ALION SCIENCE & TECHNOLOGY CORP - 10-K Annual Report

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. o Yes þ No

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. þ

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

Aggregate market value of the voting and non-voting common equity held by non-affiliates computed by reference to the price at which the common equity was last sold as of the last business day of the registrant’s most recently completed second fiscal quarter: None

The number of shares outstanding of Alion Science and Technology common stock as of September 30, 2004 was 3,376,197.

Some of the statements under “Business,” “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” and elsewhere in this Form 10-K constitute forward-looking statements, which involve known and unknown 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,” “could,” “estimate,” “may,” “potential,” “should,” “would” 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; undertaking acquisitions that could increase our costs or liabilities or be disruptive; taking on additional debt to fund acquisitions; failure to adequately integrate acquired businesses; material changes in laws or regulations applicable to the Company’s businesses; as well as other risk factors discussed elsewhere in this annual report.

Readers are cautioned not to place undue reliance on these forward-looking statements, which reflect management’s view only as of December 22, 2004. We undertake no obligation to update any of these factors or to publicly announce any change to our forward-looking statements made herein, whether as a result of new information, future events, changes in expectations or otherwise.

On December 20, 2002, Alion acquired Selected Operations of IIT Research Institute (“IITRI”) in a business combination accounted for using the purchase method (the Transaction). Prior to December 20, 2002, Alion was a shell company with limited operating activity. All operating data for the fiscal years ended September 30, 2003 and 2002 are pro forma as described and presented in Item 6, “Selected Financial Data” and assume that the acquisition was completed on October 1, 2001. All pro forma information included in this annual report is based upon the assumptions described in Item 6.

Alion Science and Technology Corporation (“Alion”, “the Company”, “we”, “our”) is an employee-owned company. We apply our scientific and engineering experience to research and develop technological solutions for problems relating to national defense, public health and safety, and nuclear safety and analysis. We provide our research and development and engineering services primarily to agencies of the federal government, but also to departments of state and local government and foreign governments, as well as commercial customers both in the U.S. and abroad.

Our revenue for fiscal year ended September 30, 2004 was $269.9 million, a 26.6% increase over the prior fiscal year. As of September 30, 2004, our contract backlog was $1,954.0 million, of which $160.6 million was funded. As of September 30, 2003, our contract backlog was $1,542.0 million, of which $107.0 million was funded. Federal government contracts accounted for approximately 98% of our revenues in the fiscal year ended September 30, 2004, of which approximately 91% came from the U.S. Department of Defense (DoD)

We apply our expertise to a range of specialized fields, which we refer to as core business areas. The core business areas are further described below. The estimated percentage distribution of our annual revenues, by core business area, is provided in the table below.


a)	For fiscal years ended September 30, 2003 and 2002, revenues associated with the Modeling and Simulation business were included in Defense Operations business area. Beginning in fiscal year 2004, revenue associated with the Modeling and Simulation business area is separately identified.

b)	For fiscal years ended September 30, 2003 and 2002, revenue associated with the Chemical, Environmental and Biodefense Technologies business area was separate from revenues associated with Explosive Science business area. Beginning fiscal year 2004, revenue in the Chemical, Environmental and Biodefense Technologies business area is combined with the Explosive Science business area to form the Chemical, Biological, and Explosive Science business area.

c)	Beginning in fiscal year 2004, revenues in the Transport Systems business area were combined with the Modeling and Simulation business area.

d)	Revenue associated with the Nuclear Safety and Analysis business area began in fiscal year 2004 as it relates to our acquisition of Innovative Technology Solutions Corporation (ITSC), which occurred in October 2003.

Wireless Communications. We provide wireless communications research and spectrum engineering services primarily to the U.S. Department of Defense, but also to other agencies of the federal government. To a lesser extent, we provide wireless communications research and spectrum engineering services to commercial customers and foreign governments. We have expertise in four primary areas:


	•	Wireless and communications-electronics engineering: we perform work for the government “communications-electronics” and commercial wireless communities. The term “communications-electronics” refers to all devices or systems that use the radio frequency spectrum. Our work for the government sector includes such tasks as conducting modeling and simulation of communications networks, testing and evaluating navigational systems, and analyzing radar and space systems performance. For our commercial customers, both foreign and domestic, we determine whether wireless communication networks have the geographic coverage the customers desire, and whether the


		systems operate free of interference, and we make recommendations designed to improve network performance. We also evaluate and make recommendations for the design of radio transmitters, receivers and antennas for our commercial customers.

	•	Spectrum management: we perform studies and analyses related to the manner in which the radio frequency spectrum may be utilized without interruption or interference by both new and existing users and technologies. In addition, we assess existing and new technologies for their ability to utilize the radio frequency spectrum efficiently — in other words, to accomplish designated tasks without using too much of the available radio frequency spectrum. Our services, which include providing spectrum policy advice, are used to support decisions of senior government officials in the U.S. and abroad.

	•	C4ISR system engineering: we deliver Command, Control, Communication and Computer Intelligence, Surveillance, and Reconnaissance (C4ISR) engineering and analysis support for radio frequency communications, radar, Identification Friend or Foe (IFF), and navigation systems to the U.S. Department of Defense system developers and integrators. We also develop automated spectrum management software to assign frequencies to multiple users of the radio frequency spectrum in an effort to minimize interference. Our software tool, Spectrum XXI, is the automated spectrum management system used worldwide by the U.S. Department of Defense, and it is now also being used by other agencies of the federal government. We also design, integrate and deploy spectrum monitoring software to locate and track violators of the rules and regulations of spectrum usage.

	•	Electromagnetic environmental effects: we perform studies and analyses to measure and predict electromagnetic environmental effects for both government and commercial customers. Our work has involved building automated tools designed to predict the effects of potential hazards of electromagnetic radiation to ordnance, fuel and personnel. We also analyze electronic components in automotive parts such as brakes and airbags for electromagnetic interference issues on behalf of various commercial customers.

Defense Operations. Our defense operations units provide the following services to the U.S. Department of Defense, including individual service components:


	•	Homeland security: we provide integrated solutions and vulnerability analysis for protecting people and systems, and we provide critical infrastructure tools for decision support, risk assessment, information assurance, and physical security.

	•	Strategic planning and operational analysis: we assist the U.S. Army in its objective to become a more technologically sophisticated and versatile combat force by providing readiness studies that employ decision support tools to improve strategic planning and decision making.

	•	Military transformation: we identify and analyze issues and programs of major importance for the Office of the Secretary of Defense (OSD) and related U.S. military services transformation initiatives such as joint warfare experimentation and integrate command, control, communication and computer intelligence (C4I) initiatives.

	•	Logistics management: we provide support to the U.S. Army on a broad range of requirements including infrastructure assessment, reserve force mobilization, defense industrial base assessment, financial management, cost analysis, and base realignment.

	•	Readiness assessments and operational support: we deliver strategic planning and decision-making process improvements by providing technical assistance and decision support tools, such as Full Spectrum Analysis and Distributed Information System Collaboration Architecture (DISCATM).

	•	Distance learning services: we develop policy and technology solutions to permit training and education from remote locations. We develop the necessary technology, compile the information to be used in the courseware, and then translate this into an electronic or web-based advanced distant learning medium so that the student can interact with the courseware from a remote location.

Modeling and Simulation. Our modeling and simulation operations assist our customers in examining the outcome of events by providing services such as:


	•	Wargaming, experimentation, scenario design and execution: we design and conduct strategic and operations analytic wargames to evaluate future operational concepts and force transformation initiatives, create and implement training scenarios for 2 dimensional and 3 dimensional simulation systems, support Joint Forces Command’s (JFCOM) Millennium Challenge, and we support Joint Conflict and Tactical Simulation (JCATS) scenarios.

	•	C4I integration: for the U.S. Department of Defense, we design and develop policies to enable standard automated interfaces between simulation and Command, Control, Communication and Computer Intelligence systems which support improved planning, training and military operations.

	•	Analysis and visualization: we develop terrain modeling and manage the Modeling and Simulation Information Analysis Center (MSIAC) for the U.S. Department of Defense (DoD).

	•	Phenomenological modeling: we develop phenomenological models for nuclear, chemical, biological and electromagnetic environments.

	•	Transport systems: we design and build railroad car simulators and complementary training programs for railway carriers to train their employees. Participation in our simulation training is designed to improve safety and to minimize fuel consumption for carriers. Our training tools range from training simulators based on desktop computers to full motion simulators for both electric and diesel-electric locomotives. We have delivered our training tools and services to domestic government and commercial customers and to customers in the U.K., Brazil, Turkey, India, Australia and South Africa.

Information Technology. Our information technology operations provide the following research primarily to agencies of the federal government, including the U.S. Department of Defense, the Internal Revenue Service and the National Institutes of Health, but also to commercial customers:


	•	Enterprise architecture development and integration: we design, develop and implement enterprise information systems.

	•	Applications development: we develop web-based and stand-alone solutions, as well as decision support tools.

	•	Knowledge management: we deliver solutions for data warehousing/mining, decision support, and information analysis.

	•	Network design and secure network operations: we provide information assurance, business continuity and disaster planning, network planning, and call center modeling.

	•	Independent verification and validation: we implement modeling and simulation, test and evaluation, and database monitoring.

Industrial Technology Solutions. We provide the following services to the U.S. Department of Defense and, to a lesser extent, to commercial customers:


	•	Reliability, material and manufacturing engineering: we apply technology to enhance production, improve performance, reduce cost and extend life of complex engineered products.

	•	Sensor technology development: we develop, evaluate, adapt and integrate sensor technologies.

	•	Facilities engineering: we provide expertise in engineering, architecture and related disciplines (e.g., construction management, logistics, design oversight and inspection).

	•	Research and analysis center management: we manage numerous U.S. Department of Defense information and analysis centers such as the: Reliability Analysis Center (RAC), Advanced Materials and Processes Technology Information Analysis Center (AMPTIAC), Manufacturing Technology Information Analysis Center (MTIAC), Electronic Packaging and Interconnection Technology Center and DuPage Manufacturing Research Center.


	•	Acoustic engineering: we test and evaluate various components for sound transmission, absorption and intensity.

	•	Aerospace coating production and application: we develop and apply coatings to protect government and commercial satellites.

	•	Innovative manufacturing technologies: we develop and integrate systems for low-volume productivity (e.g., laser cladding of parts), micro-machines and rapid manufacturing systems.

Chemical, Biological and Explosive Science. Our chemical, biological and explosive science operations provide a wide range of research primarily to the U.S. Department of Defense and the U.S. Environmental Protection Agency, but also to other departments of federal, state and local governments, including:


	•	Chemical and biological research: we provide research that examines the fundamentals necessary to improve defense strategy against chemical and biological weapons.

	•	Analytical and design methods: we provide analytical methods to enhance safe handling of chemical substances and design methods to convert harmful chemical and biological materials into harmless materials.

	•	Threat reduction: we provide technical expertise to branches of the U.S. military, the FBI, police departments, hospitals, fire departments, and other federal government and commercial customers, to reduce the threat of chemical-biological terrorism.

	•	Laboratory support: we provide support to U.S. Environmental Protection Agency laboratories in their pursuit of identifying and monitoring chemical contaminants in soil, air and water at specified Superfund sites.

	•	Explosive sciences: we provide unexploded ordnance services to the U.S. Army Corps of Engineers and to other departments of the U.S. military. Through our wholly-owned subsidiary, Human Factors Applications, Inc. (HFA), we develop and use technologies for detection, recovery and disposal of unexploded ordnance in the U.S. and abroad. We also perform decontamination and demolition of buildings and equipment contaminated with explosive materials.

	•	Ordnance management: we provide ordnance management services to the U.S. Navy, which includes the maintenance of, and accounting for, weapons inventories.

Nuclear Safety and Analysis. we provide nuclear safety and analysis services to the U.S. Department of Energy (DOE) and its National Laboratories as well as to the commercial nuclear power industry. Our services include:


	•	Modeling and simulation: we provide services in the areas of computational fluid dynamics, structural response, materials behavior, and neutronics.

	•	Safety and risk performance analysis: we provide services in the areas of probabilistic safety assessments, accident consequence analysis, and source term dose assessment.

	•	Design and performance assessments: we provide services related to nuclear power facilities in the areas of control room habitability, power rate analysis, and license extension.

	•	Management systems and program services: we provide technical expertise in the areas of compliance (e.g., regulatory analysis, policy development, and audits), project management, and training.

	•	Regulatory compliance support services: we provide technical support in the areas of nuclear plant operational readiness reviews and conduct of operations.

Software Tools and Technology Products. We have developed a series of software tools and technology products that complement our core business areas. Examples include:


	•	Frequency Assignment & Certification Engineering Tool (FACET^TM). This software tool automates the assignment of radio frequencies, which we refer to as spectrum management, in a way that is designed to minimize interference between multiple users of the radio frequency spectrum.

	•	Advanced Cosite Analysis Tool (ACAT^TM). This software tool is designed to permit co-location of numerous antennas on towers, rooftops and other platforms by predicting interference between the various systems and informing the user how to minimize interference.

	•	Individual Isolation Pod (IIP^TM). This transport pod is designed to isolate and transport individuals contaminated with biological or chemical agents. The transport pod is designed to enable first responders to administer emergency medical treatment.

	•	Spectrum Monitoring Automatic Reporting and Tracking System (SMART^TM). This system characterizes the frequency usage in a given geographic area, allowing the customer to remotely monitor the spectrum to identify unauthorized users and to look for gaps in the spectrum usage.

	•	Cave Dog: This product is a small, remote-controlled hemispherical, multi-spectral vision robot vehicle used for surveillance and reconnaissance.

	•	Real Time Location System (RTLS). This product is designed to enable customers to track thousands of users in a defined area, such as a seaport, a football stadium or an office building, using low cost antennas and badges.

Alion Science and Technology Corporation, formerly known as Beagle Holdings, Inc., was organized on October 10, 2001, as a for-profit Delaware corporation for the purposes of purchasing substantially all of the assets and assuming certain liabilities of IITRI, a not-for-profit Illinois corporation. Alion is an employee-owned company that is the successor in interest to IITRI, a government contractor in existence for more than sixty years. On December 20, 2002, some of the eligible employees of IITRI directed funds from their eligible retirement account balances into Alion’s Employee Stock Ownership Plan (ESOP). State Street Bank and Trust Company, the ESOP Trustee, used these proceeds, together with funds described elsewhere in this annual report, to purchase substantially all of IITRI’s assets and certain liabilities (hereafter referred to as the “Selected Operations of IITRI”). We refer to this purchase as “the Transaction.” Given the significance of the Transaction, and its effect on Alion’s capital structure, summary descriptions of the acquisition and the related deal terms, the purchase of Alion common stock by the ESOP, and Alion’s ESOP are provided below.

Acquired Business. On December 20, 2002, Alion acquired substantially all of the assets, rights and liabilities of IITRI’s business except for, amongst others, those assets, rights and liabilities associated with the Life Sciences Operation (other than its accounts receivable, which Alion did acquire), and IITRI’s real property, some of which we leased upon completion of the acquisition.

Purchase Price. The aggregate purchase price we paid to IITRI for its assets was approximately $127.3 million that included the following components:

Assumption of Liabilities. Alion assumed substantially all of the liabilities of IITRI’s business, with certain identified exceptions.

Indemnification. IITRI agreed to indemnify us, within limits agreed to by the parties, against any losses resulting from its breach of any of its representations, warranties or covenants and against losses resulting from liabilities retained by IITRI. We, in turn, indemnified IITRI, within limits agreed to by the parties, against losses resulting from our breach of any of our representations, warranties or covenants and against losses resulting from liabilities we assumed.

On December 20, 2002, we entered into a stock purchase agreement with the ESOP trust pursuant to which at closing we issued 2,575,408 shares of our common stock at $10 per share, in exchange for the funds our employees directed to be invested in the ESOP component of the KSOP (a “KSOP” is an employee benefit plan that consists of an ESOP and a 401(k) element, which allows employees to have diversified retirement savings in other investments) in the initial one-time ESOP investment election.

Representations and Warranties. Within the stock purchase agreement, we made representations and warranties to the ESOP trust that are customary to transactions of this type, related to, but not limited, to:


	•	Alion’s and HFA’s organization and corporate standing, their authority to enter into the stock purchase agreement and the binding effect of the agreement on us;

	•	the accuracy, compliance with U.S. generally accepted accounting principles and consistency with past practice of the financial statements with respect to the portion of IITRI’s business transferred to Alion; and

	•	our obligation to repurchase any shares of our common stock distributed to ESOP participants.

The ESOP trustee, on behalf of the ESOP trust, made representations and warranties to us, including, but not limited to:


	•	the trustee’s authority to enter into the stock purchase agreement and the binding effect of the agreement on the ESOP trust; and

	•	the investment intent of the ESOP trust.

Covenants. As part of the stock purchase agreement, we agreed with the ESOP trust that:


	•	we will not take any steps without the ESOP trust’s consent to change our status as an S corporation;

	•	we will not enter into any transactions with any of our officers or directors without approval from our board of directors or compensation committee;

	•	we will enforce our obligations under the asset purchase agreement with IITRI and other related agreements;

	•	we will obtain the ESOP trust’s consent before effecting our first public offering of stock to be listed on any securities exchange;

	•	we will not take actions that would prevent the ESOP trust from acquiring any additional shares of our stock under the control share acquisition provisions of the Delaware General Corporation Law;

	•	we will repurchase any shares of common stock distributed to participants in the ESOP component of the KSOP, to the extent required by the ESOP, any ESOP related documents and applicable laws;

	•	we will maintain the KSOP and the ESOP trust so that they will remain in compliance with the qualification and tax exemption requirements under the Internal Revenue Code; and

	•	we will use our best efforts to ensure that the ESOP trust fully enjoys its right to elect a majority of our board of directors and to otherwise control Alion.

Certain of the covenants listed above will lapse if the ESOP trust fails to own or otherwise control at least 20% of the voting power of all our capital stock.

Indemnification. We agreed to indemnify the ESOP trust, within limits agreed to by the parties, against any losses resulting from our breach of any of our representations, warranties or covenants. The ESOP trust will indemnify us, within limits agreed to by the parties, against losses resulting from its breach of any of its representations, warranties or covenants.

The Alion Science and Technology Corporation Employee Ownership, Savings and Investment Plan, which we refer to as the KSOP, is a qualified retirement plan and is comprised of what we refer to as an ESOP component and a non-ESOP component. The ESOP component of the KSOP owns 100% of the Company’s outstanding shares of common stock.

Eligible employees of the Company can purchase beneficial interests in the Company’s common stock by:


	•	rolling over their eligible retirement account balances into the ESOP component of the KSOP by making an individual one-time ESOP investment election available to new hires; and/or

	•	directing a portion of their pre-tax payroll income to be invested in the ESOP component of the KSOP.

The Company’s ESOP trustee, State Street Bank & Trust Company, uses the monies that eligible employees invest in the ESOP to purchase shares of the Company’s common stock, for allocation to those employees’ ESOP accounts.

The Company makes retirement plan contributions to all its employees who are eligible participants in the Alion KSOP. These retirement plan contributions are made to eligible employees’ accounts in both the ESOP and the non-ESOP components of the KSOP. The Company also makes matching contributions on behalf of eligible employees, in the ESOP component, based on their pre-tax deferrals of their Alion salary.

The ESOP trustee holds record title to all of the shares of Company common stock allocated to the employees’ ESOP accounts, and except in certain limited circumstances, the ESOP trustee will vote those shares on behalf of the employees at the direction of the ESOP committee. The ESOP committee is comprised of four members of Alion’s management team and three other Alion employees and is responsible for the financial management and administration of the ESOP component.

By law, Alion is required to value the common stock held in the ESOP component at least once a year. Alion has elected to have the common stock in the ESOP component valued by the ESOP trustee twice a year — as of March 31 and September 30. Because all ESOP transactions must occur at the current fair market value of the common stock held in the ESOP trust, having bi-annual valuations affords eligible employees the opportunity to invest in Company common stock and, when applicable, request distributions of their ESOP accounts at the end of each semi-annual period, rather than waiting until the end of each plan year.

Our objective is to continue to grow by capitalizing on our highly educated work force, our established position in our core business areas and by synergistic acquisitions. Our strategies for meeting this objective are:


	To build on our experience in wireless communications. We anticipate that U.S. Department of Defense budgets for the next few years will reflect an increased emphasis on communications and spectrum issues in which we have established expertise. For example, we expect to play a significant role for the U.S. Department of Defense in the development of Global Electromagnetic Spectrum Information (GEMSIS) as part of the Department of Defense’s move toward net-centric warfare. In addition, civilian agencies of the federal government are interested in the communications solutions we have developed for the U.S. Department of Defense. We also intend to try to expand our communications research base to include more foreign and commercial customers.

	To support the nation in homeland security. Alion has a long history of research and development in defense and destruction of chemical and biological agents. We have also developed a suite of software tools to support first responders in training to deal with potential release of chemical, biological, or nuclear material. We plan to expand our support to the Department of Homeland Security (DHS) and state and local governments in these areas.

	To expand our defense operations research. We will seek to provide new services to the U.S. Department of Defense. We intend to expand our military planning, operations, readiness assessment, and distance learning services to the Navy; historically, more of our services in the defense arena have been provided to the Army and Air Force. We also intend to use our technical capabilities to develop modeling and simulation systems for all branches of the U.S. armed forces.


	To expand our information technology research. We intend to promote our specialized information technology expertise to a broader range of customers, including the civilian agencies of the federal government, primarily by applying technology research and solutions originally developed for military use.

	To develop new software tool and technical products. We will seek to capture some of our intellectual property in the form of stand-alone tools and products to increase revenue. We intend to develop these tools and products to better serve existing customers, and to offer them separately as stand-alone tools and products for new customers.

	To recruit and retain highly skilled employees. We will seek to recruit and retain engineers, scientists, and technical experts with the experience, skills and innovation necessary to design and implement solutions to the complex problems our customers face. We will also seek to attract and retain other motivated professionals who have the qualities necessary to assist us in implementing our future business strategy and meeting our future business goals. As an employee owned company, we believe we will be able to provide enhanced financial incentives to our employees, and that those incentives will be important recruitment and retention tools.

	To pursue strategic acquisitions. We intend to broaden our customer base and our capabilities in our core research fields by pursuing strategic acquisitions from companies with talent and technologies complementary to our current fields and to our future business goals in order to add new clients and expand our core competencies. During fiscal year 2004, Alion completed the following acquisitions:


	•	Integrated Technology Solutions Corporation (ITSC) — On October 31, 2003, Alion completed the acquisition of ITSC, a New Mexico corporation that had approximately 53 employees, the majority of whom were 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.

	•	Identix Public Sector, Inc. (IPS) — On February 13, 2004, Alion completed the acquisition of IPS, a Virginia-based company that provides program and acquisition management support, integrated logistics support, and foreign military support primarily to U.S. Navy customers. IPS was a wholly-owned subsidiary of Identix Incorporated.

Funding for our federal government contracts is linked to trends in U.S. defense spending. We believe that domestic defense spending will grow over the next several years as a result of the following trends and developments:


	•	Increased Spending on National Defense. The terrorist attacks of September 11, 2001 and subsequent events have intensified the federal government’s commitment to strengthen our country’s military, intelligence, and homeland security capabilities. Department of Defense appropriations, excluding military construction and supplemental appropriations to pay for the ongoing efforts in Iraq and Afghanistan, were increased from $366 billion in federal fiscal year 2004 to $391 billion for federal fiscal year 2005 and grew at an average annual growth rate over the past five years of 5.9%. In addition, the federal fiscal year 2005 Homeland Security budget proposal totaled $47 billion, with $27 billion allocated to initiatives in the Department of Homeland Security, $8 billion allocated to the Department of Defense, and $12 billion allocated to other federal agencies.

	•	Increased interest in procurement and development. We expect that the U.S. Department of Defense budget for research and development, testing and evaluation (R,D,T&E), all of which fund our programs, will grow proportionately with overall defense spending.

We believe that the increase in spending for defense and homeland security will result in a growth of our revenues because of the correlation between the areas of projected growth in spending and our core business areas. The following areas of projected growth in spending for defense and homeland security, as identified in the U.S. Budget for fiscal year 2005, have a direct correlation with our core business areas:


	•	training and training transformation;

	•	modeling and simulation as basis for mission planning and preparation;

	•	the enhancement of defenses against biological, chemical and nuclear attacks;

	•	the use of information technology for national security; and

	•	an overall increase in spending for homeland defense.

For fiscal years ended September 30, 2004, 2003 (on a pro forma basis), and 2002 (on a pro forma basis), revenue that we obtained from federal government contracts was approximately 98% of our total revenue for each respective year. The U.S. Department of Defense is our largest customer. We expect that most of our revenues will continue to result from contracts with the federal government. We perform our government contracts as a prime contractor or as a subcontractor. As a prime contractor, we have direct contact with the applicable government agency. As a subcontractor, we perform work for a prime contractor, which serves as the point of contact with the government agency overseeing the program.

Our federal government contracts are generally multi-year contracts but are funded on an annual basis at the discretion of Congress. Congress usually appropriates funds for a given program on an October 1 fiscal year commencement basis. That means that at the outset of a major program, the contract is usually only partially funded, and normally the procuring agency commits additional monies to the contract only as Congress makes appropriations for future fiscal years. The government can modify or discontinue any contract at its discretion or due to default by the contractor. Termination or modification of a contract at the government’s discretion may be for any of a variety of reasons, including funding constraints, modified government priorities or changes in program requirements. If one of our contracts is terminated at the government’s discretion, we typically get reimbursed for all of our services performed and costs incurred up to the point of termination, a negotiated amount of the fee on the contract, and termination-related costs we incur.

Contract Types. As of September 30, 2004, we had over 275 active contract engagements, each employing one of three types of price structures: cost-reimbursement, time-and-materials, or fixed-price.


	•	Cost-reimbursement contracts allow us to recover our direct labor and allocable indirect costs, plus a fee which may be fixed or variable depending on the contract arrangement. Allocable indirect costs refer to those costs related to operating our business that can be recovered under a contract.

	•	Time-and-material contracts allow us to recover our labor costs, based on negotiated, fixed hourly rates, as well as certain other costs.

	•	Under fixed-price contracts, customers pay us a fixed dollar amount to cover all direct and indirect costs, plus a fee. Under fixed-price contracts, we assume the risk of any cost overruns and receive the benefit of any cost savings.

Our historical contract mix, measured as a percentage of total revenue for the fiscal years ended September 30, 2004 and on a pro forma basis for fiscal years ended September 30, 2003 and 2002, is summarized in the table below.

Any costs we incur prior to the award of a new contract or prior to modification of an existing contract are at our own risk. This is a practice that is customary in our industry, particularly when a contractor has received verbal advice of a contract award, but has not yet received the authorizing contract documentation. In most cases the contract is later executed or modified and we receive full reimbursement for our costs. We cannot be certain, however, when we commence work prior to authorization of a contract, that the contract will be executed or that we will be reimbursed for our costs. As of September 30, 2004, we had incurred $2.0 million in pre-contract costs at our own risk.

Government Oversight. Our contract administration and cost accounting policies and practices are subject to oversight by federal government inspectors, technical specialists and auditors. All costs associated with a federal government contract are subject to audit by the federal government. An audit may reveal that some of the costs that we may have charged against a government contract are not in fact allowable, either in whole or in part. In these circumstances, we would have to return to the federal government any monies paid to us for non-allowable costs, plus interest and possibly penalties. The federal government has audited all indirect costs for our government contracts through fiscal year 2001, and any impact of these audits is reflected in our financial statements. Our contracts for fiscal year 2002 and subsequent periods have not yet been audited. The findings of an audit could result in adjustments that may change the financial data reported for fiscal year 2002 and subsequent periods.

Backlog. Contract backlog represents an estimate, as of a specific date, of the remaining future revenues anticipated from our existing contracts. It consists of two elements:


	•	funded backlog, which refers to contracts that have been awarded to us and whose funding has been authorized by the customer, less revenue previously recognized under the same contracts, and

	•	unfunded backlog, which refers to the total estimated value of contracts awarded to us, but whose funding has not yet been authorized by the customer.

Options not yet exercised by a customer for additional years and other extension opportunities included in contracts are included in unfunded backlog. Contract backlog does include pre-negotiated options to continue existing contracts. Changes in our contract backlog calculation result from additions for future revenues as a result of the execution of new contracts or the extension or renewal of existing contracts, reductions as a result of completing contracts, reductions due to early termination of contracts, and adjustments due to changes in estimates of the revenues to be derived from previously included contracts. Estimates of future revenues from contract backlog are by their nature inexact and the receipt and timing of these revenues are subject to various contingencies, many of which are outside of our control. The table below shows the value of our funded and unfunded contract backlog as of September 30, 2004, 2003, and 2002, respectively.

Proposal backlog represents an estimate, as of a specific date, of the proposals we have in process or submitted and for which we are waiting to hear results of the award. It consists of two elements:


	•	in-process backlog, which refers to proposals that we are preparing to submit following a request from a customer, and

	•	submitted backlog, which refers to proposals that we have submitted to a customer and for which we are awaiting an award decision.

The amount of our proposal backlog that ultimately may be realized as revenues depends upon our success in the competitive proposal process, and on the receipt of tasking and associated funding under the

ensuing contracts. We will not be successful in winning contract awards for all of the proposals that we submit to potential customers. Our past success rates for winning contract awards from our proposal backlog should not be viewed as an indication of our future success rates. The table below shows the value of our proposal backlog as of September 30, 2004, 2003, and 2002, respectively.

We believe that our business may be subject to seasonal fluctuations. The federal government’s fiscal year end (i.e., September 30) can trigger increased purchase requests from our customers for equipment and materials. Any increased purchase requests we receive as a result of the federal government’s fiscal year end would serve to increase our fourth quarter revenues but will generally decrease profit margins for that quarter, as these activities typically are not as profitable as our normal service offerings. In addition, expenditures by our customers tend to vary in cycles that reflect overall economic conditions as well as budgeting and buying patterns. Our revenue has in the past been, and may in the future be materially affected by a decline in the defense budget or in the economy in general. Such future declines could alter our current or prospective customers’ spending priorities or budget cycles which has the affect of extending our sales cycle.

Employees and Recruiting. We strive to create organizational culture that promotes excellence in job performance, respect for the ideas and judgment of our colleagues and recognition of the value of the unique skills and capabilities of our professional staff. We seek to attract highly qualified and ambitious staff. We strive to establish an environment in which all employees can make their best personal contribution and have the satisfaction of being part of a unique team. We believe that we have in the past successfully attracted and retained highly skilled employees because of the quality of our work environment, the professional challenges of our assignments, and the financial and career advancement opportunities we make available to our staff.

We view our employees as our most valuable asset. Our success depends in large part on attracting and retaining talented, innovative and experienced professionals at all levels. We rely on the availability of skilled technical and administrative employees to perform our research, development and technological services for our customers. The market for certain skills in areas such as information technology and wireless communications is at times extremely competitive. This makes recruiting and retention of employees in these and other specialized areas extremely important. We recognize that our benefits package, work environment, incentive compensation, and employee-owned culture will be important in recruiting and retaining these highly skilled employees.

As of September 30, 2004, we had 1,880 employees, of which 1,730 were full-time, 56 half-time, and 94 part-time employees. Over 70% of our employees have federal government security clearances. Approximately 5% of our employees have Ph.D.’s, approximately 34% have masters degrees, and approximately 65% of our employees have undergraduate degrees. We also use consultants from time to time for technical work, promotional activities, and proposal preparation. We believe that our relationship with our employees is good. None of our employees are covered by a collective bargaining agreement.

Our facilities include laboratory facilities at locations in Chicago, Illinois; Annapolis, Maryland; West Conshohocken, Pennsylvania; Lanham, Maryland; Geneva, Illinois; Huntsville, Alabama; Rome, New York; and Albuquerque, New Mexico, where we provide our engineers and scientists with advanced tools to research and apply new technologies to issues of national significance.

During the fiscal year ended September 30, 2004, we derived approximately 98% of our revenue from contracts with various agencies or departments of the federal government. Of our total revenue, we derived 91% from contracts with the U.S. Department of Defense. On a pro forma basis, for the fiscal year ended September 30, 2003, approximately 98% of our revenue was from contracts with the federal government, and 95% was derived from contracts with the U.S. Department of Defense. The balance of our revenue was from a variety of commercial customers, U.S. state and local governments and foreign governments. We derived less than 1% of our revenues from international customers in the fiscal years ended September 30, 2004, 2003, and 2002. The table below shows revenues, by customer, for fiscal years 2004, 2003, and 2002, respectively:

Our industry is very competitive. In most significant federal government procurements, we compete with much larger, well-established companies, as well as a number of smaller companies. They include Booz-Allen Hamilton, Computer Sciences Corporation, Science Applications International Corporation, Litton Industries, Sverdrup, Battelle Memorial Institute, Lockheed Martin Corporation, Northrop Grumman Corporation, and Mitretek Systems, Inc. In the commercial arena, we compete most often with smaller, but highly specialized technical companies, as well as a number of larger companies. They include CRIL Technology, Tadiran Communications Ltd., Spectrocan, Orthstar Incorporated, and Elite Electronic Engineering.

In most cases, government contracts for which we compete are awarded based on a competitive process. We believe that in general, the key factors considered in awarding contracts are:


	•	technical capabilities and approach;

	•	quality of the personnel, including management capabilities;

	•	successful past contract performance; and

	•	price.

It is our experience that in awarding contracts to perform complex technological programs, the two most important considerations for a customer are technical capabilities and price.

The Internal Revenue Code provides that a corporation that meets certain requirements may elect to be taxed as an S corporation for federal income tax purposes. These requirements provide that an S corporation may only have:


	•	one class of stock;

	•	up to 75 shareholders; and

	•	certain types of shareholders, such as individuals, trusts and some tax-exempt organizations, including ESOPs.

Since the ESOP (which counts as one shareholder for S corporation purposes) is our only stockholder, we currently meet the requirements to be taxed as an S corporation.

Alion filed an election with the IRS to be treated as an S corporation under the Internal Revenue Code. The election was accepted and became effective on October 11, 2001. An S corporation, unlike a C corporation, generally does not pay federal corporate income tax on its net income. Rather, such income is allocated to the S corporation’s shareholders. Shareholders must take into account their allocable share of income when filing their income tax returns. An ESOP is a tax-exempt entity and does not pay tax on its allocable share of S corporation income. Because neither we nor the ESOP should be required to pay federal corporate income tax, we expect to have substantially more cash available to repay our debt and invest in our operations than we would if Alion were to be taxed as a C corporation.

Many states follow the federal tax treatment of S corporations. In some states, Alion is subject to different tax treatment for state income tax purposes than for federal income tax purposes. The Company and its subsidiaries operate in several states where we are subject to state income taxes. The Company is also subject to other taxes such as franchise and business taxes in certain jurisdictions.

The Company’s wholly-owned operating subsidiaries are qualifying subchapter S subsidiaries. For federal income tax purposes, these subsidiaries are consolidated into Alion’s federal income tax returns.

Under a provision of the Internal Revenue Code, significant penalties can be imposed on a subchapter S employer which maintains an ESOP (i) if the amount of ESOP stock allocated to certain “disqualified persons” exceeds certain statutory limits or (ii) if disqualified persons together own 50% or more of the company’s stock. For this purpose, a “disqualified person” is generally someone who owns 10% or more of the subchapter S employer’s stock (including deemed ownership through stock options, warrants, stock appreciation rights, or SARs, phantom stock, and similar rights). The KSOP, the SAR plan and the phantom stock plan include provisions designed to prohibit allocations in violation of these Internal Revenue Code limits. We expect never to exceed the 50% limit. Apart from the warrants representing approximately 38% of our common stock that were issued to IITRI at the closing of the Transaction (and subsequently transferred to the Illinois Institute of Technology), no one person is expected to hold ownership interests representing more than 5% of Alion.

We primarily promote our contract research services by meeting face-to-face with customers or potential customers, by obtaining repeat work from satisfied customers, and by responding to requests for proposals, referred to as RFPs, and international tenders that our customers and prospective customers publish or direct to our attention from time to time. We use our knowledge of and experience with federal government procurement procedures, and relationships with government personnel, to help anticipate the issuance of RFPs or tenders and to maximize our ability to respond effectively and in a timely manner to these requests. We use our resources to respond to RFPs and tenders that we believe we have a good opportunity to win and that represent either our core research fields or logical extensions to those fields for new research. In responding to an RFP or tender, we draw on our expertise in our various business areas to reflect the technical skills we could bring to the performance of that contract.

Our technical staff is an integral part of our promotional efforts. They develop relationships with our customers over the course of contracts that can lead to additional work. They also become aware of new research opportunities in the course of performing tasks on current contracts.

We hold weekly company-wide business development meetings to review specific proposal opportunities and to agree on our strategy in pursuing these opportunities. At times we also use independent consultants for promoting business, developing proposal strategies and preparing proposals.

We spent approximately $0.4 million on internal research and development in fiscal year 2004, and, on a pro forma basis, approximately $0.2 million and $0.6 million in fiscal years 2003 and 2002, respectively. This is in addition to the substantial research and development activities that we have undertaken on projects funded by our customers. We believe that actively fostering an environment of innovation is critical to our future

For most of our work, we use computer and laboratory equipment and other supplies that are readily available from multiple vendors. As such, disruption in availability of these types of resources from any particular vendor should not have a material impact on our ability to perform our contracts. In some of the specialized work we perform in a laboratory, we depend on the supply of special materials and equipment whose unavailability could have adverse effects on the experimental tasks performed at the laboratory. However, we believe that the overall impact of these types of delays or disruptions on our total operations and financial condition is likely to be minimal.

Our patent portfolio consists of sixteen issued and active U.S. patents, seven pending U.S. patents, three active foreign patents and thirteen pending foreign patents. We routinely enter into intellectual property assignment agreements with our employees to protect our rights to any patents or technologies developed during their employment with us. However, our research and development and engineering services do not depend on patent protection.

Our federal government contracts often provide the federal government with certain rights to our inventions and copyright works, including use of the inventions by government agencies, and a right to exploit these inventions or have them exploited by third-party contractors, including our competitors. Similarly, our federal government contracts often license to us patents and copyright works owned by others.

In fiscal years 2004 and 2003, nearly 100% of the Company’s revenue was derived from services provided under contracts with U.S.-based customers. The Company treats revenues resulting from U.S. government customers as sales within the United States regardless of where the services are performed.

The Company’s internet address is www.alionscience.com. The Company makes available free of charge through its internet site, via a hyperlink to the U.S. Securities and Exchange Commission EDGAR filings web site, its annual report on Form 10-K; quarterly reports on Form 10-Q; current reports on Form 8-K; and any amendments to those reports filed or furnished pursuant to the Securities Exchange Act of 1934, or the “Exchange Act,” as soon as reasonably practicable after such material is electronically filed with, or furnished to, the U.S. Securities and Exchange Commission.

Our operations are subject to federal, state and local laws and regulations relating to, among other things:


	•	emissions into the air,

	•	discharges into the environment,

	•	handling and disposal of regulated substances, and

	•	contamination by regulated substances.

Operating and maintenance costs associated with environmental compliance and prevention of contamination at our facilities are a normal, recurring part of our operations, are not material relative to our total operating costs or cash flows, and are generally allowable as contract costs under our contracts with the federal government. These costs have not been material in the past and, based on information presently available to us and on federal government environmental policies relating to allowable costs in effect at this time, all of which

Under existing U.S. environmental laws, potentially responsible parties are jointly and severally liable and, therefore, we would be potentially liable to the government or third parties for the full cost of remediating contamination at our sites or at third-party sites in the event contamination is identified and remediation is required. In the unlikely event that we were required to fully fund the remediation of a site, the statutory framework would allow us to pursue rights of contribution from other potentially responsible parties.

Our business, financial condition and results of operations may be affected by various economic factors. Unfavorable economic conditions may make it more difficult for us to maintain and continue our revenue growth. In an economic recession, or under other adverse economic conditions, customers and vendors may be more likely to be unable to meet contractual terms or their payment obligations. A decline in economic conditions may have a material adverse effect on our business.

We operate in highly competitive markets and generally encounter intense competition to win contracts. If we are unable to successfully compete for new business, our revenue growth and operating margins may decline. Many of our competitors are larger and have greater financial, technical, marketing, and public relations resources, larger client bases, and greater brand or name recognition than we do. Larger competitors include federal systems integrators such as Computer Sciences Corporation and Science Applications International Corporation, and divisions of large defense contractors such as Lockheed Martin Corporation and Northrop Grumman Corporation. Our larger competitors may be able to compete more effectively for very large-scale government contracts. Our larger competitors also may be able to provide clients with different or greater capabilities or benefits than we can provide in areas such as technical qualifications, past performance on large-scale contracts, geographic presence, price, and the availability of key professional personnel. Our competitors also have established or may establish relationships among themselves or with third parties, including through mergers and acquisitions, to increase their ability to address client needs. Accordingly, it is possible that new competitors or alliances among competitors may emerge.

In order to complete the acquisition of IITRI’s assets, we incurred a substantial amount of indebtedness. On August 2, 2004, we refinanced the Company which makes available approximately $180 million of debt financing which may be used to fund future acquisitions, refinance existing debt, and provide working capital. Our consolidated debt was approximately $103.2 million at September 30, 2004. We do not have extensive experience in functioning as a highly leveraged company.


	•	limit our ability to obtain additional financing for working capital, capital expenditures, acquisitions and other general corporate activities;

	•	limit our flexibility in planning for, or reacting to, changes in our business and the industry in which we operate;


	•	make it more difficult for us to satisfy our obligations to our creditors, including our repurchase obligations to ESOP participants, and, if we fail to comply with the requirements of the indebtedness, may require refinancing on terms unfavorable to us, or if refinancing is not possible, our creditors could accelerate the maturity of our indebtedness, which could cause us to default under other indebtedness, dispose of assets or declare bankruptcy;

	•	limit our ability to successfully withstand a downturn in our business or the economy generally; and

	•	place us at a competitive disadvantage against other less leveraged competitors.

Our ability to meet our payment obligations and to comply with the financial covenants contained in the agreements relating to our indebtedness is subject to a variety of factors, including changes in:


	•	funding of our contract backlog;

	•	the time within which our customers pay our accounts receivable;

	•	new contract awards and our performance under these contracts;

	•	continued increase in revenues on an annual basis;

	•	interest rate levels;

	•	our status as an S corporation for federal income tax purposes; and

	•	general economic conditions.

These factors will also affect our ability in the future to meet our obligations related to the put rights associated with the warrants and to our repurchase obligations under the KSOP. We also have significant debt obligations which become due in 2009 and 2010.

We may not generate sufficient cash flows to comply with our financial covenants and to meet our payment obligations when they become due. If we are unable to comply with our financial covenants, or if we are unable to generate sufficient cash flow or otherwise obtain funds necessary to make the required payments on our indebtedness, then we may be required to refinance our indebtedness. We cannot be certain that our indebtedness could be refinanced on terms that are favorable to us, if at all. In the absence of a refinancing, our lenders would be able to accelerate the maturity of our indebtedness, which could cause us to default under our other indebtedness, dispose of assets or declare bankruptcy.

Approximately 98% of our revenues for fiscal year 2004 were derived from contracts with the federal government. Contracts with the U.S. Department of Defense accounted for approximately 91%, and contracts with other government agencies accounted for approximately 7%, of our total revenues in fiscal year 2004. On a pro forma basis for fiscal year 2003, contracts with the U.S. Department of Defense accounted for approximately 95% of our revenues, and contracts with other government agencies accounted for approximately 3% of our revenues. We expect that government contracts are likely to continue to account for a significant portion of our revenues in the future. A significant decline in government expenditures, or a shift of expenditures away from government programs that we support, could cause a decline in our revenues.

On an annual basis, Congress must approve budgets that govern spending by each of the federal agencies we support. When Congress is unable to agree on budget priorities, and thus is unable to pass the annual

budget on a timely basis, then Congress typically enacts a continuing resolution. A continuing resolution allows government agencies to operate at spending levels approved in the previous budget cycle. When government agencies must operate on the basis of a continuing resolution it may delay funding we expect to receive from clients on work we are already performing and will likely result in any new initiatives being delayed, and in some cases being cancelled, both of which may adversely affect our business.

The following five large federal government contracts accounted for approximately 61% of our revenues for the fiscal year ended September 30, 2004:


	1.	Information Technology Services for General Services Administration — U.S. Department of Defense (18%);

	2.	Joint Spectrum Center Engineering Support Services for the U.S. Department of Defense Joint Spectrum Center (18%);

	3.	Modeling and Simulation Information Analysis Center for the U.S. Department of Defense — Defense Information Systems Agency (13%);

	4.	Modeling and Simulation for the U.S. Department of Defense — Defense Logistics Agency (7%); and

	5.	Subcontract (to Parsons Corporation) for decommissioning and demilitarization services to the U.S. Army’s Newport Chemical Agent Disposal Facility (5%).

These contracts, some of which are performed for multiple customers, are likely to continue to account for a significant percentage of our revenues in the future. Termination of these contracts or our inability to renew or replace them when they expire could cause our revenues to decrease.

Generally, government agencies can terminate contracts with their suppliers at any time without cause. If a government agency does terminate one of its contracts with us without cause, we will likely be entitled to receive compensation for the services provided or costs incurred up to the date of termination as well as a negotiated amount of the fee on the contract and termination-related costs we incur. Further, if a government contract is terminated because we defaulted under the terms of the contract, we will likely be entitled to receive compensation for the services provided and accepted up to the date of termination plus a percentage of the fee relating to the provided and accepted services. However, if a default were to occur, we may be liable for excess costs the government incurs in procuring the undelivered portion of the contract from another source. Termination of any of our large government contracts may negatively impact our revenues.

Government agencies have conflict of interest policies that may prevent us from bidding on or performing certain contracts. Typically, a conflict of interest policy prohibits a contractor that assisted the government agency in the design of a program and/or the associated procurement process from competing to perform the resulting contract. When dealing with government agencies that have conflict of interest policies, we must decide, at times with insufficient information, whether to participate in the design process and lose the chance of performing the contract or to turn down the opportunity to assist in the design process for the chance of performing on the contract. We have, on occasion, declined to bid on particular projects because of actual or perceived conflicts of interest, and we are likely to continue encountering such conflicts of interest in the future, particularly if we acquire other government contractors. Future conflicts of interest could cause us to be unable to secure key research and technology contracts with government customers.

The maximum contract value specified under a government contract is not necessarily indicative of revenues that we will realize under that contract. Congress normally appropriates funds for a given program on a fiscal year basis, even though actual contract performance may take many years. As a result, contracts ordinarily are only partially funded at the time of award, and normally the procuring agency commits additional monies to the contract only as Congress makes appropriations in subsequent fiscal years. The portion of a government contract which has not yet been performed is referred to as backlog. The original value of a government contract is used in estimating the amount of our backlog. We define backlog to include both funded and unfunded orders for services under existing signed contracts, assuming the exercise of all options relating to those contracts that have been priced. We define funded backlog to be the portion of backlog for which funding currently is appropriated and obligated to us under a contract or other authorization for payment which an authorized purchasing authority signs, less the amount of revenue we have previously recognized under the contract. We define unfunded backlog as the total estimated value of signed contracts, less funding to date. Unfunded backlog includes all contract options that have been priced but not yet funded. Estimates of future revenues attributed to backlog are not necessarily precise and the receipt and timing of any of these revenues are subject to various contingencies such as changed federal government spending priorities and government decisions not to exercise options on existing contracts. Many of these contingencies are beyond our control. The backlog on a given contract may not ultimately be funded or may only be partially funded, which may cause our revenues to be lower than anticipated.

Government contract payments received that are in excess of allowable costs are subject to adjustment and repayment after government audit of the contract payments. Government audits have been completed on indirect costs related to our federal government contracts through fiscal year 2001, and are continuing for subsequent periods. We have included estimated reserves in our financial statements for excess billings and contract losses, which we believe are adequate based on our interpretation of contracting regulations and past experience. These reserves, however, may not be adequate. If our reserves are not adequate, revenues attributed to our contracts may be lower than expected.

As a prime contractor, we often rely significantly upon other companies as subcontractors to perform work we are obligated to deliver to our customers. A failure by one or more of our subcontractors to satisfactorily perform the agreed-upon services on a timely basis may cause us to be unable to perform our duties as a prime contractor. We have limited involvement in the work our subcontractors perform, and as a result, we may have exposure to problems our subcontractors cause. Performance deficiencies on the part of our subcontractors could result in a government customer terminating our contract for default. A default termination could expose us to liability for the customer’s costs of reprocurement, damage our reputation, and hurt our ability to compete for future contracts.

Any costs we incur before the execution of a contract or contract renewal are incurred at our risk, and it is possible that the customer will not reimburse us for these pre-contract costs. At September 30, 2004, we had pre-contract costs of $2.0 million. While such costs were associated with specific anticipated contracts and we believe their recoverability from such contracts is probable, we cannot be certain that contracts or contract renewals will be executed or that we will recover the related pre-contract costs.

Cost-reimbursement contracts provided approximately 59% of our revenues for the fiscal year ended September 30, 2004, 62% of our pro forma revenues for the fiscal year ended September 30, 2003 and 60% of our pro forma revenues for the fiscal year ended September 30, 2002. Fixed-price contracts provided approximately 16% of our revenues for fiscal year 2004, and 16% of our pro forma revenues for the fiscal year ended September 30, 2003, and 18% of our pro forma revenues for the fiscal year ended September 30, 2002.

In a cost-reimbursement contract, we are allowed to recover our approved costs plus a negotiated fee. The total price on a cost-reimbursement contract is based primarily on allowable costs incurred, but generally is subject to a maximum contract funding limit. Federal government regulations require us to notify our customers of any cost overruns or underruns on a cost-reimbursement contract. If we incur costs in excess of the funding limitation specified in the contract, we may not be able to recover those cost overruns. As a result, on a cost-reimbursement contract we may not earn the full amount of the anticipated fee.

In a fixed-price contract, we estimate the costs of the project and agree to deliver the project for a definite, predetermined price regardless of our actual costs to be incurred over the life of the project. We must fully absorb cost overruns. Our failure to anticipate technical problems, estimate costs accurately or control costs during performance of a fixed-price contract may reduce the fee margin of a fixed-price contract or cause a loss. Although we have not historically experienced significant contract losses on fixed-price contracts, the provisions in our financial statements for estimated losses on our fixed-price contracts may not be adequate to cover all actual future losses.

In general, cost-reimbursement contracts are the least profitable of our contract types. Our government customers typically determine what type of contract will be awarded to us. Cost-reimbursement contracts accounted for 59%, 62%, and 60% of our revenue for fiscal 2004, pro forma revenue for fiscal 2003, and pro forma revenue for fiscal 2002, respectively. To the extent that we enter into more or larger cost-reimbursement contracts in proportion to our total contract mix in the future, our operating margins and operating results may suffer.

We have historically earned higher relative profits on our fixed-price contracts. Fixed-price contracts accounted for 16%, 16%, and 18% of our revenue for fiscal 2004, pro forma revenue for fiscal 2003, and pro forma revenue for fiscal 2002, respectively. If the volume of services we deliver under fixed-price contracts decreases, or shifts to other types of contracts, our operating margins and operating results may suffer. Furthermore, we cannot assure you that we will be able to maintain our historic levels of profitability on fixed-price contracts in general.

We must comply with and are affected by laws and regulations relating to the formation, administration and performance of federal government contracts, which may impose added costs on our business. If a government review or investigation uncovers improper or illegal activities, we may be subject to civil and criminal penalties and administrative sanctions, including termination of contracts, forfeiture of fees, suspension of payments, fines and suspension or debarment from doing business with federal government agencies, which may impair our ability to conduct our business. To the knowledge of management, we are not at present the subject of any investigation that may adversely affect our ability to secure future government work.

As of September 30, 2004, we have approximately one hundred U.S. Department of Defense (DoD) classified contracts that require the Company to maintain facility security clearances at our fifteen sites. Approximately 1,400 of our employees hold security clearances to enable performance on these classified contracts. Each cleared facility has a Facility Security Officer and Key Management Personnel whom the DoD-Defense Security Service requires to be cleared to the level of the facility security clearance. In addition to these clearances, individual employees are selected to be cleared, based on the task requirement of the specific classified contract, for their technical, administrative or management expertise. Once the security clearance is granted, the employee is allowed access to the classified information on the contract based on the clearance and need to know for the information within the contract. Protection of classified information with regard to a classified contract is paramount. Loss of a facility clearance or an employee’s inability to obtain and/or maintain a security clearance could result in a government customer terminating an existing contract or choosing not to renew a contract upon its expiration. If we cannot maintain or obtain the required security clearances for our facilities or our employees, or if these clearances are not obtained in a timely manner, we may be unable to perform on a contract. Lack of required clearances could also impede our ability to bid on or win new contracts, which may result in the termination of current research activities. Termination of current research activities may damage our reputation and our revenues would likely decline.

We obtain most of our government contracts through a competitive bidding process that subjects us to risks associated with:


	•	the frequent need to bid on programs in advance of the completion of their design, which may result in unforeseen technological difficulties and/or cost overruns;

	•	the substantial time and effort, including design, development and promotional activities, required to prepare bids and proposals for contracts that may not be awarded to us; and

	•	the design complexity and rapid rate of technological advancement of most of our research offerings.

Upon expiration, government contracts may be subject to a competitive rebidding process. We may not be successful in winning contract awards or renewals in the future. Our failure to win contract awards, or to renew or replace existing contracts when they expire, would negatively impact our future business and the value of your investment.

We expect to encounter significant competition for government contracts from other companies, especially in our information technology and defense operations units. Some of our competitors will have substantially greater financial, technical and marketing resources than we do.


	•	the effectiveness of our research and development programs;

	•	our ability to offer better performance than our competitors at a lower or comparable cost;

	•	the readiness of our facilities, equipment and personnel to perform the programs for which we compete; and

	•	our ability to attract and retain key personnel.

If we do not continue to compete effectively and win contracts, our future business will be materially compromised.

We believe that our future success will be due, in part, to the continued services of our senior management team. The loss of any one of these individuals could cause our operations to suffer. On December 20, 2002, we entered into new employment agreements with most of these individuals for five-year terms. We do not, however, maintain key man life insurance policies on any members of management.

In addition, competition for certain employees, such as scientists and engineers, is intense. Our ability to implement our business plan is dependent on our ability to hire and retain these technically skilled professionals. Our failure to recruit and retain qualified scientists and engineers may cause us to be unable to obtain and perform future contracts.

The availability of highly trained and skilled professional, administrative and technical personnel is critical to our future growth and profitability. Competition for scientists, engineers, technicians, management and professional personnel is intense and competitors aggressively recruit key employees. Due to our growth and this competition for experienced personnel, particularly in highly specialized areas, it has become more difficult to meet all of our needs for these employees in a timely manner. We intend to continue to devote significant resources to recruit, train and retain qualified employees; however, we cannot be certain that we will be able to attract and retain such employees on acceptable terms. Any failure to do so could have a material adverse effect on our operations. If we are unable to recruit and retain a sufficient number of these employees, our ability to maintain and grow our business could be negatively impacted. In addition, some of our contracts contain provisions requiring us to commit to staff a program with certain personnel the customer considers key to our successful performance under the contract. In the event we are unable to provide these key personnel or acceptable substitutions, the customer may terminate the contract, and we may not be able to recover our costs.

We are exposed to the risk that employee fraud or other misconduct could occur. Misconduct by employees could include intentional failures to comply with federal government procurement regulations, engaging in unauthorized activities, seeking reimbursement for improper expenses or falsifying time records. Employee misconduct could also involve the improper use of our customers’ sensitive or classified information, which could result in regulatory sanctions against us and serious harm to our reputation. It is not always possible to deter employee misconduct, and the precautions we take to prevent and detect this activity may not be effective in controlling unknown or unmanaged risks or losses, which could harm our business.

Sustaining our company’s growth has placed significant demands on management, as well as on our administrative, operational and financial resources. To continue to manage our growth, we must continue to improve our operational, financial and management information systems and expand, motivate and manage our workforce. If we are unable to successfully manage our growth without compromising our quality of service and our profit margins, or if new systems we implement to assist in managing our growth do not produce the expected benefits, our business, prospects, financial condition or operating results could be adversely affected.

One of our key operating strategies is to selectively pursue acquisitions. We have made a number of acquisitions in the past, are currently pursuing a number of potential acquisition opportunities, and will consider other acquisitions in the future. We may not be able to consummate the acquisitions we are currently

pursuing on favorable terms, or at all. We may not be able to locate other suitable acquisition candidates at prices we consider appropriate or to finance acquisitions on terms that are satisfactory to us. If we do identify an appropriate acquisition candidate, we may not be able to successfully negotiate the terms of an acquisition, finance the acquisition or, if the acquisition occurs, integrate the acquired business into our existing business. Negotiations of potential acquisitions and the integration of acquired business operations could disrupt our business by diverting management away from day-to-day operations. Acquisitions of businesses or other material operations may require additional debt or equity financing, resulting in additional leverage or dilution of ownership. The difficulties of integration may be increased by the necessity of coordinating geographically dispersed organizations, integrating personnel with disparate business backgrounds and combining different corporate cultures. We also may not realize cost efficiencies or synergies that we anticipated when selecting our acquisition candidates. In addition, we may need to record write-downs from future impairments of intangible assets, which could reduce our future reported earnings. At times, acquisition candidates may have liabilities or adverse operating issues that we fail to discover through due diligence prior to the acquisition, but which we generally assume as part of an acquisition. Such liabilities could have a material adverse effect on our financial condition.

Our credit facility contains covenants that limit or restrict, among other things, our ability to borrow money outside of the amounts committed under the credit facility, make other restricted payments, sell or otherwise dispose of assets other than in the ordinary course of business, or make acquisitions, in each case without the prior written consent of our lenders. Our credit facility also requires us to maintain specified financial covenants relating to the interest coverage and maximum debt coverage. Our ability to satisfy these financial ratios can be affected by events beyond our control, and we cannot assure ourselves that we will meet these ratios. Default under our credit facility could allow the lenders to declare all amounts outstanding to be immediately due and payable. We have pledged substantially all of our assets, to secure the debt under our credit facility. If the lenders declare amounts outstanding under the credit facility to be due, the lenders could proceed against those assets. Any event of default, therefore, could have a material adverse effect on our business if the creditors determine to exercise their rights. We also may incur future debt obligations that might subject us to restrictive covenants that could affect our financial and operational flexibility, or subject the company to other events of default. Any such restrictive covenants in any future debt obligations the company incurs could limit our ability to fund our business operations or expand our business.

From time to time we may require consents or waivers from our lenders to permit actions that are prohibited by our credit facility. If, in the future, our lenders refuse to provide waivers of our credit facility’s restrictive covenants and/or financial ratios, then we may be in default under the terms of the credit facility, and we may be prohibited from undertaking actions that are necessary or desirable to maintain and expand its business.

Our operations are subject to federal, state and local environmental laws and regulations, as well as environmental laws and regulations in the various countries in which we operate. In addition, our operations are subject to environmental laws and regulations relating to the discharge, storage, treatment, handling, disposal and remediation of regulated substances and waste products, such as radioactive materials and explosives. The following may require us to incur substantial costs in the future:


	•	modifications to current laws and regulations;

	•	new laws and regulations;

	•	new guidance or new interpretation of existing laws and regulations; or

	•	the discovery of previously unknown contamination.

Our principal operating facilities are located in Chicago, Illinois and McLean, Virginia, and consist of approximately 49,231 square feet and 21,573 square feet of office space, respectively, held under leases. We also lease an additional 34 office facilities totaling approximately 482,125 square feet. Of these, our largest offices are located in Fairfax, Virginia; Washington, DC; Hampton, Virginia; West Conshohocken, Pennsylvania; Huntsville, Alabama; Rockville, Maryland; Annapolis, Maryland; Waldorf, Maryland; Lanham, Maryland; Orlando, Florida; Rome, New York; Fairborn, Ohio; O’ Fallon, Illinois; Mt. Clements, Michigan; Charlottesville, Virginia; Warren, Michigan; Ishpeming, Michigan; King George County, Virginia; San Diego, California; Albuquerque, New Mexico; Los Alamos, New Mexico; Naperville, Illinois; and two in Alexandria, Virginia.

We lease twelve laboratory facilities totaling 119,872 square feet, for research functions in connection with the performance of our contracts. Of these, our largest laboratories are located in Geneva, Illinois; Lanham, Maryland; Annapolis, Maryland; West Conshohocken, Pennsylvania; Huntsville, Alabama; Rome, New York; Orlando, Florida; and three in Chicago, Illinois. The lease terms are annual, varying from one to eight years, and are generally at market rates.

Aggregate average monthly base rental expense for fiscal year 2004 was $953,120 and, on a pro forma basis, the aggregate average monthly base rental expense for fiscal year 2003 was $667,043.

We periodically enter into other lease agreements that are, in most cases, directly chargeable to current contracts. These obligations are usually either covered by currently available contract funds or cancelable upon termination of the related contracts.

All leased space is considered to be adequate for the operation of our business, and no difficulties are foreseen in meeting any future space requirements.

The Company is not involved in any legal proceeding other than routine legal proceedings occurring in the ordinary course of business. The Company believes that these routine legal proceedings, in the aggregate, are not material to its financial condition and results of operations.

As a government contractor, the Company may be subject from time to time to federal government inquiries relating to its operations and audits by the Defense Contract Audit Agency. Contractors found to have violated the False Claims Act, or which are indicted or convicted of violations of other federal laws, may be suspended or debarred from federal 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 it. The Company is not aware of any such pending federal government claims or investigations.

No matters were submitted to the vote of security holders for the fourth quarter of the fiscal year ended September 30, 2004.

There is no established public trading market for Alion’s common stock. As of September 30, 2004, the ESOP was the only holder of our common stock.

Unlike regular C corporations, S corporations do not pay “dividends.” Rather, S corporations make “distributions.” Use of the term “distributions” in this context is unrelated to the term when used in the context of our repurchase obligations under the KSOP. To avoid confusion, when referring to a distribution that would constitute a dividend in a C corporation, we will use the term distribution/dividend. We do not expect to pay any distributions/dividends. We currently intend to retain future earnings, if any, for use in the operation of our business. Any determination to pay cash distributions/dividends in the future will be at the discretion of our board of directors and will be dependent on our results of operations, financial condition, contractual restrictions and other factors our board of directors determines to be relevant, as well as applicable law. The terms of the senior credit facility and the subordinated note prohibit us from paying distributions/dividends without the consent of the respective lenders.

The following table presents selected historical and pro forma consolidated financial data for Alion or the Selected Operations of IITRI for each of the fiscal years in the five-year period ended September 30, 2004. The information set forth below should be read in conjunction with “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and our historical consolidated financial statements and notes to those statements included elsewhere in this annual report. The consolidated operating data for the fiscal years ended September 30, 2004 and 2003 and the consolidated balance sheet data as of September 30, 2004 and 2003 are derived from, and are qualified by reference to, the consolidated financial statements of Alion included elsewhere in this annual report.

The consolidated operating data for the fiscal years ended September 30, 2002, 2001, and 2000 and the consolidated balance sheet data as of September 30, 2002 and 2001 are derived from and are qualified by reference to, the consolidated financial statements of Selected Operations of IIT Research Institute, included elsewhere in this annual report. The consolidated balance sheet data as of September 30, 2000 is derived from unaudited financial data that is not included in this annual report. The historical consolidated financial information has been carved out from the consolidated financial statements of IITRI using the historical results of operations and bases of assets and liabilities of the portion of IITRI’s business that was sold and gives effect to allocations of expenses from IITRI.

Alion completed the acquisition of substantially all of the assets and certain of the liabilities of IITRI on December 20, 2002 (the Transaction). The pro forma consolidated data for fiscal years ended September 30, 2003 and 2002, assume that the acquisition had been consummated as of October 1, 2001.

Our historical consolidated financial information may not be indicative of our future performance and does not necessarily reflect what our financial position and results of operations would have been had we operated as a separate, stand-alone entity during the periods presented.


	(1)	On October 31, 2003, Alion acquired 100% of the outstanding shares of Innovative Technologies Solutions Corporation (ITSC) for $4.0 million. The transaction is 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. As of September 30, 2004, the Company has recorded approximately $3.5 million of goodwill relating to this acquisition.


		On February 13, 2004, Alion acquired 100% of the outstanding stock of Identix Public Sector, Inc. (IPS) for $8.0 million in cash. At closing, the Company reimbursed IPS’s parent company $0.9 million


		for intercompany payables. Subsequent payments totaling approximately $1.7 million for intercompany payables were made in the three successive months following the closing. Per the agreement, a contingent payment of $0.5 million was placed in escrow and may be due from the Company in the future. The payment is contingent on the Company having the opportunity to compete or bid for services on certain government solicitations. While the allocation of purchase price is preliminary, as of September 30, 2004, the Company has recorded approximately $6.1 million of goodwill and approximately $1.1 million of intangible assets relating to this acquisition. Founded in 1980, IPS is based in Fairfax, Virginia and provides program and acquisition management, integrated logistics support, and foreign military support primarily to U.S. Navy customers. IPS, formerly ANADAC, was a wholly-owned subsidiary of Identix Incorporated.

		Operating results for these businesses are included in our consolidated totals from the respective dates of acquisitions.


	(2)	For historical fiscal year 2003 (October 1, 2002 to September 30, 2003), the operations data presented reflects approximately nine months of Alion operations since the Transaction occurred on December 20, 2002, which was at the end of IITRI’s first quarter of operations for fiscal 2003. During the period October 1, 2002 to December 20, 2002, Alion was organizationally a business shell, operationally inactive until the Transaction occurred.

	(3)	Represents consolidated operating and balance sheet data of the Selected Operations of IIT Research Institute which was acquired by Alion on December 20, 2002.

	(4)	Operating expenses include (i) non-recurring transaction expenses of approximately $6.7 million and $6.4 million for fiscal years ended September 30, 2003 and 2002, respectively and (ii) non-recurring, conversion and roll-out expenses of approximately $1.5 million for the fiscal year ended September 30, 2003.

	(5)	Other income (expense) for the year ended September 30, 2004 includes a gain of approximately $2.1 million on the sale of the Company’s minority interest in Matrics Incorporated. For the years ended September 30, 2004 and 2003, other income (expense) includes approximately $16.8 million and $13.9 million, respectively, in interest-related expense associated with the debt financing (which includes the related change in warrant valuation associated with the change in the share price of Alion stock) resulting from the Transaction. For the year ended September 30, 2000, other income includes a gain of $1.3 million on the sale of land in Annapolis, Maryland and a $0.5 million loss in equity of an affiliate.

	(6)	Income tax (expense) benefit primarily relates to income (loss) of our for-profit, wholly-owned subsidiary, HFA prior to HFA becoming a Q-sub beginning on December 21, 2002.

	(7)	The decrease in net income for the year ended September 30, 2002, as compared to the year ended September 30, 2001 is primarily attributable to approximately $6.4 million in non-recurring costs (e.g., outside legal, finance, accounting and audit fees) related to the acquisition of the Selected Operations of IITRI.

	(8)	IITRI has operated as a non-stock, not-for-profit corporation since its inception. Therefore, prior to 2003, our historical capital structure is not indicative of our current capital structure and, accordingly, historical earnings per share information has not been presented. Pro forma basic and diluted earnings per common share are computed based upon approximately 2.575 million shares of our stock outstanding after closing of the Transaction and completion of the one-time ESOP investment election being reflected as outstanding for the period prior to the closing of the Transaction. As of September 30, 2003, the pro forma basic and diluted earnings per common share are computed based upon approximately 2.65 million weighted average shares outstanding.

	(9)	Funded backlog represents the total amount of contracts that have been awarded and whose funding has been authorized minus the amount of revenue booked under the contracts from their inception to date.


(10)	Unfunded backlog refers to the estimated total value of contracts which have been awarded but whose funding has not yet been authorized for expenditure.

(11)

The unaudited pro forma consolidated statements of operations set forth below should be read in connection with, and are qualified by reference to, our consolidated financial statements and related notes, as well as “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” included elsewhere in this annual report. We believe that the assumptions used in the preparation of this unaudited pro forma information provide a reasonable basis for presenting the significant effects directly attributable to the transactions discussed below. The unaudited pro forma consolidated operating data are not necessarily indicative of the results that would have been reported had such events actually occurred on the dates described below, nor are they indicative of our future results. The unaudited pro forma consolidated operating data have been prepared to reflect the following adjustments to our historical results of operations and to give effect to the following transactions as if those transactions had been consummated on October 1, 2001:


	•	our incurrence of approximately $96.1 million of debt with detachable warrants to purchase common stock, in connection with the purchase of IITRI’s assets;

	•	the acquisition of IITRI’s assets, which was accounted for under the purchase method of accounting; and

	•	the purchase of our common stock for approximately $25.8 million by the ESOP Trust.

See accompanying notes to unaudited pro forma consolidated statements of operations.


(1)	Represents Alion board of director expenses and interest expense on the $0.9 million note due to officer under terms of a compensation agreement, net of estimated fair value of detachable warrants.


(2)	Represents the elimination of the amortization of the deferred gain related to the sale of real estate during the year ended September 30, 2001.

(3)	Reversal of IITRI’s historical amortization expense related to pre-acquisition goodwill.

(4)	Under the provisions of SFAS No. 141,“Business Combinations”, the Transaction purchase price was allocated between net tangible assets, the value attributed to identifiable intangible assets (purchased contracts) and goodwill. For purposes of the pro forma consolidated statements of operations, the excess purchase price over the identifiable net assets acquired is considered to be goodwill with an indefinite life and therefore is not amortizable. The estimated value of $30.6 million attributed to intangible assets has an estimated useful life of three years and has been amortized accordingly using the straight-line method in the pro forma statements of operations. Additionally, an estimated value of approximately $1.5 million was assigned to a single lot of non-capitalized assets (e.g., office furnishings, laptop computers, etc.). This asset has an estimated useful life of three years and has been amortized accordingly using the straight-line method in the pro forma statement of operations.

(5)	Represents interest expense on approximately $96.1 million of debt, utilizing a weighted average interest factor of approximately 8.1% per year, issued to finance the Transaction. The senior term note is a variable rate note that is indexed to the prime rate. The prime rate used for the weighted average interest rate calculation was 4.25%.

(6)	Represents amortization of debt issuance costs under the effective interest method over the life of the senior term note of five years.

(7)	Represents accretion of long-term debt to face value over the term of the debt using the effective interest method. Discount to debt reflects estimated fair value of detachable warrants of $10.3 million.

(8)	Our historical capital structure is not indicative of our current structure, and accordingly, historical earnings per share information has not been presented. For the fiscal year ended September 30, 2003, unaudited pro forma basic and diluted loss per share of common stock has been calculated in accordance with the rules for initial public offerings. These rules require that the weighted average share calculation give retroactive effect to any changes in our capital structure. Accordingly, pro forma weighted average shares assume the approximately 2.575 million shares issued by Alion after completion of the initial one-time ESOP investment on December 20, 2002, were outstanding for the entire period presented.

The following discussion of Alion’s financial condition and results of operations should be read together with the consolidated financial statements and the notes to those statements included elsewhere in this annual report. This discussion contains forward-looking statements about our business and operations that involve risks and uncertainties. Our actual results may differ materially from those we currently anticipate as a result of the “Risk Factors” described beginning on page 18, and elsewhere in this annual report.


	•	provide an overview of our business;

	•	explain the year-over-year trends in our results of operations;

	•	describe our liquidity and capital resources; and,

	•	explain our critical accounting policies.

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 Transaction), 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 fiscal year ended September 30, 2004 and for the pro forma results of operations for the fiscal years ended September 30, 2003 and September 30, 2002, as if the IITRI acquisition had been consummated on October 1, 2001.

We apply our scientific and engineering expertise to research and develop technological solutions for problems relating to national defense, public health and safety, and nuclear safety and analysis. We provide our research and development and engineering services primarily to agencies of the federal government, but also to state, local and foreign governments as well as commercial customers both in the U.S. and abroad. Our revenues increased 26.6%, 5.7%, and 4.4% for the fiscal years ended September 30, 2004, 2003, and 2002, respectively, through a combination of internal growth and acquisitions. The following table reflects, for each fiscal year indicated, summary results of operations and contract backlog data:

We contract primarily with the federal government. We expect most of our revenues to continue to come from government contracts and we expect that most of these contracts will be with the U.S. Department of Defense. The balance of our revenue comes from a variety of commercial customers, state and local governments, and foreign governments. The following table reflects, for each fiscal year indicated, the percentage of the Company’s revenue derived from each of its major types of customers:

We intend to expand our research offerings in commercial and international markets; however, the expansion, if any, will be incremental. Revenues from commercial/ state and local government/ international research together amounted to approximately 2%, of total revenues in each of fiscal years 2004, 2003, and 2002, respectively. We derive our international revenue from spectrum management research and software tools and our locomotive simulation and training services to foreign governmental customers.

Most of our revenue is generated based on services provided either by our employees or subcontractors. To a lesser degree, the revenue we earn includes reimbursable travel and other items to support the contractual effort. Thus, once we win new business, the key to delivering the revenue is through hiring new employees to meet customer requirements, retaining our employees, and ensuring that we deploy them on direct-billable jobs. Therefore, we closely monitor hiring success, attrition trends, and direct labor utilization. A key challenge in growing our business is to hire enough employees with appropriate security clearances. Since we earn higher profits from the labor services that our employees provide compared with subcontracted efforts

The table below provides a summary of annual revenues by significant contracts performed by the Company.


*	The total annual revenue identified with a sponsor/government agency may include revenue within multiple business areas. The primary core business area is the single largest business area with the sponsor/government agency.

Our revenues and our operating margins are affected by, among other things, our mix of contract types (e.g., cost-reimbursement, fixed-price, and time-and-material). Significant portions of our revenues are generated by services performed on cost-reimbursement contracts under which we are reimbursed for approved costs, plus a fee, which reflects our profit on the work performed. We recognize revenue on cost-reimbursement contracts based on actual costs incurred plus a proportionate share of the fees earned. We also have a number of fixed-price government contracts. We use the percentage-of-completion method to recognize revenue on fixed-price contracts. These contracts involve higher financial risks, and in some cases higher margins, because we must deliver the contracted services for a predetermined price regardless of our actual costs incurred in the project. Our failure to anticipate technical problems, estimate costs accurately or control costs during performance of a fixed-price contract may reduce the overall fee on the contract or cause a loss. 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

For the three years ended September 30, 2004, 2003, and 2002, the percentage distribution among these three types of contracts has remained relatively constant. Nonetheless, the percentage distribution reflects, to some extent, the increased use by governmental procuring agencies of General Services Administration Schedules which usually involve an increased number both of time-and-material and fixed-price orders.

Our objective is to continue to grow by capitalizing on our highly educated work force and our established position in our core research fields, and by synergistic acquisitions. From 1998 through September 30, 2004, the Company and its predecessor, IITRI, completed the following six acquisitions:


	•	In September 1998, we acquired Human Factors Applications, Inc. (HFA), a supplier of ordnance and explosive waste remediation services. HFA has core competencies in demilitarization, de-mining, environmental remediation, explosion sciences, ordnance management, and training.

	•	In May 1999, we acquired EMC Science Center, Inc. which has technical expertise in electromagnetic environmental effects research and training, and an analytical laboratory.

	•	In February 2000, we completed our acquisition of AB Technologies, Inc. which specializes in defense operations research, training-related modeling and simulation, education and training support, complex problem analysis, and military policy development for the federal government.

	•	In May 2002, we acquired Daedalic, Inc., which develops modeling and simulation software for large-scale vehicle and air mobility operations.

	•	In October 2003, we completed the acquisition of Innovative Technology Solutions Corporation (ITSC) which provides nuclear safety and analysis services for the U.S. Department of Energy (DOE) and the commercial nuclear power industry.

	•	In February 2004, we completed the acquisition of Identix Public Sector, Inc. (IPS) which provides program management and acquisition management services, integrated logistics support, and foreign military support primarily to U.S. Navy customers.

Except for HFA, which is a separately operated wholly-owned subsidiary, we have fully integrated these acquired entities into our research base and capabilities, enabling us to expand our research offerings for our government and commercial customers. Management believes that synergistic acquisitions like these provide several potential benefits to our organization and the public in that they:


	•	help us expand our research base to include increasingly large and complex programs;

	•	increase our opportunities to exploit the synergies between different research fields in which we work to broaden our offerings to our existing customers;

	•	bring new strengths to our technical capabilities through cross-utilization of research technology and engineering skills; and

	•	increase the overall depth and experience of our management.

For fiscal years ended September 30, 2004, 2003 and 2002, the Transaction had two significant impacts on net income: first, the value assigned to the purchased contracts are amortized on a straight-line basis over three years resulting in approximately a $10.5 million, non-cash expense per year, and second, there are two additional expense categories that appear on the operating statements: non-recurring third party transaction expenses (e.g. outside legal, finance, accounting and audit fees of approximately $6.7 million for fiscal year 2003 and approximately $6.4 million for fiscal year 2002) and the interest-related expense associated with the debt financing which includes the related change in warrant valuation associated with change in share price of Alion common stock of approximately $16.8 million, $13.9 million, and $9.6 million for the fiscal years ended September 30, 2004, 2003, and 2002, respectively.

For purposes of comparability, the table below reflects the relative financial impact of the ITSC and IPS acquisitions as they relate to the financial performance of Alion for the fiscal year ended September 30, 2004 compared to the pro forma financial performance for fiscal year ended September 30, 2003. The discussion of the results of operations will include references to the financial information shown in the table below in conjunction with the consolidated financial statements of Alion provided elsewhere in this document. The financial information provided in the table is based on estimates from Alion management.


	•	We completed the acquisition of ITSC on October 31, 2003. ITSC is a New Mexico corporation that had approximately 53 employees, the majority of whom were 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.

	•	We completed the acquisition of IPS on February 13, 2004. IPS is based in Fairfax, Virginia. IPS provides program and acquisition management, integrated logistics support, and foreign military support primarily to U.S. Navy customers.


*	The operations of the acquired entities, ITSC and IPS, have been fully integrated within Alion on a consolidated basis. The financial information attributed to these entities are the estimates of management.

Contract Revenues. Revenues increased $56.7 million, or 26.6%, to $269.9 million for the year ended September 30, 2004, from $213.2 million for the year ended September 30, 2003. The $56.7 million increase is attributable to the following:

For the year ended September 30, 2004, our performance of additional work under Company contracts that were in existence during the prior year includes 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. that accounted for approximately $4.2 million of increased revenue, while our continued support to the Department of Defense Joint Spectrum Center (JSC) accounted for approximately $4.1 million of increased revenue. The Modeling and Simulation Information Analysis Center (MSIAC) contract to the Department of Defense accounted for approximately $3.5 million of the revenue increase.

As a component of revenue, material and subcontract (M&S) revenue increased approximately $26.9 million, or 62.1%, to $70.3 million for the year ended September 30, 2004 from $43.4 million for the year ended September 30, 2003. As a percentage of revenue, M&S revenue was 26.0% for the fiscal year ended September 30, 2004 as compared to 20.4% for the year ended September 30, 2003. The increase in M&S revenue content can be attributed to two factors: 1) the M&S revenue of the acquired operations was approximately $11.5 million, or 40.5% of total acquired revenue, and 2) the M&S revenue content performed under existing contracts increased to approximately 24.4% of revenue. The revenue activity of the acquired operations has an increased percentage level of M&S revenue that results from the amount of subcontractor support which is provided to the commercial utility customers of the ITSC operation and the increased level of subcontract activity required under our support contracts to the U.S. Navy performed by the IPS operation.

Direct Contract Expenses. Direct contract expenses increased $41.2 million, or 26.5%, to $196.4 million for the year ended September 30, 2004 from $155.2 million for the year ended September 30, 2003. As a percentage of revenue, direct contract expenses were 72.8% for the years ended September 30, 2004 and 2003. The changes in specific components of direct contract expenses are:


	•	Direct labor costs for the year ended September 30, 2004 increased by $14.5 million, or 13.8%, to $120.0 million from $105.5 million for the year ended September 30, 2003. As a percentage of revenue, direct labor cost was 44.5% for the year ended September 30, 2004 as compared to 49.5% for the year ended September 30, 2003. The percentage decrease in direct labor cost is directly associated with the relative percentage increase in M&S cost associated with the M&S revenue of the acquired operations, as described above.

	•	M&S cost increased approximately $26.2 million, or 62.1%, to $68.3 million for the year ended September 30, 2004, compared to $42.1 million for the year ended September 30, 2003. As a percentage of revenue, M&S cost was 25.3% for the year ended September 30, 2004 as compared to 19.8% for the year ended September 30, 2003. The percentage increase in M&S cost is directly associated with the relative percentage increase in M&S cost of the contracts performed by acquired operations, as described above. As a percentage of M&S revenue, M&S cost was approximately 97.1% during the years ended September 30, 2004 and 2003.

Gross Profit. Gross profit increased $15.6 million, or 26.9%, to $73.6 million for the year ended September 30, 2004, from $58.0 million for the year ended September 30, 2003. The $15.6 million increase is attributable to the following:

As a percentage of revenue, gross profit was 27.2% for years ended September 30, 2004 and 2003. For the year ended September 30, 2004, we experienced an increased proportion of M&S contract revenue, which typically generates lower profit margins; however, we were able to sustain our overall gross profit margin due to the increase in the proportionate amount of time-and-material and fixed price contract work, which typically generate higher profit margins.

Operating Expenses. Operating expenses increased $8.9 million, or 13.7%, to $73.7 million for the year ended September 30, 2004, from $64.8 million for the year ended September 30, 2003. However, for the year ended September 30, 2003, there was approximately $6.7 million in non-recurring, transaction-related expense associated with Alion’s purchase of the Selected Operations of IITRI. There were no such costs incurred for the year ended September 30, 2004. As such, the adjusted increase in operating expense was approximately $15.6 million ($8.9 million plus $6.7 million). The $15.6 million adjusted increase is attributable to the following:

As a percentage of revenue, operating expense was 27.3% for the year ended September 30, 2004 as compared to 30.4% for the year ended September 30, 2003. For the year ended September 30, 2004, the percentage decrease in operating expense is directly attributable to the absence of Transaction-related expenses.


	•	Operating expenses, net of depreciation, amortization, and non-recurring Transaction-related expense increased approximately $14.5 million, or 31.7%, to $60.2 million for the year ended September 30, 2004, from $45.7 million for the year ended September 30, 2003. As a percentage of revenue, operating expense net of depreciation, amortization, and non-recurring Transaction-related expense was 22.3% for the year ended September 30, 2004 as compared to 21.4% for the year ended September 30, 2003. Approximately 0.5 percentage points of the 0.9 percentage point increase is attributable to the increase in stock-based compensation, as described below.

	•	Overhead expenses for indirect personnel and facilities costs related to rental and occupancy expenses increased approximately $8.3 million, or 40.8%, to $28.6 million for the year ended September 30, 2004, from $20.3 million for the year ended September 30, 2003. As a percentage of revenue, operating expense relating to indirect personnel and facilities expense was 10.6% for the year ended September 30, 2004 as compared to 9.5% for the year ended September 30, 2003. The increase, as a percentage of revenue, is partially attributable to the increase in indirect labor costs associated with the integration activities of the ITSC and IPS acquisitions.

	•	General and administrative (G&A) expense increased approximately $3.6 million, or 14.1%, to $28.1 million for the year ended September 30, 2004, compared to $24.7 million for the year ended September 30, 2003. As a percentage of revenues, general and administrative expenses were 10.4% for the year ended September 30, 2004, compared to 11.6% for the year ended September 30, 2003. As a result of integrating the activities of ITSC and IPS, the costs associated with providing G&A activities


		for the acquired operations have been partially absorbed by the existing G&A infrastructure, resulting in a decrease in expense expressed as a percentage of revenue.

	•	Stock-based compensation and deferred compensation relate primarily to the expense associated with the SAR and phantom stock plans. Stock-based compensation increased approximately $1.6 million, or 178% to $2.5 million for year ended September 30, 2004, from approximately $0.9 million for the year ended September 30, 2003. As a percentage of revenue, operating expense relating to stock-based compensation and deferred compensation expense was 0.9% for the year ended September 30, 2004 as compared to 0.4% for the year ended September 30, 2003. The increase in stock based compensation and deferred compensation is a result of the increase in the value of Alion’s common stock and the increase in awards granted.

