UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D. C. 20549

FORM 10-Q

(Mark One)

x	Quarterly report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934

FOR THE QUARTERLY PERIOD ENDED June 30, 2006

¨	Transition report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934

COMMISSION FILE NUMBER: 333-13105

FIREARMS TRAINING SYSTEMS, INC.

(Exact name of registrant as specified in its charter)

DELAWARE

57-0777018

(State or other jurisdiction of

incorporation or organization)

(I.R.S. Employer

Identification No.)

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 a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act.


Large accelerated filer ¨		Accelerated filer ¨		Non-accelerated filer x

Indicate by checkmark whether the registrant is a shell company (as defined in Rule 126-2 of the Exchange Act) Yes ¨ No x

As of August 8, 2006, there were 76,059,735 shares of the Registrant’s Class A Common Stock outstanding.

FIREARMS TRAINING SYSTEMS, INC.

INDEX


		PAGE
PART I.	FINANCIAL INFORMATION
ITEM1.	CONDENSED CONSOLIDATED FINANCIAL STATEMENTS:

	Condensed Consolidated Statements of Income Three months ended June 30, 2006 (unaudited) and 2005 (unaudited)	3

	Condensed Consolidated Balance Sheets June 30, 2006 (unaudited) and March 31, 2006	4

	Condensed Consolidated Statements of Cash Flows Three months ended June 30, 2006 (unaudited) and 2005 (unaudited)	5

	Notes to Condensed Consolidated Financial Statements (unaudited)	6

ITEM 2.	MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS	12

ITEM 3.	QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK	17

ITEM 4.	CONTROLS AND PROCEDURES	17

PART II.	OTHER INFORMATION

ITEM 1.	LEGAL PROCEEDINGS	18

ITEM 1A.	RISK FACTORS	18

ITEM 6.	EXHIBITS	19

	SIGNATURES	20

PART I. FINANCIAL INFORMATION

ITEM 1. CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

FIREARMS TRAINING SYSTEMS, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF INCOME

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


	Three Months Ended June 30,
	2006			2005
Revenue	$	16,886		$	16,539
Cost of revenue		10,657			10,872

Gross margin		6,229			5,667

Operating expenses:
Selling, general and administrative		3,955			3,715
Research and development		1,027			1,403

Total operating expenses		4,982			5,118

Operating income		1,247			549

Other income (expense), net
Interest expense on debt		(993	)		(902	)
Other, net		(337	)		236

Total other income (expense)		(1,330	)		(666	)

Loss before benefit for income taxes		(83	)		(117	)
Benefit for income taxes		(113	)		(126	)

Net income	$	30		$	9

Income per share
Basic income per share	$	0.00		$	0.00

Diluted income per share	$	0.00		$	0.00

Weighted average common shares outstanding – basic		76,056			75,945
Weighted average common shares outstanding – diluted		78,836			80,693

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

FIREARMS TRAINING SYSTEMS, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED BALANCE SHEETS

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


	June 30, 2006			March 31, 2006
	(unaudited)
ASSETS
Current assets:
Cash and cash equivalents	$	2,478		$	4,479
Restricted cash		2,854			2,838
Accounts receivable, net of allowance of $350		12,324			16,948
Costs and estimated earnings in excess of billings on incomplete contracts		10,296			9,518
Unbilled receivables		391			442
Inventories		14,332			13,786
Income taxes receivable		389			7
Deferred income taxes		385			126
Prepaid expenses and other current assets		1,457			1,763

Total current assets		44,906			49,907

Property and equipment, net		1,953			1,972

Other noncurrent assets:
Other		132			149
Deferred income taxes		404			638
Intangible assets, net		986			1,063

Total assets	$	48,381		$	53,729

LIABILITIES AND STOCKHOLDERS’ DEFICIT
Current Liabilities:
Long-term debt due within one year	$	3,847		$	3,540
Accounts payable		3,244			4,901
Accrued liabilities		4,817			5,514
Accrued interest		284			312
Income taxes payable		1,317			1,119
Billings in excess of cost and estimated earnings on incomplete contracts		2,072			2,216
Deferred revenue		1,354			758
Contract cost reserve		93			277
Warranty cost reserve		482			483

Total current liabilities		17,510			19,120

Long-term debt		23,438			27,845

Other noncurrent liabilities		336			438

Total liabilities		41,284			47,403

Commitments and contingencies

Preferred stock, 3,500 shares authorized; 3,203 shares issued and outstanding; liquidation value of $11,945 and $11,597 per share		32,028			32,028

Stockholders’ deficit:
Class A common stock, $0.000006 par value; 100 million shares authorized, 76,059,735 and 76,056,402 shares issued and outstanding		—			—
Additional paid-in capital		128,405			128,049
Accumulated deficit		(154,365	)		(154,395	)
Accumulated other comprehensive income		1,029			644

Total stockholders’ deficit		(24,931	)		(25,702	)

Total liabilities and stockholders’ deficit	$	48,381		$	53,729

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

FIREARMS TRAINING SYSTEMS, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(unaudited and in thousands)


	Three Months Ended June 30,
	2006			2005
Cash flows from operating activities:
Net income	$	30		$	9

Adjustments for non-cash items:
Non-cash interest and financing costs		150			132
Depreciation and amortization		284			270
Non-cash stock compensation		355			—
Change in inventory reserve		(50	)		63
Change in warranty cost and contract loss reserve		(185	)		117
Loss on disposal of assets		—			13
Deferred income taxes		(25	)		—
Changes in assets and liabilities:
Accounts receivable, net		4,624			(538	)
Income taxes receivable		(382	)		(155	)
Costs and estimated earnings in excess of billings on uncompleted contracts		(778	)		2,127
Unbilled receivables		51			157
Inventories		(496	)		(2,100	)
Prepaid expenses and other current assets		306			(596	)
Accounts payable		(1,657	)		(1,766	)
Accrued liabilities		(725	)		(1,686	)
Income taxes payable		198			110
Billings in excess of costs and estimated earnings on uncompleted contracts		(144	)		(1,719	)
Deferred revenue		596			643
Noncurrent liabilities		(102	)		(55	)

Total adjustments		2,020			(4,983	)

Net cash provided by (used in) operating activities		2,050			(4,974	)

Cash flows from investing activities:
Change in restricted cash		(16	)		15
Purchase of property and equipment		(252	)		(278	)

Net cash used in investing activities		(268	)		(263	)

Cash flows from financing activities:
Proceeds from long-term debt		981			3,500
Payments on long-term debt		(5,138	)		(532	)
Payment of deferred financing costs		—			(17	)
Exercise of stock options		1			—

Net cash provided by (used in) financing activities		(4,156	)		2,951

Effect of exchange rate changes on cash		373			(444	)

Net decrease in cash and cash equivalents		(2,001	)		(2,730	)
Cash and cash equivalents, beginning of period		4,479			6,456

Cash and cash equivalents, end of period	$	2,478		$	3,726

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

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 months ended June 30, 2006, are not necessarily indicative of the results that may be expected for the full year ending March 31, 2007. 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, 2006, included in our 2006 Annual Report on Form 10-K filed with the Securities and Exchange Commission (“SEC”).

2. Revenue recognition

A large portion of the Company’s small and supporting arms training simulator revenue is derived from contracts with large governmental agencies. Governmental contracts that involve high volume purchases of the Company’s standard systems and related accessories are accounted for as multiple-deliverable arrangements, in accordance with EITF 00-21, Revenue Arrangements with Multiple Deliverables, based on the relative fair values of the deliverables specified in the contract. These contracts require little or no modifications to the existing proprietary platform and specify pricing terms by product, with billings generally corresponding 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 in accordance with SOP 81-1, Accounting for Performance of Construction-Type and Certain Production-Type Contracts, measured by the percentage of cost incurred to date to the total costs 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.

Revenues 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.

3. Stock-based compensation

Effective April 1, 2006, we adopted Statement of Financial Accounting Standards No. 123 (revised 2004), Share-Based Payment (“SFAS 123R”), using the modified-prospective-transition approach method. Under this transition method, compensation costs for fiscal 2007 include costs for options granted prior to, but not vested at, March 31, 2006, and options vested in fiscal 2007. Therefore, results for prior periods have not been restated.

The adoption of SFAS 123R decreased net income by approximately $227,000 for the three months ended June 30, 2006, compared to our previous method of accounting for share-based compensation under Accounting Principal Board Opinion No. 25, Accounting for Stock Issued to Employees.

