10-Q 1 d61565_10q.txt QUARTERLY REPORT ================================================================================ FORM 10-Q SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 --------------------------- (mark one) |x| QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the Quarterly Period Ended October 31, 2004 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) (IRS Employer Identification number) 24007 Ventura Boulevard, Suite 200, Calabasas, California (Address of registrant's principal executive office) (818) 591-0776 91302 (Registrant's telephone number) (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 an accelerated filer (as defined in Rule 12b-2 of the Exchange Act). YES |_| NO |X| The number of shares of common stock, no par value, outstanding as of December 6, 2004 was 9,009,927. NATIONAL TECHNICAL SYSTEMS, INC. AND SUBSIDIARIES Index PART I. FINANCIAL INFORMATION Page No. Item 1. Financial Statements: Condensed Consolidated Balance Sheets as of October 31, 2004 (unaudited) and January 31, 2004 3 Unaudited Condensed Consolidated Statements of Income For the Nine Months Ended October 31, 2004 and 2003 4 Unaudited Condensed Consolidated Statements of Income For the Three Months Ended October 31, 2004 and 2003 5 Unaudited Condensed Consolidated Statements of Cash Flows For the Nine Months Ended October 31, 2004 and 2003 6 Notes to the Unaudited Condensed Consolidated Financial Statements 7 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations 10 Item 4. Controls and Procedures 19 PART II. OTHER INFORMATION & SIGNATURE Item 6. Exhibits and Reports on Form 8-K 20 2 PART I - FINANCIAL ITEM 1. FINANCIAL STATEMENTS NATIONAL TECHNICAL SYSTEMS, INC. AND SUBSIDIARIES Condensed Consolidated Balance Sheets

October 31, January 31, 2004 2004 ASSETS (unaudited) ---------------------------- CURRENT ASSETS: Cash $ 3,994,000 $ 4,661,000 Accounts receivable, less allowance for doubtful accounts of $943,000 at October 31, 2004 and $938,000 at January 31, 2004 19,212,000 18,822,000 Income taxes receivable 858,000 320,000 Inventories 1,775,000 1,995,000 Deferred tax assets 1,193,000 1,184,000 Prepaid expenses 939,000 827,000 ---------------------------- Total current assets 27,971,000 27,809,000 Property, plant and equipment, at cost 88,617,000 83,312,000 Less: accumulated depreciation (57,034,000) (53,357,000) ---------------------------- Net property, plant and equipment 31,583,000 29,955,000 Goodwill 2,740,000 2,740,000 Other assets 3,561,000 3,128,000 ---------------------------- TOTAL ASSETS $ 65,855,000 $ 63,632,000 ============================ LIABILITIES AND SHAREHOLDERS' EQUITY CURRENT LIABILITIES: Accounts payable $ 3,725,000 $ 4,485,000 Accrued expenses 3,476,000 3,514,000 Income taxes payable -- 23,000 Deferred income 424,000 185,000 Current installments of long-term debt 1,004,000 1,052,000 ---------------------------- Total current liabilities 8,629,000 9,259,000 Long-term debt, excluding current installments 20,629,000 19,754,000 Deferred income taxes 5,424,000 4,875,000 Deferred compensation 869,000 799,000 Minority interest 91,000 113,000 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, 8,992,000 as of October 31, 2004 and 8,863,000 as of January 31, 2004 14,028,000 13,760,000 Retained earnings 16,217,000 15,123,000 Accumulated other comprehensive income (32,000) (51,000) ---------------------------- Total shareholders' equity 30,213,000 28,832,000 ---------------------------- ---------------------------- TOTAL LIABILITIES AND SHAREHOLDERS' EQUITY $ 65,855,000 $ 63,632,000 ============================

See accompanying notes. 3 NATIONAL TECHNICAL SYSTEMS, INC. AND SUBSIDIARIES Unaudited Condensed Consolidated Statements of Income for the Nine Months Ended October 31, 2004 2003 -------------------------- Net revenues $80,715,000 $79,640,000 Cost of sales 63,041,000 61,916,000 -------------------------- Gross profit 17,674,000 17,724,000 Selling, general and administrative expense 15,414,000 15,111,000 -------------------------- Operating income 2,260,000 2,613,000 Other income (expense): Interest expense, net (787,000) (855,000) Other Income 157,000 50,000 -------------------------- Total other expense (630,000) (805,000) Income before income taxes and minority interest 1,630,000 1,808,000 Income taxes 558,000 838,000 -------------------------- Income before minority interest 1,072,000 970,000 Minority interest 22,000 (29,000) -------------------------- Net income $ 1,094,000 $ 941,000 ========================== Net income per common share: Basic $ 0.12 $ 0.11 ========================== Diluted $ 0.11 $ 0.10 ========================== Weighted average common shares outstanding 8,924,000 8,629,000 Dilutive effect of stock options 622,000 531,000 -------------------------- Weighted average common shares outstanding, assuming dilution 9,546,000 9,160,000 ========================== See accompanying notes 4 NATIONAL TECHNICAL SYSTEMS, INC. AND SUBSIDIARIES Unaudited Condensed Consolidated Statements of Income for the Three Months Ended October 31,

2004 2003 -------------------------- Net revenues $26,293,000 $25,591,000 Cost of sales 20,467,000 19,791,000 -------------------------- Gross profit 5,826,000 5,800,000 Selling, general and administrative expense 5,077,000 5,087,000 -------------------------- Operating income 749,000 713,000 Other income (expense): Interest expense, net (264,000) (250,000) Other (6,000) 43,000 -------------------------- Total other expense (270,000) (207,000) Income before income taxes and minority interest 479,000 506,000 Income taxes 137,000 236,000 -------------------------- Income before minority interest 342,000 270,000 Minority interest (23,000) 3,000 -------------------------- Net income $ 319,000 $ 273,000 ========================== Net income per common share: Basic $ 0.04 $ 0.03 ========================== Diluted $ 0.03 $ 0.03 ========================== Weighted average common shares outstanding 8,969,000 8,637,000 Dilutive effect of stock options 521,000 588,000 -------------------------- Weighted average common shares outstanding, assuming dilution 9,490,000 9,225,000 ==========================

See accompanying notes. 5 NATIONAL TECHNICAL SYSTEMS, INC. AND SUBSIDIARIES Unaudited Consolidated Statements of Cash Flows for the Nine Months Ended October 31, 2004 and 2003

2004 2003 -------------------------- CASH FLOWS FROM OPERATING ACTIVITIES: Net income $ 1,094,000 $ 941,000 Adjustments to reconcile net income to cash provided by operating activities: Depreciation and amortization 3,746,000 3,530,000 Provisions for losses (recoveries) on receivables 5,000 97,000 Gain on sale of assets (158,000) -- Undistributed earnings of affiliate (22,000) 29,000 Deferred income taxes 540,000 487,000 Tax benefit from stock options exercised -- 23,000 Changes in assets and liabilities (net of acquisition): Accounts receivable (395,000) 1,830,000 Inventories 220,000 623,000 Prepaid expenses (112,000) (409,000) Other assets and intangibles (333,000) (260,000) Accounts payable (760,000) (1,281,000) Accrued expenses (38,000) (839,000) Income taxes payable (23,000) -- Deferred income 239,000 334,000 Deferred compensation 70,000 67,000 Income taxes receivable (538,000) (137,000) -------------------------- Cash provided by operating activities 3,535,000 5,035,000 -------------------------- CASH FLOWS FROM INVESTING ACTIVITIES: Purchase of property, plant and equipment (4,464,000) (2,802,000) Sale of property, plant and equipment 311,000 -- Investment in life insurance (130,000) (118,000) Acquisition of assets, net of cash (1,033,000) -- -------------------------- Net cash used for investing activities (5,316,000) (2,920,000) -------------------------- CASH FLOWS FROM FINANCING ACTIVITIES: Proceeds from current and long-term debt 1,994,000 294,000 Repayments of current and long-term debt (1,167,000) (1,743,000) Proceeds from stock issuance 268,000 125,000 Common stock repurchase -- (105,000) -------------------------- Net cash provided by (used for) financing activities 1,095,000 (1,429,000) -------------------------- Effect of exchange rate changes on cash and cash equivalents 19,000 -- -------------------------- Net increase (decrease) in cash (667,000) 686,000 Beginning cash balance 4,661,000 3,559,000 -------------------------- ENDING CASH BALANCE $ 3,994,000 $ 4,245,000 ==========================

See accompanying notes. 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 accounting principles generally accepted in the United States. These statements should not be construed as representing pro rata results of the Company's fiscal year 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, 2004. The statements presented as of and for the three and nine months ended October 31, 2004 and 2003 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. The Company recorded income tax expense of $137,000 and $558,000 for the three and nine months ended October 31, 2004, respectively, and $236,000 and $838,000 for the three and nine months ended October 31, 2003, respectively. 3. Comprehensive Income Accumulated other comprehensive income on the Company's Condensed Consolidated Balance Sheets consists of cumulative equity adjustments from foreign currency translation. During the three and nine months ended October 31, 2004 other comprehensive income was $19,000. Other comprehensive income was $0 for the three and nine months ended October 31, 2003. The tax effect related to foreign currency translation adjustments is immaterial and has not been recognized as part of comprehensive income or in accumulated other comprehensive income. 4. Inventories Inventories consist of accumulated costs applicable to uncompleted contracts and are stated at actual cost which is not in excess of estimated net realizable value. 5. Interest and Taxes Cash paid for interest and taxes for the nine months ended October 31, 2004 was $823,000 and $590,000, respectively. Cash paid for interest and taxes for the nine months ended October 31, 2003 was $872,000 and $523,000, 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. Stock Repurchase On February 6, 2001, the Company's Board of Directors authorized the repurchase of shares in the Company's common stock in open market purchases. As of January 31, 2004, the Company had purchased 169,750 shares at an average price of $2.54 per share. The Company elected to discontinue the repurchase of shares as of 7 September 29, 2003; therefore no shares were repurchased during the current quarter. 8. Earnings per share Basic and diluted net income per common share is presented in conformity with Statement of Financial Accounting Standards ("SFAS") No. 128, "Earnings Per Share" for all periods presented. In accordance with SFAS No. 128, basic earnings per share have been computed using the weighted average number of shares of common stock outstanding during the year. Basic earnings per share excludes any dilutive effects of options, warrants and convertible securities. 9. Intangible Assets The Company adopted the new rules on accounting for goodwill and other intangible assets beginning in the first quarter of fiscal year 2003 in accordance with SFAS No. 142, "Goodwill and Other Intangible Assets." There have been no indications of any impairments through October 31, 2004. As of October 31, 2004 and January 31, 2004, the Company had the following acquired intangible assets:

October 31, 2004 January 31, 2004 --------------------------------------------- ---------------------------------------------- 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: Covenant not to compete $ 148,000 $ 69,000 $ 79,000 3-5 years $ 148,000 $ 39,000 $ 109,000 3-5 years ================================== ================================== Intangible assets not subject to amortization: Goodwill $3,537,000 $ 797,000 $2,740,000 $3,537,000 $ 797,000 $2,740,000 ================================== ==================================

Amortization expense for intangible assets subject to amortization was $30,000 and $22,000 for the nine months ended October 31, 2004 and 2003, respectively. 10. Long-Lived Assets: Adoption of Statement 144 In August 2001, the Financial Accounting Standards Board ("FASB") issued SFAS No. 144, "Accounting for the Impairment or Disposal of Long-Lived Assets," which is effective for fiscal years beginning after December 15, 2001. SFAS No. 144 supersedes FASB Statement No. 121, "Accounting for the Impairment or Disposal of Long-Lived Assets and for Long-Lived Assets to Be Disposed Of," and the accounting and reporting provisions relating to the disposal of a segment of a business of Accounting Principles Board Opinion No. 30. The Company has adopted SFAS No. 144 beginning in the first quarter of fiscal year 2003. The adoption had no impact on the Company's consolidated financial position or results of operations. 8 11. Stock-Based Compensation As of October 31, 2004, the Company had one stock-based employee compensation plan, the 2002 stock option plan. The Company also had a 1994 stock option plan, which expired, but still has options outstanding. The Company accounts for these plans under the intrinsic value method recognition and measurement principles of Accounting Principles Board ("APB") Opinion No. 25, "Accounting for Stock Issued to Employees" and related Interpretations. No stock-based employee compensation cost is reflected in net income, as all options granted under these plans had an exercise price equal to the market value of the underlying common stock on the date of grant. The following table illustrates the effect on net income and net income per share as if the Company had applied the fair value recognition provisions of SFAS No. 123, "Accounting for Stock-Based Compensation," to stock-based employee compensation using the Black-Scholes option pricing model:

Nine Months Ended Three Months October 31, October 31, ------------------------------------------------- 2004 2003 2004 2003 ---- ---- ---- ---- Net Income As reported $1,094,000 $ 941,000 $ 319,000 $ 273,000 Stock compensation expense, net of tax (412,000) (288,000) (141,000) (125,000) ------------------------------------------------- Pro forma $ 682,000 $ 653,000 $ 178,000 $ 148,000 Basic earnings per common share As reported $ 0.12 $ 0.11 $ 0.04 $ 0.03 Pro forma $ 0.08 $ 0.08 $ 0.02 $ 0.02 Diluted earnings per common share As reported $ 0.11 $ 0.10 $ 0.03 $ 0.03 Pro forma $ 0.07 $ 0.07 $ 0.02 $ 0.02

12. Recently Issued Accounting Standards In January 2003, the FASB issued Interpretation No. 46, "Consolidation of Variable Interest Entities" (FIN 46) Until this interpretation, a company generally included another entity in its consolidated financial statements only if it controlled the entity through voting interests. FIN 46 requires a variable interest entity, as defined, to be consolidated by a company if that company is subject to a majority of the risk of loss from the variable interest entity's activities or entitled to receive a majority of the entity's residual returns. The adoption of FIN 46 did not have a material impact on the Company's financial position, cash flows or results of operations. 13. Acquisition of Assets 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 telecommunication equipment, located in Calgary, Alberta, Canada, for a total purchase price of $1,033,000. By making this acquisition, the Company intends to expand its presence to Canada and increase its opportunities in the testing of telecommunication equipment. 9 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. OVERVIEW The Company is a diversified business to business services organization that supplies testing, certification services, engineering and information technology 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 management and profit center. 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 revenue and operating cost information for each of its operating units. Revenues and booking activities are also tracked by industry. 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, Canada, Japan 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 is a provider of professional and information business technology services, including contract services, temporary and full-time placements, providing specialty solutions services to its customers specifically in the area of information technology, information systems, software engineering and design, test and product compliance engineering support. 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 product compliance 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 nine months ended October 31. 10 RESULTS OF OPERATIONS REVENUES Nine months ended October 31, 2004 % Change 2003 ------------------------------ (Dollars in thousands) Engineering & Evaluation $46,695 5.9% $44,073 Technical Solutions 34,020 (4.3)% 35,567 ------- ------- Total revenues $80,715 1.3% $79,640 ======= ======= For the nine months ended October 31, 2004, consolidated revenues increased by $1,075,000 or 1.3% when compared to the same period in fiscal 2004. Engineering & Evaluation: For the nine months ended October 31, 2004, Engineering and Evaluation revenues increased by $2,622,000 or 5.9% when compared to the same period in fiscal 2004, primarily due to revenues of $2,563,000 from the acquisition of DTI Holdings, LLC, located in Rustburg, Virginia, which was effective on January 1, 2004, and revenues of $229,000 from the acquisition of a telecommunications test laboratory in Calgary, Canada in August of 2004. Revenues also increased in the Company's space and automotive testing businesses and the computer testing business in Japan. 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, which included revenues from a major contract related to the war on terrorism. The contract was completed during the second quarter of fiscal 2004. Technical Solutions: For the nine months ended October 31, 2004, revenues in Technical Solutions decreased by $1,547,000 or 4.3% when compared to the same period in fiscal 2004, due to the continued weakness in the IT market staffing business. GROSS PROFIT Nine months ended October 31, 2004 % Change 2003 ------------------------------ (Dollars in thousands) Engineering & Evaluation $12,233 0.6% $12,160 % to segment revenue 26.2% 27.6% Technical Solutions 5,441 (2.2)% 5,564 % to segment revenue 16.0% 15.6% ------- ------- Total $17,674 (0.3)% $17,724 ======= ======= % to total revenue 21.9% 22.3% Total gross profit for the nine months ended October 31, 2004 decreased by $50,000 or 0.3% when compared to the same period in fiscal 2004. Engineering & Evaluation: For the nine months ended October 31, 2004, gross profit for the Engineering & Evaluation Group increased by $73,000 or 0.6% when compared to the same period in fiscal 2004, primarily as a result of the revenue increase discussed above. However, the gross profit margin as a percentage of revenues decreased in the current year primarily due to the decreases in gross profit from the passive fiber optic testing business and completion of the Camden, Arkansas project, as discussed above. These lost revenues had higher than average gross margins. 11 Technical Solutions: For the nine months ended October 31, 2004, gross profit decreased by $123,000 or 2.2% in the Technical Solutions Group when compared to the same period in fiscal 2004, primarily as a result of the revenue decrease discussed above. Gross profit margin as a percentage of revenues slightly increased when compared to the same period in the prior year. SELLING, GENERAL & ADMINISTRATIVE Nine months ended October 31, 2004 % Change 2003 ------------------------------ (Dollars in thousands) Engineering & Evaluation $10,588 8.9% $ 9,726 % to segment revenue 22.7% 22.1% Technical Solutions 4,826 (10.4)% 5,385 % to segment revenue 14.2% 15.1% ------- ------- Total $15,414 2.0% $15,111 ======= ======= % to total revenue 19.1% 19.0% Total selling, general and administrative expenses increased $303,000 or 2.0% for the nine months ended October 31, 2004 when compared to the same period in fiscal 2004. Engineering & Evaluation: For the nine months ended October 31, 2004, selling, general and administrative expenses increased by $862,000 or 8.9% when compared to the same period in fiscal 2004, primarily due to one-time start-up costs associated with the development of new test specifications for the emerging wireless technologies and the development of capabilities to perform testing on new DSL services, and costs incurred by the Company to prepare for Section 404 of the Sarbanes-Oxley Act, that makes reporting on internal controls mandatory for all SEC registrants. Selling, general and administrative expenses also increased due to sales costs related to efforts to expand the Company nationally and internationally, the addition of new sales and customer service representatives and costs related to the improvement of the Company's internal IT infrastructure and website. Technical Solutions: For the nine months ended October 31, 2004, selling, general and administrative expenses decreased by $559,000 or 10.4% when compared to the same period in fiscal 2004, primarily due to the reduction in selling costs associated with the lower revenues and other administrative cost reductions. OPERATING INCOME Nine months ended October 31, 2004 % Change 2003 ------------------------------ (Dollars in thousands) Engineering & Evaluation $ 1,645 (32.4)% $ 2,434 % to segment revenue 3.5% 5.5% Technical Solutions 615 243.6% 179 % to segment revenue 1.8% 0.5% ------- ------- Total $ 2,260 (13.5)% $ 2,613 ======= ======= % to total revenue 2.8% 3.3% Operating income for the nine months ended October 31, 2004 decreased by $353,000 or 13.5% when compared to fiscal 2004. Engineering & Evaluation: For the nine months ended October 31, 2004, operating income in the Engineering & Evaluation Group decreased by 12 $789,000 or 32.4% when compared to the same period in fiscal 2004, as a result of the increase in selling, general and administrative expenses discussed above, partially offset by a slight increase in gross profit discussed above. Technical Solutions: For the nine months ended October 31, 2004, operating income in the Technical Solutions Group increased by $436,000 or 243.6% when compared to the same period in 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 Net interest expense decreased by $68,000 in the nine months ended October 31, 2004 when compared to the same period in fiscal 2004. This decrease was primarily due to higher average debt balances during the nine months ended October 31, 2004, when compared to the same period last year. INCOME TAXES The income tax provisional rate of 34.2% for the nine months ended October 31, 2004 is based on the estimated provision for fiscal year ending January 31, 2005 and is lower than normal due to the earnings associated with the Company's foreign subsidiary which significantly increased in the current year and are considered to be permanently invested and no provision for U.S. federal or state income taxes has been made for this subsidiary. Management has determined that it is more likely than not that the deferred tax asset will be realized on the basis of offsetting it against 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 The increase in net income for the nine months ended October 31, 2004, compared to the same period in fiscal 2004, was primarily due to the increase in other income and minority interest, decrease in interest expense and income taxes, partially offset by a lower operating income. The following information is based upon results for National Technical Systems, Inc. for the three months ended October 31. RESULTS OF OPERATIONS REVENUES Three months ended October 31, 2004 % Change 2003 ------------------------------ (Dollars in thousands) Engineering & Evaluation $15,378 8.3% $14,196 Technical Solutions 10,915 (4.2)% 11,395 ------- ------- Total revenues $26,293 2.7% $25,591 ======= ======= For the three months ended October 31, 2004, consolidated revenues increased by $702,000 or 2.7% when compared to the same period in fiscal 2004. Engineering & Evaluation: For the three months ended October 31, 2004, Engineering and Evaluation revenues increased by $1,182,000 or 8.3% when compared to the same period in fiscal 2004, primarily due to revenues of $822,000 from the acquisition of DTI Holdings, which was effective on January 1, 2004 and revenues of $229,000 from the acquisition of a 13 telecommunications test laboratory in Calgary, Canada in August of 2004. The Company also experienced increases in revenues from the automotive testing business and the Company's computer testing business in Japan. These increases were partially offset by the decrease in the passive fiber optic testing business and a decrease in revenues at the Santa Clarita facility. Technical Solutions: For the three months ended October 31, 2004, Technical Solutions revenues decreased by $480,000 or 4.2% when compared to the same period in fiscal 2004, due to the continued weakness in the IT market staffing business. GROSS