**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**WASHINGTON,D.C. 20549**

----

FORM 10-K

**AnnualReport Pursuant to Section 13 or 15(d) of the Securities Exchange Actof 1934For the fiscal year ended January 31, 2005Commission file number 0-16438**

----

NATIONAL TECHNICAL SYSTEMS, INC.

(Exact name of company asspecified in its charter)
| **CALIFORNIA**                                                   | ** ** | **95-4134955**                        |
|------------------------------------------------------------------|------------|---------------------------------------|
| (State or other  jurisdiction of  incorporation or organization) |       | (I.R.S. Employer  Identification No.) |
| **24007 Ventura Boulevard, Suite 200  Calabasas, CA**       | ** ** | **91302**                             |
| (Address of  principal executive offices)                        |       | (Zip Code)                            |

 

**(818) 591-0776**

(Registrant’s telephonenumber, including area code)

**Securities registeredpursuant to Section 12(b) of the Act:**

None

**Securities registeredpursuant to Section 12(g) of the Act:**

Common Stock—No Par Value

(Titleof class)

----

Indicate by check mark whetherthe registrant (1) has filed all reports required to be filed by Section 13or 15(d) of the Securities Exchange Act of 1934 during the preceding 12months (or for such shorter period that the registrant was required to filesuch reports), and (2) has been subject to such filing requirements forthe past 90 days.  YES  x  NO  o

Indicate by check mark ifdisclosure of delinquent filers pursuant to Item 405 of Regulation S-K is notcontained herein, and will not be contained, to the best of registrant’sknowledge, in definitive proxy or information statements incorporated byreference in Part III of this Form 10-K or any amendment to this Form 10-K.  x

Indicate by check markwhether the registrant is an accelerated filer (as defined in Rule 12b-2of the Act).  YES  o  NO  x

State the aggregate marketvalue of the voting and non-voting common equity held by non-affiliatescomputed by reference to the price at which the common equity was last sold, orthe average bid and asked price of such common equity, as of the last businessday of the registrant’s most recently completed second fiscal quarter—$23,833,000(as of July 31, 2004).

The number of shares ofregistrant’s Common Stock outstanding on April 15, 2005 was 9,051,427.

**DocumentsIncorporated by Reference**

Portions of the Proxy Statement of the Company for theAnnual Meeting of Shareholders to be held on June 28, 2005, areincorporated by reference into Part III of this report.

 

----

**NATIONAL TECHNICALSYSTEMS, INC.FORM 10-KFISCAL YEAR ENDED JANUARY 31, 2005**
| PART I   |     |
|---------------|----------|
|          | ITEM 1.  | BUSINESS. | 3 |
|          | ITEM 2.  | PROPERTIES. | 11 |
|          | ITEM 3.  | LEGAL PROCEEDINGS. | 12 |
|          | ITEM 4.  | SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS. | 12 |
| PART II  |     |
|          | ITEM 5.  | MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED SHAREHOLDER MATTERS AND  ISSUER PURCHASES OF EQUITY SECURITIES. | 12 |
|          | ITEM 6.  | SELECTED  CONSOLIDATED FINANCIAL DATA. | 13 |
|          | ITEM 7.  | MANAGEMENT’S  DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS. | 14 |
|          | ITEM 8.  | CONSOLIDATED  FINANCIAL STATEMENT AND SUPPLEMENTARY  DATA. | 27 |
|          | ITEM 9.  | CHANGES IN  AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURES. | 49 |
|          | ITEM 9A. | CONTROLS  AND PROCEDURES. | 49 |
|          | ITEM 9B. | OTHER  INFORMATION. | 49 |
| PART III |     |
|          | ITEM 10. | DIRECTORS  AND EXECUTIVE OFFICERS OF THE COMPANY. | 50 |
|          | ITEM 11. | EXECUTIVE  COMPENSATION. | 50 |
|          | ITEM 12. | SECURITY  OWNERSHIP OF CERTAIN BENEFICIAL OWNERS, MANAGEMENT AND RELATED STOCKHOLDER  MATTERS. | 50 |
|          | ITEM 13. | CERTAIN  RELATIONSHIPS AND RELATED TRANSACTIONS. | 51 |
|          | ITEM 14. | PRINCIPAL  ACCOUNTANT FEES AND SERVICES. | 51 |
| PART IV  |     |
|          | ITEM 15. | EXHIBITS  AND FINANCIAL STATEMENT SCHEDULES. | 51 |
| SIGNATURES    | 53       |

 

This report containscertain statements that may be deemed “forward-looking statements” within themeaning of the Private Securities Litigation Reform Act of 1995. Suchstatements can be identified by the use of forward-looking words such as “may”,“will”, “expect”, “anticipate”, “intend”, “estimate”, “continue”, “behave” andsimilar words. Financial information contained herein, to the extent it ispredictive of financial condition and results of operations that would haveoccurred on the basis of certain stated assumptions may also be characterizedas forward-looking statements. Although forward-looking statements are based onassumptions made, and information believed by management to be reasonable, noassurance can be given that such statements will prove to be correct. Suchstatements are subject to certain risks, uncertainties and assumptions. Actualoutcomes are dependent upon National Technical Systems, Inc.’s (“NTS” or “theCompany”) successful performance of internal plans, ability to effectivelyintegrate acquired companies, customer changes in short range and long rangeplans, competition in the Company’s services areas and pricing, continuedacceptance of new services, performance issues with key customers, and generaleconomic risks and uncertainties.

2

----

**NATIONAL TECHNICAL SYSTEMS, INC.Annual Report (Form 10-K)For Year Ended January 31, 2005**

**PART I**

**ITEM1**.   *BUSINESS*.

**A.   *General.***

National Technical Systems, Inc. (“NTS” or the “Company”)is a diversified services company that supplies technical services andsolutions to a variety of industries including aerospace, defense,transportation, electronics, power, computers and telecommunications. NTS,utilizing its various testing facilities, staffing solutions and certificationservices, helps its customers sell their products in world markets. NTS isaccredited by numerous national and international technical organizations whichallow the Company to have its test data accepted in most countries.

NTS operates in two segments: “Engineering andEvaluation” and “Technical Solutions.” The business of the Company is conductedby a number of operating units, each with its own organization. The managementof each operating unit has responsibility for its operations and for achievingsales and profit goals. The executive staff from the Company’s corporateheadquarters maintains overall supervision, coordination and financial control.

The Company’s principalexecutive offices are located at 24007 Ventura Boulevard, Suite 200,Calabasas, CA 91302 (telephone: 818-591-0776).

**B.   *History.***

The Company was founded in 1961, incorporated in 1968in California and subsequently was reincorporated in Delaware in 1987 to serveas a holding company for its subsidiaries. On January 31, 1997, theCompany was merged into a newly formed California corporation named NationalTechnical Systems, Inc. On October 30, 1998, the Company completedits merger with XXCAL, Inc. and acquisition of XXCAL Limited (together, “XXCAL”).In fiscal 2003, the Company acquired the U.S. assets and business of the InformationTechnology Staffing Division of TRS Staffing Solutions, a New Hampshirecorporation and wholly-owned subsidiary of Fluor Corporation. In fiscal 2004,the Company acquired substantially all of the assets and business of DTIHoldings, LLC, doing business as Dynamic Testing (“DTI”). In fiscal 2005, theCompany acquired substantially all of the fixed assets of a Canadian TestLaboratory involved in the testing of telecommunication equipment, located inCalgary, Alberta, Canada.

Unless indicated otherwise,the term “Company” or “NTS” includes NTS—Technical Systems and its wholly ownedsubsidiaries, Acton Environmental Testing Corporation, a Massachusettscorporation, Approved Engineering Test Laboratories, Inc., a Californiacorporation, ETCR Inc., a California corporation, XXCAL, Inc., aCalifornia corporation, National Quality Assurance, Inc. (NQA, Inc.),a 50% owned Massachusetts corporation, NTS Europe, GmbH, a German Corporation,XXCAL, Japan K.K., a 50% owned Japanese Corporation and AETL Testing, Inc.,a Canadian Corporation.

**C.   *Financial Information About Industry Segments.***

See Note 10 toConsolidated Financial Statements in Item 8.

3

----

**D.   *Description of Business.***

**(i)   *Engineering & Evaluation (“E&E”)***

*Overview*

The E&E segment of NTS is one of the largestindependent conformity assessment and management system registrationorganizations in the U. S., with facilities throughout the country and atlocations in Japan, Germany and Canada. E&E provides highly trainedtechnical personnel for product certification, product safety testing and productevaluation to allow customers to sell their products in world markets. Inaddition, E&E performs management registration and certification servicesto ISO related standards. NTS is accredited by numerous national andinternational technical organizations which allows the Company to have its testdata accepted in most countries.

E&E revenues represented 59%, 56% and 64% of NTStotal revenues in fiscal years 2005, 2004 and 2003, respectively. E&Eserves high technology companies, predominantly in the defense, aerospace,transportation, telecommunications, electronics, power and computers markets.E&E has approximately 4,000 customers. Approximately 2,500 of thosecustomers use the Company’s services on a regular basis. The ability for thesecustomers to offer certification activities and provide test data that isaccepted in world markets is critical for manufactured products acceptance.

E&E can create environments that simulate changesin temperature, altitude, moisture, and virtually every other environmentalfactor that might affect product performance. In addition, E&E hasdeveloped expertise and specialized skills over decades of testing in multipleindustries as well as investing heavily in equipment including a full spectrumof EMI chambers, data acquisition systems, seismic simulators, environmentalsimulation equipment, environmental chambers, fire chambers and mixed gas flowchambers.

E&E also providesinternational registration of companies requiring quality and environmentalmanagement system registration. With the increasing globalization of industryand trade, the international community has developed, and continually updates,management systems standards to insure that products manufactured conform toacceptable standards when sold anywhere in the world. These standards,developed by the International Standards Organization (ISO), and applicable todifferent industries, such as aerospace, transportation and environmental, areused to provide compliance by manufacturers certified by third partyregistrants. Third party registrants are accredited by industry regulatedaccreditation bodies. E&E is certified to provide third party registrationsto a variety of industries. To accomplish certification, E&E audits acompany’s quality policy, quality system documentation and quality recordsthrough on-site assessment. Such assessment determines whether thequality system is defined, documented, deployed and consistently implemented,and that the required documentation and records are current and available. Ifthe customer’s quality system is verified to conform to the requirements of theapplicable ISO standard, National Quality Assurance “NQA”, USA issues acertificate describing the scope of the customer’s quality system, which hasbeen certified. The customer is then entitled to display the Registrar’s markon advertising and stationery as evidence that it has achieved ISOregistration. Thereafter, E&E performs periodic follow-upsurveillance assessments to assure that the customer remains in compliance. Inthe Quality Audit field, the Company is the tenth largest ISO 9000 assessmentcompany in the United States as reported by “Quality Systems Update.” TheCompany believes that NQA USA has approximately 7% of the total registrationmarket.

*E&E Markets*

E&E serves customers primarily in the defense,aerospace, transportation, telecommunications, electronics, power and computersmarkets. Defense and aerospace markets account for approximately 57% of E&Erevenues.

4

----

**Defense.  **E&E plays anactive role in numerous U.S. defense related programs, performing almost everytype of test discipline, including complete functionality and performance,reliability, safety, life prediction, structural/mechanical, fluids related,material science, vibration, shock, climatic exposure, radiation, acousticnoise and electromagnetic interference, compatibility and Lithium BatteryTesting. Examples of items tested include components for small fixed wingaircraft, helicopters, submarines, aircraft carriers and other naval ships, tanksand other tracked vehicles, trucks and road vehicles, command/control/communication systems, electronics, weapon systems and complete ordnance andmunitions testing. E&E has facilities that are specially constructed tohandle munitions and hazardous materials where routine testing includesvibration and cook-off of explosive materials, ballistics tests and hydraulicburst tests. E&E performs virtually any ballistics related testing, up to155 mm rounds. E&E’s data acquisition systems are capable of collecting1,000,000 data points and 22,000 photos per second. Additional instrumentationincludes Doppler radar, 35 mm still cameras, digital recording, data loggersand real-time color and IR video. E&E’s customers in this market includevarious major defense contractors, as well as the U.S. Department of Defense(DOD) and other government entities.

**Aerospace.**   E&Eperforms almost all tests required on manned and unmanned flights and hasparticipated in virtually every major space project since the inception of themanned exploration of space. E&E offers complete acceleration testfacilities, G-tables and centrifuges with diameters ranging from one foot to102 feet, with weight capacities from a few grams to 20,000 pounds. In climatictesting, E&E utilizes hundreds of test chambers to simulate nearly anyenvironment: temperature, humidity, altitude, rain, salt spray, sand and dust,sunshine, explosive atmosphere or any combination. E&E designs and buildscustom facilities and advanced instrumentation and data acquisition systems tosupport all types of flow testing for gases, liquids and cryogenics. E&E iscapable of performing structural testing and analysis, and, in particular,structural loading of large objects such as complete airframes. It alsoperforms fatigue testing of critical hardware items such as engine blades andhigh-pressure fluid components and also offers customers a way to minimizetheir personnel, testing time and costs by utilizing the Company’s on-siteclimatic, dynamic, safety and electromagnetic compatibility test capabilities.E&E also has anechoic and reverberant chambers that are used for acousticemission measurements or high­ level noise exposure.

**Transportation.**   E&Eperforms fluids and gas tests that measure the flow of fuels, propellants,chemicals, water, steam and others. It also provides tests that measuretemperature, thermal shock, leak detection and efficiencies in objects likefilters and other components. Other more specialized tests include cryogenicprotocols for elements such as liquid nitrogen, liquid hydrogen and liquidoxygen, as well as liquefied natural gas. E&E also performs dynamometertesting to measure the performance and power output of engines drive trains orany other rotating machinery. It also performs HALT/HASS (Highly acceleratedStress Screen). These tests combine extremes of temperature, rapid temperaturechange, and multi-axis vibration to rapidly expose design weaknesses andprocess flaws. NTS is accredited to ISO 17025 through the AmericanAccreditation of Laboratories Association (A2LA). This accreditation allows NTSautomotive test reports to be accepted in the USA and internationally.

**Telecommunications.**   E&Eprovides certification and evaluation of a broad array of telecommunicationsequipment and systems for major manufacturers. E&E’s services are performedin accordance with the Network Equipment Building Systems specifications (NEBS)and fiber optics General Requirements (GRs) as required by thetelecommunications industry. E&E is also an independent test laboratorycertified by Verizon, which allows manufacturers to use E&E as a marketchannel for products tested at Original Equipment Manufacturers’ (“OEM”)facilities that are being developed for use in the regional bell operatingcompanies’ (“RBOCs”) central offices. Currently, E&E is approved by Verizonfor certifying passive fiber optics components (PFOC) to sixteen GeneralRequirements. E&E performs product certification for the major RBOCs. TheCompany has been approved as an Independent Test laboratory (ITL) by the RBOCsto test and certify central office equipment developed by manufactures to theNEBS specifications. The Company is currently providing this service atlaboratories in California, 

5

----

Massachusetts, Texas,Calgary and Germany. The Company has been approved as an (ITL) to offer acomplete suite of passive fiber components certifications and DigitalSubscriber Line (DSL) certification. This service currently is being providedat laboratories in California. As service providers gradually convert to VOIParchitectures, interoperability becomes critical to ensure a seamlesstransition to next generation networks. E&E recently acquired a networkarchitecture and interoperability laboratory in Northern California to extendthe E&E’s service offering to handle the anticipated demand forinteroperability testing and FTTP (fiber to the premise) deployment as carriersbegin to deploy voice, video, and broadband offerings over FTTP passive fibernetworks.

**Electronics.**   As aNationally Recognized Test Lab (NRTL), NTS provides electrical safety productcertification, in the US, EU, Canada, Australia and many other countries. NTShas been designated as a Conformity Assessment Body (CAB) for the EMC directivethrough the US-EU Mutual Recognition Agreement (MRA). NTS conducts EMC testingand provides customers with certification in the US and many other countries,particularly, Japan, Taiwan, Europe and Australia.

**Power.  **E&E conducts avariety of tests relevant to the ongoing operations, safety and maintenance ofnuclear facilities. These tests include mechanical aging, normal or accidentradiation exposure, reliability simulation, evaluation, thermal aging, analysis,vacuum testing, leak detection, Nuclear Steam Accident, Loss Of CoolingAccident (LOCA), High Expansion Line Break (HELB) to 600F/300psig E&E alsoperforms seismic simulation tests up to 100,000 force-lbs, single axis,dependent and independent biaxial systems, vibration aging and fatigue studies,up to 45,000 force-lbs. E&E is active in industry task groups thatinfluence the latest dedication guidelines. Through direct participation,E&E is involved in resolution of key NRC questions such as selection and verificationof critical characteristics, sampling, traceability, surveys, and like-for-likereplacements. E&E engineers and technicians involved in the dedicationprocess meet ANSI N45.2.6 Level II Inspectors guidelines. The Company’sdedication programs utilize the best approach for each specified product.E&E also provides technical evaluations, critical characteristics andsafety class determinations and focuses on solving plant needs in areas such asmotor rewinds, governor rebuilds, modifications or design of replacementsystems and instrumentation panel and component design.

**Computer.  **E&Eperforms computer product testing, providing compatibility, stress/performance,functionality and compliance testing services for hardware, software,telecommunications and networking companies worldwide. E&E performssoftware game and game console testing including Microsoft Xbox compliancetesting. E&E is the exclusive test center for Microsoft Xbox third partyperipheral compatibility testing. E&E also provides testing for Data OverCable Service Interface Specification (DOCSIS) cable modem, DSL modem, Set TopBox, Residential Gateway and Fiber Optics GR-253 testing, interoperabilitytesting of broadband and network products such as cable modems, DSL modems,Cable Modem Termination System (CMTS), Digital Subscriber Line AccessMultiplexer (DSLAM), Routers, HomePNA Gateways, Wireless Wi-Fi devices, MediaServers, Fiber Optics SONET switches, and systems network testing. E&E alsoperforms USB certification testing and was able to successfully transfer itsUSB technology to Japan this year.

*Industry Overview*

Manufacturers oftenfulfill their evaluation testing on an outsourcing basis in order to reducecosts, avoid large capital expenditures, save time and remain competitive. Dueto regulations requiring third party certification, manufacturers use thirdparty certifiers to position their products for sale in world markets. NTS iscurrently geographically located to serve customers at locations close to theirplants and NTS facilities are capable of providing the complete conformityassessment activity necessary to reduce product-handling costs and serve as amarket gateway for manufacturers to sell products globally. E&E provides a “onestop” resource and single source responsibility for all conformity assessmentrequirements in the several markets it serves.

6

----

*Geographiclocations*

In the United States,E&E’s facilities are located in Acton and Boxborough, **Massachusetts,**Tinton Falls, **New Jersey**, Rustburg, **Virginia,** Camden, **Arkansas**,Detroit, **Michigan**, Plano, **Texas,**Tempe, **Arizona**, Los Angeles, Fullerton, CulverCity and Santa Clarita, **California** andinternationally, in Yokohama, **Japan**, Calgary,**Canada** and Munich, **Germany**.

*Business Strategy*

To meet its customers’ needs, E&E continuouslyupgrades its facilities, equipment, accreditations, partnerships and personnelin line with market requirements. In addition, E&E’s continuing expansioninto new areas of technology will require it to invest in equipment needed toadequately service customers’ needs. Through close consultation with itsexisting and prospective customers to ascertain their needs for the future,E&E is able to better determine its equipment needs. In fiscal 2005, theCompany made additional investments to enhance its munitions and ordnanceservice offering in Camden, Arkansas and expand its telecommunications testingequipment in Culver City, California.

The Company continues to use the Balanced ScorecardSystem as a tool to assist management in achieving its strategy: “Navigate aShort Course to Global Markets.” NTS is using this system to maximizeefficiency in all aspects of its business.

**(ii)*   TechnicalSolutions (“TS”)***

*Overview*

The Technical Solutions segment of NTS is a nationalprovider of technical experts for engineering and information technologyservices. In a strategic initiative developed in 2003, the Company has migratedthe service offerings to more closely align its TS services with the E&Egroup and thus capitalize on NTS’s long history of testing and engineeringservices. As a valuable and respected resource, TS has developed long-termrelationships with its clients for whom it supports with engineering and ITpersonnel.

TS’s operational and technical knowledge allows it toeffectively identify and screen highly skilled technical professionals. TSprovides the technical resources its clients need to continually evaluateprocesses and products and meet the demands of compressing development cyclesand critical time-to-market requirements. TS places its professionals onassignment at a client site to perform specific tasks and projects for apredetermined period of time. At the completion of an assignment, customersmay, under some previously negotiated terms and circumstances, directly hire anindividual. TS also supports its clients in sourcing and identifying candidatesfor direct hire. Its comprehensive registry of engineering and informationtechnology professionals allows it to provide fully screened and qualifiedindividuals very rapidly. TS can support its customers’ needs, whether the needis to manage a project or an entire test facility; provide a team to take aproduct from design to production, or staff a project on a temporary basis.

