ALION SCIENCE & TECHNOLOGY CORP - 10-Q Quarterly Report

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Quarter Ended December 31, 2003 and Interim Period Ended December 20, 2002 (unaudited)

Alion Science and Technology Corporation (Alion or the Company) provides scientific and engineering expertise to research and develop technological solutions for problems relating to national defense, public health and safety. The Company provides these research services primarily to agencies of the federal government and, to a lesser extent, to commercial and international customers.

Alion, a for-profit S Corporation, was formed in October 2001 for the purpose of purchasing substantially all of the assets and certain of the liabilities of IIT Research Institute (IITRI), a not-for-profit membership corporation affiliated with and controlled by the Illinois Institute of Technology. Prior to the acquisition of substantially all of the assets and liabilities of IITRI (the Transaction), the Company’s activities had been organizational in nature.

On December 20, 2002, Alion acquired substantially all of the assets and liabilities of IITRI (Business), excluding the assets and liabilities of IITRI’s Life Sciences Operation, for aggregate total proceeds of $127.3 million consisting of (in thousands):


	•	$58,571 cash, consisting of $56,721 paid to IITRI and $1,517 paid for certain transaction expenses on behalf of IITRI, and $333 paid for other transaction expenses;

	•	$39,900 in seller notes to IITRI, with detachable warrants representing approximately 26% of the outstanding common stock of Alion (on a fully diluted basis). The seller notes bear interest at an effective interest rate of 6.71% per annum. See notes 4 and 6;

	•	$20,343 in mezzanine notes to IITRI, with detachable warrants representing 12% of the outstanding common stock of Alion (on a fully diluted basis). The mezzanine notes bear interest at 12% per annum. See notes 4 and 6;

	•	$2,300 in transaction costs less the $1,517 referenced above;

	•	$6,188 in assumed IITRI debt due to its bank; and

	•	$1,520 in additional amounts due to IITRI for purchase price adjustments related to the Life Sciences Operation.

The acquisition was accounted for using the purchase method. The purchase price has been allocated to the acquired assets and assumed liabilities based on their estimated fair values at the date of acquisition. As a result of the Transaction, the Company recorded goodwill of approximately $63.6 million, which is subject to an annual impairment review, as discussed below. In addition, the Company recorded intangible assets of approximately $30.6 million, comprised of purchased contracts. The intangible assets have an estimated useful life of three years and are amortized using the straight-line method.

The total purchase consideration of approximately $127.3 million was allocated to the fair value of the net assets acquired as follows (in thousands):

The accompanying unaudited consolidated financial statements include the accounts of Alion and its wholly owned subsidiary Human Factors Applications, Inc. (HFA) and have been prepared pursuant to the rules and regulations of the Securities and Exchange Commission regarding interim financial information. Certain information and note disclosures normally included in the annual financial statements, prepared in accordance with accounting principles generally accepted in the United States of America, have been condensed or omitted pursuant to those rules and regulations. In the opinion of management, all adjustments (consisting of normal recurring accruals) considered necessary for a fair presentation have been included. Operating results for the quarter ended December 31, 2003 are not necessarily indicative of the results that may be expected for the fiscal year ending September 30, 2004. For further information, refer to the consolidated financial statements and notes thereto included in the Post Effective Amendment No. 4 to the Company’s registration statement on Form S-1 (No. 333-89756) filed with the SEC on January 22, 2004.

The preparation of financial statements, in conformity with generally accepted accounting principles, requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosures of contingencies at the date of the financial statements as well as the reported amounts of revenues and expenses during the reporting period. Estimates have been prepared on the basis of the most current and best available information and actual results could differ from those estimates.

The consolidated financial statements are prepared on the accrual basis of accounting and include the accounts of Alion prior to the Transaction and the accounts of Alion and its wholly owned subsidiary HFA subsequent to the Transaction. All significant intercompany accounts have been eliminated in consolidation.

The Company’s fiscal year ends on September 30. Beginning with the fiscal year ending September 30, 2004, the Company has been operating based on a three-month quarter, four-quarter fiscal year whereas for the fiscal year ended September 30, 2003 the Company operated on a 13-period fiscal year that consisted of three, four-week periods in its first interim period; three, four-week periods in its second interim period; four, four-week periods in its third interim period; and the balance of the fiscal year of approximately three, four-week periods in its fourth interim period. For the quarter ended December 31, 2003, there were sixty-four available work days (based on a standard work week of Monday through Friday and excluding designated holidays recognized by Alion) as compared to fifty-eight available workdays for the interim period ended December 20, 2002. Accordingly, comparisons between the three-

On January 12, 2004, the Financial Accounting Standards Board (FASB) issued Staff Position No. FAS 106-1 “Accounting and Disclosure Requirements Related to the Medicare Prescription Drug, Improvement and Modernization Act of 2003” (FSP 106-1). FSP 106-1 permits employers that sponsor postretirement benefit plan to defer accounting for any effects of the Medicare Prescription Drug, Improvement and Modernization Act of 2003 that was signed into law on December 8, 2003.

In accordance with the FSP 106-1, neither the accumulated postretirement benefit obligation nor the net periodic postretirement benefit costs reflected in the accompanying financial statements reflect the effect of the Medicare Prescription Drug Improvement and Modernization Act of 2003 on Alion’s plan. Authoritative guidance, when issued, could require the Company to change previously reported information.

For the pro forma interim period ended December 20, 2002, pro forma loss per share has been computed as though the 2,575,408 shares of common stock sold by the Company to the employee stock ownership plan (ESOP) component of its Employee Ownership Savings and Investment Plan (KSOP) on December 20, 2002 to fund the Transaction described in Note 1, were outstanding for the entire period presented. Prior to the sale of shares of common stock to the ESOP, the Company’s capital structure consisted of 100 shares of common stock issued and outstanding. Accordingly, historical earnings per share information for periods prior to the Transaction has not been presented as it is not indicative of the Company’s ongoing capital structure.

Loss per share excludes the impact of warrants and stock appreciation rights described herein as the impact of their inclusion would be anti-dilutive for all periods presented.

The Company accounts for goodwill and other intangible assets in accordance with the provisions of SFAS No. 142, which requires, among other things, the discontinuance of goodwill amortization. In addition, goodwill is to be reviewed at least annually for impairment. The Company has elected to perform this review annually at the end of each fiscal year. The accompanying pro forma statement of operations excludes historical goodwill amortization expense.

As a result of the Transaction described in Note 1, for the fiscal year ended September 30, 2003, the Company recorded goodwill of approximately $63.6 million, which is subject to the aforementioned annual impairment review. During fiscal year 2003 and for the quarter ended December 31, 2003, goodwill increased by $1.9 million and $9.4 million, respectively, as a result of recording additional obligations related to earnout arrangements and the acquisition described in Note 9. In addition, the Company recorded intangible assets of approximately $30.6 million during fiscal year 2003 comprised primarily of purchased contracts. The intangible assets have an estimated useful life of three years and are being amortized using the straight-line method.

In connection with the issuance of the Mezzanine Note, Subordinated Note, and the Deferred Compensation Agreement described in Note 7, the Company issued 524,229, 1,080,437, and 22,062, respectively, detachable redeemable common stock warrants (the Warrants) to the holders of those instruments. The Warrants have an exercise price of $10 per share and are exercisable until December 20, 2008 for the warrants associated with the Mezzanine Note and the Deferred Compensation Agreement and until December 20, 2010 for the warrants associated with the Subordinated Note. In addition, the

Warrants enable the holders to sell the warrants back to the Company, at predetermined times, at the then current fair value of the common stock less the exercise price. Accordingly, the warrants are classified as debt instruments in accordance with Emerging Issues Task Force Issue No. 00-19, Accounting for Derivative Financial Instruments Indexed to, and Potentially Settled in, a Company’s Own Stock. The estimated fair value of the Warrants of approximately $10.3 million on the date of issuance was recorded as a discount to the face value of the notes issued and as a liability in the accompanying consolidated balance sheet. The estimated fair value of the Warrants was $15.5 million as of December 31, 2003. Changes in the estimated fair value of the Warrants are recorded as interest expense in the accompanying consolidated statement of operations.

On December 20, 2002, the Company executed a senior credit agreement among LaSalle Bank National Association, US Bank, National Cooperative Bank, Orix Financial Services, Inc. and BB&T Bank to refinance and replace IITRI’s prior credit arrangements and to finance, in part, the Transaction. The senior credit facility consists of a $25.0 million revolving credit facility and a $35.0 million term loan. All principal obligations under the revolving credit facility are to be repaid in full no later than December 20, 2007. The senior credit facility is secured by a first priority, perfected security interest in all of the Company’s current and future tangible and intangible property. As of December 31, 2003, the Company had approximately $8.3 million borrowed under the revolving credit facility.

As of December 31, 2003, the remaining principal repayments (taking into account previous repayments) of $28.0 million under the term loan will be payable in quarterly installments, yielding remaining fiscal year repayments in the following amounts:

For the periods until the receipt of the compliance certificate and audited financial statements for the fiscal year ended September 30, 2003, the Company’s borrowings under the senior credit facility were to bear interest at either of two floating rates: a per year rate equal to the Eurodollar rate plus 350 basis points, or LaSalle’s prime rate (base rate) plus 200 basis points.

