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UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

For the quarterly period ended March 31, 2003

OR

For the transition period from          to         

Commission file number 1-7348

DYNAMICS RESEARCH CORPORATION

(Exact Name of Registrant as Specified in Its Charter)

Registrant’s telephone number, including area code (978) 475-9090

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.

Yes  X          No        .

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act).

Yes  X          No        .

As of May 2, 2003, the number of shares outstanding of the Registrant’s Common Stock, $.10 par value, was 8,287,553 shares.

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DYNAMICS RESEARCH CORPORATION

For the quarter ended March 31, 2003

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DYNAMICS RESEARCH CORPORATION

Consolidated Balance Sheets (unaudited)

(in thousands of dollars, except share and per share data)

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

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DYNAMICS RESEARCH CORPORATION

Consolidated Statements of Operations (unaudited)

(in thousands of dollars, except share and per share data)

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

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DYNAMICS RESEARCH CORPORATION

Consolidated Statements of Cash Flows (unaudited)

(in thousands of dollars)

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

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DYNAMICS RESEARCH CORPORATION

Notes to Unaudited Consolidated Financial Statements

Note 1. Basis of Presentation

Principles of Consolidation

The accompanying consolidated financial statements include the accounts of the company and its wholly owned subsidiaries. All material intercompany transactions and balances have been eliminated in consolidation. Certain prior period amounts have been reclassified to conform to current period presentation.

On October 18, 2002, the company announced that it was actively pursuing the divestiture of the Encoder Division, a manufactured products business, (previously reported as a segment) due to continued weakness in the manufacturing sector. In accordance with Statement of Financial Accounting Standard (“SFAS”) No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets, the consolidated financial statements of the company have been restated to reflect the discontinuation of the Encoder Division (see Note 2).

Certain information in footnote disclosures normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States has been condensed or omitted pursuant to the rules and regulations of the Securities and Exchange Commission. The company believes that the disclosures are adequate to make the information presented not misleading. The financial information is unaudited, but reflects all normal adjustments which are, in the opinion of the management, necessary to fairly present the results of operations and financial position. The financial statements should be read in conjunction with the financial statements in the company’s Annual Report on Form 10-K for the year ended December 31, 2002. The results of the three-month period ended March 31, 2003 may not be indicative of the results that may be expected for the fiscal year ended December 31, 2003.

Inventories

Inventories are stated at the lower of cost (first-in, first-out) or market, and consist of materials, labor and overhead. There are no amounts in inventories relating to contracts having production cycles longer than one year. Work-in-process, raw materials and subassemblies were $46,000 at March 31, 2003 and $58,000 at December 31, 2002.

Property, Plant and Equipment

Property, plant and equipment are stated at cost. Plant and equipment are depreciated principally on a straight-line basis over their estimated useful lives. Useful lives for equipment range from three to eight years. The corporate office building has a useful life of 31 years. Leasehold improvements are amortized over the shorter of the remaining term of the lease or the life of the related asset.

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Property, plant and equipment stated at cost :

Stock-Based Compensation

The company accounts for stock option plans under APB Opinion No. 25, Accounting for Stock Issued to Employees, and related Interpretations. The following table illustrates the effect of net income per common share if the company had applied the fair value based method of SFAS No. 123, Accounting for Stock-Based Compensation, to all outstanding and unvested awards in each period to record expense for stock option compensation.

The weighted average fair value of options granted was $8.33 in the first quarter of 2003 and $13.27 in the first quarter of 2002. The fair value of each option for the company’s plans is estimated on the date of the grant using the Black-Scholes option pricing model, with the following weighted average assumptions.

New Accounting Pronouncements

In April 2002, the Financial Accounting Standards Board (the “FASB”) issued SFAS No. 145, Rescission of FASB Statements Nos. 4, 44 and 64, Amendment of FASB Statement No. 13 and Technical Corrections. It rescinds SFAS No. 4, Reporting Gains and Losses from Extinguishment of Debt, SFAS No. 44, Accounting for Intangible Assets of Motor Carriers and SFAS No. 64, Extinguishment of Debt Made to Satisfy Sinking-Fund Requirements.

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SFAS No. 145 also amends SFAS No. 13, Accounting for Leases, to eliminate the inconsistency in the required accounting for sale-leaseback transactions. SFAS No. 145 also amends other existing authoritative pronouncements to make various technical corrections, clarify meanings or describe their applicability under changed conditions. The new rule is effective for the company beginning January 1, 2003. The adoption of SFAS No.145 did not have a material impact on the company’s financial position or results of operations.

In June 2002, the FASB issued SFAS No. 146, Accounting for Costs Associated with Exit or Disposal Activities. SFAS No. 146 requires companies to recognize costs associated with exit or disposal activities when they are incurred rather than at the date of a commitment to the exit or disposal plan. The new rule is effective for the company beginning January 1, 2003. The adoption of SFAS No. 146 did not have a material impact on the company’s financial position or results of operations.

In December 2002, the FASB issued SFAS No. 148, Accounting for Stock-Based Compensation-Transition and Disclosure-An Amendment of SFAS No. 123. SFAS No. 148 amends SFAS No. 123, Accounting for Stock-Based Compensation, to provide alternative methods of transition for a voluntary change to the fair-value-based method of accounting for stock-based employee compensation. Also, this Statement amends the disclosure requirements of SFAS No. 123 to require prominent disclosures in interim financial statements in addition to the annual disclosures about the effect the fair value method would have had on reported results. The transition and annual disclosure requirements of SFAS No. 148 are effective for fiscal years ending after December 15, 2002. The interim disclosure requirements are effective for interim periods beginning after December 15, 2002. As permitted by SFAS No. 148, the company continues to apply the disclosure alternative adopted under SFAS No. 123 to account for its stock option grants to employees, under which compensation expense is not typically recognized.

In November 2002, the FASB issued FASB Interpretation No. (“FIN”) 45, Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others, an Interpretation of SFAS No. 5, 57, and 107 and Rescission of FASB Interpretation No. 34. FIN No. 45 clarifies requirements relating to the guarantor’s accounting for, and disclosure of, the issuance of certain types of guarantees. FIN No. 45 requires that upon issuance of a guarantee, companies recognize a liability for the fair value of the obligation it assumes under that guarantee. The company adopted the annual disclosure provisions of FIN No. 45 in the year ended December 31, 2002. The company adopted the provisions for initial recognition and measurement and the interim disclosures during the first quarter of 2003. The adoption of FIN No. 45 did not have a material effect on the consolidated financial statements.

Income (Loss) Per Common Share

Basic income (loss) per share is computed by dividing net income (loss) by the weighted average number of shares of common stock outstanding during the period. For years in which there is net income, diluted income per share is determined by using the weighted average number of common and dilutive common equivalent shares outstanding during the period unless the effect is antidilutive.

Due to their antidilutive effect, 100,260 and 1,000 stock options were excluded from the calculation of diluted income per share in the first quarter of 2003 and 2002, respectively.

Note 2. Discontinued Operations

On October 18, 2002, the company announced that it was actively pursuing the divestiture of the Encoder Division. Effective in the fourth quarter of 2002, and in accordance with SFAS No. 144, the

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Encoder Division has been reflected as discontinued operations for all periods presented in the company’s financial statements. Accordingly, the revenue, costs, expenses, assets, liabilities and cash flows of the Encoder Division have been reported separately in the Consolidated Statements of Operations, Consolidated Balance Sheets and Consolidated Statements of Cash Flows for all periods presented. The results of discontinued operations do not reflect any interest expense or any allocation of corporate general and administrative expense.

Loss from discontinued operations for the first quarter of 2003 was $0.4 million or $0.04 per diluted share, compared with $0.2 million, or $0.02 per diluted share for the first three months of 2002.

Current assets of discontinued operations consist of the following:

Noncurrent assets of discontinued operations consist of net property, plant and equipment and was $0.3 million at both March 31, 2003 and December 31, 2002.

Current liabilities of discontinued operations consist of the following:

On May 2, 2003, the company completed the sale of its Encoder Division assets and certain liabilities to GSI Lumonics in Billerica, Massachusetts for $3.3 million in cash subject to adjustment. As a result, an impairment charge of $1.1 million before taxes was recorded as a loss on disposal of discontinued operations in the first quarter of 2003, reflecting $0.3 million of professional fees and $0.8 million of other costs to exit the business.

Loss on disposal of discontinued operations also includes royalty income. The company recognized royalty income associated with the company’s 1999 sale of its discontinued Telecommunications Fraud Control business on a cash basis and reported no income in the first quarter

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of 2002. In the first quarter of 2003, the company received the final royalty payment associated with this transaction of $0.7 million, and included $0.4 million, net of tax, in loss on disposal of discontinued operations for the first quarter of 2003.

Note 3. Debt

At December 31, 2002, the company had $12.4 million in notes payable associated with the purchase of Andrulis Corporation (“ANDRULIS”). The $12.4 million in notes payable had an interest rate of 4.0% and a maturity date of January 2, 2003. In January 2003, the notes payable associated with the purchase of ANDRULIS were paid in full with proceeds from the company’s revolving credit agreement.

Effective June 28, 2002, the company obtained a $50 million revolving credit agreement (the “Revolver”), replacing the previous revolver. The Revolver has a three-year term and is available to the company for general corporate purposes, including strategic acquisitions. The fee on the unused portion of the Revolver ranges from 0.25% to 0.5% depending on the company’s most recently reported leverage ratio and is payable quarterly in arrears. The company has the option to elect on a fixed 30, 60 or 90-day term, an interest rate of LIBOR plus 2.0% to 3.0%, depending on the company’s most recently reported leverage ratio, or the prime rate on any outstanding balance. Interest on the outstanding balance of the Revolver is payable monthly under the prime rate option or at the end of the elected term for the LIBOR rate option. At March 31, 2003, the outstanding balance under the Revolver was $14.0 million. The weighted average interest rate on the balance outstanding under the Revolver was 3.28% based on $10.0 million borrowed under the 60 day LIBOR option at a rate of 3.28% and $4.0 million borrowed under the 30 day LIBOR option at a rate of 3.27%. At December 31, 2002, the outstanding balance under the Revolver was $2.2 million.

The company has a 10-year mortgage loan (the “Mortgage”), dated June 12, 2000, as amended and restated on June 28, 2002, on the corporate office facility in Andover, Massachusetts. The outstanding balance of the Mortgage was $8.6 million at March 31, 2003. The agreement requires quarterly principal payments of $125,000, with a final payment of $5 million in May 2010. Interest on the Mortgage accrued at the rate of LIBOR plus 2.5% through November 5, 2001. Effective November 6, 2001, the interest rate on the Mortgage was reduced to LIBOR plus 2.0%. The interest rate on the Mortgage under the 90-day LIBOR option, elected at February 12, 2003, was 3.34%, which was effective at March 31, 2003.

The Revolver and Mortgage agreements, as currently amended, require the company to meet certain financial covenants including maintaining a minimum net worth, cash flow and debt coverage ratios, and limit the company’s ability to incur additional debt, pay dividends, purchase capital assets, sell or dispose of assets, make additional acquisitions or investments, or enter into new leases, among other restrictions. In addition, the loan agreements contain a subjective acceleration clause allowing the lender to require payment upon the occurrence of a material adverse change.

The company was in compliance with all loan covenants on March 31, 2003.

Note 4. Stock Plans

The company has stock option plans, which are administered by the Compensation Committee of the Board of Directors (the “Committee”). The Committee oversees which employees receive options, the number of options granted and the option prices of the shares covered by each stock option grant.

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On January 30, 2001, company’s shareholders approved the adoption of the 2000 Employee Stock Purchase Plan (the “ESPP”). The ESPP is designed to give eligible employees an opportunity to purchase common stock of the company through accumulated payroll deductions. The purchase price of the stock is equal to 85% of the fair market value of a share of common stock on the first day or last day of each three-month offering period, whichever is lower. All employees of the company or designated subsidiaries who customarily work at least 20 hours per week and do not own five percent or more of the company’s common stock are eligible to participate in the purchase plan. A total of 800,000 shares have been reserved for issuance under the ESPP of which 574,583 shares remain unissued at March 31, 2003. The program commenced in May 2001. In the first quarter of 2003 and 2002, 40,068 and 27,664 shares, respectively, were issued through the plan.

During the second quarter of 2001, the Board of Directors approved the Executive Long Term Incentive Program (the “ELTIP”), implemented under the provisions of the shareholder approved 2000 Incentive Plan. The ELTIP provides incentives to program participants through a combination of stock options and restricted stock grants, which vest fully in seven years. The ELTIP allows for accelerated vesting based on the company’s achievement of specified financial performance goals. During the second quarter of 2001, the company granted under this plan stock options totaling 750,000 shares of common stock at fair market value and granted 121,000 shares of restricted common stock, of which 3,000 shares were forfeited in 2002, with approximately $1.1 million of compensatory value to be amortized over the seven-year vesting period of the grant. During the first quarter of 2003, the company granted under this plan 23,100 shares of restricted common stock with approximately $0.2 million of compensatory value to be amortized over the two-year vesting period of the grant. In the first three months of 2003 and 2002, the company recognized approximately $49,000 and $39,000 of compensation expense, respectively, under this plan.

On February 19, 2003, the Board of Directors authorized the grant of 100,000 non-qualified stock options as an inducement for the hiring of a new executive officer. The grant was made on April 7, 2003. The option price was the fair market value of the common stock at the date of grant. The options will vest one-third on the first anniversary of employment and one-third on each successive anniversary. The options expire 10 years from the date of grant.

Note 5. Commitments and Contingencies

As a defense contractor, the company is subject to many levels of audit and review from various government agencies, including the Defense Contract Audit Agency, the Inspector General, the Defense Criminal Investigative Service, the General Accounting Office, the Department of Justice and congressional committees. Both related to and unrelated to its defense industry involvement, the company is, from time to time, involved in audits, lawsuits, claims, administrative proceedings and investigations. The company accrues for liabilities associated with these activities when it becomes probable that future expenditures will be made and such expenditures can be reasonably estimated. The company’s evaluation of the likelihood of expenditures related to these matters is subject to change in future periods, depending on then current events and circumstances, which could have material adverse effects on the company’s results of operations, financial position and cash flows.

As previously disclosed, on October 26, 2000, two former company employees were indicted for conspiracy to defraud the United States Air Force and pled guilty. The United States Attorney’s office continues to discuss the possibility of civil liability on the part of the company arising from the former employees’ conspiracy to defraud the United States Air Force of a claimed $10 million dollars, a substantial portion of which has been recovered. If a suit is brought the company will vigorously defend itself. The company does not have a sufficient basis to determine whether this matter will have a material adverse effect on the company’s financial position or results of operations.

On September 5, 2002, Genesis Tactical Group LLC (“Genesis”) asserted a cross-claim against Lockheed Martin Corporation (“Lockheed”) seeking $50 million in damages and against the company seeking $35 million in damages. These cross-claims arise out of a suit filed on July 30, 2002 by

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Lockheed against Tactical Communications Group LLC, Genesis and the company in the State of New York Supreme Court, County of Onondaga. The Lockheed suit relates to a contract for services which was sold to Genesis by the company pursuant to an asset purchase agreement in 2001. By the terms of the asset purchase agreement the company’s liability is limited to $300,000, other than for intentional misrepresentation, willful breach or fraud. Lockheed has asserted breach of contract and is seeking damages from and performance of the contract by Genesis and unspecified compensatory damages from the company. Genesis’ cross-claims relate to alleged breaches of the contract by Lockheed and for alleged breaches of the asset purchase agreement by the company. The company has asserted claims against Lockheed and Genesis and believes that the Lockheed and Genesis claims against the company are without merit. The parties have exchanged settlement offers while litigation has been postponed. If the company’s settlement offer is accepted, the company would not be obligated to make any payments. While the company believes that the possibility of a material adverse effect on the company’s financial position or results of operations is remote, there can be no assurance as to the outcome.

The company has provided documents in response to a previously disclosed grand jury subpoena issued on October 15, 2002 by the United States District Court for the District of Massachusetts directing the company to produce specified documents dating back to 1996. The subpoena relates to an investigation, currently focused on the period from 1996 to 1999, by the Antitrust Division of the Department of Justice into bidding and procurement activities involving the company and several other defense contractors who have received similar subpoenas and may also be subjects of the investigation. Although the company is cooperating in the investigation, it does not have a sufficient basis to predict the outcome of the investigation. Should the company be found to have violated the antitrust laws, the matter could have a material adverse effect on the company’s financial position and results of operations.

Note 6. Acquisitions and Goodwill

On May 31, 2002, the company completed its acquisition of HJ Ford Associates, Inc. (“HJ Ford”) for $9.9 million in net cash, including transaction costs of $0.4 million and exit costs of $0.1 million, in exchange for all of the outstanding voting common stock. HJ Ford helps their clients manage operational processes and acquisition programs by drawing on their core competencies of systems and information engineering, acquisition logistics and logistics engineering, information technology, enterprise engineering, and acquisition program support. Pursuant to certain provisions of the purchase agreement, the price was adjusted downward in the third quarter of 2002 by $0.5 million. The company also agreed to compensate the seller $1.3 million, which was accounted for as additional purchase price for sellers’ consent to treat the transaction as an asset purchase for tax purposes, under Section 338(h)10 of the Internal Revenue Code. This tax treatment enables the company to take future tax deductions for the goodwill amortization reported for tax purposes. The total resulting purchase price was $10.7 million. The purchase agreement also requires payment by the company to the sellers of an additional $1.0 million in 2005, subject to the occurrence of certain events related to contract renewals. Should these events occur, the additional payment would be recorded as additional purchase price.

The Unaudited Consolidated Statements of Operations include the results of HJ Ford beginning May 31, 2002. The company obtained an independent valuation of the fair value of assets acquired, and allocated $1.8 million of the purchase price to intangible assets related to customer relationships and non-competition agreements with estimated useful lives ranging from two to four years.

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On December 20, 2002, the company completed its acquisition of ANDRULIS for $13.6 million in net cash, including transaction costs of $1.1 million and exit costs of $0.7 million, and issued three separate promissory notes payable with an aggregate amount of approximately $12.4 million, each of which were due and payable on January 2, 2003, in exchange for all of the outstanding shares of capital stock. The resulting preliminary purchase price was $26.1 million, which is subject to revision based on the final determination of appraisals and fair values and was funded from cash on-hand and the company’s $50 million revolving credit facility. Headquartered in Washington, D.C., ANDRULIS has approximately 300 employees in Washington, D.C.; San Diego, California; and Norfolk, Virginia. ANDRULIS provides information technology and engineering solutions to federal government customers in the defense and federal civilian sectors.

The Unaudited Consolidated Statements of Operations include the results of ANDRULIS beginning December 18, 2002, the designated effective date. The company obtained an independent valuation of the fair value of intangible assets acquired, and allocated $2.6 million of the purchase price to intangible assets related to customer relationships and non-competition agreements with estimated useful lives ranging from two to four years.

The Unaudited Consolidated Balance Sheets reflect this allocation between goodwill and intangible assets for both acquisitions. The amortization expense related to the intangible assets commenced upon acquisition.

The preliminary purchase prices of the HJ Ford and ANDRULIS acquisitions have been allocated as follows:

The company paid the long-term debt of $0.7 million in the second quarter of 2002 and canceled the related loan agreement.

The company acquired, as part of the HJ Ford purchase, a 40% ownership interest in a small disadvantaged business, which is accounted for using the equity method. The company has continuing business relationships with this business and as of December 31, 2002 had provided it with a line of credit guarantee in the amount of $0.2 million. The small business paid the line of credit in the first quarter of 2003.

The following table represents the company’s unaudited pro forma results of operations for the quarter ended March 31, 2002, as if the HJ Ford and ANDRULIS acquisitions had occurred on January 1, 2002.

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These pro forma results include adjustments for the amortization of intangible assets with finite useful lives, the elimination of intercompany transactions and adjustments for income tax effects. The table has been prepared for comparative purposes only and does not purport to be indicative of what would have occurred had the acquisition been made at the beginning of the period noted or of results that may occur in the future.

Effective January 1, 2002, the company adopted SFAS No. 142, which addresses financial accounting and reporting for acquired goodwill and other intangible assets.

Identifiable intangible assets as of March 31, 2003 are as follows:

The accumulated amortization expense for all acquired intangible assets was $0.8 million at March 31, 2003.

The estimated amortization expense for the remainder of each of the five succeeding years is as follows:

Note 7. Segment Information

Identifiable assets by business segment include both assets directly identified with those operations and an allocable share of jointly used assets.

Summarized financial information by business segment for the three months ended March 31, 2003 and March 31, 2002 are as follows (in thousands of dollars):

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Net sales and operating income (loss) are presented after the elimination of intersegment transactions, which are not material.

During the first quarter of 2003 and 2002, revenue from Department of Defense (DoD) customers represented approximately 77% and 78% of total revenue, respectively. Revenue earned from one significant DoD contract represented approximately 8% and 12% of total revenue in the first three months of 2003 and 2002, respectively.

Note 8. Subsequent Event

On May 2, 2003, the company completed the sale of its Encoder Division assets and certain liabilities to GSI Lumonics in Billerica, Massachusetts for $3.3 million in cash subject to adjustment. On October 18, 2002, the company announced that it was actively pursuing the divestiture of the Encoder Division. The Encoder Division’s financial results have been reported as a discontinued operation beginning in the fourth quarter of 2002 (see Note 2).

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

On April 7, 2003, the company announced that it appointed William C. Hoover, President and Chief Operating Officer. Mr. Hoover has primary responsibility for the company’s operating and business development groups. Mr. Hoover brings more than 20 years experience in managing growth, building shareholder value and leading dynamic organizational change.

Results of Operations

Total revenue increased 24.5% to $58.6 million in the first quarter of 2003 compared with $47.1 million in the first quarter of 2002.

Contract revenue for the Systems and Services Segment increased 27.2% to $56.9 million in the first three months of 2003 compared with $44.8 million in the same period last year. Defense revenues grew 23.4%, or $8.7 million in the first quarter of 2003 compared with the same quarter last year. Revenue from federal civilian agencies was $9.0 million for the quarter ended March 31, 2003, up from $3.7 million in the same quarter last year. The company’s acquisition of HJ Ford and ANDRULIS added $16.2 million to the first quarter of 2003 revenue for the federal defense and civilian sectors. On a year over year basis, this increase was partially offset by a reduction in subcontractor revenue with the Air Force Electronic Systems Center of $3.2 million and a reduction in Navy Strategic Systems Guidance work of $1.1 million. Absent these effects, federal revenue grew approximately $2.0 million in the first quarter of 2003 when compared with the same quarter last year.

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State and local government revenue was $2.6 million and $4.5 million for the first quarter of 2003 and 2002, respectively, reflecting completion of the Colorado Trails project and curtailment of work in Ohio during 2002.

