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 SEPTEMBER 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 November  1, 1996,  there were  4,694,250  shares of common  stock,  $.01 par
value, outstanding.

<PAGE>

                                      INDEX

                                                                          Page
                                                                          Number
                                                                          ------

PART I.   FINANCIAL INFORMATION

 Item 1.  Financial Statements

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

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

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

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

          Notes to Consolidated Financial Statements                         7

 Item 2.  Management's Discussion and Analysis of
          Financial Condition and Results of Operations                     12

PART II.  OTHER INFORMATION

 Item 1.  Legal Proceedings                                                 25

 Item 2.  Exhibits and Reports on Form 8-K                                  25

                                       2

<PAGE>

                         PART I - FINANCIAL INFORMATION

ITEM 1.  FINANCIAL STATEMENTS

                         TECHNOLOGY SERVICE GROUP, INC.

                           CONSOLIDATED BALANCE SHEETS
<TABLE>
<CAPTION>

                                                                SEPTEMBER 27,     MARCH 29,
                                                                    1996            1996
                                                                ------------    ------------
                                                                 (UNAUDITED)
<S>                                                             <C>             <C>         
ASSETS
Current assets:
  Cash                                                          $    157,365    $     19,787
  Accounts receivable, less allowance for doubtful
    accounts of $272,000 and $216,000                              2,954,596       3,866,372
  Inventories                                                     13,635,212       8,658,669
  Deferred tax asset                                                 425,277          50,544
  Prepaid expenses and other current assets                          127,655         146,117
                                                                ------------    ------------
      Total current assets                                        17,300,105      12,741,489
Property and equipment, net                                        1,955,084       2,198,625
Deferred tax asset                                                   145,312            --
Other assets                                                       3,775,747       4,693,650
                                                                ------------    ------------
                                                                $ 23,176,248    $ 19,633,764
                                                                ============    ============

LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
  Bank overdraft                                                $  1,033,672    $  1,002,403
  Borrowings under revolving credit agreement                      1,795,377            --
  Current maturities under long-term debt and
    capital lease obligations                                         47,905         118,444
  Accounts payable                                                 4,418,745       5,030,945
  Income taxes payable                                               396,478         165,666
  Deferred revenue                                                      --           541,245
  Accrued liabilities                                              1,107,883       1,472,379
  Accrued restructuring charges                                       78,927          16,427
                                                                ------------    ------------
      Total current liabilities                                    8,878,987       8,347,509
Borrowings under revolving credit agreement                             --         1,093,735
Long-term debt and capital lease obligations                         890,666       3,414,586
Notes payable to stockholders                                           --         2,800,000
Deferred revenue                                                     375,000         375,000
Other liabilities                                                      3,198           3,198
                                                                ------------    ------------
                                                                  10,147,851      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,
    4,693,750 and 3,500,000 shares issued and outstanding             46,938          35,000
  Capital in excess of par value                                  11,912,987       3,465,000
  Retained earnings                                                1,082,259         111,790
  Cumulative translation adjustment                                  (13,787)        (12,054)
                                                                ------------    ------------
      Total stockholders' equity                                  13,028,397       3,599,736
                                                                ------------    ------------
                                                                $ 23,176,248    $ 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              Six Months Ended
                                         ----------------------------    ----------------------------
                                         September 27,   September 29,   September 27,   September 29,
                                             1996            1995            1996            1995
                                         ------------    ------------    ------------    ------------
<S>                                      <C>             <C>             <C>             <C>         
Net sales                                $ 10,061,718    $  7,737,680    $ 22,140,214    $ 14,091,825
                                         ------------    ------------    ------------    ------------
Costs and expenses:
  Cost of goods sold                        7,769,914       6,145,900      17,610,363      11,441,027
  General and administrative expenses         717,871         544,257       1,362,856       1,078,615
  Marketing and selling expenses              193,630         321,928         555,108         586,652
  Engineering, research and
    development expenses                      655,526         265,611       1,064,621         552,040
  Litigation settlement                          --              --          (105,146)           --
  Interest expense                             63,047         231,304         204,587         437,889
  Restructuring charges                        62,500            --            62,500            --
  Other (income) expense                      (13,413)         (7,424)        (29,600)         (9,844)
                                         ------------    ------------    ------------    ------------
                                            9,449,075       7,501,576      20,725,289      14,086,379
                                         ------------    ------------    ------------    ------------
Income (loss) before income tax
  expense                                     612,643         236,104       1,414,925           5,446
Income tax provision                         (227,254)           --          (444,456)           --
                                         ------------    ------------    ------------    ------------
Net income (loss)                        $    385,389    $    236,104    $    970,469    $      5,446
                                         ============    ============    ============    ============
Income (loss) per common and
 common equivalent share:
  Primary                                $       0.08    $       0.06    $       0.21    $       --
                                         ============    ============    ============    ============
  Assuming full dilution                 $       0.08    $       0.06    $       0.21    $       --
                                         ============    ============    ============    ============

