DYNAMICS RESEARCH CORP - 10-Q Quarterly Report

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

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 September 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)


Massachusetts (State or other Jurisdiction of Incorporation or Organization)		04-2211809 (I.R.S. Employer Identification No.)

60 Frontage Road Andover, Massachusetts (Address of Principal Executive Offices)		01810-5498 (Zip Code)

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 Noo.

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 October 28, 2004, there were 8,683,065 shares of the Registrant’s Common Stock, $0.10 par value, outstanding.

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


	September 30,			December 31,
	2004			2003
	(unaudited)			(audited)
Assets
Current assets
Cash and cash equivalents	$	150		$	2,724
Accounts receivable, net of allowances of $364 and $321
at September 30, 2004 and December 31, 2003, respectively		49,134			28,251
Unbilled expenditures and fees on contracts in process		47,982			34,257
Prepaid expenses and other current assets		1,871			2,145

Total current assets		99,137			67,377

Noncurrent assets
Property, plant and equipment, net		21,903			20,672
Deferred income taxes		1,032			2,337
Goodwill		64,109			26,711
Intangible assets, net		12,508			2,343
Other noncurrent assets		4,842			1,630

Total noncurrent assets		104,394			53,693

Total assets	$	203,531		$	121,070

Liabilities and stockholders’ equity
Current liabilities
Current portion of long-term debt	$	8,356		$	500
Notes payable and revolver		15,404			8,500
Accounts payable		19,194			13,351
Accrued payroll and employee benefits		19,060			15,657
Deferred income taxes		9,569			9,698
Other accrued expenses		6,688			2,371
Discontinued operations		401			778

Total current liabilities		78,672			50,855

Long-term liabilities
Long-term debt, less current portion		52,920			7,750
Accrued pension liability		10,208			12,030
Other long-term liabilities		1,880			1,386
Discontinued operations		—			398

Total long-term liabilities		65,008			21,564

Total liabilities		143,680			72,419

Commitments and contingencies
Stockholders’ equity
Preferred stock, $0.10 par value, 5,000,000 shares authorized,
no shares issued		—			—
Common stock, $0.10 par value, 30,000,000 shares authorized:
Issued - 8,676,955 and 9,822,508 shares at September 30,
2004 and December 31, 2003, respectively		868			982
Treasury stock -1,379,426 shares at December 31, 2003		—			(138	)
Capital in excess of par value		40,121			36,642
Unearned compensation		(1,743	)		(797	)
Accumulated other comprehensive loss		(5,424	)		(7,556	)
Retained earnings		26,029			19,518

Total stockholders’ equity		59,851			48,651

Total liabilities and stockholders’ equity	$	203,531		$	121,070

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

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


	Three months ended						Nine months ended
	September 30,						September 30,
	2004			2003			2004			2003
Contract revenue	$	68,659		$	60,602		$	192,361		$	177,840
Product sales		1,792			1,830			5,108			5,336

Total revenue		70,451			62,432			197,469			183,176

Cost of contract revenue		58,022			51,386			164,017			150,389
Cost of product sales		1,274			1,342			3,774			3,877
Selling, general and administrative expenses		6,141			5,018			16,411			16,908
Amortization of intangible assets		573			423			1,335			1,301

Total operating costs and expenses		66,010			58,169			185,537			172,475

Operating income		4,441			4,263			11,932			10,701
Interest expense, net		(559	)		(182	)		(1,133	)		(696	)
Other income		48			51			485			131

Income from continuing operations before provision for income taxes		3,930			4,132			11,284			10,136
Provision for income taxes		1,662			1,745			4,773			4,159

Income from continuing operations		2,268			2,387			6,511			5,977
Loss from discontinued operations, net of tax benefits of $100 and $914 in the three and nine months ended September 30, 2003, respectively		—			(147	)		—			(1,360	)
Loss on disposal of discontinued operations, net of tax benefit of
$157 in the nine months ended September 30, 2003		—			—			—			(233	)

Net income	$	2,268		$	2,240		$	6,511		$	4,384

Earnings (loss) per common share
Basic
Income from continuing operations	$	0.27		$	0.29		$	0.77		$	0.73
Loss from discontinued operations		—			(0.02	)		—			(0.16	)
Loss on disposal of discontinued operations		—			—			—			(0.03	)

Net earnings per common share	$	0.27		$	0.27		$	0.77		$	0.54

Diluted
Income from continuing operations	$	0.25		$	0.27		$	0.72		$	0.68
Loss from discontinued operations		—			(0.02	)		—			(0.15	)
Loss on disposal of discontinued operations		—			—			—			(0.03	)

Net earnings per common share	$	0.25		$	0.25		$	0.72		$	0.50

Weighted average shares outstanding
Weighted average shares outstanding — basic		8,538,353			8,259,833			8,464,854			8,192,299
Dilutive effect of options		551,109			735,157			567,252			584,324

Weighted average shares outstanding — diluted		9,089,462			8,994,990			9,032,106			8,776,623

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

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


					Common stock
	Preferred stock				Issued						Treasury stock
	Shares		Par value		Shares			Par value			Shares			Par value
Three months ended September 30, 2004
Balance June 30, 2004		—	$	—		10,008		$	1,001			(1,379	)	$	(138	)
Issuance of common stock through stock options exercised and employee stock purchase plan		—		—		50			5			—			—
Issuance of restricted stock		—		—		—			—			—			—
Forfeiture of restricted stock		—		—		(2	)		—			—			—
Repurchase and retirement of restricted stock		—		—		—			—			—			—
Amortization of unearned compensation, net of forfeiture		—		—		—			—			—			—
Tax benefit from stock options exercised and employee stock purchase plan		—		—		—			—			—			—
Redesignation of treasury stock to common stock in accordance with Massachusetts Business Corporation Act, Chapter 156D		—		—		(1,379	)		(138	)		1,379			138
Unrealized gain on investment in Lucent Technologies		—		—		—			—			—			—
Net income		—		—		—			—			—			—

Balance September 30, 2004		—	$	—		8,677		$	868			—		$	—

Nine months ended September 30, 2004
Balance December 31, 2003 (audited)		—	$	—		9,822		$	982			(1,379	)	$	(138	)
Issuance of common stock through stock options exercised and employee stock purchase plan		—		—		171			17			—			—
Issuance of restricted stock		—		—		88			9			—			—
Forfeiture of restricted stock		—		—		(22	)		(2	)		—			—
Repurchase and retirement of restricted stock		—		—		(3	)		—			—			—
Amortization of unearned compensation, net of forfeiture		—		—		—			—			—			—
Tax benefit from stock options exercised and employee stock purchase plan		—		—		—			—			—			—
Redesignation of treasury stock to common stock in accordance with Massachusetts Business Corporation Act, Chapter 156D		—		—		(1,379	)		(138	)		1,379			138
Unrealized gain on investment in Lucent Technologies		—		—		—			—			—			—
Net income		—		—		—			—			—			—

Balance September 30, 2004		—	$	—		8,677		$	868			—		$	—


							Accumulated
	Capital in						other
	excess of			Unearned			comprehensive			Retained
	par value			compensation			loss			earnings		Total
Three months ended September 30, 2004
Balance June 30, 2004	$	39,538		$	(1,953	)	$	(7,556	)	$	23,761	$	54,653
Issuance of common stock through stock options exercised and employee stock purchase plan		595			—			—			—		600
Issuance of restricted stock		6			(6	)		—			—		—
Forfeiture of restricted stock		(34	)		34			—			—		—
Repurchase and retirement of restricted stock		—			—			—			—		—
Amortization of unearned compensation, net of forfeiture		—			182			—			—		182
Tax benefit from stock options exercised and employee stock purchase plan		16			—			—			—		16
Redesignation of treasury stock to common stock in accordance with Massachusetts Business Corporation Act, Chapter 156D		—			—			—			—		—
Unrealized gain on investment in Lucent Technologies		—			—			2,132			—		2,132
Net income		—			—			—			2,268		2,268

Balance September 30, 2004	$	40,121		$	(1,743	)	$	(5,424	)	$	26,029	$	59,851

Nine months ended September 30, 2004
Balance December 31, 2003 (audited)	$	36,642		$	(797	)	$	(7,556	)	$	19,518	$	48,651
Issuance of common stock through stock options exercised and employee stock purchase plan		1,969			—			—			—		1,986
Issuance of restricted stock		1,576			(1,585	)		—			—		—
Forfeiture of restricted stock		(246	)		248			—			—		—
Repurchase and retirement of restricted stock		(36	)		—			—			—		(36	)
Amortization of unearned compensation, net of forfeiture		—			391			—			—		391
Tax benefit from stock options exercised													—
and employee stock purchase plan		216			—			—			—		216
Redesignation of treasury stock to common stock in accordance with Massachusetts Business Corporation Act, Chapter 156D		—			—			—			—		—
Unrealized gain on investment in Lucent Technologies		—			—			2,132			—		2,132
Net income		—			—			—			6,511		6,511

Balance September 30, 2004	$	40,121		$	(1,743	)	$	(5,424	)	$	26,029	$	59,851

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

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


					Common stock
	Preferred stock				Issued				Treasury stock
	Shares		Par value		Shares		Par value		Shares			Par value
Three months ended September 30, 2003
Balance June 30, 2003		—	$	—		9,672	$	967		(1,379	)	$	(138	)
Issuance of common stock through stock options exercised and employee stock purchase plan		—		—		72		7		—			—
Issuance of restricted stock		—		—		—		—		—			—
Amortization of unearned compensation		—		—		—		—		—			—
Tax benefit from stock options exercised and employee stock purchase plan		—		—		—		—		—			—
Net income		—		—		—		—		—			—

Balance September 30, 2003		—	$	—		9,744	$	974		(1,379	)	$	(138	)

Nine months ended September 30, 2003
Balance December 31, 2002		—	$	—		9,544	$	954		(1,379	)	$	(138	)
Issuance of common stock through stock options exercised and employee stock purchase plan		—		—		177		17		—			—
Issuance of restricted stock		—		—		23		3		—			—
Amortization of unearned compensation		—		—		—		—		—			—
Tax benefit from stock options exercised and employee stock purchase plan		—		—		—		—		—			—
Net income		—		—		—		—		—			—

Balance September 30, 2003		—	$	—		9,744	$	974		(1,379	)	$	(138	)

[Additional columns below]

[Continued from above table, first column(s) repeated]


						Accumulated
	Capital in					other
	excess of		Unearned			comprehensive			Retained
	par value		compensation			loss			earnings		Total
Three months ended September 30, 2003
Balance June 30, 2003	$	34,965	$	(933	)	$	(6,881	)	$	14,990	$	42,970
Issuance of common stock through stock options exercised and employee stock purchase plan		587		—			—			—		594
Issuance of restricted stock		—		—			—			—		—
Amortization of unearned compensation		—		70			—			—		70
Tax benefit from stock options exercised and employee stock purchase plan		102		—			—			—		102
Net income		—		—			—			2,240		2,240

