10-Q 1 d72698_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 July 31, 2007 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 September 11, 2007 was 8,814,351 NATIONAL TECHNICAL SYSTEMS, INC. AND SUBSIDIARIES Index PART I. FINANCIAL INFORMATION Page No. Item 1. Financial Statements: Condensed Consolidated Balance Sheets as of July 31, 2007 (unaudited) and January 31, 2007 3 Unaudited Condensed Consolidated Statements of Income For the Six Months Ended July 31, 2007 and 2006 4 Unaudited Condensed Consolidated Statements of Income For the Three Months Ended July 31, 2007 and 2006 5 Unaudited Condensed Consolidated Statements of Cash Flows For the Six Months Ended July 31, 2007 and 2006 6 Notes to the Unaudited Condensed Consolidated Financial Statements 7 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations 11 Item 3. Quantitative and Qualitative Disclosures About Market Risk 20 Item 4. Controls and Procedures 20 PART II. OTHER INFORMATION & SIGNATURE Item 1. Legal Proceedings 21 Item 1A. Risk Factors 21 Item 2. Unregistered Sales of Equity Securities and Use of Proceeds 21 Item 3. Defaults Upon Senior Securities 21 Item 4 Submission of Matters to a Vote of Security Holders 21 Item 5. Other Information 21 Item 6. Exhibits 21 Signature 22 2 PART I - FINANCIAL ITEM 1. FINANCIAL STATEMENTS NATIONAL TECHNICAL SYSTEMS, INC. AND SUBSIDIARIES Condensed Consolidated Balance Sheets

At At July 31, January 31, 2007 2007 ASSETS (unaudited) --------------------------------- CURRENT ASSETS: Cash $ 3,969,000 $ 3,221,000 Accounts receivable, less allowance for doubtful accounts of $944,000 at July 31, 2007 and $691,000 at January 31, 2007 24,115,000 21,900,000 Inventories, net 2,868,000 2,892,000 Deferred income taxes 1,821,000 1,690,000 Prepaid expenses 1,158,000 958,000 --------------------------------- Total current assets 33,931,000 30,661,000 Property, plant and equipment, at cost 103,718,000 101,489,000 Less: accumulated depreciation (69,004,000) (66,055,000) --------------------------------- Net property, plant and equipment 34,714,000 35,434,000 Goodwill 4,390,000 4,126,000 Other assets 5,328,000 4,618,000 --------------------------------- TOTAL ASSETS $ 78,363,000 $ 74,839,000 ================================= LIABILITIES AND SHAREHOLDERS' EQUITY CURRENT LIABILITIES: Accounts payable $ 5,300,000 $ 5,843,000 Accrued expenses 6,038,000 5,213,000 Income taxes payable 144,000 401,000 Deferred income 2,064,000 832,000 Current installments of long-term debt 3,610,000 3,285,000 --------------------------------- Total current liabilities 17,156,000 15,574,000 Long-term debt, excluding current installments 19,412,000 19,238,000 Deferred income taxes 4,754,000 5,052,000 Deferred compensation 992,000 946,000 Minority interest 276,000 250,000 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, 8,814,000 as of July 31, 2007 and 8,717,000 as of January 31, 2007 13,504,000 12,863,000 Retained earnings 22,332,000 20,971,000 Accumulated other comprehensive loss (63,000) (55,000) --------------------------------- Total shareholders' equity 35,773,000 33,779,000 --------------------------------- TOTAL LIABILITIES AND SHAREHOLDERS' EQUITY $ 78,363,000 $ 74,839,000 =================================

See accompanying notes to condensed consolidated financial statements. 3 NATIONAL TECHNICAL SYSTEMS, INC. AND SUBSIDIARIES Unaudited Condensed Consolidated Statements of Income for Six Months Ended July 31, 2007 and 2006

2007 2006 ------------------------------- Net revenues $ 60,829,000 $ 56,589,000 Cost of sales 45,685,000 43,772,000 ------------------------------- Gross profit 15,144,000 12,817,000 Selling, general and administrative expense 12,082,000 11,157,000 Equity income from non-consolidated subsidiary (71,000) (135,000) ------------------------------- Operating income 3,133,000 1,795,000 Other income (expense): Interest expense, net (932,000) (812,000) Other income, net 127,000 129,000 ------------------------------- Total other expense, net (805,000) (683,000) Income before income taxes and minority interest 2,328,000 1,112,000 Income taxes 942,000 474,000 ------------------------------- Income before minority interest 1,386,000 638,000 Minority interest (25,000) (39,000) ------------------------------- Net income $ 1,361,000 $ 599,000 =============================== Earnings per common share: Basic $ 0.16 $ 0.07 =============================== Diluted $ 0.15 $ 0.06 =============================== Weighted average common shares outstanding 8,761,000 8,718,000 Dilutive effect of stock options 620,000 799,000 ------------------------------- Weighted average common shares outstanding, assuming dilution 9,381,000 9,517,000 ===============================