PROFIT Three months ended October 31, 2004 % Change 2003 ------------------------------ (Dollars in thousands) Engineering & Evaluation $ 4,021 (0.6)% $ 4,045 % to segment revenue 26.1% 28.5% Technical Solutions 1,805 2.8% 1,755 % to segment revenue 16.5% 15.4% ------- ------- Total $ 5,826 0.4% $ 5,800 ======= ======= % to total revenue 22.2% 22.7% Total gross profit for the three months ended October 31, 2004 increased by $26,000 or 0.4% when compared to the same period in fiscal 2004. Engineering & Evaluation: For the three months ended October 31, 2004, gross profit for the Engineering & Evaluation Group decreased by $24,000 or 0.6% when compared to the same period in fiscal 2004, primarily as a result of the revenue decreases in the passive fiber optic testing business and the decrease in revenues at the Santa Clarita facility. These decreases were partially offset by the increase in gross profit from the acquisition of DTI Holdings, the improved business in Japan and the increase in automotive revenues. Technical Solutions: For the three months ended October 31, 2004, gross profit increased by $50,000 or 2.8% in the Technical Solutions Group when compared to the same period in fiscal 2004. This increase is primarily due to a slight improvement in contract margins. Gross profit as a percentage of revenue increased slightly to 16.5 % from 15.4% when compared to the same period in the prior year. SELLING, GENERAL & ADMINISTRATIVE Three months ended October 31, 2004 % Change 2003 ------------------------------ (Dollars in thousands) Engineering & Evaluation $ 3,565 6.5% $ 3,348 % to segment revenue 23.2% 23.6% Technical Solutions 1,512 (13.1)% 1,739 % to segment revenue 13.9% 15.3% ------- ------- Total $ 5,077 (0.2)% $ 5,087 ======= ======= % to total revenue 19.3% 19.9% Total selling, general and administrative expenses decreased $10,000 or 0.2% for the three months ended October 31, 2004 when compared to the same period in fiscal 2004. 14 Engineering & Evaluation: For the three months ended October 31, 2004, selling, general and administrative expenses increased by $217,000 or 6.5% when compared to the same period in fiscal 2004, primarily due to one-time start-up costs associated with the development of new test specifications for the emerging wireless technologies and the development of capabilities to perform testing on new DSL services, and costs incurred by the Company to prepare for Section 404 of the Sarbanes-Oxley Act. Selling, general and administrative expenses also increased due to sales costs related to efforts to expand the Company nationally and internationally, the addition of new sales and customer service representatives and costs related to the improvement of the Company's internal IT infrastructure and website. Technical Solutions: For the three months ended October 31, 2004, selling, general and administrative expenses decreased by $227,000 or 13.1% when compared to the same period in fiscal 2004, primarily due to the reduction in selling costs associated with the lower revenues and other administrative cost reductions. OPERATING INCOME Three months ended October 31, 2004 % Change 2003 ------------------------------ (Dollars in thousands) Engineering & Evaluation $ 456 (34.6)% $ 697 % to segment revenue 3.0% 4.9% Technical Solutions 293 1731.3% 16 % to segment revenue 2.7% 0.1% ------- ------- Total $ 749 5.0% $ 713 ======= ======= % to total revenue 2.8% 2.8% Operating income for the three months ended October 31, 2004 increased by $36,000 or 5.0% when compared to fiscal 2004. Engineering & Evaluation: For the three months ended October 31, 2004, operating income in the Engineering & Evaluation Group decreased by $241,000 or 34.6% when compared to the same period in fiscal 2004, as a result of the slight decrease in gross profit and the increase in selling and general and administrative expenses discussed above. Technical Solutions: For the three months ended October 31, 2004, operating income in the Technical Solutions Group increased by $277,000 when compared to the same period in fiscal 2004, primarily as a result of the decrease in selling and general and administrative expenses and the increase in gross profit. INTEREST EXPENSE Net interest expense increased by $14,000 in the three months ended October 31, 2004 when compared to the same period in fiscal 2004. This increase was primarily due to higher interest rate levels for the three months ended October 31, 2004, and slightly higher average debt balances for the three months ended October 31, 2004 when compared to the same period last year. 15 INCOME TAXES The income tax provisional rate of 28.6% for the three months ended October 31, 2004 reflects a rate that is lower than the U.S. federal statutory rate due to the earnings associated with the Company's foreign subsidiary which significantly increased in the second and third quarters and are considered to be permanently invested and no provision for U.S. federal or state income taxes has been made for this