open-label, Phase 2 study will enroll up to 12 patients with ischemic DCM and 12 patients with non-ischemic DCM at clinical sites across the United States. Participants must meet the same criteria above for the IMPACT-DCM surgical trial. The first patient was enrolled into the trial in April 2010 and enrollment is progressing. As of October 31, 2010, 20 patients had been enrolled in the study and we expect to conclude enrollment by December 2010. Results of Operations The Company had no revenue during the quarter ended September 30, 2010 compared to $73,000 for the quarter ended September 30, 2009. Sales in 2009 related to cell production sales for investigator sponsored clinical trials in Spain and limited cell manufacturing supplies to a research institute in the United States. At such time as we satisfy applicable regulatory approval requirements, we expect the sales of our cell-based products will constitute nearly all of our product sales revenues. Research and development expenses were $4,167,000 for the quarter ended September 30, 2010, compared to $2,911,000 for the quarter ended September 30, 2009. This increase was associated with preparations for the Phase 3 CLI development program. Research and development expenses also include non-cash stock-based compensation expense of $255,000 and $186,000 for the quarters ended September 30, 2010 and 2009, respectively, which reflects the increased headcount from the prior year. Selling, general and administrative expenses were $1,686,000 for the quarter ended September 30, 2010, compared to $946,000 for the quarter ended September 30, 2009. The increase relates to employee expenses, general consulting costs and an increase in non-cash stock-based compensation expense to $230,000 for the quarter ended September 30, 2010, from a net expense reversal of $139,000 for the quarter ended September 30, 2009. Stock-based compensation expense for the quarter ended September 30, 2009 was impacted by the reversal of previously recognized expense of $279,000 for options held by our former Chief Executive Officer, President and Chief Financial Officer, George W. Dunbar, that were forfeited in excess of our estimated rate of forfeiture. The remaining increase from the prior year is primarily due the hiring of new senior management subsequent to the first quarter of fiscal 2010. Income (expense) from the change in fair value of warrants was $(99,000) for the quarter ended September 30, 2010 compared to $9,000 for the quarter ended September 30, 2009. The fluctuation is due primarily to changes in the fair value of our common stock and the related impact on our warrant liabilities. Our net loss was $5,932,000, or $0.21 per share for the quarter ended September 30, 2010, compared to $3,792,000, or $0.18 per share for the quarter ended September 30, 2009. The changes in net loss are due to the fluctuations in research and development expenses and selling, general and administrative expenses as described above. The loss per share comparisons are impacted by the issuance of 6.5 million shares of common stock on January 21, 2010. Our major ongoing research and development programs are focused on the clinical development of our technology platform for treatment of severe, chronic cardiovascular diseases. Research and development expenses outside of the development of our technology platform consist primarily of engineering and cell production costs. Because of the uncertainties of clinical trials and the evolving regulatory requirements applicable to our products, estimating the completion dates or cost to complete our major research and development programs would be highly speculative and subjective. The risks and uncertainties associated with developing our products, including significant and changing governmental regulation and the uncertainty of future clinical study results, are discussed in greater detail under the caption “Risk Factors” in Part I, Item 1A of our Annual Report on Form 10-K/A for the year-ended June 30, 2010. The lengthy process of seeking regulatory approvals for our product candidates, and the subsequent compliance with applicable regulations, will require the expenditure of substantial resources. Any failure by us to obtain, or any delay in obtaining, regulatory approvals could cause our research and development expenditures to increase and, in turn, could have a material adverse effect on our results of operations. We cannot be certain when any net cash inflow from products validated under our major research and development project, if any, will commence. Liquidity and Capital Resources We are currently focused on utilizing our technology to produce autologous cell-based products for use in regenerative medicine applications. At such time as we satisfy applicable regulatory approval requirements, we expect the sales of our cell-based products to constitute nearly all of our product sales revenues. We do not expect to generate positive cash flows from our consolidated operations for at least the next several years and then only if we achieve significant product sales. Until that time, we expect that our revenue sources from our current activities will consist of only minor sales of our cell products and manufacturing supplies to our academic collaborators, grant revenue, research funding and potential licensing fees or other financial support from potential future corporate collaborators. To date, we have financed our operations primarily through public and private sales of our equity securities, and we expect to continue to seek to obtain the required capital in a similar manner. As a development stage company, we have never been profitable and do not anticipate having net income unless and until significant product sales commence. With respect to our current activities, this is not likely to occur until we obtain significant additional funding, complete the required clinical trials for regulatory approvals, and receive the necessary approvals to market our products. Through September 30, 2010, we had accumulated a net loss of approximately $208,056,000. We cannot provide any assurance that we will be able to achieve profitability on a sustained basis, if at all, obtain the required funding, obtain the required regulatory approvals, or complete additional corporate partnering or acquisition transactions. We have financed our operations since inception primarily through public and private sales of our equity securities, which, from inception through September 30, 2010, have totaled approximately $218,358,000 and, to a lesser degree, through grant funding, payments received under research agreements and collaborations, interest earned on cash, cash equivalents, and short-term investments, and funding under equipment leasing agreements. These financing sources have generally allowed us to maintain adequate levels of cash and other liquid investments. Our combined cash, cash equivalents and short-term investments totaled $14,466,000 at September 30, 2010, a decrease of $4,653,000 from June 30, 2010. The primary use of cash, cash equivalents and short-term investments during the quarter ended September 30, 2010 included $4,530,000 to finance our operations and working capital requirements, and $68,000 in capital expenditures. Our cash and cash equivalents included money market securities with maturities of three months or less. Our future cash requirements will depend on many factors, including continued scientific progress in our research and development programs, the scope and results of clinical trials, the time and costs involved in obtaining regulatory approvals, the costs involved in filing, prosecuting and enforcing patents, competing technological and market developments, costs of possible acquisition or development of complementary business activities and the cost of product commercialization. We do not expect to generate positive cash flows from operations for at least the next several years due to the expected spending for research and development programs and the cost of commercializing our product candidates. We intend to seek additional funding through research and development agreements or grants, distribution and marketing agreements and through public or private debt or equity financing transactions. Successful future operations are subject to several technical and risk factors, including our continued ability to obtain future funding, satisfactory product development, obtaining regulatory approval and market acceptance for our products. We believe that we will have adequate liquidity to finance our operations, including development of our products and product candidates, via our cash and cash equivalents on hand as of September 30, 2010 until at least June 30, 2011. While our budgeted cash usage and operating plan through June 30, 2011 does not currently contemplate taking additional actions to reduce the use of cash over that period, we could, if necessary, delay or forego certain budgeted discretionary expenditures such as anticipated hiring plans or certain non-critical research and development expenditures. In addition, we could slow down or delay certain clinical trial activity (without jeopardizing our pursuit of a Phase 3 clinical trial for CLI) such that we will have sufficient cash on hand through June 30, 2011. The Company will need to raise additional funds in order to complete its product development programs, complete clinical trials needed to market its products (including for a Phase 3 clinical trial for CLI), and commercialize these products. The Company cannot be certain that such funding will be available on favorable terms, if at all. Some of the factors that will impact the Company’s ability to raise additional capital and its overall success include: the rate and degree of progress for its product development, the rate of regulatory approval to proceed with clinical trial programs, the level of success achieved in clinical trials, the requirements for marketing authorization from regulatory bodies in the United States and other countries, the liquidity and market volatility of the Company’s equity securities, regulatory and manufacturing requirements and uncertainties, technological developments by competitors, and other factors. If the Company cannot raise such funds, it may not be able to develop or enhance products, take advantage of future opportunities, or respond to competitive pressures or unanticipated requirements, which would have a material adverse impact on the Company’s business, financial condition and results of operations. These estimates are based on certain assumptions which could be negatively impacted by the matters discussed under this heading and under the caption “Risk Factors,” in Item 1A of our 2010 Annual Report on Form 10-K/A filed with the SEC. Off-Balance Sheet Arrangements At September 30, 2010, we were not party to any off-balance sheet arrangements. Forward-Looking Statements This report, including the documents that we incorporate by reference, contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934, as amended. Any statements about our expectations, beliefs, plans, objectives, assumptions or future events or performance are not historical facts and may be forward-looking. These statements are often, but are not always, made through the use of words or phrases such as “anticipates,” “estimates,” “plans,” “projects,” “trends,” “opportunity,” “comfortable,” “current,” “intention,” “position,” “assume,” “potential,” “outlook,” “remain,” “continue,” “maintain,” “sustain,” “seek,” “achieve,” “continuing,” “ongoing,” “expects,” “management believes,” “we believe,” “we intend” and similar words or phrases, or future or conditional verbs such as “will,” “would,” “should,” “could,” “may,” or similar expressions. Accordingly, these statements involve estimates, assumptions and uncertainties which could cause actual results to differ materially from those expressed in them. The factors described in Part I, Item 1A, “Risk Factors,” in our Annual Report on Form 10-K/A for the year-ended June 30, 2010, among others, could have a material adverse effect upon our business, results of operations and financial conditions. Because the factors referred to in the preceding paragraph could cause actual results or outcomes to differ materially from those expressed in any forward-looking statements we make, you should not place undue reliance on any such forward-looking statements. Further, any forward-looking statement speaks only as of the date on which it is made, and we undertake no obligation to update any forward-looking statement or statements to reflect events or circumstances after the date on which such statement is made or to reflect the occurrence of unanticipated events. New factors emerge from time to time, and it is not possible for us to predict which factors will arise. In addition, we cannot assess the impact of each factor on our business or the extent to which any factor, or combination of factors, may cause actual results to differ materially from those contained in any forward-looking statements. These forward-looking statements include statements regarding: • potential strategic collaborations with others; • future capital needs and financing sources; • adequacy of existing capital to support operations for a specified time; • product development and marketing plan; • clinical trial plans and anticipated results; • anticipation of future losses; • commercialization plans; and • revenue expectations and operating results. Item 3. Quantitative and Qualitative Disclosures About Market Risk Not Applicable. Item 4. Controls and Procedures Disclosure Controls and Procedures Our management, with the participation of our Chief Executive Officer and Chief Financial Officer, evaluated the effectiveness of our disclosure controls and procedures as of September 30, 2010. The term “disclosure controls and procedures” is defined in Rules 13a-15(e) and 15d-15(e) under the Securities and Exchange Act of 1934 (“the Exchange Act”). Management recognizes that any disclosure controls and procedures no matter how well designed and operated, can only provide reasonable assurance of achieving their objectives and management necessarily applies its judgment in evaluating the cost-benefit relationship of possible controls and procedures. At the time that our Quarterly Report on Form 10-Q for the quarter ended September 30, 2010 was filed on November 8, 2010, our Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures were effective as of September 30, 2010. Subsequent to that evaluation, our management, including our Chief Executive Officer and Chief Financial Officer, concluded that our disclosure controls and procedures were not effective to provide reasonable assurance as of September 30, 2010 because of a material weakness in our internal control over financial reporting described below. Material Weakness A material weakness is a deficiency, or a combination of deficiencies, in internal control over financial reporting, such that there is a reasonable possibility that a