**UNITED STATESSECURITIES 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 1934**For the fiscal yearended January 31, 2007 Commission file number 0-16438

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**NATIONAL TECHNICAL SYSTEMS, INC.**(Exact name of registrant as specified in its charter)

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

 

**(818)591-0776**(Registrant’s telephonenumber, including area code)

**Securitiesregistered pursuant to Section 12(b) of the Act:**

|                                 | **Title  of each class** | ** **                   |   | ** ** | **Name of each exchange on  which registered** | ** ** |
|---------------------------------|--------------------------|------------------------------|--------|------------|------------------------------------------------|------------|
| Common stock—no  par value |                     | The NASDAQ stock  market LLC |

 

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

None

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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 oNox

Indicate by check mark if the registrant is notrequired to file reports pursuant to Section 13 or Section 15(d) ofthe Act. Yes o Nox

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 xNoo

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 oNo 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—$41,350,000 (as of July 31,2006).

The number of shares of registrant’s Common Stockoutstanding on April 24, 2007 was 8,795,797.

**Documents Incorporated by Reference**

Portions of the Proxy Statement of the Company for theAnnual Meeting of Shareholders to be held on July 12, 2007, areincorporated by reference into Part III of this report.

 

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**NATIONAL TECHNICALSYSTEMS, INC.FORM 10-KFISCAL YEAR ENDED JANUARY 31, 2007**
| PART I     |   | 3                                                                                                                  |
|------------|--------|--------------------------------------------------------------------------------------------------------------------|
| ITEM 1.    |   | BUSINESS                                                                                                           |   | 3 |
| ITEM  1A.  |   | RISK FACTORS                                                                                                       |   | 11 |
| ITEM 1B.   |   | UNRESOLVED STAFF COMMENTS                                                                                          |   | 12 |
| ITEM 2.    |   | PROPERTIES                                                                                                         |   | 13 |
| ITEM  3.   |   | LEGAL  PROCEEDINGS                                                                                                 |   | 14 |
| ITEM 4.    |   | SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS                                                                |   | 14 |
| PART II    |   | 14                                                                                                                 |
| ITEM 5.    |   | MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED  STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES |   | 14 |
| ITEM 6.    |   | SELECTED FINANCIAL DATA                                                                                            |   | 16 |
| ITEM 7.    |   | MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL  CONDITION AND RESULTS OF OPERATIONS                        |   | 17 |
| ITEM 7A.   |   | QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET  RISK                          |   | 29 |
| ITEM 8.    |   | FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA                                                                        |   | 31 |
| ITEM 9.    |   | CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON  ACCOUNTING AND FINANCIAL DISCLOSURES                             |   | 58 |
| ITEM 9A.   |   | CONTROLS AND PROCEDURES                                                                                            |   | 58 |
| ITEM  9B.  |   | OTHER  INFORMATION                                                                                                 |   | 58 |
| PART III   |   | 59                                                                                                                 |
| ITEM 10.   |   | DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE                                                             |   | 59 |
| ITEM 11.   |   | EXECUTIVE COMPENSATION                                                                                             |   | 59 |
| ITEM 12.   |   | SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS,  MANAGEMENT AND RELATED STOCKHOLDER MATTERS                       |   | 59 |
| ITEM 13.   |   | CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS AND  DIRECTOR INDEPENDENCE                                          |   | 60 |
| ITEM 14.   |   | PRINCIPAL ACCOUNTANT FEES AND SERVICES                                                                             |   | 60 |
| PART IV    |   | 60                                                                                                                 |
| ITEM 15.   |   | EXHIBITS AND FINANCIAL STATEMENT SCHEDULES                                                                         |   | 60 |
| SIGNATURES |   | 63                                                                                                                 |

 

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)**

**For Year Ended January 31,2007**

**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,California 91302 (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 enable customers to sell their products in world markets.In addition, E&E performs management registration and certificationservices to ISO related standards. NTS is accredited by numerous national andinternational technical organizations which allows the Company to have its testdata accepted in most countries.

E&E revenues represented 69%, 65% and 59% of NTStotal revenues in fiscal years 2007, 2006 and 2005, respectively. E&Eserves high technology companies, predominantly in the defense, aerospace,transportation, telecommunications, electronics, power and computers markets.In fiscal 2007, E&E serviced approximately 2,800 customers. The ability ofthese customers to offer certifications and provide test data that is acceptedin world markets is critical for the sale of manufactured products ininternational markets. Information about our E&E segment’s net revenues,gross profit and assets is described in Note 10 to the consolidated financialstatements included in Item 8 of this annual report on Form 10-K.

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E&E simulates environments that replicate changesin temperature, altitude, moisture, and virtually every other environmentalfactor that might affect product performance. In addition, E&E hasdeveloped expertise and specialized skills over decades of testing in multipleindustries and has invested heavily in equipment including a full spectrum ofEMI chambers, data acquisition systems, seismic simulators, environmentalsimulation equipment, environmental chambers, fire chambers, mixed gas flowchambers and munitions and ordnance performance testing equipment.

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 ensure that manufactured products 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. The customer is then entitled to display the Registrar’s markon advertising and stationery as evidence that it has achieved ISOregistration. Thereafter, E&E performs periodic follow-upsurveillance assessments to ensure 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 combined account for approximately 58%of E&E testing revenues.

**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 interferenceand compatibility. Examples of items tested include components for small fixedwing aircraft, helicopters, submarines, aircraft carriers and other navalships, tanks and other tracked vehicles, trucks and road vehicles,command/control communication systems, electronics, weapon systems and completeordnance and munitions testing. E&E has facilities that are speciallyconstructed to handle munitions and hazardous materials where routine testingincludes vibration and cook-off of explosive materials, ballistics tests andhydraulic burst tests. E&E performs a broad variety of ballistics relatedtesting, up to 155 mm rounds. E&E’s data acquisition systems are capable ofcollecting 1,000,000 data points and 22,000 photos per second. Additionalinstrumentation includes Doppler radar, 35 mm still cameras, digital recording,data loggers and real-time color and IR video. E&E’s customers in thismarket include various major defense contractors, as well as the U.S.Department of Defense (DOD) and other government entities.

**Aerospace.**   E&Eperforms a wide variety of tests required on civil aircraft, space, militaryand missiles. E&E offers acceleration test facilities, G-tables andcentrifuges with diameters ranging from one foot to 102 feet, with weightcapacities from a few grams to 20,000 pounds. In climatic testing, E&Eutilizes hundreds of test chambers to simulate nearly any environment:temperature, humidity, altitude, rain, salt 

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spray, sand and dust,sunshine, explosive atmosphere or any combination. E&E designs and buildscustom facilities and advanced instrumentation and data acquisition systems tosupport all types of flow testing for gases, liquids and cryogenics. E&E iscapable of performing structural testing and analysis, and, in particular,structural loading of large objects such as entire airframes. It also performsfatigue testing of critical hardware items such as engine blades andhigh-pressure fluid components. The Company also enables its customers tominimize their personnel, testing time and costs by utilizing the Company’son-site climatic, dynamic, safety and electromagnetic compatibility testcapabilities. E&E also has anechoic and reverberant chambers that are usedfor acoustic emission measurements or high­ level noise exposure.

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

**Telecommunications.**   E&Eprovides certification and evaluation of a broad array of telecommunicationsequipment and systems for manufacturers of central office equipment and thecarriers. E&E’s services are performed in accordance with the NetworkEquipment Building Systems specifications (NEBS) and fiber optics GeneralRequirements (GRs) as required by the telecommunications industry. E&E isalso an independent test laboratory certified and recognized by most carriers,which allows manufacturers to use E&E as a market channel for productstested at Original Equipment Manufacturers’ (“OEM”) facilities that are beingdeveloped for use in the regional bell operating companies’ (“RBOCs”) centraloffices. Currently, E&E is approved by most carriers for certifying passivefiber optics components (PFOC) to sixteen GRs. The Company has been approved asan Independent Test Laboratory (ITL) by the carriers to test and certifycentral office equipment developed by manufactures to the NEBS specifications.The Company is currently providing this service at laboratories in California,Massachusetts, Texas, Calgary, Canada and Germany. The Company has beenapproved as an ITL to offer a complete suite of passive fiber componentscertifications, Digital Subscriber Line (DSL) certification, Video ElectronicsStandard Association (VESA) certification and Multimedia over Coax (MoCA)certification. The Company is in the process of developing certificationsprograms for XM Radio and High Definition Audio-Video Networks (HANA).

**Electronics.****  **As a Nationally Recognized Test Lab (NRTL), NTSprovides electrical safety product certification, in the US and many othercountries. NTS has been designated as a Conformity Assessment Body (CAB) forthe EMC directive through the US-EU Mutual Recognition Agreement (MRA). NTSconducts EMC testing and provides customers with certification in the US andmany 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 Nuclear Regulatory Commission (NRC) questions such asselection and verification of critical characteristics, sampling, traceability,surveys, and like-for-like replacements. E&E engineers and 

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technicians involved inthe dedication 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 as cablemodems, DSL modems, Cable Modem Termination System (CMTS), Digital SubscriberLine Access Multiplexer (DSLAM), Routers, Home PNA Gateways, Wireless Wi-Fidevices, Media Servers, Fiber Optics SONET switches, and systems networktesting. E&E also performs Universal Serial Bus (USB) certification testingand was able to successfully 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 theconformity assessment activity necessary to reduce product-handling costs andserve as a market gateway for manufacturers to sell products globally. E&Eprovides a “one stop” resource and single source responsibility for allconformity assessment requirements in the several markets it serves.

*GeographicLocations*

In the United States,E&E’s facilities are located in Acton and Boxborough, Massachusetts, TintonFalls, New Jersey, Rustburg, Virginia, Camden, Arkansas, Detroit, Michigan,Plano, Texas, Tempe, Arizona, Los Angeles, Fullerton, Culver City, SantaClarita, Santa Rosa and Ventura, California, Albuquerque, New Mexico andinternationally, in Yokohama, Japan, Calgary, Canada and Munich, Germany. TheCompany has signed cooperative agreements with SGS in Taiwan and STC in HongKong to provide certification and compliance testing for USB, USB on the Go andCable and Connectors for manufacturers in Taiwan, Korea, Hong Kong and mainlandChina.

*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 2007, theCompany made additional investments to enhance both its capacity andcapability. The Company acquired Dynamic Test Laboratory in Arizona. Thisacquisition allowed the Company to add EMI/EMC capability at its Tempe, Arizonafacility. It also expanded the Company’s capacity to perform additional testingin the vibration and climatic departments in California, Massachusetts andTexas as a result of the additional equipment acquired. The Company alsoacquired a Quality Management Registration business which expanded the Company’scustomer base and capability in California.

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In line with the Company’s strategy to expand itsservices in the design and development area, the Company acquired a systemintegrations company B & B Technologies located in Albuquerque, NewMexico. This organization enhances the Company’s offerings in the area ofdesign and integration of data acquisition and control systems throughstate-of-the-art automation techniques and hardware platforms.

The Company continues touse the Balanced Scorecard System as a tool to assist management in setting andexecuting strategy and achieving its mission, “helping our customers tonavigate a short course to global markets.” NTS is using this system tomaximize efficiency in all aspects of its business.

**(ii)        *Technical Solutions (“TS”)***

*Overview*

The Technical Solutions segment of NTS is a nationalprovider of technical experts for engineering and information technologyservices. As a result of a strategic initiative developed in 2003, the Companyaligned its service offerings to more closely match its TS services with itsE&E group and thus capitalize on NTS’s long history of testing andengineering services. This strategy has resulted in TS moving out of certaintypes of customers in recent years; however, with the strengthening of demandfor IT professionals, TS will be looking to expand its IT related business. Asa valuable and respected resource, TS has developed long-term relationshipswith its customers for whom it provides engineering and IT personnel.

TS revenues represented 31%, 35% and 41% of NTS totalrevenues in fiscal years 2007, 2006 and 2005, respectively. TS’s operationaland technical knowledge allows it to effectively identify and screen highlyskilled professionals. TS provides the technical resources its customers needto evaluate processes and products to meet the demands of compressingdevelopment cycles and critical time-to-market requirements. TS places itsprofessionals on assignment at a customer site to perform specific tasks andprojects for a predetermined period. Under negotiated terms, at the completionof an assignment, customers may directly hire an individual. TS also supportsits customers in sourcing and identifying candidates for direct hire. Itscomprehensive registry of engineering and information technology professionalsallows it to provide fully screened and qualified individuals. TS can supportits customers’ needs, whether the need is to manage a project or an entire testfacility; provide a team to take a product from design to production, or staffa project on a temporary basis. Information about our TS segment’s netrevenues, gross profit and assets is described in Note 10 to the consolidatedfinancial statements included in Item 8 of this annual report on Form 10-K.

The majority of TScustomers are located in the United States. In August 2004, TS opened atest facility in Ho Chi Minh City, Vietnam. This facility provides a low costtesting alternative. TS’s capabilities in Vietnam consist of a variety ofservices including system compatibility and integration testing for computersoftware and hardware testing for business PC platforms for Windows and Linuxoperating systems.

*Industry Overview*

The U.S. staffing industry is expected to grow fasterand add more new jobs over the next decade than just about any other industry,according to the Bureau of Labor Statistics’ (BLS) estimates. In recentprojections, BLS says the employment services industry, which is primarilystaffing, will grow at an average annual rate of more than 3.5%, adding nearly1.6 million new jobs.

The catalyst for the employment services industry’sgrowth will be increases in the demand for temporary staffing services asflexible work arrangements and schedules continue to proliferate and businessesmake their staffing patterns more responsive to market changes. Businesses havebecome increasingly dependent on the use of contingent and consulting technicalstaff to manage operations more 

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efficiently and to remaincompetitive. Important internal functions, ranging from financial reporting toproduction and inventory management, are automated with applications software.

Companies that can demonstrate that they can lowercosts and improve the speed and quality of hiring will see growth over the nextthree years. Using outside technical resources and consultants allows a company’smanagement to focus on core business operations, affords greater flexibilityand increases a company’s ability to adapt to and keep pace with rapidlychanging and increasingly complex technologies. It also provides access tospecialized technical skills on a project-by-project basis which better matchesstaffing levels to current needs, converts fixed labor costs into variablecosts, and reduces the cost of recruiting, training and terminating employeesas evolving technologies require new programming skills.

Overall, the staffing industry’s projected growth isdependent on the following assumptions: (i) the economy will continue togrow at a strong pace and inflation will be restrained. It also assumes (ii) productivitygrowth will moderate closer to historical norms; (iii) the rate ofunemployment will remain steady at about 4%; and (iv) both the USpopulation and workforce will grow at an annual rate of 1%.

Although TechnicalSolutions revenues have been declining in recent years, the Company anticipatesTS growing again in fiscal 2008. The Company is in contract negotiations withtwo major financial institutions and anticipates receiving significant businessfrom these customers starting with the first quarter of fiscal 2008.

*Technical SolutionsServices*

In fiscal 2007, information technology servicesrepresented 49% of the overall TS revenues and engineering services represented51% of the overall TS revenues.

TS continues to leverageits technical competencies to provide customers with on-site program managementto augment their testing and staffing activities. Managed Services supportsboth Engineering and IT service areas.

*GeographicLocations*

In the United States,Technical Solutions offices are located in Culver City, San Mateo, California,Lowell, Massachusetts, Columbia, South Carolina, and Troy, Michigan. Internationally,TS has an office in Ho Chi Minh City, Vietnam. TS’s headquarters are located inCulver City, California. In addition, TS has program managers on customer sitesin 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, starting in 2003, TS transformed how itmanages its sourcing, training, qualifying and relationships with its expertsand consultants. This allowed the Company to adjust to the dramatic changescreated by the demand for highly skilled consultants in both engineering andIT.

With nearly 30 years of experience in technicalproject outsourcing services, TS continues to focus on supplying: (i) projectteams managed by the Company, (ii) project teams managed by the customer, (iii) individualpersonnel and (iv) managed service programs. TS expects to continue todevelop and expand its customer relationships.

TS’s extensive and actively managed proprietarydatabase is quality driven and includes core competency skill-sets that arecustomer focused. The IT, finance, accounting and computer applicationsindustries are experiencing labor shortages and have a greater need forsourcing and recruiting processes 

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to find and retain highlyskilled workers. TS utilizes advanced and long-term strategic processesproviding direct fulfillment to its customers, and is not heavily dependent onsubcontract relationships.

The continuous development of TS’s proprietarydatabase has enabled the Company to support its customers in recruiting qualitypersonnel. TS also continues to enhance operational efficiencies in itsaccounting, sales, recruiting and marketing operations. TS continues todifferentiate itself from its competitors by using NTS’s testing, engineeringand compliance capabilities to maximize its customers’ return on human assets.

TS’s strategy is toimprove revenue and profit by rigorously focusing on industries, markets andcustomers that have the strongest long-term growth opportunities. The strategyis expected to increase productivity by improving internal processes,diversifying the range of services the Company provides to its existingcustomers, attracting and retaining qualified technical consultants from avariety of sources, both national and international, and pursuing strategicrelationships with non-competing organizations. TS’s company-wide sales forceis aligned with the Company’s strategy and promotes cross-selling and leadgeneration between existing customers of one business unit to another. TSstrives to provide its customers with technical personnel with the rightskills, at the right time, for the right duration and at a cost that is lowerthan what its customers could otherwise achieve.

**(iii)       *Competition***

*Engineering &Evaluation*

In the aerospace anddefense markets, the main competition for independent laboratories is thecustomers’ own laboratories, including government laboratories. E&E alsocompetes with a small number of large conformity assessment organizations,within each of the markets it serves. It also competes with a large number ofsmall niche oriented test laboratories. It has competitive advantages inseveral areas which include the following: (i) ability to servicecustomers at facilities close to their locations; (ii) ability to providecomplete conformity assessment activities at a single location, which reducesproduct-handling cost for the customers and enhances timeliness of service; (iii) diverseand technically competent employees; and (iv) accreditations that allowthe E&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.

*Technical Solutions*

Potential customers for services offered by theTechnical Solutions segment are from a broad base of high technology andproduct manufacturing companies. Competition in this segment comes from a largenumber of public and privately held companies and more recently, from off-shorecompanies. The Company competes in this segment primarily on its nicheposition, price and quality of service.

The Company believes its engineering and testingservices gives the Company an advantage over most staffing companies, whichmerely provide personnel as contractors, by understanding the technicalchallenges facing its customers and providing the expertise to meet thosechallenges.

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.

