Back to GetFilings.com

Table of Contents

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D. C. 20549

FORM 10-Q

(Mark One)

FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 30, 2004

OR

COMMISSION FILE NUMBER: 333-13105

FIREARMS TRAINING SYSTEMS, INC.

(Exact name of registrant as specified in its charter)

7340 MCGINNIS FERRY ROAD

SUWANEE, GEORGIA 30024

(Address of principal executive offices)

TELEPHONE NUMBER (770) 813-0180

(Registrant’s telephone number, including area code)

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

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act).    Yes  ¨    No  x

As of November 8, 2004, there were 70,516,401 shares of the Registrant’s Class A Common Stock outstanding.

Table of Contents

FIREARMS TRAINING SYSTEMS, INC.

INDEX

2

Table of Contents

PART I. FINANCIAL INFORMATION

ITEM 1. CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

FIREARMS TRAINING SYSTEMS, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(unaudited and in thousands, except for per share amounts)

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

3

Table of Contents

PART I. FINANCIAL INFORMATION

ITEM 1. CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

FIREARMS TRAINING SYSTEMS, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED BALANCE SHEETS

(in thousands, except for shares authorized, issued and outstanding)

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

4

Table of Contents

PART I. FINANCIAL INFORMATION

ITEM 1. CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

FIREARMS TRAINING SYSTEMS, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(unaudited and in thousands)

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

5

Table of Contents

FIREARMS TRAINING SYSTEMS, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(unaudited)

1. Basis of presentation

The unaudited condensed consolidated financial statements of Firearms Training Systems, Inc. and subsidiaries (the “Company”) have been prepared in accordance with accounting principles generally accepted in the United States of America and with the instructions to Form 10-Q and Article 10 of Regulation S-X. In the opinion of management, all adjustments (consisting of normal recurring accruals) considered necessary for a fair presentation have been included. Operating results for the three-month and six-month period ended September 30, 2004 are not necessarily indicative of the results that may be expected for the full year ending March 31, 2005. We suggest that these condensed consolidated financial statements be read in conjunction with the consolidated financial statements and notes thereto for the year ended March 31, 2004, included in our 2004 Annual Report on Form 10-K filed with the Securities and Exchange Commission (“SEC”).

A significant amount of the Company’s revenue is derived from the sale of small and supporting arms training simulators and accessories. Revenue from sales to commercial customers and small governmental agencies is primarily recognized upon shipment when title passes, as all material commitments have been fulfilled, the sales price is fixed and determinable and collectibility is reasonably assured.

A large portion of the Company’s small and supporting arms training simulator revenue is derived from contracts with various large governmental agencies. Governmental contracts that involve high volume purchases of the Company’s standard systems and related accessories are accounted for as multiple-element arrangements. These contracts require little or no modifications to the existing proprietary platform, specify pricing terms by product and billings generally correspond to the underlying shipment schedule. Revenue under these contracts is recognized upon delivery. Advanced billings related to these contracts are recorded as deferred revenue and are recognized ratably as units are delivered.

Other governmental contracts require significant customization of the Company’s existing proprietary platform or require the development of new systems to meet required customer specifications. These contracts are accounted for under the percentage of completion method, measured by the percentage of cost incurred to date to the estimated total cost for each contract. Contract costs include all direct material, direct labor and other costs directly related to the contract. Selling, general, and administrative costs are charged to expense as incurred. Changes in job performance, job conditions, and estimated profitability, including those arising from contract penalty provisions, and final contract settlements may result in revisions to costs and income and are recognized in the period in which the revisions are determined.

Provisions for estimated losses on uncompleted contracts accounted for under both methods described above are made in the period in which such losses are determined.

Revenue from extended warranty sales and customer logistics support sales are recorded as deferred revenue and are recognized ratably as income over the lives of the related service agreements, which generally range from one to three years. Costs associated with these sales are recorded in the period incurred.