subsidiary. Management has determined that it is more likely than not that the deferred tax asset will be realized on the basis of offsetting it against 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 The increase in net income for the three months ended October 31, 2004, compared to the same period in fiscal 2004, was primarily due to the higher operating income and lower income taxes, partially offset by higher interest expense, other expense and minority interest. BUSINESS ENVIRONMENT Engineering & Evaluation: The Company provides product certification, product safety testing and product evaluation to ensure its high tech clients' products meet established specifications or standards. In recent years, domestic and worldwide political and economic developments have impacted positively the market needs for defense and advanced technology systems. The Company is well positioned to service these emerging test and certification needs. Also, the Company continues to add capability to provide high tech product compliance services for the telecommunications industry, both domestically and internationally. The Company currently offers a complete suite of product certification (NEBS testing) in its laboratories in California, Massachusetts, Texas and Germany to support legacy communication networks. The Company also offers a complete suite of passive fiber components certifications in California as regional Bell operating companies continue to upgrade their networks for fiber transmission. Regional Bell operating companies are also upgrading their networks for DSL services. NTS has recently achieved approvals, and recently developed in California test suites, to certify DSL modems for the Regional Bell operating companies. NTS believes DSL certification is an emerging market and NTS, with its recent approvals and recently developed test suites is well positioned to service the demand. In addition, NTS believes that certification of wireless products is an emerging market and NTS has recently invested personnel and capital to develop test specifications and test suites to service this future business need. In addition, NTS has experienced an increased customer demand for environmental testing for satellite and automotive components. The Company believes this demand will continue for the foreseeable future. The Company anticipates budget increases for operational readiness spending as well as research and development spending for homeland security and defeating terrorism. As products are developed for these activities, the Company is well positioned to meet the test and evaluation requirements. The Company's Camden facility performed a major weapons testing program in fiscal 2004 which resulted in a one time significant growth of revenue and margin. The Company does not foresee in the immediate future a similar program to replace this activity. The Company believes however the demand for overall defense related testing will continue to increase for the foreseeable future. The Company's Santa Clarita facility, its largest aerospace facility, continues to experience a decline in sales during this period, following construction of a public highway immediately adjacent to the Santa Clarita facility. A portion of the highway was built on real property taken from the Company by eminent domain. The Company is seeking, through the appeal process, appropriate compensation for the taking of the Company's property. In an effort to maintain the economic viability of the facility, several new capabilities have been added which include fuel cell testing, upgraded acoustical testing, clean environment satellite testing and installation of a high pressure air system. New business is currently being booked for these services. The Fullerton facility performed extensive passive fiber optics component testing in accordance with the Fiber Distributing Frames Certification. These tests resulted in significant revenue and margin growth for this facility. This level of activity has reduced significantly as market demands subsided. The Company does not believe the demand level for this specific activity will be repeated in the foreseeable future. The Company does believe however the demand for general Passive Fiber Component Certification will continue, as Regional Bell operating companies continue to upgrade their networks. The Company does anticipate an increase in DSL modem certification 16 starting in January as a result of the new requirements for certification developed by Verizon, Bell South, Bell Canada and SBC. Technical Staffing: 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. One of the strategies for growth is to extend the offering of the Company's technical staffing services to the Engineering & Evaluations segment's customers to provide them with technical and engineering personnel as part of a complete suite of certification, registration and test services. The goal is to offer a complete solution to the customers' product development needs, which include consultants and technical experts provided by Technical Staffing. 