UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

FORM 10-Q

(Mark One)

For the quarterly period ended: December 25, 2004

or

For the transition period from          to         

Commission File Number: 000-03905

Transcat, Inc.

35 Vantage Point Drive, Rochester, New York 14624
(Address of principal executive offices) (Zip Code)

(585) 352-7777
(Registrant’s telephone number, including area code)

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

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

The number of shares of Common Stock of the Registrant outstanding as of February 4, 2005 was 6,465,323.

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PART 1. FINANCIAL INFORMATION

See the notes to these financial statements.

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See the notes to these financial statements.

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Cooperative Advertising Income. We follow 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. We report 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 our Canadian subsidiary are maintained in 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 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 our subsidiary balance sheets into United States dollars are recorded directly to the accumulated comprehensive income component of stockholders’ equity. Currency gains and losses on business transactions are included in other expense (income) 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 ended December 25, 2004, the net additional Common Stock equivalents had no effect on the calculation of dilutive earnings per share. For the nine months ended December 25, 2004, there were no dilutive shares. For the third quarter ended December 27, 2003, there were no dilutive shares. For the nine months ended December 27, 2003, the net additional Common Stock equivalents had no effect on the calculation of dilutive earnings per share. The total number of dilutive and anti-dilutive Common Stock equivalents resulting from outstanding stock options, warrants, and non-vested restricted stock are summarized as follows (shares in thousands, except per share amounts):

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. 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. 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.

Inventories. Inventories consist of finished goods and are valued at the lower of standard cost or market. Standard costs approximate the average cost method of inventory valuation. Inventories are 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.

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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 terms of the related leases. Maintenance and repairs are expensed as incurred.

Goodwill. We estimate the fair value of our 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. 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 catalog supplements over a three month period.

Deferred Compensation. Previously, some of our directors had elected to defer receipt of their non-discretionary awards of shares of our Common Stock under our Amended and Restated Directors’ Stock Plan. Deferred shares were expensed at the market value of our Common Stock at the date of award, and the associated liability is adjusted quarterly based on the quarter end market price of our Common Stock. Directors voluntary elected to cease deferring shares effective as of April 1, 2003. In addition, we provide an annual benefit to a former president’s spouse and former executive under the terms of a deferred compensation agreement.

Deferred Gain on Sale of TPG. As a result of certain post divestiture commitments, according to GAAP, we are unable to recognize the gain of $1.5 million on the divestiture of Transmation Products Group (“TPG”), which took place in fiscal year 2002, until those commitments expire in fiscal year 2007.

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 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. The carrying amounts reported on our Consolidated Balance Sheets for cash, accounts receivables, and accounts payable approximate fair value due to their short-term nature.

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Stock Options. We follow the provisions of Accounting Principles Board (“APB”) 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 stock option plan had exercise prices equal to the market value of the underlying Common Stock at grant date.

The following table provides pro forma amounts, if we accounted for stock-based compensation under the fair value method (in thousands, except per share amounts):

In the third quarter of fiscal year 2005, we acquired treasury stock from a cashless stock option exercise, in which, a Board of Director immediately used shares acquired, by exercising a portion of an option, to exercise the remaining shares under the same option.
As a result, we recognized $0.1 million in compensation expense from the difference in the market value and exercise value of the immature shares in accordance with APB No. 25. This transaction resulted in an increase to Common Stock of 0.2 million shares, $0.1 million, an increase to Capital in Excess of Par Value of $0.5 million, and an increase in our Treasury Stock of 0.1 million shares, and $0.4 million.

Reclassification of Amounts. Certain reclassifications of prior fiscal periods’ financial information have been made to conform with current fiscal periods’ presentation.

NOTE 3 - DEBT

Description. On November 13, 2002, we entered into a Revolving Credit and Loan Agreement (the “Credit Agreement”) with GMAC Business Credit, LCC (“GMAC”). The Credit Agreement consisted of a term loan, a revolving line of credit (“LOC”), and certain material terms of 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 (“Second Amendment”) to waive compliance with our 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 we had committed to dissolve by a specific date (that has been subsequently dissolved), and increase the Credit Agreement restriction on our Master Catalog spending.

We 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 if certain conditions are met, and certain material terms of which are as set forth below. The Third Amendment also waived compliance with our EBITDA (earnings before interest, income taxes, depreciation and amortization) covenant for the second quarter of fiscal year 2005 and extended the Credit Agreement expiration from November 13, 2005 to October 31, 2007.

