Transcat - 10-Q quarterly report FY

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 þ      No o

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.

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes o No þ

The number of shares of Common Stock, par value $0.50 per share, of the registrant outstanding as of February 3, 2006 was 6,733,175.

Description of Business: Transcat, Inc. (“Transcat” or “the Company”) is a leading distributor of professional grade test, measurement, and calibration instruments and a provider of calibration and repair services, primarily throughout the process, life science, and manufacturing industries.

Basis of Presentation: Transcat’s unaudited Consolidated Financial Statements have been prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”) for interim financial information and in accordance with the instructions to Form 10-Q and Article 10 of Regulation S-X of the Securities and Exchange Commission (“SEC”). Accordingly, the Consolidated Financial Statements do not include all of the information and footnotes required by GAAP for complete financial statements. In the opinion of the Company’s management, all adjustments considered necessary for a fair presentation (consisting of normal recurring adjustments) have been included. The results for the interim periods are not necessarily indicative of the results to be expected for the fiscal year. The accompanying Consolidated Financial Statements should be read in conjunction with the audited Consolidated Financial Statements as of and for the fiscal year ended March 26, 2005 (“fiscal year 2005”) contained in the Company’s 2005 Annual Report on Form 10-K filed with the SEC.

Principles of Consolidation: The Consolidated Financial Statements of Transcat include the accounts of Transcat, Inc. and all of the Company’s wholly owned subsidiaries. All significant intercompany balances and transactions are eliminated in consolidation.

Use of Estimates: The preparation of Transcat’s Consolidated Financial Statements in accordance with GAAP requires that the Company make estimates and assumptions that affect the reported amounts of assets and liabilities, and the disclosure of contingent assets and liabilities at the date of the financial statements, and the reported amounts of revenues and expenses during the reporting period. Significant estimates and assumptions are used for, but not limited to, allowance for doubtful accounts and returns, depreciable lives of assets, estimated lives of major catalogs (“Master Catalog”), and tax valuation allowances. Future events and their effects cannot be predicted with certainty; accordingly, accounting estimates require the exercise of judgment. The accounting estimates used in the preparation of the Consolidated Financial Statements will change as new events occur, as more experience is acquired, as additional information is obtained, and as the operating environment changes. Actual results could differ from those estimates.

Changes in Estimates: In the ordinary course of accounting for items discussed above, Transcat makes changes in estimates as appropriate, and as the Company becomes aware of changed circumstances surrounding those estimates. Such changes and refinements in estimation methodologies are reflected in reported results of operations in the period in which the changes are made and, if material, their effects are disclosed in the Notes to the Consolidated Financial Statements.

Fiscal Year: We operate on a 52/53 week fiscal year, ending the last Saturday in March. In a 52-week fiscal year, each of our four quarters is a 13-week period, and the final month of each quarter is a 5-week period.

Revenue Recognition: Sales are recorded when products are shipped or services are rendered to customers, as the Company generally has no significant post delivery obligations. The Company’s prices are fixed and determinable, collection of the resulting receivable is probable, and returns are reasonably estimated. Provisions for customer returns are provided for in the period the related sales are recorded based upon historical data. The Company recognizes the majority of service revenue based upon when the calibration or repair activity is performed then shipped and/or delivered to the customer. Some of the service revenue is generated from managing customers’ calibration programs in which the Company recognizes revenue in equal amounts at fixed intervals. Shipments are generally free on board shipping point and customers are generally invoiced for freight, shipping, and handling charges.

Shipping and Handling Costs: Freight expense and direct shipping costs are included in cost of sales. Direct handling costs, which primarily represent direct compensation of employees who pick, pack, and otherwise prepare, if necessary, merchandise for shipment to customers are reflected in selling, marketing, and warehouse expenses.

Rebates: Rebates are based on a specified cumulative level of purchases and are recorded as a reduction of cost of sales as the milestone is achieved.

Cooperative Advertising Income: Transcat follows the provisions of the Emerging Issues Task Force (“EITF”) Issue No. 02-16, “Accounting by a Reseller for Cash Consideration Received from a Vendor” which provides that cash consideration received from a vendor by a reseller be reported as a reduction of cost of sales as the related inventory is sold.

