**EXHIBIT 13**

**PORTIONS OF**

**ENVIRONMENTAL TECTONICS CORPORATION**

**2006**

**ANNUAL REPORT TO STOCKHOLDERS**

**FINANCIAL REVIEW**

(amounts in thousands, except share and per share information)

 

| **Fiscal Year End**                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       |   | **2006** |   | **2005** |   | **2004** |   | **2003** |   | **2002** |   |
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|  

 

 

 

 

 

Net sales

 

$

25,069

 

$

27,814

 

$

25,995

 

$

43,123

 

$

32,527

 

Gross profit

 

 

5,350

 

 

6,176

 

 

9,943

 

 

14,198

 

 

11,465

 

Operating (loss)/income

 

 

(4,719

)

 

(7,130

)

 

131

 

 

4,116

 

 

2,873

 

Net (loss)/income

 

 

(6,714

)

 

(8,113

)

 

(793

)

 

2,493

 

 

1,741

 

(Loss)/earnings per common share:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Basic

 

 

(0.74

)

 

(1.06

)

 

(.11

)

 

.35

 

 

.24

 

Diluted

 

 

(0.74

)

 

(1.06

)

 

(.11

)

 

.33

 

 

.23

 

Working capital

 

 

19,820

 

 

29,818

 

 

29,907

 

 

31,216

 

 

30,683

 

Long-term obligations

 

 

8,376

 

 

12,087

 

 

12,157

 

 

12,643

 

 

16,688

 

Total assets

 

 

33,667

 

 

47,909

 

 

48,696

 

 

47,698

 

 

48,482

 

Total stockholders’ equity

 

 

17,553

 

 

24,355

 

 

25,054

 

 

25,907

 

 

20,782

 

Weighted average common shares:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Basic

 

 

9,021,000

 

 

7,656,000

 

 

7,163,000

 

 

7,153,000

 

 

7,143,000

 

Diluted

 

 

9,021,000

 

 

7,656,000

 

 

7,163,000

 

 

7,497,000

 

 

7,499,000

 

No cash dividends have ever been paid on the Company’s common stock, and the Company is prohibited from declaring any cash dividends on its common stock under the terms of its existing credit facilities. 

 

**Management’s Discussion and Analysis of Financial Condition and Results of Operations**

**FORWARD-LOOKING STATEMENTS**

This Annual Report on Form 10-K includes forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. These forward-looking statements are based on the Company’s current expectations and projections about future events. These forward-looking statements are subject to known and unknown risks, uncertainties and assumptions about the Company and its subsidiaries that may cause actual results, levels of activity, performance or achievements to be materially different from any future results, levels of activity, performance or achievements expressed or implied by such forward-looking statements. 

These forward-looking statements include statements with respect to the Company’s vision, mission, strategies, goals, beliefs, plans, objectives, expectations, anticipations, estimates, intentions, financial condition, results of operations, future performance and business of the company, including but not limited to, (i) projections of revenues, costs of raw materials, income or loss, earnings or loss per share, capital expenditures, growth prospects, dividends, capital structure, other financial items and the effects of currency fluctuations, (ii) statements of our plans and objectives of the Company or its management or Board of Directors, including the introduction of new products, or estimates or predictions of actions of customers, suppliers, competitors or regulatory authorities, (iii) statements of future economic performance, (iv) statements of assumptions and other statementsabout the Company or its business, (v) statements made about the possible outcomes of litigation involving the Company; and (vi) statements preceded by, followed by or that include the words, “may,” “could,” “should,” “looking forward,” “would,” “believe,” “expect,” “anticipate,” “estimate,” “intend,” “plan,” or the negative of such terms or similar expressions. These forward-looking statements involve risks and uncertainties which are subject to change based on various important factors. Some of these risks and uncertainties, in whole or in part, are beyond the Company’s control. Factors that might cause or contribute to such a material difference include, but are not limited to, those discussed in the Company’s Annual Report on Form 10-K, in the section entitled “Risks Particular to Our Business.”  Shareholders are urged to review these riskscarefully prior to making an investment in the Company’s common stock.

The Company cautions that the foregoing list of important factors is not exclusive. The Company does not undertake to update any forward-looking statement, whether written or oral, that may be made from time to time by or on behalf of the Company.

**Overview**

We are principally engaged in the design, manufacture and sale of software driven products used to create and monitor the physiological effects of motion on humans and equipment and to control, modify, simulate and measure environmental conditions. These products include aircrew training systems, entertainment products, sterilizers, environmental and hyperbaric chambers and other products that involve similar manufacturing techniques and engineering technologies. 

The following factors had an adverse impact on our performance for the fiscal year ended February 24, 2006:

 

**•**

unfavorable global economic and political conditions for our aeromedical products;

Historically our ATS open contract mix has included one large order (e.g., a centrifuge or an order for an entire training center of equipment), a few medium-priced simulators, and other low-end trainers. Large dollar contracts have tended to be received every 18 months to two years, although some significant events such as September 11, 2001, and the action in Iraq have disrupted this cycle. The ATS product line is especially sensitive to global economic and political pressures including anti-American sentiment. Fiscal 2006 saw a continuation of the new contract delays due to budget constraints and other issues of our customers located throughout the world. Most of our ATS sales are to international government defense customers. 

Our continuing development of the Advanced Tactical Flight Simulation (“ATFS”) technology is a response to these changing world conditions. Fiscal 2006 saw the continuation of our education and marketing efforts to introduce our ATFS to the U.S. military. Although the cost of developing and marketing this technology is high, the evolution of these exciting and state-of-the-art technologies is an important step in our goal of integrating flight and aeromedical training in a simulator device. ****This technology allows a fighter pilot to practice tactical air combat maneuvers such as dodging enemy missiles, ground fire and aircraft obstacles while experiencing the real life environment of a high-G Force fighter aircraft. These flight trainers provide a low cost and extremely less risky alternative to actual air flight. We believe thatarmed forces agencies of various governments will appreciate the efficiency of these technologies, especially in this time of fiscal conservatism and budgetary constraints throughout the world.

 

**•**

continued        development of flexibility and functionality in our Advanced Disaster        Management Senario product line;

 

We        have made significant progress in advancing and enhancing our ADMS line        of products. Graphics are sharper and more realistic, interactivity and        connectivity of objects is tighter, additional disaster scenarios have        been added, and we have made the hardware configuration more user friendly.        However, this effort has put pressure on our gross margins. Also, until        recently our marketing efforts were not focused and ineffective. Late        in the fiscal year we began a telemarketing campaign and added experienced        marketing staff. Although these actions will initially increase operating        expenses, early responses from the market imply that these marketing efforts        will result in an increased order flow for this line.

 

 

**•**

limited        revenue generation coupled with high development costs in our low-end        entertainment products;

 

Certain        actions by a former major entertainment customer have effectively closed        the high-end amusement market to us. Our low-end products have encountered        customer resistance due to pricing and those units under a revenue share        contract have failed to generate sufficient income to justify an expansion        of this line. Consequently, this line has suffered from high development        costs with low payback. We consider this line to be an opportunistic business        and will plan our development accordingly.

 

**•**

higher        costs of capital and amortization of deferred finance charges;

 

 

Interest        expense for fiscal 2006 was $1,857,000 or 7.4% of sales. This included        approximately $1,100,000 million of non-cash charges for amortization/write-off        of deferred finance and debt discount expenses. We anticipate that this        number will decrease significantly going forward.

 

**•**

Higher        bad debt and inventory reserves;

 

During        fiscal 2006 we significantly increased both our accounts receivable and        inventory reserves. We fully reserved for a large international receivable        which has been adjudicated in our favor but which may be difficult to        collect. In inventory, we partially reserved for some of our mid-line        trainers which have experienced slow sales in the most recent periods.

 

**•**

litigation        and claims costs;

 

Although        down significantly from fiscal 2005, these costs continue to be a major        component of our general, administrative and selling costs. 

 

**•**

cash        flow;

 

One of the greatest challenges we face is adequately funding the cash requirements of large, long-term multi-year projects. Although these contracts normally incorporate milestone payments, the cash flows associated with production and material requirements tend to vary significantly over time. These projects are usually cash positive in the early stages and cash negative during the production phase. Funding these contracts requires a significant amount of operating funds and may hamper other types of business. On May 19, 2006 we signed an amendment to our bank agreement with PNC Bank, National Association extending the termination date to June 30, 2006. This $5,000,000 facility is restricted to use for issuing letters of credit. As of May 12, 2006, we had used approximately $2,900,000 million of this facility for international letters of credit. However, we may have access to funds underan equity line agreement executed on April 7, 2006 with H.F. Lenfest, holder of the Company’s subordinated debt. Under certain conditions, we will have access to up to $15 million in cash to support operations. Given our low beginning sales backlog and ongoing difficulty in obtaining new contracts, we may need to obtain additional sources of capital in order to continue growing and operating our business. Because we have established businesses in many markets, significant fixed assets including a building, and other business assets which can be used for security, we believe that we will be able to locate such additional sources of capital, although there is no assuredness that we will be successful in this endeavor. 

We face the following challenges and business goals in order to make fiscal 2007 a successful year:

Aircrew Training Systems

 

**•**

Market        all the aeromedical products we technologically enhanced in the prior        fiscal years.

 

**•**

We        have heavily invested in enhancing functionality and product capability        of three ATS products: our centrifuge-based flight simulator, our General        Aviation Trainer (GAT), and our Gyro-IPT. Repeat sales of these state-of-the-art        simulators will allow us to recoup the costs of our non-recurring engineering        and design effort.

 

**•**

Continue        to evolve Advanced Tactical Flight Simulation (ATFS). Our challenge will        be to find funding to continue this critical development objective, either        through federal, state or local government grants or a customer order.

 

NASTAR

 

**•**

In        fiscal 2006, we began construction of the National AeroSpace Training        and Research Center (NASTAR Center). This center, set to open in January        2007, will offer a complete range of aviation training and research support        for military and civil aviation as well as space travel and tourism. The        NASTAR Center will house state of the art equipment including the ATFS-400,        GYROLAB GL-2000 Advanced Spatial Disorientation Trainer, Hypobaric Chamber        and Night Vision and Night Vision Goggle Training System. These products        represent 37 years of pioneering development and training solutions for        the most rigorous stresses encountered during high performance aircraft        flight including the effects of altitude exposure, High G exposure, spatial        disorientation and escape from a disabled aircraft. Our challenge for        fiscal 2007 is to locate outside funding to support this initiative.

Environmental

 

**•**

Our        product emphasis in this line has been the automotive industry, an industry        which has been hit with huge losses and financial pressure. We will need        to revisit products we marketed for other applications in the past to        support the overhead of this group.

ADMS

 

**•**

In        prior years, we have spent significant time and funds to develop and refine        this technology. In fiscal 2007, we need to emphasize our sales and marketing        efforts for this product group. Demonstrations, exhibiting at trade shows,        tele-marketing, visiting potential customer sites: These and other approaches        need to be explored to develop awareness for this simulation product.        An additional objective for fiscal 2007 is to facilitate customer’s        utilizing Homeland Security funds to purchase our products.

Claims/Litigation

 

**•**

Continue        to pursue outstanding commercial litigation and the Company’s claim        against the U.S. government with a goal of mediation or settlement.

ETC-PZL

 

**•**

During        fiscal 2006, ETC-PZL performed under a significant contract from L-3 Communications.        This contract was virtually complete at the end of fiscal 2006. ETC-PZL        will need to replace this revenue with other contracts, either in or outside        of Poland.

At February 24, 2006, we were involved in major commercial and government litigation which will require a significant amount of our time and effort. These activities will potentially detract from other business issues and require significant funding.

 

Liquidity

 

**•**

We do not currently have a bank facility which can be used to borrow funds for operations.

On May 19, 2006 we signed an amendment to our bank agreement with PNC Bank, National Association extending the termination date to June 30, 2006. This $5,000,000 facility is restricted to use for issuing letters of credit. As of May 12, 2006, we had used approximately $2,900,000 million of this facility for international letters of credit. On April 7, 2006, we entered into a Preferred Stock Purchase Agreement (the “Agreement”) with H. F. “Gerry” Lenfest, a Director, significant shareholder and holder of our subordinated debt. The Agreement permits us to unilaterally draw down up to $15 million over the next eighteen (18) months in exchange for shares of our newly-created Series B Cumulative Convertible Preferred Stock (“Preferred Stock”). The Preferred Stock provides for a dividend equal to six (6) percent per annum. After three (3) years, the Preferred Stockwill be convertible, at Mr. Lenfest’s request, into ETC common shares at a conversion price (the “Conversion Price”) which will be set on the day of each draw down. The Conversion Price will be equal to the closing price of the Company’s common stock on the trading day immediately preceding the day in which the draw down occurs, subject to a floor price of $4.95 per common share. Drawdowns will not be permitted on any day when the Conversion Price would be less than this floor price. On the sixth anniversary of the Agreement, any issued and outstanding Preferred Stock will be mandatorily converted into ETC common stock at each set Conversion Price. The Agreement also allows for us to redeem any outstanding Preferred Stock any time within the six (6) year term of the Agreement. The Preferred Stock will vote with the ETC common stock on an as converted basis.

In connection with the execution of the Agreement, we drew down $3 million by issuing 3,000 shares of Preferred Stock with a Conversion Price equal to $4.95 per share.

**Revenue Recognition**

We currently market our products and services primarily through our sales offices and employees. In addition, we also utilize the services of approximately 100 independent sales agents and organizations in seeking foreign orders for our products.

We generally customize our products using our proprietary software based on specifications provided by our customers. Many of these products are capital intensive and take more than one year to manufacture and deliver to the customer. In the ATS segment, we sell our Aircrew Training Devices to military and commercial airline operators both in the United States and internationally. We sell our Entertainment products to amusement parks, zoos and museums. We sell our Disaster Management Simulation products to state and local governments. In our Industrial Group, we sell our sterilizers to pharmaceutical and medical device manufacturers. We sell our Environmental systems primarily to commercial automobile manufacturers and heating, ventilation and air conditioning (HVAC) manufacturers and our Hyperbaric products to the military (mainly larger chambers) and hospitals and clinics (mainlymonoplace chambers). To a lesser degree, we provide upgrade, maintenance and repair services for our products and for products manufactured by other parties. 

We recognize revenue using three methods:

On long-term contracts over $250,000 in value and over six months in length the percentage of completion method is applied based on costs incurred as a percentage of estimated total costs. This percentage is multiplied by the total estimated revenue under a contract to calculate the amount of revenue recognized in an accounting period. Revenue recognized on uncompleted long-term contracts in excess of amounts billed to customers is reflected as a current asset. Amounts billed to customers in excess of revenue recognized on uncompleted long-term contracts are reflected as a current liability. When it is estimated that a contract will result in a loss, the entire amount of the estimated loss is accrued. The effect of revisions in cost and profit estimates for long-term contracts is reflected in the accounting period in which we learn the facts which require us to revise our cost and profitestimates. Contract progress billings are based upon contract provisions for customer advance payments, contract costs incurred, and completion of specified contract milestones. Contracts may provide for customer retainage of a portion of amounts billed until contract completion. Retainage is generally due within one year of completion of the contract. Revenue recognition under the percentage of completion method involves significant estimates. 

Revenue for contracts under $250,000, or to be completed in less than six months, and where there are no post-shipment services (such as installation and customer acceptance) is recognized on the date that the finished product is shipped to the customer. 

Revenue derived from the sale of parts and services is also recognized on the date that the finished product is shipped to the customer or when the service is completed. Revenue for service contracts is recognized ratably over the life of the contract with related material costs expensed as incurred. 

 

In accordance with accounting principles generally accepted in the United States of America, recognizing revenue on contract claims and disputes, related to customer caused delays, errors in specifications and designs, and other unanticipated causes, and for amounts in excess of contract value, is generally appropriate if it is probable that the claim will result in additional contract revenue and if the Company can reliably estimate the amount of additional contract revenue. However, revenue recorded on a contract claim cannot exceed the incurred contract costs related to that claim. Claims are subject to negotiation, arbitration and audit by the customer or governmental agency.

We have operating subsidiaries in the United Kingdom and Poland, maintain regional offices in the Middle East, Asia and Canada, and use the services of approximately 100 independent sales organizations and agents throughout the world. ETC International Corporation is a holding company established for federal income tax purposes and is not an operating subsidiary. We consider our business activities to be divided into two segments: Aircrew Training Systems (ATS) and the Industrial Group.

**Critical Accounting Policies**

The discussion and analysis of our financial condition and results of operations are based upon our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amount of assets and liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities at the date of our financial statements. Actual results may differ from these estimates under different assumptions or conditions.

Critical accounting policies are defined as those that reflect significant judgments and uncertainties, and potentially result in materially different results under different assumptions and conditions. We believe that our critical accounting policies include those described below. For a detailed discussion on the application of these and other accounting policies, see Note 1 to the Consolidated Financial Statements, Summary of Significant Accounting Policies.

Revenue Recognition on Long-Term Contracts

On long-term contracts over $250,000 in value and six months in length, the percentage of completion method is applied based on costs incurred as a percentage of estimated total costs. This percentage is multiplied by the total estimated revenue under a contract to calculate the amount of revenue recognized in an accounting period. Revenue recognized on uncompleted long-term contracts in excess of amounts billed to customers is reflected as a current asset. Amounts billed to customers in excess of revenue recognized on uncompleted long-term contracts are reflected as a current liability. When it is estimated that a contract will result in a loss, the entire amount of the loss is accrued. The effect of revisions in cost and profit estimates for long-term contracts is reflected in the accounting period in which we learn the facts which require us to revise our cost and profit estimates.Contract progress billings are based upon contract provisions for customer advance payments, contract costs incurred, and completion of specified contract milestones. Contracts may provide for customer retainage of a portion of amounts billed until contract completion. Retainage is generally due within one year of completion of the contract. Revenue recognition under the percentage of completion method involves significant estimates. 

We account for some of our largest contracts, including our contracts with the U.S. and other foreign governments, using the percentage-of-completion method. If we do not accurately estimate the total cost to be incurred on this type of contract, or if we are unsuccessful in the ultimate collection of associated contract claims, estimated gross margins may be significantly impacted or losses may need to be recognized in future periods. Any resulting reductions in margins or contract losses could be material to our results of operations and financial position.

Revenue for contracts under $250,000, or to be completed in less than six months, and where there are no post-shipment services (such as installation and customer acceptance) is recognized on the date that the finished product is shipped to the customer or the service is completed. 

Accounts Receivable

We perform ongoing credit evaluations of its customers and adjusts credit limits based on payment history and the customer’s current creditworthiness. We continuously monitor collections and payments from our customers and maintain a provision for estimated credit losses based on historical experience and any specific customer collection issues that have been identified. While our credit losses have historically been within our expectations and the provisions established, we cannot guarantee that we will continue to experience the same credit loss rates that we have in the past. Additionally, as a result of the concentration of international receivables, we cannot predict the effect, if any, which geopolitical risk and uncertainty will have on the ultimate collection of our international receivables. 

 

In accordance with accounting principles generally accepted in the United States of America, recognizing revenue on contract claims and disputes related to customer caused delays, errors in specifications and designs, and other unanticipated causes, and for amounts in excess of contract value, is generally appropriate if it is probable that the claim will result in additional contract revenue and if we can reliably estimate the amount of additional contract revenue. However, revenue recorded on a contract claim cannot exceed the incurred contract costs related to that claim. Claims are subject to negotiation, arbitration and audit by the customer or governmental agency.

**Results of Operations**

We have historically experienced significant variability in our quarterly revenue, earnings and other operating results, and our performance may fluctuate significantly in the future. 

**Fiscal 2006 versus Fiscal 2005**

 

 

 

**Summary        Table of Results**

 

 

 

 

 

 

**52        weeks ended****Feb. 24, 06**

 

**52        weeks ended****Feb. 25, 05**

 

**Variance****$**

 

**Variance****%**

 

 

 

 

 

 

 

 

 

**(amounts        in thousands)**

 

**(        ) = Unfavorable**

 

Sales:

 

 

 

 

 

 

 

 

 

 

 

 

Domestic

 

$

9,140

 

$

11,998

 

$

(2,858

)

(23.8

%)

US        Government

 

 

2,586

 

 

2,904

 

 

(318

)

(11.0

%)

International

 

 

13,343

 

 

12,912

 

 

431

 

3.3

%

 

 

 

 

 

 

Total        Sales

 

 

25,069

 

 

27,814

 

 

(2,745

)

(9.9

%)

 

 

 

 

 

 

 

 

 

 

 

 

 

Gross        Profit

 

 

5,350

 

 

6,176

 

 

(826

)

(13.4

%)

Selling,        general & administrative

 

 

9,625

 

 

12,450

 

 

2,825

 

22.7

%

Research        & development

 

 

422

 

 

856

 

 

434

 

50.7

%

Impairment        expense 

 

 

22

 

 

—

 

 

—

 

n/a

 

Operating        loss

 

 

(4,719

)

 

(7,130

)

 

2,411

 

33.8

%

Interest        expense, net

 

 

1,857

 

 

1,792

 

 

(65

)

(3.6

%)

Other        expense, net

 

 

7

 

 

308

 

 

301

 

97.7

%

Income        taxes

 

 

136

 

 

(1,117

)

 

(1,253

)

(1,021.3

%)

Minority        Interest

 

 

17

 

 

—

 

 

(17

)

n/a

 

 

 

 

 

 

 

Net        loss

 

$

(6,714

)

$

(8,113

)

$

1,399

 

17.2

%

Net        loss per common share

 

$

(0.74

)

$

(1.06

)

$

0.32

 

30.2

%

 

 

 

 

 

 

Net Loss.

The Company had a net loss of $6,714,000 or ($0.74) per share (diluted) in 2006 versus a net loss of $8,113,000 or ($1.06) per share (diluted) in fiscal 2005, an improvement of $1,399,000 or 17.2%. Operating loss was $4,719,000 versus an operating loss of $7,130,000 in 2005, an improvement of $2,411,000 or 33.8%. The improvement in operating loss resulted from lower selling, general and administrative costs and research and development costs which were only partially offset by reduced gross profit. Net loss in fiscal 2006 did not have any income tax benefit offset. (See the section on income taxes following.)

Sales.

For the fiscal year ended February 24, 2006, total sales were $25,069,000, a decrease of $2,745,000 or 9.9% from fiscal 2005. The reduction reflected a significant ($7,041,000, 26.3%) decrease in our domestic operation which was only partially offset by a correspondingly significant ($4,417,000, 577.4%) increase in our Polish subsidiary, ETC-PZL. Product line sales in ETC Southampton in the current period were down in all categories except sterilizers versus the prior period. The decrease in Aircrew Training Systems (ATS) sales in ETC Southampton ($4,327,000, 32.6%) reflected completion of a centrifuge device for Malaysia in the prior period and revenue for the aforementioned claim settlement. Hyperbaric was down reflecting, again in the prior period, the near completion of two large chambers destined for a Middle Eastern navy. Entertainment was down $1,168,000, 85.6%, reflecting reducedsales of the Wild Earth amusement ride. The increase in sterilizers ($1,522,000, 82.6%) primarily reflected increased sales for mid-size steam units.

 

Geographically, domestic sales were $9,140,000, down $2,858,000, or 23.8%, from fiscal 2005, and represented 36.5% of total sales, down from 43.1% in fiscal 2005, primarily reflecting reduced activity for hyperbaric, entertainment and PTS. U.S. government sales decreased to $2,586,000, as compared to $2,904,000 in fiscal 2005, and represented 10.3% of total sales, down from 10.4% in fiscal 2005. International sales, including those in the Company’s foreign subsidiaries, were $13,343,000, up $431,000 or 3.3%, and represented 53.2% of total sales, up from 46.4% in fiscal 2005, primarily reflecting significantly increased sales in ETC-PZL. Throughout our history, most of the sales for ATS products have been made to international customers. 

In fiscal 2006 two customers represented individually 10% or more of total sales, L-3 Communications and the Pakistan Air Force, which together generated $7,509,000 or 30% of total sales. International sales totaling at least $500,000 per country were made to customers in Pakistan, Japan and China. Fluctuations in sales to international countries from year to year primarily reflect percentage of completion revenue recognition on the level and stage of development and production on multi-year long-term contracts. Open orders for two international customers and one domestic customer represented 47.4% of our backlog at February 24, 2006. For a discussion of the additional risks associated with our international operations, see “Risks Particular to Our Business—There are certain risks inherent in our international business activities, which constitute a significant portion of ourbusiness,” in our Annual Report on Form 10-K. 

We have historically experienced significant variability in our sales performance. This reflects the existing sales backlog, product and the nature of contract (size and performance time) mix, the manufacturing cycle and amount of time to effect installation and customer acceptance, and certain factors not in our control such as customer delays and the time required to obtain U.S. Government export licenses. One or a few contract sales may account for a substantial percentage of our quarterly revenue. 

Domestic Sales.

Overall, domestic sales in fiscal 2006 were $9,140,000 as compared to $11,998,000 in fiscal 2005, a decrease of $2,858,000 or 23.8%, reflecting reduced activity for all product types except sterilizers. Most significantly, hyperbaric (down $1,828,000, 67.6%) suffered from the near completion in the prior year period on a POC revenue basis of a contract for two large chambers destined for a foreign navy. Entertainment sales were down from the prior period as fiscal 2005 reflected significant revenue for the first year orders of “Wild Earth” and “Monster Truck” amusement rides. ATS sales were down as the prior period included a sale of a Gyro-IPT. Domestic sales represented 36.5% of our total sales in fiscal 2006, down from 43.1% in fiscal 2005. Sales to the U.S. Government in fiscal 2006 were $2,586,000 as compared $2,904,000 in fiscal 2005, and represented 10.3% of totalsales in fiscal 2006 versus 10.4% in fiscal 2005. 

International Sales.

International sales in fiscal 2006, including those in our foreign subsidiaries, were $13,343,000 as compared to $12,912,000 in fiscal 2005, an increase of $431,000 or 3.3%, and represented 53.2% of total sales as compared to 46.4% in fiscal 2005. Throughout our history, most of the sales for ATS have been made to international customers. In fiscal 2006 international sales totaling at least ten percent of total international sales were made in our Polish subsidiary to L-3 Communications ($4,599,000) and to a government customer in Pakistan ($2,910,000). In fiscal 2005 international sales totaling at least ten percent of total international sales were made to government or commercial accounts in Malaysia ($3,388,000) and Egypt ($2,309,000). Fluctuations in sales to international countries from year to year primarily reflect revenue recognition on the level and stage of development andproduction on multi-year long-term contracts.

Segment Sales.

Segment Sales ($000 except for %)

 

 

 

**Aircrew Training Systems**

 

**Industrial Group**

 

**Total**

 

 

 

 

 

 

 

 

**$**

 

**%**

 

**$**

 

**%**

 

**$**

 

**%**

 

 

 

 

 

 

 

 

 

Fiscal 2006

 

15,100

 

60.2

 

9,969

 

39.8

 

25,069

 

100.0

 

Fiscal 2005

 

16,787

 

60.3

 

11,027

 

39.7

 

27,814

 

100.0

 

 

On a segment basis, sales of our ATS products, which create and monitor the physiological effects of motion (including spatial disorientation and centrifugal forces) on humans and equipment for medical, training, research and entertainment markets, were $15,100,000 in fiscal 2006, a decrease of $1,687,000, or 10.1% from fiscal 2005. Sales of these products accounted for 60.2% of our sales versus 60.3% in fiscal 2005. Sales in our other segment, the Industrial Group, which designs and produces chambers that create environments that are used for sterilization, research and medical applications, decreased $1,058,000 to $9,969,000, a decrease of 9.6%, and constituted 39.8% of our total sales compared to 39.7% in fiscal 2005. 

Significant claims outstanding at February 24, 2006 and February 25, 2005 included a claim with the U.S. Navy for a submarine decompression chamber ($3.0 million recorded). We have settled two international claims in the last two fiscal years. On February 8, 2005, we reached an agreement totaling $4.7 million on an international claim and effective February 27, 2004 we reached an agreement totaling $10.5 million on another international claim. Although recorded as a current asset in the financial statements, all remaining claim revenues may not be received in full during fiscal 2007. For a more complete discussion of outstanding claims, see “Note 3. Accounts Receivable” to our consolidated financial statements in the Annual Report to Stockholders following.

Gross Profit.

Gross profit for fiscal 2006 decreased by $826,000 or 13.4% from fiscal 2005 reflecting the sales decrease and a slight (0.9 percentage point) decrease in the gross profit rate as a percent of sales. The dollar decrease primarily resulted from the aforementioned sales reductions in our domestic operation’s ATS, hyperbaric and entertainment product areas coupled with an increase in inventory reserves. The reduction in the rate as a percent of sales primarily reflected reduced margin performance in ETC-PZL and the impact of additional reserves as the margin rates for most product areas in our domestic operation were favorable versus the prior period, most significantly double digit increases in environmental, PTS and simulation. Acting as a partial offset was increased gross profit dollars at a slightly better rate. This improvement reflected the aforementioned significant increase insales primarily for mid-sized steam units. Both PTS and simulation margin performance reflected continued additional product development costs, both to enhance functionality of existing products and to develop product extensions, which negatively impacted gross profit as these costs are primarily charged directly to the cost of sales for specific orders. 

Selling and Administrative Expenses.

Selling and administrative expenses decreased $2,825,000, or 22.7%, from fiscal 2005. The major difference during the periods was reduced legal and claim expenses. During fiscal 2005, we incurred significant legal costs and claims expenses to support an international claim which was settled on February 8, 2005. Acting as a partial offset were additional bad debt reserves. As a percentage of sales, selling and administrative expenses were 38.4% in fiscal 2006 compared to 44.8% in fiscal 2005.

Research and Development Expenses. 

Research and development expenses decreased $434,000 or 50.7% in fiscal 2006 as compared to fiscal 2005. This decrease reflected both reduced spending and the timing of reimbursement for government grants in our Turkish subsidiary under a government research award for two projects. Most of our research efforts, which were and continue to be a significant cost of our business, are included in cost of sales for applied research for specific contracts, as well as research for feasibility and technology updates. Capitalized software development costs for fiscal 2006 were $850,000 compared to $1,466,000 in fiscal 2005. Amortization of software costs, which was charged to cost of sales, was $1,224,000 and $988,000 for fiscal 2006 and fiscal 2005, respectively.

Impairment Expense.

Impairment expense resulted from the write-off of goodwill associated with our European subsidiary located in the United Kingdom. Although this subsidiary performs sales and service support for us, as of fiscal year end there were no open local contracts which would generate sufficient income to justify the carrying value of goodwill. 

Operating Loss.

Operating loss was $4,719,000 compared to an operating loss of $7,130,000 in 2005, an improvement of $2,411,000 or 33.8%. This improvement primarily reflected reduced general and administrative spending partially offset by a reduced gross profit.

On a segment basis, ATS had an operating loss of $3,555,000, an improvement of $1,213,000 or 25.4% over fiscal 2005, while the Industrial Group had an operating loss of $362,000 in fiscal 2006, a reduction in operating loss of $1,156,000 from fiscal 2005. These segment operating results were offset, in part, by unallocated corporate expenses of $780,000, a decrease of $66,000 from fiscal 2005. 

 

The decrease in operating loss for the ATS segment in fiscal 2006 reflected lower operating expenses, primarily claims and legal expenses, as both sales and corresponding gross profit were down from fiscal 2005.

The Industrial Group segment’s improved performance in fiscal 2006 reflected a higher gross margin despite the sales decrease coupled with slightly lower (down 9.8%) operating expenses.

Interest Expense. 

Interest expense (net of interest income) increased $65,000 or 3.6% in fiscal 2006 from fiscal 2005 primarily reflecting additional deferred finance charges resulting from a settlement of a lawsuit which was partially offset by reduced interest expense on lower debt including the redemption on August 1, 2005, of our long-term bonds. Interest expense includes interest on our debt, amortization of debt discount resulting from the beneficial conversion option of our subordinated debt and associated warrants issued with the debt, amortization of deferred financing costs from our previous Refinancing, and amortization of debt discount resulting from the additional warrants issued to H.F. Lenfest in exchange for his guarantee on a portion of the bank facility in August 2004.

Bank Fees.

Bank fees decreased $308,000 or 76.8% in fiscal 2006 versus fiscal 2005 reflecting significantly reduced charges for bank agreement amendments and covenant violation waivers.

Letter of Credit Fees.

Letter of credit fees increased $39,000 or 76.5% in fiscal 2006 versus fiscal 2005 reflecting additional international contracts banking charges.

Other Income, net. 

Other income, net, increased $55,000 or 38.5% in fiscal 2006 versus fiscal 2005 reflecting higher exchange gain in our Polish subsidiary, ETC-PZL.

Provision for/(Benefit from) Income Taxes.

Income tax expense in fiscal 2006 represented income taxes on pre-tax earnings in ETC-PZL and the establishment of a reserve for prior income tax benefits accrued on intercompany transactions losses. Although we reported a pre-tax consolidated operating loss during fiscal 2006, no offsetting income tax benefit and corresponding deferred tax asset was recorded, due to the uncertain nature of their ultimate realization based on past performance and the potential that sufficient taxable income may not be generated in the near future. We will recognize these benefits only as reassessment demonstrates that they are realizable. Realization is entirely dependent upon future earnings in specific tax jurisdictions. 

The fiscal 2005 tax benefit reflects the realization of tax loss carry backs resulting from the fiscal 2005 loss. During fiscal 2006, we applied for and received refunds approximating $580,000. 

Reflecting the Company’s significant losses in the current and prior fiscal years, the Company has approximately $12.6 million of federal and $17.9 million of state net loss carry forwards available to offset future income tax liabilities, expiring in 2025. However, due to the uncertain nature of their ultimate realization based on past performance, and the potential that sufficient taxable income may not be generated in the near future, we have established a full valuation allowance of the same amount against these carry forward benefits and will recognize these benefits only as reassessment demonstrates that they are realizable. Realization is entirely dependent upon future earnings in specific tax jurisdictions. While the need for this valuation allowance is subject to periodic review, if the allowance is reduced, the tax benefits of the carry forwards will be recorded in futureoperations as a reduction of our income tax expense.

 

**Fiscal 2005 versus Fiscal 2004**

 

 

 

**Summary Table of Results**

 

 

 

 

 

 

**52 weeks ended****Feb. 25, 05**

 

**52 weeks ended****Feb. 27, 04**

 

**Variance****$**

 

**Variance****%**

 

 

 

 

 

 

 

 

 

**(amounts in thousands)**

 

**( ) =Unfavorable**

 

Sales:

 

 

 

 

 

 

 

 

 

 

 

 

Domestic

 

$

11,998

 

$

8,856

 

$

3,142

 

35.5

%

US Government

 

 

2,904

 

 

1,717

 

 

1,187

 

69.1

%

International

 

 

12,912

 

 

15,422

 

 

(2,510

)

(16.3

%)

 

 

 

 

 

 

Total Sales

 

 

27,814

 

 

25,995

 

 

1,819

 

7.0

%

Gross Profit

 

 

6,176

 

 

9,943

 

 

(3,767

)

(37.9

%)

Selling, general & administrative

 

 

12,450

 

 

9,454

 

 

(2,996

)

(31.7

%)

Research & development

 

 

856

 

 

358

 

 

(498

)

(139.1

%)

Operating (loss)/income

 

 

(7,130

)

 

131

 

 

(7,261

)

(5,642.8

%)

Interest expense, net

 

 

1,792

 

 

1,606

 

 

(186

)

(11.6

%)

Other expense, net

 

 

308

 

 

130

 

 

(178

)

(136.9

%)

Income taxes

 

 

(1,117

)

 

(810

)

 

307

 

37.9

%

Minority Interest

 

 

—

 

 

(2

)

 

(2

)

(100.0

%)

 

 

 

 

 

 

Net loss

 

$

(8,113

)

$

(793

)

$

(7,320

)

(923.1

%)

Net loss per common share

 

$

(1.06

)

$

(0.11

)

$

(0.95

)

(863.6

%)

 

 

 

 

 

 

Net Loss.

The Company had a net loss of $8,113,000 or $1.06 per share (diluted) in 2005 versus a net loss of $793,000 or $.11 per share (diluted) in fiscal 2004. Operating loss was $7,130,000 versus an operating income of $131,000 in 2004. This decrease was primarily the result of reduced gross profits primarily in sterilizers, Pilot Training Systems (PTS) and simulation coupled with higher expenses in all spending categories. Acting as a partial offset were the increased sales volume and a higher income tax benefit.

Sales.

Total sales in fiscal 2005 were $27,814,000, an increase of $1,819,000 or 7.0% over 2004, representing significant increases in environmental ($2,143,000 or 102.6%), hyperbaric ($1,510,000 or 81.3%) and entertainment ($1,031,000 or 308.8%) partially offset by a significant ($2,731,000 or 59.7%) decrease in sterilizer sales. ATS sales were basically flat between the years. Environmental sales benefited from a $1,907,000 or 158.1% increase in domestic sales primarily for automotive applications. Hyperbaric equipment sales were up domestically primarily due to a large multi-place chamber sale from a domestic customer destined for a Middle Eastern navy. Entertainment sales reflected the first year orders of our “Wild Earth” and “Monster Truck” amusement rides. The decrease in sterilizer sales domestically primarily reflected reduced activity for a large Ethylene Oxide(“ETO”) project. Geographically, domestic sales were up $3,142,000 or 35.5%, and represented 43.1% of total sales, up from 34.1% in fiscal 2004, primarily reflecting the increased activity as noted above. U.S. government sales increased to $2,904,000, as compared to $1,717,000 in fiscal 2004, and represented 10.4% of total sales, up from 6.6% of total sales in fiscal 2004. International sales, including those from the Company’s foreign subsidiaries, were down $2,510,000 or 16.3%, and represented 46.5% of total sales, down from 59.3% in fiscal 2004, primarily reflecting significantly reduced sales for ATS. Throughout the Company’s history, most of the sales for Aircrew Training Systems products have been made to international customers. 

Only one customer represented 10% or more of sales in fiscal 2005, the Royal Malaysian Air Force, which generated $3,388,000 or 12.2% of total sales. In fiscal 2005, international sales totaling at least $500,000 per country were made to customers in Malaysia, the United Kingdom, Egypt, the Czech Republic, Australia, China, Italy and the United Arab Emirates. Fluctuations in sales to international countries from year to year primarily reflect percentage of completion revenue recognition on the level and stage of development and production on multi-year long-term contracts. Open orders for two international customers represented 24.2% of the Company’s backlog at February 25, 2005. For a discussion of the additional risks associated with our international operations, see “Risks Particular to Our Business—There are certain risks inherent in our international businessactivities, which constitute a significant portion of our business,” in our Annual Report on Form 10-K. 

