UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, DC 20549

 

FORM 10-Q

QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF
THE SECURITIES EXCHANGE ACT OF 1934

ENVIRONMENTAL TECTONICS CORPORATION

Pennsylvania		23-1714256
(State or other jurisdiction of incorporation or organization)		(I.R.S. Employer Identification No.)

County Line Industrial Park
Southampton, Pennsylvania 18966
(Address of principal executive offices, Zip Code)

Registrant’s telephone number, including area code (215) 355-9100

          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 has submitted electronically and posted on its corporate website, if any, every Interactive Data File required to be submitted and posted, pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or such shorter period that the registrant was required to submit and post such files). Yes þ     No o

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

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

          As of September 30, 2010, there were 9,092,197 shares of the registrant’s common stock issued and outstanding.

 

 

Index

PART I — FINANCIAL INFORMATION			3
Item 1. Financial Statements (unaudited)			3
Condensed Consolidated Income Statements (unaudited) for the thirteen and twenty-six week periods ended August 27, 2010 and August 28, 2009			3
Condensed Consolidated Balance Sheets (unaudited) as of August 27, 2010 and February 26, 2010			4
Condensed Consolidated Statements of Cash Flows (unaudited) for the twenty-six week periods ended August 27, 2010 and August 28, 2009			5
Notes to the Condensed Consolidated Financial Statements (unaudited)			6
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations			18
Item 4T. Controls and Procedures			29
PART II — OTHER INFORMATION			29
Item 1. Legal Proceedings			29
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds			30
Item 3. Defaults Upon Senior Securities			30
Item 4. Other Information			30
Item 5. Exhibits			30
Signatures			31

          When used in this Quarterly Report on Form 10-Q, except where the context otherwise requires, the terms “we”, “us”, “our”, “ETC” and the “Company” refer to Environmental Tectonics Corporation and its subsidiaries.

PART I — FINANCIAL INFORMATION

Item 1. Financial Statements (unaudited)

Environmental Tectonics Corporation
Condensed Consolidated Income Statements

(unaudited)
(in thousands, except share and per share information)

		Thirteen week								Twenty-six week
		Periods ended								periods ended
		August 27,				August 28,				August 27,				August 28,
		2010				2009				2010				2009
Net sales		$	13,244			$	9,860			$	25,365			$	19,441
Cost of goods sold			8,450				4,904				15,441				10,058
Gross profit			4,794				4,956				9,924				9,383
Operating expenses:
Selling and marketing			1,020				1,270				2,122				2,524
General and administrative			1,623				1,568				3,086				3,170
Research and development			240				227				564				455
			2,883				3,065				5,772				6,149
Operating income			1,911				1,891				4,152				3,234
Other expenses:
Interest expense			189				350				417				866
Loss on extinguishment of debt			—				224				—				224
Other, net			56				66				128				121
			245				640				545				1,211
Income before income taxes			1,666				1,251				3,607				2,023
Provision for income taxes			—				—				—				—
Income before noncontrolling interest			1,666				1,251				3,607				2,023
Income attributable to noncontrolling interest			—				2				5				4
Net income			1,666				1,249				3,602				2,019
Preferred stock dividend			(568	)			(460	)			(1,145	)			(695	)
Income applicable to common shareholders		$	1,098			$	789			$	2,457			$	1,324
Per share information:
Earnings per common share:
Basic		$	0.12			$	0.09			$	0.27			$	0.15
Diluted		$	0.08			$	0.06			$	0.17			$	0.09
Weighted average common shares:
Basic			9,090,000				9,069,000				9,088,000				9,063,000
Diluted			20,719,000				21,122,000				20,718,000				21,266,000

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

Environmental Tectonics Corporation
Condensed Consolidated Balance Sheets

(in thousands, except share information)

		August 27,				February 26,
		2010				2010
		(unaudited)
ASSETS
Cash and cash equivalents		$	854			$	2,408
Restricted cash			5,477				2,751
Accounts receivable, net			2,918				17,356
Costs and estimated earnings in excess of billings on uncompleted contracts			8,108				3,576
Inventories, net			3,667				5,114
Deferred tax assets, current			5,699				4,983
Prepaid expenses and other current assets			2,592				545
Total current assets			29,315				36,733
Property, plant and equipment, at cost, net			13,698				13,643
Construction in progress			352				316
Software development costs, net			831				691
Other assets			204				346
Total assets		$	44,400			$	51,729
LIABILITIES
Current portion of long-term debt		$	122			$	285
Accounts payable — trade			1,554				1,783
Billings in excess of costs and estimated earnings on uncompleted contracts			6,091				13,944
Customer deposits			1,687				1,799
Accrued interest and dividends			868				782
Other accrued liabilities			3,002				2,814
Total current liabilities			13,324				21,407
Long-term obligations, less current portion:
Credit facility payable to bank			8,653				9,808
Other long-term debt			—				12
			8,653				9,820
Deferred tax liabilities			3,598				3,066
Unearned interest			15				22
Total liabilities			25,590				34,315
Commitments and contingencies			—				—
STOCKHOLDERS’ EQUITY
Cumulative convertible participating preferred stock, Series D, $.05 par value, 11,000 shares authorized; 155 shares outstanding			155				155
Cumulative convertible participating preferred stock, Series E, $.05 par value, 25,000 shares authorized; 22,241 and 23,741 shares outstanding at August 27, 2010 and February 26, 2010			22,241				23,741
Common stock, $.05 par value, 50,000,000 shares authorized; 9,090,635 and 9,083,573 shares issued and outstanding at August 27, 2010 and February 26, 2010			454				454
Additional paid-in capital			12,974				14,050
Accumulated other comprehensive loss			(66	)			(431	)
Accumulated deficit			(16,991	)			(20,593	)
Total stockholders’ equity before noncontrolling interest			18,767				17,376
Noncontrolling interest			43				38
Total stockholders’ equity			18,810				17,414
Total liabilities and stockholders’ equity		$	44,400			$	51,729

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

Environmental Tectonics Corporation
Condensed Consolidated Statements of Cash Flows

(unaudited)
(in thousands)

		Twenty-six week periods
		ended
		August 27,				August 28,
		2010				2009
Cash flows from operating activities:
Net income		$	3,602			$	2,019
Adjustments to reconcile net income to net cash provided by (used in) operating activities:
Depreciation and amortization			727				982
Decrease in valuation allowance for deferred tax assets			(867	)			—
Accretion of debt discount			55				132
Increase in allowances for accounts receivable and inventories, net			104				444
Income attributable to noncontrolling interest			5				4
Stock compensation expense			49				—
Changes in operating assets and liabilities:
Accounts receivable			14,434				1,023
Costs and estimated earnings in excess of billings on uncompleted contracts			(4,532	)			(2,072	)
Inventories			1,347				(359	)
Prepaid expenses and other assets			(1,960	)			247
Deferred tax assets, net			683				—
Accounts payable			(229	)			(44	)
Billings in excess of costs and estimated earnings on uncompleted contracts			(7,853	)			(2,359	)
Customer deposits			(112	)			(712	)
Accrued interest and dividends			86				—
Other accrued liabilities			181				1,232
Net cash provided by operating activities			5,720				537
Cash flows from investing activities:
Acquisition of equipment			(636	)			(698	)
Capitalized software development costs			(322	)			(176	)
Net cash used in investing activities			(958	)			(874	)
Cash flows from financing activities:
(Repayment) borrowings under line of credit			(1,155	)			700
Repurchase of preferred stock			(1,500	)			—
Issuance of common stock			20				1
Payment of preferred stock dividends			(1,145	)			—
Payments of other debt obligations			(175	)			(5	)
Increase in restricted cash for performance guarantee			(2,726	)			(12	)
Net cash (used in) provided by financing activities			(6,681	)			684
Effect of exchange rate changes on cash			365				99
Net decrease in cash			(1,554	)			446
Cash at beginning of period			2,408				520
Cash at end of period		$	854			$	966
Supplemental schedule of cash flow information:
Interest paid		$	174			$	209
Income taxes paid			220				—
Supplemental information on non-cash operating and investing activities:
Accrued dividends on preferred stock		$	569			$	695

          On July 2, 2009, the Company exchanged certain existing related-party financial instruments for a newly-created class of Series E Convertible Preferred Stock. The value of this exchange was $23,741. Additionally, the Company issued $155 of Series D Preferred Stock as loan origination fees in connection with the $7,500 Lenfest Credit Facility. See Note 6 — Long-Term Obligations and Credit Arrangements.