Comprehensive Income: Transcat reports comprehensive income under Statement of Financial Accounting Standards (“SFAS”) No. 130, “Reporting Comprehensive Income”. Other comprehensive income is comprised of net income (loss) and currency translation adjustments.

Currency Translation Adjustment: The accounts of Transcat’s Canadian subsidiary are maintained in the local currency and have been translated to United States dollars in accordance with SFAS No. 52, “Foreign Currency Translation”. Accordingly, the amounts representing assets and liabilities, except for long-term intercompany accounts and equity, have been translated at the period-end rates of exchange and related revenue and expense accounts have been translated at average rates of exchange during the period. Gains and losses arising from translation of the Company’s subsidiary balance sheets into United States dollars are recorded directly to the accumulated other comprehensive income component of stockholders’ equity.

Currency gains and losses on business transactions are included in other expense on the Consolidated Statements of Operations.

Earnings Per Share: Basic earnings per share of Common Stock are computed based on the weighted average number of shares of Common Stock outstanding during the period. Diluted earnings per share of Common Stock reflect the assumed conversion of dilutive stock options, warrants, and non-vested restricted stock awards. In computing the per share effect of assumed conversion, funds which would have been received from the exercise of options, warrants, and non-vested restricted stock are considered to have been used to purchase shares of Common Stock at the average market prices during the period, and the resulting net additional shares of Common Stock are included in the calculation of average shares of Common Stock outstanding.

For the third quarter of the fiscal year ending March 25, 2006 (“fiscal year 2006”), the net additional Common Stock equivalents had no effect on the calculation of dilutive earnings per share. For the first nine months of fiscal year 2006, the net additional Common Stock equivalents had a $0.01 per share effect on the calculation of dilutive earnings per share. For the third quarter of fiscal year 2005, the net additional Common Stock equivalents had no effect on the calculation of dilutive earnings per share. For the first nine months of fiscal year 2005, there were no dilutive shares. The total number of dilutive and anti-dilutive Common Stock equivalents resulting from stock options, warrants, and non-vested restricted stock are summarized as follows:

Accounts Receivable: Accounts receivable represent receivables from customers in the ordinary course of business. These amounts are recorded net of the allowance for doubtful accounts and returns in the Consolidated Balance Sheets. The allowance for doubtful accounts is based upon the expected collectibility of accounts receivable. Transcat applies a specific formula to its accounts receivable aging, which may be adjusted on a specific account basis where the specific formula may not appropriately reserve for loss exposure. After all attempts to collect a receivable have failed, the receivable is written-off against the allowance for doubtful accounts. The returns reserve is calculated based upon the historical rate of returns applied to sales over a specific timeframe. The returns reserve will increase or decrease as a result of changes in the level of sales and/or the historical rate of returns.

Inventory: Inventory consists of finished goods and is valued at the lower of cost or market. Costs are determined using the average cost method of inventory valuation. Inventory is reduced by a reserve for items not saleable at or above standard cost. Transcat reserves specifically for certain items of inventory and, for other items, the Company applies a specific loss factor, based on historical experience, to specific categories of inventory. The Company evaluates the adequacy of the reserve on a regular basis.

Properties, Depreciation, and Amortization: Properties are stated at cost. Depreciation and amortization is computed primarily under the straight-line method with useful lives of 3 to 10 years for the following major classifications: machinery, equipment, software, and furniture and fixtures. Properties determined to have no value are written off at their then remaining net book value. Transcat accounts for software costs in accordance with Statement of Position No. 98-1, “Accounting for the Costs of Computer Software Developed or Obtained for Internal Use”. Leasehold improvements are amortized under the straight-line method over the estimated useful life or the lease term, whichever is shorter. Maintenance and repairs are expensed as incurred.

Goodwill: Transcat estimates the fair value of the Company’s reporting units in accordance with SFAS No. 142, “Goodwill and Other Intangible Assets”, using the fair market value measurement requirement, rather than the undiscounted cash flows approach. The Company tests goodwill for impairment on an annual basis, or immediately if conditions indicate that such impairment could exist.

Deferred Catalog Costs: Transcat amortizes the cost of each Master Catalog mailed over such catalog’s estimated productive life. The Company reviews response results from catalog mailings on a continuous basis, and if warranted, modifies the period over which costs are recognized. The Company amortizes the cost of each Master Catalog over an eighteen month period and amortizes the cost of each catalog supplement over a three month period.

