**UNITED STATES**

**SECURITIES AND EXCHANGE COMMISSION**

**WASHINGTON, D.C. 20549**

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**FORM 10-K**

**Annual Report Pursuant to Section 13or 15(d) of the Securities Exchange Act of 1934For the fiscal year ended January 31, 2006Commission file number 0-16438**

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**NATIONAL TECHNICAL SYSTEMS, INC.**

(Exact name of registrantas specified in its charter)

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

 

**(818) 591-0776**

(Registrant’s telephone number, including area code)

**Securities registered pursuant to Section 12(b) ofthe Act:**

None

**Securities registered pursuant to Section 12(g) ofthe Act:**

Common Stock—No ParValue

(Title of class)

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Indicate by check mark if the registrant is awell-known seasoned issuer, as defined in Rule 405 of the Securities Act. YES o NO x

Indicate by check mark if the registrant is not requiredto file reports pursuant to Section 13 or Section 15(d) of theAct. YES o NO x

Indicate by check mark whether the registrant (1) hasfiled all reports required to be filed by Section 13 or 15(d) of theSecurities Exchange Act of 1934 during the preceding 12 months (or for suchshorter period that the registrant was required to file such reports), and (2) hasbeen subject to such filing requirements for the past 90 days. YES x NO o

Indicate by check mark if disclosure of delinquentfilers pursuant to Item 405 of Regulation S-K is not contained herein, and willnot be contained, to the best of registrant’s knowledge, in definitive proxy orinformation statements incorporated by reference in Part III of this Form 10-Kor any amendment to this Form 10-K. x

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

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

 

Indicate by check mark whether the registrant is ashell company (as defined in Rule 12b-2 of Act). YES o NO x

State the aggregate market value of the voting andnon-voting common equity held by non-affiliates computed by reference to theprice at which the common equity was last sold, or the average bid and askedprice of such common equity, as of the last business day of the registrant’smost recently completed second fiscal quarter—$38,791,000 (as of July 31,2005).

Thenumber of shares of registrant’s Common Stock outstanding on April 24,2006 was 8,414,743

**DocumentsIncorporated by Reference**

Portions of the ProxyStatement of the Company for the Annual Meeting of Shareholders to be held on June 29,2006, are incorporated by reference into Part III of this report.

 

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**NATIONALTECHNICAL SYSTEMS, INC.FORM 10-KFISCAL YEAR ENDED JANUARY 31, 2006**

| PART I   |         |                                                                                                               |         |   |
|---------------|--------------|--------------------------------------------------------------------------------------------------------------------|--------------|--------|
| ITEM 1.       |         | BUSINESS                                                                                                           |         | 3      |
| ITEM  1A.     |         | RISK  FACTORS                                                                                                      |         | 10     |
| ITEM 1B.      |         | UNRESOLVED STAFF COMMENTS                                                                                          |         | 11     |
| ITEM 2.       |         | PROPERTIES                                                                                                         |         | 12     |
| ITEM  3.      |         | LEGAL  PROCEEDINGS                                                                                                 |         | 13     |
| ITEM 4.       |         | SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS                                                                |         | 13     |
| PART II  |         |                                                                                                               |         |   |
| ITEM 5.       |         | MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED  SHAREHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES |         | 13     |
| ITEM 6.       |         | SELECTED CONSOLIDATED FINANCIAL DATA                                                                               |         | 14     |
| ITEM 7.       |         | MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL  CONDITION AND RESULTS OF OPERATIONS                        |         | 15     |
| ITEM 7A.      |         | QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET  RISK                                                        |         | 27     |
| ITEM 8.       |         | CONSOLIDATED FINANCIAL STATEMENT AND SUPPLEMENTARY  DATA                                                           |         | 28     |
| ITEM 9.       |         | CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON  ACCOUNTING AND FINANCIAL DISCLOSURES                             |         | 52     |
| ITEM 9A.      |         | CONTROLS AND  PROCEDURES                                                                                           |         | 52     |
| ITEM  9B.     |         | OTHER  INFORMATION                                                                                                 |         | 52     |
| PART III | *** *** | *** ***                                                                                                       | *** *** |   |
| ITEM 10.      |         | DIRECTORS AND EXECUTIVE OFFICERS OF THE COMPANY                                                                    |         | 53     |
| ITEM 11.      |         | EXECUTIVE COMPENSATION                                                                                             |         | 53     |
| ITEM 12.      |         | SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS,  MANAGEMENT AND RELATED STOCKHOLDER MATTERS                       |         | 53     |
| ITEM 13.      |         | CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS                                                                     |         | 54     |
| ITEM 14.      |         | PRINCIPAL ACCOUNTANT FEES AND SERVICES                                                                             |         | 54     |
| PART IV  | *** *** | *** ***                                                                                                       | *** *** |   |
| ITEM 15.      |         | EXHIBITS AND FINANCIAL STATEMENT SCHEDULES                                                                         |         | 54     |
| SIGNATURES    |         | 56                                                                                                                 |

 

This report contains certain statements that may bedeemed “forward-looking statements” within the meaning of the PrivateSecurities Litigation Reform Act of 1995. Such statements can be identified bythe use of forward-looking words such as “may”, “will”, “expect”, “anticipate”,“intend”, “estimate”, “continue”, “behave” and similar words. Financialinformation contained herein, to the extent it is predictive of financialcondition and results of operations that would have occurred on the basis ofcertain stated assumptions may also be characterized as forward-lookingstatements. Although forward-looking statements are based on assumptionsmade, and information believed by management to be reasonable, no assurance canbe given that such statements will prove to be correct. Such statements aresubject to certain risks, uncertainties and assumptions. Actual outcomes aredependent upon National Technical Systems, Inc.’s (“NTS” or “the Company”)successful performance of internal plans, ability to effectively integrateacquired companies, customer changes in short range and long range plans,competition in the Company’s services areas and pricing, continued acceptanceof new services, performance issues with key customers, and general economicrisks and uncertainties.

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**NATIONAL TECHNICALSYSTEMS, INC.**

**Annual Report (Form 10-K)**

**ForYear Ended January 31, 2006**

**PART I**

**ITEM 1.**                *BUSINESS.*

***General***

National Technical Systems, Inc. (“NTS” or the “Company”)is a diversified services company that supplies technical services and solutionsto a variety of industries including aerospace, defense, transportation,electronics, power, computers and telecommunications. NTS, utilizing itsvarious testing facilities, staffing solutions and certification services,helps its customers sell their products in world markets. NTS is accredited bynumerous national and international technical organizations which allow theCompany to have its test data accepted in most countries.

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.

The Company’s principal executiveoffices are located at 24007 Ventura Boulevard, Suite 200, Calabasas, California91302 (telephone: 818-591-0776).

***Description of Business***

NTS operates in twosegments: “Engineering and Evaluation” and “Technical Solutions.” The businessof the Company is conducted by a number of operating units, each with its ownorganization. The management of each operating unit has responsibility for itsoperations and for achieving sales and profit goals. The executive staff fromthe Company’s corporate headquarters maintains overall supervision,coordination and financial control.

***(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 andproduct evaluation to allow customers to sell their products in world markets.In addition, E&E  performs managementregistration and certification services to ISO related standards. NTS isaccredited by numerous national and international technical organizations whichallows the Company to have its test data accepted in most countries.

E&E revenues represented 65%, 59% and 56% of NTStotal revenues in fiscal years 2006, 2005 and 2004, respectively. E&Eserves high technology companies, predominantly in the defense, aerospace,transportation, telecommunications, electronics, power and computers markets.In fiscal 2006, E&E serviced. approximately 2,600 customers. The abilityfor these customers to offer certifications and provide test data that isaccepted in world markets is critical for manufactured products acceptance.

E&E creates environments that simulate changes intemperature, altitude, moisture, and virtually every other environmental factorthat might affect product performance. In addition, E&E has developedexpertise and specialized skills over decades of testing in multiple industriesand has invested heavily in 

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equipment including a fullspectrum of EMI chambers, data acquisition systems, seismic simulators,environmental simulation equipment, environmental chambers, fire chambers,mixed gas flow chambers and munitions and ordnance performance testingequipment.

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, an affiliateof the Company, issues a certificate describing the scope of the customer’squality system, which has been certified. The customer is then entitled todisplay the Registrar’s mark on advertising and stationery as evidence that ithas achieved ISO registration. 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 60% of E&Erevenues.

**Defense.****  **E&E plays an active role in numerous U.S. defenserelated programs, performing almost every type of test discipline, includingcomplete functionality and performance, reliability, safety, life prediction,structural/mechanical, fluids related, material science, vibration, shock,climatic exposure, radiation, acoustic noise and electromagnetic interference,compatibility and Lithium Battery Testing. Examples of items tested includecomponents for small fixed wing aircraft, helicopters, submarines, aircraftcarriers and other naval ships, tanks and other tracked vehicles, trucks androad vehicles, command/control/ communication systems, electronics, weaponsystems and complete ordnance and munitions testing. E&E has facilitiesthat are specially constructed to handle munitions and hazardous materialswhere routine testing includes vibration and cook-off of explosive materials,ballistics tests and hydraulic burst tests. E&E performs virtually anyballistics related testing, up to 155 mm rounds. E&E’s data acquisitionsystems are capable of collecting 1,000,000 data points and 22,000 photos persecond. Additional instrumentation includes Doppler radar, 35 mm still cameras,digital recording, data loggers and real-time color and IR video. E&E’scustomers in this market include various major defense contractors, as well asthe 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 test facilities, G-tables and centrifuges withdiameters ranging from one foot to 102 feet, with weight capacities from a fewgrams to 20,000 pounds. In climatic testing, E&E utilizes hundreds of testchambers to simulate nearly any environment: temperature, humidity, altitude,rain, salt spray, sand and dust, sunshine, explosive atmosphere or anycombination. E&E designs and builds custom facilities and advancedinstrumentation and data acquisition systems to support all types of flowtesting for 

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gases, liquids andcryogenics. E&E is capable of performing structural testing and analysis,and, in particular, structural loading of large objects such as completeairframes. It also performs fatigue testing of critical hardware items such asengine blades and high-pressure fluid components and also offers customers away to minimize their personnel, testing time and costs by utilizing theCompany’s on-site climatic, dynamic, safety and electromagnetic compatibilitytest capabilities. E&E also has  anechoic and reverberant chambers that are used for acoustic emissionmeasurements 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 temperature change,and multi-axis vibration to rapidly expose design weaknesses and process flaws.NTS is accredited to ISO 17025 through the American Accreditation ofLaboratories Association (A2LA). This accreditation allows NTS automotive testreports 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, Massachusetts, Texas, Calgary and Germany. TheCompany has been approved as an (ITL) to offer a complete suite of passivefiber components certifications and Digital Subscriber Line (DSL)certification. This service currently is being provided at laboratories inCalifornia. As service providers gradually convert to VOIP architectures,interoperability becomes critical to ensure a seamless transition to nextgeneration networks. E&E owns a network architecture and interoperabilitylaboratory in Northern California to extend E&E’s service offering tohandle the anticipated demand for interoperability testing and FTTP (fiber tothe premises) deployment as carriers begin to deploy voice, video, andbroadband offerings over FTTP passive fiber networks.

**Electronics.****  **As a Nationally Recognized Test Lab (NRTL), NTSprovides electrical safety product certification, in the US, EU, Canada,Australia and many other countries. NTS has been designated as a ConformityAssessment Body (CAB) for the EMC directive through the US-EU MutualRecognition Agreement (MRA). NTS conducts EMC testing and provides customerswith certification in the US and many other countries, particularly, Japan,Taiwan, Europe and Australia.

**Power.****  **E&E conducts a variety of tests relevant to theongoing operations, safety and maintenance of nuclear facilities. These testsinclude mechanical aging, normal or accident radiation exposure, reliabilitysimulation, evaluation, thermal aging, analysis, vacuum testing, leakdetection, Nuclear Steam Accident, Loss Of Cooling Accident (LOCA), HighExpansion Line Break (HELB) to 600F/300psig E&E also performs seismicsimulation tests up to 100,000 force-lbs, single axis, dependent andindependent biaxial systems, vibration aging and fatigue studies, up to 45,000force-lbs. E&E is active in industry task groups that influence the latestdedication guidelines. Through direct participation, E&E is involved inresolution of key NRC questions such as selection and verification of criticalcharacteristics, sampling, 

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traceability, surveys, andlike-for-like replacements. E&E engineers and technicians involved in thededication process meet ANSI N45.2.6 Level II Inspectors guidelines. TheCompany’s dedication programs utilize the best approach for each specifiedproduct. E&E also provides technical evaluations, critical characteristicsand safety class determinations and focuses on solving plant needs in areassuch as motor rewinds, governor rebuilds, modifications or design ofreplacement systems and instrumentation panel and component design.

**Computer.****  **E&E performs computer product testing, providingcompatibility, stress/performance, functionality and compliance testingservices for hardware, software, telecommunications and networking companiesworldwide. E&E performs software game and game console testing includingMicrosoft Xbox compliance testing. E&E is the exclusive test center forMicrosoft Xbox third party peripheral compatibility testing. E&E alsoprovides testing for Data Over Cable Service Interface Specification (DOCSIS)cable modem, DSL modem, Set Top Box, Residential Gateway and Fiber Optics GR-253testing, interoperability testing of broadband and network products such ascable modems, DSL modems, Cable Modem Termination System (CMTS), DigitalSubscriber Line Access Multiplexer (DSLAM), Routers, HomePNA Gateways, WirelessWi-Fi devices, Media Servers, Fiber Optics SONET switches, and systems networktesting. E&E also performs USB certification testing and was able tosuccessfully transfer its USB technology to Japan.

*Industry Overview*

Manufacturers oftenfulfill their evaluation testing needs on an outsourcing basis in order toreduce costs, avoid large capital expenditures, save time and remaincompetitive. Due to regulations requiring third party certification,manufacturers use third party certifiers to position their products for sale inworld markets. NTS is currently geographically located to serve customers atlocations close to their plants and NTS facilities are capable of providing thecomplete conformity assessment activity necessary to reduce product-handlingcosts and serve as a market gateway for manufacturers to sell productsglobally. E&E provides a “one stop” resource and single sourceresponsibility for all conformity assessment requirements in the severalmarkets it serves.

*Geographic Locations*

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, Santa Clarita and Santa Rosa, **California** andinternationally, in Yokohama, **Japan**, Calgary,**Canada** and Munich, **Germany**.The Company has signed cooperative agreements with SGS in Taiwan and STC inHong Kong to provide certification and compliance testing for USB, USB on theGo and Cable and Connectors for manufacturers in Taiwan, Korea, Hong Kong andmainland China.

*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 2006, theCompany made additional investments to enhance its munitions and ordnanceservice offering in Camden, Arkansas which now includes small and mediumcaliber testing, upgraded its Santa Clarita facility to support the aerospaceneeds in the technical areas of altitude testing; high temperature/high flowtesting and high level acoustic noise testing, and added additional  test capacity in Tinton Falls, New Jersey,Plano, Texas, Rustburg, Virginia and Boxborough, Massachusetts.

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The Company continues touse the Balanced Scorecard System as a tool to assist management in settingstrategy and achieving its mission “Navigate a Short Course to Global Markets.”NTS is using this system to maximize efficiency 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 aligned theservice offerings to more closely align it TS services with its E&E groupand thus capitalize on NTS’s long history of testing and engineering services. Asa valuable and respected resource, TS has developed long-term relationshipswith its clients for whom it provides engineering and IT personnel.

TS revenues represented 35%, 41% and 44% of NTS totalrevenues in fiscal years 2006, 2005 and 2004, respectively. TS’s operationaland technical knowledge allows it to effectively identify and screen highlyskilled technical professionals. TS provides the technical resources itsclients need to continually evaluate processes and products and meet thedemands of compressing development cycles and critical time-to-marketrequirements. TS places its professionals on assignment at a client site toperform specific tasks and projects for a predetermined period of time. At thecompletion of an assignment, customers may, under some previously negotiatedterms and circumstances, directly hire an individual. TS also supports itsclients in sourcing and identifying candidates for direct hire. Itscomprehensive registry of engineering and information technology professionalsallows it to provide fully screened and qualified individuals very rapidly. TScan support its customers’ needs, whether the need is to manage a project or anentire test facility; provide a team to take a product from design toproduction, 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 expensive, more powerful andeasier to use, the number and level of employees who use and depend upon thesesystems have significantly increased.

As employment growth slows overall, companies thatprovide personnel will have a slightly larger share of the overall number of employedpersons. Temporary workers continue to make inroads notably engineering, lawinformation technology and finance. Public companies having implementedSarbanes-Oxley, have established new bookkeeping rules and have turnedtheir interest to financial information collection and dissemination which hasstarted to translate into demand for information technology personnel.Companies that can demonstrate that they can lower costs and improve the speedand quality of hiring will see growth over the next three years.

Using outside technicalresources and consultants allows a company’s management to focus on corebusiness operations, affords greater flexibility and increases a company’sability to adapt to and keep pace with rapidly changing and increasingly complextechnologies. It also provides access to specialized technical skills on aproject-by-project basis which better matches staffing levels to current needs,converts 

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fixedlabor costs into variable costs, and reduces the cost of recruiting, andtraining and terminating employees as evolving technologies require newprogramming skills.

*Technical SolutionsServices*

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

**ITTesting & Software Engineering.**   Infiscal 2006, information technology services represented **51%**of the overall TS revenues. This area significantly increased as we focused onthe engineering segment of information technology, including such skill areasas systems and software engineers. Approximately **24%** of the revenue in this segment came from financial andcommercial clients.

**Engineering.**   Infiscal 2006, engineering services represented **21%**of the overall TS revenues. We saw a significant increase in our engineeringdirect hire activity throughout this fiscal year.

**Managed Services.**   ManagedServices provided to clients on site represented **28%**of the overall TS revenues. TS continues to leverage its technical competenciesto provide clients with on-site program management to augment their test andstaff augmentation activities. Managed Services supports both Engineering andIT service areas.

*Geographic Locations*

In the United States,Technical Solutions offices are located in Culver City, San Mateo, **California**, Salem, **New Hampshire**,Columbia, **South Carolina,**Austin,**Texas** and Troy, **Michigan.**Internationally, TS has an office 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*

TS continues to strengthen its proprietary database tomeet the changes and demands in the business environment. Recognizing that theera of human capital has arrived, we know that the transformation we started in2003 related to how we source, train, qualify and maintain relationships withour experts and consultants will allow us to adjust rapidly to the dramaticchanges created by the demand for “hot skills,” both engineering and IT, and beahead of the predictions of the looming U.S. labor shortage. Our recruitmentprocess has “come of age” and having our experts accessible and ready at theright time is a key component of our business strategy.

TS continues to source, quality and develop a databaseof engineering and technical skills that support the technical requirements ofcustomers. The development of the proprietary database, the centerpiece of ourtransformation, is making a difference, as we are able to support our clientsin recruiting the brightest and best. TS also continues to enhance operationalefficiencies in its accounting, sales, recruiting and marketing operations. TScontinues to differentiate itself from its competitors by using NTS’ testing,engineering and compliance capabilities to maximize its customers’ return onhuman assets.

TS’s strategy is tocontinue efforts to improve revenue and profit by rigorously focusing onindustries, markets and clients that have the strongest long-term growthopportunities, increasing productivity by improving its internal processes,diversifying the range of services it provides to its existing customers,attracting and retaining qualified technical consultants from a variety ofsources, both national and international, and pursuing strategic relationshipswith non-competing organizations. Our company-wide sales force, aligned withour strategy, promotes cross-selling and lead generation between existingcustomers of one business unit to another. TS strives to provide its customerswith technical personnel with the right skills, at the right time, for theright duration and at a cost that is lower than what its customers couldotherwise achieve.

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***(iii)*   Competition**

*Engineering &Evaluation*

E&E competes with a small number of largeconformity assessment organizations, including government laboratories, withineach of the markets it serves. It also competes with a large number of smallniche oriented test laboratories. It has competitive advantages in severalareas which include the following: (1) ability to service customers atfacilities close to their locations; (2) ability to provide completeconformity assessment activities at a single location, which reducesproduct-handling cost for the customers and enhances timeliness of service; (3) diverseand technically competent employees; and (4) accreditations that allow theE&E segment’s test data to be accepted worldwide. Customers can use theCompany’s complete services, including quality registration, to position theirproducts for the world markets.

In the aerospace anddefense markets, the main competition for independent laboratories is thecustomers’ own laboratories, including 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 areincreasingly using primary suppliers to fulfill their staffing needs. TechnicalSolutions competes with and, in certain relationships, teams with other majorstaffing companies in actively pursuing primary supplier relationships withlarge customers in its existing markets. These relationships can have asignificant impact on Technical Solutions’ revenues and operating profits.

***(iv)*   Backlog**

The Company’s backlog at January 31, 2006 and2005 was as follows:

| ** **                    | ** ** | **2006**  | ** ** | **2005**   | ** ** |
|-------------------------------|------------|-----------|------------|------------|------------|
| Engineering &  Evaluation |       | $         | 28,698,000 |       | $          | 25,513,000 |   |
| Technical  Solutions          |       | 9,095,000 |       | 10,472,000 |       |
| Total Backlog                 |       | $         | 37,793,000 |       | $          | 35,985,000 |   |

 

The Company estimates thatapproximately 85% of the backlog at January 31, 2006 will be completed by January 31,2007.

***(v)  *General**

*a.*   Service Marks.

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

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*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 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. Heavy rainfall lastyear 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 will be conducted in cooperationwith the government agency having oversight responsibility for the adjacentsite. No cleanup activity has been conducted on the Santa Clarita property andit has yet to be determined whether remediation will be required at the site,or, if required, the extent and cost of any remediation. The Company believesthat in the event it does incur remediation costs that it will have validclaims for indemnification against the owner of the adjacent site and themunicipality that built a road between the adjacent site and the Santa Claritaproperty that appears to have contributed to the runoff from the adjacent site.Recovery of such remediation costs may, however, be uncertain and may involvesignificant litigation expense.

*c.*   Seasonal Effect.

The Company experiences nomaterial seasonal effects.

*Employees.*

TheCompany employed 847 individuals at January 31, 2006 and 887 at January 31,2005, as follows:

| ** **                    | ** ** | **2006** | ** ** | **2005** | ** ** |
|-------------------------------|------------|----------|------------|----------|------------|
| Engineering &  Evaluation |       |     | 441        |     |       |   | 408 |   |   |
| Technical  Solutions *        |       |     | 389        |     |       |   | 463 |   |   |
| Corporate  Administration     |       |     | 17         |     |       |   | 16 |   |   |
| Total                         |       |     | 847        |     |       |   | 887 |   |   |

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*                    TheTechnical Solutions total for 2006 includes 274 contract employees and 72subcontractors, as compared to 318 contract employees and 98 subcontractors for2005. None of the employees of the Company are represented by a union. TheCompany considers its relationship with its employees to be good.

**ITEM 1A.**        *RISK FACTORS.*

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.

10

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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.

The Company experienced significant growth in recentyears, partly due to domestic and worldwide political and economic developmentsthat have positively affected the markets for defense and advanced technologysystems. Homeland security and defeating terrorism have been among theDepartment of Defense’s main initiatives. A slowing in defense spending due topolitical or budget shifts will put downward pressure on the Company’s revenuesand gross margins.

Resultsmay be adversely affected by:

·       Increasedcompetition from the Company’s own customers’ in-house testing laboratories orfrom government laboratories;

·       Increasedcompetition from large conformity assessment organizations and small nicheoriented test laboratories;

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

·       Environmentalissues arising from the use of hazardous substances;

·       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;

·       Theinability to expand in international markets due to the Company’s limitedexperience;

·       TheCompany may be required to record a charge to earnings if  goodwill becomes impaired;

·       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; and

·       To remain competitive, theCompany must be able to respond effectively to technological changes and beable to hire, train and retain highly skilled sales, engineering and technicalpersonnel.

**ITEM 1B.***       UNRESOLVEDSTAFF COMMENTS*.

Not applicable.

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**ITEM 2.**                *PROPERTIES.*

**A.*****   Operations.******  ***The Companyowns/leases and operates the following properties:

| **State**                   | ** ** | **Owned Properties  City** | ** **  | **Business  Segment** | ** ** | **Buildings  (Sq.Ft.)** | ** ** | **Land  (Acres)** | ** ** |
|-----------------------------|------------|---------------------------------|-------------|-----------------------|------------|-------------------------|------------|-------------------|------------|
| California                  |       | Fullerton                       |        | E&E               |       |                    | 36,000     |              |       |   | 3 |   |   |
|                        |       | Santa Clarita *                 |        | E&E               |       |                    | 60,000     |              |       |   | 145 |   |   |
| Massachusetts               |       | Acton                           |        | TS and E&E        |       |                    | 30,000     |              |       |   | 5 |   |   |
|                        |       | Boxborough                      |        | E&E               |       |                    | 25,000     |              |       |   | 4 |   |   |
| Texas                       |       | Plano                           |        | E&E               |       |                    | 1,000      |              |       |   | 1 |   |   |
| Virginia                    |       | Fredericksburg                  |        | E&E               |       |                    | 66,000     |              |       |   | 87 |   |   |
| **Total  owned properties** | ** ** |                            | **218,000** |                  |       |                    | **245**    |              |       |

 

| **State**      | ** ** | **Leased Properties  City** | ** ** | **Business  Segment** | ** ** | **Buildings  (Sq.Ft.)** | ** ** | **Land  (Acres)** | ** ** |
|----------------|------------|----------------------------------|------------|-----------------------|------------|-------------------------|------------|-------------------|------------|
| Arizona        |       | Tempe                            |       | E&E               |       |                    | 17,000     |              |       |   | n/a |   |   |
| Arkansas       |       | Camden                           |       | E&E               |       |                    | 22,000     |              |       |   | 216 |   |   |
| California     |       | Anaheim Hills                    |       | Corp                  |       |                    | 2,000      |              |       |   | n/a |   |   |
|           |       | Calabasas                        |       | Corp                  |       |                    | 7,000      |              |       |   | n/a |   |   |
|           |       | Culver City                      |       | TS and E&E        |       |                    | 24,000     |              |       |   | n/a |   |   |
|           |       | Fullerton                        |       | E&E               |       |                    | 20,000     |              |       |   | n/a |   |   |
|           |       | Los Angeles (LAX)                |       | E&E               |       |                    | 16,000     |              |       |   | 2 |   |   |
|           |       | San Mateo                        |       | TS                    |       |                    | 2,000      |              |       |   | n/a |   |   |
|           |       | Santa Rosa                       |       | E&E               |       |                    | 18,000     |              |       |   | n/a |   |   |
| Massachusetts  |       | Boston                           |       | TS                    |       |                    | 1,000      |              |       |   | n/a |   |   |
| Michigan       |       | Detroit                          |       | E&E               |       |                    | 65,000     |              |       |   | n/a |   |   |
|           |       | Troy                             |       | TS                    |       |                    | 1,000      |              |       |   | n/a |   |   |
| New Jersey     |       | Tinton Falls                     |       | E&E               |       |                    | 17,000     |              |       |   | n/a |   |   |
| New Hampshire  |       | Salem                            |       | TS                    |       |                    | 3,000      |              |       |   | n/a |   |   |
| South Carolina |       | Columbia                         |       | TS                    |       |                    | 3,000      |              |       |   | n/a |   |   |
| Texas          |       | Austin                           |       | TS                    |       |                    | 2,000      |              |       |   | n/a |   |   |
|           |       | Plano                            |       | E&E               |       |                    | 24,000     |              |       |   | n/a |   |   |
| Virginia       |       | Rustburg                         |       | E&E               |       |                    | 8,000      |              |       |   | 33 |   |   |

 

| **International**           | ** ** | ** **    | ** **  | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
|-----------------------------|------------|---------------|-------------|------------|------------|------------|------------|------------|------------|
| Calgary                     |       | Canada        |        | E&E    |       |       | 14,000     |       |       |   | n/a |   |   |
| Germany                     |       | Munich        |        | E&E    |       |       | 300        |       |       |   | n/a |   |   |
| Japan                       |       | Yokohama      |        | E&E    |       |       | 500        |       |       |   | n/a |   |   |
| Vietnam                     |       | Software City |        | TS         |       |       | 1,000      |       |       |   | n/a |   |   |
| **Total leased properties** | ** ** |          | **267,800** |       |       |       | **251**    |       |       |

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*                    Please referto “Environmental Matters” in Item 7a

The Company believes that the space occupied by all ofits operations is adequate for its current and near-term requirements. Shouldadditional space be required, the Company does not anticipate problems insecuring such additional space.

***B.*   Investment Properties.**

In fiscal year 2005, theCompany sold a condominium in Palm Desert and purchased a new condominium,which is also located in Palm Desert. The Company recorded a gain ofapproximately $158,000 from the sale of the old condominium in fiscal year 2005.In fiscal year 2006, the Company sold the new condominium in Palm Desert andrecorded a gain of approximately $163,000.

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**ITEM 3.**                *LEGAL PROCEEDINGS.*

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 pending claims or suits would materially affect the financial position orthe results of the operations of the Company. (See Note 9 to the ConsolidatedFinancial Statements in Item 8.)

**ITEM 4.**                *SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS*.

Not applicable.

**PART II**

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

***A.*   Market Information.**

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, 2006 and 2005is presented below:

| ** **     | ** ** | **2006** | ** ** | **2005** | ** ** |
|----------------|------------|----------|------------|----------|------------|
| ** **     | ** ** | **High** | ** ** | **Low**  | ** ** | **High** | ** ** | **Low** | ** ** |
| First Quarter  |       | $        | 5.14       |     | $          | 3.97 |   | $ | 5.75 |   | $ | 4.25 |   |
| Second Quarter |       | 5.81     |       | 4.01     |       | 5.17 |   | 3.47 |   |
| Third Quarter  |       | 5.85     |       | 4.02     |       | 5.24 |   | 3.39 |   |
| Fourth Quarter |       | 5.25     |       | 4.05     |       | 5.37 |   | 4.18 |   |
|                |            |          |            |          |            |  |  |  |  |  |  |  |  |

 

**B.   *Holders*.**

As of the close of business on April 17, 2006,there were 781 holders of record of the Company’s common stock. The number ofholders of record is based on the actual number of holders registered on thebooks of the Company’s transfer agent and does not reflect holders of shares in“street name” or persons, partnerships, associations, corporations or otherentities identified in security position listings maintained by depositorytrust companies.

***C.*   Dividends.**

The Company’s Board of Directors announced thediscontinuance of the Company’s policy of paying ordinary and special dividendson February 6, 2001. The Company does not anticipate paying dividends inthe foreseeable future.

***D.*   Securities Authorized for Issuance UnderEquity Compensation Plans.**

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

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**ITEM 6.***                SELECTEDCONSOLIDATED 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,**                            | ** ** |
|----------------------------------------------------------------|------------|----------------------------------------------------------------------|------------|
| ** **                                                     | ** ** | **2006**                                                             | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** |
| ** **                                                     | ** ** | **(in thousands except per share amounts)** | ** ** |
| **INCOME  STATEMENT DATA:**                                    |       |                                                                 |       |   |   |   |   |   |   |   |   |
| Net revenues                                                   |       | $                                                                    | 111,524    |   | $ | 106,514 |   | $ | 104,550 |   | $ | 85,772 |   | $ | 75,333 |   |
| Gross profit                                                   |       | 27,230                                                               |       | 23,687 |   | 22,612 |   | 19,111 |   | 17,975 |   |
| Operating income                                               |       | 6,077                                                                |       | 3,521 |   | 3,215 |   | 2,764 |   | 2,028 |   |
| Interest expense,  net                                         |       | 1,298                                                                |       | 1,091 |   | 1,097 |   | 1,226 |   | 1,740 |   |
| Income before  income taxes and minority interest              |       | 4,955                                                                |       | 2,592 |   | 2,310 |   | 1,549 |   | 432 |   |
| Income taxes                                                   |       | 1,966                                                                |       | 910 |   | 1,056 |   | 676 |   | 188 |   |
| Income from  continuing operations before minority interest    |       | 2,989                                                                |       | 1,682 |   | 1,254 |   | 873 |   | 244 |   |
| Minority interest                                              |       | (50                                                                  | )          | — |   | 39 |   | (15 | ) | (31 | ) |
| Net income                                                     |       | $                                                                    | 2,939      |   | $ | 1,682 |   | $ | 1,293 |   | $ | 858 |   | $ | 213 |   |
| Net income per  common share:                                  |       |                                                                 |       |   |   |   |   |   |   |   |   |
| Basic                                                          |       | $                                                                    | 0.32       |   | $ | 0.19 |   | $ | 0.15 |   | $ | 0.10 |   | $ | 0.03 |   |
| Diluted                                                        |       | $                                                                    | 0.30       |   | $ | 0.18 |   | $ | 0.14 |   | $ | 0.10 |   | $ | 0.03 |   |
| Weighted average  common shares outstanding               |       | 9,125                                                                |       | 8,946 |   | 8,640 |   | 8,656 |   | 8,468 |   |
| Dilutive effect  of stock options                              |       | 537                                                                  |       | 620 |   | 566 |   | 39 |   | 9 |   |
| Weighted average  common shares outstanding, assuming dilution |       | 9,662                                                                |       | 9,566 |   | 9,206 |   | 8,695 |   | 8,477 |   |
| **BALANCE SHEET DATA:**                                        |       |                                                                 |       |   |   |   |   |   |   |   |   |
| Working capital                                                |       | $                                                                    | 16,276     |   | $ | 20,481 |   | $ | 18,550 |   | $ | 19,292 |   | $ | 16,579 |   |
| Total assets                                                   |       | 69,133                                                               |       | 66,669 |   | 63,632 |   | 61,334 |   | 56,781 |   |
| Long-term debt,  excluding current installments           |       | 15,579                                                               |       | 20,557 |   | 19,754 |   | 19,863 |   | 18,657 |   |
| Shareholders' equity                                           |       | 34,378                                                               |       | 30,951 |   | 28,832 |   | 26,417 |   | 25,477 |   |

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

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**ITEM 7.**                *MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF 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 is a diversified services company that suppliestesting outsourcing services and conformity assessment and personnel tobusinesses in a variety of industries including aerospace, defense,transportation, power products, electronics, computers and telecommunications.Through its wide range of testing facilities, staffing solutions andcertification services, NTS provides its customers with the ability to selltheir products globally and enhance their overall competitiveness. 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 &Evaluation” and “Technical Solutions”.  The business of the Company is conducted by anumber of operating units, each with its own organization. Each segment isunder the direction of its own executive and management team. In makingfinancial and operational decisions, NTS relies on an internal managementreporting process that provides revenues and operating cost information foreach of its operating units. Revenues and booking activities are also trackedby market type.