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Term Loans. As of March 27, 2004, we had a term loan balance in the amount of $0.7 million in favor of GMAC. This term loan required annual payments totaling $0.5 million, payable in equal monthly installments, commencing on December 1, 2002, and was repaid in full on November 1, 2004.

Under the Third Amendment, we made two term loans, Term Loan A and Term Loan B, in the amounts of $1.5 million and $0.5 million, respectively. These term notes 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 Third Amendment requires us to make the following principal payments on combined term loans (in thousands):

We made a principal payment of $0.1 million in the third quarter of fiscal year 2005 in accordance with the above schedule, leaving a term loan balance of $1.9 million as of December 25, 2004.

In addition, under the Third Amendment, we are 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 our 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 our excess cash flow, not to exceed $0.2 million, annually.

LOC. Under the Third Amendment, the maximum amount available under the LOC portion is $9.0 million. As of December 25, 2004, we were eligible to borrow up to $7.8 million based on our assets and borrowed $4.7 million. Availability under the LOC is determined by a formula based on eligible accounts receivable (85%) and inventory (50%).

The Credit Agreement requires both a subjective acceleration clause and a requirement to maintain a lock-box arrangement. These requirements resulted in a short-term classification of the LOC in accordance with EITF 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. Under the Third Amendment, interest on the term loans and LOC is fixed at Tier 2 (see chart below) through March 2005. The prime rate and the 30-day London Interbank Offered Rate (“LIBOR”) as of December 25, 2004 were 5.25% and 2.42%, respectively. Interest on the term loans and LOC after March 2005, is adjusted on a quarterly basis based upon our calculated Fixed Charge Coverage Ratio, as defined in the Third Amendment, as follows:

Covenants. The Credit Agreement has certain covenants with which we had to comply, including a minimum EBITDA covenant, as well as restrictions on capital expenditures and Master Catalog spending. The Third Amendment includes a revised EBITDA covenant, a fixed charge coverage ratio covenant, as well as, revised restrictions on capital expenditures and Master Catalog spending. As previously indicated, the Third Amendment waived compliance with our EBITDA covenant for the second quarter of fiscal year 2005. We were in compliance with all loan covenants and requirements for the third quarter of fiscal year 2005.

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Loan Costs. In accordance with EITF 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, will be amortized over the term of the Third Amendment.

Other Terms. The Credit Agreement requires an increase in our borrowing rate of two percentage points should an event of default occur and a termination premium of 1% of the maximum available borrowing under the revolving line of credit plus the then outstanding balance owed under the term note if the Credit Agreement was terminated after November 13, 2003 and prior to November 13, 2005. Under the Third Amendment, if the agreement is terminated prior to its expiration date of October 31, 2007, a termination premium of 2% in year one, 1% in year two, and 0.5% in the third year of the advance limit, as defined in the agreement, will be incurred. The Third Amendment also reduced other certain recurring loan costs and fees.

Additionally, we have 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”). If prior to September 30, 2005, we have achieved an EBITDA, as defined in the agreement, of $2.4 million on a trailing twelve months basis, we may make a Cap-x Loan of up to $1.0 million for qualifying capital expenditures. As of December 25, 2004, we have not made this milestone. 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 our calculated Fixed Charge Coverage Ratio with the same terms as Term Loan A (see chart above).

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NOTE 5 - COMMITMENTS

Unconditional Purchase Obligation. On October 31, 2002, with an effective date of September 1, 2002, we entered into a new distribution agreement (the “New Agreement”) with Fluke Electronics Corporation (“Fluke”), which replaced a previous distribution agreement with Fluke. The New Agreement continues to allow us to be the exclusive worldwide distributor of TPG products, until December 25, 2006. We also agreed, among other items, to purchase a pre-determined amount of inventory across a broad array of products and brands during each calendar year. Our purchases for calendar years 2003 and 2004 exceeded our commitment under the New Agreement. We believe that this commitment to future purchases is consistent with our business needs and plans. The New Agreement extends through December 31, 2006.

NOTE 6 - VENDOR CONCENTRATION

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

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

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.

Reclassification of Amounts. Certain reclassifications of prior fiscal periods’ financial information have been made to conform with current fiscal periods’ presentation.

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

CRITICAL ACCOUNTING POLICIES AND ESTIMATES

Use of Estimates. The preparation of our Consolidated Financial Statements in accordance with GAAP requires that we make estimates and assumptions that affect the reported amounts of assets and liabilities, as well as 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, inventory valuation, depreciable lives of assets, economic lives of leased assets, impairment of goodwill, 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.