Deferred Compensation: Previously, some of Transcat’s directors had elected to defer receipt of their non-discretionary awards of shares of Common Stock under the Amended and Restated Directors’ Stock Plan. Deferred shares were expensed at the market value of Common Stock at the date of award, and the associated liability is adjusted quarterly based on the quarter end market price of Common Stock. Directors voluntarily elected to cease deferring shares as of April 1, 2003.

In addition, the Company provides an annual benefit to a former president’s spouse and former executive under the terms of a deferred compensation agreement.

Deferred Gain on TPG: As a result of certain post divestiture commitments, Transcat is unable to recognize the gain of $1.5 million on the divestiture of Transmation Products Group (“TPG”), which took place in the fiscal year ended March 31, 2002 (“fiscal year 2002”), until those commitments expire on December 31, 2006. See Note 5 of the Consolidated Financial Statements for further disclosure.

Deferred Taxes: Transcat accounts for certain income and expense items differently for financial reporting purposes than for income tax reporting purposes. Deferred taxes are provided in recognition of these temporary differences. A valuation allowance on net deferred tax assets is provided for items for which it is more likely than not that the benefit of such items will not be realized, in accordance with the provisions of SFAS No. 109, “Accounting for Income Taxes”. SFAS No. 109 requires an assessment of both positive and negative evidence when measuring the need for a deferred tax valuation allowance.

Fair Value of Financial Instruments: Transcat has determined the fair value of debt and other financial instruments using available market information and appropriate valuation methodologies as follows:

Stock Options: Transcat follows the provisions of Accounting Practice Board No. 25, “Accounting for Stock Issued to Employees”, which does not require compensation costs related to stock options to be recorded in net income, as all options granted under the Transcat, Inc. 2003 Incentive Plan had exercise prices equal to the market value of the underlying Common Stock at grant date.

Pro forma amounts are as follows:

Description. On November 13, 2002, Transcat entered into a Revolving Credit and Loan Agreement (the “Credit Agreement”) with GMAC Business Credit, LLC (“GMAC”). The Credit Agreement consisted of a term loan, a revolving line of credit (“LOC”), and certain material terms which are as set forth below.

The Credit Agreement was amended on April 11, 2003 to address certain non-material post closing conditions.

The Credit Agreement was further amended on July 22, 2004 to waive compliance with an EBITDA (earnings before interest, income taxes, depreciation and amortization) covenant for the first quarter of fiscal year 2005, permanently waive a requirement relating to an inactive subsidiary that the Company had committed to dissolve by a specific date (that has been subsequently dissolved), and increase the Credit Agreement restriction on Master Catalog spending.

Transcat amended the Credit Agreement again on November 1, 2004 (“Third Amendment”). The Third Amendment consists of two term notes, a LOC, a capital expenditure loan option if certain conditions are met, and certain material terms which are as set forth below. The Third Amendment also waived compliance with the Company’s EBITDA covenant for the second quarter of fiscal year 2005 and extended the Credit Agreement expiration from November 13, 2005 to October 31, 2007.

Term Loans. Under the Third Amendment, the Company entered into two term loans, Term Loan A and Term Loan B, in the amounts of $1.5 million and $0.5 million, respectively. The notes representing the term loans require annual payments of $0.5 million and $0.2 million, respectively, payable over three years in equal monthly installments, commencing on December 1, 2004. The Company is further required to reduce the term loans on an annual basis by a percentage of excess cash flow, as defined in the Third Amendment. Term Loan B will be reduced by the lesser of the balance owed on Term Loan B or 50% of the Company’s excess cash flow payable in three monthly installments. Once Term Loan B has been repaid, the excess cash flow payment required against Term Loan A is 20% of the Company’s excess cash flow, not to exceed $0.2 million, annually. As of December 24, 2005, the Third Amendment requires the Company to make the following principal payments on combined term loans, after giving effect to any excess cash flow payments to be made:

LOC. Under the Third Amendment, the maximum amount available under the LOC portion is $9.0 million. As of December 24, 2005, the Company was eligible to borrow up to $8.8 million based on assets and borrowed $4.0 million. Availability under the LOC is determined by a formula based on eligible accounts receivable (85%) and inventory (50%).

