FORM 10-Q

                UNITED STATES SECURITIES AND EXCHANGE COMMISSION
                             Washington, D.C. 20549


       QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
                              EXCHANGE ACT OF 1934


                FOR THE QUARTERLY PERIOD ENDED DECEMBER 27, 1996

                         Commission file number 0-28352


                         TECHNOLOGY SERVICE GROUP, INC.
             (Exact name of Registrant as specified in its charter)


            Delaware                                     59-1637426
(State or other jurisdiction of                       (I.R.S. Employer
 Incorporation or Organization)                     Identification Number)

20 Mansell Court East - Suite 200                          30076
           Roswell, Georgia                              (Zip Code)
(Address of  principal executive offices)
                                 (770) 587-0208
                         (Registrant's Telephone Number,
                              including area code)

Indicate by check mark whether  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 ___

At January 31,  1997,  there were  4,701,010  shares of common  stock,  $.01 par
value, outstanding.

<PAGE>

                                      INDEX

                                                                          Page
                                                                          Number

PART I.   FINANCIAL INFORMATION

 Item 1.  Financial Statements

          Consolidated Balance Sheets at December 27, 1996
            (unaudited) and March 29, 1996                                   3

          Consolidated Statements of Operations for the
            three months and nine months ended December 27, 1996
            (unaudited) and December 29, 1995 (unaudited)                    4

          Consolidated Statements of Cash Flows for the
            nine months ended December 27, 1996 (unaudited) and
            December 29, 1995 (unaudited)                                    5

          Consolidated Statement of Changes in Stockholders'
            Equity for the nine months ended December 27, 1996
            (unaudited)                                                      6

          Notes to Consolidated Financial Statements                         7

 Item 2.  Management's Discussion and Analysis of
          Financial Condition and Results of Operations                     13

PART II.  OTHER INFORMATION

 Item 6.  Exhibits and Reports on Form 8-K                                  28


                                       2
<PAGE>

                         PART I - FINANCIAL INFORMATION

Item 1.  Financial Statements

                         TECHNOLOGY SERVICE GROUP, INC.
                           CONSOLIDATED BALANCE SHEETS

<TABLE>
<CAPTION>
                                                                     December 27,      March 29,
                                                                         1996            1996
                                                                     ------------    ------------
                                                                     (Unaudited)
<S>                                                                  <C>             <C>         
ASSETS
Current assets:
    Cash                                                             $     45,108    $     19,787
    Accounts receivable, less allowance for doubtful
        accounts of $227,000 and $216,000                               2,071,105       3,866,372
    Inventories                                                        13,053,079       8,658,669
    Deferred tax asset                                                    616,539          50,544
    Prepaid expenses and other current assets                             166,652         146,117
                                                                     ------------    ------------
          Total current assets                                         15,952,483      12,741,489
Property and equipment, net                                               831,496       2,198,625
Other assets                                                            3,925,715       4,693,650
                                                                     ============    ============
                                                                     $ 20,709,694    $ 19,633,764
                                                                     ============    ============

LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
    Bank overdraft                                                   $    277,303    $  1,002,403
    Borrowings under revolving credit agreement                         3,949,303            --
    Current maturities under long-term debt and
         capital lease obligations                                           --           118,444
    Accounts payable                                                    1,842,157       5,030,945
    Income taxes payable                                                  164,019         165,666
    Deferred revenue                                                      375,000         541,245
    Accrued liabilities                                                   965,072       1,472,379
    Accrued restructuring charges                                          29,044          16,427
                                                                     ------------    ------------
          Total current liabilities                                     7,601,898       8,347,509
Borrowings under revolving credit agreement                                  --         1,093,735
Long-term debt and capital lease obligations                                 --         3,414,586
Notes payable to stockholders                                                --         2,800,000
Deferred revenue                                                             --           375,000
Other liabilities                                                           3,198           3,198
                                                                     ------------    ------------
                                                                        7,605,096      16,034,028
                                                                     ------------    ------------
Commitments and contingencies                                                --              --
Stockholders' equity:
    Preferred stock, $100 par value, 100,000 authorized,
        none issued or outstanding                                           --              --
    Common stock, $.01 par value, 10,000,000 shares authorized,
        4,701,010 and 3,500,000 shares issued and outstanding              47,010          35,000
    Capital in excess of par value                                     11,962,114       3,465,000
    Retained earnings                                                   1,109,404         111,790
    Cumulative translation adjustment                                     (13,930)        (12,054)
                                                                     ------------    ------------
          Total stockholders' equity                                   13,104,598       3,599,736
                                                                     ------------    ------------
                                                                     $ 20,709,694    $ 19,633,764
                                                                     ============    ============
</TABLE>

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


                                       3
<PAGE>

                         TECHNOLOGY SERVICE GROUP, INC.
                      CONSOLIDATED STATEMENTS OF OPERATIONS
                                   (Unaudited)

<TABLE>
<CAPTION>
                                                     Three Months Ended               Nine Months Ended
                                                 ----------------------------    ----------------------------
                                                 December 27,    December 29,    December 27,    December 29,
                                                     1996            1995            1996            1995
                                                 ------------    ------------    ------------    ------------
<S>                                              <C>             <C>             <C>             <C>         
Net sales                                        $  5,651,655    $  9,585,664    $ 27,791,869    $ 23,677,489
                                                 ------------    ------------    ------------    ------------
Costs and expenses:
    Cost of goods sold                              4,588,941       7,416,123      22,199,304      18,857,150
    General and administrative expenses               503,331         634,295       1,866,187       1,712,910
    Marketing and selling expenses                    179,743         320,102         734,851         906,754
    Engineering, research and
        development expenses                          331,865         296,994       1,396,486         849,034
    Litigation settlement                                --              --          (105,146)           --
    Interest expense                                   99,780         267,991         304,367         705,880
    Restructuring charges                                --              --            62,500            --
    Other income                                      (73,464)         (4,798)       (103,064)        (14,642)
                                                 ------------    ------------    ------------    ------------
                                                    5,630,196       8,930,707      26,355,485      23,017,086
                                                 ------------    ------------    ------------    ------------
Income before income tax
    (expense) benefit                                  21,459         654,957       1,436,384         660,403
Income tax (expense) benefit                            5,686            --          (438,770)           --
                                                 ------------    ------------    ------------    ------------
Net income                                       $     27,145    $    654,957    $    997,614    $    660,403
                                                 ============    ============    ============    ============
Income per common and common 
  equivalent share:
      Primary                                    $       0.01    $       0.17    $       0.21    $       0.17
                                                 ============    ============    ============    ============
      Assuming full dilution                     $       0.01    $       0.17    $       0.21    $       0.17
                                                 ============    ============    ============    ============

Weighted average number of common and
  common equivalent shares outstanding :
      Primary                                       5,059,505       3,870,889       4,793,020       3,870,889
                                                 ============    ============    ============    ============
      Assuming full dilution                        5,059,505       3,870,889       4,793,020       3,870,889
                                                 ============    ============    ============    ============
</TABLE>

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



                                       4
<PAGE>
                         TECHNOLOGY SERVICE GROUP, INC.
                      CONSOLIDATED STATEMENTS OF CASH FLOWS
                                   (Unaudited)

<TABLE>
<CAPTION>
                                                              Nine Months Ended
                                                          --------------------------
                                                          December 27,   December 29,
                                                              1996           1995
                                                          -----------    -----------
<S>                                                       <C>            <C>        
Cash flows from operating activities
    Net income                                            $   997,614    $   660,403
    Adjustments to reconcile net income to net cash
      provided by (used for) operating activities
        Depreciation and amortization                         837,099        777,574
        Gain on disposition of assets                         (46,908)          --
        Provisions for inventory losses and
          warranty expense                                    397,139        238,057
        Provision for uncollectible accounts receivable        14,268         58,745
        Restructuring charges                                  62,500           --
        Net deferred tax benefit                              (63,152)          --
        Changes in certain assets and liabilities
          (Increase) decrease in accounts receivable        1,780,999     (5,779,384)
          (Increase) in inventories                        (4,630,141)    (1,077,648)
          (Increase) decrease in prepaid expenses
            and other current assets                          (20,535)        22,380
          (Increase) in other assets                         (282,282)      (140,651)
          Increase (decrease) in accounts payable          (3,188,788)     1,454,523
          (Decrease) in income taxes payable                   (1,647)          --
          (Decrease) in accrued liabilities                  (668,715)      (223,872)
          (Decrease) in accrued restructuring charges          (8,750)       (61,890)
          Increase (decrease) in deferred revenue
            and other liabilities                            (541,245)         3,199
          Other                                                  (615)        (4,411)
                                                          -----------    -----------
            Net cash used for operating activities         (5,363,159)    (4,072,975)
                                                          -----------    -----------
Cash flows from investing activities
    Proceeds from disposition of assets                        57,800           --
    Capital expenditures                                     (247,764)      (164,593)
                                                          -----------    -----------
            Net cash used for investing activities           (189,964)      (164,593)
                                                          -----------    -----------
Cash flows from financing activities
    Net proceeds under revolving credit
      agreement                                             2,855,568      4,576,332
    Proceeds from initial public offering, net of
      issuance expenses                                     8,631,532           --
    Proceeds from exercise of common stock
      options and warrants                                    215,964           --
    Repayment of notes payable to stockholders             (2,800,000)          --
    Principal payments on long-term debt and
      capital lease obligations                            (2,599,520)      (778,243)
    Increase (decrease) in bank overdraft                    (725,100)       222,022
                                                          -----------    -----------
            Net cash provided by financing
              activities                                    5,578,444      4,020,111
                                                          -----------    -----------
Increase (decrease) in cash                                    25,321       (217,457)
Cash, beginning of period                                      19,787        265,576
                                                          ===========    ===========
Cash, end of period                                       $    45,108    $    48,119
                                                          ===========    ===========
</TABLE>

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



                                       5
<PAGE>

                         TECHNOLOGY SERVICE GROUP, INC.
                  STATEMENT OF CHANGES IN STOCKHOLDERS' EQUITY
                   FOR THE NINE MONTHS ENDED DECEMBER 27, 1996
                                   (Unaudited)

<TABLE>
                                                    Capital in                   Cummulative
                                        Common       Excess of      Retained     Translation
                                        Stock        Par Value      Earnings      Adjustment         Total
                                    ------------   ------------   ------------   ------------    ------------
<S>                                 <C>            <C>            <C>            <C>             <C>         
Balance at March 29, 1996           $     35,000   $  3,465,000   $    111,790   $    (12,054)   $  3,599,736
Issuance of 1,150,000 shares in
  initial public offering, net of
  issuance expenses                       11,500      8,281,660           --             --         8,293,160
Issuance of 40,000 shares upon
  exercise of common stock
  purchase warrants                          400        159,600           --             --           160,000

Issuance of 4,250 shares upon
  exercise of common stock
  options                                     42          4,208           --             --             4,250

Issuance of 6,760 shares under
  1995 Employee Stock Purchase
  Plan                                        68         51,646           --             --            51,714

Net income for the period                   --             --          997,614           --           997,614

Foreign currency translation
  adjustment                                --             --             --           (1,876)         (1,876)
                                    ------------   ------------   ------------   ------------    ------------
Balance at December 27, 1996        $     47,010   $ 11,962,114   $  1,109,404   $    (13,930)   $ 13,104,598
                                    ============   ============   ============   ============    ============

</TABLE>

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



                                       6
<PAGE>

                         TECHNOLOGY SERVICE GROUP, INC.

                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

1.   GENERAL

     The accompanying  unaudited  consolidated  balance sheet as of December 27,
1996, unaudited  consolidated  statements of operations for the three months and
nine  months  ended   December  27,  1996  and  December  29,  1995,   unaudited
consolidated  statements  of cash flows for the nine months  ended  December 27,
1996 and December 29, 1995, and unaudited  consolidated  statement of changes in
stockholders'  equity for the nine  months  ended  December  27,  1996 have been
prepared  in  accordance  with  instructions  to  Form  10-Q.  Accordingly,  the
financial  information  does not include all of the  information  and  footnotes
required by generally  accepted  accounting  principles  for complete  financial
statements.  In the opinion of management,  all adjustments,  consisting only of
normal recurring accruals and adjustments,  necessary for a fair presentation of
the  financial  position of the Company at December 27, 1996 and its  operations
and its cash flows for the three months and nine months ended  December 27, 1996
and  December  29, 1995 have been made.  For further  information,  refer to the
audited  financial  statements  and footnotes  included in the Company's  annual
report on Form 10-K for the fiscal year ended March 29, 1996.

     The  results  of  operations  for the three  months and nine  months  ended
December 27, 1996 are not  necessarily  indicative of the results for the entire
fiscal year ending March 28, 1997.

2.   INVENTORIES

     Inventories  at  December  27,  1996 and March 29,  1996  consisted  of the
following:

                                            December 27,         March 29,
                                                1996                1996
                                            -----------         -----------

     Raw materials                          $ 7,377,762         $ 6,056,702
     Work-in-process                          4,672,562           1,207,080
     Finished goods                           1,002,755           1,394,887
                                            ===========         ===========
                                            $13,053,079         $ 8,658,669
                                            ===========         ===========

     Reserves for  potential  inventory  losses due to  obsolescence  and excess
quantities  recorded  at  December  27,  1996  and  March  29,  1996  aggregated
$1,245,146 and $1,606,195, respectively.

3.   BORROWINGS UNDER REVOLVING CREDIT AGREEMENT, LONG-TERM DEBT, 
     CAPITAL LEASE OBLIGATIONS AND NOTES PAYABLE TO STOCKHOLDERS

     At December 27,  1996,  the Company is able to borrow up to a maximum of $9
million under a revolving credit  agreement  pursuant to the terms of a Loan and
Security  Agreement (the "Loan Agreement")  between the Company and its bank. At
December  27,  1996 and March 29,  1996,  the Company  had  outstanding  debt of
$3,949,303 and $1,093,735,  respectively,  under the revolving credit agreement.
At March 29, 1996,  the Company also had  outstanding  debt of $2,525,000  under
term and  installment  notes issued pursuant to the terms of the Loan Agreement.
Indebtedness  outstanding  under the Loan Agreement is secured by  substantially
all  assets  of the  Company  including  accounts  receivable,  inventories  and
property and  equipment.  At December 27, 1996,  the  borrowing  limit under the
revolving credit agreement was based upon specified  percentages  applied to the
value of collateral, consisting of eligible accounts receivable and inventories.
At March 29, 1996, the borrowing limit under the revolving  credit agreement was
based upon  specified  percentages  applied to the value of eligible  collateral
less  indebtedness  outstanding  under a $2.2 million term note due November 30,


                                       7
<PAGE>

1997.  Interest  is payable  monthly at a variable  rate per annum equal to 1.5%
above a base rate quoted by Citibank  (8.25% at December  27, 1996 and March 29,
1996).

     In May 1996,  the Company  completed an initial  public  offering of equity
securities  (see Note 4). A portion  of the  proceeds  from the  initial  public
offering  was used to repay  the  Company's  then  outstanding  indebtedness  of
$2,509,524 pursuant to the term and installment notes. In addition, a portion of
the proceeds was used to repay $3,808,589 of indebtedness  outstanding under the
revolving credit agreement.  Accordingly,  the Company classified  $1,093,735 of
indebtedness  outstanding under the revolving credit agreement and $2,509,524 of
indebtedness   outstanding   under  term  and  installment  notes  as  long-term
obligations at March 29, 1996.

     Long-term debt and capital lease  obligations  payable at December 27, 1996
and March 29, 1996 consisted of the following:

                                                       December 27,   March 29,
                                                           1996         1996
                                                       -----------  -----------

     Loan and Security Agreement
         $2.2 million secured term note, principal
           balance due November 30, 1997               $      --    $ 2,200,000
         $650,000 secured term note, principal
           payable in sixty equal monthly installments
           of $7,738, with remaining principal balance
           due November 30, 1997                              --        325,000
     Unsecured non-interest bearing promissory
       note, payable in nineteen equal monthly
       installments of $10,873                                --         32,620
     Obligations under capital leases                         --        975,410
                                                       -----------  -----------
                                                              --      3,533,030
     Less - current maturities                                --       (118,444)
                                                       -----------  -----------
                                                       $      --    $ 3,414,586
                                                       ===========  ===========

     During the three months ended  December 27, 1996,  the Company closed a one
hundred thousand square foot manufacturing facility located in Paducah, Kentucky
(see  Note  7)  and  assigned  the  related  capital  lease   obligation  to  an
unaffiliated  party.  Accordingly,  the Company  recorded the  retirement of the
outstanding  capital lease obligation and the disposition of the property during
the three  months  ended  December  27,  1996,  and  realized  a gain of $44,169
representing the difference between the outstanding lease obligation  ($933,510)
and  proceeds  received  ($50,000)  and  the  net  book  value  of the  property
($939,341).

     On October 31,  1994,  the Company  entered into an  Investment  Agreement.
Pursuant to the terms of the  Investment  Agreement,  the Company  borrowed $2.8
million from stockholders and issued subordinated  promissory notes due November
1, 1999 bearing  interest at a rate of 10% per annum.  In May 1996,  the Company
repaid the  outstanding  indebtedness  pursuant to the  subordinated  promissory
notes from the proceeds of its initial public offering.


                                       8
<PAGE>

4.   STOCKHOLDERS' EQUITY

Initial Public Offering

     In May 1996, the Company  completed an initial public offering of 1,150,000
units (the "Units"),  each Unit  consisting of one share of common stock and one
redeemable  warrant  ("Redeemable  Warrant"),  at a price of $9.00  per Unit for
gross  proceeds of  $10,350,000.  In connection  with the offering,  the Company
issued warrants to the  Underwriters to purchase  100,000 shares of Common Stock
(the "Underwriter Warrants") for gross proceeds of $10. Net proceeds received by
the Company,  after underwriting  discounts and expenses of $1,231,897 and other
expenses of $824,953,  amounted to $8,293,160. As of March 29, 1996, the Company
had  incurred,  and  deferred as other  assets,  offering  expenses of $338,372.
Accordingly,  net  proceeds  during the nine  months  ended  December  27,  1996
amounted to $8,631,532.

     Two Redeemable Warrants entitle the holder thereof to purchase one share of
common  stock at an exercise  price of $11.00 per share.  Unless the  Redeemable
Warrants  are  redeemed,  the  Redeemable  Warrants may be exercised at any time
beginning on May 10, 1996 and ending May 9, 1999,  at which time the  Redeemable
Warrants will expire.  Beginning on February 10, 1997, the  Redeemable  Warrants
are redeemable by the Company at its option, as a whole and not in part, at $.05
per  Redeemable  Warrant on 30 days' prior  written  notice,  provided  that the
average closing bid price of the common stock equals or exceeds $12.00 per share
for 20 consecutive trading days ending within five days prior to the date of the
notice of redemption. The Redeemable Warrants will be entitled to the benefit of
adjustments  in the  exercise  price and in the number of shares of common stock
deliverable  upon the exercise  thereof upon the  occurrence of certain  events,
including a stock dividend, stock split or similar reorganization.

     The Underwriter Warrants are initially exercisable at a price of $10.80 per
share of common stock. The Underwriter Warrants contain anti-dilution provisions
providing  for  adjustments  of the number of warrants and exercise  price under
certain  circumstances.  The  Underwriter  Warrants grant to the holders thereof
certain rights of registration  of the securities  issuable upon exercise of the
Underwriter  Warrants.  The  Underwriter  Warrants  may be exercised at any time
beginning on May 10, 1997 and ending May 9, 2001, at which time the  Underwriter
Warrants will expire.

Common Stock Purchase Warrants

     On May 23, 1995, the Company issued a warrant to a contract manufacturer to
purchase 40,000 shares of common stock,  $.01 par value, at a price of $4.00 per
share in return for the  extension of credit under the terms of a  manufacturing
agreement between the Company and the contract  manufacturer.  On June 17, 1996,
the warrant was exercised  and the Company  issued 40,000 shares of common stock
for aggregate proceeds of $160,000.

Income Per Common and Common Equivalent Share

     Income per common and common equivalent share for the three months and nine
months ended December 27, 1996 and December 29, 1995 is computed on the basis of
the weighted  average number of common shares  outstanding  and dilutive  common
equivalent  shares  outstanding  during  the  period,   except  as  required  by
Accounting  Principles Board Opinion No. 15, Earnings per Share, all outstanding
options and warrants  during the three months and nine months ended December 27,
1996 have been  included in the  calculation  in  accordance  with the  modified
treasury  stock  method  and  except as  required  by  Securities  and  Exchange
Commission  Staff  Accounting  Bulletin  ("SECSAB")  Topic 4:D, shares of common
stock underlying  warrants issued and options granted during the 12 months prior
to the Company's May 10, 1996 initial public offering at prices below the public
offering  price have been  included in the  calculation  of weighted  average of


                                       9
<PAGE>

common and common equivalent  shares  outstanding as if they were outstanding as
of the beginning of the periods.