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

Environmental Tectonics Corporation
Notes to the Condensed Consolidated Financial Statements

1. Nature of Business:

          Environmental Tectonics Corporation (“ETC”, “we” or the “Company”) was incorporated in 1969 in Pennsylvania. For over forty years, we have provided our customers with products, service and support. Innovation, continuous technological improvement and enhancement, and product quality are core values and critical to our success. The Company is a significant supplier and innovator in the following product areas: (1) software driven products and services used to create and monitor the physiological effects of flight; (2) high performance jet tactical flight simulation; (3) steam and gas sterilization; (4) testing and simulation devices for the automotive industry; (5) hyperbaric and hypobaric chambers; and (6) driving and disaster simulation systems.

          The Company operates in two business segments — Training Services Group (“TSG”) and Control Systems Group (“CSG”). Our core technologies in TSG include the design, manufacture and sale of training services which includes (1) software driven products and services used to create and monitor the physiological effects of flight; (2) high performance jet tactical flight simulation; and (3) driving and disaster simulation systems, and in CSG include: (1) steam and gas sterilization; (2) testing and simulation devices for the automotive industry; and (3) hyperbaric and hypobaric chambers. Product categories included in TSG are Authentic Tactical Fighting Systems (ATFS), Aircrew Training Systems (ATS) and disaster management systems. CSG includes sterilizers, environmental control devices and hyperbaric chambers along with parts and service support.

          The Company’s fiscal year is the 52 or 53-week annual accounting period ending the last Friday in February. Certain amounts from prior consolidated financial statements have been reclassified to conform to the presentation in fiscal 2011.

2. Summary of Significant Accounting Policies

          Basis of Presentation

          The accompanying interim condensed consolidated financial statements include the accounts of ETC, ETC’s wholly-owned subsidiaries (Entertainment Technology Corporation, ETC International Corporation and ETC-Delaware), ETC’s 99%-owned subsidiary located in London, England (“ETC Europe”), and ETC’s 95%-owned subsidiary located in Warsaw, Poland (ETC-PZL Aerospace Industries, Ltd. (“ETC-PZL”)). “ETC Southampton” refers to the Company’s corporate headquarters and main production plant located in Southampton, Pennsylvania. All significant inter-company accounts and transactions have been eliminated in consolidation.

          The accompanying condensed consolidated financial statements have been prepared by ETC, without audit, pursuant to the rules and regulations of the Securities and Exchange Commission (“SEC”), and reflect all adjustments which, in the opinion of management, are necessary for a fair presentation of the results for the interim periods presented. All such adjustments are of a normal recurring nature.

          Certain information in footnote disclosures normally included in financial statements prepared in conformity with accounting principles generally accepted in the United States of America has been condensed or omitted pursuant to such rules and regulations. The financial results for the periods presented may not be indicative of the full year’s results. Despite these condensations or omissions, the Company believes the disclosures are adequate to make the information presented not misleading. These financial statements should be read in conjunction with the financial statements and the notes thereto included in the Company’s Annual Report on Form 10-K for the fiscal year ended February 26, 2010.

          References to fiscal second quarter 2011 are references to the thirteen week period ended August 27, 2010. References to fiscal second quarter 2010 are references to the thirteen week period ended August 28, 2009. References to the first half of fiscal 2011 are references to the twenty-six week period ended August 27, 2010. References to the first half of fiscal 2010 are references to the twenty-six week period ended August 28, 2009.

          Significant Accounting Policies

          There have been no material changes in the Company’s significant accounting policies during fiscal 2011 as compared to what was previously disclosed in the Company’s Annual Report on Form 10-K for the fiscal year ended February 26, 2010.

Environmental Tectonics Corporation
Notes to the Condensed Consolidated Financial Statements, continued

          Recent Accounting Pronouncements

          In October 2009, the FASB issued ASU No. 2009-13, Multiple-Deliverable Revenue Arrangements (“ASU 2009-13”). ASU 2009-13, amends existing revenue recognition accounting pronouncements that are currently within the scope of Codification Subtopic 605-25 (previously included within EITF 00-21, Revenue Arrangements with Multiple Deliverables (“EITF 00-21”). The consensus to ASU 2009-13 provides accounting principles and application guidance on whether multiple deliverables exist, how the arrangement should be separated, and the consideration allocated. This guidance eliminates the requirement to establish the fair value of undelivered products and services and instead provides for separate revenue recognition based upon management’s estimate of the selling price for an undelivered item when there is no other means to determine the fair value of that undelivered item. EITF 00-21 previously required that the fair value of the undelivered item be the price of the item either sold in a separate transaction between unrelated third parties or the price charged for each item when the item is sold separately by the vendor. Under EITF 00-21, if the fair value of all of the elements in the arrangement was not determinable, then revenue was deferred until all of the items were delivered or fair value was determined. This new approach is effective prospectively for revenue arrangements entered into or materially modified in fiscal years beginning on or after June 15, 2010 and allows for retroactive application. The Company is currently evaluating the potential impact of this standard on its financial position and results of operations.

          In April 2010, the FASB issued ASU No. 2010-17, Milestone Method of Revenue Recognition (“ASU 2010-17”). ASU 2010-17, updates guidance on the criteria that should be met for determining whether the milestone method of revenue recognition is appropriate with the scope of Codification Subtopic 605 (previously included within EITF 00-21, Revenue Arrangements with Multiple Deliverables (“EITF 00-21”). The consensus to ASU 2010-17 provides guidance on defining a milestone and determining when it may be appropriate to apply the milestone method of revenue recognition in which arrangements include payment provisions whereby a portion or all of the consideration is contingent upon milestone events such as successful completion of phases or a specific result. This new approach is effective prospectively for milestones achieved in fiscal years beginning on or after June 15, 2010 and allows for retroactive application. The Company is currently evaluating the potential impact of this standard on its financial position and results of operations as there are not currently any milestones that will be achieved.

          In January 2010, the FASB issued ASU No. 2010-06, “Fair Value Measurements and Disclosures (ASC 820): Improving Disclosures about Fair Value Measurements,” which requires additional disclosures on transfers in and out of Level I and Level II and on activity for Level III fair value measurements. The new disclosures and clarifications on existing disclosures are effective for interim and annual reporting periods beginning after December 15, 2009, except for the disclosures on Level III activity, which are effective for fiscal years beginning after December 15, 2010 and for interim periods within those fiscal years. The Company does not expect the adoption of ASU No. 2010-06 to have a material impact on our consolidated financial condition or results of operations.

Environmental Tectonics Corporation
Notes to the Condensed Consolidated Financial Statements, continued

3. Earnings Per Common Share:

          Basic earnings per share is computed on the basis of the weighted average number of common shares outstanding. Diluted earnings per share is computed on the basis of the weighted average number of common shares outstanding plus the effect of outstanding stock options and common stock warrants using the “treasury stock” method, plus the effect of all convertible financial instruments, including preferred stock, as if they had been converted at the beginning of each period presented. If the effect of the conversion of any financial instrument would be anti-dilutive, it is excluded from the diluted earnings per share calculation.

          On August 27, 2010, there was $22,396,000 of cumulative convertible participating preferred stock. This consisted of the following:

	•		$55,000 of Series D Preferred Stock convertible at $0.94 per share, equating to 58,511 shares of common stock, issued in April 2009;
	•		$100,000 of Series D Preferred Stock convertible at $1.11 per share, equating to 90,090 shares of common stock, issued in July 2009;
	•		$22,241,000 of Series E Preferred Stock convertible at $2.00 per share, equating to 11,120,500 shares of common stock, issued in July 2009.

          On February 20, 2009, in connection with the issuance of a $2,000,000 promissory note, the Company issued warrants to purchase 143,885 shares of the Company’s common stock at $1.39 per share. Additionally, on July 2, 2009, in consideration of an increase of the personal guarantee by H.F. Lenfest of the Company’s PNC line of credit, the Company issued warrants to purchase 450,450 shares of the Company’s common stock at $1.11 per share. (See Note 6, Long-Term Obligations and Credit Arrangements.)

          On August 27, 2010 and August 28, 2009, respectively, there were options to purchase the Company’s common stock totaling 156,185 and 157,652 shares at an average price of $6.06 and $5.90 per share. Given the conversion price of these common stock options, these shares were excluded from the calculation of diluted earnings per share since the effect of their conversion would be antidulutive.

		Thirteen week period ended												Thirteen week period ended
		August 27, 2010												August 28, 2009
		Income				Weighted				Per				Income				Weighted				Per
		(amounts in				average				share				(amounts in				average				share
		thousands)				shares				amount				thousands)				shares				amount
Net income		$	1,666											$	1,249
Less: preferred stock dividends			(568	)											(460	)
Basic earnings per share:
Basic earnings available to common shareholders		$	1,098				9,090,000			$	0.12			$	789				9,069,000			$	0.09
Effect of dilutive securities:
Preferred stock							11,269,000												12,019,000
Stock options and warrants							360,000												34,000
Diluted earnings per share:
Basic earnings available to common shareholders		$	1,098											$	789
Add: preferred stock dividend			568												460
Income available to common shareholders plus effect of dilutive securities		$	1,666				20,719,000			$	0.08			$	1,249				21,122,000			$	0.06

Environmental Tectonics Corporation
Notes to the Condensed Consolidated Financial Statements, continued

		Twenty-six week period ended												Twenty-six week period ended
		August 27, 2010												August 28, 2009
		Income				Weighted				Per				Income				Weighted				Per
		(amounts in				average				share				(amounts in				average				share
		thousands)				shares				amount				thousands)				shares				amount
Net income		$	3,602											$	2,019
Less: preferred stock dividends			(1,145	)											(695	)
Basic earnings per share:
Basic earnings available to common shareholders		$	2,457				9,088,000			$	0.27			$	1,324				9,063,000			$	0.15
Effect of dilutive securities:
Preferred stock							11,269,000												12,019,000
Stock options and warrants							361,000												184,000
Diluted earnings per share:
Basic earnings available to common shareholders		$	2,457											$	1,324
Add: preferred stock dividend			1,145												695
Income available to common shareholders plus effect of dilutive securities		$	3,602				20,718,000			$	0.17			$	2,019				21,266,000			$	0.09

Environmental Tectonics Corporation
Notes to the Condensed Consolidated Financial Statements, continued

4. Inventories

          Inventories are valued at the lower of cost or market using the first in, first out (FIFO) method and consist of the following:

		August 27,
		2010				February 26,
		(unaudited)				2010
		(in thousands)
Raw materials		$	—			$	—
Work in process			3,444				4,764
Finished goods			223				350
Total		$	3,667			$	5,114

          Inventory is presented net of an allowance for obsolescence of $2,445,000 (Raw material $121,000, Work in process $1,623,000 and Finished goods $701,000) and $2,345,000 (Raw material $138,000, Work in process $1,506,000 and Finished goods $701,000) at August 27, 2010 and February 26, 2010, respectively.

5. Accounts Receivable:

          The components of accounts receivable are as follows:

		August 27,
		2010				February 26,
		(unaudited)				2010
		(in thousands)
U.S. government		$	1,276			$	438
U.S. commercial			591				1,403
International			1,471				15,930
			3,338				17,771
Less: allowance for doubtful accounts			(420	)			(415	)
		$	2,918			$	17,356

6. Long-Term Obligations and Credit Arrangements:

Lenfest Financing Transaction

          On April 24, 2009, the Company entered into a transaction (the “Lenfest Financing Transaction”), which was approved by shareholders on July 2, 2009, with H.F. Lenfest (“Lenfest”), a major shareholder and member of our Board of Directors, that provided for the following: (i) a $7,500,000 credit facility provided by Lenfest to ETC, which expires on December 31, 2012; (ii) exchange of a $10 million Subordinated Note held by Lenfest, together with all accrued interest and warrants issuable under the Subordinated Note, and all Series B Preferred Stock and Series C Preferred Stock held by Lenfest, together with all accrued dividends thereon, for a new class of preferred stock, Series E Preferred Stock, of the Company; and (iii) the guarantee by Lenfest of all of ETC’s obligations to PNC Bank, National Association (“PNC Bank”) in connection with an increase of the Company’s existing $15,000,000 revolving line of credit with PNC Bank (the “2007 PNC Credit Facility”) to $20,000,000, and in connection with this guarantee, the pledge by Lenfest to PNC Bank of $10,000,000 in marketable securities.

Lenfest Credit Facility

          As part of the Lenfest Financing Transaction, the Company established a credit facility in the maximum amount of $7,500,000 with Lenfest (the “Lenfest Credit Facility”) to be used to finance certain government projects that ETC has been awarded. The terms of the Lenfest Credit Facility are set forth in a Secured Credit Facility and Warrant Purchase Agreement between the Company and Lenfest, dated as of April 24, 2009 (the “Lenfest Credit Agreement”). In connection with the Lenfest Credit Agreement, the Company has executed, and will in the future execute, promissory notes in favor of Lenfest, in the aggregate principal amount of up to $7,500,000 (the “Lenfest Credit Facility Note”) based on the amount borrowed by the Company pursuant to the Lenfest Credit Agreement. Each Lenfest Credit Facility Note issued under the Lenfest Credit Facility will accrue interest at the rate of 10% per annum, payable in cash or, at the option of Lenfest, in shares of Series D Preferred Stock of the Company, as described below. The Lenfest Credit Facility expires on December 31, 2012. As of August 27, 2010, the Company had not utilized any of the $7.5 million available funding under this facility.

Environmental Tectonics Corporation
Notes to the Consolidated Financial Statements, continued

Bank Credit and Facility

Increased PNC Bank Credit Facility and Issuance of New Guarantee

          On April 24, 2009, PNC Bank agreed to increase the amount of financing available under the 2007 PNC Credit Facility from $15,000,000 to $20,000,000, subject to the condition that Lenfest continue to personally guarantee all of ETC’s obligations to PNC Bank (the “Lenfest Guaranty”) and that Lenfest pledge $10,000,000 in marketable securities as collateral security for his guarantee (the “Lenfest Pledge”).

          Following the receipt of shareholder approval for the Lenfest Financing Transaction, ETC and PNC Bank entered into the Amended and Restated Credit Agreement (the “Amended and Restated PNC Credit Agreement”) and the Second Amended and Restated Reimbursement Agreement for Letters of Credit (the “Amended and Restated Reimbursement Agreement”). The 2007 promissory note was cancelled and replaced with an amended and restated promissory note in the principal amount of $20,000,000 (the “Amended and Restated PNC Note”).

          In connection with the execution of the amended and restated agreements and note with PNC, ETC paid to Lenfest an origination fee of 100 shares of Series D Convertible Preferred Stock of the Company (the “Series D Preferred Stock”), which is equal to 1% of the market value of the $10,000,000 in marketable securities pledged by Lenfest to PNC Bank to secure ETC’s obligations to PNC Bank. The 100 shares of Series D Preferred Stock have a stated value of $1,000 per share, or $100,000 in the aggregate. These shares of Series D Preferred Stock have a conversion price per share equal to $0.94, which price equaled the average closing price of ETC common stock during the 120 days prior to the issuance of such shares. Additionally, ETC will pay Lenfest annual interest equal to 2% of the amount of the Lenfest Pledge, payable in Series D Preferred Stock. On October 6, 2010, the Company issued to Lenfest 231 shares of Series D Preferred Stock with a stated value of $1,000 in payment of $231,000 of interest due under the Lenfest Pledge agreement for the period July 2, 2009 through August 27, 2010. The 231 shares of have a conversion price per shared equal to $3.02, which price equaled the average closing price of ETC common stock during the 120 days prior to the issuance of such shares, and would convert into 76,490 shares of ETC common stock.

          In consideration of Lenfest entering into the amended and restated guaranty, ETC issued to Lenfest warrants equal in value to 10% of the amount of the $5,000,000 increase under the 2007 PNC Bank Credit Facility. The warrants are exercisable for seven years following issuance to purchase 450,450 shares of ETC Common Stock at an exercise price per share equal to $1.11, which price equaled the average closing price of ETC common stock during the 120 days prior to the issuance of the warrant. The Company recorded a loan origination deferred charge associated with these warrants of $487,000 using the Black-Scholes options-pricing model with the following weighted average assumptions: expected volatility of 91.9%; risk-free interest rate of 0.49%; and an expected life of seven years.

          Originally, amounts borrowed under the Amended and Restated PNC Credit Agreement could be borrowed, repaid and reborrowed from time to time until June 30, 2010. Borrowings made pursuant to the Amended and Restated PNC Credit Agreement bear interest at either the prime rate (as described in the promissory note executed pursuant to the Amended and Restated PNC Credit Agreement) plus 0.50 percentage points or the London Interbank Offered Rate (“LIBOR”) (as described in the Promissory Note) plus 2.50 percentage points. Additionally, ETC is obligated to pay a fee of 0.125% per year for unused but available funds under the line of credit.

Amendments to the Credit Agreement

          On October 1, 2009, the Amended and Restated PNC Credit Agreement was amended to extend the maturity date to June 30, 2011. Additionally, the affirmative covenants were adjusted. The Consolidated Tangible Net Worth covenant was modified to reflect the impact on the Company’s balance sheet of the Lenfest Financing Transaction. Effective with each fiscal quarter ending after October 1, 2009, the Company must maintain a minimum Consolidated Tangible Net Worth of at least $10,000,000. The EBITDA covenant was changed for fiscal periods beginning after December 1, 2009. Beginning with the first fiscal quarter ending after December 1, 2009, and for each fiscal quarter ending thereafter, the Company must maintain a minimum cumulative aggregate EBITDA (earnings before interest, taxes, depreciation and amortization) of $4,000,000 for the fiscal quarter then ending and the three preceding fiscal quarters. The Company is in compliance with its covenants as of August 27, 2010.

          On August 18, 2010, the 2007 PNC Credit Facility was amended a second time to extend the maturity date from June 30, 2011 to June 30, 2013.

          As of August 27, 2010, the Company’s availability under the Amended and Restated PNC Credit Agreement was approximately $9,964,000. This reflected cash borrowings of $8,477,000 and outstanding letters of credit of approximately $1,559,000.

          Due to the Company’s accumulated deficit, all dividends accruing for the outstanding Series D and E Preferred Stock have been recorded in the accompanying financial statements as a reduction in additional paid-in capital.

Environmental Tectonics Corporation
Notes to the Consolidated Financial Statements, continued

Dedicated Line of Credit Agreement with PNC Bank

          On November 16, 2009, the Company and PNC Bank entered into a Letter Agreement, Reimbursement Agreement, Pledge Agreement, and Amendment to Subordination Agreement (collectively, the “Dedicated Line of Credit Agreement”), pursuant to which the Company received a committed line of credit in the amount of $5,422,405 (the “Line of Credit”) which the Company used to satisfy performance bond and repayment guarantee requirements in a newly awarded contract. Use of this dedicated line of credit is restricted to funding contract performance and repayment guarantee requirements under this specific contract.

          Initially, as security for the Line of Credit, ETC and Lenfest were each required to provide PNC Bank with the equivalent of $2,711,000 in the form of cash or other financial instruments. To meet this requirement, ETC deposited cash in this amount in a restricted bank account with PNC Bank. Lenfest had guaranteed the Company’s obligations under the Dedicated Line of Credit Agreement, and had pledged to PNC Bank $2,711,000 in certificated securities. Under the terms of the line, ETC was required, by August 19, 2010, to place additional cash funds of $2,711,000 with PNC Bank, at which time the Lenfest guarantee would be terminated and the Lenfest securities would be returned to Lenfest.

          During the first quarter of fiscal 2011, the Company fulfilled its requirement to fund the balance of the security to collateralize the committed line of credit by depositing approximately $2,711,000 in a certificate of deposit with PNC. This amount is included in Restricted Cash in the Condensed Consolidated Balance Sheet. As a result, Lenfest’s securities were returned and his guarantee to cover the $5.4 million line was terminated.

ETC-PZL Project Financing

          In September 2009, ETC-PZL, located in Warsaw, Poland, entered into a project financing agreement with a Warsaw bank to fund a research and development contract with the Polish government. The amount of this facility is $604,000 and it is being repaid in quarterly installments of approximately $70,000 which commenced in September 2009. This facility will expire in September 2011. Use of this line of credit is restricted to funding contract requirements under a specific research and development contract with the Polish government.

          Long-term obligations at August 27, 2010 and February 26, 2010 consist of the following:

		August 27,				February 26,
		2010				2010
		(amounts in thousands)
Note payable to bank		$	8,477			$	9,600
ETC-PZL project financing			296				486
Automobile loan			2				7
Total debt obligations			8,775				10,093
Less current maturities			122				285
Long-term obligations, net of current maturities		$	8,653			$	9,808

Environmental Tectonics Corporation
Notes to the Condensed Consolidated Financial Statements, continued

7. Fair Value of Financial Instrument —

          The carrying amounts of cash, accounts receivable and accounts payable approximate fair value because of the short maturity associated with these instruments. Derivative financial instruments are recorded at fair value.

          Fair value is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants. The hierarchy below lists three levels of fair value based on the extent to which inputs used in measuring fair value are observable in the market. The Company categorizes each of its fair value measurements in one of these three levels based on the lowest level input that is significant to the fair value measurement in its entirety. These levels are:

	•		Level 1: Observable inputs such as quoted prices in active markets for identical assets of liabilities;
	•		Level 2: Inputs other than quoted prices that are observable for the asset or liability, either directly or indirectly; these include quoted prices for similar assets or liabilities in active markets and quoted prices or identical assets or liabilities in markets that are not active;
	•		Level 3: Unobservable inputs that are supported by little or no market activity, which require the reporting entity’s judgment or estimation.

The assessment of the significance of a particular input to the fair value measurement requires judgment and may affect the valuation of financial assets and financial liabilities and their placement within the fair value hierarchy. The Company’s financial liabilities that are accounted for at fair value on a recurring basis using the discounted cash flow methodology are summarized below:

		Fair Value Measurement at
		August 27, 2010 using:
Liabilities		Level 1				Level 2				Level 3				Total
		(amounts in thousands)
Credit facility payable to bank		$	—			$	—			$	9,023			$	9,023
ETC-PZL contract financing			—				—				270				270
Total		$	—			$	—			$	9,293			$	9,293

Environmental Tectonics Corporation
Notes to the Condensed Consolidated Financial Statements, continued

8. Income Taxes

          The Company uses the asset and liability method of accounting for income taxes. Deferred income taxes reflect the net tax effects of temporary differences between the carrying amounts of assets and liabilities for financial and tax reporting purposes as well as the valuation of net loss carryforwards. Valuation allowances are reviewed each fiscal period to determine whether there is sufficient positive or negative evidence to support a change in judgment about the realizability of the related deferred tax asset.

          The Company has reviewed the components of its deferred tax asset and has determined, based upon all available information, that its current and expected future operating income will more likely than not result in the realization of a portion of its deferred tax assets relating primarily to its net operating loss carryforwards. As of August 27, 2010, the Company had approximately $34.0 million of federal net loss carry forwards available to offset future income tax liabilities, beginning to expire in 2025. In addition, the Company has the ability to offset deferred tax assets against deferred tax liabilities created for such items as depreciation and amortization.

          As a result of the Company’s analysis, no provision for income taxes was recorded in the Condensed Consolidated Income Statements for the thirteen and twenty-six week periods ended August 27, 2010. For the thirteen week and twenty-six week periods ended August 28, 2009, the Company did not record any provision for income taxes due to the utilization of net operating loss carryforwards.

          During the fiscal years ended February 26, 2010 and February 27, 2009, the Company did not have any unrecognized tax benefits and accordingly did not recognize interest expense or penalties related to unrecognized tax benefits. The Company is no longer subject to U.S. federal tax examinations by tax authorities for the fiscal years before 2007.

          The tax effects of the primary components of the temporary differences are as follows:

		August 27,				February 26,
		2010				2010
		(amounts in thousands)
Deferred tax assets:
Net operating loss and credits		$	14,610			$	15,607
Vacation reserve			80				80
Inventory reserve			918				880
Receivable reserve			157				156
Warranty reserve			117				117
Compensation and other reserves			158				32
Other, net			19				74
			16,059				16,946
Valuation Reserve			(10,360	)			(11,963	)
Total current deferred tax asset			5,699				4,983
Deferred tax liabilities:
Amortization of capitalized software			393				350
Depreciation			3,205				2,716
Total non-current deferred tax liability			3,598				3,066
Net deferred tax asset		$	2,101			$	1,917

Environmental Tectonics Corporation
Notes to the Consolidated Financial Statements, continued

9. Commitments and Contingencies

Mends International, Ltd.

          On May 29, 2008, a Request for Arbitration was filed against the Company with the Secretariat of the International Court of Arbitration by Mends International Ltd. (“Mends”). Mends’ Request for Arbitration arose out of a February 3, 1999 contract between the Company and Mends wherein Mends purchased aeromedical equipment for sale to the Nigerian Air Force. On July 1, 2010, the International Court of Arbitration issued a Partial Final Award which was within the scope of the Company’s reserve and which did not have a material adverse effect on the Company’s financial condition or results of operations. Additionally, the International Court of Arbitration may make an additional award to allocate the costs of the arbitration (including attorneys’ fees) between the parties. It is not expected that any additional award, if any, will have a material adverse effect on the Company’s financial position or results of operation.

Administrative Agreement with U.S. Navy

          In 2007, the Company entered into a settlement agreement with the Department of the Navy to resolve litigation filed by the Company in May 2003 in connection with a contract for submarine rescue decompression chambers. As of May 14, 2008, the Company made all payments required under this settlement agreement and transferred the chambers to the Department of the Navy. From October 2, 2007 through December 12, 2007, the Company was suspended by the Department of the Navy from soliciting work for the federal government pursuant to the Federal Acquisition Regulation. However, effective December 12, 2007, the Department of the Navy lifted the Company’s suspension pursuant to the execution by the Company and the Department of the Navy of an Administrative Agreement. In accordance with the Administrative Agreement, the Company has established and implemented a program of compliance reviews, audits and reports.

Environmental Tectonics Corporation
Notes to the Condensed Consolidated Financial Statements, continued

10. Segment Information (unaudited):

          The Company operates in two business segments — Training Services Group (“TSG”) and Control Systems Group (“CSG”). The Company’s core technologies in TSG include the design, manufacture and sale of training services which includes (1) software driven products and services used to create and monitor the physiological effects of flight; (2) high performance jet tactical flight simulation; and (3) driving and disaster simulation systems, and in CSG include: (1) steam and gas sterilization; (2) testing and simulation devices for the automotive industry; and (3) hyperbaric and hypobaric chambers. Product categories included in TSG are Authentic Tactical Fighting Systems (ATFS), Aircrew Training Systems (ATS) and disaster management systems. CSG includes sterilizers, environmental control devices and hyperbaric chambers along with parts and service support.

		Training Services				Control Systems								Company
		Group (TSG)				Group (CSG)				Corporate				Total
		(amounts in thousands)
Thirteen week period ended August 27, 2010:
Net sales		$	8,675			$	4,569			$	—			$	13,244
Interest expense			183				6				—				189
Depreciation and amortization			305				76				—				381
Operating income (loss)			1,373				813				(275	)			1,911
Income tax benefit			—				—				—				—
Identifiable assets			21,101				3,611				19,688				44,400
Expenditures for segment assets			198				119				62				379
Thirteen week period ended August 28, 2009:
Net sales		$	6,391			$	3,469			$	—			$	9,860
Interest expense			128				222				—				350
Depreciation and amortization			345				76				—				421
Operating income (loss)			1,938				316				(363	)			1,891
Income tax benefit			—				—				—				—
Identifiable assets			5,388				5,629				25,616				36,633
Expenditures for segment assets			170				132				—				302

		Thirteen weeks				Thirteen weeks
		ended August 27,				ended August 28,
Reconciliation to consolidated net income:		2010:				2009
Operating income		$	1,911			$	1,891
Interest expense			(189	)			(350	)
Other, net			(56	)			(66	)
Loss on extinguishment of debt			—				(224	)
Noncontrolling interest			—				(2	)
Net income		$	1,666			$	1,249

		Training Services				Control Systems								Company
		Group (TSG)				Group (CSG)				Corporate				Total
		(amounts in thousands)
Twenty-six week period ended August 27, 2010:
Net sales		$	16,607			$	8,758			$	—			$	25,365
Interest expense			317				100				—				417
Depreciation and amortization			497				230				—				727
Operating income (loss)			2,782				1,923				(553	)			4,152
Income tax benefit			—				—				—				—
Identifiable assets			21,101				3,611				19,688				44,400
Expenditures for segment assets			574				200				184				958
Twenty-six week period ended August 28, 2009:
Net sales		$	13,306			$	6,135			$	—			$	19,441
Interest expense			427				439				—				866
Depreciation and amortization			495				487				—				982
Operating income (loss)			3,832				146				(744	)			3,234
Income tax benefit			—				—				—				—
Identifiable assets			5,388				5,629				25,616				36,633
Expenditures for segment assets			411				287				—				698

		Twenty-six weeks				Twenty-six weeks
		ended August 27,				ended August 28,
Reconciliation to consolidated net income (loss):		2010:				2009
Operating income		$	4,152			$	3,234
Interest expense			(417	)			(866	)
Other, net			(128	)			(121	)
Loss on extinguishment of debt			—				(224	)
Noncontrolling interest			(5	)			(4	)
Net income		$	3,602			$	2,019

Concentration of Sales Greater than 10%

          Approximately 74% of sales totaling $9,860,000 in the thirteen weeks ended August 27, 2010 were made to the U.S. Government and to one international customer. Approximately 36% of sales totaling $3,582,000 in the thirteen weeks ended August 28, 2009 were made to two international customers.