In fiscal 2006, NTS improved its top-line andbottom-line results. Revenues increased 5% to approximately $112 million andnet income increased 75% to approximately $2.9 million. Diluted earnings pershare increased to 30 cents per share in fiscal 2006 compared to 18 cents pershare in fiscal 2005.

Summary of Revenues for fiscal years 2006 and 2005:

| ** **                             | ** ** | **FY 2006**                     | ** ** | **FY 2005** | ** ** | **Change** | ** ** | **% Change** | ** ** |
|----------------------------------------|------------|--------------------------------------|------------|------------------|------------|------------|------------|-------------------|------------|
| ** **                             | ** ** | **(Dollars in thousands)** | ** ** | ** **       | ** ** |
| Engineering &  Evaluation Revenues |       | $                                    | 72,411     |             | $          | 62,753     |       | $                 | 9,658      |   |   | 15.40 | % |   |
| Technical  Solutions Revenues          |       | 39,113                               |       | 43,761           |       | (4,648     | )          |              | (10.60     | %) |   |
| Total Revenues                         |       | $                                    | 111,524    |             | $          | 106,514    |       | $                 | 5,010      |   |   | 4.70 | % |   |

 

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. The Engineering & Evaluation segment isone of the largest independent conformity assessment organizations 

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in the U.S., withfacilities throughout the United States and in Japan, Canada and Germany,serving a large variety of industries.

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 March 18, 2005, the Company acquired theoutstanding stock of Phase Seven Laboratories, located in Santa Rosa,California, for a total purchase price of $652,000, paid in cash and NTS stock.Phase Seven Laboratories provides carrier-class network interoperability,functionality and performance testing for new and emerging technologies andtheir integration with legacy systems. The results of operations of theacquired business are included in the accompanying consolidated statement ofoperations from March 18, 2005 to January 31, 2006.

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. This acquisition is intendedto expand the Company’s presence in Canada and increase its opportunities inthe testing of telecommunication equipment. The results of operations of theacquired business are included in the accompanying consolidated statement of operationsfrom 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”), for a total purchase price of $3,687,000. DTI provideslarge-scale shock and vibration testing services used to qualify missioncritical equipment such as navigation, communication and guidance weaponsinstalled on U.S. Navy combatants.

Summaryof Cash Flows for fiscal years 2006 and 2005:

| ** **                                                    | ** ** | **FY 2006**                     | ** ** | **FY 2005** | ** ** | **Change** | ** ** | **% Change** | ** ** |
|---------------------------------------------------------------|------------|--------------------------------------|------------|------------------|------------|------------|------------|-------------------|------------|
| ** **                                                    | ** ** | **(Dollars in thousands)** | ** ** | ** **       | ** ** |
| Net cash provided  by operating activities                    |       | $                                    | 9,535      |             | $          | 6,590      |       | $                 | 2,945      |   |   | 44.7 | % |   |
| Net cash used for  investing activities                       |       | (7,408                               | )          | (6,089           | )          | (1,319     | )          |              | (21.7      | %) |   |
| Net cash provided  by (used in) financing activities          |       | (4,180                               | )          | 1,026            |       | (5,206     | )          |              | 507.4      | % |   |
| Effect of  exchange rate changes on cash and cash equivalents |       | 48                                   |       | 13               |       | 35         |       |              | (269.2     | %) |   |
| Net increase (decrease)  in cash                              |       | $                                    | (2,005     | )                | $          | 1,540      |       | $                 | (3,545     | ) |   | (230.2 | %) |   |

 

The increase in net cashprovided by operating activities from FY 2005 to FY 2006 was primarily due tothe increase in net income, depreciation expense and the effect of the changesin working capital. The Company used the cash generated from its operatingactivities to pay for capital expenditures, pay down debt and complete theacquisition of PhaseSeven Laboratories. Overall, net cash decreased by $2,005,000 in fiscal2006, compared to an increase of$1,540,000 in fiscal 2005.

**Critical AccountingPolicies**

The consolidated financial statements of the Companyare prepared in accordance with U.S. generally accepted accounting principles (“GAAP”),which require the Company to make certain estimates and assumptions (see Note 1to the consolidated financial statements in Item 8). Estimatesare based on historical experience and on various other assumptions that arebelieved to be reasonable under the 

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circumstances, the resultsof which form the basis for making judgments about the carrying value of assetsand liabilities that are not readily apparent from other sources.

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.

Revenue from fixed pricetesting contracts is generally recorded upon completion of the contracts, whichare generally short-term, or upon completion of identifiable contractual tasks.At the time the Company enters into a contract that includes multiple tasks,the Company estimates the amount of actual labor and other costs that will berequired to complete each task based on historical experience. Revenues arerecognized which provide for a profit margin relative to the testing performed.Revenue relative to each task and from contracts which are time and materialsbased is recorded as effort is expended. Billings in excess of amounts earnedare deferred. Any anticipated losses on contracts are charged to income whenidentified. To the extent management does not accurately forecast the level ofeffort required to complete a contract, or individual tasks within a contract,and the Company is unable to negotiate additional billings with a customer forcost over-runs, the Company may incur losses on individual contracts. Allselling, general and administrative costs are treated as period costs andexpensed 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.

*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, 2006,the Company has recorded a deferred tax asset of $1,747,000. The Company hasrecorded 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. At January 31,2006, the Company was in a net deferred tax loss position of $3,337,000.

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*Recently IssuedAccounting Standards*

On December 16, 2004, the Financial AccountingStandards Board (“FASB”) issued FASB Statement No. 123 (revised 2004), “Share-BasedPayment”, which is a revision of FASB Statement No. 123, “Accounting forStock-Based Compensation”. Statement 123 (R) supersedes APB Opinion No. 25,Accounting for Stock Issued to Employees, and amends FASB Statement No. 95,“Statement of Cash Flows”. Generally, the approach in Statement 123 (R) issimilar to the approach described in Statement 123. However,Statement 123 (R) requires all share-based payments to employees,including grants of employee stock options, to be recognized in theConsolidated Statements of Income based on their fair values.

In April 2005, the Securities and ExchangeCommission (“SEC”) extended the adoption date for Statement 123 (R) untilthe first quarter of the first fiscal year beginning after June 15, 2005,which in the case of National Technical Systems, Inc. will be the firstquarter ending April 30, 2006.

As permitted by Statement 123, through January 31,2006, the Company accounted for share-based payments to employees using APBOpinion 25’s intrinsic value method and, as such, generally recognize nocompensation cost for employee stock options. Accordingly, the adoption ofStatement 123 (R)’s fair value method is expected to reduce earnings pershare by less than $.01 per share on a quarterly basis, beginning infiscal year 2007. Had we adopted Statement 123 (R) in prior periods,the impact of that standard would have approximated the impact ofStatement 123 as described in the disclosure of pro forma net income andearnings per share presented above. Statement 123 (R) also requiresthe benefits of tax deductions in excess of recognized compensation cost to bereported as a financing cash flow, rather than as an operating cash flow asrequired under current literature. This requirement will reduce net operatingcash flows and increase net financing cash flows in periods after adoption.While we cannot estimate what those amounts will be in the future (because theydepend on, among other things, when employees exercise stock options), theamount of operating cash flows recognized for such tax deductions were $56,000,$74,000 and $44,000, respectively,  forthe years ended January 31, 2006, 2005 and 2004.

The pro forma informationin the accompanying financial statements presents the estimated compensationcharges under Statement 123. The Company’s assessment of the estimatedcompensation charges is affected by the Company’s stock price as well asassumptions regarding a number of complex and subjective variables and therelated tax impact. These variables include, but are not limited to, theCompany’s stock price volatility and employee stock option exercise behaviors.The Company will recognize the compensation cost for stock-based awards on astraight-line basis over the requisite service period for the entire award.

**Off-Balance SheetArrangements**

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

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**Results ofOperations**

The following discussionshould be read in conjunction with the consolidated financial statements andnotes thereto.

***REVENUES***

| ** **                    | ** ** | **Twelve months ended January 31,** | ** ** |
|-------------------------------|------------|---------------------------------------------------------|------------|
| ** **                    | ** ** | **2006**                                                | ** ** | **% Change** | ** ** | **2005** | ** ** | **% Change** | ** ** | **2004** | ** ** |
| ** **                    | ** ** | **(Dollars in thousands)**                    | ** ** |
| Engineering &  Evaluation |       | $                                                       | 72,411     |   |   | 15.4 | % |   | $ | 62,753 |   |   | 7.6 | % |   | $ | 58,312 |   |
| Technical Solutions           |       | 39,113                                                  |       |   | (10.6 | )% |   | 43,761 |   |   | (5.4 | )% |   | 46,238 |   |
| Total revenues                |       | $                                                       | 111,524    |   |   | 4.7 | % |   | $ | 106,514 |   |   | 1.9 | % |   | $ | 104,550 |   |

 

For the year ended January 31, 2006, totalrevenues increased $5,010,000 or 4.7%, as compared to the prior year. The yearover year growth was primarily attributable to strong organic growth in theEngineering and Evaluation segment combined with growth from acquisitions,offset by a decrease in revenues in the Technical Solutions segment.

For the year ended January 31,2005, total revenues increased $1,964,000 or 1.9%, as compared to fiscal 2004.

*Engineering &Evaluation:*

For the year ended January 31, 2006, revenues inthe Engineering & Evaluation segment increased $9,658,000 or 15.4%, ascompared to the prior year, primarily due to strong testing revenues in theaerospace and defense markets. Revenues also increased in thetelecommunications market, as a result of additional revenues of $1,330,000from the acquisition of the testing laboratory in Calgary, Canada on August 1,2004 and revenues of $934,000 from the acquisition of Phase Seven Laboratoriesin Santa Rosa, California on March 18, 2005. These increases werepartially offset by a decrease in passive fiber optic testing, and decrease inthe electronic and automotive testing businesses.

For the year ended January 31,2005, revenues in the Engineering & Evaluation segment increased$4,441,000 or 7.6%, as compared to fiscal 2004, primarily due to revenues of$3,718,000 and $531,000, respectively, in fiscal 2005 from the acquisition ofDTI Holdings, LLC, in Rustburg Virginia, and the acquisition of atelecommunications test laboratory in Calgary, Canada. Revenues also increasedin the Company’s space and automotive testing businesses. These increases werepartially offset by the decrease in the passive fiber optic testing businessand the decrease in defense related business at the Camden, Arkansas facilitydue to revenues from a major contract related to the war on terrorism that wascompleted in fiscal 2004.

*TechnicalSolutions:*

For the year ended January 31, 2006, revenues inthe Technical Solutions segment decreased by $4,648,000 or 10.6%, as comparedto the prior year, primarily due to the competitive environment in the generalIT service business from off-shore companies and the discontinuance of certainservices that did not fit the Company’s overall strategy. To offset thisdecline, the Company is deploying a migration strategy by cross selling toclients currently being serviced by the Engineering and Evaluation segment.

For the year ended January 31,2005, revenues in the Technical Solutions segment decreased by $2,477,000 or5.4%, as compared to fiscal 2004, as a result of the continued degradation ofthe IT market staffing business due to competition from off-shore companies andthe loss of certain customers in geographic areas where the Companydiscontinued its sales and marketing efforts.

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**GROSS PROFIT**

| ** **                    | ** ** | **Twelve months ended January 31,** | ** ** |
|-------------------------------|------------|---------------------------------------------------------|------------|
| ** **                    | ** ** | **2006**                                                | ** ** | **% Change** | ** ** | **2005** | ** ** | **% Change** | ** ** | **2004** | ** ** |
| ** **                    | ** ** | **(Dollars in thousands)**                    | ** ** |
| Engineering &  Evaluation |       | $                                                       | 20,422     |   |   | 22.1 | % |   | $ | 16,724 |   |   | 8.0 | % |   | $ | 15,492 |   |
| % to segment  revenue         |       | 28.2                                                    | %          |   |   |   |   | 26.7 | % |   |   |   |   | 26.6 | % |
| Technical Solutions           |       | 6,808                                                   |       |   | (2.2 | )% |   | 6,963 |   |   | (2.2 | )% |   | 7,120 |   |
| % to segment  revenue         |       | 17.4                                                    | %          |   |   |   |   | 15.9 | % |   |   |   |   | 15.4 | % |
| Total                         |       | $                                                       | 27,230     |   |   | 15.0 | % |   | $ | 23,687 |   |   | 4.8 | % |   | $ | 22,612 |   |
| % to total revenue            |       | 24.4                                                    | %          |   |   |   |   | 22.2 | % |   |   |   |   | 21.6 | % |

 

For the year ended January 31, 2006, total grossprofit increased $3,543,000 or 15.0%, as compared to the prior year. The yearover year growth was primarily attributable to the strong growth in revenues inthe Engineering and Evaluation segment, combined with cost reductionsattributable to increased process efficiencies.

For the year endedJanuary 31, 2005, total gross profit increased $1,075,000 or 4.8%, ascompared to fiscal 2004.

*Engineering &Evaluation:*

For the year ended January 31, 2006, gross profitin the Engineering & Evaluation segment increased by $3,698,000 or22.1%, as compared to the prior year, primarily as a result of the revenueincrease discussed above. Gross profit margin as a percentage of revenuesincreased to 28.2% in the current year from 26.7% in the prior year, primarily dueto labor cost containments as a result of improved process efficiencies. Thiswas offset by increases in depreciation expense as a result of capital spendingon machinery and equipment and increases in utilities expense.

For the year ended January 31, 2005, gross profitin the Engineering & Evaluation segment increased by $1,232,000 or8.0%, as compared to fiscal 2004, primarily as a result of the increase inrevenues. Gross profit margin as a percentage of revenues increased slightly to26.7% in fiscal 2005, compared to 26.6% in fiscal 2004.

*TechnicalSolutions:*

For the year ended January 31, 2006, gross profitin the Technical Solutions segment decreased by $155,000 or 2.2%, as comparedto the prior year, primarily as a result of the revenue decrease discussedabove. The Company was successful in minimizing this decrease as a result ofthe increased focus in specialized compliance and engineering support serviceswhich generally produce higher margins. Gross profit margin as a percentage ofrevenues increased to 17.4% in the current year from 15.9% in the prior year.

For the year ended January 31,2005, gross profit in the Technical Solutions segment decreased by $157,000 or2.2%, as compared to fiscal 2004, primarily as a result of the decrease inrevenues. Gross profit margin as a percentage of revenues increased to 15.9% infiscal 2005 from 15.4% in fiscal 2004.