material misstatement of the company’s annual or interim financial statements will not be prevented or detected on a timely basis. We did not maintain effective controls relating to accounting for warrants. Specifically, we did not maintain effective controls over the identification and proper accounting treatment of certain terms and conditions in our warrant agreements. This material weakness resulted in a material misstatement of our liabilities, non-cash expense relating to the changes in fair value of common stock warrants and accumulated deficit accounts and related financial disclosures and the restatement of our consolidated financial statements for the years ended June 30, 2008, 2009 and 2010, the period from Inception to June 30, 2010, and each of the quarterly periods (including the period from Inception) from September 30, 2008 through September 30, 2010 (the “Affected Periods”) as discussed below and in Note 3 to the consolidated financial statements included in this Quarterly Report on Form 10-Q/A. Additionally, this deficiency could result in misstatements of the aforementioned accounts and disclosures that would result in a material misstatement of the consolidated financial statements that would not be prevented or detected. Restatement of Consolidated Financial Statements On February 11, 2011, in connection with responding to certain comments raised by the Staff of the SEC in its periodic review of the Company’s SEC filings, the Company in consultation with its Audit Committee, concluded that its previously issued consolidated financial statements for the Affected Periods should be restated because of a misapplication in the guidance around accounting for warrants and should no longer be relied upon. However, the non-cash adjustments to the financial statements, in all of the Affected Periods, do not impact the amounts previously reported for the Company’s cash and cash equivalents, operating expenses or cash flows. Remediation Plan Management has been actively engaged in developing a remediation plan to address the material weakness. Implementation of the remediation plan is in process and consists of the hiring of new accounting/finance personnel and their revisiting the original accounting assessment for each of their historical warrants and assessing the original accounting and the on-going accounting impact. Management has completed this assessment during February 2011 and the results of this analysis have been used to adjust the Affected Periods in the restated documents. Management believes the foregoing efforts will effectively remediate the material weakness. As the Company continues to evaluate and work to improve its internal control over financial reporting, management may execute additional measures to address potential control deficiencies or modify the remediation plan described above. Management will continue to review and make necessary changes to the overall design of the Company’s internal control. Changes in Internal Control Over Financial Reporting There have been no changes in the Company’s internal control over financial reporting during the quarter ended September 30, 2010 that have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting. --- Management’s Discussion and Analysis of Financial Condition and Results of Operations Except for the historical information contained herein, we wish to caution you that certain matters discussed in this report constitute forward-looking statements that involve risks and uncertainties. Our actual results could differ materially from those stated or implied in forward-looking statements due to a number of factors, including, without limitation, those risks and uncertainties discussed under the heading “Risk Factors” contained in our Annual Report on Form 10-K for the fiscal year ended July 31, 2010. The information discussed in this report should be read in conjunction with our Annual Report on Form 10-K and other reports we file from time to time with the SEC. We disclaim any intention or obligation to update or revise any forward-looking statements, whether as a result of new information, future results or otherwise. Forward-looking statements include statements regarding our expectations, beliefs, intentions or strategies regarding the future and can be identified by forward-looking words such as “anticipate,” “believe,” “could,” “estimate,” “expect,” “intend,” “may,” “should,” “will,” and “would” or similar words. Available Information We file annual reports on Form 10-K, quarterly reports on Form 10-Q, and current reports on Form 8-K with the SEC. These reports, any amendments to these reports, proxy and information statements and certain other documents we file with the SEC are available through the SEC’s website at www.sec.gov or free of charge on our website as soon as reasonably practicable after we file the documents with the SEC. The public may also read and copy these reports and any other materials we file with the SEC at the SEC’s Public Reference Room at 100 F Street, NE, Washington, D.C. 20549. You may obtain information on the operation of the Public Reference Room by calling the SEC at 1-800-SEC-0330. Executive Summary We develop and market Intelligent Bandwidth Management solutions for fixed line and mobile network operators worldwide and provide services associated with such products. Our current and prospective customers include domestic and international wireline and wireless network service providers, utility companies, large enterprises, multiple systems operators and government entities (collectively referred to as “service providers”). Our existing bandwidth management portfolio of optical switches, multiservice cross-connects and multiservice access platforms serve applications that extend across the network infrastructure, from multiservice access and regional backhaul to the optical core. We are also developing and marketing a mobile broadband optimization solution designed to help mobile operators reduce congestion in mobile access networks. We believe our products enable network operators to efficiently and cost-effectively provision and manage network capacity to support a wide range of converged services such as voice, video and data. Revenue for the three months ended January 29, 2011, which was derived exclusively from our Intelligent Bandwidth Management products and services, decreased 25% to $12.2 million year over year. Net loss was $3.5 million for the three months ended January 29, 2011, compared to net loss of $1.2 million for the same period ended January 23, 2010. The market for bandwidth management products continues to be challenged by high customer concentration, the project-oriented nature of purchasing patterns and customer migration to next-generation transmission technologies. In addition, the current economic climate continues to create uncertainty with regard to the level and timing of capital expenditures by service providers. With purchasing power concentrated in a small number of customers and with an excess of suppliers, competition remains intense. We believe that these factors will result in a limited number of new opportunities for revenue growth, and will continue to create quarterly revenue variability in this area of our business. Accordingly, our investments in these products will remain focused on customer support and sustaining engineering efforts, including targeted, incremental feature development tied to tangible revenue opportunities, and we will not be focusing on the development of next-generation transmission products. At the same time, we continue to invest in the area of mobile broadband optimization, which we believe represents an emerging market opportunity. In July 2010, we announced the introduction of IQstream®, a mobile broadband optimization solution designed to help operators reduce congestion in mobile backhaul networks caused by rising demand for Internet video and other rich media subscriber content. IQstream is designed to lower the cost of delivering mobile data services by freeing up capacity in the cost-sensitive access network. In response to evolving customer requirements and market opportunities identified during the latter part of the first quarter of fiscal 2011, we made the decision to expand the scope of our first release of IQstream beyond our initial target set of features. We believe this expanded set of features will enhance the overall value of our solution and benefit the majority of our target customers. We anticipate attaining general availability of IQstream by the end of March 2011. We are taking a systematic approach to our trial opportunities for IQstream. We continue to work with a focused set of customers that have specific backhaul implementations. This systematic approach provides us with the opportunity to more rigorously test our solution against specific interoperability, security and reliability requirements. The resultant trial process, while longer than originally envisioned, reflects the strategic nature of the location in which IQstream operates in the network, the complexities of the mobile backhaul environment, and the effects of the dynamic changes driving traffic growth. Given the early stage of IQstream and the extended trial process, we are not providing a date for expected first revenue for IQstream. On December 22, 2010, the Company made a cash distribution to its stockholders of $6.50 per share of its common stock, par value $0.001, amounting to $185.4 million in the aggregate. As a result of having an accumulated deficit, the cash distribution has been recorded as a reduction to additional paid in capital. In addition, we will continue to consider other strategic options that may serve to enhance stockholder value. These strategic options include, but are not limited to: acquisitions of, or mergers or other business combinations with, companies with complementary technologies or companies in other market segments; the sale or spin-off of certain assets; strategic alliances with, or investments in, other entities; the discontinuation or divestiture of certain products; and recapitalization alternatives, including stock buybacks, cash distributions or cash dividends. Our cash, cash equivalents and investments totaled $445.0 million at January 29, 2011. We intend to fund our operations for the foreseeable future, including fixed commitments under operating leases and any required capital expenditures, utilizing these funds. We believe that existing cash, cash equivalents and investments will be sufficient to satisfy our operating requirements and enable us to pursue strategic alternatives. Critical Accounting Policies and Estimates Preparation of financial statements requires management to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenue and expenses. Management believes the most complex and sensitive judgments, because of their significance to the consolidated financial statements, result primarily from the need to make estimates about the effects of matters that are inherently uncertain. Management’s Discussion and Analysis in the Company’s Annual Report on Form 10-K for the fiscal year ended July 31, 2010 describes the significant accounting estimates and policies used in the preparation of the financial statements. Actual results in these areas could differ from management’s estimates. There have been no significant changes in the Company’s critical accounting policies during the first six months of fiscal 2011, other than the new revenue recognition guidance as discussed in the recent accounting pronouncement section. Results of Operations 2010. Product revenue decreased for the three and six months ended January 29, 2011 compared to the same periods ended January 23, 2010, primarily due to a decrease in demand for our optical switching products. Service revenue consists primarily of fees for services relating to the maintenance of our products, installation services and training. Service revenue increased for the three and six months ended January 29, 2011 compared to the same periods ended January 23, 2010, primarily due to increased maintenance revenue. For the three months ended January 29, 2011, two customers each accounted for more than 10% of our total revenue. International revenue represented 38% of our total revenue. We expect future revenue will continue to be highly concentrated in a relatively small number of customers. The timing of customer requirements during a fiscal year may cause shifts between quarterly periods in the level and type of revenue, the number of customers who account for more than 10% of our revenue, and in the mix of domestic versus international revenue. The loss or any substantial reduction or delay in orders by any one of these customers could materially adversely affect our business and, accordingly, our financial condition and results of operations. Gross Profit Product gross profit Cost of product revenue consists primarily of amounts paid to third-party contract manufacturers for purchased materials and services, other fixed manufacturing costs and provisions for warranty, scrap, rework, and provisions which may be taken for excess or slow moving inventory. Product gross profit decreased for the three and six months ended January 29, 2011 compared to the same periods ended January 23, 2010. The decrease for the three months ended January 29, 2011 was primarily due to lower revenue for our optical switching products. The decrease for the six months ended January 29, 2011 was primarily due to lower revenue for our optical switching products, a provision in our first quarter of fiscal 2011 of $0.9 million for certain inventory which, based on the company’s then current forecast, was deemed to be in excess of foreseeable demand, and a provision of $0.3 million for severance and benefits related to the restructuring of our operations organization. Product gross profit may fluctuate from period to period due to volume fluctuations, pricing pressures resulting from intense competition in our industry, and the enhanced negotiating leverage of larger customers. In addition, product gross profit may be affected by changes in the mix of products sold, channels of distribution, overhead absorption, sales discounts, increases in labor costs, excess inventory and obsolescence charges, increases in component pricing or other material costs, the introduction of new products, or the entry into new markets with different pricing and cost structures. Service gross profit Cost of service revenue consists primarily of costs of providing services under customer service contracts which include salaries and related expenses and other fixed costs. Service gross profit increased for the three and six months ended January 29, 2011 compared to the same periods ended January 23, 2010. The increase in service gross profit was primarily due to higher maintenance revenue and lower service cost. As most of our service cost of revenue is fixed, increases or decreases in revenue can have a significant impact on service gross profit. Service gross profit may also be affected in future periods by various factors including, but not limited to, the change in mix between technical support services and advanced services, competitive and economic pricing pressures, the enhanced negotiating leverage of certain larger customers, maintenance contract renewals, and the timing of renewals. Research and development expenses consist primarily of salaries and related expenses and prototype costs relating to design, development, testing and enhancements of our products. Research and development expenses decreased for the three and six months ended January 29, 2011 compared to the same periods ended January 23, 2010. The decrease was primarily due to lower fixed and allocated expenses of $0.6 million and $1.5 million for the three and six months ended January 29, 2011 as a result of our cost containment initiatives. The decrease was also due to lower personnel expenses of $0.6 million and $1.3 million for the three and six months ended January 29, 2011 as a result of lower headcount and a change in estimate of certain compensation related obligations. Sales and Marketing Expenses Sales and marketing expenses consist primarily of salaries, commissions and related expenses, and other sales and marketing support expenses. Sales and marketing expenses decreased slightly for the three and six months ended January 29, 2011 compared to the same periods ended January 23, 2010 primarily due to lower personnel expenses on lower revenue. Within our existing spending levels, we continue to allocate sales and marketing resources to those geographic regions where we see the most attractive opportunities. General and Administrative Expenses General and administrative expenses consist primarily of salaries and related expenses, professional fees and other general corporate expenses. General and administrative costs are net of insurance recoveries associated with the Company’s now concluded stock option investigation. General and administrative expenses decreased for the three and six months ended January 29, 2011 compared to the same periods ended January 23, 2010. The decrease was primarily due to a decrease in discretionary spending of $0.4 million and $0.6 million for the three and six months ended January 29, 2011 compared to the same periods ended January 23, 2010. Restructuring and Impairment Charges During the first quarter of fiscal 2011, the Company made the decision to integrate and realign its operations group with other functional areas to enhance operational efficiency and realize the benefits of identified synergies within the respective groups. The realignment resulted in the elimination of four positions. The Company recorded a restructuring charge of $0.3 million which was charged to cost of product revenue. This charge relates to employee separation packages including severance pay, benefits continuation and outplacement costs. During the first quarter of fiscal 2010 the Company recorded a restructuring and related asset impairment charge of $6.4 million of which $6.3 million was charged to operating expense and $0.1 million to cost of product revenue. This charge relates to (i) employee separation packages including severance pay, benefits continuation and outplacement costs amounting to $3.4 million, of which $3.3 million was charged to operating expense and $0.1 million to cost of product revenue, (ii) a facility related termination agreement of $1.9 million, and (iii) a related asset impairment charge of $1.1 million. During the second quarter of fiscal 2010, the Company recorded an adjustment of $0.1 million for unused outplacement services. We continuously monitor our costs and therefore future restructuring and/or impairment charges may be necessary in response to future market or economic conditions. Interest and Other Income, Net Interest and other income net decreased for the three and six months ended January 29, 2011, compared to the same periods ended January 23, 2010. The decrease was primarily due to lower interest rates in fiscal 2011 when compared to fiscal 2010 and a lower average investment balance as a result of the cash distributions that were paid on December 15, 2009 and December 22, 2010. Income Tax Expense/Benefit Income tax expense was $0.1 million and $0.2 million for the three and six months ended January 29, 2011, respectively, primarily related to income tax expense in certain states and profitable foreign jurisdictions. The income tax benefit was $0.7 million and $0.6 million for the three and six months ended January 23, 2010, respectively. The recognized tax benefit reflects the tax effect of the November 2009 enactment of the Home Ownership and Business Assistance Act of 2009. The new law provided for the utilization of 100% (previously 90%) of certain net operating loss carrybacks against alternative minimum taxable income and resulted in an aggregate refund of alternative minimum tax paid of $0.8 million for fiscal 2006 and fiscal 2007. As a result of having substantial accumulated net operating losses, the Company determined that it is more likely than not that our deferred tax assets may not be realized. Therefore, we maintain a full valuation allowance. If the Company generates sustained future taxable income against which these tax attributes may be applied, some or all of the net operating loss carryforwards may be utilized and the valuation allowance reversed. If the valuation allowance is reversed, portions would be recorded as an increase to paid-in capital and the remainder would be recorded as a reduction in income tax expense. Liquidity and Capital Resources Total cash, cash equivalents and short and long term investments were $445.0 million at January 29, 2011. Included in this amount were cash and cash equivalents of $215.0 million compared to $104.4 million at July 31, 2010. The increase in cash and cash equivalents was primarily attributable to the maturity of various short term investments. Net cash provided by investing activities was $300.6 million for the six months ended January 29, 2011 and consisted primarily of net proceeds from the maturity of investments of $301.8 million partially offset by purchases of property and equipment of $1.2 million. Net cash used in operating activities was $7.2 million for the six months ended January 29, 2011. Net loss for the six months ended January 29, 2011 was $10.0 million and included non-cash charges including share-based compensation of $0.9 million, and depreciation and amortization of $2.0 million. Accounts receivable decreased to $10.5 million at January 29, 2011 from $14.2 million at July 31, 2010. The decrease was primarily due to lower revenue in the six months ended January 29, 2011. Our accounts receivable and days sales outstanding are impacted primarily by the timing of shipments, collections performance and timing of support contract renewals. Deferred revenue decreased to $12.9 million at January 29, 2011 from $14.8 million at July 31, 2010 due to the timing of service contract renewals. Net cash used in financing activities was $182.8 million. On December 22, 2010, the Company made a cash distribution to its stockholders of $6.50 per share of its common stock, par value $0.001, amounting to $185.4 million in the aggregate. As a result of having an accumulated deficit, the cash distribution has been recorded as a reduction to additional paid in capital. The impact of the cash distribution was partially offset by proceeds from the exercise of employee stock options of $2.6 million. Our primary source of liquidity comes from our cash, cash equivalents and investments, which totaled $445.0 million at January 29, 2011. Our investments are classified as available-for-sale and consist of securities that are readily convertible to cash, including certificates of deposits and government securities. At January 29, 2011, $217.9 million of investments with maturities of less than one year were classified as short-term investments. Based on our current expectations, we anticipate that some portion of our existing cash, cash equivalents and investments may be consumed by operations. Our accounts receivable, while not considered the primary source of liquidity, represents a concentration of credit risk because the accounts receivable balance at any point in time typically consists of a relatively small number of customer account balances. At January 29, 2011, more than 50% of our accounts receivable balance was attributable to five of our customers. As of January 29, 2011, we have no outstanding debt or credit facilities and do not anticipate entering into any debt or credit agreements in the foreseeable future. Our fixed commitments for cash expenditures consist primarily of payments under operating leases and inventory purchase commitments. We do not currently have any material commitments for capital expenditures. We currently intend to fund our operations, including our fixed operating leases, purchase commitments and any required capital expenditures using our existing cash, cash equivalents and investments. As of January 29, 2011, future cash restructuring payments of $0.6 million consist primarily of costs related to rent and employee separation packages that will be paid over the next 15 months. We believe that our current cash, cash equivalents and investments will be sufficient to satisfy our anticipated cash requirements for at least the next twelve months. We will continue to consider appropriate action with respect to our cash position in light of present and anticipated business needs as well as providing a means by which our stockholders may realize value in connection with their investment. Commitments, Contractual Obligations and Off-Balance Sheet Arrangements At January 29, 2011, our future obligations, which consist of contractual commitments for operating leases and inventory and other purchase commitments, were as follows (in thousands): Payments made under operating leases will be treated as rent expense for the facilities currently being utilized, or as a reduction of the restructuring liability for payments relating to excess facilities. Payments made for inventory purchase commitments will initially be capitalized as inventory and will then be recorded as cost of revenue as the inventory is sold or otherwise disposed of. Reserves for unrecognized tax benefits of $1.6 million have not been included in the above table because the periods of cash settlement with the respective tax authority cannot be reasonably estimated. Recent Accounting Pronouncements In September 2009, the Emerging Issues Task Force issued new guidance pertaining to the accounting for revenue arrangements with multiple deliverables. The new guidance addresses how to determine whether an arrangement involving multiple deliverables contains more than one unit of accounting, and how the arrangement consideration should be allocated among the separate units of accounting. The new guidance became effective for fiscal years beginning after June 15, 2010 and may be applied retrospectively or prospectively for new or materially modified arrangements. In addition, early adoption was permitted. The new guidance is applicable to the Company and became effective beginning August 1, 2010. The Company adopted the new guidance in the first quarter of fiscal 2011, on a prospective basis. In September 2009, the Emerging Issues Task Force issued new guidance that changes the accounting model for revenue arrangements that include both tangible products and software elements that are “essential to the functionality” and removes these products from the scope of current software revenue guidance. The new guidance shall be applied on a prospective basis for revenue arrangements entered into or materially modified in fiscal years beginning on or after June 15, 2010. Earlier application was permitted as of the beginning of a company’s fiscal year provided the company has not previously issued financial statements for any period within that year. An entity shall not elect early application of this guidance unless it also elects early application of the new rule pertaining to accounting for revenue arrangements with multiple deliverables. The new guidance is applicable to the Company and became effective beginning August 1, 2010. The Company adopted the new guidance in the first quarter of fiscal 2011. During the second quarter of fiscal 2011, the Company entered into a multiple element arrangement that included hardware and non-essential software deliverables. The hardware element was delivered during the second quarter and the non-essential software element was undelivered as of the end of the second quarter. The Company recognized $0.7 million in revenue and deferred $0.1 million related to this multiple element transaction. Under the prior revenue recognition guidance the Company would have deferred $0.8 million for this multiple element transaction. The new guidance does not change the units of accounting. --- Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations General The following Discussion and Analysis should be read in conjunction with Management’s Discussion and Analysis of Financial Condition and Results of Operations included in Item 7 of the Company’s Annual Report on Form 10-K for its fiscal year ended October 31, 2010. This Quarterly Report, and other periodic reports filed by the Company under the Securities Exchange Act of 1934, and other written or oral statements made by it or on its behalf, may include forward-looking statements, which are based on a number of assumptions about future events and are subject to various risks, uncertainties and other factors that may cause actual results to differ materially from the views, beliefs and estimates expressed in such statements. These risks, uncertainties and other factors include, but are not limited to the following: (1) Changes in the market price for the Company’s finished products and feed grains, both of which may fluctuate substantially and exhibit cyclical characteristics typically associated with commodity markets. (2) Changes in economic and business conditions, monetary and fiscal policies or the amount of growth, stagnation or recession in the global or U.S. economies, either of which may affect the value of inventories, the collectability of accounts receivable or the financial integrity of customers, and the ability of the end user or consumer to afford protein. (3) Changes in the political or economic climate, trade policies, laws and regulations or the domestic poultry industry of countries to which the Company or other companies in the poultry industry ship product, and other changes that might limit the Company’s or the industry’s access to foreign markets. (4) Changes in laws, regulations, and other activities in government agencies and similar organizations applicable to the Company and the poultry industry and changes in laws, regulations and other activities in government agencies and similar organizations related to food safety. (5) Various inventory risks due to changes in market conditions. (6) Changes in and effects of competition, which is significant in all markets in which the Company competes, and the effectiveness of marketing and advertising programs. The Company competes with regional and national firms, some of which have greater financial and marketing resources than the Company. (7) Changes in accounting policies and practices adopted voluntarily by the Company or required to be adopted by accounting principles generally accepted in the United States. (8) Disease outbreaks affecting the production performance and/or marketability of the Company’s poultry products, or the contamination of its products. (9) Changes in the availability and cost of labor and growers. (10) The loss of any of the Company’s major customers. (11) Inclement weather that could hurt Company flocks or otherwise adversely affect its operations, or changes in global weather patterns that could impact the supply of feed grains. (12) Failure to respond to changing consumer preferences. (13) Failure to successfully and efficiently start up and run a new plant or integrate any business the Company might acquire. Readers are cautioned not to place undue reliance on forward-looking statements made by or on behalf of Sanderson Farms. Each such statement speaks only as of the day it was made. The Company undertakes no obligation to update or to revise any forward-looking statements. The factors described above cannot be controlled by the Company. When used in this report, the words “believes”, “estimates”, “plans”, “expects”, “should”, “outlook”, and “anticipates” and similar expressions as they relate to the Company or its management are intended to identify forward-looking statements. Examples of forward-looking statements include statements about management’s beliefs about future demand for fresh chicken and future chicken market prices. The Company’s poultry operations are integrated through its control of all functions relative to the production of its chicken products, including hatching egg production, hatching, feed manufacturing, raising chickens to marketable age (“grow out”), processing, and marketing. Consistent with the poultry industry, the Company’s profitability is substantially impacted by the market prices for its finished products and feed grains, both of which may fluctuate substantially and exhibit cyclical characteristics typically associated with commodity markets. Other costs, excluding feed grains, related to the profitability of the Company’s poultry operations, including hatching egg production, hatching, growing, and processing cost, are responsive to efficient cost containment programs and management practices. The Company’s prepared chicken product line includes approximately 65 institutional and consumer packaged chicken items that it sells nationally, primarily to distributors and food service establishments. A majority of the prepared chicken items are made to the specifications of food service users. Sanderson Farms announced plans on April 24, 2008, to invest approximately $126.5 million for construction of a new feed mill, poultry processing plant and hatchery on separate sites in Kinston and Lenoir County, North Carolina. On June 26, 2008, the Company announced its decision to postpone the project due to market conditions and escalating grain prices. On July 23, 2009, the Company announced plans to proceed with the construction and start-up of the Company’s Kinston, North Carolina, poultry complex with a revised budget of approximately $121.4 million. The new complex was completed within budget and initial operations began as expected during January 2011. The Kinston facilities comprise a state-of-the-art poultry complex with the capacity, at full production, to process 1,250,000 birds per week for the retail chill pack market. At full capacity, which is expected to be reached early during calendar 2012, the complex will employ approximately 1,500 people, will require 130 contract growers, and will be equipped to process and sell 6.7 million pounds per week of dressed poultry meat. On March 29, 2010, the Company announced intentions to construct a potential second new poultry complex in North Carolina, subject to various contingencies including, among others, obtaining an acceptable economic incentive package from the state and local governments. The Company announced on February 24, 2011 that this new complex will be placed on hold pending improvement in market fundamentals, including assurance that the supply of corn and other feed grains in the United States and the world will be adequate to meet the demands of end users of such grains at reasonable prices. The project, if completed, will consist of an expansion of the feed mill for the Kinston, North Carolina plant, a hatchery, a processing plant with capacity to process 1.25 million chickens per week and a waste water treatment facility. At full capacity, the plant is expected to employ approximately 1,100 people, will require approximately 150 contract growers and will be equipped to process and sell 8.9 million pounds of dressed poultry per week. We will need to indentify a site, obtain permits, enter into construction contracts and complete construction before the complex can open. See “The construction and potential benefits of our new North Carolina facilities are subject to risks and uncertainties” in the Risk Factors Section of our annual report on Form 10-K for the year ended October 31, 2010. On February 23, 2011, the Company entered into a new revolving credit facility to, among other things, increase the available credit to $500.0 million from $300.0 million, and to increase the annual capital expenditure limitation to $60.0 million during fiscal years 2011 and $55.0 million for fiscal years 2012, 2013, 2014 and 2015. The new credit facility also permits the Company to spend up to $115.0 million in capital expenditures on the construction of a second poultry complex in North Carolina, which expenditures are in addition to the annual limits. Under the new revolving credit facility the Company may not exceed a maximum debt to total capitalization ratio of 55% from the date of the agreement through October 30, 2014, and 50% thereafter. The Company has a onetime right, at any time during the Company’s fiscal year ending October 31, 2011 or October 31, 2012, to increase the maximum debt to total capitalization ratio then in effect by 5% for the four fiscal quarters beginning on the first day of the fiscal quarter during which the Company gives written notice of its intent to exercise this right. The credit remains unsecured and, unless extended, will expire on February 23, 2016. EXECUTIVE OVERVIEW OF RESULTS During the first quarter of fiscal 2011, the Company’s margins decreased primarily as a result of higher costs of feed grains in flocks sold and lower overall market prices for poultry products as compared to the first quarter of fiscal 2010. In addition, because of the increased costs of corn and soybean meal, the Company recorded a net realizable loss of $22.3 million during the first quarter of fiscal 2011 to lower the value of the Company’s inventory of live broilers at January 31, 2011 from cost to expected market value. While demand for fresh chicken in the retail grocery store market has been stable, demand from food service customers has remained soft as the supply of poultry meat has increased, resulting in lower market prices for poultry products during the first quarter of fiscal 2011 as compared to the first quarter of 2010. The Company expects this trend to continue at least through the second quarter of fiscal 2011. In addition, the costs of corn and soybean meal have increased significantly due to several factors, including lower than expected yields of both corn and soybeans during the 2010 crop year and uncertainty regarding the size and quality of the 2011 crop. The Company has not priced a significant portion of its remaining grain needs for fiscal 2011. Had it priced those needs at February 22, 2011 market prices, including the additional volume needed during fiscal 2011, cash feed grain prices would be approximately $330.7 million higher during fiscal 2011 as compared to fiscal 2010. RESULTS OF OPERATIONS Net sales during the three months ended January 31, 2011 were $427.7 million as compared to $420.1 million for the three months ended January 31, 2010, an increase of $7.6 million or 1.8%. Net sales of poultry products for the three months ended January 31, 2011 and January 31, 2010 were $402.4 million and $391.5 million, respectively, an increase of $10.9 million or 2.8%. The increase in net sales of poultry products resulted from an increase in the pounds of poultry products sold of 7.9%, partially offset by a decrease in the average sales price of poultry products of 4.8%. During the first quarter of fiscal 2011 the Company sold 630.7 million pounds of poultry products, up from 584.3 million pounds during the first quarter of fiscal 2010. The additional pounds of poultry products sold resulted from an increase in the number of chickens produced of 6.9% and an increase in the average live weight of chickens produced of 3.1%. The new Kinston complex began initial operation during January 2011 and sold 8.3 million pounds of poultry, or 1.3% of the total poultry pounds sold during the first quarter of fiscal 2011. The Company expects the new Kinston complex to process 21.1, 38.9 and 51.1 million pounds of dressed poultry in each of the subsequent quarters of fiscal 2011. Overall market prices for poultry products decreased during the first quarter of fiscal 2011 as compared to the first quarter of fiscal 2010 as a result of an increase in the supply of poultry products and sluggish demand from food service customers. Urner Barry market prices for boneless breast meat, tenders and jumbo wings decreased significantly during the first quarter of fiscal 2011 as compared to the first quarter of fiscal 2010 by 3.1%, 10.1% and 36.6%, respectively. However, the impact of these decreases was partially offset by improvements in the average Urner Barry prices for bulk leg quarters and the average market price for Georgia Dock whole birds of 2.8% and 3.5%, respectively, as compared to the same period a year ago. Net sales of prepared chicken products for the three months ended January 31, 2011 and 2010 were $25.3 million and $28.6 million, respectively, or a decrease of 11.7%, resulting from a decrease in the average sales price of prepared chicken products sold of 4.2% and a decrease in the pounds of prepared chicken products sold of 7.8% from 14.0 million during the first quarter of fiscal 2010 to 12.9 million pounds sold during the first quarter of fiscal 2011. Cost of sales for the first quarter of fiscal 2011 was $436.6 million as compared to $378.0 million during the first quarter of fiscal 2010, an increase of $58.6 million or 15.5%. Cost of sales of poultry products sold during the first quarter of fiscal 2011 as compared to the first quarter of fiscal 2010 were $414.2 million and $352.6 million, respectively, an increase of $61.6 million or 17.5%. As illustrated in the table below, the increase in the cost of sales of poultry products sold resulted from an increase in the pounds of poultry products sold of 7.9%, and an increase in feed costs per pound of 21.0%. Poultry Cost of Sales The average cost of feed in broiler flocks sold during the first quarter of fiscal 2011 as compared to the same quarter a year ago increased $50.6 million or $0.059 per pound. Excluding feed in broiler flocks sold, all other costs of sales increased $11.0 million, or a decrease of $0.006 per pound of poultry products sold compared to the same period a year ago. These other costs of sales of poultry products include labor, contract grower pay, packaging, freight and certain fixed costs, among other costs. Costs of sales of the Company’s prepared chicken products were $22.4 million as compared to $25.4 million during fiscal 2010, a decrease of $3.0 million or 11.7%. Selling, general and administrative costs during the first fiscal quarter of 2011 and 2010 were $20.4 million and $16.4 million, respectively. The following table includes the components of selling, general and administrative costs for the three months ended January 31, 2011 and 2010. Selling, General and Administrative Costs As illustrated in the table above, the increase in selling, general and administrative costs during the first fiscal quarter of 2011 as compared to fiscal 2010 resulted from additional administrative costs related to start up of the new Kinston and Lenoir County poultry complex. The Company began operations at the new Kinston complex during January 2011, at which time all Kinston costs, excluding customer service department costs, were included in cost of sales. The Company will not have any start up costs in subsequent quarters related to the Kinston complex. The Company recorded a charge of $22.3 million to lower the value of live broiler inventories on hand at January 31, 2011 from cost to market value, which resulted primarily from the significant increase in costs for corn and soybean meal. When market conditions are favorable, the Company values the broiler inventories on hand at cost, and accumulates costs as the birds are grown to a marketable age subsequent to the balance sheet date. However, the Company estimates that the cost to grow live birds in inventory on January 31, 2011 to a marketable age and then process and distribute those birds during February and March 2011 will be higher than the anticipated sales price during those months. Accordingly, the Company adjusted the value of live inventory from cost to market. For the first quarter of fiscal 2011, the Company’s operating loss was $51.6 million as compared to an operating income of $25.7 million for the first quarter of fiscal 2010. The reduction in the Company’s operating margin resulted primarily from higher cost of feed grains included in flocks sold and a decline in overall market prices of poultry products during the first quarter of fiscal 2011 as compared to the first quarter of fiscal 2010, as described above. In addition, because of the increased costs of corn and soybean meal the Company recorded a charge of $22.3 million during the first quarter of fiscal 2011 to lower the value of the Company’s inventory of live broilers at January 31, 2011 from cost to market value. Interest expense during the first quarter of fiscal 2011 and fiscal 2010 was $456,000 and $1.1 million, respectively. The decrease in interest expense during the first quarter of fiscal 2011 as compared to the first quarter of fiscal 2010 resulted primarily from capitalized interest of $630,000 related to the construction of the new complex in Kinston and Lenoir County, North Carolina. During the first quarter of fiscal 2010 the Company capitalized $51,000 in interest cost for the construction of the new complex in Kinston and Lenoir County, North Carolina. The Company’s effective tax rates for the first quarter of fiscal 2011 and fiscal 2010 were 35.5% and 