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**(iv)        *Backlog***

TheCompany’s backlog at January 31, 2007 and 2006 was as follows:

| ** **                         | ** ** | **2007**  | ** ** | **2006**  | ** ** |
|------------------------------------|------------|-----------|------------|-----------|------------|
| Engineering &  Evaluation |       | $         | 32,000,000 |      | $          | 28,698,000 |   |
| Technical  Solutions               |       | 8,390,000 |       | 9,095,000 |       |
| Total Backlog                      |       | $         | 40,390,000 |      | $          | 37,793,000 |   |

 

The Company estimates thatapproximately 85% of the backlog at January 31, 2007 will be completed by January 31,2008.

**(v)         *General***

a.      *Service Marks*

TheCompany has registered its service marks “NTS” and “XXCAL” with the U.S. Patentand Trademark Office.

b.     *Environmental Effect*

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

The Company’s Santa Clarita, California test facilityis located immediately adjacent to property owned by a third party which hasbeen the subject of extensive environmental remediation. The adjacent site has,in the past, been used for manufacture of solid rocket fuel propellants,munitions and flares that contained perchlorate, a hazardous substance. Soilsamples taken from the western portion of the Santa Clarita property in 2003were inconclusive as to the existence of perchlorate. Further testing isplanned in cooperation with the government agency having oversightresponsibility for the adjacent site. No cleanup activity has been conducted onthe Santa Clarita property and it has yet to be determined whether remediationwill be required at the site, or, if required, the extent and cost of anyremediation. The Company believes that in the event it does incur remediationcosts on the western portion of the property, that it will have valid claimsfor indemnification against the owner of the adjacent site and the municipalitythat built a road between the adjacent site and the Santa Clarita property thatappears to have contributed to the runoff from the adjacent site. Recovery ofsuch remediation costs may, however, be uncertain and may involve significantlitigation expense.

In January 2007,a sampling program was conducted on the eastern portion of the site in accordancewith a voluntary clean up agreement the Company entered into with theDepartment of Toxic Substance Control (DTSC). The sampling did not detect anyperchlorate in the soil, but one surface sample at a hazardous materialsstorage area did detect lead, cadmium, chromium, copper and nickel atconcentrations in excess of typical background levels. As a result, additionaltesting will be conducted at that location to determine the extent of thelevels of the identified compounds. The extent and cost of remediation, if anyis required, is unknown at this time.

c.      *Seasonal Effect*

The Company experiences nomaterial seasonal effects.

10

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*Employees*

TheCompany employed 874 individuals at January 31, 2007 and 847 at January 31,2006, as follows:

| ** **                         | ** ** | **2007** | ** ** | **2006** | ** ** |
|------------------------------------|------------|----------|------------|----------|------------|
| Engineering &  Evaluation |       |     | 484        |     |       |   | 441 |   |   |
| Technical  Solutions *             |       |     | 373        |     |       |   | 389 |   |   |
| Corporate  Administration          |       |     | 17         |     |       |   | 17 |   |   |
| Total                              |       |     | 874        |     |       |   | 847 |   |   |

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*                    TheTechnical Solutions total for 2007 includes 237 contract employees and 97subcontractors, as compared to 274 contract employees and 72 subcontractors for2006. None of the employees of the Company are represented by a union. TheCompany considers its relationship with its employees to be good.

**AVAILABLEINFORMATION**

Our website address is http://www.ntscorp.com. We makeavailable, free of charge through our website, our Annual Reports on Form 10-K,Quarterly Reports on Form 10-Q, Current Reports on Form 8-K,Proxy Statements, and amendments to those reports filed or furnished pursuantto Section 13(a) or 15(d) of the Exchange Act as soon asreasonably practicable after such material is electronically filed with orfurnished to the Securities and Exchange Commission (the “SEC”).

Our filings may also beread and copied at the SEC’s Public Reference Room at 100 F Street NE, Room 1580Washington, DC 20549. Information on the operation of the Public Reference Room maybe obtained by calling the SEC at 1-800-SEC-0330. The SECalso maintains an Internet site that contains reports, proxy and informationstatements, and other information regarding issuers that file electronicallywith the SEC. The address of that website is www.sec.gov.

**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.

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 the Departmentof Defense’s main initiatives. A slowing in defense spending due to politicalor budget shifts will put downward pressure on the Company’s revenues and grossmargins.

Results may beadversely 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;

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·       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 becomesimpaired;

·       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 customers;

·       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.**       *UNRESOLVED STAFF COMMENTS*.

None.

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**ITEM 2.**                *PROPERTIES*.

**A.*   Operations.  ***The Company owns/leases and operates the followingproperties:

| **State**                   | ** ** | **Owned Properties  City** | ** **  | **Business  Segment** | ** ** | **Buildings  (Sq.Ft.)** | ** ** | **Land  (Acres)** | ** ** |
|-----------------------------|------------|---------------------------------|-------------|-----------------------|------------|-------------------------|------------|-------------------|------------|
| California                  |       | Fullerton                       |        | E&E               |       |                    | 36,000     |              |       |   | 3 |   |   |
|                        |       | Santa Clarita  (a), (b)         |        | E&E               |       |                    | 60,000     |              |       |   | 145 |   |   |
| Massachusetts               |       | Acton                           |        | 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               |       |                    | 30,000     |              |       |   | 258 |   |   |
| 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 |   |   |
|           |       | Ventura                          |       | E&E               |       |                    | 870        |              |       |   | n/a |   |   |
| Massachusetts  |       | Lowell                           |       | TS                    |       |                    | 1,000      |              |       |   | n/a |   |   |
|           |       | Boxborough                       |       | E&E               |       |                    | 12,000     |              |       |   | 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 Mexico     |       | Albuquerque                      |       | E&E               |       |                    | 6,500      |              |       |   | n/a |   |   |
| South Carolina |       | Columbia                         |       | TS                    |       |                    | 3,000      |              |       |   | n/a |   |   |
| Texas          |       | 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                     |       | Ho Chi Minh |        | TS         |       |       | 1,000      |       |       |   | n/a |   |   |
| **Total leased properties** | ** ** | ** **  | **282,170** |       | ** ** | ** ** | **293**    |       |       |

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(a)           See “EnvironmentalMatters” in Item 7A.

(b)          Approximately 120 acreson this site have been listed for sale by the Company. See “InvestmentProperies” in Item 2B.

The Company believes thatthe space occupied by all of its operations is adequate for its current andnear-term requirements. Should additional space be required, the Company doesnot anticipate problems in securing such additional space.

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**B.   *Investment Properties.***

In fiscal year 2005, theCompany sold a condominium in Palm Desert, California 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 2005.In fiscal year 2006, the Company sold the new condominium in Palm Desert andrecorded a gain of approximately $163,000. There were no properties purchasedor sold in fiscal year 2007. The Company has listed approximately 120 acres ofits Santa Clarita, California land for sale, but because it does not meet allthe criteria for accounting classification as an “asset held for sale”, it wasnot classified as such in the accompanying consolidated financial statements.

**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.

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

None.

**PART II**

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

**A.   *Market Information***

The Company’scommon stock is traded on the Nasdaq Global Market under the symbol “NTSC”. Therange of high and low quotations as reported by the Nasdaq Global Market foreach of the quarters of the fiscal years ended January 31, 2007 and 2006is presented below:

| ** **     | ** ** | **2007** | ** ** | **2006** | ** ** |
|----------------|------------|----------|------------|----------|------------|
| ** **     | ** ** | **High** | ** ** | **Low**  | ** ** | **High** | ** ** | **Low** | ** ** |
| First Quarter  |       | $        | 7.38       |     | $          | 4.87 |   | $ | 5.14 |   | $ | 3.97 |   |
| Second Quarter |       | 8.47     |       | 5.73     |       | 5.81 |   | 4.01 |   |
| Third Quarter  |       | 7.47     |       | 5.89     |       | 5.85 |   | 4.02 |   |
| Fourth Quarter |       | 7.00     |       | 5.93     |       | 5.25 |   | 4.05 |   |
|                |            |          |            |          |            |  |  |  |  |  |  |  |  |

 

**B.   *Holders***

**As ofthe close of business on April 23, 2007, there were 722 holders of record ofthe Company’s common stock. The number of holders of record is based on theactual number of holders registered on the books of the Company’s transferagent and does not reflect holders of shares in “street name” or persons,partnerships, associations, corporations or other entities identified insecurity position listings maintained by depository trust companies.**

**C.**   *Dividends*

**TheCompany’s Board of Directors announced the discontinuance of the Company’spolicy of paying ordinary and special dividends on February 6, 2001. TheCompany does not anticipate paying dividends in the foreseeable future.**

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**D.**   *Securities Authorized for Issuance Under Equity Compensation Plans*

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

**E.   *Performance Graph***

This performance graph shall not be deemed “filed” forpurposes of Section 18 of the Securities Exchange Act of 1934, as amended (the“Exchange Act”) or otherwise subject to the liabilities under that Section andshall not be deemed to be incorporated by reference into any filing of NationalTechnical Systems, Inc. under the Securities Act of 1933, as amended or theExchange Act.

The following graph compares,for the five year period ended January 31, 2007, the cumulative totalstockholder return for the Company’s common stock, the Russell 2000 Index andthe Standard & Poor’s Information Technology Index. Measurement points arethe last trading day of each of the Company’s fiscal years ended January 31,2002, January 31, 2003, January 31, 2004, January 31, 2005, January 31, 2006and January 31, 2007. The graph assumes that $100 was invested on January 31,2002 in the common stock of the Company, the Russell 2000 Index and theStandard & Poor’s Information Technology Index and assumes reinvestment ofany dividends. The stock price performance on the following graph is notnecessarily indicative of future stock price performance.

| ** **                             | ** ** | **1/02** | ** ** | **1/03** | ** ** | **1/04** | ** ** | **1/05** | ** ** | **1/06** | ** ** | **1/07** | ** ** |
|----------------------------------------|------------|----------|------------|----------|------------|----------|------------|----------|------------|----------|------------|----------|------------|
| National  Technical Systems, Inc. |       | 100.00   |       | 173.33   |       | 391.85   |       | 334.81   |       | 379.26   |       | 445.93   |       |
| Russell 2000                           |       | 100.00   |       | 78.13    |       | 123.46   |       | 134.17   |       | 159.51   |       | 176.17   |       |
| S & P  Information Technology |       | 100.00   |       | 60.69    |       | 94.06    |       | 88.33    |       | 97.16    |       | 103.68   |       |

 

15

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**ITEM 6.**                *SELECTED 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,**                            | ** ** |
|----------------------------------------------------------------|------------|----------------------------------------------------------------------|------------|
| ** **                                                     | ** ** | **2007**                                                             | ** ** | **2006** | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** |
| ** **                                                     | ** ** | **(in thousands except per share amounts)** | ** ** |
| **INCOME  STATEMENT DATA:**                                    | ** ** | ** **                                                           | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Net revenues                                                   |       | $                                                                    | 115,673    |   | $ | 111,524 |   | $ | 106,514 |   | $ | 104,550 |   | $ | 85,772 |   |
| Gross profit                                                   |       | 26,643                                                               |       | 27,230 |   | 23,687 |   | 22,612 |   | 19,111 |   |
| Operating income                                               |       | 4,668                                                                |       | 6,077 |   | 3,521 |   | 3,215 |   | 2,764 |   |
| Interest expense,  net                                         |       | 1,801                                                                |       | 1,298 |   | 1,091 |   | 1,097 |   | 1,226 |   |
| Income before  income taxes and minority interest              |       | 2,978                                                                |       | 4,955 |   | 2,592 |   | 2,310 |   | 1,549 |   |
| Income taxes                                                   |       | 1,309                                                                |       | 1,966 |   | 910 |   | 1,056 |   | 676 |   |
| Income from  continuing operations before minority interest    |       | 1,669                                                                |       | 2,989 |   | 1,682 |   | 1,254 |   | 873 |   |
| Minority interest  in earnings                                 |       | (88                                                                  | )          | (50 | ) | — |   | 39 |   | (15 | ) |
| Net income                                                     |       | $                                                                    | 1,581      |   | $ | 2,939 |   | $ | 1,682 |   | $ | 1,293 |   | $ | 858 |   |
| Net income per  common share:                                  |       |                                                                 |       |   |   |   |   |   |   |   |   |
| Basic                                                          |       | $                                                                    | 0.18       |   | $ | 0.32 |   | $ | 0.19 |   | $ | 0.15 |   | $ | 0.10 |   |
| Diluted                                                        |       | $                                                                    | 0.17       |   | $ | 0.30 |   | $ | 0.18 |   | $ | 0.14 |   | $ | 0.10 |   |
| Weighted average  common shares outstanding                    |       | 8,705                                                                |       | 9,125 |   | 8,946 |   | 8,640 |   | 8,656 |   |
| Dilutive effect  of stock options                              |       | 800                                                                  |       | 537 |   | 620 |   | 566 |   | 39 |   |
| Weighted average  common shares outstanding, assuming dilution |       | 9,505                                                                |       | 9,662 |   | 9,566 |   | 9,206 |   | 8,695 |   |
| **BALANCE SHEET DATA:**                                        | ** ** | ** **                                                           | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Working capital                                                |       | $                                                                    | 15,087     |   | $ | 16,276 |   | $ | 20,481 |   | $ | 18,550 |   | $ | 19,292 |   |
| Total assets                                                   |       | 74,839                                                               |       | 69,133 |   | 66,669 |   | 63,632 |   | 61,334 |   |
| Long-term debt,  excluding current installments                |       | 19,238                                                               |       | 15,579 |   | 20,557 |   | 19,754 |   | 19,863 |   |
| Shareholders’ equity                                      |       | 33,779                                                               |       | 34,378 |   | 30,951 |   | 28,832 |   | 26,417 |   |

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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 RESULTSOF OPERATIONS*.

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

***OVERVIEW***

NTS 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 2007, total revenues increased 4% toapproximately $116 million.

Summaryof Revenues for fiscal years 2007 and 2006:

| ** **                                  | ** ** | **FY 2007**                     | ** ** | **FY 2006** | ** ** | **Change** | ** ** | **% Change** | ** ** |
|---------------------------------------------|------------|--------------------------------------|------------|------------------|------------|------------|------------|-------------------|------------|
| ** **                                  | ** ** | **(Dollars in thousands)** | ** ** | ** **       | ** ** |
| Engineering &  Evaluation Revenues |       | $                                    | 80,030     |             | $          | 72,411     |       | $                 | 7,619      |   |   | 10.5 | % |   |
| Technical  Solutions Revenues               |       | 35,643                               |       | 39,113           |       | (3,470     | )          |              | (8.9       | )% |   |
| Total Revenues                              |       | $                                    | 115,673    |             | $          | 111,524    |       | $                 | 4,149      |   |   | 3.7 | % |   |

 

Revenues in the Engineering & Evaluationsegment increased 10.5% primarily due to organic growth combined with revenuesfrom new acquisitions. Revenues in this segment are generated from physicaltesting services which include simulation of harsh environments such ashigh/low temperature, shock, vibration, seismic and electromagnetic interference,and functional testing which requires equipment such as switches, routers,servers and high bandwidth access to the Internet to subject telecommunicationequipment to a full spectrum of performance type testing. Revenues in thissegment also include registration services which perform quality managementaudits to ISO 9000, quality training and laboratory accreditation. TheEngineering & Evaluation segment is one of the largest independentconformity 

17

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assessment organizationsin the U.S., with facilities throughout the United States and in Japan, Canadaand Germany, serving a large variety of industries.

Revenues in the Technical Solutions segment decreased8.9% primarily due to increased price compression due to competition fromoff-shore companies and delay in hiring at two major customer sites. Revenuesin this segment are generated from a variety of staffing and workforcemanagement services and solutions, including contract services, temporary andfull time placements to meet its customers’ information technology (“IT”) suchas help-desk analysts and managers, relational database administrators anddevelopers, application and systems programmers, configuration and projectmanagers and engineering service needs.

On August 1, 2006, the Company acquired theassets and the existing business of Dynamic Labs, an EMI and environmentaltesting laboratory with locations in Phoenix, Arizona and Austin, Texas for atotal purchase price of $2,254,000, paid in cash. The Phoenix laboratoryprovided EMI, environmental and dynamics testing for the aerospace and defenseindustries. The Austin facility also provided aerospace, environmental, anddynamic testing. The majority of the machinery and equipment at the Phoenixfacility was relocated to the NTS Tempe, Arizona laboratory with the rest ofthe equipment distributed to other NTS facilities. All of the machinery andequipment at the Austin facility were relocated to other NTS facilities.

On June 9, 2006, NTS Technical Systems, a whollyowned subsidiary of NTS, acquired the assets and the existing business of B &B Technologies, Inc. (“BBT”), a systems integration firm headquartered inAlbuquerque, New Mexico, for a total purchase price of $1,065,000, paid in cashand 83,243 shares of NTS common stock, valued using the ten days averageclosing price of the Company’s stock prior to the closing date. BBT designs andintegrates test, measurement, automation, data acquisition and control systemsutilizing diverse hardware platforms, operating systems, and instrumentationstandards. The results of operations of the acquired business are included inthe accompanying consolidated statement of operations from June 9, 2006 toJanuary 31, 2007.

On April 12, 2006, NQA, USA, a 50% ownedconsolidated subsidiary of NTS, acquired the existing business of AmericanInternational Registrars Corporation (“AIR”), located in Ventura, California,for a total purchase price of $386,000, paid in cash. All existing AIRcustomers and associated certifications and backlog were transferred to NQA,USA. The purchase was recorded $105,000 to customer relationships and $281,000to goodwill.

Summaryof Cash Flows for fiscal years 2007 and 2006:

| ** **                                                    | ** ** | **FY 2007**                     | ** ** | **FY 2006** | ** ** | **Change** | ** ** | **% Change** | ** ** |
|---------------------------------------------------------------|------------|--------------------------------------|------------|------------------|------------|------------|------------|-------------------|------------|
| ** **                                                    | ** ** | **(Dollars in thousands)** | ** ** | ** **       | ** ** |
| Net cash provided  by operating activities                    |       | $                                    | 6,253      |             | $          | 9,535      |       | $                 | (3,282     | ) |   | (34.4 | )% |   |
| Net cash used for  investing activities                       |       | (9,280                               | )          | (7,408           | )          | (1,872     | )          |              | (25.3      | )% |   |
| Net cash provided  by (used in) financing activities          |       | 2,117                                |       | (4,180           | )          | 6,297      |       |              | 150.6      | % |   |
| Effect of  exchange rate changes on cash and cash equivalents |       | (65                                  | )          | 48               |       | (113       | )          |              | 235.4      | % |   |
| Net increase (decrease)  in cash                              |       | $                                    | (975       | )                | $          | (2,005     | )          | $                 | 1,030      |   |   | (51.4 | )% |   |

 

The decrease in net cashprovided by operating activities from FY 2006 to FY 2007 was primarily due tothe decrease in net income and the decrease in change in accrued expenses. TheCompany used the cash generated from its operating activities primarily to payfor capital expenditures. The increase in net cash used for investingactivities is primarily due to increased spending for acquisitions. Theincrease in net cash provided by financing activities was primarily due toborrowings related to the common stock repurchase 

18

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of$3,893,000 from a former executive officer and director of the Company. Overall,net cash decreased by $975,000 in fiscal 2007, compared to a decrease of $2,005,000 in fiscal 2006.