6

Table of Contents

3. Stock-based compensation

The Company accounts for stock incentives available to employees and non-employee directors under its stock-based compensation plans using the intrinsic value method prescribed in Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees as allowed under FAS No. 123, Accounting for Stock-Based Compensation. The Company has adopted the provisions of FAS No. 123 and FAS 148, Accounting for Stock-Based Compensation - Transition and Disclosure, which require disclosure of the pro forma effects on earnings and earnings per share as if SFAS No. 123 had been adopted.

The Company has computed for pro forma disclosure purposes the value of all options using the Black-Scholes option pricing model as prescribed by SFAS No. 123 using the following assumptions:

The Company issued options to purchase a total of 5.8 million shares of its common stock under its option plan on May 1, 2003, with an exercise price equal to the $.40 per share market value of the stock on that date.

The weighted average grant-date fair value of options granted during the six-month period ended September 30, 2004 was computed as approximately $450,000 or $.60 per share under option.

The weighted average grant-date fair value of options granted during the six-month period ended September 30, 2003 was computed as approximately $2.2 million or $.385 per share under option.

The values above and the value computed for unvested options granted in prior years is being amortized on a pro forma basis over the vesting period of the options. Pro forma information (in thousands, except per share amounts) regarding net loss and loss per share as if the Company had accounted for options using the fair value method is as follows:

7

Table of Contents

4. Inventory

Inventories consist primarily of simulators, computer hardware, projectors, and component parts. Inventories are valued at the lower of cost on a moving weighted average or market basis. Cost includes materials, labor, and factory overhead. Market is defined as net realizable value.

Inventories consist of the following (in thousands):

5. Long-term contracts

Costs and estimated earnings on uncompleted contracts and related amounts billed as of September 30 and March 31, 2004, respectively, are as follows (in thousands):

8

Table of Contents

6. Other noncurrent assets

Other noncurrent assets consist of the following intangible assets (in thousands):

At September 30, 2004, the Company had debt issuance costs of $1.5 million related to the New Credit Agreement discussed in Note 7. For the three and six-month periods ended September 30, 2004, amortization expense, related to the previous credit facility, was $322,000 and $419,000, respectively. For the year ending March 31, 2005, amortization expense is expected to be approximately $570,000.

7. Long-term debt

Long-term debt consists of the following (in thousands):

On September 30, 2004, the Company entered into a Revolving Credit, Term Loan and Security Agreement (the “New Credit Agreement”) with CapitalSource Finance LLC (“CapitalSource”), as administrative, payment and collateral agent for the lenders named therein. The New Credit Agreement permits a maximum borrowing capacity of $42 million and matures on September 30, 2009.

The New Credit Agreement provides for a revolving credit facility on which up to $12,000,000 may be drawn (subject to adjustment based on letter of credit usage and compliance with identified leverage ratios), a $15,000,000 “Term A” loan and a $15,000,000 “Term B” loan. The revolving credit facility requires the Company to pay interest on a monthly basis in cash at an annual rate equal to the “prime rate” plus .5% subject to a floor of 4.75% (5.25% at September 30, 2004). At September 30, 2004, the amount available on the revolving credit facility was $4,850,000. All amounts outstanding under the revolving credit facility are due in full on September 30, 2009.

The Term A loan requires the Company to pay interest on a monthly basis in cash at an annual rate equal to the “prime rate” plus 3% subject to a floor of 7.25% (7.75% at September 30, 2004). The Company must also make scheduled quarterly payments of principal under the Term A loan. The quarterly principal payments required are in the amount of $531,250 for the first year of the term, $750,000 for the second through fourth years of the term, and $968,750 in the fifth year of the term.

