##### Table of Contents

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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D. C. 20549



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FORM 10-Q



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(Mark One)

|x | Quarterly report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934
|- | ---------------------------------------------------------------------------------------



FOR THE QUARTERLY PERIOD ENDED DECEMBER 31, 2004



OR



| ̈ | Transition report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934
|- | ----------------------------------------------------------------------------------------



COMMISSION FILE NUMBER: 333-13105



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FIREARMS TRAINING SYSTEMS, INC.

(Exact name of registrant as specified in its charter)



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|                                                               |  |                                     
|-------------------------------------------------------------- |  | ------------------------------------
|DELAWARE                                                       |  | 57-0777018                          
|(State or other jurisdiction of incorporation or organization) |  | (I.R.S. Employer Identification No.)



7340 MCGINNIS FERRY
ROAD

SUWANEE, GEORGIA 30024

(Address of principal executive offices)



TELEPHONE NUMBER (770) 813-0180

(Registrants telephone number, including area code)



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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



As of February 9, 2005, there were 70,694,173 shares of the Registrants
Class A Common Stock outstanding.



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##### Table of Contents

FIREARMS TRAINING SYSTEMS, INC.

INDEX



|         |  |                                                                                                                   |  |     
|-------- |  | ----------------------------------------------------------------------------------------------------------------- |  | ----
|         |  |                                                                                                                   |  | PAGE
|PART I.  |  | FINANCIAL INFORMATION                                                                                             |  |     
|         |  |                                                                                                                  
|ITEM 1.  |  | CONDENSED CONSOLIDATED FINANCIAL STATEMENTS:                                                                      |  |     
|         |  |                                                                                                                  
|         |  | Condensed Consolidated Statements of OperationsThree and Nine months ended December 31, 2004 and 2003 (unaudited) |  | 3   
|         |  |                                                                                                                  
|         |  | Condensed Consolidated Balance SheetsDecember 31, 2004 (unaudited) and March 31, 2004                             |  | 4   
|         |  |                                                                                                                  
|         |  | Condensed Consolidated Statements of Cash FlowsNine months ended December 31, 2004 and 2003 (unaudited)           |  | 5   
|         |  |                                                                                                                  
|         |  | Notes to Condensed Consolidated Financial Statements (unaudited)                                                  |  | 6   
|         |  |                                                                                                                  
|ITEM 2.  |  | MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS                             |  | 13  
|         |  |                                                                                                                  
|ITEM 3.  |  | QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK                                                        |  | 19  
|         |  |                                                                                                                  
|ITEM 4.  |  | CONTROLS AND PROCEDURES                                                                                           |  | 20  
|         |  |                                                                                                                  
|PART II. |  | OTHER INFORMATION                                                                                                 |  |     
|         |  |                                                                                                                  
|ITEM 1.  |  | LEGAL PROCEEDINGS                                                                                                 |  | 20  
|         |  |                                                                                                                  
|ITEM 6.  |  | EXHIBITS AND REPORTS ON FORM 8-K                                                                                  |  | 20  
|         |  |                                                                                                                  
|         |  | SIGNATURES                                                                                                        |  | 21  





2



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##### Table of Contents

PART I. FINANCIAL INFORMATION



ITEM 1. CONDENSED CONSOLIDATED FINANCIAL STATEMENTS



FIREARMS TRAINING SYSTEMS, INC. AND SUBSIDIARIES



CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(unaudited and in thousands, except for per share
amounts)



|                                                          |  |                                |        |   |                               |   |        |      |  |   |        |   |  |   |        |  
|--------------------------------------------------------- |  | ------------------------------ | ------ | - | ----------------------------- | - | ------ | ---- |  | - | ------ | - |  | - | ------ | -
|                                                          |  | Three Months EndedDecember 31, |        |   | Nine Months EndedDecember 31, |  
|                                                          |  | 2004                           |        |   | 2003                          |   |        | 2004 |  |   | 2003   |  
|Revenue                                                   |  | $                              | 21,029 |   |                               | $ | 16,479 |      |  | $ | 59,171 |   |  | $ | 45,027 |  
|Cost of revenue                                           |  |                                | 14,080 |   |                               |   | 10,270 |      |  |   | 39,710 |   |  |   | 30,644 |  
|                                                          |  |                                |        |   |                               |   |        |      |  |   |        |   |  |   |        |  
|Gross margin                                              |  |                                | 6,949  |   |                               |   | 6,209  |      |  |   | 19,461 |   |  |   | 14,383 |  
|                                                          |  |                                |        |   |                               |   |        |      |  |   |        |   |  |   |        |  
|Operating expenses:                                       |  |                                |        |   |                               |   |        |      |  |   |        |   |  |   |        |  
|Selling, general and administrative                       |  |                                | 3,317  |   |                               |   | 3,161  |      |  |   | 10,341 |   |  |   | 9,068  |  
|Research and development                                  |  |                                | 947    |   |                               |   | 766    |      |  |   | 2,689  |   |  |   | 2,013  |  
|Depreciation and amortization                             |  |                                | 121    |   |                               |   | 102    |      |  |   | 352    |   |  |   | 335    |  
|                                                          |  |                                |        |   |                               |   |        |      |  |   |        |   |  |   |        |  
|Total operating expenses                                  |  |                                | 4,385  |   |                               |   | 4,029  |      |  |   | 13,382 |   |  |   | 11,416 |  
|                                                          |  |                                |        |   |                               |   |        |      |  |   |        |   |  |   |        |  
|Operating income                                          |  |                                | 2,564  |   |                               |   | 2,180  |      |  |   | 6,079  |   |  |   | 2,967  |  
|                                                          |  |                                |        |   |                               |   |        |      |  |   |        |   |  |   |        |  
|Other income (expense), net                               |  |                                |        |   |                               |   |        |      |  |   |        |   |  |   |        |  
|Interest expense, net                                     |  |                                |        |   |                               |   |        |      |  |   |        |   |  |   |        |  
|Debt, net                                                 |  |                                | (935   | ) |                               |   | (1,369 | )    |  |   | (3,443 | ) |  |   | (3,790 | )
|Dividends on mandatorily redeemable preferred stock       |  |                                |       |   |                               |   | (725   | )    |  |   | (1,543 | ) |  |   | (2,124 | )
|Other, net                                                |  |                                | (287   | ) |                               |   | 166    |      |  |   | (1,192 | ) |  |   | 151    |  
|                                                          |  |                                |        |   |                               |   |        |      |  |   |        |   |  |   |        |  
|Total other expense                                       |  |                                | (1,222 | ) |                               |   | (1,928 | )    |  |   | (6,178 | ) |  |   | (5,763 | )
|                                                          |  |                                |        |   |                               |   |        |      |  |   |        |   |  |   |        |  
|Income (loss) before provision (benefit) for income taxes |  |                                | 1,342  |   |                               |   | 252    |      |  |   | (99    | ) |  |   | (2,796 | )
|Provision (benefit) for income taxes                      |  |                                | 569    |   |                               |   | 332    |      |  |   | 556    |   |  |   | (229   | )
|                                                          |  |                                |        |   |                               |   |        |      |  |   |        |   |  |   |        |  
|Net income (loss)                                         |  | $                              | 773    |   |                               | $ | (80    | )    |  | $ | (655   | ) |  | $ | (2,567 | )
|                                                          |  |                                |        |   |                               |   |        |      |  |   |        |   |  |   |        |  
|Income (loss) per share                                   |  |                                |        |   |                               |   |        |      |  |   |        |   |  |   |        |  
|Basic and diluted income (loss) per share                 |  | $                              | 0.01   |   |                               | $ | (0.00  | )    |  | $ | (0.01  | ) |  | $ | (0.04  | )
|                                                          |  |                                |        |   |                               |   |        |      |  |   |        |   |  |   |        |  
|Weighted average common shares outstanding  basic        |  |                                | 70,313 |   |                               |   | 70,153 |      |  |   | 70,313 |   |  |   | 70,153 |  
|                                                          |  |                                |        |  
|Weighted average  common shares outstanding  diluted    |  |                                | 76,112 |   |                               |   | 70,153 |      |  |   | 70,313 |   |  |   | 70,153 |  



The accompanying notes
are an integral part of these condensed consolidated statements.