Product sales for the Metrigraphics Segment decreased 27.7% to $1.7 million in the first three months of 2003 compared with $2.3 million in the same period of 2002. The decrease in 2003 was due to continued weak economic conditions. The company remains cautious that further economic weakness could adversely affect the Metrigraphics Division.

Total gross margin was $9.2 million and $7.0 million in the first quarter of 2003 and 2002, respectively, representing 15.7% and 14.9% of total revenue in the first three months of both 2003 and 2002, respectively.

Gross margin on contract revenue increased 43.6% to $8.8 million in the first three months of 2003 compared with $6.1 million for the first three months 2002, representing 15.4% and 13.6% of contract revenue in the first quarter of 2003 and 2002, respectively. Gross margin on contract revenue improved primarily due to a decrease in lower margin subcontract work and the receipt of $0.4 million related to a completed contract with no additional costs.

Gross margin on product sales was $0.4 million and $0.9 million, in the first quarter of 2003 and 2002, respectively, representing 25.3% and 40.2% of product sales in the first three months of 2003 and 2002, respectively. Continued weak economic conditions impacted gross margin on product sales in the first quarter of 2003 due to a lower revenue base over which to spread fixed costs.

Operating expenses were $5.8 million and $4.1 million for the first three months of 2003 and 2002, respectively. The company incurred $0.7 million of incremental legal and benefit costs and $0.7 million of expenses in support of acquired operations in the first quarter of 2003 compared to the same quarter last year.

Amortization expense of $0.5 million for the first quarter of 2003 reflects the amortization of intangible assets associated with the HJ Ford and ANDRULIS acquisitions (see Note 6 of Notes to the unaudited Consolidated Financial Statements).

Total operating income was $3.0 million and $2.9 million for the first three months of 2003 and 2002, respectively. As a percent of revenue, operating income was 5.1% and 6.1% for the first quarter of 2003 and 2002, respectively. Most of the reduction in operating margin resulted from lower product sales and related profits.

Net interest expense was $0.3 million and $39,000 for the first three months of 2003 and 2002, respectively, reflecting a higher debt level in 2003 due to the acquisition of ANDRULIS.

Income tax expense for the first quarter of 2003 and 2002 was $1.1 million and $1.2 million, respectively, representing 40.2% and 40.7% of pre-tax income for the first three months of 2003 and 2002, respectively.

Loss from discontinued operations for the first quarter of 2003 was $0.4 million, or $0.04 per diluted share, compared with a loss of $0.2 million, or $0.02 per diluted share for the first three months of 2002. The loss for the first quarter of 2003 includes $0.3 million in fees to re-audit 2000 and 2001

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results, necessitated by the company’s decision to divest the Encoder Division, combined with the fact that the prior audits had been performed by Arthur Andersen.

For the first quarter of 2003, loss on disposal of discontinued operations of $0.4 million before taxes includes professional fees and exit cost accruals related to the sale of the Encoder Division totaling $1.1 million. The Encoder Division was sold on May 2, 2003 for book value (see Note 2 of Notes to the Unaudited Consolidated Financial Statements).

Loss on disposal of discontinued operations also includes royalty income. The company recognized royalty income associated with the company’s 1999 sale of its discontinued Telecommunications Fraud Control business on a cash basis and reported no income in the first quarter of 2002. In the first quarter of 2003, the company received a final royalty payment associated with this transaction of $0.7 million, and included $0.4 million, net of tax, in loss on disposal of discontinued operations for the first quarter of 2003.

At March 31, 2003, the company had 1,910 employees, including 90 employees associated with discontinued operations. At December 31, 2002, the company had 1,858 employees, including 93 employees associated with discontinued operations. The company considers its relationship with its employees to be satisfactory.

The company’s funded backlog, excluding discontinued operations, was $119.2 million at March 31, 2003 and $111.1 million at December 31, 2002. The funded backlog generally is subject to possible termination at the convenience of the contracting counterparty. The company has a number of multi-year contracts with agencies of the United States and state governments on which actual funding generally occurs on an annual basis. A portion of its funded backlog is based on annual purchase contracts and subject to annual governmental approval or appropriations legislation, and the amount of funded backlog as of any date can be affected by the timing of order receipts and deliveries.

Liquidity and Capital Resources

Cash provided by continuing operations for the first three months of 2003 was $1.5 million, principally from income from continuing operations, increased accrued payroll and employee benefits and decreased accounts receivable, partially offset by increased unbilled expenditures and fees on contracts in process and decreased accounts payable. Cash provided by continuing operations in the first quarter of 2002 was $3.5 million, primarily resulting from net income, increased accounts payable and decreased unbilled expenditures and fees on contracts in process, partially offset by decreased accrued payroll and employee benefits and other accrued expenses.

Net cash provided by discontinued operations was $0.9 million and $0.2 million in the first quarter of 2003 and 2002, respectively.

As previously reported, the company was experiencing slow payment from one commercial customer having an account balance of $0.3 million at March 31, 2003. On March 31, 2003, the company became aware that on March 28, 2003 the customer’s parent company, located in the Netherlands, announced that a bankruptcy filing in the United States was being considered. On May 2, 2003, the parent company filed for bankruptcy protection. However, the bankruptcy did not include the United States subsidiary. At May 6, 2003, the customer’s balance was $0.1 million. Should the company determine

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that the account or a portion thereof, is uncollectible a provision for the loss will be made in the period in which this determination is made. In addition, under United States Bankruptcy code, certain amounts collected by the company from the customer may be deemed preference payments, requiring the amounts to be forfeited by the company.

Cash used for investing activities for continuing operations was $0.9 million and $1.0 million in the first three months of 2003 and 2002, respectively, primarily related to the purchase of plant and equipment.

At December 31, 2002, the company had $12.4 million in notes payable associated with the purchase of ANDRULIS. The $12.4 million in notes payable had an interest rate of 4.0% and a maturity date of January 2, 2003. In January 2003, the notes payable associated with the purchase of ANDRULIS were paid in full with proceeds from the company’s revolving credit agreement.

Effective June 28, 2002, the company obtained a $50 million revolving credit agreement (the “Revolver”), replacing the previous revolver. The Revolver has a three-year term and is available to the company for general corporate purposes, including strategic acquisitions. The fee on the unused portion of the Revolver ranges from 0.25 % to 0.5% depending on the company’s most recently reported leverage ratio and is payable quarterly in arrears. The company has the option to elect on a fixed 30, 60 or 90-day term, an interest rate of LIBOR plus 2.0% to 3.0%, depending on the company’s most recently reported leverage ratio, or the prime rate on any outstanding balance. Interest on the outstanding balance of the Revolver is payable monthly under the prime rate option or at the end of the elected term for the LIBOR rate option. At March 31, 2003, the outstanding balance under the Revolver was $14.0 million. The weighted average interest rate on the balance outstanding under the Revolver was 3.28% based on $10.0 million borrowed under the 60 day LIBOR option at a rate of 3.28% and $4.0 million borrowed under the 30 day LIBOR option at a rate of 3.27%. At December 31, 2002, the outstanding balance under the Revolver was $2.2 million.

The company has a 10-year mortgage loan (the “Mortgage”), dated June 12, 2000, as amended and restated on June 28, 2002, on the corporate office facility in Andover, Massachusetts. The outstanding balance of the Mortgage was $8.6 million at March 31, 2003. The agreement requires quarterly principal payments of $125,000, with a final payment of $5 million in May 2010. Interest on the Mortgage accrued at the rate of LIBOR plus 2.5% through November 5, 2001. Effective November 6, 2001, the interest rate on the Mortgage was reduced to LIBOR plus 2.0%. The interest rate on the Mortgage under the 90-day LIBOR option, elected at February 12, 2003, was 3.34%, which was effective at March 31. 2003.

The Revolver and Mortgage agreements, as currently amended, require the company to meet certain financial covenants including maintaining a minimum net worth, cash flow and debt coverage ratios, and limit the company’s ability to incur additional debt, pay dividends, purchase capital assets, sell or dispose of assets, make additional acquisitions or investments, or enter into new leases, among other restrictions. In addition, the loan agreements contain a subjective acceleration clause allowing the lender to require payment upon the occurrence of a material adverse change.

The company was in compliance with all loan covenants on March 31, 2003.

In the first quarter of 2003, the company realized $0.1 million in proceeds from the exercise of stock options and $0.4 million in proceeds from the issuance of shares under the employee stock purchase

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plan. In the first quarter of 2002, the company realized $0.4 million in proceeds from the exercise of stock options and $0.4 million in proceeds from the issuance of shares under the employee stock purchase plan.

Commitments and Contingencies

The company has change of control agreements with certain employees of the company providing them with benefits if their employment with the company is terminated, other than for cause or their disability or death, or if they resign for good reason within a certain period of time from the date of any change of control of the company.

On December 26, 2002, the company entered into an installment payment agreement in connection with the acquisition of its enterprise business system software. The company made the first payment on January 26, 2003 and the second and last payment is due on January 26, 2004. The company recorded the liability using an imputed interest rate of 3.38%, which was its effective borrowing rate at December 31, 2002. The obligation is reflected in the table below as a purchase commitment.

Contractual obligations at March 31, 2003 were as follows:

In April 2003, the company entered into an 8-year lease agreement for office space in Vienna, Virginia for a total commitment of $10.4 million.

As a defense contractor, the company is subject to many levels of audit and review from various government agencies, including the Defense Contract Audit Agency, the Inspector General, the Defense Criminal Investigative Service, the General Accounting Office, the Department of Justice and congressional committees. Both related to and unrelated to its defense industry involvement, the company is, from time to time, involved in audits, lawsuits, claims, administrative proceedings and investigations. The company accrues for liabilities associated with these activities when it becomes probable that future expenditures will be made and such expenditures can be reasonably estimated. The company’s evaluation of the likelihood of expenditures related to these matters is subject to change in future periods, depending on then current events and circumstances, which could have material adverse effects on the company’s results of operations, financial position and cash flows.

As previously disclosed, on October 26, 2000, two former company employees were indicted for conspiracy to defraud the United States Air Force and pled guilty. The United States Attorney’s office continues to discuss the possibility of civil liability on the part of the company arising from the former employees’ conspiracy to defraud the United States Air Force of a claimed $10 million dollars, a substantial portion of which has been recovered. If a suit is brought the company will vigorously defend itself. The company does not have a sufficient basis to determine whether this matter will have a material adverse effect on the company’s financial position or results of operations.

On September 5, 2002, Genesis Tactical Group LLC (“Genesis”) asserted a cross-claim against Lockheed Martin Corporation (“Lockheed”) seeking $50 million in damages and against the company seeking $35 million in damages. These cross-claims arise out of a suit filed on July 30, 2002 by Lockheed against Tactical Communications Group LLC, Genesis and the company in the State of New York Supreme Court, County of Onondaga. The Lockheed suit relates to a contract for services which was sold to Genesis by the company pursuant to an asset purchase agreement in 2001. By the terms of the asset purchase agreement the company’s liability is limited to $300,000, other than for intentional misrepresentation, willful breach or fraud. Lockheed has asserted breach of contract and

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is seeking damages from and performance of the contract by Genesis and unspecified compensatory damages from the company. Genesis’ cross-claims relate to alleged breaches of the contract by Lockheed and for alleged breaches of the asset purchase agreement by the company. The company has asserted claims against Lockheed and Genesis and believes that the Lockheed and Genesis claims against the company are without merit. The parties have exchanged settlement offers while litigation has been postponed. If the company’s settlement offer is accepted, the company would not be obligated to make any payments. While the company believes that the possibility of a material adverse effect on the company’s financial position or results of operations is remote, there can be no assurance as to the outcome.