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 July 31, 2007 and 2006

2007 2006 ------------------------------- Net revenues $ 31,025,000 $ 28,438,000 Cost of sales 22,896,000 21,859,000 ------------------------------- Gross profit 8,129,000 6,579,000 Selling, general and administrative expense 6,300,000 5,747,000 Equity income from non-consolidated subsidiary (15,000) (60,000) ------------------------------- Operating income 1,844,000 892,000 Other income (expense): Interest expense, net (478,000) (451,000) Other income (expense), net (29,000) 123,000 ------------------------------- Total other expense, net (507,000) (328,000) Income before income taxes and minority interest 1,337,000 564,000 Income taxes 549,000 270,000 ------------------------------- Income before minority interest 788,000 294,000 Minority interest (18,000) (47,000) ------------------------------- Net income $ 770,000 $ 247,000 =============================== Earnings per common share Basic $ 0.09 $ 0.03 =============================== Diluted $ 0.08 $ 0.03 =============================== Weighted average common shares outstanding 8,779,000 8,544,000 Dilutive effect of stock options 664,000 899,000 ------------------------------- Weighted average common shares outstanding, assuming dilution 9,443,000 9,443,000 ===============================

See accompanying notes to condensed consolidated financial statements. 5 NATIONAL TECHNICAL SYSTEMS, INC. AND SUBSIDIARIES Unaudited Condensed Consolidated Statements of Cash Flows for the Six Months Ended July 31, 2007 and 2006

2007 2006 ------------------------------ CASH FLOWS FROM OPERATING ACTIVITIES: Net income $ 1,361,000 $ 599,000 Adjustments to reconcile net income to net cash provided by operating activities: Depreciation and amortization 3,013,000 2,819,000 Recoveries on receivables 254,000 111,000 Undistributed earnings of affiliate 26,000 39,000 Deferred income taxes (429,000) (154,000) Tax benefit from stock option exercises 114,000 234,000 Share based compensation 195,000 319,000 Net gain on insurance claim (97,000) -- Changes in operating assets and liabilities (net of acquisitions): Accounts receivable (2,469,000) (2,116,000) Inventories 24,000 104,000 Prepaid expenses (200,000) (343,000) Other assets and intangibles (477,000) (554,000) Accounts payable (543,000) 521,000 Accrued expenses 825,000 (1,067,000) Income taxes payable (257,000) (594,000) Deferred income 1,232,000 682,000 Deferred compensation 46,000 29,000 Income taxes receivable -- (107,000) ------------------------------ Net cash provided by operating activities 2,618,000 522,000 ------------------------------ CASH FLOWS FROM INVESTING ACTIVITIES: Purchase of property, plant and equipment (2,229,000) (3,083,000) Investment in life insurance (90,000) (91,000) Acquisitions of businesses (471,000) (773,000) Net proceeds from insurance claim 97,000 -- ------------------------------ Net cash used for investing activities (2,693,000) (3,947,000) CASH FLOWS FROM FINANCING ACTIVITIES: Proceeds from current and long-term debt 2,767,000 10,292,000 Repayments of current and long-term debt (2,268,000) (4,858,000) Proceeds from stock options exercised 332,000 424,000 Common stock repurchase -- (3,893,000) ------------------------------ Net cash provided by financing activities 831,000 1,965,000 ------------------------------ Effect of exchange rate changes on cash (8,000) (19,000) ------------------------------ Net increase (decrease) in cash 748,000 (1,479,000) Beginning cash balance 3,221,000 4,196,000 ------------------------------ ENDING CASH BALANCE $ 3,969,000 $ 2,717,000 ==============================

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, 2008 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, 2007. The statements presented as of and for the six months ended July 31, 2007 and 2006 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 $549,000 and $942,000 for the three and six months ended July 31, 2007, respectively, and $270,000 and $474,000 for the three and six months ended July 31, 2006, respectively. In July 2006, the Financial Accounting Standards Board (FASB) issued FASB Interpretation No. 48, "Accounting for Uncertainty in Income Taxes, an Interpretation of FASB Statement No. 109" ("FIN 48"). This Interpretation was effective for our fiscal year beginning February 1, 2007. FIN 48 prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. FIN 48 requires the recognition of penalties and interest on any unrecognized tax benefits. The Company's policy is to reflect penalties and interest as part of income tax expense when and if they become applicable. The Company has reviewed its positions in recording income and expenses and has no reason to record a liability under the provisions of FIN 48. The Company files income tax returns in the United States ("U.S.") on a federal basis and in many U.S. state and foreign jurisdictions. Certain tax years remain open to examination by the major taxing jurisdictions to which the Company is subject. The Company does not anticipate that its total unrecognized tax benefits will significantly change due to the settlement of examinations or the expiration of statutes of limitations during the next twelve months. 