10-Q 1 d70133_10-q.txt QUARTERLY REPORT ================================================================================ UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM 10-Q --------------------------- (Mark One) |X| QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the quarterly period ended October 31, 2006 or |_| TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For transition period from ________________ to _________________ 0-16438 (Commission File Number) NATIONAL TECHNICAL SYSTEMS, INC. (Exact name of registrant as specified in its charter) California 95-4134955 (State of incorporation) (I.R.S. Employer Identification No.) 24007 Ventura Boulevard, Suite 200, Calabasas, California (Address of principal executive offices) (818) 591-0776 91302 (Registrant's telephone number, including area code) (Zip code) Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. YES |X| NO |_| Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of "accelerated filer and large accelerated filer" in Rule 12b-2 of the Exchange Act. (Check one): Large accelerated filer |_| Accelerated filer |_| Non-accelerated filer |X| Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). YES |_| NO |X| The number of shares of common stock, no par value, outstanding as of December 11, 2006 was 8,746,689 NATIONAL TECHNICAL SYSTEMS, INC. AND SUBSIDIARIES Index PART I. FINANCIAL INFORMATION Page No. Item 1. Financial Statements: Condensed Consolidated Balance Sheets at October 31, 2006 (unaudited) and January 31, 2006 3 Unaudited Condensed Consolidated Statements of Income For the Nine Months Ended October 31, 2006 and 2005 4 Unaudited Condensed Consolidated Statements of Income For the Three Months Ended October 31, 2006 and 2005 5 Unaudited Condensed Consolidated Statements of Cash Flows For the Nine Months Ended October 31, 2006 and 2005 6 Notes to the Unaudited Condensed Consolidated Financial Statements 7 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations 14 Item 3. Quantitative and Qualitative Disclosures About Market Risk 24 Item 4. Controls and Procedures 24 PART II. OTHER INFORMATION & SIGNATURE Item 1. Legal Proceedings 25 Item 1A. Risk Factors 25 Item 2. Unregistered Sales of Equity Securities and Use of Proceeds 25 Item 3. Defaults Upon Senior Securities 25 Item 4 Submission of Matters to a Vote of Security Holders 25 Item 5. Other Information 25 Item 6. Exhibits 25 Signature 26 2 PART I - FINANCIAL ITEM 1. FINANCIAL STATEMENTS NATIONAL TECHNICAL SYSTEMS, INC. AND SUBSIDIARIES Condensed Consolidated Balance Sheets

At At October 31, January 31, 2006 2006 ASSETS (unaudited) ------------------------------- CURRENT ASSETS: Cash $ 1,885,000 $ 4,196,000 Accounts receivable, less allowance for doubtful accounts of $838,000 at October 31, 2006 and $816,000 at January 31, 2006 23,174,000 20,425,000 Income taxes receivable -- 10,000 Inventories 2,798,000 2,184,000 Deferred income taxes 1,812,000 1,747,000 Prepaid expenses 1,048,000 769,000 ------------------------------- Total current assets 30,717,000 29,331,000 Property, plant and equipment, at cost 100,532,000 93,887,000 Less: accumulated depreciation (65,052,000) (60,787,000) ------------------------------- Net property, plant and equipment 35,480,000 33,100,000 Goodwill 4,125,000 2,740,000 Other assets 4,310,000 3,962,000 ------------------------------- TOTAL ASSETS $ 74,632,000 $ 69,133,000 =============================== LIABILITIES AND SHAREHOLDERS' EQUITY CURRENT LIABILITIES: Accounts payable $ 5,111,000 $ 4,715,000 Accrued expenses 4,014,000 5,400,000 Income taxes payable 285,000 594,000 Deferred income 1,113,000 817,000 Current installments of long-term debt 2,678,000 1,529,000 ------------------------------- Total current liabilities 13,201,000 13,055,000 Long-term debt, excluding current installments 22,007,000 15,579,000 Deferred income taxes 4,858,000 5,084,000 Deferred compensation 933,000 874,000 Minority interest 238,000 163,000 Commitments and contingencies SHAREHOLDERS' EQUITY: Preferred stock, no par value, 2,000,000 shares authorized; none issued -- -- Common stock, no par value. Authorized, 20,000,000 shares; issued and outstanding, 8,701,000 as of October 31, 2006 and 9,176,000 as of January 31, 2006 12,694,000 14,624,000 Retained earnings 20,752,000 19,744,000 Accumulated other comprehensive income (loss) (51,000) 10,000 ------------------------------- Total shareholders' equity 33,395,000 34,378,000 ------------------------------- TOTAL LIABILITIES AND SHAREHOLDERS' EQUITY $ 74,632,000 $ 69,133,000 ===============================

See accompanying notes to condensed consolidated financial statements. 3 NATIONAL TECHNICAL SYSTEMS, INC. AND SUBSIDIARIES Unaudited Condensed Consolidated Statements of Income for Nine Months Ended October 31, 2006 and 2005

2006 2005 --------------------------------- Net revenues $ 86,398,000 $ 82,707,000 Cost of sales 66,726,000 63,046,000 --------------------------------- Gross profit 19,672,000 19,661,000 Selling, general and administrative expense 16,791,000 16,022,000 Equity income from non-consolidated subsidiary (192,000) (180,000) --------------------------------- Operating income 3,073,000 3,819,000 Other income (expense): Interest expense, net (1,312,000) (985,000) Other 171,000 163,000 --------------------------------- Total other expense (1,141,000) (822,000) Income before income taxes and minority interest 1,932,000 2,997,000 Income taxes 849,000 1,117,000 --------------------------------- Income before minority interest 1,083,000 1,880,000 Minority interest (75,000) (88,000) --------------------------------- Net income $ 1,008,000 $ 1,792,000 ================================= Earnings per common share: Basic $ 0.12 $ 0.20 ================================= Diluted $ 0.11 $ 0.19 ================================= Weighted average common shares outstanding 8,704,000 9,108,000 Dilutive effect of stock options 822,000 542,000 Weighted average common shares outstanding, assuming dilution --------------------------------- 9,526,000 9,650,000 =================================

See accompanying notes to condensed consolidated financial statements. 4 NATIONAL TECHNICAL SYSTEMS, INC. AND SUBSIDIARIES Unaudited Condensed Consolidated Statements of Income for Three Months Ended October 31, 2006 and 2005

2006 2005 --------------------------------- Net revenues $ 29,809,000 $ 28,508,000 Cost of sales 22,954,000 21,684,000 --------------------------------- Gross profit 6,855,000 6,824,000 Selling, general and administrative expense 5,634,000 5,687,000 Equity income from non-consolidated subsidiary (57,000) (68,000) --------------------------------- Operating income 1,278,000 1,205,000 Other income (expense): Interest expense, net (500,000) (338,000) Other income 42,000 147,000 --------------------------------- Total other expense (458,000) (191,000) Income before income taxes and minority interest 820,000 1,014,000 Income taxes 375,000 382,000 --------------------------------- Income before minority interest 445,000 632,000 Minority interest (36,000) (42,000) --------------------------------- Net income $ 409,000 $ 590,000 ================================= Earnings per common share Basic $ 0.05 $ 0.06 ================================= Diluted $ 0.04 $ 0.06 ================================= Weighted average common shares outstanding 8,676,000 9,166,000 Dilutive effect of stock options 819,000 589,000 Weighted average common shares outstanding, assuming dilution --------------------------------- 9,495,000 9,755,000 =================================

See accompanying notes to condensed consolidated financial statements. 5 NATIONAL TECHNICAL SYSTEMS, INC. AND SUBSIDIARIES Unaudited Condensed Consolidated Statements of Cash Flows for the Nine Months Ended October 31, 2006 and 2005

2006 2005 -------------------------------- CASH FLOWS FROM OPERATING ACTIVITIES: Net income $ 1,008,000 $ 1,792,000 Adjustments to reconcile net income to net cash provided by operating activities: Depreciation and amortization 4,298,000 4,028,000 Recoveries on receivables 22,000 139,000 Gain on sale of assets -- (163,000) Undistributed earnings of affiliate 75,000 88,000 Deferred income taxes (net of acquisitions) (291,000) (441,000) Tax benefit from stock options exercised 276,000 -- Share based compensation 447,000 -- Changes in operating assets and liabilities (net of acquisitions): Accounts receivable (2,523,000) (2,749,000) Inventories (579,000) (648,000) Prepaid expenses (247,000) (224,000) Other assets and intangibles 29,000 (269,000) Accounts payable 164,000 407,000 Accrued expenses (1,428,000) 341,000 Income taxes payable (309,000) 274,000 Deferred income 243,000 508,000 Deferred compensation 59,000 63,000 Income taxes receivable 10,000 521,000 -------------------------------- Cash provided by operating activities 1,254,000 3,667,000 -------------------------------- CASH FLOWS FROM INVESTING ACTIVITIES: Purchase of property, plant and equipment (4,545,000) (4,277,000) Sale of property, plant and equipment -- 543,000 Investment in life insurance (143,000) -- Acquisitions of businesses, net of cash (3,054,000) (483,000) -------------------------------- Cash used for investing activities (7,742,000) (4,217,000) CASH FLOWS FROM FINANCING ACTIVITIES: Proceeds from current and long-term debt 14,436,000 1,076,000 Repayments of current and long-term debt (6,897,000) (4,063,000) Proceeds from stock options exercised 592,000 221,000 Common stock repurchase (3,893,000) -- -------------------------------- Net cash provided by (used for) financing activities 4,238,000 (2,766,000) -------------------------------- Effect of exchange rate changes on cash (61,000) 32,000 -------------------------------- Net decrease in cash (2,311,000) (3,284,000) Beginning cash balance 4,196,000 6,201,000 -------------------------------- ENDING CASH BALANCE $ 1,885,000 $ 2,917,000 ================================

See accompanying notes to condensed consolidated financial statements. 6 NATIONAL TECHNICAL SYSTEMS, INC. AND SUBSIDIARIES Notes to the Unaudited Condensed Consolidated Financial Statements 1. Basis of Presentation In accordance with instructions to Form 10-Q, the accompanying consolidated financial statements and footnotes of National Technical Systems, Inc. ("NTS" or the "Company") have been condensed and, therefore, do not contain all disclosures required by U.S. generally accepted accounting principles. These statements should not be construed as representing pro rata results of the Company's fiscal year ending January 31, 2007 and should be read in conjunction with the financial statements and notes thereto included in the Company's Form 10-K for the year ended January 31, 2006. The statements presented as of and for the three and nine months ended October 31, 2006 and 2005 are unaudited. In management's opinion, all adjustments have been made to present fairly the results of such unaudited interim periods. All such adjustments are of a normal recurring nature. The consolidated financial statements include the accounts of the Company and its wholly owned and financially controlled subsidiaries. All significant intercompany balances and transactions have been eliminated in consolidation. 2. Income Taxes Income taxes for the interim periods are computed using the effective tax rates estimated to be applicable for the full fiscal year, as adjusted for any discrete taxable events that occur during the period. The Company recorded income tax expense of $375,000 and $849,000 for the three and nine months ended October 31, 2006, respectively, and $382,000 and $1,117,000 for the three and nine months ended October 31, 2005, respectively. 3. Comprehensive Income (Loss) Accumulated other comprehensive income (loss) on the Company's Condensed Consolidated Balance Sheets consists of cumulative equity adjustments from foreign currency translation. During the nine months ended October 31, 2006 the foreign currency translation adjustment resulted in a loss of $61,000 and total comprehensive income was $947,000. During the nine months ended October 31, 2005, the foreign currency translation adjustment was a gain of $32,000 and total comprehensive income was $1,824,000. 4. Inventories Inventories consist of accumulated costs applicable to uncompleted contracts and are stated at actual cost which is not in excess of estimated net realizable value. 5. Interest and Taxes Cash paid for interest and taxes for the nine months ended October 31, 2006 was $1,342,000 and $1,149,000, respectively. Cash paid for interest and taxes for the nine months ended October 31, 2005 was $1,000,000 and $757,000, respectively. 6. Minority Interest Minority interest in the Company's NQA, Inc. subsidiary is a result of 50% of the stock of NQA, Inc. being issued to National Quality Assurance, Ltd. Effective with fiscal 2002, profits and losses are allocated 50.1% to NTS, and 49.9% to National Quality Assurance, Ltd. 7. Earnings per share Basic and diluted net income per common share is presented in conformity with Statement of Financial Accounting Standards ("SFAS") No. 128, "Earnings Per Share" for all periods presented. In accordance with SFAS No. 128, basic earnings per share have been computed using the weighted average number of shares of common stock outstanding during the year. Basic earnings per share excludes any dilutive effects of options, warrants and convertible securities. 7 8. Intangible Assets The Company accounts for goodwill and other intangible assets in accordance with SFAS No. 142, "Goodwill and Other Intangible Assets." There have been no indications of any impairment through October 31, 2006. As of October 31, 2006 and January 31, 2006, the Company had the following acquired intangible assets:

October 31, 2006 January 31, 2006 ---------------------------------------------- ----------------------------------------------- Gross Net Estimated Gross Net Estimated Carrying Accum. Carrying Useful Carrying Accum. Carrying Useful Amount Amort. Amount Life Amount Amort. Amount Life Intangible assets subject to amortization: Covenants not to compete $ 299,000 $125,000 $ 174,000 3-5 years $ 148,000 $110,000 $ 38,000 3-5 years Customer relationships 105,000 6,000 99,000 18 months -- -- -- ---------------------------------- ---------------------------------- Total $ 404,000 $131,000 $ 273,000 $ 148,000 $110,000 $ 38,000 ====================== ========== ================================== Intangible assets not subject to amortization: Goodwill $4,922,000 $797,000 $4,125,000 $3,537,000 $797,000 $2,740,000 ====================== ========== ==================================

Amortization expense for intangible assets subject to amortization was $21,000 and $30,000 for the nine months ended October 31, 2006 and 2005, respectively. Goodwill increased by $1,385,000 due to the acquisitions of American International Registrars Corporation, B & B Technologies, Inc. and Dynamic Labs. (see note 11). 9. Employee Equity Incentive Plans Effective February 1, 2006, the Company adopted the provisions of SFAS No. 123(R). SFAS No. 123(R) requires employee stock options and rights to purchase shares under stock participation plans to be accounted for under the fair value method and requires the use of an option pricing model for estimating fair value. Accordingly, share-based compensation is measured at grant date, based on the fair value of the award. The Company previously accounted for awards granted under its equity incentive plans under the intrinsic value method prescribed by Accounting Principles Board (APB) Opinion No. 25, "Accounting for Stock Issued to Employees," and related interpretations, and provided the required pro forma disclosures prescribed by SFAS No. 123, "Accounting for Stock-Based Compensation," as amended. The exercise price of options is equal to the market price of National Technical Systems, Inc. common stock (defined as the closing price reported by the NASDAQ stock market) on the date of grant. Accordingly, no share-based compensation, other than acquisition-related compensation, was recognized in the financial statements prior to January 31, 2006. The Company used the modified prospective method of adoption for SFAS No. 123(R), under which the compensation cost recognized by the Company beginning in fiscal 2007 includes (a) compensation cost for all equity incentive awards granted prior to, but not yet vested as of February 1, 2006, based on the grant date fair value estimated in accordance with the original provisions of SFAS No. 123, and (b) compensation cost for all equity incentive awards granted subsequent to February 1, 2006, based on the grant-date fair value estimated in accordance with the provisions of SFAS No. 123(R). The Company uses the straight-line attribution method to recognize share-based compensation costs over the service period of the award. Upon exercise, cancellation, or expiration of non qualified stock options, deferred tax assets for options with multiple vesting dates are eliminated for each vesting period on a first-in, first-out basis as if each vesting period was a separate award. To calculate the excess tax benefits available for use in offsetting future tax shortfalls as of the date of implementation, the Company followed the alternative transition method discussed in FASB Staff Position No. 123(R)-3. No options have been granted by the Company during the current fiscal year. Options to be granted to existing and newly hired employees or directors will generally vest over a four-year period from the date of grant. The 8 Company may also assume the equity incentive plans and the outstanding equity awards of certain acquired companies. Once assumed, the Company does not grant additional stock under these plans. The Company may use other types of equity incentive awards, such as restricted stock. The Company's equity incentive plan also allows for performance-based vesting for equity incentive awards. Share-based compensation recognized in fiscal year 2007 as a result of the adoption of SFAS No. 123(R) as well as pro forma disclosures according to the original provisions of SFAS No. 123 for periods prior to the adoption of SFAS No. 123(R) is based on the Black-Scholes-Merton option pricing model for estimating fair value of options granted under the Company's equity incentive plans and rights to acquire stock granted under the Company's stock participation plan. The following table summarizes the effects of share-based compensation resulting from the application of SFAS No. 123(R) to options granted under the Company's equity incentive plans and rights to acquire stock granted under the Company's stock participation plan:

Nine Months Ended Three Months Ended ----------------------------- ----------------------------- October 31, October 31, October 31, October 31, 2006 2005 2006 2005 ----------- ----------- ----------- ----------- Cost of sales $ 110,000 $ -- $ 30,000 $ -- Selling, general and administrative expense 337,000 -- 99,000 -- ----------- ----------- ----------- ----------- Share-based compensation effect in income before taxes 447,000 -- 129,000 -- Income taxes (17,000) -- (4,000) -- ----------- ----------- ----------- ----------- Net share-based compensation effects in net income $ 430,000 $ -- $ 125,000 $ -- =========== =========== =========== =========== Share-based compensation effects on basic earnings per common share $ 0.05 $ -- $ 0.01 $ -- =========== =========== =========== =========== Share-based compensation effects on diluted earnings per common share $ 0.05 $ -- $ 0.01 $ -- =========== =========== =========== =========== Share-based compensation effects on cash flow from operations $ -- $ -- $ -- $ -- =========== =========== =========== =========== Share-based compensation effects on cash flow from financing activities $ -- $ -- $ -- $ -- =========== =========== =========== =========== Weighted average common shares outstanding 8,712,000 9,108,000 8,701,000 9,166,000 Dilutive effect of stock options 822,000 542,000 819,000 589,000 ----------- ----------- ----------- ----------- Weighted average common shares outstanding, assuming dilution 9,534,000 9,650,000 9,520,000 9,755,000 =========== =========== =========== =========== Stock-based compensation expense by type of award: Stock Options 439,000 -- 121,000 -- Restricted Stock 8,000 -- 8,000 -- ----------- ----------- ----------- ----------- 447,000 -- 129,000 -- =========== =========== =========== ===========

In accordance with SFAS No. 123(R), the Company adjusts share-based compensation on a quarterly basis for changes to the estimate of expected equity award forfeitures based on actual forfeiture experience. The effect of adjusting the forfeiture rate for all expense amortization after February 1, 2006 will be recognized in the period the forfeiture estimate is changed. The effect of forfeiture adjustments in the nine months ended October 31, 2006 was immaterial. Under the provisions of SFAS No. 123(R), $723,000 has been recorded as a credit to common stock. During the nine months ended October 31, 2006, the tax benefit realized for the tax deduction from option exercises totaled 9 $276,000. As of November 1, 2006, there was $453,000 of total unrecognized compensation costs related to stock options granted under the Company's equity incentive plans. The unrecognized compensation cost is expected to be recognized over a weighted average period of 39 months. Pro forma information required under SFAS No. 123 for periods prior to fiscal 2007 as if the Company had applied the fair value recognition provisions of SFAS No. 123, to options granted under the Company's equity incentive plans was as follows:

Nine Months Three Months Ended Ended October 31, October 31, 2005 2005 -------------- ------------ Net income, as reported $ 1,792,000 $ 590,000 Less: total share-based employee compensation determined under the fair value method for all awards, net of tax 292,000 75,000 -------------- ------------ Pro forma net income $ 1,500,000 $ 515,000 ============== ============ Reported basic earnings per common share $ 0.20 $ 0.06 ============== ============ Pro forma basic earnings per common share $ 0.16 $ 0.06 ============== ============ Reported diluted earnings per common share $ 0.19 $ 0.06 ============== ============ Pro forma diluted earnings per common share $ 0.16 $ 0.05 ============== ============

The Company has two employee incentive stock option plans: the "2002 stock option plan" and the "1994 stock option plan." The Company presented a new equity incentive plan for shareholder vote at its June 29, 2006 annual shareholders' meeting and it was approved by the shareholders. This new 2006 equity incentive plan replaced the 2002 stock option plan, which was terminated early and no further options will be granted under it. Initially, a total of 300,000 new shares of common stock were reserved for issuance under the new 2006 equity incentive plan. As of October 31, 2006, 43,270 shares of the Company's common stock had been issued under the 2006 Equity Incentive Plan ("EIP") and 256,730 shares were reserved for future issuance under the plan. Shares are issued under the EIP as compensation to certain employee and non-employee directors of the Company. Outstanding options under the 2002 and the 1994 stock option plans are exercisable at 100% or more of fair market (as determined by the Compensation Committee of the Board of Directors) at the date of grant. The options are contingent upon continued employment and are exercisable, unless otherwise specified, on a cumulative basis of one-fourth of the total shares each year, commencing one year from the date of grant. Options currently expire five to ten years from the date of grant. Proceeds received by the Company from the exercises are credited to common stock. Additional information with respect to the option plans as of October 31, 2006 is as follows:

Nine months ended October 31, 2006 ----------------------------- Weighted Avg. Shares Exercise Price ----------------------------- Beginning Balance 2,167,445 $3.78 Grants -- -- Exercises (264,378) 3.03 Canceled or expired (25,325) 3.77 ----------------------------- Ending balance 1,877,742 $3.89 ============================= Reserved for future grants at 10/31/2006 -- -- Exercisable 1,518,504 $3.72 =============================

10 The range of exercise prices for options outstanding at October 31, 2006 was $1.35 to $7.00. The range of exercise prices for options is wide due primarily to the fluctuating price of the Company's stock over the period of the grants. The following table summarizes information about options outstanding at October 31, 2006:

Outstanding at Weighted Avg. Range of exercise October 31, Remaining contract Weighted Avg. Number Weighted Avg. prices 2006 life in yrs. Exercise Price Exercisable Exercise Price ------------------------------------------------------------------------------------------------------------------- $1.00 to $2.00 123,250 5.1 $ 1.61 123,250 $ 1.61 $2.01 to $3.00 522,238 4.6 $ 2.58 505,988 $ 2.57 $3.01 to $4.00 199,706 3.3 $ 3.31 199,206 $ 3.31 $4.01 to $5.00 653,825 7.1 $ 4.61 343,587 $ 4.59 $5.01 to $6.00 344,306 2.8 $ 5.42 312,056 $ 5.45 $6.01 to $7.00 34,417 1.9 $ 6.36 34,417 $ 6.36 ----------- ---------- 1,877,742 5.0 $ 3.89 1,518,504 $ 3.72 =========== ==========

These options will expire if not exercised at specific dates ranging from June 2007 to December 2015. During the nine months ended October 31, 2006, 264,378 options were exercised at prices from $1.35 to $5.50 per share. The Company's non-vested shares have a vesting period of four years. Compensation expense, representing the fair market value of the shares at the date of grant, net of assumptions regarding estimated future forfeitures, is charged to earnings over the vesting period. Compensation expense included in general and administrative expenses in the Company's consolidated statement of income, relating to these grants was $8,000 for the nine months ended October 31, 2006. The following table summarizes the non-vested shares transactions for the nine months ended October 31, 2006:

Weighted-Average Grant Date Fair Number of Shares Value ----------------------------------------- Non-vested shares: Outstanding at February 1, 2006 -- -- Granted 43,270 $ 7.08 Vested -- -- Forfeited -- -- ----------------------------------------- Non-vested at October 31, 2006 43,270 $ 7.08 =========================================

As of October 31, 2006, there was $298,000 of total unrecognized compensation cost related to the non-vested share-based compensation arrangements granted under the plan. That cost is expected to be recognized over a weighted-average period of four years. 10. Repurchase of Common Stock On March 28, 2006, the Company exercised an option to repurchase 792,266 shares of its common stock from an executive officer and director of the Company. The total cash purchase price of $3,893,000, or $4.914 per share, represented the average closing price of the Company's common stock for the five trading days prior to the option exercise date minus 10%, in accordance with an agreement between the Company and the executive officer and director entered into in September 2001. The shares repurchased in this private transaction represented approximately 8.6% of the Company's outstanding common stock on the date of exercise. 11 On March 29, 2006, the Company entered into an agreement with its banks, Comerica Bank and First Bank (together, the "Banks"), to expand the existing credit facility by $3.9 million effective March 29, 2006. Interest is at the bank's prime rate less 25 basis points or at the Libor rate, at the election of the Company. Principal and interest payments are due monthly until the loan matures on March 29, 2010. The Company entered into the credit facility to fund the repurchase of the 792,266 shares discussed above. 11. Amendment to Revolving Credit Agreement On September 21, 2006, the Company amended its agreement with its banks, to include an additional $2,000,000, four year term loan to fund the purchase of Dynamic Labs with interest at the bank's prime rate less 25 basis points or at the Libor rate plus 225 basis points, at the election of the Company. The amendment also includes a $2,000,000 equipment line at the bank's prime rate less 25 basis points or at the Comerica Cost of Funds rate plus 225 basis points, at the election of the Company. This will have a one year, interest only period with the balance on the equipment line to be paid over 48 monthly payments commencing on October 31, 2007. See Exhibit 10.11 attached. 12. Acquisitions of Businesses On April 12, 2006, NQA, USA, a 50% owned consolidated subsidiary of NTS, acquired the existing business of American International Registrars Corporation ("AIR"), located in Ventura, California, for a total purchase price of $386,000, payable in cash. All existing AIR clients and associated certifications and backlog were transferred to NQA, USA. The purchase was recorded $105,000 to customer relationships and $281,000 to goodwill. On June 9, 2006, NTS Technical Systems, a wholly owned subsidiary of NTS, acquired the assets and the existing business of B & B Technologies, Inc. ("BBT"), a systems integration firm headquartered in Albuquerque, New Mexico, for a total purchase price of $1,065,000, payable in cash and 83,243 shares of NTS common stock, valued using the closing price of the Company's stock. BBT designs and integrates test, measurement, automation, data acquisition and control systems utilizing diverse hardware platforms, operating systems, and instrumentation standards. The results of operations of the acquired business are included in the accompanying consolidated statement of operations from June 9, 2006 to October 31, 2006. The preliminary allocation of the purchase price of BBT is as follows: Purchase price: Cash $ 3,000 Accounts receivable 248,000 Inventory 35,000 Property, plant and equipment 108,000 Prepaid expenses 33,000 Goodwill 1,004,000 Accounts payable (232,000) Other assumed liabilities (134,000) ----------- Purchase price $ 1,065,000 =========== Cash flow: Purchase price $ 1,065,000 Common stock issued (648,000) Cash acquired (3,000) Cash paid (414,000) On August 1, 2006, the Company acquired the assets and the existing business of Dynamic Labs, an EMI and environmental testing laboratory with locations in Phoenix, Arizona and Austin, Texas for a total purchase price of $2,254,000, paid in cash. The Phoenix laboratory provided EMI, environmental and dynamics testing for the aerospace and defense industries. The Austin facility also provided aerospace, environmental, and dynamic testing. The majority of the machinery and equipment at the Phoenix facility was relocated to the NTS Tempe, Arizona laboratory with the rest of the equipment distributed to other NTS facilities. All of the machinery and equipment at the Austin facility were relocated to other NTS facilities. The preliminary allocation of the purchase price of Dynamic Labs is as follows: 12 Purchase price: Property, plant and equipment 2,004,000 Goodwill 100,000 Covenant not to compete 150,000 ---------- Purchase price $2,254,000 ========== The purchase price allocations for AIR, BBT and Dynamic Labs have not yet been finalized. 13. Recent Accounting Pronouncements In May 2005, the FASB issued SFAS No. 154, "Accounting Changes and Error Corrections." SFAS No. 154 replaces APB Opinion No. 20, "Accounting Changes," and SFAS No. 3, "Reporting Accounting Changes in Interim Financial Statements," and is effective for fiscal years beginning after December 15, 2005, i.e. fiscal year ending January 31, 2007. SFAS No. 154 requires retrospective application to prior periods' financial statements of changes in accounting principle, unless it is impracticable to determine either the period-specific effects or the cumulative effect of the change. The Company does not expect the adoption of SFAS No. 154 to have a material impact on its condensed consolidated financial statements. In June 2006, the Financial Accounting Standards Board issued Interpretation No. 48, "Accounting for Uncertainty in Income Taxes", an interpretation of FAS109, Accounting for Income Taxes (FIN 48), to create a single model to address accounting for uncertainty in tax positions. FIN 48 clarifies the accounting for income taxes, by prescribing a minimum recognition threshold a tax position is required to meet before being recognized in the financial statements. FIN 48 also provides guidance on derecognition, measurement, classification, interest and penalties, accounting in interim periods, disclosure and transition. FIN 48 is effective for fiscal years beginning after December 15, 2006. The Company will adopt FIN 48 effective February 1, 2007, as required. The cumulative effect of adopting FIN 48, if any, will be recorded in retained earnings and other accounts as applicable. The Company does not expect that the adoption of FIN 48 will have a significant impact on the Company's financial position, cash flows, or results of operations. In September 2006, the FASB issued SFAS No. 157, "Fair Value Measurements" ("SFAS 157"), which clarifies the definition of fair value, establishes guidelines for measuring fair value, and expands disclosures regarding fair value measurements. SFAS 157 does not require any new fair value measurements and eliminates inconsistencies in guidance found in various prior accounting pronouncements. SFAS 157 will be effective for the Company on February 1, 2008. The Company will be evaluating the impact of adopting SFAS 157 on its financial position, cash flows, and results of operations. In September 2006, the Securities and Exchange Commission ("SEC") released Staff Accounting Bulletin No. 108, "Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements" ("SAB 108"). SAB 108 provides interpretive guidance on the SEC's views on how the effects of the carryover or reversal of prior year misstatements should be considered in quantifying a current year misstatement. The provisions of SAB 108 will be effective for the Company for the fiscal year ended January 31, 2007. The Company is currently evaluating the impact of applying SAB 108 but does not believe that the application of SAB 108 will have a material effect on its financial position, cash flows, and results of operations. 13 ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Except for the historical information contained herein, the matters addressed in this Item 2 contain forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. Such statements can be identified by the use of forward-looking words such as "may", "will", "expect", "anticipate", "intend", "estimate", "continue", "behave" and similar words. Financial information contained herein, to the extent it is predictive of financial condition and results of operations that would have occurred on the basis of certain stated assumptions, may also be characterized as forward-looking statements. Although forward-looking statements are based on assumptions made, and information believed by management to be reasonable, no assurance can be given that such statements will prove to be correct. Such statements are subject to certain risks, uncertainties and assumptions. Should one or more of these risks or uncertainties occur, or should underlying assumptions prove incorrect, actual results may vary materially from those anticipated. These forward-looking statements are not guarantees of future performance. Readers are cautioned not to place undue reliance on these forward-looking statements, which speak only as of the date hereof. This discussion should be read in conjunction with "Management's Discussion and Analysis of Financial Condition and Results of Operations" included in the Company's Annual Report on Form 10-K for the year ended January 31, 2006 and the condensed consolidated financial statements included elsewhere in this report. GENERAL The Company is a diversified business to business services organization that supplies technical services and solutions to a variety of industries including aerospace, defense, automotive, power products, electronics, computers and telecommunications. Through its wide range of testing facilities, solutions and certification services, the Company provides its customers the ability to sell their products globally and enhance their overall competitiveness. NTS is accredited by numerous national and international technical organizations which allow the Company to have its test data accepted in most countries. The Company operates in two segments: "Engineering & Evaluation" and "Technical Solutions". The business of the Company is conducted by a number of operating units, each with its own organization. Each segment is under the direction of its own executive and operational management team. In making financial and operational decisions, NTS relies on an internal management reporting process that provides revenues and operating cost information for each of its operating units. Revenues and booking activities are also tracked by market type. The Engineering & Evaluation segment is one of the largest independent conformity assessment and management system registration organizations in the U.S., with facilities throughout the United States and in Japan, Canada and Germany, serving a large variety of high technology industries, including aerospace, defense, automotive, power products, electronics, computers and telecommunications. This segment provides highly trained technical personnel for product certification, product safety testing and product evaluation to allow customers to sell their products in world markets. In addition, it performs management registration and certification services to ISO related standards. The Technical Solutions segment provides professional and specialty staffing services, including contract services, temporary and full time placements and specialty solutions services to its customers specifically in the areas of information technology, information systems, software engineering and construction. Technical Solutions supplies professionals in support of customers who need help-desk analysts and managers, relational database administrators and developers, application and systems programmers, configuration and project managers, engineering personnel and multiple levels of system operations personnel. For a discussion of the Company's critical accounting policies, refer to the Company's Form 10-K for the year ended January 31, 2006. The following discussion should be read in conjunction with the consolidated quarterly financial statements and notes thereto. All information is based upon operating results of the Company for the three and nine month periods ended October 31. 14 RESULTS OF OPERATIONS REVENUES Nine months ended October 31, 2006 % Change 2005 (Dollars in thousands) ---------------------------------------- Engineering & Evaluation $ 59,060 12.3% $ 52,610 Technical Solutions 27,338 (9.2)% 30,097 ----------- ----------- Total revenues $ 86,398 4.5% $ 82,707 =========== =========== For the nine months ended October 31, 2006, consolidated revenues increased by $3,691,000 or 4.5% when compared to the same period in fiscal 2006. Engineering & Evaluation: For the nine months ended October 31, 2006, Engineering & Evaluation segment revenues increased by $6,450,000 or 12.3% when compared to the same period in fiscal 2006, primarily due to additional revenues of $1,812,000 from the acquisition on June 9, 2006 of B&B Technologies, an engineering systems integration company located in Albuquerque, New Mexico, $2.5 million in increased aerospace revenues from the Santa Clarita, California laboratory as a result of the enhanced capability and capacity at that facility and increases in revenues from telecommunications, electronics, power products and registration markets. These increases were partially offset by decreases in the automotive testing business at the Detroit, Michigan facility and defense testing business at the Camden, Arkansas facility. Technical Solutions: For the nine months ended October 31, 2006, Technical Solutions segment revenues decreased by $2,759,000 or 9.2% when compared to the same period in fiscal 2006, primarily due to increased price compression in this market as a result of customers insisting on fixed mark-up pricing and competition from off-shore companies. GROSS PROFIT Nine months ended October 31, 2006 % Change 2005 (Dollars in thousands) ---------------------------------------- Engineering & Evaluation $ 15,018 3.4% $ 14,530 % to segment revenue 25.4% 27.6% Technical Solutions 4,654 (9.3)% 5,131 % to segment revenue 17.0% 17.0% ----------- ----------- Total $ 19,672 0.1% $ 19,661 =========== =========== % to total revenue 22.8% 23.8% Total gross profit for the nine months ended October 31, 2006 increased by $11,000 or 0.1% when compared to the same period in fiscal 2006. Engineering & Evaluation: For the nine months ended October 31, 2006, gross profit for the Engineering & Evaluation segment increased by $488,000 or 3.4% and gross profit as a percentage of revenues decreased by 2.2% when compared to the same period in fiscal 2006, primarily due to the continued weakness in the automotive industry, program delays at the Camden, Arkansas facility and lower gross margins at the Company's Tinton Falls, New Jersey and Santa Rosa, California facilities as a result of the investments made for expansion at these facilities and not achieving the desired revenues yet. Gross profit was also impacted by high energy costs, particularly at the Santa Clarita, California facility and losses from one program at Santa Clarita due to contractual issues. The performance at the Company's Fullerton, California facility 15 was negatively impacted during the second quarter as a result of a quality system deficiency in the Company's "NEBS" (Network Equipment Building Specification) testing under the "ITL" (Independent Test Laboratory) program and suspended testing under this program. The testing was reinstated after the Company took the necessary corrective actions. Additionally, share-based compensation expense included in cost of sales for the nine months ended October 31, 2006 was $110,000, compared with no share-based compensation expense in fiscal 2006. Technical Solutions: For the nine months ended October 31, 2006, gross profit decreased by $477,000 or 9.3% in the Technical Solutions segment when compared to the same period in fiscal 2006. This decrease was due to the lower revenues discussed above. For the nine months ended October 31, 2006, gross profit as a percentage of revenues remained the same at 17.0% when compared to the same period in the prior year. SELLING, GENERAL & ADMINISTRATIVE Nine months ended October 31, 2006 % Change 2005 (Dollars in thousands) ----------------------------------------- Engineering & Evaluation $ 12,353 9.6% $ 11,276 % to segment revenue 20.9% 21.4% Technical Solutions 4,438 (6.5)% 4,746 % to segment revenue 16.2% 15.8% ----------- ----------- Total $ 16,791 4.8% $ 16,022 =========== =========== % to total revenue 19.4% 19.4% Total selling, general and administrative expenses increased $769,000 or 4.8% for the nine months ended October 31, 2006 when compared to the same period in fiscal 2006. Engineering & Evaluation: For the nine months ended October 31, 2006, selling, general and administrative expenses increased by $1,077,000 or 9.6% when compared to the same period in fiscal 2006, primarily due to the effects of share-based compensation expense of $337,000 resulting from the application of SFAS No. 123(R), as described in Note 9 of the financial statements, and increased use of outside services related to the improvement of the Company's internal IT infrastructure and data automation and increased travel and conference expenses. Technical Solutions: For the nine months ended October 31, 2006, selling, general and administrative expenses decreased by $308,000 or 6.5% when compared to the same period in fiscal 2006, primarily due to the reduction in selling costs associated with the lower revenues discussed above. Equity Income from Non-Consolidated Subsidiary: Engineering & Evaluation: For the nine months ended October 31, 2006, equity income from XXCAL Japan was $192,000, compared to $180,000 for the same period in fiscal 2006. XXCAL Japan is 50% owned by NTS and is accounted for under the equity method since NTS does not have management or board control. 16 OPERATING INCOME Nine months ended October 31, 2006 % Change 2005 (Dollars in thousands) ----------------------------------------- Engineering & Evaluation $ 2,857 (16.8)% $ 3,434 % to segment revenue 4.8% 6.5% Technical Solutions 216 (43.9)% 385 % to segment revenue 0.8% 1.3% ----------- ----------- Total $ 3,073 (19.5)% $ 3,819 =========== =========== % to total revenue 3.6% 4.6% Operating income for the nine months ended October 31, 2006 decreased by $746,000 or 19.5% when compared to the same period in fiscal 2006. Engineering & Evaluation: For the nine months ended October 31, 2006, operating income in the Engineering & Evaluation segment decreased by $577,000 or 16.8% when compared to the same period in fiscal 2006, primarily as a result of the decrease in gross profit and the increase in selling, general and administrative expenses, partially offset by the increase in equity income from non-consolidated subsidiary. Technical Solutions: For the nine months ended October 31, 2006, operating income in the Technical Solutions segment decreased by $169,000 or 43.9% when compared to the same period in fiscal 2006, as a result of the decrease in gross profit, partially offset by the decrease in selling, general and administrative expenses, discussed above. INTEREST EXPENSE Net interest expense increased by $327,000 to $1,312,000 in the nine months ended October 31, 2006 when compared to the same period in fiscal 2006. This increase was principally due to higher interest rate levels for the nine months ended October 31, 2006 and higher average debt balances for the nine months ended October 31, 2006 when compared with the same period last year. OTHER INCOME Other income was $171,000 in the nine months ended October 31, 2006 compared to $163,000 for the same period in fiscal 2006. INCOME TAXES The income tax provision rate of 43.9% for the nine months ended October 31, 2006 is higher than the 37.3% income tax rate in the prior year, primarily due to non-deductible share-based compensation expense recorded for the nine months ended October 31, 2006 as compared to none for the same period in the prior year. This rate is based on the estimated provision accrual for fiscal year ending January 31, 2007. Management has determined that it is more likely than not that the deferred tax assets will be realized on the basis of offsetting them against the reversal of deferred tax liabilities. It is the Company's intention to assess the need for a valuation account by evaluating the realizability of the deferred tax asset quarterly based upon projected future taxable income of the Company. NET INCOME Net income for the nine months ended October 31, 2006 was $1,008,000, a decrease of $784,000 compared to the same period in fiscal 2006. This decrease was primarily due to the lower operating income, higher interest expense and higher income tax rate. 17 The following information is based upon results for National Technical Systems, Inc. for the three months ended October 31. RESULTS OF OPERATIONS REVENUES Three months ended October 31, 2006 % Change 2005 (Dollars in thousands) ------------------------------------------ Engineering & Evaluation $ 20,706 14.3% $ 18,108 Technical Solutions 9,103 (12.5)% 10,400 ---------- ---------- Total revenues $ 29,809 4.6% $ 28,508 ========== ========== For the three months ended October 31, 2006, consolidated revenues increased by $1,301,000 or 4.6% when compared to the same period in fiscal 2006. Engineering & Evaluation: For the three months ended October 31, 2006, Engineering & Evaluation revenues increased by $2,598,000 or 14.3% when compared to the same period in fiscal 2006, primarily due to additional revenues of $1,094,000 from the acquisition on June 9, 2006 of B&B Technologies, an engineering systems integration company located in Albuquerque, New Mexico, $1 million in increased aerospace revenues from the Santa Clarita, California laboratory as a result of the enhanced capability and capacity at that facility and increases in revenues from telecommunications, software testing, power products and registration markets. These increases were partially offset by decreases in electronics testing business at the Fullerton, California facility and defense testing business at the Camden, Arkansas facility due to customer program delays. Technical Solutions: For the three months ended October 31, 2006, Technical Solutions revenues decreased by $1,297,000 or 12.5% when compared to the same period in fiscal 2006, primarily as a result of increased price compression in the general IT service business and competition from off-shore companies. GROSS PROFIT Three months ended October 31, 2006 % Change 2005 (Dollars in thousands) ----------------------------------------- Engineering & Evaluation $ 5,256 9.4% $ 4,804 % to segment revenue 25.4% 26.5% Technical Solutions 1,599 (20.8)% 2,020 % to segment revenue 17.6% 19.4% ---------- ---------- Total $ 6,855 0.5% $ 6,824 ========== ========== % to total revenue 23.0% 23.9% Total gross profit for the three months ended October 31, 2006 increased by $31,000 or 0.5% when compared to the same period in fiscal 2006. Engineering & Evaluation: For the three months ended October 31, 2006, gross profit for the Engineering & Evaluation segment increased by $452,000 or 9.4% when compared to the same period in fiscal 2006, primarily as a result of the increase in revenues 18 discussed above. Gross profit as a percentage of revenues decreased by 1.1% for the three months ended October 31, 2006, compared with the same period last year. This decrease was primarily due to program delays at the Camden, Arkansas facility and reduced margins at the Santa Rosa and Fullerton, California facilities. Gross profit was also impacted by higher energy costs. Additionally, share-based compensation expense included in cost of sales for the three months ended October 31, 2006 was $30,000, compared to no share-based compensation expense in fiscal 2006. Technical Solutions: For the three months ended October 31, 2006, gross profit decreased by $421,000 or 20.8% in the Technical Solutions segment when compared with the same period in fiscal 2006. This decrease was primarily due to workers compensation insurance credit received in the prior year and the decrease in revenues. Gross profit as a percentage of revenues decreased for the three months ended October 31, 2006 to 17.6% from 19.4% for the same period in the prior year. SELLING, GENERAL & ADMINISTRATIVE Three months ended October 31, 2006 % Change 2005 (Dollars in thousands) -------------------------------------------- Engineering & Evaluation $ 4,171 4.4% $ 3,995 % to segment revenue 20.1% 22.1% Technical Solutions 1,463 (13.5)% 1,692 % to segment revenue 16.1% 16.3% ---------- ---------- Total $ 5,634 (0.9)% $ 5,687 ========== ========== % to total revenue 18.9% 19.9% Total selling, general and administrative expenses decreased $53,000 or 0.9% for the three months ended October 31, 2006 when compared with the same period in fiscal 2006. Engineering & Evaluation: For the three months ended October 31, 2006, selling, general and administrative expenses increased by $176,000 or 4.4% when compared with the same period in fiscal 2006, primarily due to the share-based compensation expense of $99,000 resulting from the application of SFAS No. 123(R), as described in Note 9 of the financial statements, and increased use of outside services related to the improvement of the Company's internal IT infrastructure and data automation. Technical Solutions: For the three months ended October 31, 2006, selling, general and administrative expenses decreased by $229,000 or 13.5% when compared to the same period in fiscal 2006, primarily due to the reduction in selling costs associated with the lower revenues discussed above. Equity Income from Non-Consolidated Subsidiary: Engineering & Evaluation: For the three months ended October 31, 2006, equity income from XXCAL Japan was $57,000, compared to $68,000 for the same period in fiscal 2006. XXCAL Japan is 50% owned by NTS and is accounted for under the equity method since NTS does not have management or board control. 19 OPERATING INCOME Three months ended October 31, 2006 % Change 2005 (Dollars in thousands) -------------------------------------------- Engineering & Evaluation $ 1,142 30.2% $ 877 % to segment revenue 5.5% 4.8% Technical Solutions 136 (58.5)% 328 % to segment revenue 1.5% 3.2% ---------- ---------- Total $ 1,278 6.1% $ 1,205 ========== ========== % to total revenue 4.3% 4.2% Operating income for the three months ended October 31, 2006 increased by $73,000 or 6.1% when compared with the same period in fiscal 2006. Engineering & Evaluation: For the three months ended October 31, 2006, operating income in the Engineering & Evaluation segment increased by $265,000 or 30.2% when compared with the same period in fiscal 2006, primarily as a result of the increase in gross profit, partially offset by the increase in selling, general and administrative expenses and the decrease in equity income from non-consolidated subsidiary. Technical Solutions: For the three months ended October 31, 2006, operating income in the Technical Solutions segment decreased by $192,000 when compared to the same period in fiscal 2006, as a result of the decrease in gross profit, partially offset by the decrease in selling, general and administrative expenses discussed above. INTEREST EXPENSE Net interest expense increased by $162,000 to $500,000 in the three months ended October 31, 2006 when compared to the same period in fiscal 2006. This increase was principally due to higher interest rate levels for the three months ended October 31, 2006 and the higher average debt balances for the three months ended October 31, 2006 when compared with the same period last year. OTHER INCOME Other income decreased by $105,000 to $42,000 in the three months ended October 31, 2006 when compared with the same period in fiscal 2006, primarily due to the inclusion of gain on the sale of real estate in the prior year. INCOME TAXES The income tax provision rate of 45.7% for the three months ended October 31, 2006 is higher than the 37.7% income tax rate in the prior year, primarily due to non-deductible share-based compensation expense recorded for the three months ended October 31, 2006 as compared to none for the same period in the prior year. This rate is based on the estimated provision accrual for fiscal 2007. Management has determined that it is more likely than not that the deferred tax assets will be realized on the basis of offsetting them against the reversal of deferred tax liabilities. It is the Company's intention to assess the need for a valuation account by evaluating the realizability of the deferred tax asset quarterly based upon projected future taxable income of the Company. NET INCOME Net income for the three months ended October 31, 2006 was $409,000, a decrease of $181,000, compared to the same period in fiscal 2006. This decrease was primarily due to the higher interest expense, lower other income and higher income tax rate, partially offset by higher operating income. 20 OFF BALANCE SHEET ARRANGEMENTS None. BUSINESS ENVIRONMENT In the Engineering & Evaluation segment, the Company tests and certifies high tech products for seven distinct markets: defense, aerospace, telecommunications, transportation, power, computer and electronics. The Company also provides ISO 9000 Quality Management System Registration. The defense and aerospace markets generate approximately 60% of the overall Engineering and Evaluation revenues. In recent years, domestic and worldwide political and economic developments have impacted positively the market demands for defense and advanced technology systems. Government research and development funding specifically for defense has increased this year. In addition, both the commercial and military aerospace markets are increasing and it is predicted that this growth will continue for the next several years. Also, the increase in government outsourcing activity has created additional opportunities for NTS. The Company has ten fully equipped defense and aerospace environmental simulation laboratories located throughout the United States and is well equipped to handle this increase in demand. The Company has experienced an increase in demand for the evaluation of military equipment and weapons systems, which has positively affected business at its laboratories. Currently the Company is experiencing a moderate increase in its aerospace business this year. The trend in the telecommunications market appears to be stable in the short term and growing in the future. Carriers are deploying voice, video and data using fiber networks. This may increase the demand for certification of suppliers' premises equipment, fiber component certification and certification of additional central office equipment. The Company has been approved as an Independent Test laboratory (ITL) by the regional bell operating companies (RBOCs) to test and certify central office equipment developed by manufactures to the Network Equipment Building Specifications (NEBS). The Company is currently providing this service at laboratories in California, Massachusetts, Texas, Alberta, Canada and Germany. The Company has been approved as an (ITL) to offer a complete suite of passive fiber components certifications and Digital Subscriber Line (DSL) certification. This service currently is being provided at laboratories in California. The Company expects an increase in business demand as RBOCs upgrade networks packet-based Voice Over Internet Protocol (VOIP) devices. As service providers gradually convert to VOIP architectures, interoperability becomes critical to ensure a seamless transition to next generation networks. The Company also expects an increase in demand as carriers begin to deploy "triple play" (voice, video, and broadband) offerings over FTTP (fiber to the premises) passive fiber networks (PON). The Company is currently evaluating the overall compliance requirements for the deployment of wireless products and how best to position NTS to service the anticipated growth for this technology. The Company may continue to experience a moderate increase in the Telecom business. The transportation market and power markets have been stable with the Company continuing to experience a slight decrease in the transportation business, while the Company has recently experienced a moderate increase in the power business. The computer and electronics markets have been stable. The Company anticipates growth in these markets as it captures additional market share due to the planned international expansion. NTS has signed cooperative agreements in Taiwan and Korea with SGS and STC in Hong Kong and mainland China. The cooperative agreements will focus on providing USB, USB on the go, Connector and Zigbee certification to device manufacturers and industrial products manufactured in Asia. The Company believes that the demand for these certification activities will increase in Asia. In the Technical Solutions segment, the Company provides a variety of staffing and workforce management services and solutions, including contract, contract-to-hire and full time placements to meet its customers' needs with a focus on IT and engineering. Over the past few years, the IT general services business transferred to off-shore facilities and became a commodity service for some of the Company's largest competitors. In 2003, the Company deployed a transformation strategy which focused on meeting the anticipated increase in demand for specialized IT, compliance, engineering support services at Company locations as well as taking advantage of offshore opportunities. As part of this transformation, the Company developed a proprietary database and put in place a customer service team which maintains relationships and manages the availability of the technical experts which support these specialized services. The Company has also set up a test and compliance laboratory in Vietnam to support the needs of a major US Fortune 500 computer company and to take advantage of the low cost highly skilled labor in Vietnam. The Company is now expanding this offshore offering to additional clients. TS continues to differentiate itself from its competitors by using 21 NTS' testing, engineering and compliance capabilities to maximize its customers' return on human assets. Notwithstanding the foregoing, and because of factors affecting the Company's operating results, past financial performance should not be considered to be a reliable indicator of future performance. 22 LIQUIDITY AND CAPITAL RESOURCES Net cash provided by operating activities of $1,254,000 in the nine months ended October 31, 2006 primarily consisted of net income of $1,008,000 adjusted for non-cash items of $4,298,000 in depreciation and amortization, share based compensation of $447,000, other non cash items of $82,000, partially offset by changes in working capital of $4,581,000. Net cash provided by operating activities in the nine months ended October 31, 2005 was $3,667,000. Net cash provided by operating activities decreased from the nine months ended October 31, 2005 to the nine months ended October 31, 2006 by $2,413,000, primarily as a result of the decrease in net income, accrued expenses and income taxes payable. Cash used for investing activities in the nine months ended October 31, 2006 of $7,742,000 was primarily attributable to capital spending of $4,545,000, cash used to acquire American International Registrars Corporation ("AIR") of $386,000, cash used to acquire B&B Technologies of $414,000 and cash used to acquire Dynamic Labs of $2,254,000. Capital spending is generally comprised of purchases of machinery and equipment, building, leasehold improvements, computer hardware, software and furniture and fixtures. Cash used for investing activities in the nine months ended October 31, 2005 was $4,217,000. Net cash used by investing activities increased from the nine months ended October 31, 2005 to the nine months ended October 31, 2006 by $3,525,000, primarily as a result of additional cash paid for acquisitions and capital spending in fiscal 2007 and cash proceeds in fiscal 2006 from the sale of property. Net cash provided by financing activities in the nine months ended October 31, 2006 of $4,238,000 consisted of proceeds from borrowings of $14,436,000, proceeds from stock options exercised of $592,000, partially offset by repayment of debt of $6,897,000, and common stock repurchase of $3,893,000 from an executive officer and director of the Company. Net cash used for financing activities for the nine months ended October 31, 2005 was $2,766,000. On November 25, 2002, the Company increased the revolving line of credit under its credit agreement with Comerica Bank California and First Bank to $20,000,000. Comerica Bank California, as the agent, retained 60% of the line with First Bank, as the participant, holding 40% of the line. The revolving line of credit was reduced by $1,750,000 on August 1, 2003 and was reduced again on August 1, 2004 by $1,750,000, bringing the maximum line of credit available down to $16,500,000. The interest rate is at the agent's prime rate, with an option for the Company to convert to loans at the Libor rate plus 250 basis points for 30, 60, 90, 180 or 365 days, with minimum advances of $1,000,000. The Company paid a 0.5% commitment fee of the total line amount and is paying an additional 0.25% of the commitment amount annually and a 0.25% fee for any unused line of credit. On July 1, 2005, the agreement was amended to include a $2,500,000 term loan to be repaid in 60 equal monthly payments. The proceeds were used to pay down the line of credit. In addition, the requirement of the $1,750,000 reduction of the line was removed from the agreement. The amendment also included an additional equipment line of credit for $2,000,000. On March 29, 2006, the Company increased the term loan by an additional $3,900,000 to fund the repurchase of 792,266 shares of common stock from an executive officer and director, as discussed above. On September 21, 2006, the agreement was amended again to include an additional equipment line of credit of $2,000,000 and an additional $2,000,000 in term loan, to be repaid in 48 equal monthly payments, to fund the purchase of Dynamic Labs. The outstanding balance on the revolving line of credit at October 31, 2006 was $11,093,000. This balance is reflected in the accompanying condensed consolidated balance sheets as long-term. The amount available on the line of credit was $5,407,000 as of October 31, 2006. The aggregate outstanding balance on the term loans at October 31, 2006 was $7,165,000. The aggregate outstanding balance 23 on the equipment line of credit at October 31, 2006 was $2,594,000. This agreement is subject to certain covenants, which require the maintenance of certain working capital, debt-to-equity, earnings-to-expense and cash flow ratios. The Company was in full compliance with all of the covenants with its banks at October 31, 2006. The Company has additional equipment line of credit agreements (at interest rates of 5.56% to 9.82%) to finance various test equipment with terms of 60 months for each equipment schedule. The outstanding balance at October 31, 2006 was $1,362,000. The balance of other notes payable collateralized by land and building was $2,462,000 and the balance of unsecured notes was $9,000 at October 31, 2006. ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK There have been no material changes in the Company's quantitative and qualitative market risk since the disclosure in the Company's Annual Report on Form 10-K for the year ended January 31, 2006, filed with the Securities and Exchange Commission on April 28, 2006. ITEM 4. CONTROLS AND PROCEDURES Evaluation of Disclosure Controls and Procedures The Company's Chief Executive Officer and Chief Financial Officer carried out an evaluation with the participation of the Company's management, of the effectiveness of the design and operation of the Company's disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended (the "Exchange Act")). Based upon that evaluation, the Chief Executive Officer and Chief Financial Officer concluded that, as of the end of the period covered by this report, the Company's disclosure controls and procedures were effective. Changes in Internal Controls Over Financial Reporting As required by Rule 13a-15(d), the Company's Chief Executive Officer and Chief Financial Officer, with the participation of the Company's management, also conducted an evaluation of the Company's internal controls over financial reporting to determine whether any changes occurred during the quarter ended October 31, 2006 that have materially affected, or are reasonably likely to affect, the Company's internal controls over financial reporting. Based on that evaluation, there has been no such change during the quarter ended October 31, 2006. Limitations of the Effectiveness A control system, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of the internal control system are met. Because of the inherent limitations of any internal control system, no evaluation of controls can provide absolute assurance that all control issues, if any, within a company have been detected. Notwithstanding these limitations, the Company's disclosure controls and procedures are designed to provide reasonable assurance of achieving their objectives. The Company's Chief Executive Officer and Chief Financial Officer have concluded that the Company's disclosure controls and procedures are, in fact, effective at the "reasonable assurance" level. 24 PART II. OTHER INFORMATION Item 1. Legal Proceedings From time to time the Company may be involved in judicial or administrative proceedings concerning matters arising in the ordinary course of business. Management does not expect that any of these matters, individually or in the aggregate, will have a material adverse effect on the Company's business, financial condition, cash flows or results of operation. Item 1A. Risk Factors There have been no material changes in the Company's risk factors since the disclosure in the Company's Annual Report on Form 10-K for the year ended January 31, 2006 filed with the Securities and Exchange Commission on April 28, 2006. Item 2. Unregistered Sales of Equity Securities None. Item 3. Defaults Upon Senior Securities None. Item 4. Submission of Matters to a Vote of Security Holders None. Item 5. Other Information None. Item 6. Exhibits 10.11 - Amendment number seven to revolving credit agreement between the Company and Comerica Bank effective September 21, 2006. 10.12 - National Technical Systems, Inc. 2006 Long-Term Incentive Plan. 10.13 - National Technical Systems, Inc. 2006 Supplemental Executive Retirement Plan. 31.1 - Certification of the Principal Executive Officer pursuant to rule 13a-14(a) and 15d-14(a) of the Securities Exchange Act of 1934, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. 31.2 - Certification of the Principal Financial Officer pursuant to rule 13a-14(a) and 15d-14(a) of the Securities Exchange Act of 1934, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. 32.1 - Certification of the Principal Executive Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. 32.2 - Certification of the Principal Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. 25 SIGNATURE Pursuant to the requirements of the Securities Exchange Act of 1934 the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. NATIONAL TECHNICAL SYSTEMS, INC. Date: December 12, 2006 By: /s/ Lloyd Blonder --------------------- ------------------------------- Lloyd Blonder Senior Vice President Chief Financial Officer (Signing on behalf of the registrant and as principal financial officer) 26