**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 circumstances, the results of which formthe basis for making judgments about the carrying value of assets andliabilities that are not readily apparent from other sources.

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 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. Revenuerelative to each task and from contracts which are time and materials based isrecorded as effort is expended. Billings in excess of amounts earned aredeferred. 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 made to theCompany by customers under contract provisions, including those related totravel and other out-of-pocket expenses are recorded as revenues. An equivalentamount of reimbursable expenses is recorded as cost of sales.

*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.

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*Accounting forIncome Taxes*

We account for income taxes under the liabilitymethod. Deferred tax assets and liabilities are recognized for the future taxconsequences attributable to temporary differences between the financialstatement carrying amounts of existing assets and liabilities and theirrespective tax bases and operating loss and tax credit carryforwards. Deferredtax assets and liabilities are measured using enacted tax rates expected toapply to taxable income in the years in which those temporary differences areexpected to be recovered or settled. The effect on deferred tax assets andliabilities of a change in tax rates is recognized in income in the period thatincludes the enactment date. We record a valuation allowance, if necessary, toreduce deferred tax assets to an amount management believes is more likely thannot to be realized.

To the extent that we havedeferred tax assets, we must assess the likelihood that our deferred tax assetswill be recovered from taxable temporary differences, tax strategies or futuretaxable income and to the extent that we believe that recovery is not likely,we must establish a valuation allowance. As of January 31, 2007 and 2006,we have not established a valuation allowance against our deferred tax assets.In the future, we may adjust our estimates of the amount of valuation allowanceneeded and such adjustment would impact our provision for income taxes in theperiod of such change.

**Recently IssuedAccounting Standards**

In May 2005, the FASB issued SFAS No. 154, “AccountingChanges and Error Corrections.” SFAS No. 154 replaces APB Opinion No. 20,“Accounting Changes,” and SFAS No. 3, “Reporting Accounting Changes inInterim Financial Statements,” and is effective for fiscal years beginningafter December 15, 2005, i.e. fiscal year ending January 31, 2007.SFAS No. 154 requires retrospective application to prior periods’financial statements of changes in accounting principle, unless it isimpracticable to determine either the period-specific effects or the cumulativeeffect of the change. The adoption of SFAS No. 154 did not have a materialimpact on the Company’s condensed consolidated financial statements.

In June 2006, the Financial Accounting StandardsBoard issued Interpretation No. 48, “Accounting for Uncertainty in IncomeTaxes”, an interpretation of FAS109, Accounting for Income Taxes (FIN 48), tocreate a single model to address accounting for uncertainty in tax positions.FIN 48 clarifies the accounting for income taxes, by prescribing a minimumrecognition threshold a tax position is required to meet before beingrecognized in the financial statements. FIN 48 also provides guidance onderecognition, measurement, classification, interest and penalties, accountingin interim periods, disclosure and transition. FIN 48 is effective for fiscalyears beginning after December 15, 2006. The Company will adopt FIN 48effective February 1, 2007, as required. The cumulative effect of adoptingFIN 48, if any, will be recorded in retained earnings and other accounts asapplicable. The Company does not expect that the adoption of FIN 48 will have asignificant impact on the Company’s financial position, cash flows, or resultsof operations.

In September 2006, the FASB issued SFAS No. 157,“Fair Value Measurements” (“SFAS 157”), which clarifies the definition of fairvalue, establishes guidelines for measuring fair value, and expands disclosuresregarding fair value measurements. SFAS 157 does not require any new fair valuemeasurements and eliminates inconsistencies in guidance found in various prioraccounting pronouncements. SFAS 157 will be effective for the Company on February 1,2008. The Company will be evaluating the impact of adopting SFAS 157 on itsfinancial position, cash flows, and results of operations.

In September 2006,the Securities and Exchange Commission (“SEC”) released Staff AccountingBulletin No. 108, “Considering the Effects of Prior YearMisstatements when Quantifying Misstatements in Current Year FinancialStatements” (“SAB 108”). SAB 108 provides interpretive guidance on the SEC’sviews on how the effects of the carryover or reversal of prior yearmisstatements should be considered in quantifying a current year misstatement.The Company adopted the provisions of SAB 108 during the year ended January 31,2007, and, as a result, corrected one prior period misstatement that related toan 

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understatementof deferred tax liabilities for accumulated depreciation in the amount of$354,000. This correction was accounted for as a cumulative effect adjustmentunder the transition provisions of SAB 108, whereby the difference is recordedas an adjustment to beginning retained earnings in the year of adoption.

**Off-Balance SheetArrangements**

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

**Results ofOperations**

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

***REVENUES***

| ** **                         | ** ** | **Twelve months ended January 31,** | ** ** |
|------------------------------------|------------|---------------------------------------------------------|------------|
| ** **                         | ** ** | **2007**                                                | ** ** | **% Change** | ** ** | **2006** | ** ** | **% Change** | ** ** | **2005** | ** ** |
| ** **                         | ** ** | **(Dollars in thousands)**                    | ** ** |
| Engineering &  Evaluation |       | $                                                       | 80,030     |   |   | 10.5 | % |   | $ | 72,411 |   |   | 15.4 | % |   | $ | 62,753 |   |
| Technical  Solutions               |       | 35,643                                                  |       |   | (8.9 | )% |   | 39,113 |   |   | (10.6 | )% |   | 43,761 |   |
| Total revenues                     |       | $                                                       | 115,673    |   |   | 3.7 | % |   | $  | 111,524 |   |   | 4.7% |   |   | $ | 106,514 |   |

 

For the year ended January 31, 2007, totalrevenues increased $4,149,000 or 3.7%, 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 31,2006, total revenues increased $5,010,000 or 4.7%, as compared to fiscal 2005.

*Engineering &Evaluation:*

For the year ended January 31, 2007, revenues inthe Engineering & Evaluation segment increased $7,619,000 or 10.5%, ascompared to the prior year, primarily due to additional revenues of $2,844,000from the acquisition on June 9, 2006 of B&B Technologies, anengineering systems integration company located in Albuquerque, New Mexico,$2.1 million in increased aerospace revenues from the Santa Clarita, Californialaboratory as a result of the enhanced capability and capacity at that facilityand increases in revenues from telecommunications, electronics, power productsand registration markets. These increases were partially offset by decreases inthe automotive testing business at the Detroit, Michigan facility and defensetesting business at the Camden, Arkansas facility.

For the year ended January 31,2006, revenues in the Engineering & Evaluation segment increased$9,658,000 or 15.4%, as compared to the prior year, primarily due to strongtesting revenues in the aerospace and defense markets. Revenues also increasedin the telecommunications market, as a result of additional revenues of$1,330,000 from the acquisition of the testing laboratory in Calgary, Canada onAugust 1, 2004 and revenues of $934,000 from the acquisition of PhaseSeven Laboratories in Santa Rosa, California on March 18, 2005. Theseincreases were partially offset by a decrease in passive fiber optic testing,and decrease in the electronic and automotive testing businesses.

*TechnicalSolutions:*

For the year ended January 31, 2007, revenues inthe Technical Solutions segment decreased by $3,470,000 or 8.9%, as compared tofiscal 2006. This was primarily due to the continuing price compression 

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in this market as a resultof customers insisting on fixed mark-up pricing and delay in hiring at twomajor customer sites, causing a temporary decrease in revenues.

For the year ended January 31,2006, revenues in the Technical Solutions segment decreased by $4,648,000 or10.6%, as compared to the prior year, primarily due to the competitiveenvironment in the general IT service business from off-shore companies and thediscontinuance of certain services that did not fit the Company’s overallstrategy.

***GROSS PROFIT***

| ** **                         | ** ** | **Twelve months ended January 31,** | ** ** |
|------------------------------------|------------|---------------------------------------------------------|------------|
| ** **                         | ** ** | **2007**                                                | ** ** | **% Change** | ** ** | **2006** | ** ** | **% Change** | ** ** | **2005** | ** ** |
| ** **                         | ** ** | **(Dollars in thousands)**                    | ** ** |
| Engineering &  Evaluation |       | $                                                       | 20,678     |   |   | 1.3 | % |   | $ | 20,422 |   |   | 22.1 | % |   | $ | 16,724 |   |
| % to segment  revenue              |       | 25.8                                                    | %          |   |   |   |   | 28.2 | % |   |   |   |   | 26.7 | % |
| Technical  Solutions               |       | 5,965                                                   |       |   | (12.4 | )% |   | 6,808 |   |   | (2.2 | )% |   | 6,963 |   |
| % to segment  revenue              |       | 16.7                                                    | %          |   |   |   |   | 17.4 | % |   |   |   |   | 15.9 | % |
| Total                              |       | $                                                       | 26,643     |   |   | (2.2 | )% |   | $ | 27,230 |   |   | 15.0 | % |   | $ | 23,687 |   |
| % to total revenue                 |       | 23.0                                                    | %          |   |   |   |   | 24.4 | % |   |   |   |   | 22.2 | % |

 

For the year ended January 31, 2007, total grossprofit decreased $587,000 or 2.2%, as compared to the prior year. The year overyear decrease was primarily attributable to the lower revenues in the TechnicalSolutions segment and various factors as discussed below impacting Engineering &Evaluation’s gross margins.

For the year ended January 31,2006, total gross profit increased $3,543,000 or 15.0%, as compared to fiscal2005.

*Engineering &Evaluation:*

For the year ended January 31, 2007, gross profitin the Engineering & Evaluation segment increased by $256,000 or 1.3%,as compared to the prior year. Gross profit margin as a percentage of revenuesdecreased to 25.8% in the current year from 28.2%, primarily as a result of theweakness in the automotive industry, program delays by customers at the Camden,Arkansas facility and lower gross margins at the Company’s Tinton Falls, NewJersey and Santa Rosa, California facilities as a result of the investmentsmade for expansion at these facilities and not achieving the desired revenues.Gross profit was also impacted by high energy costs, particularly at the SantaClarita, California facility and losses from one program at Santa Clarita dueto contractual issues. The performance at the Company’s Fullerton, Californiafacility was negatively impacted during the second quarter as a result of aquality system deficiency in the Company’s “NEBS” (Network Equipment BuildingSpecification) testing under the “ITL” (Independent Test Laboratory) programand suspended testing under this program. The testing was reinstated after theCompany took the necessary corrective actions. Additionally, share-basedcompensation expense included in cost of sales for the year ended January 31,2007 was $135,000, compared with no share-based compensation expense in fiscal2006.

For the year ended January 31,2006, gross profit in the Engineering & Evaluation segment increasedby $3,698,000 or 22.1%, as compared to the prior year, primarily as a result ofthe revenue increase discussed above. Gross profit margin as a percentage ofrevenues increased to 28.2% in the current year from 26.7% in the prior year,primarily due to labor cost containments as a result of improved processefficiencies. This was offset by increases in depreciation expense as a resultof capital spending on machinery and equipment and increases in utilitiesexpense.

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*TechnicalSolutions:*

For the year ended January 31, 2007, gross profit inthe Technical Solutions segment decreased by $843,000 or 12.4%, as compared tothe prior year, primarily as a result of the decrease in revenues. Gross profitmargin as a percentage of revenues decreased to 16.7% in the current year from17.4% in the prior year, due to the continuing price compression.

For the year ended January31, 2006, gross profit in the Technical Solutions segment decreased by $155,000or 2.2%, as compared to the prior year, primarily as a result of the revenuedecrease discussed above. The Company was successful in minimizing thisdecrease as a result of the increased focus on specialized compliance andengineering support services, which generally produce higher margins.

***SELLING, GENERAL &ADMINISTRATIVE***

| ** **                         | ** ** | **Twelve months ended January 31,** | ** ** |
|------------------------------------|------------|---------------------------------------------------------|------------|
| ** **                         | ** ** | **2007**                                                | ** ** | **% Change** | ** ** | **2006** | ** ** | **% Change** | ** ** | **2005** | ** ** |
| ** **                         | ** ** | **(Dollars in thousands)**                    | ** ** |
| Engineering &  Evaluation |       | $                                                       | 16,391     |   |   | 7.5 | % |   | $ | 15,246 |   |   | 6.7 | % |   | $ | 14,290 |   |
| % to segment  revenue              |       | 20.5                                                    | %          |   |   |   |   | 21.1 | % |   |   |   |   | 22.8 | % |
| Technical  Solutions               |       | 5,785                                                   |       |   | (6.2 | )% |   | 6,166 |   |   | (3.0 | )% |   | 6,359 |   |
| % to segment  revenue              |       | 16.2                                                    | %          |   |   |   |   | 15.8 | % |   |   |   |   | 14.5 | % |
| Total                              |       | $                                                       | 22,176     |   |   | 3.6 | % |   | $ | 21,412 |   |   | 3.7 | % |   | $ | 20,649 |   |
| % to total revenue                 |       | 19.2                                                    | %          |   |   |   |   | 19.2 | % |   |   |   |   | 19.4 | % |

 

For the year ended January 31, 2007, totalselling, general and administrative expenses increased $764,000 or 3.6%, ascompared to the prior year. The year over year growth was primarily attributableto increased general and administrative costs in the Engineering &Evaluation segment, offset by a reduction in selling and general andadministrative costs in the Technical Solutions segment.

For the year ended January 31,2006, total selling, general and administrative expenses increased $763,000 or3.7%, as compared to fiscal 2005.

*Engineering &Evaluation:*

For the year ended January 31, 2007, selling,general and administrative expenses increased by $1,145,000 or 7.5%, ascompared to the prior year, primarily due to the effects of share-basedcompensation expense of $434,000 resulting from the application of SFAS No. 123(R),as described in Notes 1 and 5 of the consolidated financial statements, andincreased use of outside services related to the improvement of the Company’sinternal IT infrastructure and data automation and increased travel andconference expenses.

For the year endedJanuary 31, 2006, selling, general and administrative expenses increasedby $956,000 or 6.7%, as compared to the prior year, primarily due to increasedwages and incentive compensation, increased use of outside services related tothe improvement of the Company’s internal IT infrastructure and data automationand increased legal expense.

*TechnicalSolutions:*

For the year ended January 31, 2007, selling,general and administrative expenses decreased by $381,000 or 6.2% as comparedto the prior year, primarilydue to the reduction in selling costs associated with the lower revenues andlower depreciation expense.

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For the year ended January 31,2006, selling, general and administrative expenses decreased by $193,000 or3.0% as compared to the prior year, primarily due to decreases in depreciation expense, general andadministrative salaries and selling costs associated with the lower revenues.

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

*Engineering &Evaluation:*

For the year ended January 31, 2007, equityincome from XXCAL Japanwas $201,000, compared to $259,000 in the prior year. The decrease of$58,000 was primarily due to increased operating costs related to training onnew testing initiatives. XXCAL Japan is50% owned by NTS and is accounted for under the equity method since NTS doesnot have management or board control.

For the year ended January 31,2006, equity income from XXCALJapan was $259,000, compared to $483,000 in the prior year. The decreaseof $224,000 was primarily due to lower revenues caused by a reduction in testrequirements from a major Japanese customer and increased operating costsrelated to hiring and training additional technical personnel for new testinginitiatives.

***OPERATING INCOME***

| ** **                         | ** ** | **Twelve months ended January 31,** | ** ** |
|------------------------------------|------------|---------------------------------------------------------|------------|
| ** **                         | ** ** | **2007**                                                | ** ** | **% Change** | ** ** | **2006** | ** ** | **% Change** | ** ** | **2005** | ** ** |
| ** **                         | ** ** | **(Dollars in thousands)**                    | ** ** |
| Engineering &  Evaluation |       | $                                                       | 4,488      |   |   | (17.4 | )% |   | $ | 5,435 |   |   | 86.3 | % |   | $ | 2,917 |   |
| % to segment  revenue              |       | 5.6                                                     | %          |   |   |   |   | 7.5 | % |   |   |   |   | 4.6 | % |
| Technical  Solutions               |       | 180                                                     |       |   | (72.0 | )% |   | 642 |   |   | 6.3 | % |   | 604 |   |
| % to segment  revenue              |       | 0.5                                                     | %          |   |   |   |   | 1.6 | % |   |   |   |   | 1.4 | % |
| Total                              |       | $                                                       | 4,668      |   |   | (23.2 | )% |   | $ | 6,077 |   |   | 72.6 | % |   | $ | 3,521 |   |
| % to total revenue                 |       | 4.0                                                     | %          |   |   |   |   | 5.4 | % |   |   |   |   | 3.3 | % |

 

For the year ended January 31, 2007, operatingincome decreased $1,409,000 or 23.2%, as compared to the prior year. The yearover year decrease was attributable to the lower gross profit and the increasein selling, general and administrative expenses.

For the year ended January 31,2006, operating income increased $2,556,000 or 72.6%, as compared to fiscal2005.

*Engineering &Evaluation:*

For the year ended January 31, 2007, operatingincome decreased by $947,000 or 17.4%, as compared to the prior year, as aresult of the increase in selling, general and administrative expenses,partially offset by a slight increase in gross profit.

For the year ended January 31,2006, operating income increased by $2,518,000 or 86.3%, as compared to theprior year, as a result of the increase in gross profit discussed above,partially offset by the increase in selling, general and administrativeexpenses.

*TechnicalSolutions:*

For the year ended January 31, 2007, operatingincome decreased by $462,000 or 72.0%, as compared to the prior year, as aresult of the decrease in gross profit, partially offset by the decrease inselling, general and administrative expenses discussed above.

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For the year ended January 31,2006, operating income increased by $38,000 or 6.2%, as compared to the prioryear, 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 $503,000 in fiscal 2007when compared to fiscal 2006 primarily due to higher interest rate levels infiscal 2007 and higher average debt balances in fiscal 2007, as compared to theprior year. The higherdebt balance in fiscal 2007 was primarily due to $3.9 million in borrowings torepurchase 792,266 shares of its common stock from a former executive officerand director of the Company and borrowings for the Dynamic Labs acquisition.

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.

***Other Income***

Other income of $111,000in fiscal 2007 is primarily attributable to gains from investments in lifeinsurance policies. Other income of $176,000 in fiscal 2006 includesapproximately $163,000 in gain from the sale of real estate.

***Income Taxes***

The provisional income tax rate for fiscal year 2007is 44.0%, compared to 39.7% in the prior year. The increase in the income taxrate in fiscal 2007 was primarily due to non-deductible share-basedcompensation expense recorded for fiscal year 2007, as compared to none for the prior year. Theincome tax rate for fiscal year 2005 was 35.1%. See Note 4 to the consolidatedfinancial statements for a reconciliation of the provision for income taxesfrom continuing operations at the statutory rate to the provision for incometaxes 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 2007, net income decreased $1,358,000 to$1,581,000, as compared to the prior year, primarily due to the decrease inoperating income, the increase in interest expense, and the increase in theincome tax rate and minority interest.

In fiscal 2006, net incomeincreased $1,257,000 to $2,939,000, as compared to the prior year, primarilydue to the increase in operating income, partially offset by the increase ininterest expense, increase in the income tax rate and minority interestexpense.

***Business Environment***

The defense and aerospace markets generate 58% of theoverall Engineering and Evaluation testing revenues. With the federal fiscal2007 budget enacted, the United States Department of Defense (“DOD”) willreceive a record research and development test and engineering budget of $76.8billion, an increase of 4.8% from $73.2 billion in fiscal 2006. The two bigdefense winners are the Air Force and the Missile Defense Agency. The aerospaceindustry continues to experience steady growth. Aerospace sales are projectedto increase from $184 billion in fiscal 2006 to $195 billion in fiscal 2007.The largest increase is expected in the civil aircraft sector with industrysales expected to increase from $47.5 billion in fiscal 2006 

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to $54.6 billion in fiscal2007. In addition, there is a slight expected growth in industry sales for thespace, military, aircraft and missile sectors. The Company has also noted an increaserecently in funding for the evaluation of military equipment and weaponssystems. The Company expects the increased funding will positively affectbusiness at its laboratories. Management believes the Camden, Arkansas facilitywill benefit the most from the increase in defense spending because of itsunique capability to service the missile sector. The Company expects thefacilities in Boxborough, Massachusetts and in Fullerton, Santa Clarita and LosAngeles, California to benefit most from the increase in aerospace spending as theCompany anticipates the level of customer demand from expected increases in DODand aerospace research and development spending will increase for theforeseeable future.

The telecommunications worldwide market is showing amuch higher growth rate of wireless service in comparison to wireline service.Wireless service revenue is forecasted to grow at 9.9 percent over the nextseveral years, while wireline service is forecasted to grow more modestly at2.0 percent. Broadband service providers continue to create viable businessmodels in order to deliver high-speed broadband, leveraging internet protocol(IP) packet delivery to create and deliver new services. Many incumbent UScarriers are choosing to initially implement IP-based services on an overlaynetwork. Taking this approach, carriers do not have to replace circuit-switchednetworks elements, which represent sunk costs and have minimal ongoingoperational expenses. The next-generation communications networks will requirecarriers to update systems and equipment at all levels of thetelecommunications network architecture. These updates will require compliance,interoperability and testing support. The Company is well positioned to providethis support. It has been approved as an Independent Test laboratory (ITL) bymost of the US carriers to test and certify central office equipment developedby manufacturers to the Network Equipment Building Specifications (NEBS). TheCompany is currently providing this service at Laboratories in California,Massachusetts, Texas, Alberta, Canada and Germany. The Company has beenapproved as an (ITL) to provide Digital Subscriber Line (DSL) certification andrecently been approved for multimedia over coax testing (MoCA) .

The transportation market in the US continues to facestiff competition from global automotive manufacturers. This trend is expectedto continue for the foreseeable future. However, NTS continues to gain marketshare and has experienced a slight increase in transportation related revenuesfor FY 2007 compared FY 2006, particularly at its California and Arizonafacilities.

The power industry experienced an increase in demandfor safety related products and test and certifications activity. As a result,NTS has experienced an incremental year-over-year growth of approximately 19%in this market sector. Currently, the United States is engaged in discussionswith India to develop an agreement titled “123 agreement” which will allowIndia to receive technology and reactors from the United States. Passage ofthis agreement could create an increase in demand for NTS services.

The computer and electronics markets have been stable,with the Company experiencing an increase in revenues in this industry. TheCompany anticipates growth in these markets as it captures additional marketshare due to  expansion in internationalmarkets. NTS signed an agreement in fiscal 2007 with TTA in South Korea toperform Zigbee certification testing and has been selected to manage thetesting for Video Electronics Standards Association’s (VESA) newDisplayPort(TM) interface standard. The Company believes that the demand forthese certification activities will increase in Asia.

In the Technical Solutions segment, the Companyprovides a variety of staffing and workforce management services and solutions,including contract, contract-to-hire and full time placements to meet itscustomers’ needs with a focus on IT and engineering. As the IT general servicesbusiness moved off-shore and came to be treated as a commodity by largerorganizations, the Company deployed a transformation strategy in 2003 whichfocused on meeting the anticipated increase in demand for specialized IT,compliance, engineering support services at Company locations as well as takingadvantage of offshore opportunities. As part of this transformation, theCompany developed a proprietary database 

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and put in place acustomer service team which maintains relationships and manages theavailability of the technical experts which support these specialized services.The Company has also set up a test and compliance laboratory in Vietnam tosupport the needs of a major US Fortune 500 computer company and to takeadvantage of the low cost highly skilled labor in Vietnam. The Company is nowexpanding this offshore offering to additional customers. TS continues todifferentiate itself from its competitors by using NTS testing, engineering andcompliance capabilities to maximize its customers’ return on human assets.

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

***Liquidity and Capital Resources***

Summaryof cash flows:

| ** **                                                    | ** ** | **FY 2007**                     | ** ** | **FY 2006** | ** ** | **FY 2005** | ** ** |
|---------------------------------------------------------------|------------|--------------------------------------|------------|------------------|------------|------------------|------------|
| ** **                                                    | ** ** | **(Dollars in thousands)** | ** ** |
| Net cash provided  by operating activities                    |       | $                                    | 6,253      |             | $          | 9,535            |       | $ | 6,590 |   |
| Net cash used for  investing activities                       |       | (9,280                               | )          | (7,408           | )          | (6,089           | )          |
| Net cash provided  by (used in) financing activities          |       | 2,117                                |       | (4,180           | )          | 1,026            |       |
| Effect of  exchange rate changes on cash and cash equivalents |       | (65                                  | )          | 48               |       | 13               |       |
| Net increase (decrease)  in cash                              |       | $                                    | (975       | )                | $          | (2,005           | )          | $ | 1,540 |   |

 

Net cash provided by operating activities of$6,253,000 in fiscal 2007 consisted of net income of $1,581,000, adjusted fornon-cash items of $5,822,000 in depreciation and amortization, share-basedcompensation of $569,000, partially offset by $1,658,000 of changes in workingcapital and $61,000 in other non-cash items. The decrease in cash provided byoperating activities from fiscal 2006 to fiscal 2007 was primarily the resultof the lower net income in fiscal 2007 and the change in accrued expenses. Netcash provided by operating activities of $9,535,000 in fiscal 2006 consisted ofnet income of $2,939,000 adjusted for non-cash items of $5,283,000 indepreciation and amortization and $1,760,000 of changes in working capital andother activities, partially offset by $447,000 in other non-cash items. Theincrease in cash provided by operating activities from fiscal 2005 to fiscal2006 was primarily the result of higher net income in fiscal 2006, the changesin accounts payable, accrued expenses and income taxes, partially offset by thechanges in accounts receivable and inventories. Net cash provided by operating activitiesof $6,590,000 in fiscal 2005 consisted of net income of $1,682,000 adjusted fornon-cash items of $4,798,000 in depreciation and amortization and $302,000 inother non-cash items, partially offset by $192,000 of changes in workingcapital and other activities. The decrease in cash provided by operatingactivities from fiscal 2004 to fiscal 2005 was primarily the result of thechange in accounts receivable, the increase in accounts payable payments,partially offset by the higher net income in fiscal 2005.

Net cash used for investing activities in fiscal 2007of $9,280,000 was primarily attributable to capital spending of $6,028,000,cash used to acquire American International Registrars Corporation (“AIR”) of$386,000, cash used to acquire B&B Technologies of $414,000 and cash usedto acquire Dynamic Labs of $2,254,000. Capital spending is generally comprisedof purchases of machinery and equipment, building, leasehold improvements,computer hardware, software and furniture and fixtures. Cash used in investingactivities increased from fiscal 2006 to fiscal 2007 by $1,872,000 primarily asa result of the increase in cash used for acquisitions. Net cash used forinvesting activities in fiscal 2006 of $7,408,000 was primarily attributable tocapital spending of $7,287,000 and cash used in the acquisition of Phase SevenLaboratories in the amount of $483,000, partially offset by proceeds from thesale of real estate of $543,000. Cash used in investing activities increasedfrom fiscal 2005 to fiscal 2006 by $1,319,000 primarily as a result of anincrease in capital spending of $2,098,000, in fiscal 2006, partially offset bya decrease of $550,000 in cash spent on acquisitions. Net cash used forinvesting activities in fiscal 2005 of $6,089,000 was primarily 

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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 provided byfinancing activities in fiscal 2007 of $2,117,000, consisted of proceedsfrom borrowings of $15,326,000, proceeds from stock options exercised of$633,000, partially offset by repayment of debt of $9,949,000, and common stockrepurchase of $3,893,000 from a former executive officer and director of theCompany. Net cash used forfinancing activities in fiscal 2006 of $4,180,000 consisted of repayments ofdebt of $7,075,000, partially offset by proceeds from borrowings of $2,651,000and proceeds from stock options exercised of $244,000. Net cash provided byfinancing activities in fiscal 2005 of $1,026,000 consisted of proceeds fromborrowings of $2,228,000, proceeds from stock options exercised of $300,000,partially offset by repayments of debt of $1,502,000.

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 minimumadvances of $1,000,000. The Company paid a 0.5% commitment fee of the totalline amount and is paying an additional 0.25% of the commitment amount annuallyand 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. Theamendment also included an additional equipment line of credit for $2,000,000.On March 29, 2006, the Company increased the term loan by an additional$3,900,000 to fund the repurchase of 792,266 shares of common stock from aformer executive officer and director, as discussed above. On September 21,2006, the agreement was amended again to include an additional equipment lineof credit of $2,000,000 and an additional $2,000,000 in term loan, to be repaidin 48 equal monthly payments, to fund the purchase of Dynamic Labs. Theoutstanding balance on the revolving line of credit at January 31, 2007was $8,843,000. This balance is reflected in the accompanying condensedconsolidated balance sheets as long-term. The amount available on the line ofcredit was $7,657,000 as of January 31, 2007. The aggregate outstandingbalance on the term loans at January 31, 2007 was $6,587,000. Theaggregate outstanding balance on the equipment line of credit at January 31,2007 was $3,441,000. 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 requested and receivedwaivers for two covenants from its banks to remain compliant with the bankcovenants as of January 31, 2007.

The Company has additionalequipment line of credit agreements (at interest rates of 5.56% to 7.47%) tofinance various test equipment with terms of 60 months for each equipmentschedule. The outstanding balance at January 31, 2007 was $1,237,000. Thebalance of other notespayable collateralized by land and building was $2,415,000.

28

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**Contractual Obligations:**

| ** **                   | ** ** | **Payments due by period** | ** ** |
|------------------------------|------------|-------------------------------------------|------------|
| ** **                   | ** ** | **Total**                                 | ** ** | **Due in  2008** | ** ** | **Due in  2009-2010** | ** ** | **Due in  2011-2012** | ** ** | **Thereafter** | ** ** |
| ** **                   | ** ** | **(Dollars in thousands)**      | ** ** |
| Long-term debt               |       | $                                         | 22,523     |   | $ | 3,285 |   |   | $ | 15,889 |   |   |   | $ | 1,957 |   |   |   | $ | 1,392 |   |   |
| Operating lease  obligations |       | 6,660                                     |       | 2,456 |   |   | 3,228 |   |   |   | 976 |   |   |   | — |   |   |
| Total                        |       | $                                         | 29,183     |   | $ | 5,741 |   |   | $ | 19,117 |   |   |   | $ | 2,933 |   |   |   | $ | 1,392 |   |   |

 

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’s long-termdebt may be accelerated if the Company fails to meet its covenants with itsbanks. 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.

**ITEM 7A.**        *QUANTITATIVE AND 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 $88,000 at January 31, 2007 ascompared to $85,000 at January 31, 2006.

***Environmental Matters***

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

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

The Company’s Santa Clarita, California test facilityis located immediately adjacent to property owned by a third party which hasbeen the subject of extensive environmental remediation. The adjacent site has,in the past, been used for manufacture of solid rocket fuel propellants,munitions and flares that contained perchlorate, a hazardous substance. Soilsamples taken from the western portion of the Santa Clarita property in 2003were inconclusive as to the existence of perchlorate. Further testing isplanned in cooperation with the government agency having oversightresponsibility for the adjacent site. No cleanup activity has been conducted onthe Santa Clarita property and it has yet to be determined whether remediationwill be required at the site, or, if required, the extent and cost of anyremediation. The Company believes that in the event it does incur remediationcosts on the western portion of the property, that it will have valid claimsfor indemnification against the owner of the adjacent site and the municipalitythat built a road between the adjacent site and the Santa Clarita property thatappears to have contributed to the runoff from the adjacent site. Recovery ofsuch remediation costs may, however, be uncertain and may involve significantlitigation expense.

In January 2007, asampling program was conducted on the eastern portion of the site in accordancewith a voluntary clean up agreement the Company entered into with theDepartment of Toxic Substance Control (DTSC). The sampling did not detect anyperchlorate in the soil, but one surface sample at a 

29

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hazardousmaterials storage area did detect lead, cadmium, chromium, copper and nickel atconcentrations in excess of typical background levels. As a result, additionaltesting will be conducted at that location to determine the extent of thelevels of the identified compounds. The extent and cost of remediation, if anyis required, is unknown at this time.

***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.

30

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**ITEM 8.   *FINANCIAL STATEMENTS ANDSUPPLEMENTARY DATA*.**

**Indexto Consolidated Financial Statements and Schedule**

| Report of Independent Registered  Public Accounting Firm                                                    |       | 32           |       |
|-------------------------------------------------------------------------------------------------------------|------------|--------------|------------|
| Financial  Statements:                                                                                      |       |         |       |
| Consolidated  Balance Sheets—January 31, 2007 and 2006                                            |       | 33           |       |
| Consolidated Statements of Income—Years ended  January 31, 2007, 2006 and 2005                    |       | 34           |       |
| Consolidated Statements of Shareholders’ Equity—Years  ended January 31, 2007, 2006 and 2005 |       | 35           |       |
| Consolidated Statements of Cash Flows—Years ended  January 31, 2007, 2006 and 2005                |       | 36           |       |
| Notes to Consolidated Financial Statements                                                                  |       | 37           |       |
| ** **                                                                                                  | ** ** | **Schedule** | ** ** |
| Schedule  Supporting Financial Statements:                                                                  |       |         |       |
| Valuation and  Qualifying Accounts and Reserves                                                             |       | II           |       |

----

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

31

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**REPORT OF INDEPENDENTREGISTERED PUBLIC ACCOUNTING FIRM**

The Board of Directors andShareholdersNational Technical Systems, Inc.

We have audited theaccompanying consolidated balance sheets of National Technical Systems, Inc.and Subsidiaries as of January 31, 2007 and 2006, and the related consolidatedstatements of income, shareholders’ equity and cash flows for each of the threeyears in the period ended January 31, 2007. Our audits also included thefinancial statement schedule listed in the Index at Item 15(A). These financialstatements and schedule are the responsibility of the Company’s management. Ourresponsibility is to express an opinion on these financial statements andschedule based on our audits. We did not audit the financial statements of NQA,Inc., a 50% owned consolidated subsidiary, which statements reflect totalassets constituting $2,597,000 in 2007 and $2,214,000 in 2006 and totalrevenues constituting $7,463,000 in 2007, $6,714,000 in 2006 and $6,896,000 in2005 of the related consolidated totals. Those statements were audited by otherauditors whose report has been furnished to us, and our opinion, insofar as itrelates to the amounts included for NQA, Inc., is based solely on the report ofthe other auditors. The financial statements of XXCAL Japan, a corporation inwhich the Company has a 50% interest and accounted for by the Company under theequity method, 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 $1,220,000 and $1,019,000,respectively, at January 31, 2007 and 2006, and the Company’s equity in the netincome of XXCAL Japan is stated at $201,000, $259,000 and $483,000, for theyears ended January 31, 2007, 2006 and 2005, respectively.

We conducted our audits inaccordance with the standards of the Public Company Accounting Oversight Board(United States). Those standards require that we plan and perform the audit toobtain reasonable assurance about whether the financial statements are free ofmaterial misstatement. We were not engaged to perform an audit of the Company’sinternal control over financial reporting. Our audits included consideration ofinternal control over financial reporting as a basis for designing auditprocedures that are appropriate in the circumstances, but not for the purposeof expressing an opinion on the effectiveness of the Company’s internal controlover financial reporting. Accordingly, we express no such opinion. An auditalso includes examining, on a test basis, evidence supporting the amounts anddisclosures in the financial statements, assessing the accounting principlesused and significant estimates made by management, and evaluating the overallfinancial statement presentation. We believe that our audits and the reports ofother auditors provide a reasonable basis for our opinion.

In our opinion, based onour audits and the reports of other auditors, the financial statements referredto above present fairly, in all material respects, the consolidated financialposition of National Technical Systems, Inc. and Subsidiaries at January 31,2007 and 2006 and the consolidated results of their operations and their cashflows for each of the three years in the period ended January 31, 2007, inconformity with U.S. generally accepted accounting principles. Also, in ouropinion, the related financial statement schedule, when considered in relationto the basic financial statements taken as a whole, presents fairly, in allmaterial respects, the information set forth therein.

As discussed in Notes 1 and5 to the consolidated financial statements, on February 1, 2006, theCompany changed its method of accounting for share-based payments in accordancewith Statement of Financial Accounting Standards No. 123(R).

Additionally, as discussedin Note 1 to the consolidated financial statements, the Company adoptedStaff Accounting Bulletin No. 108, (“SAB 108”). The Company used theone time special transition provisions of SAB 108 and recorded an adjustmentto retained earnings effective February 1, 2006, in order to correct a priorperiod error.

/s/ Ernst & YoungLLP

Los Angeles, CaliforniaApril 24, 2007

32

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**NATIONAL TECHNICAL SYSTEMS, INC. AND SUBSIDIARIESConsolidated Balance SheetsJanuary 31,**
|                                                                                                                                                                      | ** ** | **2007**    | ** ** | **2006**    | ** ** |
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------|------------|-------------|------------|
| **ASSETS**                                                                                                                                                           |       |        |       |        |       |
| CURRENT ASSETS:                                                                                                                                                      |       |        |       |        |       |
| Cash                                                                                                                                                                 |       | $           | 3,221,000  |        | $          | 4,196,000 |   |
| Accounts receivable, net  of allowance for doubtful accounts of $691,000 at January 31, 2007 and  $816,000 at January 31, 2006                             |       | 21,900,000  |       | 20,425,000  |       |
| Income taxes receivable                                                                                                                                              |       | —      |       | 10,000      |       |
| Inventories                                                                                                                                                          |       | 2,892,000   |       | 2,184,000   |       |
| Deferred income taxes                                                                                                                                                |       | 1,690,000   |       | 1,747,000   |       |
| Prepaid expenses                                                                                                                                                     |       | 958,000     |       | 769,000     |       |
| Total current assets                                                                                                                                                 |       | 30,661,000  |       | 29,331,000  |       |
| Property, plant and  equipment, at cost                                                                                                                              |       |        |       |        |       |
| Land                                                                                                                                                                 |       | 1,415,000   |       | 1,415,000   |       |
| Buildings                                                                                                                                                            |       | 10,238,000  |       | 10,172,000  |       |
| Machinery and equipment                                                                                                                                              |       | 78,513,000  |       | 73,115,000  |       |
| Leasehold improvements                                                                                                                                               |       | 11,323,000  |       | 9,185,000   |       |
| Total property, plant  and equipment                                                                                                                                 |       | 101,489,000 |       | 93,887,000  |       |
| Less: accumulated  depreciation                                                                                                                                      |       | (66,055,000 | )          | (60,787,000 | )          |
| Net property, plant and  equipment                                                                                                                                   |       | 35,434,000  |       | 33,100,000  |       |
| Goodwill                                                                                                                                                             |       | 4,126,000   |       | 2,740,000   |       |
| Other assets                                                                                                                                                         |       | 4,618,000   |       | 3,962,000   |       |
| TOTAL ASSETS                                                                                                                                                         |       | $           | 74,839,000 |        | $          | 69,133,000 |   |
| **LIABILITIES AND SHAREHOLDERS’  EQUITY**                                                                                                                       |       |        |       |        |       |
| CURRENT LIABILITIES:                                                                                                                                                 |       |        |       |        |       |
| Accounts payable                                                                                                                                                     |       | $           | 5,843,000  |        | $          | 4,715,000 |   |
| Accrued expenses                                                                                                                                                     |       | 5,213,000   |       | 5,400,000   |       |
| Income taxes payable                                                                                                                                                 |       | 401,000     |       | 594,000     |       |
| Deferred revenue                                                                                                                                                     |       | 832,000     |       | 817,000     |       |
| Current installments of  long-term debt                                                                                                                              |       | 3,285,000   |       | 1,529,000   |       |
| Total current  liabilities                                                                                                                                           |       | 15,574,000  |       | 13,055,000  |       |
| Long-term debt,  excluding current installments                                                                                                                      |       | 19,238,000  |       | 15,579,000  |       |
| Deferred income taxes                                                                                                                                                |       | 5,052,000   |       | 5,084,000   |       |
| Deferred compensation                                                                                                                                                |       | 946,000     |       | 874,000     |       |
| Minority interest  liability                                                                                                                                         |       | 250,000     |       | 163,000     |       |
| 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, 8,717,000 as of  January 31, 2007 and 9,176,000 as of January 31, 2006 |       | 12,863,000  |       | 14,624,000  |       |
| Retained earnings                                                                                                                                                    |       | 20,971,000  |       | 19,744,000  |       |
| Accumulated other  comprehensive (loss) income                                                                                                                       |       | (55,000     | )          | 10,000      |       |
| Total shareholders’  equity                                                                                                                                     |       | 33,779,000  |       | 34,378,000  |       |
| TOTAL LIABILITIES AND SHAREHOLDERS’ EQUITY                                                                                                                      |       | $           | 74,839,000 |        | $          | 69,133,000 |   |

 

See accompanying notes.

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

| ** **                                                     | ** ** | **2007**   | ** **  | **2006**   | ** ** | **2005**    | ** ** |
|----------------------------------------------------------------|------------|------------|-------------|------------|------------|-------------|------------|
| Net revenues                                                   |       | $          | 115,673,000 |       | $          | 111,524,000 |       | $ | 106,514,000 |   |
| Cost of sales                                                  |       | 89,030,000 |        | 84,294,000 |       | 82,827,000  |       |
| Gross profit                                                   |       | 26,643,000 |        | 27,230,000 |       | 23,687,000  |       |
| Selling, general  and administrative expense                   |       | 22,176,000 |        | 21,412,000 |       | 20,649,000  |       |
| Equity income  from non-consolidated subsidiary                |       | (201,000   | )           | (259,000   | )          | (483,000    | )          |
| Operating income                                               |       | 4,668,000  |        | 6,077,000  |       | 3,521,000   |       |
| Other income (expense):                                        |       |       |        |       |       |        |       |
| Interest expense, net                                          |       | (1,801,000 | )           | (1,298,000 | )          | (1,091,000  | )          |
| Other income, net                                              |       | 111,000    |        | 176,000    |       | 162,000     |       |
| Total other  expense, net                                      |       | (1,690,000 | )           | (1,122,000 | )          | (929,000    | )          |
| Income before  income taxes and minority interest              |       | 2,978,000  |        | 4,955,000  |       | 2,592,000   |       |
| Income taxes                                                   |       | 1,309,000  |        | 1,966,000  |       | 910,000     |       |
| Income before  minority interest                               |       | 1,669,000  |        | 2,989,000  |       | 1,682,000   |       |
| Minority interest  in earnings                                 |       | (88,000    | )           | (50,000    | )          | —      |       |
| Net income                                                     |       | $          | 1,581,000   |       | $          | 2,939,000   |       | $ | 1,682,000 |   |
| Net income per common  share:                                  |       |       |        |       |       |        |       |
| Basic                                                          |       | $          | 0.18        |       | $          | 0.32        |       | $ | 0.19 |   |
| Diluted                                                        |       | $          | 0.17        |       | $          | 0.30        |       | $ | 0.18 |   |
| Weighted average  common shares outstanding                    |       | 8,705,000  |        | 9,125,000  |       | 8,946,000   |       |
| Dilutive effect  of stock options                              |       | 800,000    |        | 537,000    |       | 620,000     |       |
| Weighted average common  shares outstanding, assuming dilution |       | 9,505,000  |        | 9,662,000  |       | 9,566,000   |       |

 

See accompanying notes.

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

| ** **                                                | ** ** | ** **         | ** ** | ** ** | ** **     | ** **   | ** ** | **Accumulated**        | ** ** | ** **             | ** ** |
|-----------------------------------------------------------|------------|--------------------|------------|------------|----------------|--------------|------------|------------------------|------------|------------------------|------------|
| ** **                                                | ** ** | ** **         | ** ** | **Common** | ** **     | ** **   | ** ** | **Other**              | ** ** | **Total**              | ** ** |
| ** **                                                | ** ** | **Number of** | ** ** | **Stock**  | ** **     | **Retained** | ** ** | **Comprehensive**      | ** ** | **Shareholders’** | ** ** |
| ** **                                                | ** ** | **Shares**         | ** ** | **Amount** | ** **     | **Earnings** | ** ** | **Income (Loss)** | ** ** | **Equity**             | ** ** |
| **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** | ** ** |
| Correction of  deferred tax error from prior years        |       | —             |       | —     |           | (354,000     | )          |                   | —     |                   |       | (354,000 | ) |
| Net income                                                |       | —             |       | —     |           | 1,581,000    |       |                   | —     |                   |       | 1,581,000 |   |
| Foreign currency  translation                             |       | —             |       | —     |           | —       |       |                   | (65,000    | )                      |       | (65,000 | ) |
| Comprehensive income                                      |       |               |       |       |           |         |       |                   |       |                   |       | 1,516,000 |   |
| Stock options  exercised                                  |       | 281,000            |       | 839,000    |           | —       |       |                   | —     |                   |       | 839,000 |   |
| Stock retired for  option exercise                        |       | (31,000            | )          | (206,000   | )              | —       |       |                   | —     |                   |       | (206,000 | ) |
| Issuance of  restricted stock                             |       | —             |       | 32,000     |           | —       |       |                   | —     |                   |       | 32,000 |   |
| Share-based  compensation                                 |       | —             |       | 537,000    |           | —       |       |                   | —     |                   |       | 537,000 |   |
| Tax benefit from  stock options exercise                  |       | —             |       | 282,000    |           | —       |       |                   | —     |                   |       | 282,000 |   |
| Stock repurchase                                          |       | (792,000           | )          | (3,893,000 | )              | —       |       |                   | —     |                   |       | (3,893,000 | ) |
| Stock issued for  acquisition of B&B Technologies     |       | 83,000             |       | 648,000    |           | —       |       |                   | —     |                   |       | 648,000 |   |
| **Balance at January 31,  2007**                     | ** ** | **8,717,000**      | ** ** | **$**      | **12,863,000** | ** **   | **$**      | **20,971,000**         | ** ** |                   | **$**      | **(55,000** | **)** |   | **$** | **33,779,000** | ** ** |

 

See accompanying notes.

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**NATIONAL TECHNICAL SYSTEMS, INC. AND SUBSIDIARIES**Consolidated Statements of Cash Flows Years Ended January 31, 
|                                                                                    | ** ** | **2007**   | ** ** | **2006**   | ** ** | **2005**   | ** ** |
|------------------------------------------------------------------------------------|------------|------------|------------|------------|------------|------------|------------|
| **CASH FLOWS FROM OPERATING  ACTIVITIES:**                                         |       |       |       |       |       |       |       |
| Net income                                                                         |       | $          | 1,581,000  |       | $          | 2,939,000  |       | $ | 1,682,000 |   |
| Adjustments to reconcile  net income to net cash provided by operating activities: |       |       |       |       |       |       |       |
| Depreciation and amortization                                                      |       | 5,822,000  |       | 5,283,000  |       | 4,798,000  |       |
| Recoveries on receivables                                                          |       | (125,000   | )          | (90,000    | )          | (32,000    | )          |
| Gain on sale of assets                                                             |       | —     |       | (163,000   | )          | (158,000   | )          |
| Loss on retirement of assets                                                       |       | 24,000     |       | —     |       | 16,000     |       |
| Undistributed earnings of affiliate                                                |       | 87,000     |       | 50,000     |       | —     |       |
| Deferred income taxes (net of acquisition)                                         |       | (329,000   | )          | (300,000   | )          | 352,000    |       |
| Tax benefit from stock options exercises                                           |       | 282,000    |       | 56,000     |       | 74,000     |       |
| Share-based compensation                                                           |       | 569,000    |       | —     |       | 50,000     |       |
| Changes in  operating assets and liabilities (net of acquisitions):                |       |       |       |       |       |       |       |
| Accounts receivable                                                                |       | (1,102,000 | )          | (1,677,000 | )          | 235,000    |       |
| Inventories                                                                        |       | (673,000   | )          | (572,000   | )          | 383,000    |       |
| Prepaid expenses                                                                   |       | (157,000   | )          | (103,000   | )          | 161,000    |       |
| Other assets                                                                       |       | (244,000   | )          | (166,000   | )          | (265,000   | )          |
| Accounts payable                                                                   |       | 896,000    |       | 1,104,000  |       | (973,000   | )          |
| Accrued expenses                                                                   |       | (229,000   | )          | 1,612,000  |       | 241,000    |       |
| Income taxes payable                                                               |       | (193,000   | )          | 594,000    |       | (23,000    | )          |
| Deferred revenue                                                                   |       | (38,000    | )          | 393,000    |       | 239,000    |       |
| Deferred compensation                                                              |       | 72,000     |       | 64,000     |       | 11,000     |       |
| Income taxes receivable                                                            |       | 10,000     |       | 511,000    |       | (201,000   | )          |
| Net cash provided  by operating activities                                         |       | 6,253,000  |       | 9,535,000  |       | 6,590,000  |       |
| **CASH  FLOWS FROM INVESTING ACTIVITIES:**                                         |       |       |       |       |       |       |       |
| Purchase of property, plant and equipment                                          |       | (6,028,000 | )          | (7,287,000 | )          | (5,189,000 | )          |
| Sale of property, plant and equipment                                              |       | —     |       | 543,000    |       | 311,000    |       |
| Investment in life insurance                                                       |       | (197,000   | )          | (181,000   | )          | (178,000   | )          |
| Acquisitions of businesses, net of cash                                            |       | (3,055,000 | )          | (483,000   | )          | (1,033,000 | )          |
| Net cash used for  investing activities                                            |       | (9,280,000 | )          | (7,408,000 | )          | (6,089,000 | )          |
| **CASH  FLOWS FROM FINANCING ACTIVITIES:**                                         |       |       |       |       |       |       |       |
| Proceeds from current and long-term debt                                           |       | 15,326,000 |       | 2,651,000  |       | 2,228,000  |       |
| Repayments of current and long-term debt                                           |       | (9,949,000 | )          | (7,075,000 | )          | (1,502,000 | )          |
| Proceeds from stock options exercised                                              |       | 633,000    |       | 244,000    |       | 300,000    |       |
| Common stock repurchase                                                            |       | (3,893,000 | )          | —     |       | —     |       |
| Net cash provided  by (used for) financing activities                              |       | 2,117,000  |       | (4,180,000 | )          | 1,026,000  |       |
| Effect of exchange  rate changes on cash and cash equivalents                      |       | (65,000    | )          | 48,000     |       | 13,000     |       |
| Net (decrease)  increase in cash                                                   |       | (975,000   | )          | (2,005,000 | )          | 1,540,000  |       |
| Beginning cash  balance                                                            |       | 4,196,000  |       | 6,201,000  |       | 4,661,000  |       |
| ENDING CASH  BALANCE                                                               |       | $          | 3,221,000  |       | $          | 4,196,000  |       | $ | 6,201,000 |   |
| **SUPPLEMENTAL  DISCLOSURE OF CASH FLOW INFORMATION**                              |       |       |       |       |       |       |       |
| Cash payments during the  year for:                                                |       |       |       |       |       |       |       |
| Interest                                                                           |       | $          | 1,837,000  |       | $          | 1,333,000  |       | $ | 1,078,000 |   |
| Income taxes                                                                       |       | 1,487,000  |       | 1,089,000  |       | 667,000    |       |

 

See accompanying notes

36

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**NATIONAL TECHNICAL SYSTEMS, INC.** AND SUBSIDIARIES Notes to Consolidated Financial Statements January 31, 2007, 2006 and 2005

**(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 has consolidated NQA, Inc., a 50%owned subsidiary for which the distribution of profits and losses is 50.1% tothe Company, and 49.9% to the other shareholder. NTS controls the management decisionsand elects the president of NQA, Inc. and therefore has operating controlof the subsidiary.

XXCAL Japan is a 50% ownedsubsidiary which started in fiscal 1999 and is accounted for under the equitymethod since NTS does not have operating control. XXCAL Japan’s financialstatements are prepared in accordance with generally accepted accountingprinciples in Japan. There are no material adjustments that need to be made toXXCAL Japan’s financial statements for them to be in conformity with U.S. generallyaccepted accounting principles. The equity investment recorded in theaccompanying balance sheets is $1,220,000 and $1,019,000 at January 31,2007 and 2006, respectively. The Company’s equity earnings recorded in theaccompanying income statements totaled $201,000, $259,000 and $483,000 for theyears ended January 31, 2007, 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. Revenuerelative to each task and from contracts which are time and materials based isrecorded as effort is expended. Billings in excess of amounts earned aredeferred. Any anticipated losses on contracts are charged to income whenidentified. To the extent management does not accurately forecast the level ofeffort required to complete 

37

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**NATIONAL TECHNICAL SYSTEMS, INC.** AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued) January 31, 2007, 2006 and 2005

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

acontract, or individual tasks within a contract, and the Company is unable tonegotiate additional billings with a customer for cost over-runs, the Companymay incur losses on individual contracts. All selling, general andadministrative costs are treated as period costs and expensed as incurred.

Reimbursements made to theCompany by customers under contract provisions, including those related totravel and other out-of-pocket expenses are recorded as revenues. An equivalentamount of reimbursable expenses is recorded as cost of sales.

*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. The Company has listed approximately 120acres of its Santa Clarita, California land for sale, but because it does notmeet all the criteria for accounting classification as an “asset held for sale”,it was not classified as such in the accompanying consolidated financialstatements.

*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) |

 

38

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**NATIONAL TECHNICAL SYSTEMS, INC.** AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued) January 31, 2007, 2006 and 2005

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

*Intangible Assets*

TheCompany accounts for goodwill and other intangible assets in accordance withStatement of Financial Accounting Standards (“SFAS”) No. 141 “BusinessCombinations” and SFAS No. 142 “Goodwill and Other Intangible Assets.”

| ** **                                      | ** ** | **January 31, 2007** | ** ** | **January 31, 2006** | ** ** |
|-------------------------------------------------|------------|--------------------------------|------------|--------------------------------|------------|
| ** **                                      | ** ** | **Gross  Carrying  Amount**    | ** ** | **Accum.  Amort.**             | ** ** | **Net  Carrying  Amount** | ** ** | **Estimated   Useful  Life** | ** ** | **Gross  Carrying  Amount** | ** ** | **Accum.  Amort.** | ** ** | **Net  Carrying  Amount** | ** ** | **Estimated  Useful  Life** | ** ** |
| Intangible assets subject  to amortization:     |       |                           |       |                           |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Covenants not to compete                        |       |                           | $          | 299,000                        |       |   | $ | 135,000 |   | $ | 164,000 |   |   | 3-5  years |   |   |   | $ | 148,000 |   |   | $ | 110,000 |   | $ | 38,000 |   |   | 3-5  years |   |   |
| Customer relationships                          |       |                           | 105,000    |                           |       | 15,000 |   | 90,000 |   |   | 3  years |   |   |   | — |   |   | — |   | — |   |   |   |   |   |
| Total                                           |       |                           | $          | 404,000                        |       |   | $ | 150,000 |   | $ | 254,000 |   |   |   |   |   |   | $ | 148,000 |   |   | $ | 110,000 |   | $ | 38,000 |   |   |   |   |   |
| Intangible assets not  subject to amortization: |       |                           |       |                           |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Goodwill                                        |       |                           |       |                           |       |   |   | $ | 4,126,000 |   |   |   |   |   |   |   |   |   |   |   | $ | 2,740,000 |   |   |   |   |   |

 

Amortization expense for intangible assets subject toamortization was $40,000 and $32,000 for the twelve months endedJanuary 31,  2007 and 2006,respectively. 