3



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##### Table of Contents

PART I. FINANCIAL INFORMATION



ITEM 1.
CONDENSED CONSOLIDATED FINANCIAL STATEMENTS



FIREARMS
TRAINING SYSTEMS, INC. AND SUBSIDIARIES



CONDENSED
CONSOLIDATED BALANCE SHEETS

(in thousands, except for shares authorized, issued and outstanding)



|                                                                                                                                  |  |                  |          |   |               |   |          |  
|--------------------------------------------------------------------------------------------------------------------------------- |  | ---------------- | -------- | - | ------------- | - | -------- | -
|                                                                                                                                  |  | December 31,2004 |          |   | March 31,2004 |  
|                                                                                                                                  |  | (unaudited)      |          |   |               |  
|ASSETS                                                                                                                            |  |                  |          |   |               |   |          |  
|Current assets:                                                                                                                   |  |                  |          |   |               |   |          |  
|Cash and cash equivalents                                                                                                         |  | $                | 3,668    |   |               | $ | 2,367    |  
|Restricted cash                                                                                                                   |  |                  | 2,280    |   |               |   | 2,502    |  
|Accounts receivable, net of allowance of $350                                                                                     |  |                  | 16,675   |   |               |   | 23,317   |  
|Income taxes receivable                                                                                                           |  |                  | 110      |   |               |   | 104      |  
|Costs and estimated earnings in excess of billings on uncompleted contracts                                                       |  |                  | 6,242    |   |               |   | 4,268    |  
|Unbilled receivables                                                                                                              |  |                  | 4,799    |   |               |   | 62       |  
|Inventories, net                                                                                                                  |  |                  | 11,951   |   |               |   | 12,221   |  
|Deferred income taxes                                                                                                             |  |                  | 770      |   |               |   | 770      |  
|Prepaid expenses and other current assets                                                                                         |  |                  | 2,102    |   |               |   | 1,020    |  
|                                                                                                                                  |  |                  |          |   |               |   |          |  
|Total current assets                                                                                                              |  |                  | 48,597   |   |               |   | 46,631   |  
|                                                                                                                                  |  |                 
|Property and equipment, net                                                                                                       |  |                  | 2,137    |   |               |   | 2,398    |  
|                                                                                                                                  |  |                 
|Other noncurrent assets:                                                                                                          |  |                  |          |   |               |   |          |  
|Deferred income taxes                                                                                                             |  |                  | 2,020    |   |               |   | 2,004    |  
|Deferred financing costs, net                                                                                                     |  |                  | 1,421    |   |               |   | 187      |  
|                                                                                                                                  |  |                  |          |   |               |   |          |  
|Total assets                                                                                                                      |  | $                | 54,175   |   |               | $ | 51,220   |  
|                                                                                                                                  |  |                  |          |   |               |   |          |  
|LIABILITIES AND STOCKHOLDERS DEFICIT                                                                                             |  |                  |          |   |               |   |          |  
|Current Liabilities:                                                                                                              |  |                  |          |   |               |   |          |  
|Long-term debt due within one year                                                                                                |  | $                | 2,344    |   |               | $ | 2,953    |  
|Accounts payable                                                                                                                  |  |                  | 4,716    |   |               |   | 3,679    |  
|Accrued liabilities                                                                                                               |  |                  | 5,383    |   |               |   | 7,002    |  
|Accrued interest                                                                                                                  |  |                  | 281      |   |               |   | 949      |  
|Income taxes payable                                                                                                              |  |                  | 707      |   |               |   | 214      |  
|Billings in excess of cost and estimated earnings on uncompleted contracts                                                        |  |                  | 4,084    |   |               |   | 1,428    |  
|Deferred revenue                                                                                                                  |  |                  | 5,593    |   |               |   | 1,239    |  
|Warranty and contract cost provision reserve  current                                                                            |  |                  | 355      |   |               |   | 1,074    |  
|                                                                                                                                  |  |                  |          |   |               |   |          |  
|Total current liabilities                                                                                                         |  |                  | 23,463   |   |               |   | 18,538   |  
|                                                                                                                                  |  |                 
|Long-term debt                                                                                                                    |  |                  | 34,864   |   |               |   | 38,168   |  
|                                                                                                                                  |  |                 
|Warranty and contract cost provision reserve  noncurrent                                                                         |  |                  | 173      |   |               |   | 356      |  
|                                                                                                                                  |  |                 
|Other noncurrent liabilities                                                                                                      |  |                  | 625      |   |               |   | 587      |  
|                                                                                                                                  |  |                 
|Manditorily redeemable preferred stock                                                                                            |  |                  |         |   |               |   | 30,485   |  
|                                                                                                                                  |  |                  |          |   |               |   |          |  
|Total liabilities                                                                                                                 |  |                  | 59,125   |   |               |   | 88,134   |  
|                                                                                                                                  |  |                  |          |   |               |   |          |  
|Commitments and contingencies                                                                                                     |  |                  |          |   |               |   |          |  
|                                                                                                                                  |  |                 
|Preferred stock, 3,500 shares authorized; 3,203 shares issued and outstanding; liquidation value of $10,250 per share             |  |                  | 32,028   |   |               |   |         |  
|                                                                                                                                  |  |                  |          |   |               |   |          |  
|Stockholders deficit:                                                                                                            |  |                  |          |   |               |   |          |  
|Class A common stock, $0.000006 par value; 100 million shares authorized, 70,694,173 and 70,153,139 shares issued and
outstanding |  |                  |         |   |               |   |         |  
|Additional paid-in capital                                                                                                        |  |                  | 123,497  |   |               |   | 123,215  |  
|Stock warrants                                                                                                                    |  |                  | 613      |   |               |   | 613      |  
|Accumulated deficit                                                                                                               |  |                  | (161,836 | ) |               |   | (161,181 | )
|Accumulated other comprehensive income                                                                                            |  |                  | 748      |   |               |   | 439      |  
|                                                                                                                                  |  |                  |          |   |               |   |          |  
|Total stockholders deficit                                                                                                       |  |                  | (36,978  | ) |               |   | (36,914  | )
|                                                                                                                                  |  |                  |          |   |               |   |          |  
|Total liabilities and stockholders deficit                                                                                       |  | $                | 54,175   |   |               | $ | 51,220   |  
|                                                                                                                                  |  |                  |          |   |               |   |          |  

The accompanying notes are an integral part of these condensed consolidated statements.



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##### Table of Contents

PART I. FINANCIAL INFORMATION



ITEM 1.
CONDENSED CONSOLIDATED FINANCIAL STATEMENTS



FIREARMS
TRAINING SYSTEMS, INC. AND SUBSIDIARIES



CONDENSED
CONSOLIDATED STATEMENTS OF CASH FLOWS

(unaudited and in thousands)



|                                                                            |  |                               |         |   |      |   |        |  
|--------------------------------------------------------------------------- |  | ----------------------------- | ------- | - | ---- | - | ------ | -
|                                                                            |  | Nine Months EndedDecember 31, |        
|                                                                            |  | 2004                          |         |   | 2003 |  
|Cash flows from operating activities:                                       |  |                               |         |   |      |   |        |  
|Net loss                                                                    |  | $                             | (655    | ) |      | $ | (2,567 | )
|                                                                            |  |                               |         |   |      |   |        |  
|Adjustments for non-cash items                                              |  |                               |         |   |      |   |        |  
|Non-cash interest and financing costs                                       |  |                               | 2,582   |   |      |   | 2,945  |  
|Depreciation and amortization                                               |  |                               | 738     |   |      |   | 855    |  
|Change in inventory reserve                                                 |  |                               | (15     | ) |      |   | (513   | )
|Change in warranty and contract cost provision reserve                      |  |                               | (901    | ) |      |   | (191   | )
|Gain on sale of assets                                                      |  |                               | (5      | ) |      |   |       |  
|Deferred income taxes                                                       |  |                               | 16      |   |      |   |       |  
|Changes in assets and liabilities                                           |  |                               |         |   |      |   |        |  
|Accounts receivable, net                                                    |  |                               | 6,642   |   |      |   | 6,049  |  
|Income taxes receivable                                                     |  |                               | (6      | ) |      |   | 337    |  
|Costs and estimated earnings in excess of billings on uncompleted contracts |  |                               | (1,974  | ) |      |   | (1,713 | )
|Unbilled receivables                                                        |  |                               | (4,737  | ) |      |   | (36    | )
|Inventories                                                                 |  |                               | 286     |   |      |   | (2,342 | )
|Prepaid expenses and other current assets                                   |  |                               | (1,083  | ) |      |   | 66     |  
|Accounts payable                                                            |  |                               | 1,037   |   |      |   | (263   | )
|Accrued liabilities                                                         |  |                               | (2,290  | ) |      |   | (428   | )
|Income taxes payable                                                        |  |                               | 493     |   |      |   |       |  
|Billings in excess of costs and estimated earnings on uncompleted contracts |  |                               | 2,656   |   |      |   | 49     |  
|Deferred revenue                                                            |  |                               | 4,354   |   |      |   | (1,087 | )
|Noncurrent liabilities                                                      |  |                               | 38      |   |      |   | 157    |  
|                                                                            |  |                               |         |   |      |   |        |  
|Total adjustments                                                           |  |                               | 7,831   |   |      |   | 3,885  |  
|                                                                            |  |                               |         |   |      |   |        |  
|Net cash provided by operating activities                                   |  |                               | 7,176   |   |      |   | 1,318  |  
|                                                                            |  |                               |         |   |      |   |        |  
|Cash flows from investing activities                                        |  |                               |         |   |      |   |        |  
|Change in restricted cash                                                   |  |                               | 222     |   |      |   | (1,119 | )
|Purchase of property and equipment                                          |  |                               | (380    | ) |      |   | (902   | )
|Proceeds from disposal of property and equipment                            |  |                               | 4       |   |      |   |       |  
|                                                                            |  |                               |         |   |      |   |        |  
|Net cash used by investing activities                                       |  |                               | (154    | ) |      |   | (2,021 | )
|                                                                            |  |                               |         |   |      |   |        |  
|Cash flows from financing activities                                        |  |                               |         |   |      |   |        |  
|Proceeds from long-term debt                                                |  |                               | 37,450  |   |      |   |       |  
|Payments on long-term debt                                                  |  |                               | (42,150 | ) |      |   | (44    | )
|Payment of deferred financing costs                                         |  |                               | (1,484  | ) |      |   | (409   | )
|Exercise of stock options                                                   |  |                               | 282     |   |      |   |       |  
|                                                                            |  |                               |         |   |      |   |        |  
|Net cash used by financing activities                                       |  |                               | (5,902  | ) |      |   | (453   | )
|                                                                            |  |                               |         |   |      |   |        |  
|Effect of exchange rate changes on cash                                     |  |                               | 181     |   |      |   | 425    |  
|                                                                            |  |                               |         |   |      |   |        |  
|Net increase (decrease) in cash and cash equivalents                        |  |                               | 1,301   |   |      |   | (731   | )
|Cash and cash equivalents, beginning of period                              |  |                               | 2,367   |   |      |   | 3,457  |  
|                                                                            |  |                               |         |   |      |   |        |  
|Cash and cash equivalents, end of period                                    |  | $                             | 3,668   |   |      | $ | 2,726  |  
|                                                                            |  |                               |         |   |      |   |        |  



The accompanying notes
are an integral part of these condensed consolidated statements.



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##### Table of Contents

FIREARMS TRAINING SYSTEMS, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(unaudited)



1. Basis of presentation



The unaudited condensed consolidated financial statements of Firearms Training Systems, Inc. and subsidiaries (the Company) have been prepared
in accordance with accounting principles generally accepted in the United States of America and with the instructions to Form 10-Q and Article 10 of Regulation S-X. In the opinion of management, all adjustments (consisting of normal recurring
accruals) considered necessary for a fair presentation have been included. Operating results for the three-month and nine-month period ended December 31, 2004 are not necessarily indicative of the results that may be expected for the full year
ending March 31, 2005. We suggest that these condensed consolidated financial statements be read in conjunction with the consolidated financial statements and notes thereto for the year ended March 31, 2004, included in our 2004 Annual Report on
Form 10-K filed with the Securities and Exchange Commission (SEC).



2. Revenue recognition



A significant amount
of the Companys revenue is derived from the sale of small and supporting arms training simulators and accessories. Revenue from sales to commercial customers and small governmental agencies is primarily recognized upon shipment when title
passes, as all material commitments have been fulfilled, the sales price is fixed and determinable and collectibility is reasonably assured.



A large portion of the Companys small and supporting arms training simulator revenue is derived from contracts with various large governmental
agencies. Governmental contracts that involve high volume purchases of the Companys standard systems and related accessories are accounted for as multiple-element arrangements. These contracts require little or no modifications to the existing
proprietary platform, specify pricing terms by product and billings generally correspond to the underlying shipment schedule. Revenue under these contracts is recognized upon delivery. Advanced billings related to these contracts are recorded as
deferred revenue and are recognized ratably as units are delivered.



Other governmental contracts require significant customization of the Companys existing proprietary platform or require the development of new systems to meet required customer specifications. These contracts are accounted for under
the percentage of completion method, measured by the percentage of cost incurred to date to the estimated total cost for each contract. Contract costs include all direct material, direct labor and other costs directly related to the contract.
Selling, general, and administrative costs are charged to expense as incurred. Changes in job performance, job conditions, and estimated profitability, including those arising from contract penalty provisions, and final contract settlements may
result in revisions to costs and income and are recognized in the period in which the revisions are determined.



Provisions for estimated losses on uncompleted contracts accounted for under both methods described above are made in the period in which such losses are
determined.



Revenue from extended warranty sales and customer
logistics support sales are recorded as deferred revenue and are recognized ratably as income over the lives of the related service agreements, which generally range from one to three years. Costs associated with these sales are recorded in the
period incurred.





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##### Table of Contents

3. Stock-based compensation



The Company accounts for stock incentives available to employees and non-employee directors under its stock-based
compensation plans using the intrinsic value method prescribed in Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees as allowed under FAS No. 123, Accounting for Stock-Based Compensation. The Company
has adopted the provisions of FAS No. 123 and FAS 148, Accounting for Stock-Based CompensationTransition and Disclosure, which require disclosure of the pro forma effects on earnings and earnings per share as if SFAS No. 123 had been
adopted.



The Company has computed for pro forma disclosure
purposes the value of all options using the Black-Scholes option pricing model as prescribed by SFAS No. 123 using the following assumptions:



|                          |  |                                |   |  |        |  
|------------------------- |  | ------------------------------ | - |  | ------ | -
|                          |  | Nine Months Ended December 31, |  
|                          |  | 2004                           |   |  | 2003   |  
|Risk-free interest rate   |  | 3.27                           | % |  | 2.28   | %
|Expected dividend yields  |  | 0                              |   |  | 0      |  
|Expected lives (in years) |  | 3.5                            |   |  | 3.5    |  
|Expected volatility       |  | 196.47                         | % |  | 221.58 | %



The Company issued
options to purchase a total of 5.8 million shares of its common stock under its option plan on May 1, 2003, with an exercise price equal to the $.40 per share market value of the stock on that date.



The weighted average grant-date fair value of options granted during the
nine-month period ended December 31, 2003 was computed as approximately $2.2 million or $.38 per share under option.



The Company issued options to purchase a total of 750,000 shares of its common stock under its option plan on August 4, 2004, with an exercise price equal
to the $.64 per share market value of the stock on that date.



The weighted average grant-date fair value of options granted during the nine-month period ended December 31, 2004 was computed as approximately $450,000 or $.60 per share under option.



The values above and the value computed for unvested options granted in prior
years is being amortized on a pro forma basis over the vesting period of the options. Pro forma information (in thousands, except per share amounts) regarding net income (loss) and income (loss) per share as if the Company had accounted for options
using the fair value method is as follows:



|                                                 |  |                                          |      |   |                                |   |       |      |  |   |       |   |  |   |        |  
|------------------------------------------------ |  | ---------------------------------------- | ---- | - | ------------------------------ | - | ----- | ---- |  | - | ----- | - |  | - | ------ | -
|                                                 |  | Three Months Ended December 31,          |      |   | Nine Months Ended December 31, |  
|                                                 |  | (in thousands, except per share amounts) |     
|                                                 |  | 2004                                     |      |   | 2003                           |   |       | 2004 |  |   | 2003  |  
|Net income (loss)                                |  |                                          |      |   |                                |   |       |      |  |   |       |   |  |   |        |  
|As reported                                      |  | $                                        | 773  |   |                                | $ | (80   | )    |  | $ | (655  | ) |  | $ | (2,567 | )
|Fair value based compensation cost, net of taxes |  |                                          | (87  | ) |                                |   | (47   | )    |  |   | (262  | ) |  |   | (141   | )
|                                                 |  |                                          |      |   |                                |   |       |      |  |   |       |   |  |   |        |  
|Pro forma net income (loss)                      |  | $                                        | 686  |   |                                | $ | (127  | )    |  | $ | (917  | ) |  | $ | (2,708 | )
|                                                 |  |                                          |      |   |                                |   |       |      |  |   |       |   |  |   |        |  
|Basic and diluted income (loss) per share        |  |                                          |      |   |                                |   |       |      |  |   |       |   |  |   |        |  
|As reported                                      |  | $                                        | 0.01 |   |                                | $ | (0.00 | )    |  | $ | (0.01 | ) |  | $ | (0.04  | )
|Pro forma                                        |  | $                                        | 0.01 |   |                                | $ | (0.00 | )    |  | $ | (0.01 | ) |  | $ | (0.04  | )





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##### Table of Contents

4. Inventory



Inventories consist primarily of simulators, computer hardware, projectors, and component parts. Inventories are valued at the lower of cost on a moving
weighted average or market basis. Cost includes materials, labor, and factory overhead. Market is defined as net realizable value.



Inventories consist of the following (in thousands):



|                                          |  |                  |        |   |               |   |        |  
|----------------------------------------- |  | ---------------- | ------ | - | ------------- | - | ------ | -
|                                          |  | December 31,2004 |        |   | March 31,2004 |  
|Raw materials                             |  | $                | 7,653  |   |               | $ | 6,293  |  
|Work in process                           |  |                  | 3,130  |   |               |   | 3,918  |  
|Finished goods                            |  |                  | 1,846  |   |               |   | 2,703  |  
|                                          |  |                  |        |   |               |   |        |  
|Inventories, gross                        |  |                  | 12,629 |   |               |   | 12,914 |  
|Reserve for excess and obsolete inventory |  |                  | (678   | ) |               |   | (693   | )
|                                          |  |                  |        |   |               |   |        |  
|Inventories, net                          |  | $                | 11,951 |   |               | $ | 12,221 |  
|                                          |  |                  |        |   |               |   |        |  



5. Long-term contracts



Costs and estimated earnings on uncompleted contracts and
related amounts billed are as follows (in thousands):



|                                                                            |  |                  |         |   |               |   |         |  
|--------------------------------------------------------------------------- |  | ---------------- | ------- | - | ------------- | - | ------- | -
|                                                                            |  | December 31,2004 |         |   | March 31,2004 |  
|Costs incurred on uncompleted contracts                                     |  | $                | 40,014  |   |               | $ | 34,322  |  
|Estimated earnings                                                          |  |                  | 14,826  |   |               |   | 13,007  |  
|                                                                            |  |                  |         |   |               |   |         |  
|                                                                            |  |                  | 54,840  |   |               |   | 47,329  |  
|Less: billings to date                                                      |  |                  | (52,682 | ) |               |   | (44,489 | )
|                                                                            |  |                  |         |   |               |   |         |  
|                                                                            |  | $                | 2,158   |   |               | $ | 2,840   |  
|                                                                            |  |                  |         |   |               |   |         |  
|Such amounts are included in the following accounts (in thousands):         |  |                  |         |   |               |   |         |  
|                                                                            |  |                 
|Costs and estimated earnings in excess of billings on uncompleted contracts |  | $                | 6,242   |   |               | $ | 4,268   |  
|Billings in excess of costs and estimated earnings on uncompleted contracts |  |                  | (4,084  | ) |               |   | (1,428  | )
|                                                                            |  |                  |         |   |               |   |         |  
|                                                                            |  | $                | 2,158   |   |               | $ | 2,840   |  
|                                                                            |  |                  |         |   |               |   |         |  



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##### Table of Contents

6. Other noncurrent assets



Other noncurrent assets consist of the following intangible assets (in thousands):



|                             |  |                   |       |   |               |   |      |  
|---------------------------- |  | ----------------- | ----- | - | ------------- | - | ---- | -
|                             |  | December 31, 2004 |       |   | March 31,2004 |  
|Non-compete agreement        |  | $                 |      |   |               | $ | 33   |  
|Debt issuance costs          |  |                   | 1,495 |   |               |   | 659  |  
|                             |  |                   |       |   |               |   |      |  
|                             |  |                   | 1,495 |   |               |   | 692  |  
|Accumulated amortization     |  |                   | (74   | ) |               |   | (505 | )
|                             |  |                   |       |   |               |   |      |  
|Other noncurrent assets, net |  | $                 | 1,421 |   |               | $ | 187  |  
|                             |  |                   |       |   |               |   |      |  



At December 31, 2004,
the Company had debt issuance costs of $1.5 million related to the New Credit Agreement discussed in Note 7. For the three and nine-month periods ended December 31, 2004, amortization expense was $74,000 and $493,000, respectively. For the year
ending March 31, 2005, amortization expense is expected to be approximately $568,000.



7. Long-term debt



Long-term debt consists of
the following (in thousands):



|                             |  |                  |        |   |               |   |        |  
|---------------------------- |  | ---------------- | ------ | - | ------------- | - | ------ | -
|                             |  | December 31,2004 |        |   | March 31,2004 |  
|Working capital - borrowings |  | $                | 7,681  |   |               | $ | 230    |  
|Long-term debt  Loan A      |  |                  | 14,469 |   |               |   | 11,582 |  
|Long-term debt  Loan B      |  |                  | 15,000 |   |               |   | 29,190 |  
|Accrued PIK                  |  |                  | 58     |   |               |   | 119    |  
|                             |  |                  |        |   |               |   |        |  
|                             |  |                  | 37,208 |   |               |   | 41,121 |  
|Due within one year          |  |                  | (2,344 | ) |               |   | (2,953 | )
|                             |  |                  |        |   |               |   |        |  
|Long-term debt               |  | $                | 34,864 |   |               | $ | 38,168 |  
|                             |  |                  |        |   |               |   |        |  



On September 30, 2004,
the Company entered into a Revolving Credit, Term Loan and Security Agreement (the New Credit Agreement) with CapitalSource Finance LLC (CapitalSource), as administrative, payment and collateral agent for the lenders named
therein. The New Credit Agreement permits a maximum borrowing capacity of $42 million and matures on September 30, 2009.



The New Credit Agreement provides for a revolving credit facility on which up to $12,000,000 may be drawn (subject to adjustment based on letter of credit
usage and compliance with identified leverage ratios), a $15,000,000 Term A loan and a $15,000,000 Term B loan. The revolving credit facility requires the Company to pay interest on a monthly basis in cash at an annual rate
equal to the prime rate plus .5% subject to a floor of 4.75% (5.75% at December 31, 2004). At December 31, 2004, the amount available on the revolving credit facility was $4,272,250 (includes $46,750 related to a letter of credit). All
amounts outstanding under the revolving credit facility are due in full on September 30, 2009. For the three months ended December 31, 2004, interest expense on the revolving credit facility was approximately $95,000.



The Term A loan requires the Company to pay interest on a monthly basis in
cash at an annual rate equal to the prime rate plus 3% subject to a floor of 7.25% (8.25% at December 31, 2004). The Company must also make scheduled quarterly payments of principal under the Term A loan. The quarterly principal payments
required are in the amount of $531,250 for the first year of the term, $750,000 for the second through fourth years of the term, and $968,750 in the fifth year of the term. For the three months ended December 31, 2004, interest expense on the Term A
loan was approximately $307,000.



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The Term B loan requires the Company to pay interest on a monthly basis in cash at an annual rate equal
to the prime rate plus 6% subject to a floor of 10.25% (11.25% at December 31, 2004). The Company is also required to pay interest payable-in-kind (PIK interest), which accrues monthly at an annual rate of 1.5%. The PIK
interest is due and payable on the earlier to occur of (i) the Companys early redemption or termination of the Term B loan, (ii) the lenders demand as a result of a default or (iii) September 30, 2009. The Company has the option at any
time to pay the PIK interest in cash. Outstanding principal under the Term B loan is due in full at the maturity date. For the three months ended December 31, 2004, interest expense on the Term B loan, including PIK interest, was approximately
$483,000.



Borrowings under the New Credit Agreement are
collateralized by substantially all of the Companys assets. The Company has also pledged all of the stock of its operating subsidiary, FATS, Inc., and 65% of the stock of its foreign subsidiaries. The Company generally will be required to
apply all proceeds it receives from transactions in which it sells any material assets, sells equity securities or incurs indebtedness for borrowed money as a mandatory prepayment on the outstanding obligations under the New Credit Agreement. In
addition, subject to certain availability exceptions, the Company will be required to apply 50% of its excess cash flow each year as a mandatory prepayment. Among other restrictions, the New Credit Agreement includes certain restrictive covenants,
including covenants related to indebtedness, asset acquisitions and dispositions, investments and maintenance of required leverage ratios, minimum EBITDA and fixed charge coverage ratios.



In addition, the New Credit Agreement requires the Company to pay a number of lender fees including: (i) an unused credit
line fee equal to 0.0417% per month of the difference between average outstanding revolving loans and the revolving loan cap; (ii) a monthly collateral management fee equal to 0.0417% per month of the average outstanding revolving loans; (iii) a
monthly float day fee calculated in accordance with a specified formula; (iv) a letter of credit fee equal to 3% of the undrawn face amount of outstanding letters of credit; and (v) a termination fee (ranging from 1% to 2% of the amount prepaid as
to the Term A loan, and either a yield maintenance fee calculated in accordance with a specified formula or up to 2% of the amount prepaid depending on the timing of the prepayment as to the Term B loan) in the event the term loans are prepaid prior
to the second anniversary of the closing.



As of December 31,
2004, $37,208,000 was outstanding under the New Credit Agreement.



8.
Mandatorily redeemable preferred stock (Series B)



In
August 2000, the board of directors approved an amendment to the Companys certificate of incorporation to change the number of authorized shares of preferred stock to 100,000. The board of directors then created a new class of Series B
preferred stock with 50,000 authorized shares. Holders of the Series B preferred stock were entitled to receive cumulative dividends equal to 10% of the liquidation preference payable quarterly in additional shares of Series B preferred stock.



The Company issued 21,361.113 shares of Series B preferred
stock with a liquidation value of $1,000 per share (approximately $21.4 million) in August 2000 in conjunction with its debt restructuring (see Note 3 to the financial statements contained in the Companys most recently filed Form 10-K for the
year ended March 31, 2004). The increase in debt related to dividends earned on the Series B during the years ended March 31, 2002, 2003 and 2004 was approximately $2,353,000, $2,597,000 and $2,867,000, respectively. These amounts were previously
offset by the reduction of approximately $2,083,000 and $2,299,000 in the debt restructuring liability allocated to the preferred stock, resulting in a net increase of approximately $270,000 and $298,000 for the years ended March 31, 2002 and 2003,
respectively. As of March 31, 2003, the debt restructuring liability related to the preferred stock was fully amortized and, therefore, for the year ended March 31, 2004, the total $2,867,000 of preferred stock dividends was reported without the
related offsetting amortization.



The Company adopted the
classification provisions of SFAS No. 150, Accounting for Certain Liabilities with Characteristics of both Liabilities and Equityas of the beginning of the year ended March 31, 2004. Those provisions require the Company to include the
mandatorily redeemable preferred stock as a liability in its balance sheet and to include the dividends on the preferred stock as a component of interest expense in its income statement, and prohibit reclassification of prior year amounts.
Accordingly, the net accretion of preferred stock dividends was reported as an adjustment to net income to arrive at net income attributable to common stockholders for the years ended March 31, 2002 and 2003, and the total preferred stock dividends
was reported as interest expense in the income statement for the year ended March 31, 2004.



10



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The Series B preferred stock was subject to mandatory redemption on October 15, 2005 at its liquidation
value. Accordingly, the mandatorily redeemable preferred stock was not classified as a current liability as of March 31, 2004. All of the shares of Series B preferred stock were exchanged for shares of Series C preferred stock in connection with the
debt restructuring described in Note 7.



9. Preferred stock (Series C)



In September 2004, the board of directors created a new
class of Series C preferred stock with 3,500 authorized shares. Holders of the Series C preferred stock are entitled to receive, if declared by the board, cumulative dividends equal to (i) 10% of the liquidation preference per year through March 31,
2006; (ii) 12% of the liquidation preference per year through September 30, 2006 and (iii) 14% of the liquidation preference per year thereafter, payable in cash. Dividends are cumulative and compound quarterly whether or not there are funds
available for the payment of dividends.



The Company issued
3,202.78 shares of Series C preferred stock with a liquidation value of $10,000 (subject to adjustment to reflect any stock split, combination, reclassification or similar event involving the Series C Preferred) per share (approximately $32.03
million) in September 2004 in exchange for the then outstanding 32,027.80 shares of the Series B preferred stock. At December 31, 2004, the liquidation value was $10,250 per share.



The Company may redeem the shares of Series C Preferred at any time and from time to time at a redemption price equal to the
liquidation preference plus the amount of all accrued and unpaid dividends, whether or not earned or declared. The shares of Series C Preferred are required to be redeemed upon the occurrence of a change of control (which includes the
sale of all or substantially all of the Companys assets, merger, consolidation or similar event in which more than 50% of the voting stock of the Company is transferred). In the event the Company is legally prohibited from redeeming the shares
when required (or the Company materially breaches any of its other obligations under the Series C Designations), the applicable dividend rate payable on the Series C Preferred will be increased by 2% per annum.



The Series C Preferred ranks prior to all other classes of preferred and
common stock as to payment of dividends and the distribution of amounts upon liquidation, dissolution or winding up. Holders of shares of the Series C Preferred generally do not have any voting rights other than those provided by law. The Company
must obtain the consent from holders of at least a majority of the outstanding shares of Series C Preferred in order to: (i) enter into any plan of liquidation or dissolution (unless prior written notice of any such plan is given to the Series C
Preferred holders and, as a result of such liquidation or dissolution, the Company is able to satisfy in full the liquidation preferences together with all accrued and unpaid dividends on the shares); (ii) enter into any agreement which by its terms
would violate or conflict with the rights of the Series C Preferred holders; (iii) subject to certain exceptions, amend or waive any provision of the Series C Designations or the Companys certificate of incorporation. Any amendment that would
decrease the dividend rate payable on the Series C Preferred requires the consent of all holders of Series C Preferred. Any amendment that would increase the authorized number of Series C Preferred shares or that would result in the issuance of
capital stock ranking senior to or on parity with the Series C Preferred as to dividends or rights upon liquidation requires the consent of at least two holders who are not affiliates of each other and who hold, in the aggregate, at least a majority
of the Series C Preferred shares.



10. Related party transactions



Special Situations Opportunity Fund I, LLC, one of the
Term A lenders under the New Credit Agreement described in Note 7, is an affiliate of First Source Financial, Inc. First Source is one of the Companys Series C preferred stockholders and an affiliate of First Source owns approximately 13.4% of
the Companys outstanding common stock. In addition, the primary lenders under the credit facility that was paid in full in connection with the New Credit Agreement included Centre Capital Investors II, L.P., Centre Capital Tax-Exempt Investors
II, L.P., Centre Capital Offshore Investors II, L.P., Centre Partners Coinvestment, L.P. (collectively, the Centre Entities). The Centre Entities are among the Companys largest stockholders and have two representatives on the
Companys Board of Directors.



On September 30, 2004, the
Company entered into an Exchange Agreement with the Centre Entities, U.S. Bank National Association and First Source Financial LLP. As reflected in Note 8, in accordance with the Exchange Agreement the Company issued 3,202.78 shares of its Series C
preferred stock to these entities exchange for 32,027.80 shares of its Series B preferred stock previously held by them. As a result of the exchange, all of the previously issued shares of Series B Preferred were cancelled.



11



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##### Table of Contents

11. Net income (loss) per common share



Basic and diluted net income (loss) per share was calculated by dividing net income (loss) by the weighted average
common shares outstanding for the three and nine-month periods ended December 31, 2004 and 2003.



Options to purchase 6,735,187 shares of common stock and warrants to purchase 5,246,164 shares of common stock were outstanding at December 31, 2004, but
were not included in the computation of diluted EPS for the nine months ended December 31, 2004 because their effect would have been anti-dilutive, thereby decreasing net loss per share. However, for the three months ended December 31, 2004, the
dilutive options and warrants were included in the computation of diluted EPS as the Company incurred net income.



Options to purchase 6,834,038 shares of common stock and warrants to purchase 5,246,164 shares of common stock were outstanding at December 31, 2003, but
were not included in the computation of 2003 diluted EPS because their effect would have been anti-dilutive, thereby decreasing net loss per share.



12. Contingencies and commitments



Product Warranty Reserve



The Companys product warranty accrual reflects managements best estimate of probable liability under its product warranties. Management
determines the warranty based on known product failures (if any), historical experience, and other currently available evidence. Changes in the product warranty accrual for the three and nine-month periods ended December 31, 2004 and 2003 were as
follows (in thousands):



|                                 |  |                                |     |   |                               |   |     |      |  |   |      |   |  |   |      |  
|-------------------------------- |  | ------------------------------ | --- | - | ----------------------------- | - | --- | ---- |  | - | ---- | - |  | - | ---- | -
|                                 |  | Three Months EndedDecember 31, |     |   | Nine Months EndedDecember 31, |  
|                                 |  | 2004                           |     |   | 2003                          |   |     | 2004 |  |   | 2003 |  
|Balance  beginning              |  | $                              | 223 |   |                               | $ | 702 |      |  | $ | 214  |   |  | $ | 704  |  
|Claims paid                      |  |                                | (66 | ) |                               |   | (41 | )    |  |   | (197 | ) |  |   | (138 | )
|Warranties issued/(expired), net |  |                                | 79  |   |                               |   | 44  |      |  |   | 219  |   |  |   | 139  |  
|Revisions to estimate            |  |                                |    |   |                               |   | (90 | )    |  |   |     |   |  |   | (90  | )
|                                 |  |                                |     |   |                               |   |     |      |  |   |      |   |  |   |      |  
|Balance - ending                 |  | $                              | 236 |   |                               | $ | 615 |      |  | $ | 236  |   |  | $ | 615  |  
|                                 |  |                                |     |   |                               |   |     |      |  |   |      |   |  |   |      |  



13. Supplemental cash flow
disclosures



|                                                    |  |                               |        |      |   |      
|--------------------------------------------------- |  | ----------------------------- | ------ | ---- | - | -----
|                                                    |  | Nine Months EndedDecember 31,
|                                                    |  | 2004                          |        | 2003
|Cash paid (received) for (in thousands):            |  |                               |        |      |   |      
|Interest (includes PIK interest of $6,923 for 2004) |  | $                             | 10,321 |      | $ | 2,637
|Income taxes                                        |  |                               | 110    |      |   | 32   



14. Comprehensive income (loss)



|                                        |  |                                |       |      |                               |     |      |  |   |      |   |  |   |        |  
|--------------------------------------- |  | ------------------------------ | ----- | ---- | ----------------------------- | --- | ---- |  | - | ---- | - |  | - | ------ | -
|                                        |  | Three Months EndedDecember 31, |       |      | Nine Months EndedDecember 31, |    
|                                        |  | 2004                           |       | 2003 |                               |     | 2004 |  |   | 2003 |  
|Net income (loss)                       |  | $                              | 773   |      | $                             | (80 | )    |  | $ | (655 | ) |  | $ | (2,567 | )
|Foreign currency translation adjustment |  |                                | 311   |      |                               | 181 |      |  |   | 309  |   |  |   | 425    |  
|                                        |  |                                |       |      |                               |     |      |  |   |      |   |  |   |        |  
|Comprehensive income (loss)             |  | $                              | 1,084 |      | $                             | 101 |      |  | $ | (346 | ) |  | $ | (2,142 | )
|                                        |  |                                |       |      |                               |     |      |  |   |      |   |  |   |        |  



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ITEM 2. MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS



This Managements Discussion and Analysis of Financial Condition and Results of Operations should be read in conjunction with the Managements
Discussion and Analysis of Financial Condition and Results of Operations contained in the Companys most recently filed Form 10-K for the fiscal year ended March 31, 2004.



You should carefully review the information contained in this Report, and should particularly consider any risks and other
factors that we set forth in the most recently filed Form 10-K for the fiscal year ended March 31, 2004, and in other reports or documents that we file from time to time with the SEC. In this Report, we state our expectations as to future events and
our future financial performance. In some cases, you can identify those so-called forward-looking statements by words such as may, will, should, expects, plans,
anticipates, believes, estimates, predicts, potential, or continue or the negative of those words and other comparable words. You should be aware that those statements are only
our predictions, which are being made as of the date hereof. Actual events or results may differ materially. In evaluating those statements, you should specifically consider various factors, including the risks outlined below. Those factors may
cause our actual results to differ materially from any of our forward-looking statements. We undertake no obligation to update any forward-looking statements, whether as a result of new information, future events or otherwise.



Factors that may cause our actual results to differ materially from any of
our forward-looking statements presented in this Report include, but are not limited to:



| |  |  | changes in laws and regulations, both domestically and in the international markets in which we compete,
| | - |  | --------------------------------------------------------------------------------------------------------



| |  |  | diversion of funds in support of the war on terrorism,
| | - |  | ------------------------------------------------------



| |  |  | changes in the competitive environment, including the introduction of competitors attracted by the prospect of increased government spending on security, especially with respect to
large defense contractors,
| | - |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | changes in technology which may affect our existing and future product offerings,
| | - |  | ---------------------------------------------------------------------------------



| |  |  | disruptions in scheduled development of new products,
| | - |  | -----------------------------------------------------



| |  |  | decline in market acceptance of existing products,
| | - |  | --------------------------------------------------



| |  |  | currency fluctuations,
| | - |  | ----------------------



| |  |  | the ability to realize cost reductions and operating efficiencies in a manner that does not unduly disrupt business operations,
| | - |  | -------------------------------------------------------------------------------------------------------------------------------



| |  |  | industry consolidation and mergers that involve our competitors, especially with respect to large defense contractors,
| | - |  | ----------------------------------------------------------------------------------------------------------------------



| |  |  | market conditions that may adversely affect the availability of debt and equity financing for working capital, capital expenditures or other purposes,
| | - |  | ------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | general economic conditions including changes in customer budgets and spending profiles, and
| | - |  | --------------------------------------------------------------------------------------------



| |  |  | the other risks identified in Management Discussion and Analysis of Financial Condition and Results of Operations  Risk Factorscontained in the Companys
most recently filed Form 10-K for the fiscal year ended March 31, 2004.
| | - |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



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##### Table of Contents

Critical Accounting Policies and Estimates



The following discussion and analysis of our financial condition and results of operations is based upon our consolidated
financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these financial statements requires us to make judgments regarding estimates that affect
the reported amounts of assets, liabilities, revenues and expenses, and related disclosures. We base our judgments on historical experience and on various assumptions that we believe are reasonable under the circumstances. Actual results may differ
from these estimates under different assumptions or conditions. We believe our judgments and related estimates regarding the following accounting policies are critical in the preparation of our consolidated financial statements.



Revenue Recognition



Customer contracts that require significant customization of the
Companys existing proprietary platform or require the development of new systems to meet required customer specifications are accounted for under the percentage of completion method, measured by the percentage of cost incurred to date to the
estimated total cost for each contract. Accounting for such contracts is essentially a process of measuring the results of relatively long-term events and allocating those results to relatively short-term accounting periods. This involves
considerable use of estimates in determining costs and profits and thereby estimating the timing of revenue recognition and in assigning the amounts to accounting periods. The process is complicated by the need to evaluate continually the
uncertainties inherent in the performance of contracts and by the need to rely on estimates of revenues, costs, and the extent of progress toward completion. The Company continually monitors each of these estimates based on the most current
information available from the project managers and project engineers assigned to the programs. Changes in job performance, job conditions, and estimated profitability, including those arising from contract penalty provisions, and final contract
settlements may result in revisions to costs and income and are recognized in the period in which the revisions are determined. These revisions could materially increase or decrease profit margins on particular contracts in future periods.



Inventory Reserve



Inventories are valued at the lower of cost on a moving weighted average or
market, cost being determined on the first-in, first-out basis and market being defined as net realizable value. Management periodically reviews Company inventory for items that may be deemed obsolete, damaged or for amounts on hand in excess of
anticipated future demand. The underlying assumptions utilized in assessing the Companys inventory change from time-to-time due to change in the underlying sales mix, the release of new versions of the Companys proprietary system and
overall changes in technology and the marketplace. As the Company develops new product lines, future charges against income may be necessary to reduce inventory to its net realizable value.



Contract Cost Provision Reserve



Management routinely assesses the Companys performance and estimated
cost to complete ongoing sales contracts. Changes in job performance, job conditions, and estimated profitability, including those arising from contract penalty provisions, and final contract settlements may result in revisions to costs and income.
In the event management anticipates incurring costs in excess of contract revenues, the Company records a contract cost provision reserve in an amount equal to the estimated costs in excess of contracted revenues in the period in which such
information becomes apparent.



Warranty Cost
Provision Reserve



Management periodically
estimates expected warranty costs under the Companys standard product warranty. In determining the estimate, management analyzes the relationship of historical standard warranty costs incurred on historical sales and the underlying product mix
comprising the historical sales. Management, in turn, utilizes this historical information to estimate expected warranty costs on recent sales within the standard warranty time frame. Due to the inherent limitations in the estimation process, the
potential for product defects and other unforeseen circumstances by the Company, the possibility exists that the recorded warranty provision reserve will be inadequate to offset actual warranty costs incurred resulting in additional charges against
income. Also, actual warranty costs may be significantly lower than expected resulting in the reduction of the Companys warranty provision reserve generating an addition to income in future periods.



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##### Table of Contents

RESULTS OF OPERATIONS



The following table sets forth the operations of the Company as a percentage of gross revenues for the periods indicated:



|                                                                       |  |                                |   |  |                               |   |  |        |   |  |        |  
|---------------------------------------------------------------------- |  | ------------------------------ | - |  | ----------------------------- | - |  | ------ | - |  | ------ | -
|                                                                       |  | Three Months EndedDecember 31, |   |  | Nine Months EndedDecember 31, |  
|                                                                       |  | 2004                           |   |  | 2003                          |   |  | 2004   |   |  | 2003   |  
|Revenue                                                                |  | 100.00                         | % |  | 100.00                        | % |  | 100.00 | % |  | 100.00 | %
|Cost of revenue                                                        |  | 66.96                          |   |  | 62.32                         |   |  | 67.11  |   |  | 68.06  |  
|                                                                       |  |                                |   |  |                               |   |  |        |   |  |        |  
|Gross Margin                                                           |  | 33.04                          |   |  | 37.68                         |   |  | 32.89  |   |  | 31.94  |  
|                                                                       |  |                                |   |  |                               |   |  |        |   |  |        |  
|Operating expenses                                                     |  |                                |   |  |                               |   |  |        |   |  |        |  
|Selling, general and administrative                                    |  | 15.76                          |   |  | 19.18                         |   |  | 17.48  |   |  | 20.14  |  
|Research and development                                               |  | 4.51                           |   |  | 4.65                          |   |  | 4.54   |   |  | 4.47   |  
|Depreciation and amortization                                          |  | 0.58                           |   |  | .62                           |   |  | 0.60   |   |  | 0.74   |  
|                                                                       |  |                                |   |  |                               |   |  |        |   |  |        |  
|Total operating expenses                                               |  | 20.85                          |   |  | 24.45                         |   |  | 22.62  |   |  | 25.35  |  
|                                                                       |  |                                |   |  |                               |   |  |        |   |  |        |  
|Operating income                                                       |  | 12.19                          |   |  | 13.23                         |   |  | 10.27  |   |  | 6.59   |  
|                                                                       |  |                                |   |  |                               |   |  |        |   |  |        |  
|Other income (expense), net                                            |  |                                |   |  |                               |   |  |        |   |  |        |  
|Interest expense  debt, net                                           |  | (4.05                          | ) |  | (8.31                         | ) |  | (5.82  | ) |  | (8.42  | )
|Interest expense  dividends on mandatorily redeemable preferred stock |  |                               |   |  | (4.40                         | ) |  | (2.61  | ) |  | (4.72  | )
|Other, net                                                             |  | (1.76                          | ) |  | 1.01                          |   |  | (2.02  | ) |  | 0.34   |  
|                                                                       |  |                                |   |  |                               |   |  |        |   |  |        |  
|Total other expense                                                    |  | (5.81                          | ) |  | (11.70                        | ) |  | (10.45 | ) |  | (12.80 | )
|                                                                       |  |                                |   |  |                               |   |  |        |   |  |        |  
|Income (loss) before provision (benefit) for income taxes              |  | 6.38                           |   |  | 1.53                          |   |  | (0.18  | ) |  | (6.21  | )
|Provision (benefit) for income taxes                                   |  | 2.71                           |   |  | 2.01                          |   |  | (0.94  | ) |  | (0.51  | )
|                                                                       |  |                                |   |  |                               |   |  |        |   |  |        |  
|Net income (loss)                                                      |  | 3.67                           |   |  | (0.48                         | ) |  | (1.12  | ) |  | (5.70  | )
|                                                                       |  |                                |   |  |                               |   |  |        |   |  |        |  



Three Months Ended December 31,
2004 and 2003:



Net Revenues: Revenues increased $4.5
million, or 27.3%, to $21.0 million for the three months ended December 31, 2004, as compared to $16.5 million for the three months ended December 31, 2003. Sales to international customers for the three months ended December 31, 2004 increased $4.4
million, or 74.6%, to $10.3 million. The international sales increase is due primarily to the activation of an amendment to an existing contract with the United Kingdom. Sales to U.S. military customers for the three months ended December 31, 2004
increased by $1.1 million, or 13.4%, to $9.3 million. The U.S. military increase is due primarily to system upgrades with existing customers. Sales to U.S. law enforcement customers for the three months ended December 31, 2004 decreased $1.0
million, or 41.7%, to $1.4 million reflecting state and municipality budgeting shortfalls associated with diversion of funds to offset operational costs.



Cost of Revenues: Cost of revenues increased $3.8 million, or 36.9%, to $14.1 million for the three months ended December 31, 2004, as compared to $10.3
million for the three months ended December 31, 2003. As a percentage of revenues, cost of revenues for the three months ended December 31, 2004 increased to 67.0%, as compared to 62.3% for the three months ended December 31, 2003. The increase in
cost of revenues as a percentage of revenues is attributable primarily to the shift in weapon types delivered to domestic customers.



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Gross Profit: As a result of the foregoing, gross profit increased $0.7 million, or 11.3%, to $6.9
million, or 33.0% of revenues for the three months ended December 31, 2004, as compared to $6.2 million, or 37.7% of revenues, for the three months ended December 31, 2003.



Total Operating Expenses: Total operating expenses increased $0.4 million, or 10.0%, to $4.4 million for the three months
ended December 31, 2004 as compared to $4.0 million for the three months ended December 31, 2003. As a percentage of revenues, total operating expenses decreased to 20.9% for the three months ended December 31, 2004, as compared to 24.5% for the
three months ended December 31, 2003. Selling, general and administrative (SG&A) expenses, which include bid and proposal activities, increased from $3.2 million for the three months ended December 31, 2003 to $3.3 million for the
three months ended December 31, 2004. However, as a percentage of revenues, SG&A decreased from 19.2% at December 31, 2003 to 15.8% at December 31, 2004 due to a corporate focus of expense control initiatives. Research and development costs
increased from $0.8 million for the three months ended December 31, 2003 to $1.0 million for the three months ended December 31, 2004. Depreciation and amortization expense remained constant at $0.1 million.



Operating Income: As a result of the foregoing, operating income increased
$0.4 million to $2.6 million for the three months ended December 31, 2004 as compared to $2.2 million for the three months ended December 31, 2003. As a percentage of revenues, operating income was 12.2% of revenues for the three months ended
December 31, 2004, as compared to 13.2% of revenues for the three months ended December 31, 2003.



Other Income (Expense), net: Other income (expense), net totaled $(1.2) million, or (5.8%) of revenues for the three months ended December 31, 2004, as
compared to $(1.9) million, or (11.7%) of revenues for the three months ended December 31, 2003. Interest on debt decreased $0.5 million or 35.7%, due primarily to lower interest rates on the New Credit Agreement. Dividends on mandatorily redeemable
preferred stock decreased $0.7 million due to the conversion of the mandatorily redeemable preferred stock (Series B). In addition, due to the weaker dollar, the foreign currency exchange loss was $0.3 million for the three months ended December 31,
2004, as compared to $0.2 million gain for the three months ended December 31, 2003.



Income Before Provision for Income Taxes: As a result of the foregoing, the income before benefit for income taxes increased by $1.0 million from income of $0.3 million for the three months ended December 31, 2003 to
income of $1.3 million for the three months ended December 31, 2004.



Provision for Income Taxes: Net taxable income for the three months ended December 31, 2004 resulted in a tax provision of $569,000, while net taxable income for the three months ended December 31, 2003 resulted in a tax provision of
$332,000.



Net Income: As a result of the foregoing,
net income increased by $854,000 to $773,000, or $0.01 income per share, for the three months ended December 31, 2004 from a net loss of $80,000, or $0.0 loss per share, for the three months ended December 31, 2003.



Nine Months Ended December 31, 2004 and 2003:



Net Revenues: Revenues increased $14.2 million, or 31.6%, to $59.2 million
for the nine months ended December 31, 2004, as compared to $45.0 million for the nine months ended December 31, 2003. Sales to international customers for the nine months ended December 31, 2004 increased $5.5 million, or 29.0%, to $24.5 million.
The international sales increase is due primarily to the activation of amendments with existing contracts. Sales to U.S. military customers for the nine months ended December 31, 2004 increased by $11.5 million, or 58.7%, to $31.1 million. The
increase in U.S. military sales is due primarily to the incremental sales of weapons and system upgrades with existing customers and sales of I-FACT (Close Air Support Trainer) and VCCT (Virtual Combat Convoy Trainer). Sales to U.S. law enforcement
customers for the nine months ended December 31, 2004 decreased $2.8 million, or 43.8%, to $3.6 million reflecting state and municipality budgeting shortfalls associated with diversion of funds to offset operational costs.



Cost of Revenues: Cost of revenues increased $9.1 million, or 29.7%, to $39.7
million for the nine months ended December 31, 2004, as compared to $30.6 million for the nine months ended December 31, 2003. As a percentage of revenues, cost of revenues for the nine months ended December 31, 2004 remained fairly constant at
67.1%, as compared to 68.0% for the nine months ended December 31, 2003.



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Gross Profit: As a result of the foregoing, gross profit increased $5.1 million, or 35.4%, to $19.5
million, or 32.9% of revenues, for the nine months ended December 31, 2004, as compared to $14.4 million, or 31.9% of revenues, for the nine months ended December 31, 2003.



Total Operating Expenses: Total operating expenses increased $2.0 million, or 17.5%, to $13.4 million for the nine months
ended December 31, 2004 as compared to $11.4 million for the nine months ended December 31, 2003. As a percentage of revenues, total operating expenses decreased to 22.6% for the nine months ended December 31, 2004 as compared to 25.4% for the nine
months ended December 31, 2003. Selling, general and administrative (SG&A) expenses, which include bid and proposal activities, increased from $9.1 million for the nine months ended December 31, 2003 to $10.3 million for the nine
months ended December 31, 2004. This increase in SG&A is due primarily to increased emphasis in sales and marketing, bid and proposal for new business, and expenses associated with the reengineering of our Enterprise Resource Planning system.
Research and development costs increased $0.7 million, or 35.0%, to $2.7 million for the nine months ended December 31, 2004, as compared to $2.0 million for the nine months ended December 31, 2003. This increase is due primarily to increases in
developmental efforts related to Bluefire weapons, enhancements to our I-FACT product, and single platform initiative. Depreciation and amortization expense remained constant at $0.3 million.



Operating Income: As a result of the foregoing, operating income increased
$3.1 million to $6.1 million for the nine months ended December 31, 2004, as compared to $3.0 million for the nine months ended December 31, 2003. As a percentage of revenues, operating income was 10.3% of revenues for the nine months ended December
31, 2004, as compared to 6.6% of revenues for the nine months ended December 31, 2003.



Other Income (Expense), net: Other income (expense), net totaled $(6.2) million, or (10.5%) of revenues for the nine months ended December 31, 2004 as compared to $(5.8) million, or (12.8%) of revenues for the nine
months ended December 31, 2003. Interest on debt decreased $0.3 million, or 7.9%, due primarily to lower interest rates on the New Credit Agreement. Dividends on mandatorily redeemable preferred stock decreased $0.6 million due to conversion of the
mandatorily redeemable preferred stock (Series B). In addition, due to the weaker dollar, the foreign currency exchange loss was $0.6 million for the nine months ended December 31, 2004, as compared to $0.2 million gain for the three months ended
December 31, 2003.



Loss Before Provision (Benefit) for Income
Taxes: As a result of the foregoing, the loss before provision (benefit) for income taxes decreased by $2.7 million from a loss of $2.8 million for the nine months ended December 31, 2003 to a loss of $0.1 million for the nine months ended December
31, 2004.



Provision (Benefit) for Income Taxes: The net
taxable loss for the nine months ended December 31, 2004 produced a tax provision of $556,000 while the net taxable loss for the nine months ended December 31, 2003 resulted in tax benefit of $(229,000).



Net Loss: As a result of the foregoing, the net loss decreased by $1.9
million to $0.7 million, or $0.01 loss per share, for the nine months ended December 31, 2004 from $2.6 million, or $0.04 loss per share for the nine months ended December 31, 2003.



ANALYSIS OF BACKLOG



Backlog represents customer orders that have been contracted for future delivery. Accordingly, these orders have not yet been recognized as revenue, but
represent potential revenue. As of December 31, 2004 and 2003, the Company had a backlog of approximately $53.3 and $62.3 million, respectively. As of December 31, 2004, the backlog was comprised of $32.0 million from international customers and
$21.3 million from FATS U.S. military and law enforcement customers. Approximately $19.3 million of the contracted orders are scheduled for delivery during the remainder of fiscal year 2005.



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Changes in backlog for the three and nine-month periods ended December 31, 2004 and 2003 were as follows
(in thousands):



|                              |  |                                 |         |   |                                |   |         |      |  |   |         |   |  |   |         |  
|----------------------------- |  | ------------------------------- | ------- | - | ------------------------------ | - | ------- | ---- |  | - | ------- | - |  | - | ------- | -
|                              |  | Three Months Ended December 31, |         |   | Nine Months Ended December 31, |  
|                              |  | 2004                            |         |   | 2003                           |   |         | 2004 |  |   | 2003    |  
|Backlog  beginning of period |  | $                               | 47,304  |   |                                | $ | 65,118  |      |  | $ | 59,310  |   |  | $ | 64,346  |  
|New bookings                  |  |                                 | 27,054  |   |                                |   | 13,648  |      |  |   | 53,190  |   |  |   | 42,968  |  
|Revenue                       |  |                                 | (21,029 | ) |                                |   | (16,479 | )    |  |   | (59,171 | ) |  |   | (45,027 | )
|                              |  |                                 |         |   |                                |   |         |      |  |   |         |   |  |   |         |  
|Backlog  end of period       |  | $                               | 53,329  |   |                                | $ | 62,287  |      |  | $ | 53,329  |   |  | $ | 62,287  |  
|                              |  |                                 |         |   |                                |   |         |      |  |   |         |   |  |   |         |  



New bookings increased
$13.4 million, or 98.5%, to $27.1 million for the three months ended December 31, 2004. The increase is due primarily to major orders from the United Kingdom Ministry of Defence, U.S. Army, Baghdad Police Academy, U.S. Air Force and Belgian Defence
Force.



LIQUIDITY AND CAPITAL RESOURCES



On September 30, 2004, the Company entered into a new credit agreement (the
New Credit Agreement) with CapitalSource Finance, LLC. The New Credit Agreement provides for a revolving facility up to $12 million; a term A loan facility in an aggregate maximum principal amount of $15 million; and a term B loan facility in an
aggregate maximum principal amount of $15 million. A more complete description of the terms of the New Credit Agreement is set forth in Note 7 to the Condensed Consolidated Financial Statements contained elsewhere in this report.



As of December 31, 2004, the Company had working capital of $25.1 million
compared to a working capital deficit of $45.4 million as of December 31, 2003. The net $70.5 million increase in working capital is due primarily to debt restructuring and the conversion of the mandatorily redeemable preferred stock (Series B).



The Company had a net increase in cash and cash equivalents of
$1.3 million for the nine months ended December 31, 2004 compared to a net decrease of cash and cash equivalents of $0.7 million for the nine months ended December 31, 2003. For the period ended December 31, 2004, the Companys operating
activities generated cash of approximately $7.2 million compared to $1.3 million for the nine months ended December 31, 2003. Cash flow from operations increased primarily due to the decreased net loss, decreases in costs and estimated earnings in
excess of billings on uncompleted contracts, and the increase in deferred revenue.



The Companys principal liquidity and capital needs are to fund working capital, provide debt service, and make capital expenditures necessary to support and grow its business. Since August 2000, the Company has
financed its operations and growth primarily through internally generated funds and income tax refunds. With the issuance of the New Credit Agreement, discussed above, management believes that funds provided by operations will be sufficient to fund
its cash needs and anticipated capital expenditures through at least the next twelve months.



The Company is subject to several business and market risks. The Company must continue to achieve its revenue targets and cost reduction objectives in the current fiscal year in order to generate adequate cash flow to
fund working capital needs and to service debt requirements. Also, the Company must receive new contracts for production to be delivered in the current fiscal year to meet its revenue targets and to replenish existing backlog to sustain the revenue
targets in future periods.



CONCENTRATION OF CREDIT RISK



As of December 31, 2004, approximately $8.7 million in accounts receivable,
or 64.1% of total net accounts receivable, was due from five of the Companys customers,all of which are related to U.S. and U.K. government contracts and subcontracts.



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##### Table of Contents

COMMITMENTS AND OTHER CONTRACTURAL OBLIGATIONS



Disclosure of Commitments and Other Obligations

December 31, 2004

(amounts in thousands)



|                             |  |       |        |                  |   |                 |  |                  |        |               |   |        |  |   |  
|---------------------------- |  | ----- | ------ | ---------------- | - | --------------- |  | ---------------- | ------ | ------------- | - | ------ |  | - | -
|                             |  | Total |        | Less than 1 year |   | Within1-3 years |  | Within 4-5 years |        | After 5 years
|Long-term debt               |  |       |        |                  |   |                 |  |                  |        |               |   |        |  |   |  
|Working capital  borrowings |  | $     | 7,681  |                  | $ |                |  | $                |       |               | $ | 7,681  |  | $ | 
|Long-term debt  Senior      |  |       | 14,469 |                  |   | 2,344           |  |                  | 8,250  |               |   | 3,875  |  |   | 
|Long-term debt  Junior      |  |       | 15,000 |                  |   |                |  |                  |       |               |   | 15,000 |  |   | 
|Accrued PIK                  |  |       | 58     |                  |   |                |  |                  |       |               |   | 58     |  |   | 
|Other                        |  |       |        |                  |   |                 |  |                  |        |               |   |        |  |   |  
|Other purchase orders        |  |       | 7,395  |                  |   | 6,872           |  |                  | 523    |               |   |       |  |   | 
|Operating lease obligations  |  |       | 2,593  |                  |   | 882             |  |                  | 1,711  |               |   |       |  |   | 
|                             |  |       |        |                  |   |                 |  |                  |        |               |   |        |  |   |  
|Total                        |  | $     | 47,196 |                  | $ | 10,098          |  | $                | 10,484 |               | $ | 26,614 |  | $ | 
|                             |  |       |        |                  |   |                 |  |                  |        |               |   |        |  |   |  



OFF-BALANCE SHEET ARRANGEMENTS



As of December 31,
2004, the Company did not have any off-balance sheet financing transactions or arrangements other than disclosed above.



ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK



The Companys major market risk exposure arises from changes in interest rates and its impact on variable rate debt instruments. The Companys
objectives in interest rate risk management are to limit the impact of interest rate changes on earnings and cash flows, and to lower overall borrowing costs. To achieve its objectives, the Company may enter into derivative financial instruments,
such as interest rate swaps and caps, in order to limit its exposure to interest rate fluctuations. The Company does not enter into derivative or interest rate transactions for speculative purposes. There were no derivative contracts in effect at
December 31, 2004.



As of December 31, 2004, the Company had a
total of approximately $37.1 million in variable rate debt at a range of interest rates (the greater of prime plus .5 to 6.0 percent or four and three-quarters to ten and one-quarter percent). If interest rates on the Companys existing
variable rate debt were to increase by 10% over the next twelve months, management believes there would be no material adverse impact on the Companys results of operations.



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ITEM 4. CONTROLS AND PROCEDURES



The Company maintains disclosure controls and procedures, as defined in Rule 13a-15(e) promulgated under the Securities Exchange Act of 1934 (Exchange Act), that are designed to ensure that information required to be disclosed
in the reports that we file or submit under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the rules and forms of the SEC and that such information is accumulated and communicated to the
Companys management, including its chief executive and chief financial officers, as appropriate, to allow timely decisions regarding required disclosure. The Company carried out an evaluation, under the supervision and with the participation
of its management, including its chief executive and chief financial officer, of the effectiveness of the design and operation of its disclosure controls and procedures as of the end of the period covered by this Report. Based on the evaluation of
these disclosure controls and procedures, the chief executive and chief financial officer of the Company concluded that the Companys disclosure controls and procedures were effective as of the end of the period covered by this Report.



There were no changes in the Companys internal control
over financial reporting during the Companys fiscal quarter ended December 31, 2004 that have materially affected, or are reasonably likely to materially affect, the Companys internal control over financial reporting.



PART II. OTHER INFORMATION



ITEM 1. LEGAL PROCEEDINGS



The
Company is involved in legal proceedings in the ordinary course of its business, which in the opinion of management will not have a materially adverse effect on the Companys financial position, liquidity, or results of operation.



ITEM 6. EXHIBITS AND REPORT ON FORM 8-K



|(a) | Exhibits
|--- | --------



|     |  |                                                                                                   
|---- |  | --------------------------------------------------------------------------------------------------
|31.1 |  | Certification of Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
|     | 
|31.2 |  | Certificate of Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002  
|     | 
|32.1 |  | Certificate of Chief Executive Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002  
|     | 
|32.2 |  | Certificate of Chief Financial Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002  



|(b) | The following reports on Form 8-K were filed during the quarter ended December 31, 2004:
|--- | ----------------------------------------------------------------------------------------



On October 6, 2004, the Company filed a current report on Form 8-5 to disclose under Items 1.01, 2.03, 3.02, and 5.03 the
entry into the New Credit Agreement and Exchange Agreement and related issuances of the Series C Preferred Stock identified in Notes 7 through 10 to the financial statements included in this report.



On November 15, 2004, the Company filed a current report on Form 8-K to
disclose under Item 2.02 the issuance of its press release announcing the Companys results of operations for the quarterly period ended September 30, 2004.



On December 7, 2004, the Company filed a current report on Form 8-K to disclose under Item 5.02 the appointment of Darrell
Oyer to the Board of Directors and the Board approval to expand the Class III directors to a total of two members with Cameron Breitner appointed to fill the resulting vacancy.



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SIGNATURES



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.



DATED: February 11, 2005



FIREARMS TRAINING SYSTEMS, INC./S/ Gregory A. TonGregory A. TonChief Financial Officer and Treasurer(Principal Financial Officer and Duly Authorized Officer)




21