Effective February 14, 2003, the Company exercised its right and elected that the term note bear interest at a Eurodollar rate. This election did not affect the interest rate applicable to amounts borrowed under the revolving line of credit. As a result, interest under the term note was payable at the prime rate (base rate) plus 200 basis points until February 14, 2003. Thereafter and until December 28, 2003, the term note bore interest at the Eurodollar rate plus 350 basis points.

After December 28, 2003, based on calculation of the Company’s leverage ratio as of September 30, 2003, borrowings under the term note will bear interest at the Eurodollar rate plus 325 basis points.

The Company entered into an interest rate cap agreement effective as of February 3, 2003 with one of its senior lenders. Under this agreement, the Company’s maximum effective rate of interest payable on the first $25 million of principal under of its term note is not to exceed 6%. Any interest the Company pays on the first $25 million of principal in excess of 6% will be calculated and reimbursed to the Company semiannually by the senior lender pursuant to the cap agreement. This cap agreement expires February 3, 2007. As of December 31, 2003, the cap agreement had a fair value of approximately $0.1 million, which has been recorded in the accompanying consolidated balance sheet.

On December 20, 2002, the Company paid $1.7 million to obtain a senior credit facility that includes a $35 million Senior Term Note and a $25 million revolving credit facility which was recorded as debt

discount. The Company is using the effective interest method to accrete the value of long-term debt to its face value. For the quarter ended December 31, 2003, the Company recognized approximately $0.5 million of interest expense related to accretion of this discount.

On February 6, 2004, Amendment Number 1 to the Senior Credit Agreement was entered into, whereby the definition of “Borrowing Base (Senior Debt)” was redefined for the fiscal period ending December 31, 2003. As such, the amended definition potentially increases the Company’s borrowing capacity under the senior credit agreement.

On December 20, 2002, the Company issued to IITRI a Mezzanine Note securities purchase agreement (Mezzanine Note) with a face value of approximately $20.3 million. The Mezzanine Note served as part of the consideration for the Transaction. The Company is required to pay interest on the Mezzanine Note at a rate of 12% per year, based on a 360-day year of twelve 30-day months. Interest is payable quarterly in cash. The Company is required to pay the outstanding principal amount of the Mezzanine Note in a lump sum on December 20, 2008. The Mezzanine Note is subordinate to the senior credit facility, but ranks senior to the subordinated note.

On March 28, 2003, an officer of the Company purchased a portion of the Company’s Mezzanine Note owned by IITRI for $750,000, its face value, along with warrants to purchase 19,327 shares of Alion’s common stock at an exercise price of $10.00 per share. On November 12, 2003, the Company purchased the Mezzanine Note and warrants from the officer for an aggregate purchase price of $1,034,020.

Also, on December 20, 2002, the Company issued a seller note to IITRI under a seller note securities purchase agreement (Subordinated Note) with a face value of $39.9 million. The Subordinated Note served as part of the consideration for the Transaction. The Subordinated Note bears interest at a rate of 6% per year through December 2008 payable quarterly by the issuance of non-interest bearing notes (paid-in-kind notes or PIK notes) maturing at the same time as the Subordinated Note. The issuance of the PIK notes will have the effect of deferring the underlying cash interest expense on the Subordinated Note, but because the PIK notes will not themselves bear interest, they will not have the effect of compounding any interest on these interest payment obligations. Commencing December 2008, the Subordinated Note will bear interest at 16% per year payable quarterly in cash through the time of repayment in full of the Subordinated Note. Principal on the Subordinated Note will be payable in equal installments of $19.95 million in December 2009 and December 2010; the PIK notes are also due in equal installments of $7.2 million on these same dates.

On December 20, 2002, the Company entered into a deferred compensation agreement with Dr. Bahman Atefi, its President, CEO and Chairman, as a condition to completing the Transaction. Under the deferred compensation agreement, Dr. Atefi is entitled to a payment of approximately $857,000 on December 20, 2008, plus 12% cash interest per year.

Under the terms of the Senior Credit Facility and Mezzanine Note, the Company is subject to covenants including financial covenants with respect to minimum fixed charge coverage, maximum total senior leverage, maximum total leverage, maximum capital expenditures, minimum EBITDAE, as defined, and other customary covenants. As of December 31, 2003, the Company was in compliance with these financial covenants.

In summary, for the aforementioned debt agreements, as of December 31, 2003 the remaining fiscal year repayments (at face amount before debt discount) are as follows:

The Company operates in one segment, delivering a broad array of scientific and engineering expertise to research and develop technological solutions for problems relating to national defense, public health and safety under contracts with the U.S. Government, state and local governments, and commercial customers. The Company’s federal government customers typically exercise independent contracting authority, and even offices or divisions within an agency or department may directly, or through a prime contractor, use the Company’s services as a separate customer so long as that customer has independent decision-making and contracting authority within its organization.

For the quarter ended December 31, 2003, revenues from services provided to various agencies of the U.S. Government represented $57.8 million or approximately 98%, and $46.7 million or approximately 99% of revenues for the interim period ended December 20, 2002. Contract receivables from agencies of the U.S. Government represented approximately $46.1 million, or 94%, of accounts receivable at December 31, 2003 and $43.9 million, or 91%, at December 20, 2002.

In addition, during the quarter ended December 31, 2003, there were no sales by Alion to any customers within a single country (except for the United States) where the sales accounted for 10% or more of total revenue. The Company treats sales to U.S. Government customers as sales within the United States regardless of where the services are performed. Substantially all of the Company’s assets were located within the United States for the quarter ended December 31, 2003.

On October 31, 2003, Alion acquired 100% of the outstanding shares of Innovative Technologies Solutions Corporation (ITSC) for $4.0 million. The transaction is also subject to an earnout provision not-to-exceed $2.5 million. ITSC is a New Mexico corporation with approximately 53 employees, the majority of whom are located in New Mexico. ITSC provides nuclear safety and analysis services to the U.S. Department of Energy (DOE) as well as to the commercial nuclear power industry. While the allocation of purchase price is preliminary, the Company has recorded approximately $3.7 million of goodwill as a result of the acquisition.

On September 16, 2002, IITRI filed a lawsuit against Clyde Andrews and William Bewley, former shareholders of AB Technologies, Inc., in the U.S. District Court for the Eastern District of Virginia. IITRI acquired substantially all of the assets of AB Technologies in February 2000.

The lawsuit sought to compel the defendants to submit disputed issues to an independent accounting firm, in accordance with the terms of the asset purchase agreement. The Company also sought declaratory judgment that it was entitled to a downward adjustment to the purchase price and a finding that it properly computed the earnout required by the asset purchase agreement.

Messrs Andrews and Bewley filed a lawsuit against IITRI for breach of the AB Technologies asset purchase agreement claiming at least $8.2 million in damages. The Andrews-Bewley lawsuit was removed

to federal court and consolidated into IITRI’s lawsuit. The federal court stayed the litigation and ordered both parties to submit the dispute to the independent accounting firm of Grant Thornton for arbitration.

On January 20, 2004, the arbitrator issued a decision awarding $725,829 to Messrs. Andrews and Bewley as a purchase price adjustment under the AB Technologies asset purchase agreement and increasing the earnout payment amounts to be paid by the Company under the asset purchase agreement. The arbitrator’s adjustments reflect an increase from $457,086 to $771,038 for the fiscal year 2000 earnout payment, an increase from $395,734 to $1,165,651 for the fiscal year 2001 earnout payment, and an increase from $741,690 to $1,826,187 for the fiscal year 2002 earnout payment. In sum, the arbitrator awarded Messrs. Andrews and Bewley approximately $4.4 million of the at least $8.2 million in damages that they sought, and the arbitrator also established guidelines to be used to calculate future earnout payments through fiscal year 2005. As a result of the arbitrator’s decision, the total amount due to Messrs. Andrews and Bewley for purchase price adjustment and earnout payments through fiscal year 2002 under the AB Technologies asset purchase agreement is approximately $4.4 million, of which the Company had already accrued approximately $2.9 million as of September 30, 2003. The payment of the approximately $4.4 million amount is due from the Company in the second quarter of fiscal year 2004.

On December 20, 2002, Alion acquired substantially all of the assets and certain of the liabilities of IITRI, excluding the assets and liabilities of IITRI’s Life Sciences Operation for approximately $127.3 million as described in Note 1. In connection with the acquisition, the Company formed the KSOP, which has an ESOP component. The ESOP trustee, State Street Bank and Trust Company, used the proceeds from the ESOP aggregating approximately $25.8 million to acquire approximately 2.58 million shares or 100% of the Company’s outstanding common stock. The Company used the funds from the sale of common stock to the ESOP and proceeds from the other debt instruments described in Note 7, to fund the Transaction. The acquisition was accounted for using the purchase method. The acquisition occurred on the last day of the Company’s first interim period in fiscal 2003, and accordingly, the accompanying consolidated statements of operations exclude the results of operations of the acquired business prior to the acquisition. The purchase price has been allocated to the acquired assets and assumed liabilities based on their estimated fair values at the date of acquisition.