5.   INCOME TAXES

     There was no income tax expense for the three  months and nine months ended
December 29, 1995.  Income taxes charged  (credited) to operations for the three
months and nine months ended December 27, 1996 consisted of the following:

                                                 Three Months   Nine Months
                                                     Ended          Ended
                                                 December 27,   December 27,
                                                     1996           1996
                                                  ---------      ---------
     Current tax expense (benefit):
       Federal                                    $  (1,939)     $ 491,632
       State                                        (74,500)        10,290
                                                  ---------      ---------
                                                    (76,439)       501,922
                                                  ---------      ---------
     Deferred tax expense (benefit):
       Federal                                      (40,316)      (496,620)
       State                                         (5,633)       (69,375)
                                                  ---------      ---------
                                                    (45,949)      (565,995)
                                                  ---------      ---------
                                                   (122,388)       (64,073)
     Tax benefits applied to goodwill               116,702        502,843
                                                  =========      =========
                                                  $  (5,686)     $ 438,770
                                                  =========      =========

     Income  tax  expense  (benefit)  differs  from the  amount of income  taxes
determined by applying the applicable U.S.  statutory federal income tax rate to
income before income taxes as a result of the following differences:

<TABLE>
<CAPTION>
                                           Three Months Ended              Nine Months Ended
                                      ----------------------------    ----------------------------
                                      December 27,    December 29,    December 27,    December 29,
                                          1996            1995            1996            1995
                                      ------------    ------------    ------------    ------------
<S>                                   <C>             <C>             <C>             <C>         
Statutory U.S. tax rates              $      7,297    $    222,685    $    488,371    $    224,537
State taxes, net of federal benefit          1,633            --            45,805            --
Non-deductible expenses                     14,004          25,708          42,939          77,150
Utilization of loss carryforwards             --          (248,393)        (71,995)       (301,687)
Other                                      (28,620)        (66,350)
                                      ============    ============    ============    ============
Effective tax rates                   $     (5,686)   $       --      $    438,770    $       --
                                      ============    ============    ============    ============
</TABLE>


                                       10
<PAGE>

6.   SUPPLEMENTAL CASH FLOW INFORMATION

     Supplemental  cash flow  information for the nine months ended December 27,
1996 and December 29, 1995 consists of the following:

                                                          Nine Months Ended
                                                     ---------------------------
                                                     December 27,   December 29,
                                                        1996           1995
                                                     -----------    ------------
                                                                    
     Interest paid                                    $421,716       $731,858
     Income taxes paid                                 503,569           --
     Deferred offering expenses charged                             
       against proceeds of initial public                           
       offering                                        338,372           --
     Tax benefits applied to goodwill                  502,843           --
     Retirement of capital lease obligation                         
       and write-off of related property               933,910      
     Write-off of property and equipment                            
       against accrued restructuring charges            41,133      
     Other current assets acquired by                               
       assumption of debt obligations                     --          131,594
     Increase in goodwill from                                      
       distribution of escrow                                       
       consideration                                      --          329,709
                                                                    
7.   RESTRUCTURING

     During the nine months ended  December 27,  1996,  the Company  initiated a
consolidation  plan  intended to augment its on-going  productivity  and quality
improvement  programs.  The  consolidation  plan  provides  for the  closure the
Company's Kentucky manufacturing  facility, the closure of the Company's Georgia
corporate  office  facility,  the  consolidation  of repair,  refurbishment  and
conversion  service  operations  into the  Company's  Virginia  facility and the
consolidation of corporate activities and product assembly operations into a new
Georgia   facility.   In  connection  with  this  plan,  the  Company   recorded
restructuring charges of $62,500 during the nine months ended December 27, 1996.
These  restructuring  charges  consist of estimated  severance  obligations  and
estimated losses related to abandonment of assets.

     During the three months ended  December  27, 1996,  the Company  closed its
Kentucky   facility  and  relocated   service   operations   into  its  Virginia
manufacturing facility. Relocation expenses and other incremental costs incurred
in connection with the  consolidation and charged to operations during the three
months ended December 27, 1996 approximated $304,000.

     In November 1996, the Company  executed a lease agreement with respect to a
39,200 square foot  facility  located in Georgia that is expected to commence in
April 1997.  Upon  commencement  of the lease,  the Company intends to close its
present   corporate   office  facility  and  consolidate  its  product  assembly
operations  and corporate  activities  into the new facility.  The lease,  which
provides for a monthly payment of $17,803, has an initial term of five years and
is renewable for an additional five-year term.


                                       11
<PAGE>

8.   COMMITMENTS AND CONTINGENT LIABILITIES

     Pursuant to the terms of a settlement  agreement  and mutual  release dated
July 3, 1996, a suit filed  against the Company by a former  supplier to collect
approximately  $400,000 of unpaid  obligations  was  dismissed  with  prejudice.
Pursuant to the terms of the settlement agreement, the Company paid $180,000 and
agreed to pay an  additional  $112,500  in six  equal  monthly  installments  of
$18,750 commencing on August 15, 1996. As a result of the settlement  agreement,
the Company  realized a gain of $105,146  representing  the  difference  between
unpaid obligations  recorded in the Company's accounts and aggregate  settlement
payments  set forth in the  settlement  agreement.  The gain is reflected in the
Company's results of operations for the nine months ended December 27, 1996.


                                       12
<PAGE>

Item 2. Management's  Discussion and Analysis of Financial Condition and Results
of Operations

Forward Looking Statements

     This report  contains  certain forward  looking  statements  concerning the
Company's  operations,   economic  performance  and  financial  condition.  Such
statements are subject to various risks and uncertainties.  Actual results could
differ  materially from those currently  anticipated due to a number of factors,
including those identified herein.

Results of Operations

          For the Three Months Ended December 27, 1996 Compared to the
                      Three Months Ended December 29, 1995

     Overview. The Company's business during the three months ended December 27,
1996 was adversely  affected by a significant  decrease in sales volume of smart
payphone products, which the Company attributes to the budget cycles and related
changes in the deployment  schedules of the two primary customers  deploying the
Company's  smart payphone  products.  During the three months ended December 29,
1995, the Company  received  significant  year-end smart product orders from its
customers. The Company's net income for the three months ended December 27, 1996
decreased  by $627,812 to $27,145 as compared to $654,957  for the three  months
ended December 29, 1995.  Primary  earnings per share for the three months ended
December  27, 1996  decreased  to $.01 per share based on  5,059,505  common and
common  equivalent shares  outstanding  versus $.17 per share based on 3,870,889
common and common  equivalent  shares  outstanding  for the three  months  ended
December 29, 1995.

     Sales.  Sales decreased by $3,934,009,  or 41%, to $5,651,655 for the three
months ended  December 27, 1996 (third  quarter of fiscal 1997) from  $9,585,664
for the three months ended December 29, 1995 (third quarter of fiscal 1996). The
decrease  in sales is  primarily  attributable  to a  decrease  in sales  volume
related  to  smart  payphone   products  and  exported   wireless   products  of
approximately  $4.7  million,  which was offset by an  increase in the volume of
repair and refurbishment  services of approximately $.8 million.  Sales of smart
payphone  products and components  decreased by  approximately  $4.6 million and
accounted for approximately 38% of sales during the third quarter of fiscal 1997
as  compared  to  70%  of  sales  during  the  third  quarter  of  fiscal  1996.
Refurbishment  and  repair  services  and  related  product  sales for the third
quarter of fiscal 1997  increased by  approximately  31% as compared to the same
period last year,  and  accounted for 59% of sales as compared to 27% last year.
Sales  during  the  third  quarter  of  fiscal  1997  include  export  sales  of
approximately  $167,000 as compared to export  sales of  approximately  $304,000
during the third quarter of fiscal 1996.

     During  the third  quarter  of fiscal  1997,  the  Company  entered  into a
non-exclusive  sales agreement,  effective July 1, 1996, to provide its GeminiTM
smart payphones and processors,  CoinNetTM payphone  management system and other
smart payphone components to Telesector Resources Group, Inc. and its affiliates
("NYNEX")  for a period of five years.  The  Company has been  informed by NYNEX
that, as a result of budgetary issues and related changes in NYNEX's  deployment
schedule, the Company did not receive any significant orders under this contract
during the third quarter of fiscal 1997.

     Sales of smart  payphone  products  during the third quarter of fiscal 1997
were primarily  attributable to shipments under a former sales agreement between
the Company and NYNEX executed in December 1995.  This sales  agreement  expired
during the third  quarter of fiscal  1997,  and although the Company has entered
into the new contract,  no significant  orders were received during the quarter.
During the third quarter of fiscal 1996, a significant  portion of the Company's
sales were attributable to shipments under the former NYNEX agreement as well as
a sales agreement  between the Company and Southwestern  Bell Telephone  Company
("SWB")  executed in December 1994. SWB had purchased  approximately  65% of the


                                       13
<PAGE>

committed  volume under the agreement by June 1996, and deferred the purchase of
the remaining committed volume to its 1997 budget (calendar) year.  Accordingly,
sales to SWB  under  the 1994  contract  have not been  significant  during  the
Company's 1997 fiscal year. See "Operating Trends and Uncertainties,"  below for
a  discussion  of  the  Company's   dependence  on  significant   customers  and
contractual relationships.

     Cost of Goods Sold. Cost of goods sold decreased by $2,827,182,  or 38%, to
$4,588,941  during the third  quarter of fiscal 1997 as  compared to  $7,416,123
during the third  quarter of fiscal 1996.  The decrease in cost of products sold
is primarily  attributable to the 41% decrease in sales during the third quarter
of fiscal 1997 as compared to the third quarter of fiscal 1996. During the third
quarter of fiscal 1997, the Company closed one of its  manufacturing  facilities
and  consolidated  its repair and  refurbishment  operations  into its  Virginia
facility.  Incremental  costs  incurred  in  connection  with  the  closure  and
consolidation  approximated  $304,000 during the three months ended December 27,
1996. The incremental  costs,  certain sales price  reductions,  the decrease in
volume,  and variations in product mix had an  unfavorable  impact on production
costs as a percentage of sales.  Overall,  cost of goods sold as a percentage of
sales  increased  to 81% during the third  quarter of fiscal 1997 as compared to
77% of sales during third quarter of fiscal 1996.

     General and Administrative  Expenses.  General and administrative  expenses
decreased  by  $130,964,  or 21%,  to  $503,331  (9% of sales)  during the third
quarter of fiscal 1997 from  $634,295 (7% of sales)  during the third quarter of
fiscal 1996.  The decrease in general and  administrative  expenses is primarily
related  to the  closure of one of the  Company's  manufacturing  facilities,  a
decrease  in accrued  performance  based  compensation  and a  reduction  in the
estimate  of  doubtful  accounts  receivable,  which  resulted  in a  credit  of
approximately $56,000 during the quarter.

     Marketing and Selling Expenses. Marketing and selling expenses decreased by
$140,359,  or 44%, to $179,743 (3% of sales)  during the third quarter of fiscal
1997 as compared to $320,102  (3% of sales)  during the third  quarter of fiscal
1996.  The decrease is primarily  attributable  to the  expiration  of a royalty
agreement and the resulting decrease in royalty expense associated with sales of
smart payphone products.

     Engineering,  Research and Development Expenses. Engineering,  research and
development  expenses  increased  by $34,871,  or 12%, to $331,865 (6% of sales)
during the third  quarter of fiscal 1997 as  compared to $296,994  (3% of sales)
during  the third  quarter of fiscal  1996 due to an  expansion  of  engineering
resources and product  development  activities.  The Company began to expand its
engineering  resources  during  the first  quarter  of  fiscal  1997 in order to
facilitate  smart  product  development  activities  and the  implementation  of
lower-cost manufacturing methodologies. During the third quarter of fiscal 1997,
the Company  capitalized  approximately  $272,000 of software  development costs
with respect to its next generation smart payphone processor.


     Interest  Expense.  Interest expense  decreased to $99,780 during the third
quarter of fiscal  1997 as  compared  to  $267,991  during the third  quarter of
fiscal 1996 primarily due to the repayment of outstanding  bank and  stockholder
debt obligations  during May 1996 from proceeds of the Company's  initial public
offering.  See  "Liquidity  and Capital  Resources  - Cash Flows From  Financing
Activities," below.

     Other Income.  During the three months ended December 27, 1996, the Company
closed a one hundred  thousand  square foot  manufacturing  facility  located in
Paducah,  Kentucky and  assigned  the related  capital  lease  obligation  to an
unaffiliated  party.  Accordingly,  the Company  recorded the  retirement of the
outstanding  capital lease obligation and the disposition of the property during


                                       14
<PAGE>

the three  months  ended  December  27,  1996,  and  realized  a gain of $44,169
representing the difference between the outstanding lease obligation  ($933,510)
plus the  proceeds  received  ($50,000)  and the net book value of the  property
($939,341). The increase in other income during the third quarter of fiscal 1997
as compared to the third  quarter of fiscal 1996 is  primarily  attributable  to
this gain and to an  increase in income from a sublease of a portion of property
leased by the Company.

     Income Taxes. During the third quarter of fiscal 1997, the Company recorded
an income tax  benefit of  $5,686.  Benefits  of  acquired  deferred  tax assets
aggregating  $116,702  were  applied to goodwill  during the three  months ended
December 27, 1996.  There was no income tax  provision  during third  quarter of
fiscal 1996. Benefits of net operating loss carryforwards used to offset current
tax  expense  during the three  months  ended  December  29,  1995  approximated
$248,000.

           For the Nine Months Ended December 27, 1996 Compared to the
                       Nine Months Ended December 29, 1995

     Overview.  The  Company's  income  before  taxes for the nine months  ended
December 27, 1996  increased by $775,981,  to $1,436,384 as compared to $660,403
for the nine months  ended  December  29,  1995.  During the nine  months  ended
December 27, 1996, the Company recorded an income tax provision of $438,770.  No
income tax  provision  was recorded  during the nine months  ended  December 29,
1995.  Net income for the nine months ended  December 27, 1996  increased 51% to
$997,614  versus  $660,403 for the same period last year.  Primary  earnings per
share for the nine months ended  December  27, 1996  increased to $.21 per share
based on 4,793,020 common and common equivalent shares  outstanding  versus $.17
per share based on 3,870,889 common and common equivalent shares outstanding for
the nine months ended December 29, 1995.

     Sales.  Sales increased by $4,114,380,  or 17%, to $27,791,869 for the nine
months  ended  December  27,  1996  (first  nine  months  of fiscal  1997)  from
$23,677,489  for the nine months  ended  December 29, 1995 (first nine months of
fiscal 1996). The increase in sales is primarily  attributable to an increase in
sales  volume,  particularly  sales  related  to  smart  payphone  products  and
components.  Sales  of smart  payphone  products  and  components  increased  by
approximately  $2 million (14%),  and accounted for  approximately  60% of sales
during the first nine months of fiscal  1997 as compared to 62% of sales  during
the first nine months of fiscal  1996.  Refurbishment  and repair  services  and
related  product  sales for the first nine  months of fiscal 1997  increased  by
approximately  $2.3 million (28%) as compared to the same period last year,  and
accounted for 39% of sales as compared to 36% last year.  Sales during the first
nine months of fiscal 1997  include  export sales of  approximately  $322,000 as
compared to export sales of approximately  $561,000 during the first nine months
of fiscal 1996.

     During  the third  quarter  of fiscal  1997,  the  Company  entered  into a
non-exclusive  sales agreement,  effective July 1, 1996, to provide its GeminiTM
smart payphones and processors,  CoinNetTM payphone  management system and other
smart payphone components to Telesector Resources Group, Inc. and its affiliates
("NYNEX") for a period of five years.  Sales of smart payphone  products  during
the nine months ended December 27, 1996 were primarily attributable to shipments
under a former  sales  agreement  between  the  Company  and NYNEX  executed  in
December 1995. This sales  agreement  expired during the third quarter of fiscal
1997, and although the Company has entered into the new contract, no significant
orders were received during the quarter, which according to NYNEX, is due to its
budget cycle and related  changes in the  deployment  schedule.  During the nine
months ended  December 29, 1995, a significant  portion of the  Company's  sales
were  attributable  to shipments  under the former NYNEX  agreement as well as a
sales  agreement  between the Company and  Southwestern  Bell Telephone  Company
("SWB")  executed in December 1994. SWB had purchased  approximately  65% of the
committed volume under the agreement as of March 1996, and deferred the purchase
of  the  remaining   committed  volume  to  its  1997  budget  (calendar)  year.


                                       15
<PAGE>

Accordingly,  sales to SWB under  the 1994  contract  have not been  significant
during the Company's 1997 fiscal year. See "Operating Trends and Uncertainties,"
below for a discussion of the Company's dependence on significant  customers and
contractual relationships.

     Cost of Goods Sold. Cost of goods sold increased by $3,342,154,  or 18%, to
$22,199,304  during  the  first  nine  months  of  fiscal  1997 as  compared  to
$18,857,150 during the first nine months of fiscal 1996. The increase in cost of
products sold is primarily  attributable to the 17% increase in sales during the
first nine  months of fiscal 1997 as compared to the first nine months of fiscal
1996.  The increase in volume  offset the adverse  impact of  incremental  costs
incurred in  connection  with the plant  closure and  consolidation  and certain
sales price  reductions,  and production costs as a percentage of sales remained
stable at  approximately  80% during the nine months ended  December 27, 1996 as
compared to the nine months ended December 29, 1995.

     General and Administrative  Expenses.  General and administrative  expenses
increased by $153,277,  or 9%, to $1,866,187 (7% of sales) during the first nine
months of fiscal 1997 from $1,712,910 (7% of sales) during the first nine months
of fiscal 1996. The increase in general and administrative expenses is primarily
related to the  increase  in the volume of  business,  amortization  of deferred
patent license fees with respect to a patent license  acquired in September 1995
and an increase in accrued performance based compensation.

     Marketing and Selling Expenses. Marketing and selling expenses decreased by
$171,903,  or 19%,  to  $734,851  (3% of sales)  during the first nine months of
fiscal 1997 as compared to $906,754  (4% of sales)  during the first nine months
of fiscal 1996.  The decrease is primarily  attributable  to the expiration of a
royalty  agreement  and the  related  decrease  in  royalty  expense  offset  by
commission  compensation  accrued  pursuant to a sales  commission  plan adopted
during fiscal 1997.

     Engineering,  Research and Development Expenses. Engineering,  research and
development expenses increased by $547,452,  or 65%, to $1,396,486 (5% of sales)
during the first nine  months of fiscal  1997 as  compared  to  $849,034  (4% of
sales) during the first nine months of fiscal 1996 primarily due to an expansion
of engineering resources and product development  activities.  The Company began
to expand its engineering  resources  during the first quarter of fiscal 1997 in
order to facilitate smart product development  activities and the implementation
of lower-cost manufacturing methodologies. During the nine months ended December
27, 1996, the Company capitalized approximately $272,000 of software development
costs with respect to its next generation smart payphone processor.

     Litigation  Settlement.  Pursuant  to the terms of a  settlement  agreement
dated July 3, 1996,  a suit filed  against the  Company by a former  supplier to
collect  approximately   $400,000  of  unpaid  obligations  was  dismissed  with
prejudice. As a result of the settlement agreement,  the Company realized a gain
of $105,146  representing the difference between the unpaid obligations recorded
in the Company's accounts and the aggregate settlement payments.

     Interest  Expense.  Interest expense decreased to $304,367 during the first
nine months of fiscal 1997 as compared to $705,880  during the first nine months
of  fiscal  1996  primarily  due  to  the  repayment  of  outstanding  bank  and
stockholder  debt  obligations  during May 1996 from  proceeds of the  Company's
initial public offering.  See "Liquidity and Capital Resources - Cash Flows From
Financing Activities," below.


     Restructuring  Charges.   During  August  1996,  the  Company  initiated  a
consolidation  plan  intended to augment its on-going  productivity  and quality
improvement  programs.  The  consolidation  plan provides for the closure of the


                                       16
<PAGE>

Company's Kentucky manufacturing  facility, the closure of the Company's Georgia
corporate  office  facility,  the  consolidation  of repair,  refurbishment  and
conversion  service  operations  into the  Company's  Virginia  facility and the
consolidation of corporate activities and product assembly operations into a new
Georgia   facility.   In  connection  with  this  plan,  the  Company   recorded
restructuring charges of $62,500 during the nine months ended December 27, 1996.
These  restructuring  charges  consist of estimated  severance  obligations  and
estimated losses related to abandonment of assets.

     Other  Income.  The increase in other  income  during the nine months ended
December  27, 1996 as compared to the nine  months  ended  December  29, 1995 is
primarily  attributable  to the gain on the  disposition of the facility  closed
during the quarter ended  December 27, 1996 and an increase in income related to
the sublease of property leased by the Company.

     Income  Taxes.  During the first nine  months of fiscal  1997,  the Company
recorded an income tax  provision of $438,770 on pre-tax  income of  $1,436,384.
Benefits of net operating loss  carryforwards used to offset current tax expense
amounted to $71,995.  Deferred tax benefits of $565,995 were  recognized  during
the nine months ended December 27, 1996. However,  benefits of acquired deferred
tax assets  aggregating  $502,843 were applied to goodwill.  There was no income
tax provision  during the nine months ended  December 29, 1995.  Benefits of net
operating loss carryforwards used to offset current tax expense during the first
nine months of fiscal 1996 amounted to $301,687.

Liquidity and Capital Resources

Initial Public Offering

     During May 1996,  the  Company  completed  an initial  public  offering  of
1,150,000  Units,  each  Unit  consisting  of one  share of  common  stock and a
redeemable  warrant,  at a price  of  $9.00  per  Unit  for  gross  proceeds  of
$10,350,000. In connection with the offering, the Company issued warrants to the
underwriter  to  purchase  100,000  shares of  common  stock  (the  "Underwriter
Warrants") for gross proceeds of $10. Net proceeds received by the Company as of
December 27, 1996, after  underwriting  discounts and expenses of $1,231,897 and
other  expenses of  $824,953,  aggregated  $8,293,160.  At March 29,  1996,  the
Company had incurred and deferred  offering  expenses of $338,372.  Accordingly,
net proceeds from the Company's  initial public  offering during the nine months
ended December 27, 1996 aggregated $8,631,532.

     The proceeds of the offering,  net of underwriting  discounts and expenses,
were  initially  used to  repay  then  outstanding  indebtedness  consisting  of
subordinated notes payable to stockholders of $2.8 million and bank indebtedness
aggregating  $6,318,113  (see "Cash Flows From  Financing  Activities,"  below).
Indebtedness  pursuant  to the Loan  Agreement  between the Company and its bank
repaid with the net proceeds  consisted of a $2.2 million term note due November
30, 1997, $309,524  outstanding under a $650,000 term note due November 30, 1997
and borrowings under a revolving credit agreement of $3,808,589.

The Loan Agreement

     The Loan Agreement  between the Company and its bank provides  financing to
the Company under a revolving credit agreement and term and installment notes of
up to $9  million.  Pursuant  to an  October  31,  1994  amendment  to the  Loan
Agreement, $2.2 million of debt outstanding under the revolving credit agreement
was converted  into a term note payable on November 30, 1997,  the interest rate
on amounts  borrowed  under the terms of the Loan Agreement was reduced by 0.75%
and the term of the Loan  Agreement  was extended  from May 31, 1995 to November
30,  1997.  At March 29,  1996,  the Company  had  outstanding  indebtedness  of
$1,093,735  under the revolving  credit  agreement and $2,525,000 under term and
installment  notes,  including the $2.2 million term note due November 30, 1997.
At March 29, 1996, the term and installment  notes consisted of a term note with
an  outstanding  balance  of $2.2  million  and a term note with an  outstanding


                                       17
<PAGE>

balance  of  $325,000.  At  December  27,  1996,  the  Company  had  outstanding
indebtedness of $3,949,303 under the revolving credit agreement. At December 27,
1996,  outstanding  indebtedness  under the Loan  Agreement  bears interest at a
variable rate per annum equal to 1.5% above a base rate quoted by Citibank, N.A.
The interest rate was reduced from 2% above a base rate quoted by Citibank, N.A.
on March 1, 1996.  The base rate at  December  27,  1996 and March 29,  1996 was
8.25% per  annum.  Amounts  borrowed  under the Loan  Agreement  are  secured by
substantially  all  assets  of  the  Company,   including  accounts  receivable,
inventories and property and equipment.  The Loan Agreement  expires on November
30, 1997, and is renewable  annually for one-year  periods unless  terminated by
the bank upon an  occurrence  of an event of default or by the  Company  upon at
least 90 days notice.

     The Loan  Agreement  contains  conditions  and  covenants  that  prevent or
restrict the Company from engaging in certain  transactions  without the consent
of the  bank,  including  merging  or  consolidating,  payment  of  subordinated
stockholder  debt  obligations,   declaration  or  payment  of  dividends,   and
disposition of assets, among others.  Additionally,  the Loan Agreement requires
the Company to comply with specific  financial  covenants,  including  covenants
with respect to cash flow, working capital and net worth. Noncompliance with any
of these  conditions and covenants or the occurrence of an event of default,  if
not  waived or  corrected,  could  accelerate  the  maturity  of the  borrowings
outstanding  under the Loan  Agreement.  Although the Company was in  compliance
with the covenants set forth in the Loan  Agreement at December 27, 1996,  there
is no assurance that the Company will be able to remain in compliance  with such
covenants in the future.

     The Company used the net proceeds of its initial  public  offering to repay
outstanding  indebtedness  under  the Loan  Agreement  in order  to  reduce  its
interest expense.  The Company intends to use the financing  available under the
Loan Agreement to finance its on-going  working  capital  needs.  If an event of
default under the existing working capital facility were to occur,  however, the
Company's ability in this regard could be curtailed.  In such event, the Company
would seek alternative  financing  sources,  but there is no assurance that such
financing  sources would be available on  commercially  reasonable  terms, or at
all.

Cash Flows From Financing Activities

     Cash provided by financing activities during the nine months ended December
27, 1996  aggregated  $5,578,444,  including  the net proceeds  from the initial
public offering of $8,631,532,  as compared to $4,020,111 during the nine months
ended December 29, 1995.

     Net proceeds under the Company's revolving credit agreement during the nine
months  ended  December  27,  1996  amounted  to  $2,855,568  as compared to net
proceeds of  $4,576,332  during the nine months ended  December  29,  1995.  Net
proceeds  under the  revolving  credit  agreement  during the nine months  ended
December 27, 1996 reflect the repayment of $3,808,589 of  indebtedness  from the
proceeds of the Company's  initial pubic offering.  Exclusive of such repayment,
the net proceeds  under the revolving  credit  agreement  during the nine months
ended December 27, 1996 would have aggregated $6,664,157. The net proceeds under
the  revolving  credit  agreement  were  used to fund  the  Company's  net  cash
requirements  during the nine months  ended  December  27, 1996 and December 29,
1995.

     Principal  payments on long-term debt and capital lease obligations  during
the nine  months  ended  December  27,  1996  aggregated  $2,599,520,  including
repayment of the $2.2 million term note due November 30, 1997 and the  repayment
of $309,524  outstanding under the $650,000 term note due November 30, 1997 from
the proceeds of the Company's  initial public  offering.  Principal  payments on
long-term  debt and  capital  lease  obligations  during the nine  months  ended
December  27,  1996,  excluding  the  repayments  of term and  installment  note
indebtedness from the proceeds of the offering, amounted to $89,996, as compared
to $778,243  during the nine months ended  December  29,  1995.  The decrease in
principal payments  (exclusive of repayments made from proceeds of the offering)


                                       18
<PAGE>

for the nine months  ended  December  27, 1996 as compared to the  corresponding
period last year is  attributable  to debt  maturing  during  fiscal  1997,  the
repayments  made from the  proceeds of the offering  and the  assignment  of the
capital  lease  obligation  related to the  Company's  Kentucky  facility  to an
unrelated third party in November 1996.

     Pursuant to an October 31, 1994 Investment Agreement,  the Company borrowed
$2.8 million from its stockholders, and issued 10% interest bearing subordinated
promissory notes due November 1, 1999. These subordinated  promissory notes were
repaid  during the nine months ended  December 27, 1996 from the proceeds of the
Company's initial public offering.

     The Company has also  established a cash  management  program with its bank
pursuant to which the Company funds drafts as they clear the bank.  Accordingly,
the  Company  maintains  bank  overdrafts  representing  outstanding  drafts and
utilizes the cash  management  account as a source of funding.  Bank  overdrafts
vary according to many factors, including the volume of business, and the timing
of purchases and disbursements.  During the nine months ended December 27, 1996,
the Company's bank  overdrafts  decreased by $725,100 as compared to an increase
of $222,022 during the nine months ended December 29, 1995.

     In June  1996,  the  Company  issued  40,000  shares  of  common  stock for
aggregate  proceeds of $160,000  upon the exercise of  outstanding  common stock
purchase  warrants issued in May 1995. See "Capital  Commitments and Liquidity,"
below.  During the nine months ended December 27, 1996, the Company issued 4,250
shares of common  stock  upon the  exercise  of  incentive  stock  options at an
aggregate exercise price of $4,250, and issued 6,760 shares of common stock upon
the exercise of rights  granted under the 1995 Employee  Stock Purchase Plan for
an aggregate purchase price of $51,714.

Cash Flows From Operating Activities

     Nine Months Ended December 27, 1996. Cash used to fund operating activities
during the nine months ended  December 27, 1996 amounted to  $5,363,159.  During
the nine months ended  December 27, 1996,  the  Company's  operations  generated
$2,198,560 in cash, after adjustments related to non-cash charges and credits of
$1,200,946.  In addition,  a decrease in accounts  receivable  provided  cash of
$1,780,999  during the nine months ended  December 27, 1996.  However,  net cash
used to fund increases in inventories of $4,630,141,  prepaid expenses and other
assets of  $302,817,  including  capitalized  software  development  costs,  and
decreases in accounts  payable of $3,188,788,  deferred  revenue of $541,245 and
accrued  liabilities of $668,715  aggregated  $9,331,706  during the nine months
ended  December  27,  1996.  The decline in accounts  receivable  was  primarily
attributable  to the decline in sales during the three months ended December 27,
1996 as compared to the three  months ended  December 29, 1995.  The increase in
inventories was primarily attributable to changes in the deployment schedules of
customers, the resulting slow-down in customer smart payphone product orders and
the final  production  run of printed  circuit board  assemblies  for one of the
Company's  smart  products  to meet  anticipated  sales  requirements  until the
planned  release of the Company's  next  generation  smart product  series.  The
decrease in accounts payable is related to the decline in  manufacturing  volume
during the three months ended  December  27, 1996 and the  Company's  efforts to
reduce inventory levels.  The Company  satisfied its delivery  requirements with
respect to  revenues  deferred at the end of fiscal  1996 and  deferred  revenue
decreased accordingly.  The decrease in accrued expenses is primarily related to
the  expiration  of a royalty  agreement  and the payment of  remaining  royalty
obligations during the nine months ended December 27, 1996.

     Nine Months Ended December 29, 1995. Cash used to fund operating activities
during the nine months ended  December 29, 1995 amounted to  $4,072,975.  During
the nine months ended  December 29, 1995,  the  Company's  operations  generated
$1,734,779 in cash, after adjustments related to non-cash charges of $1,074,376.
In addition,  cash provided by an increase in accounts payable of $1,454,523 and
a decrease  in prepaid  expenses  of $22,380  aggregated  $1,476,903  during the
period.  However,  cash  used to  fund  increases  in  accounts  receivable  and


                                       19
<PAGE>

inventories amounted to $5,779,385 and $1,077,648,  respectively,  and cash used
to fund an increase in other  assets and  decreases in accrued  liabilities  and
restructuring  charges aggregated  $426,413.  The increases in accounts payable,
accounts  receivable and  inventories  during the nine months ended December 29,
1995 were  primarily  related to the  increase  in the volume of  business.  The
decrease in accrued liabilities and accrued  restructuring charges was primarily
related  to the  payment  of  accrued  interest  on  shareholder  notes  and the
settlement of a lease obligation included in formerly established  restructuring
reserves, respectively.

Cash Flows From Investing Activities

     Cash  used to fund  investing  activities  during  the  nine  months  ended
December  27, 1996  amounted  to  $189,964  as compared to $164,593  during nine
months ended December 29, 1995.  During the nine months ended December 27, 1996,
the  Company  expanded  its  investment  in  manufacturing  and  automated  test
equipment located at its contract manufacturer, began to invest in equipment and
hardware required to manufacture its next generation of smart payphone products,
and began a program to  upgrade  its  in-house  testing  capability.  During the
corresponding   period  last  year,  the  Company's  investing  activities  were
primarily  related to the  introduction  of a new smart  payphone  product.  The
Company  expects that its capital  expenditures  over the next several  quarters
will continue to grow as the Company invests in manufacturing and test equipment
required to improve its in-house  prototype and  manufacturing  capabilities and
moves  forward  to  select  and  begin  the  implementation  of  new  management
information systems (see "Capital  Commitments and Liquidity," below).  Proceeds
from  the  assignment  of the  capital  lease  obligation  with  respect  to the
Company's  Kentucky  manufacturing  facility  and the  disposition  of equipment
aggregated $57,800 during the nine months ended December 27, 1996.

Capital Commitments and Liquidity

     The  Company  has not  entered  into any  significant  commitments  for the
purchase of capital assets. However, the Company intends to purchase and install
information  systems and capital  equipment,  including  printed  circuit  board
assembly equipment and other manufacturing  equipment,  to advance its prototype
manufacturing  and  product  testing  capabilities  during the  eighteen  months
following the date of the Company's  initial public offering.  In addition,  the
Company intends to expand its manufacturing capabilities through the purchase of
capital  equipment in the future as required to meet the needs of its  business.
The Company expects to expend approximately $800,000 to fund anticipated capital
expenditures  during the eighteen  month  period  following  the initial  public
offering.  However,  there can be no assurance that capital expenditures will be
made as planned or that additional  capital  expenditures  will not be required.
The Company believes, based on its current plans and assumptions relating to its
operations,  that its sources of capital,  including capital available under its
revolving  credit line and cash flow from operations will be adequate to satisfy
its anticipated cash needs,  including anticipated capital expenditures,  for at
least the next year. However, in the event that the Company's plans or the basis
for its assumptions  change or prove to be inaccurate,  or cash flow and sources
of  capital  prove  to  be  insufficient  to  provide  for  the  Company's  cash
requirements  (due  to  unanticipated   expenses,  loss  of  sales  revenues,  a
significant  increase  in  inventories,   problems,  operating  difficulties  or
otherwise),  the Company would be required to seek additional financing. In such
an event, there can be no assurance that additional financing would be available
to the Company on commercially reasonable terms, or at all.

     Extension of credit to customers  and  inventory  purchases  represent  the
principal working capital requirements of the Company, and significant increases
in accounts  receivable  and inventory  balances could have an adverse effect on
the Company's liquidity. The Company's accounts receivable,  less allowances for
doubtful  accounts,  at  December  27,  1996 and  March  29,  1996  amounted  to
$2,071,105 and  $3,866,372,  respectively.  Accounts  receivable at December 27,
1996 and March 29, 1996 consists primarily of amounts due from the Regional Bell
Operating Companies.  The Company's  inventories,  less allowances for potential


                                       20
<PAGE>

losses due to  obsolescence  and excess  quantities  amounted to $13,053,079 and
$8,658,669 at December 27, 1996 and March 29, 1996,  respectively.  The level of
inventory  maintained  by the  Company  is  dependent  on a number  of  factors,
including  delivery  requirements  of customers,  availability  and lead-time of
components and the ability of the Company to estimate and plan the volume of its
business.  The Company  markets a wide range of services  and  products  and the
requirements  of  its  customers  vary  significantly  from  period  to  period.
Accordingly, inventory balances may vary significantly.

     In  October  1994,  the  Company  entered  into  a  contract  manufacturing
agreement that provides for the production of certain smart payphone processors.
Pursuant to the terms of the manufacturing  agreement,  the Company committed to
purchase  $12.2 million of product over an  eighteen-month  period  beginning in
December 1994. In addition,  in November 1994, the Company entered into a dealer
agreement  that  commits the Company to purchase  approximately  $3.5 million of
electronic  lock devices over a two-year  period.  Purchases  under the terms of
these  agreements  fluctuate based on delivery  requirements  established by the
Company.  The Company initially scheduled purchases pursuant to these agreements
based on  anticipated  quantities  required  to meet its sales  commitments.  At
December 27, 1996,  the Company had acquired the majority of committed  purchase
volume pursuant to these purchase agreements. However, as a result of changes in
the  deployment  schedule  of SWB,  the  Company's  inventories  related to such
agreements  increased by  approximately  $2 million during the nine months ended
December 27, 1996.  Also,  the Company's  inventories  of printed  circuit board
assemblies  related to another smart payphone product increased by approximately
$3 million during the nine months ended December 27, 1996. This increase,  which
was  attributable to the release of the final production run to meet anticipated
sales  requirements  until the planned  release of TSG's next  generation  smart
payphone  products,  was  compounded  by changes in the  deployment  schedule of
NYNEX.

     The revolving credit agreement  between the Company and its bank limits the
outstanding   indebtedness  secured  by  eligible  inventory  to  $3.1  million.
Accordingly,  the  increase in  inventory  together  with the  decrease in sales
during the third  quarter of fiscal 1997 has  adversely  affected the  Company's
liquidity under the revolving  credit  agreement.  The ability of the Company to
improve its  liquidity  and/or avoid a short-term  cash flow deficit  during the
next quarter is dependent on the level of smart  payphone  product orders during
the quarter and the extent of the related inventory reduction, if any. Also, the
Company is presently  attempting to secure a new lender and financing  agreement
to obtain a higher  level of  inventory  financing.  The Company  believes,  but
cannot  ensure,  that  its  sources  of cash  during  the next  quarter  will be
sufficient  to  overcome  its  present  concerns  with  respect  to the  funding
available under its current credit line.

     In December 1994, the Company sold the rights to certain  product  software
for an  aggregate  purchase  price of  $500,000.  The Company  received  back an
exclusive  irrevocable perpetual right to sub-license the software in connection
with  the sale of  related  products.  In  return,  the  Company  agreed  to pay
royalties on sales of licensed  products to other customers.  Such royalties are
payable  if, and only if,  laws,  regulations  or judicial  actions  occur which
permit the  purchaser  of the software to receive  such  royalty  payments.  The
Company is obligated  to repay,  three years from the date of sale, a portion of
the purchase  price up to a maximum  amount of  $375,000,  which is reflected as
deferred revenue in the Company's  consolidated financial statements at December
27, 1996 and March 29,  1996.  The actual  amount of any  repayment is dependent
upon the amount of aggregate  royalties  paid pursuant to the license  agreement
during such three-year  period. The amount of repayment will equal: (i) $375,000
if  aggregate  royalties  paid amount to less than  $125,000;  (ii)  $250,000 if
aggregate  royalties paid are greater than $125,000 but less than  $250,000;  or
(iii)  $125,000 if aggregate  royalties  paid are greater than $250,000 but less
than $375,000.  If aggregate  royalties paid during the first three years of the
agreement exceed  $375,000,  the Company is not required to repay any portion of
the purchase  price.  At December 27, 1996, the Company was not obligated to pay
and has not paid any royalties under the agreement.


                                       21
<PAGE>

Operating Trends and Uncertainties

Dependence on Large Customers and Contractual Relationships

     The Company markets its payphone products and services predominately to the
Regional Bell  Operating  Companies  ("RBOCs").  In fiscal years 1994,  1995 and
1996,  sales to RBOCs  accounting  for greater than 10% of the  Company's  sales
aggregated 73%, 72% and 88%, respectively,  of the Company's sales revenues. The
Company's  significant  customers  during  the past three  years  have  included
Ameritech  Services,  Inc.,  Bell Atlantic Corp.  ("Bell  Atlantic"),  BellSouth
Telecommunications,  Inc., Southwestern Bell Telephone Company ("SWB") and NYNEX
Corp.  ("NYNEX").  During the three  months ended  December 27, 1996,  Ameritech
Services,  Inc., Bell Atlantic,  NYNEX and SWB accounted for approximately  $1.6
million,  $1.0  million,  $2.4  million and $.3  million,  respectively,  of the
Company's sales. During the three months ended December 29, 1995, Bell Atlantic,
NYNEX and SWB accounted for  approximately  $1.6 million,  $2.4 million and $4.8
million,  respectively,  of the  Company's  sales.  During the nine months ended
December  27, 1996,  Ameritech  Services,  Inc.,  Bell  Atlantic,  NYNEX and SWB
accounted for approximately $3.8 million,  $3.7 million,  $17.4 million and $1.9
million,  respectively,  of the  Company's  sales.  During the nine months ended
December 29, 1995, Bell Atlantic, NYNEX and SWB accounted for approximately $4.5
million, $3.6 million and $12.4 million, respectively, of the Company's sales.

     The  Company  anticipates  that  it will  continue  to  derive  most of its
revenues from such customers,  and other regional telephone  companies,  for the
foreseeable future. The loss of any one RBOC customer or a significant reduction
in sales volume, such as the reduction in the third quarter of fiscal 1997, or a
reduction in sales prices to such RBOCs would have a material  adverse effect on
the Company's business.  Recently,  two mergers between Pacific Telesis Inc. and
SBC  Communications,  Inc.  (the parent of SWB),  and between Bell  Atlantic and
NYNEX were announced. The Company cannot predict the impact that such mergers or
other future mergers will or may have on the Company's business.

     The Company competes for and enters into non-exclusive  supply contracts to
provide products,  components and services to the RBOCs. The Company has entered
into sales  agreements to provide  payphone  components  to Ameritech  Services,
Inc.,  BellSouth  Telecommunications,  Inc.,  Bell Atlantic,  NYNEX and SWB. The
Company has entered into sales agreements to provide repair,  refurbishment  and
conversion services to Ameritech Services,  Inc., Bell Atlantic,  NYNEX and SWB.
These  agreements  have terms ranging from two to three years,  are renewable at
the option of and subject to the  procurement  process of the  particular  RBOC,
contain fixed sales prices for the Company's  products and services with limited
provisions  for cost  increases  and expire at various dates through March 1999.
These sales  agreements  are  frameworks  for dealing on open account and do not
specify or commit  the  Company's  customers  to  purchase a specific  volume of
products or  services.  If orders are made,  however,  the Company has agreed to
fill such orders in accordance with the customer's contract specifications.  The
agreements  are generally  subject to  termination at the option of the customer
upon 30 days  notice  to the  Company,  or if the  Company  defaults  under  any
material  provision  of the  agreements,  including  provisions  with respect to
performance.  In addition,  as further  described below, the Company has entered
into sales  agreements to provide smart  products to NYNEX and SWB. The terms of
the sales agreement  between the Company and SWB includes a provision for SWB to
purchase  specific  quantities of smart products and other  components  from the
Company at specified prices, subject to the cancellation provisions thereof.

     The Company's  prospects for continued  profitability are largely dependent
upon the RBOCs upgrading the technological  capabilities of their installed base
of payphones, and utilizing the Company's products and services for such upgrade
conversion  programs.  To date,  the Company  believes that one of the RBOCs has
completed a  technological  upgrade  program for its installed base of payphones
and that two of the RBOCs have commenced such a program. The two RBOCs that have


                                       22
<PAGE>

commenced upgrade programs,  and which are significant customers of the Company,
have entered into sales agreements with the Company as described below.

     In December  1994,  the Company  entered  into a sales  agreement  with SWB
pursuant to which the Company  agreed to supply and SWB agreed to purchase $21.3
million of smart processors and other  components,  including  electronic locks,
over a three-year  period at specified  prices.  The  agreement  also includes a
"most  favored  customer"  clause  pursuant  to which the  Company has agreed to
provide  price and other terms at least as  favorable  as those  extended by the
Company  to other  customers  for the  products  covered by the  agreement.  The
agreement contains certain covenants and conditions  relating to product quality
and delivery  requirements,  among others.  The agreement provides for penalties
and  damages in the event  that the  Company  is unable to comply  with  certain
performance  criteria.  Upon a  default  by the  Company  with  respect  to such
covenants  and  conditions,  SWB has the right to cancel the agreement or reduce
its  purchase  commitment,  provided  such  default is not cured within a 20-day
notice period. In addition, SWB may in any event terminate the agreement upon at
least 30 days  notice.  However,  upon  such a  termination,  SWB has  agreed to
purchase all finished  goods then held by the Company and to pay  contractor and
supplier  cancellation  and  restocking  charges,  if any, plus a nominal profit
percentage  above  the  cost of such  materials.  Because  SWB has the  right to
terminate  the  contract on 30 days notice as described  above,  there can be no
assurance  that  the  Company  will  ultimately  sell  $21.3  million  of  smart
processors and other  components  pursuant to such contract.  As of December 27,
1996, the Company  estimates that SWB has acquired in excess of 65% of committed
volume  under such  sales  agreement.  However,  as a result of changes in SWB's
deployment  schedule,  the Company does not  anticipate  shipping the  remaining
volume pursuant to the terms of the agreement during fiscal 1997.

     In  November  1996,  TSG  entered  into a  non-exclusive  sales  agreement,
effective July 1, 1996, to provide its GeminiTM smart  payphones and processors,
CoinNetTM  payphone  management  system and other smart  payphone  components to
NYNEX  for a period  of five  years.  The  agreement  sets  forth  the terms and
conditions  relating to the sale of  products to NYNEX,  and does not specify or
commit  NYNEX to purchase a specific  volume of products  from the  Company.  If
orders  are made,  however,  the  Company  has  agreed  to fill  such  orders in
accordance  with  NYNEX's  specifications  and at fixed  prices set forth in the
agreement.  The Company has agreed not to increase its prices during the term of
the  agreement and has agreed to implement a continuous  improvement  program to
improve  productivity and quality and to reduce product costs during the term of
the agreement.  The agreement includes provisions for reductions in sales prices
to  NYNEX  based  on  product  cost  reductions  achieved  from  the  continuous
improvement program and based on NYNEX's purchase volume. The agreement contains
a "most  favored  customer"  clause  pursuant to which the Company has agreed to
provide  price and other terms at least as  favorable  as those  extended by the
Company to other customers for similar  purchase  volumes of products covered by
the  agreement.  The Company has agreed to  indemnify  NYNEX  against  expenses,
liabilities,   claims  and  demands  resulting  from  products  covered  by  the
agreement,  including those related to patent  infringement and those related to
performance specifications. The agreement may be terminated by either party upon
default  of any  provision  of the  agreement  by the other  party upon at least
thirty days'  written  notice,  provided the default is not cured within  thirty
days from the receipt of notice of default.  Further,  NYNEX may  terminate  the
agreement  upon 120 days' written  notice to the Company.  However,  upon such a
termination,  NYNEX has agreed to purchase the Company's  inventories related to
the products  covered by  agreement,  provided  that such  obligation  shall not
exceed the value of NYNEX's  purchases for a 120-day  period,  determined  based
upon the average  monthly  volume for the previous  six-month  period,  less the
value of  outstanding  orders to be shipped,  the value of products which may be
sold to other  customers and the value of inventory  that may be returned to the
Company's suppliers. The agreement expires on July 1, 2001.

     The  termination of these or any of the Company's  sales  agreements  would
have  a  material  adverse  effect  on  the  Company's  business.  Further,  any
assessment of damages under the Company's  sales  contracts could have a further


                                       23
<PAGE>

material  adverse effect on the Company's  operating  results and liquidity.  In
April 1995, the Company  initiated a recall of products as a result of potential
product failures due to contamination  introduced into the manufacturing process
by  the  Company's  contract  manufacturer.   Although  the  Company's  contract
manufacturer  was  responsible  for the repair or  replacement  of the  recalled
product,  the Company incurred  liquidated  damages under the terms of the sales
agreement with its customer in the amount of $200,000.  The damages were paid by
an $8.00 price  reduction over the next 25,000 units shipped after July 1, 1995.
This liability was recorded in the Company's  consolidated  financial statements
at March 31,  1995.  Also,  the Company  agreed to extend its  warranty on up to
5,000 units shipped under the terms of the sales agreement  through December 31,
1998.  However,  the Company does not anticipate that it will incur  significant
warranty costs as a result of the extended warranty.

     The  Company's  prospects  and the  ability of the  Company  to  maintain a
profitable level of operations are dependent upon its ability to secure contract
awards from the RBOCs.  In  addition,  the  Company's  prospects  for growth are
dependent upon market acceptance and success of its smart payphone products,  as
well as  development  of other smart  products  containing  additional  advanced
features.  If the  Company is unable to  attract  the  interest  of the RBOCs to
deploy the Company's  smart payphone  products,  the Company's  sales  revenues,
business and  prospects  for growth would be adversely  affected.  Further,  the
Company's  ability to maintain  and/or  increase its sales is dependent upon its
ability to compete for and maintain  satisfactory  relationships with the RBOCs,
particularly  those RBOCs presently  representing  significant  customers of the
Company.  Prior to a restructuring  instituted in 1994, the Company  experienced
difficulties with a first generation smart payphone product,  which difficulties
subsequently  were  remedied.  Such  difficulties,   however,  resulted  in  the
termination  of a  contract  for such  product  with one of the  Company's  then
significant RBOC customers. There can be no assurances that similar difficulties
will not occur in the future.

Product Sales Prices

     The Company's agreements with its contract manufacturers  generally provide
that the Company will bear certain cost increases  incurred by the manufacturer.
Accordingly,  the Company's  manufacturing  costs may  fluctuate  based on costs
incurred  by its  contract  manufacturers  and such  fluctuations  could  have a
material and adverse impact on earnings.  The Company's  sales  agreements  with
customers  generally  have fixed product  prices with limited  price  escalation
provisions.  Consequently,  there is a risk that the  Company may not be able to
pass on price  increases  to its  customers.  In the event the  Company's  costs
increase or orders are lost due to price increases,  the Company's profitability
would be adversely affected. The Company encounters substantial competition with
respect to smart payphone contract awards by the RBOCs. Competition is beginning
to result in price reductions.  The Company reduced its prices to NYNEX upon the
execution of the November 1996 sales  agreement  based on the planned release of
its lower cost next generation smart product series during the fourth quarter of
fiscal  1997.  Until the Company  releases  its next  generation  smart  product
series,  the Company will  experience  a reduction in gross profit  margins with
respect to smart product sales to NYNEX,  and such  reduction  will be material.
Also,  any other price  reductions  in response  to  competition  will result in
reduced gross profit margins unless the Company is able to achieve reductions in
product costs.

Seasonality

     The Company's sales are generally stronger during periods when weather does
not interfere with the maintenance and installation of payphone equipment by the
Company's customers,  and may be adversely impacted near the end of the calendar
year by the budget  short  falls of  customers.  However,  the  Company may also
receive  large  year-end  orders  from its  customers  for  shipment in December
depending upon their budget positions. In the event the Company does not receive


                                       24
<PAGE>

any  significant end of year orders for its smart payphone  products,  its third
quarter sales may decline significantly in relation to other quarters.

Telecommunications Act of 1996

     On February 8, 1996, the President  signed into law the  Telecommunications
Act of 1996 (the  "Telecommunications  Act"), the most  comprehensive  reform of
communications  law since the enactment of the  Communications  Act of 1934. The
Telecommunications Act eliminates  long-standing legal barriers separating local
exchange carriers,  long distance carriers,  and cable television  companies and
preempts  conflicting  state laws in an effort to foster greater  competition in
all telecommunications market sectors, improve the quality of services and lower
prices.

     The  Telecommunications  Act expressly  supersedes the consent decree which
led to the AT&T Divestiture,  including the  line-of-business  restrictions that
prohibited   the  RBOCs  from   providing   inter-exchange   services  and  from
manufacturing  telecommunications  equipment.  The  RBOCs are now  permitted  to
provide  inter-exchange  service  outside  their local service areas and to seek
approval   from  the  Federal   Communications   Commission   (FCC)  to  provide
inter-exchange  service  within their local  service  areas based upon a showing
that they have opened their local exchange markets to competition.  In addition,
as a result of the  Telecommunications  Act of 1996, the RBOCs will be permitted
to  manufacture  and provide  telecommunications  equipment  and to  manufacture
customer premises equipment when certain competitive conditions have been met.

     On September 20, 1996, the FCC released its order  adopting  regulations to
implement  the  section  of  the  Telecommunications  Act  which  mandated  fair
compensation for all payphone  providers.  The order addressed  compensation for
non-coin   calls,   local  coin  calling   rates,   removal  of  subsidies   and
discrimination favoring payphones operated by local exchange carriers (LECs) and
authorization  of RBOCs and other providers to select service  providers,  among
other matters.

     The order  prescribed  interim  dial-around  compensation  for  independent
payphone  providers for both access code and subscriber 800 dial-around calls on
a flat-rate  basis of $45.85 per phone per month,  as  compared to the  previous
compensation  of $6.00 per month.  This new interim rate will be effective for a
year, and replaces all other dial around compensation prescribed at the state or
federal  level.  This  compensation  will be paid  by the  major  inter-exchange
carriers  ("IXCs")  based on their share of toll  revenues in the long  distance
market. Payphones owned by the RBOCs and other LECs will be eligible for interim
compensation  when  they have  removed  their  payphones  from  their  regulated
accounts,  which must be completed by April 15,  1997.  By October 1, 1997,  the
IXCs are  required to have  per-call  tracking  instituted.  At that point,  all
payphones  will  switch to a  per-call  compensation  rate set at $.35 per call.
Under this system,  compensation will be paid on every completed  800-subscriber
and access code call. Under the per-call compensation, compensation will be paid
by the  carrier who is the primary  beneficiary  of the call.  After one year of
deregulation  of coin rates  (October 1,  1998),  the order  indicates  that the
compensation  rate would be  adjusted  to equal the local coin rate  charge in a
particular payphone.

     The order requires LEC payphones to be removed from regulation,  separating
payphone costs from regulated  accounts by April 15, 1997.  This  requirement is
intended to eliminate all subsidies that favor LEC payphones. The FCC ruled that
the transfer of payphones from regulated  accounts  should be at net book value,
which could allow RBOCs to begin  unregulated  operations with  artificially low
asset  values,  which  may  represent  a  competitive  advantage.  LECs are also
required to reduce interstate access charges to reflect  separation of payphones
from regulated  accounts.  In order to eliminate  discrimination,  LECs are also
required to offer coin line services to  independent  providers if LECs continue
to connect their payphones to central office driven coin line services.  The FCC
did not mandate unbundling of specific coin line related services,  but did make


                                       25
<PAGE>

provisions to allow states to impose further payphone services requirements that
are consistent with the order.

     The order  authorizes RBOCs to select the operator service provider serving
their  payphones and for independent  payphone  providers to select the operator
service provider serving theirs.  This provision preempts state regulations that
require  independent  providers to route  intralata  calls to the LECs. The FCC,
however, did not establish conditions that require operator service providers to
pay independent payphone providers the same commission levels the RBOCs demand.

     The Company believes that as a result of the reform legislation, the public
communications  industry  will undergo  fundamental  changes,  many of which may
affect the Company's business.  The legislation is likely to increase the number
of providers of  telecommunications  services,  including  perhaps  providers of
payphone  services.  This  increase  in the  number  of  providers  is likely to
stimulate demand for new payphone equipment. In such event, the Company believes
that existing  payphone  providers,  including the RBOCs,  could seek to enhance
their  technology base in order to compete more  effectively with each other and
with new  entrants.  In  addition,  as the local  exchange and  intrastate  long
distance markets are opened to competition,  inter-exchange  carriers seeking to
serve these markets may deploy greater numbers of payphones to capture local and
intrastate traffic.

     In addition, as a result of the  Telecommunications  Act of 1996, the RBOCs
will be permitted to manufacture and provide telecommunications equipment and to
manufacture customer premises equipment when certain competitive conditions have
been met.  It is  possible  that one or more  RBOCs will  decide to  manufacture
payphone products, which would increase the competition faced by the Company and
could decrease demand for the Company's products by such RBOCs. Notwithstanding,
the Company  believes  that  deregulation  generally  will  benefit the Company.
However,  there  can  be  no  assurance  that  the  Company  will  benefit  from
deregulation or that it will not be adversely affected by deregulation.

Sources of Supply and Dependence on Contract Manufacturers

     The Company generally assembles its smart payphone products from assemblies
produced by certain manufacturers under contractual arrangements.  To the extent
that such  manufacturers  encounter  difficulties in their production  processes
that delay  shipment to the Company or that affect the quality of items supplied
to the  Company,  the  Company's  ability to  perform  its sales  agreements  or
otherwise to meet supply schedules with its customers can be adversely affected.
In the event that contract  manufacturers  delay  shipments or supply  defective
materials to the Company, and such delays or defects are material, the Company's
customer  relations could  deteriorate and its sales and operating results could
be materially and adversely affected.

     The  majority  of the  Company's  products  in  terms of  revenues  contain
components or assemblies  that are purchased  from single  sources.  The Company
believes that there are alternative sources of supply for most of the components
and assemblies  currently purchased from single sources.  Some of the components
and assemblies used by the Company for which there are not immediately available
alternative  sources  of supply  are  provided  to the  Company  under  standard
purchase arrangements.  If a shortage or termination of the supply of any one or
more of such  components or  assemblies  were to occur,  however,  the Company's
business could be materially and adversely affected.  In such event, the Company
would  have to incur the costs  associated  with  redesigning  its  products  to
include  available   components  or  assemblies  or  otherwise  obtain  adequate
substitutes,  which costs could be  material.  Also,  any delays with respect to
redesigning  products  or  obtaining  substitute   components  would  materially
adversely affect the Company's business.


                                       26
<PAGE>

Disputes

     In October 1994, a contract manufacturer that delivered allegedly defective
first generation smart products to the Company discontinued  operations prior to
the  scheduled   contract   termination   date.  In  April  1995,  the  contract
manufacturer formally terminated the Company's  manufacturing contract as of the
scheduled termination date. Pursuant to the terms of the manufacturing contract,
the Company was committed to acquire the manufacturer's  inventories  related to
the Company's products.  The Company has not acquired products or inventory from
the manufacturer since October 1994. The contract  manufacturer has claimed that
TSG is obligated to (i) purchase  inventories of approximating $l million,  (ii)
pay purchase obligations of approximately  $265,000,  and (iii) pay lost profits
of the contract manufacturer of approximately  $916,000 related to the Company's
minimum contract purchase commitment.  The Company has claimed that the contract
manufacturer supplied defective product, breached the agreement by discontinuing
operations prior to the scheduled  termination date of the contract and that the
delivery of defective product resulted in the termination of a significant smart
product sales agreement and the loss of significant  business and profits by the
Company.  The Company does not  believe,  but cannot  ensure,  that the contract
manufacturer  will pursue its claims  against the Company,  nor does the Company
intend to pursue  its  claims  against  the  contract  manufacturer  unless  the
manufacturer  commences  an action  against  the  Company.  Should the  contract
manufacturer  pursue its claims  against the  Company,  the  Company  intends to
defend and pursue its positions vigorously.  However, there is no assurance that
the  outcome  of any  action  will not have a  material  adverse  effect  on the
Company's financial position or results of operations.

Net Operating Loss Carryforwards

     As of December 27, 1996, the Company had net operating  loss  carryforwards
for income tax purposes of  approximately  $15 million to offset future  taxable
income.  Under Section 382 of the Internal Revenue Code of 1986, as amended, the
utilization  of net operating loss  carryforwards  is limited after an ownership
change,  as defined in such Section 382, to an annual  amount equal to the value
of the loss  corporation's  outstanding stock immediately before the date of the
ownership change multiplied by the federal  long-term  tax-exempt rate in effect
during  the  month the  ownership  change  occurred.  Such an  ownership  change
occurred on October 31,  1994 and could  occur in the future.  As a result,  the
Company will be subject to an annual  limitation on the use of its net operating
losses of  approximately  $210,000.  Such  limitation  would  have the effect of
increasing  the  Company's  tax  liability and reducing net income and available
cash  resources of the Company if the taxable  income during a year exceeded the
allowable  loss  carried  forward to that  year.  In  addition,  because of such
limitations,  the Company will be unable to use a significant portion of its net
operating loss carryforwards.


                                       27
<PAGE>

                           PART II - OTHER INFORMATION

Item 6 - Exhibits and Reports on Form 8-K

(a)  Exhibits

     The following exhibits are filed herewith as a part of this Report.


    Exhibit
      No.             Description of Exhibit
    -------           ----------------------

      11.        Statement re computation of per share earnings

      27.        Financial Data Schedule (EDGAR Filing only)

(b)  Reports of Form 8-K

     No reports on Form 8-K were filed  during the quarter for which this report
     is filed.


                                       28
<PAGE>

                                   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.


                                      TECHNOLOGY SERVICE GROUP, INC.
                                              (Registrant)


Date:  February 5 , 1996              By: /s/  Vincent C. Bisceglia
                                         ------------------------------
                                          Vincent C. Bisceglia
                                          President & Chief Executive Officer


                                      By: /s/  William H. Thompson
                                         ------------------------------
                                          William H. Thompson
                                          Vice President of Finance
                                           & Chief Financial Officer




                                       29
<PAGE>

                                  EXHIBIT INDEX



Exhibit No.                 Description of Exhibit                     At Page
-----------                 ----------------------                     -------

11.              Statement re computation of per share earnings            31

27.              Financial Data Schedule (EDGAR filing only)               32


                                       30