          Included in the segment information for the thirteen weeks ended August 27, 2010 are international sales (which include sales made by the Company’s foreign subsidiaries) of $4,239,000, including sales to the Korean government for $3,373,000. For the thirteen week period ended August 28, 2009, there were international sales of $5,307,000, including sales to or relating to government or commercial accounts in Saudi Arabia of $3,582,000.

          Approximately 72% of sales totaling $18,139,000 in the first half of fiscal 2011 were made to the U.S. Government and to one international customer. Approximately 45% of sales totaling $8,693,000 in the first half of fiscal 2010 were made to the U.S. Government and two international customers.

          Included in the segment information for the first half of fiscal 2011 are international sales (which include sales made by the Company’s foreign subsidiaries) of $9,456,000, including sales to the Korean government for $7,847,000. For the first half of fiscal 2010, there were international sales of $11,093,000, including sales to or relating to government or commercial accounts in Saudi Arabia of $6,666,000.

          Segment operating income consists of net sales less applicable costs and expenses relating to these revenues. Unallocated general corporate expenses and other expenses such as letter of credit fees have been excluded from the determination of the total profit/loss for segments. Corporate home office expenses are primarily central administrative office expenses. Other expenses include banking and letter of credit fees. Property, plant and equipment associated with the Company’s NASTAR Center are included in the TSG segment; the remaining property, plant and equipment are not identified with specific business segments, as these are common resources shared by all segments.

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

FORWARD-LOOKING STATEMENTS

          Discussions of some of the matters contained in this Quarterly Report on Form 10-Q for Environmental Tectonics Corporation may constitute forward-looking statements within the meaning of the Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities and Exchange Act of 1934, as amended, and as such, may involve risks and uncertainties. We have based these forward-looking statements on our current expectations and projections about future events or future financial performance, which include implementing our business strategy, developing and introducing new technologies, obtaining, maintaining and expanding market acceptance of the technologies we offer, and competition in our markets. These forward-looking statements are subject to known and unknown risks, uncertainties and assumptions about ETC and its subsidiaries that may cause actual results, levels of activity, performance or achievements to be materially different from any future results, levels of activity, performance or achievements expressed or implied by these forward-looking statements.

          These forward-looking statements include statements with respect to the Company’s vision, mission, strategies, goals, beliefs, plans, objectives, expectations, anticipations, estimates, intentions, financial condition, results of operations, future performance and business of the Company, including, but not limited to, (i) projections of revenues, costs of materials, income or loss, earnings or loss per share, capital expenditures, growth prospects, dividends, capital structure, other financial items and the effects of currency fluctuations, (ii) statements of our plans and objectives of the Company or its management or Board of Directors, including the introduction of new products, or estimates or predictions of actions of customers, suppliers, competitors or regulatory authorities, (iii) statements of future economic performance, (iv) statements of assumptions and other statements about the Company or its business, (v) statements made about the possible outcomes of litigation involving the Company, (vi) statements regarding the Company’s ability to obtain financing to support its operations and other expenses, and (vii) statements preceded by, followed by or that include terminology such as “may,” “will,” “should,” “expect,” “plan,” “anticipate,” “believe,” “estimate,” “future,” “predict,” “potential,” “intend,” or “continue,” and similar expressions. These forward-looking statements involve risks and uncertainties which are subject to change based on various important factors. Some of these risks and uncertainties, in whole or in part, are beyond the Company’s control. Factors that might cause or contribute to such a material difference include, but are not limited to, those discussed in our Annual Report on Form 10-K for the fiscal year ended February 26, 2010, in the section entitled “Risks Particular to Our Business.” Shareholders are urged to review these risks carefully prior to making an investment in the Company’s common stock.

          The Company cautions that the foregoing list of factors that could affect forward-looking statements by ETC is not exclusive. Except as required by federal securities law, the Company does not undertake to update any forward-looking statement, whether written or oral, that may be made from time to time by or on behalf of the Company.

          In this report all references to “ETC,” “the Company,” “we,” “us,” or “our,” mean Environmental Tectonics Corporation and our subsidiaries.

          References to fiscal second quarter 2011 are references to the thirteen week period ended August 27, 2010. References to fiscal second quarter 2010 are references to the thirteen week period ended August 28, 2009. References to the first half of fiscal 2011 are references to the twenty-six week period ended August 27, 2010. References to the first half of fiscal 2010 are references to the twenty-six week period ended August 28, 2009. References to fiscal 2011 or the 2011 fiscal year are references to the fifty-two week period through February 25, 2011. References to fiscal 2010 or the 2010 fiscal year are references to the fifty-two week period which ended February 26, 2010.

          Overview

          ETC was incorporated in 1969 in Pennsylvania. For over forty years, we have provided our customers with products, service and support. Innovation, continuous technological improvement and enhancement, and product quality are core values and critical to our success. We are a significant supplier and innovator in the following product areas: (1) software driven products and services used to create and monitor the physiological effects of flight; (2) high performance jet tactical flight simulation; (3) steam and gas sterilization; (4) testing and simulation devices for the automotive industry; (5) hyperbaric and hypobaric chambers; and (6) driving and disaster simulation systems.

          We operate in two business segments — Training Services Group (“TSG”) and Control Systems Group (“CSG”). Our core technologies in TSG include the design, manufacture and sale of training services which consists of (1) software driven products and services used to create and monitor the physiological effects of flight; (2) high performance jet tactical flight simulation; and (3) driving and disaster simulation systems, and in CSG include: (1) steam and gas sterilization; (2) testing and simulation devices for the automotive industry; and (3) hyperbaric and hypobaric chambers. Product categories included in TSG are Aircrew Training Systems (ATS) and flight simulators and disaster management systems. CSG includes sterilizers, environmental control devices and hyperbaric chambers along with parts and service support. Revenue and other

financial information regarding our segments may be found in Note 10 — Business Segment Information of the Notes to the Condensed Consolidated Financial Statements.

          The following factors had an impact on our financial performance, cash flow and financial position for the first half of fiscal 2011 which ended August 27, 2010:

•

Increased production under U.S. Government contracts

     The Base Realignment and Closure (BRAC) Act passed in 2005 by Congress mandated base closures and consolidations through all U.S. defense services. As a result of BRAC, in the past two years we have been awarded three major contracts for pilot training. Our fiscal 2011 opening backlog of firm orders included approximately $48 million for two contracts, one from the U.S. Navy for a research disorientation trainer and one from the U.S. Air Force to provide a high performance training and research human centrifuge. As a result of engineering and production activity on these two contracts, sales to the U.S. Government increased by approximately $6.5 million in our Training Services Group during the first half of fiscal 2011 versus the first half of fiscal 2010. On June 12, 2010, we were awarded an additional $38.3 million contract by the U. S. Air Force to provide a suite of altitude chambers. Although at the current time we have a significant sales backlog with the U.S. Government for equipment being procured under the BRAC Act, it should not be assumed that any additional contracts will be awarded to us at the same rate in the future.

     Historically, certain international customers have considered the sale of a simulation device to the U.S. Government as an important criterion of their evaluation to purchase ETC’s simulators.