Balance September 30, 2003	$	35,654	$	(863	)	$	(6,881	)	$	17,230	$	45,976

Nine months ended September 30, 2003
Balance December 31, 2002	$	33,844	$	(816	)	$	(6,881	)	$	12,846	$	39,809
Issuance of common stock through stock options exercised and employee stock purchase plan		1,448		—			—			—		1,465
Issuance of restricted stock		227		(230	)		—			—		—
Amortization of unearned compensation		—		183			—			—		183
Tax benefit from stock options exercised and employee stock purchase plan		135		—			—			—		135
Net income		—		—			—			4,384		4,384

Balance September 30, 2003	$	35,654	$	(863	)	$	(6,881	)	$	17,230	$	45,976


	Three		Nine
	months		months
	ended		ended
	September 30, 2003
Comprehensive income is calculated as follows:
Net income	$	2,240	$	4,384
Adjustments to Accumulated other comprehensive loss		—		—

Comprehensive income	$	2,240	$	4,384

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

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


	Nine months ended
	September 30,
	2004			2003
Operating activities
Net income	$	6,511		$	4,384
Loss from discontinued operations		—			(1,360	)
Loss on disposal of discontinued operations		—			(233	)

Income from continuing operations		6,511			5,977
Adjustments to reconcile net cash provided by (used in) operating activities
Depreciation		2,648			2,248
Non-cash interest expense		105			116
Investment income from equity interest		(204	)		(103	)
Stock compensation expense		391			183
Tax benefit from stock options exercised		216			135
Amortization of intangible assets		1,335			1,301
Deferred income taxes		1,176			441
Loss on disposal of long-lived assets		4			—
Change in operating assets and liabilities
Accounts receivable, net		(10,987	)		3,096
Unbilled expenditures and fees on contracts in process		(12,194	)		(3,677	)
Prepaid expenses and other current assets		461			(3,362	)
Accounts payable		3,296			732
Accrued payroll and employee benefits		1,430			3,144
Other accrued expenses		(35	)		129

Net cash provided by (used in) continuing operations		(5,847	)		10,360
Net cash used in discontinued operations		(775	)		(646	)

Net cash provided by (used in) operating activities		(6,622	)		9,714

Investing activities
Additions to property, plant and equipment		(3,331	)		(5,416	)
Purchase of business, net of cash acquired		(53,587	)		—
Dividends from equity investment		60			—
Proceeds from the sale of assets		10			(378	)
Increase in other assets		(984	)		(198	)

Net cash used in investing activities for continuing operations		(57,832	)		(5,992	)
Net cash provided by investing activities of discontinued operations		—			2,950

Net cash used in investing activities		(57,832	)		(3,042	)

Financing activities
Net borrowings (repayments) under revolving credit agreement and notes payable		6,904			(6,144	)
Proceeds from the issuance of long-term debt		55,000			—
Principal payments under mortgage agreement		(375	)		(375	)
Principal payments under loan agreement		(1,599	)		—
Proceeds from the exercise of stock options and issuance of common stock		1,950			1,465

Net cash provided by (used in) financing activities		61,880			(5,054	)

Net increase (decrease) in cash and cash equivalents		(2,574	)		1,618
Cash and cash equivalents, beginning of period		2,724			1,076

Cash and cash equivalents, end of period	$	150		$	2,694

Supplemental information
Cash paid for interest	$	1,366		$	670
Cash paid for income taxes, net of refunds	$	309		$	2,082

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

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 nine-month periods ended September 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.

On September 1, 2004, the company completed the previously announced acquisition of Impact Innovations Group LLC (“Impact Innovations”) from J3 Technology Services Corp. (“J3 Technology”), a Georgia corporation. Impact Innovations, based in the Washington, D.C. area, offers solutions in business intelligence, enterprise software, application development, information technology service management and other related areas. This transaction was recorded using the purchase method of accounting in accordance with Financial Accounting Standards Board (“FASB”) Statement of Financial Accounting Standards (“SFAS”) No. 141, Business Combinations (“SFAS 141”). Accordingly, the results of this acquired entity are included in the company’s Consolidated Statement of Operations and of Cash Flows for the period subsequent to its acquisition.

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.

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

Due to their antidilutive effect, approximately 66,200 and 71,100 options to purchase common stock were excluded from the calculation of diluted earnings per share for the third quarters of 2004 and 2003, respectively. Approximately 66,200 and 84,600 options to purchase common stock were excluded from the calculation of diluted income per share for the nine months ended September 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 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 stock option compensation (in thousands of dollars, except per share data).


	Three Months Ended						Nine Months Ended
	September 30,						September 30,
	2004			2003			2004			2003
Net income, as reported	$	2,268		$	2,240		$	6,511		$	4,384
Deduct: Total stock-based employee compensation determined under fair-value-based method for all awards, net of related tax effects		(170	)		(513	)		(551	)		(1,508	)

Pro forma net income	$	2,098		$	1,727		$	5,960		$	2,876

Net income per share:
Basic, as reported	$	0.27		$	0.27		$	0.77		$	0.54
Basic, pro forma	$	0.25		$	0.21		$	0.70		$	0.35
Diluted, as reported	$	0.25		$	0.25		$	0.72		$	0.50
Diluted, pro forma	$	0.23		$	0.19		$	0.66		$	0.33

The company did not grant any options during the three months ended September 30, 2004. The weighted average fair value of options granted during the three months ended September 30, 2003 was $8.76. The weighted average fair values of options granted were $11.05 and $6.63 in the nine months ended September 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:


	Three Months Ended					Nine Months Ended
	September 30,					September 30,
	2004		2003			2004			2003
Expected volatility		—		44.5	%		69.3	%		43.8	%
Dividend yield		—		—			—			—
Risk-free interest rate		—		3.79	%		3.90	%		3.93	%
Expected life in years		—		7.71			7.00			7.71

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

Investment Held for Sale

In 1998, the company obtained an ownership interest in Telica, a privately-held start-up company, in exchange for technology developed by DRC. On September 20, 2004, as a result of the acquisition of Telica by Lucent Technologies (“Lucent”), the company received 672,518 shares of common stock in Lucent (the “Lucent shares”) in exchange for the 1,627,941 shares of Telica common stock (the “Telica shares”) it was holding. The company has classified the Lucent shares as available-for-sale securities, and is accounting for them in accordance with the provisions of SFAS No. 115, Accounting for Certain Investments in Debt and Equity Securities (“SFAS 115”). Prior to the acquisition of Telica by Lucent, the company carried the Telica shares at $0, as there was no readily determinable market value for Telica, which reflected the company's cost basis in the Telica shares. The company has recorded the Lucent shares at a fair value of $2.1 million, or $3.17 per share, at September 30, 2004. An additional 74,724 Lucent shares are currently held in escrow for indemnification related to Lucent’s acquisition of Telica. The fair value of the shares has been recorded as a component of Other noncurrent assets, and unrealized holding gains and losses for these shares are reported as a component of Accumulated other comprehensive loss in the company’s Consolidated Balance Sheet. The company will record the fair value of the shares held in escrow at the time that these shares, or any portion thereof, are issued. The company currently anticipates a tax-free disposition of the Lucent shares.

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 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.

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 EITF 00-21 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.

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

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.

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.

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

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.

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”). Under service-type contracts, costs incurred are not indicative of progression toward completion of the contract. Revenue from service-type fixed price contracts is recognized ratably over the contract period or by other appropriate output methods to measure service provided, and contract costs are expensed as incurred. The risk to the company related to a fixed price contract is that if estimates to complete the contract change from one period to the next, profit levels will vary from period to period.

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

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 September 30, 2004, unbilled expenditures and fees also included subcontractor costs for the month of September 2004, for which invoices had not been received and for which revenues were not recognized, estimated at $3.7 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.

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 direct value-based 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.

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

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. BUSINESS ACQUISITION

On September 1, 2004, the company completed the previously announced acquisition of Impact Innovations from J3 Technology, a Georgia corporation, for $53.4 million in cash, subject to adjustment based upon the value of tangible net assets acquired in accordance with the provisions of the Equity Purchase Agreement among the company, Impact Innovations and J3 Technology. The company used the proceeds from the acquisition term loan portion of its new financing facility, entered into on September 1, 2004, to finance the transaction. The company acquired all of the outstanding membership interests of Impact Innovations, which constituted the government contracts business of J3 Technology. Impact Innovations, based in the Washington, D.C. area, has annual revenues approximating $47 million based on its results for the trailing twelve months ended June 30, 2004, and 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. The company believes that the acquisition of Impact Innovations enhances its CMM/level 3 software engineering core competency and enriches DRC’s business intelligence, business transformation and network engineering and operations solution sets, while adding a number of key government defense and civilian customers to the company’s portfolio, including a new customer base in the intelligence community. The transaction was accounted for as a purchase in accordance with SFAS 141. As part of this transaction, the company paid $0.2 million and accrued $0.5 million for legal, audit and other transaction costs related to the acquisition. The company also accrued $0.7 million for exit costs, primarily related to the consolidation of one of the Impact Innovations facilities into a DRC facility, including lease costs for the abandoned acquired facility. As of September 30, 2004, no significant expenditures had been charged against this accrual.

The purchase price was determined through negotiations with J3 Technology based upon the company’s access to new customers, customer relationships and cash flows. A portion of the excess of purchase price over fair value of net assets acquired was allocated on a preliminary basis to customer relationships, which the company estimates to have a useful life of five years, based upon a preliminary independent appraisal. Accordingly, the company is amortizing this intangible asset over five years, based upon the estimated future cash flows of the individual contracts related to this asset. The balance of the excess purchase price was recorded as goodwill. In accordance with SFAS No. 142, Goodwill and Other Intangible Assets (“SFAS 142”), the company will not amortize the goodwill, but will instead test for impairment at least annually. Finalization of the excess of purchase price over the fair value of net assets acquired to identifiable intangible assets and goodwill will be made after completion of the analysis of their fair values, which the company expects to occur in the fourth quarter of 2004. The company believes it has sufficient information to finalize the purchase price allocation but requires additional time to complete the analysis. A change of $1.0 million in the allocation between the acquired identifiable intangible assets and goodwill would result in a change in annual amortization expense of

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

approximately $0.2 million. An increase in the useful life of the acquired identifiable intangible asset from five years to six years would result in a decrease in annual amortization expense of approximately $0.4 million. A decrease in the useful life of the acquired identifiable intangible asset from five years to four years would result in an increase in annual amortization expense of approximately $0.6 million. This sensitivity analysis assumes any change would be allocated equally to each financial reporting period. Any actual change to the value of the customer relationships intangible asset would require analysis to calculate the new estimated future cash flows of the individual contracts related to this asset in order to determine the periodic amortization expense to be recorded. A summary of the transaction is as follows (in thousands):


Consideration:
Cash	$	53,398
Transaction costs		688
Exit costs		666

Total consideration		54,752
Preliminary fair value of net tangible assets acquired		5,854

Preliminary excess of consideration over fair value of net tangible assets acquired		48,898
Preliminary allocation of excess consideration to identifiable intangible assets:
Customer relationships		11,500

Preliminary allocation of excess consideration to goodwill	$	37,398

The following pro forma results of operations for the three and nine month periods ended September 30, 2004 and 2003 have been prepared as though the acquisition of Impact Innovations had occurred on January 1, 2003. These pro forma results include adjustments for interest expense and amortization of deferred financing costs on the acquisition term loan used to finance the transaction, amortization expense for the identifiable intangible asset recorded and the effect of income taxes. Additionally, these pro forma results include nonrecurring events recorded by Impact Innovations in the third quarter of 2004 prior to their acquisition by the company, including approximately $150,000 of revenues with no associated costs related to award fees and excess performance on service level agreements, and approximately $500,000 of reductions to selling, general and administrative expenses; primarily employee-related costs. This pro forma information does not purport to be indicative of the results of operations that would have been attained had the acquisition been made as of January 1, 2003, or of results of operations that may occur in the future (in thousands, except per share data):


	Three Months Ended				Nine Months Ended
	September 30,				September 30,
	2004		2003		2004		2003
Revenue	$	79,254	$	73,534	$	231,281	$	213,788
Net income from continuing operations	$	2,699	$	1,372	$	6,910	$	5,192
Earnings per share from continuing operations:
Basic	$	0.32	$	0.16	$	0.82	$	0.63
Diluted	$	0.30	$	0.15	$	0.76	$	0.59

The terms of the transaction and the consideration paid by the company to J3 Technology were a result of arm’s length negotiations between the company’s representatives and representatives of J3 Technology. Prior to the completion of the transaction, neither the company nor, to the company’s knowledge, any of its directors and officers and their respective associates had any material relationship with J3 Technology.