35.7%, respectively and differ from the statutory federal rate due to state income taxes, certain nondeductible expenses for federal income tax purposes and certain state and federal tax credits. The net loss for the three months ended January 31, 2011 was $33.6 million or $1.52 per share as compared to net income of $15.8 million or $0.75 per share for the three months ended January 31, 2010. Liquidity and Capital Resources The Company’s working capital, calculated by subtracting current liabilities from current assets, at January 31, 2011 was $195.9 million and its current ratio, calculated by dividing current assets by current liabilities, was 3.2 to 1. The Company’s working capital and current ratio at October 31, 2010 was $238.2 million and 3.2 to 1. These measures reflect the Company’s ability to meet its short term obligations and are included here as a measure of the Company’s short term market liquidity. The Company’s principal sources of liquidity during fiscal 2011 include cash on hand at October 31, 2010 and borrowings under the Company’s revolving credit facility with nine banks. As described below, on February 23, 2011 the Company entered into a new revolving credit facility to, among other things, to increase the line of credit to $500.0 million from $300.0 million and to extend the terms until 2016 from 2013. As of January 31, 2011, the Company has no outstanding borrowings under the revolving credit facility, but the Company does have $9.9 million outstanding letters of credit under the credit facility. The Company’s cash position at January 31, 2011 and October 31, 2010 consisted of $0.6 million and $73.4 million, respectively, in cash and cash equivalents. The Company’s ability to invest cash is limited by covenants in its revolving credit agreement to short term, conservative investments. All of the Company’s cash at January 31, 2011 and October 31, 2010 was held in checking accounts and highly liquid, overnight investment accounts maintained at two banks. There were no restrictions on the Company’s access to its cash and cash investments, and such cash and cash investments were available to the Company on demand to fund its operations. Cash flows provided by (used in) operating activities during the first quarter of fiscal 2011 and fiscal 2010 were ($53.4) million and $16.0 million, respectively. The decrease in cash flows from operating activities of $69.4 million resulted primarily from lower overall market prices for poultry products, higher prices for feed grains and funds required to pay for additional inventories of live and processed poultry at the new Kinston facility during the first quarter of fiscal 2011 as compared to the first quarter of fiscal 2010. Cash flows used in investing activities during the first quarter of fiscal 2011 and 2010 were $18.9 million and $23.3 million, respectively. The Company’s capital expenditures during the first quarter of fiscal 2011 were $18.9 million and included $10.0 million for construction of the Company’s new Kinston and Lenoir County, North Carolina complex. During the first quarter of fiscal 2010, the Company spent approximately $23.3 million and included $12.7 million for construction of the company’s new Kinston and Lenoir County, North Carolina complex. Excluding the Kinston and Lenoir County complex, the Company’s capital expenditures during fiscal 2011 and 2010 were $8.9 million and $10.6 million, respectively. Cash flows used in financing activities during the first quarter of fiscal 2011 and 2010 were $0.4 million and $0.2 million, respectively. The Company borrowed no additional funds under its revolving credit facility in either quarter ended January 31, 2011 or January 31, 2010. During the first quarter of fiscal 2011, the Company’s unfavorable profit margin required it to use cash on hand at the beginning of fiscal 2011 to fund operations and to invest in fixed assets and inventories at the Company’s new complex in Kinston and Lenoir County, North Carolina. During fiscal 2010 the Company’s operating margin was adequate to fund operations and to invest in fixed assets at the Company’s new complex in Kinston and Lenoir County, North Carolina. The Company’s capital budget for fiscal 2011 is approximately $60.5 million and will be funded by cash on hand at October 31, 2010, internally generated working capital, cash flows from operations and, as needed, draws under the Company’s revolving line of credit facility. The Company had $432.4 million available under the revolving line of credit at February 24, 2011. The fiscal 2011 capital budget includes approximately $12.8 million for construction of the poultry complex in Kinston, North Carolina and $11.9 million in vehicle operating leases, of which $7.2 million are for vehicles to be used at the Kinston, North Carolina complex. Also included in the fiscal 2011 capital budget is $4.8 million in quality control equipment that was carried forward from the Company’s fiscal 2010 capital budget and $5.1 million for software replacement. Excluding these capital items, the Company’s capital budget for fiscal 2011 would be $25.9 million. On October 9, 2008, the Company announced that it filed a Form S-3 “shelf” registration statement with the Securities and Exchange Commission to register for possible future sale shares of the Company’s common and/or preferred stock at an aggregate offering price not to exceed $1.0 billion. The stock may be offered by the Company in amounts, at prices and on terms to be determined by the board of directors if and when shares are issued. On March 29, 2010 the Company announced that it had commenced an underwritten registered public offering of 2,000,000 shares of its common stock under its shelf registration statement. In connection with this offering, the Company granted the underwriters a 30-day option to purchase up to an additional 300,000 shares of common stock to cover over-allotments, if any. On April 7, 2010 the Company announced the closing of its underwritten registered public offering of 2,300,000 shares of its common stock, including 300,000 shares issued in connection with the underwriters’ exercise of their over-allotment option. The offering price to the public was $53.00 per share. The Company also announced it intends to use the net proceeds from the offering, together with other funds, to finance the construction of its new retail poultry complex in Kinston, North Carolina, and a second potential complex to be located in North Carolina, discussed below. Pending such uses, net proceeds from the offering were used to reduce indebtedness and to invest in cash and cash equivalents. The Company has used some of the invested proceeds as working capital and for general corporate purposes. Sanderson Farms announced plans on April 24, 2008, to invest approximately $126.5 million for construction of a new feed mill, poultry processing plant and hatchery on separate sites in Kinston and Lenoir County, North Carolina. On June 26, 2008, the Company announced its decision to postpone the project due to market conditions and escalating grain prices. On July 23, 2009, the Company announced plans to proceed with the construction and start-up of the Company’s Kinston, North Carolina, poultry complex with a revised budget of approximately $121.4 million. The new complex was completed within budget and with initial operations beginning as expected during January 2011. The Kinston facilities comprise a state-of-the-art poultry complex with the capacity at full production to process 1,250,000 birds per week for the retail chill pack market. At full capacity, which is expected to be reached early during calendar 2012, the complex will employ approximately 1,500 people, will require 130 contract growers, and will be equipped to process and sell 6.7 million pounds per week of dressed poultry meat. On March 29, 2010, the Company announced intentions to construct a potential second new poultry complex in North Carolina, subject to various contingencies including, among others, obtaining an acceptable economic incentive package from the state and local governments. The Company announced on February 24, 2011 that this new complex will be placed on hold pending improvement in market fundamentals, including assurance that the supply of corn and other feed grains in the United States and the world will be adequate to meet the demands of end users of such grains at reasonable prices. The project, if completed, will consist of an expansion of the feed mill for the Kinston, North Carolina plant, a hatchery, a processing plant with capacity to process 1.25 million chickens per week and a waste water treatment facility. At full capacity, the plant is expected to employ approximately 1,100 people, will require approximately 150 contract growers and will be equipped to process and sell 8.9 million pounds of dressed poultry per week. We will need to indentify a site, obtain permits, enter into construction contracts and complete construction before the complex can open. See “The construction and potential benefits of our new North Carolina facilities are subject to risks and uncertainties” in the Risk Factors Section of our annual report on Form 10-K for the year ended October 31, 2010. On February 23, 2011, the Company entered into a new revolving credit facility to, among other things, increase the available credit to $500.0 million from $300.0 million, and to increase the annual capital expenditure limitation to $60.0 million during fiscal years 2011 and $55 million for fiscal years 2012, 2013, 2014 and 2015. The new credit facility also permits the Company to spend up to $115.0 million in capital expenditures on the construction of a second poultry complex in North Carolina, which expenditures are in addition to the annual limits. Under the new revolving credit facility the Company may not exceed a maximum debt to total capitalization ratio of 55% from the date of the agreement through October 30, 2014, and 50% thereafter. The Company has a onetime right, at any time during the Company’s fiscal year ending October 31, 2011 or October 31, 2012, to increase the maximum debt to total capitalization ratio then in effect by 5% for the four fiscal quarters beginning on the first day of the fiscal quarter during which the Company gives written notice of its intent to exercise this right. The credit remains unsecured and, unless extended, will expire on February 23, 2016. As of January 31, 2011, the Company had no outstanding borrowings under the then existing revolving credit facility, but had $9.9 million outstanding letters of credit under the facility. As of February 24, 2011, the Company had borrowed $57.7 million under the new revolving credit facility. The Company regularly evaluates both internal and external growth opportunities, including acquisition opportunities and the possible construction of new production assets, and conducts due diligence activities in connection with such opportunities. The cost and terms of any financing to be raised in conjunction with any growth opportunity, including the Company’s ability to raise debt or equity capital on terms and at costs satisfactory to the Company, and the effect of such opportunities on the Company’s balance sheet, are critical considerations in any such evaluation. Critical Accounting Policies and Estimates The preparation of financial statements in accordance with accounting standards generally accepted in the United States requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from these estimates and assumptions, and the differences could be material. The Company’s Summary of Significant Accounting Policies, as described in Note 1 of the Notes to the Consolidated Financial Statements that are filed with the Company’s latest report on Form 10-K, should be read in conjunction with this Management’s Discussion and Analysis of Financial Condition and Results of Operations. Management believes that the critical accounting policies and estimates that are material to the Company’s Consolidated Financial Statements are those described below. Allowance for Doubtful Accounts In the normal course of business, the Company extends credit to its customers on a short-term basis. Although credit risks associated with our customers are considered minimal, the Company routinely reviews its accounts receivable balances and makes provisions for probable doubtful accounts. In circumstances where management is aware of a specific customer’s inability to meet its financial obligations to the Company, a specific reserve is recorded to reduce the receivable to the amount expected to be collected. If circumstances change (i.e., higher than expected defaults or an unexpected material adverse change in a major customer’s ability to meet its financial obligations to us), our estimates of the recoverability of amounts due us could be reduced by a material amount, and the allowance for doubtful accounts and related bad debt expense would increase by the same amount. Inventories Processed food and poultry inventories and inventories of feed, eggs, medication and packaging supplies are stated at the lower of cost (first-in, first-out method) or market. If market prices for poultry or feed grains move substantially lower, the Company would record adjustments to write down the carrying values of processed poultry and feed inventories to fair market value, which would increase the Company’s costs of sales. Live poultry inventories of broilers are stated at the lower of cost or market and breeders at cost less accumulated amortization. The cost associated with broiler inventories, consisting principally of chicks, feed, medicine and payments to the growers who raise the chicks for us, are accumulated during the growing period. The cost associated with breeder inventories, consisting principally of breeder chicks, feed, medicine and grower payments are accumulated during the growing period. Capitalized breeder costs are then amortized over nine months using the straight-line method. Mortality of broilers and breeders is charged to cost of sales as incurred. If market prices for chicken, feed or medicine or if grower payments increase (or decrease) during the period, the Company could have an increase (or decrease) in the market value of its inventory as well as an increase (or decrease) in costs of sales. Should the Company decide that the nine month amortization period used to amortize the breeder costs is no longer appropriate as a result of operational changes, a shorter (or longer) amortization period could increase (or decrease) the costs of sales recorded in future periods. High mortality from disease or extreme temperatures would result in abnormal charges to cost of sales to write-down live poultry inventories. As of January 31, 2011, the Company recorded a $22.3 million adjustment to reduce the value of its inventory of live broilers from cost to market value. The adjustment was determined by estimating the extent to which the accumulated cost of live poultry inventories of broilers at January 31, 2011, plus the estimated