The Credit Agreement contains both a subjective acceleration clause and a requirement to maintain a lock-box arrangement. These conditions resulted in a short-term classification of the LOC in accordance with EITF Issue No. 95-22, “Balance Sheet Classification of Borrowings Outstanding under Revolving Credit Agreements that include both a Subjective Acceleration Clause and a Lock-Box Arrangement”.

Interest. Interest on the term loans and LOC is adjusted on a quarterly basis based upon the Company’s calculated Fixed Charge Coverage Ratio, as defined in the Third Amendment (see chart below). The prime rate and the 30-day London Interbank Offered Rate (“LIBOR”) as of December 24, 2005 were 7.25% and 4.39%, respectively. The Company’s interest rate for the first, second, and third quarters of fiscal year 2006 was at Tier 3, as described in the following chart:

Covenants. The Credit Agreement has certain covenants with which the Company has to comply, including a minimum EBITDA covenant, and restrictions on capital expenditures and Master Catalog spending. The Third Amendment includes a revised EBITDA covenant, a fixed charge coverage ratio covenant and revised restrictions on capital expenditures and Master Catalog spending. The Company was in compliance with all loan covenants and requirements for the third quarter of fiscal year 2006.

Loan Costs. In accordance with EITF Issue No. 98-14, “Debtor’s Accounting for Changes in Line-of-Credit or Revolving-Debt Arrangements”, any fees paid to GMAC, third party costs associated with the LOC of the Third Amendment, and unamortized costs remaining under the Credit Agreement, are amortized over the term of the Third Amendment.

Other Terms. The Third Amendment requires an increase in the Company’s borrowing rate of two percentage points should an event of default occur. A termination premium of 2% of the advance limit in year one, 1% in year two, and 0.5% in year three, as defined in the Credit Agreement, will be incurred if the Credit Agreement is terminated prior to its expiration date of October 31, 2007.

Additionally, the Company has pledged certain property and fixtures in favor of GMAC, including inventory, equipment, and accounts receivable as collateral security for the loans made under the Credit Agreement.

The Third Amendment also provides for a capital expenditure loan (“Cap-x Loan”). The Company has achieved an EBITDA, as defined in the Credit Agreement, of at least $2.4 million on a trailing twelve months basis in the required time frame specified in the Credit Agreement and therefore may make a Cap-x Loan of up to $1.0 million for qualifying capital expenditures. As of December 24, 2005, the Company has not borrowed any additional monies. The Cap-x Loan would be payable in equal monthly payments over a 36 month period with any residual balance resulting in a balloon payment at October 31, 2007. Interest is adjusted on a quarterly basis based upon the Company’s calculated Fixed Charge Coverage Ratio with the same terms as Term Loan A (see chart above).

Transcat has two reportable segments: Distribution Products (“Product”) and Calibration Services (“Service”). The accounting policies of the reportable segments are the same as those described above in Note 2 of the Consolidated Financial Statements. The Company has no inter-segment sales. The following table presents segment for the third quarter and nine months ended December 24, 2005 and December 25, 2004:

Unconditional Purchase Obligation: In fiscal year 2002, the Company entered into a distribution agreement (the “Distribution Agreement”) with Fluke Electronics Corporation (“Fluke”) to be the exclusive worldwide distributor of Transmation and Altek products until December 31, 2006. Under the Distribution Agreement, the Company also agreed to purchase a pre-determined amount of inventory from Fluke.

On October 31, 2002, with an effective date of September 1, 2002, the Company entered into a new distribution agreement (the “New Agreement”) with Fluke, which replaced the Distribution Agreement. The New Agreement ends on December 31, 2006. Under the terms of the New Agreement, among other items, the Company agreed to purchase a larger, pre-determined amount of inventory across a broader array of products and brands during each calendar year. The Company’s purchases for calendar years 2005, 2004, and 2003 exceeded the commitment under the New Agreement. The Company believes that this commitment to make future purchases is consistent with Transcat’s business needs and plans.

Approximately 30% of Transcat’s product purchases on an annual basis are from Fluke, which is not believed to be inconsistent with Fluke’s share of the markets the Company serves.