Most of TS customers arelocated in the United States. In August 2004, TS opened a test facility inHo Chi Min City, Vietnam. This office is now operational and provides a lowcost testing alternative. TS’s capabilities in Vietnam consist of a variety ofservices including system compatibility and integration test for computersoftware and hardware testing for business PC platforms for Windows and Linuxoperating systems.

*Industry Overview*

Over the years, businesses have become increasinglydependent on the use of contingent and consulting technical staff to manageoperations more efficiently and to remain competitive. Important internalfunctions, ranging from financial reporting to production and inventorymanagement, are automated through the use of applications software. Inaddition, as information systems have become less 

7

----

expensive, more powerfuland easier to use, the number and level of employees who use and depend uponthese systems have significantly increased.

The increase in the use of sophisticated informationtechnologies has occurred at the same time that economic factors have led toreductions in corporate workforces and a return by businesses to a focus ontheir core competencies. Faced with the challenge of implementing and operatingmore complex information systems without enlarging their corporate staffs,businesses are using technical staffing companies to supplement theiroperations.

Utilizing outsidetechnical resources and consultants allows a company’s management to focus oncore business operations, affords greater flexibility and increases a company’sability to adapt to and keep pace with rapidly changing and increasinglycomplex technologies. It also provides access to specialized technical skillson a project-by-project basis which better matches staffing levels to currentneeds, converts fixed labor costs into variable costs, and reduces the cost ofrecruiting, training and terminating employees as evolving technologies requirenew programming skills.

*Technical SolutionsServices*

Technical Solutions services comprise primarily of IT,Engineering and Managed Services.

**IT.**   In fiscal 2005,information technology services represented **38%**of the overall TS revenues. This area remained weak due to competition fromoff-shore companies and is expected to remain weak throughout fiscal 2006.

**Engineering.**   In fiscal2005, engineering services represented **29%** of theoverall TS revenues. Most of the growth in this skill area came from thesuccessful cross selling between TS and E&E’s account executives. TS hasenhanced the quality of its resources to support these skill areas and anticipatesadditional growth in fiscal 2006.

**Managed Services**.   ManagedServices provided to clients on site represented **27%**of the overall TS revenues. This area is part of TS’s core growth strategy. TScontinues to leverage its technical competencies to provide clients withon-site program management to augment their test and staff augmentationactivities. Managed Services supports both Engineering and IT service areas.

Other revenues representedthe remaining **6%** of the overall TS revenues.Other revenues include administrative and professional skills as well as revenuesfrom the Vietnam facility. TS anticipates significant growth from its Vietnamfacility in fiscal 2006.

*Geographiclocations*

In the United States,Technical Solutions offices are located in Culver City, San Mateo, **California**, Salem, **New Hampshire**,Boston, **Massachusetts**, Columbia, **South Carolina,**Austin,**Texas** andTroy, **Michigan.** Internationally, TS has anoffice in Ho Chi Min City, **Vietnam.**TS’sheadquarters are located in Culver City, California. In addition, TS hasprogram managers on client sites in Woodland Hills and San Diego, California,and Houston, Texas.

*Business Strategy*

As demand for IT personnel remains unpredictable,Technical Solutions is migrating its service offering to enhance its margins byfocusing on NTS’s core competencies and cross selling its technical services tothe approximately 2,500 customers serviced by the E&E segment. The focuscontinues on the development of niche technical expertise and to enhance TS’sdatabase through its strong sourcing capabilities. TS continues to source,quality and develop a database of engineering and technical skills that supportthe technical requirements of customers. TS also continues to enhanceoperational efficiencies in 

8

----

its accounting, sales,recruiting and marketing operations. TS differentiates itself from itscompetitors by using NTS’ testing, engineering and compliance capabilities tomaximize its customers’ return on human assets.

TS’s strategy is to continue efforts to improverevenue and profit by rigorously focusing on industries, markets and customersthat have the strongest long-term growth opportunities, increasing productivityby improving its internal processes, diversifying the range of services itprovides to its existing customers, attracting and retaining qualifiedtechnical consultants from a variety of sources, both national andinternational, and pursuing strategic relationships with non-competingorganizations. TS has a company-wide sales force that promotes cross-sellingand lead generation between existing customers of one business unit to another.TS strives to provide its customers with technical personnel with the rightskills, at the right time, for the right duration and at a cost that is lowerthan what its customers could otherwise achieve.

**(iii)*   Competition***

*Engineering &Evaluation*

E&E competes with a small number of largeconformity assessment organizations within each of the markets it serves. Italso competes with a large number of small niche oriented test laboratories. Ithas competitive advantages in several areas which include the following: (1) abilityto service customers at locations close to its customers; (2) ability toprovide complete conformity assessment activities at a single location, whichreduces product-handling cost for the customers and enhances timeliness ofservice; (3) diverse and technically competent employees; and (4) accreditationsthat allow the E&E segment’s test data to be accepted worldwide. Customerscan use the Company’s complete services, including quality registration, toposition their products for the world markets.

In the aerospace anddefense markets, the main competition for independent laboratories is thecustomers’ own laboratories. In addition, in certain unique technical servicesareas, E&E competes with government laboratories.

*Technical Solutions*

Potential customers for services offered by theTechnical Solutions segment are from a broad base of high technology andmanufacturing companies. Competition in this segment comes from a large numberof public and privately held companies. The Company competes in this segmentprimarily on the basis of its niche position, price and quality service.

The Company’s engineering and testing services givesthe Company an advantage over most staffing companies, which merely providepersonnel as contractors, by understanding the technical challenges facing itscustomers and providing the expertise to meet those challenges.

Many large companies are increasingly using primarysuppliers to fulfill their staffing needs. Technical Solutions competes withand, in certain relationships, teams with other major staffing companies inactively pursuing primary supplier relationships with large customers in itsexisting markets. These relationships can have a significant impact on TechnicalSolutions’ revenues and operating profits.

**(iv)   *Backlog***

TheCompany’s backlog at January 31, 2005 and 2004 was as follows
| ** **                         | ** ** | **2005**   | ** ** | **2004**   | ** ** |
|------------------------------------|------------|------------|------------|------------|------------|
| Engineering &  Evaluation |       | $          | 25,513,000 |       | $          | 19,885,000 |   |
| Technical  Solutions               |       | 10,472,000 |       | 12,073,000 |       |
| Total Backlog                      |       | $          | 35,985,000 |       | $          | 31,958,000 |   |

 

9

----

The Company estimates that approximately 85% of thebacklog at January 31, 2005 will be completed by January 31, 2006.

**(v)   *General***

a.    *Service Mark.*

The Company has registered its service marks “NTS” and“XXCAL” with the U.S. Patent and Trademark Office.

b.    *Environmental Effect.*

We are subject to various federal, state, local andforeign government requirements regulating the discharge of materials into theenvironment or otherwise relating to the protection of the environment. It isour policy to comply with these requirements, and we believe that, as a generalmatter, our policies, practices and procedures are properly designed to preventunreasonable risk of environmental damage, and of resulting financialliability, in connection with our business. Some risk of environmental damageis, however, inherent in some of our operations, as it is with other companiesengaged in similar businesses.

The Company’s Santa Clarita, California test facilityis located immediately adjacent to property owned by a third party which hasbeen the subject of extensive environmental remediation. The adjacent site has,in the past, been used for manufacture of solid rocket fuel propellants,munitions and flares that contained perchlorate, a hazardous substance. Soilsamples taken from the Santa Clarita property in 2003 were inconclusive as tothe existence of perchlorate. Recent heavy rainfall resulted in a run off fromthe adjacent site onto the Santa Clarita property. The Company arranged forsamples to be taken of the surface water from the adjacent site and earlyindications are that the tested water contains high levels of perchlorate.Further testing is being conducted. No cleanup activity has been conducted onthe Santa Clarita property and it has yet to be determined whether remediationwill be required at the site, or, if required, the extent and cost of anyremediation. The Company believes that in the event it does incur remediationcosts that it will have valid claims for indemnification against the owner ofthe adjacent site and the municipality that built a road between the adjacentsite and the Santa Clarita property that appears to have contributed to therunoff from the adjacent site. Recovery of such remediation costs may, however,be uncertain and may involve significant litigation expense.

c.    *Seasonal Effect.*

The Company experiences nomaterial seasonal effects.

*Employees.*

TheCompany employed 877 individuals at January 31, 2005 and 889 at January 31,2004, as follows:
| ** **                         | ** ** | **2005** | ** ** | **2004** | ** ** |
|------------------------------------|------------|----------|------------|----------|------------|
| Engineering &  Evaluation |       | 408      |       | 387      |       |
| Technical  Solutions *             |       | 463      |       | 486      |       |
| Corporate  Administration          |       | 16       |       | 16       |       |
| Total                              |       | 887      |       | 889      |       |

----

*                    TheTechnical Solutions total for 2005 includes 318 contract employees and 98subcontractors, as compared to 325 contract employees and 110 subcontractorsfor 2004. None of the employees of the Company are represented by a union. TheCompany considers its relationship with its employees to be good.

10

----

**ITEM2**.   *PROPERTIES.*

**A.*   Operations.  ***The Company owns/leases and operates the followingproperties:
| **State**                   | ** ** | ** **      | ** ** | **Owned Properties  City** | ** ** | **Buildings  (Sq.Ft.)** | ** ** | **Land  (Acres)** | ** ** |
|-----------------------------|------------|-----------------|------------|---------------------------------|------------|-------------------------|------------|-------------------|------------|
| California                  |       | Fullerton       |       | 36,000                          |       |                    | 3          |              |       |
|                        |       | Santa Clarita * |       | 60,000                          |       |                    | 145        |              |       |
| Massachusetts               |       | Acton           |       | 30,000                          |       |                    | 5          |              |       |
|                        |       | Boxborough      |       | 25,000                          |       |                    | 4          |              |       |
| Texas                       |       | Plano           |       | 1,000                           |       |                    | 1          |              |       |
| Virginia                    |       | Fredericksburg  |       | 66,000                          |       |                    | 87         |              |       |
| **Total  owned properties** |       | **218,000**     |       |                            | **245**    |                    |       |

 
| **State**      | ** ** | **Leased Properties  City** | ** ** | **Buildings  (Sq.Ft.)** | ** ** | **Land  (Acres)** | ** ** |
|----------------|------------|-----------------------------|------------|-------------------------|------------|-------------------|------------|
| Arizona        |       | Tempe                       |       | 17,000                  |       |              | n/a        |   |   |
| Arkansas       |       | Camden                      |       | 22,000                  |       |              | 216        |   |   |
| California     |       | Calabasas                   |       | 7,000                   |       |              | n/a        |   |   |
|           |       | City of Commerce            |       | 2,000                   |       |              | n/a        |   |   |
|           |       | Culver City                 |       | 24,000                  |       |              | n/a        |   |   |
|           |       | Fullerton                   |       | 20,000                  |       |              | n/a        |   |   |
|           |       | Los Angeles (LAX)           |       | 16,000                  |       |              | 2          |   |   |
|           |       | San Mateo                   |       | 2,000                   |       |              | n/a        |   |   |
| Georgia        |       | Norcross                    |       | 1,000                   |       |              | n/a        |   |   |
| Massachusetts  |       | Boston                      |       | 1,000                   |       |              | n/a        |   |   |
| Michigan       |       | Detroit                     |       | 65,000                  |       |              | n/a        |   |   |
|           |       | Troy                        |       | 1,000                   |       |              | n/a        |   |   |
| New Jersey     |       | Tinton Falls                |       | 17,000                  |       |              | n/a        |   |   |
| New Hampshire  |       | Salem                       |       | 3,000                   |       |              | n/a        |   |   |
| South Carolina |       | Columbia                    |       | 3,000                   |       |              | n/a        |   |   |
| Texas          |       | Austin                      |       | 2,000                   |       |              | n/a        |   |   |
|           |       | Plano                       |       | 24,000                  |       |              | n/a        |   |   |
| Virginia       |       | Rustburg                    |       | 8,000                   |       |              | 33         |   |   |

 
| **International**            | ** ** | ** **    | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
|------------------------------|------------|---------------|------------|------------|------------|------------|------------|------------|------------|
| Germany                      |       | Munich        |       | 300        |       |       | n/a        |       |       |
| Japan                        |       | Yokohama      |       | 500        |       |       | n/a        |       |       |
| Vietnam                      |       | Software City |       | 1,000      |       |       | n/a        |       |       |
| **Total  leased properties** |       | **236,800**   |       |       | **251**    |       |       |

----

*      Pleaserefer to “Environmental Matters” in Item 7a

**B.*  ***TheCompany believes that the space occupied by all of its operations is adequatefor its current and near-term requirements. Should additional space berequired, the Company does not anticipate problems in securing such additionalspace.

**C.   *Investment Properties.***

In fiscal 2003, theCompany sold its four acres of unimproved real property in Escondido,California and received net proceeds of $544,000 which was approximately thesame amount recorded as cost on its books. In addition, the Company owns, for investmentpurposes, a condominium located in Palm Desert, California. In fiscal year2005, the Company sold the old condominium and purchased a new 

11

----

condominium,which is also located in Palm Desert. The Company recorded a gain ofapproximately $158,000 from the sale of the old condominium. This property isrented to the public and, on occasion, used by employees of the Company.

**ITEM3**.   *LEGAL PROCEEDINGS.*

The Company is, from timeto time, the subject of claims and suits arising out of matters occurring duringthe operation of the Company’s business. In the opinion of management, nopending claims or suits would materially affect the financial position or theresults of the operations of the Company. (See Note 9 to the ConsolidatedFinancial Statements in Item 8.)

**ITEM4**.   *SUBMISSION OF MATTERS TO AVOTE OF SECURITY HOLDERS.*

Not applicable.

**PART II**

**ITEM 5**.   *MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED SHAREHOLDER MATTERS ANDISSUER PURCHASES OF EQUITY SECURITIES.*

**A.   *Principal Market.***

TheCompany’s common stock is traded in the over-the-counter bulletin board andquoted on the Nasdaq National Market under the symbol “NTSC”. The range of highand low quotations as reported by the Nasdaq Intra Dealer Quotation System foreach of the quarters of the fiscal years ended January 31, 2005 and 2004is presented below:
| ** **     | ** ** | **2005** | ** ** | **2004** | ** ** |
|----------------|------------|----------|------------|----------|------------|
| ** **     | ** ** | **High** | ** ** | **Low**  | ** ** | **High** | ** ** | **Low** | ** ** |
| First Quarter  |       | $        | 5.75       |     | $          | 4.25 |   | $ | 4.06 |   | $ | 2.15 |   |
| Second Quarter |       | 5.17     |       | 3.47     |       | 4.79 |   | 3.65 |   |
| Third Quarter  |       | 5.24     |       | 3.39     |       | 4.70 |   | 3.92 |   |
| Fourth Quarter |       | 5.37     |       | 4.18     |       | 6.48 |   | 4.11 |   |
|                |            |          |            |          |            |  |  |  |  |  |  |  |  |

 

**B.   *Holders of Common Stock.***

As of the close ofbusiness on April 15, 2005, there were 808 holders of record of the Company’scommon stock. The number of holders of record is based on the actual number ofholders registered on the books of the Company’s transfer agent and does notreflect holders of shares in “street name” or persons, partnerships,associations, corporations or other entities identified in security positionlistings maintained by depository trust companies.

**C.   *Dividends.***

The Company’s Board ofDirectors announced the discontinuance of the Company’s policy of payingordinary and special dividends on February 6, 2001. The Company does notanticipate paying dividends in the foreseeable future.

**D.   *Equity Compensation Plans.***

Refer to Item 12 below forinformation regarding the Company’s equity compensation plans.

12

----

**ITEM 6.**                *SELECTED CONSOLIDATED FINANCIAL DATA.*

Thefollowing selected consolidated financial data are derived from and should beread in conjunction with the Company’s consolidated financial statements andrelated notes set forth in Item 8 below.
| ** **                                                                        | ** ** | **Year Ended January 31,**                            | ** ** |
|-----------------------------------------------------------------------------------|------------|----------------------------------------------------------------------|------------|
| ** **                                                                        | ** ** | **2005**                                                             | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** | **2001** | ** ** |
| ** **                                                                        | ** ** | **(in thousands except per share amounts)** | ** ** |
| **INCOME  STATEMENT DATA:**                                                       |       |                                                                 |       |   |   |   |   |   |   |   |   |
| Net revenues                                                                      |       | $                                                                    | 106,997    |   | $ | 104,648 |   | $ | 85,837 |   | $ | 75,315 |   | $ | 85,613 |   |
| Gross profit                                                                      |       | 24,170                                                               |       | 22,710 |   | 19,176 |   | 17,957 |   | 21,784 |   |
| Operating income                                                                  |       | 3,521                                                                |       | 3,215 |   | 2,764 |   | 2,028 |   | 3,199 |   |
| Interest expense,  net                                                            |       | 1,091                                                                |       | 1,097 |   | 1,226 |   | 1,740 |   | 2,050 |   |
| Income from  continuing operations before income taxes and minority interest |       | 2,592                                                                |       | 2,310 |   | 1,549 |   | 432 |   | 823 |   |
| Income taxes                                                                      |       | 910                                                                  |       | 1,056 |   | 676 |   | 188 |   | 353 |   |
| Income from  continuing operations before minority interest                       |       | 1,682                                                                |       | 1,254 |   | 873 |   | 244 |   | 470 |   |
| Minority interest                                                                 |       | —                                                               |       | 39 |   | (15 | ) | (31 | ) | (39 | ) |
| Net income                                                                        |       | $                                                                    | 1,682      |   | $ | 1,293 |   | $ | 858 |   | $ | 213 |   | $ | 431 |   |
| Net income per  common share:                                                     |       |                                                                 |       |   |   |   |   |   |   |   |   |
| Basic                                                                             |       | $                                                                    | 0.19       |   | $ | 0.15 |   | $ | 0.10 |   | $ | 0.03 |   | $ | 0.05 |   |
| Diluted                                                                           |       | $                                                                    | 0.18       |   | $ | 0.14 |   | $ | 0.10 |   | $ | 0.03 |   | $ | 0.05 |   |
| Weighted average  common shares outstanding                                       |       | 8,946                                                                |       | 8,640 |   | 8,656 |   | 8,468 |   | 8,497 |   |
| Dilutive effect  of stock options                                                 |       | 620                                                                  |       | 566 |   | 39 |   | 9 |   | 135 |   |
| Weighted average  common shares outstanding, assuming dilution                    |       | 9,566                                                                |       | 9,206 |   | 8,695 |   | 8,477 |   | 8,632 |   |
| Cash dividends  paid per common share                                             |       | $                                                                    | —     |   | $ | — |   | $ | — |   | $ | — |   | $ | 0.04 |   |
| **BALANCE SHEET DATA:**                                                           |       |                                                                 |       |   |   |   |   |   |   |   |   |
| Working capital                                                                   |       | $                                                                    | 20,481     |   | $ | 18,550 |   | $ | 19,292 |   | $ | 16,579 |   | $ | 15,751 |   |
| Total assets                                                                      |       | 66,669                                                               |       | 63,632 |   | 61,334 |   | 56,781 |   | 61,321 |   |
| Long-term debt,  excluding current installments                                   |       | 20,557                                                               |       | 19,754 |   | 19,863 |   | 18,657 |   | 19,782 |   |
| Shareholders’ equity                                                         |       | 30,951                                                               |       | 28,832 |   | 26,417 |   | 25,477 |   | 25,127 |   |

----

*                    Per share datamay not always summate because each figure is independently calculated.

13

----

**ITEM 7.**                *MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTSOF OPERATIONS*.

Except for the historicalinformation contained herein, statements in the following section are forward-lookingstatements within the meaning of the Private Securities Litigation Reform Actof 1995. Such statements can be identified by the use of forward-lookingwords such as “may”, “will”, “expect”, “anticipate”, “intend”, “estimate”, “continue”,“behave” and similar words. Financial information contained herein, to theextent it is predictive of financial condition and results of operations thatwould have occurred on the basis of certain stated assumptions, may also becharacterized as forward-looking statements. Although forward-lookingstatements are based on assumptions made, and information believed bymanagement to be reasonable, no assurance can be given that such statementswill prove to be correct. Such statements are subject to certain risks,uncertainties and assumptions. Actual outcomes are dependent upon NationalTechnical Systems, Inc.’s (“NTS” or the “Company”) successful performanceof internal plans, ability to effectively integrate acquired companies,customer changes in short range and long range plans, competition in theCompany’s services areas and pricing, continued acceptance of new services,performance issues with key customers, and general economic risks anduncertainties.

***OVERVIEW***

NTS, founded in 1961, is a diversified servicescompany that supplies testing outsourcing services and conformity assessmentand personnel to businesses in a variety of industries including aerospace,defense, transportation, power products, electronics, computers andtelecommunications. Through its wide range of testing facilities, staffingsolutions and certification services, NTS provides its customers a marketchannel to sell their products globally and enhance their overallcompetitiveness. NTS is accredited by numerous national and internationaltechnical organizations which allow the Company to have its test data acceptedin most countries.