	•		Exchange of long term debt, establishment of additional facility, and increase in bank line
			Adequate cash availability, both from operations and under our loan agreements, is an important factor which allows us to efficiently produce and fulfill delivery obligations under our large multi-year contracts. These contracts require significant cash outlays for materials during certain phases of production. Additionally, as our backlog and performance have grown, cash requirements for general operations have expanded.
			On April 24, 2009, we entered into a transaction with H. F. Lenfest, a member of our Board of Directors and a significant shareholder, that provided for the following: (i) a $7,500,000 credit facility to be provided by Lenfest to ETC; (ii) exchange of a Subordinated Note held by Lenfest, together with all accrued interest and warrants issuable under the Subordinated Note, and all Series B Preferred Stock and Series C Preferred Stock held by Lenfest, together with all accrued dividends thereon, for a new class of preferred stock, Series E Preferred Stock, of the Company; and (iii) an increase of the existing $15,000,000 revolving line of credit with PNC Bank to $20,000,000. During fiscal 2011, the Company has repurchased $1,500,000 of the Series E Preferred Stock.
	•		Impact of net operating loss carryforwards and tax reserves

     Prior to fiscal 2010, we experienced significant operating losses. Over such periods, we accumulated a deferred tax asset which can be utilized to offset future income tax liabilities. In previous years (years prior to fiscal 2010), we established a full valuation reserve on our deferred tax asset because of the recurring losses sustained by the Company. Subsequently, the Company’s profitability and sales backlog has, after analysis, led to a partial release of the valuation reserve. The impact on operations and financial performance since fiscal 2009 has been twofold. First, we have been able to offset income tax expense on income by realizing a portion of our deferred tax assets via reductions in the reserve. Secondly, we have been able to conserve cash by not actually paying significant income taxes to the Internal Revenue Service and state taxing authorities that would be required to be paid absent the deferred tax assets.

     During the first half of fiscal 2011, our income tax liability was offset by a corresponding reduction in our deferred tax asset reserve. Valuation allowances are reviewed each fiscal period to determine whether there is sufficient positive or negative evidence to support a change in judgment about the realizability of the related deferred tax asset. As of August 27, 2010, the Company had approximately $34 million of federal net loss carry forwards available to offset future income tax liabilities, beginning to expire in 2025.

•

Continued expanded use of our NASTAR Center

     Our National Aerospace Training and Research (NASTAR) Center, which opened in fiscal 2008, is an integrated pilot training center offering a complete range of aviation training and research support for military aviation, civil aviation and the emerging commercial space market. The NASTAR Center houses state of the art equipment including the ATFS-400, a GYROLAB GL-2000 Advanced Spatial Disorientation Trainer, a Hypobaric Chamber, an Ejection Seat Trainer, and a Night Vision and Night Vision Goggle Training System. These products represent over forty years of pioneering development and training solutions for the most rigorous stresses encountered during high performance aircraft flight including the effects of altitude exposure, High G-force exposure, spatial disorientation and escape from a disabled aircraft.

     During the past two fiscal years we have been successful in utilizing the NASTAR Center for research, space training and as a showroom to market our Authentic Tactical Fighting System technology. We feel that demonstrating

tactical flight simulation in our NASTAR Center has been highly instrumental in our obtaining significant orders for our Aircrew Training Systems products.

     Going forward, we are hopeful for expanded research in two applications: (a) research related to the commercialization of suborbital flight, and (b) research aimed at examining the effectiveness of using centrifuge based simulation for Upset Recovery Training (“URT”) for commercial airline pilots.

     Suborbital flight: The Federal Aviation Administration currently regulates commercial flight. However, flights into very high altitudes will require additional and different pilot training. The physiology of flight into very high altitudes is significantly different than that experienced during existing commercial flight. Thus, its impact on passengers must be evaluated. Research is required to develop flight crew standards and to evaluate human factors as ordinary citizens experience physical stresses.

     Upset Recovery Training: Loss of control in flight is a major cause factor in loss of life and hull damage aircraft accidents. Modern day commercial aviation currently has no requirement for training of pilots to deal with these situations, commonly referred to as “upsets.” Realistic training for responding to and recovering from upsets, or URT, requires more than a non-centrifuged based simulator because non-centrifuge-based simulators do not reproduce the physiological stresses and disorientation that a pilot experiences during an actual upset. We believe our GYROLAB simulator series is an answer to providing pilots with the dynamic environment necessary for effective training.

•

Continued capital and consulting spending to enhance and market worldwide our Authentic Tactical Fighting Systems (ATFS) and other technologies.

     We have directed significant funds and management attention toward the marketing of our ATFS line of products. This effort includes engineering costs to improve the technical abilities of the ATFS products. Going forward, we expect to continue significant spending for these efforts.

•

Common stock dilution.

     As a result of our Lenfest Refinancing Transaction, our average fully diluted shares have increased by approximately 11.0 million shares. Given our positive financial performance, this increase in equivalent common shares has a dilutive impact on our earnings per share.

     During the first half of fiscal 2011, we repurchased $1,500,000 of Series E Preferred Stock from H.F. Lenfest.

Critical Accounting Policies

          The discussion and analysis of the Company’s financial condition and results of operation are based upon the Company’s condensed consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these condensed consolidated financial statements requires the Company to make estimates and judgments that affect the reported amount of assets and liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities at the date of the Company’s condensed financial statements. Actual results may differ from these estimates under different assumptions or conditions.

          Critical accounting policies are defined as those that reflect significant judgments and uncertainties, and potentially result in materially different results under different assumptions and conditions. For a detailed discussion on the application of these and other accounting policies, see Note 2 — Summary of Significant Accounting Policies of the Notes to the Consolidated Financial Statements in the Company’s Annual Report on Form 10-K for the fiscal year ended February 26, 2010.

Results of Operations

Thirteen week period ended August 27, 2010 compared to the thirteen week period ended August 28, 2009

          We have historically experienced significant variability in our quarterly revenue, earnings and other operating results, and our performance may fluctuate significantly in the future.

		Summary Table of Results
		Thirteen week				Thirteen week
		period ended				period ended				Variance				Variance
		August 27, 2010				August 28, 2009				$				%
		(amounts in thousands)								(   ) =Unfavorable
Sales:
Domestic		$	2,418			$	2,877			$	(459	)			(16.0	)%
US Government			6,587				1,676				4,911				293.0
International			4,239				5,307				(1,068	)			(20.1	)
Total sales			13,244				9,860				3,384				34.3
Gross profit			4,794				4,956				(162	)			(3.3	)
Selling and marketing expenses			1,020				1,270				250				19.7
General and administrative expenses			1,623				1,568				(55	)			(3.5	)
Research and development expenses			240				227				(13	)			(5.7	)
Operating income			1,911				1,891				20				1.1
Interest expense, net			189				350				161				46.0
Other expense, net			56				66				10				15.2
Loss on extinguishment of debt			—				224				224				100.0
Income taxes			—				—				—				n/a
Noncontrolling interest			—				2				2				100.0
Net income			1,666				1,249			$	417				33.4	%
Preferred stock dividend			(568	)			(460	)			(108	)			(23.5	)
Income applicable to common shareholders		$	1,098			$	789			$	309				39.2
Net income per common share (basic)		$	0.12			$	0.09			$	0.03				33.3	%
Net income per common share (diluted)		$	0.08			$	0.06			$	0.02				33.3	%

Net Income

          The Company had net income of $1,666,000 or $0.12 per share (basic) and $0.08 (diluted) during the second quarter of fiscal 2011 compared to net income of $1,249,000 or $0.09 per share (basic) and $0.06 (diluted), for the second quarter of fiscal 2010, representing an increase of $417,000 or 33.4%. The increase reflected a reduction in selling and marketing expenses, interest expense and a loss on extinguishment of debt of $224,000, which the Company recognized in the prior year.

Sales

          The following schedule presents the Company’s sales by segment, business unit and geographic area:

		(amounts in thousands)
		Thirteen week period ended																Thirteen week period ended
		August 27, 2010																August 28, 2009
										Inter-																Inter-
Segment sales:		Domestic				USG				national				Total				Domestic				USG				national				Total
Training Services Group:
Pilot Training Services		$	59			$	4,952			$	2,868			$	7,879			$	35			$	1,115			$	3,070			$	4,220
Simulation			227				—				165				392				84				—				1,609				1,693
ETC-PZL and other			94				—				310				404				203				—				275				478
Total		$	380			$	4,952			$	3,343			$	8,675			$	322			$	1,115			$	4,954			$	6,391
Control Systems Group:
Environmental		$	113			$	1,635			$	886			$	2,634			$	339			$	561			$	36			$	936
Sterilizers			1,117				—				—				1,117				1,566				—				—				1,566
Hyperbaric			355				`				—				355				289				`				303				592
Service and spares			453				—				10				463				361				—				14				375
Total			2,038				1,635				896				4,569				2,555				561				353				3,469
Company total		$	2,418			$	6,587			$	4,239			$	13,244			$	2,877			$	1,676			$	5,307			$	9,860

          Sales for the second quarter of fiscal 2011 were $13,244,000 as compared to $9,860,000 for the second quarter of fiscal 2010, an increase of $3,384,000 or 34.3%. As the table indicates, significant increases were realized in the U.S. Government market offset in part in by a decline in Domestic and International sales.

Domestic Sales

          Domestic sales in the second quarter of fiscal 2011 were $2,418,000 as compared to $2,877,000 in the second quarter of fiscal 2010, a decrease of $459,000 or 16.0%, reflecting a decrease in the sterilizer product line (down $448,000). Domestic sales represented 18.3% of the Company’s total sales in the second quarter of fiscal 2011, as compared to 29.2% for the second quarter of fiscal 2010.

U.S. Government Sales

          U.S. Government sales in the second quarter of fiscal 2011 were $6,587,000 as compared to $1,676,000 in the second quarter of fiscal 2010, an increase of $4,911,000 or 293.0%, and represented 49.7% of total sales in the second quarter of fiscal 2011 versus 17.0% for the second quarter of fiscal 2010. This increase is the result of sales of the Company’s Pilot Training Systems products under contracts from the U.S. Navy for a research disorientation trainer and the U.S. Air Force to provide a high performance training and research human centrifuge and a suite of altitude chambers.

International Sales

          For the second quarter of fiscal 2011, international sales (which include sales made by the Company’s foreign subsidiaries) were $4,239,000 as compared to $5,307,000 in the second quarter of fiscal 2010, a decrease of $1,068,000 or 20.1%, and represented 32.0% of total sales, as compared to 53.8% in the second quarter of fiscal 2010. International performance reflected lower simulation sales (down $1,444,000) primarily for a contract in the Middle East which was completed in fiscal 2010. For the thirteen week period ended August 27, 2010, there were sales to the Korean government for $3,374,000. For the thirteen week period ended August 28, 2009, there were sales to or relating to governments or commercial accounts in Saudi Arabia of $3,582,000.

Gross Profit

          Gross profit for the second quarter of fiscal 2011 was $4,794,000 as compared to $4,956,000 in the second quarter of fiscal 2010, a decrease of $162,000 or 3.3%. As a percentage of sales, gross profit for the second quarter of fiscal 2011 was 36.2% compared to 50.3% for the same period a year ago. The gross margin dollar decrease reflects a 14.1 percentage point reduction in the gross margin rate as a percentage of sales due to the higher concentration of U.S. Government contract work compared to higher margin international sales in the prior period.

Selling and Marketing Expenses

          Selling and marketing expenses for the second quarter of fiscal 2011 were $1,020,000 as compared to $1,270,000 in the second quarter of fiscal 2010, a decrease of $250,000 or 19.7%. This decrease primarily reflected reduced bid and proposal expenses and reduced commissions on the mix shift in sales in the current quarter to higher U.S. Government sales.

General and Administrative Expenses

          General and administrative expenses for the second quarter of fiscal 2011 were $1,623,000 as compared to $1,568,000 in the second quarter of fiscal 2010, an increase of $55,000 or 3.5%.

Research and Development Expenses

          Research and development expenses, which are charged to operations as incurred, were $240,000 for the second quarter of fiscal 2011 as compared to $227,000 for the second quarter of fiscal 2010. Most of the Company’s research efforts, which were and continue to be a significant cost of its business, are included in cost of sales for applied research for specific contracts, as well as research for feasibility and technology updates.

Loss on Extinguishment of Debt

          In the second quarter of fiscal 2010, the Company recorded a loss on extinguishment of debt (the Subordinated Note) of $224,000, which represented the unamortized portion of the debt discount that was recorded at the issuance of this instrument. This charge resulted from the exchange of subordinated debt for preferred stock under the Lenfest Financing Transaction which was completed in July 2009. See Note 6 — Long-term Obligations and Credit Arrangements in the accompanying Notes to the Condensed Consolidated Financial Statements.

Interest Expense

          Interest expense for the second quarter of fiscal 2011 was $189,000 as compared to $350,000 for the second quarter of fiscal 2010, representing a decrease of $161,000 or 46.0%, reflecting reduced bank borrowing and the July 2009 exchange of the Subordinated Note for preferred stock.

Other Expense, Net

          Other expense, net, was $56,000 for the second quarter of fiscal 2011 versus $66,000 for the second quarter of fiscal 2010. These expenses consist primarily of bank and letter of credit fees as well as foreign currency exchange gains or losses.

Income Taxes

          Due to the utilization of net operating loss carry forwards available the Company did not record a provision for income taxes for the thirteen week periods ended August 27, 2010 or August 28, 2009.

          The Company has reviewed the components of its deferred tax asset and has determined, based upon all available information, that its current and expected future operating income will more likely than not result in the realization of a portion of its deferred tax assets relating primarily to its net operating loss carryforwards. As of August 27, 2010, the Company had approximately $34 million of federal net loss carry forwards available to offset future income tax liabilities, beginning to expire in 2025. In addition, the Company has the ability to offset deferred tax assets against deferred tax liabilities created for such items as depreciation and amortization.

Results of Operations

Twenty-six week period ended August 27, 2010 compared to the twenty-six week period ended August 28, 2009

          We have historically experienced significant variability in our quarterly revenue, earnings and other operating results, and our performance may fluctuate significantly in the future.

		Summary Table of Results
		Twenty-six				Twenty-six
		week period				week period
		ended				ended				Variance				Variance
		August 27, 2010				August 28, 2009				$				%
		(amounts in thousands)								(   ) =Unfavorable
Sales:
Domestic		$	5,336			$	4,836			$	500				10.3	%
US Government			10,573				3,512				7,061				201.1
International			9,456				11,093				(1,637	)			(14.8	)
Total sales			25,365				19,441				5,924				30.5
Gross profit			9,924				9,383				541				5.8
Selling and marketing expenses			2,122				2,524				402				15.9
General and administrative expenses			3,086				3,170				84				2.6
Research and development expenses			564				455				(109	)			(24.0	)
Operating income			4,152				3,234				918				28.4
Interest expense, net			417				866				449				51.9
Other expense, net			128				121				(7	)			(5.8	)
Loss on extinguishment of debt			—				224				224				100.0
Income taxes			—				—				—				n/a
Noncontrolling interest			5				4				(1	)			(25.0	)
Net income			3,602				2,019				1,583				78.4	%
Preferred stock dividend			(1,145	)			(695	)			(450	)			(64.7	)
Income applicable to common shareholders		$	2,457			$	1,324			$	1,133				85.6
Net income per common share (basic)		$	0.27			$	0.15			$	0.12				80.0	%
Net income per common share (diluted)		$	0.17			$	0.09			$	0.08				88.9	%