Forward-Looking Statements. This report and, in particular, the Management’s Discussion and Analysis of Financial Condition and Results of Operations section of this report, contains forward-looking statements as defined by the Private Securities Litigation Reform Act of 1995. These include statements concerning expectations, estimates, and projections about the industry, management beliefs and assumptions of Transcat, Inc. (“Transcat”, “we”, “us”, or “our”). Words such as “anticipates”, “expects”, “intends”, “plans”, “believes”, “seeks”, “estimates”, and variations of such words and similar expressions are intended to identify such forward-looking statements. These statements are not guarantees of future performance and are subject to certain risks, uncertainties and assumptions that are difficult to forecast. Therefore, our actual results may materially differ from those expressed or forecast in any such forward-looking statements. We undertake no obligation to publicly update any forward-looking statements, whether as a result of new information, future events or otherwise.

Rounding. Certain percentages may vary depending on the basis used for the calculation, such as dollars in thousands and dollars in millions.

Use of Estimates: The preparation of our Consolidated Financial Statements in accordance with accounting principles generally accepted in the United States (“GAAP”) requires that we make estimates and assumptions that affect the reported amounts of assets and liabilities, and the disclosure of contingent assets and liabilities at the date of the financial statements, and the reported amounts of revenues and expenses during the reporting period. Significant estimates and assumptions are used for, but not limited to, allowance for doubtful accounts and returns, depreciable lives of assets, estimated lives of our major catalogs (“Master Catalog”), and tax valuation allowances. Future events and their effects cannot be predicted with certainty; accordingly, our accounting estimates require the exercise of judgment. The accounting estimates used in the preparation of our Consolidated Financial Statements will change as new events occur, as more experience is acquired, as additional information is obtained, and as our operating environment changes. Actual results could differ from those estimates.

Changes in Estimates: In the ordinary course of accounting for items discussed above, we make changes in estimates as appropriate, and as we become aware of changed circumstances surrounding those estimates. Such changes and refinements in estimation methodologies are reflected in reported results of operations in the period in which the changes are made and, if material, their effects are disclosed in the Notes to our Consolidated Financial Statements.

Revenue Recognition: Sales are recorded when products are shipped or services are rendered to customers, as we generally have no significant post delivery obligations. Our prices are fixed and determinable, collection of the resulting receivable is probable, and returns are reasonably estimated. Provisions for customer returns are provided for in the period the related sales are recorded based upon historical data. We recognize the majority of our service revenue based upon when the calibration or repair activity is performed then shipped and/or delivered to the customer. Some of our service revenue is generated from managing customers’ calibration programs in which we recognize revenue in equal amounts at fixed intervals. Our shipments are generally free on board shipping point and our customers are generally invoiced for freight, shipping, and handling charges.

Accounts Receivable: Accounts receivable represent receivables from customers in the ordinary course of business. These amounts are recorded net of the allowance for doubtful accounts and returns in our Consolidated Balance Sheets. The allowance for doubtful accounts is based upon the expected collectibility of accounts receivable. We apply a specific formula to our accounts receivable aging, which may be adjusted on a specific account basis where the specific formula may not appropriately reserve for loss exposure. After all attempts to collect a receivable have failed, the receivable is written-off against the allowance for doubtful accounts. The returns reserve is calculated based upon the historical rate of returns applied to sales over a specific timeframe. The returns reserve will increase or decrease as a result of changes in the level of sales and/or the historical rate of returns.

Inventory: Inventory consists of finished goods and is valued at the lower of cost or market. Costs are determined using the average cost method of inventory valuation. Inventory is reduced by a reserve for items not saleable at or above standard cost. We reserve specifically for certain items of our inventory and, for other items, we apply a specific loss factor, based on historical experience, to specific categories of our inventory. We evaluate the adequacy of the reserve on a regular basis.

Properties, Depreciation, and Amortization: Properties are stated at cost. Depreciation and amortization is computed primarily under the straight-line method with useful lives of 3 to 10 years for the following major classifications: machinery, equipment, software, and furniture and fixtures. Properties determined to have no value are written off at their then remaining net book value. We account for software costs in accordance with Statement of Position No. 98-1, “Accounting for the Costs of Computer Software Developed or Obtained for Internal Use”. Leasehold improvements are amortized under the straight-line method over the estimated useful life or the lease term, whichever is shorter. Maintenance and repairs are expensed as incurred.

Goodwill: We estimate the fair value of our reporting units in accordance with Statement of Financial Accounting Standards (“SFAS”) No. 142, “Goodwill and Other Intangible Assets”, using the fair market value measurement requirement, rather than the undiscounted cash flows approach. We test our goodwill for impairment on an annual basis, or immediately if conditions indicate that such impairment could exist.

Deferred Catalog Costs: We amortize the cost of each Master Catalog mailed over such catalog’s estimated productive life. We review response results from catalog mailings on a continuous basis, and if warranted, modify the period over which costs are recognized. We amortize the cost of each Master Catalog over an eighteen month period and amortize the cost of each catalog supplement over a three month period.

Deferred Gain on TPG: As a result of certain post divestiture commitments, we are unable to recognize the gain of $1.5 million on the divestiture of Transmation Products Group (“TPG”), which took place in the fiscal year ended March 31, 2002, until those commitments expire on December 31, 2006. See Note 5 of our Consolidated Financial Statements for further disclosure.

Deferred Taxes: We account for certain income and expense items differently for financial reporting purposes than for income tax reporting purposes. Deferred taxes are provided in recognition of these temporary differences. A valuation allowance on net deferred tax assets is provided for items for which it is more likely than not that the benefit of such items will not be realized, in accordance with the provisions of SFAS No. 109, “Accounting for Income Taxes”. SFAS No. 109 requires an assessment of both positive and negative evidence when measuring the need for a deferred tax valuation allowance.

Stock Options: We follow the provisions of Accounting Practice Board No. 25, “Accounting for Stock Issued to Employees”, which does not require compensation costs related to stock options to be recorded in net income, as all options granted under the Transcat, Inc. 2003 Incentive Plan had exercise prices equal to the market value of the underlying Common Stock at grant date.

Off-Balance Sheet Arrangements: We do not maintain any off-balance sheet arrangements.

The following table sets forth, for the third quarter and first nine months of the fiscal year ending March 25, 2006 (“fiscal year 2006”) and the third quarter and first nine months of the fiscal year ended March 26, 2005 (“fiscal year 2005”), the components of our Consolidated Statements of Operations (calculated on dollars in thousands).

Net sales increased $2.1 million, or 14.9% (calculated on dollars in millions) from the third quarter of fiscal year 2005 to the third quarter of fiscal year 2006.

Our distribution products net sales results, which accounted for 70.8% of our sales in the third quarter of fiscal year 2006 and 70.2% of our sales in the third quarter of fiscal year 2005 (calculated on dollars in thousands), reflect improved year over year customer response to our sales and marketing activities. Our fiscal years 2006 and 2005 product sales in relation to prior fiscal year quarter comparisons, is as follows (calculated on dollars in millions):

The majority of our distribution products net sales growth in the third quarter of fiscal year 2006 compared to the third quarter of fiscal year 2005 was primarily in our core distribution channels. In addition, we experienced product net sales growth in our other distribution channels, primarily from high-volume electrical and instrumentation wholesalers, which caused a shift in our mix by distribution channel. The following table provides the percent of net sales and the approximate gross profit percentage for significant product distribution channels for the third quarter of fiscal years 2006 and 2005 (calculated on dollars in thousands):

Customer product orders include orders for products that we routinely stock in our inventory, customized products, and other products ordered less frequently, which we do not stock. Unshippable product orders are primarily backorders, but also include products that are requested to be calibrated in our calibration laboratories prior to shipment, orders required to be shipped complete, and orders required to be shipped at a future date. Our total unshippable product orders for the third quarter of fiscal year 2006 were relatively consistent with the third quarter of fiscal year 2005. We experienced an increase in the number of backorders in the third quarter of fiscal year 2006 compared to the third quarter of fiscal year 2005 as we experienced an increase in customer special orders, which we do not inventory. The following table reflects this increase in the percentage of total unshippable product orders that are backorders at the end of each fiscal quarter and our historical trend of total unshippable product orders (calculated on dollars in millions):