We have historically experienced significant variability in our sales performance. This reflects the existing sales backlog, product and the nature of contract (size and performance time) mix, the manufacturing cycle and amount of time to effect installation and customer acceptance, and certain factors not in our control such as customer delays and the time required to obtain U.S. Government export licenses. One or a few contract sales may account for a substantial percentage of our quarterly revenue. 

 

Domestic Sales.

Overall, domestic sales in fiscal 2005 were $11,998,000 as compared to $8,856,000 in fiscal 2004, an increase of $3,142,000 or 35.5%, reflecting increases in all product types except sterilizers and simulation. Environmental benefited from a 258.1% increase in domestic sales primarily for automotive applications. Hyperbaric was up domestically primarily due to a large multi-place chamber sale. Entertainment sales reflected the first year orders of “Wild Earth” and “Monster Truck” amusement rides. The decrease in sterilizer sales domestically primarily reflected reduced activity for a large EtO project. Domestic sales represented 43.1% of the Company’s total sales in fiscal 2005, up from 34.1% in fiscal 2004. Sales to the U.S. Government in fiscal 2005 were $2,904,000 as compared $1,717,000 in fiscal 2004, and represented 6.4% of total sales in fiscal 2005 versus6.6% in fiscal 2004. 

International Sales.

International sales in fiscal 2005 were $12,912,000 as compared to $15,422,000 in the fiscal 2004, a decrease of $2,510,000 or 16.3%, and represented 46.4% of total sales as compared to 59.3% in fiscal 2004. Throughout our history, most of the sales for ATS have been made to international customers. In fiscal 2005 international sales totaling at least ten percent of total international sales were made to customers in Malaysia ($3,388,000) and Egypt ($2,309,000). In fiscal 2004 international sales totaling at least ten percent of total international sales were made to government or commercial accounts in Malaysia ($2,874,000) and the United Kingdom ($3,658,000). Fluctuations in sales to international countries from year to year primarily reflect revenue recognition on the level and stage of development and production on multi-year long-term contracts.

Segment Sales.

Segment Sales ($000 except for %)

 

 

 

**Aircrew Training Systems**

 

**Industrial Group**

 

**Total**

 

 

 

 

 

 

 

 

**$**

 

**%**

 

**$**

 

**%**

 

**$**

 

**%**

 

 

 

 

 

 

 

 

 

Fiscal 2005 

 

16,787

 

60.3

 

11,027

 

39.7

 

27,814

 

100.0

 

Fiscal 2004 

 

15,880

 

61.1

 

10,115

 

38.9

 

25,995

 

100.0

 

On a segment basis, sales of the Company’s ATS products, which create and monitor the physiological effects of motion (including spatial disorientation and centrifugal forces) on humans and equipment for medical, training, research and entertainment markets, were $16,787,000 in fiscal 2005, an increase of $907,000, or 5.7% over fiscal 2004. Sales of these products accounted for 60.3% of the Company’s sales compared to 61.1% in fiscal 2004. The increase in ATS product sales primarily reflected the increased activity in the entertainment area. Sales in the Company’s other segment, the Industrial Group, which designs and produces chambers that create environments that are used for sterilization, research and medical applications, increased $912,000 to $11,027,000, an increase of 9.0%, and constituted 39.7% of the Company’s total sales compared to 38.9% in fiscal 2004. 

Significant claims outstanding at February 25, 2005 included a claim with the U.S. Navy for a submarine decompression chamber ($3.0 million recorded). Significant claims outstanding at February 27, 2004 included $2.9 million for the aforementioned U.S. Navy claim and $2.6 million for an international customer. Effective February 27, 2004 the Company reached an agreement totaling $10.5 million on a prior international claim. This settlement was paid to the Company in March 2004. On February 8, 2005, the Company reached an agreement totaling $4.7 million on the remaining international claim. This settlement was paid to the Company in February 2005. Although recorded as a current asset in the financial statements, all remaining claim revenues may not be received in full during fiscal 2006. For a more complete discussion of outstanding claims, see “Note 3. Accounts Receivable” to ourconsolidated financial statements in the Annual Report to Stockholders following.

Gross Profit.

Gross profit for fiscal 2005 decreased by $3,767,000 or 37.9% from fiscal 2004 reflecting significant reductions in most product categories, most notably sterilizer, PTS and simulation. Sterilizers suffered from the aforementioned significant sales decrease and a reduction of the gross profit rate as a percent of sales on a product mix shift to smaller steam sterilizers. Although sales for PTS were basically flat between the periods, the prior period reflected higher claims settlement revenue which resulted in a higher gross profit rate as a percent of sales. Simulation sales were also basically flat between the periods although the current period included additional product development costs, both to enhance functionality of existing products and to develop product extensions, which negatively impacted gross profit as these costs are primarily charged directly to the cost of sales forspecific orders. Acting as a partial offset was an improvement in environmental gross profit rates as a percent of sales, although additional budget revisions for cost overruns primarily for international projects resulted in continued negative rates.

 

Operating Loss.

Operating loss was $7,130,000 vs. an operating income of $131,000 in 2004. This decrease was primarily the result of reduced gross profits primarily in sterilizers, Pilot Training Systems (PTS) and simulation coupled with higher expenses in all spending categories. Acting as a partial offset were the increased sales volume.

On a segment basis, ATS had an operating loss of $4,768,000, a decrease of $5,999,000 or 487.3% from fiscal 2004, while the Industrial Group had an operating loss of $1,518,000 in fiscal 2005, a decrease of $1,270,000 from fiscal 2005. These segment operating results were offset, in part, by unallocated corporate expenses of $846,000, a decrease of $6,000 from fiscal 2004. 

The decrease in operating income for the ATS segment in fiscal 2005 reflected lower gross margins, both dollar-wise and as a percent of revenues, for all product categories coupled with higher operating expenses, primarily legal and claims expenses. Acting as a partial offset was an increase in sales between the periods.

The Industrial Group segment’s decrease in operating income in fiscal 2005 reflected lower gross margins, primarily for sterilizers and parts and service, coupled with a slight increase in operating expenses. Acting as a partial offset was an improved gross profit, both dollar-wise and as a percent of revenue, for the environmental group.

Selling and Administrative Expenses.

Selling and administrative expenses increased $2,996,000 or 31.7% from fiscal 2004. During fiscal 2005 we incurred significant legal costs and claims expenses to support an international claim (which claim was settled on February 8, 2005) and the lawsuit against Disney, which is in the discovery phase. Approximately 44% of selling and administrative costs in fiscal 2005 were related to legal and accounting fees, claim costs and sales commissions. In fiscal 2004, these costs comprised approximately 30% of selling and administrative costs. As a percentage of sales, selling and administrative expenses were 44.8% in fiscal 2005 compared to 36.4% in fiscal 2004.

Research and Development Expenses. 

Research and development expenses increased $498,000 or 139.1% in fiscal 2005 as compared to fiscal 2004. This increase reflected both additional spending and the timing of reimbursement for government grants in our Turkish subsidiary under a government research award for two projects. Most of the Company’s research efforts, which were and continue to be a significant cost of its business, are included in cost of sales for applied research for specific contracts, as well as research for feasibility and technology updates. Capitalized software development costs for fiscal 2005 were $1,466,000 compared to $1,716,000 in fiscal 2004. Amortization of software costs, which was charged to cost of sales, was $988,000 and $851,000 for fiscal 2005 and fiscal 2004, respectively.

Interest Expense. 

Interest expense (net of interest income) increased $186,000 or 11.6% in fiscal 2005 from fiscal 2004 primarily reflecting increased amortization of both deferred finance expenses from the Company’s February 2003 refinancing and subordinated debt discount associated with the Company’s subordinated debt. Acting as a partial offset was reduced interest expense for the Company’s subordinated debt as the rate was temporarily reduced by two percentage points.

Bank Fees.

Bank fees increased $72,000 or 21.9% in fiscal 2005 over fiscal 2004 primarily reflecting additional charges for bank agreement covenant violation waivers.

Letter of Credit Fees.

Letter of credit fees decreased $76,000 or 59.8% in fiscal 2005 versus fiscal 2004 reflecting reduced international contracts and the timing of letter of credit fees.

Other Income/Expense, net. 

 

Other income/expense, net, decreased 182,000 or 55.8% in fiscal 2005 versus fiscal 2004 as the prior period included the proceeds of an insurance reimbursement for a stolen simulator.

(Benefit from)/Provision for Income Taxes.

The fiscal 2005 tax benefit reflects the realization of tax loss carry backs of the current year’s loss. During fiscal 2005 the Company applied for and received refunds approximating $900,000 of these carry backs; at February 25, 2005 an additional $536,000 remained as an income tax receivable reflecting the balance of these carry backs. 

Reflecting the Company’s significant losses in the current fiscal year, the Company has approximately $7.2 million of federal and $12.5 million of state net loss carry forwards available to offset future income taxes, expiring in 2025. However, due to the uncertain nature of their ultimate realization based on past performance, and the potential that sufficient taxable income may not be generated in the near future, the Company has established a full valuation allowance of the same amount against these carry forward benefits and will recognize these benefits only as reassessment demonstrates that they are realizable. Realization is entirely dependent upon future earnings in specific tax jurisdictions. While the need for this valuation allowance is subject to periodic review, if the allowance is reduced, the tax benefits of the carry forwards will be recorded in future operations as areduction of the Company’s income tax expense.

**Liquidity and Capital Resources**

During fiscal 2006, we used $7,849,000 of operating cash. This cash was used to fund the operating loss, a build-up of inventories, a reduction in customer deposits and payments to vendors (accounts payable and accrued liabilities). These requirements for cash were partially offset by cash generation from non-cash expenses (depreciation and amortization of software and deferred finance charges), collections in accounts and income tax receivables, and an increase in reserves for receivables and inventory. 

Our investing activities used $832,000 in fiscal 2006 and consisted of purchases of capital equipment ($343,000) and capitalized software ($489,000). Given the nature of our market and products, the continued development of generic control and core software and software tools is a critical objective of management.

Our financing activities generated $318,000 of cash during fiscal 2008. This primarily reflected the net cash impact of utilizing our restricted cash to redeem, on August 1, 2005, all outstanding long-term bonds. An additional smaller amount was received from the issuance of common stock. 

Refinancing

We have historically financed operations through a combination of cash generated from operations, equity offerings, subordinated borrowings and bank debt. On February 19, 2003, we refinanced its operations (the “Refinancing”). The Refinancing was effected through the issuance of subordinated, convertible notes to H.F. Lenfest and a credit agreement (the “PNC Agreement”) with PNC Bank, National Association (“PNC”). The total proceeds from this refinancing were $29,800,000. 

Bank Credit and Facility

Since inception, the PNC Agreement has had numerous amendments. As of fiscal year end, the facility total was $5,000,000 and use of this amount was restricted to the issuance of international letters of credit. This line was secured by all of our assets as well as a $5,000,000 personal guarantee by Mr. Lenfest. 

On May 19, 2006 we signed an amendment to our bank agreement with PNC Bank, National Association extending the termination date to June 30, 2006. This $5,000,000 facility is restricted to use for issuing letters of credit. 

As of May 12, 2006 we had used approximately $2,900,000 of the facility for international letters of credit.

Equity Line

On April 7, 2006, ETC entered into a Preferred Stock Purchase Agreement (the “Agreement”) with H. F. “Gerry” Lenfest, a Director, significant shareholder and holder of our subordinated debt. The Agreement permits us to unilaterally draw down up to $15 million over the next eighteen (18) months in exchange for shares of our newly-created Series B Cumulative Convertible Preferred Stock (“Preferred Stock”). The Preferred Stock provides for a dividend equal to six (6) percent per annum. After three (3) years, the Preferred Stock will be convertible, at Mr. Lenfest’s request, into ETC common shares at a conversion price (the “Conversion Price”) which will be set on the day of each draw down. The Conversion Price will be equal to the closing price of our common stock on the trading day immediately preceding the day in which the draw down occurs, subject to a floor price of $4.95 per common share. Drawdowns will not be permitted on any day when the Conversion Price would be less than this floor price. On the sixth anniversary of the Agreement, any issued and outstanding Preferred Stock will be mandatorily converted into ETC common stock at each set Conversion Price. The Agreement also allows us to redeem any outstanding Preferred Stock any time within the six (6) year term of the Agreement. The Preferred Stock will vote with the ETC common stock on an as converted basis.

 

In connection with the execution of the Agreement, we drew down $3 million by issuing 3,000 shares of Preferred Stock with a Conversion Price equal to $4.95 per share. The proceeds are being used for general corporate purposes.

Subordinated Convertible Debt 

In connection with the financing provided by PNC on February 19, 2003, we entered into a Convertible Note and Warrant Purchase Agreement with Mr. Lenfest (the “Note”), pursuant to which we issued to Mr. Lenfest (i) a senior subordinated convertible promissory note in the original principal amount of $10,000,000 (the “Note”) and (ii) warrants to purchase 803,048 shares of our common stock. Upon the occurrence of certain events, we will be obligated to issue additional warrants to Mr. Lenfest. The note accrues interest at the rate of 10% per annum (Mr. Lenfest reduced the rate to 8% on a temporary basis for the period December 1, 2004 through November 30, 2006) and matures on February 18, 2009. At our option, the quarterly interest payments may be deferred and added to the outstanding principal. The note entitles Mr. Lenfest to convertall or a portion of the outstanding principal of, and accrued and unpaid interest on, the note into shares of common stock at a conversion price of $6.05 per share. The warrants may be exercised into shares of common stock at an exercise price equal to the lesser of $4.00 per share or two-thirds of the average of the high and low sale prices of the common stock for the 25 consecutive trading days immediately preceding the date of exercise. 

Our obligations to Mr. Lenfest under the Convertible Note and Warrant Purchase Agreement are secured by a second lien on all of our assets, junior in rights to the lien in favor of PNC Bank, including all of our real property.

Prior to the consummation of the refinancing, Advanced Technology Asset Management, LLC (“ATAM”) (formerly ETC Asset Management, LLC), a shareholder and a holder of warrants to purchase 332,820 shares of our common stock, consented to the transactions contemplated under the Credit Agreement and the financing provided by Mr. Lenfest, including the below market issuance of warrants to Mr. Lenfest. As a result of its consent, ATAM waived, solely in connection with such issuance, the anti-dilution rights contained in its warrant. In exchange for ATAM’s consent, we issued to ATAM warrants to purchase an additional 105,000 shares of common stock. Except for the number of shares issuable upon exercise of the warrants, the new ATAM warrants have substantially the same terms as the warrants issued to Mr. Lenfest. In March 2004, ATAM exercised all its warrants andreceived a total of 437,820 shares of common stock. We received proceeds of $586,410 from the exercise of these warrants.

As a condition of amending the Agreement on August 24, 2004, Mr. Lenfest agreed to issue to PNC on our behalf a limited guarantee to secure up to $5,000,000 in principal amount of any letters of credit issued under the amended facility. In consideration for issuing this guarantee, Mr.Lenfest will receive a fee of 0.75% per annum of the average amount of letters of credit outstanding, payable on a quarterly basis, and received a warrant to purchase 200,000 shares of stock under the same terms and conditions as his existing warrant for 803,048 shares.

On February 14, 2005, Mr. Lenfest exercised all of his outstanding warrants and received 1,003,048 shares of common stock for approximately $3.9 million. Additionally, on February 14, 2005, Mr. Lenfest purchased 373,831 shares of common stock for approximately $2.0 million.

Under the Note, we must meet certain financial covenants including a Leverage Ratio, a Fixed Charge Ratio and a Tangible Net Worth Ratio. At February 24, 2006 we failed to meet any of these financial covenants but have obtained a waiver from Mr. Lenfest. This waiver applies to the period through February 25, 2007. Except as specified, the waiver does not constitute a modification or alteration of any other terms or conditions in the Note, or a release of any of the lender’s rights or remedies, all of which are reserved, nor does it release us or any guarantor from any duties, obligations, covenants or agreements including the consequences of any Event of Default, except as specified.

Long-Term Bonds

On March 15, 2000, we issued approximately $5,500,000 of unregistered Taxable Variable Rate Demand/Fixed Rate Revenue Bonds (Series of 2000). Net proceeds from these bonds were used to repay a $4,100,000 advance taken on our revolving credit facility and to finance construction of an addition to our main plant in Southampton, Pennsylvania. The bonds were secured by a $5,000,000 irrevocable direct pay Letter of Credit issued by PNC which was scheduled to expire on February 17, 2006 and which was secured by all assets of the Company. At February 25, 2005 the bonds were fully cash collateralized. The bonds carried a maturity

 

date of April 1, 2020, bore a variable interest rate which adjusted each week to a rate required to remarket the bonds at full principal value with a cap of 17%, and were subject to mandatory redemption of $275,000 per year for 19 years and $245,000 for the 20th year. 

On June 30, 2005 we directed the trustee for the bonds to issue a redemption notice for all of our outstanding bonds. On August 1, 2005, the Company utilized the restricted cash held by PNC to redeem all outstanding bonds. As of May 27, 2005, all deferred financing charges associated with this bond issue had been fully amortized to our statement of operations. 

Liquidity

Given our inability to borrow cash under the amended PNC Agreement and certain restrictions in the Equity Agreement, we may need to obtain additional sources of capital in order to continue growing and operating our business. This capital may be difficult to obtain and the cost of this additional capital is likely to be relatively high. However, because we have established businesses in many markets, significant fixed assets including a building, and other valuable business assets which can be used for security, we believe that we will be able to locate such additional capital and that the actions by PNC will not have a long-term material adverse effect on our business. 

We believe that existing cash balances at February 24, 2006, cash generated from operating activities as well as future availability under the Equity Agreement will be sufficient to meet its future obligations through at least February 25, 2007.

In reference to our outstanding claims with the U.S. Navy, to the extent we are unsuccessful in recovering a significant portion of recorded claim contract costs, and to the extent that significant additional legal expenses are required to bring the dispute to resolution, such events could have a material adverse effect on our liquidity and results of operations. Historically, we have had a favorable experience in that recoveries have exceeded recorded claims, including significant settlement agreements in fiscal 2003, 2004 and 2005. (See Note 3 to the Consolidated Financial Statements, Accounts Receivable).

The following table presents our contractual cash flow commitments on long-term debt and operating leases. See Notes 6 and 7 to the Consolidated Financial Statements for additional information on our long-term debt and operating leases.

 

 

 

**Payments        Due by Period (in thousands)**

 

 

 

 

 

 

**Total**

 

**Less        Than 1 Year**

 

**1-3        Years**

 

**4-5        Years**

 

**After        5 Years**

 

 

 

 

 

 

 

 

 

 

**(in        thousands)**

 

Long-term        debt, including current maturities

 

$

8,376

 

$

—

 

$

8,376

 

$

—

 

$

—

 

Operating        leases

 

 

663

 

 

128

 

 

338

 

 

197

 

 

—

 
       
Total

 

$

9,039

 

$

128

 

$

8,714

 

$

197

 

$

—

 

**•**

Long-term        debt is reported net of unamortized discount of $1,624,000 on the Company’s        subordinated debt. See “Note 7. Long-Term Obligations and Credit        Arrangements” to the Consolidated Financial Statements. 

Backlog

Our sales backlog at February 24, 2006 and February 25, 2005, for work to be performed and revenue to be recognized under written agreements after such dates, was $8,132,000 and $19,084,000 respectively. In addition, our training, maintenance and upgrade contracts backlog at February 24, 2006 and February 25, 2005, for work to be performed and revenue to be recognized after such dates under written agreements, was $1,774,000 and $2,232,000, respectively. Of the February 24, 2006 backlog, we have contracts for approximately $5,371,000 for aircrew training systems and maintenance support, including $2,243,000 for the Japanese****Defense Agency, $975,000 for the Pakistan Air Force, and $798,000 for Singapore. We expect to complete approximately 94% of the February 24, 2006 backlog prior to February 23, 2007, the end of our 2007 fiscal year. Of theFebruary 25, 2005 backlog, we completed approximately 82% by February 24, 2006.

Our order flow does not follow any seasonal pattern as we receive orders in each fiscal quarter of our fiscal year. 

**Off-Balance Sheet Arrangements**

There were no off-balance sheet arrangements during the fiscal year ended February 24, 2006 that have or are reasonably likely to have a current or future effect on our financial condition, changes in financial condition, revenues or expenses, results of operations, liquidity, capital expenditures or capital resources that is material to our investors.

 

**Recent Accounting Pronouncements**

**Accounting for Share-Based Payments**

In December 2004, the Financial Accounting Standards Board (FASB) issued FASB Statement No. 123(R), Share-Based Payments. Statement No. 123(R) requires that the costs of employee share-based payments be measured at fair value on the awards’ grant date using an option-pricing model and recognized in the financial statements over the requisite service period. Statement No. 123(R) does not change the accounting for stock ownership plans, which is subject to American Institute of Certified Public Accountants SOP 93-6, “Employer’s Accounting for Employee Stock Ownership Plans.” Statement No. 123(R) supercedes Opinion 25, Accounting for Stock Issued to Employees and its related interpretations, and eliminates the alternative to use Opinion 25’s intrinsic value method of accounting, which we currently use.

Statement 123(R) allows for two alternative transition methods. The first method is the modified prospective application whereby compensation cost for the portion of awards for which the requisite service has not yet been rendered that are outstanding as of the adoption date will be recognized over the remaining service period. The compensation cost for that portion of awards will be based on the grant-date fair value of those awards as calculated for pro forma disclosures under Statement No. 123, as originally issued. All new awards and awards that are modified, repurchased, or cancelled after the adoption date will be accounted for under the provisions of Statement No. 123(R). The second method is the modified retrospective application, which requires that we restate prior period financial statements. The modified retrospective application may be applied either to all prior periods oronly to prior interim periods in the year of adoption of Statement No. 123(R). We adopted SFAS 123(R) effective February 25, 2006 utilizing the modified prospective application described above. Adoption of this statement did not have a significant impact on our financial position, results of operations, EPS or cash flows.

**Accounting for Inventory Costs**

In November 2004, the FASB issued FASB Statement 151, Inventory Costs, an amendment of ARB No. 43, Chapter 4. While retaining the general principle that inventories are presumed to be stated at cost, Statement 151 amends ARB No. 43 to clarify that:

 

**•**

abnormal amounts of idle facilities, freight, handling costs, and spoilage should be recognized as charges of the current period.

 

**•**

allocation of fixed production overheads to inventories should be based on the normal capacity of the production facilities.

Statement 151 defines normal capacity as the production expected to be achieved over a number of periods or seasons under normal circumstances, taking into account the loss of capacity resulting from planned maintenance.

Statement 151 is effective for inventory costs incurred during fiscal years beginning after June 15, 2005 and should be applied prospectively. Early application is permitted. The Company is not able at this time to determine what impact, if any, adoption of Statement 151 will have on the results of operations.

 

**Market for the Registrant’s Common Stock, Related Security Holder Matters and Issuer Purchases of Equity Securities**

Our common stock is traded on the American Stock Exchange under the symbol “ETC.” As of May 11, 2006, the Company had 281 shareholders of record. 

The following table sets forth the calendar quarter ranges of high and low sale prices for shares of the common stock for the periods indicated. 

 

 

 

**Sale Prices**

 

 

 

 

 

 

**High**

 

**Low**

 

 

 

 

 

**Fiscal 2006**

 

 

 

 

 

 

 

First Quarter

 

$

6.05

 

$

4.70

 

Second Quarter

 

 

5.85

 

 

4.85

 

Third Quarter

 

 

5.52

 

 

4.89

 

Fourth Quarter

 

 

5.22

 

 

4.75

 

**Fiscal 2005**

 

 

 

 

 

 

 

First Quarter

 

$

10.05

 

$

7.25

 

Second Quarter

 

 

8.24

 

 

6.47

 

Third Quarter

 

 

7.95

 

 

6.18

 

Fourth Quarter

 

 

6.80

 

 

5.10

 

On May 11, 2006, the closing price of our common stock was $5.00. We have never paid any cash dividends on our common stock and do not anticipate that any cash dividends will be declared or paid in the foreseeable future. Our current credit facilities prohibit the payment of any dividends without the lender’s prior written consent. 

**Equity Compensation Plan Information**

 

**Plan Category**

 

**Number of securities to be****issued upon exercise of****outstanding options,****warrants and rights**

 

**Weighted-average exercise****price of outstanding options,****warrants and rights**

 

**Number of securities****remaining available****for future issuance under****equity compensation plans****(excluding securities****reflected in column (a))**

 

 

 

 

 

 

 

**(a)**

 

**(b)**

 

**(c)**

 

**Equity compensation plans approved by security holders**

 

327,939

 

$

6.77

 

1,243,521

 

**Equity compensation plans not approved by security holders**

 

—

 

 

N/A

 

204,629

 

 

 

 

 

 

**Total**

 

327,939

 

$

6.77

 

1,448,150

 

 

 

 

 

 

The following plans have not been approved by our shareholders:

Employee Stock Purchase Plan

We have an Employee Stock Purchase Plan which was adopted by the Board of Directors on November 3, 1987. All employees meeting service requirements, except officers, directors and 10% stockholders, are eligible to voluntarily purchase common stock through payroll deductions up to 10% of salary. We make a matching contribution equal to 20% of the employee’s contribution.

 

Report of Independent Registered Public Accounting Firm

Board of Directors and Shareholders Environmental Tectonics Corporation

     We have audited the accompanying consolidated balance sheets of Environmental Tectonics Corporation and Subsidiaries as of February 24, 2006 and February 25, 2005 and the related consolidated statements of operations, changes in stockholders’ equity, and cash flows for each of the three fiscal years in the period ended February 24, 2006.  These consolidated financial statements are the responsibility of the Company’s management.  Our responsibility is to express an opinion on these consolidated financial statements based on our audits.

     We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States).  Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the consolidated financial statements are free of material misstatement.  The Company is not required to have, nor were we engaged to perform an audit of its internal control over financial reporting.  Our audit included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company’s internal control over financialreporting.  Accordingly, we express no such opinion.  An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the consolidated financial statements, assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall consolidated financial statement presentation.  We believe that our audits provide a reasonable basis for our opinion.

     In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of Environmental Tectonics Corporation and Subsidiaries as of February 24, 2006 and February 25, 2005, and the consolidated results of their operations and their cash flows for the each of the three fiscal years in the period ended February 24, 2006, in conformity with accounting principles generally accepted in the United States of America.

     We have also audited the accompanying Schedule II of Environmental Tectonics Corporation and Subsidiaries as of February 24, 2006 and February 25, 2005 and for each of the three fiscal years in the period ended February 24, 2006.  In our opinion, this schedule presents fairly, in all material respects, the information required to be set forth herein.

/s/ Grant Thornton LLPPhiladelphia, PennsylvaniaMay 15, 2006

 

**Environmental Tectonics Corporation**

**Consolidated Balance Sheets (amounts in thousands, except share information)**

 

 

 

**February 24, 2006**

 

**February 25, 2005**

 

 

 

 

 

**ASSETS**

 

 

 

 

 

 

 

Cash and cash equivalents

 

$

3,566

 

$

12,041

 

Restricted cash

 

 

16

 

 

4,680

 

Accounts receivable, net

 

 

6,021

 

 

8,018

 

Costs and estimated earnings in excess of billings on uncompleted long-term contracts

 

 

3,480

 

 

3,333

 

Inventories

 

 

10,734

 

 

7,928

 

Deferred tax asset

 

 

1,558

 

 

1,786

 

Prepaid expenses and other current assets

 

 

564

 

 

1,668

 

 

 

 

 

Total current assets

 

 

25,939

 

 

39,454

 

Property, plant and equipment, net

 

 

4,392

 

 

4,331

 

Software development costs, net of accumulated amortization of $9,882 and $8,658 in 2006 and 2005, respectively

 

 

2,832

 

 

3,567

 

Goodwill, net 

 

 

455

 

 

477

 

Other assets, net

 

 

49

 

 

80

 

 

 

 

 

Total assets

 

$

33,667

 

$

47,909

 

 

 

 

 

**LIABILITIES**

 

 

 

 

 

 

 

Current portion of long-term obligations

 

$

—

 

$

275

 

Accounts payable – trade

 

 

2,111

 

 

2,893

 

Billings in excess of costs and estimated earnings on uncompleted long-term contracts

 

 

1,118

 

 

1,533

 

Customer deposits

 

 

877

 

 

2,247

 

Other accrued liabilities

 

 

2,013

 

 

2,688

 

 

 

 

 

Total current liabilities

 

 

6,119

 

 

9,636

 

 

 

 

 

Long-term obligations, less current portion:

 

 

 

 

 

 

 

Credit facility payable to banks

 

 

—

 

 

—

 

Long term bonds

 

 

—

 

 

4,095

 

Subordinated convertible debt

 

 

8,376

 

 

7,992

 

 

 

 

 

 

 

 

8,376

 

 

12,087

 

 

 

 

 

Deferred tax liability

 

 

1,558

 

 

1,786

 

 

 

 

 

Total liabilities

 

 

16,053

 

 

23,509

 

 

 

 

 

Commitments and contingencies

 

 

—

 

 

—

 

Minority interest

 

 

61

 

 

45

 

**STOCKHOLDERS’ EQUITY**

 

 

 

 

 

 

 

Common stock - authorized 20,000,000 shares, $.05 par value; 9,024,804 and 9,019,376 shares issued and outstanding in 2006 and 2005, respectively

 

 

451

 

 

450

 

Capital contributed in excess of par value of common stock

 

 

16,584

 

 

16,561

 

Accumulated other comprehensive loss

 

 

(249

)

 

(137

)

Retained earnings

 

 

767

 

 

7,481

 

 

 

 

 

Total stockholders’ equity

 

 

17,553

 

 

24,355

 

 

 

 

 

Total liabilities and stockholders’ equity

 

$

33,667

 

$

47,909

 

 

 

 

 

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

 

**Environmental Tectonics Corporation**

**Consolidated Statements of Operations (amounts in thousands, except share information)**

 

 

 

**52 Weeks Ended****February 24, 2006**

 

**52 Weeks Ended****February 25, 2005**

 

**52 Weeks Ended****February 27, 2004**

 

 

 

 

 

 

Net sales

 

$

25,069

 

$

27,814

 

$

25,995

 

Cost of goods sold

 

 

19,719

 

 

21,638

 

 

16,052

 

 

 

 

 

 

Gross profit

 

 

5,350

 

 

6,176

 

 

9,943

 

 

 

 

 

 

Operating expenses:

 

 

 

 

 

 

 

 

 

 

Selling and administrative

 

 

9,625

 

 

12,450

 

 

9,454

 

Research and development

 

 

422

 

 

856

 

 

358

 

Impairment expense

 

 

22

 

 

—

 

 

—

 

 

 

 

 

 

 

 

 

10,069

 

 

13,306

 

 

9,812

 

 

 

 

 

 

Operating (loss) income

 

 

(4,719

)

 

(7,130

)

 

131

 

 

 

 

 

 

Other expenses:

 

 

 

 

 

 

 

 

 

 

Interest expense, net

 

 

1,857

 

 

1,791

 

 

1,606

 

Bank fees

 

 

93

 

 

401

 

 

329

 

Letter of credit fees

 

 

90

 

 

51

 

 

127

 

Other, net

 

 

(198

)

 

(143

)

 

(326

)

 

 

 

 

 

 

 

 

1,842

 

 

2,100

 

 

1,736

 

 

 

 

 

 

Loss before provision for (benefit from) income taxes and minority interest

 

 

(6,561

)

 

(9,230

)

 

(1,605

)

Provision for (benefit from) income taxes

 

 

136

 

 

(1,117

)

 

(810

)

 

 

 

 

 

Loss before minority interest

 

 

(6,697

)

 

(8,113

)

 

(795

)

Income (loss) attributable to minority interest

 

 

17

 

 

—

 

 

(2

)

 

 

 

 

 

Net loss

 

$

(6,714

)

$

(8,113

)

$

(793

)

 

 

 

 

 

Per share information:

 

 

 

 

 

 

 

 

 

 

Loss per common share:

 

 

 

 

 

 

 

 

 

 

Basic

 

$

(0.74

)

$

(1.06

)

$

(.11

)

Diluted

 

$

(0.74

)

$

(1.06

)

$

(.11

)

Weighted average common shares:

 

 

 

 

 

 

 

 

 

 

Basic

 

 

9,021,000

 

 

7,656,000

 

 

7,163,000

 

Diluted

 

 

9,021,000

 

 

7,656,000

 

 

7,163,000

 

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

 

**Environmental Tectonics Corporation**

**Consolidated Statements of Changes in Stockholders’ Equity (amounts in thousands, except share information)**

**For the years ended February 24, 2006, February 25, 2005 and February 27, 2004**

 

 

 
   
 

**Capital****contributed in****excess of par****value of****common stock**

 

**Accumulated****other****comprehensive****loss**

 

**Retained****earnings**

 

**Total****stockholders’****equity**

 
   
**Common        Stock**

**Shares**

 

**Amount**

 

 

 

 

 

 

 

 

**Balance,        February 28, 2003**

 

7,157,239

 

 

358

 

 

9,331

 

 

(169

)

 

16,387

 

 

25,907

 

Net        loss for the year

 

—

 

 

—

 

 

—

 

 

—

 

 

(793

)

 

(793

)

Foreign        currency translation adjustment

 

 

 

 

 

 

 

 

 

 

(160

)

 

—

 

 

(160

)

 

 

 

 

 

 

 

 

 

 

 

 

 

Total        comprehensive loss

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

(953

)

Exercise        of employee stock options

 

19,313

 

 

1

 

 

99

 

 

—

 

 

—

 

 

100

 

 

 

 

 

 

 

 

 

**Balance,        February 27, 2004**

 

7,176,552

 

 

359

 

 

9,430

 

 

(329

)

 

15,594

 

 

25,054

 

Net        loss for the year

 

—

 

 

—

 

 

—

 

 

—

 

 

(8,113

)

 

(8,113

)

Foreign        currency translation adjustment

 

 

 

 

 

 

 

 

 

 

192

 

 

—

 

 

192

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Total        comprehensive loss

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

(7,921

)

Value        of warrants issued in connection with issuance of guarantee

 

 

 

 

 

 

 

571

 

 

 

 

 

 

 

 

571

 

Exercise        of warrants

 

1,440,868

 

 

72

 

 

4,406

 

 

 

 

 

 

 

 

4,478

 

Issuance        of common stock

 

373,831

 

 

19

 

 

1,981

 

 

 

 

 

 

 

 

2,000

 

Exercise        of employee stock options and Board of Director’s compensation

 

28,125

 

 

—

 

 

173

 

 

—

 

 

—

 

 

173

 

 

 

 

 

 

 

 

 

**Balance,        February 25, 2005**

 

9,019,376

 

 

450

 

 

16,561

 

 

(137

)

 

7,481

 

 

24,355

 

Net        loss for the year

 

 

 

 

 

 

 

 

 

 

 

 

 

(6,714

)

 

(6,714

)

Foreign        currency translation adjustment

 

 

 

 

 

 

 

 

 

 

(112

)

 

 

 

 

(112

)

 

 

 

 

 

 

 

 

Total        comprehensive loss

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

(6,826

)

Exercise        of employee stock options and Board of Director’s compensation

 

5,428

 

 

1

 

 

23

 

 

—

 

 

—

 

 

24

 

 

 

 

 

 

 

 

 

**Balance,        February 24, 2006**

 

9,024,804

 

$

451

 

$

16,584

 

$

        (249

)

$

767

 

$

17,553

 

 

 

 

 

 

 

 

 

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

 

**Environmental Tectonics Corporation**

**Consolidated Statements of Cash Flows (amounts in thousands)**

 

 

 

**52 Weeks Ended****February 24,****2006**

 

**52 Weeks Ended****February 25,****2005**

 

**52 Weeks Ended****February 27,****2004**

 

 

 

 

 

 

Cash flows from operating activities:

 

 

 

 

 

 

 

 

 

 

Net loss

 

$

(6,714

)

$

(8,113

)

$

(793

)

Adjustments to reconcile net loss to net cash (used in) provided by operating activities

 

 

 

 

 

 

 

 

 

 

Depreciation and amortization

 

 

2,570

 

 

2,414

 

 

1,847

 

Accretion of debt discount

 

 

384

 

 

326

 

 

275

 

Increase (decrease) in allowance for accounts receivable and inventory

 

 

780

 

 

274

 

 

(149

)

(Income) loss attributable to minority interest

 

 

17

 

 

—

 

 

(2

)

Impairment expense

 

 

22

 

 

—

 

 

—

 

Deferred income taxes (benefit) 

 

 

—

 

 

(165

)

 

(168

)

Changes in operating assets and liabilities:

 

 

 

 

 

 

 

 

 

 

(Increase) decrease in assets

 

 

 

 

 

 

 

 

 

 

Accounts receivable

 

 

1,518

 

 

11,108

 

 

(2,973

)

Costs and estimated earnings in excess of billings on uncompleted long-term contracts

 

 

(147

)

 

2,000

 

 

108

 

Inventories

 

 

(3,468

)

 

1,554

 

 

(1,763

)

Prepaid expenses and other current assets

 

 

480

 

 

318

 

 

(720

)

Impairment expense

 

 

22

 

 

—

 

 

—

 

Other assets

 

 

(48

)

 

—

 

 

(103

)

Increase (decrease) in liabilities:

 

 

 

 

 

 

 

 

 

 

Accounts payable

 

 

(782

)

 

462

 

 

653

 

Billings in excess of costs and estimated earnings on uncompleted long-term contracts

 

 

(415

)

 

588

 

 

(518

)

Customer deposits

 

 

(1,370

)

 

(1,410

)

 

657

 

Accrued income taxes

 

 

76

 

 

266

 

 

(247

)

Other accrued liabilities

 

 

(774

)

 

101

 

 

1,032

 

 

 

 

 

 

Net cash (used in) provided by operating activities

 

 

(7,849

)

 

9,723

 

 

(2,864

)

 

 

 

 

 

Cash flows from investing activities:

 

 

 

 

 

 

 

 

 

 

Acquisition of equipment

 

 

(343

)

 

(285

)

 

(475

)

Software development costs 

 

 

(489

)

 

(1,272

)

 

(1,220

)

 

 

 

 

 

Net cash used in investing activities

 

 

(832

)

 

(1,557

)

 

(1,695

)

 

 

 

 

 

Cash flows from financing activities:

 

 

 

 

 

 

 

 

 

 

Borrowings under credit facility

 

 

—

 

 

—

 

 

2,514

 

Payments under credit facility

 

 

—

 

 

(30

)

 

(3,084

)

Payments on long-term bonds

 

 

(4,370

)

 

(275

)

 

(275

)

Decrease (increase) in restricted cash

 

 

4,664

 

 

(3,896

)

 

2,405

 

Net (decrease) increase in other long-term obligations

 

 

—

 

 

(133

)

 

120

 

Issuance of common stock/warrants

 

 

24

 

 

6,651

 

 

100

 

 

 

  |