The company has provided documents in response to a previously disclosed grand jury subpoena issued on October 15, 2002 by the United States District Court for the District of Massachusetts directing the company to produce specified documents dating back to 1996. The subpoena relates to an investigation, currently focused on the period from 1996 to 1999, by the Antitrust Division of the Department of Justice into bidding and procurement activities involving the company and several other defense contractors who have received similar subpoenas and may also be subjects of the investigation. Although the company is cooperating in the investigation, it does not have a sufficient basis to predict the outcome of the investigation. Should the company be found to have violated the antitrust laws, the matter could have a material adverse effect on the company’s financial position and results of operations.

The company’s prospective results of operations, cash flows and financial condition are subject to certain trends, events and uncertainties, including demands for capital to support growth, economic conditions, government payment practices and contractual matters. The company’s capital expenditures, excluding business acquisitions, are expected to be in the range of $6 million to $8 million in 2003, primarily for enterprise business systems and facilities infrastructure consolidation and improvements.

The company’s need for, cost of, and access to funds are dependent on future operating results, the company’s growth and acquisition activity, as well as conditions external to the company. In 2002, the company increased the capacity of its revolving credit facility from $20 million to $50 million to enable pursuit of the company’s acquisition strategy. In 2003, the company will continue to consider acquisition opportunities, which align with its strategic objectives, along with the possibility of utilizing the credit facility as a source of financing.

Critical Accounting Policies

Use of Estimates

The preparation of financial statements requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements. Estimates and assumptions also affect the amount of revenue and expenses during the reported period. Actual results could differ from those estimates. Management must make use of estimates in the areas discussed below.

Revenue Recognition

The company’s systems and services business provides its services under time and materials, cost reimbursable and fixed-price contracts including service type contracts.

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For time and materials contracts, revenue reflects the number of direct labor hours expended in the performance of a contract multiplied by the contract billing rate, as well as reimbursement of other billable direct costs. The risk inherent in time and materials contracts is that actual costs differ materially from negotiated billing rates in the contract, which directly affects operating income.

For cost reimbursable contracts, revenue is recognized as costs are incurred and include a proportionate amount of the fee earned. Cost reimbursable contracts specify the contract fee in dollars or as a percentage of estimated costs. The primary risk on a cost reimbursable contract is that a government audit of direct and indirect costs could result in the disallowance of certain costs, which would directly impact revenue and margin on the contract. Historically, such audits have had no material impact on the company’s revenue and operating income.

Under fixed-price contracts, other than service-type contracts, revenue is recognized under the percentage of completion method, on the basis of costs incurred in relation to estimated total costs to complete the contract. Under service-type contracts, costs incurred are not indicative of progression toward completion of the contract. Revenue from service-type fixed price contracts is recognized ratably over the contract period or by other appropriate output methods to measure service provided, and contract costs are expensed as incurred. The risk to the company on a fixed-price contract is that if actual costs exceed the estimated costs to complete the contract, then profit is eroded or losses are incurred.

For all types of contracts, the company recognizes anticipated contract losses as soon as they become known and estimable. Out-of-pocket expenses that are reimbursable by the customer are included in contract revenue and cost of contract revenue.

Unbilled expenditures and fees on contracts in process are the amounts of recoverable contract revenue that have not been billed at the balance sheet date. Most of the company’s unbilled expenditures and fees relate to revenue that is billed in the month after services are performed. In certain instances, billing is deferred in compliance with contract terms, such as milestone billing arrangements and withholdings. Costs related to United States Government contracts, including applicable indirect costs, are subject to audit by the government. Revenue from such contracts has been recorded at amounts expected to be realized upon final settlement.

Valuation Allowances

The company provides for potential losses against specifically identified accounts receivable and unbilled expenditures and fees on contracts in process based on the company’s expectation of a customer’s inability to pay. These reserves are based upon specific identification of potential uncollectible accounts. In addition, payment to the company for performance on United States Government contracts are subject to audit by the Defense Contract Audit Agency. The company provides an estimated reserve for adjustments resulting from rate negotiations and audit findings. The company routinely provides for these items when they are identified and can be reasonably estimated. Due to the diversity of contracts with the United States Government, it is not probable that the company will incur a material loss.

Intangible and Other Long-lived Assets

The company uses assumptions in establishing the carrying value, fair value and estimated lives of intangible and other long-lived assets. Long-lived assets are reviewed for impairment whenever events

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or changes in circumstances indicate that the asset carrying value may not be recoverable. Recoverability is measured by a comparison of the asset’s continuing ability to generate positive income from operations and positive cash flow in future periods compared to the carrying value of the asset. If assets are considered to be impaired, the impairment is recognized in the period of identification and is measured as the amount by which the carrying value of the asset exceeds the fair value of the asset.

The useful lives and related amortization of intangible assets are based on their estimated residual value in proportion to the economic benefit consumed. The useful lives and related depreciation of other long-lived assets are based on the company’s estimate of the period over which the asset will generate revenue or otherwise be used by the company.

Goodwill

The company assesses goodwill for impairment at the segment level at least once per year by applying a fair value test. Goodwill could be impaired due to market declines, reduced expected future cash flows, or other factors or events. Should the fair value of goodwill, as determined by the company at any measurement date, fall below its carrying value, a charge for impairment of goodwill would occur in that period.

Business Combinations

During 2002, the company acquired two companies, HJ Ford and ANDRULIS. All assets and liabilities acquired have been recorded at their fair values at the date of the acquisition and the results of operations are included in the consolidated financial statements from the date of acquisition. The company has determined the fair value of all assets acquired and liabilities assumed. The company has utilized an independent valuation specialist to determine the fair value of intangible assets acquired in order to allocate a portion of the purchase price related to intangible assets.