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 based on the agreed upon terms. 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 the 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. 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.

Inventories. Inventories consist of finished goods and are valued at the lower of standard cost or market. Standard costs approximate the average cost method of inventory valuation. Inventories are 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.

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Net sales increased $0.6 million, or 4.4%, from the third quarter of fiscal year 2004 to the third quarter of fiscal year 2005.

Our product sales, which accounted for 70.2% of our sales in the third quarter of fiscal year 2005 and 68.9% of our sales in the third quarter of fiscal year 2004, have continued to reflect improved year over year economic comparisons and customer response to our marketing activities. Our product sales have improved in relation to the prior fiscal year quarter comparisons, as follows (calculated on dollars in millions):

The following table provides the percent of net sales and approximate gross profit percentage for significant product distribution channels (calculated on dollars in thousands):

(1) Calculated at net sales less purchase cost.

Customer product orders include orders for products that we routinely stock in our inventory, as well as 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, orders required to be shipped at a future date, and orders on credit hold and/or awaiting letters of credit. Our total unshippable orders decreased by approximately $0.3 million, or 18.8% from the third quarter of fiscal year 2004 to the third quarter of fiscal year 2005. We believe that the decrease is primarily attributed to vendors shipping inventory to us on a more timely basis and improvement in inventory demand planning. The following table reflects our historical trend of product orders that are unshippable at the end of each fiscal quarter and the percentage of these orders that are backorders (calculated on dollars in millions):

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Calibration services sales for the third quarter of fiscal year 2005 were unchanged when compared to the prior year third quarter. Within any quarter, there is always a netting of new customers against existing customers whose calibrations may not repeat for any number of factors. Therefore our calibration services sales can be impacted by a number of factors that can impact quarterly and annual comparisons, both within and outside of our control. Among those factors are the timing of customer periodic calibrations on equipment as well as repair services, customer capital expenditure budgets, and customer outsourcing decisions. The rate of change in our calibration services sales in relation to the prior fiscal year quarter is as follows (calculated on dollars in millions):

Gross Profit:

Gross profit increased as a percent of net sales from 22.8% in the third quarter of fiscal year 2004 to 25.1% in the third quarter of fiscal year 2005.

Product gross profit increased $0.3 million, 1.7 points as a percent of net product sales from the third quarter of fiscal year 2004 to the third quarter of fiscal year 2005. Contributing factors to this increased ratio are less aggressive discounting of sales in our core business channel and reduced sales in lower margin sales channels (see above). Our product gross profit ratio can be impacted by a number of factors that can impact quarterly and annual comparisons. Among those factors are changes in sales levels to certain channels that do not support the margins of our core customer base, periodic rebates on purchases and cooperative advertising received from suppliers and 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). Neither earned rebates on purchases nor cooperative advertising had a material effect on the comparison of product gross profit ratios between the third quarters of fiscal years 2004 and 2005. 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 increased $0.1 million, or 2.4 points as a percent of net calibration services sales from the third quarter of fiscal year 2004 to the third quarter of fiscal year 2005. This increase is attributable to lower costs as calibration services revenue has remained constant with the prior year third quarter. 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):

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Operating expenses decreased $0.1 million, or 3.1%, from the third quarter of fiscal year 2004 to the third quarter of fiscal year 2005. This decrease is primarily attributed to a reduction in selling expenses resulting from lower payroll and related costs. Administrative expenses were relatively flat from the third quarter of fiscal year 2004 to the third quarter of fiscal year 2005; however, there were some significant offsetting charges. In the third quarter of fiscal year 2004 we incurred a $0.2 million charge to settle, rather than further litigate, a lawsuit brought against us by our former chief financial officer and $0.1 million of severance costs. In the third quarter of fiscal year 2005, we incurred $0.1 million of expense from a cashless exercise of stock options and other insignificant increases in stock grant expenses, deferred compensation costs, recruiting costs, and payroll related costs that offset fiscal year 2004 third quarter total charges.

Other Expense:

Interest expense was relatively flat from the third quarter of fiscal year 2004 to the third quarter of fiscal year 2005 resulting from slightly higher interest rates applied to lower average debt. Other expenses recorded in the third quarter of fiscal year 2005 resulted primarily from foreign currency transaction losses as compared with foreign currency transaction gains in the third quarter of fiscal year 2004.