9

Table of Contents

The Term B loan requires the Company to pay interest on a monthly basis in cash at an annual rate equal to the “prime rate” plus 6% subject to a floor of 10.25% (10.75% at September 30, 2004). The Company is also required to pay interest payable-in-kind (“PIK interest”), which accrues monthly at an annual rate of 1.5%. The PIK interest is due and payable on the earlier to occur of (i) the Company’s early redemption or termination of the Term B loan, (ii) the lender’s demand as a result of a default or (iii) September 30, 2009. The Company has the option at any time to pay the PIK interest in cash. Outstanding principal under the Term B loan is due in full at the maturity date.

Borrowings under the New Credit Agreement are collateralized by substantially all of the Company’s assets. The Company has also pledged all of the stock of its operating subsidiary, FATS, Inc., and 65% of the stock of its foreign subsidiaries. The Company generally will be required to apply all proceeds it receives from transactions in which it sells any material assets, sells equity securities or incurs indebtedness for borrowed money as a mandatory prepayment on the outstanding obligations under the New Credit Agreement. In addition, subject to certain availability exceptions, the Company will be required to apply 50% of its excess cash flow each year as a mandatory prepayment. Among other restrictions, the New Credit Agreement includes certain restrictive covenants, including covenants related to indebtedness, asset acquisitions and dispositions, investments and maintenance of required leverage ratios, minimum EBITDA and fixed charge coverage ratios.

In addition, the New Credit Agreement requires the Company to pay a number of lender fees including: (i) an unused credit line fee equal to 0.0417% per month of the difference between average outstanding revolving loans and the revolving loan cap; (ii) a monthly collateral management fee equal to 0.0417% per month of the average outstanding revolving loans; (iii) a monthly float day fee calculated in accordance with a specified formula; (iv) a letter of credit fee equal to 3% of the undrawn face amount of outstanding letters of credit; and (v) a termination fee (ranging from 1% to 2% of the amount prepaid as to the Term A loan, and either a yield maintenance fee calculated in accordance with a specified formula or up to 2% of the amount prepaid depending on the timing of the prepayment as to the Term B loan) in the event the term loans are prepaid prior to the second anniversary of the closing.

As of September 30, 2004, $37,150,000 was outstanding under the New Credit Agreement.

8. Mandatorily redeemable preferred stock (Series B)

In August 2000, the board of directors approved an amendment to the Company’s certificate of incorporation to change the number of authorized shares of preferred stock to 100,000. The board of directors then created a new class of Series B preferred stock with 50,000 authorized shares. Holders of the Series B preferred stock were entitled to receive cumulative dividends equal to 10% of the liquidation preference payable quarterly in additional shares of Series B preferred stock.

The Company issued 21,361.113 shares of Series B preferred stock with a liquidation value of $1,000 per share (approximately $21.4 million) in August 2000 in conjunction with its debt restructuring (see Note 3 to the financial statements contained in the Company’s most recently filed Form 10-K for the year ended March 31, 2004). Accretion related to dividends earned on the Series B during the years ended March 31, 2002, 2003 and 2004 of approximately $2,353,000, $2,597,000 and $2,867,000, respectively. These amounts were previously offset by the reduction of approximately $2,083,000 and $2,299,000 in the debt restructuring liability allocated to the preferred stock, resulting in net accretion of approximately $270,000 and $298,000 for the years ended March 31, 2002 and 2003, respectively. As of March 31, 2003, the debt restructuring liability related to the preferred stock was fully amortized and, therefore, for the year ended March 31, 2004, the total $2,867,000 of preferred stock dividends was reported without the related offsetting amortization.

The Company adopted the classification provisions of SFAS No. 150, Accounting for Certain Liabilities with Characteristics of both Liabilities and Equity as of the beginning of the year ended March 31, 2004. Those provisions require the Company to include the mandatorily redeemable preferred stock as a liability in its balance sheet and to include the dividends on the preferred stock as a component of interest expense in its income statement, and prohibit reclassification of prior year amounts. Accordingly, the net accretion of preferred stock dividends was reported as an adjustment to net income to arrive at net income attributable to common stockholders for the years ended March 31, 2002 and 2003, and the total preferred stock dividends was reported as interest expense in the income statement for the year ended March 31, 2004.