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 income (loss) and income (loss) per share as if the Company had accounted for options using the fair value method is as follows:


	Three Months Ended June 30, 2005
Net income (loss):
As reported	$	9
Fair value based compensation cost, net of taxes		(32	)

Pro forma net (loss) attributable to common stockholders	$	(23	)

Basic and diluted income (loss) per share
As reported	$	0.00

Pro forma	$	(0.00	)

As of June 30, 2006, there was approximately $1.1 million of unrecognized compensation cost related to unvested share-based compensation awards granted. We expect to recognize this cost over the next 4 years.

The Company did not issue options during the three months ended June 30, 2006 or 2005.

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):


	June 30, 2006			March 31, 2006
Raw materials	$	8,717		$	8,027
Work in process		3,100			3,995
Finished goods		3,162			2,461

Inventories, gross		14,979			14,483
Reserve for excess and obsolete inventory		(647	)		(697	)

Inventories	$	14,332		$	13,786

5. Long-term contracts

Costs and estimated earnings on uncompleted contracts and related amounts billed are as follows (in thousands):


	June 30, 2006			March 31, 2006
Costs incurred on uncompleted contracts	$	58,333		$	55,560
Estimated earnings		28,315			25,005

		86,648			80,565
Less: billings to date		(78,424	)		(73,263	)

	$	8,224		$	7,302

Such amounts are included in the following accounts (in thousands):

Costs and estimated earnings in excess of billings on uncompleted contracts	$	10,296		$	9,518
Billings in excess of costs and estimated earnings on uncompleted contracts		(2,072	)		(2,216	)

	$	8,224		$	7,302

6. Long-term debt

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


	June 30, 2006			March 31, 2006
Revolving credit facility	$	2,843		$	6,363
Long-term debt – Loan A		9,038			9,676
Long-term debt – Loan B		15,000			15,000
Accrued PIK		404			346

		27,285			31,385
Due within one year		(3,847	)		(3,540	)

Long-term debt	$	23,438		$	27,845

On September 30, 2004, the Company and its operating subsidiary, FATS, Inc., entered into a Revolving Credit, Term Loan and Security Agreement (the “New Credit Agreement”) with CapitalSource Finance LLC (“CapitalSource”), a related party as described in Note 8, 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 pursuant to which up to $12,000,000 in principal 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% (8.75% at June 30, 2006). At June 30, 2006, the amount available on the revolving credit facility was $8,984,192, which includes $172,399 related to a letter of credit. Any amounts outstanding under the revolving credit facility are due in full on September 30, 2009. For the three months ended June 30, 2006 and 2005, interest expense on the revolving credit facility was approximately $91,000 and $17,000, respectively.

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% (11.25% at June 30, 2006). 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 $451,917 for the first year of the term, $546,588 for the second through fourth years of the term, and $706,010 in the fifth year of the term. For the three months ended June 30, 2006 and 2005, interest expense on the Term A loan was approximately $266,000 and $314,000, respectively.

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% (14.25% at June 30, 2006). 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. For the three months ended June 30, 2006 and 2005, interest expense on the Term B loan, including PIK interest, was approximately $598,000 and $513,000, respectively.

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 future indebtedness, asset

acquisitions and dispositions, investments and maintenance of required leverage ratios, minimum EBITDA, as defined, 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. For the three months ended June 30, 2006 and 2005, the expense associated with these lenders fees was approximately $29,000 for both years.

7. Preferred stock

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. No gain or loss was recognized as a result of this exchange as the fair value of Series C approximated the fair value of Series B. The fair values were obtained by a third-party valuation. At June 30, 2006, the liquidation value for the Series C preferred stock was $11,945 per share.

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.

8. Related party transactions

Special Situations Opportunity Fund I, LLC, one of the Term A lenders under the New Credit Agreement described in Note 6, is an affiliate of First Source Financial, Inc. First Source is one of the Company’s Series C preferred stockholders and an affiliate of First Source owns approximately 12.5% of the Company’s outstanding common stock. 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. Three of the Company’s six directors are affiliated with the Centre Entities.

9. Net income per common share

Basic and diluted net income per share was calculated by dividing net income by the weighted average common shares outstanding for the three months ended June 30, 2006 and 2005.

Options to purchase 6,223,622 and 6,690,737 shares of common stock were outstanding at June 30, 2006 and 2005, respectively, and were included in the computation of diluted EPS for the three months ended June 30, 2006 and 2005.

10. Contingencies and commitments

Product Warranty Cost 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 were as follows (in thousands):


	June 30, 2006			March 31, 2006
Balance – beginning	$	483		$	283
Claims paid		(130	)		(481	)
Warranties issued/(expired), net		129			681

Balance - ending	$	482		$	483

11. Supplemental cash flow disclosures


	Three Months Ended June 30,
	2006		2005
Cash paid (received) for (in thousands):
Interest	$	286	$	267
Income taxes		3		(48	)

12. Comprehensive loss


	Three Months Ended June 30,
	2006			2005
Net income	$	30		$	9
Foreign currency translation adjustment		(385	)		(480	)

Comprehensive loss	$	(355	)	$	(471	)

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, 2006.

You should carefully review the information contained in this Report and should particularly consider any risks and other factors that we set forth in this Report and in other reports or documents that we file from time to time with the SEC. Except for historical information contained herein, this Report contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended, including statements of 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:

•

changes in laws and regulations, both domestically and in the international markets in which we compete,

•

diversion of funds that otherwise might be spent on our products in support of the war on terror,

•

changes in the competitive environment, including the introduction of competitors attracted by the prospect of increased government spending on security, especially with respect to large defense contractors,

•

changes in technology which may affect our existing and future product offerings,

•

disruptions in scheduled development of new products,

•

decline in market acceptance of existing products,

•

currency fluctuations,

•

the ability to realize cost reductions and operating efficiencies in a manner that does not unduly disrupt business operations,

•

industry consolidation and mergers that involve our competitors, especially with respect to large defense contractors,

•

market conditions that may adversely affect the availability of debt and equity financing for working capital, capital expenditures or other purposes,

•

general economic conditions including changes in customer budgets and spending profiles,

•

the fact that our U.S. and other government customers may generally terminate our contracts for convenience if termination is deemed by them to be in their best interests,

•

the fact that a significant portion of our revenues are derived from international sales, which are subject to political and economic risks, including political instability, currency controls, exchange rate fluctuations and changes in import/export regulations and tariff rates, and

•

the other risks identified in Risk Factors set forth in our Annual Report on Form 10-K for the fiscal year ended March 31, 2006.

For these forward-looking statements, we claim the protection of the safe harbor for forward-looking statements in Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934.

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

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 governmental agencies is recognized upon shipment when title passes, because at the time title passes, all material commitments will have been fulfilled, the sales price is fixed and determinable and collectibility is reasonably assured. Some contracts contain acceptance clauses giving customers a right to test products. In these instances, revenue is not recognized until the customer accepts the products or the acceptance clause lapses. A large portion of the Company’s small and supporting arms training simulator revenue is derived from contracts with large governmental agencies. Governmental contracts that involve high volume purchases of the Company’s standard systems and related accessories are accounted for as multiple-deliverable arrangements, in accordance with EITF 00-21, Revenue Arrangements with Multiple Deliverables, based on the relative fair values of the deliverables specified in the contract. These contracts require little or no modifications to the existing proprietary platform and specify pricing terms by product, with billings generally corresponding 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.

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.

Inventory Valuation

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 the Company’s 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 changes in the underlying sales mix, the release of new versions of the Company’s proprietary systems 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 Loss Reserve

Management assesses the Company’s performance and estimated costs 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 loss reserve in an amount equal to the estimated costs in excess of contracted revenues in the period in which the possibility of contract loss becomes apparent.

Warranty Cost 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 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 reserve will be inadequate to offset actual warranty costs incurred resulting in additional charges against income in the period such information is determined. Also, actual warranty costs may be significantly lower than expected resulting in the reduction of the Company’s warranty reserve generating an addition to income in future periods.

SFAS No. 123(R)

On April 1, 2006, we adopted Statement of Financial Accounting Standards No. 123 (revised 2004), Share-Based Payment (“SFAS 123R”), using the modified-prospective-transition approach method. The adoption decreased our net income by $227,000 for the three months ended June 30, 2006 compared to our previous method of accounting for share-based compensation under Accounting Principal Board Opinion No. 25, Accounting for Stock Issued to Employees. We will incur approximately $1.1 million of expense over a weighted average of 4 years for all unvested options.