Weighted average number of common and
 common equivalent shares outstanding:
  Primary                                   5,007,791       3,805,625       4,726,809       3,805,625
                                         ============    ============    ============    ============
  Assuming full dilution                    5,007,791       3,805,625       4,726,809       3,805,625
                                         ============    ============    ============    ============
</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)

                                                         Six Months Ended
                                                    ---------------------------
                                                    September 27,  September 29,
                                                         1996           1995
                                                     -----------    -----------
CASH FLOWS FROM OPERATING ACTIVITIES
  Net income                                         $   970,469    $     5,446
  Adjustments to reconcile net income (loss) to net
   cash provided by (used for) operating activities
    Depreciation and amortization                        579,021        506,441
    Provisions for inventory losses and
     warranty expense                                    340,481        103,183
    Provision for uncollectible accounts receivable       55,999         34,949
    Restructuring charges                                 62,500           --
    Provision for deferred tax benefits                 (133,905)          --
    Changes in certain assets and liabilities
     (Increase) decrease in accounts receivable          855,777     (1,433,290)
     (Increase) in inventories                        (5,189,527)      (452,803)
     Decrease in prepaid expenses and
      other current assets                                18,462         29,163
     (Increase) in other assets                             (607)        (6,934)
     Increase (decrease) in accounts payable            (612,199)       720,481
     Increase in income taxes payable                    284,317           --
     (Decrease) in deferred revenue                     (541,245)          --
     (Decrease) in accrued liabilities                  (491,993)      (103,665)
     (Decrease) in accrued restructuring charges            --          (60,000)
     Other                                                   792           (576)
                                                     -----------    -----------
     Net cash used for operating activities           (3,801,658)      (657,605)
                                                     -----------    -----------
CASH FLOWS FROM INVESTING ACTIVITIES
  Capital expenditures                                  (197,512)      (132,206)
                                                     -----------    -----------
     Net cash used for investing activities             (197,512)      (132,206)
                                                     -----------    -----------
CASH FLOWS FROM FINANCING ACTIVITIES
  Net proceeds under revolving credit
   agreement                                             701,642        647,952
  Proceeds from initial public offering, net of
   issuance expenses                                   8,634,547           --
  Proceeds from exercise of common stock
   options and warrants                                  163,750           --
  Repayment of notes payable to stockholders          (2,800,000)          --
  Principal payments on long-term debt and
   capital lease obligations                          (2,594,460)      (496,303)
  Increase in bank overdraft                              31,269        402,412
                                                     -----------    -----------
      Net cash provided by financing
       activities                                      4,136,748        554,061
                                                     -----------    -----------
Increase (decrease) in cash                              137,578       (235,750)
Cash, beginning of period                                 19,787        265,576
                                                     -----------    -----------
Cash, end of period                                  $   157,365    $    29,826
                                                     ===========    ===========

              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 SIX MONTHS ENDED SEPTEMBER 27, 1996
                                   (Unaudited)

<TABLE>
<CAPTION>
                                                     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      8,284,675           --             --         8,296,175

Issuance of 40,000 shares upon
  exercise of common stock
  purchase warrants                          400        159,600           --             --           160,000

Issuance of 3,750 shares upon
  exercise of common stock
  options                                     38          3,712           --             --             3,750

Net income for the period                   --             --          970,469           --           970,469

Foreign currency translation
  adjustment                                --             --             --           (1,733)         (1,733)
                                    ============   ============   ============   ============    ============
Balance at September 27, 1996       $     46,938   $ 11,912,987   $  1,082,259   $    (13,787)   $ 13,028,397
                                    ============   ============   ============   ============    ============
</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 of the Company as of
September  27,  1996  and  the  related  unaudited  consolidated  statements  of
operations  for the three  months and six months  ended  September  27, 1996 and
September 29, 1995, and the unaudited consolidated  statements of cash flows and
statement of changes in stockholders'  equity for the six months ended September
27,  1996 have been  prepared  in  accordance  with  instructions  to Form 10-Q.
Accordingly,  the financial information does not include all 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 September 27, 1996 and
its  operations  and its cash flows for the three  months  and six months  ended
September  27,  1996  and  September  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 six  months  ended
September 27, 1996 are not necessarily  indicative of the results for the entire
fiscal year ending March 28, 1997.