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***SELLING, GENERAL& ADMINISTRATIVE***

| ** **                    | ** ** | **Twelve months ended January 31,** | ** ** |
|-------------------------------|------------|---------------------------------------------------------|------------|
| ** **                    | ** ** | **2006**                                                | ** ** | **% Change** | ** ** | **2005** | ** ** | **% Change** | ** ** | **2004** | ** ** |
| ** **                    | ** ** | **(Dollars in thousands)**                    | ** ** |
| Engineering &  Evaluation |       | $                                                       | 15,246     |   |   | 6.7 | % |   | $ | 14,290 |   |   | 13.0 | % |   | $ | 12,647 |   |
| % to segment  revenue         |       | 21.1                                                    | %          |   |   |   |   | 22.8 | % |   |   |   |   | 21.7 | % |
| Technical  Solutions          |       | 6,166                                                   |       |   | (3.0 | )% |   | 6,359 |   |   | (7.1 | )% |   | 6,848 |   |
| % to segment  revenue         |       | 15.8                                                    | %          |   |   |   |   | 14.5 | % |   |   |   |   | 14.8 | % |
| Total                         |       | $                                                       | 21,412     |   |   | 3.7 | % |   | $ | 20,649 |   |   | 5.9 | % |   | $ | 19,495 |   |
| % to total revenue            |       | 19.2                                                    | %          |   |   |   |   | 19.4 | % |   |   |   |   | 18.6 | % |

 

For the year ended January 31, 2006, totalselling, general and administrative expenses increased $763,000 or 3.7%, ascompared to the prior year. The year over year growth was primarilyattributable to increased general and administrative costs in the engineeringand evaluation segment, offset by a reduction in selling and general andadministrative costs in the technical staffing segment.

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

*Engineering &Evaluation:*

For the year ended January 31, 2006, selling,general and administrative expenses increased by $956,000 or 6.7%, as comparedto the prior year, primarily due to increased wages and incentive compensation,increased use of outside services related to the improvement of the Company’sinternal IT infrastructure and data automation and increased legal expense.

For the year ended January 31,2005, selling, general and administrative expenses increased by $1,643,000 or13.0%, as compared to fiscal 2004, primarily due to sales costs related toefforts to expand the Company nationally and internationally and the addition ofnew sales, customer service representatives and regional management, increasesin outside services related to the improvement of the Company’s internal ITinfrastructure and website and increased costs to prepare for compliance with Section 404of the Sarbanes-Oxley Act.

*TechnicalSolutions:*

For the year ended January 31, 2006, selling,general and administrative expenses decreased by $193,000 or 3.0% as comparedto the prior year, primarily due to decreases in depreciation expense, generaland administrative salaries and selling costs associated with the lowerrevenues.

For the year ended January 31,2005, selling, general and administrative expenses decreased by $489,000 or7.1%, as compared to fiscal 2004, primarily due to the reduction in sellingcosts associated with the lower revenues and other administrative costreductions.

***Equity Income from Non-Consolidated Subsidiary:***

*Engineering &Evaluation:*

For the year ended January 31,2006, equity income from XXCAL Japan was $259,000, compared to $483,000 in theprior year. The decrease of $224,000 was primarily due to lower revenues causedby a reduction in test requirements from a major Japanese client and increasedoperating costs related to hiring and training additional technical personnelfor new testing initiatives. XXCAL Japan is 50% owned by NTS and is accountedfor under the equity method since NTS does not have management or boardcontrol.

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***OPERATING INCOME***

| ** **                    | ** ** | **Twelve months ended January 31,** | ** ** |
|-------------------------------|------------|---------------------------------------------------------|------------|
| ** **                    | ** ** | **2006**                                                | ** ** | **% Change** | ** ** | **2005** | ** ** | **% Change** | ** ** | **2004** | ** ** |
| ** **                    | ** ** | **(Dollars in thousands)**                    | ** ** |
| Engineering &  Evaluation |       | $                                                       | 5,435      |   |   | 86.3 | % |   | $ | 2,917 |   |   | (0.9 | )% |   | $ | 2,943 |   |
| % to segment  revenue         |       | 7.5                                                     | %          |   |   |   |   | 4.6 | % |   |   |   |   | 5.0 | % |
| Technical  Solutions          |       | 642                                                     |       |   | 6.3 | % |   | 604 |   |   | 122.1 | % |   | 272 |   |
| % to segment  revenue         |       | 1.6                                                     | %          |   |   |   |   | 1.4 | % |   |   |   |   | 0.6 | % |
| Total                         |       | $                                                       | 6,077      |   |   | 72.6 | % |   | $ | 3,521 |   |   | 9.5 | % |   | $ | 3,215 |   |
| % to total revenue            |       | 5.4                                                     | %          |   |   |   |   | 3.3 | % |   |   |   |   | 3.1 | % |

 

For the year ended January 31, 2006, operatingincome increased $2,556,000 or 72.6%, as compared to the prior year. The yearover year growth was primarily attributable to the strong performance in theengineering and evaluation segment.

For the year ended January 31,2005, operating income increased $306,000 or 9.5%, as compared to fiscal 2004.

*Engineering &Evaluation:*

For the year ended January 31, 2006, operatingincome increased by $2,518,000 or 86.3%, as compared to the prior year, as aresult of the increase in gross profit discussed above, partially offset by theincrease in selling, general and administrative expenses.

For the year ended January 31,2005, operating income decreased by $26,000 or 0.9% as compared to fiscal 2004,as a result of the increase in selling, general and administrative expensesdiscussed above, partially offset by the increase in gross profit discussedabove.

*TechnicalSolutions:*

For the year ended January 31, 2006, operatingincome increased by $38,000 or 6.2%, as compared to the prior year, as a resultof the decrease in selling and general and administrative expenses discussedabove, partially offset by the decrease in gross profit discussed above.

For the year ended January 31,2005, operating income increased by $332,000 or 122.1% as compared to fiscal2004, as a result of the decrease in selling and general and administrativeexpenses discussed above, partially offset by the decrease in gross profitdiscussed above.

***Interest Expense***

Interest expense increased$207,000 in fiscal 2006 when compared to fiscal 2005 primarily due to higherinterest rate levels in fiscal 2006 offset by lower average debt balances infiscal 2006, as compared to the prior year. Interest expense decreased $6,000in fiscal 2005, compared to fiscal 2004 primarily due to lower interest ratelevels in fiscal 2005 offset by slightly higher average debt balances in fiscal2005 as compared to fiscal 2004.

***Other Income***

Other income of $176,000in fiscal 2006 includes approximately $163,000 in gain from the sale of realestate. Other income of $162,000 in fiscal 2005 includes approximately $158,000in gain from the sale of real estate.

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***Income Taxes***

The provisional income tax rate for fiscal year 2006is 39.7%, compared to 35.1% in the prior year. The increase in the income taxrate in fiscal 2006 was primarily due to lower earnings associated with theCompany’s foreign subsidiary in the current year, as compared to the prioryear. Earnings for this foreign subsidiary are reported net of tax and areincluded in income before income taxes and the associated tax is not separatelystated in income taxes. The income tax rate for fiscal year 2004 was 45.7%. Itreflects a rate in excess of the federal statutory rate primarily due to theinclusion of state income taxes and certain non-deductible expenses. See Note 4to the consolidated financial statements for a reconciliation of the provisionfor income taxes from continuing operations at the statutory rate to theprovision for 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 2006, net income increased $1,257,000 to$2,939,000, as compared to the prior year, primarily due to the increase inoperating income, partially offset by the increase in interest expense,increase in the income tax rate and minority interest.

In fiscal 2005, net incomeincreased $389,000 to $1,682,000, as compared to fiscal 2004. This increase wasdue to the increase in operating income and the lower income tax rate,partially offset by the decrease in other income and minority interest.

***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 60% of theoverall Engineering and Evaluation revenues. In recent years, domestic andworldwide political and economic developments have impacted positively themarket demands for defense and advanced technology systems. Also, the increasein government outsourcing activity has created additional opportunities forNTS. 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. The Company has seen an increase indemand for the evaluation of military equipment and weapons systems, which haspositively affected business at its laboratories. NTS continues to expandcapacity and capability to service this demand. In Camden, Arkansas, theCompany has installed a small and medium caliber test facility as well as addedadditional climatic environmental simulation chambers and a high performanceelectrodynamics vibration simulator. In Tinton Falls, New Jersey, the Companyadded additional electromagnetic interference and electromagnetic compatibilitysimulation capability and vibration and climatic environmental simulation. TheSanta Clarita, California, facility was completely modified to more effectivelyhandle satellite, defense and commercial aerospace work. The Companyanticipates the level of customer demand will increase for the foreseeablefuture.

Telecommunications revenues increased substantially,year over year, as a result of an increase in demand of outsourcing complianceand certification activities by the Regional Bell Operating Companies (RBOCs). Thetrend  for the foreseeable future appearsto be favorable. The Company has been approved as an Independent Testlaboratory (ITL) by the RBOCs to test and certify central office equipmentdeveloped by manufactures to the Network Equipment Building Specifications(NEBS). The Company is 

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currently providing thisservice at Laboratories in California, Massachusetts, Texas, Alberta, Canadaand Germany. The Company has been approved as an (ITL) to offer a completesuite of passive fiber components certifications and Digital Subscriber Line(DSL) certification. This service currently is being provided at laboratoriesin California. The Company expects an increase in business demand as RBOCsupgrade networks packet-based Voice Over Internet Protocol (VOIP) devices. Asservice providers gradually convert to VOIP architectures, interoperabilitybecomes critical to ensure a seamless transition to next generation networks.The Company also expects an increase in demand as carriers begin to deploy “tripleplay” (voice, video, and broadband) offerings over FTTP (fiber to the premises)passive fiber networks (PON). The Company recently acquired a networkarchitecture and interoperability laboratory in Northern California. Thislaboratory was acquired to extend the Company’s service offering to handle theanticipated demand for interoperability testing and the FTTP deployment.

The transportation and power markets have been stablewith the Company experiencing slight incremental decrease in the transportationbusiness, while the Company is experiencing a slight incremental increase inthe power business. The Company anticipates that these two markets will remainstable with no significant external growth.

The computer and electronics markets have been stablewith the Company experiencing a decrease in the Japan operation and an increasein the US operation. The Company anticipates growth in these markets as itcaptures additional market share due to the planned international expansion.NTS has signed cooperative agreements in Taiwan and Korea with SGS and STC inHong Kong and mainland China. The cooperative agreements will focus onproviding USB, USB on the go, Connector and Zigbee certification to devicemanufacturers and industrial products manufactured in Asia. The Companybelieves that the demand for these certification activities will increase inAsia.

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 and engineering. As the IT general servicesbusiness went off-shore and became commodity by the larger organizations theCompany deployed a transformation strategy in 2003 which focused on meeting theanticipated increase in demand for specialized IT, compliance, engineeringsupport services at Company locations as well as taking advantage of offshoreopportunities. As part of this transformation, the Company developed aproprietary database and put in place a customer service team which maintainsrelationships and manages the availability of the technical experts whichsupport these specialized services. The Company has also set up a test and compliancelaboratory in Vietnam to support the needs of a major US Fortune 500 computercompany and to take advantage of the low cost highly skilled labor in Vietnam. TheCompany is now expanding this offshore offering to additional clients. TScontinues to differentiate itself from its competitors by using NTS’ testing,engineering and compliance capabilities to maximize its customers’ return onhuman assets.

Notwithstanding theforegoing and because of factors affecting the Company’s operating results, pastfinancial performance should not be considered to be a reliable indicator offuture performance.

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***Liquidity and Capital Resources***

Summaryof cash flows:

| ** **                                                    | ** ** | **FY 2006**                     | ** ** | **FY 2005** | ** ** | **FY 2004** | ** ** |
|---------------------------------------------------------------|------------|--------------------------------------|------------|------------------|------------|------------------|------------|
| ** **                                                    | ** ** | **(Dollars in thousands)** | ** ** |
| Net cash provided  by operating activities                    |       | $                                    | 9,535      |             | $          | 6,590            |       | $ | 8,804 |   |
| Net cash used for  investing activities                       |       | (7,408                               | )          | (6,089           | )          | (7,470           | )          |
| Net cash provided  by (used in) financing activities          |       | (4,180                               | )          | 1,026            |       | (232             | )          |
| Effect of  exchange rate changes on cash and cash equivalents |       | 48                                   |       | 13               |       | —           |       |
| Net increase (decrease)  in cash                              |       | $                                    | (2,005     | )                | $          | 1,540            |       | $ | 1,102 |   |

 

Net cash provided by operating activities of$9,535,000 in fiscal 2006 consisted of net income of $2,939,000 adjusted fornon-cash items of $5,283,000 in depreciation and amortization and $1,760,000 ofchanges in working capital and other activities, partially offset by $447,000in other non-cash items. The increase in cash provided by operating activitiesfrom fiscal 2005 to fiscal 2006 was primarily the result of higher net incomein fiscal 2006, the increase in depreciation expense, the changes in accountspayable, accrued expenses, income taxes receivable, income taxes payable,partially offset by the changes in accounts receivable, inventories anddeferred income taxes. Net cash provided by operating activities of $6,590,000in fiscal 2005 consisted of net income of $1,682,000 adjusted for non-cashitems of $4,798,000 in depreciation and amortization and $302,000 in othernon-cash items, partially offset by $192,000 of changes in working capital andother activities. The decrease in cash provided by operating activities fromfiscal 2004 to fiscal 2005 was primarily the result of the change in accountsreceivable, the increase in accounts payable payments, partially offset by thehigher net income in fiscal 2005. Net cash provided by operating activities of$8,804,000 in fiscal 2004 consisted of net income of $1,293,000 adjusted fornon-cash items of $4,776,000 in depreciation and amortization and $379,000 inother non-cash items, and $2,356,000 of changes in working capital and otheractivities. Working capital changes included a decrease in accounts receivablebalances of approximately $2,238,000, reflecting improved collectionperformance in fiscal 2004. The increase in cash provided by operating activitiesfrom fiscal 2003 to fiscal 2004 was primarily the result of the change inaccounts receivable and the higher net income in fiscal 2004.

Net cash used for investing activities in fiscal 2006of $7,408,000 was primarily attributable to capital spending of $7,287,000 andcash used in the acquisition of Phase Seven Laboratories in the amount of$483,000, partially offset by proceeds from the sale of real estate of$543,000. Capital spending is generally comprised of purchases of machinery andequipment, building, leasehold improvements, computer hardware, software andfurniture and fixtures. Cash used in investing activities increased from fiscal2005 to fiscal 2006 by $1,319,000 primarily as a result of an increase incapital spending of $2,098,000, in fiscal 2006, partially offset by a decreaseof $550,000 in cash spent on acquisitions. Net cash used for investingactivities in fiscal 2005 of $6,089,000 was primarily attributable to capitalspending of $5,189,000 and cash used in the acquisition of the Canadian testlaboratory for $1,033,000, partially offset by proceeds from the sale of realestate of $311,000. Cash used in investing activities decreased from fiscal2004 to fiscal 2005 by $1,381,000 primarily as a result of the acquisition ofDTI in fiscal 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 for financing activities in fiscal 2006of $4,180,000 consisted of repayments of debt of $7,075,000, partially offsetby proceeds from borrowings of $2,651,000 and proceeds from stock optionsexercised of $244,000. Net cash provided by financing activities in fiscal 2005of $1,026,000 consisted of proceeds from borrowings of $2,228,000, proceedsfrom stock options exercised of $300,000, partially offset 

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by repayments of debt of$1,502,000. Net cash used for financing activities in fiscal 2004 of $232,000consisted of repayments of debt of $2,141,000, common stock repurchase of$106,000, offset by proceeds from borrowings of $1,831,000 and proceeds fromstock options exercised of $184,000.

On November 25, 2002, the Company increased therevolving line of credit under its credit agreement with Comerica BankCalifornia and First Bank to $20,000,000. Comerica Bank California, as theagent, retained 60% of the line with First Bank, as the participant, holding40% of the line. The revolving line of credit was reduced by $1,750,000 on August 1,2003 and was reduced again on August 1, 2004 by $1,750,000, bringing theline of credit balance down to $16,500,000. The interest rate is at the agent’sprime rate, with an option for the Company to convert to loans at the Liborrate plus 250 basis points for 30, 60, 90, 180 or 365 days, with minimum advancesof $1,000,000. The Company paid a 0.5% commitment fee of the total line amountand is paying an additional 0.25% of the commitment amount annually and a 0.25%fee for any unused line of credit.

On July 1, 2005, the agreement was amended toinclude a $2,500,000 term loan to be repaid in 60 equal monthly payments. Theproceeds were used to pay down the line of credit. In addition, the requirementof the $1,750,000 reduction of the line was removed from the agreement and thematurity date was extended to August 1, 2007. The outstanding balance on theterm loan at January 31, 2006 was $2,208,000. The outstanding balance onthe revolving line of credit at January 31, 2006 was $8,500,000. Thisbalance is reflected in the accompanying condensed consolidated balance sheetsas long-term. The amount available on the line of credit was $8,000,000 as of January 31,2006. The amendment also includes an additional equipment line of credit for$2,000,000. The outstanding balance on the equipment line of credit at January 31,2006 was $2,000,000, which was converted to a term loan to be repaid in 48equal monthly payments. This agreement is subject to certain covenants, whichrequire the maintenance of certain working capital, debt-to-equity,earnings-to-expense and cash flow ratios. The Company was in full compliancewith all of the covenants with its banks as of January 31, 2006, with theexception of the capital expenditure covenant which was in excess of theallowed amount. The Company requested and received a waiver from its banks.

The Company has additional equipment line of creditagreements (at interest rates of 5.56% to 9.82%) to finance various testequipment with terms of 60 months for each equipment schedule. The outstandingbalance at January 31, 2006 was $1,798,000. The balance of other notespayable collateralized by land and building was $2,602,000 at January 31,2006.

ContractualObligations:

| ** **                   | ** ** | **Payments due by period** | ** ** |
|------------------------------|------------|-------------------------------------------|------------|
| ** **                   | ** ** | **Total**                                 | ** ** | **Due in  2007** | ** ** | **Due in  2008-2009** | ** ** | **Due in  2010-2011** | ** ** | **Thereafter** | ** ** |
| ** **                   | ** ** | **(Dollars in thousands)**      | ** ** |
| Long-term debt               |       | $                                         | 17,108     |   | $ | 1,529 |   |   | $ | 11,860 |   |   |   | $ | 2,142 |   |   |   | $ | 1,577 |   |   |
| Operating lease  obligations |       | 6,980                                     |       | 2,143 |   |   | 3,234 |   |   |   | 1,488 |   |   |   | 115 |   |   |
| Total                        |       | $                                         | 24,088     |   | $ | 3,672 |   |   | $ | 15,094 |   |   |   | $ | 3,630 |   |   |   | $ | 1,692 |   |   |

 

Management is not aware ofany significant demands for capital funds that may materially affect short orlong-term liquidity in the form of large fixed asset acquisitions, unusualworking capital commitments or contingent liabilities. In addition, the Companyhas made no material commitments for capital expenditures. The Company’slong-term debt may be accelerated if the Company fails to meet its covenantswith its banks. The Company believes that the cash flow from operations and therevolving line of credit will be sufficient to fund its operations for the nexttwelve months.

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**ITEM 7A.***        QUANTITATIVEAND QUALITATIVE 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 $85,000 at January 31, 2006 ascompared to $160,000 at January 31, 2005.

***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 to identifyand 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. Heavy rainfall lastyear 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 will be conducted in cooperationwith the government agency having oversight responsibility for the adjacentsite. No cleanup activity has been conducted on the Santa Clarita property andit has yet to be determined whether remediation will be required at the site,or, if required, the extent and cost of any remediation. The Company believesthat in the event it does incur remediation costs that it will have validclaims for indemnification against the owner of the adjacent site and themunicipality that built a road between the adjacent site and the Santa Claritaproperty that appears to have contributed to the runoff from the adjacent site.Recovery of such remediation costs may, however, be uncertain and may involvesignificant litigation 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.

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

**Indexto Consolidated Financial Statements and Schedule**

| Report of Independent  Registered Public Accounting Firm                                                    |       | 29           |       |
|-------------------------------------------------------------------------------------------------------------|------------|--------------|------------|
| Financial  Statements:                                                                                      |       |         |       |
| Consolidated  Balance Sheets—January 31, 2006 and 2005                                            | ** ** | 30           | ** ** |
| Consolidated Statements of Income—Years ended  January 31, 2006, 2005 and 2004                    | ** ** | 31           | ** ** |
| Consolidated Statements of Shareholders’ Equity—Years  ended January 31, 2006, 2005 and 2004 | ** ** | 32           | ** ** |
| Consolidated Statements of Cash Flows—Years ended  January 31, 2006, 2005 and 2004                | ** ** | 33           | ** ** |
| Notes to Consolidated Financial Statements                                                                  | ** ** | 34           | ** ** |
|                                                                                                        | ** ** | **Schedule** | ** ** |
| Schedule Supporting Financial Statements:                                                                   |       |         |       |
| Valuation and  Qualifying Accounts and Reserves                                                             |       | 57           |       |

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All other schedules are omitted as inapplicable orbecause the required information is contained in the financial statements orthe notes thereto.

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**REPORTOF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM**

The Board of Directors and ShareholdersNational Technical Systems, Inc.

We have audited the accompanying consolidated balancesheets of National Technical Systems, Inc. and Subsidiaries as of January 31,2006 and 2005, and the related consolidated statements of income, shareholders’equity and cash flows for each of the three years in the period ended January 31,2006. 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. Thefinancial statements of XXCAL Japan (a corporation in which the Company has a50% interest), have been audited by other auditors whose report has beenfurnished to us, and our opinion on the consolidated financial statements,insofar as it relates to the amounts included for XXCAL Japan, is based solelyon the report of the other auditors. In the consolidated financial statements,the Company’s investment in XXCAL Japan is stated at $1,019,000 and $760,000,respectively, at January 31, 2006 and 2005, and the Company’s equity inthe net income of XXCAL Japan is stated at $259,000 and $483,000, for the yearsthen ended.

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 and the report of otherauditors provide a reasonable basis for our opinion.

In ouropinion, based on our audits and the report of other auditors, the financialstatements referred to above present fairly, in all material respects, theconsolidated financial position of National Technical Systems, Inc. andSubsidiaries at January 31, 2006 and 2005 and the consolidated results oftheir operations and their cash flows for each of the three years in the periodended January 31, 2006, 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 14, 2006 |                           |

 

29

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**NATIONAL TECHNICAL SYSTEMS, INC. AND SUBSIDIARIESConsolidated Balance SheetsJanuary 31,**

| ** **                                                                                                                                                 | ** ** | **2006**    | ** ** | **2005**    | ** ** |
|------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------|------------|-------------|------------|
| **ASSETS**                                                                                                                                                 | ** ** | ** **  | ** ** | ** **  | ** ** |
| CURRENT ASSETS:                                                                                                                                            |       |        |       |        |       |
| Cash                                                                                                                                                       |       | $           | 4,196,000  |        | $          | 6,201,000 |   |
| Accounts receivable,  less allowance for doubtful accounts of $816,000 at January 31, 2006 and  $906,000 at January 31, 2005                               |       | 20,425,000  |       | 18,618,000  |       |
| Income taxes receivable                                                                                                                                    |       | 10,000      |       | 521,000     |       |
| Inventories                                                                                                                                                |       | 2,184,000   |       | 1,612,000   |       |
| Deferred income taxes                                                                                                                                      |       | 1,747,000   |       | 1,529,000   |       |
| Prepaid expenses                                                                                                                                           |       | 769,000     |       | 666,000     |       |
| Total current assets                                                                                                                                       |       | 29,331,000  |       | 29,147,000  |       |
| Property, plant and equipment, at cost                                                                                                                     |       |        |       |        |       |
| Land                                                                                                                                                       |       | 1,415,000   |       | 1,415,000   |       |
| Buildings                                                                                                                                                  |       | 10,172,000  |       | 10,165,000  |       |
| Machinery and equipment                                                                                                                                    |       | 73,115,000  |       | 70,069,000  |       |
| Leasehold improvements                                                                                                                                     |       | 9,185,000   |       | 7,664,000   |       |
| Total property, plant  and equipment                                                                                                                       |       | 93,887,000  |       | 89,313,000  |       |
| Less: accumulated  depreciation                                                                                                                            |       | (60,787,000 | )          | (58,073,000 | )          |
| Net property,  plant and equipment                                                                                                                         |       | 33,100,000  |       | 31,240,000  |       |
| Goodwill                                                                                                                                                   |       | 2,740,000   |       | 2,740,000   |       |
| Other assets                                                                                                                                               |       | 3,962,000   |       | 3,542,000   |       |
| TOTAL ASSETS                                                                                                                                               |       | $           | 69,133,000 |        | $          | 66,669,000 |   |
| **LIABILITIES AND SHAREHOLDERS'  EQUITY**                                                                                                                  | ** ** | ** **  | ** ** | ** **  | ** ** |
| CURRENT LIABILITIES:                                                                                                                                       |       |        |       |        |       |
| Accounts payable                                                                                                                                           |       | $           | 4,715,000  |        | $          | 3,512,000 |   |
| Accrued expenses                                                                                                                                           |       | 5,400,000   |       | 3,755,000   |       |
| Income taxes payable                                                                                                                                       |       | 594,000     |       | —      |       |
| Deferred income                                                                                                                                            |       | 817,000     |       | 424,000     |       |
| Current installments of  long-term debt                                                                                                                    |       | 1,529,000   |       | 975,000     |       |
| Total current  liabilities                                                                                                                                 |       | 13,055,000  |       | 8,666,000   |       |
| Long-term debt,  excluding current installments                                                                                                            |       | 15,579,000  |       | 20,557,000  |       |
| Deferred income taxes                                                                                                                                      |       | 5,084,000   |       | 5,572,000   |       |
| Deferred compensation                                                                                                                                      |       | 874,000     |       | 810,000     |       |
| Minority interest                                                                                                                                          |       | 163,000     |       | 113,000     |       |
| 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, 9,176,000 as of  January 31, 2006 and 9,025,000 as of January 31, 2005 |       | 14,624,000  |       | 14,184,000  |       |
| Retained earnings                                                                                                                                          |       | 19,744,000  |       | 16,805,000  |       |
| Accumulated other  comprehensive income (loss)                                                                                                             |       | 10,000      |       | (38,000     | )          |
| Total shareholders'  equity                                                                                                                                |       | 34,378,000  |       | 30,951,000  |       |
| TOTAL LIABILITIES AND SHAREHOLDERS' EQUITY                                                                                                                 |       | $           | 69,133,000 |        | $          | 66,669,000 |   |

 

See accompanying notes.

30

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**NATIONAL TECHNICAL SYSTEMS, INC. AND SUBSIDIARIESConsolidated Statements of IncomeYears Ended January 31,**

| ** **                                                     | ** ** | **2006**   | ** **  | **2005**   | ** ** | **2004**    | ** ** |
|----------------------------------------------------------------|------------|------------|-------------|------------|------------|-------------|------------|
| Net revenues                                                   |       | $          | 111,524,000 |       | $          | 106,514,000 |       | $ | 104,550,000 |   |
| Cost of sales                                                  |       | 84,294,000 |        | 82,827,000 |       | 81,938,000  |       |
| Gross profit                                                   |       | 27,230,000 |        | 23,687,000 |       | 22,612,000  |       |
| Selling, general  and administrative expense                   |       | 21,412,000 |        | 20,649,000 |       | 19,495,000  |       |
| Equity income  from non-consolidated subsidiary                |       | (259,000   | )           | (483,000   | )          | (98,000     | )          |
| Operating income                                               |       | 6,077,000  |        | 3,521,000  |       | 3,215,000   |       |
| Other income (expense):                                        |       |       |        |       |       |        |       |
| Interest expense, net                                          |       | (1,298,000 | )           | (1,091,000 | )          | (1,097,000  | )          |
| Other income                                                   |       | 176,000    |        | 162,000    |       | 192,000     |       |
| Total other  income (expense)                                  |       | (1,122,000 | )           | (929,000   | )          | (905,000    | )          |
| Income before  income taxes and minority interest              |       | 4,955,000  |        | 2,592,000  |       | 2,310,000   |       |
| Income taxes                                                   |       | 1,966,000  |        | 910,000    |       | 1,056,000   |       |
| Income before  minority interest                               |       | 2,989,000  |        | 1,682,000  |       | 1,254,000   |       |
| Minority interest                                              |       | (50,000    | )           | —     |       | 39,000      |       |
| Net income                                                     |       | $          | 2,939,000   |       | $          | 1,682,000   |       | $ | 1,293,000 |   |
| Net income per common  share:                                  |       |       |        |       |       |        |       |
| Basic                                                          |       | $          | 0.32        |       | $          | 0.19        |       | $ | 0.15 |   |
| Diluted                                                        |       | $          | 0.30        |       | $          | 0.18        |       | $ | 0.14 |   |
| Weighted average  common shares outstanding                    |       | 9,125,000  |        | 8,946,000  |       | 8,640,000   |       |
| Dilutive effect  of stock options                              |       | 537,000    |        | 620,000    |       | 566,000     |       |
| Weighted average  common shares outstanding, assuming dilution |       | 9,662,000  |        | 9,566,000  |       | 9,206,000   |       |

 

See accompanying notes.

31

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**NATIONAL TECHNICAL SYSTEMS, INC. AND SUBSIDIARIESConsolidated Statements of Shareholders’ Equity**

| ** **                                                | ** ** | ** **         | ** **    | ** ** | ** ** | ** **      | ** **     | **Accumulated**        | ** ** | ** **             | ** **   |
|-----------------------------------------------------------|------------|--------------------|---------------|------------|------------|-----------------|----------------|------------------------|------------|------------------------|--------------|
| ** **                                                | ** ** | ** **         | ** **    | **Common** | ** ** | ** **      | ** **     | **Other**              | ** ** | **Total**              | ** **   |
| ** **                                                | ** ** | **Number of** | ** **    | **Stock**  | ** ** | **Retained**    | ** **     | **Comprehensive**      | ** ** | **Shareholders’** | ** **   |
| ** **                                                | ** ** | **Shares**         | ** **    | **Amount** | ** ** | **Earnings**    | ** **     | **Income (Loss)** | ** ** | **Equity**             | ** **   |
| **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** | ** ** |
| Net income                                                |       |               | —        |       |       | —          |           | 2,939,000              |       |                   | —       | ** ** |   | 2,939,000 |   |
| Foreign currency  translation                             |       |               | —        |       |       | —          |           | —                 |       |                   | 48,000       | ** ** |   | 48,000 |   |
| Comprehensive income                                      |       |               |          |       |       |            |           |                   |       |                   |         | ** ** |   | 2,987,000 |   |
| Stock options  exercised                                  |       |               | 148,000       |       |       | 414,000         |           | —                 |       |                   | —       | ** ** |   | 414,000 |   |
| Stock retired for  option exercise                        |       |               | (30,000       | )          |       | (170,000        | )              | —                 |       |                   | —       | ** ** |   | (170,000 | ) |
| Tax benefit from  stock options exercise                  |       |               | —        |       |       | 56,000          |           | —                 |       |                   | —       | ** ** |   | 56,000 |   |
| Stock issued for  acquisition of Phase Seven Laboratories |       |               | 33,000        |       |       | 140,000         |           | —                 |       |                   | —       | ** ** |   | 140,000 |   |
| **Balance  at January 31, 2006**                     | ** ** |               | **9,176,000** | ** ** |       | **$**           | **14,624,000** | ** **             | **$**      | **19,744,000**         | ** **   |   | **$** | **10,000** | ** ** |   | **$** | **34,378,000** | ** ** |
|                                                           |            |                    |               |            |            |                 |                |                        |            |                        |              |  |  |  |  |  |  |  |  |

 

See accompanying notes.

32

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**NATIONAL TECHNICAL SYSTEMS, INC. AND SUBSIDIARIESConsolidated Statements of Cash FlowsYears Ended January 31,**

| ** **                                                                                     | ** ** | **2006**   | ** ** | **2005**   | ** ** | **2004**   | ** ** |
|------------------------------------------------------------------------------------------------|------------|------------|------------|------------|------------|------------|------------|
| **CASH FLOWS FROM OPERATING ACTIVITIES:**                                                      |       |       |       |       |       |       |       |
| Net income                                                                                     |       | $          | 2,939,000  |       | $          | 1,682,000  |       | $ | 1,293,000 |   |
| Adjustments to reconcile net income from operations  to cash provided by operating activities: |       |       |       |       |       |       |       |
| Depreciation and  amortization                                                                 |       | 5,283,000  |       | 4,798,000  |       | 4,776,000  |       |
| Recoveries on  receivables                                                                     |       | (90,000    | )          | (32,000    | )          | (359,000   | )          |
| Gain on sale of  assets                                                                        |       | (163,000   | )          | (158,000   | )          | —     |       |
| Loss on retirement  of assets                                                                  |       | —     |       | 16,000     |       | —     |       |
| Undistributed  earnings of affiliate                                                           |       | 50,000     |       | —     |       | (38,000    | )          |
| Deferred income  taxes (net of acquisition)                                                    |       | (300,000   | )          | 352,000    |       | 732,000    |       |
| Tax benefit from  stock options exercised                                                      |       | 56,000     |       | 74,000     |       | 44,000     |       |
| Issuance of  restricted common stock for services                                              |       | —     |       | 50,000     |       | —     |       |
| Changes in assets and  liabilities (net of acquisition):                                       |       |       |       |       |       |       |       |
| Accounts  receivable                                                                           |       | (1,677,000 | )          | 235,000    |       | 2,238,000  |       |
| Inventories                                                                                    |       | (572,000   | )          | 383,000    |       | 514,000    |       |
| Prepaid expenses                                                                               |       | (103,000   | )          | 161,000    |       | 303,000    |       |
| Other assets and  intangibles                                                                  |       | (166,000   | )          | (265,000   | )          | (199,000   | )          |
| Accounts payable                                                                               |       | 1,104,000  |       | (973,000   | )          | (207,000   | )          |
| Accrued expenses                                                                               |       | 1,612,000  |       | 241,000    |       | (119,000   | )          |
| Income taxes  payable                                                                          |       | 594,000    |       | (23,000    | )          | 23,000     |       |
| Deferred income                                                                                |       | 393,000    |       | 239,000    |       | 10,000     |       |
| Deferred  compensation                                                                         |       | 64,000     |       | 11,000     |       | 3,000      |       |
| Common stock  compensation                                                                     |       | —     |       |       |       |       |       |
| Income taxes  receivable                                                                       |       | 511,000    |       | (201,000   | )          | (210,000   | )          |
| Cash provided by  operations                                                                   |       | 9,535,000  |       | 6,590,000  |       | 8,804,000  |       |
| **CASH FLOWS FROM INVESTING ACTIVITIES:**                                                      |       |       |       |       |       |       |       |
| Purchase of  property, plant and equipment                                                     |       | (7,287,000 | )          | (5,189,000 | )          | (4,599,000 | )          |
| Sale of property,  plant and equipment                                                         |       | 543,000    |       | 311,000    |       | —     |       |
| Investment in life  insurance                                                                  |       | (181,000   | )          | (178,000   | )          | (184,000   | )          |
| Acquisition of  business, net of cash                                                          |       | (483,000   | )          | (1,033,000 | )          | (2,687,000 | )          |
| Net cash used for  investing activities                                                        |       | (7,408,000 | )          | (6,089,000 | )          | (7,470,000 | )          |
| **CASH FLOWS FROM FINANCING ACTIVITIES:**                                                      |       |       |       |       |       |       |       |
| Proceeds from  current and long-term debt                                                      |       | 2,651,000  |       | 2,228,000  |       | 1,831,000  |       |
| Repayments of  current and long-term debt                                                      |       | (7,075,000 | )          | (1,502,000 | )          | (2,141,000 | )          |
| Proceeds from  stock options exercised                                                         |       | 244,000    |       | 300,000    |       | 184,000    |       |
| Common stock  repurchase                                                                       |       | —     |       | —     |       | (106,000   | )          |
| Net cash provided  by (used for) financing activities                                          |       | (4,180,000 | )          | 1,026,000  |       | (232,000   | )          |
| Effect of exchange  rate changes on cash and cash equivalents                                  |       | 48,000     |       | 13,000     |       | —     |       |
| Net increase  (decrease) in cash                                                               |       | (2,005,000 | )          | 1,540,000  |       | 1,102,000  |       |
| Beginning cash  balance                                                                        |       | 6,201,000  |       | 4,661,000  |       | 3,559,000  |       |
| ENDING CASH BALANCE                                                                            |       | $          | 4,196,000  |       | $          | 6,201,000  |       | $ | 4,661,000 |   |
| **SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION**                                           |       |       | ** ** | ** ** |       |       |       |
| Cash payments during the year for:                                                             |       |       |       |       |       |       |       |
| Interest                                                                                       |       | $          | 1,333,000  |       | $          | 1,078,000  |       | $ | 1,171,000 |   |
| Income taxes                                                                                   |       | 1,089,000  |       | 667,000    |       | 529,000    |       |
| Cash received during the year for:                                                             |       |       |       |       |       |       |       |
| Income taxes                                                                                   |       | —     |       | —     |       | 5,000      |       |

 

See accompanying notes.

33

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**NATIONAL TECHNICAL SYSTEMS, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements January 31, 2006, 2005 and 2004**

**(1)   Summaryof Significant Accounting Policies**

*Principles ofConsolidation*

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 $1,019,000 and $760,000 at January 31,2006 and 2005, respectively.

*Risks andUncertainties*

The preparation of financial statements in conformitywith U.S. 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 isgenerally recorded upon completion of the contracts, which are generallyshort-term, or upon completion of identifiable contractual tasks. At the timethe Company 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. Revenues are recognizedwhich provide for a profit margin relative to the testing performed. Revenue relativeto each task and from contracts which are time and materials based is recordedas effort is expended. Billings in excess of amounts earned are deferred. Anyanticipated losses on contracts are charged to income when identified. To theextent management does not accurately forecast the level of effort required tocomplete a contract, or individual tasks within a contract, and the Company isunable to negotiate additional billings with a customer for cost over-runs, theCompany may incur losses on individual contracts. All selling, general andadministrative costs are 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.

34

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**NATIONAL TECHNICAL SYSTEMS, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued) January 31, 2006, 2005 and 2004**

**(1)**   Summary of Significant 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 forSale*

In fiscal year 2005, theCompany sold the old 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. In fiscal year2006, the Company sold the new Palm Desert, California condominium and recordeda gain of approximately $163,000.

*Property, Plant andEquipment*

Property,plant, and equipment is stated at actual cost and is depreciated and amortizedusing the straight-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*

The Company adopted the new rules on accountingfor goodwill and other intangible assets beginning in the first quarter offiscal year 2003 in accordance with Statement of Financial Accounting StandardsNo. 142 (“SFAS No. 142”), “Goodwill and Other Intangible Assets.”

**As of January 31, 2006 and 2005, the Company had thefollowing acquired intangible assets:**

| ** **                                      | ** ** | **January 31, 2006** | ** ** | **January 31, 2005** | ** ** |
|-------------------------------------------------|------------|--------------------------------|------------|--------------------------------|------------|
| ** **                                      | ** ** | **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    |                           | $          | 110,000 |   | $ | 38,000 |   |   | 3-5  years |   |   | $ | 148,000 |   | $ | 78,000 |   | $ | 70,000 |   |   | 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 for intangible assets subject toamortization was $32,000 and $39,000 for the years ended January 31,  2006 and 2005, respectively.

35

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**NATIONAL TECHNICAL SYSTEMS, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued) January 31, 2006, 2005 and 2004**

**(1)**   Summary of Significant 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 threereporting units in the Engineering and Evaluation segment and one reportingunit in the Technical Solutions segment, which constitute components of itsbusiness that include goodwill. The Company completed its annual goodwillimpairment test and has determined that the fair value of each of the reportingunits exceeded the reporting unit’s carrying amount, and no impairment wasindicated.

*Long-lived Assets*

The Company periodicallyevaluates the recoverability of the carrying amount of long-lived assets(including property, plant and equipment, and intangible assets withdeterminable lives) whenever events or changes in circumstances indicated thatthe carrying amount of an asset may not be fully recoverable. The Companyevaluates events or changes in circumstances based on a number of factorsincluding operating results, business plans and forecasts, general and industrytrends and, economic projections and anticipated cash flows. An impairment isassessed when the undiscounted expected future cash flows derived from an assetare less than its carrying amount. Impairment losses are measured as the amountby which the carrying value of an asset exceeds its fair value and arerecognized in earnings.

*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 31,1996 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:

| ** **                | ** ** | **2006** | ** ** | **2005** | ** ** | **2004** | ** ** |
|---------------------------|------------|----------|------------|----------|------------|----------|------------|
| Expected life (in  years) |       | 7.48     |       | 7.68     |       | 8.54     |       |
| Risk-free  interest rate  |       | 4.47     | %          | 3.71     | %          | 3.31     | %          |
| Expected  volatility      |       | 70       | %          | 76       | %          | 86       | %          |
| Expected dividend yield   |       | 0        | %          | 0        | %          | 0.65     | %          |

 

36

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**NATIONAL TECHNICAL SYSTEMS, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued) January 31, 2006, 2005 and 2004**

**(1)**   Summary of Significant Accounting Policies (Continued)

The Black-Scholes optionvaluation model was developed for use in estimating the fair value of thetraded options that have no vesting restrictions and are fully transferable. Inaddition, option valuation models require the input of highly subjectiveassumptions, including the expected stock price volatility. Because the Company’soptions have characteristics significantly different from those of tradedoptions, and because changes in the subjective input assumptions can materiallyaffect the fair value estimate, in the opinion of management, the existingmodels do not necessarily provide a reliable single measure of the fair valueof its options. The weighted average estimated fair value of employee stockoptions granted during 2006 was $4.70 per share. Had compensation cost for theCompany’s stock option plan been determined consistent with the fair valuemethod outlined in SFAS No. 123, the Company’s net income and earnings pershare would have been as indicated below:

| ** **                         | ** ** | **January 31, 2006** | ** ** | **January 31, 2005** | ** ** | **January 31, 2004** | ** ** |
|------------------------------------|------------|--------------------------------|------------|--------------------------------|------------|--------------------------------|------------|
| Net income                         |       |                           |       |                           |       |                           |       |   |   |   |   |   |   |
| As reported                        |       |                           | $          | 2,939,000                      |       |                           |       | $ | 1,682,000 |   |   |   | $ | 1,293,000 |   |   |
| Pro forma                          |       |                           | $          | 2,562,000                      |       |                           |       | $ | 1,155,000 |   |   |   | $ | 876,000 |   |   |
| Basic earnings  per common share   |       |                           |       |                           |       |                           |       |   |   |   |   |   |   |
| As reported                        |       |                           | $          | 0.32                           |       |                           |       | $ | 0.19 |   |   |   | $ | 0.15 |   |   |
| Pro forma                          |       |                           | $          | 0.28                           |       |                           |       | $ | 0.13 |   |   |   | $ | 0.10 |   |   |
| Diluted earnings  per common share |       |                           |       |                           |       |                           |       |   |   |   |   |   |   |
| As reported                        |       |                           | $          | 0.30                           |       |                           |       | $ | 0.18 |   |   |   | $ | 0.14 |   |   |
| Pro forma                          |       |                           | $          | 0.27                           |       |                           |       | $ | 0.12 |   |   |   | $ | 0.10 |   |   |

 

*ComprehensiveIncome*

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. Theeffect of the foreign currency translation was $48,000 and $13,000 for fiscalyears 2006 and 2005, respectively. Accumulated other comprehensive income was$10,000 and accumulated other comprehensive loss was $38,000 as of January 31,2006 and 2005, 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,basic earnings 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 CurrencyTranslation*

The accounts of the foreign divisions are translatedinto United States dollars in accordance with SFAS No. 52, “ForeignCurrency Translation”. All balance sheet accounts, except for certain fixedassets accounts, have been translated using the current rate of exchange at thebalance sheet date. Results of 

37

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**NATIONAL TECHNICAL SYSTEMS, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued) January 31, 2006, 2005 and 2004**

**(1)**   Summary of Significant Accounting Policies (Continued)

operationshave been translated using the average rates prevailing throughout the year.Translation gains or losses resulting from the changes in the exchange ratesfrom year-to-year are accumulated in a separate component of shareholders’equity. The translation of the balance sheet accounts resulted in $48,000 and$13,000 in unrealized gain in fiscal years 2006 and 2005, respectively.

*Related PartyTransactions*

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 2006, 2005 and2004 were $376,000, $214,000 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 2006,2005 and 2004 were $376,000, $214,000 and $241,000, respectively.

NQA, Inc. leasesspace from NTS and was assessed $71,000 for rent and utilities in fiscal years2006, 2005 and 2004.

*Reclassifications*

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

*Recently IssuedAccounting Standards*

On December 16, 2004, the Financial AccountingStandards Board (“FASB”) issued FASB Statement No. 123 (revised 2004), “Share-BasedPayment”, which is a revision of FASB Statement No. 123, “Accounting forStock-Based Compensation”. Statement 123 (R) supersedes APB Opinion No. 25,Accounting for Stock Issued to Employees, and amends FASB Statement No. 95,“Statement of Cash Flows”. Generally, the approach in Statement 123 (R) issimilar to the approach described in Statement 123. However,Statement 123 (R) requires all share-based payments to employees,including grants of employee stock options, to be recognized in income based ontheir fair values.

In April 2005, the Securities and ExchangeCommission (“SEC”) extended the adoption date for Statement 123 (R) untilthe first quarter of the first fiscal year beginning after June 15, 2005,which in the case of National Technical Systems, Inc. will be the first quarterending April 30, 2006.

As permitted by Statement 123, through January 31,2006, the Company accounted for share-based payments to employees using APBOpinion 25’s intrinsic value method and, as such, generally recognize nocompensation cost for employee stock options. Accordingly, the adoption ofStatement 123 (R)’s fair value method is expected to reduce earnings pershare by less than $.01 per share on a quarterly basis, beginning infiscal year 2007. Had we adopted Statement 123 (R) in prior periods,the impact of that 

38

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**NATIONAL TECHNICAL SYSTEMS, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued) January 31, 2006, 2005 and 2004**

**(1)**   Summary of Significant Accounting Policies (Continued)

standard would haveapproximated the impact of Statement 123 as described in the disclosure ofpro forma net income and earnings per share presented above. Statement 123(R) also requires the benefits of tax deductions in excess of recognizedcompensation cost to be reported as a financing cash flow, rather than as anoperating cash flow as required under current literature. This requirement willreduce net operating cash flows and increase net financing cash flows inperiods after adoption. While we cannot estimate what those amounts will be inthe future (because they depend on, among other things, when employees exercisestock options), the amount of operating cash flows recognized for such taxdeductions were $56,000, $74,000 and $44,000, respectively,  for the years ended January 31, 2006,2005 and 2004.

The pro forma informationin the accompanying financial statements presents the estimated compensationcharges under Statement 123. The Company’s assessment of the estimatedcompensation charges is affected by the Company’s stock price as well asassumptions regarding a number of complex and subjective variables and therelated tax impact. These variables include, but are not limited to, theCompany’s stock price volatility and employee stock option exercise behaviors.The Company will recognize the compensation cost for stock-based awards on astraight-line basis over the requisite service period for the entire award.

**(2)**   BusinessAcquisition and Disposition

Thefollowing table summarizes the acquisitions completed during fiscal years 2006,2005 and 2004 that were accounted for under the purchase method of accounting:

| ** ** | ** ** | ** **                                          | ** ** | **Purchase Price** | ** ** | **Goodwill** | ** ** | **Other Intangibles** | ** ** |
|------------|------------|-----------------------------------------------------|------------|-------------------------|------------|--------------|------------|----------------------------|------------|
| FY 06      |       | Phase  Seven Laboratories                      |       |                    | $          | 652,000      |       |                       | —     |   |   | — |   |   |
| FY 05      |       | Telecommunications Test    Laboratory, Calgary |       |                    | $          | 1,033,000    |       |                       | —     |   |   | — |   |   |
| FY 04      |       | DTI Holdings, LLC                                   |       |                    | $          | 3,687,000    |       |                       | $          | 1,870,000 |   |   | $ | 59,000 |   |   |
|            |            |                                                     |            |                         |            |              |            |                            |            |  |  |  |  |  |  |  |

 

*Acquisition ofPhase Seven Laboratories*

On March 18, 2005, the Company acquired theoutstanding stock of Phase Seven Laboratories, located in Santa Rosa,California, for a total purchase price of $652,000, paid in cash and NTS stock.Phase Seven Laboratories provides carrier-class network interoperability,functionality and performance testing for new and emerging technologies andtheir integration with legacy systems. The results of operations of theacquired business are included in the accompanying consolidated statement ofoperations from March 18, 2005 to January 31, 2006.

39

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**NATIONAL TECHNICAL SYSTEMS, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued) January 31, 2006, 2005 and 2004**

**(2)**   Business Acquisition and Disposition (Continued)

The allocation of thepurchase price to the assets acquired and liabilities assumed was as follows:

| Assets acquired:              |   |    |    |
|-------------------------------|--------|---------|---------|
| Current assets                |   | $       | 69,000  |   |
| Property plant and  equipment |   | 204,000 |    |
| Deferred tax  assets          |   | 406,000 |    |
| Other assets                  |   | 105,000 |    |
| Total assets  acquired        |   | 784,000 |    |
| Liabilities  assumed:         |   |    |    |
| Current  liabilities          |   | 132,000 |    |
| Total liabilities  assumed    |   | 132,000 |    |
| Net assets acquired           |   | $       | 652,000 |   |

 

*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 31,2006.

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.

40

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**NATIONAL TECHNICAL SYSTEMS, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued) January 31, 2006, 2005 and 2004**

**(3) Debt**

Long-termdebt consists of the following:

| ** **                                       | ** ** | **2006**   | ** ** | **2005**   | ** ** |
|--------------------------------------------------|------------|------------|------------|------------|------------|
| Revolving lines  of credit (a)                   |       | $          | 8,500,000  |       | $          | 15,502,000 |   |
| Notes payable  secured by land and buildings (b) |       | 2,602,000  |       | 2,775,000  |       |
| Secured notes  payable (c)                       |       | 6,006,000  |       | 2,775,000  |       |
| Loans from  employee and officers (d)            |       | —     |       | 480,000    |       |
| Subtotal                                         |       | 17,108,000 |       | 21,532,000 |       |
| Less current  installments                       |       | 1,529,000  |       | 975,000    |       |
| Total                                            |       | $          | 15,579,000 |       | $          | 20,557,000 |   |

----

(a)           On November 25,2002, the Company increased the revolving line of credit under its creditagreement with Comerica Bank California and First Bank to $20,000,000. ComericaBank California, 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, bringing the maximum line of credit available down to$16,500,000. The interest rate is at the agent’s prime rate, with an option forthe Company to convert to loans at the Libor rate plus 250 basis points for 30,60, 90, 180 or 365 days, with minimum advances of $1,000,000. The Company paida 0.5% commitment fee of the total line amount and is paying an additional0.25% of the commitment amount annually and a 0.25% fee for any unused line ofcredit. On July 1, 2005, the agreement was amended to include a $2,500,000term loan (see (c)) and the maturity date was extended to August 1, 2007.The proceeds were used to pay down the line of credit. In addition, the requirementof the $1,750,000 per year reduction of the line was removed from the agreement.The outstanding balance on the revolving line of credit at January 31,2006 was $8,500,000. This balance is reflected in the accompanying consolidatedbalance sheets as long-term. The amount available on the line of credit was$8,000,000 as of January 31, 2006. 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 Company was infull compliance with all of the covenants with its banks as of January 31,2006, with the exception of the capital expenditure covenant which was inexcess of the allowed amount. The Company requested and received a waiver fromits banks.

(b)          The amount of $2,602,000represents 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)           On July 1, 2005,the Company amended its agreement with Comerica Bank California and First Bankto include a $2,500,000 term loan to be repaid in 60 equal monthly payments.The proceeds were used to pay down the line of credit. The outstanding balanceon the term loan at January 31, 2006 was $2,208,000. The amendment alsoincludes an additional equipment line of credit for $2,000,000. The outstandingbalance on the equipment line of credit at January 31, 2006 was$2,000,000, which was converted to a term loan to be repaid in 48 equal monthlypayments.

41

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**NATIONAL TECHNICAL SYSTEMS, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued) January 31, 2006, 2005 and 2004**

**(3) Debt(Continued)**

The Company has additional equipment line of creditagreements (at interest rates of 5.56% to 7.47%) to finance various testequipment with terms of 60 months for each equipment schedule. The outstandingbalance at January 31, 2006 was 1,798,000.

(d)          In fiscal 2005, theCompany had unsecured demand notes payable to two officers of the Company andone employee in the aggregate amount of $480,000 as of January 31, 2005.The interest was payable monthly and was based on the bank’s reference rateless three basis points. In fiscal 2006 all loans from officers and employeeswere paid off by the Company.

Maturitiesof long-term debt for five years subsequent to January 31, 2006 are asfollows:

| 2007       |   | $          | 1,529,000  |   |
|------------|--------|------------|------------|--------|
| 2008       |   | 10,173,000 |       |
| 2009       |   | 1,686,000  |       |
| 2010       |   | 1,524,000  |       |
| 2011       |   | 618,000    |       |
| Thereafter |   | 1,578,000  |       |
|       |   | $          | 17,108,000 |   |

 

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:

| ** **                        | ** ** | **2006**     | ** ** | **2006**            | ** ** | **2005**     | ** ** | **2005**            | ** ** |
|-----------------------------------|------------|--------------|------------|---------------------|------------|--------------|------------|---------------------|------------|
| ** **                        | ** ** | **Carrying** | ** ** | **Estimated**       | ** ** | **Carrying** | ** ** | **Estimated**       | ** ** |
| ** **                        | ** ** | **amount**   | ** ** | **fair value** | ** ** | **amount**   | ** ** | **fair value** | ** ** |
| Notes payable                     |       | $            | 2,602,000  |                | $          | 2,730,000    |       | $                   | 2,775,000  |   | $ | 3,223,000 |   |
| Secured notes  payable            |       | 6,006,000    |       | 5,300,000           |       | 2,775,000    |       | 2,717,000           |       |
| Revolving lines  of credit        |       | 8,500,000    |       | 8,500,000           |       | 15,502,000   |       | 15,502,000          |       |
| Loans from employee and  officers |       | —       |       | —              |       | 480,000      |       | 480,000             |       |
|                                   |            |              |            |                     |            |              |            |                     |            |  |  |  |  |

 

42

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**NATIONAL TECHNICAL SYSTEMS, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued) January 31, 2006, 2005 and 2004**

**(4)   Income Taxes**

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 generated from foreignoperations was $259,000, $522,000 and $95,000 in fiscal 2006, 2005 and 2004,respectively. Accumulated foreign earnings were $1,000,000 as of January 31,2006. The earnings associated with the Company’s foreign subsidiary areconsidered to be permanently re-invested and are reported net of tax and areincluded in operating income. During fiscal 2004, the Company liquidated its UKsubsidiary the tax effect after the foreign tax credit was an additional$76,000 in income taxes.

Theprovision (benefit) for income tax expense from continuing operations consistsof:

| ** **         | ** ** | **2006**  | ** ** | **2005** | ** ** | **2004** | ** ** |
|--------------------|------------|-----------|------------|----------|------------|----------|------------|
| Current:           |       |      |       |     |       |     |       |
| Federal            |       | $         | 1,911,000  |     | $          | 358,000  |       | $ | 151,000 |   |
| State              |       | 379,000   |       | 137,000  |       | 174,000  |       |
| Foreign            |       | (2,000    | )          | 14,000   |       | —   |       |
|               |       | 2,288,000 |       | 509,000  |       | 325,000  |       |
| Deferred:          |       |      |       |     |       |     |       |
| Federal            |       | (323,000  | )          | 187,000  |       | 663,000  |       |
| State              |       | 1,000     |       | 214,000  |       | 68,000   |       |
|               |       | (322,000  | )          | 401,000  |       | 731,000  |       |
| Income tax expense |       | $         | 1,966,000  |     | $          | 910,000  |       | $ | 1,056,000 |   |

 

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:

| ** **                                                 | ** ** | **2006** | ** ** | **2005** | ** ** | **2004**  | ** ** |
|------------------------------------------------------------|------------|----------|------------|----------|------------|-----------|------------|
| Income from  before income taxes and minority interest     |       | $        | 4,955,000  |     | $          | 2,592,000 |       | $ | 2,310,000 |   |
| Federal income  tax computed at statutory rate             |       | $        | 1,685,000  |     | $          | 881,000   |       | $ | 785,000 |   |
| State income  taxes, net of federal benefits               |       | 252,000  |       | 89,000   |       | 114,000   |       |
| Accumulated  earnings from Foreign Corporation             |       | —   |       | —   |       | 76,000    |       |
| Equity income net  of tax in a non consolidated subsidiary |       | (104,000 | )          | (164,000 | )          | —    |       |
| Other,  principally non-deductible expenses                |       | 133,000  |       | 104,000  |       | 81,000    |       |
| Income tax expense                                         |       | $        | 1,966,000  |     | $          | 910,000   |       | $ | 1,056,000 |   |

 

43

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**NATIONAL TECHNICAL SYSTEMS, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued) January 31, 2006, 2005 and 2004**

**(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. Netoperating loss of $570,000 and $262,000 for federal and state, respectively,relate to the purchase of Phase Seven Laboratories, Inc. in March 2005.Of this amount $262,000 relating to the state net operating losses will expirein 2015 and $570,000 will expire in 2025. The primary components of the Company’sdeferred tax assets and liabilities at January 31 were as follows:

| ** **                              | ** ** | **2006**    | ** ** | **2005**        | ** ** |
|-----------------------------------------|------------|-------------|------------|-----------------|------------|
| ** **                              | ** ** | **Current** | ** ** | **Non-current** | ** ** | **Current** | ** ** | **Non-current** | ** ** |
| **Deferred tax assets:**                |       |        |       |            |       |   |   |   |   |
| Bad debt reserves                       |       | $           | 340,000    |            | $          | — |   | $ | 372,000 |   | $ | — |   |
| Vacation accrual                        |       | 476,000     |       | —          |       | 420,000 |   | — |   |
| State taxes                             |       | 314,000     |       | —          |       | 252,000 |   | — |   |
| Deferred  compensation                  |       | 402,000     |       | —          |       | 375,000 |   | — |   |
| Net operating  loss                     |       | 215,000     |       | —          |       | 40,000 |   | — |   |
| Other                                   |       | —      |       | —          |       | 70,000 |   | — |   |
| Total deferred  tax assets              |       | 1,747,000   |       | —          |       | 1,529,000 |   | — |   |
| **Deferred  tax liabilities:**          |       |        |       |            |       |   |   |   |   |
| Goodwill                                |       | —      |       | (195,000        | )          | — |   | (111,000 | ) |
| Installment gain  deferral              |       | —      |       | (24,000         | )          | — |   | (112,000 | ) |
| Tax over book  depreciation             |       | —      |       | (4,865,000      | )          | — |   | (5,299,000 | ) |
| Other                                   |       | —      |       | —          |       | — |   | (50,000 | ) |
| **Net deferred tax asset  (liability)** |       | $           | 1,747,000  |            | $          | (5,084,000 | ) | $ | 1,529,000 |   | $ | (5,572,000 | ) |

 

**(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 2006 there were 202,000 sharesgranted under the 2002 stock option plan and 128,425 shares were reserved forfuture grants under the 2002 stock option plan. At January 31, 2006 therewere 1,331,245 shares authorized and granted under the 1994 stock option planand there were no shares reserved for future grants.

44

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**NATIONAL TECHNICAL SYSTEMS, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued) January 31, 2006, 2005 and 2004**

**(5)**   Stock Options and 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:

| ** **                               | ** ** | **2006**   | ** ** | **2005**                                    | ** ** |
|------------------------------------------|------------|------------|------------|---------------------------------------------|------------|
| ** **                               | ** ** | **Shares** | ** ** | **Weighted Avg.  Exercise Price** | ** ** | **Shares** | ** ** | **Weighted Avg.  Exercise Price** | ** ** |
| Beginning Balance                        |       | 2,128,202  |       |                                        | $          | 3.63 |   |   | 2,192,196 |   |   | $ | 3.47 |   |   |
| Grants                                   |       | 202,000    |       |                                        | 4.70       |   |   | 172,500 |   |   | 4.67 |   |   |
| Exercises                                |       | (148,382   | )          |                                        | 2.79       |   |   | (172,644 | ) |   | 2.44 |   |   |
| Canceled or expired *                    |       | (14,375    | )          |                                        | 4.09       |   |   | (63,850 | ) |   | 4.23 |   |   |
| Ending balance                           |       | 2,167,445  |       |                                        | $          | 3.78 |   |   | 2,128,202 |   |   | $ | 3.63 |   |   |
| Reserve for future  grants at year end * |       | 128,425    |       |                                        | —     |   |   | 317,925 |   |   | — |   |   |
| Exercisable                              |       | 1,620,220  |       |                                        | $          | 3.60 |   |   | 1,505,199 |   |   | $ | 3.59 |   |   |

----

*                    For fiscalyear ended 2006, of the 14,375 canceled or expired options, only 12,500 wereadded back to the reserve for future grants, the remaining 1,875 were from the1994 stock option plan that was discontinued.

*                    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, 2006 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 31,2006.

| **Range of  exercise prices** | ** ** | **Outstanding at  January 31,  2006** | ** ** | **Weighted Avg.  Remaining  contract life  in yrs.** | ** ** | **Weighted Avg.  Exercise  Price** | ** ** | **Number  Exercisable** | ** ** | **Weighted Avg.  Exercisable  Price** | ** ** |
|-----------------------------------------|------------|-------------------------------------------------|------------|---------------------------------------------------------------------|------------|-----------------------------------------|------------|-------------------------|------------|--------------------------------------------|------------|
| $1.00 to $2.00                          |       |                                            | 154,625    |                                                                |       |                                    | 5.8        |                    |       |                                       | $          | 1.63 |   |   | 133,375 |   |   | $ | 1.66 |   |   |
| $2.01 to $3.00                          |       |                                            | 704,421    |                                                                |       |                                    | 4.6        |                    |       |                                       | $          | 2.62 |   |   | 657,546 |   |   | $ | 2.63 |   |   |
| $3.01 to $4.00                          |       |                                            | 214,783    |                                                                |       |                                    | 3.8        |                    |       |                                       | $          | 3.30 |   |   | 213,783 |   |   | $ | 3.30 |   |   |
| $4.01 to $5.00                          |       |                                            | 686,318    |                                                                |       |                                    | 7.8        |                    |       |                                       | $          | 4.59 |   |   | 251,343 |   |   | $ | 4.61 |   |   |
| $5.01 to $6.00                          |       |                                            | 372,881    |                                                                |       |                                    | 3.5        |                    |       |                                       | $          | 5.41 |   |   | 329,756 |   |   | $ | 5.45 |   |   |
| $6.01 to $7.00                          |       |                                            | 34,417     |                                                                |       |                                    | 2.6        |                    |       |                                       | $          | 6.36 |   |   | 34,417 |   |   | $ | 6.36 |   |   |
|                                    |       |                                            | 2,167,445  |                                                                |       |                                    |       |                    |       |                                       |       |   |   | 1,620,220 |   |   |   |   |   |

 

45

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**NATIONAL TECHNICAL SYSTEMS, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued) January 31, 2006, 2005 and 2004**

**(5)**   Stock Options and Pension Plans (Continued)

These options will expire if not exercised at specificdates ranging from September 2006 to December 2015. During the yearended January 31, 2006, 148,382 options were exercised at prices from$1.81 to $4.45 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 plans is toprovide retirement benefits to all employees of the Company. The Company’semployees can contribute a portion of their salary into the 401(k) planand the Company’s Board of Directors, at its discretion, will determine eachyear the amount of matching contribution the Company will make. Employercontributions are allocated based on participants own contribution percentage amount to the total amountcontributed by all employees in each plan. In fiscal 2006, the Board ofDirectors and management of the Company approved a contribution to the 401(k) profitsharing plan of $233,000 as compared to $239,000 in 2005 and $221,000 in 2004.

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 $89,000,$93,000 and $86,000 for the years ended January 31, 2006, 2005 and 2004,respectively. Included in other assets is $2,228,000 and $2,046,000 for thecash surrender values as of January 31, 2006 and 2005, respectively.

**(6)   Capital Stock**

As of January 31, 2006 and 2005, the Company had20,000,000 authorized common shares with no par value. At January 31, 2006and January 31, 2005, 9,176,000 shares and 9,025,000 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 stock vote together on matterssubmitted to shareholders, including the election of directors. Except asrequired by law, the powers, preferences and rights of all common stock and thequalifications, limitations or restrictions thereof, shall in all respects beidentical. The common stock shareholders will be entitled to receive, to theextent permitted by law, and to share equally and ratably, share for share, anysuch dividends as may be declared from time to time by the board of directors.

**(7)**   Commitments

The Company leases certain of its operating facilitiesand equipment under operating leases which principally expire at various datesthrough fiscal year 2012. 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 

46

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**NATIONAL TECHNICAL SYSTEMS, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued) January 31, 2006, 2005 and 2004**

**(7)**   Commitments (Continued)

leases. Gross rentalexpense was $3,038,000, $2,346,000 and $2,273,000 for the years ended January 31,2006, 2005 and 2004, respectively.

At January 31, 2006,minimum rental payment obligations under operating leases were as follows:

| 2007       |   | $         | 2,143,000 |   |
|------------|--------|-----------|-----------|--------|
| 2008       |   | 1,862,000 |      |
| 2009       |   | 1,372,000 |      |
| 2010       |   | 1,010,000 |      |
| 2011       |   | 478,000   |      |
| Thereafter |   | 115,000   |      |
|       |   | $         | 6,980,000 |   |

 

**(8)**   AccruedExpenses

Asummary of accrued expenses at January 31 is as follows:

| ** **                          | ** ** | **2006**  | ** ** | **2005** | ** ** |
|-------------------------------------|------------|-----------|------------|----------|------------|
| Compensation and  employee benefits |       | $         | 4,208,000  |     | $          | 2,840,000 |   |
| Other                               |       | 1,192,000 |       | 915,000  |       |
| Total accrued expenses              |       | $         | 5,400,000  |     | $          | 3,755,000 |   |

 

**(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 the resultsof the operations or cash flows of the Company.

**(10)**   Segmentof 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., Canada 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 

47

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**NATIONAL TECHNICAL SYSTEMS, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued) January 31, 2006, 2005 and 2004**

**(10)**   Segment of Business Information (Continued)

evaluations include anexamination of the companies’ quality policy, quality system documentation andquality records.

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 uses the informationreported below in evaluating results and allocating resources pertaining tosegment operations.

The Company did not have any revenues from a singlecustomer in the Engineering & Evaluation Group, which represented in excessof 10% of total segment revenues. Three major customers represented $8,041,000,$5,812,000 and $4,793,000 of fiscal 2006 Technical Solutions net revenues ascompared to three major customers representing $7,915,000, $5,876,000 and$4,918,000 of fiscal 2005 Technical Solutions net revenues. Total revenues fromcustomers in foreign operations were $2,624,000 in fiscal 2006, $840,000 infiscal 2005 and $80,000 in fiscal 2004.

48

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**NATIONAL TECHNICAL SYSTEMS, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued) January 31, 2006, 2005 and 2004**

**(10)**   Segment of Business Information (Continued)

The following tableillustrates each segment’s operating income for 2006, 2005 and 2004. 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, 2006** | ** ** |
|---------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                                        | ** ** | **Engineering &  Evaluation**              | ** ** | **Technical  Solutions** | ** ** | **Corporate** | ** ** | **Total** | ** ** |
| Net revenues                                      |       |                                                | $          | 72,411,000 |   |   | $ | 39,113,000 |   | $ | — |   | $ | 111,524,000 |   |
| Gross profit                                      |       |                                                | 20,422,000 |   |   | 6,808,000 |   | — |   | 27,230,000 |   |
| Selling, general  and administrative expense      |       |                                                | 15,246,000 |   |   | 6,166,000 |   | — |   | 21,412,000 |   |
| Equity income  from non-consolidated subsidiary   |       |                                                | 259,000    |   |   | — |   | — |   | 259,000 |   |
| Operating income                                  |       |                                                | 5,435,000  |   |   | 642,000 |   | — |   | 6,077,000 |   |
| Other income (expense):                           |       |                                                |       |   |   |   |   |   |   |   |   |
| Interest expense, net                             |       |                                                | (1,186,000 | ) |   | (112,000 | ) | — |   | (1,298,000 | ) |
| Other income (expense)                            |       |                                                | 175,000    |   |   | 1,000 |   | — |   | 176,000 |   |
| Income before  income taxes and minority interest |       |                                                | $          | 4,424,000 |   |   | $ | 531,000 |   | $ | — |   | $ | 4,955,000 |   |
| Assets                                            |       |                                                | $          | 55,610,000 |   |   | $ | 9,116,000 |   | $ | 4,407,000 |   | $ | 69,133,000 |   |
| Equity  investments                               |       |                                                | 1,019,000  |   |   | — |   | — |   | 1,019,000 |   |
| Expenditures for  long-lived assets               |       |                                                | 7,326,000  |   |   | 53,000 |   | 112,000 |   | 7,491,000 |   |
| Depreciation and  amortization                    |       |                                                | 4,010,000  |   |   | 548,000 |   | 725,000 |   | 5,283,000 |   |
| Goodwill                                          |       |                                                | 2,544,000  |   |   | 196,000 |   | — |   | 2,740,000 |   |

 

49

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**NATIONAL TECHNICAL SYSTEMS, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued) January 31, 2006, 2005 and 2004**

**(10)**   Segment of Business Information (Continued)

| ** **                                        | ** ** | **Year Ended January 31, 2005** | ** ** |
|---------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                                        | ** ** | **Engineering &  Evaluation**              | ** ** | **Technical  Solutions** | ** ** | **Corporate** | ** ** | **Total** | ** ** |
| Net revenues                                      |       |                                                | $          | 62,753,000 |   |   | $ | 43,761,000 |   | $ | — |   | $ | 106,514,000 |   |
| Gross profit                                      |       |                                                | 16,724,000 |   |   | 6,963,000 |   | — |   | 23,687,000 |   |
| Selling, general  and administrative expense      |       |                                                | 14,290,000 |   |   | 6,359,000 |   | — |   | 20,649,000 |   |
| Equity income  from non-consolidated subsidiary   |       |                                                | 483,000    |   |   | — |   | — |   | 483,000 |   |
| Operating income                                  |       |                                                | 2,917,000  |   |   | 604,000 |   | — |   | 3,521,000 |   |
| Other income (expense):                           |       |                                                |       |   |   |   |   |   |   |   |   |
| Interest expense, net                             |       |                                                | (1,168,000 | ) |   | (130,000 | ) | — |   | (1,298,000 | ) |
| Other income (expense)                            |       |                                                | 162,000    |   |   | 14,000 |   | — |   | 176,000 |   |
| Income before  income taxes and minority interest |       |                                                | $          | 1,911,000 |   |   | $ | 488,000 |   | $ | — |   | $ | 2,399,000 |   |
| 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                    |       |                                                | 3,953,000  |   |   | 640,000 |   | 205,000 |   | 4,798,000 |   |
| Goodwill                                          |       |                                                | 2,544,000  |   |   | 196,000 |   | — |   | 2,740,000 |   |

 

| ** **                                        | ** ** | **Year Ended January 31, 2004** | ** ** |
|---------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                                        | ** ** | **Engineering &  Evaluation**              | ** ** | **Technical  Solutions** | ** ** | **Corporate** | ** ** | **Total** | ** ** |
| Net revenues                                      |       |                                                | $          | 58,312,000 |   |   | $ | 46,238,000 |   | $ | — |   | $ | 104,550,000 |   |
| Gross profit                                      |       |                                                | 15,492,000 |   |   | 7,120,000 |   | — |   | 22,612,000 |   |
| Selling, general  and administrative expense      |       |                                                | 12,647,000 |   |   | 6,848,000 |   | — |   | 19,495,000 |   |
| Equity income  from non-consolidated subsidiary   |       |                                                | 98,000     |   |   | — |   | — |   | 98,000 |   |
| 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 |   |

 

50

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**NATIONAL TECHNICAL SYSTEMS, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued) January 31, 2006, 2005 and 2004**

**(11)**   QuarterlyFinancial Data (Unaudited)

| ** **                                                     | ** ** | **Three months ended,** | ** ** |
|----------------------------------------------------------------|------------|-----------------------------------|------------|
| **2006**                                                       | ** ** | ** **                        | ** ** | **Apr 30** | ** ** | **Jul 31** | ** ** | **Oct 31** | ** ** | **Jan 31** | ** ** |
| Net revenues                                                   |       | $                                 | 27,444,000 |   | $ | 26,755,000 |   | $ | 28,508,000 |   | $ | 28,817,000 |   |
| Gross profit                                                   |       | 6,598,000                         |       | 6,239,000 |   | 6,824,000 |   | 7,569,000 |   |
| Net income                                                     |       | 734,000                           |       | 468,000 |   | 590,000 |   | 1,147,000 |   |
| Earnings per common  share                                     |       |                              |       |   |   |   |   |   |   |
| Basic                                                          |       | 0.08                              |       | 0.05 |   | 0.06 |   | 0.13 |   |
| Diluted*                                                       |       | 0.08                              |       | 0.05 |   | 0.06 |   | 0.12 |   |
| Weighted average  common shares outstanding                    |       | 9,052,000                         |       | 9,106,000 |   | 9,166,000 |   | 9,175,000 |   |
| Dilutive effect  of stock options                              |       | 494,000                           |       | 541,000 |   | 589,000 |   | 524,000 |   |
| Weighted average common  shares outstanding, assuming dilution |       | 9,546,000                         |       | 9,647,000 |   | 9,755,000 |   | 9,699,000 |   |
|                                                                |            |                                   |            |  |  |  |  |  |  |  |  |  |  |  |  |

** **

| ** **                                                     | ** ** | **Three months ended,** | ** ** |
|----------------------------------------------------------------|------------|-----------------------------------|------------|
| **2005**                                                       | ** ** | ** **                        | ** ** | **Apr 30** | ** ** | **Jul 31** | ** ** | **Oct 31** | ** ** | **Jan 31** | ** ** |
| Net revenues                                                   |       | $                                 | 27,472,000 |   | $ | 27,189,000 |   | $ | 26,353,000 |   | $ | 25,500,000 |   |
| Gross profit                                                   |       | 6,038,000                         |       | 5,813,000 |   | 5,752,000 |   | 6,084,000 |   |
| 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 |   |
|                                                                |            |                                   |            |  |  |  |  |  |  |  |  |  |  |  |  |

----

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

**(12)**   SubsequentEvents

On March 28, 2006,the Company exercised an option to repurchase 792,266 shares of its commonstock from an executive officer and director of the Company. The total cashpurchase price of $3,893,000, or $4.914 per share, represented the averageclosing price of the Company’s common stock for the five trading days prior tothe option exercise date minus 10%, in accordance with an agreement between theCompany and the executive officer entered into in September 2001. Theshares repurchased in this private transaction represented approximately 8.6%of the Company’s outstanding common stock on the date of exercise.

On March 29, 2006,the Company entered into an agreement with its banks, Comerica Bank and FirstBank (together, the “Banks”), to expand the existing credit facility by $3.9million effective March 29, 2006. The Company entered into the creditfacility to fund the repurchase of the 792,266 shares discussed above.

51

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**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 Company’s fourth fiscal quarter that havematerially affected, or are reasonably likely to affect, the Company’s internalcontrols over financial reporting. Based on that evaluation, there has been nosuch change during the Company’s fourth fiscal quarter.

***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.

52

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**PART III**

**ITEM 10.**         *DIRECTORS AND EXECUTIVE OFFICERS 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 29,2006 are incorporated herein by reference.

***Executive Officersof the Company***

| **Name**         | ** ** | ** ** | ** ** | **Age**                                                                                                            | ** ** | **Position** |
|------------------|------------|------------|------------|--------------------------------------------------------------------------------------------------------------------|------------|--------------|
| Lloyd Blonder    |       | 66         |       | Senior Vice President and Chief Financial Officer,  Treasurer. He has been associated with the Company since 1983. |
| Doug Briskie     |       | 42         |       | Co-President. He has been associated with the  Company since 1987.                                                 |
| Aaron Cohen      |       | 69         |       | Senior Vice President. He has been associated with  the Company since 1961.                                        |
| Marvin Hoffman   |       | 72         |       | Senior Vice President, Chief Information Officer. He  has been associated with the Company since 1998.             |
| Jack Lin         |       | 73         |       | Chairman of the Company. He has been associated with  the Company since 1961.                                      |
| Raffy Lorentzian |       | 50         |       | Vice President, Chief Accounting Officer. He has  been associated with the Company since 1997.                     |
| Cynthia Maher    |       | 47         |       | Corporate Secretary, Corporate Counsel, Human  Resources Director.                                                 |
| William McGinnis |       | 47         |       | Chief Executive Officer of the Company. He has been  associated with the Company since 1980.                       |
| Dwight Moore     |       | 43         |       | Co-President. 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’swebsite. Any amendments to, or waivers from, a provision of our code of ethicsthat applies to our principal executive officer, principal financial officer,controller, or persons performing similar functions and that relates to anyelement of the code of ethics enumerated in paragraph (b) of Item 406 ofRegulations S-K shall be disclosed by posting such information on our website.

**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 29, 2006 is incorporated herein by reference.

**ITEM 12.**         *SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS, MANAGEMENT AND RELATEDSTOCKHOLDER 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 29, 2006 are incorporated herein by reference.

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**ITEM13.**         *CERTAINRELATIONSHIPS AND RELATED 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 29, 2006 is incorporated herein by reference.

**ITEM14.**         *PRINCIPALACCOUNTANT FEES AND 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 29, 2006 is incorporated herein by reference.

**PART IV**

**ITEM15.**         *EXHIBITS ANDFINANCIAL STATEMENT SCHEDULES.*

**A.*     Consolidated FinancialStatements and Schedules.***

| Financial statements  required by Item 15 are included in Item 8 above.                                     |
|-------------------------------------------------------------------------------------------------------------|
| Financial  Statements:                                                                                      |
| Consolidated Balance Sheets—January31, 2006 and 2005                                                   |
| Consolidated Statements of Income—Years ended  January 31, 2006, 2005 and 2004                    |
| Consolidated Statements of Shareholders’ Equity—Years  ended January 31, 2006, 2005 and 2004 |
| Consolidated Statements of Cash Flows—Years ended  January 31, 2006, 2005 and 2004                |
| Notes to  Consolidated Financial Statements                                                                 |
| ** **                                                                                                  | **Schedule** |
| Schedule  Supporting Financial Statements:                                                                  |   |
| Valuation and Qualifying Accounts and Reserves                                                              | II |

 

**B.     *Exhibits.***

| 2.1  |   | 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 January 30, 2004 and is incorporated herein by reference  thereto). |
|------|--------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 2.2  |   | 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 Annual Report on Form 10-K 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 Annual Report on Form 10-K 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).                                                                                                                                        |

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| 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).                    |
| 10.8  |   | Employment agreement between the Company and  Dr. Jack Lin dated April 28, 2005 (filed on May 3, 2005 and is  incorporated herein by reference thereto).                                                        |
| 10.9  |   | Amendment number five to revolving credit agreement  between the Company and Comerica Bank effective July 1, 2005 (filed on  September 14, 2005 and is incorporated herein by reference thereto).                    |
| 10.10 |   | Amendment number six to revolving credit agreement  between the Company and Comerica Bank effective March 29, 2006 (filed on  March 30, 2006 and is incorporated herein by reference thereto).                       |
| 14.1  |   | Code of Business Ethics.                                                                                                                                                                                                       |
| 21.1  |   | Subsidiaries of the Company.                                                                                                                                                                                                   |
| 23.1  |   | Consent of Independent Registered Public Accounting  Firm.                                                                                                                                                                     |
| 23.2  |   | Consent of XXCAL Japan, Inc. Independent  Auditors.                                                                                                                                                                       |
| 23.3  |   | XXCAL Japan, Inc. Independent Auditor’s Report.                                                                                                                                                                           |
| 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.                                                         |

 

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**SIGNATURES**

Pursuant to the requirements of Section 13 or 15(d) ofthe Securities and Exchange Act of 1934, the registrant has duly caused thisreport to be signed on its behalf by the undersigned, thereunto dulyauthorized.

| April 28, 2006 | **NATIONAL TECHNICAL SYSTEMS, INC.** |
|---------------------|--------------------------------------|
|                | By                                   | /s/ WILLIAM MCGINNIS |
|                |                                 | William McGinnis, |
| * *            |                                 | *Chief  Executive Officer and* |
| * *            |                                 | *Director* |
| * *            |                                 | *(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, 2006.

| /s/ JACK LIN                                   |     | /s/ AARON COHEN                  |
|------------------------------------------------|----------|----------------------------------|
| Jack Lin,                                      |     | Aaron Cohen,                     |
| *Chairman  of the Board*                       | * * | *Senior  Vice President and*     |
| * *                                       | * * | *Vice  Chairman of the Board*    |
|                                           |     |                             |
| /s/ WILLIAM MCGINNIS                           |     | /s/ MARVIN HOFFMAN               |
| William McGinnis,                              |     | Marvin Hoffman,                  |
| *Chief  Executive Officer*                     | * * | *Senior  Vice President,*        |
| *and  Director*                                | * * | *Chief  Information Officer and* |
| *(Principal  Executive Officer)*               | * * | *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*                                     | * * | * *                         |

 

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**ScheduleII**

**NATIONAL TECHNICAL SYSTEMS, INC. AND SUBSIDIARIESValuation and Qualifying Accounts and ReservesYears ended January 31, 2006, 2005 and 2004**

| **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 2006                                      |       | $                 | 906,000    |                                           |       | $                                                                  | 140,000    |                              |       |   | $ | (229,000 | ) |   | $ | 816,000 |   |
| FY 2005                                      |       | $                 | 938,000    |                                           |       | $                                                                  | 252,000    |                              |       |   | $ | (284,000 | ) |   | $ | 906,000 |   |
| FY 2004                                      |       | $                 | 1,230,000  |                                           |       | $                                                                  | 425,000    |                              |       |   | $ | (785,000 | ) |   | $ | 938,000 |   |
|                                              |            |                   |            |                                                |            |                                                                    |            |                                   |            |  |  |  |  |  |  |  |  |  |  |

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

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