UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

FORM 10-Q

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

For the quarterly period ended June 30, 2004

OR

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

For the transition period from            to

Commission file number 000-02479

DYNAMICS RESEARCH CORPORATION

(Exact Name of Registrant as Specified in Its Charter)

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

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

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

As of July 29, 2004, there were 8,640,618 shares of the Registrant’s Common Stock, $0.10 par value, outstanding.

DYNAMICS RESEARCH CORPORATION

INDEX

Dynamics Research Corporation
Consolidated Balance Sheets
(in thousands, except share data)

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

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Dynamics Research Corporation
Consolidated Statements of Operations
(unaudited)
(in thousands, except share and per share data)

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

4

Dynamics Research Corporation
Consolidated Statements of Operations
(unaudited)
(in thousands, except share and per share data)

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

5

Dynamics Research Corporation
Consolidated Statement of Changes in Stockholders’ Equity and Comprehensive Income
Three and six months ended June 30, 2004
(unaudited)
(in thousands)

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

6

Dynamics Research Corporation
Consolidated Statement of Changes in Stockholders’ Equity and Comprehensive Income
Three and six months ended June 30, 2003
(unaudited)
(in thousands)

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

7

Dynamics Research Corporation
Consolidated Statements of Cash Flows
(unaudited)
(in thousands)

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

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DYNAMICS RESEARCH CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

NOTE 1. BASIS OF PRESENTATION

The unaudited consolidated financial statements of Dynamics Research Corporation (“DRC” or the “company”) and its subsidiaries included herein have been prepared in accordance with accounting principles generally accepted in the United States of America. In the opinion of management, all material adjustments that are of a normal and recurring nature necessary for a fair presentation of the results for the periods presented have been reflected. All material intercompany transactions and balances have been eliminated in consolidation. Certain amounts in previously issued financial statements have been reclassified to conform to current presentation. The results of the three and six-month periods ended June 30, 2004 may not be indicative of the results that may be expected for the year ended December 31, 2004. The accompanying financial information should be read in conjunction with the consolidated financial statements and notes thereto contained in the company’s Annual Report on Form 10-K, filed with the U.S. Securities and Exchange Commission (“SEC”) for the year ended December 31, 2003.

The company has a 40% ownership interest in a small disadvantaged business, as defined by the United States Government, which is accounted for using the equity method. This ownership interest is reported as a component of “Other noncurrent assets” in the company’s Consolidated Balance Sheets.

Earnings (Loss) Per Share

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

Restricted shares of common stock that are subject to the satisfaction of certain conditions are treated as contingently issuable shares until the conditions are satisfied. These shares are excluded from the basic earnings (loss) per share calculation and included in the diluted earnings (loss) per share calculation.

Due to their antidilutive effect, approximately 66,000 and 98,000 options to purchase common stock were excluded from the calculation of diluted earnings per share for the second quarters of 2004 and 2003, respectively. Approximately 66,000 and 198,000 options to purchase common stock were excluded from the calculation of diluted income per share for the six months ended June 30, 2004 and 2003, respectively, as their effect would be antidilutive. However, these options could become dilutive in future periods.

Stock-Based Compensation

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

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DYNAMICS RESEARCH CORPORATION

stock option compensation (in thousands of dollars, except per share data).

The weighted average fair values of options granted were $11.12 and $8.48 in the first quarters of 2004 and 2003, respectively. The weighted average fair values of options granted were $11.18 and $8.21 in the six months ended June 30, 2004 and 2003, respectively. The fair value of each option for the company’s plans is estimated on the date of the grant using the Black-Scholes option-pricing model, with the following weighted average assumptions:

Recent Accounting Pronouncements

In December 2003, the staff of the Securities and Exchange Commission issued Staff Accounting Bulletin (“SAB”) No. 104 (“SAB 104”). SAB 104 revises or rescinds certain portions of the interpretative guidance related to revenue recognition as previously interpreted in SAB No. 101, Revenue Recognition in Financial Statements (“SAB 101”). The implementation of the interpretative guidance in SAB 104 has not had any effect on the company’s financial position, results of operations or cash flows.

In December 2003, the Financial Accounting Standards Board (“FASB”) issued SFAS No. 132R (“SFAS 132R”), a revision of its original SFAS No. 132, Employers’ Disclosures About Pensions and Other Postretirement Benefits (“SFAS 132”). SFAS 132R revises employers’ disclosures about pension plans and other postretirement benefit plans. It does not change the measurement or recognition of those plans required by SFAS No. 87, Employers’ Accounting for Pensions, SFAS No. 88, Employers’ Accounting for Settlements and Curtailments of Defined Benefit Pension Plans and for Termination Benefits and SFAS No. 106, Employers’ Accounting for Postretirement Benefits Other Than Pensions. SFAS 132R retains the disclosure requirements contained in SFAS 132 and requires additional disclosures about the assets, obligations, cash flows and net periodic benefit cost of defined benefit pension plans and other defined benefit postretirement plans. The company adopted these disclosure provisions for the year ended December 31, 2003.

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DYNAMICS RESEARCH CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) (continued)

In May 2003, the Emerging Issues Task Force (“EITF”) reached a consensus on EITF Issue No. 00-21, Revenue Arrangements with Multiple Deliverables (“EITF 00-21”). EITF 00-21 addresses when an arrangement with multiple deliverables should be divided into separate units of accounting. The company adopted the consensus in the third quarter of 2003. The adoption of EITF 00-21 did not have a material effect on the company’s financial position, results of operations or cash flows.

In May 2003, the FASB issued SFAS No. 150, Accounting for Certain Financial Instruments with Characteristics of Both Liabilities and Equity (“SFAS 150”). SFAS 150 requires issuers to classify as liabilities (or assets in some circumstances) three classes of freestanding financial instruments that embody obligations for the issuer. Generally, SFAS 150 is effective for financial instruments entered into or modified after May 31, 2003 and is otherwise effective at the beginning of the first interim period beginning after June 15, 2003. The company adopted the provisions of SFAS 150 on July 1, 2003. The company did not have any financial instruments within the scope of SFAS 150 at June 30, 2004, and, accordingly, the adoption of SFAS 150 did not have a material effect on its financial position, results of operations or cash flows.

In April 2003, the FASB issued SFAS No. 149, Amendment of Statement 133 on Derivative Instruments and Hedging Activities (“SFAS 149”). SFAS 149 amends and clarifies financial accounting and reporting for derivative instruments and hedging activities under SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities (“SFAS 133”), for decisions made: (a) as part of the Derivative Implementation Group process that requires amendment to SFAS 133; (b) in connection with other FASB projects dealing with financial instruments; and (c) in connection with the implementation issues raised related to the application of the definition of derivative. SFAS 149 is effective for contracts entered into or modified after June 30, 2003 and for designated hedging relationships after June 30, 2003. SFAS 149 is required to be applied prospectively. The company does not currently have any derivative instruments and, accordingly, the adoption of SFAS 149 has not had any effect on its financial position, results of operations or cash flows.