remaining costs of their grow-out, processing, marketing and sale, exceeded the ultimate expected sales prices of finished products resulting from the processing of such broiler inventories. In making this adjustment, the value of no individual live broiler flock was reduced by an amount greater than its’ accumulated cost as of January 31, 2011. The Company used the latest available information in making these estimates, including the expected cost of grain needed to complete the grow out of live inventories and the expected market prices for the finished products. However, as with any sensitive estimate, there are uncertainties inherent in making forward-looking projections and the Company’s actual results could vary from those estimated. Long-Lived Assets Depreciable long-lived assets are primarily comprised of buildings and machinery and equipment. Depreciation is provided by the straight-line method over the estimated useful lives, which are 15 to 39 years for buildings and 3 to 12 years for machinery and equipment. An increase or decrease in the estimated useful lives would result in changes to depreciation expense. The Company continually evaluates the carrying value of its long-lived assets for events or changes in circumstances that indicate that the carrying value may not be recoverable. As part of this evaluation, the Company estimates the future cash flows expected to result from the use of the asset and its eventual disposal. If the sum of the expected future cash flows (undiscounted and without interest charges) is less than the carrying amount of the asset, an impairment loss is recognized to reduce the carrying value of the long-lived asset to the estimated fair value of the asset. If the Company’s assumptions with respect to the future expected cash flows associated with the use of long-lived assets currently recorded change, then the Company’s determination that no impairment charges are necessary may change and result in the Company recording an impairment charge in a future period. The Company did not identify any indicators of impairment during the current fiscal period. Accrued Self Insurance Insurance expense for workers’ compensation benefits and employee-related health care benefits are estimated using historical experience and actuarial estimates. Stop-loss coverage is maintained with third party insurers to limit the Company’s total exposure. Management regularly reviews the assumptions used to recognize periodic expenses. Any resulting adjustments to accrued claims are reflected in current operating results. If historical experience proves not to be a good indicator of future expenses, if management were to use different actuarial assumptions, or if there is a negative trend in the Company’s claims history, there could be a significant increase or decrease in cost of sales depending on whether these expenses increased or decreased, respectively. Income Taxes The Company determines its effective tax rate by estimating its permanent differences resulting from differing treatment of items for financial and income tax purposes. The Company is periodically audited by taxing authorities and considers any adjustments made as a result of the audits in considering the tax expense. Any audit adjustments affecting permanent differences could have an impact on the Company’s effective tax rate. Contingencies The Company is involved in various claims and litigation incidental to its business. Although the outcome of these matters cannot be determined with certainty, management, upon the advice of counsel, is of the opinion that the final outcome should not have a material effect on the Company’s consolidated results of operations or financial position. The Company recognizes the costs of legal defense for the legal proceedings to which it is a party in the periods incurred. After a considerable analysis of each case, the Company determines the amount of reserves required, if any. At this time, the Company has not accrued any reserve for any of these matters. Future reserves may be required if losses are deemed reasonably estimable and probable due to changes in the Company’s assumptions, the effectiveness of legal strategies, or other factors beyond the Company’s control. Future results of operations may be materially affected by the creation of reserves or by accruals of losses to reflect any adverse determinations in these legal proceedings. New Accounting Pronouncements In January 2010, FASB issued ASU 2010-6, “Improving Disclosures About Fair Measurements”. ASU 2010-6 provides amendments to subtopic 820-10 that require separate disclosure of significant transfers in and out of Level 1 and Level 2 fair value measurements and the presentation of separate information regarding purchases, sales, issuances and settlements for Level 3 fair value measurements. Additionally, ASU 2010-6 provides amendments to subtopic 820-10 that clarify existing disclosures about the level of disaggregation and inputs and valuation techniques. ASU 2010-6 is effective for financial statements issued for interim and annual periods ending after December 15, 2010. The adoption of ASU 2010-6 did not have a material impact on the Company’s consolidated financial position, results of operations or cash flows. --- ITEM 2 – MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Throughout this Form 10-Q, the terms “we”, “us” or “our” refer to William Penn Bancorp, Inc. or William Penn Bank, FSB, or both, as the context indicates. We also refer to William Penn Bank, FSB as “the Bank” and to William Penn Bancorp, Inc. as “the Registrant” or “the Company.” Forward-Looking Statements This Form 10-Q contains forward-looking statements, which can be identified by the use of words such as “believes,” “expects,” “anticipates,” “estimates” or similar expressions. Forward-looking statements include: • statements of our goals, intentions and expectations; • statements regarding our business plans, prospects, growth and operating strategies; • statements regarding the quality of our loan and investment portfolios; and • estimates of our risks and future costs and benefits. These forward-looking statements are subject to significant risks and uncertainties. Actual results may differ materially from those contemplated by the forward-looking statements due to, among others, the following factors: • general economic conditions, either nationally or in our market area, that are worse than expected; • changes in the interest rate environment that reduce our interest margins or reduce the fair value of financial instruments; • our ability to enter into new markets and/or expand product offerings successfully and take advantage of growth opportunities; • increased competitive pressures among financial services companies; • changes in consumer spending, borrowing and savings habits; • legislative or regulatory changes that adversely affect our business; • adverse changes in the securities markets; • our ability to successfully manage our growth; and • changes in accounting policies and practices, as may be adopted by the bank regulatory agencies, the Financial Accounting Standards Board or the Public Company Accounting Oversight Board. Any of the forward-looking statements that we make in this Form 10-Q and in other public statements we make may turn out to be wrong because of inaccurate assumptions we might make, because of the factors illustrated above or because of other factors that we cannot foresee. Consequently, no forward-looking statement can be guaranteed. Overview This discussion and analysis reflects the Company’s consolidated financial statements and other relevant statistical data and is intended to enhance your understanding of our financial condition and results of operations. You should read the information in this section in conjunction with the Company’s unaudited consolidated financial statements and accompanying notes thereto included in this Form 10-Q. Our primary business is attracting retail deposits from the general public and using those deposits, together with funds generated from operations, principal repayments on securities and loans, and borrowed funds, for our lending and investing activities. Our results of operations depend mainly on our net interest income, which is the difference between the interest income earned on our loan and investment portfolios and interest expense paid on our deposits and borrowed funds. Net interest income is a function of the average balances of loans and investments versus deposits and borrowed funds outstanding in any one period and the yields earned on those loans and investments and the cost of those deposits and borrowed funds. Anticipated Increase in Operating Expenses Noninterest expense in the future will be impacted by our plan to expand our branch network. Construction is in progress on a new branch in Levittown which will be completed in the Spring of 2011. We also anticipate additional branch expansion over the next five years. This will lead to higher compensation and benefits expenses going forward as the result of our plans to hire additional personnel and expand the size of our lending department. As part of their regular examinations of the Bank, federal regulators review the adequacy of the allowance and may require us to make additions to the allowance based on their judgments. The Bank’s deposits are insured to applicable limits by the FDIC. The maximum deposit insurance amount has been permanently increased from $100,000 to $250,000 by the Dodd-Frank Act. On October 13, 2008, the FDIC established a Temporary Liquidity Guarantee Program under which the FDIC fully guarantees all non-interest-bearing transaction accounts until December 31, 2009 (the “Transaction Account Guarantee Program”) and all senior unsecured debt of insured depository institutions or their qualified holding companies issued between October 14, 2008 and June 30, 2009, with the FDIC’s guarantee expiring by June 30, 2012 (the “Debt Guarantee Program”). Senior unsecured debt would include federal funds purchased and certificates of deposit standing to the credit of the bank. After November 12, 2008, institutions that did not opt out of the Programs by December 5, 2008 were assessed at the rate of ten basis points for transaction account balances in excess of $250,000 and at a rate between 50 and 100 basis points of the amount of debt issued. In May, 2009, the Debt Guarantee Program issue end date and the guarantee expiration date were both extended, to October 31, 2009 and December 31, 2012, respectively. Participating holding companies that have not issued FDIC-guaranteed debt prior to April 1, 2009 must apply to remain in the Debt Guarantee Program. Participating institutions will be subject to surcharges for debt issued after that date. Effective October 1, 2009, the Transaction Account Guarantee Program was extended until December 31, 2010, with an assessment of between 15 and 25 basis points after January 1, 2010. The Company and the Bank did not opt out of the Debt Guarantee Program but did not issue any debt thereunder. The Bank did not opt out of the original Transaction Account Guarantee Program or its extension. The Dodd-Frank Act has extended unlimited deposit insurance to non-interest-bearing transaction accounts until December 31, 2013. The FDIC has adopted a risk-based premium system that provides for quarterly assessments based on an insured institution’s ranking in one of four risk categories based on their examination ratings and capital ratios. Well-capitalized institutions with the CAMELS ratings of 1 or 2 are grouped in Risk Category I and, until 2009, were assessed for deposit insurance at an annual rate of between five and seven basis points with the assessment rate for an individual institution determined according to a formula based on a weighted average of the institution’s individual CAMELS component ratings plus either five financial ratios or the average ratings of its long-term debt. Institutions in Risk Categories II, III and IV were assessed at annual rates of 10, 28 and 43 basis points, respectively. Pursuant to the Federal Deposit Insurance Reform Act of 2005 (the “Reform Act”), the FDIC is authorized to set the reserve ratio for the Deposit Insurance Fund annually at between 1.15% and 1.5% of estimated insured deposits. Due to recent bank failures, the FDIC determined that the reserve ratio was 1.01% as of June 30, 2008. In accordance with the Reform Act, as amended by the Helping Families Save Their Home Act of 2009, the FDIC established and implemented a plan to restore the reserve ratio to 1.15% within eight years. For the quarter beginning January 1, 2009, the FDIC raised the base annual assessment rate for institutions in Risk Category I to between 12 and 14 basis points while the base annual assessment rates for institutions in Risk Categories II, III and IV were increased to 17, 35 and 50 basis points, respectively. For the quarter beginning April 1, 2009 the FDIC set the base annual assessment rate for institutions in Risk Category I to between 12 and 16 basis points and the base annual assessment rates for institutions in Risk Categories II, III and IV at 22, 32 and 45 basis points, respectively. An institution’s assessment rate could be lowered by as much as five basis points based on the ratio of its long-term unsecured debt to deposits or, for smaller institutions based on the ratio of certain amounts of Tier 1 capital to adjusted assets. The assessment rate may be adjusted for Risk Category I institutions that have a high level of brokered deposits and have experienced higher levels of asset growth (other than through acquisitions) and could be increased by as much as ten basis points for institutions in Risk Categories II, III and IV whose ratio of brokered deposits to deposits exceeds 10%. Reciprocal deposit arrangements like CDARS® were treated as brokered deposits for Risk Category II, III and IV institutions but not for institutions in Risk Category I. An institution’s base assessment rate would also be increased if an institution’s ratio of secured liabilities (including FHLB advances and repurchase agreements) to deposits exceeds 25%. The maximum adjustment for secured liabilities for institutions in Risk Categories I, II, III and IV would be 8, 11, 16 and 22.5 basis points, respectively, provided that the adjustment may not increase an institution’s base assessment rate by more than 50%. The FDIC imposed a special assessment equal to five basis points of assets less Tier 1 capital as of June 30, 2009, payable on September 30, 2009, and reserved the right to impose additional special assessments. In November, 2009, instead of imposing additional special assessments, the FDIC amended the assessment regulations to require all insured depository institutions to prepay their estimated risk-based assessments for the fourth quarter of 2009, and for all of 2010, 2011 and 2012 on December 30, 2009. For purposes of estimating the future assessments, each institution’s base assessment rate in effect on September 30, 2009 was