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 five reportingunits in the Engineering and Evaluation segment and one reporting unit in theTechnical Solutions segment, which constitute components of its business thatinclude goodwill. The Company completed its annual goodwill impairment test andhas determined that the fair value of each of the reporting units exceeded thereporting unit’s carrying amount, and no impairment was indicated.

*Long-lived Assets*

In accordance with SFAS No. 144,“Accounting for the Impairment or Disposal of Long-Lived Assets”, the Companyperiodically evaluates the recoverability of the carrying amount of long-livedassets (including property, plant and equipment, and intangible assets withdeterminable lives) whenever events or changes in circumstances indicate 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 lossis recorded when the undiscounted expected future cash flows derived from anasset are 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.

39

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**NATIONAL TECHNICAL SYSTEMS, INC.** AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued) January 31, 2007, 2006 and 2005

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

*Share-BasedCompensation*

Effective February 1, 2006, the Company adoptedthe provisions of SFAS No. 123(R). SFAS No. 123(R) requiresemployee stock options and rights to purchase shares under stock participationplans to be accounted for under the fair value method and requires the use ofan option pricing model for estimating fair value. Accordingly, share-basedcompensation is measured at grant date, based on the fair value of the award.The Company previously accounted for awards granted under its equity incentiveplans under the intrinsic value method prescribed by Accounting PrinciplesBoard (APB) Opinion No. 25, “Accounting for Stock Issued toEmployees,” and related interpretations, and provided the required pro formadisclosures prescribed by SFAS No. 123, “Accounting for Stock-BasedCompensation,” as amended. The exercise price of options is equal to the marketprice of National Technical Systems, Inc. common stock (defined as theclosing price reported by the NASDAQ stock market) on the date of grant.Accordingly, no share-based compensation, other than acquisition-relatedcompensation, was recognized in the financial statements prior to January 31,2006.

The Company used the modified prospective method ofadoption for SFAS No. 123(R), under which the compensation cost recognizedby the Company beginning in fiscal 2007 includes (a) compensation cost forall equity incentive awards granted prior to, but not yet vested as of February 1,2006, based on the grant date fair value estimated in accordance with theoriginal provisions of SFAS No. 123, and (b) compensation cost forall equity incentive awards granted subsequent to February 1, 2006, basedon the grant-date fair value estimated in accordance with the provisions ofSFAS No. 123(R). The Company uses the straight-line attribution method torecognize share-based compensation costs over the service period of the award.Upon exercise, cancellation, or expiration of non qualified stock options, deferredtax assets for options with multiple vesting dates are eliminated for eachvesting period on a first-in, first-out basis as if each vesting period was aseparate award. To calculate the excess tax benefits available for use inoffsetting future tax shortfalls as of the date of implementation, the Companyfollowed the alternative transition method discussed in FASB Staff Position No. 123(R)-3.

No options have been granted by the Company duringfiscal year 2007. Options to be granted to existing and newly hired employeesor directors will generally vest over a four-year period from the date of grant.The Company may also assume the equity incentive plans and the outstandingequity awards of certain acquired companies. Once assumed, the Company does notgrant additional stock under these plans. The Company may use other types ofequity incentive awards, such as restricted stock. The Company’s equityincentive plan also allows for performance-based vesting for equity incentiveawards.

Share-based compensation recognized in fiscal year2007 as a result of the adoption of SFAS No. 123(R) as well as proforma disclosures according to the original provisions of SFAS No. 123 forperiods prior to the adoption of SFAS No. 123(R) is based on theBlack-Scholes-Merton option pricing model for estimating fair value of optionsgranted under the Company’s equity incentive plans and rights to acquire stockgranted under the Company’s stock participation plan.

40

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**NATIONAL TECHNICAL SYSTEMS, INC.** AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued) January 31, 2007, 2006 and 2005

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

The followingtable summarizes the effects of share-based compensation resulting from theapplication of SFAS No. 123(R) for the year ended January 31,2007:

| ** **                                                               | ** ** | **Twelve Months Ended** | ** ** |
|--------------------------------------------------------------------------|------------|-----------------------------------|------------|
| ** **                                                               | ** ** | **January 31, 2007**    | ** ** |
| Cost of sales                                                            |       |                              | $          | 135,000 |   |   |
| Selling, general  and administrative expense                             |       |                              | 434,000    |   |   |
| Share-based  compensation effect on income before taxes                  |       |                              | 569,000    |   |   |
| Income taxes                                                             |       |                              | (20,000    | ) |   |
| Net share-based  compensation effects in net income                      |       |                              | $          | 549,000 |   |   |
| Share-based  compensation effects on basic earnings per common share     |       |                              | $          | 0.06 |   |   |
| Share-based  compensation effects on diluted earnings per common share   |       |                              | $          | 0.06 |   |   |
| Share-based  compensation effects on cash flow from operations           |       |                              | $          | — |   |   |
| Share-based  compensation effects on cash flow from financing activities |       |                              | $          | — |   |   |
| Weighted average  common shares outstanding                              |       |                              | 8,705,000  |   |   |
| Dilutive effect  of stock options                                        |       |                              | 800,000    |   |   |
| Weighted average  common shares outstanding assuming dilution            |       |                              | 9,505,000  |   |   |
| Stock-based  compensation expense by type of award:                      |       |                              |       |   |   |
| Stock options                                                            |       |                              | 537,000    |   |   |
| Non-vested shares                                                        |       |                              | 32,000     |   |   |
|                                                                     |       |                              | 569,000    |   |   |

 

In accordance with SFAS No. 123(R), the Companyadjusts share-based compensation on a quarterly basis for changes to theestimate of expected equity award forfeitures based on actual forfeiture experience.The effect of adjusting the forfeiture rate for all expense amortization after February 1,2006 is recognized in the period the forfeiture estimate is changed. The effectof forfeiture adjustments for fiscal year 2007 was immaterial.

Under the provisions of SFAS No. 123(R), $851,000has been recorded as a credit to common stock. During fiscal year 2007, the taxbenefit realized for the tax deduction from option exercises totaled $282,000.As of February 1, 2007, there was $359,000 of total unrecognizedcompensation costs related to stock options granted under the Company’s equityincentive plans. The unrecognized compensation cost is expected to berecognized over a weighted average period of three years.

41

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**NATIONAL TECHNICAL SYSTEMS, INC.** AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued) January 31, 2007, 2006 and 2005

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

Thefair value of each option grant is estimated on the date of grant using theBlack-Scholes-Merton option pricing model with the following assumptions:

| ** **                | ** ** | **2007** | ** ** | **2006** | ** ** | **2005** | ** ** |
|---------------------------|------------|----------|------------|----------|------------|----------|------------|
| Expected life (in  years) |       | N/A      |       | 7.48     |       | 7.68     |       |
| Risk-free  interest rate  |       | N/A      |       | 4.47     | %          | 3.71     | %          |
| Expected  volatility      |       | N/A      |       | 70       | %          | 76       | %          |
| Expected dividend yield   |       | N/A      |       | 0        |       | 0        |       |

 

There were no stock option grants in fiscal year 2007.

If thefair value based method under SFAS 123 had been applied in measuringstock-based compensation expense, the pro forma effect on net income and netincome per share for the years ended January 31, 2006 and 2005 would havebeen as follows:

| ** **                                              | ** ** | **January 31, 2006** | ** ** | **January 31, 2005** | ** ** |
|---------------------------------------------------------|------------|--------------------------------|------------|--------------------------------|------------|
| Net income                                              |       |                           |       |                           |       |   |   |   |   |
| As reported                                             |       |                           | $          | 2,939,000                      |       |   |   | $ | 1,682,000 |   |   |
| Stock compensation expense, under SFAS 123, net of  tax |       |                           | (377,000   | )                              |       |   | (527,000 | ) |   |
| Pro forma                                               |       |                           | $          | 2,562,000                      |       |   |   | $ | 1,155,000 |   |   |
| Basic earnings per  common share                        |       |                           |       |                           |       |   |   |   |   |
| As reported                                             |       |                           | $          | 0.32                           |       |   |   | $ | 0.19 |   |   |
| Pro forma                                               |       |                           | $          | 0.28                           |       |   |   | $ | 0.13 |   |   |
| Diluted earnings per  common share                      |       |                           |       |                           |       |   |   |   |   |
| As reported                                             |       |                           | $          | 0.30                           |       |   |   | $ | 0.18 |   |   |
| Pro forma                                               |       |                           | $          | 0.27                           |       |   |   | $ | 0.12 |   |   |

 

*Accounting forIncome Taxes*

Income taxes are accountedfor under the liability method. Deferred income taxes are recognized for thefuture tax consequences attributable to temporary differences between thefinancial statement carrying amounts of existing assets and liabilities andtheir respective tax bases and operating loss and tax credit carry forwards.Deferred tax assets and liabilities are measured using enacted tax ratesexpected to apply to taxable income in the years in which those temporarydifferences are expected to be recovered or settled. The effect on deferred taxassets and liabilities of a change in tax rates is recognized in income in theperiod that includes the enactment date. A valuation allowance is recorded, ifnecessary, to reduce deferred tax assets to an amount management believes ismore likely than not to be realized.

*ComprehensiveIncome*

In accordance with SFAS No. 130, “ReportingComprehensive Income”, the Company is required to report and display thecomponents of comprehensive income including unrealized gains or losses on 

42

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**NATIONAL TECHNICAL SYSTEMS, INC.** AND SUBSIDIARIES Notes to Consolidated Financial Statements (Continued) January 31, 2007, 2006 and 2005

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

foreigncurrency translation adjustments. The effect of the foreign currencytranslation was $65,000 loss, $48,000 gain, and $13,000 gain for fiscal years2007, 2006 and 2005, respectively. Accumulated other comprehensive loss was$55,000 and accumulated other comprehensive income was $10,000 as of January 31,2007 and 2006, respectively, due to foreign currency translation adjustments.

*Earnings Per Share*

Basic and diluted net income per common share ispresented in conformity with SFAS No. 128, “Earnings Per Share” for allperiods presented. In accordance with SFAS No. 128, basic earnings pershare has been computed using the weighted average number of shares of commonstock outstanding during the year. Basic earnings per share excludes anydilutive effects of options, warrants and convertible securities and non-vestedrestricted shares. Diluted earnings per share excludes any non-vestedrestricted shares with an anti-dilutive effect.

*Foreign Currency Translation*

The accounts of theforeign divisions are translated into United States dollars in accordance withSFAS No. 52, “Foreign Currency Translation”. All balance sheet accounts,except for certain fixed assets accounts, have been translated using thecurrent rate of exchange at the balance sheet date. Results of operations havebeen 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 $65,000 inunrealized loss, $48,000 in unrealized gain and $13,000 in unrealized gain infiscal years 2007, 2006 and 2005, respectively.

*Related Party Transactions*

NTS provides managementand consulting services to NQA, Inc. for an agreed upon management fee.Such services include, but are not limited to, advice and assistance concerningany and all aspects of the operations of the Company. Management fees earned bythe Company for fiscal 2007, 2006 and 2005 were $475,000, $376,000 and$214,000, respectively.

NQA, Ltd., the minorityshareholder of NQA, Inc., provides certification oversight and advice andprocesses and issues ISO registration certificates. NQA, Ltd. chargesNQA, Inc. an agreed upon fee for each certificate in place at thebeginning of the year and issued during the year together with the appropriateUnited Kingdom Accreditation Service (“UKAS”) and Raad voor Accreditatie(“RVA”) levy. Certification fees for fiscal 2007, 2006 and 2005 were $475,000,$376,000 and $214,000, respectively.

NQA, Inc. leasesspace from NTS and was assessed $71,000 for rent and utilities in fiscal years2007, 2006 and 2005.

*Reclassifications*

Certain amounts in the prior year financial statementshave been reclassified to conform to the current year financial statementpresentation.

43

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**NATIONAL TECHNICAL SYSTEMS, INC.** AND SUBSIDIARIESNotes to Consolidated Financial Statements (Continued) January 31, 2007, 2006 and 2005

**(1)**   Summaryof Significant Accounting Policies (Continued)

*Recently Issued Accounting Standards*

In May 2005, the FASBissued SFAS No. 154, “Accounting Changes and Error Corrections.” SFAS No. 154replaces APB Opinion No. 20, “Accounting Changes,” and SFAS No. 3, “ReportingAccounting Changes in Interim Financial Statements,” and is effective forfiscal years beginning after December 15, 2005, i.e. fiscal year ending January 31,2007. SFAS No. 154 requires retrospective application to prior periods’financial statements of changes in accounting principle, unless it isimpracticable to determine either the period-specific effects or the cumulativeeffect of the change. The adoption of SFAS No. 154 did not have a materialimpact on the Company’s condensed consolidated financial statements.

In June 2006, theFinancial Accounting Standards Board issued Interpretation No. 48, “Accountingfor Uncertainty in Income Taxes”, an interpretation of FAS109, Accounting forIncome Taxes (FIN 48), to create a single model to address accounting foruncertainty in tax positions. FIN 48 clarifies the accounting for income taxes,by prescribing a minimum recognition threshold a tax position is required tomeet before being recognized in the financial statements. FIN 48 also providesguidance on derecognition, measurement, classification, interest and penalties,accounting in interim periods, disclosure and transition. FIN 48 is effectivefor fiscal years beginning after December 15, 2006. The Company will adoptFIN 48 effective February 1, 2007, as required. The cumulative effect ofadopting FIN 48, if any, will be recorded in retained earnings and otheraccounts as applicable. The Company does not expect that the adoption of FIN 48will have a material impact on the Company’s financial position, cash flows, orresults of operations.

In September 2006, the FASB issued SFAS No. 157,“Fair Value Measurements” (“SFAS 157”), which clarifies the definition of fairvalue, establishes guidelines for measuring fair value, and expands disclosuresregarding fair value measurements. SFAS 157 does not require any new fair valuemeasurements and eliminates inconsistencies in guidance found in various prioraccounting pronouncements. SFAS 157 will be effective for the Company on February 1,2008. The Company is evaluating the impact of adopting SFAS 157 on itsfinancial position, cash flows, and results of operations.

In September 2006,the Securities and Exchange Commission (“SEC”) released Staff AccountingBulletin No. 108, “Considering the Effects of Prior YearMisstatements when Quantifying Misstatements in Current Year FinancialStatements” (“SAB 108”). SAB 108 provides interpretive guidance on the SEC’sviews on how the effects of the carryover or reversal of prior yearmisstatements should be considered in quantifying a current year misstatement.The Company adopted the provisions of SAB 108 during the year ended January 31,2007, and, as a result, corrected one prior period misstatement that related toan understatement of deferred tax liabilities for accumulated depreciation inthe amount of $354,000. The misstatement was detected upon the implementationof a new property accounting system, and accumulated during years ended January 31,1990 and prior. This correction was accounted for as a cumulative effectadjustment under the transition provisions of SAB 108, whereby the offsettingentry is recorded against beginning retained earnings in the year of adoption.

44

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**NATIONAL TECHNICAL SYSTEMS, INC.** AND SUBSIDIARIESNotes to Consolidated Financial Statements (Continued) January 31, 2007, 2006 and 2005

**(2)   BusinessAcquisitions**

*Acquisition of Dynamic Labs*

On August 1, 2006,the Company acquired the assets and the existing business of Dynamic Labs, anElectromagnetic Interference (EMI) and environmental testing laboratory withlocations in Phoenix, Arizona and Austin, Texas for a total purchase price of$2,254,000, paid in cash. The Phoenix laboratory provided EMI, environmentaland dynamics testing for the aerospace and defense industries. The Austinfacility also provided aerospace, environmental, and dynamic testing. Themajority of the machinery and equipment at the Phoenix facility was relocatedto the NTS Tempe, Arizona laboratory with the rest of the equipment distributedto other NTS facilities. All of the machinery and equipment at the Austinfacility were  relocated to other NTSfacilities. The results of operations for Dynamic Labs are included in theCompany’s consolidated statement of income from August 1, 2006 to January 31,2007.

Thepreliminary allocation of the purchase price of Dynamic Labs is as follows:

| **Purchase price:**       | ** ** | ** ** | ** ** | ** ** | ** ** |
|--------------------------------|------------|------------|------------|------------|------------|
| Property, plant  and equipment |       | $          | 2,004,000  |       |
| Goodwill                       |       | 100,000    |       |
| Covenant not to  compete       |       | 150,000    |       |
| Purchase price                 |       | $          | 2,254,000  |       |

 

*Acquisition of B&B Technologies, Inc.*

On June 9, 2006, NTS Technical Systems, a whollyowned subsidiary of NTS, acquired the assets and the existing business of B &B Technologies, Inc. (“BBT”), a systems integration firm headquartered inAlbuquerque, New Mexico, for a total purchase price of $1,065,000, payable incash and 83,243 shares of NTS common stock, valued using the closing price ofthe Company’s stock. BBT designs and integrates test, measurement, automation,data acquisition and control systems utilizing diverse hardware platforms,operating systems, and instrumentation standards. The results of operations ofthe acquired business are included in the accompanying consolidated statementof income from June 9, 2006 to January 31, 2007.