In January 2003, the FASB issued FASB Interpretation No. (“FIN”) 46, Consolidation of Variable Interest Entities, an interpretation of ARB No. 51 (“FIN 46”). In December 2003, the FASB issued FIN No. 46R (“FIN 46R”), to clarify some of the provisions of FIN 46 and to exempt certain entities from its requirements. The primary objectives of FIN 46 are to provide guidance on the identification of entities for which control is achieved through means other than through voting rights (“variable interest entities”) and how to determine when and which business enterprise should consolidate the variable interest entity. This new model for consolidation applies to an entity in which either: (a) the equity investors (if any) do not have a controlling financial interest; or (b) the equity investment at risk is insufficient to finance that entity’s activities without receiving additional subordinated financial support from other parties. In addition, FIN 46 requires that both the primary and all other enterprises with a significant variable interest in a variable interest entity make additional disclosures. FIN 46 was effective immediately for variable interest entities created after January 31, 2003. FIN 46 had previously been effective for interim periods beginning after June 15, 2003, for variable interests in place prior to February 1, 2003; however, on October 10, 2003, the FASB issued a statement deferring the implementation of FIN 46 for these variable interests until the first reporting period beginning after December 15, 2003. The company acquired, as part of the May 31, 2002 purchase of HJ Ford Associates, Inc., a 40% ownership interest in a small disadvantaged business, as defined by the United States Government, which has been accounted for using the equity method. The company had provided a guarantee of the business’s line of credit, under which its maximum exposure was $0.2 million. On April 1, 2004, the company was released as guarantor for this line of credit. The company has evaluated this investment and determined that it does not fall under the scope of FIN 46. Accordingly, the company will continue to account for this investment under the equity method, with no impact on the company’s financial position, results of operations or cash flows as a result of the adoption of FIN 46. The company currently has no other investments subject to the provisions of FIN 46.

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DYNAMICS RESEARCH CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) (continued)

In December 2002, the FASB issued SFAS No. 148, Accounting for Stock-Based Compensation-Transition and Disclosure-An Amendment of SFAS No. 123 (“SFAS 148”). SFAS 148 amends SFAS 123 to provide alternative methods of transition for a voluntary change to the fair-value-based method of accounting for stock-based employee compensation. SFAS 148 also amends the disclosure requirements of SFAS 123 to require prominent disclosures in interim financial statements in addition to the annual disclosures about the effect the fair value method would have had on reported results. As permitted by SFAS 148, the company continues to apply the disclosure-only alternative adopted under SFAS 123 to account for its stock option grants to employees, under which compensation expense is not typically recognized. The company adopted the interim disclosure provisions of SFAS 148 in its Form 10-Q for the quarterly period ended March 31, 2003. The adoption of these disclosure provisions did not have a material effect on the company’s financial position, results of operations or cash flows.

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

In April 2002, the FASB issued SFAS No. 145, Rescission of FASB Statements No. 4, 44 and 64, Amendment of FASB Statement No. 13 and Technical Corrections (“SFAS 145”). SFAS 145 rescinds SFAS No. 4, Reporting Gains and Losses from Extinguishment of Debt, SFAS No. 44, Accounting for Intangible Assets of Motor Carriers and SFAS No. 64, Extinguishment of Debt Made to Satisfy Sinking-Fund Requirements. SFAS 145 also amends SFAS No. 13, Accounting for Leases, to eliminate the inconsistency in the required accounting for sale-leaseback transactions and other existing authoritative pronouncements to make various technical corrections, clarify meanings or describe their applicability under changed conditions. The company adopted the provisions of SFAS 145 on January 1, 2003. The adoption of SFAS 145 did not have a material effect on the company’s financial position, results of operations or cash flows.

Critical Accounting Policies

There are business risks specific to the industries in which the company operates. These risks include, but are not limited to, estimates of costs to complete contract obligations, changes in government policies and procedures, government contracting issues and risks associated with technological development. The preparation of financial statements requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements. Estimates and assumptions also affect the amount of revenue and expenses during the reported period. Actual results could differ from those estimates.

The company believes the following accounting policies affect the more significant judgments made and estimates used in the preparation of its consolidated financial statements.

Revenue Recognition

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

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

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DYNAMICS RESEARCH CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) (continued)

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

Under fixed price contracts, other than service-type contracts, revenue is recognized as services are performed, primarily using the percentage of completion method, or, for certain short-term contracts, by the completed contract method, in accordance with American Institute of Certified Public Accountants Statement of Position 81-1, Accounting for Performance of Construction-Type and Certain Production-Type Contracts (“SOP 81-1”). Revenue from service-type fixed price contracts is recognized ratably over the contract period or by other appropriate output methods to measure service provided, and contract costs are expensed as incurred. The risk to the company related to a fixed price contract is that if actual costs exceed the estimated costs to complete the contract, then profit is eroded or losses are incurred.

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

Unbilled expenditures and fees on contracts in process primarily represent the amounts of recoverable contract revenue that have not been billed at the balance sheet date. Generally, the company’s unbilled expenditures and fees relate to revenue that is billed in the month after services are performed. In certain instances, billing is deferred in compliance with contract terms, such as milestone billing arrangements and withholdings or delayed for other reasons. In 2004, the company encountered delays in billing activity related to the start-up of its PeopleSoft-based enterprise business system. Costs related to United States Government contracts, including applicable indirect costs, are subject to audit by the government. Revenue from such contracts has been recorded at amounts the company expects to realize upon final settlement. At June 30, 2004, unbilled expenditures and fees also included subcontractor costs for the month of June 2004, for which invoices had not been received and for which revenues were not recognized, estimated at $3.3 million. The comparable amount included in unbilled expenditures and fees at December 31, 2003, was $2.4 million. The related liabilities were recorded as accounts payable.

Valuation Allowances

The company provides for potential losses against specifically identified accounts receivable and unbilled expenditures and fees on contracts in process based on the company’s expectation of a customer’s inability to pay. These reserves are based primarily upon specific identification of potential uncollectible accounts. In addition, payments to the company for performance on United States Government contracts are subject to audit by the Defense Contract Audit Agency. If necessary, the company provides an estimated reserve for adjustments resulting from rate negotiations and audit findings. The company routinely provides for these items when they are identified and can be reasonably estimated.

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DYNAMICS RESEARCH CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) (continued)

Intangible and Other Long-lived Assets

The company uses assumptions in establishing the carrying value, fair value and estimated lives of intangible and other long-lived assets. Long-lived assets are reviewed for impairment whenever events or changes in circumstances indicate that the asset carrying value may not be recoverable. Recoverability is measured by a comparison of the asset’s continuing ability to generate positive income from operations and positive cash flow in future periods compared to the carrying value of the asset. If assets are considered to be impaired, the impairment is recognized in the period of identification and is measured as the amount by which the carrying value of the asset exceeds the fair value of the asset.

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

Goodwill

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

Deferred Taxes

The company records a valuation allowance to reduce its deferred tax assets to the amount that is more likely than not to be realized. The company has considered future taxable income and ongoing prudent and feasible tax planning strategies in assessing the need for the valuation allowance. In the event it is determined that the company would be able to realize its deferred tax assets in excess of their net recorded amount, an adjustment to the deferred tax asset would increase income in the period such determination was made. Likewise, should the company determine it would not be able to realize all or part of its net deferred tax asset in the future, an adjustment to the deferred tax asset would be charged to income in the period such determination was made.

Pensions

Accounting and reporting for the company’s pension plan requires the use of assumptions, including but not limited to, discount rate, rate of compensation increases and expected return on assets. If these assumptions differ materially from actual results, the company’s obligations under the pension plan could also differ materially, potentially requiring the company to record an additional pension liability. An actuarial valuation is performed each year. The results of this actuarial valuation are reflected in the accounting for the pension plan upon determination.

NOTE 2. DISCONTINUED OPERATIONS

On May 2, 2003, the company completed the sale of its Encoder Division assets and certain liabilities to GSI Lumonics Inc. (“GSI”) in Billerica, Massachusetts. In connection with this transaction, in the first quarter of 2003, the company recorded charges aggregating $1.1 million before taxes as a loss on the disposal of discontinued operations. The components of these charges were $0.3 million of professional fees and $0.8 million of exit costs, comprised of $0.5 million for severance costs for

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DYNAMICS RESEARCH CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) (continued)

approximately 45 Encoder Division employees and $0.3 million for future lease costs, net of contractual sublease income from GSI for the Encoder facility. During the first quarter of 2003, the company recognized, on a cash basis, $0.7 million received as the final royalty payment associated with the 1999 sale of its discontinued Telecommunications Fraud control business, which was recorded against the loss on the disposal of discontinued operations. This income, net of the $1.1 million of charges described above, resulted in a loss on the disposal of discontinued operations of $0.4 million before taxes, or a loss of $0.2 million, net of $0.2 million of income tax benefit, in the three months ended March 31, 2003 and the six months ended June 30, 2003. The company did not record any charges related to this disposal in the three months ended June 30, 2003.

The company’s loss from discontinued operations, net of taxes, was $0.9 million, or $0.10 per diluted share, and $1.2 million, or $0.14 per diluted share, in the three and six months ended June 30, 2003, respectively. The second-quarter loss included one month of operating loss from the Encoder Division and an accrual of $1.1 million for future lease costs of the Encoder facility, net of estimated sublease income from GSI. The six-month loss included four months of operating loss for the Encoder Division and the aforementioned charge for accrued lease costs. The company did not record any charges for discontinued operations in either the three or six months ended June 30, 2004.

The activity for the three and six months ended June 30, 2004, related to the company’s exit cost accrual is as follows (in thousands):

In addition to the exit cost accruals described above, liabilities of discontinued operations also include approximately $14,000 related to liabilities of the Encoder Division not assumed by GSI in the purchase transaction.

The balance sheet captions for discontinued operations include the following (in thousands):

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DYNAMICS RESEARCH CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) (continued)

The lease on the Encoder facility will expire in August 2005; accordingly, lease payments and payments for other associated costs will be made and charged to the accrual through that date. The difference between the fair value of the total lease costs and the total cash payments will be charged to discontinued operations as expense through the expiration of the lease term, including sublease income initially estimated at the time the accrual was recorded, but not subsequently realized.

NOTE 3. GOODWILL AND INTANGIBLE ASSETS

Components of the company’s identifiable intangible assets are as follows (in thousands):

The company recorded amortization expense for its identifiable intangible assets of $0.4 million and $0.4 million for the three months June 30, 2004 and 2003, respectively, and $0.8 million and $0.9 million for the six months then ended. Estimated amortization expense on the company’s identifiable intangible assets for the remainder of the current year and each of the four subsequent years is as follows (in thousands):

There were no changes in the carrying amount of goodwill during the six months ended June 30, 2004, as illustrated in the table below (in thousands):

NOTE 4. STOCK PLANS

The company has stock option plans that are administered by the Compensation Committee of the Board of Directors and the company’s Chief Executive Officer.

The company’s 2003 Incentive Plan allows the company to grant incentive stock options, non-qualified stock options, stock appreciation rights, awards of nontransferable shares of restricted common stock and deferred grants of common stock to directors or key employees of the company.

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) (continued)

The company’s 2000 Incentive Plan (the “2000 Plan”) allows the company to grant incentive stock options, nonqualified stock options, stock appreciation rights, awards of nontransferable shares of restricted common stock and deferred grants of common stock. The company’s Executive Long Term Incentive Program (the “ELTIP”), implemented under the provisions of the 2000 Plan, provides incentives to program participants through a combination of stock options and restricted stock grants, which vest fully in seven years. The ELTIP allows for accelerated vesting contingent upon the company’s achievement of specific financial performance goals.

The company’s 2000 Employee Stock Purchase Plan allows eligible employees to purchase the company’s common stock through accumulated payroll deductions at a price per share of 85% of the lower of the fair market value price per share on the first or last day of each three month offering period. Participating employees may elect to have up to 10% of base pay withheld and applied toward the purchase of such shares.

The company’s 1995 Stock Option Plan for Non-Employee Directors provides for each outside director to receive options to purchase shares of common stock at the first annual meeting at which the director is elected and at each subsequent annual meeting, provided he or she remains an eligible director and meets certain other independence criteria.

NOTE 5. BUSINESS SEGMENT, GEOGRAPHIC, MAJOR CUSTOMER AND RELATED PARTY INFORMATION

The company has two reportable business segments: Systems and Services, and Metrigraphics.

The Systems and Services segment provides technical and information technology services to government customers. The segment was comprised of five operating groups that provide similar services and are subject to similar regulations. These services included the design, development, operation and maintenance of information technology systems, engineering services, complex logistics planning systems and services, defense program administrative support services, simulation, modeling, training systems and services, and custom built electronic test equipment and services. On July 1, 2004, the company announced that it had sharpened its government customer focus by consolidating and realigning its operations to better facilitate the execution of its recently developed business growth strategy, better address the needs of its customers and further strengthen the delivery of its solutions-based services. Accordingly, effective July 1, 2004, the company has consolidated its five Systems and Services segment operating groups into two organizations. The two new organizations encompass all of the capabilities of the five former groups. This realignment will not impact the company’s business segments, as the new groups both provide solutions-based services and are subject to similar regulations.

The Metrigraphics segment develops and builds components for original equipment manufacturers in the computer peripheral device, medical electronics, telecommunications and other industries, with the focus on the custom design and manufacture of miniature electronic parts that are intended to meet high precision requirements through the use of electroforming, thin film deposition and photolithography technologies.

The company evaluates performance and allocates resources based on operating income (loss). The operating income (loss) for each segment includes amortization of intangible assets and selling, general and administrative expenses directly attributable to the segment. All corporate operating expenses are allocated between the segments based on segment revenues, including depreciation. Sales between segments represent less than 1% of total revenues and are accounted for at cost. Corporate assets are primarily comprised of cash and cash equivalents, the company’s corporate headquarters facility in Andover, Massachusetts, the new PeopleSoft-based enterprise business system, the deferred tax asset, certain corporate prepaid expenses and other current assets, and valuation allowances.

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) (continued)

Results of operations information for the company’s business segments for the three and six month periods ended June 30, 2004 and 2003, are as follows (in thousands):

Asset information for the company’s business segments and a reconciliation of segment assets to the corresponding consolidated amounts as of June 30, 2004 and December 31, 2003 is as follows (in thousands):

Revenue is attributed to geographic areas based on the customer’s location. The company does not have locations outside the United States; however, in rare instances, it may have contracts with sales representatives located in foreign countries and provide services at customer locations outside the United States. Domestic revenues consistently represent approximately 98% of the company’s consolidated revenues.

Revenues from Department of Defense (“DoD”) customers accounted for 80.0% and 77.7% of total revenues in the second quarters of 2004 and 2003, respectively, and 80.1% and 77.5% of total revenues in the six months then ended. Revenues earned from one significant DoD contract in the Systems and Services segment accounted for approximately 17% of the company’s total revenues in both the three and six months ended June 30, 2004, and 18% in both of the comparable prior year periods. This customer had no outstanding accounts receivable balance at either June 30, 2004, or December 31, 2003. A second significant contract in the Systems and Services segment comprised approximately 13% and 11% of the company’s total revenues in the second quarters of 2004 and 2003, respectively, and 12% of revenues in both six month periods. This customer had accounts receivable balances of $7.7 million and $1.6 million at June 30, 2004 and December 31, 2003, respectively. The company had no other customers that accounted for more than 10% of revenues in either the three or six months ended June 30, 2004 or 2003.

The company has a 40% interest in HMR Tech, a small disadvantaged business, as defined by the United States government, which it accounts for using the equity method of accounting. This interest was acquired as a result of the company’s May 31, 2002 acquisition of HJ Ford Associates, Inc. (“HJ Ford”). Accordingly, HMR Tech is considered a related party for all periods subsequent to May 31, 2002. Revenues from HMR Tech for the three and six months ended June 30, 2004, were approximately $93,000 and $190,000, respectively. Revenues from HMR Tech were approximately $40,000 for both the three and six months ended June 30, 2002, as the company did not recognize any revenues from HMR Tech in the first quarter of 2003. The amounts due from HMR Tech included in accounts receivable at June 30, 2004 and December 31, 2003, were approximately $223,000 and $501,000, respectively.

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) (continued)

NOTE 6. FINANCING ARRANGEMENTS

The company had outstanding debt of $28.9 million at June 30, 2004, comprised of $8.0 million on the mortgage on the company’s headquarters facility in Andover, Massachusetts and $20.9 million under the company’s revolving credit agreement. The company’s outstanding debt of $16.8 million at December 31, 2003, was comprised of $8.3 million on the mortgage on the company’s headquarters facility and $8.5 million under the company’s revolving credit agreement.

On December 26, 2002, the company entered into an installment payment agreement in connection with the purchase of its PeopleSoft-based enterprise business system software. The company made the first payment on January 26, 2003, and the second and final payment of $0.6 million on January 26, 2004. The company had recorded the liability using an imputed interest rate of 3.38%, which was its effective borrowing rate at December 31, 2002. This purchase commitment is included as a component of “Other accrued expenses” in the company’s Consolidated Balance Sheet as of December 31, 2003.

The company obtained a $50.0 million revolving credit agreement (the “Revolver”), effective June 28, 2002. This Revolver replaced the company’s former revolving credit facility. The Revolver has a three-year term and is available to the company for general corporate purposes, including strategic acquisitions. The fee on the unused portion of the Revolver ranges from 0.25% to 0.50%, depending on the company’s most recently reported leverage ratio, and is payable quarterly in arrears. The company has the option to elect a fixed 30, 60 or 90-day term, at an interest rate of LIBOR plus 2.0% to 3.0%, depending on the company’s most recently reported leverage ratio, or to pay the base rate on any outstanding balance. Interest on the outstanding principal balance of the Revolver is payable monthly under the base rate option or at the end of the elected term for the LIBOR rate option. At June 30, 2004, the outstanding principal balance under the Revolver was $20.9 million, with $8.4 million borrowed at the base rate of 4.0% and $12.5 million borrowed at 3.11% under a 30-day LIBOR option elected on June 2, 2004. The weighted average interest rate on the $20.9 million outstanding at June 30, 2004, was 3.47%. At December 31, 2003, the outstanding principal balance under the Revolver was $8.5 million. The interest rate on $7.5 million of this outstanding amount was 3.17% under the 60-day LIBOR rate option elected on December 15, 2003. The interest rate on the remaining $1.0 million principal amount outstanding was 3.16% under the 30-day LIBOR rate option elected on December 15, 2003.

The company has a ten-year mortgage loan (the “Mortgage”), dated June 12, 2000, as amended and restated on June 28, 2002, on its corporate office facility in Andover, Massachusetts. The agreement requires quarterly principal payments of $125,000, with a final payment of $5.0 million due in May 2010. Interest on the Mortgage accrues at the rate of LIBOR plus 2.0%. The interest rate on the Mortgage was 3.14% at June 30, 2004, under the 90-day LIBOR option elected on April 12, 2004. The company’s outstanding principal balance on the Mortgage was $8.0 million and $8.3 million at June 30, 2004 and December 31, 2003, respectively.

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

On December 23, 2003, the Revolver was amended to increase the capital expenditure limits in 2003 and 2004 to $9.0 million and $7.0 million, respectively, to allow for adjustments to the scheduled renovations of the company’s Andover, Massachusetts corporate office facility and the company’s investment in its new PeopleSoft-based enterprise business system. On March 26, 2003, the tangible net worth covenant of the Revolver was amended to base the covenant on total net worth and to exclude any adjustments to Accumulated other comprehensive loss from the covenant calculation. Management believes the company was in compliance with the Revolver and Mortgage agreements on June 30, 2004.

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) (continued)

NOTE 7. DEFINED BENEFIT PENSION PLAN

The components of net periodic benefit cost for the company’s defined benefit pension plan are below (in thousands):

The company’s defined benefit pension plan is frozen. No credit is earned for current service and no new participants are eligible to enter the plan; accordingly, the net periodic benefit costs do not include any charges for service cost. The company previously disclosed in its Annual Report on Form 10-K for the year ended December 31, 2003, that it expected to contribute $3,725,000 to its pension plan in 2004. As of June 30, 2004, $1.5 million of contributions had been made. The company currently expects to contribute an additional $1.4 million to fund its pension plan in 2004, for a total contribution of $2.9 million. The reduction in the expected cash contribution in 2004 from the previously disclosed estimate is a result of interest rate relief promulgated by the Internal Revenue Service in April 2004, coupled with the finalization of the company’s contribution requirement calculation.

NOTE 8. CONTINGENCIES

The company has a 40% ownership interest in a small disadvantaged business, as defined by the United States Government, which is accounted for using the equity method. The company has continuing business relationships with this business and had provided a guarantee of the business’s line of credit, under which its maximum exposure was $0.2 million. On April 1, 2004, the company was released as guarantor for this line of credit.

The company has change of control agreements with certain of its employees that provide them with benefits should their employment with the company be terminated other than for cause or their disability or death, or if they resign for good reason, as defined in these agreements, within a certain period of time from the date of any change of control of the company.

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

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) (continued)

As previously disclosed, on October 26, 2000, two former company employees were indicted and charged with, among other violations, wire fraud and a conspiracy scheme to defraud the United States Air Force out of approximately $10 million through kickbacks and overcharging for computer components and services. The former employees collected the kickbacks and overcharges through separate and independent businesses. The company received no money from their scheme. When notified by the government of the employees’ conspiracy, the company fired the two employees and voluntarily cooperated with the government’s investigation. The company was not charged in the criminal case. Both former employees pled guilty and were sentenced to prison. The company believes that the government has recovered a substantial portion of the defrauded funds from the co-conspirators. Notwithstanding the company’s efforts to settle any claims against the company arising from the co-conspirators’ scheme, on October 9, 2003, the United States Attorney filed a civil complaint against the company in the United States District Court for the District of Massachusetts based in substantial part upon the actions and omissions of the former employees which gave rise to the criminal cases against them. In the civil action, the United States Attorney is asserting on behalf of the government claims against the company based upon the False Claims Act and the Anti-Kickback Act, in addition to certain common law and equitable claims. The United States Attorney seeks to recover up to three times its actual damages and penalties under the False Claims Act and double damages and penalties under the Anti-Kickback Act and to recover costs and interest. The company disputes the claims, believes it has substantive defenses, and intends to vigorously defend itself. However, the outcome of such litigation, if unfavorable, could have a material adverse effect on the company’s business, financial position, results of operations and cash flows. The company has filed a third party complaint, as part of the United States Attorney’s civil action, including an affirmative multiple damage claim for unfair and deceptive practices, against Storage Engine, Inc. (“Storage Engine”), formerly known as ECCS, Inc., and its president and director. The complaint alleges that Storage Engine directly benefited from the kickback scheme alleged by the United States Attorney. Storage Engine, a supplier of computer components for the Air Force, made payments to the company’s two former employees through separate and independent businesses. Storage Engine and its president have denied the allegations. The company’s claim against Storage Engine, which filed for reorganization under Chapter 11 of the United States Bankruptcy Code, has survived the bankruptcy proceeding and remains a claim against Storage Engine.

On September 5, 2002, Genesis Tactical Group LLC (“Genesis”) asserted a cross-claim against Lockheed Martin Corporation (“Lockheed”) in the State of New York Supreme Court, County of Onondaga, seeking $50.0 million in damages and against the company seeking $35.0 million in damages. These cross-claims arise out of a suit filed on July 30, 2003, by Lockheed against Tactical Communications Group LLC, Genesis and the company in the State of New York Supreme Court, County of Onondaga. The Lockheed suit relates to a contract for services that was sold to Genesis by the company pursuant to an asset purchase agreement in 2001. By the terms of the asset purchase agreement, the company’s liability to Genesis is limited to $300,000, other than for intentional misrepresentation, willful breach or fraud. Lockheed and Genesis have settled their outstanding issues, including a software ownership issue, and filed a stipulation of dismissal with prejudice. In connection with this settlement, the Genesis claim for $35.0 million against the company was eliminated. Lockheed’s settlement demand to the company was $496,000 plus interest. The company believes that $312,000 of the demanded amount is for extra work and materials procured by Lockheed from Genesis and disputes the balance due to other mutually agreed contract changes between Lockheed and Genesis. The company expects to continue to defend against any and all claims by Lockheed and/or Genesis. While the company believes that the possibility of a material adverse effect on the company’s business, financial position, results of operations and cash flows is remote, there can be no assurance as to the outcome.

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

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) (continued)

In the first half of 2004 and the year ended December 31, 2003, approximately 91% and 93%, respectively, of the company’s revenues were derived from sales to United States Government agencies, primarily the Department of Defense. All of the company’s United States Government contracts are subject to termination for convenience in accordance with government regulations. In the first half of 2004 and the year ended December 31, 2003, sales to agencies of state and local governments comprised approximately 7% and 5%, respectively, of revenues. Many of the contracts the company has won are multi-year efforts. In accordance with state laws, funding must be approved annually by the respective state’s legislature.

NOTE 9. SUBSEQUENT EVENTS

On August 2, 2004, the company announced that it signed a definitive agreement to acquire the government division of Impact Innovations LLC (“Impact Innovations”) for $53.4 million in cash, subject to certain closing provisions. Impact Innovations’ government group has annual revenues approximating $47 million and is based in the Washington, D.C. area. The government group offers solutions in business intelligence, enterprise software, application development, information technology service management and other related areas. Its customers include United States government intelligence agencies and various Department of Defense agencies, as well as federal civilian agencies. In connection with the acquisition, the company expects to amend its existing credit facility to provide for a $55.0 million term loan and a $37.0 million revolver for working capital. The acquisition is also subject to seller shareholder and regulatory approvals and completion of the financing discussed below.

On July 31, 2004, the company received a commitment letter from its bank group to restructure and increase the company’s credit facilities to $100.0 million, inclusive of the current mortgage on the corporate headquarters in Andover, Massachusetts. The secured financing agreement will provide for a $55.0 million, five-year term loan with a seven-year amortization schedule for the purchase of Impact Innovations’ government division and a $37.0 million, five-year revolving credit agreement for working capital. The bank group, led by Brown Brothers Harriman, also includes KeyBank, Bank North and BancAmerica. Although the company has received the commitment letter, there can be no assurance that the transaction will be completed.

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

FORWARD-LOOKING STATEMENTS

Certain statements in this quarterly report constitute “forward-looking statements” which involve known risks, uncertainties and other factors which may cause the actual results, performance or achievements of Dynamics Research Corporation (“DRC” or the “company”) to be materially different from any future results, performance or achievements expressed or implied by such forward-looking statements. Such factors include the “Factors That May Affect Future Results” set forth in Management’s Discussion and Analysis of Financial Condition and Results of Operations, which is included in this report. Precautionary statements made herein should be read as being applicable to all related forward-looking statements whenever they appear in this report.

OVERVIEW

DRC, founded in 1955, and headquartered in Andover, Massachusetts, provides information technology, engineering and other services focused on defense, public safety and citizen services for federal, state and local governments. DRC’s core capabilities are focused on information technology, engineering and technical subject matter expertise that pertain to the knowledge domains relevant to the company’s core customers.

The company has two reportable business segments: Systems and Services, and Metrigraphics. The Systems and Services segment provides technical and information technology services to government customers. These services include logistics information systems; business transformation; design, development, operation and maintenance of information technology systems; engineering services; defense acquisition management services; modeling and simulation; decision support; training systems and services; automated case management; and custom-built electronic test equipment and services. Revenues in this segment are reported in the caption “Contract revenue” in the company’s Consolidated Statements of Operations. The Metrigraphics segment develops and builds components for original equipment manufacturers (“OEM”) in the computer peripheral device, medical electronics, telecommunications and other industries, with the focus on the custom design and manufacture of miniature electronic parts that meet high precision requirements through the use of electroforming, thin film deposition and photolithography technologies. Revenues in this segment are reported in the caption “Product sales” in the company’s Consolidated Statements of Operations.

The company’s business growth strategy is focused on developing relationships with customers in defense, public safety and state citizen services markets whose missions are focused on one or more of these six strategic business areas: C4ISR (command, control, communications, computing, intelligence, surveillance and reconnaissance), logistics, readiness, military space, homeland security and health and human services. The strategy is intended to leverage six solution sets where DRC believes it has strong competencies and a record of meeting its customers’ most difficult challenges. These solutions are business intelligence, acquisition managements, training, business transformation, child welfare case management and network services management.

DRC has a balanced organic and acquisition growth strategy aimed at gaining market segment leadership and penetrating new market segments, with specific focus on sustained organic growth. This strategy is intended to achieve four key objectives: to increase shareholder value; to grow in selected markets; to achieve operational excellence; and to become an employer of choice.

On July 1, 2004, the company announced that it had sharpened its government customer focus by consolidating and realigning its operations to better facilitate the execution of its recently developed business growth strategy, better address the needs of its customers and further strengthen the delivery of its solutions-based services. Accordingly, effective July 1, 2004, the company has consolidated its five Systems and Services segment operating groups into two organizations. The two new organizations encompass all of the capabilities of the five former groups. This realignment will not impact the company’s business segments, as the new groups both provide solutions-based services and are subject to similar regulations.

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MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS (continued)

RECENT DEVELOPMENTS

On August 2, 2004, the company announced that it signed a definitive agreement to acquire the government division of Impact Innovations LLC (“Impact Innovations”) for $53.4 million in cash, subject to certain closing provisions. Impact Innovations’ government group has annual revenues approximating $47 million and is based in the Washington, D.C. area. The government group offers solutions in business intelligence, enterprise software, application development, information technology service management and other related areas. Its customers include United States government intelligence agencies and various Department of Defense agencies, as well as federal civilian agencies. In connection with the acquisition, the company expects to amend its existing credit facility to provide for a $55.0 million term loan and a $37.0 million revolver for working capital. The acquisition is also subject to seller shareholder and regulatory approvals and completion of the financing discussed below.

On July 31, 2004, the company received a commitment letter from its bank group to restructure and increase the company’s credit facilities to $100.0 million, inclusive of the current mortgage on the corporate headquarters in Andover, Massachusetts. The secured financing agreement will provide for a $55.0 million, five-year term loan with a seven-year amortization schedule for the purchase of Impact Innovations’ government division and a $37.0 million, five-year revolving credit agreement for working capital. The bank group, led by Brown Brothers Harriman, also includes KeyBank, Bank North and BancAmerica. The company expects to complete the financing in late August 2004. Although the company has received the commitment letter, there can be no assurance that the transaction will be completed.

RESULTS OF OPERATIONS THREE AND SIX MONTHS ENDED JUNE 30, 2004 AND 2003

Revenues

The company reported revenues of $64.9 million in the second quarter of 2004, compared to $62.1 million in the same prior year period. The company’s revenues for the six months ended June 30, 2004, were $127.0 million, compared to $120.7 million in the same prior year period.

Contract revenues for the Systems and Services segment increased 4.6%, to $63.0 million, in the second quarter of 2004, from $60.3 million in the comparable prior year period. Contract revenues were $123.7 million and $117.2 million, respectively, in the first six months of 2004 and 2003. Defense revenues grew 7.6%, or $3.7 million, in the second quarter of 2004, from $48.2 million in the second quarter of 2003. Defense revenues were $101.7 million and $93.5 million in the six months ended June 30, 2004 and 2003, respectively. The increase in defense revenues in both the current year three and six-month periods is attributable to internally generated growth, primarily in the C4ISR (Command, control, communications, computing, intelligence, surveillance and reconnaissance), readiness and logistics markets.

Revenues from federal civilian agencies were $7.1 million for the quarter ended June 30, 2004, a decrease of 22.2% from the $9.1 million reported in the same prior year quarter. Revenues from federal civilian agencies in the six months ended June 30, 2004 and 2003, were $13.6 million and $18.1 million, respectively. The decrease in federal civilian agency revenues is primarily the result of the completion late in 2003 of the company’s quality assurance work at the Bureau of Citizenship and Immigration Services and delays in new contract awards by this agency. The company continues to await new contract awards by agencies in this sector and is pursuing business opportunities in this area.

State and local government revenues increased to $3.9 million in the second quarter of 2004, from $2.9 million in the second quarter of 2003, resulting from the commencement of work on a new multi-year software development contract with the State of Ohio. State and local government revenues were $8.3 million and $5.5 million in the six month periods ended June 30, 2004 and 2003, respectively. The increase in the current year was due to the new Ohio contract, as well as higher revenues from training and network management services with health and human services customers.

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MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS (continued)

Product sales for the Metrigraphics segment increased by $0.1 million, to $1.9 million, in the second quarter of 2004, from $1.8 million in the same quarter of 2003. Product sales for this segment decreased by $0.2 million, to $3.3 million, in the first half of 2004, compared to the same prior year period. This segment’s increase in the second quarter of 2004 is due in part to an overall improvement in order levels, combined with an acceleration of orders by one customer from the third quarter to the second quarter. The company expects 2004 revenues for this segment to be comparable to 2003 revenues. However, the company remains concerned that further economic weakness could increase the adverse effect on this segment.

Gross margin

Gross margins were 14.5% and 16.1% in the second quarters of 2004 and 2003, respectively, and 14.6% and 15.9% in the six months then ended.

The company’s Systems and Services segment’s gross margin on contract revenues decreased to 14.1% in the second quarter of 2004, from 15.7% in the comparable prior year quarter. The segment’s gross margin for the six months ended June 30, 2004, also decreased, to 14.3%, compared to 15.6% in the same prior year period. The decrease in both current year periods is primarily attributable to increased subcontractor costs and amortization and maintenance expenses related to the implementation of the company’s new PeopleSoft-based enterprise business system, which was placed into service on January 1, 2004. These factors were partially offset by efficiencies realized from the integration of recent acquisitions into the company’s operations, primarily facility consolidation and lower overhead as a percentage of revenues.

The Metrigraphics segment’s gross margin on product sales decreased in both the three and six-month periods ended June 30, 2004, to 27.9% and 24.6%, respectively, compared to 29.9% and 27.7% in the same prior year periods. However, the segment’s gross margin in the second quarter of the current year reflected improved performance in comparison to the first quarter, and is consistent with higher revenues in the second quarter. Despite these increased revenues, gross margin declined in the current year, compared to the same prior year periods. This decrease is primarily attributable to product mix. The company remains concerned that further economic weakness in this sector could exert additional downward pressure on this segment’s gross margin.

Selling, general and administrative expenses

Selling, general and administrative expenses for the second quarter of 2004 were $5.0 million, a decrease of $1.1 million, compared to $6.1 million in the same prior year quarter. Selling, general and administrative expenses also decreased in the six months ended June 30, 2004, by $1.6 million, to $10.3 million, compared to $11.9 million in the six months ended June 30, 2003. This decrease is primarily attributable to reduced legal and marketing costs, partially offset by costs related to the implementation of the company’s new PeopleSoft-based enterprise business system.

Amortization of intangible assets

Amortization expense of $0.4 million in the second quarters of both 2004 and 2003, and $0.8 million and $0.9 million in the six months ended June 30, 2004 and 2003, respectively, relates to intangible assets acquired in the company’s 2002 purchases of Andrulis Corporation and HJ Ford Associates, Inc.

Operating income

The company reported operating income of $4.1 million, or 6.3% of revenues, and $3.4 million, or 5.6% of revenues, in the second quarters of 2004 and 2003, respectively. The company’s operating income in the six months ended June 30, 2004 and 2003, was $7.5 million, or 5.9% of revenues, and $6.4 million, or 5.3% of revenues, respectively. The increase in both operating income and margin in the current year periods is primarily attributable to reduced selling, general and administrative expenses.

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MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS (continued)

Interest income and expense

Interest income increased to approximately $24,000 in the second quarter of 2004, from approximately $12,000 in the comparable prior year period. Interest income in the six months ended June 30, 2004, was approximately $31,000, an increase from the amount reported for the same prior year period, which approximated $18,000. Interest expense increased by approximately $136,000, to approximately $385,000, in the second quarter of 2004, compared to the same prior year period. Interest expense for the six months ended June 30, 2004, approximated $606,000, an increase of approximately $73,000 from the same prior year period. The increase in interest expense in both current year periods is primarily attributable to the higher outstanding principal balance on the company’s revolving credit facility during the second quarter of 2004. Borrowings during the first half of 2004 have been used to support the start-up of the company’s new PeopleSoft-based enterprise business system, which was placed into service on January 1, 2004.

Income tax provision

The company recorded income tax provisions of $3.1 million, or 42.3% of pre-tax income, and $2.4 million, or 40.2% of pre-tax income, in the first six months of 2004 and 2003, respectively. The increase in the 2004 tax rate reflects changes in estimates during 2003 for non-deductible expenses.

Discontinued operations

On May 2, 2003, the company completed the sale of its Encoder Division assets and certain liabilities to GSI Lumonics Inc. (“GSI”) in Billerica, Massachusetts, for $3.3 million in cash, subject to post-closing adjustments related to a valuation of the net assets of the Encoder Division and the assumption by GSI of certain of DRC’s liabilities with respect to the assets acquired.

In connection with this transaction, in the first quarter of 2003, the company recorded charges aggregating $1.1 million before taxes as a loss on the disposal of discontinued operations. The components of these charges were $0.3 million of professional fees and $0.8 million of exit costs, comprised of $0.5 million for severance costs for approximately 45 Encoder Division employees and $0.3 million for future lease costs, net of contractual sublease income from GSI for the Encoder facility. During the first quarter of 2003, the company recognized, on a cash basis, $0.7 million received as the final royalty payment associated with the 1999 sale of its discontinued Telecommunications Fraud control business, which was recorded against the loss on the disposal of discontinued operations. This income, net of the $1.1 million of charges described above, resulted in a loss on the disposal of discontinued operations of $0.4 million before taxes, or a loss of $0.2 million, net of $0.2 million of income tax benefit, in the three months ended March 31, 2003 and the six months ended June 30, 2003. The company did not record any charges related to this disposal in the three months ended June 30, 2003.

The company’s loss from discontinued operations, net of taxes, was $0.9 million, or $0.10 per diluted share, and $1.2 million, or $0.14 per diluted share, in the three and six months ended June 30, 2003, respectively. The second-quarter loss included one month of operating loss from the Encoder Division and an accrual of $1.1 million for future lease costs of the Encoder facility, net of estimated sublease income from GSI. The six-month loss included four months of operating loss for the Encoder Division and the aforementioned charge for accrued lease costs. The company did not record any charges for discontinued operations in either the three or six months ended June 30, 2004.

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DYNAMICS RESEARCH CORPORATION
MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS (continued)

Backlog

The company’s funded backlog was $123.4 million and $118.5 million at June 30, 2004 and 2003, respectively, and $123.9 million at December 31, 2003. The funded backlog generally is subject to possible termination at the convenience of the customer. The company has a number of multi-year contracts with agencies of the United States and state governments for which actual funding generally occurs on an annual basis. A portion of the company’s funded backlog is based on annual purchase contracts and subject to annual governmental approval or appropriations legislation, and the amount of funded backlog as of any date can be affected by the timing of order receipts and deliveries. Backlog does not necessarily equate to future revenues.

LIQUIDITY AND CAPITAL RESOURCES

At June 30, 2004 and December 31, 2003, the company had cash and cash equivalents aggregating $145,000 and $2.7 million, respectively. The decrease in cash and cash equivalents is primarily the result of $13.6 million of net cash used in operating activities, including $0.4 million used in discontinued operations, and $2.2 million of capital expenditures. These amounts were partially offset by $12.4 million of additional borrowings under the company’s revolving credit facility and $1.3 million of proceeds from the exercise of stock options and participation in the company’s employee stock purchase plan.

Cash used in operating activities totaled $13.6 million, and is primarily attributable to $10.9 million of increased accounts receivable, $10.0 million of increases in unbilled expenditures and fees on contracts in process, and $1.0 million of reduced accrued payroll and employee benefits. These amounts were partially offset by $4.2 million of net income, depreciation and amortization expenses aggregating $2.5 million and $0.9 million of increased accounts payable.

The company’s days sales outstanding, or DSO, was 114 at June 30, 2004 and 89 at December 31, 2003. These amounts include the amounts reported under the captions “Accounts receivable, net of allowances” and “Unbilled expenditures and fees on contracts in process” with the exception of subcontractor costs accrued, for which revenues were not recognized, described below. As reported in the company’s Annual Report on Form 10-K for the year ended December 31, 2003, and Quarterly Report on Form 10-Q for the quarterly period ended March 31, 2004, the company encountered start-up delays in billing activity in the first quarter of 2004, related to the implementation of its PeopleSoft-based enterprise business system. Progress was made in the second quarter; the company generated invoices totaling $70 million, well in excess of second quarter revenues, and compared to invoices totaling $47 million generated in the first quarter of 2004. However, delayed timing of cash collections resulted in an increase in DSO, from 106 days at March 31, 2004 to 114 days at June 30, 2004. The company has no indication of concerns of collectibility.

At June 30, 2004 unbilled expenditures and fees on contracts in process included subcontractor costs for the month of June, for which invoices had not been received and for which revenues were not recognized, estimated at $3.3 million. The corresponding amount recorded at December 31, 2003, was $2.4 million. Related liabilities were recorded as accounts payable.

Cash used for investing activities totaled $2.5 million, and is primarily attributable to $2.2 million of capital expenditures, including $0.9 million for renovations to the company’s Andover, Massachusetts corporate headquarters and $0.7 million related to the implementation of the company’s new PeopleSoft-based enterprise business system.

The company has a revolving credit facility (the “Revolver”), entered into on June 28, 2002. The Revolver has a three-year term and is available to the company for general corporate purposes, including strategic acquisitions. The fee on the unused portion of the Revolver ranges from 0.25 % to 0.50% depending on the company’s most recently reported leverage ratio, and is payable quarterly in arrears. The company has the option to elect on a fixed 30, 60 or 90-day term, at an interest rate of LIBOR plus 2.0% to 3.0%, depending on the company’s most recently reported leverage ratio, or to pay the base rate on any outstanding balance. Interest on the Revolver’s outstanding principal balance is payable monthly under the base rate option or at the end of the elected term for the LIBOR rate option. At June 30, 2004, the outstanding principal balance under the Revolver was $20.9 million, with $8.4 million borrowed at the base rate of 4.0% and $12.5 million borrowed at 3.11% under a 30-day LIBOR option elected on June 2, 2004. The weighted average interest rate on the outstanding principal balance was 3.47% at June 30, 2004.

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MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS (continued)

The company has a ten-year mortgage loan (the “Mortgage”), dated June 12, 2000, as amended and restated on June 28, 2002, on the corporate office facility in Andover, Massachusetts. The outstanding principal balance of the Mortgage was $8.0 million at June 30, 2004. The agreement requires quarterly principal payments of $125,000, with a final payment of $5.0 million in May 2010. Interest on the Mortgage accrues at the rate of LIBOR plus 2.0%. The interest rate on the Mortgage at June 30, 2004, was 3.14% under the 90-day LIBOR option, elected on April 12, 2004.

On December 26, 2002, the company entered into an installment payment agreement in connection with the purchase of its PeopleSoft-based enterprise business system software. The company made the first payment on January 26, 2003, and the second and final payment of $0.6 million on January 26, 2004. The company had recorded the liability using an imputed interest rate of 3.38%, which was its effective borrowing rate at December 31, 2002. This purchase commitment is included as a component of Other accrued expenses in the company’s Consolidated Balance Sheet as of December 31, 2003.

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

On December 23, 2003, the Revolver was amended to increase the capital expenditure limits in 2003 and 2004 to $9.0 million and $7.0 million, respectively, to allow for adjustments to the scheduled renovations of the company’s Andover, Massachusetts corporate headquarters and the company’s investment in its new PeopleSoft-based enterprise business system. On March 26, 2003, the tangible net worth covenant of the Revolver was amended to base the covenant on total net worth and to exclude any adjustments to “Accumulated other comprehensive loss” from the covenant calculation. Management believes the company was in compliance with the Revolver and Mortgage agreements amounts on June 30, 2004.

On July 31, 2004, the company received a commitment letter from its bank group to restructure and increase the company’s credit facilities to $100.0 million, inclusive of the current mortgage on the corporate headquarters in Andover, Massachusetts. The secured financing agreement will provide for a $55.0 million, five-year term loan with a seven-year amortization schedule for the purchase of Impact Innovations’ government division and a $37.0 million, five-year revolving credit agreement for working capital. This financing is intended to replace the Revolver, which expires on June 27, 2005. The bank group, led by Brown Brothers Harriman, also includes KeyBank, Bank North and BancAmerica. The company expects to complete the financing in late August. Although the company has received the commitment letter, there can be no assurance that the transaction will be completed.

Cash provided by financing activities was comprised of $12.4 million of net borrowings under the company’s revolving credit agreement and $1.3 million of cash proceeds from the exercise of stock options and issuance of shares under the employee stock purchase plan. The company has increased its borrowings under the revolving credit agreement to support its temporary resource allocation related to the start-up of the company’s new PeopleSoft-based enterprise business system. This resource allocation was necessary to address billing issues encountered during the system implementation; these issues have been identified and are being addressed. The company’s proceeds from financing activities were partially offset by $0.3 million of principal payments under the company’s Mortgage agreement.

The company’s results of operations, cash flows and financial condition are subject to certain trends, events and uncertainties, including demands for capital to support growth, economic conditions, government payment practices and contractual matters. The company believes that selective acquisitions are an important component of its growth strategy. The company may acquire, from time to time, firms or properties that are aligned with the company’s core capabilities and which complement the company’s customer base. The company’s capital expenditures, excluding business acquisitions, are expected to be in the range of $6 million to $7 million in 2004, primarily for facilities infrastructure consolidation and improvements.

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DYNAMICS RESEARCH CORPORATION
MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS (continued)

The company’s need for, cost of, and access to funds are dependent on future operating results, the company’s growth and acquisition activity, as well as conditions external to the company. The company will continue to consider acquisition opportunities that align with its strategic objectives, along with the possibility of utilizing the credit facility as a source of financing.

Based upon its present business plan and operating performance, the company believes that cash provided by operating activities, combined with amounts available for borrowing under the Revolver, will be adequate to fund the capital requirements of its existing operations during the remainder of 2004 and for the foreseeable future and that it will be able to obtain replacement financing on competitive terms at or prior to the expiration of the Revolver on June 27, 2005. However, the development of adverse economic or business conditions could significantly affect the need for and availability of capital resources.

The company’s contractual obligations as of June 30, 2004 consist of the following (in thousands):