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. 17 LIQUIDITY AND CAPITAL RESOURCES Net cash provided by operating activities of $3,535,000 in the nine months ended October 31, 2004 primarily consisted of net income of $1,094,000 adjusted for non-cash items of $3,746,000 in depreciation and amortization offset by a decrease of $1,147,000 of changes in working capital and the effect of the gain on sale of assets of $158,000. The decrease in working capital changes was primarily due to the decreases in the changes in accounts receivable, inventories, other assets and intangibles, deferred income and income taxes receivable, partially offset by an increase in the changes in prepaid expenses, accounts payable and accrued expenses. Net cash used for investing activities in the nine months ended October 31, 2004 of $5,316,000 was attributable to capital spending of $4,464,000, the acquisition of the Canadian test laboratory for $1,033,000 and cash used in life insurance of $130,000, offset by cash provided from the sale of property of $311,000. 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 the nine months ended October 31, 2003 to the nine months ended October 31, 2004, by $2,396,000 primarily as a result of the increase in capital spending in the current year and the acquisition of the Canadian test laboratory. Net cash provided by financing activities in the nine months ended October 31, 2004 of $1,095,000 consisted of proceeds from borrowings of debt of $1,994,000, proceeds from stock options exercised of $268,000, offset by cash used for repayment of debt of $1,167,000. Net cash provided by financing activities increased from the nine months ended October 31, 2003 to the nine months ended October 31, 2004, by $2,524,000 primarily as a result of the increase in borrowings of debt and the decrease in repayments of debt. On November 25, 2002, the Company increased the revolving line of credit 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 and will be reduced by $1,750,000 each year thereafter. If during any fiscal year, the Company's net income equals or exceeds $2,000,000, there will be no required reduction in the revolving line of credit. 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. The outstanding balance on the revolving line of credit at October 31, 2004 was $15,502,000. This balance is reflected in the accompanying condensed consolidated balance sheets as long-term. 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 amount available on the line of credit was $998,000 as of October 31, 2004. The Company is currently in negotiations with its banks to increase its lines of credit. The Company was in full compliance with all of the covenants with its banks as of October 31, 2004. The Company has additional equipment line of credit agreements (at interest rates of 4.81 % to 10.21%) to finance various test equipment with terms of 60 months for each equipment schedule. The outstanding balance at October 31, 2004 was $2,592,000. The balance of other notes payable collateralized by land and building was $3,012,000, and the balance of unsecured notes was $527,000 at October 31, 2004. 18 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 are effective in timely alerting them to material information relating to the Company (including its consolidated subsidiaries) required to be included in the Company's Exchange Act filings. Disclosure controls and procedures, no matter how well designed and implemented, can provide only reasonable assurance of achieving an entity's disclosure objectives. The likelihood of achieving such objectives is affected by limitations inherent in disclosure controls and procedures. These include the fact that human judgment in decision-making can be faulty and that breakdowns in internal control can occur because of human failures such as simple errors or mistakes or intentional circumvention of the established process. Changes in Internal Controls There was no change in the Company's internal control over financial reporting, known to the Chief Executive Officer or Chief Financial Officer that occurred during the period covered by this report that has materially affected, or is reasonably likely to materially affect, the Company's internal control over financial reporting. 19 PART II. OTHER INFORMATION Item 6. Exhibits and Reports on Form 8-K (a) Exhibits 10.8 - Amendment number four to revolving credit agreement between the Company and Comerica Bank effective July 30, 2004. 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. (b) Reports on Form 8-K None. 20 SIGNATURE Pursuant to the requirements of the Securities Exchange Act of 1934 the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. NATIONAL TECHNICAL SYSTEMS, INC. Date: December 14, 2004 By: /s/ Lloyd Blonder ------------------------------ Lloyd Blonder Senior Vice President Chief Financial Officer (Signing on behalf of the registrant and as principal financial officer) 21