used, assuming a 5% annual growth rate in the assessment base and a 3 basis point increase in the assessment rate in 2011 and 2012. The prepaid assessment will be applied against actual quarterly assessments until exhausted. Any funds remaining after June 30, 2013 will be returned to the institution. Requiring this prepaid assessment does not preclude the FDIC from changing assessment rates or from further revising the risk-based assessment system. The Dodd-Frank Act requires the FDIC to increase the reserve ratio of the Deposit Insurance Fund from 1.15% to 1.35% of insured deposits by September 30, 2020 and eliminates the requirement that the FDIC pay dividends to insured depository institutions when the reserve ratio exceeds certain thresholds. The Dodd-Frank Act also broadens the base for FDIC insurance assessments. Assessments will now be based on the average consolidated total assets less tangible equity capital of a financial institution. In setting the assessments necessary to meet the minimum reserve ratio, the FDIC must offset the effect on depository institutions with total consolidated assets of less than $10.0 billion. The FDIC has adopted a new restoration plan reflecting the new statutory requirements. Under the revised restoration plan, the DIF reserve ratio will reach 1.35% by September 30, 2020. Because of lower projected losses, the FDIC has determined that the reserve ratio will reach 1.15% by the fourth quarter of 2018 without a 3 basis point increase in assessment rates and the FDIC has determined to forgo such increase. The FDIC has indicated that it will pursue further rulemaking in 2011 regarding the method that will be used to reach 1.35% by September 30, 2020 and offset the effect on insured depository institutions with total consolidated assets of less than $10.0 billion as required by the Dodd-Frank Act. Critical Accounting Policies Our accounting policies are integral to understanding the results reported and our significant policies are described in Note 2 to our consolidated financial statements included in the William Penn Bancorp, Inc. 2010 Annual Report on Form 10-K. In preparing the consolidated financial statements, management is required to make estimates and assumptions that affect the reported amounts of assets and liabilities as of the dates of the consolidated balance sheets and statements of income for the periods then ended. Actual results could differ significantly from those estimates. Material estimates that are particularly susceptible to significant change relate to the determination of the allowance for loan losses, the valuation allowance for deferred tax assets and other-than-temporary impairment of securities. Allowance for Loan Losses. The allowance for loan losses is maintained by management at a level which represents their evaluation of known and inherent losses in the loan portfolio at the consolidated balance sheet date that are both probable and reasonable to estimate. Management’s periodic evaluation of the adequacy of the allowance is based on the Bank’s past loan loss experience, known and inherent losses in the portfolio, adverse situations that may affect the borrower’s ability to repay, the estimated value of any underlying collateral, composition of the loan portfolio, current economic conditions, and other relevant factors. This evaluation is inherently subjective as it requires material estimates that may be susceptible to significant change, including the amounts and timing of future cash flows expected to be received on impaired loans. The allowance consists of specific and general components. The specific component relates to loans that are classified as doubtful, substandard, or special mention. For such loans that are also classified as impaired, an allowance is established when the discounted cash flows (or collateral value or observable market price) of the impaired loan is lower than the carrying value of that loan. The general component covers nonclassified loans and is based on historical loss experience adjusted for qualitative factors. Although specific and general loan loss allowances are established in accordance with management’s best estimate, actual losses are dependent upon future events and, as such, further provisions for loan losses may be necessary. For example, our evaluation of the allowance includes consideration of current economic conditions, and a change in economic conditions could reduce the ability of our borrowers to make timely repayments of their loans. This could result in increased delinquencies and increased non-performing loans, and thus a need to make increased provisions to the allowance for loan losses, which would require us to record a charge against income during the period the provision is made, resulting in a reduction of our earnings. A change in economic conditions could also adversely affect the value of the properties collateralizing our real estate loans, resulting in increased charge-offs against the allowance and reduced recoveries of loans previously charged-off, and thus a need to make increased provisions to the allowance for loan losses. Furthermore, a change in the composition of our loan portfolio or growth of our loan portfolio could result in the need for additional provisions. Deferred Income Taxes. We use the asset and liability method of accounting for income taxes. Under this method, deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. If current available information raises doubt as to the realization of the deferred tax assets, a valuation allowance is established. We consider the determination of this valuation allowance to be a critical accounting policy because of the need to exercise significant judgment in evaluating the amount and timing of recognition of deferred tax liabilities and assets, including projections of future taxable income. These judgments and estimates are reviewed on a continual basis as regulatory and business factors change. A valuation allowance for deferred tax assets may be required if the amount of taxes recoverable through loss carryback declines, or if we project lower levels of future taxable income. Such a valuation allowance would be established through a charge to income tax expense which would adversely affect our operating results. Other-than-Temporary Investment Security Impairment. Securities are evaluated periodically to determine whether a decline in their value is other-than-temporary. Management utilizes criteria such as the magnitude and duration of the decline, in addition to the reasons underlying the decline, to determine whether the loss in value is other-than-temporary. The term “other-than-temporary” is not intended to indicate that the decline is permanent, but indicates that the prospect for a near-term recovery of value is not necessarily favorable, or that there is a lack of evidence to support a realizable value equal to or greater than the carrying value of the investment. Once a decline in value is determined to be other-than-temporary, the value of the security is reduced and a corresponding charge to earnings is recognized. Comparison of Financial Condition at December 31, 2010 and June 30, 2010 Our total assets decreased by $6.7 million to $319.7 million at December 31, 2010 from $326.4 million at June 30, 2010, primarily due to a $16.9 million decrease in securities held-to-maturity. The decrease in held-to-maturity securities was mainly due to maturities, calls and paydown of US Government and agencies. This decrease was partially offset by a $9.6 million increase in net loans receivable to $240.0 million at December 31, 2010 from $230.4 million at June 30, 2010. The growth in the loan portfolio was mainly due to an increase in home equity lines of credit by $6.0 million to $24.7 million at December 31, 2010 as compared to $18.7 million at June 30, 2010. There was also an increase of $2.9 million in one-to-four family residential loans to $148.1 million at December 31, 2010 from $145.2 million at June 30, 2010. Multi-family residential loans also grew by $2.0 million to $12.1 million at December 31, 2010 from $10.1 million at June 30, 2010. Non-residential loans decreased by $1.6 million to $42.6 million at December 31, 2010 from $44.2 million at June 30, 2010. Available for sale securities at December 31, 2010 decreased to $16.1 million compared to $16.4 million at June 30, 2010 which offset the increase in interest-bearing time deposits to $1.1 million at December 31, 2010 from $800,000 at June 30, 2010. Premises and equipment increased to $3.0 million at December 31, 2010 from $2.2 million at June 30, 2010, due to construction-in-progress on our new Levittown branch. This increase was partially offset a slight decrease in cash and cash equivalents and Federal Home Loan Bank stock. Real Estate Owned increased to $449,000 at December 31, 2010 from $233,000 at June 30, 2010. Deposits decreased by $4.4 million to $176.9 million at December 31, 2010 from $181.3 million at June 30, 2010. Advances from the FHLB decreased by $3.5 million to $85.5 million at December 31, 2010, from $89.0 million at June 30, 2010. One borrowing with a high interest rate of 6.54% matured, resulting in a decrease in the average cost of borrowings. Also advances from borrowers for taxes and insurance decreased to $1.4 million at December 31, 2010 from $2.1 million at June 30, 2010. This was attributable to the real estate taxes paid on behalf of our borrowers. Stockholders’ equity grew by $1.8 million to $53.0 million at December 31, 2010, from $51.2 million at June 30, 2010. The increase was primarily the result of the Company’s net income of $1.6 million for the six months ended December 31, 2010 and a $92,000 increase in accumulated other comprehensive income relating to unrealized gains on the available-for-sale securities portfolio. Comparison of Operating Results for the Three and Six Months Ended December 31, 2010 and 2009 General. Net income for the three months ended December 31, 2010 was $782,000 ($0.22 per share) compared to a net income of $838,000 ($0.23 per share) for the same period ending December 31, 2009. Net income for the six months ended December 31, 2010 was $1.6 million ($0.45 per share) compared to a net income of $1.7 million ($0.47 per share) for the same period ending December 31, 2009. The decrease in net income for both periods reflects increase in the provision for loan losses and other expenses. Interest Income. Total interest income declined $344,000 for the three months ended December 31, 2010 to $3.8 million compared to $4.1 million for the same period ending December 31, 2009. The decrease was primarily due to a decrease in interest income from securities. Interest income from securities declined by $244,000 from $591,000 for the three months ended December 31, 2009 to $347,000 for the three month period ended December 31, 2010. The average balance of securities went down by $7.7 million, to $51.8 million for the three months ended December 31, 2010 from $59.5 million for the three months ended December 31, 2009. The average yield declined 129 basis points, decreasing the interest income on securities. Interest income from loans receivable for the three months ended December 31, 2010 and 2009 was $3.4 million and $3.5 million respectively, a very nominal decrease of $91,000. Average loan balances increased from $230.5 million for the three months ended December 31, 2009 to $241.1 million for the three months ended December 31, 2010. Even though the average balance of loans receivable increased by $10.6 million, the average yield declined by 42 basis points, resulting in the interest income on loans receivable to be approximately the same for the two periods. The average balance of other interest earning assets increased to $22.7 million for the three months ended December 31, 2010 compared to $17.4 million for the three months ended December 31, 2009. The average yield on interest earning assets, however declined 27 basis points resulting in a decrease in interest income from other interest earning assets. Total interest income declined $500,000 for the six months ended December 31, 2010 to $7.6 million compared to $8.1 million for the same period ending December 31, 2009. The decrease was primarily due to a decrease in interest income from securities. Interest income from securities declined by $481,000 from $1.2 million for the six months ended December 31, 2009 to $756,000 for the six month period ended December 31, 2010. The average balance of securities went down by $3.6 million, to $56.4 million for the six months ended December 31, 2010 from $60.0 million for the same period ended December 31, 2009. The average yield declined 144 basis points, decreasing the interest income on securities. Interest income from loans receivable for the six months ended December 31, 2010 and 2009 remained virtually the same. Even though the average balance of loans receivable increased by $11.2 million, the average yield declined by 29 basis points, resulting in approximately the same interest income for the two periods. The average balance of other interest earning assets increased to $22.8 million for the six months ended December 31, 2010 compared to $18.8 million for the same period ended December 31, 2009. The average yield on interest earning assets declined 23 basis points resulting in a decrease in interest income from other interest earning assets despite the increase in average balance. Interest Expense. Total interest expense decreased $343,000 to $1.4 million for the three months ended December 31, 2010 as compared to $1.8 million for the same period in 2009. The decrease resulted from a decrease in interest expense on deposits to $624,000 for the three months ended December 31, 2010 from $807,000 for the same period in 2009. The average balance of interest bearing deposits went up to $176.2 million for the three months ended December 31, 2010 as compared to $168.3 million for the same period ended December 31, 2009, however due to the low interest rate environment; there was a 50 basis point decrease in the average cost of the deposits resulting in a decline in interest expense. Even though the average balance of certificate of deposits went up by $3.1 million to $104.0 million at December 31, 2010 from $101.0 at December 31, 2009, the average cost declined 53 basis points. Interest expense on borrowings decreased by $160,000 to $803,000 for the three months ended December 31, 2010 from $963,000 for the same period ending December 31, 2009 due to a 52 basis point decrease in the average cost and also a decrease in the average balance of Federal Home Loan Bank advances (“FHLB”) to $85.5 million for the three months ended December 31, 2010 from $89.9 million for the same period ended December 31, 2009. Total interest expense decreased $682,000 to $2.9 million for the six months ended December 31, 2010 as compared to $3.6 million for the same period in 2009. The decrease resulted from a decrease in interest expense on deposits to $1.3 million for the six months ended December 