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

NOTE 3. 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 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 nine months ended September 30, 2003. The company did not record any charges related to this disposal in the three months ended September 30, 2003.

The company did not record any charges for discontinued operations in either the three or nine months ended September 30, 2004. The company’s loss from discontinued operations, net of taxes, was $147,000, or $0.02 per diluted share, and $1.4 million, or $0.15 per diluted share, in the three and nine months ended September 30, 2003, respectively. The nine months ended September 30, 2003, include four months of operating loss from the Encoder division, as well as costs incurred subsequent to the transaction related to certain liabilities that GSI did not assume.

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


	Three months ended September 30, 2004
	Balance				Adjustments		Expenditures			Balance
	June 30,				for changes		charged against			September 30,
	2004		Provision		in estimate		accrual			2004

Severance	$	—	$	—	$	—	$	—		$	—
Lease		720		—		—		(319	)		401

	$	720	$	—	$	—	$	(319	)	$	401


	Nine months ended September 30, 2004
	Balance				Adjustments		Expenditures			Balance
	December 31,				for changes		charged against			September 30,
	2003		Provision		in estimate		accrual			2004

Severance	$	74	$	—	$	—	$	(74	)	$	—
Lease		932		—		—		(531	)		401

	$	1,006	$	—	$	—	$	(605	)	$	401

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


	September 30,		December 31,
	2004		2003
Current liabilities
Accrued payroll and employee benefits	$	—	$	74
Other accrued expenses		401		704

Total current liabilities	$	401	$	778

Long-term liabilities
Other long-term liabilities	$	—	$	398

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 4. GOODWILL AND INTANGIBLE ASSETS

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


	September 30, 2004				December 31, 2003
			Accumulated				Accumulated
	Cost		amortization		Cost		amortization
Customer relationships	$	14,200	$	1,896	$	2,700	$	1,187
Non-competition agreements		1,740		1,536		1,740		910

	$	15,940	$	3,432	$	4,440	$	2,097

The company recorded amortization expense for its identifiable intangible assets of $0.6 million and $0.4 million for the three months ended September 30, 2004 and 2003, respectively, and $1.3 million in both of the nine month periods then ended. The amounts recorded in both the three and nine months ended September 30, 2004, include $0.2 million related to the September 1, 2004 acquisition of Impact Innovations. Estimated amortization expense on the company’s identifiable intangible assets for the remainder of the current year and each of the five subsequent years is as follows (in thousands):


Remainder of 2004	$	987
2005	$	3,108
2006	$	2,787
2007	$	2,581
2008	$	2,021
2009	$	1,024
Thereafter	$	—

The changes in the carrying amount of goodwill for the nine months ended September 30, 2004 are as follows (in thousands):


	Systems and
	Services		Metrigraphics		Total
Balance at December 31, 2003	$	26,711	$	—	$	26,711
Business acquisition		37,398		—		37,398

Balance at September 30, 2004	$	64,109	$	—	$	64,109

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

NOTE 5. STOCK PLANS AND STOCKHOLDERS’ EQUITY

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.

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.

Stockholders’ Equity

Effective July 1, 2004, companies incorporated in Massachusetts became subject to the Massachusetts Business Corporation Act, Chapter 156D. Chapter 156D eliminates the concept of “treasury shares” and provides that shares reacquired by a company become “authorized but unissued” shares. As a result of this change, the company has redesignated its existing treasury shares, with a par value of approximately $138,000, to common stock.

NOTE 6. 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 does not impact the company’s business segments, as the new groups both provide solutions-based services and are subject to similar regulations.

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

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.

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


	Three Months Ended				Nine Months Ended
	September 30,				September 30,
	2004		2003		2004		2003
Revenue
Systems and Services	$	68,659	$	60,602	$	192,361	$	177,840
Metrigraphics		1,792		1,830		5,108		5,336

	$	70,451	$	62,432	$	197,469	$	183,176

Operating income
Systems and Services	$	4,382	$	4,027	$	11,860	$	10,149
Metrigraphics		59		236		72		552

	$	4,441	$	4,263	$	11,932	$	10,701

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


	September 30,		December 31,
	2004		2003
Segment assets
Systems and Services	$	181,031	$	98,274
Metrigraphics		1,756		2,004

Total segment assets		182,787		100,278
Corporate assets		20,744		20,792

	$	203,531	$	121,070

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.

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

Revenues from Department of Defense (“DoD”) customers accounted for 74.6% and 78.2% of total revenues in the third quarters of 2004 and 2003, respectively, and 78.2% and 77.7% of total revenues in the nine months ended September 30, 2004 and 2003, respectively. Revenues earned from one significant DoD customer group in the Systems and Services segment comprised approximately 17% and 19% of the company’s total revenues in the three months ended September 30, 2004 and 2003, respectively, and 16% and 18% of revenues in the nine months ended September 30, 2004 and 2003, respectively. This customer group had an outstanding accounts receivable balance of approximately $39,000 at September 30, 2004, and none at December 31, 2003. A second significant customer group in the Systems and Services segment accounted for approximately 12% and 11% of the company’s total revenues in the three and nine months ended September 30, 2004, and approximately 12% of the company’s total revenues in the same prior year periods. This customer group had accounts receivable balances aggregating $2.7 million and $1.6 million at September 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 nine months ended September 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 nine months ended September 30, 2004, were approximately $306,000 and $801,000, respectively. Revenues from HMR Tech were approximately $40,000 for the nine months ended September 30, 2003. The company did not record any revenues from HMR Tech for the three months ended September 30, 2003. The amounts due from HMR Tech included in accounts receivable at September 30, 2004 and December 31, 2003, were approximately $246,000 and $501,000, respectively.

NOTE 7. FINANCING ARRANGEMENTS

On September 1, 2004, the company entered into a new secured financing agreement (the “facility”) with its bank group to restructure and increase the company’s credit facilities to $100.0 million, inclusive of the current mortgage on the company’s Andover, Massachusetts corporate headquarters, which had a balance of $7.9 million at closing (the “term loan”). The facility provides for a $55.0 million, five-year term loan (the “acquisition term loan”) with a seven-year amortization schedule for the acquisition of Impact Innovations and a $37.0 million, five-year revolving credit agreement for working capital (the “revolver”). The bank group, led by Brown Brothers Harriman & Co. as a lender and as administrative agent (when acting in such capacity, the “Administrative Agent”), also includes KeyBank National Association, Banknorth, NA and Fleet National Bank. The facility replaces the company’s previous $50.0 million revolving credit agreement, which was entered into on June 28, 2002.

All of the obligations of the company and its subsidiaries under the new facility are secured by a security interest in substantially all of the assets of the company and its subsidiaries granted to the Administrative Agent. The agreement requires financial covenant tests to be performed against the company’s annual results beginning with the results for the year ended December 31, 2005, that, if met, would result in the release of all collateral securing the facility except for the mortgage that secures the term loan. If the company’s results do not meet specific financial ratio requirements, the company and its subsidiaries will be required to perfect the security interest granted to the Administrative Agent in all of the government contracts of the company and its subsidiaries.

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

On an ongoing basis, the facility requires 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 facility provides that the bank group may accelerate payment of all unpaid principal and all accrued and unpaid interest under the facility, upon the occurrence and continuance of certain events of default, including, among others, the following:

	•		Any failure by the company and its subsidiaries to make any payment of principal, interest and other sums due under the facility within three calendar days of the date when such payment is due;

	•		Any breach by the company or any of its subsidiaries of certain covenants, representations and warranties;

	•		Any default and acceleration of any indebtedness owed by the company or any of its subsidiaries to any person (other than the bank group) which is in excess of $1,000,000;

	•		Any final judgment against the company or any of its subsidiaries in excess of $1,000,000 which has not been insured to the reasonable satisfaction of the Administrative Agent;

	•		Any bankruptcy (voluntary or involuntary) of the company or any of its subsidiaries; and

	•		Any material adverse change in the business or financial condition of the company and its subsidiaries; or

	•		Any change in control of the company.

Acquisition term loan
Proceeds of $53.4 million from the term loan were used to complete the acquisition of Impact Innovations. The company repaid $1.6 million of the original $55.0 million financed on September 1, 2004. The facility requires quarterly principal payments on the acquisition term loan of approximately $2 million, with a final payment of approximately $16 million on September 1, 2009.

The company has the option of selecting an interest rate for the acquisition term loan equal to either: (a) the then applicable London Inter-Bank Offer Rate (the “LIBOR Rate”) plus 1.75% to 3.25% per annum, depending on the company’s most recently reported leverage ratio; or (b) the base rate as announced from time to time by the Administrative Agent (the “Base Rate”) plus 0.00% to 0.50% per annum, depending on the company’s most recently reported leverage ratio. For those portions of the acquisition term loan accruing at the LIBOR Rate, the company has the option of selecting interest periods of 30, 60, 90 or 180 days.

Term loan
The company has a ten-year term loan as amended and restated on September 1, 2004, with an outstanding principal balance of $7.9 million, which is secured by a mortgage on the company’s headquarters in Andover, Massachusetts. The agreement requires quarterly principal payments of $125,000, with a final payment of $5.0 million due on May 1, 2010. The company has the option of selecting an interest rate for the term loan equal to either: (a) the then applicable LIBOR Rate plus 1.50% to 3.00% per annum, depending on the company’s most recently reported leverage ratio; or (b) the Base Rate plus 0.00% to 0.50% per annum, depending on the company’s most recently reported leverage ratio. For those portions of the term loan accruing at the LIBOR Rate, the company has the option of selecting interest periods of 30, 60, 90 or 180 days.

Revolver
The revolver has a five-year term and is available to the company for general corporate purposes, including strategic acquisitions. The outstanding balance of approximately $23 million on the company’s previous revolving credit facility was transferred to the new revolver as part of the transaction. The fee on the unused portion of the

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

revolver ranges from 0.25% to 0.50%, depending on the company’s leverage ratio, and is payable quarterly in arrears. The company has the option of selecting an annual interest rate for the revolver equal to either: (a) the then applicable LIBOR Rate plus 1.50% to 3.00% per annum, depending on the company’s most recently reported leverage ratio; or (b) the Base Rate plus 0.00% to 0.50% per annum, depending on the company’s leverage ratio. For those portions of the revolver accruing at the LIBOR rate, the company has the option of selecting interest periods of 30, 60, 90 or 180 days. The revolver matures on September 1, 2009.

Excess cash flow recapture
In addition to the principal payments required on the acquisition term loan and the term loan, the company will also make annual payments on February 15 of each year, commencing in 2006. The payment amount will be equal to 60.0% of the company’s excess cash flow, defined as EBITDA (earnings before interest, taxes, depreciation and amortization) plus net decreases in working capital or less net increases in working capital, minus interest expense and principal payments on the acquisition term loan and term loan, capital expenditures, and all cash taxes and cash dividends paid for the most recently completed fiscal year, commencing with the year ended December 31, 2005. Each payment will be applied: first, to the outstanding balance of the revolver, provided the outstanding balance on the last day of the fiscal year compared with the outstanding balance of the revolver on the last day of the previous fiscal year does not already reflect such a reduction; second, to the outstanding principal balance of the acquisition term loan; and lastly, to the outstanding principal balance of the term loan.

Outstanding borrowings
The company had outstanding debt of $76.7 million at September 30, 2004, comprised of $53.4 million on the acquisition term loan, $7.9 million on the term loan and $15.4 million on the revolver. The interest rate on the acquisition term loan was 4.98% at September 30, 2004, under the 60 day LIBOR Rate option elected on September 3, 2004. The interest rate on the term loan was 4.72% at September 30, 2004, under the 60 day LIBOR Rate option elected on September 1, 2004. The revolver’s outstanding balance at September 30, 2004 was comprised of $3.4 million with an interest rate of 5.25% under the Base Rate option and $12.0 million with an interest rate of 4.65% under the 30 day LIBOR Rate option. The weighted average interest rate on the company’s revolver was 4.78% at September 30, 2004. Both options were elected on September 1, 2004.

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 previous revolving credit facility. At December 31, 2003, the interest rate on the mortgage on the company’s headquarters facility was 3.15%, under a 90 day LIBOR option, elected on October 14, 2003. At December 31, 2003, the interest rate on $7.5 million of the outstanding principal balance of the revolver was 3.17% under a 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 a 30 day LIBOR rate option elected on December 15, 2003. These rates and options were elected under the company’s previous financing arrangements, which were replaced by the new financing arrangement entered into on September 1, 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.

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) (continued)

NOTE 8. DEFINED BENEFIT PENSION PLAN

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


	Three Months Ended						Nine Months Ended
	September 30,						September 30,
	2004			2003			2004			2003
Interest cost	$	993		$	1,181		$	2,947		$	2,678
Expected return on plan assets		(945	)		(1,026	)		(2,903	)		(2,327	)
Recognized actuarial loss		314			371			968			842

Net periodic benefit cost	$	362		$	526		$	1,012		$	1,193

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 currently expects to contribute $2.9 million in 2004 to fund its pension plan. Of this amount, $2.0 million had been contributed as of September 30, 2004. The company intends to contribute the remaining $0.9 million of its 2004 pension plan funding obligations in the fourth quarter of 2004.

NOTE 9. 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 Internal Revenue Service has recently initiated an audit of the company’s federal income tax return for the tax year ended December 31, 2002. The company believes that it is too early to determine the impact, if any, of the resolution of this audit. 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.

DYNAMICS RESEARCH CORPORATION
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 has asserted 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, presently remains in effect as a claim against Storage Engine. The company and the United States Attorney have expressed a willingness to enter mediation.

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, which it has since reduced to $319,000. The company believes that most, if not all, of the amount now demanded 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, which contract changes have been accepted by Lockheed and fully performed by 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 arising out of this case is remote, there can be no assurance as to the outcome.

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) (continued)

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.

In the nine months ended September 30, 2004 and in the year ended December 31, 2003, approximately 90% 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 nine months ended September 30, 2004 and in 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.

DYNAMICS RESEARCH CORPORATION

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. 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 management; 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 does not impact the company’s business segments, as the new groups both provide solutions-based services and are subject to similar regulations.

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

BUSINESS ACQUISITION

On September 1, 2004, the company completed the previously announced acquisition of Impact Innovations Group LLC (“Impact Innovations”) from J3 Technology Services Corp. (“J3 Technology”), a Georgia corporation. Impact Innovations, based in the Washington, D.C. area, offers solutions in business intelligence, enterprise software, application development, information technology service management and other related areas. This transaction was recorded using the purchase method of accounting in accordance with Financial Accounting Standards Board (“FASB”) Statement of Financial Accounting Standards (“SFAS”) No. 141, Business Combinations (“SFAS 141”). Accordingly, the results of this acquired entity is included in the company’s Consolidated Statement of Operations and of Cash Flows for the period subsequent to its acquisition.

RESULTS OF OPERATIONS
THREE AND NINE MONTHS ENDED SEPTEMBER 30, 2004 AND 2003

Revenues

The company reported revenues of $70.5 million in the third quarter of 2004, compared to $62.4 million in the same prior year period. The company’s revenues for the nine months ended September 30, 2004, were $197.5 million, compared to $183.2 million in the same prior year period. The increase in revenues in both periods is due to organic growth and $4.2 million of revenues contributed by Impact Innovations from the date of its acquisition by the company. These increases were partially offset by the completion in 2003 of the company’s quality assurance work at the Homeland Security Bureau of Citizenship and Immigration Services, which had contributed $1.9 million and $7.0 million to revenues during the three and nine month periods ended September 30, 2003, respectively. This contract ended in December 2003 without recompetition, following the Bureau’s reorganization at that time.

Contract revenues for the Systems and Services segment increased 13.3%, to $68.7 million, in the third quarter of 2004, from $60.6 million in the comparable prior year period. Contract revenues were $192.4 million and $177.9 million, respectively, in the nine months ended September 30, 2004 and 2003. Defense revenues grew 7.7%, or $3.7 million, in the third quarter of 2004, from $49.0 million in the third quarter of 2003. Defense revenues were $154.4 million and $142.5 million in the nine months ended September 30, 2004 and 2003, respectively. The increase in defense revenues in both the current year three and nine-month periods is primarily 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 $9.4 million for the quarter ended September 30, 2004, an increase of 3.4% from the $9.2 million reported in the same prior year quarter. The increase in the current year quarter is primarily attributable to the acquisition of Impact Innovations, partially offset by decreases due to the completion late in 2003 of the company’s quality assurance work at the Homeland Security Bureau of Citizenship and Immigration Services and delays in new contract awards by this agency. Revenues from federal civilian agencies in the nine months ended September 30, 2004 and 2003 were $23.0 million and $27.3 million, respectively. The decrease in the current year nine month period is primarily attributable to the completion in 2003 of the company’s quality assurance work at the Bureau of Citizenship and Immigration Services discussed above.

State and local government revenues increased to $6.2 million in the third quarter of 2004, from $2.6 million in the third 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 $14.5 million and $8.1 million in the nine month periods ended September 30, 2004 and 2003, respectively. The increase in the current year was principally due to the new Ohio contract, as well as higher revenues from training and network management services with health and human services customers.

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

Product sales for the Metrigraphics segment were $1.8 million in the third quarters of both 2004 and 2003. Product sales for this segment decreased by $0.2 million, to $5.1 million, in the nine months ended September 30, 2004, compared to the same prior year period. This segment’s flat revenues in the third quarter of 2004, compared to a decrease in the current year nine month period from the same period last year, are due in part to an overall improvement in order levels, partially offset by acceleration of orders by one customer from the third quarter to the second quarter of this year. The company expects 2004 revenues for this segment to be comparable to 2003 revenues.

Gross margin

Gross margins were 15.8% and 15.5% in the third quarters of 2004 and 2003, respectively, and 15.0% and 15.8% in the nine months ended September 30, 2004 and 2003, respectively.

The company’s Systems and Services segment’s gross margin on contract revenues increased to 15.5% in the third quarter of 2004, compared to 15.2% in the comparable prior year quarter. However, the segment’s gross margin for the nine months ended September 30, 2004 decreased, to 14.7%, compared to 15.4% in the same prior year period. This segment’s 2004 gross margin has been negatively impacted by increased subcontractor costs and amortization and maintenance expense 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 have been partially offset by efficiencies realized from the integration of the company’s earlier acquisitions into the company’s operations, primarily through facility consolidation and lower overhead as a percentage of revenues, and the favorable effects of the Impact Innovations acquisition.

The Metrigraphics segment’s gross margin on product sales increased in the three month period ended September 30, 2004, to 28.9%, compared to 26.7% in the same prior year period. However, this segment’s gross margin decreased on a year-to-date basis in 2004, to 26.1%, compared to 27.3% in the same prior year period.

Selling, general and administrative expenses

Selling, general and administrative expenses for the third quarter of 2004 were $6.1 million, an increase of $1.1 million, compared to $5.0 million in the same prior year quarter. Operating expenses of $0.4 million arising from the acquired operations of Impact Innovations accounted for most of the increases in expenses in the third quarter of 2004, compared to the same prior year quarter. Higher benefit costs also contributed to the 2004 third quarter increase. Selling, general and administrative expenses decreased in the nine months ended September 30, 2004, by $0.5 million, to $16.4 million, compared to $16.9 million in the nine months ended September 30, 2003. The year-to-date decrease is attributable to lower legal costs in the first half of 2004.

Amortization of intangible assets

Amortization expense of $0.5 million and $1.3 million in the three and nine months ended September 30, 2004, respectively, relates to intangible assets acquired in the company’s recent purchase of Impact Innovations and the company’s 2002 purchases of Andrulis Corporation and HJ Ford Associates, Inc. Amortization expense related to the company’s 2002 acquisitions was $0.4 million and $1.3 million in the three and nine months ended September 30, 2003, respectively.

Operating income

The company reported operating income of $4.4 million, or 6.3% of revenues, and $4.3 million, or 6.8% of revenues, in the third quarters of 2004 and 2003, respectively. Higher selling, general and administrative expenses in the third quarter of 2004 resulted in the lower operating margin for that period. The company’s operating income in the nine months ended September 30, 2004 and 2003, was $11.9 million, or 6.0% of revenues, and $10.7 million, or 5.8% of revenues, respectively. Lower legal expenses in the first half of 2004 were a primary contributor to the improved operating margin for the nine month period ended September 30, 2004.

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

Interest expense

Interest expense increased by approximately $379,000 in the third quarter of 2004, to approximately $566,000. Interest expense for the nine months ended September 30, 2004, approximated $1.2 million, an increase from approximately $720,000 in the comparable 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, coupled with interest on the company’s new acquisition term loan described in the discussion of the company’s liquidity below. Due to the company’s increased outstanding debt, higher interest charges will be recorded in subsequent periods. Borrowings against the company’s revolving credit facility during 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 $4.8 million, or 42.3% of pre-tax income, and $4.2 million, or 41.0% of pre-tax income, in the first nine 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.

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 nine months ended September 30, 2003. The company did not record any charges related to this disposal in the three months ended September 30, 2003.

The company did not record any charges for discontinued operations in either the three or nine months ended September 30, 2004. The company’s loss from discontinued operations, net of taxes, was $147,000, or $0.02 per diluted share, and $1.4 million, or $0.15 per diluted share, in the three and nine months ended September 30, 2003. The nine months ended September 30, 2003, include four months of operating loss from the Encoder division, as well as costs incurred subsequent to the transaction related to certain liabilities that GSI did not assume.

Bookings and Backlog

Bookings for the three and nine month periods ended September 30, 2004, were $70.1 million and $190.2 million, respectively. The company’s funded backlog was $151.0 million and $109.2 million at September 30, 2004 and 2003, respectively, and $123.9 million at December 31, 2003. Funded backlog represented 5.7 months of trailing revenues at September 30, 2004. Backlog does not necessarily equate to future revenues.

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

LIQUIDITY AND CAPITAL RESOURCES

At September 30, 2004 and December 31, 2003, the company had cash and cash equivalents aggregating $150,000 and $2.7 million, respectively. The decrease in cash and cash equivalents is primarily the result of $6.6 million of net cash used in operating activities, including $0.8 million used in discontinued operations, $3.3 million of capital expenditures, and principal payments on the company’s term loan and acquisition term loan aggregating $2.0 million. These amounts were partially offset by $6.9 million of net additional borrowings under the company’s revolving credit facility and $1.9 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 $6.6 million for the nine months ended September 30, 2004, and is primarily attributable to $11.0 million of increased accounts receivable and $12.2 million of increases in unbilled expenditures and fees on contracts in process. These amounts were partially offset by $6.5 million of net income, depreciation and amortization expenses aggregating $4.0 million and a $3.3 million increase in accounts payable.

Receivables days sales outstanding, or DSO, was 110 at September 30, 2004, down from 117 days at June 30, 2004. The company’s DSO was 91 at December 31, 2003. Improved billing activity and the acquisition of Impact Innovations have both contributed to the reduction in DSO from the previous quarter. These amounts include the amounts reported under the captions “Accounts receivable, net of allowances” and “Unbilled expenditures and fees on contracts in process.” 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. The delays in generating invoices have been overcome. As a result, accounts receivable have risen sharply; the company is aggressively pursuing collection of outstanding invoices, and the company has no indication of concerns of collectibility of the outstanding invoices.

At September 30, 2004 unbilled expenditures and fees on contracts in process included subcontractor costs for the month of September, for which invoices had not been received and for which revenues were not recognized, estimated at $3.7 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 $57.8 million, and is primarily attributable to $53.6 million of cash expended to acquire Impact Innovations on September 1, 2004. The company’s capital expenditures of $3.3 million in the nine months ended September 30, 2004, included $1.5 million for renovations to the company’s Andover, Massachusetts corporate headquarters and $0.8 million related to the implementation of the company’s new PeopleSoft-based enterprise business system.

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

• Any failure by the company and its subsidiaries to make any payment of principal, interest and other sums due under the facility within three calendar days of the date when such payment is due;

• Any breach by the company or any of its subsidiaries of certain covenants, representations and warranties;

• Any default and acceleration of any indebtedness owed by the company or any of its subsidiaries to any person (other than the bank group) which is in excess of $1,000,000;

• Any final judgment against the company or any of its subsidiaries in excess of $1,000,000 which has not been insured to the reasonable satisfaction of the Administrative Agent;

• Any bankruptcy (voluntary or involuntary) of the company or any of its subsidiaries; and

• Any material adverse change in the business or financial condition of the company and its subsidiaries; or

• Any change in control of the company.

Proceeds of $53.4 million from the acquisition term loan were used to complete the acquisition of Impact Innovations. The company repaid $1.6 million of the original $55.0 million financed on September 1, 2004. The facility requires quarterly principal payments on the acquisition term loan of approximately $2 million, with a final payment of approximately $16 million on September 1, 2009.

The company has a ten-year term loan as amended and restated on September 1, 2004, with an outstanding principal balance of $7.9 million, which is secured by a mortgage on the company’s headquarters in Andover, Massachusetts. The agreement requires quarterly principal payments of $125,000, with a final payment of $5.0 million due on May 1, 2010. The company has the option of selecting an interest rate for the term loan equal to either: (a) the then applicable LIBOR Rate plus 1.50% to 3.00% per annum, depending on the company’s most recently reported leverage ratio; or (b) the Base Rate plus 0.00% to 0.50% per annum, depending on the company’s most recently reported leverage ratio. For those portions of the term loan accruing at the LIBOR Rate, the company has the option of selecting interest periods of 30, 60, 90 or 180 days. The interest rate on the term loan was 4.72% at September 30, 2004, under the 60 day LIBOR Rate option elected on September 1, 2004.

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

The revolver has a five-year term and is available to the company for general corporate purposes, including strategic acquisitions. The outstanding balance of approximately $23 million on the company’s previous revolving credit facility was transferred to the new revolver as part of the transaction. The fee on the unused portion of the revolver ranges from 0.25% to 0.50%, depending on the company’s leverage ratio, and is payable quarterly in arrears. The company has the option of selecting an annual interest rate for the revolver equal to either: (a) the then applicable LIBOR Rate plus 1.50% to 3.00% per annum, depending on the company’s most recently reported leverage ratio; or (b) the Base Rate plus 0.00% to 0.50% per annum, depending on the company’s leverage ratio. For those portions of the revolver accruing at the LIBOR rate, the company has the option of selecting interest periods of 30, 60, 90 or 180 days. The revolver matures on September 1, 2009. The revolver’s outstanding balance at September 30, 2004 was comprised of $3.4 million with an interest rate of 5.25% under the Base Rate option and $12.0 million with an interest rate of 5.25% under the 30 day LIBOR Rate option. The weighted average interest rate on the company’s revolver was 4.78% at September 30, 2004. Both options were elected on September 1, 2004.

In addition to the principal payments required on the acquisition term loan and the term loan, the company will also make annual payments on February 15 of each year, commencing in 2006. The payment amount will be equal to 60.0% of the company’s excess cash flow, defined as EBITDA (earnings before interest, taxes, depreciation and amortization) plus net decreases in working capital or less net increases in working capital, minus interest expense and principal payments on the acquisition term loan and term loan, capital expenditures, and all cash taxes and cash dividends paid for the most recently completed fiscal year, commencing with the year ended December 31, 2005. Each payment will be applied: first, to the outstanding balance of the revolver, provided the outstanding balance on the last day of the fiscal year compared with the outstanding balance of the revolver on the last day of the previous fiscal year does not already reflect such a reduction; second, to the outstanding principal balance of the acquisition term loan; and lastly, to the outstanding principal balance of the term loan.

Cash provided by financing activities was comprised of $55.0 million from the company’s new acquisition term loan, described above, $6.9 million of net borrowings under the company’s revolver and $1.9 million of cash proceeds from the exercise of stock options and issuance of shares under the employee stock purchase plan. As discussed above, the company entered into a new financing arrangement, of which $55.0 million was related to the acquisition of Impact Innovations. The company repaid $1.6 million of the principal borrowed immediately after consideration paid for Impact Innovations was reduced to $53.4 million. The company’s proceeds from financing activities were partially offset by the $1.6 million acquisition term loan principal payment and $0.5 million of principal payments under the company’s term loan.

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 approximate $5 million in 2004, primarily for facilities infrastructure consolidation and improvements.

The company’s need for, cost of, and access to funds are dependent on future operating results, the company’s growth and acquisition activity, as well as conditions external to the company. 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.

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

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. 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 September 30, 2004 consist of the following (in thousands):


	Less than		Two to three		Four to five
	one year		years		years		Thereafter		Total

Revolver	$	15,404	$	—	$	—	$	—	$	15,404
Long-term debt		8,356		16,712		16,712		19,496		61,276
Operating leases		4,826		5,907		4,121		2,250		17,104

Total contractual obligations	$	28,586	$	22,619	$	20,833	$	21,746	$	93,784

The amounts above related to the revolver and long-term debt do not include interest payments on any outstanding principal balance, because the interest rates on the company’s financing arrangements are not fixed.

The amounts above related to operating leases include payments on facilities that the company either no longer occupies or is in the process of abandoning, for which the company is contractually obligated.

The company currently expects to contribute $2.9 million in 2004 to fund its pension plan. Of this amount, $2.0 had been contributed as of September 30, 2004. The company intends to contribute the remaining $0.9 million of its 2004 pension plan funding obligations in the fourth quarter of 2004. Based upon preliminary estimates, the company currently anticipates contributing approximately $4.6 million to its pension plan in 2005.

COMMITMENTS AND CONTINGENCIES

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

In the nine months ended September 30, 2004 and in 2003, approximately 90% 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.

CRITICAL ACCOUNTING POLICIES

Use of Estimates

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

Revenue Recognition

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

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

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

Under fixed price contracts, other than service-type contracts, revenue is recognized primarily under 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”).

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

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 estimates to complete the contract change from one period to the next, profit levels will vary from period to period.

Unbilled expenditures and fees on contracts in process are the amounts of recoverable contract revenue that have not been billed at the balance sheet date. 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 September 30, 2004, unbilled expenditures and fees also included subcontractor costs for the month of September, for which invoices had not been received and for which revenues were not recognized, estimated at $3.7 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

Intangible and Other Long-lived Assets

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

Goodwill

Deferred Taxes

Pensions

RECENT ACCOUNTING PRONOUNCEMENTS

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. The adoption of these disclosure provisions did not have a material effect on the company’s financial position, results of operations or cash flows.

DYNAMICS RESEARCH CORPORATION
MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS (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 EITF 00-21 in the third quarter of 2003. The impact of adopting EITF 00-21 did not have a material impact on the company’s financial position, results of operations or cash flows.

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

FACTORS THAT MAY AFFECT FUTURE RESULTS

You should carefully consider the risks described below and the information in our Annual Report on Form 10-K for the year ended December 31, 2003, filed with the Securities and Exchange Commission (“SEC”) on March 15, 2004, as well as our Quarterly Reports on Form 10-Q and our Current Reports on Form 8-K filed with the SEC, before deciding to invest in shares of our common stock. These are risks and uncertainties we believe are most important for you to consider. Additional risks and uncertainties not presently known to us, or which we currently deem immaterial, or which are similar to those faced by other companies in our industry or business in general, may also impair our business operations. If any of the following risks or uncertainties actually occurs, our business, financial condition, results of operations or cash flows would likely suffer. In that event, the market price of our common stock could decline.

Our Revenue is Highly Dependent on the Department of Defense and Other Federal Agencies. Decreases in Their Budgets, Changes in Program Priorities or Military Base Closures Could Affect Our Results.

In the nine months ended September 30, 2004 and in 2003, approximately 90% and 93% of our revenue, respectively, was derived from United States government agencies, primarily the Department of Defense. Our revenue could be adversely affected by significant changes in defense spending during periods of declining United States defense budgets. Among the effects of this general decline has been increased competition within a consolidating defense industry.

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

Under procedures established by the Base Reduction and Closure Act, the Department of Defense has announced its intention to select in 2005 certain military bases for closure. In 2003 the Department of Defense published an initial list of bases from which it is expected the final selections will be made. Hanscom Air Force Base and other installations at which the company does business were included on the initial list for consideration. Should a base be selected for closure at which the company has significant business, the company’s business, financial condition, results of operations and cash flows could be adversely affected.

It is not possible for us to predict whether defense budgets will increase or decline in the future. Further, changing missions and priorities in the defense budget may have adverse effects on our business. Funding limitations could result in a reduction, delay or cancellation of existing or emerging programs. We anticipate there will continue to be significant competition when our defense contracts are re-bid, as well as significant competitive pressure to lower prices, which may reduce profitability in this area of our business, which would adversely affect our business, financial condition, results of operations and cash flows.

We Must Bear the Risk of Various Pricing Structures Associated With Government Contracts.

We historically have derived a substantial portion of our revenue from contracts and subcontracts with the United States Government. A significant portion of our federal and state government contracts are undertaken on a time and materials nature, with fixed hourly rates that are intended to cover salaries, benefits, other indirect costs of operating the business and profit. The pricing of such contracts is based upon estimates of future costs and assumptions as to the aggregate volume of business that we will perform in a given business division or other relevant unit.

Alternatively, we undertake various government projects on a fixed price basis, as distinguished from billing on a time and materials basis. Under a fixed price contract, the government pays an agreed upon price for our services or products, and we bear the risk that increased or unexpected costs may reduce our profits or cause us to incur a loss. Significant cost overruns can occur if we fail to:

• adequately estimate the resources required to complete a project;

• properly determine the scope of an engagement; or

• complete our contractual obligation in a manner consistent with the project plan.

For fixed price contracts, we must estimate the costs necessary to complete the defined statement of work and recognize revenue or losses in accordance with such estimates. Actual costs may vary materially from the estimates made from time to time, necessitating adjustments to reported revenue and net income. Underestimates of the costs associated with a project could adversely affect our overall profitability and could have a material adverse effect on our business, financial condition, results of operations and cash flows. While we endeavor to maintain and improve contract profitability, we cannot be certain that any of our existing or future time and materials or fixed price projects will be profitable.

A substantial portion of our United States Government business is as a subcontractor. In such circumstances, we generally bear the risk that the prime contractor will meet its performance obligations to the United States Government under the prime contract and that the prime contractor will have the financial capability to pay us amounts due under the subcontract. The inability of a prime contractor to perform or make required payments to us could have a material adverse effect on our business, financial condition, results of operations and cash flows.

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

Our Contracts and Subcontracts with Government Agencies are Subject to a Competitive Bidding Process and to Termination Without Cause by the Government.

A significant portion of our federal and state government contracts are renewable on an annual basis, or are subject to the exercise of contractual options. Multi-year contracts often require funding actions by the United States Government, state legislature or others on an annual or more frequent basis. As a result, our business could experience material adverse consequences should such funding actions or other approvals not be taken.

Recent federal regulations and renewed congressional interest in small business set aside contracts are likely to influence decisions pertaining to contracting methods for many of the company’s customers. These regulations require more frequent review and certification of small business contractor status, so as to ensure that companies competing for contracts intended for small business are qualified as such at the time of the competition. In 2003 and 2002, the company derived $42.4 million and $17.1 million, respectively, of revenue from a small business set aside contract held by its HJ Ford Associates, Inc. subsidiary and due for re-competition in 2005. The customer has currently indicated that the re-competition will continue to be set aside, or reserved, to include only prime contractors that qualify as small businesses under regulations established by the Small Business Administration (“SBA”). The company has formed a mentor-protégé joint venture expected to qualify as a small business under these SBA regulations. The company will strive to retain its current direct labor work by moving that work to the joint venture. To the extent these efforts are not successful, the company’s business, financial condition, results of operations and cash flows could be adversely affected.

The company’s contracts with the Internal Revenue Service and the U.S. Army Aviation and Missile Command, which represented revenues of approximately $15 million and $6 million, respectively, in the year ended December 31, 2003, are subject to re-competition in 2005.

Governmental awards of contracts are subject to regulations and procedures that permit formal bidding procedures and protests by losing bidders. Such protests may result in significant delays in the commencement of expected contracts, the reversal of a previous award decision or the reopening of the competitive bidding process, which could have a material adverse effect on our business, financial condition, results of operations and cash flows.

Because of the complexity and scheduling of contracting with government agencies, from time to time we may incur costs before receiving contractual funding by the United States Government. In some circumstances, we may not be able to recover such costs in whole or in part under subsequent contractual actions. Failure to collect such amounts may have material adverse consequences on our business, financial condition, results of operations and cash flows.

In addition, the United States Government has the right to terminate contracts for convenience. If the government terminated contracts with us, we would generally recover costs incurred up to termination, costs required to be incurred in connection with the termination and a portion of the fee earned commensurate with the work we have performed to termination. However, significant adverse effects on our indirect cost pools may not be recoverable in connection with a termination for convenience. Contracts with state and other governmental entities are subject to the same or similar risks.

We Are Subject to a High Level of Government Regulations, and Audits and Cost Adjustments Under Our Government Contracts and Subcontracts.

As a defense contractor, we are subject to many levels of audit and review, including by the Defense Contract Audit Agency, various inspectors general, the Defense Criminal Investigative Service, the General Accounting Office, the Department of Justice and congressional committees. These audits, reviews and the pending grand jury investigation and civil suit in the United States District Court for the District of Massachusetts could result in the termination of contracts, the imposition of fines or penalties, the withholding of payments due to us or the prohibition from participating in certain United States government contracts for a specified period of time. Any such action could have a material adverse effect on our business, financial condition, results of operations and cash flows.

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

The federal government audits and reviews our performance on contracts, pricing practices, cost structure and compliance with applicable laws, regulations and standards. Like most government contractors, the company’s contract costs are audited and reviewed on a continual basis. Although audits have been completed on the company’s incurred contract costs through 2002 for the parent company, and through 2000 for our Andrulis Corporation and HJ Ford Associates, Inc. subsidiaries, audits for costs incurred or work performed subsequent to these dates remains ongoing and, for much of our work in recent years, have not yet commenced. In addition, non-audit reviews by the government may still be conducted on all of our government contracts. An audit of the company’s work, including an audit of work performed by the companies we have acquired or may acquire, could result in a substantial adjustment to our revenues because any costs found to be improperly allocated to a specific contract will not be reimbursed, and revenues we have already recognized may need to be refunded. If a government audit uncovers improper or illegal activities, we may be subject to civil and criminal penalties and administrative sanctions, including termination of contracts, forfeiture of profits, suspension of payments, fines and suspension or debarment from doing business with federal government agencies. In addition, our reputation could suffer serious harm if allegations of impropriety were made against us.

Loss of Key Personnel Could Limit Our Growth.

We are dependent on our ability to attract and retain highly skilled technical personnel. Many of our technical personnel may have specific knowledge and experience related to various government customer operations and these individuals would be difficult to replace in a timely fashion. In addition, qualified technical personnel are in high demand worldwide and are likely to remain a limited resource. The loss of services of key personnel could impair our ability to perform required services under some of our contracts, to retain such business after the expiration of the existing contract, or to win new business in the event that we lost the services of individuals who have been identified in a given proposal as key personnel in the proposal. Any of these situations could have a material adverse effect on our business, financial condition, results of operations and cash flows.

Our Failure to Obtain and Maintain Necessary Security Clearances May Limit Our Ability to Perform Classified Work for Government Clients, Which Could Harm Our Business.

Some government contracts require us to maintain facility security clearances, and require some of our employees to maintain individual security clearances. If our employees lose or are unable to obtain security clearances on a timely basis, or we lose a facility clearance, the government client can terminate the contract or decide not to renew the contract upon its expiration. As a result, to the extent that we cannot obtain the required security clearances for our employees working on a particular contract, or we fail to obtain them on a timely basis, we may not derive the revenue anticipated from the contract, which could have a material adverse effect on our business, financial condition, results of operations and cash flows.

Security Breaches in Sensitive Government Systems Could Harm Our Business.

Many of the systems we develop, install and maintain involve managing and protecting information involved in intelligence, national security, and other sensitive or classified government functions. A security breach in one of these systems could cause serious harm to our business, damage our reputation, and prevent us from being eligible for further work on sensitive or classified systems for federal government clients. We could incur losses from such a security breach that could exceed the policy limits under our errors and omissions and product liability insurance. Damage to our reputation or limitations on our eligibility for additional work resulting from a security breach in one of our systems could have a material adverse effect on our business, financial condition, results of operations and cash flows.

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

Our Employees May Engage in Misconduct or Other Improper Activities, Which Could Harm Our Business.

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, or falsifying time records. Employee misconduct could also involve the improper use of our clients’ sensitive or classified information, which could result in regulatory sanctions against us and cause 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 have a material adverse effect on our business, financial condition, results of operations and cash flows.

We Are Involved in Various Litigation Matters Which, If Not Resolved in Our Favor, Could Harm Our Business.

On October 26, 2000, two former company employees were indicted and charged with conspiracy to defraud the United States, and wire fraud, among other charges, arising out of a scheme to defraud the United States out of approximately $10 million. Both men subsequently pled guilty to the principal charges against them. On October 9, 2003, the United States Attorney’s office filed a civil complaint in the District Court of Massachusetts against the company based in substantial part upon the actions and omissions of the former executives that gave rise to the criminal cases against them. In the civil action, the United States is asserting claims against the company based on the False Claims Act and the Anti-Kickback Act, in addition to certain common law and equitable claims. The United States 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. The United States also seeks to recover its costs and interest in this action. The company believes it has substantive defenses to these claims and intends to vigorously defend itself. However, the outcome of this litigation and other proceedings to which the company is a part, if unfavorable, could have a material adverse effect on the company’s business, financial position, results of operations and cash flows.

Additionally, the Antitrust Division of the Department of Justice is engaged in an investigation, currently focused on the period from 1996 to 1999, into bidding and procurement activities involving the company and several other defense contractors who 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 antitrust laws, the matter could have a material adverse effect on the company’s business, financial position, results of operations and cash flows.

If We Are Unable to Effectively and Efficiently Eliminate the Significant Deficiencies That Have Been Identified in Our Internal Controls and Procedures, There Could Be a Material Adverse Effect On Our Operations or Financial Results.

In March 2004, our management and Audit Committee were notified by our independent accountants, Grant Thornton LLP, of two significant deficiencies in our internal controls and procedure regarding, first, the accrual of subcontractor work performed and, second, our manually intensive financial reporting process. In 2003, our management and Audit Committee were notified by our then engaged independent accountants, KPMG LLP, of three significant deficiencies relating to contract initiation and set-up for certain fixed price contracts, inefficiencies in our quarterly and year-end closing procedures and consolidation and the level of SEC and generally accepted accounting principles, or GAAP, experience of our personnel responsible for accounting and financial reporting. Although we are committed to addressing these deficiencies, we cannot assure you that we will be able to successfully implement the revised controls and procedures or that our revised controls and procedures will be effective in remedying all of the identified significant deficiencies. Our inability to successfully eliminate these significant deficiencies could have a material adverse effect on our business, financial condition, results of operations and cash flows.

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

We Operate in Highly Competitive Markets and May Have Difficulties Entering New Markets.

The markets for our services are highly competitive. The government contracting business is subject to intense competition from numerous companies, many of which have significantly greater financial, technical and marketing resources than we do. The principal competitive factors are prior performance, previous experience, technical competence and price.