NTS operates in two segments: “Engineering &Evaluation” and “Technical Solutions”.  The business of the Company is conducted by anumber of operating units, each with its own operational organization. Eachsegment is under the direction of its own executive and management team. Inmaking financial and operational decisions, NTS relies on an internalmanagement reporting process that provides revenue and operating costinformation for each of its operating units. Revenues and booking activitiesare also tracked by market type.

In fiscal 2005, NTS improved its top-line andbottom-line results. Revenues increased 2.2% to approximately $107 million andnet income increased 30% to approximately $1.7 million. Diluted earnings pershare increased to 18 cents per share in fiscal 2005 compared to 14 cents pershare in fiscal 2004.

Summaryof Revenues for fiscal years 2005 and 2004:
| ** **                                  | ** ** | **FY 2005** | ** **  | **FY 2004** | ** ** | **Change**  | ** ** | **% Change** | ** ** |
|---------------------------------------------|------------|------------------|-------------|------------------|------------|-------------|------------|-------------------|------------|
| Engineering &  Evaluation Revenues |       | $                | 63,236,000  |             | $          | 58,410,000  |       | $                 | 4,826,000  |   |   | 8.30 | % |   |
| Technical  Solutions Revenues               |       | 43,761,000       |        | 46,238,000       |       | (2,477,000  | )          |              | -5.40      | % |   |
| Total Revenues                              |       | $                | 106,997,000 |             | $          | 104,648,000 |       | $                 | 2,349,000  |   |   | 2.20 | % |   |

 

Revenues in the Engineering & Evaluationsegment are generated from physical testing services which include simulationof harsh environments such as high/low temperature, shock, vibration, seismicand electromagnetic interference, and functional testing which requiresequipment such as switches, routers, servers and high bandwidth access to theInternet to subject telecommunication equipment to a full spectrum ofperformance type testing. Revenues in this segment also include registrationservices which perform quality management audits to ISO 9000, quality trainingand laboratory accreditation.

14

----

Revenues in the Technical Solutions segment aregenerated from a variety of staffing and workforce management services andsolutions, including contract services, temporary and full time placements tomeet its customers’ information technology (“IT”) such as help-desk analystsand managers, relational database administrators and developers, applicationand systems programmers, configuration and project managers and engineeringservice needs.

On July 30, 2004, AETL Testing Inc. (a Canadiancorporation), a wholly-owned subsidiary of the Company (“AETL”), acquiredsubstantially all of the fixed assets of a Canadian test laboratory involved inthe testing of telecommunications equipment, located in Calgary, Alberta,Canada, for a total purchase price of $1,033,000. By making this acquisition,the Company intends to expand its presence to Canada and increase itsopportunities in the testing of telecommunication equipment. The results ofoperations of the acquired business are included in the accompanying consolidatedstatement of operations from August 1, 2004 to January 31, 2005.

In January of 2004, NTS acquired substantiallyall of the assets and business of DTI Holdings, LLC, doing business as DynamicTesting (“DTI”). DTI provides large-scale shock and vibration testing servicesthat are used to qualify mission critical equipment such as navigation,communication and guidance weapons installed on U.S. Navy combatants.

On October 14, 2002, NTS acquired the U.S. assetsand business of the Information Technology Staffing Division of TRS StaffingSolutions, a subsidiary of Fluor Corporation. The acquired business had sixoffices serving approximately 50 customers with more than 330 IT professionals.

Summaryof Cash Flows for fiscal years 2005 and 2004:
| ** **                                                              | ** ** | **FY 2005** | ** ** | **FY 2004** | ** ** | **Change** | ** ** | **% Change** | ** ** |
|-------------------------------------------------------------------------|------------|------------------|------------|------------------|------------|------------|------------|-------------------|------------|
| Net cash provided  by operating activities                              |       | $                | 6,590,000  |             | $          | 8,804,000  |       | $                 | (2,214,000 | ) |   | -25.1 | % |   |
| Net cash used for  investing activities                                 |       | (6,089,000       | )          | (7,470,000       | )          | 1,381,000  |       |              | 18.5       | % |   |
| Net cash provided  by (used in) financing activities                    |       | 1,026,000        |       | (232,000         | )          | 1,258,000  |       |              | 542.2      | % |   |
| Effect of  exchange rate changes on cash and cash equivalents |       | 13,000           |       | —           |       | 13,000     |       |              | n/a        |   |   |
| Net increase in cash                                                    |       | $                | 1,540,000  |             | $          | 1,102,000  |       | $                 | 438,000    |   |   | 39.7 | % |   |

 

The decrease in net cashprovided by operating activities was primarily due to the increase in accountspayable payments in FY 2005 and the effect of the change in accounts receivablebalance in FY 2005 compared to the change in FY 2004, partially offset by theincrease in net income. A portion of this increase was used to pay for capitalexpenditures and to complete the acquisition of the Canadian test laboratory. Cash used infinancing activities increased as borrowings on current and long-term debt werehigher than repayments. Overall, net cash increased by $1,540,000 in fiscal2005, compared to an increase of$1,102,000 in fiscal 2004.

**Critical Accounting Policies**

The consolidated financial statements of the Companyare prepared in accordance with U.S. Generally accepted accounting principles,which require the Company to make estimates and assumptions (see Note 1 to theconsolidated financial statements in Item 8). Estimatesare based on historical experience and on various other assumptions that arebelieved to be reasonable under the circumstances, the results of which formthe basis for making judgments about the carrying value of assets andliabilities that are not readily apparent from other sources.

15

----

Management believes thefollowing critical accounting policies, among others, affect its moresignificant judgments and estimates used in the preparation of its consolidatedfinancial statements.

*Revenue Recognition*

Revenues are derived from development, qualificationand production testing and engineering services for commercial products, spacesystems and military equipment of all types. The Company also providestechnical staffing, qualification of safety related systems and components, andISO 9000 certification services.

Revenues from fixed pricetesting contracts are recorded upon completion of contracts, which aregenerally short-term, or identifiable contractual tasks. At the time theCompany enters into a contract that includes multiple tasks, the Companyestimates the amount of actual labor and other costs that will be required tocomplete each task based on historical experience. Milestone payments relatedto each task are then established in the contract, which provide for a normalprofit margin relative to similar testing performed for similar taskshistorically. Revenues relative to each task and from contracts which are timeand materials based are recorded as effort is expended (hours charged). Billingsin excess of amounts earned are deferred. Any anticipated losses on contractsare charged to income when identified.  To the extent management does not accuratelyforecast the level of effort required to complete a contract, or individualtasks within a contract, and the Company is unable to negotiate additionalbillings with a customer for cost over-runs, the Company may incur losses onindividual contracts. All selling, general and administrative costs are treatedas period costs and expensed as incurred.

*Allowance forUncollectible Receivables*

The Company maintains anallowance for doubtful accounts for estimated losses resulting from theinability of customers to make required payments. The Company uses acombination of write-off history, aging analysis and any specific knowntroubled accounts in determining the allowance. If the financial condition ofcustomers were to deteriorate, resulting in an impairment of their ability tomake payments, additional allowances could be required.

*Inventories*

Inventories consist ofaccumulated costs including direct labor, material and overhead applicable touncompleted contracts and are stated at actual cost, which is not in excess ofestimated net realizable value. Such inventories for each contract are reviewedon a monthly basis over the life of the contract and additional write-downs ofinventories are made if there are insufficient revenues remaining on thecontract.

*Deferred IncomeTaxes*

At January 31, 2005,the Company has recorded a net deferred tax asset of $1,529,000. The Companyhas recorded this asset as it believes that it is more likely than not that theCompany will be able to realize the asset through reduction of future taxableincome. The Company bases this belief upon the levels of taxable incomehistorically generated by its business, as well as projections of futuretaxable income. If future levels of taxable income are not consistent with itsexpectations, the Company may be required to record a valuation allowance,which could reduce its net income by a material amount.

*Recently IssuedAccounting Standards*

In December 2004, the FASB issued SFAS No. 123R,“Share-Based Payment,” which requires companies to recognize in the statementof operations all share-based payments to employees, including grants ofemployee stock options, based on their fair values. Accounting for share-basedcompensation 

16

----

transactionsusing the intrinsic method supplemented by pro forma disclosures will no longerbe permissible. The new statement will be effective for NTS in the fiscal yearbeginning February 2006. The Company has not yet completed its analysis ofthe impact of adopting SFAS 123R and is therefore currently unable toquantify the effect on its financial statements. However, the adoption of thisnew statement will have a significant impact on the results of operations andnet income per share of the Company as the Company will be required to expensethe fair value of all share based payments.

**Off-Balance Sheet Arrangements**

The Company does not haveany special purpose entities or off-balance sheet financing arrangements.

**Results of Operations**

Thefollowing discussion should be read in conjunction with the consolidatedfinancial statements and notes thereto.

***REVENUES***
| ** **                         | ** ** | **Twelve months ended January 31,** | ** ** |
|------------------------------------|------------|---------------------------------------------------------|------------|
| ** **                         | ** ** | **2005**                                                | ** ** | **% Change** | ** ** | **2004** | ** ** | **% Change** | ** ** | **2003** | ** ** |
| ** **                         | ** ** | **(Dollars in thousands)**                    | ** ** |
| Engineering &  Evaluation |       | $                                                       | 63,236     |   |   | 8.3 | % |   | $ | 58,410 |   |   | 6.1 | % |   | $ | 55,037 |   |
| Technical  Solutions               |       | 43,761                                                  |       |   | (5.4 | )% |   | 46,238 |   |   | 50.1 | % |   | 30,800 |   |
| Total revenues                     |       | $                                                       | 106,997    |   |   | 2.2 | % |   | $ | 104,648 |   |   | 21.9 | % |   | $ | 85,837 |   |

 

For the year ended January 31, 2005, total revenuesincreased $2,349,000 or 2.2% when compared with fiscal 2004.

For the year ended January31, 2004, total revenues increased $18,811,000 or 21.9% when compared withfiscal 2003.

*Engineering &Evaluation:*

For the year ended January 31, 2005, revenues in theEngineering & Evaluation segment increased $4,826,000 or 8.3% when comparedto the same period in fiscal 2004, primarily due to revenues of $3,718,000 and$531,000, respectively, in fiscal 2005 from the acquisition of DTI Holdings,LLC, in Rustburg Virginia, and the acquisition of a telecommunications testlaboratory in Calgary, Canada. The DTI acquisition was effective on January 1,2004 and revenues of $142,000 were recorded in fiscal 2004. Thetelecommunications test laboratory acquisition in Calgary was effective onAugust 1, 2004. Revenues also increased in the Company’s space and automotivetesting businesses and the computer testing business. These increases werepartially offset by the decrease in the passive fiber optic testing businessand the decrease in defense related business at the Camden, Arkansas facility.The decrease in revenues at the Camden facility was due to revenues from amajor contract related to the war on terrorism that was completed in fiscal2004.

For the year ended January31, 2004, Engineering & Evaluation revenues increased by $3,373,000 or 6.1%when compared to the same period in fiscal 2003, primarily due to increases inmilitary business at the Camden, Arkansas facility, passive fiber opticstesting at the Fullerton, California facility, testing on space programs at theLos Angeles facility, military and commercial electronics testing at the Plano,Texas facility, automotive and registration business and the inclusion ofapproximately $142,000 in revenues from DTI, which was acquired in January of2004. These increases were partially offset by a decrease in the computertesting business and a decrease in the traditional testing business at theBoxborough, Massachusetts facility and at the Santa Clarita, Californiafacility.

17

----

*TechnicalSolutions:*

For the year ended January 31, 2005, revenues in theTechnical Solutions segment decreased by $2,477,000 or 5.4% when compared tothe same period in fiscal 2004, as a result of the continued degradation of theIT market staffing business due to competition from off-shore companies and theloss of certain customers in geographic areas where the Company discontinuedits sales and marketing efforts.

For the year ended January31, 2004, revenues in the Technical Solutions segment increased by $15,438,000or 50.1% when compared to the same period in fiscal 2003, due to theacquisition of TRS Staffing Solutions, effective October 14, 2002, offset by adecrease in revenues due to weak demand for full-time and contract help duringthe year and a decrease in engineering personnel at a major customer.

***GROSS PROFIT***
| ** **                         | ** ** | **Twelve months ended January 31,** | ** ** |
|------------------------------------|------------|---------------------------------------------------------|------------|
| ** **                         | ** ** | **2005**                                                | ** ** | **% Change** | ** ** | **2004** | ** ** | **% Change** | ** ** | **2003** | ** ** |
| ** **                         | ** ** | **(Dollars in thousands)**                    | ** ** |
| Engineering &  Evaluation |       | $                                                       | 17,207     |   |   | 10.4 | % |   | $ | 15,590 |   |   | 13.3 | % |   | $ | 13,766 |   |
| % to segment  revenue              |       | 27.2                                                    | %          |   |   |   |   | 26.7 | % |   |   |   |   | 25.0 | % |
| Technical  Solutions               |       | 6,963                                                   |       |   | (2.2 | )% |   | 7,120 |   |   | 31.6 | % |   | 5,410 |   |
| % to segment  revenue              |       | 15.9                                                    | %          |   |   |   |   | 15.4 | % |   |   |   |   | 17.6 | % |
| Total                              |       | $                                                       | 24,170     |   |   | 6.4 | % |   | $ | 22,710 |   |   | 18.4 | % |   | $ | 19,176 |   |
| % to total revenue                 |       | 22.6                                                    | %          |   |   |   |   | 21.7 | % |   |   |   |   | 22.3 | % |

 

For the year ended January 31, 2005, total gross profitincreased $1,460,000 or 6.4% when compared with fiscal 2004.

For the year ended January31, 2004, total gross profit increased $3,534,000 or 18.4% when compared withfiscal 2003.

*Engineering &Evaluation:*

For the year ended January 31, 2005, gross profit forthe Engineering & Evaluation segment increased by $1,617,000 or 10.4% whencompared with the same period in fiscal 2004, primarily as a result of therevenue increase discussed above. Gross profit margin as a percentage ofrevenues increased to 27.2% in the current year from 26.7% in the prior year,primarily due to the DTI acquisition which has a higher gross profit marginthan the average gross profit percentage for the Engineering & Evaluationsegment and higher gross margins generated from the software testing business.

For the year ended January31, 2004, gross profit for the Engineering & Evaluation segment increasedby $1,824,000 or 13.3% when compared with the same period in fiscal 2003,primarily as a result of the revenue increase discussed above and the increasein gross profit as a percentage of revenue which increased to 26.7% from 25.0%when compared to the same period in the prior year.

*TechnicalSolutions:*

For the year ended January 31, 2005, gross profitdecreased by $157,000 or 2.2% in the Technical Solutions segment when comparedto the same period in fiscal 2004, primarily as a result of the revenuedecrease discussed above. Gross profit margin as a percentage of revenuesincreased to 15.9% in the current year from 15.4% in the prior year as a resultof the increase in specialty and technical service customers which have highermargins.

Forthe year ended January 31, 2004, gross profit increased by $1,710,000 or 31.6%in the Technical Solutions segment when compared to the same period in fiscal2003, due to the acquisition of TRS Staffing 

18

----

Solutions. Gross profit as a percentage of revenuedecreased however to 15.4 % from 17.6% when compared to the same period in theprior year, primarily due to the competitive pricing pressures in the technicalstaffing industry.

***SELLING, GENERAL & ADMINISTRATIVE***
| ** **                         | ** ** | **Twelve months ended January 31,** | ** ** |
|------------------------------------|------------|---------------------------------------------------------|------------|
| ** **                         | ** ** | **2005**                                                | ** ** | **% Change** | ** ** | **2004** | ** ** | **% Change** | ** ** | **2003** | ** ** |
| ** **                         | ** ** | **(Dollars in thousands)**                    | ** ** |
| Engineering &  Evaluation |       | $                                                       | 14,290     |   |   | 13.0 | % |   | $ | 12,647 |   |   | 10.4 | % |   | $ | 11,458 |   |
| % to segment  revenue              |       | 22.6                                                    | %          |   |   |   |   | 21.7 | % |   |   |   |   | 20.8 | % |
| Technical  Solutions               |       | 6,359                                                   |       |   | (7.1 | )% |   | 6,848 |   |   | 38.2 | % |   | 4,954 |   |
| % to segment  revenue              |       | 14.5                                                    | %          |   |   |   |   | 14.8 | % |   |   |   |   | 16.1 | % |
| Total                              |       | $                                                       | 20,649     |   |   | 5.9 | % |   | $ | 19,495 |   |   | 18.8 | % |   | $ | 16,412 |   |
| % to total revenue                 |       | 19.3                                                    | %          |   |   |   |   | 18.6 | % |   |   |   |   | 19.1 | % |

 

For the year ended January 31, 2005, total selling,general and administrative expenses increased $1,154,000 or 5.9% when comparedwith fiscal 2004.

For the year ended January31, 2004, total selling, general and administrative expenses increased$3,083,000 or 18.8% when compared with fiscal 2003.

*Engineering &Evaluation:*

For the year ended January 31, 2005, selling, generaland administrative expenses increased by $1,643,000 or 13.0% when compared withthe same period in fiscal 2004, primarily due to: approximately $430,000 due tosales costs related to efforts to expand the Company nationally andinternationally and the addition of new sales and customer servicerepresentatives, approximately $325,000 in one-time start-up costs associatedwith the development of new test specifications for the emerging wirelesstechnologies and the development of capabilities to perform testing on new DSLservices, approximately $320,000 in regional management salaries and relatedcosts, approximately $230,000 in outside services and consulting costs,approximately $165,000 in costs related to the improvement of the Company’sinternal IT infrastructure and website and approximately $160,000 in costsincurred by the Company to prepare for compliance with Section 404 of theSarbanes-Oxley Act, that makes reporting on internal controls mandatory for allregistrants under the Securities Act of 1934. All other selling, general andadministrative expenses increased by a net amount of approximately $13,000.

For the year ended January31, 2004, selling, general and administrative expenses increased by $1,189,000or 10.4% when compared with the same period in fiscal 2003, primarily due tothe increase in selling costs related to the restructuring of the sales organizationwhich is now designed to more effectively bring new customers to the Companyand the addition of customer service personnel within the facilities to provideenhanced existing customer service and customer retention.

*TechnicalSolutions:*

For the year ended January 31, 2005, selling, generaland administrative expenses decreased by $489,000 or 7.1% when compared withfiscal 2004, primarily due to the reduction in selling costs associated withthe lower revenues and other administrative cost reductions.

For the year ended January31, 2004, selling, general and administrative expenses increased by $1,894,000or 38.2% when compared with fiscal 2003, due to the additional expenses relatedto the acquired business of TRS Staffing Solutions which has allowed TechnicalSolutions to expand into new geographic markets with a significantly expandedsales force. The Company restructured its sales and operations units and wasable to reduce selling and administrative costs and improve performance.

19

----

***OPERATING INCOME***
| ** **                         | ** ** | **Twelve months ended January 31,** | ** ** |
|------------------------------------|------------|---------------------------------------------------------|------------|
| ** **                         | ** ** | **2005**                                                | ** ** | **% Change** | ** ** | **2004** | ** ** | **% Change** | ** ** | **2003** | ** ** |
| ** **                         | ** ** | **(Dollars in thousands)**                    | ** ** |
| Engineering &  Evaluation |       | $                                                       | 2,917      |   |   | (0.9 | )% |   | $ | 2,943 |   |   | 27.5 | % |   | $ | 2,308 |   |
| % to segment  revenue              |       | 4.6                                                     | %          |   |   |   |   | 5.0 | % |   |   |   |   | 4.2 | % |
| Technical  Solutions               |       | 604                                                     |       |   | 122.1 | % |   | 272 |   |   | (40.4 | )% |   | 456 |   |
| % to segment  revenue              |       | 1.4                                                     | %          |   |   |   |   | 0.6 | % |   |   |   |   | 1.5 | % |
| Total                              |       | $                                                       | 3,521      |   |   | 9.5 | % |   | $ | 3,215 |   |   | 16.3 | % |   | $ | 2,764 |   |
| % to total revenue                 |       | 3.3                                                     | %          |   |   |   |   | 3.1 | % |   |   |   |   | 3.2 | % |

 

For the year ended January 31, 2005, operating incomeincreased $306,000 or 9.5% when compared with fiscal 2004.

For the year ended January31, 2004, operating income increased $451,000 or 16.3% when compared withfiscal 2003.

*Engineering &Evaluation:*

For the year ended January 31, 2005, operating incomedecreased by $26,000 or 0.9% when compared with fiscal 2004, as a result of theincrease in selling, general and administrative expenses discussed above,partially offset by the increase in gross profit discussed above.

For the year ended January31, 2004, operating income increased by $635,000 or 27.5% when compared withfiscal 2003, as a result of the increase in gross profit, partially offset bythe increase in selling, general and administrative expenses discussed above.

*TechnicalSolutions:*

For the year ended January 31, 2005, operating incomeincreased by $332,000 or 122.1% when compared with the same period in fiscal2004, as a result of the decrease in selling and general and administrativeexpenses discussed above, partially offset by the decrease in gross profit discussedabove.

For the year ended January31, 2004, operating income decreased by $184,000 or 40.4% when compared withthe same period in fiscal 2003, as a result of the lower gross margins, theincrease in selling and general and administrative expenses discussed above,partially offset by the increase in gross profit discussed above.

***Interest Expense***

Interest expense decreased$6,000 in fiscal 2005 when compared to fiscal 2004 primarily due to lowerinterest rate levels in fiscal 2005 offset by slightly higher average debtbalances in fiscal 2005 when compared to the same period last year. Interestexpense decreased $129,000 in fiscal 2004 when compared to fiscal 2003primarily due to lower interest rate levels in fiscal 2004 offset by slightlyhigher average debt balances in fiscal 2004 when compared to the same periodlast year.

***Other Income***

Other income of $162,000in fiscal 2005 includes approximately $158,000 in gain from the sale of realestate. Other income of $192,000 in fiscal 2004 included approximately $149,000in insurance proceeds for equipment damage incurred at the Camden facility dueto severe weather. It also included proceeds from the transfer of a portion ofland to the city of Santa Clarita taken by eminent domain for a new highway.

20

----

***Income Taxes***

The income tax provisional rate of 35.1% for fiscal2005 is lower than normal due to the earnings associated with the Company’sforeign subsidiary which significantly increased in the current year and areconsidered to be permanently invested. Earnings for this foreign subsidiary arereported net of tax and are included in income before income taxes and theassociated tax is not separately stated in income taxes. The income tax ratesfor fiscal years 2004 and 2003 are 45.7% and 43.6% respectively. They reflect arate in excess of the federal statutory rate primarily due to the inclusion ofstate income taxes and certain non-deductible expenses. See Note 4 to theconsolidated financial statements for a reconciliation of the provision forincome taxes from continuing operations at the statutory rate to the provisionfor income taxes from continuing operations.

Management has determinedthat it is more likely than not that the Company’s deferred tax asset will berealized on the basis of offsetting it against deferred tax liabilities andfuture income. The Company analyzes the value of the deferred income tax assetquarterly in conjunction with external reporting.

***Net Income***

In fiscal 2005, net income increased $389,000 to$1,682,000 when compared to fiscal 2004. This increase was due to the increasein operating income and the lower income tax rate, partially offset by thedecrease in other income and minority interest in fiscal 2005, when compared tofiscal 2004.

In fiscal 2004, net incomeincreased $435,000 to $1,293,000 when compared to fiscal 2003. This increasewas due to the increase in operating income of the E&E segment, thedecrease in interest expense and the increase in other income in fiscal 2004compared to fiscal 2003.

***Business Environment***

In the Engineering & Evaluation segment, TheCompany tests and certifies high tech products for seven distinct markets:defense, aerospace, telecommunications, transportation, power, computer andelectronics. The Company also provides ISO 9000 Quality Management SystemRegistration.

The defense and aerospace markets generate 57% of theoverall Engineering and Evaluation revenues. In recent years, domestic andworldwide political and economic developments have impacted positively themarket needs for defense and advanced technology systems. Also, the increase ingovernment outsourcing activity has created additional opportunities for NTS.The Company has ten fully equipped defense and aerospace environmentalsimulation laboratories located throughout the United States and is wellequipped to handle this increase in demand. After the 9/11 incident, theCompany has seen an increase in demand for the evaluation of military equipmentand weapons systems, which has positively affected business at the Company’s Arkansasfacility. NTS has installed a new rocket firing range and has upgraded it’scapability to handle large weapons systems as well as maintaining shockmachines, centrifuges, acoustical chambers, hydraulic and electro-dynamicvibration equipment. The Company believes it operates more of these systemsthan any other company. The Company anticipates the level of need will increasefor the foreseeable future and has expanded its service offering, particularlyat the Camden, Arkansas facility and the Tinton Falls, New Jersey facility tohandle the anticipated increase in demand.

The telecommunications market in the past three yearshas not been favorable. The Company has experienced a decline in business inthis market. The outlook for the foreseeable future appears favorable, however,due to the increase in product certification outsourcing by the major RegionalBell Operating Companies (RBOCs). The Company has been approved as anIndependent Test laboratory (ITL) by the RBOCs to test and certify central officeequipment developed by manufactures to the Network Equipment BuildingSpecifications (NEBS). The Company is currently providing this service atlaboratories in 

21

----

California, Massachusetts,Texas, Alberta, Canada and Germany. The Company has been approved as an ITL tooffer a complete suite of passive fiber components certifications and DigitalSubscriber Line (DSL) certification. This service currently is being providedat laboratories in California. The Company expects an increase in businessdemand as RBOCs upgrade networks packet-based Voice Over Internet Protocol(VOIP) devices. As service providers gradually convert to VOIP architectures,interoperability becomes critical to ensure a seamless transition to nextgeneration networks. The Company also expects an increase in demand as carriersbegin to deploy “triple play” (voice, video, and broadband) offerings over FTTP(fiber to the premise) passive fiber networks. The Company recently acquired anetwork architecture and interoperability laboratory in Northern California.This laboratory was acquired to extend the Company’s service offering to handlethe anticipated demand for interoperability testing and the FTTP deployment.

The transportation and power markets have been stablewith the Company experiencing slight incremental growth in the transportationbusiness, while the Company is experiencing no growth in the power business.The Company anticipates that these two markets will remain stable with nosignificant external growth.

The Computer and Electronics Markets have been stablewith the Company experiencing growth in the Japan operation. This growth isdirectly attributed to the USB certification technology transfer that wascompleted this year. The Company anticipates growth in these markets as theinternational expansion strategy is deployed this year. Development plansinclude cooperative agreements in Taiwan, Hong Kong and mainland China. Thecooperative agreements will focus on providing USB, USB on the go, Connectorand Zigbee certification to device manufacturers and industrial productsmanufactured in Asia. The Company believes that the demand for thesecertification activities will increase in Asia.

In the Technical Solutions segment, the Companyprovides a variety of staffing and workforce management services and solutions,including contract, contract-to-hire and full time placements to meet itscustomers’ needs with a focus on IT development. The IT general servicesbusiness is extremely competitive with a portion of this work being outsourcedto off-shore providers. The Company has experienced a decline in the generalservice IT business as a result of the current adverse market trends. To offsetthis competitive environment, the Company is deploying a migration strategyfocusing on meeting the anticipated increase in demand for specializedcompliance and engineering support services at Company locations as well astaking advantage of offshore opportunities. The Company is now offering aspecialized niche oriented compliance and engineering service. This service isbeing deployed by cross selling to the clients currently being serviced by theEngineering and Evaluation segment. The Company has also set up a test andcompliance laboratory in Vietnam for a major US Fortune 500 computer company totake advantage of the low cost highly skilled labor in Vietnam. The Companybelieves it has a competitive advantage because of the existing relationshipswith the Engineering and Evaluation clients and anticipates the specializedcompliance and engineering service need will continue to grow both domesticallyas well as internationally as a result of the continued outsourcing trend.

Notwithstanding theforegoing and because of factors affecting the Company’s operating results,past financial performance should not be considered to be a reliable indicatorof future performance.

22

----

***Liquidity and Capital Resources***

**Summary of cash flows:**
| ** **                                                    | ** ** | **FY 2005** | ** ** | **FY 2004** | ** ** | **FY 2003** | ** ** |
|---------------------------------------------------------------|------------|------------------|------------|------------------|------------|------------------|------------|
| Net cash provided  by operating activities                    |       | $                | 6,590,000  |             | $          | 8,804,000        |       | $ | 3,739,000 |   |
| Net cash used for  investing activities                       |       | (6,089,000       | )          | (7,470,000       | )          | (4,785,000       | )          |
| Net cash provided  by (used in) financing activities          |       | 1,026,000        |       | (232,000         | )          | 822,000          |       |
| Effect of  exchange rate changes on cash and cash equivalents |       | 13,000           |       | —           |       | —           |       |
| Net increase (decrease)  in cash                              |       | $                | 1,540,000  |             | $          | 1,102,000        |       | $ | (224,000 | ) |

 

Net cash provided by operating activities of$6,590,000 in fiscal 2005 primarily consisted of net income of $1,682,000adjusted for non-cash items of $4,798,000 in depreciation and amortization and$302,000 in other non-cash items, partially offset by $192,000 of changes inworking capital and other activities. Working capital changes included adecrease in accounts payable balances of $973,000. The decrease in cashprovided by operating activities from fiscal 2004 to fiscal 2005 was primarilythe result of the change in accounts receivable, the increase in accountspayable payments, partially offset by the higher net income in fiscal 2005. Netcash provided by operating activities of $8,804,000 in fiscal 2004 primarilyconsisted of net income of $1,293,000 adjusted for non-cash items of $4,776,000in depreciation and amortization and $379,000 in other non-cash items, and$2,356,000 of changes in working capital and other activities. Working capitalchanges included a decrease in accounts receivable balances of approximately$2,238,000, reflecting improved collection performance in fiscal 2004. Theincrease in cash provided by operating activities from fiscal 2003 to fiscal2004 was primarily the result of the change in accounts receivable and thehigher net income in fiscal 2004. Net cash provided by operating activities of$3,739,000 in fiscal 2003 primarily consisted of net income of $858,000,adjusted for non-cash items of $4,615,000 in depreciation and amortization and$616,000 in other non-cash items, partially offset by $2,350,000 of changes inworking capital and other activities. Working capital changes included anincrease in accounts receivable balances of approximately $3,534,000, primarilydue to the acquisition of TRS Staffing Solutions. The decrease in cash providedby operating activities from fiscal 2002 to fiscal 2003 was primarily theresult of the change in accounts receivable.

Net cash used for investing activities in fiscal 2005of $6,089,000 was primarily attributable to capital spending of $5,189,000 andcash used in the acquisition of the Canadian test laboratory for $1,033,000,partially offset by proceeds from the sale of real estate of $311,000. Capitalspending is generally comprised of purchases of machinery and equipment,building, leasehold improvements, computer hardware, software and furniture andfixtures. Cash used in investing activities decreased from fiscal 2004 tofiscal 2005 by $1,381,000 primarily as a result of the acquisition of DTI infiscal 2004. Net cash used for investing activities in fiscal 2004 of$7,470,000 was primarily attributable to capital spending of $4,599,000 andcash used in the acquisition of DTI for $2,687,000. Cash used in investingactivities increased from fiscal 2003 to fiscal 2004 by $2,685,000 primarily asa result of the acquisition of DTI and an increase of approximately $1 millionin capital spending in fiscal 2004. Net cash used in investing activities infiscal 2003 of $4,785,000 was primarily attributable to capital spending of$3,620,000 and cash used in the acquisition of TRS Staffing Solutions for$1,589,000, partially offset by the sale of land for $594,000. Cash used ininvesting activities increased from fiscal 2002 to fiscal 2003 by $2,003,000primarily as a result of the acquisition of TRS Staffing Solutions and anincrease of approximately $400,000 in capital spending in fiscal 2003.

Net cash provided by financing activities in fiscal2005 of $1,026,000 consisted of proceeds from borrowings of $2,228,000,proceeds from stock options exercised of $300,000, partially offset byrepayments 

23

----

of debt of $1,502,000. Netcash used for financing activities in fiscal 2004 of $232,000 consisted ofrepayments of debt of $2,141,000, common stock repurchase of $106,000, offsetby proceeds from borrowings of $1,831,000 and proceeds from stock optionsexercised of $184,000. Net cash provided by financing activities in fiscal 2003of $822,000 consisted of proceeds from borrowings of $4,650,000 offset byrepayments of debt of $3,635,000, common stock repurchase of $154,000 andpayments of cash dividends to NQA of $39,000.

On November 25, 2002, the Company increased therevolving line of credit with Comerica Bank California and First Bank to$20,000,000. Comerica Bank California, as the agent, retained 60% of the linewith First Bank, as the participant, holding 40% of the line. The revolvingline of credit was reduced by $1,750,000 on August 1, 2003 and was reducedagain on August 1, 2004 by $1,750,000 and will be reduced by $1,750,000each year thereafter. If during any fiscal year, the Company’s net incomeequals or exceeds $2,000,000, there will be no required reduction in therevolving line of credit. The interest rate is at the agent’s prime rate, withan option for the Company to convert to loans at the Libor rate plus 250 basispoints for 30, 60, 90, 180 or 365 days, with minimum advances of $1,000,000.The Company paid a 0.5% commitment fee of the total line amount and is payingan additional 0.25% of the commitment amount annually and a 0.25% fee for anyunused line of credit. The outstanding balance on the revolving line of creditat January 31, 2005 was $15,502,000. This balance is reflected in theaccompanying condensed consolidated balance sheets as long-term. This agreementis subject to certain covenants, which require the maintenance of certainworking capital, debt-to-equity, earnings-to-expense and cash flow ratios. Theamount available on the line of credit was $998,000 as of January 31, 2005.The Company was in full compliance with all of the covenants with its banks asof January 31, 2005 with the exception of the capital expenditurecovenant, which was in excess of the allowed amount by approximately $189,000. TheCompany requested and received a waiver from its banks. The Company iscurrently in negotiations with its banks to increase its lines of credit.

The Company has additionalequipment line of credit agreements (at interest rates of 5.56% to 9.82%) tofinance various test equipment with terms of 60 months for each equipmentschedule. The outstanding balance at January 31, 2005 was $2,775,000. Thebalance of other notes payable collateralized by land and building was$2,775,000, and the balance of unsecured notes was $480,000 at January 31,2005.

***Contractual Obligations:***
| ** **                   | ** ** | **2006**  | ** ** | **2007 through  2009** | ** ** | **After 2009** | ** ** | **Total** | ** ** |
|------------------------------|------------|-----------|------------|-----------------------------|------------|---------------------|------------|-----------|------------|
| Long-term debt               |       | $         | 975,000    |                        | $          | 18,132,000          |       | $         | 2,425,000  |   | $ | 21,532,000 |   |
| Operating lease  obligations |       | 1,611,000 |       | 2,598,000                   |       | 336,000             |       | 4,545,000 |       |
| Total                        |       | $         | 2,586,000  |                        | $          | 20,730,000          |       | $         | 2,761,000  |   | $ | 26,077,000 |   |

 

Management is not aware of any significant demands forcapital funds that may materially affect short or long-term liquidity in theform of large fixed asset acquisitions, unusual working capital commitments orcontingent liabilities. In addition, the Company has made no materialcommitments for capital expenditures. The Company’s long-term debt may beaccelerated if the Company fails to meet its covenants with its banks. TheCompany believes that the cash flow from operations and the revolving line ofcredit will be sufficient to fund its operations for the next twelve months.

24

----

**ITEM 7A.   *QUANTITATIVE ANDQUALITATIVE DISCLOSURES ABOUT MARKET RISK.***

***Interest Rate Risk***

The Company****is exposed to changes in interest ratesprimarily from its long-term revolving line of credit arrangement. Under itscurrent policies, the Company does not use interest rate derivative instrumentsto manage exposure to interest rate changes. A hypothetical one percentagepoint adverse move in interest rates along the entire interest rate yield curvewould adversely affect interest expense by$160,000 at January 31, 2005 ascompared with $161,000 at January 31, 2004.

***Risks That Could Affect Future Results***

The factors discussed below are cautionary statementsthat identify important factors that could cause actual results to differmaterially from those anticipated in the forward-looking statements in this Form 10-K.Any of the following risks may have a material negative impact on the Company’sfinancial condition.

The Company is subject to the effects of generaleconomic and market conditions (including economic disruption caused byterrorist acts). If the economic conditions worsen, the Company may experiencematerial adverse effects on its business, operating results, and financialcondition.

Results may beadversely affected by:

·       Theloss of significant customers or significant decreases in their purchasingvolume;

·       Pricingconcessions that may be given on volume sales due to competition;

·       Therescheduling or cancellation of customer orders;

·       Fluctuationsand availability of certain raw materials or components that are needed to testcustomers’ products;

·       Theloss of key management or technical personnel;

·       Thefinancial condition of the Company’s major customers;

·       Fraudulenttransactions committed against the Company;

·       U.S.government defense programs are subject to special risk, including dependenceon government appropriations, contract termination without cause, contractrenegotiations, and intense competition for the available defense business;

·       Inabilityto find temporary workers with the skills required by customers in theTechnical Solutions segment;

·       Theinability to procure sufficient insurance to cover operational and contractualrisks;

·       Programperformance (including the ability to perform fixed-price contracts withinestimated costs and the timing of test report deliveries);

·       Futurechanges in zoning could adversely affect the Company’s ability to fully utilizeits facilities to service its clients;

·       TheCompany’s California facilities, including its principal executive offices, arelocated near major earthquake fault lines. A major earthquake or any othernatural disaster in a region near any of the Company’s facilities, couldmaterially and adversely affect the Company’s business;

·       Toremain competitive, the Company must be able to respond effectively totechnological changes and be able to hire, train and retain highly skilledsales, engineering and technical personnel.

25

----

***Environmental Matters***

An internal environmental compliance group formed in1991 continues to review environmental matters for the Company.

Although the Company’s business does not involve themanufacture or extensive use of hazardous substances, the Company does have aprogram to ensure compliance with applicable environmental laws at its varioustesting facilities, which includes conducting regular internal audits toidentify and categorize potential environmental exposure.

The Company’s SantaClarita, California test facility is located immediately adjacent to propertyowned by a third party which has been the subject of extensive environmentalremediation. The adjacent site has, in the past, been used for manufacture ofsolid rocket fuel propellants, munitions and flares that contained perchlorate,a hazardous substance. Soil samples taken from the Santa Clarita property in2003 were inconclusive as to the existence of perchlorate. Recent heavyrainfall resulted in a run off from the adjacent site onto the Santa Claritaproperty. The Company arranged for samples to be taken of the surface waterfrom the adjacent site and early indications are that the tested water containshigh levels of perchlorate. Further testing is being conducted. No cleanupactivity has been conducted on the Santa Clarita property and it has yet to bedetermined whether remediation will be required at the site, or, if required,the extent and cost of any remediation. The Company believes that in the eventit does incur remediation costs that it will have valid claims forindemnification against the owner of the adjacent site and the municipalitythat built a road between the adjacent site and the Santa Clarita property thatappears to have contributed to the runoff from the adjacent site. Recovery ofsuch remediation costs may, however, be uncertain and may involve significantlitigation expense.

***Impact of Inflation***

The Company continues to incur increased costs in theareas of wages, insurance, workers compensation, and utilities which it cannotpass along to customers in the current economic environment. To date, theseincreases have been partially offset by reductions in other operating areasthrough improved efficiencies. The Company can give no assurances, however,that in the future it can offset such increased costs.

26

----

**ITEM8.**                *CONSOLIDATED FINANCIAL STATEMENT AND SUPPLEMENTARY DATA.*

**Indexto Consolidated Financial Statements and Schedule**
| Report of Independent  Registered Public Accounting Firm                                                    |       | 28           |   |
|-------------------------------------------------------------------------------------------------------------|------------|--------------|--------|
| Financial  Statements:                                                                                      |       |         |   |
| Consolidated Balance Sheets—January 31,  2005 and 2004                                            |       | 29           |   |
| Consolidated Statements of  Income—Years ended January 31, 2005, 2004 and 2003                    |       | 30           |   |
| Consolidated Statements of  Shareholders’ Equity—Years ended January 31, 2005, 2004 and 2003 |       | 31           |   |
| Consolidated Statements of  Cash Flows—Years ended January 31, 2005, 2004 and 2003                |       | 32           |   |
| Notes  to Consolidated Financial Statements                                                                 |       | 33           |   |
| ** **                                                                                                  | ** ** | **Schedule** |
| Schedule Supporting Financial Statements:                                                                   |       |         |   |
| Valuation  and Qualifying Accounts and Reserves                                                             |       | II           |   |

----

All other schedules areomitted as inapplicable or because the required information is contained in thefinancial statements or the notes thereto.

27

----

**REPORTOF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM**

TheBoard of Directors and Shareholders

National Technical Systems, Inc.

We have audited the accompanying consolidated balancesheets of National Technical Systems, Inc. and Subsidiaries as of January 31,2005 and 2004, and the related consolidated statements of income, shareholders’equity and cash flows for each of the three years in the period ended January 31,2005. Our audits also included the financial statement schedule listed in theIndex at Item 15(a). These financial statements and schedule are theresponsibility of the Company’s management. Our responsibility is to express anopinion on these financial statements and schedule based on our audits.

We conducted our audits in accordance with thestandards of the Public Company Accounting Oversight Board (United States). Thosestandards require that we plan and perform the audit to obtain reasonableassurance about whether the financial statements are free of materialmisstatement. We were not engaged to perform an audit of the Company’s internalcontrol over financial reporting. Our audits included consideration of internalcontrol over financial reporting as a basis for designing audit procedures thatare appropriate in the circumstances, but not for the purpose of expressing anopinion on the effectiveness of the Company’s internal control over financialreporting. Accordingly, we express no such opinion. An audit also includesexamining, on a test basis, evidence supporting the amounts and disclosures inthe financial statements, assessing the accounting principles used andsignificant estimates made by management, and evaluating the overall financialstatement presentation. We believe that our audits provide a reasonable basisfor our opinion.

In our opinion, thefinancial statements referred to above present fairly, in all materialrespects, the consolidated financial position of National Technical Systems, Inc.and Subsidiaries at January 31, 2005 and 2004 and the consolidated resultsof their operations and their cash flows for each of the three years in theperiod ended January 31, 2005, in conformity with U.S. generally acceptedaccounting principles. Also, in our opinion, the related financial statementschedule, when considered in relation to the basic financial statements takenas a whole, presents fairly, in all material respects, the information setforth therein.
|                             | /s/ Ernst & Young LLP |
|-----------------------------|--------------------------------|
| Woodland Hills,  California |
| April 15, 2005         |

 

28

----

**NATIONAL TECHNICAL SYSTEMS, INC. AND SUBSIDIARIESConsolidated Balance SheetsJanuary 31,**
| ** **                                                                                                                                                                     | ** ** | **2005**    | ** ** | **2004**    | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------|------------|-------------|------------|
| **ASSETS**                                                                                                                                                                     | ** ** | ** **  | ** ** | ** **  | ** ** |
| CURRENT ASSETS:                                                                                                                                                                |       |        |       |        |       |
| Cash                                                                                                                                                                           |       | $           | 6,201,000  |        | $          | 4,661,000 |   |
| Accounts receivable,  less allowance for doubtful accounts of $906,000 at January 31,  2005 and $938,000 at January 31, 2004                                    |       | 18,618,000  |       | 18,822,000  |       |
| Income taxes receivable                                                                                                                                                        |       | 521,000     |       | 320,000     |       |
| Inventories                                                                                                                                                                    |       | 1,612,000   |       | 1,995,000   |       |
| Deferred income taxes                                                                                                                                                          |       | 1,529,000   |       | 1,184,000   |       |
| Prepaid expenses                                                                                                                                                               |       | 666,000     |       | 827,000     |       |
| Total current assets                                                                                                                                                           |       | 29,147,000  |       | 27,809,000  |       |
| Property, plant and equipment, at cost                                                                                                                                         |       |        |       |        |       |
| Land                                                                                                                                                                           |       | 1,415,000   |       | 1,455,000   |       |
| Buildings                                                                                                                                                                      |       | 10,165,000  |       | 9,802,000   |       |
| Machinery and equipment                                                                                                                                                        |       | 70,069,000  |       | 64,511,000  |       |
| Leasehold improvements                                                                                                                                                         |       | 7,664,000   |       | 7,544,000   |       |
| Total property, plant  and equipment                                                                                                                                           |       | 89,313,000  |       | 83,312,000  |       |
| Less: accumulated  depreciation                                                                                                                                                |       | (58,073,000 | )          | (53,357,000 | )          |
| Net property, plant and  equipment                                                                                                                                             |       | 31,240,000  |       | 29,955,000  |       |
| Goodwill                                                                                                                                                                       |       | 2,740,000   |       | 2,740,000   |       |
| Other assets                                                                                                                                                                   |       | 3,542,000   |       | 3,128,000   |       |
| TOTAL ASSETS                                                                                                                                                                   |       | $           | 66,669,000 |        | $          | 63,632,000 |   |
| **LIABILITIES  AND SHAREHOLDERS’ EQUITY**                                                                                                                                 |       |        |       |        |       |
| CURRENT LIABILITIES:                                                                                                                                                           |       |        |       |        |       |
| Accounts payable                                                                                                                                                               |       | $           | 3,512,000  |        | $          | 4,485,000 |   |
| Accrued expenses                                                                                                                                                               |       | 3,755,000   |       | 3,514,000   |       |
| Income taxes payable                                                                                                                                                           |       | —      |       | 23,000      |       |
| Deferred income                                                                                                                                                                |       | 424,000     |       | 185,000     |       |
| Current installments of  long-term debt                                                                                                                                        |       | 975,000     |       | 1,052,000   |       |
| Total current  liabilities                                                                                                                                                     |       | 8,666,000   |       | 9,259,000   |       |
| Long-term debt,  excluding current installments                                                                                                                                |       | 20,557,000  |       | 19,754,000  |       |
| Deferred income taxes                                                                                                                                                          |       | 5,572,000   |       | 4,875,000   |       |
| Deferred compensation                                                                                                                                                          |       | 810,000     |       | 799,000     |       |
| Minority interest                                                                                                                                                              |       | 113,000     |       | 113,000     |       |
| Commitments and contingencies                                                                                                                                                  |       |        |       |        |       |
| SHAREHOLDERS’ EQUITY:                                                                                                                                                     |       |        |       |        |       |
| Preferred stock, no par  value, 2,000,000 shares authorized; none issued                                                                                                       |       | —      |       | —      |       |
| Common stock, no par  value. Authorized, 20,000,000 shares; issued and outstanding, 9,025,000  as of January 31, 2005 and 8,863,000 as of January 31, 2004 |       | 14,184,000  |       | 13,760,000  |       |
| Retained earnings                                                                                                                                                              |       | 16,805,000  |       | 15,123,000  |       |
| Accumulated other  comprehensive loss                                                                                                                                          |       | (38,000     | )          | (51,000     | )          |
| Total shareholders’ equity                                                                                                                                                |       | 30,951,000  |       | 28,832,000  |       |
| TOTAL LIABILITIES AND SHAREHOLDERS’ EQUITY                                                                                                                                |       | $           | 66,669,000 |        | $          | 63,632,000 |   |

 

See accompanying notes.

29

----

**NATIONAL TECHNICAL SYSTEMS, INC. AND SUBSIDIARIESConsolidated Statements ofIncomeYears Ended January 31,**
| ** **                                                     | ** ** | **2005**   | ** **  | **2004**   | ** ** | **2003**    | ** ** |
|----------------------------------------------------------------|------------|------------|-------------|------------|------------|-------------|------------|
| Net revenues                                                   |       | $          | 106,997,000 |       | $          | 104,648,000 |       | $ | 85,837,000 |   |
| Cost of sales                                                  |       | 82,827,000 |        | 81,938,000 |       | 66,661,000  |       |
| Gross profit                                                   |       | 24,170,000 |        | 22,710,000 |       | 19,176,000  |       |
| Selling, general  and administrative expense                   |       | 20,649,000 |        | 19,495,000 |       | 16,412,000  |       |
| Operating income                                               |       | 3,521,000  |        | 3,215,000  |       | 2,764,000   |       |
| Other income (expense):                                        |       |       |        |       |       |        |       |
| Interest expense, net                                          |       | (1,091,000 | )           | (1,097,000 | )          | (1,226,000  | )          |
| Other income                                                   |       | 162,000    |        | 192,000    |       | 11,000      |       |
| Total other  income (expense)                                  |       | (929,000   | )           | (905,000   | )          | (1,215,000  | )          |
| Income before  income taxes and minority interest              |       | 2,592,000  |        | 2,310,000  |       | 1,549,000   |       |
| Income taxes                                                   |       | 910,000    |        | 1,056,000  |       | 676,000     |       |
| Income before  minority interest                               |       | 1,682,000  |        | 1,254,000  |       | 873,000     |       |
| Minority interest                                              |       | —     |        | 39,000     |       | (15,000     | )          |
| Net income                                                     |       | $          | 1,682,000   |       | $          | 1,293,000   |       | $ | 858,000 |   |
| Net income per  common share:                                  |       |       |        |       |       |        |       |
| Basic                                                          |       | $          | 0.19        |       | $          | 0.15        |       | $ | 0.10 |   |
| Diluted                                                        |       | $          | 0.18        |       | $          | 0.14        |       | $ | 0.10 |   |
| Weighted average  common shares outstanding                    |       | 8,946,000  |        | 8,640,000  |       | 8,656,000   |       |
| Dilutive effect  of stock options                              |       | 620,000    |        | 566,000    |       | 39,000      |       |
| Weighted average common  shares outstanding, assuming dilution |       | 9,566,000  |        | 9,206,000  |       | 8,695,000   |       |

 

See accompanying notes.

30

----

**NATIONAL TECHNICAL SYSTEMS, INC. AND SUBSIDIARIESConsolidated Statements ofShareholders’ Equity**
| ** **                                        | ** ** | ** **         | ** ** | **Common**     | ** **     | ** **     | ** ** | **Accumulated**        | ** **  | **Total**              | ** ** |
|---------------------------------------------------|------------|--------------------|------------|----------------|----------------|----------------|------------|------------------------|-------------|------------------------|------------|
| ** **                                        | ** ** | **Number of** | ** ** | **Stock**      | ** **     | **Retained**   | ** ** | **Comprehensive**      | ** **  | **Shareholders’** | ** ** |
| ** **                                        | ** ** | **Shares**         | ** ** | **Amount**     | ** **     | **Earnings**   | ** ** | **Income (Loss)** | ** **  | **Equity**             | ** ** |
| **Balance  at January 31, 2002**             | ** ** | **8,667,000**      | ** ** | **$**          | **12,517,000** | ** **     | **$**      | **13,011,000**         | ** **  | ** **             | **$**      | **(51,000** | **)** | ** ** | **$** | **25,477,000** | ** ** |
| Net income                                        |       | —             |       | —         |           | 858,000        |       |                   | —      |                   |       | 858,000 |   |
| Foreign currency  translation                     |       | —             |       | —         |           | —         |       |                   | —      |                   |       | — |   |
| Comprehensive income                              |       |               |       |           |           |           |       |                   |        |                   |       | 858,000 |   |
| NQA equity  infusion                              |       | —             |       | 275,000        |           | —         |       |                   | —      |                   |       | 275,000 |   |
| Stock repurchase                                  |       | (57,000            | )          | (154,000       | )              | —         |       |                   | —      |                   |       | (154,000 | ) |
| Cash dividends  NQA, Ltd                          |       | —             |       | —         |           | (39,000        | )          |                   | —      |                   |       | (39,000 | ) |
| **Balance at January 31, 2003**              | ** ** | **8,610,000**      | ** ** | **12,638,000** | ** **     | **13,830,000** | ** ** | ** **             | **(51,000** | **)**                  | ** ** | **26,417,000** | ** ** |
| Net income                                        |       | —             |       | —         |           | 1,293,000      |       |                   | —      |                   |       | 1,293,000 |   |
| Foreign currency  translation                     |       | —             |       | —         |           | —         |       |                   | —      |                   |       | — |   |
| Comprehensive income                              |       |               |       |           |           |           |       |                   |        |                   |       | 1,293,000 |   |
| Stock options  exercised                          |       | 81,000             |       | 184,000        |           | —         |       |                   | —      |                   |       | 184,000 |   |
| Tax benefit from  stock options exercise          |       | —             |       | 44,000         |           | —         |       |                   | —      |                   |       | 44,000 |   |
| Stock repurchase                                  |       | (24,000            | )          | (106,000       | )              | —         |       |                   | —      |                   |       | (106,000 | ) |
| Stock issued to  DTI Holdings, LLC           |       | 196,000            |       | 1,000,000      |           | —         |       |                   | —      |                   |       | 1,000,000 |   |
| **Balance at January 31, 2004**              | ** ** | **8,863,000**      | ** ** | **13,760,000** | ** **     | **15,123,000** | ** ** | ** **             | **(51,000** | **)**                  | ** ** | **28,832,000** | ** ** |
| Net income                                        |       | —             |       | —         |           | 1,682,000      |       |                   | —      |                   |       | 1,682,000 |   |
| Foreign currency  translation                     |       | —             |       | —         |           | —         |       |                   | 13,000      |                   |       | 13,000 |   |
| Comprehensive income                              |       |               |       |           |           |           |       |                   |        |                   |       | 1,695,000 |   |
| Stock options  exercised                          |       | 173,000            |       | 423,000        |           | —         |       |                   | —      |                   |       | 423,000 |   |
| Stock retired for  option exercise                |       | (25,000            | )          | (123,000       | )              | —         |       |                   | —      |                   |       | (123,000 | ) |
| Issuance of  restricted common stock for services |       | 14,000             |       | 50,000         |           | —         |       |                   | —      |                   |       | 50,000 |   |
| Tax benefit from  stock options exercise          |       | —             |       | 74,000         |           | —         |       |                   | —      |                   |       | 74,000 |   |
| **Balance  at January 31, 2005**             | ** ** | **9,025,000**      | ** ** | **$**          | **14,184,000** | ** **     | **$**      | **16,805,000**         | ** **  | ** **             | **$**      | **(38,000** | **)** | ** ** | **$** | **30,951,000** | ** ** |

 

See accompanying notes.

31

----

**NATIONAL TECHNICAL SYSTEMS, INC. AND SUBSIDIARIESConsolidated Statements ofCash FlowsYears Ended January 31,**
| ** **                                                                     | ** ** | **2005**   | ** ** | **2004**   | ** ** | **2003**   | ** ** |
|--------------------------------------------------------------------------------|------------|------------|------------|------------|------------|------------|------------|
| **CASH FLOWS FROM OPERATING ACTIVITIES:**                                      |       |       |       |       |       |       |       |
| Net income                                                                     |       | $          | 1,682,000  |       | $          | 1,293,000  |       | $ | 858,000 |   |
| Adjustments to reconcile net income to cash provided  by operating activities: |       |       |       |       |       |       |       |
| Depreciation and  amortization                                                 |       | 4,798,000  |       | 4,776,000  |       | 4,615,000  |       |
| Provisions for  losses (recoveries) on receivables                             |       | (32,000    | )          | (359,000   | )          | 199,000    |       |
| Gain on sale of  assets                                                        |       | (158,000   | )          | —     |       | (50,000    | )          |
| Loss on retirement  of assets                                                  |       | 16,000     |       | —     |       | 17,000     |       |
| Undistributed  earnings of affiliate                                           |       | —     |       | (38,000    | )          | 15,000     |       |
| Deferred income  taxes                                                         |       | 352,000    |       | 732,000    |       | 435,000    |       |
| Tax benefit from  stock options exercised                                      |       | 74,000     |       | 44,000     |       | —     |       |
| Issuance of  restricted common stock for services                              |       | 50,000     |       | —     |       | —     |       |
| Changes in assets and  liabilities (net of acquisition):                       |       |       |       |       |       |       |       |
| Accounts  receivable                                                           |       | 235,000    |       | 2,238,000  |       | (3,534,000 | )          |
| Inventories                                                                    |       | 383,000    |       | 514,000    |       | (919,000   | )          |
| Prepaid expenses                                                               |       | 161,000    |       | 303,000    |       | (78,000    | )          |
| Other assets and  intangibles                                                  |       | (265,000   | )          | (199,000   | )          | (4,000     | )          |
| Accounts payable                                                               |       | (973,000   | )          | (207,000   | )          | 1,390,000  |       |
| Accrued expenses                                                               |       | 241,000    |       | (119,000   | )          | 1,031,000  |       |
| Income taxes  payable                                                          |       | (23,000    | )          | 23,000     |       | —     |       |
| Deferred income                                                                |       | 239,000    |       | 10,000     |       | (322,000   | )          |
| Deferred  compensation                                                         |       | 11,000     |       | 3,000      |       | 13,000     |       |
| Income taxes  receivable                                                       |       | (201,000   | )          | (210,000   | )          | 73,000     |       |
| Cash provided by  operating activities                                         |       | 6,590,000  |       | 8,804,000  |       | 3,739,000  |       |
| **CASH FLOWS FROM INVESTING ACTIVITIES:**                                      |       |       |       |       |       |       |       |
| Purchase of  property, plant and equipment                                     |       | (5,189,000 | )          | (4,599,000 | )          | (3,620,000 | )          |
| Sale of property,  plant and equipment                                         |       | 311,000    |       | —     |       | 594,000    |       |
| Investment in life  insurance                                                  |       | (178,000   | )          | (184,000   | )          | (170,000   | )          |
| Acquisition of  assets, net of cash                                            |       | (1,033,000 | )          | (2,687,000 | )          | (1,589,000 | )          |
| Net cash used for  investing activities                                        |       | (6,089,000 | )          | (7,470,000 | )          | (4,785,000 | )          |
| **CASH FLOWS FROM FINANCING ACTIVITIES:**                                      |       |       |       |       |       |       |       |
| Proceeds from  current and long-term debt                                      |       | 2,228,000  |       | 1,831,000  |       | 4,650,000  |       |
| Repayments of  current and long-term debt                                      |       | (1,502,000 | )          | (2,141,000 | )          | (3,635,000 | )          |
| Cash dividends  paid to NQA, Ltd.                                              |       | —     |       | —     |       | (39,000    | )          |
| Proceeds from  stock options exercised                                         |       | 300,000    |       | 184,000    |       | —     |       |
| Common stock  repurchase                                                       |       | —     |       | (106,000   | )          | (154,000   | )          |
| Net cash provided  by (used for) financing activities                          |       | 1,026,000  |       | (232,000   | )          | 822,000    |       |
| Effect of exchange  rate changes on cash and cash equivalents                  |       | 13,000     |       | —     |       | —     |       |
| Net increase  (decrease) in cash                                               |       | 1,540,000  |       | 1,102,000  |       | (224,000   | )          |
| Beginning cash  balance                                                        |       | 4,661,000  |       | 3,559,000  |       | 3,783,000  |       |
| ENDING CASH  BALANCE                                                           |       | $          | 6,201,000  |       | $          | 4,661,000  |       | $ | 3,559,000 |   |
| **SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION**                           |       |       |       |       |       |       |       |
| Cash payments during the year for:                                             |       |       |       |       |       |       |       |
| Interest                                                                       |       | $          | 1,078,000  |       | $          | 1,171,000  |       | $ | 1,253,000 |   |
| Income taxes                                                                   |       | 667,000    |       | 529,000    |       | 130,000    |       |
| Cash received during the year for:                                             |       |       |       |       |       |       |       |
| Income taxes                                                                   |       | —     |       | 5,000      |       | 41,000     |       |
| **SUPPLEMENTAL DISCLOSURE OF NON-CASH TRANSACTIONS**                           |       |       |       |       |       |       |       |
| NQA, Ltd. equity infusion                                                      |       |       |       |       |       |       |       |
| Forgiveness of  certification fee for equity                                   |       | $          | —     |       | $          | —     |       | $ | 275,000 |   |

 

See accompanying notes.

32

----

**NATIONAL TECHNICAL SYSTEMS, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements January 31, 2005, 2004 and 2003**

**(1)   Summary**ofSignificant Accounting Policies

*Principles of Consolidation*

The consolidated financial statements include theaccounts of National Technical Systems, Inc. (“NTS” or the “Company”) andits subsidiaries. All significant intercompany balances and transactions havebeen eliminated in consolidation.

The Company hasconsolidated NQA, Inc., a 50% owned subsidiary for which the distributionof profits and losses is 50.1% to the Company, and 49.9% to the othershareholder. NTS controls the management decisions and elects the president ofNQA, Inc. and therefore has complete operating control of the subsidiary. XXCALJapan is a 50% owned subsidiary which started in fiscal 1999 and is accountedfor under the equity method since NTS does not have management or boardcontrol. The equity investment is $760,000, $284,000 and $179,000 at January 31,2005, 2004 and 2003, respectively.

*Risks and Uncertainties*

The preparation of financial statements in conformitywith generally accepted accounting principles requires management to makeestimates and assumptions that affect the amounts reported in the financialstatements and accompanying notes. Estimates made by the Company relateprimarily to the recognition of revenue under long-term contracts and valuationof contract claims. Actual results could differ from those estimates.

The Company performsongoing credit evaluations of its customers’ financial condition and generallyrequires no collateral.

*Revenue Recognition*

Revenues are derived from development, qualificationand production testing and engineering services for commercial products, spacesystems and military equipment of all types. The Company also providestechnical staffing, qualification of safety related systems and components, andISO 9000 certification services.

Revenue from fixed price testing contracts is recordedupon completion of the contracts, which are generally short-term, oridentifiable contractual tasks. At the time the Company enters into a contractthat includes multiple tasks, the Company estimates the amount of actual laborand other costs that will be required to complete each task based on historicalexperience. Milestone payments related to each task are then established in thecontract, which provide for a normal profit margin relative to similar testingperformed for similar tasks historically. Revenue relative to each task andfrom contracts which are time and materials based is recorded as effort isexpended (hours charged). Billings in excess of amounts earned are deferred. Anyanticipated losses on contracts are charged to income when identified.  All selling, general and administrative costsare treated as period costs and expensed as incurred.

Reimbursements, includingthose related to travel and other out-of-pocket expenses are included inrevenues and an equivalent amount of reimbursable expenses is included inoperating costs and expenses.

33

----

**NATIONAL TECHNICAL SYSTEMS, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued) January 31, 2005, 2004 and 2003**

**(1)**   Summary ofSignificant Accounting Policies (Continued)

*Inventories*

Inventories consist ofaccumulated costs including direct labor, material and overhead applicable touncompleted contracts and are stated at actual cost, which is not in excess ofestimated net realizable value.

*Property Held for Sale*

In fiscal year 2005, theCompany sold the Palm Desert, California condominium and purchased a newcondominium, which is also located in Palm Desert. The Company recorded a gainof approximately $158,000 from the sale of the old condominium. During fiscalyear ended January 31, 2003, the Company sold a parcel of land in SanDiego County, California. Net proceeds from the sale were $544,000 which wasthe same amount recorded as cost.

*Property, Plant and Equipment*

Property, plant, andequipment is stated at actual cost and is depreciated and amortized using thestraight-line method over the following estimated useful lives:
| Buildings               |   | 30  to 35 years        |
|-------------------------|--------|------------------------|
| Machinery and equipment |   | 3 to  20 years         |
| Leasehold improvements  |   | Terms  of lease, or    |
|                         |   | estimated  useful life |
|                         |   | (whichever is less)    |

 

*Intangible Assets*

TheCompany adopted the new rules on accounting for goodwill and otherintangible assets beginning in the first quarter of fiscal year 2003 inaccordance with Statement of Financial Accounting Standards No. 142 (“SFASNo. 142”), “Goodwill and Other Intangible Assets.”

**As of January 31, 2005 and 2004, the Company hadthe following acquired intangible assets:**
| ** **                                      | ** ** | **January 31, 2005** | ** ** | **January 31, 2004** | ** ** |
|-------------------------------------------------|------------|--------------------------------|------------|--------------------------------|------------|
| ** **                                      | ** ** | **Gross**                      | ** ** | ** **                     | ** ** | **Net** | ** ** | **Estimated** | ** ** | **Gross** | ** ** | ** ** | ** ** | **Net** | ** ** | **Estimated** | ** ** |
| ** **                                      | ** ** | **Carrying**                   | ** ** | **Accum.**                     | ** ** | **Carrying** | ** ** | **Useful** | ** ** | **Carrying** | ** ** | **Accum.** | ** ** | **Carrying** | ** ** | **Useful** | ** ** |
| ** **                                      | ** ** | **Amount**                     | ** ** | **Amort.**                     | ** ** | **Amount** | ** ** | **Life** | ** ** | **Amount** | ** ** | **Amort.** | ** ** | **Amount** | ** ** | **Life** | ** ** |
| Intangible assets subject  to amortization:     |       |                           |       |                           |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Covenant not to compete                         |       | $                              | 148,000    |                           | $          | 78,000 |   | $ | 70,000 |   |   | 3-5  years |   |   | $ | 148,000 |   | $ | 39,000 |   | $ | 109,000 |   |   | 3-5  years |   |   |
| Intangible assets not  subject to amortization: |       |                           |       |                           |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Goodwill                                        |       | $                              | 3,537,000  |                           | $          | 797,000 |   | $ | 2,740,000 |   |   |   |   |   | $ | 3,537,000 |   | $ | 797,000 |   | $ | 2,740,000 |   |   |   |   |   |

 

Amortization expense forintangible assets subject to amortization was $39,000 and $30,000 for the yearsended January 31, 2005 and 2004, respectively.

34

----

**NATIONAL TECHNICAL SYSTEMS, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued) January 31, 2005, 2004 and 2003**

**(1)**   Summary ofSignificant Accounting Policies (Continued)

Under SFAS No. 142,goodwill and intangible assets that have indefinite useful lives are notamortized but are tested at least annually for impairment. The goodwill testfor impairment consists of a two-step process that begins with an estimation ofthe fair value of the reporting unit. The first step of the test is a screenfor potential impairment and the second step measures the amount of impairment,if any. The first step of the goodwill impairment test includes a comparison ofthe fair value of each reporting unit that has associated goodwill with thecarrying value of the reporting unit. The Company has identified two reportingunits in the Engineering and Evaluation segment and one reporting unit in theTechnical Solutions segment, which constitute components of its business thatinclude goodwill. The Company completed its annual goodwill impairment test andhas determined that the fair value of each of the reporting units exceeded thereporting unit’s carrying amount, and no impairment was indicated.

*Long-lived assets*

The Company periodically evaluatesthe recoverability of the carrying amount of long-lived assets (includingproperty, plant and equipment, and intangible assets with determinable lives)whenever events or changes in circumstances indicate that the carrying amountof an asset may not be fully recoverable. The Company evaluates events orchanges in circumstances based on a number of factors including operatingresults, business plans and forecasts, general and industry trends and,economic projections and anticipated cash flows. An impairment is assessed whenthe undiscounted expected future cash flows derived from an asset are less thanits carrying amounts. Impairment losses are measured as the amount by which thecarrying value of an asset exceeds its fair value and are recognized inearnings.

*Stock-BasedCompensation*

The Company has elected to continue to follow APB No. 25, “Accounting for Stock Issued to Employees”, in accounting for its employeestock options because, as discussed below, the alternative fair valueaccounting provided under SFAS No. 123, “Accounting for Stock BasedCompensation”, requires the use of option valuation models that were notdeveloped for use in valuing employee stock options. Under APB No. 25, nocompensation expense is recognized in the Company’s financial statements, sincethe exercise price of the Company’s employee stock options is not less than themarket price of the underlying stock on the date of grant.

Proforma information regarding net income and earnings per share is required bySFAS No. 123. This information is required to be determined as if theCompany had accounted for its employee stock options granted subsequent to January 31,1995 under the fair value method of that statement. The fair value of optionsgranted reported below has been estimated at the date of grant using theBlack-Scholes option pricing model with the following weighted averageassumptions:
| ** **                | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** |
|---------------------------|------------|----------|------------|----------|------------|----------|------------|
| Expected life (in  years) |       | 7.68     |       | 8.5      |       | 8.4      |       |
| Risk-free  interest rate  |       | 3.71     | %          | 3.31     | %          | 3.10     | %          |
| Expected  volatility      |       | 76       | %          | 86       | %          | 94       | %          |
| Expected dividend yield   |       | 0.00     | %          | 0.65     | %          | 0.71     | %          |

 

35

----

**NATIONAL TECHNICAL SYSTEMS, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued) January 31, 2005, 2004 and 2003**

**(1)**   Summary ofSignificant Accounting Policies (Continued)

The Black-Scholes option valuation model was developedfor use in estimating the fair value of the traded options that have no vestingrestrictions and are fully transferable. In addition, option valuation modelsrequire the input of highly subjective assumptions, including the expectedstock price volatility. Because the Company’s options have characteristicssignificantly different from those of traded options, and because changes inthe subjective input assumptions can materially affect the fair value estimate,in the opinion of management, the existing models do not necessarily provide areliable single measure of the fair value of its options. The weighted averageestimated fair value of employee stock options granted during 2005 was $4.67per share. Had compensation cost for the Company’s stock option plan beendetermined consistent with the fair value method outlined in SFAS No. 123,the Company’s net income (loss) and earnings (loss) per share would have beenas indicated below:
| ** **                                | ** ** | **January 31, 2005** | ** ** | **January 31, 2004** | ** ** | **January 31, 2003** | ** ** |
|-------------------------------------------|------------|--------------------------------|------------|--------------------------------|------------|--------------------------------|------------|
| Net income (loss)                         |       |                           |       |                           |       |                           |       |   |   |   |   |   |   |
| As reported                               |       |                           | $          | 1,682,000                      |       |                           |       | $ | 1,293,000 |   |   |   | $ | 858,000 |   |   |
| Pro forma                                 |       |                           | $          | 1,155,000                      |       |                           |       | $ | 876,000 |   |   |   | $ | 533,000 |   |   |
| Basic earnings (loss)  per common share   |       |                           |       |                           |       |                           |       |   |   |   |   |   |   |
| As reported                               |       |                           | $          | 0.19                           |       |                           |       | $ | 0.15 |   |   |   | $ | 0.10 |   |   |
| Pro forma                                 |       |                           | $          | 0.13                           |       |                           |       | $ | 0.10 |   |   |   | $ | 0.06 |   |   |
| Diluted earnings (loss)  per common share |       |                           |       |                           |       |                           |       |   |   |   |   |   |   |
| As reported                               |       |                           | $          | 0.18                           |       |                           |       | $ | 0.14 |   |   |   | $ | 0.10 |   |   |
| Pro forma                                 |       |                           | $          | 0.12                           |       |                           |       | $ | 0.10 |   |   |   | $ | 0.06 |   |   |

 

*Comprehensive Income*

In accordance with SFAS No. 130,“Reporting Comprehensive Income”, the Company is required to report and displaythe components of comprehensive income including unrealized gains or losses onavailable-for-sale securities and foreign currency translation adjustments.Comprehensive income was $13,000 for fiscal year 2005. There was nocomprehensive income or loss in fiscal year 2004. Accumulated othercomprehensive loss was $38,000 and $51,000 as of January 31, 2005 and2004, respectively, due to foreign currency translation adjustments.

*Earnings Per Share*

Basic and diluted netincome per common share is presented in conformity with SFAS No. 128, “EarningsPer Share” for all periods presented. In accordance with SFAS No. 128, basicearnings per share has been computed using the weighted average number ofshares of common stock outstanding during the year. Basic earnings per shareexcludes any dilutive effects of options, warrants and convertible securities.

*Foreign Currency Translation*

The accounts of theforeign divisions are translated into United States dollars in accordance withSFAS No. 52, “Foreign Currency Translation”. All balance sheet accountshave been translated using the current rate of exchange at the balance sheet date.Results of operations have been translated using the average rates prevailingthroughout the year. Translation gains or losses resulting from the changes inthe exchange rates from year-to-year are accumulated in a separate component ofshareholders’ equity. In 

36

----

**NATIONAL TECHNICAL SYSTEMS, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued) January 31, 2005, 2004 and 2003**

**(1)**   Summary ofSignificant Accounting Policies (Continued)

fiscalyear 2005, the translation of the balance sheet accounts resulted in a $13,000unrealized gain. There was no translation gain or loss adjustment in fiscalyears 2004 and 2003.

*Related Party Transactions*

NTS provides management and consulting services to NQA, Inc.for an agreed upon management fee. Such services include, but are not limitedto, advice and assistance concerning any and all aspects of the operations ofthe Company. Management fees earned by the Company for fiscal 2005, 2004 and2003 were $214,000, $241,000 and $241,000, respectively.

NQA, Ltd., the minority shareholder of NQA, Inc.,provides certification oversight and advice and processes and issues ISOregistration certificates. NQA, Ltd. charges NQA, Inc. an agreed upon feefor each certificate in place at the beginning of the year and issued duringthe year together with the appropriate United Kingdom Accreditation Service (“UKAS”)and Raad voor Accreditatie (“RVA”) levy. Certification fees for fiscal 2005,2004 and 2003 were $214,000, $241,000 and $241,000, respectively.

NQA, Inc. leasesspace from NTS and was assessed $71,000 for rent and utilities in fiscal years2005 and 2004, respectively.

*Reclassifications*

Certain amounts in theprior year financial statements have been reclassified to conform to thecurrent year financial statement presentation.

*Recently IssuedAccounting Standards*

In December 2004,the FASB issued SFAS No. 123R, “Share-Based Payment,” which requirescompanies to recognize in the statement of operations all share-based paymentsto employees, including grants of employee stock options, based on their fairvalues. Accounting for share-based compensation transactions using theintrinsic method supplemented by pro forma disclosures will no longer bepermissible. The new statement will be effective for NTS in the fiscal yearbeginning February 2006. The Company has not yet completed its analysis ofthe impact of adopting SFAS 123R and is therefore currently unable toquantify the effect on its financial statements. However, the adoption of thisnew statement will have a significant impact on the results of operations andnet income per share of the Company as the Company will be required to expensethe fair value of all share based payments.

**(2)   BusinessAcquisition and Disposition**

Thefollowing table summarizes the acquisitions completed during fiscal years 2005,2004 and 2003 that were accounted for under the purchase method of accounting:
| ** ** | ** ** | ** **                                   | ** ** | **Purchase Price** | ** ** | **Goodwill** | ** ** | **Other Intangibles** | ** ** |
|------------|------------|----------------------------------------------|------------|-------------------------|------------|--------------|------------|----------------------------|------------|
| FY 05      |       | Telecommunications  Test Laboratory, Calgary |       |                    | $          | 1,033,000    |       |                       | —     |   |   | — |   |   |
| FY 04      |       | DTI  Holdings, LLC                           |       |                    | $          | 3,687,000    |       |                       | $          | 1,870,000 |   |   | $ | 59,000 |   |   |
| FY 03      |       | TRS Staffing Solutions                       |       |                    | $          | 1,589,000    |       |                       | —     |   |   | $ | 89,000 |   |   |
|            |            |                                              |            |                         |            |              |            |                            |            |  |  |  |  |  |  |  |

 

37

----

**NATIONAL TECHNICAL SYSTEMS, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued) January 31, 2005, 2004 and 2003**

**(2)**   BusinessAcquisition and Disposition (Continued)

*Acquisition ofTelecommunications Test Laboratory, Calgary*

On July 30, 2004, AETL Testing Inc. (a CanadianCorporation), a wholly-owned subsidiary of the Company (“AETL”), acquiredsubstantially all of the fixed assets of a Canadian Test Laboratory involved inthe testing of telecommunication equipment, located in Calgary, Alberta,Canada, for a total purchase price of $1,033,000. By making this acquisition,the Company intends to expand its presence to Canada and increase itsopportunities in the testing of telecommunication equipment. The results ofoperations of the acquired business are included in the accompanyingconsolidated statement of operations from August 1, 2004 to January 31,2005.

Theallocation of the purchase price to the assets acquired and liabilities assumedwas as follows:
| GST receivable                 |   | $       | 68,000    |   |
|--------------------------------|--------|---------|-----------|--------|
| Property, plant  and equipment |   | 965,000 |      |
| Totals assets  acquired        |   | $       | 1,033,000 |   |

 

*Acquisition of DTIHoldings, LLC*

On January 23, 2004,NTS through its wholly owned subsidiary, NTS Technical Systems, acquiredsubstantially all of the assets and business of DTI Holdings, LLC, doingbusiness as Dynamic Testing (“DTI”), with an effective date of January 1,2004. At the closing, NTS delivered $2,583,000 in cash and 195,695 shares ofNTS common stock, no par value, with a market value of $1,000,000 and agreed toassume certain liabilities of DTI. In addition, NTS paid $104,000 intransaction related costs. DTI provides its customers with large-scale shockand vibration testing services that are used to qualify mission criticalequipment such as navigation, communication and guidance weapons installed onU.S. Navy combatants. Its customers include the U.S. Navy and other U.S. andforeign government agencies, as well as prime contractors and commercialorganizations. In addition to testing services, DTI offers its customers a fullline of shock isolators. These factors contributed to a purchase price inexcess of the fair value of DTI’s net worth, and as a result, the Company hasrecorded goodwill in connection with this transaction.

*Acquisition of TRSStaffing Solutions*

On October 14, 2002,XXCAL, Inc. (“XXCAL”), a wholly-owned subsidiary of the Company, acquiredsubstantially all of the U.S. assets and business of the Information TechnologyStaffing Division of TRS Staffing Solutions (“TRS”), a New Hampshirecorporation and wholly-owned subsidiary of Fluor Corporation for a totalpurchase price of $1,589,000 consisting of the sum of $1,500,000 paid in cashto several subsidiaries of Fluor Corporation and $89,000 of transaction relatedcosts. $1,500,000 of the initial purchase price of $1,589,000 has beenallocated to property, plant and equipment consisting of furniture andequipment based on an initial estimate of the respective fair values as of thedate of acquisition and the remaining balance of $89,000 was allocated to acovenant not to compete. The acquired business had six offices servingapproximately 50 customers with more than 330 IT professionals. The results ofoperations of the acquired business are included in the accompanyingconsolidated statement of operations from October 14, 2002.

38

----

**NATIONAL TECHNICAL SYSTEMS, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued) January 31, 2005, 2004 and 2003**

**(3)   Debt**

Long-termdebt consists of the following:
| ** **                                       | ** ** | **2005**   | ** ** | **2004**   | ** ** |
|--------------------------------------------------|------------|------------|------------|------------|------------|
| Revolving lines of  credit (a)                   |       | $          | 15,502,000 |       | $          | 15,502,000 |   |
| Notes payable secured by  land and buildings (b) |       | 2,775,000  |       | 3,050,000  |       |
| Secured notes payable  (c)                       |       | 2,775,000  |       | 1,620,000  |       |
| Loans from employee and  officers (d)            |       | 480,000    |       | 634,000    |       |
| Subtotal                                         |       | 21,532,000 |       | 20,806,000 |       |
| Less current  installments                       |       | 975,000    |       | 1,052,000  |       |
| Total                                            |       | $          | 20,557,000 |       | $          | 19,754,000 |   |

----

(a)           OnNovember 25, 2002, the Company increased the revolving line of credit withComerica Bank California and First Bank to $20,000,000. Comerica BankCalifornia, as the agent, retained 60% of the line with First Bank, as theparticipant, holding 40% of the line. The revolving line of credit was reducedby $1,750,000 on August 1, 2003 and was reduced again on August 1,2004 by $1,750,000 and will be reduced by $1,750,000 each year thereafter. Ifduring any fiscal year, the Company’s net income equals or exceeds $2,000,000,there will be no required reduction in the revolving line of credit. Theinterest rate is at the agent’s prime rate, with an option for the Company toconvert to loans at the Libor rate plus 250 basis points for 30, 60, 90, 180 or365 days, with minimum advances of $1,000,000. The Company paid a 0.5%commitment fee of the total line amount and is paying an additional 0.25% ofthe commitment amount annually and a 0.25% fee for any unused line of credit. Theoutstanding balance on the revolving line of credit at January 31, 2005was $15,502,000. This balance is reflected in the accompanying condensedconsolidated balance sheets as long-term. This agreement is subject to certaincovenants, which require the maintenance of certain working capital,debt-to-equity, earnings-to-expense and cash flow ratios. The amount availableon the line of credit was $998,000 as of January 31, 2005. The Company wasin full compliance with all of the covenants with its banks as of January 31,2005 with the exception of the capital expenditure covenant, which was inexcess of the allowed amount by approximately $189,000. The Company requestedand received a waiver from its banks. The Company is currently in negotiationswith its banks to increase its lines of credit.

(b)          The amount of $2,775,000represents mortgage notes on land and buildings owned by the Company inCalifornia and Massachusetts. The notes carry fixed interest rates ranging from5.5% to 9.0% and they are collateralized by those properties.

(c)**          **Infiscal 2002 the Company entered into equipment line of credit agreements withBank of America and the Fifth Third Leasing Company (interest rates of 5.56% to9.82%) in order to finance various equipment with terms of 60 months for eachequipment schedule. The outstanding balances at January 31, 2005 on these noteswere $2,481,000 and $22,000, respectively.

In fiscal 2003 the Company entered into a newequipment line of credit agreement with First Bank (interest rate of 7.09%) inorder to finance various equipment with terms of 60 months for each equipmentschedule. The outstanding balances at January 31, 2005 on this note was$50,000.

Other secured notes payable at January 31, 2005amounted to $221,000. This balance consisted of two separate loans; one loanfor $189,000 was subsequently paid off on March 15, 2005.

39

----

**NATIONAL TECHNICAL SYSTEMS, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued) January 31, 2005, 2004 and 2003**

**(3)**   Debt(Continued)

(d)          The Company hasunsecured demand notes payable to two officers of the Company and one employeein the aggregate amount of $480,000 as of January 31, 2005. The interestis payable monthly and is based on the bank’s reference rate less three basispoints.

Maturitiesof long-term debt for five years subsequent to January 31, 2005 are asfollows:
| 2006       |   | $          | 975,000    |   |
|------------|--------|------------|------------|--------|
| 2007       |   | 16,744,000 |       |
| 2008       |   | 679,000    |       |
| 2009       |   | 709,000    |       |
| 2010       |   | 550,000    |       |
| Thereafter |   | 1,875,000  |       |
|       |   | $          | 21,532,000 |   |

 

In accordance with the requirements of SFAS No. 107,“Disclosure about Fair Value of Financial Instruments”, a reasonable estimateof fair value for the Company’s fixed rate debt was based on a discounted cashflow analysis. The carrying amount of variable rate debt, including borrowingsunder the Company’s revolving lines of credit, approximate their fair values.

Thecarrying amounts and estimated fair values of the Company’s financialinstruments are:
| ** **                        | ** ** | **2005**     | ** ** | **2005**            | ** ** | **2004**     | ** ** | **2004**            | ** ** |
|-----------------------------------|------------|--------------|------------|---------------------|------------|--------------|------------|---------------------|------------|
| ** **                        | ** ** | **Carrying** | ** ** | **Estimated**       | ** ** | **Carrying** | ** ** | **Estimated**       | ** ** |
| ** **                        | ** ** | **amount**   | ** ** | **fair value** | ** ** | **amount**   | ** ** | **fair value** | ** ** |
| Notes payable                     |       | $            | 2,775,000  |                | $          | 3,223,000    |       | $                   | 3,050,000  |   | $ | 3,983,000 |   |
| Secured notes  payable            |       | 2,775,000    |       | 2,717,000           |       | 1,620,000    |       | 1,709,000           |       |
| Revolving lines  of credit        |       | 15,502,000   |       | 15,502,000          |       | 15,502,000   |       | 15,502,000          |       |
| Loans from employee and  officers |       | 480,000      |       | 480,000             |       | 634,000      |       | 634,000             |       |
|                                   |            |              |            |                     |            |              |            |                     |            |  |  |  |  |

 

40

----

**NATIONAL TECHNICAL SYSTEMS, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued) January 31, 2005, 2004 and 2003**

**(4)**   IncomeTaxes

Income taxes are provided for the tax effects oftransactions reported in the financial statements and consist of taxescurrently due plus deferred taxes. Pre-tax profit (loss) generated from foreignoperations was $522,000, $95,000 and $65,000 in fiscal 2005, 2004 and 2003,respectively. Accumulated foreign earnings were $741,000 as of January 31,2005. The earnings associated with the Company’s foreign subsidiary, whichsignificantly increased in the current year, are considered to be permanentlyinvested and are reported net of tax and are included in income before incometaxes and the associated tax is not separately stated in income taxes. Duringfiscal 2004, the Company liquidated its UK subsidiary, the tax effect after theforeign tax credit was an additional $76,000 in income taxes.

Theprovision (benefit) for income tax expense from continuing operations consistsof:
| ** **         | ** ** | **2005** | ** ** | **2004** | ** ** | **2003**  | ** ** |
|--------------------|------------|----------|------------|----------|------------|-----------|------------|
| Current:           |       |     |       |     |       |      |       |
| Federal            |       | $        | 358,000    |     | $          | 151,000   |       | $ | 136,000 |   |
| State              |       | 137,000  |       | 174,000  |       | 100,000   |       |
| Foreign            |       | 14,000   |       | —   |       | —    |       |
|               |       | 509,000  |       | 325,000  |       | 236,000   |       |
| Deferred:          |       |     |       |     |       |      |       |
| Federal            |       | 187,000  |       | 663,000  |       | 427,000   |       |
| State              |       | 214,000  |       | 68,000   |       | 13,000    |       |
|               |       | 401,000  |       | 731,000  |       | 440,000   |       |
| Income tax expense |       | $        | 910,000    |     | $          | 1,056,000 |       | $ | 676,000 |   |

 

Thefollowing is a reconciliation of the difference between the actual provisionfor income taxes and the provision computed by applying the federal statutorytax rate on income from continuing operations before income taxes:
| ** **                                                | ** ** | **2005** | ** ** | **2004** | ** ** | **2003**  | ** ** |
|-----------------------------------------------------------|------------|----------|------------|----------|------------|-----------|------------|
| Income before  income taxes and minority interest         |       | $        | 2,592,000  |     | $          | 2,310,000 |       | $ | 1,549,000 |   |
| Federal income  tax computed at statutory rate            |       | $        | 881,000    |     | $          | 785,000   |       | $ | 526,000 |   |
| Tax on  liquidation of XXCAL LTD                          |       | —   |       | 76,000   |       | —    |       |
| State income  taxes, net of federal benefits              |       | 89,000   |       | 114,000  |       | 66,000    |       |
| Equity income in  non-consolidated subsidiary, net of tax |       | (164,000 | )          | —   |       | —    |       |
| Other,  principally non-deductible expenses               |       | 104,000  |       | 81,000   |       | 84,000    |       |
| Income tax expense                                        |       | $        | 910,000    |     | $          | 1,056,000 |       | $ | 676,000 |   |

 

41

----

**NATIONAL TECHNICAL SYSTEMS, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued) January 31, 2005, 2004 and 2003**

**(4)**   Income Taxes(Continued)

Deferred income taxes onthe consolidated balance sheets reflect the net tax effects of temporarydifferences between the carrying amounts of assets and liabilities forfinancial reporting purposes and the amounts used for income tax purposes. Theprimary components of the Company’s deferred tax assets and liabilities at January 31were as follows:
| ** **                              | ** ** | **2005**    | ** ** | **2004**        | ** ** |
|-----------------------------------------|------------|-------------|------------|-----------------|------------|
| ** **                              | ** ** | **Current** | ** ** | **Non-current** | ** ** | **Current** | ** ** | **Non-current** | ** ** |
| **Deferred tax assets:**                |       |        |       |            |       |   |   |   |   |
| Bad debts  reserves                     |       | $           | 372,000    |            | $          | — |   | $ | 346,000 |   | $ | — |   |
| Vacation accrual                        |       | 420,000     |       | —          |       | 354,000 |   | — |   |
| State taxes                             |       | 252,000     |       | —          |       | 105,000 |   | 129,000 |   |
| Deferred  Compensation                  |       | 375,000     |       | —          |       | 370,000 |   | — |   |
| Net operating  loss                     |       | 40,000      |       | —          |       | 34,000 |   | — |   |
| Other                                   |       | 70,000      |       | —          |       | 2,000 |   | — |   |
| Total deferred  tax assets              |       | 1,529,000   |       | —          |       | 1,211,000 |   | 129,000 |   |
| **Deferred  tax liabilities:**          |       |        |       |            |       |   |   |   |   |
| Goodwill                                |       | —      |       | (111,000        | )          | (27,000 | ) | — |   |
| Gain on  installment sale of asset      |       | —      |       | (45,000         | )          | — |   | (61,000 | ) |
| Gain on  involuntary conversion         |       | —      |       | (112,000        | )          | — |   | (116,000 | ) |
| Tax over book  depreciation             |       | —      |       | (5,299,000      | )          | — |   | (4,827,000 | ) |
| Other                                   |       | —      |       | (5,000          | )          | — |   | — |   |
| **Net  deferred tax asset (liability)** |       | $           | 1,529,000  |            | $          | (5,572,000 | ) | $ | 1,184,000 |   | $ | (4,875,000 | ) |

 

**(5)   Stock Optionsand Pension Plans**

The Company has two employee incentive stock optionplans; the “2002 stock option plan” and the “1994 stock option plan.”

Under both stock option plans, officers, keyemployees, non-employee directors and consultants may be granted options topurchase shares of the Company’s authorized but unissued common stock. At theannual meeting held on June 28, 2002, the 2002 stock option plan wasapproved. The number of shares approved for issuance under the 2002 stockoption plan was 1,000,000 shares. During fiscal 2005 there were 172,500 sharesgranted under the 2002 stock option plan and 317,925 shares were reserved forfuture grants under the 2002 stock option plan. At January 31, 2005 therewere 1,461,127 shares authorized and granted under the 1994 stock option planand there were no shares reserved for future grants.

42

----

**NATIONAL TECHNICAL SYSTEMS, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued) January 31, 2005, 2004 and 2003**

**(5)**   Stock Optionsand Pension Plans (Continued)

Outstanding options underall plans are exercisable at 100% or more of fair market (as determined by thecompensation committee of the Board of Directors) at the date of grant. Theoptions are contingent upon continued employment and are exercisable, unlessotherwise specified, on a cumulative basis of one-fourth of the total shareseach year, commencing one year from the date of grant. Options currently expirefive to ten years from the date of grant. Proceeds received by the Company fromthe exercises are credited to common stock. Additional information with respectto the option plans as of January 31, is as follows:
| ** **                               | ** ** | **2005**   | ** ** | **2004**                                    | ** ** |
|------------------------------------------|------------|------------|------------|---------------------------------------------|------------|
| ** **                               | ** ** | **Shares** | ** ** | **Weighted Avg.  Exercise Price** | ** ** | **Shares** | ** ** | **Weighted Avg.  Exercise Price** | ** ** |
| Beginning Balance                        |       | 2,192,196  |       |                                        | $          | 3.47 |   |   | 1,983,108 |   |   | $ | 3.25 |   |   |
| Grants                                   |       | 172,500    |       |                                        | 4.67       |   |   | 348,450 |   |   | 4.50 |   |   |
| Exercises                                |       | (172,644   | )          |                                        | 2.44       |   |   | (83,437 | ) |   | 2.29 |   |   |
| Canceled or expired *                    |       | (63,850    | )          |                                        | 4.23       |   |   | (55,925 | ) |   | 3.75 |   |   |
| Ending balance                           |       | 2,128,202  |       |                                        | $          | 3.63 |   |   | 2,192,196 |   |   | $ | 3.47 |   |   |
| Reserve for future  grants at year end * |       | 317,925    |       |                                        | —     |   |   | 454,300 |   |   | — |   |   |
| Exercisable                              |       | 1,505,199  |       |                                        | $          | 3.59 |   |   | 1,364,941 |   |   | $ | 3.63 |   |   |

----

*                    For fiscalyear ended 2005, of the 63,850 canceled or expired options, only 36,125 wereadded back to the reserve for future grants, the remaining 27,725 were from the1994 stock option plan that was discontinued.

The range of exercise prices for options outstandingat January 31, 2005 was $1.35 to $7.00. The range of exercise prices foroptions is wide due primarily to the fluctuating price of the Company’s stockover the period of the grants.

Thefollowing tables summarize information about options outstanding at January 31,2005:
| **Range of  exercise prices** | ** ** | **Outstanding at  January 31,  2005** | ** ** | **Weighted Avg.  Remaining  contract life  in yrs.** | ** ** | **Weighted Avg.  Exercise  Price** | ** ** | **Number  Exercisable** | ** ** | **Weighted Avg.  Exercisable  Price** | ** ** |
|-----------------------------------------|------------|-------------------------------------------------|------------|---------------------------------------------------------------------|------------|-----------------------------------------|------------|-------------------------|------------|--------------------------------------------|------------|
| $1.00 to $2.00                          |       |                                            | 164,125    |                                                                |       |                                    | 6.6        |                    |       |                                       | $          | 1.65 |   |   | 95,375 |   |   | $ | 1.70 |   |   |
| $2.01 to $3.00                          |       |                                            | 816,796    |                                                                |       |                                    | 5.6        |                    |       |                                       | $          | 2.62 |   |   | 669,506 |   |   | $ | 2.68 |   |   |
| $3.01 to $4.00                          |       |                                            | 234,283    |                                                                |       |                                    | 4.6        |                    |       |                                       | $          | 3.31 |   |   | 232,783 |   |   | $ | 3.31 |   |   |
| $4.01 to $5.00                          |       |                                            | 512,575    |                                                                |       |                                    | 8.0        |                    |       |                                       | $          | 4.55 |   |   | 154,862 |   |   | $ | 4.66 |   |   |
| $5.01 to $6.00                          |       |                                            | 366,006    |                                                                |       |                                    | 4.4        |                    |       |                                       | $          | 5.42 |   |   | 318,256 |   |   | $ | 5.47 |   |   |
| $6.01 to $7.00                          |       |                                            | 34,417     |                                                                |       |                                    | 3.6        |                    |       |                                       | $          | 6.36 |   |   | 34,417 |   |   | $ | 6.36 |   |   |
|                                    |       |                                            | 2,128,202  |                                                                |       |                                    |       |                    |       |                                       |       |   |   | 1,505,199 |   |   |   |   |   |

 

These options will expire if not exercised at specificdates ranging from September 2004 to December 2014. During the yearended January 31, 2005, 172,644 options were exercised at prices from$1.49 to $3.25 per share.

The Company offers three 401(k) profit sharingplans: National Technical Systems 401(k) Profit Sharing Plan, XXCAL 401(k) ProfitSharing Plan and NQA 401(k) Pension Plan. The purpose of these 

43

----

**NATIONAL TECHNICAL SYSTEMS, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued) January 31, 2005, 2004 and 2003**

**(5)**   Stock Optionsand Pension Plans (Continued)

plans is to provideretirement benefits to all employees of the Company. The Company’s employeescan contribute a portion of their salary into the 401(k) plan and theCompany’s Board of Directors, at its discretion, will determine each year theamount of matching contribution the Company will make. Employer contributionsare allocated based on participants own contribution percentage amount to thetotal amount contributed by all employees in each plan. In fiscal 2005, theBoard of Directors and management of the Company approved a contribution to the401(k) profit sharing plan of $239,000 as compared to $221,000 in 2004 and$172,000 in 2003.

The former president of XXCAL has elected to receivethe cash surrender value of life insurance owned by the Company on his life, inlieu of lifetime periodic deferred compensation payments. The cash surrendervalue is included in other assets and the deferred compensation liability isincluded in deferred compensation.

The deferred compensationbenefits are accrued and recognized over each employee’s expected term ofemployment. The Company’s total deferred compensation expenses were $93,000,$86,000 and $95,000 for the years ended January 31, 2005, 2004 and 2003,respectively. Included in other assets is $2,046,000 and $1,868,000 for thecash surrender values as of January 31, 2005 and 2004, respectively.

**(6)   Capital Stock**

As of January 31, 2005 and 2004, the Company had20,000,000 authorized common shares with no par value. At January 31, 2005and January 31, 2004, 9,025,000 shares and 8,863,000 shares were issuedand outstanding, respectively. On February 6, 2001, the Company’s Board ofDirectors authorized the repurchase of common stock in open market purchases. TheCompany completed its common stock repurchase program in fiscal 2004 and hadpurchased 169,750 shares at an average price of $2.54.

Holders of common stockvote together on matters submitted to shareholders, including the election ofdirectors. Except as required by law, the powers, preferences and rights of allcommon stock and the qualifications, limitations or restrictions thereof, shallin all respects be identical. The common stock shareholders will be entitled toreceive, to the extent permitted by law, and to share equally and ratably,share for share, any such dividends as may be declared from time to time by theboard of directors.

**(7)   Commitments**

The Company leases certain of its operating facilitiesand equipment under operating leases which principally expire at various datesthrough fiscal year 2010. The leases are generally on a net-rent basis, wherebythe Company pays taxes, maintenance, insurance and other operating expenses. Managementexpects that, in the normal course of business, leases that expire will berenewed or replaced by other leases. Gross rental expense was $2,346,000 in2005, $2,273,000 in 2004, and $2,155,000 in 2003.

44

----

**NATIONAL TECHNICAL SYSTEMS, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued) January 31, 2005, 2004 and 2003**

**(7)**   Commitments(Continued)

At January 31, 2005,minimum rental payment obligations under operating leases were as follows:
| 2006       |   | $         | 1,611,000 |   |
|------------|--------|-----------|-----------|--------|
| 2007       |   | 1,167,000 |      |
| 2008       |   | 911,000   |      |
| 2009       |   | 520,000   |      |
| 2010       |   | 197,000   |      |
| Thereafter |   | 139,000   |      |
|       |   | $         | 4,545,000 |   |

 

**(8)   Accrued Expenses**

Asummary of accrued expenses at January 31 is as follows:
| ** **                          | ** ** | **2005** | ** ** | **2004** | ** ** |
|-------------------------------------|------------|----------|------------|----------|------------|
| Compensation and  employee benefits |       | $        | 2,840,000  |     | $          | 2,794,000 |   |
| Other                               |       | 915,000  |       | 720,000  |       |
| Total accrued expenses              |       | $        | 3,755,000  |     | $          | 3,514,000 |   |

 

**(9)   Contingencies**

The Company is, from timeto time, the subject of claims and suits arising out of matters occurringduring the operation of the Company’s business. In the opinion of management,no claims or suits would materially affect the financial position or theresults of the operations or cash flows of the Company.

**(10)**   Segment of Business Information

The Company maintains two core operating segments:Engineering & Evaluation and Technical Solutions.

The Engineering & Evaluation segment operatestest laboratories in various states in the U.S., Japan and Germany and providestechnical support and technical support personnel to assist clients in a broadrange of industries (aerospace, defense, telecommunications, power products,transportation and computer, among others) in the solving of technical problemsvia analysis and testing of materials, components, subsystems and systems,electro-magnetic interference testing and product safety testing under itsnewly granted NRTL status by the United States’ Department of Labor,Occupational Safety and Health Administration. This segment also providesregistration, certification and conformance evaluation services to its clients,particularly with regard to EU standards. In addition, it performscompatibility testing of hardware and software components. This segment alsoperforms quality registration services by evaluating a supplier’s systems forconformity to ISO 9000, the international quality standard. The evaluationsinclude an examination of the companies’ quality policy, quality systemdocumentation and quality records.

45

----

**NATIONAL TECHNICAL SYSTEMS, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued) January 31, 2005, 2004 and 2003**

**(10)**   Segment ofBusiness Information (Continued)

The Technical Solutions segment locates, recruits, andhires a wide variety of technical personnel, engineers, drafters, designers,computer programmer technicians and others and assigns them to clients eitheron a temporary or permanent basis.

The Company’s reportable segments each representstrategic business units that offer different, yet related services. They aremanaged differently because each requires differing technical skills and salesstrategies. Each segment is led by a chief operating decision maker, who, incoordination with the Company’s Chief Executive Officer utilizes theinformation reported below in evaluating results and allocating resourcespertaining to segment operations.

The Company did not have any revenues from a singlecustomer in the Engineering & Evaluation Group, which represented inexcess of 10% of total segment revenues. Three major customers represented$7,915,000, $5,876,000 and $4,918,000 of fiscal 2005 Technical Solutions netrevenues and two major customers represented $6,860,000 and $5,865,000 offiscal 2004 Technical Solutions net revenues. Total revenues from customers inforeign operations were $840,000 in fiscal 2005 and $80,000 in fiscal 2004.

The following tableillustrates each segment’s operating income for 2005, 2004 and 2003. Assets bysegment are those assets that are used in the Company’s operations in eachsegment. Corporate assets consist of cash, accounts receivable, income taxesreceivable, investments in securities, real estate and fixed assets notallocated to segments. Corporate general and administrative expenses wereallocated on the basis of revenues, gross profit, net property, plant andequipment and payroll expenses of the respective segments. Interest expense isallocated to the segments based on average borrowing rates and segmentadvances.
| ** **                                        | ** ** | **Year Ended January 31, 2005** | ** ** |
|---------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                                        | ** ** | **Engineering &  Evaluation**              | ** ** | **Technical  Solutions** | ** ** | **Corporate** | ** ** | **Total** | ** ** |
| Net revenues                                      |       | $                                                   | 63,236,000 |   | $ | 43,761,000 |   | $ | — |   | $ | 106,997,000 |   |
| Gross profit                                      |       | 17,207,000                                          |       | 6,963,000 |   | — |   | 24,170,000 |   |
| Selling, general  and administrative expense      |       | 14,290,000                                          |       | 6,359,000 |   | — |   | 20,649,000 |   |
| Operating income                                  |       | 2,917,000                                           |       | 604,000 |   | — |   | 3,521,000 |   |
| Other income (expense):                           |       |                                                |       |   |   |   |   |   |   |
| Interest expense, net                             |       | (983,000                                            | )          | (108,000 | ) | — |   | (1,091,000 | ) |
| Other income (expense)                            |       | 148,000                                             |       | 14,000 |   | — |   | 162,000 |   |
| Income before  income taxes and minority interest |       | $                                                   | 2,082,000  |   | $ | 510,000 |   | $ | — |   | $ | 2,592,000 |   |
| Assets                                            |       | $                                                   | 50,092,000 |   | $ | 10,356,000 |   | $ | 6,221,000 |   | $ | 66,669,000 |   |
| Equity  investments                               |       | 760,000                                             |       | — |   | — |   | 760,000 |   |
| Expenditures for  long-lived assets               |       | 5,470,000                                           |       | 150,000 |   | 534,000 |   | 6,154,000 |   |
| Depreciation and  amortization                    |       | 4,421,000                                           |       | 171,000 |   | 206,000 |   | 4,798,000 |   |
| Goodwill                                          |       | 2,544,000                                           |       | 196,000 |   | — |   | 2,740,000 |   |

 