2.   INVENTORIES

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

                                            September 27,         March 29,
                                                1996                1996
                                            -----------         -----------

     Raw materials                          $ 7,050,708         $ 6,056,702
     Work-in-process                          4,236,267           1,207,080
     Finished goods                           2,348,237           1,394,887
                                            -----------         -----------
                                            $13,635,212         $ 8,658,669
                                            ===========         ===========

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

     At September 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
September  27, 1996 and March 29,  1996,  the Company  had  outstanding  debt of
$1,795,377 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 September 27, 1996,  the borrowing  limit under the
revolving credit agreement was based upon specified  percentages  applied to the
value of collateral, consisting of 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 collateral less indebtedness
outstanding  under a $2.2 million  term note due November 30, 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 September 27, 1996 and March 29, 1996).


                                       7
<PAGE>

     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 at March 29, 1996 as
long-term obligations.

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

                                                    September 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                      938,571        975,410
                                                     -----------    -----------
                                                         938,571      3,533,030
   Less - current maturities                             (47,905)      (118,444)
                                                     -----------    -----------
                                                     $   890,666    $ 3,414,586
                                                     ===========    ===========

     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
30, 1999 that bear 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.

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 $821,938,  amounted to $8,296,175. As of March 29, 1996, the Company
had  incurred,  and  deferred as other  assets,  offering  expenses of $338,372.
Accordingly,  net  proceeds  during  the six months  ended  September  27,  1996
amounted to $8,634,547.


                                       8
<PAGE>

     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 one of its  contract
manufacturers  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 (Loss) Per Common and Common Equivalent Share

     Income (loss) per common and common  equivalent  share for the three months
and six months ended  September  27, 1996 and  September 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  pursuant to Accounting  Principles  Board Opinion No. 15, Earnings per
Share,  all  outstanding  options and  warrants  during the three months and six
months  ended  September  27,  1996 have been  included  in the  calculation  in
accordance  with the  modified  treasury  stock  method and  except as  required
pursuant  to  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 (see Note 4) at prices below the public offering price have been
included in the calculation of weighted average of common and common  equivalent
shares  outstanding  as if they  were  outstanding  as of the  beginning  of the
periods.

                                       9

<PAGE>

5.   INCOME TAXES

     There was no provision for income taxes for the three months and six months
ended  September 29, 1995.  The provision for income taxes charged to operations
for the three months and six months ended September 27, 1996 was as follows:

                                                   Three Months     Six Months
                                                      Ended           Ended
                                                   September 27,   September 27,
                                                       1996            1996   
                                                    ---------       ---------
                                                                   
     Current tax expense:                                                
       Federal                                      $ 274,618       $ 565,566
       State                                           41,150          84,790
                                                    ---------       ---------
                                                      315,768         650,356
                                                    ---------       ---------
     Deferred tax benefit:                      
       Federal                                       (143,609)       (323,528)
       State                                          (20,064)        (45,199)
                                                    ---------       ---------
                                                     (163,673)       (368,727)
                                                    ---------       ---------
                                                      152,095         281,629
     Tax benefits of operating loss carryforwards        --           (71,995)
     Tax benefits applied to goodwill                  75,159         234,822
                                                    ---------       ---------
                                                    $ 227,254       $ 444,456
                                                    =========       =========
                                                                    
     The  provision  for income  taxes  differs  from the amount of income taxes
determined by applying the applicable U.S.  statutory federal income tax rate to
income (loss) before income taxes as a result of the following differences:

<TABLE>
<CAPTION>

                                                       Three Months Ended                    Six Months Ended
                                                 -------------------------------     -------------------------------
                                                 September 27,     September 29,     September 27,     September 29,
                                                      1996              1995              1996              1995
                                                   ---------         ---------         ---------         ---------
<S>                                                <C>               <C>               <C>               <C>      
     Statutory U.S. tax rates                      $ 208,298         $  80,275         $ 481,074         $   1,852
     State taxes, net of federal benefit              17,896              --              44,172              --
     Non-deductible expenses                          14,003            25,721            28,935            51,442
     Losses for which no tax benfit was
       provided                                         --                --                --              52,702
     Utilization of loss carryforwards                  --            (105,996)          (71,995)         (105,996)
     Net deferred tax benefits                       (12,943)             --             (37,730)             --
                                                   ---------         ---------         ---------         ---------
     Effective tax rates                           $ 227,254         $    --           $ 444,456         $    --
                                                   =========         =========         =========         =========
</TABLE>

                                       10

<PAGE>

6.   SUPPLEMENTAL CASH FLOW INFORMATION

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

                                                     Six Months Ended
                                              --------------------------------
                                              September 27,      September 29,
                                                  1996               1995
                                                --------           --------
                                                                 
     Interest paid                              $339,836           $456,533
     Income taxes paid                           294,044               --
     Deferred offering expenses charged                          
       against proceeds of initial public                        
       offering                                  338,372               --
     Realization of deferred tax assets                          
       applied to goodwill                       159,663               --
     Other current assets acquired by                            
       assumption of debt obligations               --              131,594
     Write-off of property and                                   
       equipment against accounts                                
       payable                                      --                1,600
     Increase in goodwill from                                   
       distribution of escrow                                    
       consideration                                --              329,709
                                                                 

     In addition,  during the six months ended  September 27, 1996,  the Company
applied  $151,318 of deferred tax benefits to goodwill  with respect to acquired
deferred  tax  assets as of March  29,  1996 as a result a  reassessment  of the
realizability thereof.

7.   RESTRUCTURING CHARGES

     During August 1996, the Company initiated a consolidation  plan intended to
augment  its  on-going   productivity  and  quality  improvement   programs.  In
connection  with this plan,  the  Company  initiated  the  closure of one of its
manufacturing  facilities,  and  recorded  a  restructuring  charge  of  $62,500
consisting primarily of estimated severance obligations.  The Company intends to
consolidate its service operations into its other manufacturing  facility and to
lease a new facility to enable the consolidation of product assembly  operations
and corporate headquarters by the end of fiscal 1997.

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 six months ended September 27, 1996.

                                       11

<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 September 27, 1996 Compared to the
                      Three Months Ended September 29, 1995

     Overview.  The  Company's  income  before  taxes for the three months ended
September  27, 1996  increased by $376,539,  or 159%, to $612,643 as compared to
$236,104 for the three months ended September 29, 1995.  During the three months
ended  September  27,  1996,  the Company  recorded an income tax  provision  of
$227,254.  No income tax  provision  was recorded  during the three months ended
September  29, 1995.  Net income for the three months ended  September  27, 1996
increased  by 63% to  $385,389  versus  $236,104  for the same period last year.
Primary  earnings  per share for the  three  months  ended  September  27,  1996
increased  to $.08 per share  based on  5,007,791  common and common  equivalent
shares  outstanding  versus $.06 per share based on 3,805,625  common and common
equivalent shares outstanding for the three months ended September 29, 1995.

     Sales. Sales increased by $2,324,038,  or 30%, to $10,061,718 for the three
months ended  September 27, 1996 (second quarter of fiscal 1997) from $7,737,680
for the three months ended  September 29, 1995 (second  quarter of fiscal 1996).
The increase in sales is primarily  attributable to an increase in sales volume,
particularly sales that related to smart payphone products and components. Sales
of smart  payphone  products  and  components  increased by  approximately  $2.1
million (43%),  and accounted for  approximately  69% of sales during the second
quarter of fiscal 1997 as compared to 63% of sales during the second  quarter of
fiscal 1996. Refurbishment and repair services and related product sales for the
second  quarter of fiscal  1997  increased  by  approximately  $225,000  (8%) as
compared  to the  same  period  last  year,  and  accounted  for 29% of sales as
compared  to 35% last  year.  Sales  during the  second  quarter of fiscal  1997
include  export sales of  approximately  $160,000 as compared to export sales of
approximately $127,000 during the second quarter of fiscal 1996.

     A significant  portion of the Company's  sales during the second quarter of
fiscal 1997 were attributable to shipments pursuant to a sales agreement between
the Company  and NYNEX Corp.  ("NYNEX")  executed in December  1995.  During the
second quarter of fiscal 1996, a significant portion of the Company's sales were
attributable to shipments  pursuant to a sales agreement between the Company and
Southwestern  Bell  Telephone  Company  ("SWB")  executed in December  1994. See
"Liquidity and Capital  Resources - 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 $1,624,014,  or 26%, to
$7,769,914  during the second  quarter of fiscal 1997 as compared to  $6,145,900
during the second  quarter of fiscal 1996. The increase in cost of products sold
is primarily attributable to the 30% increase in sales during the second quarter
of fiscal  1997 as  compared  to the  second  quarter of fiscal  1996.  Although
certain sales price  reductions had a negative  impact on product  margins,  the
increase  in volume and  variations  in product  mix had a  favorable  impact on
production  costs as a  percentage  of sales.  Overall,  cost of goods sold as a
percentage of sales  declined to 77% during the second quarter of fiscal 1997 as
compared to 79% of sales during second quarter of fiscal 1996.