Competition in the market for our commercial products is also intense. There is a significant lead-time for developing such business, and it involves substantial capital investment including development of prototypes and investment in manufacturing equipment. Principal competitive factors are product quality, the ability to specialize our engineering in order to meet our customers’ specific system requirements and price. Our precision products business has a number of competitors, many of which have significantly greater financial, technical and marketing resources than we do. Competitive pressures in our government and commercial businesses could have a material adverse effect on our business, financial condition, results of operations and cash flows.

In our efforts to enter new markets, including commercial markets and United States Government agencies other than the Department of Defense, we generally face significant competition from other companies that have prior experience with such potential customers, as well as significantly greater financial, technical and marketing resources than we have. As a result, we may not achieve the level of success that we expect in our efforts to enter such new markets.

Our Business is Highly Concentrated and a Significant Portion of Our Revenue is Derived From a Few Customers.

Our revenue from contracts with the Department of Defense, either as prime contractor or subcontractor, accounted for approximately 78% of our total revenue in both the nine months ended September 30, 2004 and the year ended December 31, 2003, respectively. Within the Department of Defense, certain individual programs account for a significant portion of our United States Government business. We cannot provide any assurance that any of these programs will continue as such or will continue at current levels. A decrease in orders from the Department of Defense or any of these customers would have an adverse effect on our profitability, and the loss of any large customer could have a material adverse effect on our business, financial condition, results of operations and cash flows.

We May Be Subject to Product Liability Claims.

Our precision manufactured products are generally designed to operate as important components of complex systems or products. Defects in our products could cause our customer’s product or systems to fail or perform below expectations. Although we attempt to contractually limit our liability for such defects or failures, we cannot assure you that our attempts to limit our liability will be successful. Like other manufacturing companies, we may be subject to claims for alleged performance issues related to our products. Such claims, if made, could damage our reputation and could have a material adverse effect on our business, financial condition, results of operations and cash flows.

Economic Events May Affect Our Business Segments.

Many of our precision products are components of commercial products. Factors that affect the production and demand for such products, including economic events both domestically and in other regions of the world, competition, technological change and production disruption, could adversely affect demand for our products.

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

Many of our products are incorporated into capital equipment, such as machine tools and other automated production equipment, used in the manufacture of other products. As a result, this portion of our business may be subject to fluctuations in the manufacturing sector of the overall economy. An economic recession, either in the United States or elsewhere in the world, could have a material adverse effect on the rate of orders received by the commercial division. Significantly lower production volumes resulting in under-utilization of our manufacturing facilities would adversely affect our business, financial condition, results of operations and cash flows.

Our Products and Services Could Become Obsolete Due to Rapid Technological Changes in the Industry.

We offer sophisticated products and services in areas in which there have been and are expected to continue to be significant technological changes. Many of our products are incorporated into sophisticated machinery, equipment or electronic systems. Technological changes may be incorporated into competitors’ products that may adversely affect the market for our products. If our competitors introduce superior technologies or products, we cannot assure you that we will be able to respond quickly enough to such changes or to offer services that satisfy our customers’ requirements at a competitive price. Further, we cannot provide any assurance that our research and product development efforts will be successful or result in new or improved products that may be required to sustain our market position.

Our Financing Requirements May Increase and We Could Have Limited Access to Capital Markets.

While we believe that our current resources and access to capital markets are adequate to support operations over the near term and foreseeable future, we cannot assure you that these circumstances will remain unchanged. Our need for capital is dependent on operating results and may be greater than expected. Our ability to maintain our current sources of debt financing depends on our ability to remain in compliance with certain covenants contained in our financing agreements, including, among other requirements, maintaining a minimum total net worth and minimum cash flow and debt coverage ratios. If changes in capital markets restrict the availability of funds or increase the cost of funds, we may be required to modify, delay or abandon some of our planned expenditures, which could have a material adverse effect on our business, financial condition, results of operations and cash flows.

Accounting System Upgrades and Conversions May Delay Billing and Collections of Our Accounts Receivable.

We have recently installed a new PeopleSoft-based enterprise business system, and from time to time, we may be required to make changes to that system as we integrate businesses or upgrade to new technologies. The implementation of the company’s new PeopleSoft-based enterprise business system caused certain delays in billing and collection of accounts receivable, which we are addressing. Future accounting system conversions and upgrades could cause delays in billing and collection of accounts receivable under our contracts, which could adversely affect our business, financial condition, results of operations and cash flows.

Our Quarterly Operating Results May Vary Significantly From Quarter to Quarter.

Our revenue and earnings may fluctuate from quarter to quarter depending on a number of factors, including:

• the number, size and timing of client projects commenced and completed during a quarter;

• bid and proposal efforts undertaken;

• progress on fixed-price projects during a given quarter;

• employee productivity and hiring, attrition and utilization rates;

• accuracy of estimates of resources required to complete ongoing projects; and

• general economic conditions.

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

Demand for our products and services in each of the markets we serve can vary significantly from quarter to quarter due to revisions in customer budgets or schedules and other factors beyond our control. In addition, because a high percentage of our expenses is fixed and does not vary relative to revenue, a decrease in revenue may cause a significant variation in our operating results.

We May Not Make or Complete Future Mergers, Acquisitions or Strategic Alliances or Investments.

On September 1, 2004, we acquired Impact Innovations LLC for $53.4 million in cash. In 2002, we acquired HJ Ford Associates, Inc. and Andrulis Corporation. We may seek to continue to expand our operations through mergers, acquisitions or strategic alliances with businesses that will complement our existing business. However, we may not be able to find attractive candidates, or enter into acquisitions on terms that are favorable to us, or successfully integrate the operations of companies that we acquire. In addition, we may compete with other companies for these acquisition candidates, which could make an acquisition more expensive for us. If we are able to successfully identify and complete an acquisition or similar transaction, it could involve a number of risks, including, among others:

• the difficulty of assimilating the acquired operations and personnel;

• the potential disruption of our ongoing business and diversion of resources and management time;

• the potential failure to retain key personnel of the acquired business;

• the difficulty of integrating internal controls and procedures, systems, operations and cultures; and

• the potential impairment of relationships with customers as a result of changes in management or otherwise arising out of such transactions.

We cannot assure you that any acquisition will be made, that we will be able to obtain financing needed to fund such acquisitions and, if any acquisitions are so made, that the acquired business will be successfully integrated into our operations or that the acquired business will perform as expected. In addition, if we were to proceed with one or more significant strategic alliances, acquisitions or investments in which the consideration consists of cash, a substantial portion of our available cash could be used to consummate the strategic alliances, acquisitions or investments. The financial impact of acquisitions, investments and strategic alliances could have a material adverse effect on our business, financial condition, results of operations and cash flows and could cause substantial fluctuations in our quarterly and annual operating results.

The Market Price of Our Common Stock May Be Volatile.

The market price of securities of technology companies historically has faced significant volatility. The stock market in recent years has also experienced significant price and volume fluctuations that often have been unrelated or disproportionate to the operating performance of particular companies. Many factors that have influenced trading prices will vary from period to period, including:

• decreases in our earnings and revenue or quarterly operating results;

• changes in estimates by analysts;

• market conditions in the industry;

• announcements and new developments by competitors; and

• regulatory reviews.

Any of these events could have a material adverse effect on the market price of our common stock.

DYNAMICS RESEARCH CORPORATION

Item 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

The company is subject to interest rate risk associated with our acquisition term loan, term loan and revolver, where interest payments are tied to either the LIBOR or prime rate. At any time, a sharp rise in interest rates could have an adverse effect on net interest expense as reported in the company’s Consolidated Statements of Operations. A one full percentage point increase in the interest rate on the balance of the acquisition term loan, term loan and revolver at September 30, 2004 would result in an increase of $0.8 million in interest expense per year. The company does not currently hedge these interest rate exposures.

The company presently has no investments and, accordingly, no exposure to market interest rates on investments.

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

Item 4. CONTROLS AND PROCEDURES

We strive to maintain disclosure controls and procedures that are designed to ensure that information required to be disclosed in our Securities and Exchange Act of 1934 reports is recorded, processed, summarized and reported within the time periods specified in rules and forms of the Securities and Exchange Commission, or SEC, and that such information is accumulated and communicated to our management, including our chief executive officer and chief financial officer, as appropriate, to allow timely decisions regarding required disclosure. In designing and evaluating the disclosure controls and procedures, management recognizes that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives, and management necessarily is required to apply its judgment in evaluating the cost-benefit relationship of possible controls and procedures.

Our company carried out an evaluation, under the supervision and with the participation of its chief executive officer and chief financial officer, pursuant to Rule 13a-15 promulgated under the Securities Exchange Act of 1934, as amended, of the effectiveness of the design and operation of its disclosure controls and procedures as of September 30, 2004. While we have previously identified internal control weaknesses, which are discussed below, our current evaluation indicated that these weaknesses did not impair the effectiveness of our overall disclosure controls and procedures and we have concluded that the company’s disclosure controls and procedures are effective to ensure that information required to be disclosed in the reports that the company files or submits under the Securities Exchange Act of 1934 is recorded, processed, summarized and reported as specified in the SEC’s rules and forms.

In evaluating our internal controls we sought to determine whether there were any significant deficiencies under standards established by the American Institute of Certified Public Accountants, or AICPA. Prior to filing our Annual Report on Form 10-K for the year ended December 31, 2003, our management and Audit Committee were notified by our engaged accountants, Grant Thornton LLP (“Grant Thornton”), of the existence of two significant deficiencies.

The first significant deficiency related to the company’s accounting policy regarding the recognition of liabilities for subcontractor work performed but not invoiced. Under the company’s accounting policy, at the end of each reporting period, the company’s recognition of liabilities for un-invoiced subcontractor work performed was deferred until the following accounting period, which is not consistent with generally accepted accounting principles, or GAAP. Grant Thornton recommended that the company develop policies and procedures to estimate and capture this data and record the amounts in the proper period. This condition also suggested the need for the company to review its GAAP training procedures and strengthen its accounting resources.

The company concurred with Grant Thornton’s finding, recorded liabilities and related assets of $2.4 million at December 31, 2003, and revised its accounting policy to record the liabilities and related assets in the period in which the services are performed. With respect to this matter, the company has not yet completed its review and implementation of control procedures. The company expects that the control procedures will be finalized and implemented in the fourth quarter. The company continues to recognize costs and revenues consistent with this policy and continues to develop the procedures necessary to estimate and record this information.

The company believes that during 2004 it has taken measures designed to address this deficiency by adding two highly experienced professionals to its existing staff and conducting a training program on internal controls. In April 2004, the company hired an Assistant Controller for Financial Reporting, and, in June 2004, appointed a new Corporate Controller and Chief Accounting Officer with extensive experience in COSO-compliant internal control implementation, complex enterprise systems implementation and transaction processing and general accounting practices. The former Corporate Controller and Chief Accounting Officer has assumed responsibility for operations control matters, such as forecasting and business transaction review. The company will continue to seek and identify opportunities to strengthen staff skills through training. In 2004, the company’s training has been and continues to be primarily focused on internal controls, recent tax law changes and procedures related to the implementation of the company’s new PeopleSoft-based enterprise business system.

The second significant deficiency relates to the company’s manually intensive financial reporting process, which can limit the time for internal review. Although Grant Thornton did not note any material adjustments as a result of this condition, the potential for errors existed. Grant Thornton recommended that the company consider updating its current accounting and reporting system to a more automated system so that management will have adequate time to analyze, record and review account balances for accuracy, and that senior management reevaluate the current organizational structure to determine if additional resources are necessary. Both the company and Grant Thornton expect the implementation of the company’s new PeopleSoft-based enterprise business system, which was placed into service in January 2004, to assist in resolving this deficiency. The company encountered start-up delay in billing activity in the first quarter of 2004, related to this implementation. In the third quarter of 2004, the company resolved the delays in generating invoices, generating approximately $72 million in invoices during that quarter.

The company placed its PeopleSoft-based enterprise business system into service effective January 1, 2004. The company has realized benefits resulting from the new PeopleSoft-based enterprise business system, including a reduction in the number of adjusting journal entries required during the close, easier reconciliation of financial applications and a shortened close schedule, which provides additional time for both reconciliation and value-added analysis.

During 2004, in conjunction with both the installation of the new PeopleSoft-based enterprise business system and the company’s preparation for the attestation requirements prescribed by Section 404 of the Sarbanes-Oxley Act of 2002, the company has been performing an extensive review of its existing internal control structure. As a result of this endeavor, many policies and procedures have been created, modified or formalized. The company continues its efforts to strengthen its internal controls. Additionally, the company plans to assess regularly the quantity and effectiveness of its resources and to continue to invest in its employees in an effort to improve the effectiveness of both the individual employees and the overall organization.

In 2003, our management and Audit Committee were notified by our then engaged accountants, KPMG LLP, of the existence of three significant deficiencies relating to our operations for the year ended December 31, 2002. These significant deficiencies were not believed to be material weaknesses, either individually or in the aggregate. The first significant deficiency related to contract initiation and set-up for certain fixed price contracts. The second significant deficiency related to our quarterly and year-end closing procedures and consolidation. The third significant deficiency related to the level of SEC and GAAP experience of our personnel responsible for accounting and financial reporting. The measures discussed above as well as those discussed in the company’s other periodic reports filed with the Commission were designed to address the significant deficiencies identified by KPMG LLP. We believe these measures serve to further strengthen our internal controls over financial reporting.

DYNAMICS RESEARCH CORPORATION

PART II. OTHER INFORMATION

Item 1. LEGAL PROCEEDINGS

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, which it has since reduced to $319,000. The company believes that most, if not all, of the amount now demanded 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, which contract changes have been accepted by Lockheed and fully performed by 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 arising out of this case is remote, there can be no assurance as to the outcome.

2.1		Equity Purchase Agreement among Dynamics Research Corporation and Impact Innovations Group LLC and J3 Technology Services Corp., dated August 2, 2004.

10.1		Form of grant of stock options under the 2000 Incentive Plan.

10.2		Form of grant of stock options under the 2003 Incentive Plan.

10.3		Form of grant of restricted stock under the 2000 Incentive Plan.

10.4		Form of grant of restricted stock under the 2003 Incentive Plan.

10.5		Second Amended and Restated Loan Agreement by and among Dynamics Research Corporation, DRC International Corporation, H.J. Ford Associates, Inc., Andrulis Corporation and Impact Innovations Group LLC as the Borrowers, and The Lenders Party hereto and Brown Brothers Harriman & Co., as Administrative Agent and BankNorth, N.A. as documentation Agent and Key Bank National Association as Co-Syndication Agent and Fleet National Bank, a Bank of America company as Co-Syndication Agent, as of September 1, 2004.

10.6		Master Unlimited Guaranty dated as of September 1, 2004 by each of Dynamics Research Corporation, DRC International Corporation, H.J. Ford Associates, Inc., Andrulis Corporation and Impact Innovations Group LLC, in favor of Brown Brothers Harriman & Co., for itself and as Administrative Agent for each of the Lenders which are and which may become parties to the Loan Agreement.

10.7		Security Agreement among Brown Brothers Harriman & Co., as Administrative Agent for the Lenders Party to the Loan Agreement and Dynamics Research Corporation, DRC International Corporation, H.J. Ford Associates, Inc., Andrulis Corporation and Impact Innovations Group LLC, dated September 1, 2004.

10.8		Pledge Agreement by and between Dynamics Research Corporation and Brown Brothers Harriman & Co., for itself and as Administrative Agent for each of the Lenders which are and which may become parties to the Loan Agreement, as of September 1, 2004.

10.9		Patent and Patent Application Security Agreement by Dynamics Research Corporation and Brown Brothers Harriman & Co., as administrative agent for itself and for each of the other Lenders as may become parties to the Loan Agreement, dated September 1, 2004.

10.10		Trademark and Trademark Application Security Agreement by Dynamics Research Corporation and Brown Brothers Harriman & Co., as administrative agent for itself and for each of the other Lenders as may become parties to the Loan Agreement, dated September 1, 2004.

31.1		Certification of the Chief Executive Officer pursuant to Rule 13a-14(a) under the Securities Exchange Act of 1934, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.

31.2		Certification of the Chief Financial Officer pursuant to Rule 13a-14(a) under the Securities Exchange Act of 1934, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.

32.1		Certification of the Chief Executive Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

32.2		Certification of the Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.


Exhibit
Number	Exhibit Name	Location
2.1	Equity Purchase Agreement among Dynamics Research Corporation and Impact Innovations Group LLC and J3 Technology Services Corp., dated August 2, 2004.		(1	)

10.1	Form of grant of stock options under the 2000 Incentive Plan.		(2	)

10.2	Form of grant of stock options under the 2003 Incentive Plan.		(2	)

10.3	Form of grant of restricted stock under the 2000 Incentive Plan.		(2	)

10.4	Form of grant of restricted stock under the 2003 Incentive Plan.		(2	)

10.5	Second Amended and Restated Loan Agreement by and among Dynamics Research Corporation, DRC International Corporation, H.J. Ford Associates, Inc., Andrulis Corporation and Impact Innovations Group LLC as the Borrowers, and The Lenders Party hereto and Brown Brothers Harriman & Co., as Administrative Agent and BankNorth, N.A. as documentation Agent and Key Bank National Association as Co-Syndication Agent and Fleet National Bank, a Bank of America company as Co-Syndication Agent, as of September 1, 2004.		(1	)

10.6	Master Unlimited Guaranty dated as of September 1, 2004 by each of Dynamics Research Corporation, DRC International Corporation, H.J. Ford Associates, Inc., Andrulis Corporation and Impact Innovations Group LLC, in favor of Brown Brothers Harriman & Co., for itself and as Administrative Agent for each of the Lenders which are and which may become parties to the Loan Agreement.		(1	)

10.7	Security Agreement among Brown Brothers Harriman & Co., as Administrative Agent for the Lenders Party to the Loan Agreement and Dynamics Research Corporation, DRC International Corporation, H.J. Ford Associates, Inc., Andrulis Corporation and Impact Innovations Group LLC, dated September 1, 2004.		(1	)

10.8	Pledge Agreement by and between Dynamics Research Corporation and Brown Brothers Harriman & Co., for itself and as Administrative Agent for each of the Lenders which are and which may become parties to the Loan Agreement, as of September 1, 2004.		(1	)

10.9	Patent and Patent Application Security Agreement by Dynamics Research Corporation and Brown Brothers Harriman & Co., as administrative agent for itself and for each of the other Lenders as may become parties to the Loan Agreement, dated September 1, 2004		(1	)

10.10	Trademark and Trademark Application Security Agreement by Dynamics Research Corporation and Brown Brothers Harriman & Co., as administrative agent for itself and for each of the other Lenders as may become parties to the Loan Agreement, dated September 1, 2004.		(1	)

31.1	Certification of the Chief Executive Officer pursuant to Rule 13a-14(a) under the Securities Exchange Act of 1934, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.		(2	)

31.2	Certification of the Chief Financial Officer pursuant to Rule 13a-14(a) under the Securities Exchange Act of 1934, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.		(2	)

32.1	Certification of the Chief Executive Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.		(3	)

32.2	Certification of the Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.		(3	)


	Page Number
PART I. FINANCIAL INFORMATION
Item 1. Consolidated Financial Statements
Consolidated Balance Sheets as of September 30, 2004 (unaudited) and December 31, 2003 (audited)		3
Consolidated Statements of Operations for the three and nine months ended September 30, 2004 and 2003 (unaudited)		4
Consolidated Statement of Changes in Stockholders’ Equity and Comprehensive Income for the three and nine months ended September 30, 2004 (unaudited)		5
Consolidated Statement of Changes in Stockholders’ Equity and Comprehensive Income for the three and nine months ended September 30, 2003 (unaudited)		6
Consolidated Statements of Cash Flows for the nine months ended September 30, 2004 and 2003 (unaudited)		7
Notes to Consolidated Financial Statements (unaudited)		8
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations		26
Item 3. Quantitative and Qualitative Disclosures about Market Risk		47
Item 4. Controls and Procedures		47
PART II. OTHER INFORMATION
Item 1. Legal Proceedings		50
Item 6. Exhibits		52
Signatures		53
Ex-10.1 Form of grant of stock options under the 2000 Incentive Plan
Ex-10.2 Form of grant of stock options under the 2003 Incentive Plan
Ex-10.3 Form of grant of restricted stock options under the 2000 Stock Incentive Plan
Ex-10.4 Form of grant of restricted stock options under the 2003 Stock Incentive Plan
Ex-31.1 Section 302 Certification of CEO
Ex-31.2 Section 302 Certification of CFO
Ex-32.1 Section 906 Certification of CEO
Ex-32.2 Section 906 Certification of CFO


		DYNAMICS RESEARCH CORPORATION (Registrant)
Date: November 9, 2004		/s/ David Keleher David Keleher Senior Vice President and Chief Financial Officer
		/s/ Francis Murphy Francis Murphy Corporate Controller and Chief Accounting Officer

(1)		Previously filed as an exhibit to Dynamics Research Corporation’s Current Report on Form 8-K, dated September 1, 2004 and filed with the Securities and Exchange Commission on September 8, 2004, and incorporated herein by reference.

(2)		Filed herewith.

(3)		Furnished herewith.

	•		adequately estimate the resources required to complete a project;
	•		properly determine the scope of an engagement; or
	•		complete our contractual obligation in a manner consistent with the project plan.

	•		the number, size and timing of client projects commenced and completed during a quarter;
	•		bid and proposal efforts undertaken;
	•		progress on fixed-price projects during a given quarter;
	•		employee productivity and hiring, attrition and utilization rates;
	•		accuracy of estimates of resources required to complete ongoing projects; and
	•		general economic conditions.

	•		the difficulty of assimilating the acquired operations and personnel;
	•		the potential disruption of our ongoing business and diversion of resources and management time;
	•		the potential failure to retain key personnel of the acquired business;
	•		the difficulty of integrating internal controls and procedures, systems, operations and cultures; and
	•		the potential impairment of relationships with customers as a result of changes in management or otherwise arising out of such transactions.

	•		decreases in our earnings and revenue or quarterly operating results;
	•		changes in estimates by analysts;
	•		market conditions in the industry;
	•		announcements and new developments by competitors; and
	•		regulatory reviews.