31, 2010 from $1.7 million for the same period in 2009. The average balance of interest bearing deposits went up to $177.2 million for the six months ended December 31, 2010 as compared to $166.8 million for the same period ended December 31, 2009. However due to the low interest rate environment; there was a 52 basis point decrease in the average cost of the deposits resulting in a decline in interest expense. The decline in interest expense of deposits was mainly due to certificate of deposits and money market category. Certificate of deposits increased to $104.2 million at December 31, 2010 from $99.0 million at December 31, 2009, though the average balance increased, the average cost declined 63 basis points. Money Market deposits grew up by $2.1 million to $42.6 million at December 31, 2010 from $40.4 million at December 31, 2009, however the average cost declined 36 basis points. Interest expense on borrowings decreased by $325,000 to $1.6 million for the six months ended December 31, 2010 from $1.9 million for the same period ending December 31, 2009 due to a 60 basis point decrease in the average cost and also a decrease in the average balance of Federal Home Loan Bank advances (“FHLB”) to $86.2 million for the six months ended December 31, 2010 from $89.3 million for the same period ended December 31, 2009. One borrowing with a high interest rate of 6.54% matured, resulting in the decreased average cost of borrowings. Net Interest Income. Our interest rate spread and net interest margin for the three months ended December 31, 2010, were 2.61% and 2.98%, respectively, compared to 2.62% and 3.06%, respectively, for the three months ended December 31, 2009. Though the average balance of the interest earning assets increased to $315.6 million for the three months ended December 31, 2010 from $307.4 million for the same period ended December 31, 2009 the average yield declined 57 basis points. Average interest-bearing liabilities were $261.7 million and $258.2 million for the three months ended December 31, 2010 and 2009, respectively. Average cost of interest bearing liabilities declined 56 basis points, resulting in virtually the same interest rate spread for both periods. There was also an 8 basis point decrease in our net interest margin for the three months ended December 31, 2010, resulting in the same net interest income for both periods. Our interest rate spread and net interest margin for the six months ended December 31, 2010, were 2.61% and 2.99%, respectively, compared to 2.53% and 2.98%, respectively, for the six months ended December 31, 2009. Though the average balance of the interest earning assets increased to $317.2 million for the six months ended December 31, 2010 from $305.5 million for the same period in December 31, 2009 the average yield declined 51 basis points. Average interest-bearing liabilities were $263.4 million and $256.2 million for the six months ended December 31, 2010 and 2009, respectively. Average cost of interest bearing liabilities decreased 59 basis points, resulting in an increase in interest rate spread. Net interest margin for the six months ended December 31, 2010 remained virtually the same as compared to the same period in 2009. Provision for Loan Losses. We charge to operations provisions for loan losses at a level required to reflect credit losses in the loan portfolio that are both probable and reasonable to estimate. Management, in determining the allowance for loan losses, considers the losses inherent in the loan portfolio and changes in the nature and volume of our loan activities, along with general economic and real estate market conditions. We utilize a two-tier approach: (1) identification of impaired loans and establishment of specific loss allowances on such loans; and (2) establishment of general valuation allowances on the remainder of our loan portfolio. We establish a specific loan loss allowance for an impaired loan based on delinquency status, size of loan, type of collateral and/or appraisal of the underlying collateral and financial condition of the borrower. We base general loan loss allowances upon a combination of factors including, but not limited to, actual loan loss experience, composition of the loan portfolio, current economic conditions, industry trends and management’s judgment. There were provisions for loan losses of $164,000 and $92,000 made during the three months ended December 31, 2010 and 2009, respectively. There were provisions for loan losses of $309,000 and $186,000 made during the six months ended December 31, 2010 and 2009, respectively. The allowance as a percentage of total loans was 1.17% at December 31, 2010 as compared to 1.14% at June 30, 2010. Management believes that the allowance for loan and lease losses is sufficient given the status of the loan portfolio at this time. Other Income. Other income increased by $99,000 to $197,000 for the three months ended December 31, 2010 compared to $98,000 for the same period in 2009. This was primarily due to an $89,000 profit on the sale of a private label CMO investment during the three months ended December 31, 2010. Gain on sale of loans increased to $25,000 for the three months ended December 31, 2010 from $11,000 for the same period ending December 31, 2009. There was a very nominal increase in service fees of $11,000 which was offset by a decrease in other miscellaneous income. Other income increased to $290,000 for the six months ended December 31, 2010 from $238,000 for the same period ending December 31, 2009. Gain on sale of loans increased to $52,000 for the six months ended December 31, 2010 from $18,000 for the same period ending December 31, 2009. Traditionally, other income has not been a significant part of our operations as we have not in the past focused on fee generation. We hold the bulk of our securities portfolio as held to maturity so gains or losses on the sales of securities are not expected to be a large item in non interest income. We have no current plans to seek additional fee income generation through the offering of complementary services or acquisition of fee-producing subsidiaries such as title insurance or third-party securities sales. Other Expenses. There was an increase of $110,000 in other expenses for the three months ended December 31, 2010 as compared to the same period ending December 31, 2009. There was an $119,000 increase in salaries and employee benefits as a result of normal salary increases, combined with the increased cost of maintaining benefits. Occupancy and equipment expense increased by $44,000 to $205,000 for three months ended December 31, 2010 from $161,000 for the three months ended December 31, 2009, due to some minor renovations to all our branches which were expensed. These increases were partially offset by a $70,000 decrease in other miscellaneous expenses. There was an increase of $244,000 in other expenses for the six months ended December 31, 2010 as compared to the same period in 2009. Salaries and employee benefits increased $202,000 for the six month period ending December 31, 2010. There was an increase in occupancy and equipment expense of $53,000 for the six months ended December 31, 2010. These increases were partially offset by a $24,000 decrease in other miscellaneous expenses. Provision for Income Taxes. Income tax expense was $384,000 and $412,000 for the three months ending December 31, 2010 and 2009. The Company’s effective tax rates for the three months ended December 31, 2010 and 2009 were 32.9% and 33.0%, respectively. Income tax expense was $790,000 and $842,000 for the six months ended December 31, 2010 and 2009, respectively. The Company’s effective tax rates for the six months ended December 31, 2010 and 2009 were 32.9% and 33.2%, respectively. Average Balance Sheets. The following table sets forth certain information for the three and six months ended December 31, 2010 and 2009. The average yields and costs are derived by dividing income or expense by the average balance of assets or liabilities, respectively, for the periods presented. Average balances are derived from daily average balances. Repossessed assets were $449,000 and $233,000 as of December 31, 2010 and June 30, 2010, respectively. The allowance includes a provision of $300,000 on a land loan secured by a tract of land in Wildwood, New Jersey due to the ongoing concerns about the financial condition of the borrower on this loan. Monthly payments were current as of December 31, 2010; however payments are being received not from the borrower but from the borrower’s business partner, who could cease payment at any time as he is not a party to the loan agreement and has no legal obligation to make payments on this loan. The most recent appraisal the Bank has on this property was prepared in 2004, and although that “as is” appraisal for this undeveloped site was greater than the outstanding balance of the loan, the Bank has designated the loan as special mention in light of the uncertainty related to the development of the property. The issues that could impede the development include zoning, wetlands preservation, site improvements and environmental cleanup. The bank has also established a specific reserve of $620,000 against the balances of six impaired loans to a troubled borrower. The loans have balances totaling $1,249,000, and they are secured by first liens against ten residential properties, eight properties are located in Trenton NJ, and two are located in Freehold, NJ. The borrowing entities have filed bankruptcy and we are concerned that resolution of the situation will be prolonged. We did not have any troubled debt restructuring (wherein the borrower is granted a concession that we would not otherwise consider under current market conditions) as of the dates shown in the above table. Liquidity, Commitments and Capital Resources The Company must be capable of meeting its customer obligations at all times. Potential liquidity demands include funding loan commitments, cash withdrawals from deposit accounts and other funding needs as they present themselves. Accordingly, liquidity is measured by our ability to have sufficient cash reserves on hand, at a reasonable cost and/or with minimum losses. The Asset and Liability Management Committee and the Board of Directors set limits and controls to guide senior management’s monitoring of our overall liquidity position and risk. The Board of Directors and its Committee, along with senior management, are responsible for ensuring that our liquidity needs are being met on both a daily and long term basis. Our approach to managing day-to-day liquidity is measured through our daily calculation of investable funds and/or borrowing needs to ensure adequate liquidity. In addition, we constantly evaluate our short-term and long-term liquidity risk and strategy based on current market conditions, outside investment and/or borrowing opportunities, short and long-term economic trends, and anticipated short and long-term liquidity requirements. The Company’s loan and deposit rates may be adjusted as another means of managing short and long-term liquidity needs. We do not at present participate in derivatives or other types of hedging instruments to meet liquidity demands. At December 31, 2010, the total approved loan origination commitments outstanding amounted to $7.5 million. At that date, construction loans in process were $4.3 million. Certificates of deposit scheduled to mature in one year or less at December 31, 2010, totaled $52.3 million. Based on the competitive rates and on historical experience, management believes that a significant portion of maturing deposits will remain with the Company. At December 31, 2010, we had an unused borrowing capacity of $58.5 million from the Federal Home Loan Bank of Pittsburgh which we may use as a funding source to meet commitments and for liquidity purposes. Regulatory Capital Compliance Consistent with its goals to operate a sound and profitable financial organization, the Bank actively seeks to maintain its status as a well-capitalized institution in accordance with regulatory standards. As of December 31, 2010, the Bank exceeded all applicable regulatory capital requirements and was well capitalized. As of December 31, 2010, our regulatory capital amounts and ratios were as follows: Off-Balance Sheet Arrangements We are a party to financial instruments with off-balance-sheet risk in the normal course of our business of investing in loans and securities as well as in the normal course of maintaining and improving the Company’s facilities. These financial instruments include significant purchase commitments, such as commitments related to capital expenditure plans and commitments to purchase investment securities or mortgage-backed securities, and commitments to extend credit to meet the financing needs of our customers. At December 31, 2010, we had no significant off-balance sheet commitments other than commitments to extend credit totaling $7.5 million and unfunded commitments under lines of credit totaling $14.1 million. Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Our exposure to credit loss in the event of nonperformance by the other party to the financial instrument for commitments to extend credit is represented by the contractual amount of those instruments. We use the same credit policies in making commitments and conditional obligations as we do for on-balance-sheet instruments. Since a number of commitments typically expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. Impact of Inflation and Changing Prices The financial statements included in this document have been prepared in accordance with accounting principles generally accepted in the United States of America. These principles require the measurement of financial position and operating results in terms of historical dollars, without considering changes in the relative purchasing power of money over time due to inflation. Our primary assets and liabilities are monetary in nature. As a result, interest rates have a more significant impact on our performance than the effects of general levels of inflation. Interest rates, however, do not necessarily move in the same direction or with the same magnitude as the price of goods and services, since such prices are affected by inflation. In a period of rapidly rising interest rates, the liquidity and maturities of our assets and liabilities are critical to the maintenance of acceptable performance levels. The principal effect of inflation on earnings, as distinct from levels of interest rates, is in the area of non interest expense. Expense items such as employee compensation, employee benefits and occupancy and equipment costs may be subject to increases as a result of inflation. An additional effect of inflation is the possible increase in the dollar value of the collateral securing loans that we have made. We are unable to determine the extent, if any, to which properties securing our loans have appreciated in dollar value due to inflation or depreciated due to economic recession.