Thepreliminary allocation of the purchase price of BBT is as follows:

| **Purchase price:**       | ** ** | ** ** | ** ** | ** ** | ** ** |
|--------------------------------|------------|------------|------------|------------|------------|
| Cash                           |       | $          | 3,000      |       |
| Accounts  receivable           |       | 248,000    |       |
| Inventory                      |       | 35,000     |       |
| Property, plant and  equipment |       | 108,000    |       |
| Prepaid expenses               |       | 33,000     |       |
| Goodwill                       |       | 1,004,000  |       |
| Accounts payable               |       | (232,000   | )          |
| Other assumed  liabilities     |       | (134,000   | )          |
| Purchase price                 |       | $          | 1,065,000  |       |

 

45

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**NATIONAL TECHNICAL SYSTEMS, INC.** AND SUBSIDIARIESNotes to Consolidated Financial Statements (Continued) January 31, 2007, 2006 and 2005

**(2)**   Business Acquisitions (Continued)

| **Other  purchase price information:** | ** ** | ** ** | ** ** | ** ** | ** ** |
|----------------------------------------|------------|------------|------------|------------|------------|
| Purchase price                         |       | $          | 1,065,000  |       |
| Common stock  issued                   |       | (648,000   | )          |
| Cash acquired                          |       | (3,000     | )          |
| Cash paid                              |       | (414,000   | )          |
|                                        |            |            |            |            |            |  |

 

*Acquisition ofAmerican International Registrars*

On April 12, 2006,NQA, USA, a 50% owned consolidated subsidiary of NTS, acquired the existingbusiness of American International Registrars Corporation (“AIR”), located inVentura, California, for a total purchase price of $386,000, payable in cash.All existing AIR customers and associated certifications and backlog weretransferred to NQA, USA. The purchase was recorded as $105,000 to customerrelationships and $281,000 to goodwill. The results of operations for AmericanInternational Registrars are included in the Company’s consolidated statementof income from April 12, 2006 to January 31, 2007.

**(3)   Debt**

Long-termdebt consists of the following:

| ** **                                            | ** ** | **2007**   | ** ** | **2006**   | ** ** |
|-------------------------------------------------------|------------|------------|------------|------------|------------|
| Revolving lines  of credit (a)                   |       | $          | 8,843,000  |       | $          | 8,500,000 |   |
| Notes payable  secured by land and buildings (b) |       | 2,415,000  |       | 2,602,000  |       |
| Secured notes  payable (c)                       |       | 11,265,000 |       | 6,006,000  |       |
| Subtotal                                              |       | 22,523,000 |       | 17,108,000 |       |
| Less current  installments                            |       | 3,285,000  |       | 1,529,000  |       |
| Total                                                 |       | $          | 19,238,000 |       | $          | 15,579,000 |   |

----

(a)           The Company has a$16,500,000 revolving line of credit under its credit agreement with ComericaBank California and First Bank. Comerica Bank California, as the agent, holds60% of the line with First Bank, as the participant, holding 40% of the line.The interest rate is at the agent’s prime rate, with an option for the Companyto convert to loans at the Libor rate plus 250 basis points for 30, 60, 90, 180or 365 days, with minimum advances of $1,000,000. The outstanding balance onthe revolvingline of credit at January 31, 2007 was $8,843,000. This balance isreflected in the accompanying condensed consolidated balance sheets as long-term.The amount available on the line of credit was $7,657,000 as of January 31,2007. This agreement is subject to certain covenants, which require themaintenance of certain working capital, debt-to-equity, earnings-to-expense andcash flow ratios. The Company requested and received waivers for two covenantsfrom its banks to remain compliant with the bank covenants as of January 31,2007.

(b)          Theamount of $2,415,000 represents mortgage notes on land and buildings owned bythe Company in California and Massachusetts. The notes carry fixed interestrates ranging from 5.5% to 9.0% and they are collateralized by thoseproperties.

(c)           On July 1, 2005, theCompany amended its credit agreement to include a $2,500,000 term loan to berepaid in 60 equal monthly payments. The proceeds were used to pay down theline of credit. The 

46

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**NATIONAL TECHNICAL SYSTEMS, INC.** AND SUBSIDIARIESNotes to Consolidated Financial Statements (Continued) January 31, 2007, 2006 and 2005

**(3)**   Debt (Continued)

amendment alsoincluded an additional equipment line of credit for $2,000,000. On March 29,2006, the Company increased the term loan by an additional $3,900,000 to fundthe repurchase of 792,266 shares of common stock from a former executiveofficer and director. On September 21, 2006, the agreement was amended again toinclude an additional equipment line of credit of $2,000,000 and an additional$2,000,000 in term loan, to be repaid in 48 equal monthly payments, to fund thepurchase of Dynamic Labs. The aggregate outstanding balance on the term loansat January 31, 2007 was $6,587,000. The aggregate outstanding balance on theequipment line of credit at January 31, 2007 was $3,441,000. The Company hasadditional equipment line of credit agreements (at interest rates of 5.56% to7.47%) to finance various test equipment with terms of 60 months for eachequipment schedule. The outstanding balance at January 31, 2007 was $1,237,000.

Maturitiesof long-term debt for five years subsequent to January 31, 2007 are asfollows:

| 2008       |   | $          | 3,285,000  |   |
|------------|--------|------------|------------|--------|
| 2009       |   | 12,446,000 |       |
| 2010       |   | 3,443,000  |       |
| 2011       |   | 1,512,000  |       |
| 2012       |   | 445,000    |       |
| Thereafter |   | 1,392,000  |       |
|       |   | $          | 22,523,000 |   |

 

In accordance with therequirements of SFAS No. 107, “Disclosure about Fair Value of FinancialInstruments”, a reasonable estimate of fair value for the Company’s fixed ratedebt was based on a discounted cash flow analysis. The carrying amount ofvariable rate debt, including borrowings under the Company’s revolving lines ofcredit, approximate their fair values.

The carrying amounts andestimated fair values of the Company’s financial instruments are:

| ** **                 | ** ** | **2007  Carrying  amount** | ** ** | **2007  Estimated  fair value** | ** ** | **2006  Carrying  amount** | ** ** | **2006  Estimated  fair value** | ** ** |
|----------------------------|------------|----------------------------|------------|--------------------------------------|------------|----------------------------|------------|--------------------------------------|------------|
| Notes payable              |       | $                          | 2,415,000  |                                 | $          | 2,451,000                  |       | $                                    | 2,602,000  |   | $ | 2,730,000 |   |
| Secured notes  payable     |       | 11,265,000                 |       | 8,359,000                            |       | 6,006,000                  |       | 5,300,000                            |       |
| Revolving lines of  credit |       | 8,843,000                  |       | 8,843,000                            |       | 8,500,000                  |       | 8,500,000                            |       |
|                            |            |                            |            |                                      |            |                            |            |                                      |            |  |  |  |  |

 

47

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**NATIONAL TECHNICAL SYSTEMS, INC.** AND SUBSIDIARIESNotes to Consolidated Financial Statements (Continued) January 31, 2007, 2006 and 2005

**(4)**   IncomeTaxes

Pre-tax profit generated from foreign operations was$658,000, $259,000 and $522,000 in fiscal 2007, 2006 and 2005, respectively. Theearnings associated with the Company’s foreign subsidiary in Japan areconsidered to be permanently re-invested and are reported net of tax and areincluded in operating income. Accumulated foreign earnings were $1,220,000 asof January 31, 2007.

Theprovision (benefit) for income taxes from continuing operations consists of:

| ** **         | ** ** | **2007**  | ** ** | **2006**  | ** ** | **2005**  | ** ** |
|--------------------|------------|-----------|------------|-----------|------------|-----------|------------|
| Current:           |       |      |       |      |       |      |       |
| Federal            |       | $         | 1,244,000  |      | $          | 1,911,000 |       | $ | 358,000 |   |
| State              |       | 264,000   |       | 379,000   |       | 137,000   |       |
| Foreign            |       | 120,000   |       | (2,000    | )          | 14,000    |       |
|               |       | 1,628,000 |       | 2,288,000 |       | 509,000   |       |
| Deferred:          |       |      |       |      |       |      |       |
| Federal            |       | (292,000  | )          | (323,000  | )          | 187,000   |       |
| State              |       | (27,000   | )          | 1,000     |       | 214,000   |       |
|               |       | (319,000  | )          | (322,000  | )          | 401,000   |       |
| Income tax expense |       | $         | 1,309,000  |      | $          | 1,966,000 |       | $ | 910,000 |   |

 

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:

| ** **                                                 | ** ** | **2007** | ** ** | **2006** | ** ** | **2005**  | ** ** |
|------------------------------------------------------------|------------|----------|------------|----------|------------|-----------|------------|
| Income before  income taxes and minority interest          |       | $        | 2,978,000  |     | $          | 4,955,000 |       | $ | 2,592,000 |   |
| Federal income  tax computed at statutory rate             |       | $        | 1,010,000  |     | $          | 1,685,000 |       | $ | 881,000 |   |
| State income  taxes, net of federal benefits               |       | 153,000  |       | 252,000  |       | 89,000    |       |
| Equity income net  of tax in a non consolidated subsidiary |       | (224,000 | )          | (104,000 | )          | (164,000  | )          |
| Foreign tax                                                |       | 120,000  |       | (2,000   | )          | 14,000    |       |
| Other,  principally non-deductible expenses                |       | 250,000  |       | 135,000  |       | 90,000    |       |
| Income tax expense                                         |       | $        | 1,309,000  |     | $          | 1,966,000 |       | $ | 910,000 |   |

 

48

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**NATIONAL TECHNICAL SYSTEMS, INC.** AND SUBSIDIARIESNotes to Consolidated Financial Statements (Continued) January 31, 2007, 2006 and 2005

**(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 $524,000 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 $524,000 will expire in 2025. The primary components of the Company’sdeferred tax assets and liabilities at January 31 were as follows:

| ** **                              | ** ** | **2007**    | ** ** | **2006**        | ** ** |
|-----------------------------------------|------------|-------------|------------|-----------------|------------|
| ** **                              | ** ** | **Current** | ** ** | **Non-current** | ** ** | **Current** | ** ** | **Non-current** | ** ** |
| **Deferred tax assets:**                |       |        |       |            |       |   |   |   |   |
| Allowance for  doubtful accounts        |       | $           | 240,000    |            | $          | — |   | $ | 340,000 |   | $ | — |   |
| Vacation accrual                        |       | 567,000     |       | —          |       | 476,000 |   | — |   |
| State taxes                             |       | 264,000     |       | —          |       | 314,000 |   | — |   |
| Deferred  compensation                  |       | 407,000     |       | —          |       | 402,000 |   | — |   |
| Net operating  loss                     |       | 199,000     |       | —          |       | 215,000 |   | — |   |
| Other                                   |       | 13,000      |       | —          |       | — |   | — |   |
| Total deferred  tax assets              |       | 1,690,000   |       | —          |       | 1,747,000 |   | — |   |
| **Deferred  tax liabilities:**          |       |        |       |            |       |   |   |   |   |
| Goodwill                                |       | —      |       | (280,000        | )          | — |   | (195,000 | ) |
| Installment gain  deferral              |       | —      |       | (13,000         | )          | — |   | (24,000 | ) |
| Tax over book  depreciation             |       | —      |       | (4,759,000      | )          | — |   | (4,865,000 | ) |
| Total deferred tax  liabilties          |       | —      |       | (5,052,000      | )          | — |   | (5,084,000 | ) |
| **Net deferred tax asset  (liability)** |       | $           | 1,690,000  |            | $          | (5,052,000 | ) | $ | 1,747,000 |   | $ | (5,084,000 | ) |

 

**(5)   Stock Options,Equity Incentive and 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 2007 there were no sharesgranted under the 2002 stock option plan. At January 31, 2007 there were1,070,517 shares authorized and granted under the 1994 stock option plan andthere were no shares reserved for future grants.

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**NATIONAL TECHNICAL SYSTEMS, INC.** AND SUBSIDIARIESNotes to Consolidated Financial Statements (Continued) January 31, 2007, 2006 and 2005

**(5)**   Stock Options, Equity Incentive 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. A summary of option activity underthe Plan as of January 31, 2007, and changes during the year then ended ispresented below:

| ** **                       | ** ** | **Shares** | ** ** | **Weighted Avg.  Exercise Price** | ** ** | **Weighted Avg.  Remaining Contract  Life in years** | ** ** | **Aggregate  Intrinsic Value** | ** ** |
|----------------------------------|------------|------------|------------|---------------------------------------------|------------|--------------------------------------------------------------------------|------------|-------------------------------------|------------|
| Outstanding at  February 1, 2006 |       | 2,167,445  |       |                                        | $          | 3.78                                                                     |       |                                |       |   |   |   |   |   |   |   |
| Granted                          |       | —     |       |                                        | —     |                                                                     |       |                                |       |   |   |   |   |   |   |
| Exercised                        |       | (280,028   | )          |                                        | 3.00       |                                                                     |       |                                |       |   |   |   |   |   |   |
| Canceled or  expired             |       | (25,575    | )          |                                        | 3.68       |                                                                     |       |                                |       |   |   |   |   |   |   |
| Outstanding at  January 31, 2007 |       | 1,861,842  |       |                                        | $          | 3.90                                                                     |       |                                |       | 4.74 |   |   |   | $ | 3,960,000 |   |   |
| Exercisable at January  31, 2007 |       | 1,556,479  |       |                                        | $          | 3.75                                                                     |       |                                |       | 4.14 |   |   |   | $ | 3,571,000 |   |   |

 

The aggregate intrinsic value in the table aboverepresents the total pre-tax intrinsic value (the aggregate difference betweenthe closing stock price of the Company’s common stock on January 31, 2007 andthe exercise price for in-the-money options) that would have been received bythe option holders if all in-the-money options had been exercised on January31, 2007.

The total intrinsic value of options exercised duringthe years ended January 31, 2007, 2006 and 2005, was $1,051,000, $346,000 and$421,000, respectively.

The range of exercise prices for options outstandingat January 31, 2007 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.

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**NATIONAL TECHNICAL SYSTEMS, INC.** AND SUBSIDIARIESNotes to Consolidated Financial Statements (Continued) January 31, 2007, 2006 and 2005

**(5)**   Stock Options, Equity Incentive and Pension Plans (Continued)

The following tablessummarize information about options outstanding at January 31, 2007.

| **Range of  exercise prices** | ** ** | **Outstanding at  January 31,  2007** | ** ** | **Weighted Avg.  Remaining  contract life  in yrs.** | ** ** | **Weighted Avg.  Exercise  Price** | ** ** | **Number  Exercisable** | ** ** | **Weighted Avg.  Exercisable  Price** | ** ** |
|-----------------------------------------|------------|-------------------------------------------------|------------|---------------------------------------------------------------------|------------|-----------------------------------------|------------|-------------------------|------------|--------------------------------------------|------------|
| $1.00 to $2.00                          |       |                                            | 123,250    |                                                                |       |                                    | 4.8        |                    |       |                                       | $          | 1.61 |   |   | 123,250 |   |   | $ | 1.61 |   |   |
| $2.01 to $3.00                          |       |                                            | 507,338    |                                                                |       |                                    | 4.3        |                    |       |                                       | $          | 2.58 |   |   | 507,338 |   |   | $ | 2.58 |   |   |
| $3.01 to $4.00                          |       |                                            | 199,706    |                                                                |       |                                    | 3.0        |                    |       |                                       | $          | 3.31 |   |   | 199,206 |   |   | $ | 3.31 |   |   |
| $4.01 to $5.00                          |       |                                            | 652,825    |                                                                |       |                                    | 6.8        |                    |       |                                       | $          | 4.61 |   |   | 377,462 |   |   | $ | 4.61 |   |   |
| $5.01 to $6.00                          |       |                                            | 344,306    |                                                                |       |                                    | 2.6        |                    |       |                                       | $          | 5.42 |   |   | 314,806 |   |   | $ | 5.44 |   |   |
| $6.01 to $7.00                          |       |                                            | 34,417     |                                                                |       |                                    | 1.6        |                    |       |                                       | $          | 6.36 |   |   | 34,417 |   |   | $ | 6.36 |   |   |
|                                    |       |                                            | 1,861,842  |                                                                |       |                                    |       |                    |       |                                       |       |   |   | 1,556,479 |   |   |   |   |   |

 

These options will expire if not exercised at specificdates ranging from September 2007 to December 2015. During the year ended January31, 2007, 280,028 options were exercised at prices from $1.35 to $5.50 pershare.

The Company presented a new equity incentive plan forshareholder vote at its June 29, 2006 annual shareholders’ meeting and itwas approved by the shareholders. This new 2006 equity incentive plan replacedthe 2002 stock option plan, which was terminated early and no further optionswill be granted under it. Additionally, 143,050 shares that were reservedfor future grants, were cancelled. Initially, a total of 300,000 new shares ofcommon stock were reserved for issuance under the new 2006 equity incentiveplan. As of January 31, 2007, 43,270 shares of the Company’s common stockhad been issued under the 2006 Equity Incentive Plan (“EIP”) and 256,730 shareswere reserved for future issuance under the plan. Shares are issued under theEIP as compensation to certain employee and non-employee directors of theCompany.

The Company’s non-vested shares have a vesting periodof four years. Compensation expense, representing the fair market value of theshares at the date of grant, net of assumptions regarding estimated futureforfeitures, is charged to earnings over the vesting period. Compensationexpense included in general and administrative expenses in the Company’sconsolidated statement of income, relating to these grants was $32,000 forfiscal year 2007.

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**NATIONAL TECHNICAL SYSTEMS, INC.** AND SUBSIDIARIESNotes to Consolidated Financial Statements (Continued) January 31, 2007, 2006 and 2005

**(5)**   StockOptions, Equity Incentive and Pension Plans (Continued)

Thefollowing table summarizes the non-vested shares transactions for fiscal year2007:

| ** **                            | ** ** | **Number of  Shares** | ** ** | **Weighted-Average  Grant Date  FairValue** | ** ** |
|---------------------------------------|------------|----------------------------|------------|--------------------------------------------------|------------|
| Non-vested shares:                    |       |                       |       |                                             |       |   |   |   |   |
| Outstanding at  February 1, 2006 |       |                       | —     |                                             |       |   | — |   |   |
| Granted                               |       |                       | 43,270     |                                             |       |   | $ | 7.08 |   |   |
| Vested                                |       |                       | —     |                                             |       |   | — |   |   |
| Forfeited                             |       |                       | —     |                                             |       |   | — |   |   |
| Non-vested at  January 31, 2007  |       |                       | 43,270     |                                             |       |   | $ | 7.08 |   |   |

 

As of January 31, 2007, there was $274,000 oftotal unrecognized compensation cost related to the non-vested share-basedcompensation arrangements granted under the plan. That cost is expected to berecognized over a weighted-average period of 43 months.

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) plan andthe Company’s Board of Directors, at its discretion, will determine each yearthe amount of matching contribution the Company will make. Employercontributions are allocated based on participants’ own contribution percentageamount to the total amount contributed by all employees in each plan. In fiscal2007, the Company contributed $261,000 to the 401(k) profit sharing plan ascompared to $233,000 in 2006 and $239,000 in 2005.

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 $81,000,$89,000 and $93,000 for the years ended January 31, 2007, 2006 and 2005,respectively. Included in other assets is $2,425,000 and $2,228,000 for thecash surrender values as of January 31, 2007 and 2006, respectively.

**(6)   Capital Stock**

As of January 31,2007 and 2006, the Company had 20,000,000 authorized common shares with no parvalue. At January 31, 2007 and January 31, 2006, 8,717,000 shares and9,176,000 shares were issued and outstanding, respectively.

On March 28, 2006, the Company exercised anoption to repurchase 792,266 shares of its common stock from a former executiveofficer and director of the Company. The total cash purchase price of$3,893,000, or $4.914 per share, represented the average closing price of theCompany’s common stock for the five trading days prior to the option exercisedate minus 10%, in accordance with an agreement between the Company and theexecutive officer and director entered into in September 2001. The shares 

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**NATIONAL TECHNICAL SYSTEMS, INC.** AND SUBSIDIARIESNotes to Consolidated Financial Statements (Continued) January 31, 2007, 2006 and 2005

**(6)**   Capital Stock (Continued)

repurchased in thisprivate transaction represented approximately 8.6% of the Company’s outstandingcommon stock on the date of exercise.

Holders of common stock vote on matters submitted toshareholders, including the election of directors. Except as required by law,the powers, preferences and rights of all common stock and the qualifications,limitations or restrictions thereof, shall in all respects be identical. Thecommon stock shareholders will be entitled to receive, to the extent permittedby law, and to share equally and ratably, share for share, any such dividendsas may be declared from time to time by the board of directors.

**(7)   Commitments**

TheCompany leases certain of its operating facilities and equipment underoperating leases which principally expire at various dates through fiscal year2012. The leases are generally on a net-rent basis, whereby the Company paystaxes, maintenance, insurance and other operating expenses. Management expectsthat, in the normal course of business, leases that expire will be renewed orreplaced by other leases. Total rental expense was $3,383,000, $3,038,000 and$2,346,000 for the years ended January 31, 2007, 2006 and 2005,respectively.

| 2008       |   | $         | 2,456,000 |   |
|------------|--------|-----------|-----------|--------|
| 2009       |   | 1,778,000 |      |
| 2010       |   | 1,450,000 |      |
| 2011       |   | 832,000   |      |
| 2012       |   | 144,000   |      |
| Thereafter |   | —    |      |
|       |   | $         | 6,660,000 |   |

 

At January 31, 2007,minimum rental payment obligations under operating leases were as follows:

**(8)   Accrued Expenses**

A summary of accrued expenses at January 31 is asfollows:

| ** **                          | ** ** | **2007**  | ** ** | **2006**  | ** ** |
|-------------------------------------|------------|-----------|------------|-----------|------------|
| Compensation and  employee benefits |       | $         | 3,845,000  |      | $          | 4,208,000 |   |
| Other                               |       | 1,368,000 |       | 1,192,000 |       |
| Total accrued expenses              |       | $         | 5,213,000  |      | $          | 5,400,000 |   |

 

**(9)   Contingencies**

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

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**NATIONAL TECHNICAL SYSTEMS, INC.** AND SUBSIDIARIESNotes to Consolidated Financial Statements (Continued) January 31, 2007, 2006 and 2005

**(10)   Segment ofBusiness 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 andprovides technical support and technical support personnel to assist customersin a broad range of industries (aerospace, defense, telecommunications, powerproducts, transportation and computer, among others) in the solving oftechnical problems via analysis and testing of materials, components,subsystems and systems, electro-magnetic interference testing and productsafety testing under its newly granted NRTL status by the United States’Department of Labor, Occupational Safety and Health Administration. Thissegment also provides registration, certification and conformance evaluationservices to its customers, particularly with regard to EU standards. Inaddition, it performs compatibility testing of hardware and softwarecomponents. This segment also performs quality registration services byevaluating a supplier’s systems for conformity to ISO 9000, the internationalquality standard. The evaluations include an examination of the companies’quality policy, quality system documentation and quality 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 customers 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 inexcess of 10% of total segment revenues. Three major customers represented$8,765,000, $7,311,000 and $4,951,000 of fiscal 2007 Technical Solutions netrevenues as compared to three major customers representing $8,041,000,$5,812,000 and $4,793,000 of fiscal 2006 Technical Solutions net revenues. Totalrevenues from customers in foreign operations were $6,564,000 in fiscal 2007,$2,624,000 in fiscal 2006 and $840,000 in fiscal 2005.

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**NATIONAL TECHNICAL SYSTEMS, INC.** AND SUBSIDIARIESNotes to Consolidated Financial Statements (Continued) January 31, 2007, 2006 and 2005

**(10)**   Segment of BusinessInformation (Continued)

The following tableillustrates each segment’s operating income for 2007, 2006 and 2005. 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, 2007** | ** ** |
|---------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                                        | ** ** | **Engineering &  Evaluation**              | ** ** | **Technical  Solutions** | ** ** | **Corporate** | ** ** | **Total** | ** ** |
| Net revenues                                      |       |                                                | $          | 80,030,000 |   |   | $ | 35,643,000 |   | $ | — |   | $ | 115,673,000 |   |
| Gross profit                                      |       |                                                | 20,678,000 |   |   | 5,965,000 |   | — |   | 26,643,000 |   |
| Selling, general  and administrative expense      |       |                                                | 16,391,000 |   |   | 5,785,000 |   | — |   | 22,176,000 |   |
| Equity income  from non-consolidated subsidiary   |       |                                                | 201,000    |   |   | — |   | — |   | 201,000 |   |
| Operating income                                  |       |                                                | 4,488,000  |   |   | 180,000 |   | — |   | 4,668,000 |   |
| Other income (expense):                           |       |                                                |       |   |   |   |   |   |   |   |   |
| Interest expense, net                             |       |                                                | (1,677,000 | ) |   | (125,000 | ) | — |   | (1,802,000 | ) |
| Other income, net                                 |       |                                                | 18,000     |   |   | 94,000 |   | — |   | 112,000 |   |
| Income before  income taxes and minority interest |       |                                                | $          | 2,829,000 |   |   | $ | 149,000 |   | $ | — |   | $ | 2,978,000 |   |
| Assets                                            |       |                                                | $          | 61,398,000 |   |   | $ | 8,279,000 |   | $ | 5,162,000 |   | $ | 74,839,000 |   |
| Equity  investments                               |       |                                                | 1,220,000  |   |   | — |   | — |   | 1,220,000 |   |
| Expenditures for  long-lived assets               |       |                                                | 5,960,000  |   |   | 57,000 |   | 11,000 |   | 6,028,000 |   |
| Depreciation and  amortization                    |       |                                                | 5,072,000  |   |   | 548,000 |   | 202,000 |   | 5,822,000 |   |
| Goodwill                                          |       |                                                | 3,930,000  |   |   | 196,000 |   | — |   | 4,126,000 |   |

 

55

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**NATIONAL TECHNICAL SYSTEMS, INC.** AND SUBSIDIARIESNotes to Consolidated Financial Statements (Continued) January 31, 2007, 2006 and 2005

**(10)**   Segment of BusinessInformation (Continued)

| ** **                                        | ** ** | **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, net                                 |       |                                                | 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 |   |

 

| ** **                                        | ** ** | **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                            |       |                                                | (983,000   | ) |   | (108,000 | ) | — |   | (1,091,000 | ) |
| Other income, net                                 |       |                                                | 148,000    |   |   | 14,000 |   | — |   | 162,000 |   |
| Income before  income taxes and minority interest |       |                                                | $          | 2,082,000 |   |   | $ | 510,000 |   | $ | — |   | $ | 2,592,000 |   |
| Assets                                            |       |                                                | $          | 50,092,000 |   |   | $ | 10,356,000 |   | $ | 6,221,000 |   | $ | 66,669,000 |   |
| Equity  investments                               |       |                                                | 760,000    |   |   | — |   | — |   | 760,000 |   |
| Expenditures for  long-lived assets               |       |                                                | 5,470,000  |   |   | 150,000 |   | 534,000 |   | 6,154,000 |   |
| Depreciation and  amortization                    |       |                                                | 3,953,000  |   |   | 640,000 |   | 205,000 |   | 4,798,000 |   |
| Goodwill                                          |       |                                                | 2,544,000  |   |   | 196,000 |   | — |   | 2,740,000 |   |

 

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**NATIONAL TECHNICAL SYSTEMS, INC.** AND SUBSIDIARIESNotes to Consolidated Financial Statements (Continued) January 31, 2007, 2006 and 2005

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

| ** **                                                     | ** ** | **Three months ended,** | ** ** |
|----------------------------------------------------------------|------------|-----------------------------------|------------|
| **2007**                                                       | ** ** | ** **                        | ** ** | **Apr 30** | ** ** | **Jul 31** | ** ** | **Oct 31** | ** ** | **Jan 31** | ** ** |
| Net revenues                                                   |       | $                                 | 28,151,000 |   | $ | 28,438,000 |   | $ | 29,809,000 |   | $ | 29,275,000 |   |
| Gross profit                                                   |       | 6,238,000                         |       | 6,579,000 |   | 6,855,000 |   | 6,971,000 |   |
| Net income                                                     |       | 352,000                           |       | 247,000 |   | 409,000 |   | 573,000 |   |
| Earnings per common  share                                     |       |                              |       |   |   |   |   |   |   |
| Basic*                                                         |       | 0.04                              |       | 0.03 |   | 0.05 |   | 0.07 |   |
| Diluted                                                        |       | 0.04                              |       | 0.03 |   | 0.04 |   | 0.06 |   |
| Weighted average  common shares outstanding                    |       | 8,892,000                         |       | 8,544,000 |   | 8,676,000 |   | 8,707,000 |   |
| Dilutive effect  of stock options                              |       | 683,000                           |       | 899,000 |   | 819,000 |   | 759,000 |   |
| Weighted average  common shares outstanding, assuming dilution |       | 9,575,000                         |       | 9,443,000 |   | 9,495,000 |   | 9,466,000 |   |
|                                                                |            |                                   |            |  |  |  |  |  |  |  |  |  |  |  |  |

 

| ** **                                                    | ** ** | **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 |   |
|                                                               |            |                                   |            |  |  |  |  |  |  |  |  |  |  |  |  |

----

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

57

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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 have materiallyaffected, or are reasonably likely to affect, the Company’s internal controlsover financial reporting. Based on that evaluation, there has been no suchchange during the 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.

58

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**PART III**

**ITEM 10.**         *DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE.*

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 July 12,2007 are incorporated herein by reference.

***Executive Officersof the Company***
| Name             | ** ** | ** ** | ** ** | **Age**                                                                                                                 | ** ** | **Position** |
|------------------|------------|------------|------------|-------------------------------------------------------------------------------------------------------------------------|------------|--------------|
| Lloyd Blonder    |       | 67         |       | Senior Vice President and Chief Financial Officer,  Treasurer. He has  been associated with the Company since 1983.     |
| Doug Briskie     |       | 43         |       | Vice President, Corporate Development. He has been  associated withthe Company since 1987.                              |
| Aaron Cohen      |       | 70         |       | Senior Vice President. He has been associated with  the Company since 1961.                                             |
| Jack Lin         |       | 74         |       | Chairman of the Company. He has been associated with  the Company since 1961.                                           |
| Raffy Lorentzian |       | 51         |       | Vice President, Chief Accounting Officer. He has  been associated with the Company since 1997.                          |
| Cynthia Maher    |       | 48         |       | Corporate Secretary, Corporate Counsel, Human  Resources Director. She has been associated with the Company since 2005. |
| William McGinnis |       | 48         |       | President and Chief Executive Officer of the  Company. He has been associated with the Company since 1980.              |
| Dwight Moore     |       | 44         |       | Vice President,  Chief Operating Officer. 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 July 12, 2007 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 July 12, 2007 are incorporated herein by reference.

59

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**ITEM 13.**         *CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS AND DIRECTOR INDEPENDENCE.*

The section entitled “Transactionswith Management and Other” and “Nomination and Election of Directors” in theCompany’s definitive Proxy Statement to be furnished to shareholders inconnection with the Annual Meeting of Shareholders to be held on July 12,2007 is incorporated herein by reference.

**ITEM 14.**         *PRINCIPAL ACCOUNTANT 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 July 12, 2007 is incorporated herein by reference.

**PART IV**

**ITEM 15.**         *EXHIBITS AND FINANCIAL STATEMENT SCHEDULES.*

**A.*****               ConsolidatedFinancial Statements and Schedules.***

Financial statements required by Item 15 are includedin Item 8 above.

Financial Statements:

Consolidated BalanceSheets—January 31, 2007 and 2006

Consolidated Statements ofIncome—Years ended January 31, 2007, 2006 and 2005

Consolidated Statements ofShareholders’ Equity—Years ended January 31, 2007, 2006 and 2005

Consolidated Statements ofCash Flows—Years ended January 31, 2007, 2006 and 2005

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).                            |
| 3.3 |   | Bylaws of National Technical Systems, Inc., a  California corporation, as adopted on December 14, 2004. (filed on  September 13,2006 and is incorporated herein by reference thereto).                                                                                                                                                            |

60

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| 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).      |
| 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).                       |
| 10.11 |   | Amendment number seven to revolving credit agreement  between the Company and Comerica Bank effective September 21, 2006  (filed on December 14, 2006 and is incorporated herein by reference  thereto).             |
| 10.12 |   | National Technical Systems, Inc. 2006 Long-Term  Incentive Plan. (filed on December 14, 2006 and is incorporated herein  by reference thereto).                                                                      |
| 10.13 |   | National Technical Systems, Inc. 2006  Supplemental Executive Retirement Plan. (filed on December 14, 2006 and  is incorporated herein by reference thereto).                                                        |
| 14.1  |   | Code of Business Ethics (filed with the Company’s  Annual Report on Form 10-K on April 28, 2006 and is  incorporated herein by reference thereto).                                                              |
| 21.1  |   | Subsidiaries of the Company.                                                                                                                                                                                                   |
| 23.1  |   | Consent of Independent Registered Public Accounting  Firm.                                                                                                                                                                     |
| 23.2  |   | Consent of XXCAL Japan, Inc. Independent  Auditors and .Independent Auditor’s Report.                                                                                                                                |
| 23.3  |   | Consent of NQA, Inc. Independent Auditors and  Report of Independent Registered Public Accounting Firm.                                                                                                                   |
| 31.1  |   | Certification of the Principal Executive Officer  pursuant to rule 13a-14(a) and 15d-14(a) of the  Securities Exchange Act of 1934, as adopted pursuant to Section 302 of  the Sarbanes-Oxley Act of 2002. |
| 31.2  |   | Certification of the Principal Financial Officer  pursuant to rule 13a-14(a) and 15d-14(a) of the  Securities Exchange Act of 1934, as adopted pursuant to Section 302 of  the Sarbanes-Oxley Act of 2002. |

61

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| 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**

Pursuantto the requirements of Section 13 or 15(d) of the Securities and ExchangeAct of 1934, the registrant has duly caused this report to be signed on itsbehalf by the undersigned, thereunto duly authorized.
|                | **NATIONAL TECHNICAL SYSTEMS, INC.** |
|----------------|--------------------------------------|
| April 30, 2007 | 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
| /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/  LLOYD BLONDER                                                     |
| William McGinnis,                                                       |     | Lloyd Blonder,                                                         |
| *Chief  Executive Officer  and Director  (Principal Executive Officer)* | * * | *Senior  Vice President  and Treasurer  (Principal Financial Officer)* |
| /s/  RAFFY LORENTZIAN                                                   |     | /s/  JOHN GIBBONS                                                      |
| Raffy Lorentzian,                                                       |     | John Gibbons,                                                          |
| *Vice  President and  Chief Accounting Officer*                         | * * | *Director*                                                             |
| /s/  DAN YATES                                                          |     | /s/  RALPH F. CLEMENTS                                                 |
| Dan Yates,                                                              |     | Ralph F.  Clements,                                                    |
| *Director*                                                              | * * | *Director*                                                             |
| /s/  NORMAN S. WOLFE                                                    |     | /s/  DONALD J. TRINGALI                                                |
| Norman S. Wolfe,                                                        |     | Donald J.  Tringali,                                                   |
| *Director*                                                              | * * | *Director*                                                             |
| /s/  ROBERT I. LIN                                                      |     |                                                                   |
| Robert I. Lin,                                                          |     |                                                                   |
| *Director*                                                              | * * | * *                                                               |

 

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**Schedule II**

**NATIONAL TECHNICALSYSTEMS, INC. AND SUBSIDIARIES**

**Valuation and Qualifying Accounts and Reserves**

**Years ended January 31,2007, 2006 and 2005**

| **Column A**                            | ** ** | **Column B**     | ** ** | **Column C**              | ** ** | **Column D**     | ** ** | **Column E** | ** ** |
|----------------------------------------------|------------|-----------------------|------------|--------------------------------|------------|-----------------------|------------|-------------------|------------|
| ** **                                   | ** ** | **Balance at**   | ** ** | **Additions—**            | ** ** | ** **            | ** ** | **Balance**       | ** ** |
| ** **                                   | ** ** | **beginning of** | ** ** | **charged to costs** | ** ** | ** **            | ** ** | **at end**   | ** ** |
| **Description**                              | ** ** | ** **            | ** ** | **period**                     | ** ** | **and expenses** | ** ** | **Deductions**    | ** ** | **of period** | ** ** |
| Allowance for doubtful  accounts receivable: |       |                  |       |                           |       |                  |       |              |       |   |   |   |   |
| Year ended  January 31,                 |       |                  |       |                           |       |                  |       |              |       |   |   |   |   |
| 2007                                         |       |                  | $          | 816,000                        |       |                  |       | $                 | 314,000    |   |   | $ | (439,000 | ) | $ | 691,000 |   |
| 2006                                         |       |                  | $          | 906,000                        |       |                  |       | $                 | 140,000    |   |   | $ | (229,000 | ) | $ | 816,000 |   |
| 2005                                         |       |                  | $          | 938,000                        |       |                  |       | $                 | 252,000    |   |   | $ | (284,000 | ) | $ | 906,000 |   |
|                                              |            |                       |            |                                |            |                       |            |                   |            |  |  |  |  |  |  |  |  |  |  |

 

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