The Series B preferred stock was subject to mandatory redemption on October 15, 2005 at its liquidation value. Accordingly, the mandatorily redeemable preferred stock was not classified as a current liability as of March 31, 2004. All of the shares of Series B preferred stock were exchanged for shares of Series C preferred stock in connection with the debt restructuring described in Note 7.

10

Table of Contents

9. Preferred stock (Series C)

In September 2004, the board of directors created a new class of Series C preferred stock with 3,500 authorized shares. Holders of the Series C preferred stock are entitled to receive, if declared by the board, cumulative dividends equal to (i) 10% of the liquidation preference per year through March 31, 2006; (ii) 12% of the liquidation preference per year through September 30, 2006 and (iii) 14% of the liquidation preference per year thereafter, payable in cash. Dividends are cumulative and compound quarterly whether or not there are funds available for the payment of dividends.

The Company issued 3,202.78 shares of Series C preferred stock with a liquidation value of $10,000 (subject to adjustment to reflect any stock split, combination, reclassification or similar event involving the Series C Preferred) per share (approximately $32.03 million) in September 2004 in exchange for the then outstanding 32,027.80 shares of the Series B preferred stock.

The Company may redeem the shares of Series C Preferred at any time and from time to time at a redemption price equal to the liquidation preference plus the amount of all accrued and unpaid dividends, whether or not earned or declared. The shares of Series C Preferred are required to be redeemed upon the occurrence of a “change of control” (which includes the sale of all or substantially all of the Company’s assets, merger, consolidation or similar event in which more than 50% of the voting stock of the Company is transferred). In the event the Company is legally prohibited from redeeming the shares when required (or the Company materially breaches any of its other obligations under the Series C Designations), the applicable dividend rate payable on the Series C Preferred will be increased by 2% per annum.

The Series C Preferred ranks prior to all other classes of preferred and common stock as to payment of dividends and the distribution of amounts upon liquidation, dissolution or winding up. Holders of shares of the Series C Preferred generally do not have any voting rights other than those provided by law. The Company must obtain the consent from holders of at least a majority of the outstanding shares of Series C Preferred in order to: (i) enter into any plan of liquidation or dissolution (unless prior written notice of any such plan is given to the Series C Preferred holders and, as a result of such liquidation or dissolution, the Company is able to satisfy in full the liquidation preferences together with all accrued and unpaid dividends on the shares); (ii) enter into any agreement which by its terms would violate or conflict with the rights of the Series C Preferred holders; (iii) subject to certain exceptions, amend or waive any provision of the Series C Designations or the Company’s certificate of incorporation. Any amendment that would decrease the dividend rate payable on the Series C Preferred requires the consent of all holders of Series C Preferred. Any amendment that would increase the authorized number of Series C Preferred shares or that would result in the issuance of capital stock ranking senior to or on parity with the Series C Preferred as to dividends or rights upon liquidation requires the consent of at least two holders who are not affiliates of each other and who hold, in the aggregate, at least a majority of the Series C Preferred shares.

10. Related party transactions

Special Situations Opportunity Fund I, LLC, one of the Term A lenders under the New Credit Agreement described in Note 7, is an affiliate of First Source Financial, Inc. First Source is a preferred stockholder of FATS and an affiliate of First Source owns approximately 13.5% of the outstanding common stock of FATS. In addition, the primary lenders under the credit facility that was paid in full in connection with the New Credit Agreement included Centre Capital Investors II, L.P., Centre Capital Tax-Exempt Investors II, L.P., Centre Capital Offshore Investors II, L.P., Centre Partners Coinvestment, L.P. (collectively, the “Centre Entities”). The Centre Entities are among the Company’s largest stockholders and have a representative on the Company’s Board of Directors.

On September 30, 2004, the Company entered into an Exchange Agreement with the Centre Entities, U.S. Bank National Association and First Source Financial LLP. As reflected in Note 8, in accordance with the Exchange Agreement the Company issued 3,202.78 shares of its Series C preferred stock to these entities exchange for 32,027.80 shares of its Series B preferred stock previously held by them. As a result of the exchange, all of the previously issued shares of Series B Preferred were cancelled.

11

Table of Contents

11. Net loss per common share

Basic and diluted net loss per share was calculated by dividing net loss by the weighted average common shares outstanding for the three and six-month periods ended September 30, 2004 and 2003.

Options to purchase 7,022,046 shares of common stock at September 30, 2004 and 7,133,738 shares of common stock at September 30, 2003 and warrants to purchase 5,246,164 shares of common stock at September 30, 2004 and 2003 were outstanding, but were not included in the computation of the diluted EPS because their effect would have been anti-dilutive, thereby increasing net loss per share.

12. Contingencies and commitments

Product Warranty Reserve

The Company’s product warranty accrual reflects management’s best estimate of probable liability under its product warranties. Management determines the warranty based on known product failures (if any), historical experience, and other currently available evidence.

Changes in the product warranty accrual for the three and six-month periods ended September 30, 2004 and 2003 were as follows (in thousands):

13. Supplemental cash flow disclosures

14. Comprehensive loss

12

Table of Contents

ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

This Management’s Discussion and Analysis of Financial Condition and Results of Operations should be read in conjunction with the Management’s Discussion and Analysis of Financial Condition and Results of Operations contained in the Company’s most recently filed Form 10-K for the fiscal year ended March 31, 2004.

You should carefully review the information contained in this Report, and should particularly consider any risks and other factors that we set forth in the most recently filed Form 10-K for the fiscal year ended March 31, 2004, and in other reports or documents that we file from time to time with the SEC. In this Report, we state our expectations as to future events and our future financial performance. In some cases, you can identify those so-called “forward-looking statements” by words such as “may,” “will,” “should,” “expects,” “plans,” “anticipates,” “believes,” “estimates,” “predicts,” “potential,” or “continue” or the negative of those words and other comparable words. You should be aware that those statements are only our predictions, which are being made as of the date hereof. Actual events or results may differ materially. In evaluating those statements, you should specifically consider various factors, including the risks outlined below. Those factors may cause our actual results to differ materially from any of our forward-looking statements. We undertake no obligation to update any forward-looking statements, whether as a result of new information, future events or otherwise.

Factors that may cause our actual results to differ materially from any of our forward-looking statements presented in this Report include, but are not limited to:

13

Table of Contents

Critical Accounting Policies and Estimates

The following discussion and analysis of our financial condition and results of operations is based upon our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these financial statements requires us to make judgments regarding estimates that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosures. We base our judgments on historical experience and on various assumptions that we believe are reasonable under the circumstances. Actual results may differ from these estimates under different assumptions or conditions. We believe our judgments and related estimates regarding the following accounting policies are critical in the preparation of our consolidated financial statements.

Revenue Recognition

Customer contracts that require significant customization of the Company’s existing proprietary platform or require the development of new systems to meet required customer specifications are accounted for under the percentage of completion method, measured by the percentage of cost incurred to date to the estimated total cost for each contract. Accounting for such contracts is essentially a process of measuring the results of relatively long-term events and allocating those results to relatively short-term accounting periods. This involves considerable use of estimates in determining costs and profits and thereby estimating the timing of revenue recognition and in assigning the amounts to accounting periods. The process is complicated by the need to evaluate continually the uncertainties inherent in the performance of contracts and by the need to rely on estimates of revenues, costs, and the extent of progress toward completion. The Company continually monitors each of these estimates based on the most current information available from the project managers and project engineers assigned to the programs. Changes in job performance, job conditions, and estimated profitability, including those arising from contract penalty provisions, and final contract settlements may result in revisions to costs and income and are recognized in the period in which the revisions are determined. These revisions could materially increase or decrease profit margins on particular contracts in future periods.

Inventory Reserve

Inventories are valued at the lower of cost on a moving weighted average or market, cost being determined on the first-in, first-out basis and market being defined as net realizable value. Management periodically reviews Company inventory for items that may be deemed obsolete, damaged or for amounts on hand in excess of anticipated future demand. The underlying assumptions utilized in assessing the Company’s inventory change from time-to-time due to change in the underlying sales mix, the release of new versions of the Company’s proprietary system and overall changes in technology and the marketplace. As the Company develops new product lines, future charges against income may be necessary to reduce inventory to its net realizable value.

Contract Cost Provision Reserve

Management routinely assesses the Company’s performance and estimated cost to complete ongoing sales contracts. Changes in job performance, job conditions, and estimated profitability, including those arising from contract penalty provisions, and final contract settlements may result in revisions to costs and income. In the event management anticipates incurring costs in excess of contract revenues, the Company records a contract cost provision reserve in an amount equal to the estimated costs in excess of contracted revenues in the period in which such information becomes apparent.

Warranty Cost Provision Reserve

Management periodically estimates expected warranty costs under the Company’s standard product warranty. In determining the estimate, management analyzes the relationship of historical standard warranty costs incurred on historical sales and the underlying product mix comprising the historical sales. Management, in turn, utilizes this historical information to estimate expected warranty costs on recent sales within the standard warranty time frame. Due to the inherent limitations in the estimation process, the potential for product defects and other unforeseen circumstances by the Company, the possibility exists that the recorded warranty provision reserve will be inadequate to offset actual warranty costs incurred resulting in additional charges against income. Also, actual warranty costs may be significantly lower than expected resulting in the reduction of the Company’s warranty provision reserve generating an addition to income in future periods.

14

Table of Contents

RESULTS OF OPERATIONS

The following table sets forth the operations of the Company as a percentage of gross revenues for the periods indicated:

Three Months Ended September 30, 2004 and 2003:

Net Revenues: Revenues increased $7.2 million, or 55.7%, to $20.1 million for the three months ended September 30, 2004, as compared to $12.9 million for the three months ended September 30, 2003. Sales to international customers for the three months ended September 30, 2004 increased $.2 million, or 3.9%, to $5.7 million. Sales to U.S. military customers for the three months ended September 30, 2004 increased by $8.7 million, or 182.0%, to $13.4 million. The U.S. military increase is due primarily to the incremental sales and system upgrades with existing customers and initial sales of I-FACT (Close Air Support Trainer) and VCCT (Virtual Combat Convoy Trainer). Sales to U.S. law enforcement customers for the three months ended September 30, 2004 decreased $1.7 million, or 62.5%, to $1.0 million reflecting state and municipality budgeting shortfalls associated with diversion of funds to offset operational costs.

Cost of Revenues: Cost of revenues increased $4.7 million, or 52.5%, to $13.8 million for the three months ended September 30, 2004, as compared to $9.0 million for the three months ended September 30, 2003. As a percentage of revenues, cost of revenues for the three months ended September 30, 2004 decreased to 68.4%, as compared to 69.8% for the three months ended September 30, 2003. The decrease in cost of revenues as a percentage of revenues is attributable primarily to the discipline of pursuing new business that reflects the corporate margin objective and continued internal cost control initiatives.

15

Table of Contents

Gross Profit: As a result of the foregoing, gross profit increased $2.5 million, or 63.1%, to $6.4 million, or 31.6% of revenues, for the three months ended September 30, 2004, as compared to $3.9 million, or 30.2% of revenues, for the three months ended September 30, 2003.

Total Operating Expenses: Total operating expenses increased $0.7 million, or 17.9%, to $4.5 million for the three months ended September 30, 2004 as compared to $3.8 million for the three months ended September 30, 2003. As a percentage of revenues, total operating expenses decreased to 22.5% for the three months ended September 30, 2004, as compared to 29.7% for the three months ended September 30, 2003. Selling, general and administrative (“SG&A”) expenses, which include bid and proposal activities, increased from $3.0 million for the three months ended September 30, 2003 to $3.7 million for the three months ended September 30, 2004. This increase in SG&A is due primarily to legal fees associated with protecting intellectual property rights, increased emphasis in marketing costs, and costs associated with the severance of the former CFO. Research and development (R&D) costs remained constant at $0.7 million, as well as depreciation and amortization expense, which remained constant at $0.1 million.

Operating Income: As a result of the foregoing, operating income increased $1.8 million to $1.8 million for the three months ended September 30, 2004, as compared to $61,000 for the three months ended September 30, 2003. As a percentage of revenues, operating income was 9.1% of revenues for the three months ended September 30, 2004, as compared to 0.5% of revenues for the three months ended September 30, 2003.

Other Income (Expense), net: Other income (expense), net totaled $(2.7) million, or (13.4%) of revenues for the three months ended September 30, 2004, as compared to $(2.1) million, or (16.4%) of revenues for the three months ended September 30, 2003. Interest on debt increased $0.3 or 19.2%, due primarily to the increased rates and amortization of financing costs related to an earlier extension of the Company’s prior credit facility that was replaced by the New Credit Agreement on September 30, 2004. Dividends on mandatorily redeemable preferred stock increased $74,000, or 10.5%, due to the compounding effect of the 10% dividends, which were paid in additional shares of the preferred stock. In addition, due to the weaker dollar, the foreign currency exchange loss was $0.3 million for the three months ended September 30, 2004.

Loss Before Benefit for Income Taxes: As a result of the foregoing, the loss before benefit for income taxes decreased by $1.2 million from a loss of $2.1 million for the three months ended September 30, 2003 to a loss of $0.9 million for the three months ended September 30, 2004.

Benefit for Income Taxes: The net taxable loss for the three months ended September 30, 2004 produced a tax benefit of $53,000, while the net taxable loss for the three months ended September 30, 2003 resulted in a tax benefit of $458,000.

Net Loss: As a result of the foregoing, the net loss decreased by $0.8 million to $0.8 million, or $0.01 loss per share, for the three months ended September 30, 2004 from $1.6 million, or $0.02 loss per share, for the three months ended September 30, 2003.

Six Months Ended September 30, 2004 and 2003:

Net Revenues: Revenues increased $9.6 million, or 33.6%, to $38.1 million for the six months ended September 30, 2004, as compared to $28.5 million for the six months ended September 30, 2003. Sales to international customers for the six months ended September 30, 2004 increased $1.1 million, or 8.3%, to $14.2 million. Sales to U.S. military customers for the six months ended September 30, 2004 increased by $10.4 million, or 91.7%, to $21.8 million. The increase in U.S. military sales is due primarily to the incremental sales and system upgrades with existing customers and initial sales of I-FACT (Close Air Support Trainer) and VCCT (Virtual Combat Convoy Trainer). Sales to U.S. law enforcement customers for the six months ended September 30, 2004 decreased $1.9 million, or (46.9)%, to $2.2 million reflecting state and municipality budgeting shortfalls associated with diversion of funds to offset operational costs.

Cost of Revenues: Cost of revenues increased $5.3 million, or 25.8%, to $25.6 million for the six months ended September 30, 2004, as compared to $20.4 million for the six months ended September 30, 2003. As a percentage of revenues, cost of revenues for the six months ended September 30, 2004 decreased to 67.2%, as compared to 71.4% for the six months ended September 30, 2003. The decrease in cost of revenues as a percentage of revenues is attributable primarily to the discipline of pursuing sales at or above the corporate margin objective, execution of existing contracts without margin erosion, and the positive results of continuing positive cost control initiatives.