Calibration services net sales increased $0.5 million, or 11.9% (calculated on dollars in millions), from the third quarter of fiscal year 2005 to the third quarter of fiscal year 2006. This increase is attributable to both customer acquisition in our regulated industry markets and customer service efforts to retain existing customers. In addition, within any quarter, there is typically a netting of new customers against existing customers whose calibrations may not repeat for any number of factors. Among those factors are the timing of customer periodic calibrations on equipment and repair services, customer capital expenditure budgets, and customer outsourcing decisions. Our fiscal years 2006 and 2005 calibration service sales in relation to prior fiscal year quarter comparisons, is as follows (calculated on dollars in millions):

Gross profit decreased as a percent of net sales from 25.1% in the third quarter of fiscal year 2005 to 23.7% in the third quarter of fiscal year 2006 (calculated on dollars in thousands).

Product gross profit increased $0.5 million, or 21.7% (calculated on dollars in millions) from the third quarter of fiscal year 2005 to the third quarter of fiscal year 2006, primarily attributable to the 16.2% (calculated on dollars in millions) increase in product net sales. As a percent of product net sales, product gross profit increased 0.7 points (calculated on dollars in thousands) from the third quarter of fiscal year 2005 to the third quarter of fiscal year 2006, primarily attributable to the mix of products being sold within our core distribution channels. This product gross profit increase was partially offset by product net sales growth in our other distribution channels that typically support lower margins discussed above.

Our product gross profit can be impacted by a number of factors that can impact quarterly comparisons. Among those factors are sales to certain channels that do not support the margins of our core customer base, periodic rebates on purchases discussed above, and cooperative advertising received from suppliers reported as a reduction of cost of sales in accordance with Emerging Issues Task Force Issue No. 02-16 (see Note 2 to our Consolidated Financial Statements). The following table reflects the quarterly historical trend of our product gross profit as a percent of net sales (calculated on dollars in millions):

Calibration services gross profit decreased $0.1 million, or 6.1 points (calculated on dollars in thousands) from the third quarter of fiscal year 2005 to the third quarter of fiscal year 2006. This decrease is primarily due to calibration service mix and investment in calibration service capacity. The following table reflects the quarterly historical trend of our calibration services gross profit as a percent of net sales (calculated on dollars in millions):

Operating expenses increased $0.4 million, or 12.9% (calculated on dollars in millions), from the third quarter of fiscal year 2005 to the third quarter of fiscal year 2006. Selling, marketing, and warehouse expenses increased $0.4 million primarily as a result of an increase in payroll and related costs and an increase in marketing initiatives. Administrative expenses were relatively consistent from the third quarter of fiscal year 2005 to the third quarter of fiscal year 2006 and declined as a percent of net sales from 8.3% in the third quarter of fiscal year 2005 to 7.3% in the third quarter of fiscal year 2006 (calculated on dollars in thousands).

Interest expense was consistent from the third quarter of fiscal year 2005 to the third quarter of fiscal year 2006. Other expense, primarily attributable to net losses in Canadian currency transactions, was insignificant in both periods.

We have not recognized any provision for income taxes in the third quarter of fiscal years 2006 and 2005 as pretax income was offset by a reduction in our deferred tax asset valuation reserve. When calculating income tax expense, we recognize valuation allowances for deferred tax assets, which may not be realized using a “more likely than not” approach, as is more fully described in Note 2 to our Consolidated Financial Statements.

Net sales increased $4.7 million, or 11.8% (calculated on dollars in millions), from the first nine months of fiscal year 2005 to the first nine months of fiscal year 2006.

Our distribution products net sales results, which accounted for 68.2% of our sales in the first nine months of fiscal year 2006 and 68.0% of our sales in the first nine months of fiscal year 2005 (calculated on dollars in thousands), reflect improved year over year customer response to our sales and marketing activities.