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 six months ended July 31, 2007 the foreign currency translation adjustment resulted in a loss of $8,000 and total comprehensive income was $1,353,000. During the six months ended July 31, 2006 the foreign currency translation adjustment resulted in a loss of $19,000 and total comprehensive income was $580,000. 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 six months ended July 31, 2007 was $961,000 and $1,079,000, respectively. Cash paid for interest and taxes for the six months ended July 31, 2006 was $822,000 and 7 $1,053,000, 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, non-vested restricted shares and convertible securities. 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 July 31, 2007. As of July 31, 2007 and January 31, 2007, the Company had the following acquired intangible assets:

July 31, 2007 January 31, 2007 ---------------------------------------------- ---------------------------------------------- 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 $ 649,000 $ 166,000 $ 483,000 3-5 years $ 299,000 $ 135,000 $ 164,000 3-5 years Customer relationships 312,000 48,000 264,000 3 years 105,000 15,000 90,000 3 years ----------------------------------- ----------------------------------- Total $ 961,000 $ 214,000 $ 747,000 $ 404,000 $ 150,000 $ 254,000 =================================== =================================== Intangible assets not subject to amortization: Goodwill $ 4,390,000 $ 4,126,000 =========== ===========

Amortization expense for intangible assets subject to amortization was $64,000 and $5,000 for the six months ended July 31, 2007 and 2006, respectively. 9. Employee Equity Incentive Plans The Company has two employee incentive stock option plans: the "2002 stock option plan" and the "2006 equity incentive plan." The 2006 equity incentive plan replaced the 2002 stock option plan, which was terminated early and no further options will be granted under it. Additional information with respect to the option plans as of July 31, 2007 is as follows:

Weighted Avg. Weighted Avg. Remaining Contract Aggregate Shares Exercise Price Life in years Intrinsic Value ------------------------------ ------------------------------------ Outstanding at February 1, 2007 1,861,842 $ 3.90 Granted -- -- Exercised (102,533) 3.54 Canceled or expired (6,500) 5.19 -------------------------- Outstanding at July 31, 2007 1,752,809 $ 3.92 4.34 $4,500,000 ========================== ============================== Exercisable at July 31, 2007 1,565,059 $ 3.82 3.92 $4,166,000 ========================== ==============================

8 Compensation expense related to stock options was $149,000 and $318,000 for the six months ended July 31, 2007 and 2006, respectively. Compensation expense related to stock options was $69,000 and $150,000 for the three months ended July 31, 2007 and 2006, respectively. As of July 31, 2007, there was $209,000 of unamortized stock-based compensation expense related to unvested stock options which is expected to be recognized over a remaining period of 30 months. 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 $46,000 for the six months ended July 31, 2007. During the first six months of fiscal 2008, 43,766 non-vested shares were granted at a grant price of $7.00 per share. As of July 31, 2007, there was $535,000 of unamortized stock-based compensation cost related to unvested shares which is expected to be recognized over a remaining period of 47 months. 10. Recent Accounting Pronouncements 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 is currently evaluating the impact of adopting SFAS 157 on its financial position, cash flows, and results of operations. In February 2007, the FASB issued SFAS No. 159, "The Fair Value Option for Financial Assets and Financial Liabilities"("SFAS 159") which permits entities to choose to measure many financial instruments and certain other items at fair value that are not currently required to be measured at fair value. SFAS 159 will be effective for the Company on February 1, 2008. The Company is currently evaluating the impact of adopting SFAS 159 on its financial position, cash flows and results of operations. 11. Segments The following table presents summarized information by segment: 9

Six Months Ended -------------------------------- July 31, 2007 July 31, 2006 ------------- ------------- Revenues by segment: Engineering & Evaluation $ 44,224,000 $ 38,354,000 Technical Solutions 16,605,000 18,235,000 ------------- ------------- Total revenues $ 60,829,000 $ 56,589,000 ============= ============= Operating income by segment: Engineering & Evaluation $ 2,995,000 $ 1,715,000 Technical Solutions 138,000 80,000 ------------- ------------- Total operating income $ 3,133,000 $ 1,795,000 ============= ============= Income before income taxes and minority interest by segment: Engineering & Evaluation $ 2,222,000 $ 1,005,000 Technical Solutions 106,000 107,000 ------------- ------------- Total income before income taxes and minority interest $ 2,328,000 $ 1,112,000 ============= ============= Assets by segment: Engineering & Evaluation $ 63,873,000 $ 57,700,000 Technical Solutions 8,660,000 8,990,000 Corporate 5,830,000 6,017,000 ------------- ------------- Total assets $ 78,363,000 $ 72,707,000 ============= =============

12. Acquisition of TRA Certification, Inc. On May 31, 2007, NQA, USA, a 50% owned consolidated subsidiary of NTS, acquired the assets of TRA Certification, Inc. ("TRA"), located in Elkhart, Indiana, for a total purchase price of $821,000. The Company paid $471,000 in cash and will pay an additional $350,000 which is payable in five annual payments of $70,000 each, starting upon the first anniversary of the purchase. All existing TRA customers and associated certifications and backlog were transferred to NQA, USA. The preliminary purchase price was allocated $350,000 to covenant not to compete, $207,000 to customer relationships and $264,000 to goodwill. The results of operations for TRA are included in the Company's consolidated statement of income from June 1, 2007 to July 31, 2007. 10 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, 2007 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. 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 six month period ended July 31, 2007. 11 RESULTS OF OPERATIONS REVENUES Six months ended July 31, 2007 % Change 2006 Diff ------------------------------------------------ (Dollars in thousands) Engineering & Evaluation $ 44,224 15.3% $ 38,354 $ 5,870 Technical Solutions 16,605 (8.9)% 18,235 (1,630) --------- ---------------------- Total revenues $ 60,829 7.5% $ 56,589 $ 4,240 ========= ====================== For the six months ended July 31, 2007, consolidated revenues increased by $4,240,000 or 7.5% when compared to the same period in fiscal 2007. Engineering & Evaluation: For the six months ended July 31, 2007, Engineering & Evaluation segment revenues increased by $5,870,000 or 15.3% when compared to the same period in fiscal 2007, primarily due to strong revenues from aerospace and defense contracts and additional revenues of approximately $1,300,000 from new acquisitions. The Company's Camden facility has recently received large contracts from its existing customers and from the Army. The Company also experienced modest increases in revenues in all other markets it serves. Technical Solutions: For the six months ended July 31, 2007, Technical Solutions segment revenues decreased by $1,630,000 or 8.9% when compared to the same period in fiscal 2007, primarily due to the decrease in contractor headcount as demand fell with certain clients. GROSS PROFIT Six months ended July 31, 2007 % Change 2006 Diff ------------------------------------------------- (Dollars in thousands) Engineering & Evaluation $ 12,217 25.1% $ 9,762 $ 2,455 % to segment revenue 27.6% 25.5% 2.2% Technical Solutions 2,927 (4.2)% 3,055 (128) % to segment revenue 17.6% 16.8% 0.9% ---------- ------------------------ Total $ 15,144 18.2% $ 12,817 $ 2,327 ========== ======================== % to total revenue 24.9% 22.6% 2.2% Total gross profit for the six months ended July 31, 2007 increased by $2,327,000 or 18.2% when compared to the same period in fiscal 2007. Engineering & Evaluation: For the six months ended July 31, 2007, gross profit for the Engineering & Evaluation segment increased by $2,455,000 or 25.1% when compared to the same period in fiscal 2007, primarily due to the increased revenues discussed above and the effect of fixed costs not increasing proportionately with sales. Technical Solutions: For the six months ended July 31, 2007, gross profit decreased by $128,000 or 4.2% in the Technical Solutions segment when compared to the same period in fiscal 2007. This decrease was primarily due to the lower revenues discussed above, offset by an increase in margins due to the higher mix of permanent placement revenues in the first quarter of the current year, when compared to the same period in the prior year. 12 SELLING, GENERAL & ADMINISTRATIVE Six months ended July 31, 2007 % Change 2006 Diff ------------------------------------------------- (Dollars in thousands) Engineering & Evaluation $ 9,293 13.6% $ 8,182 $ 1,111 % to segment revenue 21.0% 21.3% -0.3% Technical Solutions 2,789 (6.3)% 2,975 (186) % to segment revenue 16.8% 16.3% 0.5% -------- -------------------------- Total $ 12,082 8.3% $ 11,157 $ 925 ======== ========================== % to total revenue 19.9% 19.7% 0.1% Total selling, general and administrative expenses increased $925,000 or 8.3% for the six months ended July 31, 2007 when compared to the same period in fiscal 2007. Engineering & Evaluation: For the six months ended July 31, 2007, selling, general and administrative expenses increased by $1,111,000 or 13.6% when compared to the same period in fiscal 2007, primarily due to higher selling and incentive compensation costs associated with the increased revenues and margins discussed above and additional costs related to professional and accounting fees. Technical Solutions: For the six months ended July 31, 2007, selling, general and administrative expenses decreased by $186,000 or 6.3% when compared to the same period in fiscal 2007, 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 six months ended July 31, 2007, equity income from XXCAL Japan was $71,000, compared to $135,000 for the same period in fiscal 2007. This decrease was primarily due to a decline in revenues in the second quarter of the current year. XXCAL Japan is 50% owned by NTS and is accounted for under the equity method since NTS does not have management or board control. OPERATING INCOME Six months ended July 31, 2007 % Change 2006 Diff ------------------------------------------------ (Dollars in thousands) Engineering & Evaluation $ 2,995 74.6% $ 1,715 $ 1,280 % to segment revenue 6.8% 4.5% 2.3% Technical Solutions 138 72.5% 80 58 % to segment revenue 0.8% 0.4% 0.4% --------- ----------------------- Total $ 3,133 74.5% $ 1,795 $ 1,338 ========= ======================= % to total revenue 5.2% 3.2% 2.0% Operating income for the six months ended July 31, 2007 increased by $1,338,000 or 74.5% when compared to the same period in fiscal 2007. 13 Engineering & Evaluation: For the six months ended July 31, 2007, operating income in the Engineering & Evaluation segment increased by $1,280,000 or 74.6% when compared to the same period in fiscal 2007, primarily as a result of the increase in gross profit, partially offset by the increase in selling, general and administrative expenses. Technical Solutions: For the six months ended July 31, 2007, operating income in the Technical Solutions segment increased by $58,000 or 72.5% when compared to the same period in fiscal 2007, primarily as a result of the decrease in selling, general and administrative expenses and the higher mix of permanent placement revenues, discussed above. INTEREST EXPENSE Net interest expense increased by $120,000 in the six months ended July 31, 2007 when compared to the same period in the prior year, primarily due to slightly higher interest rate levels for the six months ended July 31, 2007 and higher average debt balances for the six months ended July 31, 2007 when compared with the same period last year. OTHER INCOME Other income was $127,000 for the six months ended July 31, 2007, compared to $129,000 for the same period in the prior year. Other income in the current year includes proceeds received from insurance recoveries. INCOME TAXES The income tax provision rate of 40.5% for the six months ended July 31, 2007 is based on the estimated provision accrual for fiscal year ending January 31, 2008. 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 six months ended July 31, 2007 was $1,361,000 compared to $599,000 for the same period in fiscal 2007, an increase of $762,000 or 127%. This increase was primarily due to the higher operating income, partially offset by higher interest expense and higher income taxes. 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 month period ended July 31, 2007. RESULTS OF OPERATIONS REVENUES Three months ended July 31, 2007 % Change 2006 Diff -------------------------------------------------- (Dollars in thousands) Engineering & Evaluation $ 22,815 18.6% $ 19,230 $ 3,585 Technical Solutions 8,210 (10.8)% 9,208 (998) --------- ----------------------- Total revenues $ 31,025 9.1% $ 28,438 $ 2,587 ========= ======================= For the three months ended July 31, 2007, consolidated revenues increased by $2,587,000 or 9.1% when compared to the same period in fiscal 2007. 14 Engineering & Evaluation: For the three months ended July 31, 2007, Engineering & Evaluation segment revenues increased by $3,585,000 or 18.6% when compared to the same period in fiscal 2007, due to strong revenues from the aerospace, defense and power products markets. The Company's Camden facility has recently received large contracts from its existing customers and from the Army. Technical Solutions: For the three months ended July 31, 2007, Technical Solutions segment revenues decreased by $998,000 or 10.8% when compared to the same period in fiscal 2007, primarily due to the decrease in contractor headcount as demand fell with certain clients. GROSS PROFIT Three months ended July 31, 2007 % Change 2006 Diff ------------------------------------------------- (Dollars in thousands) Engineering & Evaluation $ 6,700 36.0% $ 4,928 $ 1,772 % to segment revenue 29.4% 25.6% 3.7% Technical Solutions 1,429 (13.4)% 1,651 (222) % to segment revenue 17.4% 17.9% -0.5% --------- ----------------------- Total $ 8,129 23.6% $ 6,579 $ 1,550 ========= ======================= % to total revenue 26.2% 23.1% 3.1% Total gross profit for the three months ended July 31, 2007 increased by $1,550,000 or 23.6% when compared to the same period in fiscal 2007. Engineering & Evaluation: For the three months ended July 31, 2007, gross profit for the Engineering & Evaluation segment increased by $1,772,000 or 36.0% when compared to the same period in fiscal 2007, primarily due to the increased revenues discussed above and the effect of fixed costs not increasing proportionately with sales. Technical Solutions: For the three months ended July 31, 2007, gross profit decreased by $222,000 or 13.4% in the Technical Solutions segment when compared to the same period in fiscal 2007, primarily due to the decreased revenues discussed above. SELLING, GENERAL & ADMINISTRATIVE Three months ended July 31, 2007 % Change 2006 Diff ------------------------------------------------- (Dollars in thousands) Engineering & Evaluation $ 4,887 16.0% $ 4,214 $ 673 % to segment revenue 21.4% 21.9% -0.5% Technical Solutions 1,413 (7.8)% 1,533 (120) % to segment revenue 17.2% 16.6% 0.6% -------- ----------------------- Total $ 6,300 9.6% $ 5,747 $ 553 ======== ======================= % to total revenue 20.3% 20.2% 0.1% Total selling, general and administrative expenses increased $553,000 or 9.6% for the three months ended July 31, 2007 when compared to the same period in fiscal 2007. 15 Engineering & Evaluation: For the three months ended July 31, 2007, selling, general and administrative expenses increased by $673,000 or 16.0% when compared to the same period in fiscal 2007, primarily due to higher selling and incentive compensation costs associated with the increased revenues and margins discussed above and additional costs related to professional and accounting fees. Technical Solutions: For the three months ended July 31, 2007, selling, general and administrative expenses decreased by $120,000 or 7.8% when compared to the same period in fiscal 2007, 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 July 31, 2007, equity income from XXCAL Japan was $15,000, compared to $60,000 for the same period in fiscal 2007. This decrease was primarily due to a decline in revenues in the current quarter. XXCAL Japan is 50% owned by NTS and is accounted for under the equity method since NTS does not have management or board control. OPERATING INCOME Three months ended July 31, 2007 % Change 2006 Diff ------------------------------------------------ (Dollars in thousands) Engineering & Evaluation $ 1,828 136.2% $ 774 $ 1,054 % to segment revenue 8.0% 4.0% 4.0% Technical Solutions 16 (86.4)% 118 (102) % to segment revenue 0.2% 1.3% (1.1)% -------- ---------------------- Total $ 1,844 106.7% $ 892 $ 952 ======== ====================== % to total revenue 5.9% 3.1% 2.8% Operating income for the three months ended July 31, 2007 increased by $952,000 or 106.7% when compared to the same period in fiscal 2007. Engineering & Evaluation: For the three months ended July 31, 2007, operating income in the Engineering & Evaluation segment increased by $1,054,000 or 136.2% when compared to the same period in fiscal 2007, primarily as a result of the increase in gross profit, partially offset by the increase in selling, general and administrative expenses. Technical Solutions: For the three months ended July 31, 2007, operating income in the Technical Solutions segment decreased by $102,000 or 86.4% when compared to the same period in fiscal 2007, as a result of the decrease in gross profit, partially offset by a decrease in selling, general and administrative expenses. INTEREST EXPENSE Net interest expense increased by $27,000 in the three months ended July 31, 2007 when compared to the same period in the prior year, primarily due to higher average debt balances for the three months ended July 31, 2007 when compared with the same period last year. OTHER INCOME Other income decreased by $152,000 in the three months ended July 31, 2007 when compared to the same period in the prior year, primarily due to a reduction in deferred compensation expense in the three months ended July 31, 2006. 16 INCOME TAXES The income tax provision rate of 41.1% for the three months ended July 31, 2007 is based on the estimated provision accrual for fiscal year ending January 31, 2008. 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 July 31, 2007 was $770,000, an increase of $523,000 when compared to the same period in fiscal 2007. This increase was primarily due to the higher operating income, partially offset by lower other income, higher interest expense and higher taxes. OFF BALANCE SHEET ARRANGEMENT 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 Company's 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 line with this additional funding, is the recently announced contract received from the U.S. Army to test Insensitive Munitions (munitions that will not detonate under any conditions other than their intended mission to destroy a target). In addition, both the commercial and military aerospace markets are strengthening and it is anticipated that this growth will continue for the next several years. Also, the increase in government outsourcing activity has created additional opportunities for NTS. An example of the outsourcing activity is the recently announced agreement to transfer the complete dynamics and environmental test Laboratory from the U.S. Navy's NSWC Panama City, Florida base to the Company's Camden, Arkansas operations facility. 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. 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 is expected to grow in the future. Carriers are deploying voice, video and data using fiber networks. This may increase the demand for certification of suppliers' premises equipment, 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 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 Broadband wireless products and how best to position NTS to service the anticipated growth of this technology. The 17 Company anticipates a moderate increase in the telecom business. The transportation market and power markets have been stable with the Company continuing to experience a decrease in the transportation business at its Detroit facility, 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. Currently NTS is developing compliance and interoperabiltiy testing for emerging technologies; Multimedia over Coax Cable (MoCA), Video Electronics Standards (VESA), WiMedia, satellite radio and electronic product compliance for Zune applications. The Company believes these compliance activities will have applicability in both the Asian and US markets. In the Technical Solutions segment (TS), 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 part of this strategy, 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 who support these specialized services. 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. 18 LIQUIDITY AND CAPITAL RESOURCES Net cash provided by operating activities of $2,618,000 in the six months ended July 31, 2007 primarily consisted of net income of $1,361,000 adjusted for non-cash items of $3,013,000 in depreciation and amortization, share based compensation of $195,000, partially offset by changes in working capital of $1,819,000 and other non cash items of $132,000. Net cash provided by operating activities of $522,000 in the six months ended July 31, 2006 primarily consisted of net income of $599,000 adjusted for non-cash items of $2,819,000 in depreciation and amortization, share based compensation of $319,000, other non cash items of $230,000, partially offset by changes in working capital of $3,445,000. Cash used for investing activities in the six months ended July 31, 2007 of $2,693,000 was primarily attributable to capital spending of $2,229,000, cash used to acquire TRA Certification, Inc. of $471,000 and investment in life insurance of $90,000, partially offset by net proceeds from insurance claim of $97,000. Cash used for investing activities in the six months ended July 31, 2006 of $3,947,000 was attributable to capital spending of $3,083,000, cash used to acquire American International Registrars Corporation ("AIR") of $386,000, cash used to acquire B&B Technologies of $387,000 and investment in life insurance of $91,000. Net cash provided by financing activities in the six months ended July 31, 2007 of $831,000 consisted primarily of proceeds from borrowings of $2,767,000 and proceeds from stock options exercised of $332,000, partially offset by repayment of debt of $2,268,000. Net cash provided by financing activities in the six months ended July 31, 2006 of $1,965,000 consisted of proceeds from borrowings of $10,292,000 and proceeds from stock options exercised of $424,000, partially offset by repayment of debt of $4,858,000 and common stock repurchase of $3,893,000 from an executive officer and director of the Company. The Company has a $16,500,000 revolving line of credit under its credit agreement with Comerica Bank California and First Bank. Comerica Bank California, as the agent, holds 60% of the line with First Bank, as the participant, holding 40% of the line. The interest rate is at the agent's prime rate minus 25 basis points, with an option for the Company to convert to loans at the Libor rate plus 225 basis points for 30, 60, 90, 180 or 365 days, with minimum advances of $1,000,000. The outstanding balance on the revolving line of credit at July 31, 2007 was $10,643,000. This balance is reflected in the accompanying condensed consolidated balance sheets as long-term. The amount available on the line of credit was $5,857,000 as of July 31, 2007. 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 compliance with all of the covenants with its banks at July 31, 2007. The credit agreement with Comerica Bank California and First Bank also includes a $2,500,000 term loan to be repaid in 60 equal monthly payments and an 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 a former executive officer and director. 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 term loan, to be repaid in 48 equal monthly payments, to fund the purchase of Dynamic Labs. The aggregate outstanding balance on the term loans at July 31, 2007 was $5,600,000. The aggregate outstanding balance on the equipment line of credit at July 31, 2007 was $3,458,000. The Company has additional equipment line of credit agreements (at interest rates of 5.56% to 7.47%) to finance various test equipment with terms of 60 months for each equipment schedule. The outstanding balance at July 31, 2007 was $1,006,000. The balance of other notes payable collateralized by land and building was $2,315,000 at July 31, 2007. 19 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, 2007, filed with the Securities and Exchange Commission on April 30, 2007. 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 July 31, 2007 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 July 31, 2007. 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. 20 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, 2007 filed with the Securities and Exchange Commission on April 30, 2007. 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 At the Company's Annual Meeting of shareholders held on July 12, 2007, four nominees of the Board of Directors were elected directors for three year terms as Class II Directors expiring on the date of the annual meeting in 2010. The votes were as follows: --------------------------------------------------------------------- For Withheld --------------------------------------------------------------------- Ralph Clements 7,209,752 991,981 --------------------------------------------------------------------- Aaron Cohen 7,209,722 992,011 --------------------------------------------------------------------- Donald Tringali 7,209,981 991,752 --------------------------------------------------------------------- Dan Yates 7,209,981 991,752 --------------------------------------------------------------------- The shareholders of the Company voted to ratify Ernst & Young LLP as auditors for the year ending January 31, 2008. The results of the vote of the shareholders were as follows: -------------------------------------------------------------------------- For Against Abstain -------------------------------------------------------------------------- Ratify Ernst & Young LLP as auditors for the year ending January 31, 2008 7,241,977 958,551 1,206 -------------------------------------------------------------------------- Item 5. Other Information None. Item 6. Exhibits 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. 21 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: September 13, 2007 By: /s/ Raffy Lorentzian -------------------------- ------------------------------- Raffy Lorentzian Senior Vice President Chief Financial Officer (Signing on behalf of the registrant and as principal financial officer) 22