Prior to the Transaction, the Company’s activities had been organizational in nature. The consolidated balance sheet as of December 20, 2002 reflects the estimated fair values of the acquired assets and assumed liabilities, the sale of common stock to the ESOP, and the debt and warrants issued as described in Notes 6 and 7.

The pro forma consolidated statement of operations for the interim period ended December 20, 2002 has been prepared by giving effect to the following transactions as if those transactions had been consummated on October 1, 2002:


	•	The incurrence of debt with detachable warrants to purchase common stock as described in Notes 6 and 7;

	•	The consummation of the Transaction, accounted for using the purchase method; and

	•	The purchase of common stock by the ESOP.

For the interim period ended December 20, 2002, the pro forma consolidated statement of operations includes pro forma adjustments to reverse historical amortization expense related to pre-Transaction goodwill, to record the amortization of identifiable intangible assets, to record interest expense on debt issued to finance the Transaction, to record the amortization of debt issuance costs, and to record the accretion of debt to face value to reflect the discount for the estimated fair value of Warrants issued.

The pro forma information does not purport to be indicative of the results of operations that would have actually been obtained if the transactions had occurred on the dates indicated or the results of operations that will be reported in the future.

On February 13, 2004, the Company purchased all the outstanding capital stock of Identix Public Sector, Inc. (IPS), a Virginia corporation, for approximately $8 million, using proceeds from the Company’s existing line of credit. In addition, at closing the Company reimbursed IPS’s parent company $0.9 million for intercompany payables. A contingent payment of $0.5 million may be due from the Company in the future. Alion expects the IPS acquisition to enable the Company to expand its program management support within the U.S. Navy and provide a new core competency in facilities engineering management.

The following discussion of our financial condition and results of operations should be read together with the consolidated financial statements and the notes to those statements. This discussion contains forward-looking statements that involve risks and uncertainties. These statements relate to our future plans, objectives, expectations and intentions and are for illustrative purposes only. These statements may be identified by the use of words such as “believe,” “expect,” “intend,” “plan,” “anticipate,” “likely,” “will,” “pro forma,” “forecast,” “projections,” and similar expressions.

The factors that could cause actual results to differ materially from those anticipated include, but are not limited to, the following: changes to the ERISA laws related to the Company’s Employee Ownership, Savings and Investment Plan; changes to the tax laws relating to the treatment and deductibility of goodwill, the Company’s subchapter S status, or any change in the Company’s effective tax rate; additional costs associated with compliance with the Sarbanes-Oxley Act of 2002, including any changes in the SEC’s rules, and other corporate governance requirements; failure of government customers to exercise options under contracts; funding decisions relating to U.S. Government projects; government contract procurement (such as bid protest) and termination risks; competitive factors such as pricing pressures and/or competition to hire and retain employees; the results of current and/or future legal proceedings and government agency proceedings which may arise out of our operations (including our contracts with government agencies) and the attendant risks of fines, liabilities, penalties, suspension and/or debarment; material changes in laws or regulations applicable to the Company’s businesses; as well as other risk factors discussed in the Company’s registration statement on Form S-1 filed with the SEC on January 22, 2004.

Readers are cautioned not to place undue reliance on these forward-looking statements, which reflect management’s view only as of February 13, 2004. The Company undertakes no obligation to update any of the forward-looking statements made herein, whether as a result of new information, future events, changes in expectations or otherwise. This discussion addresses only our continuing operations.

Our significant accounting policies are described in Note 2 to the consolidated financial statements included in Post-Effective Amendment No. 4 to the Company’s registration statement on Form S-1 (No. 333-89756) filed with the SEC on January 22, 2004.

Critical accounting policies are defined as those that are reflective of significant judgments and uncertainties, which potentially result in materially different results under different assumptions and conditions. Application of these policies is a critical element in the portrayal of our financial condition and results of operations. The discussion and analysis of our financial condition and results of operations are based on our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these quarterly and interim period consolidated financial statements requires management to make estimates and judgments that affect the reported amount of assets, liabilities, revenues and expenses. Actual results may differ from these estimates under different assumptions or conditions.

We recognize revenue when persuasive evidence of an arrangement exists, services have been rendered, the contract price is fixed or determinable, and collectibility is reasonably assured. We have a standard internal process that we use to determine whether all required criteria for revenue recognition have been met. This standard internal process includes a monthly review of contract revenues and expenses by several levels of management. This review covers, among other matters, progress against schedule, project staffing and levels of effort, risks and issues, subcontract management, incurred and estimated costs, and disposition of prior action items. This monthly internal review is designed to determine whether the overall progress on a contract is consistent with the effort expended and revenue recognized to date.

Our revenues consist primarily of payments for the work of our employees, and to a lesser extent, related costs for materials and subcontract efforts under contracts with our customers. Cost of services consists primarily of compensation expenses for program personnel, the fringe benefits associated with this compensation, and other direct expenses incurred to complete programs, including cost of materials and subcontract efforts.

The Company’s revenue results from contract research and other services under a variety of contracts, some of which provide for reimbursement of cost plus fees and others of which are fixed-price or time-and-material type contracts. Absent evidence to the contrary, we recognize revenues as follows:

Revenue on cost-reimbursement contracts is recognized as costs are incurred and include an estimate of applicable fees earned.

The percentage of completion method is used to recognize revenue on fixed-price contracts based on various performance measures. From time to time, facts develop that require the Company to revise its estimated total costs or revenues expected. The cumulative effect of revised estimates is recorded in the period in which the facts requiring revisions become known. The full amount of anticipated losses on any type of contract are recognized in the period in which they become known.

Under time-and-material contracts, labor and related costs are reimbursed at negotiated, fixed hourly rates. Revenue on time-and-material contracts is recognized at contractually billable rates as labor hours and direct expenses are incurred.

Contracts with agencies of the federal government are subject to periodic funding by the contracting agency concerned. Funding for a contract may be provided in full at inception of the contract or ratably throughout the term of the contract as the services are provided. If funding is not assessed as probable, revenue recognition is deferred until realization is probable.

Contract costs on federal government contracts, including indirect costs, are subject to audit by the federal government and adjustment pursuant to negotiations between the Company and government representatives. All of the Company’s federal contract indirect costs have been audited and agreed upon through fiscal year 2001. Contract revenues on federal government contracts have been recorded in amounts that are expected to be realized upon final settlement. The Company has submitted its fiscal year 2002 indirect cost submission to its cognizant government audit agency; this submission is undergoing the audit process at this time. The Company intends to submit its fiscal year 2003 indirect cost submission on or about March 31, 2004.

The Company recognizes revenue on unpriced change orders as expenses are incurred only to the extent that the Company expects it is probable that such costs will be recovered. The Company recognizes revenue in excess of costs on unpriced change orders only when management can also reliably estimate the amount of excess and experience provides a sufficient basis for recognition. The Company recognizes revenue on claims as expenses are incurred only to the extent that the Company expects it is probable that such costs will be recovered and the amount of recovery can be reliably estimated.

Contract revenue recognition inherently involves estimation. Examples of estimates include the contemplated level of effort to accomplish the tasks under contract, the cost of the effort, and the ongoing assessment of our progress towards completing the contract. From time to time, as part of our standard management processes, facts develop that require us to revise our estimated total costs or revenues. In most cases, these revisions relate to changes in the contractual scope of our work. To the extent that a revised estimate affects contract profit or revenue previously recognized, we record the cumulative effect of the revision in the period in which the facts requiring the revision become known. Anticipated losses are recognized in the accounting period in which they are first determined.

For the quarter ended December 31, 2003, we derived approximately 64%, 23% and 13% of our revenues from cost-plus, time-and-material and fixed-price contracts, respectively.

Our most significant expense is our cost of services, which consists primarily of direct labor costs for program personnel and direct expenses incurred to complete contracts, including cost of materials and subcontract efforts. Our ability to accurately predict personnel requirements, salaries and other costs, as well as to manage personnel levels and successfully redeploy personnel, can have a significant impact on our cost of services. Overhead costs consist primarily of indirect costs such as facility lease expenses, indirect labor expenses, supplies and other office expenses in support of our direct contract activities. General and administrative expenses consist primarily of costs associated with our management, finance and administrative groups; personnel training; sales and marketing expenses which include bid and proposal efforts; and certain occupancy, travel and other corporate costs.

The majority of our revenues is earned under contracts with various departments and agencies, or prime contractors, of the federal government. Certain revenues and payments we receive are based on provisional billings and payments that are subject to adjustment under audit. Federal government agencies and departments have the right to challenge our cost estimates and allocations with respect to government contracts. Also, contracts with such agencies are subject to audit and possible adjustment to account for unallowable costs under cost-type contracts or other regulatory requirements that affect both cost-type and fixed-price contracts.

The Company accounts for goodwill and other intangible assets in accordance with the provisions of SFAS No. 142, which requires, among other things, the discontinuance of goodwill amortization. In accordance with the provisions of SFAS No. 142, the Company no longer amortizes goodwill, however goodwill is to be reviewed at least annually for impairment. The Company has elected to perform the annual review at the end of each fiscal year. In addition, the Company will assess the impairment of goodwill and identifiable intangible assets whenever events or changes in circumstances indicate that the carrying value may not be recoverable. Factors considered important to possibly trigger an impairment review consist of:


	•	Significant underperformance relative to expected historical or projected future operating results;

	•	Significant changes in the manner of use of the acquired assets or the strategy for the overall business;

	•	Significant negative industry or economic trends; and

	•	Significant decline in Alion’s stock price for a sustained period.

When it is determined that the carrying value of intangibles and goodwill may not be recoverable based upon the existence of one or more of the above indicators of impairment, management measures any impairment based upon a projected discounted cash flow method or other measure of fair value including independent valuation.

As of December 31, 2003, the Company has goodwill of approximately $74.9 million, which will be subject to the aforementioned annual impairment review. In addition, in connection with the IITRI acquisition, the Company recorded intangible assets of approximately $30.6 million, comprised primarily of

The Company’s fiscal year ends on September 30. Beginning with the fiscal year ending September 30, 2004, the Company began operating on a three-month quarter, four-quarter fiscal year whereas for the fiscal year ended September 30, 2003 the Company operated on a 13-period fiscal year consisting of three, four-week periods in its first interim period; three, four-week periods in its second interim period; four, four-week periods in its third interim period; and the balance of the fiscal year of approximately three, four-week periods in its fourth interim period. For the quarter ended December 31, 2003, there were sixty-four available work days (based on a standard, five-day work week of Monday through Friday and excluding designated holidays recognized by Alion) as compared to fifty-eight available work days for the interim period ended December 20, 2002. Accordingly, comparisons between the three-month quarter ended December 31, 2003 and the twelve-week interim period ended December 20, 2002 will need to take into account the differing lengths of time.

As described in the notes to the accompanying consolidated financial statements, Alion completed the acquisition of substantially all of the assets and certain of the liabilities of IIT Research Institute on December 20, 2002, the last day of the Company’s first interim period for the fiscal year ended September 30, 2003. The following discussion and analysis of results of operations relates to the results of operations for the quarter ended December 31, 2003 and for the pro forma results of operations for the interim period ended December 20, 2002, assuming that the IITRI acquisition had been consummated on the first day of the interim period, October 1, 2002.

The following table sets forth, for each period indicated, the percentage of our revenues derived from each of our major types of customers.

Quarter Ended December 31, 2003 Compared to Pro Forma Interim Period Ended December 20, 2002

Revenues. Revenues increased $11.3 million, or 24.0%, to $58.6 million for the quarter ended December 31, 2003, from $47.3 million for the interim period ended December 20, 2002. This $11.3 million increase is attributable to the following events or circumstances:


	•	For the quarter ended December 31, 2003 there were sixty-four available workdays (based on a standard five-day work week of Monday through Friday and excluding designated holidays recognized by Alion) as compared to fifty-eight for the interim period ended December 20, 2002. The six-day increase in the number of available work days for the quarter ended December 31, 2003 resulted in additional revenue of approximately $5.4 million of the $11.3 million increase.

	•	Alion completed the acquisition and purchase of Integrated Technology Solutions Corporation (ITSC) on October 31, 2003. For the nine-week period for November 1, 2003 to December 31, 2003, the revenue generated by the activities of ITSC was approximately $1.4 million which contributed to the $11.3 million increase in revenue.

	•	Our performance of additional work under contracts that were in existence during the prior year. An increase in our decommissioning and demilitarization support services to the U.S. Army’s


		Newport Chemical Agent Disposal Facility (NECDF), under a subcontract to Parsons Infrastructure and Technology Group, Inc., accounted for approximately $1.1 million of increased revenue, while our support to the Department of Defense Joint Spectrum Center (JSC) accounted for approximately $0.3 million of increased revenue. Additional work in modeling and simulation services performed under the MSIAC contract with the Department of Defense contributed approximately $0.2 million of the revenue increase.

On the balance of our contracts, revenue increased approximately $2.9 million for the quarter ended December 31, 2003 as compared to the interim period ended December 20, 2002.

Excluding the $5.4 million and $1.4 million increases in revenue associated with the impact of the additional six working days during the quarter ended December 31, 2003 and the purchase of ITSC operations (which occurred on October 31, 2003), respectively, revenue increased approximately $4.5 million, or 9.5%, to $51.8 million (as adjusted) for the quarter ended December 31, 2003 from $47.3 million for the interim period ended December 20, 2002.

As a component of revenue, material and subcontract (M&S) revenue increased approximately $4.8 million, or 46.6%, to $15.1 million for the quarter ended December 31, 2003 from $10.3 million for the interim period ended December 20, 2002. Approximately $1.4 million of the $4.8 million increase is due to the six-day increase in available workdays for the quarter ended December 31, 2003 as compared to the interim period ended December 20, 2002. Also, approximately $0.5 million of the $4.8 million increase in M&S revenue is related to activities performed by ITSC, which began to be included in the Company’s operations on November 1, 2003. Approximately $2.9 million of the $4.8 million increase is associated with M&S activity on the balance of our contracts. M&S revenues vary in both dollar amount and schedule which are dependent on the requirements of the contracts.

Direct Contract Expenses. Direct contract expenses increased $7.4 million, or 21.3%, to $42.1 million for the quarter ended December 31, 2003, from $34.7 million for the interim period ended December 20, 2002. As a component of direct contract expenses, direct labor costs for the quarter ended December 31, 2003 increased by $3.5 million or 15.0%. Approximately $2.5 million of the $3.5 million increase in direct labor cost is due to the impact of the additional six working days in the quarter ended December 31, 2003. Also, approximately $0.7 million of the increase in direct labor cost is attributable to the direct labor performed by ITSC, which was included in our operations beginning November 1, 2003. The remaining $0.3 million increase is attributable to increased direct labor cost incurred on existing contracts. As a component of direct contract expense, other direct costs (ODC’s) increased by $0.4 million or 24.0% when compared to the interim period ended December 20, 2002. As a component of direct contract expense, material and subcontract cost increased approximately $4.4 million, or 46.3%, to $13.9 million for the quarter ended December 31, 2003, compared to $9.5 million for the interim period ended December 20, 2002. Approximately $1.3 million of the $4.4 million increase in M&S costs is due to the impact of the additional six working days that occurred for the quarter ended December 31, 2003. Approximately $0.4 million of the increase in M&S is related to the M&S activities performed by the ITSC, which was included in our operations beginning November 1, 2003. The remaining increase of $2.7 million is attributable to increased M&S cost incurred on existing contracts. As a percentage of revenue, direct contract expenses decreased to 71.9% for the quarter ended December 31, 2003 from 73.3% for the interim period ended December 20, 2002.

Gross Profit. Gross profit increased $3.9 million, or 30.9%, to $16.5 million for the quarter ended December 31, 2003, from $12.6 million for the interim period ended December 20, 2002. Approximately $1.5 million of the $3.9 million increase is due to the additional gross profit recognized on the revenue generated during the six additional working days during the quarter ended December 31, 2003. Also, approximately $0.3 million of the $3.9 million increase is attributable to the gross profit generated by the contracts performed by ITSC which was included in our operations beginning November 1, 2003. Gross profit as a percentage of revenue increased to 28.1% for the quarter ended December 31, 2003, from 26.7% for the interim period ended December 20, 2002. For the interim period ended December 20, 2002, revenue was partially offset by approximately $0.6 million, or 1.3% of revenue, related to certain additional

costs on a fixed-price contract and non-reimbursable direct costs on a cost-reimbursement contract. Excluding this adjustment, gross margin for the interim period ended December 20, 2002 would have been 28.0%, which is comparable to the 28.1% gross margin for the quarter ended December 31, 2003.

Operating Expenses. Operating expenses, net of depreciation and amortization, decreased approximately $1.7 million, or 10.8%, to $14.0 million for the quarter ended December 31, 2003, from $15.7 million for the interim period ended December 20, 2002. However, included in the $15.7 million of operating expenses for the interim period ended December 20, 2002 were approximately $5.5 million of non-recurring transaction-related expenses (e.g., third party legal, accounting, finance, etc.) incurred in connection with the purchase of assets from IITRI. No such transaction-related expenses were incurred for the quarter ended December 31, 2003. Accordingly, operating expenses, net of depreciation and amortization and adjusted for non-recurring transaction-related expenses, increased approximately $3.8 million, or 37.2%, to $14.0 million for the quarter ended December 31, 2003 from $10.2 million (i.e. $15.7 million less $5.5 million) for the interim period ended December 20, 2002. Approximately $1.3 million of the increase in total operating expenses is due to the impact of the six additional working days during the quarter ended December 31, 2003 as compared to interim period ended December 20, 2002. Approximately $0.3 million of the $3.8 million increase is attributable to the operating expenses incurred by ITSC, which was included in our operations beginning November 1, 2003.

As a component of our operating expenses, overhead expenses for indirect personnel and facilities costs related to rental and occupancy expenses increased approximately $1.7 million, or 35.4%, to $6.5 million for the quarter ended December 31, 2003, from $4.8 million for the interim period ended December 20, 2002. Approximately $0.6 million of the $1.7 million increase is due to the additional six working days during the quarter ended December 30, 2003, and approximately $0.3 million is attributable to facility and occupancy costs incurred by ITSC. The remaining $0.8 million increase was driven by infrastructure needs in support of the revenue growth.

As a second component of our operating expenses, general and administrative expense increased approximately $2.1 million, or 39.6%, to $7.4 million for the quarter ended December 31, 2003, compared to $5.3 million for the interim period ended December 20, 2002. Approximately $0.7 million of the $2.1 million increase is due to the impact of the additional six working days. Additionally, outside legal fees of approximately $0.5 million associated with the AB Technologies arbitration proceedings and year-end audit fees of approximately $0.2 million were incurred for the quarter ended December 31, 2003. The remaining $0.7 million increase is due to additional costs to support the infrastructure. As a percentage of revenues, general and administrative expenses increased to 12.6% for the quarter ended December 31, 2003, compared to 11.3% for the interim period ended December 20, 2002. For the quarter ended December 31, 2003, approximately 1.1 percentage points of the 12.6% is associated with the approximate $0.7 million increase in general and administrative expenses related to outside legal and audit fees.

Depreciation and Amortization. Depreciation and amortization expense increased approximately $0.2 million, or 6.9%, to $3.1 million for the quarter ended December 31, 2003, as compared to $2.9 million for the interim period ended December 31, 2003. The increase in depreciation expense is due to the amortization associated with approximately $1.3 million of capital expenditures incurred during the year ended September 30, 2003. For each respective quarter or interim period, approximately $2.4 million of total amortization expense was incurred associated with the intangible asset value assigned to purchased customer contracts. Additionally, for each respective quarter or interim period, approximately $0.1 million of depreciation expense was incurred associated with the fair market value assigned to the purchased assets.

Income from Operations. For the quarter ended December 31, 2003, we sustained a $0.6 million loss from operations compared with $6.0 million operating loss for the interim period ended December 20, 2002. For the interim period ended December 20, 2002, the $6.0 million operating loss included approximately $5.5 million of transaction-related expenses, described above. Transaction-related costs of a similar nature did not occur during the quarter ended December 31, 2003.

Other Income and Expense. Other expenses increased approximately $1.4 million, or 60.8%, to $3.7 million for the quarter ended December 31, 2003 as compared to $2.3 million for the interim period ended December 20, 2002. Approximately $0.9 million of the $1.4 million increase is associated with the interest expense incurred related to the debt financing associated with the purchase of the assets from IITRI; specifically, the warrant liabilities increased as a result of an increase in the share price of Alion’s common stock which resulted in additional interest expense. Also, approximately $0.4 million of the $1.4 million increase is associated with an increase in the deferred compensation expense related to Alion’s stock appreciation rights and Phantom Stock plans. For the quarter ended December 31, 2003, the deferred compensation expense was approximately $0.4 million while for the interim period ended December 20, 2002, the deferred compensation expense was zero. The remaining $0.1 million of the $1.4 million increase is associated with interest expense on the revolving credit facility.

Income Tax (Expense) Benefit. Our wholly-owned subsidiary, HFA, had operating income of approximately $0.4 million for the quarter ended December 31, 2003, compared to $0.1 million for the interim period ended December 20, 2002. As of December 20, 2002, HFA was determined to be a qualified subchapter S subsidiary and is no longer treated as a taxable corporation for federal income tax purposes. As a result, HFA recorded no income tax provision for the quarter ended December 31, 2003 and approximately $0.03 million for the interim period ended December 20, 2002.

Net Income (Loss). The net loss of $4.3 million for the quarter ended December 31, 2003, as compared to net loss of $8.2 million for the interim period ended December 20, 2002, is due to the factors discussed above.

On January 12, 2004, the Financial Accounting Standards Board (FASB) issued Staff Position No. FAS 106-1 “Accounting and Disclosure Requirements Related to the Medicare Prescription Drug, Improvement and Modernization Act of 2003” (FSP 106-1). FSP 106-1 permits employers that sponsor postretirement benefit plans to defer accounting for any effects of the Medicare Prescription Drug Improvement and Modernization Act of 2003 that was signed into law on December 8, 2003.

In accordance with FSP 106-1, neither the accumulated postretirement benefit obligation nor the net periodic postretirement benefit costs reflected in the accompanying financial statements reflect the effect of the Medicare Prescription Drug Improvement and Modernization Act of 2003 on Alion’s plan. Authoritative guidance, when issued, could require the Company to change previously reported information.

Historically, primary sources of liquidity of the business we acquired on December 20, 2002 have been cash provided by operations and revolving credit and term-loan facilities. We intend to fund our operations primarily through cash provided by operating activities and drawdowns from our revolving credit facility.

The following discussion relates to both the cash flows of Alion for the quarter ended December 31, 2003 and the cash flows of the business we acquired from IITRI for the interim period ended December 20, 2002. Alion’s Consolidated Statements of Cash Flows are provided herein. The statements of cash flow for the business we acquired from IITRI are included in Post-Effective Amendment No. 4 to the Company’s Registration Statement on Form S-1 filed with the SEC on January 22, 2004.

Net cash used in operating activities was $0.6 million for the quarter ended December 31, 2003, a decrease in use of $3.3 million from $3.9 million used in operating activities of the business we acquired on December 20, 2002 for the interim period ended December 20, 2002. The primary reason for this $3.3 million decrease in cash used in operations was that during the interim period ended December 20, 2002, approximately $3.2 million in cash was used to pay the transaction costs associated with IITRI’s sale of assets to Alion. For the quarter ended December 31, 2003, there were no such transaction-related costs incurred.

Net cash used in investing activities was $4.3 million for the quarter ended December 31, 2003, and $0.5 million for the interim period ended December 20, 2002 of the business we acquired on December 20,

2002. Approximately $3.7 million of the $4.3 million of cash used during the quarter ended December 31, 2003 was for the acquisition and purchase of ITSC. During the interim period ended December 20, 2002, the cash Alion paid for the selected operations of IITRI was $58.6 million. Cash of $25.5 million was generated from the sale of Alion common stock to the ESOP Trust, and $33.1 million resulted from borrowings under the Senior Term Note.

Net cash provided by financing activities was $6.4 million for the quarter ended December 31, 2003, compared to cash provided by financing activities of $4.0 million for the interim period ended December 20, 2002 of the business we acquired on December 20, 2002. This increase of $2.4 million in net cash provided by financing activities was primarily due to an increase in borrowings under Alion’s working capital bank facility. For the quarter ended December 31, 2003, the balance drawn under the working capital facility was approximately $8.3 million. For the interim period ended December 20, 2002, the balance drawn was approximately $6.1 million. During the 2002 interim period, the additional financing required to complete the purchase of the selected operations of IITRI included a $35.0 million Senior Term Note, a $20.3 million Mezzanine Note (with warrants), a $39.9 million Subordinated Note (with warrants), and the sale of $25.5 million of common stock to the ESOP Trust.

For the quarter ended December 31, 2003, net cash used in operating activities of $2.0 million is associated with approximately a $1.6 million increase in accounts receivable related to growth in our business. Other assets increased approximately $1.5 million associated with a $1.3 million investment in non-marketable securities and $0.2 million in prepaid insurance. Increases in trade accounts payable and other liabilities resulted in cash provided by operations of approximately $1.0 million and $0.2 million, respectively.

On December 20, 2002, the Company entered into a senior credit agreement among LaSalle Bank National Association, US Bank, National Cooperative Bank, Orix Financial Services, Inc. and BB&T Bank to refinance and replace IITRI’s prior credit arrangements. The new agreement consists of a $25.0 million revolving credit facility and a $35.0 million term loan to finance, in part, the IITRI acquisition. Principal repayments under the term loan are payable in quarterly installments. As of December 31, 2003, the approximate remaining fiscal year principal repayments (taking into account previous repayments) of $28.0 million are as follows:

The Company must repay all principal obligations under the revolving credit facility no later than December 20, 2007. The senior credit facility is secured by a first priority, perfected security interest in all of the Company’s current and future tangible and intangible property.

From December 20, 2002 until January 31, 2004, the term note and the revolving line of credit under the senior credit facility bore interest at either of two floating rates at the Company’s choice: an annual rate equal to the Eurodollar rate plus 350 basis points, or the LaSalle Bank prime rate plus 200 basis points. After January 31, 2004, the interest rate equals the Eurodollar rate or the prime rate plus margins which will vary depending upon the Company’s leverage ratio. Leverage is the ratio of total funded debt, excluding the Subordinated Note (described below), to earnings before interest, taxes, depreciation, amortization, ESOP repurchase obligations and non-cash compensation expenses.

Effective February 14, 2003, the Company exercised its right to have the term note bear interest at a Eurodollar rate. This does not affect the interest rate on the revolving line of credit. Interest on the term note was payable at the LaSalle Bank prime rate plus 200 basis points through February 14, 2003. Thereafter and until December 28, 2003, the term note bore interest at the Eurodollar rate plus 350 basis points.

On February 6, 2004, Amendment Number 1 to the Senior Credit Agreement was executed by and among the parties whereby the definition of “Borrowing Base (Senior Debt)” has been redefined for the fiscal period ending December 31, 2003. As such, the amended definition potentially increases the Company’s borrowing capacity under the Senior Credit Agreement.

The Company and one of its senior lenders entered into an interest rate cap agreement which runs from February 3, 2003 through February 3, 2007. Under this agreement, the Company’s maximum effective interest rate on the first $25.0 million of term loan principal will not exceed 6%. The senior lender counterparty to the cap agreement will semiannually calculate and reimburse the Company for all interest payments in excess of this 6% ceiling.

On July 3, 2003, July 18, 2003, and September 18, 2003, the Company made $0.6 million, $0.7 million, and $0.7 million advance payments, respectively, on the senior term loan. The Company paid the second, third and fourth quarterly installments of $1.25 million each on the senior term loan on Monday, July 7, 2003 (with the approval of the senior lender because Friday, July 4, 2003, was a bank holiday) , September 30, 2003, and December 19, 2003 respectively. On December 31, 2003, the Company had approximately $28.0 million in borrowings outstanding under the senior term note with approximately $8.3 million outstanding under the revolving credit facility.

The revolving credit facility bears interest at the LaSalle Bank prime rate plus 200 basis points, which was 6.0% as of December 31, 2003. The approximately $28.0 million balance remaining under the senior term note bears interest at the Eurodollar rate plus 350 basis points, which was 4.61% as of December 31, 2003.

The Company may prepay its borrowings under the senior credit facility in designated minimum amounts without premium or penalty, other than (i) customary breakage costs related to repayment of Eurodollar-based loans prior to the end of an interest period, and (ii) breakage costs associated with the early termination of any interest rate derivative related to the senior credit facilities. The Company must prepay its borrowings with a portion of its excess cash flow each year along with proceeds of any permitted debt or equity issuance or asset sale.

On December 20, 2002, the Company issued a Mezzanine Note to IITRI with a face value of approximately $20.3 million, as part of the consideration for the IITRI acquisition. The Mezzanine Note is junior to the senior credit facility, but ranks senior to the Subordinated Note. The Company must pay the outstanding Mezzanine Note principal in a lump sum on December 20, 2008. Each quarter, the Company

On March 28, 2003, an officer of the Company purchased a portion of the Company’s mezzanine note owned by IITRI for $750,000, its face value, along with warrants to purchase 19,327 shares of Alion’s common stock at an exercise price of $10.00 per share. On November 12, 2003, the Company purchased the Mezzanine Note and warrants from the officer for an aggregate purchase price of $1,034,020.

Also on December 20, 2002, the Company issued the Subordinated Note to IITRI, with a face value of $39.9 million, as part of the consideration for the IITRI acquisition. The Subordinated Note bears interest at a rate of 6% per year through December 2008, payable quarterly by the issuance of non-interest bearing notes, called paid-in-kind or (PIK) notes, which mature at the same time as the Subordinated Note. Issuance of the PIK notes will have the effect of deferring the underlying cash interest expense on the Subordinated Note. The PIK notes do not bear interest and therefore will not compound any interest on these payment obligations. Commencing December 2008, the Subordinated Note will bear interest at 16% per year payable quarterly in cash until the Subordinated Note has been repaid in full. Principal on the Subordinated Note is payable in equal installments of $19.95 million in December 2009 and December 2010; the PIK notes are also due in equal installments of $7.2 million on these same dates.

On December 20, 2002, the Company entered into a $0.9 million deferred compensation agreement with Dr. Atefi, with payment terms substantially equivalent to those of the Mezzanine Note previously described.

The Company issued detachable warrants with the Mezzanine Note and the Subordinated Note. The outstanding warrants associated with the Mezzanine Note represent the right to buy approximately 12% of the Company’s shares of common stock on a fully diluted basis (assuming the exercise of all warrants outstanding on September 30, 2003), at an exercise price of $10.00 per share. These warrants are exercisable until December 20, 2008 and contain a put right giving the holder the right to require the Company to purchase the warrants back at the then-current fair value of the Company’s common stock, minus the warrants’ exercise price. The put right can be exercised within thirty days after a change in control, or within thirty days prior to December 20, 2008, or within thirty days after delivery to the current holders of an appraisal of the per share value of the Company’s common stock as of September 30, 2008, if the ESOP still exists and no public market price exists for the Company’s common stock. The warrants associated with the Subordinated Note represent the right to buy approximately 26% of the Company’s shares of common stock on a fully diluted basis (assuming the exercise of all warrants outstanding on September 30, 2003), at an exercise price of $10.00 per share. These warrants are exercisable until December 20, 2010 and also contain a put right giving the holder the right to require the Company to purchase the warrants back at the then-current fair value of the Company’s common stock, minus the warrants’ exercise price. This put right applies to up to 50% of these warrants within thirty days prior to December 20, 2009 (or within thirty days after delivery to the warrantholders of an appraisal of the per share value of the Company’s common stock as of September 30, 2009, if the ESOP still exists and no public market price exists for its common stock), and up to 100% of these warrants within thirty days prior to December 20, 2010 (or within thirty days after delivery to the warrant holders of an appraisal of the per share value of its common stock as of September 30, 2010, if the ESOP still exists and no public market value exists for its common stock). All put rights terminate upon one or more underwritten public offerings of Alion common stock resulting in aggregate gross proceeds of at least $30.0 million to the sellers (excluding proceeds received from certain affiliates of Alion).

Under the terms of the senior credit facility, the Company is subject to covenants including financial covenants with respect to minimum fixed charge coverage, maximum total senior leverage, maximum total leverage, maximum capital expenditures and minimum EBITDAE. EBITDAE is defined in the senior credit facility as earnings before interest, taxes, depreciation, amortization, ESOP repurchase obligations and non-cash compensation expenses. The Mezzanine Note contains financial covenants similar to those contained in the senior credit facility, but on less onerous terms mutually agreed upon by the Company,

The Company has a maximum $11.5 million earnout payment obligation to the former shareholders of AB Technologies arising from IITRI’s acquisition of their company. The earnout arrangement applies to results of certain operations for part of fiscal year 2000, all of fiscal years 2001 through 2004, and part of fiscal year 2005. Messrs. Andrews and Bewley filed a lawsuit against IITRI for breach of the AB Technologies asset purchase agreement claiming at least $8.2 million in damages. The Andrews-Bewley lawsuit was removed to federal court and consolidated into IITRI’s lawsuit. The federal court stayed the litigation and ordered both parties to submit the dispute to the independent accounting firm of Grant Thornton for arbitration.

The Company’s minimum lease payment obligations under non-cancelable operating leases for years ending 2004, 2005, 2006, 2007 and 2008, are $8.3 million, $7.5 million, $5.4 million, $5.2 million and $5.2 million, respectively. The remaining aggregate obligations on these leases thereafter are approximately $7.4 million. Commercial facility lease expenses are included in these amounts. These commercial facility lease obligations are currently reimbursable costs under the Company’s government contracts.

Other contingent liabilities which will impact the Company’s cash flow relate to:


	•	Repurchase obligations under the KSOP which may be significant commencing in 2004;

	•	Obligations related to the holders’ put right associated with the Mezzanine Note warrants;

	•	Obligations related to the holder’s put right associated with the Subordinated Note warrants;

	•	Obligations relating to our stock appreciation rights and phantom stock programs; and

	•	Obligations relating to deferred compensation programs for senior managers.

In December 2003, the Company spent $0.7 million to re-purchase 50,031 shares of its common stock from the ESOP Trust at $14.71 per share to satisfy obligations to terminated employees.

The Company believes that cash flow from operations and cash available under its revolving credit facility will provide it with sufficient capital to fulfill its current business plan and to fund its working capital needs for at least the next 36 months. Although the Company expects to continue to have positive cash flow from operations, it will need to generate significant additional revenues beyond its current revenue base and to earn net income in order to repay principal and interest on the indebtedness it assumed to finance the IITRI acquisition.

Additionally, the Company’s business plan calls for it to continue to acquire companies with complementary technologies. If the Company does not have sufficient cash on hand to fund such acquisitions, it will be required to obtain financing to do so. Such financing may not be available to us on favorable terms, if at all.

Given the Company’s significant obligations that become due in years 2007 through 2010, it expects that it will need to refinance a portion of its indebtedness at least by fiscal year 2007. The Company’s cash from operations will be insufficient to satisfy all of its obligations and it cannot be certain that it will be able to refinance on terms that will be favorable to the Company, if at all. Moreover, if the Company’s plans or assumptions change, if its assumptions prove inaccurate, if it consummates investments in or acquisitions of other companies, if it experiences unexpected costs or competitive pressures, or if its existing cash and projected cash flow from operations prove insufficient, it may need to obtain greater amounts of additional financing and sooner than expected. While it is the Company’s intention only to enter into new financing or refinancing that it considers advantageous, it cannot be certain that such sources of financing will be available to the Company in the future, or, if available, that financing could be obtained on terms favorable to the Company.

The Company’s exposure to interest rate risk is primarily due to the additional debt it incurred to finance the IITRI acquisition. The Mezzanine Note and Subordinated Note have fixed interest rates, and therefore present no risk of change to interest charges as a result of an increase in market interest rates. The balance drawn under the $25.0 million senior revolving credit facility and $3.0 million of the Company’s $28.0 million remaining balance on its senior term note, however, bear interest at variable rates tied to the Eurodollar rate. Such variable rates increase the risk that interest charges will increase materially if market interest rates increase. The Company has reduced, in part, the maximum total amount of variable interest rate risk by entering into an interest rate cap agreement which caps at 6% the first $25.0 million of principal borrowed under the term note effective until February 3, 2007. For a description of the arrangement, refer to “Discussion of Debt Structure” in “Management’s Discussion and Analysis of Financial Condition and Results of Operations.”

The Company does not use derivatives for trading purposes. It invests its excess cash in short-term, investment grade, and interest-bearing securities.

Because the Company’s expenses and revenues from its international research contracts are generally denominated in U.S. dollars, the Company does not believe that its operations are subject to material risks associated with currency fluctuations.

The Company’s exposure to change in the fair market value of Alion’s stock as the economic basis for the estimate of contingent liabilities relates to:


	•	Repurchase obligations under the KSOP which may be significant commencing in 2004;

	•	Obligations related to the holders’ put rights associated with the Mezzanine Note warrants;

	•	Obligations related to the holder’s put rights associated with the Subordinated Note warrants;

	•	Obligations relating to its stock appreciation rights and phantom stock programs; and

	•	Obligations relating to deferred compensation programs for senior managers.

(a)

Disclosure Controls and Procedures. The Company’s management, with the participation of the Company’s Chief Executive Officer and Chief Financial Officer, has evaluated the effectiveness of the Company’s disclosure controls and procedures (as such term is defined in Rule 15d–15(e) under the Securities Exchange Act of 1934, as amended (the “Exchange Act”)) as of the end of the period covered by this quarterly report. Based on such evaluation, the Company’s Chief Executive Officer and Chief Financial Officer have concluded that, as of the end of such period, the Company’s disclosure controls and procedures are effective in recording, processing, summarizing and reporting, on a timely basis, information required to be disclosed by us in the reports that the Company file or submit under the Exchange Act.


(b)	Internal Control Over Financial Reporting. There have not been any changes in the Company’s internal control over financial reporting (as such term is defined in Rule 15d–15(f) under the Exchange Act) during the fiscal quarter to which this report relates that have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting.

On September 16, 2002, IITRI, Alion’s predecessor entity, filed a lawsuit against Clyde Andrews and William Bewley in the U.S. District Court for the Eastern District of Virginia, which we refer to as the Court. Messrs. Andrews and Bewley were formerly the shareholders of AB Technologies, Inc. IITRI acquired substantially all of the assets of AB Technologies in February 2000.

The lawsuit sought to compel the defendants to submit disputed issues to an independent accounting firm, in accordance with the terms of the asset purchase agreement. The Company also sought declaratory judgment that it is entitled to a downward adjustment to the purchase price and a finding that it properly computed the earnout required by the asset purchase agreement.

Messrs. Andrews and Bewley filed a lawsuit against IITRI for breach of the AB Technologies asset purchase agreement claiming at least $8.2 million in damages. The Andrews-Bewley lawsuit was removed to federal court and consolidated into IITRI’s lawsuit. The federal court stayed the litigation and ordered both parties to submit the dispute to the independent accounting firm of Grant Thornton for arbitration. The consolidated federal action was subsequently dismissed without prejudice. Alion assumed responsibility for and acquired all claims under both of these lawsuits, and the ensuing arbitration, as part of its acquisition of IITRI’s assets.

On January 20, 2004, the arbitrator issued a decision awarding $725,829 to Messrs. Andrews and Bewley as a purchase price adjustment under the AB Technologies asset purchase agreement and increasing the earnout payment amounts to be paid by the Company under the asset purchase agreement. The arbitrator’s adjustments reflect an increase from $457,086 to $771,038 for the fiscal year 2000 earnout payment, an increase from $395,734 to $1,165,651 for the fiscal year 2001 earnout payment, and an increase from $741,690 to $1,826,187 for the fiscal year 2002 earnout payment. In sum, the arbitrator awarded Messrs. Andrews and Bewley approximately $4.5 million of the $8.2 million in damages that they sought, and the arbitrator also established guidelines to be used to calculate future earnout payments through fiscal year 2005. As a result of the arbitrator’s decision, the total amount due to Messrs. Andrews and Bewley for purchase price adjustment and earnout payments through fiscal year 2002 under the AB Technologies asset purchase agreement is approximately $4.4 million, of which the Company had already accrued approximately $2.9 million as of September 30, 2003. The payment of the approximately $4.4 million amount is due from the Company in the second quarter of fiscal year 2004.

On February 28, 2003, Alion filed a lawsuit against Isovac Products, L.L.C., Inteledatics, Inc., James R. Gauger, George L. Stefanek and Joseph J. Petrovic in the Circuit Court of Cook County, Illinois, Chancery Division. Messrs. Gauger, Stefanek and Petrovic were formerly employed by IITRI.


	•	Under contract to the U.S. Army, IITRI developed a mobile rescue device — an Emergency Personal Isolation and Containment (“EPIC®”) Pod — to enable rescuers to safely attend to and support victims of chemical or biological attacks;

	•	IITRI assembled a team of employees to conceive the device, including Messrs. Gauger, Stefanek and Petrovic, each of whom executed an agreement assigning to IITRI all intellectual property rights arising out of his employment. Messrs. Gauger, Stefanek and Petrovic also acknowledged receipt of the IITRI Code of Ethics prohibiting outside activities in conflict with IITRI’s interests;

	•	In December 1998, IITRI filed a provisional patent application for the device;


	•	In August 1999, Messrs. Gauger, Stefanek and Petrovic and IITRI employee Robert Mullins jointly filed a patent application, which assigned the patent to IITRI and that related back to IITRI’s December 1998 provisional patent application. The patent was awarded to IITRI in November 2001;

	•	Messrs. Gauger, Stefanek and Petrovic began a process starting in March 1999, while they were still IITRI employees, to form companies that would compete with IITRI using IITRI’s trade secrets;

	•	Isovac Products, L.L.C., Inteledatics, Inc., James R. Gauger, George L. Stefanek and Joseph J. Petrovic, collectively the defendants, misappropriated IITRI’s trade secrets and filed a patent application on behalf of Isovac Products, L.L.C.;

	•	Mr. Petrovic defamed IITRI’s product in an interview with the New York Times for the defendants’ pecuniary gain and to cause harm to the reputation of IITRI’s products; and

	•	IITRI assigned to Alion its intellectual property rights in the EPIC Pod and its rights to claims against the defendants as part of Alion’s purchase of substantially all of IITRI’s assets.

Discovery has commenced and is ongoing. Alion is seeking an injunction barring the defendants from using Alion’s trade secrets, as well as exemplary damages.

Other than the foregoing actions, the Company is not involved in any legal proceeding other than routine legal proceedings occurring in the ordinary course of business.

As a government contractor, the Company may be subject from time to time to federal government inquiries relating to our operations and audits of our accounting procedures by the Defense Contract Audit Agency. Government contractors who are found to have violated the False Claims Act, or who are indicted or convicted for violations of other federal laws, may be suspended or debarred from government contracting for some period. Such an event could also result in fines or penalties. Given the Company’s dependence on federal government contracts, suspension or debarment could have a material adverse effect on the Company. The Company is not aware of any such claims or investigations against it.


(1)	Incorporated by reference to the corresponding exhibit previously filed as an exhibit to the Company’s Pre-Effective Amendment No. 2 to the Registration Statement on Form S-1 filed with the Securities and Exchange Commission on September 17, 2002 (File no. 950133-2-3224).

(2)	Incorporated by reference to the corresponding exhibit previously filed as an exhibit to the Company’s Pre-Effective Amendment No. 3 to the Registration Statement on Form S-1 filed with the Securities and Exchange Commission on October 7, 2002 (File no. 950133-2-3343).

(3)	Incorporated by reference to the corresponding exhibit previously filed as an exhibit to the Company’s Post-Effective Amendment No. 2 to the Registration Statement on Form S-1 filed with the Securities and Exchange Commission on December 9, 2002 (File no. 950133-2-4018).

(4)	Incorporated by reference to the corresponding exhibit previously filed as an exhibit to the Company’s Post-Effective Amendment No. 3 to the Registration Statement on Form S-1 filed with the Securities and Exchange Commission on March 24, 2003 (File no. 950133-3-862).

(5)	Incorporated by reference to the corresponding exhibit previously filed as an exhibit to the Company’s quarterly report on Form 10-Q for the quarterly period ended July 4, 2003, filed with the Securities and Exchange Commission on August 15, 2003 (File no. 950133-03-002960).

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.

Date: February 17, 2004


	By:	/s/ John M. Hughes



	Name: John M. Hughes
	Title: Chief Financial Officer
	(Principal Financial and Accounting Officer
	and Duly Authorized Officer)


(1)	Incorporated by reference to the corresponding exhibit previously filed as an exhibit to the Company’s Pre-Effective Amendment No. 2 to the Registration Statement on Form S-1 filed with the Securities and Exchange Commission on September 17, 2002 (File no. 950133-2-3224).

(2)	Incorporated by reference to the corresponding exhibit previously filed as an exhibit to the Company’s Pre-Effective Amendment No. 3 to the Registration Statement on Form S-1 filed with the Securities and Exchange Commission on October 7, 2002 (File no. 950133-2-3343).

(3)	Incorporated by reference to the corresponding exhibit previously filed as an exhibit to the Company’s Post-Effective Amendment No. 2 to the Registration Statement on Form S-1 filed with the Securities and Exchange Commission on December 9, 2002 (File no. 950133-2-4018).

(4)	Incorporated by reference to the corresponding exhibit previously filed as an exhibit to the Company’s Post-Effective Amendment No. 3 to the Registration Statement on Form S-1 filed with the Securities and Exchange Commission on March 24, 2003 (File no. 950133-3-862).

(5)	Incorporated by reference to the corresponding exhibit previously filed as an exhibit to the Company’s quarterly report on Form 10-Q for the quarterly period ended July 4, 2003, filed with the Securities and Exchange Commission on August 15, 2003 (File no. 950133-03-002960).


DELAWARE		54-2061691
(State or Other Jurisdiction of Incorporation of Organization)		(I.R.S. Employer Identification No.)

10 West 35th Street Chicago, IL 60616 (312) 567-4000		1750 Tysons Boulevard, Suite 1300 McLean, VA 22102 (703) 918-4480


PART I — FINANCIAL INFORMATION		1

Item 1.	Financial Statements	1
	Consolidated Balance Sheets	1
	Consolidated Statements of Operations	2
	Consolidated Statement of Operations and Pro Forma Consolidated Statement of Operations	3
	Consolidated Statements of Cash Flows	4
	Notes to Consolidated Financial Statements	5

Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	12

Item 3.	Quantitative and Qualitative Disclosures About Market Risk	23

Item 4.	Controls and Procedures	23
PART II — OTHER INFORMATION		24

Item 1.	Legal Proceedings	24

Item 2.	Changes in Securities and Use of Proceeds	25

Item 3.	Defaults Upon Senior Securities	25

Item 4.	Submission of Matters to a Vote of Security Holders	25

Item 5.	Other Information	25

Item 6.	Exhibits and Reports on Form 8-K	26


			December 31,			September 30,
			2003			2003

Assets
Current assets:
	Cash		$	606		$	494
	Restricted cash			—			5
	Accounts receivable, less allowance of $2,552 at December 31, 2003 and $2,484 at September 30, 2003			46,282			42,777
	Stock subscriptions receivable			—			1,246
	Prepaid expense			1,902			974
	Other current assets			2,942			2,155

		Total current assets		51,732			47,651
Fixed assets, net				8,785			8,696
Intangible assets, net				20,256			22,788
Goodwill				74,893			65,522
Other				97			97

		Total assets	$	155,763		$	144,754

Liabilities and Shareholder’s Equity
Current liabilities:
	Note payable to bank		$	8,300		$	—
	Current portion of senior note payable			5,000			5,000
	Acquisition obligations			8,584			—
	Trade accounts payable and accrued liabilities			15,260			9,661
	Accrued payroll and related liabilities			11,065			15,385
	Advance payments			—			5
	ESOP liabilities			1,181			320
	Billings in excess of costs and estimated earnings on uncompleted contracts			475			409

		Total current liabilities		49,865			30,780
Long-term debt				466			2,928
Senior note payable, excluding current portion				21,759			22,903
Mezzanine note payable				17,112			17,636
Subordinated note payable				33,619			33,437
Agreement with officer				748			743
Accrued postretirement benefit obligation				3,364			3,319
Deferred rent				501			346
Redeemable common stock warrants				15,454			14,762

		Total liabilities		142,888			126,854
Shareholder’s equity, subject to redemption:
	Common stock (subject to redemption), $0.01 par value, 15,000,000 shares authorized, 2,973,813 shares and 2,973,813 shares issued, 2,923,782 and 2,973,813 shares outstanding, at December 31, 2003 and September 30, 2003 respectively			29			29
	Additional paid-in capital			30,579			30,578
	Treasury stock, at cost (50,031 shares)			(736	)		—
	Accumulated deficit			(16,997	)		(12,707	)

		Total shareholder’s equity, subject to redemption		12,875			17,900

	Total liabilities and shareholder’s equity, subject to redemption		$	155,763		$	144,754


			Quarter			Interim Period
			Ended			Ended
			December 31,			December 20,
			2003			2002

Contract revenue			$	58,591		$	—
Direct contract expense				42,113			—

		Gross profit		16,478			—

Operating expenses:
	Indirect contract expense			3,989			—
	Research and development			74			—
	General and administrative			7,385			41
	Rental and occupancy expense			2,513			—
	Depreciation and amortization			3,104			—
	Bad debt expense			42			—

Total operating expenses				17,107			41

		Operating income (loss)		(629	)		41
Other income (expense):
	Interest income			2			—
	Interest expense			(3,236	)		—
	Other			(429	)		—

		Income (loss) before income taxes		(4,292	)		41
	Income tax expense			—			—

		Net income (loss)	$	(4,292	)	$	41

Basic and diluted loss per share			$	(1.45	)

Basic and diluted weighted average common shares outstanding				2,966,743


						Pro Forma
			Quarter			Interim Period
			Ended			Ended
			December 31,			December 20,
			2003			2002

Contract revenue			$	58,591		$	47,265
Direct contract expenses				42,113			34,655

		Gross profit		16,478			12,610

Operating expenses:
	Indirect contract expense			3,989			2,568
	Research and development			74			36
	General and administrative			7,385			5,313
	Non-recurring transaction costs			—			5,448
	Rental and occupancy expense			2,513			2,201
	Depreciation and amortization			3,104			2,883
	Bad debt expense			42			120

Total operating expenses				17,107			18,569

		Operating loss		(629	)		(5,958	)
Other income (expense):
	Interest income			2			22
	Interest expense			(3,236	)		(2,252	)
	Other			(429	)		(23	)

		Loss before income taxes		(4,292	)		(8,211	)
	Income tax expense			—			(27	)

		Net loss	$	(4,292	)	$	(8,238	)

Basic and diluted loss per share			$	(1.45	)

Basic and diluted weighted average common shares outstanding				2,966,743
Proforma basic and diluted loss per share						$	(3.20	)

Proforma basic and diluted weighted average common shares outstanding							2,575,508


Cash and restricted cash	$	1,187
Accounts receivable		47,485
Other current assets		3,784
Acquired contracts		30,645
Goodwill		63,610
Fixed assets		9,094
Liabilities assumed		(28,500	)

	$	127,305


Fiscal Year Ending September 30,	(In thousands)
2004	$	3,750
2005	$	6,875
2006	$	8,250
2007	$	8,875
2008	$	250



	Post-Transaction 8-Year Period (in thousands)

	2004		2005		2006		2007		2008		2009		2010		2011		Total
Principal payments
Senior term note	$	3,750	$	6,875	$	8,250	$	8,875	$	250							$	28,000
Mezzanine note and agreement with officer											$	21,200						21,200
Subordinated note													$	19,950	$	19,950		39,900

Total principal payments	$	3,750	$	6,875	$	8,250	$	8,875	$	250	$	21,200	$	19,950	$	19,950	$	89,100


9.	Acquisition of Innovative Technologies Solutions Corporation


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


	Quarter Ended			Interim Period Ended
	December 31, 2003			December 20, 2002

Department of Defense		93.0	%		93.0	%
Federal Civilian Agencies		4.9			5.8
Commercial/State/Local		2.1			1.2

Total		100.0	%		100.0	%


Fiscal Year Ended September 30, 2004	$	3.8 million
Fiscal Year Ended September 30, 2005	$	6.9 million
Fiscal Year Ended September 30, 2006	$	8.3 million
Fiscal Year Ended September 30, 2007	$	8.3 million
Fiscal Year Ended September 30, 2008	$	0.3 million


Exhibit
No.			Description

	3	.1	Second Amended and Restated Certificate of Incorporation of Beagle Holdings, Inc.(1)
	3	.2	Amended and Restated By-laws of Alion Science and Technology Corporation.(3)
	4	.1	Amended and Restated Alion Science and Technology Corporation Employee Ownership, Savings and Investment Plan.(2)
	4	.2	First Amendment to The Alion Science and Technology Corporation Employee Ownership, Savings and Investment Plan.(4)
	4	.3	Second Amendment to The Alion Science and Technology Corporation Employee Ownership, Savings and Investment Plan.(5)
	4	.4	Third Amendment to The Alion Science and Technology Corporation Employee Ownership, Savings and Investment Plan. (5)
	4	.5	Fourth Amendment to The Alion Science and Technology Corporation Employee Ownership, Savings and Investment Plan. (5)
	10	.29	First Amendment to the Credit Agreement by and among LaSalle Bank National Association as agent, various lenders and Alion Science and Technology Corporation.
	31	.1	Certification of Chief Executive Officer of Alion Science and Technology Corporation pursuant to Rule 15d-14(a) promulgated under the Securities Exchange Act of 1934, as amended.
	31	.2	Certification of Chief Financial Officer of Alion Science and Technology Corporation pursuant to 15d-14(a) promulgated under the Securities Exchange Act of 1934, as amended.
	32	.1	Certification of Chief Executive Officer of Alion Science and Technology Corporation, pursuant to 18 U.S.C. Section 1350 as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
	32	.2	Certification of Chief Financial Officer of Alion Science and Technology Corporation, pursuant to 18 U.S.C. Section 1350 as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.


1.	Description and Formation of the Business


2.	Basis of Presentation


3.	Summary of Significant Accounting Policies


	Recently Issued Accounting Pronouncements