The majority of our distribution products net sales growth in the first nine months of fiscal year 2006 compared to the first nine months of fiscal year 2005 was primarily in our core distribution channels. In addition, we experienced product net sales growth in our other distribution channels, primarily from high-volume electrical and instrumentation wholesalers, which caused a shift in our mix by distribution channel. The following table provides the percent of net sales and approximate gross profit percentage for significant product distribution channels (calculated on dollars in thousands):

Calibration services net sales increased $1.4 million, or 11.0% (calculated on dollars in millions), in the first nine months of fiscal year 2006 when compared to the first nine months of fiscal year 2005. This increase is attributable to both customer acquisition in our regulated industry markets and customer service efforts to retain existing customers. In addition, within any quarter, there is typically a netting of new customers against existing customers whose calibrations may not repeat for any number of factors. Among those factors are the timing of customer periodic calibrations on equipment and repair services, customer capital expenditure budgets, and customer outsourcing decisions.

Gross profit increased as a percent of sales from 24.0% in the first nine months of fiscal year 2005 to 24.9% in the first nine months of fiscal year 2006 (calculated on dollars in thousands).

Product gross profit increased $1.2 million, or 19.4% (calculated on dollars in millions) from the first nine months of fiscal year 2005 to the first nine months of fiscal year 2006, primarily attributable to the 12.2% (calculated on dollars in millions) increase in product net sales. As a percent of net sales, product gross profit increased 1.4 points (calculated on dollars in thousands) from the first nine months of fiscal year 2005 to the first nine months of fiscal year 2006. This increase is primarily the result of the mix of products being sold within our core distribution channels. We also experienced an increase from earned product purchase rebates and an increase in cooperative advertising income which was partially offset by product net sales growth in our other distribution channels that typically support lower margins discussed above.

Our product gross profit can be impacted by a number of factors that can impact quarterly comparisons. Among those factors are sales to certain channels that do not support the margins of our core customer base, periodic rebates on purchases discussed above, and cooperative advertising received from suppliers reported as a reduction of cost of sales in accordance with Emerging Issues Task Force Issue No. 02-16 discussed above (see Note 2 to our Consolidated Financial Statements).

Calibration services gross profit increased $0.4 million (calculated on dollars in thousands) from the first nine months of fiscal year 2005 to the first nine months of fiscal year 2006, primarily from an 11.0% (calculated on dollars in millions) increase in service sales. As a percent of net sales, calibration services gross profit decreased 0.1 points (calculated on dollars in thousands) from the first nine months of fiscal year 2005 to the first nine months of fiscal year 2006, primarily due to calibration service mix and investment in calibration service capacity that took place in our current third quarter.

Operating expenses increased $0.4 million, or 4.3% (calculated on dollars in millions), from the first nine months of fiscal year 2005 to the first nine months of fiscal year 2006. Selling, marketing, and warehouse expenses increased $0.4 million primarily as a result of an increase in payroll and related costs and an increase in marketing initiatives. Administrative expenses were relatively consistent from the first nine months of fiscal year 2005 to the first nine months of fiscal year 2006 and declined as a percent of net sales from 9.0% in the first nine months of fiscal year 2005 to 8.1% in the first nine months of fiscal year 2006 (calculated on dollars in thousands).

Interest expense increased from the first nine months of fiscal year 2005 to the first nine months of fiscal year 2006 resulting from higher interest rates applied to lower average debt. Other expense decreased in the first nine months of fiscal year 2005 to the first nine months of fiscal year 2006 primarily attributable to a decrease in net losses in Canadian currency transactions.

We have not recognized any provision (benefit) for income taxes in the first nine months of fiscal years 2006 and 2005 as pretax income (loss) was offset by a reduction (increase) in our deferred tax asset valuation reserve. When calculating income tax expense or benefit, we recognize valuation allowances for deferred tax assets, which may not be realized using a “more likely than not” approach, as is more fully described in Note 2 to our Consolidated Financial Statements.

Cash Flows. The following table is a summary of our Consolidated Statements of Cash Flows (in thousands):

Operating Activities: Cash provided by operating activities for the first nine months of fiscal year 2006 was $2.4 million, an increase of $2.1 million when compared to the $0.3 million of cash provided by operating activities in the first nine months of fiscal year 2005. This $2.1 million increase was primarily the result of an increase in net income of $1.1 million and an increase in cash provided by working capital of $1.3 million, primarily from relatively stable inventory levels in the first nine months of fiscal year 2006 compared to a large increase in inventory levels in the first nine months of fiscal year 2005. The increase in cash provided by operating activities was offset by a decrease in non-cash charges of $0.3 million. Significant working capital fluctuations were as follows: