UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-K

Annual Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934
For the fiscal year ended January 31, 2006
Commission file number 0-16438

NATIONAL TECHNICAL SYSTEMS, INC.

(Exact name of registrant as specified in its charter)

 

(818) 591-0776

(Registrant’s telephone number, including area code)

Securities registered pursuant to Section 12(b) of the Act:

None

Securities registered pursuant to Section 12(g) of the Act:

Common Stock—No Par Value

(Title of class)

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. YES o NO x

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act. YES o NO x

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 o

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. x

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):

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of Act). YES o NO x

State the aggregate market value of the voting and non-voting common equity held by non-affiliates computed by reference to the price at which the common equity was last sold, or the average bid and asked price of such common equity, as of the last business day of the registrant’s most recently completed second fiscal quarter—$38,791,000 (as of July 31, 2005).

The number of shares of registrant’s Common Stock outstanding on April 24, 2006 was 8,414,743

Documents Incorporated by Reference

Portions of the Proxy Statement of the Company for the Annual Meeting of Shareholders to be held on June 29, 2006, are incorporated by reference into Part III of this report.

NATIONAL TECHNICAL SYSTEMS, INC.
FORM 10-K
FISCAL YEAR ENDED JANUARY 31, 2006

 

This report contains certain statements that may be deemed “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. Actual outcomes are dependent upon National Technical Systems, Inc.’s (“NTS” or “the Company”) successful performance of internal plans, ability to effectively integrate acquired companies, customer changes in short range and long range plans, competition in the Company’s services areas and pricing, continued acceptance of new services, performance issues with key customers, and general economic risks and uncertainties.

2

NATIONAL TECHNICAL SYSTEMS, INC.

Annual Report (Form 10-K)

For Year Ended January 31, 2006

PART I

ITEM 1.                BUSINESS.

General

National Technical Systems, Inc. (“NTS” or the “Company”) is a diversified services company that supplies technical services and solutions to a variety of industries including aerospace, defense, transportation, electronics, power, computers and telecommunications. NTS, utilizing its various testing facilities, staffing solutions and certification services, helps its customers sell their products in world markets. 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 was founded in 1961, incorporated in 1968 in California and subsequently was reincorporated in Delaware in 1987 to serve as a holding company for its subsidiaries. On January 31, 1997, the Company was merged into a newly formed California corporation named National Technical Systems, Inc.

The Company’s principal executive offices are located at 24007 Ventura Boulevard, Suite 200, Calabasas, California 91302 (telephone: 818-591-0776).

Description of Business

NTS operates in two segments: “Engineering and Evaluation” and “Technical Solutions.” The business of the Company is conducted by a number of operating units, each with its own organization. The management of each operating unit has responsibility for its operations and for achieving sales and profit goals. The executive staff from the Company’s corporate headquarters maintains overall supervision, coordination and financial control.

(i)   Engineering & Evaluation (“E&E”)

Overview

The E&E segment of NTS is one of the largest independent conformity assessment and management system registration organizations in the U. S., with facilities throughout the country and at locations in Japan, Germany and Canada. E&E 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, E&E  performs management registration and certification services to ISO related standards. NTS is accredited by numerous national and international technical organizations which allows the Company to have its test data accepted in most countries.

E&E revenues represented 65%, 59% and 56% of NTS total revenues in fiscal years 2006, 2005 and 2004, respectively. E&E serves high technology companies, predominantly in the defense, aerospace, transportation, telecommunications, electronics, power and computers markets. In fiscal 2006, E&E serviced. approximately 2,600 customers. The ability for these customers to offer certifications and provide test data that is accepted in world markets is critical for manufactured products acceptance.

E&E creates environments that simulate changes in temperature, altitude, moisture, and virtually every other environmental factor that might affect product performance. In addition, E&E has developed expertise and specialized skills over decades of testing in multiple industries and has invested heavily in

3

---

equipment including a full spectrum of EMI chambers, data acquisition systems, seismic simulators, environmental simulation equipment, environmental chambers, fire chambers, mixed gas flow chambers and munitions and ordnance performance testing equipment.

E&E also provides international registration of companies requiring quality and environmental management system registration. With the increasing globalization of industry and trade, the international community has developed, and continually updates, management systems standards to insure that products manufactured conform to acceptable standards when sold anywhere in the world. These standards, developed by the International Standards Organization (ISO), and applicable to different industries, such as aerospace, transportation and environmental, are used to provide compliance by manufacturers certified by third party registrants. Third party registrants are accredited by industry regulated accreditation bodies. E&E is certified to provide third party registrations to a variety of industries. To accomplish certification, E&E audits a company’s quality policy, quality system documentation and quality records through on-site assessment. Such assessment determines whether the quality system is defined, documented, deployed and consistently implemented, and that the required documentation and records are current and available. If the customer’s quality system is verified to conform to the requirements of the applicable ISO standard, National Quality Assurance (“NQA”), USA, an affiliate of the Company, issues a certificate describing the scope of the customer’s quality system, which has been certified. The customer is then entitled to display the Registrar’s mark on advertising and stationery as evidence that it has achieved ISO registration. Thereafter, E&E performs periodic follow-up surveillance assessments to assure that the customer remains in compliance. In the Quality Audit field, the Company is the tenth largest ISO 9000 assessment company in the United States as reported by “Quality Systems Update.” The Company believes that NQA USA has approximately 7% of the total registration market.

E&E Markets

E&E serves customers primarily in the defense, aerospace, transportation, telecommunications, electronics, power and computers markets. Defense and aerospace markets account for approximately 60% of E&E revenues.

Defense.   E&E plays an active role in numerous U.S. defense related programs, performing almost every type of test discipline, including complete functionality and performance, reliability, safety, life prediction, structural/mechanical, fluids related, material science, vibration, shock, climatic exposure, radiation, acoustic noise and electromagnetic interference, compatibility and Lithium Battery Testing. Examples of items tested include components for small fixed wing aircraft, helicopters, submarines, aircraft carriers and other naval ships, tanks and other tracked vehicles, trucks and road vehicles, command/control/ communication systems, electronics, weapon systems and complete ordnance and munitions testing. E&E has facilities that are specially constructed to handle munitions and hazardous materials where routine testing includes vibration and cook-off of explosive materials, ballistics tests and hydraulic burst tests. E&E performs virtually any ballistics related testing, up to 155 mm rounds. E&E’s data acquisition systems are capable of collecting 1,000,000 data points and 22,000 photos per second. Additional instrumentation includes Doppler radar, 35 mm still cameras, digital recording, data loggers and real-time color and IR video. E&E’s customers in this market include various major defense contractors, as well as the U.S. Department of Defense (DOD) and other government entities.

Aerospace.   E&E performs almost all tests required on manned and unmanned flights and has participated in virtually every major space project since the inception of the manned exploration of space. E&E offers  complete acceleration test facilities, G-tables and centrifuges with diameters ranging from one foot to 102 feet, with weight capacities from a few grams to 20,000 pounds. In climatic testing, E&E utilizes hundreds of test chambers to simulate nearly any environment: temperature, humidity, altitude, rain, salt spray, sand and dust, sunshine, explosive atmosphere or any combination. E&E designs and builds custom facilities and advanced instrumentation and data acquisition systems to support all types of flow testing for

4

---

gases, liquids and cryogenics. E&E is capable of performing structural testing and analysis, and, in particular, structural loading of large objects such as complete airframes. It also performs fatigue testing of critical hardware items such as engine blades and high-pressure fluid components and also offers customers a way to minimize their personnel, testing time and costs by utilizing the Company’s on-site climatic, dynamic, safety and electromagnetic compatibility test capabilities. E&E also has   anechoic and reverberant chambers that are used for acoustic emission measurements or high­ level noise exposure.

