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UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Form 10-Q

Commission File Number: 000-22125

DiamondCluster International, Inc.

(312) 255-5000

     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 þ          No o

      Indicate by check mark whether the Registrant is an accelerated filer:     Yes þ          No o

      As of October 31, 2004, there were 34,191,509 shares of Common Stock of the Registrant outstanding.

DIAMONDCLUSTER INTERNATIONAL, INC.

QUARTERLY REPORT ON FORM 10-Q

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DIAMOND CLUSTER INTERNATIONAL, INC.

See accompanying notes to condensed consolidated financial statements.

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DIAMONDCLUSTER INTERNATIONAL, INC.

*	If stock-based compensation expense had been distributed to the operating expense line items below, the allocation would be as follows:

See accompanying notes to condensed consolidated financial statements.

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DIAMONDCLUSTER INTERNATIONAL, INC.

See accompanying notes to condensed consolidated financial statements.

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DIAMONDCLUSTER INTERNATIONAL, INC.

A.     Basis of Reporting

      The accompanying unaudited interim condensed consolidated financial statements include the accounts of DiamondCluster International, Inc., and its wholly-owned subsidiaries (the “Company”). All intercompany transactions and balances have been eliminated in consolidation. In the opinion of management, the condensed consolidated financial statements reflect all adjustments that are necessary for a fair presentation of the Company’s financial position, results of operations, and cash flows as of the dates and for the periods presented. The accompanying unaudited condensed consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America for interim financial information. Consequently, these statements do not include all the disclosures normally required by accounting principles generally accepted in the United States of America for annual financial statements nor those normally made in the Company’s Annual Report on Form 10-K. Accordingly, reference should be made to the Company’s Annual Report on Form 10-K for the fiscal year ended March 31, 2004 for additional disclosures, including a summary of the Company’s accounting policies, which have not changed. The consolidated results of operations for the three and six months ended September 30, 2004 are not necessarily indicative of results for the full fiscal year.

B.     Stock-based Compensation

      The Company has adopted various stock incentive and option plans that authorize the granting of qualified and non-qualified stock options, stock appreciation rights (“SARs”) and stock awards (restricted stock and restricted stock units (“RSUs”)) to officers and employees and non-qualified stock options, SARs and stock awards to certain persons who were not employees on the date of grant, including non-employee members of the Company’s Board of Directors.

      Effective April 1, 2003, the Company adopted the fair value-based recognition provisions of Statement of Financial Accounting Standards (“SFAS”) No. 123, “Accounting for Stock-based Compensation,” in accounting for stock awards to officers and other employees. Under the recognition provisions of SFAS No. 123, stock-based compensation expense is measured at the grant date based on the fair value of the award and is recognized as expense over the vesting period. The Company elected the prospective method of transition as described in SFAS No. 148, “Accounting for Stock-based Compensation-Transition and Disclosure,” which applies the recognition provisions to all employee awards granted, modified or settled on or after April 1, 2003, in accounting for employee stock-based compensation. Awards that were outstanding as of March 31, 2003, if not subsequently modified, continue to be accounted for under Accounting Principles Board Opinion (“APB”) No. 25, “Accounting for Stock Issued to Employees,” and related interpretations. Under APB 25, compensation cost of stock options is measured as the excess, if any, of the quoted market price of the Company’s stock at the date of the grant over the option’s exercise price, and is recognized over the vesting period. The Company applies SFAS No. 123 in accounting for all stock awards issued to individuals or groups other than employees. Compensation expense for stock awards is measured based on the number of shares granted and the stock price at the grant date and is recognized over the required service period.

      Had compensation expense on options granted prior to April 1, 2003 been determined based on the fair value at the grant date consistent with the methodology prescribed under SFAS No. 123, the Company’s net

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

income (loss) and basic and diluted net earnings (loss) per share would have been equal to the pro forma amounts indicated below (in thousands, except per share data):

(1)	In the six month period ended September 30, 2003, this amount includes $0.08 million of compensation expense related to restricted stock that was classified as part of the restructuring charge expense in the accompanying Condensed Consolidated Statements of Operations and Comprehensive Income (Loss).
(2)	As a result of the reversal of previously recognized expense related to stock option forfeitures during the six month period ended September 30, 2003, this amount results in net stock-based employee compensation income.

C.     Net Income (Loss) Per Share

      Basic net income (loss) per share is computed using the weighted average number of common shares outstanding. Diluted net income (loss) per share is computed using the weighted average number of common shares outstanding and, where dilutive, the assumed exercise of stock options and SARs and vesting of restricted stock and restricted stock units (using the treasury stock method). Following is a reconciliation of

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

the shares used in computing basic and diluted net income (loss) per share for the three and six months ended September 30, 2003 and 2004 (in thousands):

D.     Restructuring Charges

      The Company restructured its workforce and operations in fiscal years 2002, 2003 and 2004 in order to better align the Company’s operating infrastructure with the then anticipated levels of business in fiscal 2004 and beyond.

     Fiscal Year 2004 Restructuring Charges

      In the first quarter of fiscal year 2004, the Company recorded restructuring charge expense of $4.2 million, $2.5 million of which was related to a restructuring plan implemented in June 2003 and $1.7 million of which was recorded as an adjustment to the restructuring charge recorded in September 2002 to reflect a change in estimate of future sublease income for a contractual lease obligation related to office space reductions. In connection with the restructuring plan implemented in June 2003, the Company recorded a restructuring charge of $2.5 million ($1.5 million on an after-tax basis, or $0.05 per share), consisting solely of severance and related expenses. The principal actions in the June 2003 restructuring plan included workforce reductions in the Europe and Latin America region, resulting in the termination of approximately 30 employees, none of whom were still employed by the Company as of September 30, 2004. Of the total employees severed, 40% were project personnel and 60% were operational personnel.

      The total cash outlay for the restructuring plan announced in June 2003 was $2.3 million. The remaining $0.1 million of restructuring costs consisted of non-cash charges related to equity grants issued in connection with certain severance agreements. In March 2004, the Company adjusted the remaining restructuring accrual balance for $0.1 million which represented the excess of the accrual estimate over actual expense. The Company does not expect any further activity related to the June 2003 restructuring charge.

     Fiscal Year 2003 Restructuring Charges

      In connection with the restructuring plan implemented in December 2002, the Company recorded a restructuring charge of $8.4 million ($5.4 million on an after-tax basis, or $0.17 per share). The $8.4 million charge consisted of $7.8 million for severance and related expenses, $0.4 million related to office space reductions and $0.2 million for the write-off of various depreciable assets. The principal actions in the December 2002 restructuring plan included workforce reductions, resulting in the termination of approximately 115 employees, none of whom were still employed by the Company as of September 30, 2004. Of the total employees severed, 79% were project personnel and 21% were operational personnel.

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

      The total cash outlay for the restructuring announced in December 2002 was $7.3 million. The remaining $0.9 million of restructuring costs consisted of non-cash charges primarily related to non-cash severance items and the write-down of certain assets to their estimated net realizable value. In March 2004, the Company adjusted the remaining restructuring accrual balance for $0.2 million which represented the excess of the accrual estimate over actual expense. The Company does not expect any further activity related to the December 2002 restructuring charge.

      In connection with the restructuring plan implemented in September 2002, the Company recorded a restructuring charge of $20.5 million ($12.8 million on an after-tax basis or $0.41 per share). In June 2003, the Company adjusted this charge and recognized $1.7 million of additional expense to reflect a change in the estimate of future sublease income related to contractual lease obligations, bringing the total restructuring charge to $22.2 million ($14.5 million on an after-tax basis). The $22.2 million charge consisted of $13.8 million for contractual commitments related to office space reductions, $5.7 million for severance and related expenses and $2.7 million for the write-off of various depreciable assets and the termination of certain equipment leases. The principal actions in the September 2002 restructuring plan involved office space reductions, which included further consolidation of office space in multiple offices globally. Estimated costs for the reduction in physical office space are comprised of contractual rental commitments for office space vacated, attorney fees and related costs to sublet the vacated office space, offset by estimated sub-lease rental income. The restructuring plan also included workforce reductions, resulting in the termination of approximately 90 employees, none of whom were still employed by the Company as of September 30, 2004. Of the total employees severed, 60% were project personnel and 40% were operational personnel.

      The total cash outlay for the restructuring announced in September 2002 is expected to approximate $19.7 million (after the adjustment to reflect the revised estimate of sublease rental income described above). The remaining $2.5 million of restructuring costs consist of non-cash charges primarily for the write-down of certain assets to their estimated net realizable value, as well as the write-off of sign-on bonuses previously paid to terminated employees. As of September 30, 2004, $12.7 million of cash had been expended for this initiative, primarily related to contractual commitments for office space reductions, severance and related costs. Cash payments related to this accrual are expected to be made through July 2012.