16

Table of Contents

Gross Profit: As a result of the foregoing, gross profit increased $4.3 million, or 53.1%, to $12.5 million, or 32.8% of revenues, for the six months ended September 30, 2004, as compared to $8.2 million, or 28.6% of revenues, for the six months ended September 30, 2003.

Total Operating Expenses: Total operating expenses increased $1.6 million, or 21.8%, to $9.0 million for the six months ended September 30, 2004 as compared to $7.4 million for the six months ended September 30, 2003. As a percentage of revenues, total operating expenses decreased to 23.6% for the six months ended September 30, 2004 as compared to 25.9% for the six months ended September 30, 2003. Selling, general and administrative (“SG&A”) expenses, which include bid and proposal activities, increased from $5.9 million for the six months ended September 30, 2003 to $7.0 million for the six months ended September 30, 2004. This increase in SG&A is due primarily to increased emphasis in marketing, bid and proposal for new business, primarily related to the Singapore Police Coast Guard contract, and costs associated with the severance of the former CFO. Research and development (R&D) costs increased $0.5 million, or 39.7%, to $1.7 million for the six months ended September 30, 2004, as compared to $1.2 million for the six months ended September 30, 2003, due primarily to increases in developmental efforts related to Bluefire weapons, enhancements to our I-FACT product, and single platform initiative. Depreciation and amortization expense remained constant at $0.2 million.

Operating Income: As a result of the foregoing, operating income increased $2.7 million to $3.5 million for the six months ended September 30, 2004, as compared to $0.8 million for the six months ended September 30, 2003. As a percentage of revenues, operating income was 9.2% of revenues for the six months ended September 30, 2004, as compared to 2.8% of revenues for the six months ended September 30, 2003.

Other Income (Expense), net: Other income (expense), net totaled $(5.0) million, or (13.0%) of revenues for the six months ended September 30, 2004 as compared to $(3.8) million, or (13.4%) of revenues for the six months ended September 30, 2003. Interest on debt increased $0.6 or 24.3%, due primarily to the increased rates and amortization of financing costs related to the extension of the debt maturity date (related to the previous financing arrangement prior to the most recent arrangement dated September 30, 2004 as discussed herein). Dividends on mandatorily redeemable preferred stock increased $145,000, or 10.4%, due to the compounding effect of the 10% dividends, which were paid in additional shares of the preferred stock. In addition, due to the weaker dollar, the foreign currency exchange loss was $0.3 million for the six months ended September 30, 2004.

Loss Before Benefit for Income Taxes: As a result of the foregoing, the loss before benefit for income taxes decreased by $1.6 million from a loss of $3.0 million for the six months ended September 30, 2003 to a loss of $1.4 million for the six months ended September 30, 2004.

Benefit for Income Taxes: The net taxable loss for the six months ended September 30, 2004 produced a tax benefit of $13,000 while the net taxable loss for the six months ended September 30, 2003 resulted in tax benefit of $561,000.

Net Loss: As a result of the foregoing, the net loss decreased by $1.1 million to $1.4 million, or $0.02 loss per share, for the six months ended September 30, 2004 from $2.5 million, or $0.04 loss per share, for the six months ended September 30, 2003.

ANALYSIS OF BACKLOG

Backlog represents customer orders that have been contracted for future delivery. Accordingly, these orders have not yet been recognized as revenue, but represent potential revenue. As of September 30, 2004 and 2003, the Company had a backlog of approximately $47.3 and $65.1 million, respectively. As of September 30, 2004, the backlog was comprised of $28.8 million from international customers and $18.5 million from FATS U.S. military and law enforcement customers. Approximately $33.2 million of the contracted orders are scheduled for delivery during fiscal year 2005.

17

Table of Contents

Changes in backlog for the three and six-month periods ended September 30, 2004 and 2003 were as follows (in thousands):