Transportation.   E&E performs fluids and gas tests that measure the flow of fuels, propellants, chemicals, water, steam and others. It also provides tests that measure temperature, thermal shock, leak detection and efficiencies in objects like filters and other components. Other more specialized tests include cryogenic protocols for elements such as liquid nitrogen, liquid hydrogen and liquid oxygen, as well as liquefied natural gas. E&E also performs dynamometer testing to measure the performance and power output of engines drive trains or any other rotating machinery. It also performs HALT/HASS (Highly Accelerated Stress Screen). These tests combine extremes of temperature, rapid temperature change, and multi-axis vibration to rapidly expose design weaknesses and process flaws. NTS is accredited to ISO 17025 through the American Accreditation of Laboratories Association (A2LA). This accreditation allows NTS automotive test reports to be accepted in the USA and internationally.

Telecommunications.   E&E provides certification and evaluation of a broad array of telecommunications equipment and systems for major manufacturers. E&E’s services are performed in accordance with the Network Equipment Building Systems specifications (NEBS) and fiber optics General Requirements (GRs) as required by the telecommunications industry. E&E is also an independent test laboratory certified by Verizon, which allows manufacturers to use E&E as a market channel for products tested at Original Equipment Manufacturers’ (“OEM”) facilities that are being developed for use in the regional bell operating companies’ (“RBOCs”) central offices. Currently, E&E is approved by Verizon for certifying passive fiber optics components (PFOC) to sixteen General Requirements. E&E performs product certification for the major RBOCs. The Company has been approved as an Independent Test Laboratory (ITL) by the RBOCs to test and certify central office equipment developed by manufactures to the NEBS specifications. The Company is currently providing this service at laboratories in California, Massachusetts, Texas, Calgary 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. As service providers gradually convert to VOIP architectures, interoperability becomes critical to ensure a seamless transition to next generation networks. E&E owns a network architecture and interoperability laboratory in Northern California to extend E&E’s service offering to handle the anticipated demand for interoperability testing and FTTP (fiber to the premises) deployment as carriers begin to deploy voice, video, and broadband offerings over FTTP passive fiber networks.

Electronics.   As a Nationally Recognized Test Lab (NRTL), NTS provides electrical safety product certification, in the US, EU, Canada, Australia and many other countries. NTS has been designated as a Conformity Assessment Body (CAB) for the EMC directive through the US-EU Mutual Recognition Agreement (MRA). NTS conducts EMC testing and provides customers with certification in the US and many other countries, particularly, Japan, Taiwan, Europe and Australia.

Power.   E&E conducts a variety of tests relevant to the ongoing operations, safety and maintenance of nuclear facilities. These tests include mechanical aging, normal or accident radiation exposure, reliability simulation, evaluation, thermal aging, analysis, vacuum testing, leak detection, Nuclear Steam Accident, Loss Of Cooling Accident (LOCA), High Expansion Line Break (HELB) to 600F/300psig E&E also performs seismic simulation tests up to 100,000 force-lbs, single axis, dependent and independent biaxial systems, vibration aging and fatigue studies, up to 45,000 force-lbs. E&E is active in industry task groups that influence the latest dedication guidelines. Through direct participation, E&E is involved in resolution of key NRC questions such as selection and verification of critical characteristics, sampling,

5

---

traceability, surveys, and like-for-like replacements. E&E engineers and technicians involved in the dedication process meet ANSI N45.2.6 Level II Inspectors guidelines. The Company’s dedication programs utilize the best approach for each specified product. E&E also provides technical evaluations, critical characteristics and safety class determinations and focuses on solving plant needs in areas such as motor rewinds, governor rebuilds, modifications or design of replacement systems and instrumentation panel and component design.

Computer.   E&E performs computer product testing, providing compatibility, stress/performance, functionality and compliance testing services for hardware, software, telecommunications and networking companies worldwide. E&E performs software game and game console testing including Microsoft Xbox compliance testing. E&E is the exclusive test center for Microsoft Xbox third party peripheral compatibility testing. E&E also provides testing for Data Over Cable Service Interface Specification (DOCSIS) cable modem, DSL modem, Set Top Box, Residential Gateway and Fiber Optics GR-253 testing, interoperability testing of broadband and network products such as cable modems, DSL modems, Cable Modem Termination System (CMTS), Digital Subscriber Line Access Multiplexer (DSLAM), Routers, HomePNA Gateways, Wireless Wi-Fi devices, Media Servers, Fiber Optics SONET switches, and systems network testing. E&E also performs USB certification testing and was able to successfully transfer its USB technology to Japan.

Industry Overview

Manufacturers often fulfill their evaluation testing needs on an outsourcing basis in order to reduce costs, avoid large capital expenditures, save time and remain competitive. Due to regulations requiring third party certification, manufacturers use third party certifiers to position their products for sale in world markets. NTS is currently geographically located to serve customers at locations close to their plants and NTS facilities are capable of providing the complete conformity assessment activity necessary to reduce product-handling costs and serve as a market gateway for manufacturers to sell products globally. E&E provides a “one stop” resource and single source responsibility for all conformity assessment requirements in the several markets it serves.

Geographic Locations

In the United States, E&E’s facilities are located in Acton and Boxborough, Massachusetts, Tinton Falls, New Jersey, Rustburg, Virginia, Camden, Arkansas, Detroit, Michigan, Plano, Texas, Tempe, Arizona, Los Angeles, Fullerton, Culver City, Santa Clarita and Santa Rosa, California and internationally, in Yokohama, Japan, Calgary, Canada and Munich, Germany. The Company has signed cooperative agreements with SGS in Taiwan and STC in Hong Kong to provide certification and compliance testing for USB, USB on the Go and Cable and Connectors for manufacturers in Taiwan, Korea, Hong Kong and mainland China.

Business Strategy

To meet its customers’ needs, E&E continuously upgrades its facilities, equipment, accreditations, partnerships and personnel in line with market requirements. In addition, E&E’s continuing expansion into new areas of technology will require it to invest in equipment needed to adequately service customers’ needs. Through close consultation with its existing and prospective customers to ascertain their needs for the future, E&E is able to better determine its equipment needs. In fiscal 2006, the Company made additional investments to enhance its munitions and ordnance service offering in Camden, Arkansas which now includes small and medium caliber testing, upgraded its Santa Clarita facility to support the aerospace needs in the technical areas of altitude testing; high temperature/high flow testing and high level acoustic noise testing, and added additional  test capacity in Tinton Falls, New Jersey, Plano, Texas, Rustburg, Virginia and Boxborough, Massachusetts.

6

---

The Company continues to use the Balanced Scorecard System as a tool to assist management in setting strategy and achieving its mission “Navigate a Short Course to Global Markets.” NTS is using this system to maximize efficiency in all aspects of its business.

(ii)   Technical Solutions (“TS”)

Overview

The Technical Solutions segment of NTS is a national provider of technical experts for engineering and information technology services. In a strategic initiative developed in 2003, the Company aligned the service offerings to more closely align it TS services with its E&E group and thus capitalize on NTS’s long history of testing and engineering services. As a valuable and respected resource, TS has developed long-term relationships with its clients for whom it provides engineering and IT personnel.

TS revenues represented 35%, 41% and 44% of NTS total revenues in fiscal years 2006, 2005 and 2004, respectively. TS’s operational and technical knowledge allows it to effectively identify and screen highly skilled technical professionals. TS provides the technical resources its clients need to continually evaluate processes and products and meet the demands of compressing development cycles and critical time-to-market requirements. TS places its professionals on assignment at a client site to perform specific tasks and projects for a predetermined period of time. At the completion of an assignment, customers may, under some previously negotiated terms and circumstances, directly hire an individual. TS also supports its clients in sourcing and identifying candidates for direct hire. Its comprehensive registry of engineering and information technology professionals allows it to provide fully screened and qualified individuals very rapidly. TS can support its customers’ needs, whether the need is to manage a project or an entire test facility; provide a team to take a product from design to production, or staff a project on a temporary basis.

Most of TS customers are located in the United States. In August 2004, TS opened a test facility in Ho Chi Min City, Vietnam. This office is now operational and provides a low cost testing alternative. TS’s capabilities in Vietnam consist of a variety of services including system compatibility and integration test for computer software and hardware testing for business PC platforms for Windows and Linux operating systems.

Industry Overview

Over the years, businesses have become increasingly dependent on the use of contingent and consulting technical staff to manage operations more efficiently and to remain competitive. Important internal functions, ranging from financial reporting to production and inventory management, are automated through the use of applications software. In addition, as information systems have become less expensive, more powerful and easier to use, the number and level of employees who use and depend upon these systems have significantly increased.

As employment growth slows overall, companies that provide personnel will have a slightly larger share of the overall number of employed persons. Temporary workers continue to make inroads notably engineering, law information technology and finance. Public companies having implemented Sarbanes-Oxley, have established new bookkeeping rules and have turned their interest to financial information collection and dissemination which has started to translate into demand for information technology personnel. Companies that can demonstrate that they can lower costs and improve the speed and quality of hiring will see growth over the next three years.

Using outside technical resources and consultants allows a company’s management to focus on core business operations, affords greater flexibility and increases a company’s ability to adapt to and keep pace with rapidly changing and increasingly complex technologies. It also provides access to specialized technical skills on a project-by-project basis which better matches staffing levels to current needs, converts

7

---

fixed labor costs into variable costs, and reduces the cost of recruiting, and training and terminating employees as evolving technologies require new programming skills.

Technical Solutions Services

Technical Solutions services comprise primarily of IT, Engineering and Managed Services.

IT Testing & Software Engineering.   In fiscal 2006, information technology services represented 51% of the overall TS revenues. This area significantly increased as we focused on the engineering segment of information technology, including such skill areas as systems and software engineers. Approximately 24% of the revenue in this segment came from financial and commercial clients.

Engineering.   In fiscal 2006, engineering services represented 21% of the overall TS revenues. We saw a significant increase in our engineering direct hire activity throughout this fiscal year.

Managed Services.   Managed Services provided to clients on site represented 28% of the overall TS revenues. TS continues to leverage its technical competencies to provide clients with on-site program management to augment their test and staff augmentation activities. Managed Services supports both Engineering and IT service areas.

Geographic Locations

In the United States, Technical Solutions offices are located in Culver City, San Mateo, California, Salem, New Hampshire, Columbia, South Carolina, Austin, Texas and Troy, Michigan. Internationally, TS has an office in Ho Chi Min City, Vietnam. TS’s headquarters are located in Culver city, California. In addition, TS has program managers on client sites in Woodland Hills and San Diego, California, and Houston, Texas.

Business Strategy

TS continues to strengthen its proprietary database to meet the changes and demands in the business environment. Recognizing that the era of human capital has arrived, we know that the transformation we started in 2003 related to how we source, train, qualify and maintain relationships with our experts and consultants will allow us to adjust rapidly to the dramatic changes created by the demand for “hot skills,” both engineering and IT, and be ahead of the predictions of the looming U.S. labor shortage. Our recruitment process has “come of age” and having our experts accessible and ready at the right time is a key component of our business strategy.

TS continues to source, quality and develop a database of engineering and technical skills that support the technical requirements of customers. The development of the proprietary database, the centerpiece of our transformation, is making a difference, as we are able to support our clients in recruiting the brightest and best. TS also continues to enhance operational efficiencies in its accounting, sales, recruiting and marketing operations. TS continues to differentiate itself from its competitors by using NTS’ testing, engineering and compliance capabilities to maximize its customers’ return on human assets.

TS’s strategy is to continue efforts to improve revenue and profit by rigorously focusing on industries, markets and clients that have the strongest long-term growth opportunities, increasing productivity by improving its internal processes, diversifying the range of services it provides to its existing customers, attracting and retaining qualified technical consultants from a variety of sources, both national and international, and pursuing strategic relationships with non-competing organizations. Our company-wide sales force, aligned with our strategy, promotes cross-selling and lead generation between existing customers of one business unit to another. TS strives to provide its customers with technical personnel with the right skills, at the right time, for the right duration and at a cost that is lower than what its customers could otherwise achieve.

8

---

(iii)   Competition

Engineering & Evaluation

E&E competes with a small number of large conformity assessment organizations, including government laboratories, within each of the markets it serves. It also competes with a large number of small niche oriented test laboratories. It has competitive advantages in several areas which include the following: (1) ability to service customers at facilities close to their locations; (2) ability to provide complete conformity assessment activities at a single location, which reduces product-handling cost for the customers and enhances timeliness of service; (3) diverse and technically competent employees; and (4) accreditations that allow the E&E segment’s test data to be accepted worldwide. Customers can use the Company’s complete services, including quality registration, to position their products for the world markets.

In the aerospace and defense markets, the main competition for independent laboratories is the customers’ own laboratories, including government laboratories.

Technical Solutions

Potential customers for services offered by the Technical Solutions segment are from a broad base of high technology and manufacturing companies. Competition in this segment comes from a large number of public and privately held companies. The Company competes in this segment primarily on the basis of its niche position, price and quality service.

The Company’s engineering and testing services gives the Company an advantage over most staffing companies, which merely provide personnel as contractors, by understanding the technical challenges facing its customers and providing the expertise to meet those challenges.

Many large companies are increasingly using primary suppliers to fulfill their staffing needs. Technical Solutions competes with and, in certain relationships, teams with other major staffing companies in actively pursuing primary supplier relationships with large customers in its existing markets. These relationships can have a significant impact on Technical Solutions’ revenues and operating profits.

(iv)   Backlog

The Company’s backlog at January 31, 2006 and 2005 was as follows:

 

The Company estimates that approximately 85% of the backlog at January 31, 2006 will be completed by January 31, 2007.

(v)   General

a.   Service Marks.

The Company has registered its service marks “NTS” and “XXCAL” with the U.S. Patent and Trademark Office.

9

---

b.   Environmental Effect.

We are subject to various federal, state, local and foreign government requirements regulating the discharge of materials into the environment or otherwise relating to the protection of the environment. It is our policy to comply with these requirements, and we believe that, as a general matter, our policies, practices and procedures are properly designed to prevent unreasonable risk of environmental damage, and of resulting financial liability, in connection with our business. Some risk of environmental damage is, however, inherent in some of our operations, as it is with other companies engaged in similar businesses.

The Company’s Santa Clarita, California test facility is located immediately adjacent to property owned by a third party which has been the subject of extensive environmental remediation. The adjacent site has, in the past, been used for manufacture of solid rocket fuel propellants, munitions and flares that contained perchlorate, a hazardous substance. Soil samples taken from the Santa Clarita property in 2003 were inconclusive as to the existence of perchlorate. Heavy rainfall last year resulted in a run off from the adjacent site onto the Santa Clarita property. The Company arranged for samples to be taken of the surface water from the adjacent site and early indications are that the tested water contains high levels of perchlorate. Further testing will be conducted in cooperation with the government agency having oversight responsibility for the adjacent site. No cleanup activity has been conducted on the Santa Clarita property and it has yet to be determined whether remediation will be required at the site, or, if required, the extent and cost of any remediation. The Company believes that in the event it does incur remediation costs that it will have valid claims for indemnification against the owner of the adjacent site and the municipality that built a road between the adjacent site and the Santa Clarita property that appears to have contributed to the runoff from the adjacent site. Recovery of such remediation costs may, however, be uncertain and may involve significant litigation expense.

c.   Seasonal Effect.

The Company experiences no material seasonal effects.

Employees.

The Company employed 847 individuals at January 31, 2006 and 887 at January 31, 2005, as follows:

*                    The Technical Solutions total for 2006 includes 274 contract employees and 72 subcontractors, as compared to 318 contract employees and 98 subcontractors for 2005. None of the employees of the Company are represented by a union. The Company considers its relationship with its employees to be good.

ITEM 1A.        RISK FACTORS.

The factors discussed below are cautionary statements that identify important factors that could cause actual results to differ materially from those anticipated in the forward-looking statements in this Form 10-K. Any of the following risks may have a material negative impact on the Company’s financial condition.

10

---

The Company is subject to the effects of general economic and market conditions (including economic disruption caused by terrorist acts). If the economic conditions worsen, the Company may experience material adverse effects on its business, operating results, and financial condition.

The Company experienced significant growth in recent years, partly due to domestic and worldwide political and economic developments that have positively affected the markets for defense and advanced technology systems. Homeland security and defeating terrorism have been among the Department of Defense’s main initiatives. A slowing in defense spending due to political or budget shifts will put downward pressure on the Company’s revenues and gross margins.

Results may be adversely affected by:

·       Increased competition from the Company’s own customers’ in-house testing laboratories or from government laboratories;

·       Increased competition from large conformity assessment organizations and small niche oriented test laboratories;

·       The loss of significant customers or significant decreases in their purchasing volume;

·       Environmental issues arising from the use of hazardous substances;

·       Pricing concessions that may be given on volume sales due to competition;

·       The rescheduling or cancellation of customer orders;

·       Fluctuations and availability of certain raw materials or components that are needed to test customers’ products;

·       The loss of key management or technical personnel;

·       The financial condition of the Company’s major customers;

·       Fraudulent transactions committed against the Company;

·       U.S. government defense programs are subject to special risk, including dependence on government appropriations, contract termination without cause, contract renegotiations, and intense competition for the available defense business;

·       Inability to find temporary workers with the skills required by customers in the Technical Solutions segment;

·       The inability to procure sufficient insurance to cover operational and contractual risks;

·       The inability to expand in international markets due to the Company’s limited experience;

·       The Company may be required to record a charge to earnings if  goodwill becomes impaired;

·       Program performance (including the ability to perform fixed-price contracts within estimated costs and the timing of test report deliveries);

·       Future changes in zoning could adversely affect the Company’s ability to fully utilize its facilities to service its clients;

·       The Company’s California facilities, including its principal executive offices, are located near major earthquake fault lines. A major earthquake or any other natural disaster in a region near any of the Company’s facilities, could materially and adversely affect the Company’s business; and

·       To remain competitive, the Company must be able to respond effectively to technological changes and be able to hire, train and retain highly skilled sales, engineering and technical personnel.

ITEM 1B.       UNRESOLVED STAFF COMMENTS.

Not applicable.

11

ITEM 2.                PROPERTIES.

A.   Operations.   The Company owns/leases and operates the following properties:

 

 

*                    Please refer to “Environmental Matters” in Item 7a

The Company believes that the space occupied by all of its operations is adequate for its current and near-term requirements. Should additional space be required, the Company does not anticipate problems in securing such additional space.

B.   Investment Properties.

In fiscal year 2005, the Company sold a condominium in Palm Desert and purchased a new condominium, which is also located in Palm Desert. The Company recorded a gain of approximately $158,000 from the sale of the old condominium in fiscal year 2005. In fiscal year 2006, the Company sold the new condominium in Palm Desert and recorded a gain of approximately $163,000.

12

---

ITEM 3.                LEGAL PROCEEDINGS.

The Company is, from time to time, the subject of claims and suits arising out of matters occurring during the operation of the Company’s business. In the opinion of management, no pending claims or suits would materially affect the financial position or the results of the operations of the Company. (See Note 9 to the Consolidated Financial Statements in Item 8.)

ITEM 4.                SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS.

Not applicable.

PART II

ITEM 5.                MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED SHAREHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES.

A.   Market Information.

The Company’s common stock is traded in the over-the-counter bulletin board and quoted on the Nasdaq National Market under the symbol “NTSC”. The range of high and low quotations as reported by the Nasdaq Intra Dealer Quotation System for each of the quarters of the fiscal years ended January 31, 2006 and 2005 is presented below:

 

B.   Holders.

As of the close of business on April 17, 2006, there were 781 holders of record of the Company’s common stock. The number of holders of record is based on the actual number of holders registered on the books of the Company’s transfer agent and does not reflect holders of shares in “street name” or persons, partnerships, associations, corporations or other entities identified in security position listings maintained by depository trust companies.

C.   Dividends.

The Company’s Board of Directors announced the discontinuance of the Company’s policy of paying ordinary and special dividends on February 6, 2001. The Company does not anticipate paying dividends in the foreseeable future.

D.   Securities Authorized for Issuance Under Equity Compensation Plans.

Refer to Item 12 below for information regarding the Company’s equity compensation plans.

13

---

ITEM 6.                SELECTED CONSOLIDATED FINANCIAL DATA.

The following selected consolidated financial data are derived from and should be read in conjunction with the Company’s consolidated financial statements and related notes set forth in Item 8 below.

*                    Per share data may not always summate because each figure is independently calculated.

14

ITEM 7.                MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS.

Except for the historical information contained herein, statements in the following section are 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. Actual outcomes are dependent upon National Technical Systems, Inc.’s (“NTS” or the “Company”) successful performance of internal plans, ability to effectively integrate acquired companies, customer changes in short range and long range plans, competition in the Company’s services areas and pricing, continued acceptance of new services, performance issues with key customers, and general economic risks and uncertainties.

OVERVIEW

NTS is a diversified services company that supplies testing outsourcing services and conformity assessment and personnel to businesses in a variety of industries including aerospace, defense, transportation, power products, electronics, computers and telecommunications. Through its wide range of testing facilities, staffing solutions and certification services, NTS provides its customers with 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.

NTS 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 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.

In fiscal 2006, NTS improved its top-line and bottom-line results. Revenues increased 5% to approximately $112 million and net income increased 75% to approximately $2.9 million. Diluted earnings per share increased to 30 cents per share in fiscal 2006 compared to 18 cents per share in fiscal 2005.

Summary of Revenues for fiscal years 2006 and 2005:

 

Revenues in the Engineering & Evaluation segment are generated from physical testing services which include simulation of harsh environments such as high/low temperature, shock, vibration, seismic and electromagnetic interference, and functional testing which requires equipment such as switches, routers, servers and high bandwidth access to the Internet to subject telecommunication equipment to a full spectrum of performance type testing. Revenues in this segment also include registration services which perform quality management audits to ISO 9000, quality training and laboratory accreditation. The Engineering & Evaluation segment is one of the largest independent conformity assessment organizations

15

---

in the U.S., with facilities throughout the United States and in Japan, Canada and Germany, serving a large variety of industries.

Revenues in the Technical Solutions segment are generated from a variety of staffing and workforce management services and solutions, including contract services, temporary and full time placements to meet its customers’ information technology (“IT”) such as help-desk analysts and managers, relational database administrators and developers, application and systems programmers, configuration and project managers and engineering service needs.

On March 18, 2005, the Company acquired the outstanding stock of Phase Seven Laboratories, located in Santa Rosa, California, for a total purchase price of $652,000, paid in cash and NTS stock. Phase Seven Laboratories provides carrier-class network interoperability, functionality and performance testing for new and emerging technologies and their integration with legacy systems. The results of operations of the acquired business are included in the accompanying consolidated statement of operations from March 18, 2005 to January 31, 2006.

On July 30, 2004, AETL Testing Inc. (a Canadian corporation), a wholly-owned subsidiary of the Company (“AETL”), acquired substantially all of the fixed assets of a Canadian test laboratory involved in the testing of telecommunications equipment, located in Calgary, Alberta, Canada, for a total purchase price of $1,033,000. This acquisition is intended to expand the Company’s presence in Canada and increase its opportunities in the testing of telecommunication equipment. The results of operations of the acquired business are included in the accompanying consolidated statement of operations from August 1, 2004 to January 31, 2005.

In January of 2004, NTS acquired substantially all of the assets and business of DTI Holdings, LLC, doing business as Dynamic Testing (“DTI”), for a total purchase price of $3,687,000. DTI provides large-scale shock and vibration testing services used to qualify mission critical equipment such as navigation, communication and guidance weapons installed on U.S. Navy combatants.

Summary of Cash Flows for fiscal years 2006 and 2005:

 

The increase in net cash provided by operating activities from FY 2005 to FY 2006 was primarily due to the increase in net income, depreciation expense and the effect of the changes in working capital. The Company used the cash generated from its operating activities to pay for capital expenditures, pay down debt and complete the acquisition of Phase Seven Laboratories. Overall, net cash decreased by $2,005,000 in fiscal 2006, compared to an increase of $1,540,000 in fiscal 2005.

Critical Accounting Policies

The consolidated financial statements of the Company are prepared in accordance with U.S. generally accepted accounting principles (“GAAP”), which require the Company to make certain estimates and assumptions (see Note 1 to the consolidated financial statements in Item 8). Estimates are based on historical experience and on various other assumptions that are believed to be reasonable under the

16

---

circumstances, the results of which form the basis for making judgments about the carrying value of assets and liabilities that are not readily apparent from other sources.

Management believes the following critical accounting policies, among others, affect its more significant judgments and estimates used in the preparation of its consolidated financial statements.

Revenue Recognition

Revenues are derived from development, qualification and production testing and engineering services for commercial products, space systems and military equipment of all types. The Company also provides technical staffing, qualification of safety related systems and components, and ISO 9000 certification services.

Revenue from fixed price testing contracts is generally recorded upon completion of the contracts, which are generally short-term, or upon completion of identifiable contractual tasks. At the time the Company enters into a contract that includes multiple tasks, the Company estimates the amount of actual labor and other costs that will be required to complete each task based on historical experience. Revenues are recognized which provide for a profit margin relative to the testing performed. Revenue relative to each task and from contracts which are time and materials based is recorded as effort is expended. Billings in excess of amounts earned are deferred. Any anticipated losses on contracts are charged to income when identified. To the extent management does not accurately forecast the level of effort required to complete a contract, or individual tasks within a contract, and the Company is unable to negotiate additional billings with a customer for cost over-runs, the Company may incur losses on individual contracts. All selling, general and administrative costs are treated as period costs and expensed as incurred.

Reimbursements, including those related to travel and other out-of-pocket expenses are included in revenues and an equivalent amount of reimbursable expenses is included in operating costs and expenses.

Allowance for Uncollectible Receivables

The Company maintains an allowance for doubtful accounts for estimated losses resulting from the inability of customers to make required payments. The Company uses a combination of write-off history, aging analysis and any specific known troubled accounts in determining the allowance. If the financial condition of customers were to deteriorate, resulting in an impairment of their ability to make payments, additional allowances could be required.

Inventories

Inventories consist of accumulated costs including direct labor, material and overhead applicable to uncompleted contracts and are stated at actual cost, which is not in excess of estimated net realizable value. Such inventories for each contract are reviewed on a monthly basis over the life of the contract and additional write-downs of inventories are made if there are insufficient revenues remaining on the contract.

Deferred Income Taxes

At January 31, 2006, the Company has recorded a deferred tax asset of $1,747,000. The Company has recorded this asset as it believes that it is more likely than not that the Company will be able to realize the asset through reduction of future taxable income. The Company bases this belief upon the levels of taxable income historically generated by its business, as well as projections of future taxable income. If future levels of taxable income are not consistent with its expectations, the Company may be required to record a valuation allowance, which could reduce its net income by a material amount. At January 31, 2006, the Company was in a net deferred tax loss position of $3,337,000.

17

---

Recently Issued Accounting Standards

On December 16, 2004, the Financial Accounting Standards Board (“FASB”) issued FASB Statement No. 123 (revised 2004), “Share-Based Payment”, which is a revision of FASB Statement No. 123, “Accounting for Stock-Based Compensation”. Statement 123 (R) supersedes APB Opinion No. 25, Accounting for Stock Issued to Employees, and amends FASB Statement No. 95, “Statement of Cash Flows”. Generally, the approach in Statement 123 (R) is similar to the approach described in Statement 123. However, Statement 123 (R) requires all share-based payments to employees, including grants of employee stock options, to be recognized in the Consolidated Statements of Income based on their fair values.

In April 2005, the Securities and Exchange Commission (“SEC”) extended the adoption date for Statement 123 (R) until the first quarter of the first fiscal year beginning after June 15, 2005, which in the case of National Technical Systems, Inc. will be the first quarter ending April 30, 2006.

As permitted by Statement 123, through January 31, 2006, the Company accounted for share-based payments to employees using APB Opinion 25’s intrinsic value method and, as such, generally recognize no compensation cost for employee stock options. Accordingly, the adoption of Statement 123 (R)’s fair value method is expected to reduce earnings per share by less than $.01 per share on a quarterly basis, beginning in fiscal year 2007. Had we adopted Statement 123 (R) in prior periods, the impact of that standard would have approximated the impact of Statement 123 as described in the disclosure of pro forma net income and earnings per share presented above. Statement 123 (R) also requires the benefits of tax deductions in excess of recognized compensation cost to be reported as a financing cash flow, rather than as an operating cash flow as required under current literature. This requirement will reduce net operating cash flows and increase net financing cash flows in periods after adoption. While we cannot estimate what those amounts will be in the future (because they depend on, among other things, when employees exercise stock options), the amount of operating cash flows recognized for such tax deductions were $56,000, $74,000 and $44,000, respectively,  for the years ended January 31, 2006, 2005 and 2004.

The pro forma information in the accompanying financial statements presents the estimated compensation charges under Statement 123. The Company’s assessment of the estimated compensation charges is affected by the Company’s stock price as well as assumptions regarding a number of complex and subjective variables and the related tax impact. These variables include, but are not limited to, the Company’s stock price volatility and employee stock option exercise behaviors. The Company will recognize the compensation cost for stock-based awards on a straight-line basis over the requisite service period for the entire award.

Off-Balance Sheet Arrangements

The Company does not have any special purpose entities or off-balance sheet financing arrangements.

18

---

Results of Operations

The following discussion should be read in conjunction with the consolidated financial statements and notes thereto.

REVENUES

 

For the year ended January 31, 2006, total revenues increased $5,010,000 or 4.7%, as compared to the prior year. The year over year growth was primarily attributable to strong organic growth in the Engineering and Evaluation segment combined with growth from acquisitions, offset by a decrease in revenues in the Technical Solutions segment.

For the year ended January 31, 2005, total revenues increased $1,964,000 or 1.9%, as compared to fiscal 2004.

Engineering & Evaluation:

For the year ended January 31, 2006, revenues in the Engineering & Evaluation segment increased $9,658,000 or 15.4%, as compared to the prior year, primarily due to strong testing revenues in the aerospace and defense markets. Revenues also increased in the telecommunications market, as a result of additional revenues of $1,330,000 from the acquisition of the testing laboratory in Calgary, Canada on August 1, 2004 and revenues of $934,000 from the acquisition of Phase Seven Laboratories in Santa Rosa, California on March 18, 2005. These increases were partially offset by a decrease in passive fiber optic testing, and decrease in the electronic and automotive testing businesses.

For the year ended January 31, 2005, revenues in the Engineering & Evaluation segment increased $4,441,000 or 7.6%, as compared to fiscal 2004, primarily due to revenues of $3,718,000 and $531,000, respectively, in fiscal 2005 from the acquisition of DTI Holdings, LLC, in Rustburg Virginia, and the acquisition of a telecommunications test laboratory in Calgary, Canada. Revenues also increased in the Company’s space and automotive testing businesses. These increases were partially offset by the decrease in the passive fiber optic testing business and the decrease in defense related business at the Camden, Arkansas facility due to revenues from a major contract related to the war on terrorism that was completed in fiscal 2004.

Technical Solutions:

For the year ended January 31, 2006, revenues in the Technical Solutions segment decreased by $4,648,000 or 10.6%, as compared to the prior year, primarily due to the competitive environment in the general IT service business from off-shore companies and the discontinuance of certain services that did not fit the Company’s overall strategy. To offset this decline, the Company is deploying a migration strategy by cross selling to clients currently being serviced by the Engineering and Evaluation segment.

For the year ended January 31, 2005, revenues in the Technical Solutions segment decreased by $2,477,000 or 5.4%, as compared to fiscal 2004, as a result of the continued degradation of the IT market staffing business due to competition from off-shore companies and the loss of certain customers in geographic areas where the Company discontinued its sales and marketing efforts.

19

GROSS PROFIT

 

For the year ended January 31, 2006, total gross profit increased $3,543,000 or 15.0%, as compared to the prior year. The year over year growth was primarily attributable to the strong growth in revenues in the Engineering and Evaluation segment, combined with cost reductions attributable to increased process efficiencies.

For the year ended January 31, 2005, total gross profit increased $1,075,000 or 4.8%, as compared to fiscal 2004.

Engineering & Evaluation:

For the year ended January 31, 2006, gross profit in the Engineering & Evaluation segment increased by $3,698,000 or 22.1%, as compared to the prior year, primarily as a result of the revenue increase discussed above. Gross profit margin as a percentage of revenues increased to 28.2% in the current year from 26.7% in the prior year, primarily due to labor cost containments as a result of improved process efficiencies. This was offset by increases in depreciation expense as a result of capital spending on machinery and equipment and increases in utilities expense.

For the year ended January 31, 2005, gross profit in the Engineering & Evaluation segment increased by $1,232,000 or 8.0%, as compared to fiscal 2004, primarily as a result of the increase in revenues. Gross profit margin as a percentage of revenues increased slightly to 26.7% in fiscal 2005, compared to 26.6% in fiscal 2004.

Technical Solutions:

For the year ended January 31, 2006, gross profit in the Technical Solutions segment decreased by $155,000 or 2.2%, as compared to the prior year, primarily as a result of the revenue decrease discussed above. The Company was successful in minimizing this decrease as a result of the increased focus in specialized compliance and engineering support services which generally produce higher margins. Gross profit margin as a percentage of revenues increased to 17.4% in the current year from 15.9% in the prior year.

For the year ended January 31, 2005, gross profit in the Technical Solutions segment decreased by $157,000 or 2.2%, as compared to fiscal 2004, primarily as a result of the decrease in revenues. Gross profit margin as a percentage of revenues increased to 15.9% in fiscal 2005 from 15.4% in fiscal 2004.

20

---

SELLING, GENERAL & ADMINISTRATIVE

 

For the year ended January 31, 2006, total selling, general and administrative expenses increased $763,000 or 3.7%, as compared to the prior year. The year over year growth was primarily attributable to increased general and administrative costs in the engineering and evaluation segment, offset by a reduction in selling and general and administrative costs in the technical staffing segment.

For the year ended January 31, 2005, total selling, general and administrative expenses increased $1,154,000 or 5.9%, as compared to fiscal 2004.

Engineering & Evaluation:

For the year ended January 31, 2006, selling, general and administrative expenses increased by $956,000 or 6.7%, as compared to the prior year, primarily due to increased wages and incentive compensation, increased use of outside services related to the improvement of the Company’s internal IT infrastructure and data automation and increased legal expense.

For the year ended January 31, 2005, selling, general and administrative expenses increased by $1,643,000 or 13.0%, as compared to fiscal 2004, primarily due to sales costs related to efforts to expand the Company nationally and internationally and the addition of new sales, customer service representatives and regional management, increases in outside services related to the improvement of the Company’s internal IT infrastructure and website and increased costs to prepare for compliance with Section 404 of the Sarbanes-Oxley Act.

Technical Solutions:

For the year ended January 31, 2006, selling, general and administrative expenses decreased by $193,000 or 3.0% as compared to the prior year, primarily due to decreases in depreciation expense, general and administrative salaries and selling costs associated with the lower revenues.

For the year ended January 31, 2005, selling, general and administrative expenses decreased by $489,000 or 7.1%, as compared to fiscal 2004, primarily due to the reduction in selling costs associated with the lower revenues and other administrative cost reductions.

Equity Income from Non-Consolidated Subsidiary:

Engineering & Evaluation:

For the year ended January 31, 2006, equity income from XXCAL Japan was $259,000, compared to $483,000 in the prior year. The decrease of $224,000 was primarily due to lower revenues caused by a reduction in test requirements from a major Japanese client and increased operating costs related to hiring and training additional technical personnel for new testing initiatives. XXCAL Japan is 50% owned by NTS and is accounted for under the equity method since NTS does not have management or board control.

21

---

OPERATING INCOME

 

For the year ended January 31, 2006, operating income increased $2,556,000 or 72.6%, as compared to the prior year. The year over year growth was primarily attributable to the strong performance in the engineering and evaluation segment.

For the year ended January 31, 2005, operating income increased $306,000 or 9.5%, as compared to fiscal 2004.

Engineering & Evaluation:

For the year ended January 31, 2006, operating income increased by $2,518,000 or 86.3%, as compared to the prior year, as a result of the increase in gross profit discussed above, partially offset by the increase in selling, general and administrative expenses.

For the year ended January 31, 2005, operating income decreased by $26,000 or 0.9% as compared to fiscal 2004, as a result of the increase in selling, general and administrative expenses discussed above, partially offset by the increase in gross profit discussed above.

Technical Solutions:

For the year ended January 31, 2006, operating income increased by $38,000 or 6.2%, as compared to the prior year, as a result of the decrease in selling and general and administrative expenses discussed above, partially offset by the decrease in gross profit discussed above.

For the year ended January 31, 2005, operating income increased by $332,000 or 122.1% as compared to fiscal 2004, as a result of the decrease in selling and general and administrative expenses discussed above, partially offset by the decrease in gross profit discussed above.

Interest Expense

Interest expense increased $207,000 in fiscal 2006 when compared to fiscal 2005 primarily due to higher interest rate levels in fiscal 2006 offset by lower average debt balances in fiscal 2006, as compared to the prior year. Interest expense decreased $6,000 in fiscal 2005, compared to fiscal 2004 primarily due to lower interest rate levels in fiscal 2005 offset by slightly higher average debt balances in fiscal 2005 as compared to fiscal 2004.

Other Income

Other income of $176,000 in fiscal 2006 includes approximately $163,000 in gain from the sale of real estate. Other income of $162,000 in fiscal 2005 includes approximately $158,000 in gain from the sale of real estate.

22

---

Income Taxes

The provisional income tax rate for fiscal year 2006 is 39.7%, compared to 35.1% in the prior year. The increase in the income tax rate in fiscal 2006 was primarily due to lower earnings associated with the Company’s foreign subsidiary in the current year, as compared to the prior year. Earnings for this foreign subsidiary are reported net of tax and are included in income before income taxes and the associated tax is not separately stated in income taxes. The income tax rate for fiscal year 2004 was 45.7%. It reflects a rate in excess of the federal statutory rate primarily due to the inclusion of state income taxes and certain non-deductible expenses. See Note 4 to the consolidated financial statements for a reconciliation of the provision for income taxes from continuing operations at the statutory rate to the provision for income taxes from continuing operations.

Management has determined that it is more likely than not that the Company’s deferred tax asset will be realized on the basis of offsetting it against deferred tax liabilities and future income. The Company analyzes the value of the deferred income tax asset quarterly in conjunction with external reporting.

Net Income

In fiscal 2006, net income increased $1,257,000 to $2,939,000, as compared to the prior year, primarily due to the increase in operating income, partially offset by the increase in interest expense, increase in the income tax rate and minority interest.

In fiscal 2005, net income increased $389,000 to $1,682,000, as compared to fiscal 2004. This increase was due to the increase in operating income and the lower income tax rate, partially offset by the decrease in other income and minority interest.

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 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. 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 seen an increase in demand for the evaluation of military equipment and weapons systems, which has positively affected business at its laboratories. NTS continues to expand capacity and capability to service this demand. In Camden, Arkansas, the Company has installed a small and medium caliber test facility as well as added additional climatic environmental simulation chambers and a high performance electrodynamics vibration simulator. In Tinton Falls, New Jersey, the Company added additional electromagnetic interference and electromagnetic compatibility simulation capability and vibration and climatic environmental simulation. The Santa Clarita, California, facility was completely modified to more effectively handle satellite, defense and commercial aerospace work. The Company anticipates the level of customer demand will increase for the foreseeable future.

Telecommunications revenues increased substantially, year over year, as a result of an increase in demand of outsourcing compliance and certification activities by the Regional Bell Operating Companies (RBOCs). The trend  for the foreseeable future appears to be favorable. The Company has been approved as an Independent Test laboratory (ITL) by the RBOCs to test and certify central office equipment developed by manufactures to the Network Equipment Building Specifications (NEBS). The Company is

23

---

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 recently acquired a network architecture and interoperability laboratory in Northern California. This laboratory was acquired to extend the Company’s service offering to handle the anticipated demand for interoperability testing and the FTTP deployment.

The transportation and power markets have been stable with the Company experiencing slight incremental decrease in the transportation business, while the Company is experiencing a slight incremental increase in the power business. The Company anticipates that these two markets will remain stable with no significant external growth.

The computer and electronics markets have been stable with the Company experiencing a decrease in the Japan operation and an increase in the US operation. 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. As the IT general services business went off-shore and became commodity by the larger organizations the Company deployed a transformation strategy in 2003 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 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.

24

---

Liquidity and Capital Resources

Summary of cash flows:

 

Net cash provided by operating activities of $9,535,000 in fiscal 2006 consisted of net income of $2,939,000 adjusted for non-cash items of $5,283,000 in depreciation and amortization and $1,760,000 of changes in working capital and other activities, partially offset by $447,000 in other non-cash items. The increase in cash provided by operating activities from fiscal 2005 to fiscal 2006 was primarily the result of higher net income in fiscal 2006, the increase in depreciation expense, the changes in accounts payable, accrued expenses, income taxes receivable, income taxes payable, partially offset by the changes in accounts receivable, inventories and deferred income taxes. Net cash provided by operating activities of $6,590,000 in fiscal 2005 consisted of net income of $1,682,000 adjusted for non-cash items of $4,798,000 in depreciation and amortization and $302,000 in other non-cash items, partially offset by $192,000 of changes in working capital and other activities. The decrease in cash provided by operating activities from fiscal 2004 to fiscal 2005 was primarily the result of the change in accounts receivable, the increase in accounts payable payments, partially offset by the higher net income in fiscal 2005. Net cash provided by operating activities of $8,804,000 in fiscal 2004 consisted of net income of $1,293,000 adjusted for non-cash items of $4,776,000 in depreciation and amortization and $379,000 in other non-cash items, and $2,356,000 of changes in working capital and other activities. Working capital changes included a decrease in accounts receivable balances of approximately $2,238,000, reflecting improved collection performance in fiscal 2004. The increase in cash provided by operating activities from fiscal 2003 to fiscal 2004 was primarily the result of the change in accounts receivable and the higher net income in fiscal 2004.

Net cash used for investing activities in fiscal 2006 of $7,408,000 was primarily attributable to capital spending of $7,287,000 and cash used in the acquisition of Phase Seven Laboratories in the amount of $483,000, partially offset by proceeds from the sale of real estate of $543,000. Capital spending is generally comprised of purchases of machinery and equipment, building, leasehold improvements, computer hardware, software and furniture and fixtures. Cash used in investing activities increased from fiscal 2005 to fiscal 2006 by $1,319,000 primarily as a result of an increase in capital spending of $2,098,000, in fiscal 2006, partially offset by a decrease of $550,000 in cash spent on acquisitions. Net cash used for investing activities in fiscal 2005 of $6,089,000 was primarily attributable to capital spending of $5,189,000 and cash used in the acquisition of the Canadian test laboratory for $1,033,000, partially offset by proceeds from the sale of real estate of $311,000. Cash used in investing activities decreased from fiscal 2004 to fiscal 2005 by $1,381,000 primarily as a result of the acquisition of DTI in fiscal 2004. Net cash used for investing activities in fiscal 2004 of $7,470,000 was primarily attributable to capital spending of $4,599,000 and cash used in the acquisition of DTI for $2,687,000. Cash used in investing activities increased from fiscal 2003 to fiscal 2004 by $2,685,000 primarily as a result of the acquisition of DTI and an increase of approximately $1 million in capital spending in fiscal 2004.

Net cash used for financing activities in fiscal 2006 of $4,180,000 consisted of repayments of debt of $7,075,000, partially offset by proceeds from borrowings of $2,651,000 and proceeds from stock options exercised of $244,000. Net cash provided by financing activities in fiscal 2005 of $1,026,000 consisted of proceeds from borrowings of $2,228,000, proceeds from stock options exercised of $300,000, partially offset

25

---

by repayments of debt of $1,502,000. Net cash used for financing activities in fiscal 2004 of $232,000 consisted of repayments of debt of $2,141,000, common stock repurchase of $106,000, offset by proceeds from borrowings of $1,831,000 and proceeds from stock options exercised of $184,000.

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 line of credit balance 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 and the maturity date was extended to August 1, 2007. The outstanding balance on the term loan at January 31, 2006 was $2,208,000. The outstanding balance on the revolving line of credit at January 31, 2006 was $8,500,000. This balance is reflected in the accompanying condensed consolidated balance sheets as long-term. The amount available on the line of credit was $8,000,000 as of January 31, 2006. The amendment also includes an additional equipment line of credit for $2,000,000. The outstanding balance on the equipment line of credit at January 31, 2006 was $2,000,000, which was converted to a term loan to be repaid in 48 equal monthly payments. 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 as of January 31, 2006, with the exception of the capital expenditure covenant which was in excess of the allowed amount. The Company requested and received a waiver from its banks.

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 January 31, 2006 was $1,798,000. The balance of other notes payable collateralized by land and building was $2,602,000 at January 31, 2006.

Contractual Obligations:

 

Management is not aware of any significant demands for capital funds that may materially affect short or long-term liquidity in the form of large fixed asset acquisitions, unusual working capital commitments or contingent liabilities. In addition, the Company has made no material commitments for capital expenditures. The Company’s long-term debt may be accelerated if the Company fails to meet its covenants with its banks. The Company believes that the cash flow from operations and the revolving line of credit will be sufficient to fund its operations for the next twelve months.

26

---

ITEM 7A.        QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.

Interest Rate Risk

The Company is exposed to changes in interest rates primarily from its long-term revolving line of credit arrangement. Under its current policies, the Company does not use interest rate derivative instruments to manage exposure to interest rate changes. A hypothetical one percentage point adverse move in interest rates along the entire interest rate yield curve would adversely affect interest expense by $85,000 at January 31, 2006 as compared to $160,000 at January 31, 2005.

Environmental Matters

An internal environmental compliance group formed in 1991 continues to review environmental matters for the Company.

Although the Company’s business does not involve the manufacture or extensive use of hazardous substances, the Company does have a program to ensure compliance with applicable environmental laws at its various testing facilities, which includes conducting regular internal audits to identify and categorize potential environmental exposure.

The Company’s Santa Clarita, California test facility is located immediately adjacent to property owned by a third party which has been the subject of extensive environmental remediation. The adjacent site has, in the past, been used for manufacture of solid rocket fuel propellants, munitions and flares that contained perchlorate, a hazardous substance. Soil samples taken from the Santa Clarita property in 2003 were inconclusive as to the existence of perchlorate. Heavy rainfall last year resulted in a run off from the adjacent site onto the Santa Clarita property. The Company arranged for samples to be taken of the surface water from the adjacent site and early indications are that the tested water contains high levels of perchlorate. Further testing will be conducted in cooperation with the government agency having oversight responsibility for the adjacent site. No cleanup activity has been conducted on the Santa Clarita property and it has yet to be determined whether remediation will be required at the site, or, if required, the extent and cost of any remediation. The Company believes that in the event it does incur remediation costs that it will have valid claims for indemnification against the owner of the adjacent site and the municipality that built a road between the adjacent site and the Santa Clarita property that appears to have contributed to the runoff from the adjacent site. Recovery of such remediation costs may, however, be uncertain and may involve significant litigation expense.

Impact of Inflation

The Company continues to incur increased costs in the areas of wages, insurance, workers compensation, and utilities which it cannot pass along to customers in the current economic environment. To date, these increases have been partially offset by reductions in other operating areas through improved efficiencies. The Company can give no assurances, however, that in the future it can offset such increased costs.

27

ITEM 8.                CONSOLIDATED FINANCIAL STATEMENT AND SUPPLEMENTARY DATA.

Index to Consolidated Financial Statements and Schedule

All other schedules are omitted as inapplicable or because the required information is contained in the financial statements or the notes thereto.

28

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

The Board of Directors and Shareholders
National Technical Systems, Inc.

We have audited the accompanying consolidated balance sheets of National Technical Systems, Inc. and Subsidiaries as of January 31, 2006 and 2005, and the related consolidated statements of income, shareholders’ equity and cash flows for each of the three years in the period ended January 31, 2006. Our audits also included the financial statement schedule listed in the Index at Item 15(a). These financial statements and schedule are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements and schedule based on our audits. The financial statements of XXCAL Japan (a corporation in which the Company has a 50% interest), have been audited by other auditors whose report has been furnished to us, and our opinion on the consolidated financial statements, insofar as it relates to the amounts included for XXCAL Japan, is based solely on the report of the other auditors. In the consolidated financial statements, the Company’s investment in XXCAL Japan is stated at $1,019,000 and $760,000, respectively, at January 31, 2006 and 2005, and the Company’s equity in the net income of XXCAL Japan is stated at $259,000 and $483,000, for the years then ended.

We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. We were not engaged to perform an audit of the Company’s internal control over financial reporting. Our audits included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company’s internal control over financial reporting. Accordingly, we express no such opinion. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits and the report of other auditors provide a reasonable basis for our opinion.

In our opinion, based on our audits and the report of other auditors, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of National Technical Systems, Inc. and Subsidiaries at January 31, 2006 and 2005 and the consolidated results of their operations and their cash flows for each of the three years in the period ended January 31, 2006, in conformity with U.S. generally accepted accounting principles. Also, in our opinion, the related financial statement schedule, when considered in relation to the basic financial statements taken as a whole, presents fairly, in all material respects, the information set forth therein.

 

29

NATIONAL TECHNICAL SYSTEMS, INC. AND SUBSIDIARIES
Consolidated Balance Sheets
January 31,

 

See accompanying notes.

30

NATIONAL TECHNICAL SYSTEMS, INC. AND SUBSIDIARIES
Consolidated Statements of Income
Years Ended January 31,

 

See accompanying notes.

31