Taxes:

We have not recognized any provision in the third quarter of fiscal year 2005 as pretax income was offset by a reduction in our deferred tax asset valuation reserve. We did not recognize any tax benefit for the loss in the third quarter of fiscal year 2004 as any benefit required on the pretax loss was offset by an increase in our deferred tax asset valuation reserve.

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Net sales increased $1.6 million, or 4.2%, from the first nine months of fiscal year 2004 to the first nine months of fiscal year 2005.

Our product sales, which accounted for 68.0% of our sales in the first nine months of fiscal year 2005 and 65.7% of our sales in the first nine months of fiscal year 2004, have improved due to customer response to our enhanced marketing programs, targeted sales efforts in new distribution channels and improved economic conditions over the first nine months of fiscal year 2004.

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 sales declined $0.4 million, or 3.1%, in the first nine months of fiscal year 2005 when compared to the first nine months of fiscal year 2004. Within any quarter, there is always netting of new customers against existing customers whose calibrations may not repeat for any number of factors. Therefore our calibration services sales can be impacted by a number of factors that can impact quarterly and annual comparisons, both within and outside of our control. Among those factors are the timing of customer periodic calibrations on equipment as well as repair services, customer capital expenditure budgets, and customer outsourcing decisions.

Gross Profit:

Gross profit decreased as a percent of sales from 25.7% in the first nine months of fiscal year 2004 to 24.0% in the first nine months of fiscal year 2005.

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Gross profit on product sales for the first nine month of fiscal year 2005 was relatively flat (in dollars) compared to the first nine months of fiscal year 2004 but declined 1.8 points as a percent of net product sales from the first nine months of fiscal year 2004 to the first nine months of fiscal year 2005. Contributing factors to this decrease on a higher sales base include increased sales in new channels of distribution that typically do not support the margins of our core customer base (see above) and an increased level of allowances to stimulate sales growth that we experienced in the first nine months (and first six months in particular) of fiscal year 2004. In addition, periodic rebates on purchases and cooperative advertising income received from suppliers and reported as a reduction of cost sales do not necessarily repeat in the same fiscal quarters. The first nine months of fiscal year 2004 included $0.1 million dollars more of such income than in the first nine months of fiscal year 2005, accounting for 0.3 points as a percent of sales of the margin ratio decline.

Calibration services gross profit declined $0.2 million in the first nine months of fiscal year 2005 when compared to the first nine months of fiscal year 2004, and declined 0.7 points as a percent of net calibration services sales when comparing the same periods. The primary reason behind this decrease was the decrease in calibration services sales where our cost structure has a significant fixed component.

Operating Expenses:

Operating expenses decreased $0.1 million, or 1.1%, in the first nine months of fiscal year 2005 when compared to the first nine months of fiscal year 2004, and decreased 1.2 points as a percent of net sales on an increased sales base. The reduction in selling, marketing, and warehouse expense is primarily the result of reduced sales payroll and related expenses ($0.4 million) and overall ongoing expense control. The increase in administrative expenses is primarily attributable to a $0.2 million increase in expenses associated with executive stock grants, $0.1 million of expense from a cashless exercise of stock options in fiscal year 2005, a $0.1 million reduction in the bad debt reserve in fiscal year 2004, and a $0.1 million increase in other insignificant areas, offset by, a $0.2 million charge to settle, rather than further litigate, a lawsuit brought against us by our former chief financial officer we incurred in fiscal year 2004.

Other Expense:

Consistent with our level of debt, interest expense has remained relatively flat when comparing the first nine months of fiscal year 2005 to that of fiscal year 2004. Other expense recorded in the first nine months of fiscal year 2005 resulted from foreign currency transaction losses as compared with foreign currency transaction gains in the first nine months of fiscal year 2004.

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We did not recognize any tax benefit for the loss in the first nine months of fiscal year 2005 as any benefit on the pretax loss was offset by an increase in our deferred tax asset valuation reserve. We have not recognized any provision in the first nine months of fiscal year 2004 as pretax income was offset by a reduction in our deferred tax asset valuation reserve. We did record a net $0.1 million benefit for losses in the first nine months of fiscal year 2004 primarily from a non-recurring election allowing a carry back of certain tax liabilities, previously subject to a valuation allowance. We received the refund in the second quarter of fiscal year 2005.

LIQUIDITY AND CAPITAL RESOURCES

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