                                       12
<PAGE>

     General and Administrative  Expenses.  General and administrative  expenses
increased  by  $173,614,  or 32%,  to $717,871  (7% of sales)  during the second
quarter of fiscal 1997 from $544,257 (7% of sales) during the second  quarter 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,
an  increase  in accrued  compensation  pursuant  to the terms of an  employment
agreement  between the Company and its president and accrued  compensation  with
respect to a bonus  plan  adopted  by the Board of  Directors  during the second
quarter of fiscal 1997.  Pursuant to the terms of the bonus plan,  key employees
of the  Company  will  receive  additional  compensation  based  on  the  annual
operating  results of the Company in excess of a defined return on stockholders'
equity.

     Marketing and Selling Expenses. Marketing and selling expenses decreased by
$128,298,  or 40%, to $193,630 (2% of sales) during the second quarter of fiscal
1997 as compared to $321,928 (4% of sales)  during the second  quarter of fiscal
1996. The decrease is primarily  attributable  to a decrease in royalty  expense
associated  with  sales  of  smart  payphone  products.  The  obligation  to pay
royalties on sales of the Company's smart payphone  products expired on June 30,
1996.

     Engineering,  Research and Development Expenses. Engineering,  research and
development  expenses increased by $389,915,  or 147%, to $655,526 (7% of sales)
during the second  quarter of fiscal 1997 as compared to $265,611  (3% of sales)
during the second  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.

     Restructuring  Charges.   During  August  1996,  the  Company  initiated  a
consolidation  plan  intended to augment its on-going  productivity  and quality
improvement  programs.  In connection with this plan, the Company  initiated the
closure of one of its  manufacturing  facilities,  and recorded a  restructuring
charge of $62,500 consisting primarily of estimated severance  obligations.  The
Company   intends  to  consolidate   its  service   operations  into  its  other
manufacturing  facility and to lease a new facility to enable the  consolidation
of product assembly  operations and corporate  headquarters by the end of fiscal
1997.  In order to  assure  continuity  of  supply,  the  Company  has  recently
out-sourced  in-house  printed circuit board assembly  operations  until the new
facility is established and commences assembly operations.

     Interest  Expense.  Interest expense decreased to $63,047 during the second
quarter of fiscal  1997 as compared  to  $231,304  during the second  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.

     Income  Taxes.  During  the  second  quarter of fiscal  1997,  the  Company
recorded an income tax  provision of  $227,254,  net of deferred tax benefits of
$88,514, on pre-tax income of $612,643. Benefits of acquired deferred tax assets
aggregating  $75,159  were  applied to goodwill  during the three  months  ended
September 27, 1996.  There was no income tax provision  during second quarter of
fiscal 1996. Benefits of net operating loss carryforwards used to offset current
taxable  income  during the three months ended  September  29, 1995  amounted to
$105,996.


                                       13
<PAGE>

           For the Six Months Ended September 27, 1996 Compared to the
                       Six Months Ended September 29, 1995

     Overview.  The  Company's  income  before  taxes for the six  months  ended
September 27, 1996 increased by $1,409,479,  to $1,414,925 as compared to $5,446
for the six months  ended  September  29,  1995.  During  the six  months  ended
September 27, 1996, the Company recorded an income tax provision of $444,456. No
income tax  provision  was recorded  during the six months ended  September  29,
1995.  Net income for the six months  ended  September  27,  1996  increased  to
$970,469 versus $5,446 for the same period last year. Primary earnings per share
for the six months ended September 27, 1996 increased to $.21 per share based on
5,007,791 common and common equivalent shares  outstanding versus $.00 per share
based on 3,805,625 common and common equivalent  shares  outstanding for the six
months ended September 29, 1995.

     Sales.  Sales  increased by $8,048,389,  or 57%, to $22,140,214 for the six
months  ended  September  27,  1996  (first  six  months  of fiscal  1997)  from
$14,091,825  for the six months  ended  September  29, 1995 (first six months of
fiscal  1996).  As with  the  three  month  periods,  the  increase  in sales is
primarily  attributable to an increase in sales volume,  particularly sales that
related to smart  payphone  products  and  components.  Sales of smart  payphone
products and  components  increased by  approximately  $7.6 million  (94%),  and
accounted for  approximately  71% of sales during the first six months of fiscal
1997 as  compared  to 57% of sales  during the first six months of fiscal  1996.
Refurbishment  and repair  services and related  product sales for the first six
months of fiscal 1997  increased by  approximately  $517,000 (9%) as compared to
the same period  last year,  and  accounted  for 28% of sales as compared to 41%
last year. Sales during the first six months of fiscal 1997 include export sales
of approximately  $160,000 as compared to export sales of approximately $256,000
during the first six months of fiscal 1996.

     A significant portion of the Company's sales during the first six months of
fiscal 1997 were attributable to shipments pursuant to the aforementioned  sales
agreement  between the Company and NYNEX.  During the first six months of fiscal
1996,  a  significant  portion  of the  Company's  sales  were  attributable  to
shipments pursuant to the aforementioned sales agreement between the Company and
SWB.  Sales  volume  during the first six months of fiscal  1996,  however,  was
adversely  affected by a recall of smart products  initiated by the Company as a
result of potential  product  failures from  contamination  introduced  into the
manufacturing process by the Company's contract manufacturer. See "Liquidity and
Capital Resources - Operating Trends and Uncertainties,"  below for a discussion
of  the  Company's   dependence  on   significant   customers  and   contractual
relationships and for further information concerning the recall.

     Cost of Goods Sold. Cost of goods sold increased by $6,169,336,  or 54%, to
$17,610,363  during  the  first  six  months  of  fiscal  1997  as  compared  to
$11,441,027  during the first six months of fiscal 1996. The increase in cost of
products sold is primarily  attributable to the 57% increase in sales during the
first six months of fiscal  1997 as  compared  to the first six months of fiscal
1996.  Although  certain sales price reductions had an adverse impact on product
margins,  the increase in volume and  variations  in product mix had a favorable
impact on production costs as a percentage of sales. Overall, cost of goods sold
as a percentage  of sales  declined to 80% during the first six months of fiscal
1997 as compared to 81% of sales during first six months of fiscal 1996.

     General and Administrative  Expenses.  General and administrative  expenses
increased by $284,241,  or 26%, to $1,362,856 (6% of sales) during the first six
months of fiscal 1997 from  $1,078,615 (8% of sales) during the first six 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,
an increase in accrued  compensation  pursuant to the aforementioned  employment


                                       14
<PAGE>

agreement between the Company and its president and accrued  compensation  under
to the bonus plan adopted during the three months ended September 27, 1997.

     Marketing and Selling Expenses. Marketing and selling expenses decreased by
$31,544,  or 5%, to $555,108 (3% of sales) during the first six months of fiscal
1997 as compared to $586,652 (4% of sales) during the first six months of fiscal
1996. The decrease is primarily  attributable  to a decrease in royalty  expense
associated   with  sales  of  smart  payphone   products  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 $512,581,  or 93%, to $1,064,621 (5% of sales)
during the first six months of fiscal 1997 as compared to $552,040 (4% of sales)
during the first six 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.

     Litigation Settlement.  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. 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.

     Interest  Expense.  Interest expense decreased to $204,587 during the first
six months of fiscal 1997 as compared to $437,889 during the first six 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.

     Income  Taxes.  During the first six  months of fiscal  1997,  the  Company
recorded  an  income  tax  provision  of  $444,456,  net of net  operating  loss
carryforwards  and  deferred  tax  benefits of  $205,900,  on pre-tax  income of
$1,414,925.  Benefits  of acquired  deferred  tax assets  aggregating  $234,822,
including benefits of acquired net operating loss carryforwards of $38,360, were
applied to  goodwill.  There was no income tax  provision  during the six months
ended September 29, 1995.  Benefits of net operating loss  carryforwards used to
offset  current  taxable  income  during  the  first six  months of fiscal  1996
amounted to $105,996.

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
Underwriters  to  purchase  100,000  shares of Common  Stock  (the  "Underwriter
Warrants") for gross proceeds of $10. Net proceeds received by the Company as of
September 27, 1996, after underwriting  discounts and expenses of $1,231,897 and
other  expenses of $821,938,  aggregated  $8,296,175.  As of 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 six months
ended September 27, 1996 aggregated $8,634,547.

     The  net  proceeds  of the  offering  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


                                       15
<PAGE>

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 ae% 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 balance
of $325,000. At September 27, 1996, the Company had outstanding  indebtedness of
$1,795,377  under the revolving  credit  agreement after repayments from the net
proceeds of the initial public offering.  As of September 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  September  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 is in compliance with
the covenants set forth in the Loan Agreement as of September 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.

Cash Flows From Financing Activities

     Cash provided by financing activities during the six months ended September
27, 1997  aggregated  $4,136,748,  including  the net proceeds  from the initial
public  offering of  $8,634,547,  as compared to $554,061  during the six months
ended September 29, 1995.