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 June 30,
	2006		2005
Revenue	100.00	%	100.00	%
Cost of revenue	63.12		65.74

Gross Margin	36.88		34.26

Operating expenses
Selling, general and administrative	23.42		22.46
Research and development	6.08		8.48

Total operating expenses	29.50		30.94

Operating income	7.38		3.32

Other income (expense), net
Interest expense on debt	(5.88	)	(5.45	)
Other, net	(2.00	)	1.43

Total other income (expense)	(7.88	)	(4.02	)

Loss before benefit for income taxes	(0.50	)	(0.70	)
Benefit for income taxes	(0.67	)	(0.76	)

Net income	.17		0.06

Three Months Ended June 30, 2006 Compared to Three Months Ended June 30, 2005:

Net Revenues: Revenues increased $0.4 million, or 2.4%, to $16.9 million for the three months ended June 30, 2006, as compared to $16.5 million for the three months ended June 30, 2005. Sales to international customers for the three months ended June 30, 2006 increased $0.5 million, or 6.4%, to $8.3 million. The international sales increase is due primarily to the effort in a large, long-term percentage-of-completion contract in the Asian-Pacific region. Sales to U.S. military customers for the three months ended June 30, 2006 increased $0.1 million, or 1.3%, to $7.9 million. Sales to U.S. law enforcement customers for the three months ended June 30, 2006 decreased $0.2 million, or 22.8%, to $0.7 million.

Cost of Revenues: Cost of revenues decreased $0.2 million, or 1.8%, to $10.7 million for the three months ended June 30, 2006, as compared to $10.9 million for the three months ended June 30, 2005. As a percentage of revenues, cost of revenues for the three months ended June 30, 2006 decreased to 63.1%, as compared to 65.7% for the three months ended June 30, 2005. The decrease in cost of revenues as a percentage of revenues is attributed primarily to attaining significant cost reductions through more effective supply chain management and continued improvements in the manufacturing process.

Gross Profit: As a result of the foregoing, gross profit increased $0.5 million, or 8.8%, to $6.2 million, or 36.9% of revenues for the three months ended June 30, 2006, as compared to $5.7 million, or 34.2% of revenues, for the three months ended June 30, 2005.

Total Operating Expenses: Total operating expenses decreased $0.1 million, or 2.0%, to $5.0 million for the three months ended June 30, 2006, as compared to $5.1 million for the three months ended June 30, 2005. As a percentage of revenues, total operating expenses decreased to 29.5% for the three months ended June 30, 2006, as compared to 30.9% for the three months ended June 30, 2005. Selling, general and administrative (“SG&A”) expenses, which include bid and proposal activities, increased from $3.7 million for the three months ended June 30, 2005 to $4.0 million for the three months ended June 30, 2006. In addition, as a percentage of revenues, SG&A increased from 22.5% at June 30, 2005 to 23.4% at June 30, 2006. The increase in SG&A as a percentage of revenues is attributed primarily to the adoption of SFAS 123(R). Research and development costs decreased $0.4 million from $1.4 million for the three months ended June 30, 2005 to $1.0 million for the three months ended June 30, 2006 due primarily to the mix of effort between internal and customer-paid research and development during the quarter.

Operating Income: As a result of the foregoing, operating income increased $0.7 million to $1.2 million for the three months ended June 30, 2006, as compared to $0.5 million for the three months ended June 30, 2005. As a percentage of revenues, operating income was 7.4% of revenues for the three months ended June 30, 2006, as compared to 3.3% of revenues for the three months ended June 30, 2005.

Other Income (Expense), net: Other income (expense), net totaled $(1.3) million, or (7.9%) of revenues, for the three months ended June 30, 2006, as compared to $(0.7) million, or (4.0%) of revenues, for the three months ended June 30, 2005. The increase in other expense of $0.6 million is attributed primarily to the weaker U.S. dollar. The foreign exchange loss was $0.3 million for the three months ended June 30, 2006, as compared to a $0.2 million gain for the three months ended June 30, 2005.

Loss Before Benefit for Income Taxes: As a result of the foregoing, the loss before benefit for income taxes decreased $34,000 from a loss of $117,000 for the three months ended June 30, 2005 to a loss of $83,000 for the three months ended June 30, 2006.

Benefit for Income Taxes: The loss before income taxes for the three months ended June 30, 2006 resulted in a tax benefit of $113,000, while the loss before income taxes for the three months ended June 30, 2005 resulted in a tax benefit of $126,000.

Net Income: As a result of the foregoing, net income increased by $21,000 to net income of $30,000, or $0.00 diluted loss per share, for the three months ended June 30, 2006, from net income of $9,000, or $0.00 diluted income per share, for the three months ended June 30, 2005.

ANALYSIS OF BACKLOG

As of June 30, 2006, the Company had a backlog of approximately $51.4 million compared with $50.9 million as of June 30, 2005. As of June 30, 2006, our backlog consisted of $35.9 million from international customers, $15.2 million from U.S. military customers and $0.3 million from U.S. law enforcement customers. Management expects that approximately $33.2 million of backlog will be delivered during the remainder of fiscal 2007. The U.S. and other government customers may generally terminate contracts, in whole or in part, for default or convenience if such termination would be in the best interest of the customer. However, these contracts generally provide for reimbursement of actual costs incurred plus a reasonable profit through the date of termination.

A summary of changes in the Company’s backlog is as follows (in thousands):


	Three Months Ended June 30,
	2006			2005
Backlog – beginning of period	$	62,771		$	58,411
New bookings		5,505			9,070
Revenue		(16,884	)		(16,539	)

Backlog – end of period	$	51,392		$	50,942

LIQUIDITY AND CAPITAL RESOURCES

As of June 30, 2006, we had working capital of $27.4 million compared to a working capital of $27.1 million as of June 30, 2005. The net $0.3 million increase in working capital is due primarily to a $2.5 million increase in costs and estimated earnings in excess of billings on incomplete contracts, $2.5 million decrease in deferred revenue and a net $1.0 million decrease in accounts payable and various accrued liability accounts, offset partially by a $1.3 million decrease in cash, $2.9 million decrease in accounts receivable and a net $1.4 million decrease in various other current asset accounts.

We had a net decrease in cash and cash equivalents of $2.0 million for the three months ended June 30, 2006, as compared to a net decrease of cash and cash equivalents of $2.7 million for the three months ended June 30, 2005. For the three months ended June 30, 2006, the Company’s operating activities provided cash of approximately $2.1 million compared to the use of cash of $5.0 million for the three months ended June 30, 2005. During the three months ended June 30, 2006, cash flows from operations had a positive impact from significant cash receipts on accounts receivable. During this same period, cash outflows from financing activities were $5.1 million for long-term debt payments.

Our primary capital requirements are for working capital, debt service, and capital expenditures. Since August of 2000, we have financed our operations and growth primarily through internally generated funds and income tax refunds. With the issuance of the New Credit Agreement, which decreased debt and provided lower interest rates, management believes that funds provided by operations will be sufficient to fund our cash needs and anticipated capital expenditures through the next twelve months. As previously disclosed, however, the Company has retained Houlihan Lokey Howard & Zukin Capital, Inc. as its exclusive financial advisor to assist the company in evaluating various strategic alternatives, including recapitalization, sale of stock, merger or asset disposition possibilities, all with the goal of maximizing shareholder value. The Company expects to complete its review of strategic alternatives and take any actions arising from this review during the next several months. However, there can be no assurance that this process will result in a transaction, any proposal or agreement for a transaction, or any other action by the Company.

CONCENTRATION OF CREDIT RISK

As of June 30, 2006, approximately $10.7 million in accounts receivable, or 87% of total net accounts receivable, was due from five of the Company’s customers.

COMMITMENTS AND OTHER CONTRACTURAL OBLIGATIONS

Disclosure of Commitments and Other Obligations

June 30, 2006

(amounts in thousands)


	Total		Less than 1 year		Within 1-3 years		Within 4-5 years		After 5 years
Long-term debt
Revolving credit facility	$	2,843	$	—	$	—	$	2,843	$	—
Long-term debt – Term A		9,038		3,847		4,851		340		—
Long-term debt – Term B		15,000		—		—		15,000		—
Accrued PIK		404		—		—		404		—
Other
Purchase orders		10,058		6,489		3,569		—		—
Operating lease obligations		1,888		955		888		42		3

Total	$	39,231	$	11,291	$	9,308	$	18,629	$	3

OFF-BALANCE SHEET ARRANGEMENTS

As of June 30, 2006, the Company did not have any off-balance sheet financing transactions or arrangements other than disclosed in the table above.

ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

Our major market risk exposure arises from changes in interest rates and its impact on variable rate debt instruments. Our objectives in interest rate risk management are to limit the impact of interest rate changes on earnings and cash flows, and to lower overall borrowing costs. To achieve these objectives, we borrow at fixed rates when we have the opportunity and believe it is in the Company’s best interests to do so, and may enter into derivative financial instruments, such as interest rate swaps and caps, in order to limit our exposure to interest rate fluctuations. We do not enter into derivative or interest rate transactions for speculative purposes. There were no derivative contracts in effect related to debt instruments at June 30, 2006 or 2005.

As of June 30, 2006, we had a total of approximately $23.4 million in variable rate debt at differing interest rates tied to the prime rate. If interest rates on the Company’s existing variable rate debt were to increase by 10% over the next twelve months, management believes there would be no material adverse impact on the Company’s results of operations or cash flow.

ITEM 4. CONTROLS AND PROCEDURES

We maintain disclosure controls and procedures, as defined in Rule 13a-15(e) under the Securities Exchange Act of 1934, that are designed to provide reasonable assurance that information required to be disclosed in the reports that we file or submit under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the rules and forms of the Securities and Exchange Commission and that such information is accumulated and communicated to the Company’s management, including its chief executive and chief financial officers, as appropriate, to allow timely decisions regarding required disclosure. It should be noted, however, that because of inherent limitations, the Company’s disclosure controls and procedures, however well designed and operated, can provide only reasonable assurance that the objectives of the disclosure controls and procedures are met.

The Company carried out an evaluation, under the supervision and with the participation of its management, including its chief executive and chief financial officer, of the effectiveness of the design and operation of its disclosure controls and procedures as of the end of the period covered by this Report. Based on the evaluation of these disclosure controls and procedures, the chief executive and chief financial officer of the Company concluded that the Company’s disclosure controls and procedures as of the end of the period covered by this Report were effective at a reasonable assurance level.

There were no changes in the Company’s internal control over financial reporting during the Company’s fiscal quarter ended June 30, 2006, that have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting.

PART II. OTHER INFORMATION

ITEM 1. LEGAL PROCEEDINGS

The Company is involved in legal proceedings in the ordinary course of its business, which in the opinion of management will not have a materially adverse effect on the Company’s financial position, liquidity, or results of operation.

ITEM 1A. RISK FACTORS

Item 1A of Part I of our Form 10-K for the fiscal year ended March 31, 2006 summarizes various material risks that investors should carefully consider before deciding to buy or maintain an investment in our common stock. Any of those risks, if they actually occur, would likely harm our business, financial condition and results of operations and could cause the trading price of our common stock to decline. The following sets forth material changes from the risk factors set forth in our most recent Form 10-K.

The following risk factors are updated:

Our business relies on maintaining key customer relationships and certain key contracts.

In fiscal 2005, the Company’s largest customers accounted for approximately 69.8% of the Company’s revenues, with three customers accounting for more than 10% of revenues. In fiscal 2006, the Company’s largest customers accounted for approximately 75.1% of the Company’ revenues, with two customers accounting for more than 10% of revenues. In fiscal 2007, for the three months ended June 30, 2006, the Company’s largest customers accounted for approximately 78.8% of the Company’s revenues, with 3 customers each accounting for more than 10% of revenues. Given the nature of our contracts, revenues attributable to specific customers are likely to vary from year to year, and a significant customer in one year may not be a significant customer in a subsequent year. In order to reach our growth objectives, we will be required to seek contracts from new domestic and international customers as well as orders from existing customers for additional types of virtual simulated training solutions or increased quantities of previously ordered systems and simulated weapons. A significant decrease in demand by or the loss of one or more significant customers could have a material adverse effect on our results of operations or financial condition.

Our business relies on obtaining key government contracts that are subject to regulatory requirements and availability of public funds.

Most of our customers to date have been in the public sector of the U.S., including the federal, state and local governments, and in the public sectors of a number of other countries. Approximately 55.0% of our revenues for fiscal 2006 were attributable to sales to military authorities in the U.S., 5.7% were attributable to sales to law enforcement authorities in the U.S. and 39.3%, were attributable to sales to military and law enforcement authorities internationally. For fiscal 2007, approximately 46.6% of our revenues for the three months ended June 30, 2006 were attributable to sales to military authorities in the U.S, 4.2% were attributable to sales to law enforcement authorities in the U.S. and 49.2%, were attributable to sales to military and law enforcement authorities internationally. Sales to public sector customers are subject to a multiplicity of detailed regulatory requirements and public policies. For example, we are subject to export licensing requirements with respect to the transfer of arms and technical data used by our foreign subsidiaries to modify simulated weapons for use in systems supplied to international customers. The key regulatory requirements for FATS are (1) the International Traffic in Arms Regulations (ITAR) whose oversight is performed by the Directorate of Defense Controls (DDTC) of the U.S. State Department and (2) the U.S. Government Firearms Control Act whose oversight is performed by the Bureau of Alcohol, Tobacco and Firearms.

The ITAR regulates exports of U.S. military equipment and technical data to our subsidiaries and foreign customers. The DDTC may revoke, suspend or amend our licenses without notice. The Bureau of Alcohol, Tobacco and Firearms (ATF) authorize FATS to be a dealer in regulated firearms and other destructive materials. The ATF, like the DDTC, may revoke licenses or deny their renewal for failure to follow prescribed regulations or as a result of the commission of criminal offenses. All of our subsidiaries also have similar licenses in their jurisdictions of incorporation.

Any revocation of or refusal to renew our licenses would have a material adverse effect on the conduct of our operations and financial condition since we must posses such licenses and comply with governmental regulations in order to manufacture and market our products. In addition, public sector customer contracts may be conditioned upon the continuing availability of public funds, which in turn depends upon lengthy and complex budgetary procedures, and may be subject to certain pricing constraints. Moreover, U.S. government contracts and those of many international government customers may generally be terminated for convenience for a variety of factors when it is in the best interest of the government. There can be no assurance that these factors or others unique to government contracts will not have a material adverse effect on our future results of operations and financial condition.

Our business relies on maintaining and growing sales to international customers.

A significant portion of our sales is made to customers located outside the U.S., primarily in Europe and Asia. In fiscal 2006, 2005 and 2004, 39.3%, 45.1% and 51.6% of our revenues, respectively, were derived from sales to customers located outside the U.S. For the three months ended June 30, 2006, 49.2% of our revenues were derived from sales to customers located outside the U.S. We expect that our international customers will continue to account for a substantial portion of our revenues in the near future. Sales to international customers may be subject to political and economic risks, including political instability, wars, civil unrest, acts of terrorism and other conflicts, currency controls, exchange rate fluctuations and changes in import/export regulations and tariff rates. In addition, various forms of protectionist trade legislation have been and in the future may be proposed in the U.S. and certain other countries. Any resulting changes in current tariff structures or other trade and monetary policies could adversely affect our sales to international customers. Political and economic factors have been identified by the Company with respect to certain of the markets in which we compete. There can be no assurance that these factors will not result in defaults by customers in making payments due to the Company, in reductions in the purchases of our products by international customers or in foreign currency exchange losses. We do not currently hedge these foreign currency transactions. In certain cases, we have reduced certain of the risks associated with international contracts by obtaining bank letters of credit to support the payment obligations of our customers and/or by providing in our contracts for payment in U.S. dollars.

Our financial condition, and the restrictive covenants contained in our credit facility may limit our ability to borrow additional funds or raise additional equity as may be required to fund our future operations.

Our accumulated deficit and stockholders’ deficit was approximately $154.4 million and $25.7 million, respectively, as of March 31, 2006 and $154.4 million and $24.9 million, respectively, as of June 30, 2006. Moreover, the terms of our New Credit Agreement may limit our ability to, among other things:

•

incur additional debt;

•

retire or exchange outstanding debt;

•

pay cash dividends, redeem, retire or repurchase our stock or change our capital structure;

•

acquire assets or businesses or make investments in other entities;

•

enter into certain transactions with affiliates;

•

merge or consolidate with other entities;

•

sell or otherwise dispose of assets or use the proceeds from any asset sale or other disposition; and

•

create additional liens on our assets.

ITEM 6. EXHIBITS


31.1		Certification of Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002

31.2		Certificate of Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002

32.1		Certificate of Chief Executive Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002

32.2		Certificate of Chief Financial Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002

SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

DATED: August 14, 2006

FIREARMS TRAINING SYSTEMS, INC.

/S/ Gregory A. Ton

Gregory A. Ton

Chief Financial Officer and Treasurer

(Principal Financial Officer and
Duly Authorized Officer)

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FIREARMS TRAINING SYSTEMS INC 10-Q