Pensions

Accounting and reporting for the company’s pension plan requires the use of assumptions, including but not limited to, discount rate, rate of compensation increases and expected return on assets. If these assumptions materially differ from actual results, the company’s obligations under the pension plan could also materially differ, requiring the company to record an additional pension liability.

Forward-Looking Information

Safe harbor statements under the Private Securities Litigation Reform Act of 1995: Some statements contained or implied in this quarterly report which are not historical fact such as financial forecasts, contain forward-looking information. These statements may be identified by forward-looking words such as “expect,” “look,” “believe,” “anticipate,” “may,” “will” and other forward-looking terminology. Such statements are subject to risks and uncertainties that could cause actual results to differ materially, including uncertainties regarding contractual requirements, actions by customers and actual costs to complete; federal budget matters; government contracting risks, competitive market conditions; customer requirements, schedules and related funding; technological change; uncertainty of future financing; overall economic factors; ability to successfully complete and integrate acquisitions and other matters. These factors are discussed in more detail in the company’s Annual Report on Form 10-K for the year ended December 31, 2002. The company assumes no obligation to update any forward-looking information.

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Item 3. Quantitative And Qualitative Disclosures About Market Risk

The company is subject to interest rate risk associated with our Mortgage and Revolver where interest payments are tied to either the LIBOR or prime rate. At any time a sharp rise in interest rates could have an adverse effect on net interest expense as reported in the Consolidated Statements of Operations. A one full percentage point increase in the interest rate on the balance of the Mortgage and Revolver at March 31, 2003 would result in a $0.2 million increase in interest expense per year. The company does not currently hedge these interest rate exposures.

The company presently has minimal exposure to market interest rates with regards to investments. At March 31, 2003, the company had investments of $0.9 million, which consisted primarily of money market accounts.

The company has no significant exposure to foreign currency fluctuations. Foreign sales, which are nominal, are primarily denominated in United States dollars.

Item 4. Controls And Procedures

Based on their evaluation as of a date within 90 days of the filing of this Form 10-Q, the company’s Chief Executive Officer and Chief Financial Officer have concluded that the company’s disclosure controls and procedures are effective to ensure that information required to be disclosed in the reports that the company files or submits under the Securities Exchange Act of 1934 is recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission’s rules and forms. There have been no significant changes in the company’s internal controls or in other factors that could significantly affect those controls subsequent to the date of their evaluation.

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PART II. OTHER INFORMATION

Item 1. Legal Proceedings

As a defense contractor, the company is subject to many levels of audit and review from various government agencies, including the Defense Contract Audit Agency, the Inspector General, the Defense Criminal Investigative Service, the General Accounting Office, the Department of Justice and congressional committees. Both related to and unrelated to its defense industry involvement, the company is, from time to time, involved in audits, lawsuits, claims, administrative proceedings and investigations. The company accrues for liabilities associated with these activities when it becomes probable that future expenditures will be made and such expenditures can be reasonably estimated. The company’s evaluation of the likelihood of expenditures related to these matters is subject to change in future periods, depending on then current events and circumstances, which could have material adverse effects on the company’s results of operations, financial position and cash flows.

As previously disclosed, on October 26, 2000, two former company employees were indicted for conspiracy to defraud the United States Air Force and pled guilty. The United States Attorney’s office continues to discuss the possibility of civil liability on the part of the company arising from the former employees’ conspiracy to defraud the United States Air Force of a claimed $10 million dollars, a substantial portion of which has been recovered. If a suit is brought the company will vigorously defend itself. The company does not have a sufficient basis to determine whether this matter will have a material adverse effect on the company’s financial position or results of operations.

On September 5, 2002, Genesis Tactical Group LLC (“Genesis”) asserted a cross-claim against Lockheed Martin Corporation (“Lockheed”) seeking $50 million in damages and against the company seeking $35 million in damages. These cross-claims arise out of a suit filed on July 30, 2002 by Lockheed against Tactical Communications Group LLC, Genesis and the company in the State of New York Supreme Court, County of Onondaga. The Lockheed suit relates to a contract for services which was sold to Genesis by the company pursuant to an asset purchase agreement in 2001. By the terms of the asset purchase agreement the company’s liability is limited to $300,000, other than for intentional misrepresentation, willful breach or fraud. Lockheed has asserted breach of contract and is seeking damages from and performance of the contract by Genesis and unspecified compensatory damages from the company. Genesis’ cross-claims relate to alleged breaches of the contract by Lockheed and for alleged breaches of the asset purchase agreement by the company. The company has asserted claims against Lockheed and Genesis and believes that the Lockheed and Genesis claims against the company are without merit. The parties have exchanged settlement offers while litigation has been postponed. If the company’s settlement offer is accepted, the company would not be obligated to make any payments. While the company believes that the possibility of a material adverse effect on the company’s financial position or results of operations is remote, there can be no assurance as to the outcome.

The company has provided documents in response to a previously disclosed grand jury subpoena issued on October 15, 2002 by the United States District Court for the District of Massachusetts directing the company to produce specified documents dating back to 1996. The subpoena relates to an investigation, currently focused on the period from 1996 to 1999, by the Antitrust Division of the Department of Justice into bidding and procurement activities involving the company and several other defense contractors who have received similar subpoenas and may also be subjects of the investigation. Although the company is cooperating in the investigation, it does not have a sufficient basis to predict the outcome of the investigation. Should the company be found to have

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violated the antitrust laws, the matter could have a material adverse effect on the company’s financial position and results of operations.

Item 6. Exhibits and Reports on Form 8-K

(a) The following Exhibits are filed herewith:

*Identifies management contracts and compensatory plans or arrangements.

(b) Reports on Form 8-K

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SIGNATURES

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

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Certifications

I, James P. Regan, certify that:

Date: May 12, 2003

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I, David Keleher, certify that:

Date: May 12, 2003

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EXHIBIT INDEX

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