     Net proceeds under the Company's  revolving credit agreement during the six
months ended September 27, 1996 amounted to $701,642 as compared to net proceeds
of $647,952  during the six months ended  September 29, 1995. Net proceeds under
the revolving  credit  agreement  during the six months ended September 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 six months ended September 27,
1997  aggregated  $4,510,231.  The  net  proceeds  under  the  revolving  credit

                                       16
<PAGE>

agreement were used to fund the Company's net cash  requirements  during the six
months ended September 27, 1997 and September 29, 1995.

     Principal  payments on long-term debt and capital lease obligations  during
the six  months  ended  September  27,  1996  aggregated  $2,594,460,  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 six  months  ended
September  27, 1996,  excluding  the  repayments  of term and  installment  note
indebtedness from the proceeds of the offering, amounted to $84,936, as compared
to $496,303  during the six months ended  September  29,  1995.  The decrease in
principal payments  (exclusive of repayments made from proceeds of the offering)
for the six months  ended  September  27, 1996 as compared to the  corresponding
period last year is attributable to debt maturing during fiscal 1997.

     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 six months ended  September 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 six months ended September 27, 1996,
the Company's bank overdrafts increased by $31,269 as compared to an increase of
$402,412 during the six months ended September 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.  In September  1996, the Company issued 3,750 shares of common stock upon
the  exercise of  incentive  stock  options at an  aggregate  exercise  price of
$3,750.

Cash Flows From Operating Activities

     Six Months Ended September 27, 1996. Cash used to fund operating activities
during the six months ended  September 27, 1996 amounted to  $3,801,658.  During
the six months ended  September  27, 1996,  the Company's  operations  generated
$1,874,565 in cash, after adjustments related to non-cash charges and credits of
$904,096.  In addition,  a decrease in accounts  receivable and prepaid expenses
and other assets  provided  cash of $855,777 and $17,855,  respectively,  and an
increase in income taxes payable provided cash of $284,317 during the six months
ended  September  27,  1996.  However,  net  cash  used  to  fund  increases  in
inventories  of  $5,189,527  and  decreases  in  accounts  payable of  $612,199,
deferred  revenue of $541,245  and accrued  liabilities  of $491,993  aggregated
$6,834,964  during the six months  ended  September  27,  1996.  The  decline in
accounts receivable was primarily  attributable to the rescheduling of shipments
in  accordance  with  customer  requirements  and  installation  schedules.  The
increase  in  inventories  was  primarily  attributable  to  the  aforementioned
rescheduling of shipments 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  Company's
efforts to reduce the  increase  in  inventories  during the latter  part of the
period. 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
royalty agreements and the payment of remaining  royalties during the six months
ended September 27, 1996.

     Six Months Ended September 29, 1995. Cash used to fund operating activities
during the six months ended September 29, 1995 amounted to $657,605.  During the
six months ended September 29, 1995, the Company's operations generated $650,019
in cash, after adjustments related to non-cash charges of $644,573. In addition,


                                       17
<PAGE>

cash  provided by an increase in accounts  payable of $720,481 and a decrease in
prepaid  expenses and other  assets of $22,229  aggregated  $742,710  during the
period.  However,  cash  used to  fund  increases  in  accounts  receivable  and
inventories amounted to $1,433,290 and $452,803  respectively,  and cash used to
fund  decreases in accrued  liabilities  and  restructuring  charges  aggregated
$163,665. The increases in accounts payable, accounts receivable and inventories
during the six months ended  September  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  six  months  ended
September  27, 1996  amounted  to  $197,512  as compared to $132,206  during six
months ended September 29, 1995. During the six months ended September 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 smart product series,  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 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).

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,  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 will 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  September  27,  1996 and March  29,  1996  amounted  to
$2,954,596 and $3,866,372,  respectively.  Accounts  receivable at September 27,
1996 and March 29, 1996  consists  primarily of amounts due from the RBOCs.  The
Company's inventories,  less allowances for potential losses due to obsolescence
and excess  quantities  amounted to $13,635,212  and $8,658,669 at September 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


                                       18
<PAGE>

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.  As of
September 27, 1996, the Company had acquired the majority of committed  purchase
volume pursuant to these purchase agreements. However, as a result of changes in
delivery  requirements  of  one  of  the  Company's  customers,   the  Company's
inventories  related to such agreements  increased by  approximately  $2 million
during the six months ended September 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 six months ended September 27,
1996  as a  result  of the  final  production  run  to  meet  anticipated  sales
requirements  until the planned release of TSG's next  generation  smart product
series.

     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 sublicense 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 would
be payable  commencing if, and only if, laws,  regulations  or judicial  actions
occur which would  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 September 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.  As of September 27, 1996,  the Company is not obligated to
pay and has not paid any royalties under the agreement.

Operating Trends and Uncertainties

Dependence on 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  September 27, 1996,  Ameritech
Services,  Inc., Bell Atlantic,  NYNEX and SWB accounted for approximately  $1.0
million,  $1.3  million,  $6.9  million and $.4  million,  respectively,  of the
Company's  sales.  During  the three  months  ended  September  29,  1995,  Bell
Atlantic,  NYNEX and SWB accounted for approximately  $1.4 million,  $.6 million
and $4.5 million,  respectively,  of the Company's sales.  During the six months
ended September 27, 1996, Ameritech Services, Inc., Bell Atlantic, NYNEX and SWB
accounted for approximately $2.2 million,  $2.7 million,  $15.0 million and $1.6
million,  respectively,  of the  Company's  sales.  During the six months  ended
September 29, 1995,  Bell  Atlantic,  NYNEX and SWB accounted for  approximately
$2.9  million,  $1.2 million and $7.6  million,  respectively,  of the Company's
sales.



                                       19
<PAGE>

     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 of such RBOC customers or a significant
reduction  in sales  volume or 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 smart products to Ameritech Services,  Inc. and
U.S.  West.  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  from  July  1996 to  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 these sales
agreements (the "firm commitment sales agreements"), however, include provisions
for the customers 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
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 September 27,
1996,  the Company  estimates that the customer has acquired in excess of 65% of
committed volume under such sales agreement.  However, as a result of changes in
SWB's  delivery  requirements,  the Company  does not  anticipate  shipping  the
remaining  volume pursuant to the terms of the agreement during the remainder of
the 1996 calendar year.



                                       20
<PAGE>

     In  December  1995,  the  Company  entered  into  an  amendment  to a sales
agreement  with NYNEX  pursuant to which the Company  agreed to supply and NYNEX
agreed  to  purchase  approximately  $12  million  of smart  products  and other
components  over a eight-month  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.  Upon a default by the Company with
respect  to such  covenants  and  conditions,  NYNEX has the right to cancel the
contract,  provided  such  default is not cured within a 14-day  notice  period.
Either party may terminate the agreement  upon default by the other party of any
material  provision of the agreement provided such default is not cured within a
10-day  notice  period.  In  addition,  NYNEX has the  right to cancel  prior to
shipment any and all orders  under the  agreement  and, in such event,  would be
liable to the Company only for the cost of goods not otherwise usable or salable
by the  Company.  Because  NYNEX has the  right to  terminate  orders  under the
contract as described  above,  there can be no  assurance  that the Company will
ultimately sell the $12 million of products under such contract.  However, as of
September  27,  1996,  the  Company  has  satisfied  the  majority  of its sales
commitment pursuant to the contract amendment,  is continuing to supply products
under the terms of the  agreement  under  modified  delivery  schedules,  and is
competing for another long-term smart product contract award from NYNEX.

     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
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
products 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 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 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.



                                       21
<PAGE>

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, which 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
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 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.

     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.


                                       22
<PAGE>

However,  there  can  be  no  assurance  that  the  Company  will  benefit  from
deregulation or that it will not be adversely affected by deregulation.

     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  LEC  payphones  and  authorization  of RBOCs and other
providers  to  select  service  providers,  among  other  matters.  The  Company
believes,  but cannot assure,  that the order will have a significant  favorable
impact on the  revenues of the  payphone  industry  and will  further  stimulate
deployment of new payphone equipment by providers,  including the RBOCs, and the
technological upgrade of the installed base of payphones operated by the RBOCs.

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.

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, and has not paid certain  obligations that
were recorded as of the date the manufacturer  ceased  operations.  The contract
manufacturer  has claimed  that TSG is  obligated  to (i)  purchase  inventories
approximating  $l  million,   (ii)  pay  outstanding   payable   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 assure, 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.

                                       23
<PAGE>

Net Operating Loss Carryforwards

     As of September 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.




                                       24
<PAGE>

                           PART II - OTHER INFORMATION

Item 1 - Legal Proceedings

         The Company has no pending material litigation.

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.




                                       25
<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:    October 31 , 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
                                


                                       26
<PAGE>

                                  EXHIBIT INDEX

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

  11.          Statement re computation of per share earnings              28

  27.          Financial Data Schedule (EDGAR filing only)                 29



                                       27