United States
SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C.
20549



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FORM 10-Q



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|  |                                                                                                                                                     
|- | ----------------------------------------------------------------------------------------------------------------------------------------------------
|x | Quarterly Report Pursuant to Section 13 or 15 (d) of
  the Securities Exchange Act of 1934 for the Quarterly period ended December
  31, 2005       
|  |                                                                                                                                                     
|  | or                                                                                                                                                  
|  |                                                                                                                                                     
|o | Transition Report Pursuant to Section 13 or 15(d) of
  the Securities Exchange Act of 1934 for the transition period from __________
  to __________



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Commission File Number 0-2382

MTS SYSTEMS CORPORATION(Exact name of Registrant as specified in its charter)

| |                                                                  |                                        | 
| | ---------------------------------------------------------------- | -------------------------------------- | 
| | MINNESOTA                                                        | 41-0908057                             | 
| | (State or other jurisdiction of
  incorporation or organization) | (I.R.S. Employer
  Identification No.) | 

14000 Technology Drive, Eden Prairie, MN
55344
(Address of principal executive offices)     (Zip
Code)

Registrants telephone number: (952) 937-4000



---

Indicate by
check mark whether the Registrant (1) has filed all reports required to be
filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the
preceding 12 months (or for such shorter period that the Registrant was required
to file such reports), and (2) has been subject to such filing requirements for
the past 90 days.

| |   |     |   |   
| | - | --- | - | --
| | x | Yes | o | No

Indicate by
check mark whether the registrant is a large accelerated filer, an accelerated
filer, or a non-accelerated filer. See definition of accelerated filer and
large accelerated filer in Rule 12b-2 of the Exchange Act. (Check one):

|                                |                           |                              
|------------------------------- | ------------------------- | -----------------------------
|Large
  accelerated filer     o | Accelerated
  filer     x | Non-accelerated
  filer     o

Indicate by
check mark whether the registrant is a shell company (as defined in Rule 12b-2
of the Exchange Act):

| |   |     |   |   
| | - | --- | - | --
| | o | Yes | x | No

The number of
shares outstanding of the Registrants common stock as of February 1, 2006 was
19,298,136 shares.





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MTS SYSTEMS CORPORATION


REPORT ON FORM 10-Q
FOR THE THREE MONTHS ENDED DECEMBER 31, 2005

INDEX

|                               |           |    |                                                                                         |                                                                                                          |         |         
|------------------------------ | --------- | -- | --------------------------------------------------------------------------------------- | -------------------------------------------------------------------------------------------------------- | ------- | --------
|                               |           |    |                                                                                         |                                                                                                          |         | Page No.
|                               |           |    |                                                                                         |                                                                                                          |         |         
|PART I - FINANCIAL INFORMATION |           |   
|                               |           |    |                                                                                         |                                                                                                          |         |         
|                               | Item
  1. |    | Financial Statements (unaudited)                                                        |                                                                                                          |        
|                               |           |    |                                                                                         |                                                                                                          |         |         
|                               |           |    |                                                                                         | Consolidated Balance Sheets as of December
  31, 2005 and January 1, 2005                                |         | 2       
|                               |           |    |                                                                                         |                                                                                                          |         |         
|                               |           |    |                                                                                         | Consolidated Statements of Income for the
  Three Months Ended December 31, 2005 and January 1, 2005     |         | 3       
|                               |           |    |                                                                                         |                                                                                                          |         |         
|                               |           |    |                                                                                         | Consolidated Statements of Cash Flows for
  the Three Months Ended December 31, 2005 and January 1, 2005 |         | 4       
|                               |           |    |                                                                                         |                                                                                                          |         |         
|                               |           |    |                                                                                         | Condensed Notes to Consolidated Financial
  Statements                                                   |         | 5 - 13  
|                               |           |    |                                                                                         |                                                                                                          |         |         
|                               | Item
  2. |    | Managements Discussion and Analysis of
  Financial Condition and Results of Operations |                                                                                                          | 13 - 18
|                               |           |    |                                                                                         |                                                                                                          |         |         
|                               | Item
  3. |    | Quantitative and Qualitative Disclosures
  About Market Risk                            |                                                                                                          | 18     
|                               |           |    |                                                                                         |                                                                                                          |         |         
|                               | Item
  4. |    | Controls and Procedures                                                                 |                                                                                                          | 18     
|                               |           |    |                                                                                         |                                                                                                          |         |         
|PART II  OTHER INFORMATION    |           |   
|                               |           |   
|                               | Item
  1. |    | Legal Proceedings                                                                       |                                                                                                          | 19     
|                               |           |    |                                                                                         |                                                                                                          |        
|                               | Item
  2. |    | Unregistered Sales of Equity Securities and
  Use of Proceeds                           |                                                                                                          | 19     
|                               |           |    |                                                                                         |                                                                                                          |        
|                               | Item
  3. |    | Defaults Upon Senior Securities                                                         |                                                                                                          | 19     
|                               |           |    |                                                                                         |                                                                                                          |        
|                               | Item
  4. |    | Submission of Matters to a Vote of Security
  Holders                                   |                                                                                                          | 19     
|                               |           |    |                                                                                         |                                                                                                          |        
|                               | Item
  5. |    | Other Information                                                                       |                                                                                                          | 19     
|                               |           |    |                                                                                         |                                                                                                          |        
|                               | Item
  6. |    | Exhibits                                                                                |                                                                                                          | 19     
|                               |           |    |                                                                                         |                                                                                                          |        
|SIGNATURES                     |           | 20

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PART 1 
FINANCIAL INFORMATION

Item 1. Financial Statements


MTS SYSTEMS CORPORATIONConsolidated Balance Sheets
(unaudited - in thousands, except per share data)

|                                                             |  |                       |         |                   |   |         |  
|------------------------------------------------------------ |  | --------------------- | ------- | ----------------- | - | ------- | -
|                                                             |  | December
  31,
  2005 |         | October 1,
  2005 |  
|                                                             |  |                       |         |                   |  
|ASSETS                                                       |  |                       |         |                   |   |         |  
|                                                             |  |                       |         |                   |   |         |  
|Current Assets:                                              |  |                       |         |                   |   |         |  
|Cash and cash equivalents                                    |  | $                     | 89,750  |                   | $ | 83,143  |  
|Short-term investments                                       |  |                       | 54,177  |                   |   | 76,650  |  
|Accounts receivable, net of allowances for
doubtful accounts |  |                       | 70,374  |                   |   | 64,363  |  
|Unbilled accounts receivable                                 |  |                       | 26,440  |                   |   | 25,093  |  
|Inventories                                                  |  |                       | 37,877  |                   |   | 38,029  |  
|Prepaid expenses                                             |  |                       | 4,450   |                   |   | 2,600   |  
|Current deferred tax assets                                  |  |                       | 6,403   |                   |   | 6,415   |  
|Other current assets                                         |  |                       | 2,990   |                   |   | 2,351   |  
|Assets of discontinued operations                            |  |                       | 1,524   |                   |   | 1,710   |  
|                                                             |  |                       |         |                   |   |         |  
|Total current assets                                         |  |                       | 293,985 |                   |   | 300,354 |  
|                                                             |  |                       |         |                   |   |         |  
|                                                             |  |                       |         |                   |   |         |  
|Property and Equipment:                                      |  |                       |         |                   |   |         |  
|Land                                                         |  |                       | 1,668   |                   |   | 1,668   |  
|Buildings and improvements                                   |  |                       | 40,751  |                   |   | 40,906  |  
|Machinery and equipment                                      |  |                       | 74,143  |                   |   | 72,837  |  
|Accumulated depreciation                                     |  |                       | (74,024 | )                 |   | (72,458 | )
|                                                             |  |                       |         |                   |   |         |  
|Total property and equipment, net                            |  |                       | 42,538  |                   |   | 42,953  |  
|                                                             |  |                       |         |                   |   |         |  
|                                                             |  |                       |         |                   |   |         |  
|Goodwill                                                     |  |                       | 4,408   |                   |   | 4,423   |  
|Other assets                                                 |  |                       | 2,185   |                   |   | 2,291   |  
|Non-current deferred tax assets                              |  |                       | 1,674   |                   |   | 1,711   |  
|                                                             |  |                       |         |                   |   |         |  
|Total Assets                                                 |  | $                     | 344,790 |                   | $ | 351,732 |  
|                                                             |  |                       |         |                   |   |         |  
|                                                             |  |                       |         |                   |   |         |  
|LIABILITIES AND SHAREHOLDERS
INVESTMENT                     |  |                       |         |                   |   |         |  
|                                                             |  |                       |         |                   |   |         |  
|Current Liabilities:                                         |  |                       |         |                   |   |         |  
|Notes payable                                                |  | $                     | 1,502   |                   | $ | 1,582   |  
|Current maturities of long-term debt                         |  |                       | 6,691   |                   |   | 6,708   |  
|Accounts payable                                             |  |                       | 16,995  |                   |   | 16,142  |  
|Accrued payroll-related costs                                |  |                       | 21,445  |                   |   | 31,059  |  
|Advance payments from customers                              |  |                       | 67,375  |                   |   | 49,901  |  
|Accrued warranty costs                                       |  |                       | 5,045   |                   |   | 5,333   |  
|Accrued income taxes                                         |  |                       | 2,794   |                   |   | 3,643   |  
|Current deferred income taxes                                |  |                       | 3,699   |                   |   | 3,767   |  
|Other accrued liabilities                                    |  |                       | 17,105  |                   |   | 15,026  |  
|Liabilities of discontinued operations                       |  |                       | 621     |                   |   | 890     |  
|                                                             |  |                       |         |                   |   |         |  
|Total current liabilities                                    |  |                       | 143,272 |                   |   | 134,051 |  
|                                                             |  |                       |         |                   |   |         |  
|                                                             |  |                       |         |                   |   |         |  
|Deferred income taxes                                        |  |                       | 2,298   |                   |   | 2,310   |  
|Long-term debt, less current
maturities                      |  |                       | 15,673  |                   |   | 15,673  |  
|Other long-term liabilities                                  |  |                       | 11,307  |                   |   | 11,266  |  
|                                                             |  |                       |         |                   |   |         |  
|Total Liabilities                                            |  |                       | 172,550 |                   |   | 163,300 |  
|                                                             |  |                       |         |                   |   |         |  
|                                                             |  |                       |         |                   |   |         |  
|Shareholders Investment:                                    |  |                       |         |                   |   |         |  
|Common stock, $.25 par; 64,000 shares
authorized:            |  |                       |         |                   |   |         |  
|19,072 and 19,664 shares issued and
outstanding              |  |                       | 4,768   |                   |   | 4,916   |  
|Retained earnings                                            |  |                       | 159,372 |                   |   | 173,487 |  
|Accumulated other comprehensive income                       |  |                       | 8,100   |                   |   | 10,029  |  
|                                                             |  |                       |         |                   |   |         |  
|Total shareholders investment                               |  |                       | 172,240 |                   |   | 188,432 |  
|                                                             |  |                       |         |                   |   |         |  
|Total Liabilities and Shareholders
Investment               |  | $                     | 344,790 |                   | $ | 351,732 |  
|                                                             |  |                       |         |                   |   |         |  

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

2

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MTS SYSTEMS CORPORATIONConsolidated Statements of Income
(unaudited - in thousands, except per share data)

|                                                               |  |                       |        |                   |   |        |  
|-------------------------------------------------------------- |  | --------------------- | ------ | ----------------- | - | ------ | -
|                                                               |  | Three
  Months Ended  |       
|                                                               |  |                       |       
|                                                               |  | December
  31,
  2005 |        | January 1,
  2005 |  
|                                                               |  |                       |        |                   |  
|Revenue:                                                       |  |                       |        |                   |   |        |  
|Product                                                        |  | $                     | 79,489 |                   | $ | 83,232 |  
|Service                                                        |  |                       | 12,354 |                   |   | 9,849  |  
|                                                               |  |                       |        |                   |   |        |  
|Total revenue                                                  |  |                       | 91,843 |                   |   | 93,081 |  
|                                                               |  |                       |        |                   |   |        |  
|Cost of sales:                                                 |  |                       |        |                   |   |        |  
|Product                                                        |  |                       | 45,015 |                   |   | 48,118 |  
|Service                                                        |  |                       | 6,259  |                   |   | 5,227  |  
|                                                               |  |                       |        |                   |   |        |  
|Total cost of sales                                            |  |                       | 51,274 |                   |   | 53,345 |  
|                                                               |  |                       |        |                   |   |        |  
|Gross profit                                                   |  |                       | 40,569 |                   |   | 39,736 |  
|                                                               |  |                       |        |                   |   |        |  
|                                                               |  |                       |        |                   |   |        |  
|Operating expenses:                                            |  |                       |        |                   |   |        |  
|Selling                                                        |  |                       | 16,004 |                   |   | 15,183 |  
|General and
administrative                                     |  |                       | 8,104  |                   |   | 6,921  |  
|Research and
development                                       |  |                       | 4,147  |                   |   | 3,715  |  
|                                                               |  |                       |        |                   |   |        |  
|Total operating
expenses                                       |  |                       | 28,255 |                   |   | 25,819 |  
|                                                               |  |                       |        |                   |   |        |  
|                                                               |  |                       |        |                   |   |        |  
|Income from operations                                         |  |                       | 12,314 |                   |   | 13,917 |  
|                                                               |  |                       |        |                   |   |        |  
|                                                               |  |                       |        |                   |   |        |  
|Interest expense                                               |  |                       | (454   | )                 |   | (595   | )
|Interest income                                                |  |                       | 682    |                   |   | 405    |  
|Other income, net                                              |  |                       | 25     |                   |   | 155    |  
|                                                               |  |                       |        |                   |   |        |  
|                                                               |  |                       |        |                   |   |        |  
|Income before income taxes                                     |  |                       | 12,567 |                   |   | 13,882 |  
|Provision for income taxes                                     |  |                       | 4,611  |                   |   | 5,150  |  
|                                                               |  |                       |        |                   |   |        |  
|Income before discontinued
  operations                        |  |                       | 7,956  |                   |   | 8,732  |  
|                                                               |  |                       |        |                   |   |        |  
|                                                               |  |                       |        |                   |   |        |  
|Discontinued operations:                                       |  |                       |        |                   |   |        |  
|Loss from discontinued
operations, net of tax                  |  |                       |       |                   |   | (540   | )
|                                                               |  |                       |        |                   |   |        |  
|Net income                                                     |  | $                     | 7,956  |                   | $ | 8,192  |  
|                                                               |  |                       |        |                   |   |        |  
|                                                               |  |                       |        |                   |   |        |  
|Earnings per share:                                            |  |                       |        |                   |   |        |  
|Basic-                                                         |  |                       |        |                   |   |        |  
|Income before discontinued
operations                          |  | $                     | 0.41   |                   | $ | 0.44   |  
|Discontinued
operations:                                       |  |                       |        |                   |   |        |  
|Loss from discontinued
operations, net of tax                  |  |                       |       |                   |   | (0.02  | )
|                                                               |  |                       |        |                   |   |        |  
|Earnings per share                                             |  | $                     | 0.41   |                   | $ | 0.42   |  
|                                                               |  |                       |        |                   |   |        |  
|Weighted average number of
common shares outstanding - basic   |  |                       | 19,454 |                   |   | 19,709 |  
|                                                               |  |                       |        |                   |   |        |  
|                                                               |  |                       |        |                   |   |        |  
|Diluted-                                                       |  |                       |        |                   |   |        |  
|Income before discontinued
operations                          |  | $                     | 0.40   |                   | $ | 0.42   |  
|Discontinued
operations:                                       |  |                       |        |                   |   |        |  
|Loss from discontinued
operations, net of tax                  |  |                       |       |                   |   | (0.02  | )
|                                                               |  |                       |        |                   |   |        |  
|Earnings per share                                             |  | $                     | 0.40   |                   | $ | 0.40   |  
|                                                               |  |                       |        |                   |   |        |  
|Weighted average number of
common shares outstanding - diluted |  |                       | 20,004 |                   |   | 20,595 |  
|                                                               |  |                       |        |                   |   |        |  

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

3

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MTS SYSTEMS CORPORATIONConsolidated Statements of Cash Flows
(unaudited - in thousands)

|                                                                                      |  |                       |         |                   |   |         |  
|------------------------------------------------------------------------------------- |  | --------------------- | ------- | ----------------- | - | ------- | -
|                                                                                      |  | Three
  Months Ended  |        
|                                                                                      |  |                       |        
|                                                                                      |  | December
  31,
  2005 |         | January 1,
  2005 |  
|                                                                                      |  |                       |         |                   |  
|Cash flows from operating activities:                                                 |  |                       |         |                   |   |         |  
|Net income                                                                            |  | $                     | 7,956   |                   | $ | 8,192   |  
|Adjustments to reconcile net
income to net cash provided by operating
  activities:   |  |                       |         |                   |   |         |  
|Loss from discontinued
operations                                                     |  |                       |        |                   |   | 540     |  
|Depreciation and
amortization                                                         |  |                       | 1,898   |                   |   | 2,049   |  
|Deferred income taxes                                                                 |  |                       |        |                   |   | (9      | )
|Bad debt provision                                                                    |  |                       | 71      |                   |   | 65      |  
|Stock-based
compensation                                                              |  |                       | 916     |                   |   | 11      |  
|Equity compensation income tax
benefits                                               |  |                       | (160    | )                 |   |        |  
|                                                                                      |  |                       |         |                   |   |         |  
|Changes in operating assets and liabilities, net
of effects of
  businesses divested: |  |                       |         |                   |   |         |  
|Accounts and unbilled contracts
receivable                                            |  |                       | (8,259  | )                 |   | (7,920  | )
|Inventories                                                                           |  |                       | 62      |                   |   | (154    | )
|Prepaid expenses                                                                      |  |                       | (2,288  | )                 |   | (2,002  | )
|Other assets                                                                          |  |                       | (389    | )                 |   | (560    | )
|Accounts payable                                                                      |  |                       | 935     |                   |   | (1,309  | )
|Accrued payroll-related
costs                                                         |  |                       | (10,164 | )                 |   | (10,226 | )
|Advance payments from
customers                                                       |  |                       | 18,088  |                   |   | 4,517   |  
|Accrued warranty
costs                                                                |  |                       | (262    | )                 |   | 703     |  
|Other current
liabilities                                                             |  |                       | 2,869   |                   |   | 6,456   |  
|                                                                                      |  |                       |         |                   |   |         |  
|Net cash provided by operating
activities                                             |  |                       | 11,273  |                   |   | 353     |  
|                                                                                      |  |                       |         |                   |   |         |  
|                                                                                      |  |                       |         |                   |   |         |  
|Cash flows from investing activities:                                                 |  |                       |         |                   |   |         |  
|Additions to property and
equipment                                                   |  |                       | (1,613  | )                 |   | (1,720  | )
|Proceeds from maturity of
short-term investments                                      |  |                       | 36,355  |                   |   | 51,255  |  
|Purchases of short-term
investments                                                   |  |                       | (13,882 | )                 |   | (34,525 | )
|Proceeds adjustments from sale
of businesses                                          |  |                       | (490    | )                 |   |        |  
|                                                                                      |  |                       |         |                   |   |         |  
|Net cash provided by investing
activities                                             |  |                       | 20,370  |                   |   | 15,010  |  
|                                                                                      |  |                       |         |                   |   |         |  
|                                                                                      |  |                       |         |                   |   |         |  
|Cash flows from financing activities:                                                 |  |                       |         |                   |   |         |  
|Net (repayments) proceeds under
short-term borrowings                                 |  |                       | (18     | )                 |   | 68      |  
|Payments of long-term
debt                                                            |  |                       | (16     | )                 |   | (41     | )
|Equity compensation income tax
benefits                                               |  |                       | 160     |                   |   |        |  
|Cash dividends                                                                        |  |                       | (1,991  | )                 |   |        |  
|Proceeds from exercise of stock
options and employee stock purchase
  plan            |  |                       | 504     |                   |   | 3,107   |  
|Payments to purchase and retire
common stock                                          |  |                       | (22,177 | )                 |   | (5,432  | )
|                                                                                      |  |                       |         |                   |   |         |  
|Net cash used in financing
activities                                                 |  |                       | (23,538 | )                 |   | (2,298  | )
|                                                                                      |  |                       |         |                   |   |         |  
|                                                                                      |  |                       |         |                   |   |         |  
|Net cash used in discontinued
operations                                              |  |                       | (83     | )                 |   | (3,550  | )
|                                                                                      |  |                       |         |                   |   |         |  
|Effect of exchange rate on changes in
cash                                            |  |                       | (1,415  | )                 |   | 5,277   |  
|                                                                                      |  |                       |         |                   |   |         |  
|                                                                                      |  |                       |         |                   |   |         |  
|Net increase in cash and cash
equivalents                                             |  |                       | 6,607   |                   |   | 14,792  |  
|                                                                                      |  |                       |         |                   |   |         |  
|Cash and cash equivalents, at
beginning of period                                     |  |                       | 83,143  |                   |   | 66,948  |  
|                                                                                      |  |                       |         |                   |   |         |  
|Cash and cash equivalents, at
end of period                                           |  | $                     | 89,750  |                   | $ | 81,740  |  
|                                                                                      |  |                       |         |                   |   |         |  
|                                                                                      |  |                       |         |                   |   |         |  
|Supplemental disclosure of cash flow
information:                                     |  |                       |         |                   |   |         |  
|Cash paid during the period for
-                                                     |  |                       |         |                   |   |         |  
|Interest expense                                                                      |  | $                     | 393     |                   | $ | 574     |  
|Income taxes                                                                          |  | $                     | 5,217   |                   | $ | 1,990   |  
|                                                                                      |  |                       |         |                   |   |         |  

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

4

---



MTS SYSTEMS CORPORATION
CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(unaudited)

1. Basis
of Presentation

The consolidated
financial statements include the accounts of MTS SYSTEMS CORPORATION and its
wholly owned subsidiaries (the Company). All significant intercompany
balances and transactions have been eliminated.

The interim
consolidated financial statements included herein have been prepared by the
Company, without audit, pursuant to the rules and regulations of the Securities
and Exchange Commission (SEC). The information furnished in these financial
statements includes normal recurring adjustments and reflects all adjustments
which are, in the opinion of management, necessary for a fair presentation of
such financial statements. Certain information and footnote disclosures
normally included in financial statements prepared in accordance with U.S.
generally accepted accounting principles have been condensed or omitted
pursuant to such rules and regulations. The accompanying financial statements
of the Company should be read in conjunction with the audited consolidated
financial statements and notes thereto included in the Companys 2005 Form 10-K
filed with the SEC. Interim results of operations for the three-month period
ended December 31, 2005 are not necessarily indicative of the results to be
expected for the full year.

Certain prior year
amounts included in the accompanying financial statements have been
reclassified to conform to the current years presentation. Such
reclassifications had no effect on the Companys previously reported financial
position, net income, or cash flows.

Critical Accounting Policies

The Company
believes that of its significant accounting policies, the following are
particularly important to the portrayal of the Companys results of operations
and financial position and may require the application of a higher level of
judgment by the Companys management and, as a result, are subject to an
inherent degree of uncertainty.

Revenue
Recognition.  Orders that are manufactured
and delivered in less than six months with routine installations and no special
acceptance protocol are considered to involve separable elements for revenue
recognition purposes. Sufficient evidence of fair value of these elements
exists to allow revenue recognition for these systems upon shipment, less the
greater of the fair value associated with installation and training (if
applicable) or the amount of revenue that is deemed contingent upon these
elements, which is deferred until customer acceptance. In cases where special
acceptance protocols exist, installation and training are not considered to be
separable from the other elements of the arrangement. Accordingly, revenue for
these systems is recognized upon the completion of installation and fulfillment
of obligations specific to the terms of the arrangement.

Revenue on
contracts requiring longer delivery periods, generally longer than six months
(long-term contracts), is recognized using the percentage-of-completion method
based on the cost incurred to date relative to estimated total cost of the
contract. In most cases, orders with complex installations and/or unusual
acceptance protocols involve long-term contracts for custom systems that follow
the percentage-of-completion method of revenue recognition through customer
acceptance. However, when elements that would not separately fall within the
scope of accounting literature prescribing percentage-of-completion accounting
are included in an arrangement, the fair value of these elements is separated
from the arrangement and accounted for as such services are provided.

The Company enters
into long-term contracts for customized equipment sold to its customers. Under
the terms of such contracts, revenue recognized using the
percentage-of-completion method may not, in certain circumstances, be invoiced
until completion of contractual milestones, upon shipment of the equipment, or
upon installation and acceptance by the customer. Unbilled amounts for these
contracts appear in the Consolidated Balance Sheets as Unbilled Accounts
Receivable.

Revenue for
services is recognized as the service is performed and ratably over a defined
contractual period for service maintenance contracts.

Inventories.  Inventories consist of material, labor and
overhead costs and are stated at the lower of cost or market, determined under
the first-in, first-out accounting method.
Inventories at December 31, 2005 and October 1, 2005 were as follows:

5

---



|                                                    |  |                           |        |                   |   |        | 
|--------------------------------------------------- |  | ------------------------- | ------ | ----------------- | - | ------ | 
|                                                    |  | December
  31, 2005       |        | October 1,
  2005 |  
|                                                    |  |                           |        |                   |  
|                                                    |  | (in thousands of dollars) |       
|Customer
  projects in various stages of completion |  | $                         | 12,578 |                   | $ | 13,845 | 
|Components,
  assemblies and parts                  |  |                           | 25,299 |                   |   | 24,184 | 
|                                                    |  |                           |        |                   |   |        | 
|Total                                               |  | $                         | 37,877 |                   | $ | 38,029 | 
|                                                    |  |                           |        |                   |   |        | 

Warranty Obligations. Sales of the Companys products
and systems are subject to limited warranty guarantees that are included in
customer contracts. For sales that include installation services, warranty
guarantees typically extend for a period of twelve months from the date of
either shipment or acceptance. Product guarantees typically extend for a period
of twenty-four months from the date of purchase. Under the terms of these
warranties, the Company is obligated to repair or replace any components or
assemblies it deems defective due to workmanship or materials. The Company
reserves the right to reject warranty claims where it determines that failure
is due to normal wear, customer modifications, improper maintenance, or misuse.
The Company records warranty provisions monthly based on an estimated warranty
expense percentage applied to current period revenue. The percentage applied
reflects historical warranty claims experience over the preceding twelve-month
period. Both the experience percentage and the warranty liability are evaluated
on an ongoing basis for adequacy. Warranty provisions and claims for the periods ended
December 31, 2005 and January 1, 2005 were as follows:

|                       |  |                             |        |                   |   |        |  
|---------------------- |  | --------------------------- | ------ | ----------------- | - | ------ | -
|                       |  | Three
  Months Ended        |       
|                       |  |                             |       
|                       |  | December
  31, 2005         |        | January 1,
  2005 |  
|                       |  |                             |        |                   |  
|                       |  | (in
  thousands of dollars) |       
|Beginning
  balance    |  | $                           | 5,333  |                   | $ | 5,811  |  
|Warranty
  provisions  |  |                             | 1,203  |                   |   | 2,759  |  
|Warranty claims        |  |                             | (1,465 | )                 |   | (2,081 | )
|Currency
  translation |  |                             | (26    | )                 |   | 163    |  
|                       |  |                             |        |                   |   |        |  
|Ending balance         |  | $                           | 5,045  |                   | $ | 6,652  |  
|                       |  |                             |        |                   |   |        |  

2.
Stock-Based Compensation

In December 2004, the
Financial Accounting Standards Board ( FASB) issued Statement of Financial
Accounting Standard (SFAS) No. 123R, Share-Based
Payment. SFAS No. 123R is a revision of FASB Statement No. 123, Accounting for Stock-Based
Compensation,
and supersedes Accounting Principles Board (APB) Opinion No. 25, Accounting for Stock Issued to
Employees,
and amends SFAS No. 95, Statement of Cash
flows,and its related implementation guidance. SFAS 123R focuses
primarily on accounting for transactions in which an entity obtains employee
services through share-based payment transactions. SFAS 123R requires a public
entity to measure the cost of employee services received in exchange for the
award of equity instruments based on the fair value of the award at the date of
grant. The cost is to be recognized over the period during which an employee is
required to provide services in exchange for the award. SFAS 123R also requires
the benefits of tax deduction in excess of recognized compensation expense to
be reported as a financing cash flow, rather than as an operating cash flow as
prescribed under the prior accounting rules. This requirement reduces net
operating cash flows and increases net financing cash flows in periods after
adoption. Total cash flow remains unchanged from what would have been reported
under prior accounting rules. Upon adoption of SFAS 123R, the Company applied
an estimated forfeiture rate to unvested awards. Previously, the Company
recorded forfeitures as incurred.  The
Company chose to implement SFAS 123R using the modified prospective
method.  There was no impact on
previously reported interim periods upon the adoption of SFAS 123R.

Prior to the adoption of
SFAS 123R, the Company followed the intrinsic value method in accordance with
APB 25 to account for its employee stock options and employee share purchase
plan. Accordingly, no compensation expense was recognized for share purchase
rights granted in connection with the issuance of stock options under the
Companys employee stock option plan or employee stock purchase plan; however,
compensation expense was recognized in connection with the issuance of
restricted shares granted. The adoption of SFAS 123R primarily resulted in a
change in the Companys method of recognizing the fair value of share-based
compensation and estimating forfeitures for all unvested awards. The following
table shows the effect of adopting SFAS 123R on selected reported items (As
Reported) and what those items would have been under previous guidance under
APB 25:

6

---



|                                     |  |                                          |         |                           |   |            |   |   |       |  
|------------------------------------ |  | ---------------------------------------- | ------- | ------------------------- | - | ---------- | - | - | ----- | -
|                                     |  | Three Months
  Ended
  December 31, 2005 |        
|                                     |  |                                          |        
|                                     |  | As Reported                              |         | Pro Forma UnderAPB No. 25 |   | Difference |  
|                                     |  |                                          |         |                           |   |            |  
|                                     |  | (in
  thousands, except per share data)  |        
|                                     |  |                                          |         |                           |   |            |   |   |       |  
|Income from operations               |  | $                                        | 12,314  |                           | $ | 13,186     |   | $ | (872  | )
|Income before taxes                  |  |                                          | 12,567  |                           |   | 13,439     |   |   | (872  | )
|Net income                           |  |                                          | 7,956   |                           |   | 8,606      |   |   | (650  | )
|Cash flows from operating activities |  |                                          | 11,273  |                           |   | 11,433     |   |   | (160  | )
|Cash flows from financing activities |  | $                                        | (23,538 | )                         | $ | (23,698    | ) | $ | 160   |  
|                                     |  |                                          |         |                           |   |            |   |   |       |  
|Earnings per share:                  |  |                                          |         |                           |   |            |   |   |       |  
|Basic                                |  | $                                        | 0.41    |                           | $ | 0.44       |   | $ | (0.03 | )
|Diluted                              |  | $                                        | 0.40    |                           | $ | 0.43       |   | $ | (0.03 | )

The Company compensates
officers, directors, and key employees with stock-based compensation under two
stock plans approved by the Companys shareholders in 1994 and 1997 and
administered under the supervision of the Companys Board of Directors. During
the three-month periods ended December 31, 2005 and January 1, 2005, the
Company awarded incentive stock option grants and non-qualified stock option
grants under these plans. At December 31, 2005, a total of 656,323 shares were
available for future grant under the two stock plans. Stock option awards are
granted at exercise prices equal to the closing market price of the Companys
stock on the date of grant. Generally, options vest proportionally on the first
three anniversary dates of the grant and expire five years from the grant
date.  Compensation expense is
recognized evenly over the vesting period of each vesting increment. The
parameters of the Companys share purchase activities are not established
solely with reference to the dilutive impact of issuance under the incentive
plans. However, the Company expects that, over time, share purchases will
offset the dilutive impact of share issuances made under the plan.