	•	Non-recurring Transaction-related expenses (e.g., third party legal, accounting, and finance) was not incurred during the year ended September 30, 2004. For the year ended September 30, 2003, Transaction-related expenses were approximately $6.7 million.

	•	Depreciation and amortization expense increased approximately $1.0 million, or 8.1%, to $13.4 million for the year ended September 30, 2004, as compared to $12.4 million for the year ended September 30, 2003.


		For each year ended September 30, 2004 and 2003, approximately $10.2 million of amortization expense was incurred associated with the intangible asset value assigned to purchased customer contracts of IITRI. For the year ended September 30, 2004, approximately $0.3 million of amortization expense was incurred associated with intangible asset value assigned to the purchased contracts of ITSC and IPS. Also, for each respective year ended September 30, 2004 and 2003, approximately $0.5 million of depreciation expense was incurred associated with the fair value assigned to the purchased fixed assets of IITRI. As a percentage of revenue, operating expense relating to depreciation and amortization expense was 5.0% for the year ended September 30, 2004 as compared to 5.8% for the year ended September 30, 2003.


	•	Bad debt expense increased $1.0 million to $0.6 million for the year ended September 30, 2004 as compared to a recovery of $0.4 million for the year ended September 30, 2003. During the year ended September 30, 2003, approximately $0.5 million of cash was received due to the favorable resolution of a contractual dispute. As a percentage of revenue, bad debt expense was 0.2% for the year ended September 30, 2004 as compared to a recovery of 0.2% for the year ended September 30, 2003.

Income (Loss) from Operations. For the year ended September 30, 2004, the loss from operations was $0.1 million compared with $6.8 million operating loss for the year ended September 30, 2003. The $6.7 million decrease is associated with factors discussed above and is attributable to the following:

Other Income and Expense. As a category, other income and expense increased approximately $1.2 million, or 8.6%, to $15.1 million for the year ended September 30, 2004 as compared to $13.9 million for the year ended September 30, 2003. As a component of other income and expense, interest expense increased approximately $3.0 million, or 21.6%, to $16.8 million for the year ended September 30, 2004 from


(a)	Reflects change in value assigned to the detachable warrants associated with the change in the value of Alion common stock. The warrants are associated with the Mezzanine and Subordinated notes.

In September 2004, we recognized a gain of approximately $2.1 million on the sale of our minority interest in Matrics, Inc.

Income Tax (Expense) Benefit. Although HFA became a qualified subchapter S subsidiary as of December 20, 2002 and is no longer treated as a separate entity for federal income tax purposes, some states do not recognize this tax election. In addition, some states do not recognize Alion’s S corporation status. As a result, the Company recorded approximately $0.02 million of state income tax expense for the year ended September 30, 2004.

Net Loss. The net loss decreased approximately $5.7 million, or 27.4%, to $15.1 million for the year ended September 30, 2004 as compared to $20.8 million for the year ended September 30, 2003. The $5.7 million decrease is associated with factors discussed above and is attributable to the following:

Contract Revenue. Contract revenue increased $11.5 million, or approximately 5.7%, to $213.2 million for the year ended September 30, 2003 from $201.7 million for the year ended September 30, 2002. The $11.4 million increase is attributable primarily to additional work performed under contracts that were in existence during the prior year. As a percentage of revenue, material and subcontract cost-based revenue represents an increase of approximately $2.3 million for the year ended September 30, 2003 compared to the year ended September 30, 2002. In both years, material and subcontract cost-based revenue represented approximately 19.8% of total revenue.

The following activities generated large revenue increases during the year ended September 30, 2003:

The following activities resulted in large revenue decreases during the year ended September 30, 2003:

During the year ended September 30, 2003, increases in revenue were partially offset by $0.6 million in revenue reductions related to certain amounts booked on a fixed-price contract and on a cost-reimbursement contract, which were not recoverable under these contracts.

Direct Contract Expenses. Direct contract expenses increased approximately $7.8 million, or 5.3%, to $155.2 million for the year ended September 30, 2003, from $147.4 million for the year ended September 30, 2002. Direct contract expenses as a percentage of revenue decreased to 72.8% for the year ended September 30, 2003, from 73.1% for the year ended September 30, 2002. Direct labor costs for the year ended September 30, 2003, increased by approximately 9.5% or $9.2 million when compared to the year ended September 30, 2002, to support the revenue increases discussed above. Other direct costs increased by approximately 2.0% or $0.2 million when compared to the year ended September 30, 2002. Material and subcontract costs decreased approximately $1.6 million, or 3.8%, to $42.4 million for the year ended September 30, 2003, compared to $44.0 million for the year ended September 30, 2002. Material and subcontract costs vary with schedule requirements of the contract.

Gross Profit. Gross profit increased approximately $3.6 million, or 6.6%, to $58.0 million for the year ended September 30, 2003, from $54.4 million for the year ended September 30, 2002. Gross profit margin as a percentage of revenue increased to 27.2% for the year ended September 30, 2003, compared to 26.9% for the year ended September 30, 2002. The increase in gross margin is primarily related to improved performance on our firm-fixed price contracts.

Operating Expenses. Operating expenses increased approximately $6.1 million, or approximately 10.5%, to $64.0 million for the year ended September 30, 2003 from approximately $57.9 million for the year ended September 30, 2002. Operating expenses, net of depreciation and amortization expense, and non-recurring Transaction-related expenses (described below), increased approximately $5.5 million, or approximately 14.0%, to $44.9 million for the year ended September 30, 2003, from approximately $39.4 million for the year ended September 30, 2002. Of this $5.5 million increase, expenses for indirect personnel and occupancy costs increased approximately $0.9 million, or approximately 2.0%, to $20.3 million for the year ended September 30, 2003, from $19.4 million for the year ended September 30, 2002, primarily for infrastructure to support contract requirements. Bad debt expense decreased approximately $0.4 million for the year ended September 30, 2003, compared to the year end September 30, 2002. This decrease was related to a $0.4 million release of reserves associated with the Company’s performance on a subcontract to a prime contractor which were no longer required. General and administrative expense increased approximately $5.0 million, or 26.0%, to $24.2 million for the year ended September 30, 2003, compared to $19.2 million for the year ended September 30, 2002. As a percentage of revenue, general and administrative expense was 11.3% and 9.5% for the years ended September 30, 2003 and September 30, 2002, respectively. Of the $5.0 million increase in

Non-recurring Transaction-Related Expense. Non-recurring Transaction-related expense (e.g., third party legal, accounting, and finance) was approximately $6.7 million for the year ended September 30, 2003. For the year ended September 30, 2002, Transaction-related expenses were approximately $6.4 million. The increase in expense is associated with activities related to the closing of the Transaction on December 20, 2002 which was the last day of the first quarter of fiscal year 2003. Of the approximate $6.7 million in related expense for the year ended September 30, 2003, approximately $6.4 million was incurred in the first quarter.

Depreciation and Amortization. Depreciation and amortization expense was approximately $12.4 million for the year ended September 30, 2003 and $12.2 million for the year ended September 30, 2002. In each year, approximately $10.2 million of amortization expense related to customer contracts purchased from IITRI and approximately $0.4 million of depreciation expense was associated with the fair value of tangible assets acquired in the Transaction.

Loss from Operations. For the year ended September 30, 2003, the Company sustained a loss from operations of approximately $6.1 million compared with approximately a $3.6 million operating loss for the year ended September 30, 2002. The $6.1 million operating loss for the year ended September 30, 2003 included approximately $6.7 million of non-recurring Transaction-related expenses and approximately $1.6 million in non-recurring expenses associated with the conversion and roll-out of Alion (see above, “Operating Expenses”). For the year ended September 30, 2002, the operating loss of $3.6 million included approximately $6.4 million in non-recurring Transaction-related expenses. The operating losses for the respective years also included non-cash depreciation and amortization expenses of approximately $10.5 million per year which resulted from the Transaction.

Other Expense. Other expenses were approximately $14.7 million for the year ended September 30, 2003 and approximately $9.7 million for the year ended September 30, 2002. In each respective year, there was approximately $13.9 and $9.6 million of interest expense related to the debt financing associated with the purchase of assets from IITRI.

Income Tax Expense. Our wholly-owned subsidiary, Human Factors Applications, Inc. (HFA), had operating income of approximately $1.3 million for the year ended September 30, 2003, compared to $1.6 million for the year ended September 30, 2002. HFA recorded income tax provisions of approximately $0.03 and $0.6 million, for the years ended September 30, 2003 and September 30, 2002, respectively. We filed an election with the IRS to treat HFA as a qualified Subchapter S subsidiary exempt from federal income tax at the operating level, which became effective December 21, 2002.

Net Loss. The net loss of approximately $20.8 million for the year ended September 30, 2003, which compared to the net loss of $13.8 million for the year ended September 30, 2002, is due to the factors discussed above.

The Company’s primary liquidity requirements are for debt service, working capital, capital expenditures, and acquisitions. The principal working capital need is to fund accounts receivable, which increases with the growth of the business. We are funding our present operations, and we intend to fund future operations, primarily through cash provided by operating activities and through use of our revolving credit facility.

Net cash provided by operating activities of Alion was approximately $5.7 million for the year ended September 30, 2004, as compared to cash provided by operations of approximately $14.3 million for the year ended September 30, 2003. Of the $8.6 million difference, $2.5 million arises from decreased net income. Approximately $18.7 million in reduced cash flow was attributable to increases in accounts receivable offset by $8.1 million in related increases in accounts payable. Depreciation and non-cash debt-related expenses contributed approximately $3.9 million and approximately $3.1 million, respectively, to an increase in cash flow, while other assets and liabilities consumed approximately $2.5 million.

Net cash used in investing activities was approximately $23.6 million for the year ended September 30, 2004. The most significant component of the Company’s investing activities is the strategic acquisitions of, or investments in, other companies. During the year ended September 30, 2004, the Company used approximately $21.7 million to make acquisitions and pay earnout obligations. Alion paid approximately $4.0 million for the ITSC acquisition, approximately $10.6 million ($8.0 million in cash at closing plus approximately $2.6 million in subsequent payments for intercompany payables) for the IPS acquisition and $7.1 million in earn out obligations due for the AB Tech acquisition. We spent approximately $3.7 million for capital expenditures and approximately $1.0 million to make a minority investment in Matrics Incorporated. We sold our Matrics investment for $3.1 million in September 2004. During the year ended September 30, 2003, Alion paid approximately $59.9 million in cash as part of the purchase price for substantially all of the assets of IITRI and used approximately $1.3 million for capital expenditures.

Net cash provided by financing activities was approximately $22.2 million for the year ended September 30, 2004, compared to net cash provided by financing activities of approximately $47.7 million for the year ended September 30, 2003. The most significant components of the Company’s financing activities are: 1) net proceeds from (or repayment of) short term borrowings and 2) net proceeds from (or repayment of) long term debt securities. During the year ended September 30, 2004, Alion borrowed $50.0 million in proceeds under the Term B Senior Credit Facility to repay the senior term note payable and revolving line credit facility with LaSalle Bank of approximately $29.3 million and $24.0 million, respectively. During the year ended September 30, 2003, the financing was required to complete the purchase of substantially all of the assets of IITRI. Alion generated $25.8 million in cash from the initial sale of the Company’s common stock to the ESOP Trust and another approximately $0.8 million from a subsequent sale of common stock to the ESOP Trust. Alion also obtained $33.3 million from borrowings under the LaSalle Bank senior term note. During the year ended September 30, 2003, Alion repaid approximately $5.7 million of principal on the senior term loan and approximately $6.2 million of principal on LaSalle Bank’s revolving credit facility. In the year ended September 30, 2004, the Company raised approximately $7.0 million from sales of common stock to the ESOP Trust.

To fund the Transaction, the Company entered into various debt agreements (e.g., Senior Credit Agreement, Mezzanine Note, and Subordinated Note) on December 20, 2002. On August 2, 2004, the Company entered into a new Term B Senior Credit Facility, that resulted in the extinguishment of the LaSalle Bank senior term note, the LaSalle Bank revolving credit facility and the Mezzanine Note. The discussion below describes the new Term B Senior Credit Facility followed by a description of the remaining debt agreements which were used to fund the Transaction.

Term B Senior Credit Facility. On August 2, 2004, we entered into a new Term B senior credit facility for an amount up to $180.0 million with a syndicate of financial institutions for which Credit Suisse First Boston (CSFB) serves as arranger, administrative agent and collateral agent. LaSalle Bank serves as syndication agent under the Term B senior credit facility. The new Term B senior credit facility consists of a committed $100.0 million term loan, a committed $30.0 million revolving credit facility and provides for an additional $50.0 million (uncommitted) incremental term loan in which funding is available subject to lender syndication approval. The term of the facility is five years. During the first four years of the term, principal under the senior term loan is payable quarterly in an amount equal to 0.25 percent of the principal amount then outstanding. During the fifth and final year of the term, we are obligated to pay quarterly installments of principal in an amount equal to 24 percent of the principal amount then outstanding. All principal obligations under the senior revolving credit facility are to be repaid in full no later than August 2, 2009.

At our option, the Term B senior term loan and the senior revolving credit facility each may bear interest at either of two floating rates. We may elect that interest be payable on our $100.0 million senior term loan at an annual rate equal to the prime rate charged by CSFB plus a maximum spread of 225 basis points or at an annual rate equal to the Eurodollar rate plus a maximum spread of 275 basis points. If we elect a prime rate borrowing under our senior revolving credit facility, interest would be payable at an annual rate equal to the prime rate charged by CSFB plus the additional basis points reflected in the table below under the column “ABR Spread” corresponding to our leverage ratio at the time. If we elect a Eurodollar borrowing under our senior revolving credit facility, interest would be payable at an annual rate equal to the Eurodollar rate plus the additional basis points reflected in the table below under the column “Eurodollar Spread” corresponding to our leverage ratio at the time.

If we borrow under the incremental term loan facility and certain economic terms of the incremental term loan, including applicable yields, maturity dates and average life to maturity, are more favorable to the incremental term loan lenders than the comparable economic terms under the senior term loan or the senior revolving credit facility, then the Term B senior credit facility provides that the applicable interest rate spread will be adjusted upward. The upward adjustment will take place if the yield payable under the incremental term loan exceeds the yield under the senior term loan or senior revolving credit facility by more than 50 basis points. The effect of this provision is that if we borrow an incremental term loan, that borrowing may make our borrowings under the senior term loan and the senior revolving credit facility more expensive.

The Term B senior credit facility requires us to enter into an interest rate hedge agreement acceptable to CSFB which fixes or caps the actual interest we will pay on no less than 40 percent of our long-term indebtedness. On August 2, 2004, we elected to have the senior term loan bear interest at the Eurodollar rate, which was approximately 1.6 percent as of August 2, 2004, plus the applicable margin, which totaled approximately 4.35 percent (i.e., LIBOR 1.6 percent plus 2.75 percent Eurodollar spread). On August 16, 2004, we entered into an interest rate cap agreement effective September 30, 2004 with one of our senior lenders. Under this agreement, in exchange for our payment to the senior lender of approximately $319,000, our maximum effective rate of interest payable with regard to a portion of the outstanding principal balance of the Term B senior credit facility is not to exceed 6.64 percent (i.e., LIBOR 3.39 percent cap plus maximum

2.75 percent Eurodollar spread) for the period September 30, 2004 through September 29, 2005 and is not to exceed 7.41 percent (i.e., LIBOR 4.66 percent plus 2.75 percent maximum Eurodollar spread) for the period September 30, 2005 through September 29, 2007. The maximum principal balance, by quarter, to which this interest rate cap agreement applies, is as follows:

Each quarter, the senior lender counter party to this interest rate cap agreement is required to calculate and reimburse us for all interest payments under the Term B senior credit facility in excess of the applicable cap. This cap agreement expires September 30, 2007.

Under the terms of the senior credit facility, we are subject to certain financial covenants with respect to our maximum leverage ratio and our interest coverage ratio. The Term B senior credit facility is secured by a first priority, perfected security interest in all of our current and future tangible and intangible property.

On August 2, 2004, the Company borrowed $50.0 million under the new Term B senior secured loan to retire its outstanding Senior Term Note and revolving credit facility under the Senior Credit Agreement with LaSalle Bank. The Company paid approximately $47.2 million in principal (approximately $23.2 million to redeem the Senior Term Note and approximately $24.0 million to pay the revolving credit facility) and accrued and unpaid interest and approximately $3.3 million in transaction fees associated with the refinancing.

On October 1, 2004, the Company drew down approximately $22.0 million on the Term B senior term loan to retire its existing Mezzanine Note in the approximate principal amount of $19.6 million, plus approximately $1.8 million prepayment premium, and $0.6 million for accrued and unpaid interest.

The Company is permitted to use any future proceeds it might receive from the currently uncommitted Incremental Term Loan Facility to finance permitted acquisitions and to make certain put right payments required under the Company’s Mezzanine Warrant, if the put rights are exercised, and for any other purpose permitted by incremental term loans, as defined in the Senior Credit Facility, if and when they are funded.

Mezzanine Note. 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. Prepayment penalties apply for early redemption. Each quarter, the Company must pay interest on the Mezzanine Note, in cash, at a rate of 12% per year, based on a 360-day year of twelve 30-day months. As of July 1, 2004, IITRI transferred all of its rights, title and interest in the Mezzanine Note to the Illinois Institute of Technology. On October 1, 2004, Alion redeemed the Mezzanine Note with proceeds from the Term B Senior Credit Facility which included a prepayment penalty of approximately $1.8 million.

Subordinated Note. 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. As of July 1, 2004, IITRI transferred all of its rights, title and interest in the Subordinated Note to the Illinois Institute of Technology.

Warrants. 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 505,000 shares of Alion common stock 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. Although the Mezzanine Note was redeemed on October 1, 2004, the detachable warrants remain outstanding.

The warrants associated with the Subordinated Note represent the right to buy approximately 1,080,000 shares of Alion common stock 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).

As of July 1, 2004, IITRI transferred all of its rights, title and interest in the warrants to the Illinois Institute of Technology.

Other Notes and Agreements. 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 and issued Dr. Atefi detachable warrants representing the right to buy approximately 22,062 shares of Alion common stock at an exercise price of $10.00 per share, with put rights similar to those contained in the warrants accompanying the Mezzanine Note. On October 29, 2004, Dr. Atefi elected to redeem the amount due under his Deferred Compensation Agreement., Dr. Atefi was paid approximately $0.9 million, plus approximately $0.2 million in accrued interest. The warrants remain outstanding.

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 portion of the Mezzanine Note and warrants from the officer for an aggregate purchase price of $1,034,020.

On February 11, 2004, the Company borrowed $750,000 from an officer of the Company. In exchange, on June 7, 2004, the Company issued the officer a Promissory Note with interest at a rate of 15% per annum until

March 31, 2009. The annual interest period was effective beginning February 11, 2004. The Agreement essentially replaces a Note, which is described above, for the same sum previously issued to another officer of the Company, the termination of whose employment relationship resulted in repurchase of the Note. On December 9, 2004, the Promissory Note was extinguished. An amount of $750,000 plus accrued interest of $21,635 was paid to the officer.

During fiscal year 2005 and the next five fiscal years, at a minimum, we expect that we will have to make the estimated interest and principal payments set forth below.


(1)	We anticipate a continuing requirement to have in place a $30.0 million bank revolving credit facility to finance our ongoing working capital needs. In 2005, we anticipate the average balance drawn on the revolving credit facility to be approximately $5.0 million, bearing an effective interest rate of approximately 7.9%. For fiscal years 2006, 2007, 2008, and 2009, the average balance is estimated to be approximately $5.5 million, $6.0 million, $6.6 million and $7.2 million, respectively. For years 2005, 2006, 2007, 2008, and 2009, the projected effective CSFB prime rate interest rate is estimated to be approximately 7.9%, 8.8%, 9.4%, 9.9%, and 10.2%, respectively. The effective interest rate takes into account that we have entered into an interest rate cap agreement which caps the interest rate we will pay on a portion, but not all, of the outstanding principal balance of the Term B Senior Credit Facility. The current cap agreement expires in August 2007. Outstanding principal balances that are not under a cap agreement have been applied interest expense based on the alternative CSFB prime rate. The term of the revolving credit facility is five years.

(2)	Estimated balance drawn and repayment of the revolving credit facility at termination of the revolving credit facility.

(3)	The projected balance which we estimate will be drawn under the Term B senior term loan is as follows: $100.0 million, $99.0 million, $98.0 million, $97.0 million, and $96.0 million for fiscal years 2005, 2006, 2007, 2008, and 2009, respectively. The effective annual interest rate for fiscal years 2005, 2006, 2007, 2008, and 2009 is estimated to be approximately 7.0%, 7.7%, 8.4%, 9.9%, and 10.7%, respectively. The effective interest rate takes into account that we have entered into an interest rate cap agreement which

caps the interest rate we will pay on a portion, but not all, of the outstanding principal balance of the Term B Senior Credit Facility. The current cap agreement expires in August 2007. Outstanding principal balances that are not under a cap agreement have been applied interest expense based on the alternative CSFB prime rate. The term of the Term B senior term loan is five years. The approximate impact of a 1% increase in the interest rate, as applied to principal balances drawn under the Term B senior term loan that are not covered by the current interest rate cap agreement would be $0.5 million, $0.5 million, $0.5 million, $1.0 million, and $1.0 million for fiscal years September 30, 2005, 2006, 2007, 2008, and 2009, respectively.


(4)	The Term B senior credit facility requires us to repay 1 percent of the principal balance outstanding under the senior term loan during the first four years (i.e., fiscal years 2005 through 2008) of the Term B Senior Credit Facility’s term and 96 percent of the principal balance outstanding during the fifth and final year of the term. The table assumes that we will have drawn $100.0 million by the end of fiscal year 2005, resulting in expected annual principal payments of approximately $1.0 million in each of fiscal years 2005, 2006, 2007, and 2008. During the fifth year, or 2009, we expect to pay principal in the amount of $96.0 million. The Term B Senior Credit Facility also requires us to make mandatory prepayments of principal depending upon whether we generate certain excess cash flow in a given fiscal year, we issue certain equity, we issue or incur certain debt or we sell certain assets. As of September 30, 2004, no mandatory prepayments are due.

(5)	The $2.0 million payment of interest in 2005 includes approximately $1.8 million of accrued interest expense and prepayment penalties under the Mezzanine Note, and $0.2 million in interest under Dr. Atefi’s Deferred Compensation Agreement. The principal paid amount in 2005 represents the redemption of the Mezzanine Note that occurred on October 1, 2004 and the payment of the principal amount previously deferred by Dr. Atefi under his deferred compensation agreement that occurred on October 29, 2004.

(6)	Principal amount of the Promissory Note is $0.75 million and carries an annual interest rate of 15%. The Note matures in 2009. On December 9, 2004, the Promissory Note with officer was extinguished. An amount of $750,000 plus accrued interest of $21,635 was paid to the officer.

(7)	Interest expense on the subordinated note during the four fiscal years from 2005 to 2008 is 6% simple interest, paid-in-kind by the issuance of the PIK notes. These interest amounts accrue to principal during this period, thereby having the effect of increasing the principal value of the subordinated note; but because the PIK notes do not themselves bear interest, the interest obligations paid by issuance of the PIK notes will not be compounded. In other words, no interest will be paid on interest accrued under the subordinated note. In the years 2005 through 2008, the PIK interest on the Subordinated Note will be approximately $2.4 million in each fiscal year. During the eight-year term of the Subordinated Note, approximately $14.2 million of principal accretes to the note through the PIK. These amounts are included in the principal payments in fiscal years 2009 and 2010. In years 2009 and 2010, interest will be 16% paid quarterly in cash. The principal, together with the outstanding balance of the PIK notes, will be paid in equal amounts at the end of fiscal years 2009 and 2010.

Other Obligations. The Company has a maximum earn out payment obligation of $11.5 million to the former shareholders of AB Technologies arising from IITRI’s acquisition of their company. The earn out 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. The former AB Technologies shareholders filed a lawsuit against the Company for breach of the AB Technologies asset purchase agreement claiming at least $8.2 million in damages. 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 that awarded the former AB Technologies shareholders a purchase price adjustment of approximately $0.7 million and further definitized the method for calculating the earn out. For the fiscal year ended September 30, 2004, the Company recognized approximately $8.4 million, excluding interest, in purchase price adjustments and earn out obligations due the former AB Technologies shareholders. To date, a total of approximately $10.3 million in earn out obligation has been recorded.

The Company’s remaining minimum lease payment obligations under non-cancelable operating leases for the fiscal years ending 2005, 2006, 2007, 2008 and 2009 are $10.9 million, $10.4 million, $10.4 million, $10.3 million and $9.9 million, respectively. The remaining aggregate obligations on these leases thereafter are approximately $11.2 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 obligations which will impact the Company’s cash flow relate to:


	•	Repurchase obligations under the KSOP;

	•	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 our stock appreciation rights and phantom stock programs; and

	•	Obligations relating to deferred compensation programs for senior managers.

Through September 30, 2004, the Company has spent the following amounts to repurchase shares of its common stock from the ESOP Trust to satisfy obligations under the KSOP to terminated employees. All repurchased shares were contributed back to the ESOP Trust.

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 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 under the new Term B Senior Credit Facility and the remaining outstanding indebtedness it incurred to fund the Transaction.

The Company’s business plan calls for it to continue to acquire companies with complementary technologies. The Term B senior credit facility permits the Company to make certain permitted acquisitions, and the Company intends to use a portion of the financing available to it under the Term B Senior Credit Facility to make permitted acquisitions.

Given the structure of the Term B senior credit facility, the Company expects that it will need to refinance the Term B Senior Credit Facility before the end of fiscal year 2008. 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 additional or larger investments in or acquisitions of other companies than are currently planned, 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 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. The Company generally recognizes revenue when a contract has been executed, the contract price is fixed or determinable, delivery of the services or products has occurred and collectibility of the contract price is considered probable.

Revenue on cost-reimbursement contracts is recognized as costs are incurred and include a proportionate share of the 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 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.

The purchase price that we pay to acquire the stock or assets of an entity must be assigned to the net assets acquired based on the estimated fair value of those net assets. The purchase price in excess of the estimated fair value of the tangible net assets and separately identified intangible assets acquired represents goodwill. The purchase price allocation related to acquisitions involves significant estimates and management judgments that may be adjusted during the purchase price allocation period.

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.

As of September 30, 2004, the Company has goodwill of approximately $83.1 million, which will be subject to the aforementioned annual impairment review. In addition, as of September 30, 2004, the Company has a recorded net intangible asset balance of approximately $13.6 million, comprised primarily of purchased contracts which were acquired in connection with the Transaction and the ITSC and IPS acquisitions. The

The following table summarizes our contractual and other forecasted long-term debt obligations. For contractual obligations, we included payments that we have a legal obligation to make.

The Company has no off-balance sheet financing arrangements. In addition, the Company does not have any relationship with unconsolidated entities or any special purpose entities and has not issued any guarantees.

The Company’s exposure to interest rate risk is primarily due to the debt it incurred to finance the Transaction and the subsequent refinancing of a portion of that debt in August 2004. The Mezzanine Note, Subordinated Note, and the agreements with officers 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 $30.0 million senior revolving credit facility and the balance on the Term B senior term loan, 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 on the first $37.5 million of principal borrowed under the Term B senior credit facility. Under this agreement, in exchange for our payment to the senior lender of approximately $319,000, our maximum effective rate of interest payable with regard to a portion of the outstanding principal balance of the Term B Senior Credit Facility is not to exceed 6.64 percent (i.e., LIBOR 3.39 percent cap plus maximum 2.75 percent Eurodollar spread) for the period September 30, 2004 through September 29, 2005 and is not to exceed 7.41 percent (i.e., LIBOR 4.66 percent plus 2.75 percent maximum Eurodollar spread) for the period September 30, 2005 through September 29, 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 approximate impact of a 1% increase in the interest rate, as applied to principal balances drawn under the Term B Senior Credit Facility that are not covered by the current interest rate cap agreement, would be $0.5 million, $0.5 million, $0.5 million, $1.0 million, and $1.0 million for fiscal years ending September 30, 2005, 2006, 2007, 2008, and 2009, respectively.

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 obligations relate to:


	•	Repurchase obligations under the KSOP;

	•	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.

We have audited the consolidated financial statements of Alion Science and Technology Corporation and subsidiaries (the Company) as listed in the accompanying index. In connection with our audits of the consolidated financial statements, we also have audited the consolidated financial statement schedule as listed in the accompanying index. These consolidated financial statements and consolidated financial statement schedule are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements and consolidated financial statement schedule based on our audits.

We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Alion Science and Technology Corporation and subsidiaries as of September 30, 2004 and 2003, and the results of their operations and their cash flows for the years ended September 30, 2004 and 2003 and for the period from October 10, 2001 (inception) through September 30, 2002, in conformity with U.S. generally accepted accounting principles. Also in our opinion, the related consolidated financial statement schedule, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly, in all material respects, the information set forth therein.


(1)	Stock based compensation is a separately reported component of general and administrative expense.

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, and nuclear safety and analysis. 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 at the closing date (on a fully diluted basis). The seller notes bear interest at an effective interest rate of 6.71% per annum. See notes 8 and 9;

	•	$20,343 in mezzanine notes to IITRI, with detachable warrants representing 12% of the outstanding common stock of Alion at the closing date (on a fully diluted basis). The mezzanine notes bear interest at 12% per annum. See notes 8 and 9;

	•	$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 is 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 consolidated financial statements are prepared on the accrual basis of accounting and include the accounts of Alion and its wholly-owned subsidiaries: Human Factors Application, Inc. (HFA), acquired at the time of the Transaction, and Innovative Technology Solutions Corporation (ITSC) and Identix Public Sector (IPS), which were acquired during the year ended September 30, 2004. All significant intercompany accounts have been eliminated in consolidation.

The Company’s fiscal year ends on September 30. Beginning with the fiscal year ended September 30, 2004, the Company began operating based on a three-month quarter, four-quarter fiscal year. For the fiscal year ended September 30, 2003, the Company operated on a thirteen-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. Accordingly, any comparisons or references made between or with respect to interim or quarterly periods, will need to consider the differing lengths of time.

The preparation of financial statements in conformity with U.S. generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosures of contingent assets and liabilities at the date of financial statements and the reported amounts of operating results during the reported period. Actual results are likely to differ from those estimates, but the Company’s management does not believe such differences will materially affect the Company’s financial position, results of operations, or cash flows.

Where appropriate, certain items relating to prior years have been reclassified to conform to the current year presentation.

Revenue on cost-reimbursement contracts is recognized as costs are incurred and include a proportionate share of the fees earned.

The Company is an S corporation under the provisions of the Internal Revenue Code. For federal and certain state income tax purposes, the Company is not subject to tax on its income. Such income is allocated to the Company’s shareholder, Alion Science and Technology Corporation’s Employee Stock Ownership Savings and Investment Plan. The Company may be subject to state income taxes in those states that do not recognize S corporations. Additionally, the Company may be subject to additional types of taxes including franchise and business taxes. As of September 30, 2004, the Company’s tax basis in its assets exceeds its book basis by approximately $29.0 million.

The Company’s operating subsidiaries, HFA and ITSC, are qualified subchapter S entities that are not treated as separate corporations for federal income tax purposes.

Restricted cash represents short-term restricted cash received from a customer as an advance payment on a contract. This short-term restricted cash is utilized as work is performed in accordance with the contract.

Accounts receivable include billed accounts receivable, amounts currently billable and costs and estimated earnings in excess of billings on uncompleted contracts. Costs and estimated earnings in excess of billings on uncompleted contracts represent accumulated project expenses and fees which have not been billed or are not currently billable as of the date of the consolidated balance sheet. These amounts are stated at estimated realizable value and aggregated $14.6 million and $8.7 million at September 30, 2004 and 2003, respectively. Costs and estimated earnings in excess of billings on uncompleted contracts at September 30, 2004 include $2.0 million related to costs incurred on projects for which the Company has been requested by the customer to begin work under a new contract or extend work under an existing contract, but for which formal contracts or contract modifications have not been executed. The allowance for doubtful accounts is the Company’s best estimate of the amount of probable losses in the Company’s existing billed and unbilled accounts receivable. The Company determines the allowance using specific identification and historical write-off experience based on the age of the population.

Billings in excess of costs and estimated earnings and advance collections from customers represent amounts received from or billed to commercial customers in excess of project revenue recognized to date.

The Company has adopted Statement of Financial Accounting Standards (SFAS) No. 142, “Goodwill and Other Intangible Assets”, which requires, among other things, the discontinuance of goodwill amortization. Under SFAS 142, goodwill is to be reviewed at least annually for impairment or more frequently if events or changes in circumstances indicates the asset might be impaired; the Company has elected to perform this review annually at the end of each fiscal year. An impairment loss would be recognized if the carrying amount of goodwill exceeds its fair value. The Company completed the fiscal 2004 annual goodwill impairment analysis in the fourth quarter of fiscal 2004. Based on this analysis, the Company concluded that no goodwill impairment exists as of September 30, 2004.

Leasehold improvements, software and equipment are recorded at cost. Expenditures for maintenance and repairs are charged to current operations. Software and equipment are depreciated over their estimated useful lives (2 to 15 years for the various classes of software and equipment) generally using the straight-line method. Leasehold improvements are amortized on the straight-line method over the shorter of the assets’ estimated useful life or the life of the lease. Upon sale or retirement of an asset, costs and related accumulated depreciation are deducted from the accounts, and the gain or loss is recognized in the consolidated statements of operations.

The following methods and assumptions were used to estimate the fair value of each class of financial instruments for which it is practicable to estimate fair value. It is impracticable for the Company to estimate the fair value of its subordinated debt because the only market for this financial instrument consists of principal to principal transactions.

The carrying amount approximates fair value because of the short maturity of those instruments.

The fair values of these investments are estimated based on quoted or market prices for these or similar instruments.

The carrying amount of the Company’s senior debt approximates fair value which is estimated on current rates offered to the Company for debt of the same remaining maturities.

The fair value of the Company’s financial instruments is estimated based on current rates offered to the Company for contracts with similar terms and maturities.

The Company uses an option pricing model to estimate the fair value of its redeemable common stock warrants.

On December 19, 2001, the Company adopted the Alion Science and Technology Corporation Employee Ownership, Savings and Investment Plan (the “Plan”) and the Alion Science and Technology Corporation Employee Ownership, Savings and Investment Trust (the “Trust”). The Plan, a tax qualified retirement plan, includes an ESOP component and a non-ESOP component. In March 2003, the Company filed an application for a determination letter from the Internal Revenue Service that the Plan and Trust qualify under Sections 401(a) and 501(a) of the Internal Revenue Code of 1986, as amended. The Company believes that the Plan and Trust have been designed and are currently being operated in compliance with the applicable requirements of the IRC.

The Company sponsors a medical benefits plan providing certain medical, dental, and vision coverage to eligible employees and former employees. The Company has a self-insured funding policy with a stop-loss limit under an insurance agreement.

The Company also provides postretirement medical benefits for employees who meet certain age and service requirements. Retiring employees may become eligible for those benefits at age 55 if they have 20 years of service, or at age 60 with 10 years of service. The plan provides benefits until age 65 and requires employees to pay one-quarter of their health care premiums. A small, closed group of employees is eligible for coverage after age 65. These retirees contribute a fixed portion of the health care premium. The estimated contribution to premiums from retirees is an aggregate of $125,000.

There were no plan assets as of September 30, 2004 and 2003. The Company uses an October 1 measurement date.

Following is a reconciliation of the plan’s accumulated postretirement benefit obligation (in thousands):

The components of net periodic postretirement benefit cost for the years ended September 30, 2004 and 2003 are as follows (in thousands):

The weighted-average assumptions in the following table represent the rates used to develop the actuarial present value of the projected benefit obligation for the year listed and also the net periodic benefit costs.

The following table displays the assumed health care trends used to determine the accumulated postretirement benefit obligation:

A one-percentage-point change in assumed health care cost trend rates would have the following effect (in thousands):

In December 2003, the Medicare Prescription Drug, Improvement and Modernization Act of 2003 (the Act) was signed into law. The Act introduced a prescription drug benefit under Medicare Part D and a federal subsidy to sponsors of retirement health care plans that provide a benefit that is at least actuarially equivalent to Medicare Part D. The Company has elected to defer the recognition of the effect, if any, of the Act until such time when the authoritative guidance is issued. Any measures of the accumulated postretirement benefit obligation or net periodic postretirement benefit cost in the Company’s financial statements do not reflect the effect of the Act. The Company has a small, closed group of retirees covered for medical after age 65, thus the effect of the Act is not expected to be material.

Basic and diluted loss per share is computed by dividing net loss by the weighted average number of common shares outstanding. 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 have 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 this impact would be anti-dilutive for all periods presented.

The Company’s common stock is owned by the Alion Science and Technology Corporation Employee Ownership, Savings and Investment Trust (the Trust). The Company provides a put option to any participant or beneficiary who receives a distribution of common stock which permits the participant or beneficiary to sell such common stock to the Company during certain periods, at the estimated fair value price per share, which was at $19.94 per share as of September 30, 2004. Accordingly, all of the Company’s equity is classified as subject to redemption in the accompanying consolidated balance sheets. The estimated fair value price per share is determined based upon a valuation performed by an independent, third-party firm. The Company may allow the Trust to purchase shares of common stock tendered to the Company under the put option.

Certain participants have the right to sell their shares distributed from the participant’s account that were acquired on the closing date of the Transaction at a value per share equal to the greater of the original purchase price and the estimated fair value price per share of the common stock.

As of September 30, 2004, the Company has recorded goodwill of approximately $83.0 million, which is subject to an annual impairment review. During the fiscal year ended September 30, 2004, goodwill increased by approximately $17.5 million primarily as a result of recording additional obligations of $7.7 million related to earn out arrangements for historical acquisitions and approximately $9.6 million for the acquisitions described in Note 15. For the acquisitions described in Note 15, the Company’s allocation of purchase price is preliminary and subject to adjustment.

As of September 30, 2004, the Company has recorded intangible assets of approximately $13.7 million comprised primarily of contracts purchased from IITRI of approximately $12.4 million. For the acquisitions described in Note 15, as of September 30, 2004, the Company recorded intangible assets of approximately $1.2 million for purchased contracts. The intangible assets have an estimated useful life of one to three years and are being amortized using the straight-line method.

Amortization expense was approximately $10.6 million for the fiscal year ended September 30, 2004. Amortization expense is estimated to be approximately $10.7 million, $2.7 million and $0.2 million for the fiscal years ended September 30, 2005, 2006, and 2007, respectively.

To fund the Transaction described in Note 1, the Company entered into various debt agreements (i.e., Senior Credit Agreement, Mezzanine Note, and Subordinated Note) on December 20, 2002. On August 2, 2004, the Company entered into a new Term B Senior Credit Facility with Credit Suisse First Boston (CSFB)(Term B Senior Credit Facility), and used the proceeds to extinguish the LaSalle Bank senior term note, the LaSalle Bank revolving credit facility and, subsequent to September 30, 2004, the Mezzanine Note.

The discussion below describes the Term B Senior Credit Facility and the initial debt agreements used to finance the Transaction.

On August 2, 2004, the Company entered into the Term B Senior Credit Facility administered by CSFB consisting of a $30.0 million revolving credit facility, a Senior Secured Term B Loan for $100.0 million, and a $50.0 million uncommitted Incremental Term Loan “accordion” facility. The total principal amount that may be borrowed under the Senior Credit Facility is $180.0 million.

During the first four years of the term, principal under the Senior Secured Term B Loan is payable quarterly in an amount equal to 0.25 percent of the principal amount then outstanding. During the fifth and final year of the term, the Company is obligated to pay quarterly installments of principal in an amount equal to 24 percent of the principal amount then outstanding. All principal obligations under the senior revolving credit facility are to be repaid in full no later than August 2, 2009.

The Senior Secured Term B Loan and the revolving credit facility each may bear interest at either of two floating rates. The Company may elect that interest be payable on our $100.0 million Senior Secured Term B Loan at an annual rate equal to the prime rate charged by CSFB plus a maximum spread of 225 basis points or at an annual rate equal to the Eurodollar rate plus a maximum spread of 275 basis points. As of September 30, 2004, the applicable interest rate was 4.34%.

The Term B Senior Credit Facility requires the Company to enter into an interest rate hedge agreement acceptable to CSFB which fixes or caps the actual interest the Company will pay on no less than 40 percent of our long-term indebtedness. On August 2, 2004, the Company elected to have the Senior Secured Term B Loan bear interest at the Eurodollar rate, which was approximately 1.6 percent as of August 2, 2004, plus the applicable margin, which totaled approximately 4.35 percent (i.e., LIBOR 1.6 percent plus 2.75 percent Eurodollar spread). On August 16, 2004, the Company entered into an interest rate cap agreement effective September 30, 2004 with one of the Company’s senior lenders. Under this agreement, in exchange for the Company’s payment to the senior lender of approximately $319,000, the Company’s maximum effective rate of interest payable with regard to a portion of the outstanding principal balance of the Term B Senior Credit Facility is not to exceed 6.64 percent (i.e., LIBOR 3.39 percent cap plus maximum 2.75 percent Eurodollar spread) for the period September 30, 2004 through September 29, 2005 and is not to exceed 7.41 percent (i.e., LIBOR 4.66 percent plus 2.75 percent maximum Eurodollar spread) for the period September 30, 2005 through September 29, 2007.

The terms of borrowings under the Incremental Term Loan Facility will be established at the time the borrowings, if any, are made. If the Company borrows under the Incremental Term Loan facility and certain economic terms of the Incremental Term Loan, including applicable yields, maturity dates and average life to maturity, are more favorable to the incremental term loan lenders than the comparable economic terms under the Senior Secured Term B Loan or the revolving credit facility, then the Term B Senior Credit Facility provides that the applicable interest rate spread will be adjusted upward. The upward adjustment will take place if the yield payable under the incremental term loan exceeds the yield under the Senior Secured Term B Loan or revolving credit facility by more than 50 basis points. The effect of this provision is that if the Company borrows under the Incremental Term Loan Facility, that borrowing may increase the cost of borrowings under the Senior Secured Term B Loan and the revolving credit facility. Under the terms of the Senior Secured Term B Loan, the Company is subject to certain financial covenants with respect to the Company’s maximum leverage ratio and our interest coverage ratio.

On August 2, 2004, the Company borrowed $50.0 million under the Senior Secured Term B Loan to retire its outstanding Senior Term Note and revolving credit facility under the Senior Credit Agreement with LaSalle Bank. The Company paid approximately $47.2 million in principal (approximately $23.2 million to

redeem the senior term note and $24.0 million on the revolving credit facility) and accrued and unpaid interest and approximately $3.3 million in transaction fees associated with the refinancing.

On October 1, 2004, the Company drew down approximately $22.0 million on the Senior Secured Term B Loan to retire its existing Mezzanine Note in the approximate principal amount of $19.6 million, plus approximately $1.8 million prepayment premium, and $0.6 million for accrued and unpaid interest.

The Company is permitted to use any future proceeds it might receive from the currently uncommitted Incremental Term Loan Facility to finance permitted acquisitions and to make certain put right payments required under the Company’s Mezzanine Warrant, if the put rights are exercised, and for any other purpose permitted by Incremental Term Loans, as defined in the Term B Senior Credit Facility, if and when they are funded.

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 Agreement consists of a $35.0 million Senior Term Note and a $25.0 million revolving credit facility. All principal obligations under the Senior Credit Agreement are to be repaid in full no later than December 20, 2007. The Senior Credit Agreement is secured by a first priority, perfected security interest in all of the Company’s current and future tangible and intangible property. On December 20, 2002, the Company paid $1.7 million to obtain this 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 fiscal year ended September 30, 2004, the Company recognized approximately $1.3 million of interest expense related to accretion of this discount.

Under the Senior Credit Agreement, balances drawn on the revolving credit facility bore interest at the LaSalle Bank prime rate plus 200 basis points. As a result of the aforementioned refinancing, which occurred on August 2, 2004, the revolving credit facility and senior term loan were extinguished. As of August 2, 2004, the Company had approximately $24.0 million borrowed under the revolving credit facility at an interest rate equal to approximately 6.25% (LaSalle Bank prime rate plus 200 basis points).

Prior to the aforementioned refinancing, which occurred on August 2, 2004, the Company had approximately $47.2 million in borrowings under the Senior Credit Agreement, which bore 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 Senior 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. Interest under the Senior Term Note was payable at LaSalle’s prime rate (base rate) plus 200 basis points until February 14, 2003. Thereafter, the Senior Term Note bore interest at the Eurodollar rate plus 350 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 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 reimbursed to the Company semiannually by the senior lender pursuant to the cap agreement. This cap agreement expires February 3, 2007. As a result of the aforementioned refinancing, which occurred on August 2, 2004, the current cap agreement fair value of approximately $0.047 million was reduced to zero and $0.047 million was recognized as additional interest expense in the fourth quarter of fiscal year 2004.

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. On July 1, 2004, the Illinois Institute of Technology (IIT) acquired all of IITRI’s rights and interests in the Mezzanine Note and the related Warrant Agreement. 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 Term Note, but ranks senior to the Subordinated Note.

Under the terms of the Senior Credit Agreement 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.

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 (as described below in “Other Notes and Agreements”).

As a result of the aforementioned refinancing, which occurred on August 2, 2004, the Mezzanine Note in the approximate principal amount of $19.6 million was extinguished on October 1, 2004 as described in Note 19.

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. On July 1, 2004, the Illinois Institute of Technology (IIT) acquired all of IITRI’s rights and interests in the Subordinated Note and the related Warrant Agreement. 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 $0.9 million deferred compensation agreement with Dr. Bahman Atefi, its President, CEO and Chairman, as a condition to completing the Transaction, with payment terms substantially equivalent to those of the Mezzanine Note, and issued Dr. Atefi detachable warrants representing the right to buy approximately 22,062 shares of Alion common stock at an exercise price of $10.00 per share, with put rights similar to those contained in the warrants accompanying the Mezzanine Note.. On October 29, 2004, Dr. Atefi elected to redeem the amount due under his deferred compensation agreement with Alion. Dr. Atefi was paid approximately $0.9 million, plus $0.2 million in accrued interest. The warrants relating to the deferred compensation agreement remain outstanding.

stock at an exercise price of $10.00 per share. On November 12, 2003, the Company purchased the portion of the Mezzanine Note and warrants from the officer for an aggregate purchase price of $1,034,020.

On February 11, 2004, the Company borrowed $750,000 from an officer of the Company. In exchange, on June 7, 2004, the Company issued a promissory note in the principal amount of $750,000 to the officer. The promissory note bears interest at a rate of 15% per year, payable quarterly. The annual interest period was effective beginning February 11, 2004. The Company is required to pay the outstanding principal amount of the Promissory Note in a lump sum on March 31, 2009. On December 9, 2004, the Promissory Note was extinguished. An amount of $750,000 plus accrued interest of $21,635 was paid to the officer.

As of September 30, 2004, for the aforementioned debt agreements, the remaining fiscal year principal repayments (at face amount before debt discount) are as follows:


(1)	The Term B Senior Credit Facility requires the Company to repay 1 percent of the principal balance outstanding under the senior term loan during the first four years (i.e., fiscal years 2005 through 2008) of the Term B Senior Credit Facility’s term and 96 percent of the principal balance outstanding during the fifth and final year of the term. The Term B Senior Credit Facility also requires the Company to make mandatory prepayments of principal depending upon whether the Company generates certain excess cash flow in a given fiscal year, issue certain equity, issue or incur certain debt or sell certain assets. Due to the uncertainty of these payments, the table does not reflect any such payments. The approximate $50.0 million includes, as of September 30, 2004, approximately $3.2 million of the remaining unamortized debt discount. Approximately $3.3 million of debt issuance costs were originally recorded as debt discount.

(2)	Repayment of $19.6 million for the face value of Mezzanine Note. The approximate $19.6 million includes, as of September 30, 2004, approximately $2.1 million of the remaining unamortized debt discount, assigned to the fair value of the detachable warrants. At date of issuance, December 20, 2002, approximately $3.1 million was assigned as the fair value of the warrants 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 $19.6 million repayment is to be financed by the Senior Secured Term B Loan and is disclosed as a long-term liability on the consolidated balance sheet as of September 30, 2004.

(3)	Repayment of $39.9 million for the face value of the Subordinated Seller Note in two equal payments of $19.95 million in years 2009 and 2010. The $39.9 million includes, as of September 30, 2004, approximately $5.7 million of the remaining unamortized debt discount, assigned to fair value of the detachable warrants. At date of issuance, December 20, 2002, approximately $7.1 million was assigned as the fair value of the warrants 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.”


(4)	During the eight-year term of the Subordinated Note, approximately $14.4 million of principal accretes to the note through the PIK. These amounts are included in the principal payments in fiscal years 2009 and 2010. In fiscal years 2009 and 2010, interest will be 16% paid quarterly in cash. The principal, together with the outstanding balance of the PIK notes will be paid in equal amounts at the end of fiscal years 2009 and 2010.

(5)	Repayment of $0.86 million agreement with officer. Repayment of $0.75 million promissory with officer.

In connection with the issuance of the Mezzanine Note, Subordinated Note, and the Deferred Compensation Agreement described in Note 8, 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. As of July 1, 2004, IITRI transferred all of its rights, title and interest in the warrants to the Illinois Institute of Technology. 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 $20.8 million as of September 30, 2004. Changes in the estimated fair value of the Warrants are recorded as interest expense in the accompanying consolidated statements of operations.

Future minimum lease payments under non-cancelable operating leases for buildings, equipment and automobiles at September 30, 2004 are set out below. Under these operating leases, the Company subleased some excess capacity to subtenants under non-cancelable operating leases.

In connection with the IPS acquisition, the Company assumed two operating leases at above-market rates and recorded a loss accrual of $4.4 million based on the estimated fair value of the lease liabilities assumed which is being amortized over the lease terms. The loss accrued was $3.8 million at September 30, 2004. In connection with the IPS acquisition, the Company also acquired a related sub-lease at above-market rates. Based on the estimated fair value of the sublease, the Company recognized an asset of $0.6 million which is being amortized over the lease term. The remaining asset value was $0.5 million at September 30, 2004.

Rent expense under operating leases was $10.5 million and $8.2 million for the years ended September 30, 2004 and 2003, respectively. Sublease rental income under operating leases was $0.8 million for the year ended September 30, 2004.

Depreciation and leasehold amortization expense for fixed assets was approximately $2.8 million and $1.7 million for fiscal years ended September 30, 2004 and 2003, respectively.

Alion’s board of directors adopted a Stock Appreciation Rights (SAR) Plan in November 2002. The SAR plan has a term of ten years. Awards may be granted under the plan to directors, officers, and employees. Outstanding SAR awards cannot exceed the equivalent of 10% of the Company’s outstanding shares of common stock on a fully diluted basis. A grantee has the right to receive payment upon exercise equal to the difference between the appraised value of a share of Alion common stock as of the grant date and the appraised value of a share of Alion common stock as of the exercise date based on the most recent valuation of the shares of common stock held by the ESOP. Awards vest at 20% per year for employees. Awards to members of the Company’s board of directors, other than Dr. Atefi, vest ratably over each member’s then-current term of office. SARs may be exercised at any time after grant to the extent they have vested. As of September 30, 2004, the Company had granted 242,350 outstanding SARs which may be summarized as follows:

As of September 30, 2004, 12,600 SARs have been exercised and 8,850 SARs have been forfeited.

The Company recognized approximately $0.7 million and $0.2 million in compensation expense associated with this plan for the years ended September 30, 2004 and 2003, respectively.

In February 2003, the compensation committee of Alion’s board of directors approved the Company’s phantom stock plan which was subsequently adopted by the full board of directors. Phantom stock refers to hypothetical shares of Alion common stock. Upon vesting, recipients are entitled to receive an amount of

money equal to the product of the number of hypothetical shares vested and the then-current value of Alion common stock, based on the most recent valuation of the shares of common stock held by the ESOP.

The phantom stock plan has a term of ten years. The board of directors and the compensation committee may each grant key management employees awards of phantom stock. The phantom stock awards vest according to the following schedule:

As of September 30, 2004, the Company had 223,685 shares of phantom stock outstanding which may be summarized as follows:

The Company recognized approximately $1.5 million and $0.4 million in compensation expense associated with this plan for the years ended September 30, 2004 and 2003, respectively.

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, and nuclear safety and analysis under contracts with the federal 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.

Contract receivables from agencies of the federal government represented approximately $68.6 million, or 96%, of accounts receivable at September 30, 2004 and $42.1 million, or 98%, of accounts receivable at September 30, 2003. Contract revenues from agencies of the federal government represented approximately 98% and 99% of total contract revenues during the years ended September 30, 2004 and 2003, respectively.

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 debt instruments described in Note 8, 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 year 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.

On October 31, 2003, Alion acquired 100% of the outstanding stock of Innovative Technologies Solutions Corporation (ITSC) for $4.0 million. The transaction is subject to an earn out 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 provided nuclear safety and analysis services to the U.S. Department of Energy (DOE) as well as to the commercial nuclear power industry. As of September 30, 2004, the Company has recorded approximately $3.5 million of goodwill relating to this acquisition. ITSC’s results of operations are included in Alion’s operations from the date of acquisition. The pro forma impact of this acquisition was not significant.

On February 13, 2004, Alion acquired 100% of the outstanding stock of Identix Public Sector, Inc. (IPS) for $8.0 million in cash. Founded in 1980, IPS is based in Fairfax, Virginia and provides program and acquisition management, integrated logistics support, and foreign military support primarily to U.S. Navy customers. IPS, formerly ANADAC, was a wholly-owned subsidiary of Identix Incorporated.

At closing, the Company reimbursed IPS’s parent company $0.9 million for intercompany payables. Subsequent payments totaling approximately $1.7 million for intercompany payables were made in the three successive months following the closing. Per the agreement, a contingent payment of $0.5 million was placed in escrow and may be due from the Company in the future. The payment is contingent on the Company having the opportunity to compete or bid for services on certain government solicitations. The initial purchase price allocation is as follows:

The allocation of purchase price is preliminary as the Company completes its valuation of the fair value of assets acquired and liabilities assumed. As of September 30, 2004, the Company has recorded approximately $6.1 million of goodwill relating to this acquisition and approximately $1.1 million of intangible assets related to acquired contracts to be amortized over three years.

The results of operations for IPS are included in Alion’s operations from the date of acquisition.

The table below sets out the unaudited pro forma effects of the IPS acquisition on the Company’s revenue, net income and earnings per share as though the IPS acquisition had taken place on first day of each fiscal year presented. This pro forma adjustment is in addition to the unaudited pro forma effects of the Alion

acquisition of Selected Operations of IITRI included in the year-to-date numbers below for the 2003 fiscal year.

For the fiscal year ended September 30, 2003, the pro forma information 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 unaudited pro forma information does not purport to be indicative of the results of operations that would have actually been achieved if the transactions had occurred on the dates indicated or the results of operations that will be reported in the future.


(1)	The unaudited IPS pro forma loss for the year ended September 30, 2004 included a loss on the sublease of a facility of $4.1 million.

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.

On February 11, 2004, the Company borrowed $750,000 from an officer of the Company and, in exchange, the Company issued a Promissory Note in the principal amount of $750,000 with interest at a rate of 15% per annum, to be paid quarterly, until March 31, 2009 when the principal amount becomes due. The annual interest period was effective beginning February 11, 2004. On December 9, 2004, the Promissory Note with officer was extinguished. An amount of $750,000 plus accrued interest of $21,635 was paid to the officer.

AB Technologies (AB Tech) — Earn out is based on an agreed-upon formula applied to net income of the business units that formerly comprised AB Tech. The earn out obligation continues through February 7, 2005, the fifth anniversary of the original acquisition date.

ITSC — Earn out is based on a portion of the gross revenue of the business units that formerly comprised ITSC. The obligation continues through September 30, 2005.

In the opinion of management, the realization of the amounts due under these arrangements will not have a material adverse effect upon the financial position, results of operations, or the liquidity of the Company.

The Company is involved in various claims and legal actions arising in the ordinary course of business. In the opinion of management, the ultimate disposition of these matters will not have a material adverse effect upon the financial position, results of operations, or liquidity of the Company.

The amount of government contract revenue and expense reflected in the consolidated financial statements attributable to cost reimbursement contracts is subject to audit and possible adjustment by the Defense Contract Audit Agency (DCAA). The government considers the Company to be a major contractor and DCAA maintains an office on site to perform its various audits throughout the year. DCAA has concluded its audits of the Company’s indirect exp ense rates and cost accounting practices through fiscal year 2001. There were no significant cost disallowances for the fiscal years ended September 30, 2000 and 2001. The results of the audits for 2002, 2003, and 2004 are not expected to have a material effect on the results of future operations.

See Note 2 for a description of the Company’s fiscal year 2004 quarters and fiscal year 2003 interim periods.


(a)	Prior to the sale of shares of common stock to the ESOP Trust on December 20, 2002, the Company’s activities were organizational in nature and the Company’s capital structure consisted of 100 shares of common stock issued and outstanding. Accordingly, earnings per share information has not been presented as it is not indicative of the Company’s prospective capital structure.

On October 1, 2004, the Company borrowed $22.0 million under the Senior Secured Term B Loan. The Company used the proceeds of the October 1, 2004, borrowing to redeem the Mezzanine Note for approximately $19.6 million, to pay a prepayment penalty of approximately $1.8 million and to pay approximately $0.6 million in accrued interest. The Company recognized an expense of approximately $3.9 million on extinguishment of the Mezzanine Note, including approximately $2.1 million for amortization of original issue discount in addition to the $1.8 million prepayment penalty.

On October 28, 2004, Alion purchased substantially all of the assets of Countermeasures, Inc., makers of the “Buddy System”^TM Vulnerability Assessment and Management Software, for approximately $2.4 million. The purchase gives Alion ownership of this technology for identifying, quantifying and managing physical, infrastructure, program and electronic security risks. The technology can also recommend countermeasures

and advice that may significantly reduce the exposure to threats. Countermeasures, Inc. has two employees and is located in Hollywood, Maryland.

On October 29, 2004, Dr. Atefi elected to redeem the amount due under his Deferred Compensation Agreement with Alion. Dr. Atefi was paid approximately $0.9 million, plus $0.2 million in accrued interest. The warrants remain outstanding.

On December 9, 2004, the Promissory Note with the officer was extinguished. An amount of $750,000 plus accrued interest of $21,635 was paid to the officer.


(1)	Beginning balance recorded pursuant to allocation of purchase price to assets acquired and liabilities assumed in Alion’s acquisition of the Selected Operations of IITRI.

(2)	Accounts receivable written off against the allowance for doubtful accounts.

(3)	Adjustments pursuant to the allocation of purchase price to assets acquired and liabilities assumed in Alion’s acquisitions of ITSC and IPS.

We have audited the accompanying consolidated balance sheets of Selected Operations of IIT Research Institute as of September 30, 2001 and 2002, and the related consolidated statements of income, changes in owner’s net investment, and cash flows for each of the years in the three-year period ended September 30, 2002. These consolidated financial statements are the responsibility of Selected Operations of IIT Research Institute’s management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.

We conducted our audits in accordance with auditing standards generally accepted in the United States of America. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Selected Operations of IIT Research Institute as of September 30, 2001 and 2002, and the results of their operations and their cash flows for each of the years in the three-year period ended September 30, 2002, in conformity with accounting principles generally accepted in the United States of America.

IIT Research Institute (IITRI) is a not-for-profit membership corporation working for the advancement of knowledge and the beneficial application of science and engineering to meet the needs of society. IITRI’s articles of incorporation provide that in addition to its primary purpose, it will support and assist the Illinois Institute of Technology and, in the event of dissolution, IITRI’s assets are to be distributed to the Illinois Institute of Technology. In addition to its Chicago facilities, IITRI maintains offices in, amongst other places, McLean and Alexandria, Virginia; Lanham, Annapolis, and Waldorf, Maryland; Rome, New York; West Conshohocken, Pennsylvania; and Huntsville, Alabama.

In October 2001, Alion Science and Technology Corporation, (formerly known as Beagle Holdings, Inc.) (Alion), a for-profit S Corporation, was incorporated in the state of Delaware for the purpose of purchasing substantially all of the assets and liabilities of IITRI (Selected Operations of IIT Research Institute or the Business). The Business includes substantially all of the assets and liabilities of IITRI with the exception of those assets and liabilities associated with IITRI’s Life Sciences Operation.

The consolidated financial statements of the Business have been carved out from the consolidated financial statements of IITRI using the historical results of operations and bases of the assets and liabilities of the transferred operations and give effect to certain allocations of expenses from IITRI to Life Sciences Operation. Such expenses represent costs related to general and administrative services that IITRI has provided to Life Sciences Operation including interest, accounting, tax, legal, human resources, information technology, and other corporate and infrastructure services. The costs of these services have been allocated to Life Sciences Operation using relative percentages of revenues, operating expenses and headcount, and other reasonable methods, and have been excluded in preparing the Business’ financial statements. Allocations of expenses are estimates based on management’s best assessment of actual expenses incurred by Life Sciences Operation. It is management’s opinion that the expenses charged to Life Sciences Operation and the underlying assumptions used to determine the expenses are reasonable. These allocations and estimates are not necessarily indicative of the costs and expenses that would have resulted had the Business been operated as a separate entity in the past, or of the costs the Business may incur in the future.

The consolidated financial statements are prepared on the accrual basis of accounting and include the accounts of the Business and its wholly owned subsidiary Human Factors Applications, Inc. (HFA). All significant intercompany accounts have been eliminated in consolidation.

The consolidated financial statements may not be indicative of the Business’ financial position, operating results, or cash flows in the future or what the Business’ financial position, operating results, and cash flows would have been had the Business been a separate, stand-alone entity during the periods presented. The consolidated financial statements do not reflect any changes that will occur in the Business’ funding or operations as a result of the Business becoming a stand-alone entity.

The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosures of contingent assets and liabilities at the date of financial statements and the reported amounts of revenue and expenses during the reporting period.

Actual results are likely to differ from those estimates, but the Business’ management does not believe such differences will materially affect the Business’ financial position, results of operations, or cash flows.

The Business’ fiscal years end on September 30 and consist of 52 weeks. Interim periods were determined based upon the Business’ thirteen internal period closings, each of which ends on a Friday. During the fiscal year ended September 30, 2000, the interim periods ended on December 24, 1999, and March 17, July 7, and September 30, 2000. During the fiscal year ended September 30, 2001, the interim periods ended on December 22, 2000, and March 16, July 6, and September 30, 2001. During the fiscal year ended September 30, 2002, the interim periods ended on December 21, 2001, March 15, July 5, and September 30, 2002. For the fiscal year ending September 30, 2003, the first interim period ended on December 20, 2002. While the actual number of days within each interim period will vary from fiscal year to year, the first, second, and fourth interim periods will include approximately 12 weeks while the third interim period will include approximately 16 weeks. Accordingly, comparisons between interim periods will need to consider the differing length of the third interim period.

The interim period information included in the consolidated financial statements and Note 12 has been prepared by the Business and are unaudited. In the opinion of management, this financial information has been prepared in conformity with accounting principles generally accepted in the United States of America and reflects all adjustments necessary for a fair statement of the Business’ results of operations. All such adjustments are of a normal recurring nature.

The Business’ 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 which are fixed-price or time-and-material type contracts. The Business generally recognizes revenue when a contract has been executed, the contract price is fixed or determinable, delivery of the services or products has occurred and collectibility of the contract price is considered probable.

Revenue on cost-reimbursement contracts is recognized as costs are incurred and include a proportionate share of the fees earned.

The percentage of completion method is used to recognize revenue on fixed-price contracts generally based on costs incurred in relation to total estimated costs. From time to time, facts develop that require the Business 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.

Contract costs on U.S. Government contracts, including indirect costs, are subject to audit by the federal government and adjustment pursuant to negotiations between the Business and government representatives.

All of the Business’ federal contract indirect costs have been audited and agreed upon through fiscal year 2000. Contract revenue on U.S. Government contracts have been recorded in amounts that are expected to be realized upon final settlement.

The Business recognizes revenue on unpriced change orders as expenses are incurred only to the extent that the Business expects it is probable that such costs will be recovered. The Business 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 Business recognizes revenue on claims as expenses are incurred only to the extent that the Business expects it is probable that such costs will be recovered and the amount of recovery can be reliably estimated.

Costs and estimated earnings in excess of billings on uncompleted contracts represent accumulated project expenses and fees which have not been invoiced to customers as of the date of the consolidated balance sheet. These amounts, which are included in accounts receivable, are stated at estimated realizable value and aggregated $24.2 million and $12.5 million at September 30, 2001 and 2002, respectively. Billings in excess of costs and estimated earnings and advance collections from customers represent amounts received from or billed to commercial customers in excess of project revenue recognized to date. Costs and estimated earnings in excess of billings on uncompleted contracts at September 30, 2001 and 2002 include $0.6 million and $2.9 million, respectively, related to costs incurred on projects for which the Business has been requested by the customer to begin work under a new contract or extend work under an existing contract, but for which formal contracts or contract modifications have not been executed. In addition, billed receivables at September 30, 2001 and 2002 include $0.6 million of final bills that are not expected to be collected within one year.

Goodwill, which represents the excess of purchase price over fair value of net assets acquired, is amortized on a straight-line basis over the expected periods to be benefited, generally 7 years. The Business assesses the recoverability of this intangible asset by determining whether the amortization of the goodwill balance over its remaining life can be recovered through undiscounted future operating cash flows of the acquired operation. The amount of goodwill impairment, if any, is measured based on projected discounted future operating cash flows using a discount rate commensurate with the risks involved. The assessment of the recoverability of goodwill will be impacted if estimated future operating cash flows are not achieved.

Buildings, leasehold improvements, and equipment are recorded at cost. Expenditures for maintenance and repairs are charged to current operations. Buildings and equipment are depreciated over their estimated useful lives (40 years for buildings and 3 to 15 years for the various classes of equipment) generally using the straight-line method. Leasehold improvements are amortized on the straight-line method over the shorter of the assets’ estimated useful life or the life of the lease. Upon sale or retirement of an asset, costs and related accumulated depreciation are deducted from the accounts, and the gain or loss is recognized in the consolidated income statement.

Under Subchapter S of the Internal Revenue Code, the stockholder of the Company will include the Company’s income in its own income for federal and most state income tax purposes. Accordingly, the Company is not subject to federal and most state income taxes.

IITRI has received a determination letter from the Internal Revenue Service which indicates it is exempt from income taxes under Section 501(c)(3) of the Internal Revenue Code except for taxes pertaining to unrelated business income. Accordingly, the accompanying consolidated financial statements do not include provisions for income taxes except as described below.

HFA, the Business’ for-profit subsidiary, accounts for income taxes under the asset and liability method. HFA recognizes deferred tax assets and liabilities based on the differences between financial statement carrying amounts and the tax bases of assets and liabilities. HFA uses the enacted tax rates expected to apply to taxable income in the years in which these temporary differences are expected to be recovered or settled. The effect of a change in tax rates on deferred tax assets and liabilities is recognized in income in the period that includes the enactment date.

The Business’ historical structure is not indicative of its prospective capital structure and, accordingly, historical earnings per share information has not been presented.

During 2000, the Business entered into forward contracts as a hedge against certain foreign currency commitments on a contract in the United Kingdom. The total amount of the contracts was approximately $0.4 million with the final contract maturing on May 7, 2002. No contracts were outstanding at September 30, 2002. The contracts were marked to market, with gains and losses recognized in the consolidated statements of income. The Business does not use derivatives for trading purposes.

The FASB issued SFAS No. 131, Disclosures about Segments of an Enterprise and Related Information, in February 1998. SFAS No. 131 establishes standards for the way that public business enterprises report information about operating segments in annual financial statements. This statement also requires companies that have a single reportable segment to disclose information about products and services, geographic areas, and major customers. This statement requires the use of the management approach to determine the information to be reported. The management approach is based on the way management organizes the enterprise to assess performance and make operating decisions regarding the allocation of resources. It is management’s opinion that, at this time, the Business has one reportable segment.

The Business provides technical services and products through contractual arrangements as either prime contractor or subcontractor to other contractors, primarily for departments and agencies of the U.S. Government. U.S. Government contracts are subject to specific regulatory accounting and contracting guidelines including the Cost Accounting Standards and Federal Acquisition Regulations. The Business also provides technical services and products to foreign, state, and local governments, as well as customers in commercial markets. During the years ended September 30, 2000, 2001, and 2002, revenues from foreign countries were not significant.

Revenues from services provided to various agencies of the U.S. Government represented $137.5 million or 88%, $180.7 million or 94% and $198.8 million or 98% of revenues for the years ended September 30, 2000, 2001 and 2002, respectively. Contract receivables from agencies of the U.S. Government represented

$54.3 million or 94% and $48.7 million or 94% of accounts receivable at September 30, 2001 and 2002, respectively.

In June 2001, the Financial Accounting Standards Board issued SFAS No. 141, Business Combinations, and SFAS No. 142, Goodwill and Other Intangible Assets. SFAS 141 requires the purchase method of accounting to be used for all business combinations initiated after June 30, 2001. SFAS 141 also specifies criteria that intangible assets acquired in a business combination must meet to be recognized and reported apart from goodwill. As the Business is a not-for-profit, SFAS No. 141 is not applicable.

SFAS 142 is effective for fiscal years beginning after December 15, 2001. SFAS 142 will not be applied to previously recognized goodwill and intangible assets arising from the acquisition of a for-profit business enterprise by a not-for-profit organization until interpretive guidance related to the application of the purchase method to those transactions is issued. SFAS 142 will be required to be adopted by Alion in connection with the proposed acquisition of the Business discussed in Note 13. SFAS No. 142 changes the accounting for goodwill from an amortization method to an impairment-only approach. Goodwill and other intangible assets that have an indefinite life will not be amortized, but rather will be tested for impairment annually or whenever an event occurs indicating that the asset may be impaired.

In June 2001, the FASB issued SFAS No. 143, Accounting for Asset Retirement Obligations. SFAS 143 addresses financial accounting and reporting for obligations associated with the retirement of tangible long-lived assets and for the associated asset retirement costs. SFAS 143 must be applied starting with fiscal years beginning after June 15, 2002. Management is currently evaluating the impact that the adoption of SFAS 143 will have on the consolidated financial statements.

In August 2001, the FASB issued SFAS No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets. SFAS No. 144 addresses financial accounting and reporting for the impairment or disposal of long-lived assets. While SFAS No. 144 supersedes SFAS No. 121, Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed Of, it retains many of the fundamental provisions of that Statement. SFAS No. 144 also supersedes the accounting and reporting provisions of APB Opinion No. 30, Reporting the Results of Operations — Reporting the Effects of Disposal of a Segment of a Business, and Extraordinary, Unusual, and Infrequently Occurring Events and Transactions, for the disposal of a segment of a business. It retains, however, the requirement in APB Opinion No. 30 to report separately discontinued operations, and extends that reporting to a component of an entity that either has been disposed of (by sale, abandonment, or in a distribution to owners) or is classified as held for sale. SFAS No. 144 is effective for fiscal years beginning after December 15, 2001, and interim periods within those fiscal years. Management does not believe that the adoption of SFAS 144 will have a significant impact on its consolidated financial statements.

During June 2002, the FASB issued SFAS No. 146, Accounting for Costs Associated with Exit or Disposal Activities. Such standard requires costs associated with exit or disposal activities (including restructurings) to be recognized when the costs are incurred, rather than at a date of commitment to an exit or disposal plan. SFAS No. 146 nullifies Emerging Issues Task Force (“EITF”) Issue No. 94-3, Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (including Certain Costs Incurred in a Restructuring). Under SFAS No. 146, a liability related to an exit or disposal activity is not recognized until such liability has actually been incurred whereas under EITF Issue No. 94-3 a liability was recognized at the time of a commitment to an exit or disposal plan. The provisions of this standard are effective for disposal activities initiated after December 31, 2002.

Certain amounts in the prior years financial statements have been reclassified to conform to the current year’s presentation.

Effective September 30, 1998, the Business completed the acquisition of Human Factors Applications, Inc. (HFA) for $3.0 million. HFA is a U.S. supplier of ordnance and explosive waste remediation with core competencies in the areas of demilitarization, demining, environmental remediation, explosion sciences, sensor and software integration, and training. The Business purchased all the outstanding shares of HFA’s common stock. The Business allocated a portion of the purchase price to the assets acquired and liabilities assumed at the date of acquisition based upon their estimated fair values and recorded the balance of $1.5 million as goodwill. The results of HFA’s operations are included in the Business’ consolidated financial statements beginning on October 1, 1998.

Effective May 31, 1999, the Business acquired EMC Science Center, Inc. (EMC) for $3.0 million. EMC has technical expertise in electromagnetic environmental effects testing, standards and training, and operates a certified test laboratory. The Business acquired all the assets and assumed all the liabilities of EMC. The Business allocated a portion of the purchase price to the assets acquired and liabilities assumed at the date of acquisition based upon their estimated fair values and recorded the balance of $2.3 million as goodwill. The results of operations of EMC are included in the Business’ consolidated financial statements beginning on June 1, 1999.

On June 12, 1999, the Business acquired 25% of the outstanding common stock of AB Technologies, Inc. (AB) for $6.0 million. AB Technologies specializes in modeling and simulation related to training exercises, education and training support, complex problem analysis and systems, and military policy development for the U.S. Government and other customers. A portion of the purchase price was allocated to the estimated fair value of the net assets acquired while the balance of $4.2 million was recorded as goodwill. The Business used the equity method to account for its initial common stock purchase. At September 30, 1999, the Business’ investment in AB Technologies reflected its proportionate share of net losses from June 13, 1999. At September 30, 1999, the Business owed the previous owners of AB Technologies $2.0 million under notes payable. AB Technologies reported revenue of approximately $28.5 million for the nine months ended September 30, 1999.

Effective February 7, 2000, the Business acquired the remaining assets and liabilities from the other shareholders of AB Technologies for approximately $5.4 million. The acquisition was accounted for as a step acquisition. The Business allocated a portion of the purchase to the assets acquired and liabilities assumed at the date of acquisition based upon their estimated fair values. The Business recorded the remaining balance of $4.3 million as goodwill. The purchase agreement contains an earnout provision under which the Business could be required to make additional payments to the other former shareholders of AB Technologies. These payments cannot exceed $11.5 million and are based on the future net income of AB Technologies’ operations through February 7, 2005. For the years ended September 30, 2001 and 2002, the Business accrued contingent consideration obligations of $0.6 million and $0.6 million, respectively, under this purchase agreement. Such amounts are included in long-term debt in the accompanying consolidated balance sheets.

From June 12, 1999 through February 7, 2000, the Business provided management and accounting services to AB Technologies under an administrative agreement. The Business recovered expenses under this agreement of $1.5 million for the period ended September 30, 1999 and an additional $2.8 million through February 7, 2000.

The following unaudited pro forma summary information presents the results of operations as if the AB Technologies acquisition had been completed at the beginning of the period presented and is not necessarily

indicative of the results of operations of the Business that might have occurred had the acquisition been completed at the beginning of the period specified, nor is it necessarily indicative of future operating results:

In May 2002, the Business acquired the assets of Daedalic, Inc. for $0.8 million in a business combination to be accounted for as a purchase. The Business allocated the purchase price to the assets acquired and recorded the balance of $0.4 million as goodwill. The pro forma impact of this acquisition was not significant.

Aggregate goodwill amortization expense related to the aforementioned business combinations was $1.5 million, $1.8 million, and $2.0 million during the years ended September 30, 2000, 2001, and 2002, respectively.

Depreciation and leasehold improvement amortization expense for property, plant and equipment was $2.3 million, $1.7 million, and $1.5 million in the fiscal years ended September 30, 2000, 2001, and 2002, respectively.

In May 2000, the Business sold land in Annapolis, Maryland for $2.3 million, and recognized a gain of $1.3 million during fiscal year 2000.

In December 2000, the Business sold its Chicago research tower, engineering buildings, and related assets for $12.5 million to the Illinois Institute of Technology. The Business leased back six of the 19 floors in the tower under a 10-year operating lease agreement. The Business applied sale/leaseback accounting and deferred recognition of the $4.9 million gain arising from this transaction. The Business recognized $0.4 million and $0.5 million of the gain in fiscal years 2001 and 2002, respectively, and the deferred balance at September 30, 2002 was $4.0 million. The deferred gain is being recognized over the remaining life of the lease. See Note 9 for further discussion regarding lease commitments.

In fiscal year 2002, the Business completed the implementation of PeopleSoft’s human resource software. The Business capitalized $1.9 million of costs associated with the implementation including software license and consultant expenses. The Business accounted for the costs of the implementation in accordance with AICPA Statement of Position 98-1, Accounting for the Costs of Computer Software Developed or Obtained for Internal Use.

The Business maintains a revolving bank credit agreement with First Union Bank that is secured by qualifying billed and unbilled accounts receivable and allows borrowings of up to $25.0 million. The maximum amount available is calculated monthly using a borrowing base formula based on percentages of eligible billed and unbilled accounts receivable. Advances under the agreement bear interest, at the Business’ election, at either the prime rate (4.75% at September 30, 2002) or the London Interbank Offering Rate (LIBOR) plus a fee. Historically, the Business has elected the prime rate. The agreement extends through December 22, 2002. The Business also had $0.5 million in standby letters of credit outstanding at September 30, 2002 with First Union Bank.

The Business is subject to certain debt covenants relating to the revolving bank credit agreement with First Union Bank. As of September 30, 2002, all debt covenants had been met.

IITRI incurred interest expense of $1.8 million, $1.6 million, and $0.9 million and the Business was allocated interest expense of $1.4 million, $0.9 million, and $0.6 million for the years ended September 30, 2000, 2001, and 2002, respectively.

For fiscal year 2000, the Business recorded an income tax provision of $0.2 million for unrelated business income arising from the AB Technologies acquisition.

For the years ended September 30, 2000, 2001 and 2002, HFA had an operating income of $0.5 million, $1.0 million and $1.6 million, respectively. The Business recorded an income tax provision of $0.4 million, $0.3 million, and $0.6 million for the years ended September 30, 2000, 2001 and 2002, respectively, related to HFA. Deferred taxes were not significant at September 30, 2001 and 2002.

The Business sponsors two defined contribution retirement plans that cover substantially all full-time employees. The plans are funded by contributions from the Business and its employees. The employer’s contributions under the plans were $1.5 million, $3.5 million, and $4.2 million for the years ended September 30, 2000, 2001 and 2002, respectively.

The Business also sponsors a medical benefits plan providing certain medical, dental, and vision coverage to eligible employees and former employees. The Business has a self-insured funding policy with a stop-loss limit under an insurance agreement. Certain funds are set aside in a trust fund from which the medical benefit claims are paid. At September 30, 2001 and 2002, the trust fund balance was $0.9 million and $0.04 million, respectively.

The Business also provides post retirement medical benefits for employees who meet certain age and service requirements. Retiring employees may become eligible for those benefits at age 55 if they have

20 years of service, or at age 60 with 10 years of service. The plan provides benefits until age 65 and requires employees to pay one-quarter of their health care premiums. A small, closed group of employees is eligible for coverage after age 65. These retirees contribute a fixed portion of the health care premium.

Following is a reconciliation of the plan’s funded status with the accrued benefit cost shown on the consolidated balance sheets at September 30:

The components of net periodic postretirement benefit cost for the years ended September 30 are as follows:

The health care cost trend rates used to determine the accumulated postretirement benefit obligation are 11.5% in fiscal year 2002, decreasing each year to an ultimate of 5.5% per year in fiscal 2014. Based on the number of employees currently participating in these plans, it is estimated that a 1% increase each year in the health care cost trend rates would result in increases of $0.014 million in the service and interest cost

components of the net periodic postretirement benefit cost and $0.24 million in the accumulated postretirement benefit obligation. Similarly, a 1% decrease each year in the health care cost trend rates would result in decreases of $0.013 million in the service and interest cost components of the net periodic postretirement benefit cost and $0.2 million in the accumulated postretirement benefit obligation. The discount rate used to measure the accumulated postretirement benefit obligation at September 30, 2001 and 2002 was 7.5% and 7.0%, respectively.

The Business provides other deferred compensation and participation in a flexible option plan for certain key executives. Aggregate amounts granted under the flexible option plan were $0.3 million and $2.0 million as of September 30, 2001 and 2002, respectively. These amounts vest over a five-year period from the original date of grant and vesting accelerates upon a change in control. No amounts have vested as of September 30, 2002. Funds granted under the plan are invested in a limited variety of mutual funds selected by the grantee. These assets are owned by the Business and subject to the claims of general creditors of the Business. The deferred compensation liability to the participants is recorded over the service period as compensation expense.

Future minimum lease payments under non-cancelable operating leases for buildings, equipment, and automobiles at September 30, 2002, are as follows:

Rent expense under operating leases was $2.5 million, $6.3 million, and $8.3 million for the years ended September 30, 2000, 2001, and 2002, respectively.

The Business periodically enters into other lease obligations which are directly chargeable to current contracts. These obligations are covered by current available contract funds or are cancelable upon termination of the related contracts.

Except as noted in the following paragraph, the Business recognizes as operating expense amounts assessed by the Illinois Institute of Technology primarily for lease payments and utility costs related to shared facilities, including steam and electricity charges, and for shared grounds maintenance and security costs. For the fiscal years ended September 30, 2000, 2001, and 2002, such amounts totaled $1.8 million, $3.2 million, and $3.6 million, respectively.

Distributions from the Business to the Illinois Institute of Technology are determined by and made on a voluntary basis and at the direction of IITRI’s Board of Governors. For fiscal years 2000, 2001, 2002, distributions amounted to $1.3 million, $1.6 million, and $0.9 million, respectively.

The accompanying consolidated statements of changes in owner’s net investment include adjustments that represent changes in net assets of Life Sciences Operation which included the period’s net loss and capital

funding requirements. Such amounts will not be reimbursed to or refunded by the Business subsequent to the acquisition by Alion described in Note 13.

See Note 5 for a discussion of the Business’ sale of assets to the Illinois Institute of Technology.

The Business is involved in various claims and legal actions arising in the ordinary course of business. In the opinion of management, the ultimate disposition of these matters will not have a material adverse effect upon the financial position, results of operations, or liquidity of the Business.

On September 12, 2002, the former owners of AB Technologies (Former Owners) filed a lawsuit (AB Tech Lawsuit) against IITRI in Circuit Court for Fairfax County, Virginia. The complaint alleges breach of the AB Technologies asset purchase agreement (Asset Purchase Agreement), and claims damages of $8.2 million. The Former Owners asked the court to order an accounting of their earn out. IITRI has filed a Notice of Removal, asking the United States District Court for the Eastern District of Virginia to remove the AB Tech Lawsuit from the state court and assume jurisdiction over it in federal court.

On September 16, 2002, IITRI filed a lawsuit against the Former Owners which asks the court to compel the Former Owners to submit disputed issues to an independent accounting firm in accordance with the requirements of the Asset Purchase Agreement, make a declaratory judgment concluding that IITRI is entitled to an approximately $1.1 million downward adjustment of the purchase price paid under the Asset Purchase Agreement, and conclude that IITRI properly computed the earnout in accordance with the earnout formula in the Asset Purchase Agreement.

Upon the closing of the proposed acquisition of the Business by Alion, Alion assumed responsibility for and acquired all claims under these lawsuits.

IITRI has accrued its estimate of the earnout liability based on the earnout formula in the Asset Purchase Agreement.

The amount of U.S. Government contract revenue and expense reflected in the consolidated financial statements attributable to cost reimbursement contracts is subject to audit and possible adjustment by the Defense Contract Audit Agency (DCAA). The government considers the Business a major contractor and DCAA maintains an office on site to perform its various audits throughout the year. DCAA has concluded its audits of the Business’ indirect expense rates and cost accounting practices through fiscal year 2000. There were no significant cost disallowances for the fiscal years ended September 30, 1999 and 2000.

IITRI, as a not-for-profit organization receiving federal funds, is required to have an annual compliance audit in accordance with the provisions of OMB Circular A-133, Audits of States, Local Governments, and Non-profit Organizations. Accordingly, for purposes of these financial statements, the Business is subject to similar audit requirements. Although DCAA has completed its incurred cost audit for the Business’ year ended September 30, 2000, the Business’ A-133 audit for the year ended September 30, 2001, has not been completed. It is the opinion of management that unallowable costs, if any, associated with this audit will be insignificant.

On December 20, 2002, Alion purchased the Business from IITRI for total aggregate proceeds of $127,879 consisting of:


	•	$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 of stock of Alion (on a fully diluted basis) attached. The seller notes bear a weighted average interest rate of 6.7% per annum;

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

	•	transaction costs of $2,300, less the $1,517 noted above;

	•	assumption of debt from Wachovia (formerly First Union) of $6,188; and

	•	amounts due to IITRI of $2,094.

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 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 is required to file or submit under the Exchange Act.

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 fourth quarter ended September 30, 2004 that have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting.

In September 2004, the Company raised approximately $1.5 million in cash through a private placement of its common stock. The Company sold 87,971 shares to the ESOP Trust at $16.56 per share and 4,957 shares at $19.94 per share. The Company issued an additional 108,395 shares to the ESOP Trust, at $19.94 per share as a contribution to the KSOP Plan. The shares of stock were offered pursuant to an exemption from registration under Section 4(2) of the Securities Act of 1933.

The Company has reported all other information required to be disclosed in a report on Form 8-K during the quarter ended September 30, 2004.

The names, ages and positions of our directors, as of September 30, 2004, are set forth below:

Our directors are divided into three classes. The first class of directors consists of three directors — Donald E. Goss, Edward C. Aldridge, and Robert L. Growney. Their term expires on the date of the annual meeting of Alion’s shareholder(s) in 2006. The second class of directors consists of three directors — Leslie Armitage, Lewis Collens and Admiral Harold W. Gehman, Jr. Their term expires on the date of the annual meeting of Alion’s shareholder(s) in 2007. The third class of directors consists of three directors — Bahman Atefi, General George A. Joulwan and General Michael E. Ryan. The term of the third class of directors expires on the date of the annual meeting of Alion’s shareholder(s) in 2005. Under the terms of the mezzanine and subordinated notes and warrants, subject to certain requirements, IITRI may nominate three directors for election to Alion’s board. Messrs. Collens, Goss, and Growney are IITRI’s board appointees.

The following sets forth the business experience, principal occupations and employment of each of the directors.

Bahman Atefi was appointed chief executive officer of Alion in December 2001. He is also chairman of Alion’s board of directors. Dr. Atefi also serves as chairman of the ESOP committee. Dr. Atefi served as president of IITRI from August 1997, and as its chief executive officer from October 2000 until December 20, 2002, the closing date of the Transaction. Dr. Atefi has also been chairman of the board of directors of Human Factors Applications, Inc. since February 1999. From June 1994 to August 1997, Dr. Atefi served as manager of the energy and environmental group at Science Applications International Corporation. In this capacity, he was responsible for operation of a 600-person business unit, with annual revenues in 1997 of approximately $80 million, which provided scientific and engineering support to the U.S. Department of Energy, Nuclear Regulatory Commission, Environmental Protection Agency, U.S. Department of Defense, as well as commercial and international customers. Dr. Atefi is a member of the board of trustees of the Illinois Institute of Technology. Dr. Atefi received a BS in Electrical Engineering from Cornell University, a master’s degree in nuclear engineering and a doctor of science in nuclear engineering from the Massachusetts Institute of Technology.

Edward C.“Pete” Aldridge has served as a director of Alion since November 2003. Mr. Aldridge retired from government service in May 2003 as the Under Secretary of Defense for Acquisition, Technology, and Logistics, a position he held since May 2001. In this position, Mr. Aldridge was responsible for all matters relating to U.S. Department of Defense (DoD) acquisition, research and development, advanced technology, international programs, and the industrial base. From March 1991 to May 2001, Mr. Aldridge served as

Leslie Armitage has served as a director of Alion since May 2002. Since January 1999, Ms. Armitage has served as a Partner of The Carlyle Group. In June 1997, Ms. Armitage became a founding member of Carlyle Europe. Ms. Armitage currently serves on the board of directors of Vought Aircraft Industries, Inc., Honsel International Technologies, and United Component, Inc.

Lewis Collens has served as a director of Alion since May 2002. Since 1990, Mr. Collens has served as president of the Illinois Institute of Technology. Mr. Collens has also served as chief executive officer of IITRI from 1990 to October 2000. Mr. Collens also serves as chairman of the board for IITRI and as a director for Dean Foods Company, Taylor Capital, Amsted Industries and Colson Group. Mr. Collens is one of the three members of the board of directors designated by the holders of the mezzanine notes, the subordinated note and the warrants.

Admiral (Ret.) Harold W. Gehman, Jr. has served as a director of Alion since September 2002. Admiral Gehman retired from over 35 years of active duty in the U.S. Navy in October 2000. While in the U.S. Navy, Admiral Gehman served as NATO’s Supreme Allied Commander, Atlantic and as the Commander in Chief of the U.S. Joint Forces Command from September 1997 to September 2000. Since his retirement in November 2000, Admiral Gehman has served as an independent consultant to the U.S. Government from October 2000 to present and Science Applications International Corporation from January 2002 to present. Admiral Gehman currently serves on the board of directors of Maersk Lines, Ltd., Transystems Corp., and Burdeshaw Associates, Ltd. He also currently serves as a member of the board of advisors for Anser Institute for Homeland Security, Old Dominion University Research Foundation, and Old Dominion University College of Engineering. In addition, Admiral Gehman is a senior fellow at the National Defense University and is chairman of the Government of Virginia’s Advisory Commission for Veterans Affairs. Most recently, Admiral Gehman agreed to chair the Space Shuttle Mishap Interagency Investigation Board, which will provide an independent review of the events and activities that led up to the loss of seven astronauts on February 1, 2003 on board the Space Shuttle Columbia.

Donald E. Goss has served as a director of Alion since May 2002. Mr. Goss has served as trustee and chairman of the audit committee for the Illinois Institute of Technology since 1982, as well as the chairman of the audit committee and a member of the board of governors for IITRI since 1985. Mr. Goss has also served on the Finance Council and as chair of the audit committee for the Catholic Archdiocese of Chicago, Illinois since 1985. Mr. Goss has also served as a member of the board of governors for the Chicago Zoological Society at Brookfield Zoo since 1998. Mr. Goss retired from Ernst & Young as partner, after 37 years of service, in March 1990, and he has remained retired since that date. Mr. Goss is one of the three members of the board of directors designated by the holders of the mezzanine notes, the subordinated note and the warrants.

Robert L. Growney has served as a director of Alion since May 2002. Up until his retirement from Motorola in April 2002, Mr. Growney had served as a member of the board of directors for Motorola since January 1997 and as vice chairman of Motorola’s board of directors since January 2002. From January 1997 to January 2002, Mr. Growney served as president and chief operating officer for Motorola. Mr. Growney currently serves as a trustee for the Illinois Institute of Technology as well as serves as a member of its executive committee. Since May 2002, Mr. Growney has been a venture partner with Edgewater Funds. Mr. Growney is one of the three members of the board of directors designated by the holders of the mezzanine notes, the subordinated note and the warrants.

General (Ret.) George A. Joulwan has served as a director of Alion since May 2002. General Joulwan retired from 36 years of service in the military in September 1997. While in the military, General Joulwan served as commander in chief for the U.S. Army, for U.S. Southern Command in Panama from 1990-1993 and served as commander in chief of the U.S. European Command and NATO Supreme Allied Command from 1993-1997. From 1998 to 2000, General Joulwan served as an Olin Professor at the U.S. Military Academy at West Point. General Joulwan has also served as an adjunct professor at the National Defense University from 2001 to 2002. Since 1998, General Joulwan has served as president of One Team, Inc., a

General (Ret.) Michael E. Ryan has served as a director of Alion since May 2002. General Ryan retired from the military in 2001 after 36 years of service. General Ryan served his last four years as the 16th Chief of Staff of the Air Force, responsible for organizing, training and equipping over 700,000 active duty, reserve and civilian members. He is on the board of directors of the Air Force Association.

Our non-employee directors receive an annual retainer of $25,000, payable in quarterly installments, for their services as members of the board of directors. These services include preparation for and attendance in person at four board meetings per year and all committee meetings that take place on the same day as a full board meeting. In addition, each director receives a fee of $1,000 for in-person attendance at each additional board meeting, and $250 for telephone attendance at each additional board meeting. Each chairman of a board committee receives $2,500 per year for each year he or she serves in such capacity. All board committee members receive $1,000 per committee meeting if the committee meeting occurs on a day other than the day of a full Alion board meeting. Alion reimburses directors for reasonable travel expenses in connection with attendance at board of directors and board committee meetings.

Each director is eligible for a one-time award under our stock appreciation rights, or SAR, plan at the beginning of each board term that he or she serves. For more information about our SAR plan, please read “Executive Compensation — Stock Appreciation Rights Plan.” A director’s SAR awards will vest on a schedule coincident with his or her term on our board. With the exception of Dr. Atefi, each of our initial directors, irrespective of their terms, was awarded 4,200 SARs in December 2002. Each future class of directors will be elected for a three-year term and will receive 4,200 SAR awards upon the commencement of each three-year term. Our directors also have the option to participate in a deferred compensation plan for tax deferral of their annual compensation and/or payments to be made upon exercise of their SAR awards.

Our employee directors will not receive any additional compensation for their services as members of the board.

The Board of Directors has established three committees. The following is a list of the current members of each committee:

The Board of Directors has determined that Mr. Donald E. Goss qualifies as “audit committee financial expert” as defined in Item 401(h) of Regulation S-K, and that he is “independent” as the term is used in Item 7(d)(3)(iv) of Schedule 14A under the Securities Exchange Act.

In October 2003, the Board of Directors established a Compensation Committee. As indicated above, the members of the Committee are Lewis Collens (Chairman), Leslie Armitage, Harold Gehman, and Pete Aldridge. Dr. Atefi is a member of the board of trustees of the Illinois Institute of Technology where Mr. Collens is the President.

The names, ages and positions of our executive officers as of September 30, 2004, and the dates from which these positions have been held are set forth below.

The following sets forth the business experience, principal occupations and employment of each of the current executive officers who do not serve on the board. Please read “Information Regarding the Directors of the Registrant” above for the information with respect to Dr. Atefi:

Randy Crawford has served as Sector Senior Vice President and Sector Manager for Alion’s spectrum engineering sector since May 2002. He is also a member of Alion’s ESOP committee. Mr. Crawford has been a member of the board of directors of Human Factors Applications, Inc. since September 2000. Mr. Crawford served IITRI as spectrum engineering sector senior vice president and manager from October 2000 through December 20, 2002, the date of completion of the Transaction. From January 1997 to October 2000, Mr. Crawford served as group manager of IITRI’s spectrum engineering group. Mr. Crawford received a BSEE from Virginia Tech and an MSE from The George Washington University.

Barry Watson has served as Sector Senior Vice President and Sector Manager for Alion’s systems technology sector since May 2002. Mr. Watson is also a member of Alion’s ESOP committee. Mr. Watson served IITRI as systems technology sector senior vice president and manager from May 1999 until December 20, 2002, the closing date of the Transaction. From May 1997 to April 1999, Mr. Watson was senior vice president and group manager of IITRI’s advanced technology group. Mr. Watson received a BA in Mathematics from Western Maryland College and a MS in Numerical Science from Johns Hopkins University.

Rob Goff has served as Sector Senior Vice President and and Sector Manager for Alion’s defense operations sector since February 2004. Mr. Goff served as Vice President and Operations Manager for IITRI from July 1999 until September 2001. From December 20, 2002 (the closing date of the Transaction) until February 2004, Mr. Goff was Senior Vice President and Group Manager for Alion; he held this same position for IITRI from September 2001 until December 20, 2002. Prior to working for IITRI, Mr. Goff served on active duty for 30 years, retiring at the rank of Major General from the United States Army. Mr. Goff received a BS from the U.S. Army Military Academy at West Point, followed by a Masters degree in Spanish Language and Literature from Middlebury College, and a MBA from Long Island University.

John Hughes has served as Senior Vice President, Chief Financial Officer and Treasurer of Alion since October 2002. From July 1998 to September 2002, Mr. Hughes served as co-founder and principal of Phoenix Financial & Advisory Services LLC, responsible for providing strategic planning, operations, financing, merger/acquisition, marketing/communications and business development support to small and mid-sized companies in the technology, media and entertainment industries. Mr. Hughes has also served as principal consultant of HKSBS, LLC from July 2002 to September 2002 and currently serves on the HKSBS advisory board. In his position as a principal consultant, Mr. Hughes functioned as the team leader for the financial advisory services division. From November 1992 to May 1998, Mr. Hughes served as senior vice president and chief financial officer of BTG Inc., responsible for business and operations management, strategic planning, mergers and acquisitions, and arranging financing for a $600 million business with 1,650 employees. Mr. Hughes received a BS in Economics and Business from Frostburg State University and has performed graduate coursework in contract formation, government procurement and financial management.

Stacy Mendler has served as Senior Vice President and Chief Administrative Officer of Alion since May 2002. She is also a member of Alion’s ESOP committee. Ms. Mendler served IITRI as senior vice president and director of administration from October 1997 until December 20, 2002, the closing date of the Transaction. As of May 2002, Ms. Mendler was IITRI’s chief administrative officer, as well as senior vice president. She also served as IITRI’s assistant corporate secretary from November 1998 through completion of the Transaction and has been a member of the board of directors of Human Factors Applications, Inc. since February 1999. From February 1995 to October 1997, Ms. Mendler was vice president and group contracts manager for the energy and environment group at Science Applications International Corporation where she managed strategy, proposals, contracts, procurements, subcontracts and accounts receivable. Ms. Mendler received a BBA in Marketing from James Madison University and a MS in Contracts and Acquisition Management from Florida Institute of Technology.

James Fontana joined Alion in January 2004 as Senior Vice President, General Counsel and Secretary. He has 20 years of experience as an attorney specializing in government contracts and technology law, and possesses a wide range of legal subject matter expertise. From February 2003 to January 2004, Mr. Fontana was in private practice as the principal of the Law Offices of James C. Fontana, and from April 1997 to January 2003 he served as General Counsel of Getronics Government Solutions, LLC (formerly Wang Federal) and Vinnell Corporation, and was Senior Corporate Counsel to BDM International, Inc., Vinnell’s parent company. Mr. Fontana is a graduate of Temple University School of Law. He received his undergraduate degree from The American University, where he majored in economics.

The Company adopted a Code of Ethics, Conduct, and Responsibility (the “Code”) on December 21, 2001 that applies to all employees, executive officers and directors of the Company. The Code also serves as a code of ethics for the Company’s chief executive officer, chief financial officer, director of finance, controller, or any person performing similar functions. Alion provides access to a telephone hotline so that employees can report suspected instances of improper business practices such as fraud, waste, and violations of the Alion Code of Ethics, Conduct and Responsibility.

The Company recently completed an examination of the Code to determine whether it fully meets the definitional requirements of a code of ethics as set forth in the rules and regulations of the Securities and Exchange Commission. On September 15, 2004, the Company adopted a revised Code applicable to all Alion employees, including Alion’s CEO and CFO, and meeting such definitional requirements set forth in the rules and regulations of the Securities and Exchange Commission. A copy of the Code is posted for all employees on the Company’s external website at www.alionscience.com The Company intends to post on its website any amendments to, or waiver of, its Code.

The following table sets forth all compensation with respect to our chief executive officer and our other most highly paid executive officers (the “Named Executive Officers”), whose total salary and bonus exceeded $100,000 for the fiscal years ended September 30, 2004, 2003, and 2002. The acquired Selected Operations of IITRI paid all compensation for the Named Executive Officers earned or paid prior to December 20, 2002.


	(1)	Unless otherwise indicated, no executive officer named in this summary compensation table received personal benefits or perquisites with an aggregate value equal to or exceeding the lesser of $50,000 or 10% of his or her aggregate salary and bonus.

	(2)	See the “Long Term Incentive Plan — Awards in Last Fiscal Year” table, set forth below, for details related to phantom stock grants. See the “SAR Grants in Last Fiscal Year” and “Aggregate SAR Exercises in Last Fiscal Year and Fiscal Year End SAR Values” tables, set forth below, for details related to SAR grants.

	(3)	In February 2003, Dr. Atefi was awarded 65,500 shares of performance-based phantom stock. In November 2003, Dr. Atefi was awarded 18,695 shares of performance-based phantom stock as described more fully below.

	(4)	Bonus amounts for fiscal year 2004 were paid in December 2004.

	(5)	2004 includes Company matching contributions of $11,817 under Alion’s KSOP. Includes $648 in term life insurance premiums and $3,980 in club membership dues paid by Alion.

2003 includes Company matching contribution of $11,000 under Alion’s KSOP. Includes $857,000 vested under a deferred compensation arrangement with the Company. See below, “Deferred Compensation Arrangement for Bahman Atefi”. Includes $648 in term life insurance premiums and $4,430 in club membership dues paid by Alion.

2002 includes Company matching contributions of $6,000 and $9,453 under IITRI’s 403(b) and 401(a) plans, respectively. Includes $700 in term life insurance premiums paid by IITRI. Includes $5,215 in club membership dues. Includes $500 for preparation of employee’s taxes.


	(6)	In February 2003, Mr. Watson was awarded 34,000 shares of performance-based phantom stock. In November 2003, Mr. Watson was awarded 6,798 shares of performance-based phantom stock as described more fully below.

	(7)	2004 includes Company matching contributions of $13,292 under Alion’s KSOP plan. Includes $560 in term life insurance premiums paid by Alion.

2003 includes Company matching contributions of $955 and $1,910 under IITRI’s 403(b) and 401(a) plans, respectively. These contributions cover the period October 1, 2002 to December 20, 2002, prior to the Transaction. Includes Company matching contribution of $11,878 under Alion’s KSOP. Includes $295,000 vested under a Retention Incentive Agreement. Includes $533 in term life insurance premiums paid by Alion.

2002 includes Company matching contributions of $6,580 and $8,093 under IITRI’s 403(b) and 401(a) plans, respectively. Includes $482 in term life insurance premiums paid by IITRI. Includes $2,123 in club membership dues.


	(8)	In February 2003, Mr. Crawford was awarded 33,000 shares of performance-based phantom stock. In November 2003, Mr. Crawford was awarded 6,798 shares of performance-based phantom stock as described more fully below.

	(9)	2004 includes Company matching contributions of $13,291 under Alion’s KSOP. Includes $534 in term life insurance premiums paid by Alion.

2003 includes Company matching contributions of $1,175 and $2,350 under IITRI’s 403(b) and 401(a) plans, respectively. These contributions cover the period October 1, 2002 to December 20, 2002, prior to the Transaction. Includes Company matching contribution of $11,404 under Alion’s KSOP. Includes $270,000 vested under a Retention Incentive Agreement. Includes $512 in term life insurance premiums paid by Alion.

2002 includes $8,465 in cash payout for unused vacation time. Includes Company matching contributions of $6,675 and $8,095 under IITRI’s 403(b) and 401(a) plans, respectively. Includes $462 in term life insurance premiums paid by IITRI.


(10)	In February 2004, Mr. Goff was promoted to Sector Senior Vice President and Sector Manager.

(11)	Jack Hughes was appointed senior vice president, chief financial officer and treasurer of Alion as of October 1, 2002.

(12)	In February 2003, Mr. Hughes was awarded 10,000 shares of performance-based phantom stock. In November 2003, Mr. Hughes was awarded 6,798 shares of performance-based phantom stock as described more fully below.

(13)	Jack Hughes entered into an employment agreement with IITRI in September 2002, pursuant to which he received an initial base annual salary of $225,000.

(14)	Represents a signing bonus paid to Mr. Hughes upon his execution of his employment agreement with IITRI.

(15)	2004 includes Company matching contributions of $14,423 under Alion’s KSOP and $534 in term life insurance paid by Alion.

2003 includes Company matching contribution of $10,687 under Alion’s KSOP. Includes $488 in term life insurance premiums paid by Alion. Includes $500 in club membership dues.


(16)	Retention Incentive Agreements. In September 2001, IITRI entered into and funded retention incentive agreements with Bahman Atefi, Randy Crawford and Barry Watson for $550,000, $270,000 and $215,000, respectively, via a non-qualified deferred compensation agreement. Alion’s acquisition if IITRI’S assets constituted a change in control of IITRI and these retention incentive awards vested fully upon closing of the Transaction.

(17)	2004 includes Company matching contributions of $13,753 under Alion’s KSOP and $508 in term life insurance paid by Alion.

2003 includes Company matching contributions of $1,967 and $3,358 under IITRI’s 403(b) and 401(a) plans, respectively. These contributions cover the period October 1, 2002 to December 20, 2002, prior to the Transaction. Includes Company matching contribution of $10,213 under Alion’s KSOP. Includes $461 in term life insurance premiums paid by Alion.

2002 includes Company matching contributions of $5,890 and $8,657 under IITRI’s 403(b) and 401(a) plans, respectively. Includes $408 in term life insurance premiums paid by IITRI.

In November 2002, our board of directors has adopted a Stock Appreciation Rights (SAR) Plan. The purpose of the SAR plan is to attract, retain, reward and motivate employees responsible for our continued growth and development and the Company’s future financial success.

The SAR plan has a 10-year term and provides that the Company can award stock appreciation rights to Alion directors, officers, employees and/or consultants. Awards under the plan may not exceed 10% of the shares of Alion common stock on a fully diluted basis, assuming the exercise of all outstanding warrants, options, rights and convertible securities. Under the plan, the chief executive officer, with the approval of the board of directors or its compensation committee, has the authority to grant awards as he deems appropriate.

A SAR award provides a grantee with the right to receive payment for the increase in appraised value of a share of Alion common stock from the grant date to the exercise date. The SAR plan contains a provision to prevent an award to a person who is or would become (if the award were made) a “disqualified person”. For this purpose, “disqualified person” means any individual who directly or beneficially holds at least 10% of Alion equity, including outstanding common stock and “synthetic equity”, such as SARs or phantom stock. Any award that violates this provision is void.

Under the SAR plan, awards to employees vest over five years at 20% per year. Awards to directors under the plan vest ratably over each director’s term of service.

The SAR plan contains a provision for accelerated vesting. Under the SAR plan, upon a grantee’s death, one-third of any unvested award vests automatically and is considered to have been immediately exercised. Under the SAR plan, a grantee may request payment for any vested SARs at any time and can continue to hold unexercised SARs for up to 60 days after the date at which a grant becomes completely vested. The SAR plan permits the plan administrator to defer requested exercise payments for up to five years based on the current and anticipated cash needs of the Company, and provides for interest to accrue under certain circumstances. If a grantee dies or becomes disabled, the payment of vested SARs will be made 60 days after the date of death or disability. The payments are determined by the number of SARs vested multiplied by the difference between the share price at date of grant and the share price at date of payment. Awards to directors are paid out 60 days after the expiration of their term of service.

As of September 30, 2004, the Company had issued 242,350 SARs of which 209,390 were still outstanding.

Our board of directors is the fiduciary for both SAR plans and may amend or terminate either SAR plan at any time.

The following table sets forth information regarding grants of SARs to the Named Executive Officers pursuant to the SAR plan in fiscal year 2004. This table does not include warrants purchased from the Company described elsewhere in this Annual Report. The only Named Executive Officer who held warrants to purchase Alion common stock at September 30, 2004 was Dr. Atefi (22,062 shares).


	*	Refers to the “Alion Science and Technology Corporation 2002 Stock Appreciation Rights (SAR) Plan” (see above, “Stock Appreciation Rights Plan” for more information regarding the SAR Plan).


(1)	The present value of the grant at the date of grant has been calculated using the Black-Scholes method. The Black-Scholes method takes into account assumptions about future interest rates, stock volatility, and expected SAR life. The actual value, if any, that may be realized by each individual will depend upon the value of Alion’s common stock on the date of exercise.

(2)	No SAR awards as of September 30, 2004.

The following table sets forth information regarding the exercise of SARs during fiscal year 2004 by the named executive Officers and SARs held by them at September 30, 2004.

Aggregated SAR Exercises in Last Fiscal Year and Fiscal Year End/ SAR Values


*	Refers to the “Alion Science and Technology Corporation 2002 Stock Appreciation Rights (SAR) Plan” (see above, “Stock Appreciation Rights Plan” for more information regarding the SAR Plan).

(1)	No SAR awards as of September 30, 2004.

(2)	In 2003, Mr. Goff was awarded 1,200 SARs at the exercise price of $10.00 per share. As of September 30, 2004, the value of Alion common stock is $19.94 per share.

(3)	In 2004, Mr. Goff was awarded 2,500 SARs at the exercise price of $14.71 per share. As of September 30, 2004, the value of Alion common stock is $19.94 per share.


(4)	The number of exercisable and unexercisable SARs is dependent on the plan vesting schedule. For example, as of September 30, 2004, for Mr. Goff, only 20% of the 1,200 SARs awarded in 2003 have vested, resulting in 240 exercisable SARs. As of September 30, 2004, the remaining SARs are unexercisable.

(5)	The value of exercisable and unexercisable SARs is dependent on the difference between the exercise price per share and the current fair value per share of Alion common stock. For example, as of September 30, 2004, for Mr. Goff, the exercise price is $10 per share and the current value per share of Alion common stock is $19.94. The value of the exercisable SARs is $2,386 (240 shares multiplied by the difference between the current fair value per share of Alion stock, $19.94, and the exercise price per share, $10.00).

Prior to the close of the Transaction, State Street, the ESOP trustee, engaged Ernst & Young to perform an analysis of the compensation of each member of Alion’s senior management team. The ESOP trustee requested this analysis to determine how Alion’s executive officers should be compensated so as to incentivize and retain these officers to serve Alion over the long term and thereby benefit participants in the ESOP. As a result of this analysis, it was determined that additional compensation would be provided to Alion’s senior management, and that this additional compensation would take the form of awards of phantom stock that provides senior management with a simulated proprietary interest in our Company.

The terms of the phantom stock plan were approved by the compensation committee of Alion’s board of directors. Although not required by the provisions of Alion’s bylaws, the compensation committee then submitted the plan to the full Alion board of directors for its approval and adoption. In February 2003 the phantom stock plan was adopted by the full board

Phantom stock refers to hypothetical shares of Alion common stock. Each recipient of a phantom stock award receives a grant for a specified number of shares. Recipients, upon vesting, are entitled to receive an amount of money equal to the product of the number of hypothetical shares vested and the then current value of our common stock, based on the most recent valuation of the shares of common stock held by the ESOP. Alion will make cash payments pursuant to vested phantom stock awards generally within a certain specified period after vesting. Phantom stock may increase, or decrease, in value over time, resulting in cash payments under the phantom stock awards that may be greater, or less than, the value of the phantom stock at the date of grant.

The phantom stock plan has a term of ten years and provides that key management employees may be granted awards of phantom stock by the compensation committee of our board of directors. The board of directors may also grant awards of phantom stock. An employee who has received a grant of phantom stock has no right to receive payment for any share of phantom stock until it is vested.

The phantom stock plan contains a provision to prevent an award to a person who is or would become (if the award were made) a “disqualified person” for as long as we maintain the ESOP. For this purpose, “disqualified person” means any individual who directly or beneficially (such as under the Alion ESOP) holds at least 10% of Alion equity, including outstanding common stock and “synthetic equity”, such as SARs or phantom stock. Any award that violates this provision is void.


	•	Select which employees are to be awarded phantom stock and determine when it will be awarded;

	•	Determine the number of shares of common stock to be covered by or used for reference purposes for a grant of phantom stock;

	•	Adjust the number and price of shares as a result of special circumstances or certain business actions, including but not limited to mergers, reorganizations and the like;


	•	Determine, modify, and waive from time to time the terms and conditions, including without limitation vesting and other restrictions, of any grant of phantom stock;

	•	Accelerate or otherwise change the time in which a grant of phantom stock may be exercised;

	•	Impose limitations on grants of phantom stock, including limitations on transfer provisions;

	•	Modify, extend, or renew outstanding awards of phantom stock, or accept the surrender of outstanding awards of phantom stock and substitute new awards of phantom stock;

	•	Administer and interpret the provisions of the plan;

	•	Terminate the plan;

	•	Decide all questions of fact arising in the application of the plan; and

	•	Prescribe, amend, and rescind rules and regulations relating to the plan, including (under the first phantom stock plan only) rules and regulations relating to sub-plans established for the purpose of qualifying for preferred tax treatment under foreign tax laws.

Under the plan, members of our compensation committee who are eligible to receive phantom stock or who have been granted phantom stock may vote on any matters affecting the administration of the plan or the grant of phantom stock, except that a member cannot act upon the granting of phantom stock to himself or herself. These voting provisions also apply to members of our board of directors when the board resolves to act under the plan.

When granted, phantom stock provides the employee with the right to receive payment upon exercise of the phantom stock. The terms of each phantom stock grant are evidenced in a phantom stock agreement which determines the:


	•	Date of grant;

	•	Number of shares of the phantom stock awarded; and

	•	Provisions governing vesting of the phantom stock awarded.

The plan also provides that phantom stock awarded at different times need not contain similar provisions.

Other events, such as if we experience a change in control (as defined in the plan) or if an employee becomes disabled, or dies, may entitle the affected employee to vest immediately in 100% of all phantom stock that has been awarded.

Terminated employees will usually forfeit their rights to all unvested phantom stock. In certain instances, however, an employee may receive a pro rata portion of his or her unvested phantom stock upon termination. For example, when an employee voluntarily terminates for good reason or when he or she is involuntarily terminated for any reason other than cause or just cause, as defined in his or her employment agreement with us, then that employee will receive a pro rata portion of his or her unvested phantom stock based on a ratio:


	•	the numerator of which is the number of months from the date of grant of the phantom stock through the end of the month of such termination; and

	•	the denominator of which is 60.

Under the plan, the payment we will make upon the vesting of phantom stock is intended to be made in one lump sum within 60 days of the date of vesting unless a later date is set forth in an individual award agreement. The compensation committee, or our board of directors if it resolves to do so, may delay payment for five years. If the payment is delayed, it will include interest accrued at the prime rate as of the date of vesting until the payment date. In general, we expect that the compensation committee, or the board if it resolves to do so, will examine our available cash and anticipated cash needs in determining whether to delay payment. Under limited circumstances, payments from the exercise of phantom stock may be rolled over into any non-qualified deferred compensation plan available to the employee.

As of June 25, 2004, the phantom stock plan was amended to allow an employee who has elected as the exercise date for phantom stock the fifth (5th) anniversary of the date of grant of such phantom stock, and who is also a participant in the Alion Science and Technology Corporation Executive Deferred Compensation Plan (the “Deferred Compensation Plan”), to elect, at least 180 days prior to such exercise date, to defer receipt of all or a portion of the plan benefit through a contribution to the Deferred Compensation Plan equal to the amount that would otherwise have been payable.

No voting or other rights associated with ownership of our common stock is given to phantom stockholders. References to shares of common stock under the plan are for accounting and valuation purposes only. As a result, an employee who receives phantom stock does not have any of the rights of a stockholder as a result of a grant of phantom stock.

As provided by the compensation committee, or our full board, the phantom stock awards, as currently granted, vest according to the following schedules:

The number of shares of our common stock used for reference purposes with respect to grants of phantom stock under the plan is as follows:


(1)	Number of shares authorized under the phantom stock plan as periodically amended and approved by the compensation committee of Alion’s board of directors.

The following table sets forth information regarding phantom stock granted to the named executive officers pursuant to the phantom stock plan.


(1)	The awards made in November 2003 were made to executive and senior management of Alion. The initial set of awards made in February 2003 were made solely to Alion’s executive management team.

(2)	Pursuant to the phantom stock plan, recipients will become fully vested on the fifth year from the grant date, or approximately February 2008 and November 2008.

(3)	Pursuant to the phantom stock plan or applicable award agreement, recipients will be paid commencing on the fifth year from the date of grant.

Alion has entered into employment agreements with Bahman Atefi, Barry Watson, Randy Crawford, John Hughes and Robert Goff, the terms of which are set forth below.

Under his employment agreement, Dr. Atefi will serve as President and Chief Executive Officer of Alion for a term of 60 months, commencing on December 20, 2002 and ending on December 20, 2007. He will receive a base annual salary of $425,200 for fiscal year 2005 and will be eligible for a performance-based annual incentive bonus. Dr. Atefi is also eligible to participate in Alion’s Deferred Compensation Plan, Stock Appreciation Rights Plan, and Phantom Stock Plan. Under the terms of his employment agreement, Dr. Atefi will be given an allowance for a company car. In addition, his initiation fee and membership dues for a country club for business entertainment purposes are provided for under Dr. Atefi’s employment agreement. Dr. Atefi may terminate his employment agreement with 30 days advance written notice. If he does so, however, he will forfeit any incentive payments which might otherwise have been due him. Alion may terminate Dr. Atefi’s employment agreement for just cause, which includes, amongst others, theft or embezzlement of our material property, gross negligence, willful misconduct or neglect by Dr. Atefi of his duties. Alion may also terminate Dr. Atefi’s employment agreement without cause, although if Alion does so, it will have to make a lump sum severance payment to Dr. Atefi equal to the greater of


	•	Dr. Atefi’s annual base salary at the time of termination, for the unexpired term of the employment agreement up to a maximum of three years; or

	•	an amount equal to Dr. Atefi’s base salary plus $100,000.

Under his employment agreement, Dr. Atefi is entitled to terminate his employment and receive the same lump sum severance payment described above, if he terminates his employment for any of the following reasons within 24 months following a change of control event:


	•	his authority or responsibility is materially diminished;

	•	he is assigned duties inconsistent with his position, responsibility and status;

	•	there is an adverse change in his title or office;

	•	his base pay or incentive compensation is reduced; and

	•	his principal work location is more than ten miles away from his principal work location immediately prior to the change of control event.

For a minimum of one year after termination of Dr. Atefi’s employment, he is not permitted, in any way, to compete with Alion or solicit our employees.

Under his employment agreement, Mr. Watson will serve as Senior Vice President and Sector Manager of the systems technology sector for Alion for a term of 60 months, commencing on December 20, 2002 and ending on December 20, 2007. He will receive a base annual salary of $280,100 for the fiscal year 2005 and will be eligible for a performance-based annual incentive bonus. Mr. Watson is also eligible to participate in Alion’s Deferred Compensation Plan, Stock Appreciation Rights Plan, and Phantom Stock Plan. Under the terms of his employment agreement, Mr. Watson will be given an allowance for a company car. Mr. Watson may terminate his employment agreement with 30 days notice. If he does so, however, he will forfeit any incentive payments which might otherwise have been due him. Alion may terminate Mr. Watson’s employment agreement for cause, which includes, amongst others, commission of a crime involving fraud, theft or embezzlement, reckless, willful or criminal misconduct, or gross negligence in Mr. Watson’s performance of his duties. Alion may also terminate Mr. Watson’s employment without cause, although if Alion does so, it will have to make a lump sum severance payment to Mr. Watson equal to the greater of Mr. Watson’s annual base salary at the time of termination for the unexpired term of the employment agreement up to a maximum of two years; or an amount equal to Mr. Watson’s base salary.

Under his employment agreement, Mr. Watson is entitled to terminate his employment and receive the same lump sum severance payment described above, if he terminates his employment for any of the following reasons within 24 months following a change of control event:


	•	his authority or responsibility is materially diminished;

	•	he is assigned duties inconsistent with his position, responsibility and status;

	•	there is an adverse change in his title or office;

	•	his base pay or incentive compensation is reduced; and

	•	his principal work location is more than ten miles away from his principal work location immediately prior to the change of control event.

For a minimum of one year after termination of Mr. Watson’s employment, he is not permitted, in any way, to compete with Alion or solicit our employees.

Under his employment agreement, Mr. Crawford will serve as Senior Vice President and Sector Manager of the spectrum engineering sector for Alion for a term of 60 months, commencing on December 20, 2002 and ending on December 20, 2007. He will receive a base annual salary of $270,100 for fiscal year 2005 and will be eligible for a performance-based annual incentive bonus. Mr. Crawford is eligible to participate in Alion’s Deferred Compensation Plan, Stock Appreciation Rights Plan, and Phantom Stock Plan. Under the terms of his employment agreement, Mr. Crawford will be given an allowance for a company car. Mr. Crawford may terminate his employment agreement with 30 days notice. If he does so, however, he will forfeit any incentive payments which might otherwise have been due him. Alion may terminate Mr. Crawford’s employment agreement for cause, which includes, amongst others, commission of a crime involving fraud, theft or embezzlement, reckless, willful or criminal misconduct, or gross negligence in Mr. Crawford’s performance of his duties. Alion may also terminate Mr. Crawford’s employment without cause, although if Alion does so, it will have to make a lump sum severance payment to Mr. Crawford equal to the greater of


	•	Mr. Crawford’s annual base salary at the time of termination for the unexpired term of the employment agreement up to a maximum of two years; or

	•	an amount equal to Mr. Crawford’s base salary.

Under his employment agreement, Mr. Crawford is entitled to terminate his employment and receive the same lump sum severance payment described above, if he terminates his employment for any of the following reasons within 24 months following a change of control event:


	•	his authority or responsibility is materially diminished;

	•	he is assigned duties inconsistent with his position, responsibility and status;

	•	there is an adverse change in his title or office;

	•	his base pay or incentive compensation is reduced; and

	•	his principal work location is more than ten miles away from his principal work location immediately prior to the change of control event.

For a minimum of one year after termination of Mr. Crawford’s employment he is not permitted, in any way, to compete with Alion or solicit our employees.

Under his employment agreement, Mr. Hughes will serve as Senior Vice President and Chief Financial Officer of Alion for a term of 60 months, commencing on December 20, 2002 and ending on December 20, 2007. He will receive a base annual salary of $275,000 for fiscal year 2005 and will be eligible for a performance-based annual incentive bonus. Mr. Hughes is also eligible to participate in Alion’s Deferred Compensation Plan, Stock Appreciation Rights Plan, and Phantom Stock Plan. Under the terms of his employment agreement, Mr. Hughes will be given an allowance for a company car. Mr. Hughes may terminate his employment agreement with 30 days notice. If he does so, however, he will forfeit any incentive

payments which might otherwise have been due him. Alion may terminate Mr. Hughes’ employment agreement for cause, which includes, amongst others, fraud, theft or embezzlement, reckless, willful or criminal misconduct, or gross negligence in Mr. Hughes’ performance of his duties. Alion may also terminate Mr. Hughes’ employment without cause, although if Alion does so, it will have to make a lump sum severance payment to Mr. Hughes equal to the greater of


	•	Mr. Hughes’ annual base salary at the time of termination for the unexpired term of the employment agreement up to a maximum of two years; or

	•	an amount equal to Mr. Hughes base salary.

Under his employment agreement, Mr. Hughes is entitled to terminate his employment and receive the same lump sum severance payment described above, if he terminates his employment for any of the following reasons within 24 months following a change of control event:


	•	his authority or responsibility is materially diminished;

	•	he is assigned duties inconsistent with his position, responsibility and status;

	•	there is an adverse change in his title or office;

	•	his base pay or incentive compensation is reduced; and

	•	his principal work location is more than ten miles away from his principal work location immediately prior to the change of control event.

For a minimum of one year after termination of Mr. Hughes employment he is not permitted, in any way, to compete with Alion or solicit our employees.

Under his employment agreement, Mr. Goff will serve Senior Vice President and Sector Manager of the defense operations integration sector for Alion, effective February 14, 2004. He will receive a base annual salary of $270,200 for the fiscal year 2005. Mr. Goff is also eligible to participate in Alion’s Deferred Compensation Plan, Stock Appreciation Rights Plan, and Phantom Stock Plan. Mr. Goff will be given an allowance for the lease of a company car. Mr. Goff may terminate his employment agreement with 30 days notice. If he does so, however, he will forfeit any incentive payments which might otherwise have been due him. Alion may terminate Mr. Goff’s employment agreement for cause, which includes, amongst others, commission of a crime involving fraud, theft or embezzlement, reckless, willful or criminal misconduct, or gross negligence in Mr. Goff’s performance of his duties. Within two years from the effective date, Alion may also terminate Mr. Goff’s employment without cause, although if Alion does so, it will have to make a lump sum severance payment to Mr. Goff equal to one year of annual base salary as of the date of termination.

Under his employment agreement, Mr. Goff is entitled to terminate his employment and receive the same lump sum severance payment described above, if he terminates his employment for any of the following reasons within 24 months following a change of control event:


	•	his authority or responsibility is materially diminished;

	•	he is assigned duties inconsistent with his position, responsibility and status;

	•	there is an adverse change in his title or office;

	•	his base pay or incentive compensation is reduced; and his principal work location is more than ten miles away from his principal work location immediately prior to the change of control event.

Dr. Atefi entered into a Deferred Compensation Agreement with Alion as a condition to completing the acquisition, pursuant to which he has forgone an aggregate of approximately $1.0 million in deferred compensation under his retention incentive agreement with IITRI and under an Executive Deferred Compensation Plan entered into between IITRI and Dr. Atefi in 1997. Alion used this amount to decrease the principal amount of the Mezzanine Note and warrants issued to IITRI at closing. On December 20, 2002,

Alion entered into an agreement with Dr. Atefi, the payment terms of which resemble those of the Mezzanine Note, which entitle Dr. Atefi to payment by Alion of approximately $857,000 in principal amount on December 20, 2008, plus 12% cash interest per year. Under this Agreement, Dr. Atefi was also granted warrants which entitle him to purchase approximately 22,062 shares of Alion’s common stock at an exercise price of $10 per share. On October 29, 2004, Dr. Atefi elected to redeem the amount due under his Deferred Compensation Agreement. Dr. Atefi was paid $857,000 plus $193,682 in accrued interest. Dr. Atefi’s warrants remain outstanding.

We maintain two Deferred Compensation Plans. One plan, the Executive Deferred Compensation Plan, covers members of management and other highly compensated officers of the Company. The other plan, the Directors Deferred Compensation Plan, covers members of our board of directors.

Each plan permits an individual to make a qualifying election to forego current payment and defer a portion of his or her compensation. Officers may defer up to 50% of their annual base salary and up to 100% of their bonus, SAR and/or phantom stock payments. Directors may defer up to 100% of their fees and up to 100% of their SAR payments.

Each Plan permits an individual to defer payment to a specified future date and to specify whether deferrals are to be paid in a lump sum or installments. Under certain limited circumstances, deferrals may be paid out early or further deferred. In general, individuals may make only one qualifying deferral election per year.

The following table sets forth certain information as of September 30, 2004, regarding the beneficial ownership of the Company’s common stock by certain beneficial owners and all directors and Named Executive Officers, both individually and as a group. The Company knows of no other person not disclosed herein beneficially owning more than 5% of the Company’s Common Stock. The address of the beneficial owner (as required) and the dates applicable to the beneficial ownership indicated are set forth in the footnotes below.

(1)

Applicable percentages based on 3,376,197 shares outstanding on September 30, 2004, and also includes shares of Common Stock subject to warrants that may be exercised within 60 days of September 30, 2004. Such shares are deemed to be outstanding for the purposes of computing the percentage ownership of the individual or entity holding the shares, but are not deemed outstanding for purposes of computing the percentage of any other person shown in the table. This table is based upon information in the Company’s possession and believed to be accurate. Unless indicated in the footnotes to this table


	and subject to community property laws where applicable, the Company believes that each of the shareholders named in this table has sole voting and investment power with respect to the shares indicated as beneficially owned.

(2)	Illinois Institute of Technology’s address is 3300 South Federal Street, Chicago, IL 60616.

(3)	The number of shares deemed to be beneficially held by IIT represents currently exercisable warrants held by IIT under the Mezzanine Warrant and the Subordinated Warrant for an aggregate of 1,585,339 shares of Common Stock.

(4)	No directors (other than Dr. Atefi) are believed by us to be beneficial owners of our common stock.

(5)	Includes warrants to purchase 22,062 shares of common stock pursuant to Dr. Atefi’s Deferred Compensation Arrangement with Alion and interests to purchase 65,254 shares of Alion’s common stock pursuant to The Alion Science and Technology Corporation Employee Ownership, Savings and Investment Plan, which we refer to as the KSOP.

(6)	Includes interests to purchase 5,262 shares of Alion’s common stock pursuant to the KSOP.

(7)	Includes interests to purchase 51,112 shares of Alion’s common stock pursuant to the KSOP.

(8)	Includes interests to purchase 47,343 shares of Alion’s common stock pursuant to the KSOP.

(9)	Includes interests to purchase 8,105 shares of Alion’s common stock pursuant to the KSOP


(10)	Includes 119,138 shares of KSOP interests beneficially owned by the Named Executive Officers as of September 30, 2004, warrants to purchase 22,062 shares of common stock held by Dr. Atefi.

We do not know of any agreements, the operation of which may at a subsequent date result in a change in control of the Company.

On March 28, 2003, IITRI sold and Jon Emery, the then General Counsel of Alion, purchased Mezzanine Notes in the principal amount of $750,000 and accompanying Mezzanine Warrants to purchase 19,327 shares of Alion common stock at an exercise price of $10 per share, for an aggregate purchase price of $750,000. On November 12, 2003, Alion purchased the Mezzanine Note and all accompanying warrants from Mr. Emery for an aggregate purchase price of $1,034,020, which amount consisted of $795,000 for the purchase of the Notes, $193,270 for the purchase of the warrants, and $35,000 for reimbursement for legal and other professional fees and $10,750 for interest earned on the Mezzanine Note. The determination to purchase the notes and warrants for this amount was made by the Chief Executive Officer. The purchase price for the Mezzanine Notes represents a premium of 6% above the aggregate principal amount of the notes, which is derived from repurchase terms contained in the notes. The $10 per share purchase price for the warrants represents a negotiated amount with Mr. Emery in conjunction with his resignation.

On February 11, 2004, the Company borrowed $750,000 from an officer of the Company. In exchange, on June 7, 2004, the Company issued the officer a promissory note with interest at a rate of 15% per annum until March 31, 2009. The annual interest period was effective beginning February 11, 2004. The agreement essentially replaces a note, which is described above, for the same sum previously issued to another officer of the Company, the termination of whose employment relationship resulted in repurchase of the note. The agreement with the officer is subordinate to the Term B Senior Credit Facility. On December 8, 2004, the Promissory Note with the officer was extinguished. An amount of $750,000 plus accrued interest of $21,635 was paid to the officer.

Except as described above, since the beginning of our last fiscal year, including any currently proposed transactions, no directors, executive officers or immediate family members of such individuals were engaged in transactions with us or any subsidiary involving more than $60,000, other than the arrangements described in the section “Executive Compensation.”

Consistent with the charter of Audit and Finance Committee, the Committee is responsible for engaging the Company’s independent auditors. Beginning with the year ended September 30, 2003, all audit and permitted non-audit services require pre-approval by the Audit and Finance Committee. The full Committee approves proposed services and fee estimates for these services. During fiscal years 2003 and 2004 all services performed by the auditors were pre-approved.

The following table summarizes the fees of KPMG LLP, our independent auditors, billed to the Company for each of the last two fiscal years for audit services and billed to the Company in each of the last two fiscal years for other services:


(1)	Audit fees consist of fees for the audit of the Company’s financial statements, the review of the interim financial statements included in the Company’s quarterly reports on Form 10-Q, and other professional services provided in connection with statutory and regulatory filings or engagements.

(2)	Audit-related fees consist of fees for assurance and related services that are reasonably related to the performance of the audit and the review of our financial statements and which are not reported under “Audit Fees”. In fiscal 2004, these services related primarily to audit services provided in conjunction with acquisitions, accounting consultations, and audits of employee benefit plans. These services were approved by the Audit and Finance Committee.

The following documents are filed as part of the Annual Report on Form 10-K:


	(1)	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).

	(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 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).

	(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.

	(6)	Incorporated by reference to the corresponding exhibit previously filed as an exhibit to Company’s current report on Form 8-K/ A, filed with the Securities and Exchange Commission on March 5, 2004 (File no. 950133-04-000745).

	(7)	Incorporated by reference to the corresponding exhibit previously filed as an exhibit to the Company’s Registration Statement on Form S-8 filed with the Securities and Exchange Commission on April 28, 2004 (File no. 950133-04-001602).

	(8)	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 December 31, 2003, filed with the Securities and Exchange Commission on February 17, 2003 (File no. 950133-04-000432).

	(9)	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 June 30, 2004, filed with the Securities and Exchange Commission on August 13, 2004 (File no. 950133-04-003228).


(10)	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 March 31, 2004, filed with the Securities and Exchange Commission on May 17, 2004 (File no. 950113-04-002056).


(11)	Incorporated by reference to the corresponding exhibit previously filed as an exhibit to the Company’s annual report Form 10-K for the fiscal year ended September 30, 2003, filed with the Securities and Exchange Commission on December 24, 2003 (File no. 950133-03-004374).

Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, as amended, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.


	By:	/s/ BAHMAN ATEFI



	Bahman Atefi
	Chairman, Chief Executive Officer and Director

Pursuant to the requirements of the Securities Exchange Act of 1934, as amended, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated.

Supplemental Information to be Furnished with Reports Filed Pursuant to Section 15(d) of the Act by Registrants which Have Not Registered Securities Pursuant to Section 12 of the Act


Delaware	333-89756	54-2061691
(State or Other Jurisdiction of Incorporation or Organization)	(Commission File Number)	(IRS Employer Identification No.)


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


PART I
	Item 1.	Business	2
	Item 2.	Properties	26
	Item 3.	Legal Proceedings	26
	Item 4.	Submission of Matters to a Vote of Security Holders	26

PART II
	Item 5.	Market for Registrant’s Common Stock and Related Stockholder Matters	26
	Item 6.	Selected Financial Data	27
	Item 7.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	32
	Item 7a.	Quantitative and Qualitative Disclosures about Market Risk	52
	Item 8.	Financial Statements and Supplementary Data	54
	Item 9.	Changes in and Disagreements with Accountants on Accounting and Financial Disclosure	96
	Item 9a.	Controls and Procedures	96
	Item 9b.	Other Information	96

PART III
	Item 10.	Directors and Executive Officers of the Registrant	97
	Item 11.	Executive Compensation	102
	Item 12.	Security Ownership of Certain Beneficial Owners and Management	112
	Item 13.	Certain Relationships and Related Transactions	113
	Item 14.	Principal Accounting Fees and Services	114

PART IV
	Item 15.	Exhibits, Financial Statement Schedules	115
	Signatures		118



Core Business Area	2004				2003				2002



	(In millions)
- Wireless Communications	$	37	14	%	$	47	22	%	$	43	21	%
- Defense Operations(a)	$	106	39	%	$	111	52	%	$	77	38	%
- Modeling & Simulation(a)	$	22	8	%	$	N/A	N/A	%	$	N/A	N/A	%
- Information Technology	$	35	13	%	$	21	10	%	$	30	15	%
- Industrial Technology Solutions	$	36	13	%	$	13	6	%	$	34	17	%
- Chemical, Environmental, and Biodefense Technologies(b)	$	N/A	N/A	%	$	9	4	%	$	6	3	%
- Explosive Science(b)	$	N/A	N/A	%	$	10	5	%	$	10	5	%
- Chemical, Biological, and Explosive Science(b)	$	26	10	%	$	N/A	N/A	%	$	N/A	N/A	%
- Transport Systems(c)	$	N/A	N/A	%	$	2	1	%	$	2	1	%
- Nuclear Safety & Analysis(d)	$	7	3	%	$	N/A	N/A	%	$	N/A	N/A	%

	$	270	100	%	$	213	100	%	$	202	100	%


• a $57.0 million cash component, which consisted of
	- approximately $25.8 million from the sale of our common stock to the ESOP;	$25.8 million (approximately)
	- approximately $31.2 million in proceeds from a loan to Alion arranged by LaSalle Bank National Association;	$31.2 million (approximately)
• an approximate $60.2 million debt component, which consisted of
	- issuance of a promissory note, the mezzanine note, by Alion to IITRI with a face value of approximately $20.3 million;	$20.3 million (approximately)
	- issuance of a promissory note, the subordinated note, by Alion to IITRI with a face value of $39.9 million;	$39.9 million (approximately)
• the payment by Alion at closing of approximately $6.2 million for IITRI’s outstanding bank debt, $2.3 million for IITRI’s cost related to the transaction, and $1.6 million for purchase price adjustments due IITRI;		$10.1 million (approximately)
• warrants issued to IITRI to purchase up to approximately 38% of our common stock, on a fully diluted basis (assuming the exercise of all outstanding warrants), at the closing date		Warrants

		$127.3 million (approximately)	Plus warrants and the assumption of additional liabilities


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

		For the fiscal year ended September 30, 2004


	*The Acquisition and Deal Terms for the Purchase of Assets from IITRI (The “Transaction”)*


	*Trends in government spending likely to affect our business.*


	*Department of Defense spending. Congress appropriated $391 billion in defense spending for fiscal year 2005*


				Pro Forma			Pro Forma
	2004			2003			2002

Cost-reimbursement		59	%		62	%		60	%
Time-and-material		25	%		22	%		22	%
Fixed-price		16	%		16	%		18	%



			September 30,

			2004		2003		2002


			(In millions)
Backlog:
		Funded	$	161	$	107	$	72
		Unfunded		1,793		1,435		1,431

	Total		$	1,954	$	1,542	$	1,503



	For the Year Ended September 30,


	2004				2003				2002


					Pro Forma				Pro Forma
	Revenue				Revenue				Revenue



	(In millions)
U.S. Department of Defense (DoD)	$	245	91	%	$	202	95	%	$	182	90	%
Other U.S. Federal, state, and local governments		19	7			7	3			16	8
Commercial and international		6	2			4	2			4	2

	$	270	100	%	$	213	100	%	$	202	100	%


	*We face intense competition from many competitors that have greater resources than we do, which could result in price reductions, reduced profitability, and loss of market share.*


	We incurred a significant amount of debt in order to complete the IITRI acquisition and through subsequent debt refinancing, which may limit our operational flexibility and negatively affect the value of your investment in the ESOP component.


	Our ability to service our debt and meet other future obligations is dependent on our future operating results and we cannot be sure that we will be able to meet these obligations as they come due.


Item 1.	*Business*


	*Pro Forma Financial Data*


	*We are dependent on government contracts for substantially all of our revenues.*


	*The failure by Congress to approve budgets timely for the federal agencies we support could delay or reduce spending and cause us to lose revenue.*


	*Historically, a few contracts have provided us with most of our revenues, and if we do not retain or replace these contracts our operations will suffer.*


	*Government contracts contain termination provisions that are unfavorable to us.*


	*Actual or perceived conflicts of interest may prevent us from being able to bid on or perform contracts.*


	*We may not receive the full amount of our backlog, which could lower future revenues.*


	Because government contracts are subject to government audits, contract payments are subject to adjustment and repayment which may result in revenues attributed to a contract being lower than expected.


	*Our subcontractors’ failure to perform contractual obligations could damage our reputation as a prime contractor and thereby our ability to obtain future business.*


	*If we fail to recover pre-contract costs, it may result in reduced fees or in losses.*


	*If we do not accurately estimate the expenses, time and resources necessary to satisfy our contractual obligations, our profit will be lower than expected.*


	*Our operating margins and operating results may suffer if cost-reimbursement contracts increase in proportion to our total contract mix.*


	If the volume of services we provide under fixed-price contracts decreases in total or as a proportion of our total business, or if profit rates on these contracts decline, our operating margins and operating results may suffer.


	*As a federal government contractor, we must comply with complex procurement laws and regulations and our failure to do so could have a negative impact upon our business.*


	*Our failure to obtain and maintain necessary security clearances may limit our ability to carry out confidential work for government customers, which could cause our revenues to decline.*


	*We derive significant revenues from contracts awarded through a competitive bidding process which is an inherently unpredictable process.*


	*Intense competition in the technology and defense industries could limit our ability to win and retain government contracts.*


	*We depend on key management and personnel and may not be able to retain those employees due to competition for their services.*


	*Our business could suffer if we fail to attract, train and retain skilled employees.*


	*Our employees may engage in misconduct or other improper activities, which could harm our business.*


	*If we are unable to manage our growth, our business could be adversely affected.*