46

----

**NATIONAL TECHNICAL SYSTEMS, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued) January 31, 2005, 2004 and 2003**

**(10)**   Segment ofBusiness Information (Continued)
| ** **                                        | ** ** | **Year Ended January 31, 2004** | ** ** |
|---------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                                        | ** ** | **Engineering &  Evaluation**              | ** ** | **Technical  Solutions** | ** ** | **Corporate** | ** ** | **Total** | ** ** |
| Net revenues                                      |       | $                                                   | 58,410,000 |   | $ | 46,238,000 |   | $ | — |   | $ | 104,648,000 |   |
| Gross profit                                      |       | 15,590,000                                          |       | 7,120,000 |   | — |   | 22,710,000 |   |
| Selling, general  and administrative expense      |       | 12,647,000                                          |       | 6,848,000 |   | — |   | 19,495,000 |   |
| Operating income                                  |       | 2,943,000                                           |       | 272,000 |   | — |   | 3,215,000 |   |
| Other income (expense):                           |       |                                                |       |   |   |   |   |   |   |
| Interest expense, net                             |       | (976,000                                            | )          | (121,000 | ) | — |   | (1,097,000 | ) |
| Other income (expense)                            |       | 178,000                                             |       | 14,000 |   | — |   | 192,000 |   |
| Income before  income taxes and minority interest |       | $                                                   | 2,145,000  |   | $ | 165,000 |   | $ | — |   | $ | 2,310,000 |   |
| Assets                                            |       | $                                                   | 46,061,000 |   | $ | 10,310,000 |   | $ | 7,261,000 |   | $ | 63,632,000 |   |
| Equity  investments                               |       | 284,000                                             |       | — |   | — |   | 284,000 |   |
| Expenditures for  long-lived assets               |       | 5,633,000                                           |       | 138,000 |   | 153,000 |   | 5,924,000 |   |
| Depreciation and  amortization                    |       | 3,899,000                                           |       | 655,000 |   | 222,000 |   | 4,776,000 |   |
| Goodwill                                          |       | 2,544,000                                           |       | 196,000 |   | — |   | 2,740,000 |   |

 
| ** **                                        | ** ** | **Year Ended January 31, 2003** | ** ** |
|---------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                                        | ** ** | **Engineering &  Evaluation**              | ** ** | **Technical  Solutions** | ** ** | **Corporate** | ** ** | **Total** | ** ** |
| Net revenues                                      |       | $                                                   | 55,037,000 |   | $ | 30,800,000 |   | $ | — |   | $ | 85,837,000 |   |
| Gross profit                                      |       | 13,766,000                                          |       | 5,410,000 |   | — |   | 19,176,000 |   |
| Selling, general  and administrative expense      |       | 11,458,000                                          |       | 4,954,000 |   | — |   | 16,412,000 |   |
| Operating income                                  |       | 2,308,000                                           |       | 456,000 |   | — |   | 2,764,000 |   |
| Other income (expense):                           |       |                                                |       |   |   |   |   |   |   |
| Interest expense, net                             |       | (1,115,000                                          | )          | (111,000 | ) | — |   | (1,226,000 | ) |
| Other income (expense)                            |       | 10,000                                              |       | 1,000 |   | — |   | 11,000 |   |
| Income before  income taxes and minority interest |       | $                                                   | 1,203,000  |   | $ | 346,000 |   | $ | — |   | $ | 1,549,000 |   |
| Assets                                            |       | $                                                   | 42,218,000 |   | $ | 13,219,000 |   | $ | 5,897,000 |   | $ | 61,334,000 |   |
| Equity  investments                               |       | 179,000                                             |       | — |   | — |   | 179,000 |   |
| Expenditures for  long-lived assets               |       | 3,316,000                                           |       | 1,627,000 |   | 266,000 |   | 5,209,000 |   |
| Depreciation and  amortization                    |       | 3,896,000                                           |       | 462,000 |   | 257,000 |   | 4,615,000 |   |
| Goodwill                                          |       | 674,000                                             |       | 196,000 |   | — |   | 870,000 |   |

 

47

----

**NATIONAL TECHNICAL SYSTEMS, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued) January 31, 2005, 2004 and 2003**

**(11)   QuarterlyFinancial Data (Unaudited)**
| ** **                                                     | ** ** | **Three months ended,** | ** ** |
|----------------------------------------------------------------|------------|-----------------------------------|------------|
| **2005**                                                       | ** ** | ** **                        | ** ** | **Apr 30** | ** ** | **Jul 31** | ** ** | **Oct 31** | ** ** | **Jan 31** | ** ** |
| Net revenues                                                   |       | $                                 | 27,505,000 |   | $ | 27,350,000 |   | $ | 26,532,000 |   | $ | 25,610,000 |   |
| Gross profit                                                   |       | 6,071,000                         |       | 5,974,000 |   | 5,931,000 |   | 6,194,000 |   |
| Net income                                                     |       | 533,000                           |       | 242,000 |   | 319,000 |   | 588,000 |   |
| Earnings per common  share                                     |       |                              |       |   |   |   |   |   |   |
| Basic*                                                         |       | 0.06                              |       | 0.03 |   | 0.04 |   | 0.07 |   |
| Diluted                                                        |       | 0.06                              |       | 0.03 |   | 0.03 |   | 0.06 |   |
| Weighted average  common shares outstanding                    |       | 8,874,000                         |       | 8,929,000 |   | 8,969,000 |   | 9,011,000 |   |
| Dilutive effect  of stock options                              |       | 726,000                           |       | 612,000 |   | 521,000 |   | 614,000 |   |
| Weighted average  common shares outstanding, assuming dilution |       | 9,600,000                         |       | 9,541,000 |   | 9,490,000 |   | 9,625,000 |   |
|                                                                |            |                                   |            |  |  |  |  |  |  |  |  |  |  |  |  |

 
| ** **                                                     | ** ** | **Three months ended,** | ** ** |
|----------------------------------------------------------------|------------|-----------------------------------|------------|
| **2004**                                                       | ** ** | ** **                        | ** ** | **Apr 30** | ** ** | **Jul 31** | ** ** | **Oct 31** | ** ** | **Jan 31** | ** ** |
| Net revenues                                                   |       | $                                 | 26,980,000 |   | $ | 27,450,000 |   | $ | 25,772,000 |   | $ | 24,446,000 |   |
| Gross profit                                                   |       | 5,646,000                         |       | 6,278,000 |   | 5,800,000 |   | 4,986,000 |   |
| Net income                                                     |       | 327,000                           |       | 341,000 |   | 273,000 |   | 352,000 |   |
| Earnings per common  share                                     |       |                              |       |   |   |   |   |   |   |
| Basic                                                          |       | 0.04                              |       | 0.04 |   | 0.03 |   | 0.04 |   |
| Diluted*                                                       |       | 0.04                              |       | 0.04 |   | 0.03 |   | 0.04 |   |
| Weighted average  common shares outstanding                    |       | 8,616,000                         |       | 8,635,000 |   | 8,637,000 |   | 8,671,000 |   |
| Dilutive effect  of stock options                              |       | 288,000                           |       | 600,000 |   | 588,000 |   | 754,000 |   |
| Weighted average  common shares outstanding, assuming dilution |       | 8,904,000                         |       | 9,235,000 |   | 9,225,000 |   | 9,425,000 |   |
|                                                                |            |                                   |            |  |  |  |  |  |  |  |  |  |  |  |  |

----

*                    Pershare data may not always add to the total for the year because each figure isindependently calculated.

**(12)**   Subsequent Events

On March 22, 2005,the Company announced the acquisition of Phase Seven Laboratories, located inSanta Rosa, CA. Phase Seven provides carrier-class network interoperability,functionality and performance testing for new and emerging technologies andtheir integration to legacy systems. This includes complete end-to-endfunctional compliance testing of wireline and fiber optics technologies forADSL, ADSL2/2+ and fiber to the home networks with data, voice, and video.

48

----

**ITEM 9.**                *CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING ANDFINANCIAL DISCLOSURES.*

None.

**ITEM 9A.   *CONTROLS AND PROCEDURES.***

***Evaluation Of Disclosure Controls And Procedures***

The Company’s ChiefExecutive Officer and Chief Financial Officer carried out an evaluation withthe participation of the Company’s management, of the effectiveness of thedesign and operation of the Company’s disclosure controls and procedures (asdefined in Rules 13a-15(e) and 15d-15(e) under theSecurities Exchange Act of 1934, as amended (the “Exchange Act”)). Based uponthat evaluation, the Chief Executive Officer and Chief Financial Officerconcluded that, as of the end of the period covered by this report, the Company’sdisclosure controls and procedures were effective.

***Changes in Internal Controls Over Financial Reporting***

As required by Rule 13a-15(d),the Company’s Chief Executive Officer and Chief Financial Officer, with theparticipation of the Company’s management, also conducted an evaluation of theCompany’s internal controls over financial reporting to determine whether anychanges occurred during the period covered by this report that have materiallyaffected, or are reasonably likely to affect, the Company’s internal controlsover financial reporting. Based on that evaluation, there has been no suchchange during the period covered by this report.

***Limitations of the Effectiveness***

A control system, nomatter how well conceived and operated, can provide only reasonable, notabsolute, assurance that the objectives of the internal control system are met.Because of the inherent limitations of any internal control system, noevaluation of controls can provide absolute assurance that all control issues,if any, within a company have been detected. Notwithstanding these limitations,the Company’s disclosure controls and procedures are designed to providereasonable assurance of achieving their objectives. The Company’s ChiefExecutive Officer and Chief Financial Officer have concluded that the Company’sdisclosure controls and procedures are, in fact, effective at the “reasonableassurance” level.

**ITEM 9B.   *OTHER INFORMATION.***

None.

49

----

**PART III**

**ITEM 10.   *DIRECTORS AND EXECUTIVEOFFICERS OF THE COMPANY.***

The sections entitled “Nominationand Election of Directors” and “Remuneration of Directors and Officers” in theCompany’s definitive Proxy Statement to be furnished to shareholders inconnection with the Annual Meeting of Shareholders to be held on June 28,2005 are incorporated herein by reference.

***Executive Officersof the Company***
| **Name**         | ** ** | ** ** | ** ** | **Age**                                                                                                            | ** ** | **Position** |
|------------------|------------|------------|------------|--------------------------------------------------------------------------------------------------------------------|------------|--------------|
| Lloyd Blonder    |       | 65         |       | Senior Vice President and Chief Financial Officer,  Treasurer. He has been associated with the Company since 1983. |
| Doug Briskie     |       | 41         |       | Vice President, Western Operations. He has been  associated with the Company since 1987.                           |
| Aaron Cohen      |       | 68         |       | Senior Vice President, Corporate Development. He has  been associated with the Company since 1961.                 |
| Marvin Hoffman   |       | 71         |       | Senior Vice President, Chief Information Officer. He  has been associated with the Company since 1998.             |
| Andrea Korfin    |       | 58         |       | Corporate Secretary, President, Technical Solutions.  She has been associated with the Company since 1982.         |
| Jack Lin         |       | 72         |       | Chief Executive Officer of the Company. He has been  associated with the Company since 1961.                       |
| Raffy Lorentzian |       | 49         |       | Vice President, Chief Accounting Officer. He has  been associated with the Company since 1997.                     |
| William McGinnis |       | 46         |       | President and Chief Operating Officer of the  Company. He has been associated with the Company since 1980.         |
| Dwight Moore     |       | 42         |       | Vice President,  Eastern Operations. He has been associated with the Company since 1997.                           |

 

The Company’s Board ofDirectors has adopted a code of ethics that applies to our principal executiveofficers, principal financial officer, and corporate controller, as well asother employees. A copy of this code of ethics has been posted on the Company’sIntranet website. Any amendments to, or waivers from, a provision of our codeof ethics that applies to our principal executive officer, principal financialofficer, controller, or persons performing similar functions and that relatesto any element of the code of ethics enumerated in paragraph (b) of Item406 of Regulations S-K shall be disclosed by posting such information on ourwebsite.

**ITEM 11.   *EXECUTIVE COMPENSATION.***

The section entitled “Remunerationof Directors and Officers” in the Company’s definitive Proxy Statement to befurnished to shareholders in connection with the Annual Meeting of Shareholdersto be held on June 28, 2005 is incorporated herein by reference.

**ITEM12.   *SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS,MANAGEMENT AND RELATED STOCKHOLDER MATTERS.***

The sections entitled “VotingSecurities and Principal Holders Thereof” and “Nomination and Election ofDirectors” in the Company’s definitive Proxy Statement to be furnished toshareholders in connection with the Annual Meeting of Shareholders to be heldon June 28, 2005 are incorporated herein by reference.

50

----

**ITEM 13.   *CERTAIN RELATIONSHIPS ANDRELATED TRANSACTIONS.***

The section entitled “Transactionswith Management and Other” in the Company’s definitive Proxy Statement to befurnished to shareholders in connection with the Annual Meeting of Shareholdersto be held on June 28, 2005 is incorporated herein by reference.

**ITEM 14.   *PRINCIPAL ACCOUNTANT FEESAND SERVICES.***

The information under the heading “Audit Fees andAll Other Fees” in the Company’s definitive Proxy Statement to befurnished to shareholders in connection with the Annual Meeting of Shareholdersto be held on June 28, 2005 is incorporated herein by reference.

**PART IV**

**ITEM 15.   *EXHIBITS AND FINANCIALSTATEMENT SCHEDULES.***

**A.*     Consolidated Financial Statements and Schedules.***
| Financial statements  required by Item 15 are included in Item 8 above.                                      |
|--------------------------------------------------------------------------------------------------------------|
| Financial  Statements:                                                                                       |
| Consolidated Balance Sheets—January31,  2005 and 2004                                                   |
| Consolidated  Statements of Income—Years ended January 31, 2005, 2004 and 2003                     |
| Consolidated  Statements of Shareholders’ Equity—Years ended January 31, 2005, 2004  and 2003 |
| Consolidated  Statements of Cash Flows—Years ended January 31, 2005, 2004 and 2003                 |
| Notes to Consolidated Financial  Statements                                                                  |
| ** **                                                                                                   | **Schedule** |
| Schedule  Supporting Financial Statements:                                                                   |   |
| Valuation  and Qualifying Accounts and Reserves                                                         | II |

 

**B.     *Exhibits.***
|   2   |   | Asset Purchase  Agreement, dated as of January 23, 2004, by and among National Technical  Systems, Inc., NTS Technical Systems, Robert Wakefield, Randolph  Fairfield, Calvin Milam, E&C Holdings, Inc., Peterson  Builders, Inc., and DTI Holdings LLC. Filed as exhibit 2.1 to the  Company’s form 8-K, (filed January 30, 2004 and is incorporated  herein by reference thereto). |
|------------|--------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   2.1 |   | Pro forma financial  information related to the acquisition of DTI Holdings LLC. (filed with the  Company’s 8-K/A on March 22, 2004 and is incorporated herein by  reference thereto).                                                                                                                                                                                                                       |
|   3.1 |   | Articles of  Incorporation of National Technical Systems, Inc., a California  corporation, as amended to date. (filed with the Company’s 10K on  April 28, 2004 and is incorporated herein by reference thereto).                                                                                                                                                                                       |
|   3.2 |   | Bylaws of National  Technical Systems, Inc., a California corporation, as adopted on  May 29, 1996 and as amended by amendment number one thereto, adopted on  June 25, 1999. (filed with the Company’s 10K on April 28, 2004 and  is incorporated herein by reference thereto).                                                                                                              |
|  10.1 |   | Form of the  Company’s 1994 Stock Option Plan (filed as Appendix B to the Company’s Proxy  Statement for Annual Meeting of June 30, 1994, and is incorporated  herein by reference thereto).                                                                                                                                                                                                       |
|  10.2 |   | Amendment to the  Company’s 1994 Stock Option Plan (filed as Proposal No. 3 to the  Company’s Proxy Statement for Annual Meeting of June 26, 1998, and is  incorporated herein by reference thereto).                                                                                                                                                                                              |

51

----

 
|  10.3 |   | Form of the  Company’s 2002 Stock Option Plan (filed as Proposal 2 to the Company’s Proxy  Statement for Annual Meeting of June 28, 2002, and is incorporated  herein by reference thereto).               |
|------------|--------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|  10.4 |   | Amendment number  one to revolving credit agreement between NTS and Comerica Bank effective  July 17, 2002 (filed on September 12, 2002 and is incorporated  herein by reference thereto).                           |
|  10.5 |   | Amendment number two to  revolving credit agreement between the Company and Comerica Bank effective  November 25, 2002 (filed on December 13, 2002 and is incorporated  herein by reference thereto).                |
|  10.6 |   | Amendment number three  to revolving credit agreement between the Company and Comerica Bank effective  July 21, 2003 (filed on September 11, 2003 and is incorporated  herein by reference thereto).                 |
|  10.7 |   | Amendment number four to  revolving credit agreement between the Company and Comerica Bank effective  July 30, 2004 (filed on December 15, 2004 and is incorporated  herein by reference thereto).                   |
|  21   |   | Subsidiaries of the  Company.                                                                                                                                                                                                  |
|  23.1 |   | Consent of Independent  Registered Public Accounting Firm.                                                                                                                                                                     |
|  31.1 |   | Certification of the  Principal Executive Officer pursuant to rule 13a-14(a) and  15d-14(a) of the Securities Exchange Act of 1934, as adopted  pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. |
|  31.2 |   | Certification of the  Principal Financial Officer pursuant to rule 13a-14(a) and  15d-14(a) of the Securities Exchange Act of 1934, as adopted  pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. |
|  32.1 |   | Certification of the  Principal Executive Officer pursuant to 18 U.S.C. Section 1350, as  adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.                                                         |
|  32.2 |   | Certification of the  Principal Financial Officer pursuant to 18 U.S.C. Section 1350, as  adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.                                                         |
|  99.1 |   | Undertakings  incorporated by reference into Form S-8 Registration Statement  No. 333-04905.                                                                                                                         |
|  99.2 |   | Undertakings  incorporated by reference into Form S-8 Registration Statement  No. 333-106426.                                                                                                                        |

 

 

52

----

**SIGNATURES**

Pursuantto the requirements of Section 13 or 15(d) of the Securities andExchange Act of 1934, the registrant has duly caused this report to be signedon its behalf by the undersigned, thereunto duly authorized.
| April 28, 2005 | **NATIONAL TECHNICAL SYSTEMS, INC.** |
|---------------------|--------------------------------------|
|                | By                                   | /s/  JACK LIN |
|                |                                 | Jack Lin, |
| * *            |                                 | *Chief  Executive Officer and* |
| * *            |                                 | *Chairman  of the Board* |
| * *            |                                 | *(Principal  Executive Officer)* |

 

Pursuantto the requirements of Section of the Securities Exchange Act of 1934,this report has been signed below by the following persons on behalf of theregistrant and in the capacities indicated on April 28, 2004.
| /s/ JACK LIN                                   |     | /s/ AARON COHEN                  |
|------------------------------------------------|----------|----------------------------------|
| Jack Lin,                                      |     | Aaron Cohen,                     |
| *Chief  Executive Officer and*                 | * * | *Senior  Vice President and*     |
| *Chairman  of the Board*                       | * * | *Vice  Chairman of the Board*    |
| *(Principal  Executive Officer)*               | * * | * *                         |
| /s/  WILLIAM MCGINNIS                          |     | /s/  MARVIN HOFFMAN              |
| William McGinnis,                              |     | Marvin Hoffman,                  |
| *President,*                                   | * * | *Senior  Vice President,*        |
| *Chief  Operating Officer and Director*        | * * | *Chief  Information Officer and* |
| * *                                       | * * | *Vice  Chairman of the Board*    |
| /s/  LLOYD BLONDER                             |     | /s/  JOHN GIBBONS                |
| Lloyd Blonder,                                 |     | John Gibbons,                    |
| *Senior  Vice President and Treasurer*         | * * | *Director*                       |
| *(Principal  Financial Officer)*               | * * | * *                         |
| /s/  RAFFY LORENTZIAN                          |     | /s/  RALPH F. CLEMENTS           |
| Raffy Lorentzian,                              |     | Ralph F.  Clements,              |
| *Vice  President and Chief Accounting Officer* | * * | *Director*                       |
| /s/  DAN YATES                                 |     | /s/  DONALD J. TRINGALI          |
| Dan Yates,                                     |     | Donald J.  Tringali,             |
| *Director*                                     | * * | *Director*                       |
| /s/  SHELDON M. FECHTOR                        |     | /s/  ROBERT I. LIN               |
| Sheldon M.  Fechtor,                           |     | Robert I. Lin,                   |
| *Director*                                     | * * | *Director*                       |
| /s/  NORMAN S. WOLFE                           |     |                             |
| Norman S. Wolfe,                               |     |                             |
| *Director*                                     | * * | * *                         |

 

53

----

**Schedule II**

**NATIONAL TECHNICAL SYSTEMS, INC. AND SUBSIDIARIESValuation and QualifyingAccounts and ReservesYears ended January 31, 2005, 2004 and 2003**
| **Column A**                            | ** ** | **Column B** | ** ** | **Column C**                              | ** ** | **Column D**                                                  | ** ** | **Column E**                 | ** ** |
|----------------------------------------------|------------|-------------------|------------|------------------------------------------------|------------|--------------------------------------------------------------------|------------|-----------------------------------|------------|
| **Description**                              | ** ** | ** **        | ** ** | **Balance at  beginning of  period** | ** ** | **Additions—  charged to costs  and expenses** | ** ** | **Deductions—  describe(a)** | ** ** | **Balance at  end  of period** | ** ** |
| Allowance for doubtful  accounts receivable: |       |              |       |                                           |       |                                                               |       |                              |       |   |   |   |   |
| FY 2005                                      |       | $                 | 938,000    |                                           |       | $                                                                  | 252,000    |                              |       |   | $ | (284,000 | ) |   | $ | 906,000 |   |
| FY 2004                                      |       | $                 | 1,298,000  |                                           |       | $                                                                  | 425,000    |                              |       |   | $ | (785,000 | ) |   | $ | 938,000 |   |
| FY 2003                                      |       | $                 | 1,099,000  |                                           |       | $                                                                  | 546,000    |                              |       |   | $ | (347,000 | ) |   | $ | 1,298,000 |   |
|                                              |            |                   |            |                                                |            |                                                                    |            |                                   |            |  |  |  |  |  |  |  |  |  |  |

----

(a)           Write-off ofuncollectible accounts receivable, net of recoveries. Deductions for FY 2004consist of write-off of uncollectibale accounts receivable of $371,000 andadjustment to reduce the allowance for doubtful accounts by $414,000.

54

----