A summary of information
with respect to share-based compensation is as follows:

|                                                                                |  |                             |       |                   |   |    |  
|------------------------------------------------------------------------------- |  | --------------------------- | ----- | ----------------- | - | -- | -
|                                                                                |  | Three
  Months Ended        |      
|                                                                                |  |                             |      
|                                                                                |  | December
  31, 2005         |       | January 1,
  2005 |  
|                                                                                |  |                             |       |                   |  
|                                                                                |  | (in
  thousands of dollars) |      
|                                                                                |  |                             |       |                   |   |    |  
|Total share-based compensation cost                                             |  | $                           | 1,187 |                   | $ | 11 |  
|Amounts capitalized in inventory                                                |  |                             | (271  | )                 |   |   |  
|                                                                                |  |                             |       |                   |   |    |  
|Amounts charged against income, before income
tax benefit                       |  |                             | 916   |                   |   | 11 |  
|Income tax benefit related to share-based
compensation included in net
  income |  |                             | (239  | )                 |   | (4 | )
|                                                                                |  |                             |       |                   |   |    |  
|Net compensation expense included in net
income                                 |  | $                           | 677   |                   | $ | 7  |  
|                                                                                |  |                             |       |                   |   |    |  

7

---



Stock option activity was as
follows (in thousands, except per share amounts and years):

|                                                 |  |        |       |       |   |                                                             |  |                           |      |  |   |        | 
|------------------------------------------------ |  | ------ | ----- | ----- | - | ----------------------------------------------------------- |  | ------------------------- | ---- |  | - | ------ | 
|                                                 |  | Shares |       | WAEP* |   | Weighted
  Average
  Remaining
  Contractual Term(in years) |  | AggregateIntrinsicValue** |     
|                                                 |  |        |       |       |   |                                                             |  |                           |     
|Options outstanding at October 1, 2005           |  |        | 1,686 |       | $ | 22.63                                                       |  |                           |      |  |   |        | 
|Granted                                          |  |        | 5     |       |   | 39.94                                                       |  |                           |      |  |   |        | 
|Exercised                                        |  |        | (32   | )     |   | 16.97                                                       |  |                           |      |  |   |        | 
|Forfeited or expired                             |  |        | (59   | )     |   | 27.22                                                       |  |                           |      |  |   |        | 
|                                                 |  |        |      
|Options oustanding at December 31,
2005          |  |        | 1,600 |       |   | 22.69                                                       |  |                           | 3.09 |  | $ | 19,024 | 
|                                                 |  |        |      
|Options subject to exercise at December 31,
2005 |  |        | 631   |       | $ | 14.73                                                       |  |                           | 1.94 |  | $ | 12,525 | 
|                                                 |  |        |      

*Weighted Average Exercise
Price**Aggregate intrinsic value includes only those options with
intrinsic value (options where the exercise price is below the market value)

Other information pertaining
to options was as follows:

|                                                                |  |                                         |       |                   |   |       | 
|--------------------------------------------------------------- |  | --------------------------------------- | ----- | ----------------- | - | ----- | 
|                                                                |  | Three
  Months Ended                    |      
|                                                                |  |                                         |      
|                                                                |  | December
  31, 2005                     |       | January 1,
  2005 |  
|                                                                |  |                                         |       |                   |  
|                                                                |  | (in
  thousands, except per share data) |      
|                                                                |  |                                         |      
|Weighted average grant date fair value of stock
options granted |  | $                                       | 10.40 |                   | $ |      | 
|Total fair value of stock options
vested                        |  | $                                       | 84    |                   | $ | 136   | 
|Total intrinsic value of stock options
exercised                |  | $                                       | 654   |                   | $ | 4,244 | 
|                                                                |  |                                         |       |                   |   |       | 

There were 5,000 shares granted in the three month period ended
December 31, 2005, and no shares granted for the three-month period ended
January 1, 2005. For the three-month period ended December 31, 2005, cash
received from the exercise of stock options was $0.5 million, and the income tax
benefit realized from exercise of stock options was $0.2 million. At December
31, 2005, there was $4.6 million of total stock option compensation expense
related to non-vested awards not yet recognized, which is expected to be
recognized over a weighted average period of 1.0 years.

Results of operations for
fiscal year 2005 and prior periods have not been restated to reflect
recognition of stock-based compensation expense. If compensation expense for
employee stock-based compensation had been determined based on the fair value
at the grant dates consistent with the methods provided in SFAS No. 123, the
Companys net income and earnings per share for the period ended January 1,
2005 would have been as follows:

|                                                                             |                                       |   |       |  
|---------------------------------------------------------------------------- | ------------------------------------- | - | ----- | -
|                                                                             | Three
  Months Ended                  |  
|                                                                             | January 1,
  2005                     |  
|                                                                             |                                       |  
|                                                                             | (in thousands, except per share data) |  
|Net income:                                                                  |                                       |   |       |  
|As reported                                                                  |                                       | $ | 8,192 |  
|Deduct fair
  value of employee stock-based compensation expense, net of tax |                                       |   | (844  | )
|                                                                             |                                       |   |       |  
|Pro forma                                                                    |                                       | $ | 7,348 |  
|                                                                             |                                       |   |       |  
|Basic Earnings
  Per Share:                                                  |                                       |   |       |  
|As reported                                                                  |                                       | $ | 0.42  |  
|Pro forma                                                                    |                                       | $ | 0.37  |  
|                                                                             |                                       |   |       |  
|Diluted Earnings
  Per Share:                                                |                                       |   |       |  
|As reported                                                                  |                                       | $ | 0.40  |  
|Pro forma                                                                    |                                       | $ | 0.36  |  
|                                                                             |                                       |   |       |  

8

---



The fair value of options
granted under stock-based compensation programs has been estimated at the date
of each grant using a Black-Scholes multiple option valuation model. The
multiple option form of the model separately values each vesting increment of the
stock grant. This application of the Black-Scholes model values each vesting
period separately and thus allocates proportionately more of the resulting cost
to early vesting periods. In general, the fair value of a grant will increase
or decrease based on certain weighted average assumptions summarized as
follows:

|                         |  |                      |      |  
|------------------------ |  | -------------------- | ---- | -
|                         |  | Three
  Months Ended
|                         |  |                     
|                         |  | December
  31, 2005 
|                         |  |                     
|                         |  |                      |      |  
|Expected life (in years) |  |                      | 2.7  |  
|Risk-free interest rate  |  |                      | 4.5  | %
|Expected volatility      |  |                      | 36.7 | %
|Dividend yield           |  |                      | 1.0  | %

There were 5,000 shares granted in the three month period ended
December 31, 2005, and no shares granted for the three-month period ended
January 1, 2005. For the three-month period ended December 31, 2005 the Company
used a projected expected life for each award granted based on historical
experience of employees exercise behavior. The risk-free interest rate is
based on the yield of constant maturity U.S. Treasury bonds with a remaining
term equal to the expected life of the awards. The Company estimated the stock
price volatility using historical weekly price observations.

U.S. employees are eligible
to participate in the Companys Employee Stock Purchase Plan (ESPP), which
was approved by the Companys shareholders in fiscal year 2002. Purchases are
funded by payroll deductions over calendar six-month periods. The ultimate
purchase price is 85% of the lower of the market price at either the beginning
or end of the six-month period. The shares are required to be held by the employee
for at least 18 months subsequent to the purchase. An immaterial amount of
expense related to the plan was recognized in the three-month period ended
December 31, 2005. At December 31, 2005, the number of shares reserved for
issuance under the ESPP plan was 576,325.

In fiscal year 2005, the
Company awarded non-employee members of its Board of Directors restricted stock
grants totaling 15,000 shares, with an aggregate fair value of $0.4 million. In
fiscal year 2003, the Company awarded two officers restricted stock grants
totaling 12,000 shares, with an aggregate grant date fair value of $0.1
million. These grants vest over three years. In each of the three-month periods
ended December 31, 2005 and January 1, 2005, 3,333 shares of restricted stock
vested. No restricted stock grants were awarded in the three-month periods
ended December 31, 2005 and January 1, 2005.

3.
Discontinued Operations

On August 5, 2005, the
Company sold substantially all of the net assets of its engine test business,
which was based in Ann Arbor, Michigan and also maintained operations in
Byfleet, United Kingdom, to A&D Co., Ltd., of Tokyo, Japan. This sale
represented the Companys exit from the engine test business. As a result of
this sale, the Company recorded a gain of $3.8 million, net of tax of $1.1
million, in the fourth quarter of fiscal year 2005. The engine test business
was historically included in the Companys Test segment for financial
reporting. The gain on the sale of the engine test business and its results of
operations have been excluded from the results of operations of the Test
segment and are reported as discontinued operations for fiscal year 2005 and
prior fiscal years.

Effective October 1, 2005,
the Company closed its AeroMet subsidiary, a laser deposition technology
business located in Eden Prairie, Minnesota. As a result of this business
closure, the Company recorded a loss of $0.7 million, net of tax of $0.4
million, in the fourth quarter of fiscal year 2005. The AeroMet subsidiary was
historically included in the Companys Industrial segment for financial
reporting. The loss on disposition of the AeroMet business and its results of
operations have been excluded from results of operations of the Industrial
segment and are reported as discontinued operations for fiscal year 2005 and
prior fiscal years.

9

---



The Company does not
allocate interest income or interest expense to discontinued operations.
Following are the operating results of the discontinued operations included in
the Companys results for the three-month period ended January 1, 2005:

|                                                |  |                             |       |  
|----------------------------------------------- |  | --------------------------- | ----- | -
|                                                |  | Three
  Months Ended        |      
|                                                |  | January 1,
  2005           |      
|                                                |  |                             |      
|                                                |  | (in
  thousands of dollars) |      
|                                                |  |                             |       |  
|Revenue                                         |  | $                           | 5,410 |  
|Loss on
  discontinued operations before tax    |  |                             | (878  | )
|Benefit for
  income taxes                      |  |                             | (338  | )
|                                                |  |                             |       |  
|Loss from
  discontinued operations, net of tax |  | $                           | (540  | )
|                                                |  |                             |       |  

The assets and liabilities
of discontinued operations at December 31, 2005 and October 1, 2005 were as
follows:

|                                                               |  |                           |       |                   |   |       |  
|-------------------------------------------------------------- |  | ------------------------- | ----- | ----------------- | - | ----- | -
|                                                               |  | December
  31, 2005       |       | October 1,
  2005 |  
|                                                               |  |                           |       |                  
|                                                               |  | (in thousands of dollars) |      
|Accounts
  receivable, net of allowances for doubtful accounts |  | $                         | 501   |                   | $ | 12    |  
|Unbilled
  accounts receivable                                 |  |                           |      |                   |   | 258   |  
|Inventories                                                    |  |                           | 10    |                   |   | 358   |  
|Current deferred
  tax assets                                  |  |                           | 465   |                   |   | 465   |  
|Other current
  assets                                         |  |                           | 548   |                   |   | 548   |  
|                                                               |  |                           |       |                   |   |       |  
|Current assets
  of discontinued operations                    |  |                           | 1,524 |                   |   | 1,641 |  
|Machinery and
  equipment                                      |  |                           |      |                   |   | 106   |  
|Accumulated
  depreciation                                     |  |                           |      |                   |   | (37   | )
|                                                               |  |                           |       |                   |   |       |  
|Long-lived
  assets of discontinued operations                 |  |                           |      |                   |   | 69    |  
|                                                               |  |                           |       |                   |   |       |  
|Total assets of
  discontinued operations                      |  | $                         | 1,524 |                   | $ | 1,710 |  
|                                                               |  |                           |       |                   |   |       |  
|                                                               |  |                           |       |                   |   |       |  
|Accounts payable                                               |  | $                         | 150   |                   | $ | 238   |  
|Accrued
  payroll-related costs                                |  |                           | 28    |                   |   | 223   |  
|Other accrued
  liabilities                                    |  |                           | 443   |                   |   | 429   |  
|                                                               |  |                           |       |                   |   |       |  
|Total
  liabilities of discontinued operations                 |  | $                         | 621   |                   | $ | 890   |  
|                                                               |  |                           |       |                   |   |       |  

4.
Recently Issued Accounting Standards

In May 2005, the FASB issued SFAS No. 154, Accounting Changes and Error Corrections,
which supersedes APB Opinion No. 20, Accounting
Changes, and FASB Statement No. 3, Reporting
Accounting Changes in Interim Financial Statements. SFAS No. 154
requires retrospective application of changes in accounting principles to prior
periods financial statements as of the earliest date practicable. This
statement also redefines restatement as the revising of previously issued
financial statements to reflect the correction of an error. The provisions of
SFAS No. 154 are effective for fiscal years beginning after December 15, 2005.

In November 2005, the FASB issued FASB Staff Position
(FSP) FAS 115-1 and FSP FAS 124-1, The
Meaning of Other-Than-Temporary Impairment and Its Application to Certain
Investments, which amends FASB Statement No. 115, Accounting for Certain Investments in Debt and Equity
Securities, FASB Statement No. 124, Accounting
for Certain Investments Held by Not-for-Profit Organizations, and
APB Opinion No. 18, The Equity Method of
Accounting for Investments in Common Stock. FSP FAS 115-1 and FSP
FAS 124-1 provide guidance for determining whether impairments of certain debt
and equity investments are deemed other-than-temporary. The provisions of FSP
FAS 115-1 and FSP FAS 124-1 are effective for reporting periods beginning after
December 15, 2005. No material impact on the Companys financial statements is
expected from the adoption of this standard.

10

---



5.
Earnings Per Common Share

Basic net earnings per share are
computed by dividing net earnings by the weighted average number of common
shares outstanding during the applicable periods. Diluted net earnings per
share includes the potentially dilutive effect of common shares
issued in connection with outstanding stock options using the treasury stock
method. Options to acquire 0.5 million weighted common shares have been
excluded from the diluted weighted shares outstanding calculation for the
period ended December 31, 2005 because under the treasury stock method the
exercise of these options would lead to a net reduction in common shares
outstanding. Substantially all options to acquire common shares have been
included in the diluted weighted shares outstanding calculation for the period
ended January 1, 2005. A reconciliation of these amounts is as follows:

|                                              |  |                                       |        |            |   |        |  
|--------------------------------------------- |  | ------------------------------------- | ------ | ---------- | - | ------ | -
|                                              |  | Three Months Ended                    |       
|                                              |  |                                       |       
|                                              |  | December 31,                          |        | January 1, |  
|                                              |  | 2005                                  |        | 2005       |  
|                                              |  |                                       |        |            |  
|                                              |  | (in thousands, except per share data) |       
|                                              |  |                                       |        |            |   |        |  
|Income before discontinued
  operations       |  | $                                     | 7,956  |            | $ | 8,732  |  
|                                              |  |                                       |        |            |   |        |  
|Discontinued operations:                      |  |                                       |        |            |   |        |  
|Loss from discontinued operations, net of
tax |  |                                       |       |            |   | (540   | )
|                                              |  |                                       |        |            |   |        |  
|Net income                                    |  | $                                     | 7,956  |            | $ | 8,192  |  
|                                              |  |                                       |        |            |   |        |  
|Weighted average common
  shares outstanding  |  |                                       | 19,454 |            |   | 19,709 |  
|Diluted potential common
  shares             |  |                                       | 550    |            |   | 886    |  
|                                              |  |                                       |        |            |   |        |  
|Total diluted weighted
  shares outstanding   |  |                                       | 20,004 |            |   | 20,595 |  
|                                              |  |                                       |        |            |   |        |  
|                                              |  |                                       |        |            |   |        |  
|Earnings per share:                           |  |                                       |        |            |   |        |  
|Basic-                                        |  |                                       |        |            |   |        |  
|Income before discontinued operations         |  | $                                     | 0.41   |            | $ | 0.44   |  
|Discontinued operations:                      |  |                                       |        |            |   |        |  
|Loss from discontinued operations, net of
tax |  |                                       |       |            |   | (0.02  | )
|                                              |  |                                       |        |            |   |        |  
|Earnings per share                            |  | $                                     | 0.41   |            | $ | 0.42   |  
|                                              |  |                                       |        |            |   |        |  
|                                              |  |                                       |        |            |   |        |  
|Diluted -                                     |  |                                       |        |            |   |        |  
|Income before discontinued operations         |  | $                                     | 0.40   |            | $ | 0.42   |  
|Discontinued operations:                      |  |                                       |        |            |   |        |  
|Loss from discontinued operations, net of
tax |  |                                       |       |            |   | (0.02  | )
|                                              |  |                                       |        |            |   |        |  
|Earnings per share                            |  | $                                     | 0.40   |            | $ | 0.40   |  
|                                              |  |                                       |        |            |   |        |  

6. Short-Term Investments

Short-term
investments are defined as investments with original maturity dates greater
than three months. The Company currently classifies all its short-term
investments as available-for-sale investments as the Company intends to
liquidate them to fund current operations, acquisitions, or the return of
capital to shareholders. At December 31, 2005 and October 1, 2005 all
available-for-sale investments consisted of U.S. municipal debt obligations.
All investments in available-for-sale securities are carried at fair value, and
unrealized gains and losses are reported as a component of Accumulated Other
Comprehensive Income. At December 31, 2005 and October 1, 2005 unrealized gains
or losses from the investment in available-for-sale securities were immaterial.

7. Business Segment Information

The Companys
Chief Executive Officer and its management regularly review financial
information for the Companys discrete business units. Based on similarities in
the economic characteristics, nature of products and services, production
processes, type or class of customer served, method of distribution and
regulatory environments, the operating units have been aggregated for financial
statement purposes into two reportable segments, Test and Industrial. The
Test segment provides testing equipment, integrated software, and consulting
services to the ground vehicles, aerospace, and infrastructure markets. The
Industrial segment provides component solutions, such as position sensors, that
automate machines and machine tools.

11

---



The accounting
policies of the reportable segments are the same as those described in Note 1
to the Consolidated Financial Statements found in the Companys 2005 Form 10-K.
In evaluating each segments performance, management focuses on income from
operations. This measure excludes interest income and expense, income taxes and
other non-operating items. Corporate expenses, including costs associated with
various support functions such as human resources, information
technology, finance and accounting, and general and administrative costs, are
allocated to the reportable segments primarily on the basis of revenue.

Financial information by reportable segment for the
periods ended December 31, 2005 and January 1, 2005 was as follows:

|                                   |  |                             |        |            |   |        | 
|---------------------------------- |  | --------------------------- | ------ | ---------- | - | ------ | 
|                                   |  | Three
  Months Ended        |       
|                                   |  |                            
|                                   |  | December
  31,              |        | January 1, |  
|                                   |  | 2005                        |        | 2005       |  
|                                   |  |                             |        |            |  
|                                   |  | (in
  thousands of dollars) |       
|Revenue by Segment:                |  |                             |        |            |   |        | 
|Test                               |  | $                           | 76,839 |            | $ | 79,107 | 
|Industrial                         |  |                             | 15,004 |            |   | 13,974 | 
|                                   |  |                             |        |            |   |        | 
|Total revenue                      |  | $                           | 91,843 |            | $ | 93,081 | 
|                                   |  |                             |        |            |   |        | 
|                                   |  |                             |        |            |   |        | 
|Income from Operations by Segment: |  |                             |        |            |   |        | 
|Test                               |  | $                           | 9,934  |            | $ | 12,122 | 
|Industrial                         |  |                             | 2,380  |            |   | 1,795  | 
|                                   |  |                             |        |            |   |        | 
|Total income
  from operations     |  | $                           | 12,314 |            | $ | 13,917 | 
|                                   |  |                             |        |            |   |        | 

8. Derivative Instruments and Hedging Activities

The Company
periodically enters into forward and optional currency exchange contracts with
banks to exchange currencies at a set future date and rate to maintain the
functional currency value of specifically identified foreign currency
exposures. Because the market value of these currency exchange contracts is
derived from current exchange rates, they are classified as derivative
financial instruments. The Company does not use currency exchange contracts for
speculative or trading purposes.

Currency exchange
contracts utilized to maintain the reporting currency value of expected
financial transactions are matched to the identified exposures and designated
as foreign currency cash flow hedges. Subsequent changes in the market value of
the contracts are recorded in Accumulated Other Comprehensive Income within
Shareholders Investment on the Consolidated Balance Sheet until they are
recognized in earnings at the time income or loss is recognized on the
underlying forecasted transaction. The Company periodically assesses whether
the contracts are effective in offsetting the reporting currency value of the
forecasted transactions. When a contract is no longer effective as a hedge, the
Company discontinues hedge accounting prospectively and reclassifies the
unrealized gain or loss from Accumulated Other Comprehensive Income to Other
Income, net on the Consolidated Statement of Income in the current period.
Subsequent changes in the market value of the contract are recognized in
current period earnings. The Company also uses currency exchange contracts to
hedge the reporting currency value of monetary assets and liabilities
denominated in foreign currencies. The related gains and losses are included in
Other Income, net on the Consolidated Statement of Income.

At December 31,
2005 and January 1, 2005, the Company had outstanding currency exchange contracts
with gross notional U.S. dollar equivalent amounts of $122.8 million and $44.4
million, respectively. Netting offsetting contracts, net notional contracts
outstanding in U.S. dollar equivalent amounts were $23.0 million and $17.7
million, respectively. At December 31, 2005 and January 1, 2005, the market
value of the foreign currency forward exchange contracts was $1.4 million and
($1.3) million, respectively. The amount recognized in earnings as a result of
the ineffectiveness of cash flow hedges was not material and ($0.3) million for
the periods ended December 31, 2005 and January 1, 2005, respectively. At
December 31, 2005 and January 1, 2005, the amount projected to be reclassified
from Accumulated Other Comprehensive Income into earnings in the next 12 months
was $1.4 million and ($1.0) million, respectively. The maximum original
maturity of any derivative was 2.0 years and 1.75 years at December 31, 2005
and January 1, 2005, respectively.

9. Comprehensive Income

Comprehensive
income consists of net income, unrealized gains or losses on investments
classified as available-for-sale, derivative instrument gains or losses, and
foreign currency translation adjustments and is presented as a component of
Shareholders Investment on the Consolidated Balance Sheet. There were no
significant unrealized gains or losses from available-for-sale securities at December
31, 2005 and January 1, 2005.

12

---



Comprehensive
income for the periods ended December 31, 2005 and January 1, 2005 was as follows:

|                                                             |  |                             |        |            |   |        |  
|------------------------------------------------------------ |  | --------------------------- | ------ | ---------- | - | ------ | -
|                                                             |  | Three
  Months Ended        |       
|                                                             |  |                            
|                                                             |  | December
  31,              |        | January 1, |  
|                                                             |  | 2005                        |        | 2005       |  
|                                                             |  |                             |        |            |  
|                                                             |  | (in
  thousands of dollars) |       
|                                                             |  |                             |        |            |   |        |  
|Net income                                                   |  | $                           | 7,956  |            | $ | 8,192  |  
|Change in cumulative
  translation adjustment                |  |                             | (1,522 | )          |   | 6,345  |  
|Change in unrealized
  gain (loss) on derivative instruments |  |                             | (407   | )          |   | (971   | )
|                                                             |  |                             |        |            |   |        |  
|Comprehensive income                                         |  | $                           | 6,027  |            | $ | 13,566 |  
|                                                             |  |                             |        |            |   |        |  

10. Retirement Benefit Plan

One of the Companys
international subsidiaries has a non-contributory, unfunded defined benefit
retirement plan for eligible employees. This plan provides benefits based on
the employees years of service and compensation during the years immediately
preceding retirement, early retirement, termination, disability, or death, as
defined in the plan.

The cost for the
plan for the periods ended December 31, 2005 and January 1, 2005 included the following components:

|                                              |  |                             |     |            |   |     | 
|--------------------------------------------- |  | --------------------------- | --- | ---------- | - | --- | 
|                                              |  | Three
  Months Ended        |    
|                                              |  |                            
|                                              |  | December
  31,              |     | January 1, |  
|                                              |  | 2005                        |     | 2005       |  
|                                              |  |                             |     |            |  
|                                              |  | (in
  thousands of dollars) |    
|                                              |  |                             |     |            |   |     | 
|Service cost-benefit earned during the period |  | $                           | 114 |            | $ | 86  | 
|Interest cost on projected benefit obligation |  |                             | 112 |            |   | 121 | 
|Net amortization and deferral                 |  |                             | 33  |            |   | 3   | 
|                                              |  |                             |     |            |   |     | 
|Net periodic retirement
  cost                |  | $                           | 259 |            | $ | 210 | 
|                                              |  |                             |     |            |   |     | 

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

MTS Systems
Corporation is a leading global supplier of test systems and industrial
position sensors. The Companys testing hardware and software solutions help
customers accelerate and improve their design, development, and manufacturing
processes and are used for determining the mechanical behavior of materials,
products, and structures. MTS high-performance position sensors provide
controls for a variety of industrial and vehicular applications. MTS had 1,549
employees and revenue of $374 million for the fiscal year ended October 1,
2005.

Overall Results

Three Months Ended December 31, 2005 (First Quarter of
Fiscal 2006) Compared to Three Months Ended January 1, 2005 (First Quarter of
Fiscal 2005)

Orders for the First Quarter of
Fiscal 2006 increased 7.1% to $96.9 million compared to $90.5 million for the
First Quarter of Fiscal 2005, primarily driven by increased volume in the Test
segment in North America and in the Industrial segment across all geographies,
partially offset by decreased Test segment volume in Europe and Asia and
unfavorable currency translation. Backlog of undelivered orders at December 31,
2005 was approximately $216 million, a decrease of 1.8% from backlog of
approximately $220 million at October 1, 2005, primarily due to the unfavorable
impact of currency translation, partially offset by increased order volume.
Backlog at the end of the First Quarter of Fiscal 2005 was approximately $190
million. Revenue of $91.8 million for the First Quarter of Fiscal 2006
decreased 1.4% compared to revenue of $93.1 million for the First Quarter of
Fiscal 2005, primarily due to an estimated $5.2 million unfavorable impact from
currency translation, partially offset by increased short-cycle and service
business in the Test segment and continued growth in the Sensors business in
the Industrial segment. Income from operations for the First Quarter of Fiscal
2006 was $12.3 million, a decrease of 11.5% compared to $13.9 million for the
First Quarter of Fiscal 2005, primarily due to increased expenditures in
operating initiatives, stock-based compensation expense of $0.9 million, and an
estimated $0.7 million unfavorable impact of currency translation. Net income
for the First Quarter of Fiscal 2006 was $8.0 million, or
$0.40 per diluted share, a decrease of 2.4% compared to $8.2 million, or $0.40
per diluted share, for the First Quarter of Fiscal 2005, primarily due to
decreased income from operations.

13

---



Critical Accounting Policies

The consolidated
financial statements are prepared in accordance with U.S. generally accepted
accounting principles, which require the Company to make estimates and
assumptions in certain circumstances that affect amounts reported. In preparing
these financial statements, management has made its best estimates and
judgments of certain amounts, giving due consideration to materiality. The
Company believes that of its significant accounting policies, the following are
particularly important to the portrayal of the Companys results of operations
and financial position and may require the application of a higher level of
judgment by the Companys management, and as a result are subject to an
inherent degree of uncertainty. Further information is provided in Note 1 in
the Condensed Notes to Consolidated Financial Statements in this Form 10-Q.

Revenue
Recognition. Due to the diversity of its products, the Company is required to
comply with a variety of technical accounting requirements in order to achieve
consistent and accurate revenue recognition. This requires a certain amount of
judgment in the evaluation of completed contract versus
percentage-of-completion accounting, the determination of estimated costs to
complete contracts, and evaluation of customer acceptance terms.

Inventories. The Company maintains a material amount
of inventory to support its engineering and manufacturing operations, and a
certain amount of judgment is required in determining the appropriate inventory
valuation.
While the Company expects its sales to grow, a reduction in its sales could
reduce the demand for the Companys products, and additional inventory
valuation adjustments may be required.

Warranty
Obligations. The Company is subject to warranty guarantees on sales of its
products. A certain amount of judgment is required in determining appropriate
reserve levels for anticipated warranty claims. While these reserve levels are
based on historical warranty experience, they may not reflect the actual claims
that will occur over the upcoming warranty period, and additional warranty
reserves may be required.

New Accounting Principles

In May 2005, the FASB issued SFAS No. 154, Accounting Changes and Error Corrections,
which supersedes APB Opinion No. 20, Accounting
Changes, and FASB Statement No. 3, Reporting
Accounting Changes in Interim Financial Statements. SFAS No. 154
requires retrospective application of changes in accounting principles to prior
periods financial statements as of the earliest date practicable. This
statement also redefines restatement as the revising of previously issued
financial statements to reflect the correction of an error. The provisions of
SFAS No. 154 are effective for fiscal years beginning after December 15, 2005.

In November 2005, the FASB issued FASB Staff Position
(FSP) FAS 115-1 and FSP FAS 124-1, The
Meaning of Other-Than-Temporary Impairment and Its Application to Certain
Investments, which amends FASB Statement No. 115, Accounting for Certain Investments in Debt and Equity
Securities, FASB Statement No. 124, Accounting
for Certain Investments Held by Not-for-Profit Organizations, and
APB Opinion No. 18, The Equity Method of
Accounting for Investments in Common Stock. FSP FAS 115-1 and FSP
FAS 124-1 provide guidance for determining whether impairments of certain debt
and equity investments are deemed other-than-temporary. The provisions of FSP
FAS 115-1 and FSP FAS 124-1 are effective for reporting periods beginning after
December 15, 2005. No material impact on the Companys financial statements is
expected from the adoption of this standard.

Orders and Backlog

First
Quarter of Fiscal 2006 Compared to First Quarter of Fiscal 2005

Orders for the
First Quarter of Fiscal 2006 aggregated $96.9 million, an increase of 7.1%
compared to orders of $90.5 million for the First Quarter of Fiscal 2005. This
increase was primarily due to increased volume in the Test segment in North
America and in the Industrial segment across all geographies, partially offset
by decreased Test segment volume in Europe and Asia and an unfavorable impact
of currency translation.

14

---



Orders for the
Test segment in the First Quarter of Fiscal 2006 increased 6.8% to $81.7
million, compared to orders of $76.5 million for the First Quarter of Fiscal
2005. This increase was primarily due to increased volume in North America,
partially offset by decreased volume in Europe and Asia as well as unfavorable
currency translation. The Test segment accounted for
84.3% of total Company orders for the First Quarter of Fiscal 2006, compared to
84.5% for the First Quarter of Fiscal 2005.

Orders for the
Industrial segment in the First Quarter of Fiscal 2006 increased 8.6% to $15.2
million, compared to orders of $14.0 million for the First Quarter of Fiscal
2005, reflecting increased demand in the Sensors business across all
geographies. The Industrial segment accounted for 15.7% of total Company orders
in the First Quarter of Fiscal 2006, compared to 15.5% in the First Quarter of
Fiscal 2005.

Backlog of
undelivered orders at December 31, 2005 was approximately $216 million, a
decrease of 1.8% from backlog of $220 million at October 1, 2005, primarily due
to the unfavorable impact of currency translation, partially offset by
increased order volume. Backlog at January 1, 2005 was approximately $190
million. While the Companys backlog is subject to order cancellations, the
Company seldom experiences cancellations of orders larger than $1.0 million.

Results
of Operations

First Quarter of Fiscal 2006 Compared to First Quarter of
Fiscal 2005

Revenue for the First Quarter of Fiscal 2006 was $91.8 million, a
decrease of $1.3 million, or 1.4%, compared to revenue of $93.1 million for the
First Quarter of Fiscal 2005. Revenue from international customers for the
First Quarter of Fiscal 2006 represented 68.3% of total revenue, compared to
67.7% for the First Quarter of Fiscal 2005. Test segment revenue for the First
Quarter of Fiscal 2006 was $76.8 million, a decrease of $2.3 million, or 2.9%,
compared to revenue of $79.1 million for the First Quarter of Fiscal 2005. This
decrease was primarily due to an estimated $4.2 million unfavorable impact of
currency translation and a $1.8 million reduction in revenue associated with
the Companys exit of the noise and vibration software business. These negative
impacts were partially offset by increased short-cycle and service business in
the First Quarter of Fiscal 2006. Industrial segment revenue for the First
Quarter of Fiscal 2006 was $15.0 million, an increase of $1.0 million, or 7.1%,
compared to revenue of $14.0 million for the First Quarter of Fiscal 2005,
driven by increased volume in the Sensors business across all geographies,
partially offset by an estimated $1.0 million unfavorable impact of
currency translation.

Gross
profit for the First Quarter of Fiscal 2006 increased 2.3%,
to $40.6 million, compared to gross profit of $39.7 million for the First
Quarter of Fiscal 2005. Gross profit as a percent of revenue was 44.2% for the
First Quarter of Fiscal 2006, an increase of 1.5 percentage points from 42.7%
for the First Quarter of Fiscal 2005. Gross profit as a percent of revenue for
the Test segment increased 0.6 percentage points to 42.5% for the First Quarter
of Fiscal 2006, compared to 41.9% for the First Quarter of Fiscal 2005. This
increase was primarily due to improved capacity utilization, reduced warranty
expense of $1.6 million, and an estimated 1.0 percentage point favorable impact
of currency translation, partially offset by unfavorable product mix. Gross
profit as a percent of revenue for the Industrial segment increased 5.4
percentage points to 52.7% for the First Quarter of Fiscal 2005, compared to
47.3% for the First Quarter of Fiscal 2005, primarily due to favorable product
mix in the Sensors business. There was no significant impact on gross profit as
a percent of revenue from currency translation in the Industrial segment for
the First Quarter of Fiscal 2006.

Selling
expense for the First Quarter of Fiscal 2006 increased to
$16.0 million, or 5.3%, from $15.2 million for the First Quarter of Fiscal
2005, primarily due to $1.1 million increased expense associated with marketing
initiatives in the Test segment, $0.6 million increased staffing and commission
expense in the Industrial segment, as well as $0.3 million stock-based
compensation expense, partially offset by an estimated $0.6 million favorable
impact of currency translation and a $0.5 million decrease in expense
associated with the exited noise and vibration software business. Selling expense as a
percent of revenue for the First Quarter of Fiscal 2006 was 17.4%, compared to
16.3% for the First Quarter of Fiscal 2005.

General
and administrative expensetotaled $8.1 million for the First
Quarter of Fiscal 2006, an increase of 17.4% compared to $6.9 million for the
First Quarter of Fiscal 2005. This increase was primarily due to a $0.9 million
increase in consulting expenses, $0.5 million stock-based compensation expense,
and $0.4 million increased audit fees, partially offset by approximately $0.3
million decreased legal fees and an estimated $0.2 million favorable impact of
currency translation. General and administrative expense as a percent of
revenue increased to 8.8% for the First Quarter of Fiscal 2006, compared to
7.4% for the First Quarter of Fiscal 2005.

15

---



Research
and development expense totaled $4.1 million for the First
Quarter of Fiscal 2006, an increase of 10.8% compared to $3.7 million for the
First Quarter of Fiscal 2005. This increase was primarily due to a planned
increase in expenditures for new product development in the Test segment.
Research and development expense as a percent of revenue increased to 4.5% for
the First Quarter of Fiscal 2006, compared to 4.0% for the First Quarter of
Fiscal 2005. There was no significant impact on research and development
expense from currency translation or stock-based compensation for the First
Quarter of Fiscal 2006.

Income
from operations decreased 11.5% to $12.3 million for the
First Quarter of Fiscal 2006, compared to $13.9 million for the First Quarter
of Fiscal 2005. Income from operations in the Test segment decreased $2.2
million, or 18.2%, to $9.9 million for the First Quarter of Fiscal 2006,
compared to $12.1 million for the First Quarter of Fiscal 2005, primarily due
to increased expenses associated with operating initiatives, stock-based
compensation expense of $0.8 million, and an estimated $0.5 million unfavorable
impact of currency translation.
Income from operations in the Industrial segment increased by $0.6
million, or 33.3%, to $2.4 million for the First Quarter of Fiscal 2006,
compared to $1.8 million for the First Quarter of Fiscal 2005, primarily due to
higher volume, partially offset by an estimated $0.2 million unfavorable impact
of currency translation.

Interest
expensewas $0.5 million for the First Quarter of Fiscal
2006, a decrease of $0.1 million compared to $0.6 million for the First Quarter
of Fiscal 2005, due to a reduction in the Companys long-term debt obligations.

Interest
income was $0.7 million for the First Quarter of Fiscal 2006,
an increase of $0.3 million compared to interest income of $0.4 million for the
First Quarter of Fiscal 2005, primarily due to higher average interest rates.

Other
income, net was nominal for the First Quarter of Fiscal 2006,
compared to income of $0.2 million for the First Quarter of Fiscal 2005. This
decrease is primarily due to net gains on foreign currency transactions during
the First Quarter of Fiscal 2005 that did not repeat in the First Quarter of
Fiscal 2006.

Provision
for income taxes totaled $4.6 million for the First Quarter
of Fiscal 2006, a decrease of 11.5% compared to $5.2 million for the First
Quarter of Fiscal 2005, primarily due to decreased income before taxes. The
effective tax rate for the First Quarter of Fiscal 2006 was 36.7%, a decrease
of 0.4 percentage points compared to a tax rate of 37.1% for the First Quarter
of Fiscal 2005.

Net
income was $8.0 million for the First Quarter of Fiscal 2006,
compared to $8.2 million for the First Quarter of Fiscal 2005. The decrease was
primarily due to decreased income from operations. The estimated unfavorable
impact on net income from currency translation for the First Quarter of Fiscal
2006 was $0.4 million.

Capital
Resources and Liquidity

Total cash and cash equivalents increased $6.6 million
in the First Quarter of Fiscal 2006, primarily due to strong earnings, advance
payments received from customers, net proceeds generated from the conversion of
short-term investments to cash and cash equivalents, and proceeds from the
exercise of stock options, partially offset by employee incentive and related
benefits payments, increase in accounts and unbilled receivables, purchases of
the Companys common stock, and dividend payments. Total cash and cash
equivalents increased $14.8 million in the First Quarter of Fiscal 2005,
primarily due to strong earnings, net proceeds generated from the conversion of
short-term investments to cash and cash equivalents, and proceeds from the
exercise of stock options, partially offset by an increase in accounts and
unbilled receivables, employee incentive and related benefits payments, and
purchases of the Companys common stock. The Company believes that its
anticipated operating cash flow, funds available from cash, and cash
equivalents and short-term investments totaling $143.9 million at December 31,
2005 are adequate to fund ongoing operations, capital expenditures, and share
purchases, as well as to fund internal growth opportunities and strategic
acquisitions.

Cash
flows from operating activities provided cash of $11.3
million for the First Quarter of Fiscal 2006, compared to cash provided of $0.4
million for the First Quarter of Fiscal 2005. Operating cash flow for the First
Quarter of Fiscal 2006 primarily resulted from strong earnings and $18.1 million
increase in advance payments received from customers, partially offset by net
employee incentive and related benefits payments of $10.2 million and an
increase in accounts and unbilled receivables of $8.3 million. Operating cash
flow for the First Quarter of Fiscal 2005 was primarily due to strong earnings
and a $4.3 million increase in accrued income taxes, partially offset by net
employee incentive and related benefits payments of $10.2 million, and an
increase in accounts and unbilled receivables of $7.9 million.

Cash
flows from investing activities provided cash totaling $20.4
million for the First Quarter of Fiscal 2006, compared to $15.0 million cash
provided for the First Quarter of Fiscal 2005. During the Quarter of Fiscal
2006, the Company received net proceeds of $22.5 million from the conversion of
short-term investments to cash and cash equivalents, and invested $1.6 million
in property and equipment additions. During the First Quarter of Fiscal 2005,
the Company received net proceeds of $16.7 million from the conversion of
short-term investments to cash and cash equivalents, and invested $1.7 million
in property and equipment additions.

16

---



Cash
flows from financing activities required the use of cash
totaling $23.5 million for the First Quarter of Fiscal 2006, compared to a use
of cash totaling $2.3 million
for the First Quarter of Fiscal 2005. The cash usage for the First Quarter of
Fiscal 2006 was due to the use of $22.2 million to purchase shares of the
Companys common stock and payment of cash dividends of $2.0 million, partially
offset by $0.5 million received in connection with stock option exercises. The
cash usage from financing activities for the First Quarter of Fiscal 2005 was
due to the use of $5.4 million to purchase shares of the Companys common
stock, partially offset by $3.1 million received in connection with stock
option exercises.

Under the terms of
its long-term debt agreements, the Company has agreed to certain financial
covenants. At December 31, 2005, the Company was in compliance with the
financial terms and conditions of its debt and credit facility agreements.

During the First
Quarter of Fiscal 2006, the Company purchased 622,935 shares of its common
stock for $22.2 million. During the First Quarter of Fiscal 2005, the Company
purchased 183,600 shares of its common stock for $5.4 million.

Other
Matters

The Company is
exposed to market risk from changes in foreign currency exchange rates on its
operations and financial condition. The Company manages exposure to changes in
foreign currency rates through its regular operating and financing activities
and through the use of foreign currency exchange contracts. These contracts are
used to hedge the Companys overall exposure to exchange rate fluctuations, as
the gains and losses on these contracts are intended to offset gains and losses
on the Companys assets, liabilities, and cash flows.

The Companys
dividend policy is to maintain a payout ratio that allows dividends to increase
with the long-term growth of earnings per share, while sustaining dividends
through economic cycles. The Companys dividend payout ratio target is
approximately 25% of earnings per share over the long term.

Forward-Looking Statements

Statements
included or incorporated by reference in this Managements Discussion and
Analysis of Financial Condition and Results of Operations and elsewhere in this
Form 10-Q which are not historical or current facts are forward-looking
statements, as defined in the Private Securities Litigation Reform Act of 1995,
and are subject to certain risks and uncertainties that could cause actual
results to differ materially from historical results and those presently
anticipated or projected. The following important factors, among others, could
affect the Companys actual results in the future and could cause the Companys
actual financial performance to differ materially from that expressed in any
forward-looking statements:

| |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                
| | ----- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | (i)   | Possible significant volatility in backlog and/or
  quarterly operating results may result from the timing of individual large,
  fixed-price orders in connection with sales of Test segment systems.                                                                                                                                                                                                                                                         
| |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                
| | (ii)  | Order volumes and other operating considerations may
  be directly or indirectly impacted by economic conditions generally and/or in
  various geographic areas in which the Company operates. The Company derives
  significant revenue from the global ground vehicles and aerospace industries,
  and therefore is subject to economic cycles affecting these customers.                                                                                    
| |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                
| | (iii) | Export controls based on U.S. initiatives and
  foreign policy, as well as import controls imposed by foreign governments,
  may cause delays in certain shipments or the rejection of orders by the
  Company. Such delays could create material fluctuations in quarterly
  operating results and could have a material adverse effect on results of
  operations. Local political conditions and/or currency restrictions may also
  affect foreign revenue.

17

---



| |        |                                                                                                                                                                                                                                                                                                                                                                                                                                               
| | ------ | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | (iv)   | Delays in realization of orders in backlog may occur
  due to technical difficulties, export licensing approval, or the customers
  preparation of the installation site, any of which can affect the quarterly
  or annual period when backlog is recognized as revenue and could materially
  affect the results of any such period.                                                                                                       
| |        |                                                                                                                                                                                                                                                                                                                                                                                                                                               
| | (v)    | The Company experiences competition on a worldwide
  basis. Customers may choose to purchase equipment from the Company or from
  its competitors. For certain of the Companys products, customers may
  contract with testing laboratories or construct their own testing equipment
  from commercially available components. Factors that may
  influence a customers decision include price, service, and required level of
  technology.
| |        |                                                                                                                                                                                                                                                                                                                                                                                                                                               
| | (vi)   | The Company operates internationally and thus is
  subject to foreign currency exchange rate changes, which can affect its
  results from operations and financial condition.                                                                                                                                                                                                                                                                 
| |        |                                                                                                                                                                                                                                                                                                                                                                                                                                               
| | (vii)  | With regard to the Companys new product
  developments, there may be uncertainties concerning the expected results. In
  addition, the Company may not be aware of the introduction of new products or
  product enhancements by its competitors.                                                                                                                                                                                            
| |        |                                                                                                                                                                                                                                                                                                                                                                                                                                               
| | (viii) | The Companys short-term investments and borrowings
  carry floating interest rate risk. The Company has minimal earnings and cash
  flow exposure due to market risks on its long-term debt obligations as a
  result of the primarily fixed-rate nature of its debt.                                                                                                                                                                        
| |        |                                                                                                                                                                                                                                                                                                                                                                                                                                               
| | (ix)   | The Company relies on various raw material,
  component, and sub-assembly suppliers in its production processes and as
  such, business interruptions affecting these suppliers may cause delays in
  the Companys ability to convert its backlog of unfilled orders to revenue.                                                                                                                                                             

The foregoing list is not exhaustive, and the Company
disclaims any obligation to revise any forward-looking statements to reflect
new information, future events, or circumstances after the date of such
statements or to reflect the occurrence of anticipated or unanticipated events.

Item 3.
Quantitative and Qualitative Disclosures about Market Risk

The Companys investment portfolio at December 31,
2005 included $89.8 million of cash and cash equivalents, as well as short-term
investments of $54.2 million. The cash equivalent portion of the portfolio
is invested in money market funds and bank deposits with high credit ratings
and for which interest rates are re-set to market rates every 1-90
days. The short-term investment portfolio is invested in long-term
municipal debt with high credit ratings reported at market values for which
interest rates are re-set every 7-35 days. The short maturities and
frequent interest rate re-sets on these investments significantly mitigates the
potential impact of market interest rates on the value of the investment
portfolio.

The Company operates internationally and is subject to
foreign currency exchange rate fluctuations. A hypothetical 10% appreciation in
foreign currencies against the U.S. dollar, assuming all other variables were
held constant, would have resulted in an estimated increase of $4.5 million in
revenue for the three months ended December 31, 2005. A hypothetical 10%
depreciation in foreign currencies against the U.S. dollar, assuming all other
variables were held constant, would have resulted in an estimated decrease of
$4.5 million in revenue for the three months ended December 31, 2005. The
Company enters into foreign currency exchange contracts to reduce its exposure
to foreign currency exchange rate changes on forecasted foreign currency
denominated transactions and monetary balance sheet positions. Additional
information is included in Note 8 to the Condensed Notes to Consolidated
Financial Statements in this Form 10-Q.

At December 31, 2005, the Companys long-term debt
consisted of notes payable with fixed interest rates ranging from 6.6% to 7.5%.
As such, interest rate fluctuations would not have an impact on interest
expense or cash flows.

Item 4.
Controls and Procedures

The Companys management, including the Chief
Executive Officer and Chief Financial Officer, have conducted an evaluation of
the effectiveness of the design and operation of the Companys disclosure
controls and procedures pursuant to Rule 13a-15 under the Securities Exchange
Act of 1934 (the 1934 Act) as of December 31, 2005. Based on that evaluation,
the Companys Chief Executive Officer and Chief Financial Officer concluded
that the Companys disclosure controls and procedures are effective in ensuring
that information required to be disclosed by the Company in the reports it
files or submits under the 1934 Act is recorded, processed, summarized and
reported within the time periods specified in the SECs rules and forms.

There have been no changes in internal control over financial reporting
during the fiscal quarter ended December 31, 2005 that have materially
affected, or are reasonably likely to materially affect, the Companys internal
control over financial reporting.

18

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PART II
 OTHER INFORMATION

|        |                                                              
|------- | -------------------------------------------------------------
|Item 1. | Legal Proceedings                                            
|        |                                                              
|        | None                                                         
|        |                                                              
|Item 2. | Unregistered Sales of Equity
  Securities and Use of Proceeds
|        |                                                              
|        | Purchases of Company Equity Securities:                      

| |                                     |  |                                        |         |                                    |  |                                                                                                  |   |                                                                                              |  |  |  |         |  |  |  |           |  | 
| | ----------------------------------- |  | -------------------------------------- | ------- | ---------------------------------- |  | ------------------------------------------------------------------------------------------------ | - | -------------------------------------------------------------------------------------------- |  |  |  | ------- |  |  |  | --------- |  | 
| | Period                              |  | Total
  Number
  of Shares
  Purchased |         | Average
  Price
  Paid per
  Share |  | Total
  Number
  of Shares
  Purchased as
  Part of
  Publicly
  Announced
  Plans or
  Programs |   | Maximum
  Number of
  Shares
  that May Yet
  be Purchased
  Under the
  Plans or
  Programs | 
| |                                     |  |                                        |         |                                    |  |                                                                                                  |   |                                                                                              | 
| | October 2, 2005 - November 5, 2005  |  |                                        | 114,400 |                                    |  |                                                                                                  | $ | 38.62                                                                                        |  |  |  | 114,400 |  |  |  | 3,130,073 |  | 
| |                                     |  |                                        |         |                                    |  |                                                                                                  |   |                                                                                              |  |  |  |         |  |  |  |           |  | 
| | November 6, 2005 -December 3, 2005  |  |                                        | 199,935 |                                    |  |                                                                                                  | $ | 34.54                                                                                        |  |  |  | 199,935 |  |  |  | 2,930,138 |  | 
| |                                     |  |                                        |         |                                    |  |                                                                                                  |   |                                                                                              |  |  |  |         |  |  |  |           |  | 
| | December 4, 2005 -December 31, 2005 |  |                                        | 308,600 |                                    |  |                                                                                                  | $ | 34.80                                                                                        |  |  |  | 308,600 |  |  |  | 2,621,538 |  | 
| |                                     |  |                                        |         |                                    |  |                                                                                                  |   |                                                                                              |  |  |  |         |  |  |  |           |  | 
| | Total                               |  |                                        | 622,935 |                                    |  |                                                                                                  | $ | 35.40                                                                                        |  |  |  | 622,935 |  |  |  |           |  | 
| |                                     |  |                                        |         |                                    |  |                                                                                                  |   |                                                                                              |  |  |  |         |  |  |  |           |  | 

| |                                                                                                                                                                                                                                                                                                                                                                                                                                             
| | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | The Company purchases Company common stock primarily
  to offset the dilution created by employee stock compensation programs such
  as stock options plans, restricted stock grants, and the Employee Stock
  Purchase Plan. A secondary purpose is as an alternative in returning cash to
  shareholders. The Company executes all its purchases of Company stock in accordance
  with Rule 10b-18 of the Securities Exchange Act of 1934.
| |                                                                                                                                                                                                                                                                                                                                                                                                                                             
| | On August 25, 2005, the Company announced that its
  Board of Directors approved a 3.0 million share purchase program that covers
  the shares reported above. Pricing under the program has been delegated to
  management.  There is no expiration
  date for the program.                                                                                                                                                                

|        |                                                      
|------- | -----------------------------------------------------
|Item 3. | Defaults Upon Senior Securities                      
|        |                                                      
|        | None                                                 
|        |                                                      
|Item 4. | Submission of Matters to a Vote of
  Security Holders
|        |                                                      
|        | None                                                 
|        |                                                      
|Item 5. | Other Information                                    
|        |                                                      
|        | None                                                 
|        |                                                      
|Item 6. | Exhibits                                             

| |                  |  |  |                                                                                                                                                                                      |  | 
| | ---------------- |  |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------ |  | 
| | Exhibit
  Number |  |  | Description                                                                                                                                                                          | 
| |                  |  |  |                                                                                                                                                                                      | 
| | 3.a              |  |  | Restated and Amended Articles of Incorporation,
  adopted January 30, 1996, incorporated by reference from Exhibit 3.a. of Form
  10-K for the fiscal year ended September 30, 1996.
| |                  |  |  |                                                                                                                                                                                     
| | 3.b              |  |  | Restated Bylaws, incorporated by reference from
  Exhibit 3.1 of the Registrants Form 8-K filed on December 2, 2005.                                                               
| |                  |  |  |                                                                                                                                                                                     
| | 31.1             |  |  | Certification of Chief Executive Officer Pursuant to
  Section 302 of the Sarbanes-Oxley Act of 2002 (18U.S.C. 1350) (filed herewith).                                              
| |                  |  |  |                                                                                                                                                                                     
| | 31.2             |  |  | Certification of Chief Financial Officer Pursuant to
  Section 302 of the Sarbanes-Oxley Act of 2002 (18 U.S.C. 1350) (filed
  herewith).                                           
| |                  |  |  |                                                                                                                                                                                     
| | 32.1             |  |  | Certification of Chief Executive Officer Pursuant to
  Section 906 of the Sarbanes-Oxley Act of 2002 (18 U.S.C. 1350) (filed
  herewith).                                           
| |                  |  |  |                                                                                                                                                                                     
| | 32.2             |  |  | Certification of Chief Financial Officer Pursuant to
  Section 906 of the Sarbanes-Oxley Act of 2002 (18 U.S.C. 1350) (filed
  herewith).                                           

19

---



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.

|                        |  |                                                
|----------------------- |  | -----------------------------------------------
|                        |  | MTS SYSTEMS CORPORATION                        
|                        |  |                                                
|Dated: February 7, 2006 |  | /s/ Sidney W. Emery, Jr.                       
|                        |  |                                                
|                        |  | Sidney W. Emery, Jr.                           
|                        |  | Chairman, President and Chief Executive Officer
|                        |  |                                                
|Dated: February 7, 2006 |  | /s/ Susan E. Knight                            
|                        |  |                                                
|                        |  | Susan E. Knight                                
|                        |  | Vice President and Chief Financial Officer     

20

---



EXHIBIT INDEX TO FORM 10-Q

|     |                                                                                                                       
|---- | ----------------------------------------------------------------------------------------------------------------------
|31.1 | Certification of Chief Executive Officer Pursuant to
  Section 302 of the Sarbanes-Oxley Act of 2002 (18 U.S.C. 1350).
|     |                                                                                                                       
|31.2 | Certification of Chief Financial Officer Pursuant to
  Section 302 of the Sarbanes-Oxley Act of 2002 (18 U.S.C. 1350).
|     |                                                                                                                       
|32.1 | Certification of Chief Executive Officer Pursuant to
  Section 906 of the Sarbanes-Oxley Act of 2002 (18 U.S.C. 1350).
|     |                                                                                                                       
|32.2 | Certification of Chief Financial Officer Pursuant to
  Section 906 of the Sarbanes-Oxley Act of 2002 (18 U.S.C. 1350).

---