     Fiscal Year 2002 Restructuring Charges

      In connection with the restructuring plan announced in December 2001, the Company recorded a restructuring charge of $15.5 million ($9.5 million on an after-tax basis, or $0.31 per share). In September 2002, the Company adjusted this charge and recognized $0.4 million of additional expense due primarily to a change in estimate related to the cost of terminating an equipment lease, bringing the total restructuring charge to $15.9 million ($9.7 million on an after-tax basis). The $15.9 million charge consisted of $10.8 million for severance and related expenses, $3.1 million for contractual commitments and leasehold improvements related to office space reductions, and $2.0 million for other depreciable assets and certain equipment leases. The principal actions in the December 2001 restructuring plan involved workforce reductions, including the discontinuation of certain business activities within the Diamond Marketspace Solutions group which helped build and operate e-business ventures for the Company’s clients. The restructuring plan included the termination of approximately 300 employees, none of whom remained employed by the Company as of September 30, 2004. Of the total employees severed, 90% were project personnel and 10% were operational personnel. In addition, the restructuring plan included office space reductions in San Francisco, New York and Chicago. Estimated costs related to the reduction of office space comprise contractual rental commitments for office space being vacated and certain equipment leases, as well as costs associated with the write-off of leasehold improvements and write-down of other assets to their estimated net realizable value.

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

      The total cash outlay for the restructuring announced in December 2001 was $13.2 million. The remaining $2.7 million of restructuring costs consisted of non-cash charges primarily for the write-off of leasehold improvements and other related costs for the facilities being downsized, as well as the write-off of sign-on bonuses previously paid to terminated employees. The Company does not expect any further activity related to the December 2001 restructuring charge.

      The major components of the restructuring charges are summarized as follows (amounts in thousands):

(1)	Adjustment was recorded in September 2002.
(2)	Adjustment was recorded in June 2003.
(3)	Adjustment was recorded in March 2004.

    These restructuring charges and accruals required certain significant estimates and assumptions, including estimates of sub-lease rental income to be realized in the future. These estimates and assumptions are monitored on at least a quarterly basis for changes in circumstances. It is reasonably possible that such estimates could change in the near term resulting in additional adjustments to the amounts recorded, and the effect could be material.

E.     Geographic Data

      The Company operates only in one segment, providing consulting services. Even though the Company has different legal entities operating in various countries, its operations and management are performed on a global basis.

      Data for the geographic regions in which the Company operates is presented below for the periods presented in the condensed consolidated statements of operations and the condensed consolidated balance sheets (in thousands):

      The segregation of revenue by geographic region is based upon the location of the legal entity performing the services.

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      F.     Recently Adopted Accounting Pronouncements

      In March 2004, the Financial Accounting Standards Board (“FASB”) issued a consensus of the Emerging Issues Task Force (ETIF) Issue No. 03-1, “The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments.” ETIF Issue No. 03-1 clarifies when an investment is considered impaired, whether the impairment is other than temporary and the measurement of the impairment loss. The guidance also includes certain disclosure requirements regarding unrealized losses that have not been recognized as other than temporary impairments. The impairment accounting guidance was effective for reporting periods beginning after June 15, 2004 and the disclosure requirements are effective for annual reporting periods ending after June 15, 2004. The adoption of ETIF Issue No. 03-1 is not expected to have a material impact on the Company’s financial statements.

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DIAMONDCLUSTER INTERNATIONAL, INC.

      The following information should be read in conjunction with the information contained in the Condensed Consolidated Financial Statements and notes thereto appearing elsewhere in this Quarterly Report on Form 10-Q and in our Annual Report on Form 10-K for the fiscal year ended March 31, 2004. This Quarterly Report on Form 10-Q contains forward-looking statements that involve risks and uncertainties. See “Disclosure Regarding Forward-Looking Statements” below. We use the terms “we,” “our,” “us” and “the Company” in this report to refer to DiamondCluster International, Inc. and its wholly-owned subsidiaries.

Overview

      We are a premier global management consulting firm that helps leading organizations worldwide to understand and leverage technology to reduce costs, incorporate flexibility into their businesses, address changing regulations and markets, improve operations, and grow their business. We work collaboratively with our clients, utilizing small, multidisciplinary teams of consultants because we believe the most lasting and significant improvements occur when the client is integrally involved in the change. During the quarter ended September 30, 2004, we generated net revenue of $46.1 million from 63 clients. At September 30, 2004, we employed 521 consultants and had nine offices in North America, Europe and Latin America, which included Barcelona, Chicago, Düsseldorf, Lisbon, London, Madrid, Münich, Paris, and São Paulo.

      Our revenue is driven by our ability to secure new client engagements, maintain existing client engagements and develop and implement solutions that add value to our clients. Our revenue is comprised of professional fees for services rendered to our clients plus reimbursable expenses. Prior to the commencement of a client engagement, we and our client agree on fees for services based upon the scope of the project, our staffing requirements and the level of client involvement. We recognize revenue as services are performed in accordance with the terms of the client engagement agreement. We bill our clients for these services on either a monthly or semi-monthly basis in accordance with the terms of the client engagement agreement. Accordingly, we recognize amounts due from our clients as the related services are rendered and revenue is earned even though we may be contractually required to bill for those services at an earlier or later date than the date services are provided. Provisions are made based on our experience for estimated uncollectible amounts. These provisions, net of write-offs of accounts receivable, are reflected in the allowance for doubtful accounts. We also set aside a portion of the revenue from each client engagement to cover the estimated costs that are likely to be incurred subsequent to targeted project completion. This portion of the project revenue is reflected in deferred revenue and is calculated based on our historical experience. While we have been required to make revisions to our clients’ estimated deliverables and to incur additional project costs in some instances, to date there have been no such revisions that have had a material adverse effect on our operating results.

      We have had six consecutive quarters of net revenue growth resulting from an increase in the demand for our services. Net revenue for the second quarter of fiscal year 2005 increased 3% compared to the first quarter of fiscal year 2005, and 21% compared to the second quarter of the prior fiscal year. We estimate that our net revenue for the third quarter of fiscal year 2005 will be in the range of $48 million to $50 million. For fiscal year 2005, we are projecting net revenue in the range of $190 million to $196 million.

      We generate revenue in many different countries throughout the world and our revenues are denominated in multiple currencies, including the U.S. dollar, the euro, the British pound sterling and the Brazilian real. As such, our revenues and expenses may be significantly impacted by fluctuations in foreign currency exchange rates. Assuming constant foreign currency translation rates, net revenue for the quarter ended September 30, 2004 would have increased 2% compared to the first quarter of fiscal year 2005 and 18% compared to the second quarter of the prior fiscal year.

      The largest portion of our operating expenses consists of project personnel costs. Project personnel costs consist of payroll costs, variable incentive compensation, and related benefits associated with professional staff.

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MANAGEMENT’S DISCUSSION AND ANALYSIS OF

Other expenses included in project personnel costs are travel, subcontracting, third-party vendor payments and non-billable costs associated with the delivery of services to our clients. We consider the relationship between project personnel expenses and net revenue to be an important measure of our operating performance. The relationship between project personnel expenses and net revenue, or gross margin, is driven largely by the chargeability of our consultant base, the prices we charge to our clients, project personnel compensation costs, and the non-billable costs associated with securing new client engagements and developing new service offerings. To accommodate the growth in the demand for our services, we increased our practice headcount to 521 at September 30, 2004, compared to 487 at June 30, 2004 and 454 at September 30, 2003. Our gross margin increased $1.1 million, or 6%, in the second quarter of fiscal year 2005 compared to the first quarter of fiscal year 2005, and increased $5.3 million, or 41%, compared to the second quarter of fiscal year 2004. This increase is primarily due to increased headcount and higher realized billing rates. Our annualized net revenue per professional was $366 thousand for the second quarter of fiscal year 2005, compared to $371 thousand in the first quarter of fiscal year 2005, and $327 thousand in the second quarter of fiscal year 2004.

      Our other recurring operating expenses are comprised of expenses associated with the development of our business and the support of our client-serving professionals, such as professional development and recruiting, marketing and sales, management and administrative support, and stock-based compensation expense. Professional development and recruiting expenses consist primarily of recruiting and training content development and delivery costs. Marketing and sales expenses consist primarily of the costs associated with the development and maintenance of our marketing materials and programs. Management and administrative support expenses consist primarily of the costs associated with operations including finance, information systems, human resources, facilities (including the renting of office space), and other administrative support for project personnel. Stock-based compensation expense is primarily due to the amortization of the fair value of employee stock awards granted after April 1, 2003. Management believes that income from operations, which is net revenue less project personnel and other recurring operating expenses is an important measure of our operating performance. Income from operations in the quarter ended September 30, 2004 increased $0.9 million, or 28%, compared to the first quarter of fiscal year 2005, and increased $3.5 million compared to the second quarter of fiscal year 2004.

      As with revenues, the strengthening of foreign currencies relative to the U.S. dollar over the last several quarters has increased our expenses. The increases in both revenues and expenses as a result of foreign currency translation have had an immaterial impact on net income.

      We regularly review our fees for services, professional compensation and overhead costs to ensure that our services and compensation are competitive within the industry, and that our overhead costs are balanced with our revenue level. In addition, we monitor the progress of client projects with client senior management. We manage the activities of our professionals by closely monitoring engagement schedules and staffing requirements for new engagements. However, a rapid decline in the demand for the professional services that we provide could result in lower utilization of our professionals than we planned. In addition, because most of our client engagements are terminable by our clients without penalty, an unanticipated termination of a client project could require us to maintain underutilized employees. While professional staff levels must be adjusted to reflect active engagements, we must also maintain a sufficient number of senior professionals to oversee existing client engagements and participate in our sales efforts to secure new client assignments. Our utilization rate for the second quarter of fiscal year 2005 was 64% compared to 66% in the first quarter of fiscal year 2005 and 67% in the second quarter of the prior fiscal year. Utilization has decreased due to the increase in practice headcount during the second quarter of fiscal year 2005.

      Our net cash provided by operations for the six months ended September 30, 2004 was $13.3 million which included net income of $7.6 million and a decrease in accounts receivable of $2.0 million due to an increase in collections. Management believes that the free cash flow metric, defined as net cash provided by

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operating activities ($13.3 million) net of capital expenditures ($0.8 million), provides a consistent metric from which the performance of the business may be monitored. Free cash flow for the six months ended September 30, 2004 was $12.5 million. For fiscal year 2005, we are projecting free cash flow in the range of $23 million to $27 million.

Disclosure Regarding Forward Looking Statements

      This Quarterly Report on Form 10-Q contains forward-looking statements within the meaning of Section 27A of the Securities Act and Section 21E of the Exchange Act relating to our operations, results of operations and other matters that are based on our current expectations, estimates and projections. Words such as “expects,” “intends,” “plans,” “projects,” “believes,” “estimates” and similar expressions are used to identify these forward-looking statements. These statements are not guarantees of future performance and involve risks and uncertainties that are difficult to predict. Forward-looking statements are based upon assumptions as to future events that may not prove to be accurate. Actual outcomes and results may differ materially from what is expressed or forecast in these forward-looking statements. The reasons for this include changes in general economic and political conditions, including fluctuations in exchange rates, and the following factors:

	•	Our results of operations are materially affected by economic conditions, levels of business activity and rates of change in the industries we serve.
	•	Our profitability will suffer if we are not able to maintain our pricing and utilization rates and control our costs. A continuation of pricing pressures could result in permanent changes in pricing policies and delivery capabilities.
	•	If we are unable to attract, retain and motivate employees, we will not be able to compete effectively and will not be able to grow our business.
	•	We may face damage to our professional reputation or legal liability if our clients are not satisfied with our services.
	•	Our global operations pose complex management, foreign currency, legal, tax and economic risks, which we may not adequately address.
	•	Our engagements with clients may not be profitable.
	•	Our business will be negatively affected if we are not able to anticipate and keep pace with rapid changes in technology or if growth in the use of technology in business is not as rapid as in the past.
	•	The consulting and technology markets are highly competitive. As a result, we may not be able to compete effectively if we cannot efficiently respond to market developments in a timely manner.
	•	Our quarterly revenues, operating results and profitability will vary from quarter to quarter, which may result in increased volatility of our share price.

      For a more detailed discussion of these factors, see Exhibit 99.1 to this Quarterly Report on Form 10-Q for the fiscal quarter ended September 30, 2004. We undertake no obligation to update or revise any forward-looking statements.

Critical Accounting Policies and Estimates

      We prepare our consolidated financial statements in conformity with accounting principles generally accepted in the United States of America. As such, we are required to make certain estimates, judgments and assumptions that we believe are reasonable based upon the information available. These estimates and

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assumptions affect the reported amounts of assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the periods presented. For a description of the significant accounting policies which we believe are the most critical to aid in understanding and evaluating our reported financial position and results, refer to our Annual Report on Form 10-K for the fiscal year ended March 31, 2004.

Results of Operations

      The following table sets forth the percentage of net revenue of items included in our condensed consolidated statements of operations for the periods indicated: