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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

Form 10-Q

Commission file number: 0-20971

Edgewater Technology, Inc.
(Exact Name of Registrant as Specified in its Charter)

Registrant's telephone number including area code: (781) 246-3343

        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 ý    No o

        Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Securities Exchange Act of 1934). Yes o    No ý

        The number of shares of Common Stock of the Registrant, par value $.01 per share, outstanding at May 7, 2004 was 11,438,427.

EDGEWATER TECHNOLOGY, INC.

FORM 10-Q FOR THE QUARTER ENDED MARCH 31, 2004

INDEX

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EDGEWATER TECHNOLOGY, INC.

UNAUDITED CONDENSED CONSOLIDATED BALANCE SHEETS

(In Thousands, Except Per Share Data)

(1)

Includes related party amounts of $1,749 and $1,853 at March 31, 2004 and December 31, 2003, respectively.

See notes to the unaudited condensed consolidated financial statements.

3

EDGEWATER TECHNOLOGY, INC.

UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(In Thousands, Except Per Share Data)

(1)

Includes related party amounts of $2,646 and $3,045 for the three months ended March 31, 2004 and 2003, respectively

See notes to the unaudited condensed consolidated financial statements.

4

EDGEWATER TECHNOLOGY, INC.

UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(In Thousands)

See notes to the unaudited condensed consolidated financial statements.

5

EDGEWATER TECHNOLOGY, INC.

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

1. ORGANIZATION:

        Edgewater Technology, Inc. ("Edgewater," "Edgewater Technology," "the Company," "our Company," "we," "us" or "our") is an award-winning strategic consulting firm that specializes in combining strategic consulting, technical knowledge, and industry domain expertise to develop technology solutions that assist primarily middle-market companies and divisions of Global 2000 companies to align their processes with their purposes. This approach not only promotes increased efficiency, but also supports increased effectiveness. By targeting strategic, mission critical applications, our consultants collaborate with customers to translate business goals into technical strategies. Headquartered in Wakefield, Massachusetts, our Company employs approximately 154 technical consulting professionals throughout our network of strategically positioned solutions centers.

        Our Company was incorporated in the State of Delaware in 1996. Our Company's business operations are conducted primarily through two subsidiaries: Edgewater Technology (Delaware), Inc., a Delaware corporation that was incorporated in 1992 and acquired by our Company on May 17, 1999, and Edgewater Technology (Virginia), Inc. (f/k/a Intelix, Inc.), a northern Virginia corporation that was incorporated in 1993 and was acquired by our Company on June 2, 2003.

2. BASIS OF PRESENTATION:

        The accompanying unaudited condensed consolidated financial statements have been prepared by Edgewater Technology pursuant to the rules and regulations of the Securities and Exchange Commission (the "SEC") regarding interim financial reporting. Certain information and note disclosures normally included in annual financial statements prepared in accordance with accounting principles generally accepted in the United States of America have been omitted pursuant to those rules and regulations, although we believe that the disclosures made are adequate to ensure the information presented is not misleading.

        The accompanying unaudited condensed consolidated financial statements reflect all adjustments (which were of a normal, recurring nature) that, in the opinion of management, are necessary to present fairly our financial position, results of operations and cash flows as of and for the interim periods presented. All intercompany transactions have been eliminated in the accompanying unaudited condensed consolidated financial statements. These financial statements should be read in conjunction with the audited financial statements and notes thereto included in our 2003 Annual Report on Form 10-K as filed with the SEC on March 30, 2004.

        The results of operations for the three months ended March 31, 2004 are not necessarily indicative of the results to be expected for any future period or the full fiscal year. Our revenue and earnings may fluctuate from quarter to quarter based on factors within and outside our control, including variability in demand for information technology professional services, the length of the sales cycle associated with our service offerings, the number, size and scope of our projects and the efficiency with which we utilize our employees.

3. BUSINESS COMBINATION:

        On June 2, 2003, our Company acquired all of the outstanding common stock of Intelix, Inc. ("Intelix"), a provider of systems integration and custom software development services located in Fairfax, Virginia. The results of Intelix's operations have been included in the Company's accompanying unaudited condensed consolidated statements of operations since the acquisition date. The acquisition

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was made to enhance Edgewater's geographical presence and to provide additional vertical expertise in the telecommunications and real estate industries.

        Related to the purchase of Intelix, the Company recorded $1.4 million in goodwill and $0.5 million in identifiable intangible assets, all in accordance with SFAS No. 141. The identifiable intangible assets were determined by a third party appraiser and are being amortized on the straight-line basis over their estimated useful lives (4-8 years). The goodwill is an indefinite lived asset in accordance with SFAS No. 142 and is subject to periodic review for impairment. This goodwill is not deductible for tax purposes. The Intelix business is included in the Company's only reportable segment (see Note 10).

4. REVENUE RECOGNITION:

        The Company recognizes revenue from three types of contracts: time and materials, subscription services, and fixed-price. A majority of the Company's contracts are billed on a time and materials basis. Time and materials contracts represented 69.0% and 68.1% of revenues for the three months ended March 31, 2004 and 2003, respectively. Revenue under time and materials contracts is generally recognized as services are rendered and performed at contractually agreed upon rates.

        We also perform subscription services related to IT infrastructure: Strategy, Audit, Remediation and Monitoring. Subscription services represented 10.8% and 12.3% of revenues for the three months ended March 31, 2004 and 2003, respectively. Revenue under subscription services contracts is generally recognized as monthly fixed amounts, for a specified period of time, as outlined within the respective contract.

        Revenue pursuant to fixed-price contracts is generally recognized under the proportional performance method of accounting. Over the course of a fixed-price contract, we routinely evaluate whether revenue and profitability should be recognized in the current period. To measure the performance and our ability to recognize revenue and profitability on fixed-price contracts, we compare actual direct costs incurred to the total estimated direct costs and determine the percentage of the contract that is complete. This percentage is multiplied by the estimated total contract value to determine the amount of net revenue recognized, subject to any warranty provisions and other holdbacks on revenue. Any warranty provisions included in fixed-price contracts are accounted for as a holdback of revenue until such provisions are satisfied. A formal project review process takes place quarterly, although most projects are evaluated on an ongoing basis. Management reviews the estimated total direct costs on each contract to determine if the estimated amounts are reasonable, and estimates are adjusted as needed. Fixed-price contracts represented 20.2%, and 19.6% of revenues for the three months ended March 31, 2004 and 2003, respectively.

        Revenues and earnings may fluctuate from quarter to quarter based on the number, size and scope of projects in which we are engaged, the contractual terms and degree of completion of such projects, any delays incurred in connection with a project, employee utilization rates, the adequacy of provisions for losses, the use of estimates of resources required to complete ongoing projects, general economic conditions and other factors. Certain significant estimates include estimates used for fixed-price contracts and the allowance for doubtful accounts. These items are frequently monitored and analyzed by management for changes in facts and circumstances, which could affect our estimates. Reimbursement of "out-of-pocket" expenses charged to customers is reflected as revenue.

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        For the three months ended March 31, 2004 and 2003, three and two customers, respectively, including Synapse (a related party—See Note 11), accounted for more than 10% of revenues. For the three months ended March 31, 2004 and 2003, our five largest customers represented 80.9% and 88.0% of our revenues in the aggregate, respectively.

5. PROVISION FOR INCOME TAXES:

        The Company has deferred tax assets related to net operating loss carryforwards and tax credits, which expire at different times through and until 2021. Management evaluates the realizability of the deferred tax assets quarterly and may adjust the valuation allowance based on such analysis in the future. The Company has provided a valuation allowance against certain deferred tax assets aggregating approximately $14.1 million, which allowance has remained unchanged since December 31, 2003. This valuation allowance is based on management estimates and represents tax credits and certain state net operating loss carryforwards and other assets that the Company concluded were not likely to be realized. The Company concluded the remaining assets, which consist primarily of the U.S. Federal net operating loss carryforward, is more likely than not to be realized through future taxable income. The Company is recording a deferred tax provision against income earned in 2004 using an estimated effective tax rate of 40%, with a corresponding reduction in the recorded net deferred tax assets. The Company recorded a tax provision of $0.04 million for the three months ended March 31, 2004, by reducing the net deferred tax asset, resulting in a remaining net deferred tax asset of $22.1 million as of March 31, 2004. The Company does not anticipate having to expend cash for any federal income taxes in 2004 because of the availability of the net operating loss carryforwards. The effective tax rate for 2003 was 40%. The Company recorded a tax provision of $0.04 million for the three months ended March 31, 2003.

6. STOCKHOLDERS' EQUITY:

Stockholder Rights Plan:

        The Company has a stockholder rights plan, commonly referred to as a "poison pill", that may discourage an attempt to obtain control by means of a tender offer, merger, proxy contest or otherwise. Under this plan, our Board of Directors can issue preferred stock in one or more series without stockholder action. If a person acquires 20% or more of our outstanding shares of common stock, except for certain institutional stockholders, who may acquire up to 25% of our outstanding shares of common stock, then rights under this plan would be triggered, which would significantly dilute the voting rights of any such acquiring person. Certain provisions of the General Corporation Law of Delaware may also discourage someone from acquiring or merging with us. No preferred stock has been issued as of March 31, 2004.

2003 Equity Incentive Plan:

        In May 2003, the Company's Board of Directors approved the "Edgewater Technology, Inc. 2003 Equity Incentive Plan" (the "2003 Plan") for the purpose of attracting and retaining employees and providing a vehicle to increase management's equity ownership in the Company. The 2003 Plan provides for restricted share awards and grants of nonqualified stock options in the aggregate of up to 500,000 shares of the Company's common stock. In May 2003, the Company's Compensation Committee authorized restricted share awards to certain executives of the Company under the 2003

8

Plan aggregating 140,000 shares of the Company's common stock (the "Restricted Share Awards"). The aggregate compensation expense associated with the Restricted Share Awards is approximately $0.7 million, which amount is being amortized straight-line over the vesting term (five years). Compensation expense related to the Restricted Share Awards during the three months ended March 31, 2004 amounted to $0.03 million.

General:

        In December 2002, the Financial Accounting Standards Board ("FASB") issued Statement of Financial Accounting Standards ("SFAS") No. 148, "Accounting for Stock-Based Compensation—Transition and Disclosure—an amendment of FASB Statement No. 123." SFAS No. 148 provides alternative methods of transition for a voluntary change to the fair value based method of accounting for stock-based employee compensation. In addition, SFAS No. 148 amends the disclosure requirements of SFAS No. 123, "Accounting for Stock-Based Compensation", to require prominent disclosure in both annual and interim financial statements about the method of accounting for stock-based compensation and the effect of the method used on reported results.

        The Company records stock-based compensation awards issued to employees and directors using the intrinsic value method and stock-based compensation awards issued to non-employees using the fair value method of accounting. Stock-based compensation expense, if any, is recognized on awards of restricted shares or grants of stock options issued to employees and directors if the purchase price or exercise price, as applicable, is less than the market price of the underlying stock on the measurement date, generally the date of grant. The differences between accounting for stock-based compensation under the intrinsic value method and the fair value method are shown below, with the fair value estimated on the grant date or award issue date, as applicable, using the Black-Scholes Option-Pricing Model:

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        Assumptions included in Black-Scholes Option-Pricing Model:

7. SHORT TERM INVESTMENTS:

        The Company records its investments in cash and marketable securities in accordance with SFAS No. 115, "Accounting for Certain Investments in Debt and Equity Securities". Our short-term investments have maturity dates of one year or less when acquired and are classified as held-to-maturity securities, which are recorded at amortized cost and consist of marketable instruments, which include, but are not limited to, government obligations, including agencies, and commercial paper. All short-term investments with remaining maturities at the date of purchase of three months or less are considered cash equivalents. As of March 31, 2004, our short-term investments consisted of $15.3 million in commercial paper and $2.1 million in government obligations, including agencies, and amortized cost approximated fair value. As of December 31, 2003, our short-term investments consisted of $14.3 million in commercial paper and $2.1 million in government obligations, including agencies, and amortized cost approximated fair value.

8. INTANGIBLE ASSETS:

        During the first quarter of 2002, the Company adopted Statement of Financial Accounting Standards No. 142 ("SFAS 142"), "Goodwill and Other Intangible Assets". Under SFAS No. 142, goodwill and certain intangible assets are deemed to have indefinite lives and are no longer amortized, but are reviewed at least annually for impairment. Other identifiable intangible assets will continue to be amortized over their estimated useful lives. SFAS No. 142 requires that goodwill be tested for impairment at the reporting unit level at adoption and at least annually thereafter, utilizing the "fair value" methodology. The Company evaluates the fair value of its reporting unit utilizing various valuation techniques. During the first quarter of 2002, as a result of declining industry stock prices, the Company recognized a transitional impairment loss of $12.5 million as the cumulative effect of a change in accounting principle.

        Goodwill must be tested for impairment on an annual basis and between annual tests in certain circumstances. The Company performed its annual impairment test on December 2, 2003, our selected annual measurement date, and determined that there was no further impairment. Our net goodwill as of March 31, 2004 and December 31, 2003, was $12.2 million, respectively and other net intangibles amounted $0.8 million and $0.9 million as of March 31, 2004 and December 31, 2003, respectively.

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        Intangible assets consisted of the following as of:

        Total amortization expense was $0.1 million for the three months ended March 31, 2004 and 2003. This amortization expense relates to certain non-competition covenants and customer lists, which will expire from 2004 through 2010.

9. EARNINGS PER SHARE:

        A reconciliation of net income (loss) and weighted average shares used in computing basic and diluted earnings per share is as follows:

        Stock options for which the exercise price exceeds the average market price over the period have an anti-dilutive effect on earnings per share, and accordingly, are excluded from the diluted computations for all periods presented. Had such shares been included, shares for the diluted computation would have increased by approximately 0.3 million and 2.9 million for the three months ended March 31, 2004 and 2003, respectively. Total outstanding options as of March 31, 2004 and 2003 were 4.6 million shares and 3.8 million shares, respectively.

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10. SEGMENT INFORMATION:

        The Company engages in business activities under one operating segment, which combines strategic consulting, technical knowledge, and industry domain expertise to develop custom technology solutions.

11. RELATED PARTIES:

        The Synapse Group, Inc. ("Synapse"), one of our significant customers, is considered a related party as its President and Chief Executive Officer is also a member of the Company's Board of Directors. During the three months ended March 31, 2004 and 2003, revenues from Synapse represented 41.7% and 59.1%, respectively, of total revenues. Revenues, receivables and payments received from Synapse are disclosed in the accompanying unaudited condensed consolidated financial statements, which balances were within the Company's normal business terms.

        In 1999, the Company entered into a lease agreement with a stockholder, who was a former officer and director of the Company, to lease certain parcels of land and buildings in Fayetteville, Arkansas for its former corporate headquarters. Rent payments related to these facilities totaled approximately $0.06 million for the three months ended March 31, 2004 and 2003. The Company's corporate headquarters moved to Wakefield, Massachusetts during 2001, and the Company subleased the Fayetteville facility to a third party in 2002. Sublease payments of $0.05 million were received during the three months ended March 31, 2004 and 2003.

12. COMMITMENTS AND CONTINGENCIES:

        We are sometimes a party to litigation incidental to our business. We believe that these routine legal proceedings will not have a material adverse effect on our financial position. We maintain insurance in amounts with coverages and deductibles that we believe are reasonable.

        During the second quarter of 2002, our Company was notified by the Internal Revenue Service (the "IRS") that it would be auditing our consolidated income tax returns for the 1998, 1999 and 2000 fiscal years. Our Company has responded to various IRS information requests by delivering documents and answering questions. For the period of the fiscal years covered by the audit, we owned staffing-related businesses, which were sold during the 2000 and 2001 fiscal years. The results of the IRS audit could have an impact on our deferred tax asset, however as of the date of the filing of this Form 10-Q, we do not believe any such impact would be material to our financial position.

        We have received and may continue to receive various tax notices and assessments from the IRS related to our former staffing businesses, which were sold in 2000 and 2001, and related civil penalties concerning the purported untimely filing of tax information. Between the filing of our quarterly report on Form 10-Q for the quarter ended September 30, 2003 and March of 2004, we have been successful in obtaining abatements of certain IRS notices. We also continue to work to resolve other outstanding IRS assessments, which presently are in a range of $0.8 million to $1.6 million. The Company recorded a reserve in 2003 of $1.0 million under discontinued operations, representing the low end of such estimate, plus related professional fees. The accrual is carried in the other liabilities section in the March 31, 2004 balance sheet.

        The Company entered into employment agreements with certain executive officers and management personnel during the second quarter of 2003, which agreements provide for annual salaries, cost-of-living adjustments and additional compensation opportunities in the form of "performance-based" bonuses. Certain agreements include covenants against competition with our Company, which extend for a period of time after termination. These agreements extend for a four-year period through 2007.

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ITEM 2.

MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS

Business Overview

        Edgewater Technology, Inc. is an award-winning consulting firm that specializes in combining strategic consulting, technical knowledge, and industry domain expertise to develop technology solutions that assist primarily middle-market companies and divisions of Global 2000 companies to align their processes with their purposes. This approach not only promotes increased efficiency, but also supports increased effectiveness. By targeting strategic, mission-critical applications, our consultants collaborate with our customers to translate business goals into technical strategies. Headquartered in Wakefield, Massachusetts, our Company employs approximately 154 technical consulting professionals throughout our network of strategically positioned solutions centers.

        Edgewater Technology offers a full spectrum of services and expertise to ensure the success of IT projects of any size and complexity, including:

•

Strategy—In a business environment where business is supported by an ever-increasing foundation of enabling technology, customer software, packaged software, networks, and technical infrastructure, Edgewater's strategy approach is more important than ever before. While this technology has been largely responsible for huge productivity gains and innovative new business models, the downside has also grown in terms of managing an ever increasing dependence on technology that is aging faster, becoming more complex, under increasing security scrutiny, and becoming ever more expensive. The choices have increased exponentially so a simple horizontal technology-only view will no longer suffice.

Edgewater's blend of vertical industry experts and technology specialists provides our clients with long and medium term technology strategies that deliver short-term value. This multi- disciplinary approach ensures that strategic plans not only serve the business need, but also are scalable, maintainable, and ultimately deliver the expected return on investment (ROI).

•

Design—Edgewater Technology believes by placing an emphasis in the design phase, organizations will be able to:



•

Reduce development costs



•

Integrate more effectively into their current IT infrastructure



•

Provide a flexible platform for more effective maintenance

Design is critical in an ever more complex technology environment. In order to expedite the process of building of an application, businesses must evaluate all of their resources—determining what technologies and tools will integrate effectively within their current IT infrastructure. When design is done properly in the beginning, issues are addressed and rectified early which prevents cost overruns when code and systems are developed prematurely.

Within this critical phase, Edgewater's team identifies and documents the detailed design of the solution to be developed. Detailed decisions are made ranging from what technologies and tools will integrate with the client's current IT infrastructure to what creative resources will be required to maintain consistency with the client's current brand.

•

Build—Edgewater Technology focuses on top IT talent and its most effective application to any IT project build. Edgewater's team is multi-disciplinary in terms of technology, methodology, and project management, providing the ultimate in flexibility and risk management. The Company

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has achieved a better than 95% repeat business factor as a result of our extensive work in developing systems with our experienced consultants.

With more choices existing today for the IT project build than any time in the past, it is central to have efficient and cost-effective IT talent, such as Edgewater's team of professionals, available as an option. Today, projects can be built in-house, outsourced off-shore or near-shore, contracted to project companies or ultimately utilize a blend of everything. Often the rush to build can end up being a costly decision, resulting in:

•

Inadequate functional design



•

Inadequate technical architecture



•

Inability to support the ever-changing needs of the organization.



•

Maintain—With more than 150 technical consulting professionals, Edgewater Technology specializes in maintaining applications that require fast enhancement cycles, constant integration in changing environments and specialized quality assurance. The ability to cater to applications that support our customers' businesses, especially applications that are in the early stages of evolution, requires the necessary technology skills and business understanding. We assist our customers with the complete lifecycle of their custom applications. Application maintenance in today's environment can often be challenging and costly. Businesses are faced with uncovering the "hidden" costs of maintaining applications whether it includes testing, integration and/or ongoing support.



•

Operate—Edgewater Technology has the ability to provide clients with customized operations support ranging from remotely managing a customer's assets onsite at their location to facilities management of our customers' assets at Edgewater Technology's networking operating facility. The need for a reliable, scalable and available IT infrastructure is critical to any organization's success.

        In addition to our ability to provide a full spectrum of services, Edgewater Technology also has the expertise to deliver systems integration services that maximize business results and performance improvements. We focus not only on deploying new systems, but also extending the longevity of existing systems for an ever-changing marketplace. This proven expertise enables us to bring complex technologies and systems together while minimizing risk, maximizing our clients' technology investments and delivering customized solutions that address organizations' short and long-term business objectives.

        With more than ten years of operating history, Edgewater Technology focuses on five core values that differentiate us from the competition:

(1)

Delivery Excellence—Our enviable delivery history is built upon more than ten years of proven methodology and processes, and by continually delivering solutions that work. Our delivery excellence is a derivative of a well-defined business plan, highly trained professionals, strong technical expertise, and established implementation and support methodologies. Most importantly, we provide effective and continued communication with our customers throughout the entire process. Our delivery history has contributed to our ability to build long-term relationships with our customers.



(2)

Vertical Expertise/Horizontal Service Offerings—We combine vertical-industry knowledge with a broad base of key strategic technologies to serve our customers' technology needs and deliver award-winning tailored strategies and solutions. We bring vertical-industry knowledge together with a broad base of key strategic technologies. Edgewater Technology uses an iterative development methodology, with a focus on quality assurance and project management, to achieve rapid deployment capability and success in assisting organizations move through the barriers of technology transition. The primary vertical markets where we

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have developed core competencies to deliver our services include: Financial Services (Retail Banking, Portfolio/Asset Management); Health Care (Managed Care); Higher Education; Insurance; Life Sciences; Real Estate; Retail; Telecommunications; and various Emerging Markets that consist of untapped vertical markets which are just beginning to leverage the use of technology. We also focus on service offerings that cross each vertical such as Supply Chain, Customer Service and Web Services.

The diagram below illustrates our vertical and horizontal service offerings:



(3)

Technology Excellence—We extend our services through proven key strategic technologies and through the focus of vertical business practices to build scalable custom solutions providing a solid return on the investment (ROI) and thereby competitive advantage to our customers. Our team of professionals has the technology expertise, coupled with vertical knowledge, to offer comprehensive strategies and solutions. Our established partnerships with industry leaders enable us to deliver market-leading insights and innovative solutions that meet our customers' diverse business needs quickly. Our areas of technical expertise include: web-based solutions; architectural strategy; Web services; data management; transaction processing and legacy systems integration.



(4)

Middle-Market Focus—We are well positioned to serve the technology needs of the middle market through our solutions centers based where middle-market enterprises typically reside. The middle market is defined as companies and/or subsidiaries of Global 2000 corporations with $50 million to $1 billion in revenue. By leveraging our solutions centers, we are able to create a virtual development environment that allows for efficiencies in staff management, while servicing clearly defined markets to leverage technology and gain competitive advantage.



(5)

Strong Operational Metrics—Since our inception in 1992, Edgewater Technology's original management team has built an organization that is defined by a record of operational excellence, using electronic processes and systems to manage our consulting resources, company utilization and gross margin.

Critical Accounting Policies

        Our unaudited condensed consolidated financial statements are prepared in accordance with accounting principles generally accepted in the United States of America ("GAAP"). These accounting principles require us to make certain estimates, judgments and assumptions. We believe that the estimates, judgments and assumptions, upon which we rely, are reasonable based upon information available to us at the time that they are made. These estimates, judgments and assumptions can affect the reported amounts of assets and liabilities as of the date of the financial statements, as well as the

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reported amounts of revenues and expenses during the periods presented. To the extent there are differences between these estimates, judgments or assumptions and actual results, our financial statements may be affected. The accounting policies that we believe are the most critical to aid in fully understanding and evaluating our reported financial results include the following:

•

Revenue Recognition;



•

Accounting for Income Taxes; and



•

Valuation of Long-Lived and Intangible Assets.

        In many cases, the accounting treatment of a particular transaction is specifically dictated by GAAP and does not require management's judgment in its application. There are also areas in which management's judgment in selecting among available alternatives would not produce a materially different result. See notes to unaudited condensed consolidated financial statements included elsewhere herein, which contain additional information regarding our accounting policies and other disclosures required by GAAP. We have identified the policies listed above as critical to our business operations and the understanding of our results of operations.

        Revenue Recognition.    Our revenues are derived from fees for services generated on a project-by-project basis. The Company recognizes revenue from three types of contracts: time and materials, subscription services, and fixed-price. A majority of the Company's contracts are billed on a time and materials basis. Time and materials contracts represented 69.0% and 68.1% of revenues for the three months ended March 31, 2004 and 2003, respectively. Revenues related to time and materials contracts are generally recognized based on the number of hours worked by our consultants at agreed upon rates. Revenues under time and materials contracts are generally recognized in the period in which the services are performed.

        We also perform subscription services related to IT infrastructure: Strategy, Audit, Remediation and Monitoring. Subscription services represented 10.8% and 12.3% of revenues for the three months ended March 31, 2004 and 2003, respectively. Revenue under subscription services contracts is generally recognized as monthly fixed amounts, for a specified period of time, as outlined within the respective contract.

        Revenue pursuant to fixed-price contracts is recognized under the proportional performance method of accounting. Over the course of a fixed-price contract, we routinely evaluate whether revenue and profitability should be recognized in the current period. To measure the performance and our ability to recognize revenue and profitability on fixed-price contracts, we compare actual direct costs incurred to the total estimated direct costs and determine the percentage of the contract that is complete. This percentage is multiplied by the estimated total contract value to determine the amount of net revenue recognized, subject to any warranty provisions and other holdbacks on revenue. Any warranty provisions included in fixed-price contracts are accounted for as a holdback of revenue until such provisions are satisfied. A formal project review process takes place monthly although most projects are evaluated on an ongoing basis. Management reviews the estimated total direct costs on each contract to determine if the estimated amounts are reasonable, and estimates are adjusted as needed. Fixed-price contracts represented 20.2% and 19.6% of revenues for the three months ended March 31, 2004 and 2003, respectively.

        Revenues and earnings may fluctuate from year to year based on the number, size and scope of projects in which we are engaged, the contractual terms and degree of completion of such projects, any delays incurred in connection with a project, employee utilization rates, the adequacy of provisions for losses, the use of estimates of resources required to complete ongoing projects, general economic conditions and other factors. Certain significant estimates include estimates used for fixed-price contracts and the allowance for doubtful accounts. These items are frequently monitored and analyzed

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by management for changes in facts and circumstances, which could affect our estimates. Reimbursements of "out-of-pocket" expenses charged to customers are reflected as revenue.

        Accounting for Income Taxes.    As part of the process of preparing our condensed consolidated financial statements, significant judgment is required in determining our provision for income taxes, the carrying value of deferred tax assets and liabilities and the valuation allowance recorded against our net deferred tax assets. We have recorded a $14.1 million valuation allowance against our net deferred tax assets as March 31, 2004 and December 31, 2003, respectively, due to potential uncertainty related to our ability to utilize some of our deferred tax assets, primarily consisting of certain net operating losses carried forward and foreign tax credits, before they expire. We consider scheduled reversals of deferred tax liabilities, projected future taxable income, ongoing tax planning strategies and other matters, including the period over which our deferred tax assets will be recoverable in assessing the need for and the amount of the valuation allowance. In the event that actual results differ from these estimates or we adjust these estimates in future periods, adjustments to the deferred tax assets may be recorded, which could materially impact our financial position and net income (loss) in the period. The net deferred tax asset was $22.1 million as of March 31, 2004, which amount management believes will be realized.

        Valuation of Long-Lived and Intangible Assets.    We assess the impairment of identifiable intangibles, long-lived assets and related goodwill annually through the use of a third party appraiser, and whenever events or changes in circumstances indicate that the carrying value may not be recoverable. Factors we consider important, which could trigger an impairment review include: 1) significant negative industry or economic trends, 2) significant operating underperformance relative to expected historical or projected future results, 3) significant decline in our stock price or the stock price of our industry peers and/or 4) a decline in our market capitalization relative to our net book value. Our judgments regarding the existence of impairment indicators are based upon legal factors, market conditions and operational performance. Our Company adopted SFAS No. 142 in 2002 and in accordance therewith, recorded as a change in accounting principle, a non-cash impairment charge of $12.5 million upon adoption on January 1, 2002. On December 2, 2002, our selected annual measurement date, our Company recorded an additional non-cash charge of $7.4 million due to a further impairment of goodwill. As further described in Note 3 to the unaudited condensed consolidated financial statements included elsewhere herein, the Company acquired Intelix on June 2, 2003 and recorded $1.4 million in goodwill and $0.5 million in identifiable intangibles, which are being amortized over 4 to 8 years.

Financial Information

        The financial information that follows has been rounded in order to simplify its presentation. The amounts and percentages below have been calculated using the detailed financial information contained in the unaudited condensed consolidated financial statements, the notes thereto and the other financial data included in this Quarterly Report on Form 10-Q.

Results for the three months ended March 31, 2004 compared to results for the three months ended March 31, 2003

        Service Revenues.    Revenues for the three months ended March 31, 2004 increased $1.2 million, or 23.8%, to $6.4 million compared to $5.2 million for the three months ended March 31, 2003. The revenue increase reflects the acquisition of Intelix since June 2, 2003, which represents 58% of the increase, combined with organic growth from the positive effects of sales efforts designed to reduce customer concentration and engage new customers, which represents the remaining 42% of the increase. For the three months ended March 31, 2004 and 2003, three and two customers, respectively, contributed more than 10% of revenues. For the three months ended March 31, 2004 and 2003, our five largest customers represented 80.9% and 88.0% of our revenues in the aggregate, respectively.

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Expenses reimbursed by our clients are also included in revenue. Also see Note 11, Related Parties, to the unaudited condensed consolidated financial statements included elsewhere herein, for additional information.

        Cost of Services.    Project personnel costs consist principally of salaries, payroll taxes, employee benefits and travel expenses for personnel dedicated to customer projects. These costs represent the most significant expense we incur in providing our services. Project personnel costs increased $0.9 million, or 33.9%, to $3.8 million for the three months ended March 31, 2004, compared to $2.9 million for the three months ended March 31, 2003. This increase is due to the increase in billable consultants from 122 at March 31, 2003 to 154 at March 31, 2004, which is in large part a result of the acquisition of Intelix during June 2003, which added 29 billable consultants.

        Gross Profit.    Gross profit for the three months ended March 31, 2004 increased $0.3 million, or 11.2%, to $2.6 million, compared to $2.3 million for the three months ended March, 2003. The increase in gross profit directly relates to the increase in billable hours and revenues combined with gross profit related to the Intelix acquisition of $0.1 million for the three months ended March 31, 2004. Utilization rates were 75.5% for the three months ended March 31, 2004, compared to 77.2% for the three months ended March 31, 2003. Gross profit margin for the three months ended March 31, 2004 was 40.2%, compared to 44.7% during the three months ended March 31, 2003.

        Selling, General and Administrative Expense ("SG&A").    SG&A increased $0.3 million, or 11.6%, to $2.4 million for the three months ended March 31, 2004 compared to $2.1 million for the three months ended March 31, 2003. This increase is related to additional facility and overhead costs assumed with the acquisition of Intelix. SG&A, as a percentage of revenue, was 37.1% and 41.2% for the three months ended March 31, 2004 and 2003, respectively.

        Depreciation and Amortization Expense.    Depreciation and amortization expense decreased $0.01 million to $0.2 million for the three months ended March 31, 2004, compared to $0.2 million for the three months ended March 31, 2003. This decrease reflects tighter spending controls on purchases of new fixed assets and a relative reduction in depreciation as older assets fully depreciate, offset by slightly additional amortization expense due to the Intelix acquisition.

        Operating Income (Loss).    Operating income increased $0.03 million to $0.01 million for the three months ended March 31, 2004, compared to a net loss of ($0.02) million for the three months ended March 31, 2003. Operating income increased from the prior year primarily due to the increase in revenue.

        Interest Income and Other, Net.    We earned net interest income of $0.10 million for the three months ended March 31, 2004, compared to net interest income of $0.13 million for the three months ended March 31, 2003. The slight decrease in net interest income is due to the lower average cash balances as a result of common stock repurchases and discontinued operations payments made during 2003.

        Tax Provision.    The Company provides for income taxes at the end of each interim period based on the estimated effective tax rates for the full fiscal year. Cumulative adjustments to the tax provision are recorded in the interim period in which a change in the estimated annual effective rate is determined. We recorded a tax provision of $0.04 million and $0.04 million for the three months ended March 31, 2004 and 2003, respectively, which represents an estimated effective rate of 40%, which includes state and federal income tax rates. We expect the estimated effective tax rate to remain at approximately 40% for the remainder of 2004.

        Net Income.    We generated net income of $0.07 million for the three months ended March 31, 2004 compared to $0.07 million for the three months ended March 31, 2003. Year over year net income was primarily affected by the increase in service revenues in 2004 over 2003, offset by additional cost of

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sales and sales, general and administrative expenses discussed above. Basic and diluted earnings per share was $0.01 and $0.01 for the three months ended March 31, 2004 and 2003, respectively.

Liquidity and Capital Resources

        The following table summarizes our cash flow activities for the periods indicated:

        As of March 31, 2004, we had cash, cash equivalents and short-term investments of $42.4 million, a 4.1% decrease from the December 31, 2003 balance of $44.3 million. Working capital, which is defined as current assets less current liabilities, increased to $45.3 million as of March 31, 2004 compared to $44.8 million as of December 31, 2003.

        Our primary historical sources of funds are from operations and the proceeds from equity offerings. Our principal historical uses of cash have been to fund working capital requirements and capital expenditures. We generally pay our employees bi-weekly for their services, while receiving payments from customers 30 to 60 days from the date of the invoice.

        Our Board of Directors, in September 2002, authorized management, subject to legal requirements, to use up to $20.0 million to repurchase our common stock over a period, as amended, to expire December 31, 2003, which was extended through February, 2005. Repurchases have been and will be made from time to time on the open market at prevailing market prices or in negotiated transactions off the market. Under this repurchase program, during the three months ended March 31, 2004 the Company did not make any share repurchases. During the three months ended March 31, 2003, we repurchased 70,932 and shares of our common stock for $0.3 million. As part of this repurchase program, effective February 14, 2003, our Board authorized an SEC Rule 10b5-1 repurchase program with a broker that allows the Company to make more consistent repurchases of our common stock even during traditional blackout periods. As of March 31, 2004, the Company is authorized to repurchase up to $18.6 million of our common stock prior to February, 2005.

        Net cash used by operating activities was $1.5 million and $0.3 million for the three months ended March 31, 2004 and 2003, respectively. The cash used during the three months ended March 31, 2004 was primarily related to the payment of the 2003 bonus accrual, while the cash used during the three months ended March 31, 2003 was primarily attributable to cash outflows for annual insurance renewals.

        Net cash (used in) provided by investing activities was ($1.0) million and $4.1 million for the three months ended March 31, 2004 and 2003, respectively. Cash used in investing activities during the three months ended March 31, 2004 was primarily attributable to the purchases of short-term investments. Cash provided by investing activities for the three months ended March 31, 2003 was attributed to maturities of short-term investments. As of March 31, 2004, we have no long-term commitments for capital expenditures and all capital expenditures are discretionary.

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        Net cash provided by (used in) financing activities was $0.2 million and ($0.3) million for the three months ended March 31, 2004 and 2003, respectively. For the three months ended March 31, 2004, cash provided by financing activities was primarily related to cash received from stock option exercises and proceeds from the employee stock purchase program. For the three months ended March 31, 2003, cash used in financing activities was primarily related to repayments on our capital lease obligations and repurchases of common stock.

        Net cash used by previously discontinued operations was $0.5 million and $1.2 million for the three months ended March 31, 2004 and 2003, respectively. These amounts relate to expenses accrued in 2003 for discontinued operating activities, with a payment of $950,000 in February 2003 for the litigation settlement related to discontinued operations and accrued for at December 31, 2002 (See Note 12).

        As a result of the above, our combined cash and cash equivalents decreased $2.8 million and increased $2.2 million for the three months ended March 31, 2004 and 2003, respectively. The aggregate of cash, cash equivalents and short-term investments was $42.4 million and $44.3 million, as of March 31, 2004 and December 31, 2003, respectively.

        We believe that our cash flows from operations and available cash will provide sufficient liquidity for our existing operations for the foreseeable future. We periodically reassess the adequacy of our liquidity position, taking into consideration current and anticipated operating cash flow, anticipated capital expenditures, business combinations, and public or private offerings of debt or equity securities.

Acquisition of Intelix, Inc.

        On June 2, 2003, the Company acquired all of the outstanding common stock of Intelix, Inc. ("Intelix"), a provider of systems integration and custom software development services located in Fairfax, Virginia. The results of Intelix's operations have been included in the Company's accompanying unaudited condensed consolidated statements of operations since the acquisition date. The acquisition was made to enhance Edgewater's geographical presence and will provide additional vertical expertise in the telecommunications and real estate industries.

Other Tax Matters

        During the second quarter of 2002, our Company was notified by the Internal Revenue Service (the "IRS") that it would be auditing our consolidated income tax returns for the 1998, 1999 and 2000 fiscal years. Our Company has responded to various IRS information requests by delivering documents and answering questions. For the period of the fiscal years covered by the audit, we owned staffing-related businesses, which were sold during the 2000 and 2001 fiscal years. The results of the IRS audit could have an impact on our deferred tax asset, however, as of the date of the filing of this Form 10-Q, we do not believe any such impact would be material to our financial position.

Off Balance Sheet Arrangements, Contractual Obligations and Contingent Liabilities and Commitments

        We lease office space and certain equipment under noncancelable operating and capital lease arrangements through 2009. Rent expense, including amounts paid to related parties for discontinued operations, was approximately $0.2 million, and $0.2 million for the three months ended March 31, 2004 and 2003, respectively.

        The Company entered into employment agreements with certain executive officers and management personnel during the second quarter of 2003, which agreements provide for annual salaries, cost-of-living adjustments and additional compensation opportunities in the form of "performance-based" bonuses. Certain agreements include covenants against competition with our Company, which extend for a period of time after termination. These agreements extend for a four-year period through 2007.

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Special Note Regarding Forward Looking Statements

        Some of the statements in this Quarterly Report on Form 10-Q (this "10-Q") constitute forward-looking statements under Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended, including statements made with respect to significant customers, revenues, backlog, competitive and strategic initiatives, growth plans, potential stock repurchases, future results, tax consequences and liquidity needs. These statements involve known and unknown risks, uncertainties and other factors that may cause results, levels of activity, growth, performance, tax consequences or achievements to be materially different from any future results, levels of activity, growth, performance, tax consequences or achievements expressed or implied by such forward-looking statements. Such factors include, among other things, those listed below, as well as those further set forth under the heading "Business—Factors Affecting Finances, Business Prospects and Stock Volatility" in our 2003 Annual Report on Form 10-K as filed with the SEC on March 30, 2004.

        The forward-looking statements included in this Form 10-Q relate to future events or our future financial performance. In some cases, you can identify forward-looking statements by terminology such as "may," "believe," "enable" "will," "provide," "anticipate," "future," "could," "growth," "increase," "modifying," "reacting," or the negative of such terms or comparable terminology. These forward-looking statements inherently involve certain risks and uncertainties, although they are based on our current plans or assessments which are believed to be reasonable as of the date of this 10-Q. Factors that may cause actual results, financial statement effects, disposition plans or proceeds, goals, targets, objectives or repurchases to differ materially from those contemplated, projected, forecast, estimated, anticipated, planned or budgeted in such forward-looking statements include, among others, the following possibilities: (1) inability to execute upon growth objectives; including growth in entities acquired by our Company: (2) changes in industry trends, such as a decline in the demand for solutions services or delays in industry-wide IT spending, whether on a temporary or permanent basis and/or delays by customers in initiating new projects or continuing new project milestones; (3) unanticipated events or the occurrence of fluctuations or variability in the matters identified under "Critical Accounting Policies"; (4) failure of our sales pipeline to be converted to billable work and recorded as revenue; (5) potential quarterly revenue variability that could arise under contracts where our customers have the flexibility to determine the level of services they may require of us; (6) adverse developments and volatility involving geopolitical or technology market conditions; (7) the occurrence of lawsuits or adverse results in tax matters; (8) loss of key executives; (9) failure of the middle market and the needs of middle-market enterprises for business services to develop as anticipated; (10) inability to recruit and retain professionals with the high level of information technology skills and experience needed to provide our services; (11) expanding outsourcing services to generate additional revenue; (12) any changes in ownership, adverse developments concerning the IRS audit of our corporate tax returns for the 1998-2000 fiscal years, that would result in a limitation on the use of the net operating loss carry-forward under applicable tax laws, which is referred to as a net deferred tax asset of approximately $22.1 million as of March 31, 2004; and/or (13) the failure to obtain remaining predecessor entity tax records that are not in our control and/or successfully resolve remaining outstanding IRS matters relating to our former staffing businesses. In evaluating these statements, you should specifically consider various factors described above as well as the risks outlined under Item I "Business—Factors Affecting Finances, Business Prospects and Stock Volatility" in our 2003 Form 10-K filed with the SEC on March 30, 2004. These factors may cause our actual results to differ materially from those contemplated, projected, anticipated, planned or budgeted in any such forward-looking statements.

        Although we believe that the expectations in the forward-looking statements are reasonable, we cannot guarantee future results, levels of activity, performance, growth or achievements. However, neither we nor any other person assumes responsibility for the accuracy and completeness of such

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statements. We are under no duty to update any of the forward-looking statements after the date of this Form 10-Q to conform such statements to actual results.

Item 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

        Our primary financial instruments include investments in money market funds, short-term municipal bonds, commercial paper and U.S. government securities that are sensitive to market risks and interest rates. The investment portfolio is used to preserve our capital until it is required to fund operations, to fund strategic acquisitions, or other transactions which may be authorized by our Company's Board of Directors. None of our market-risk sensitive instruments are held for trading purposes. We do not purchase derivative financial instruments.

ITEM 4. CONTROLS AND PROCEDURES

Evaluation of Disclosure Controls and Procedures

        General.    As of March 31, 2004 (the "Evaluation Date"), the Company evaluated the effectiveness of our "disclosure controls and procedures" ("Disclosure Controls") and the Company's "internal controls and procedures for financial reporting" ("Internal Controls"). This evaluation (the "Controls Evaluation") was carried out by the Company's disclosure controls and procedures committee under the supervision and with the participation of management, including our President and Chief Executive Officer ("the CEO") and Chief Financial Officer ("the CFO"). Rules adopted by the SEC require that in this section of this report, that the Company present the conclusions of the CEO and the CFO about the effectiveness of our Disclosure Controls and Internal Controls as of the Evaluation Date.

        CEO and CFO Certifications.    Appearing as exhibits 31.1 and 31.2 to this quarterly report there are two separate forms of "Certifications" of the CEO and the CFO. These Certifications are required under Rule 13a-14(a) of the Exchange Act (the "13a-14 Certifications"). This section of this report, which you are currently reading, is the information concerning the Controls Evaluation referred to in the 13a-14 Certifications and this information should be read in conjunction with the 13a-14 Certifications for a more complete understanding of the topics presented. In addition to the 13a-14 Certifications, a certification of the CEO and the CFO under 18 USC § 1350 is included as Exhibit 32 of this Quarterly Report. The 1350 Certification requires the CEO and the CFO to certify to the best of their knowledge that this Quarterly Report complies with Section 13(a) or 15(d) of the Exchange Act (as defined below) and that such Quarterly Report fairly presents, in all material respects, the financial condition of the Company at the end of the period covered by this Quarterly Report. You are referenced to this certification for more information regarding the 1350 Certification.

        Disclosure Controls and Internal Controls.    Disclosure Controls are procedures that are designed with the objective of ensuring that information required to be disclosed in our reports filed under the Securities Exchange Act of 1934, as amended (the "Exchange Act"), such as this report, is recorded, processed, summarized and reported within the time periods specified in the SEC rules. Disclosure Controls are also designed with the objective of ensuring that such information is accumulated and communicated to our management, including the CEO and the CFO, as appropriate to allow timely decisions regarding required disclosure. Internal Controls are procedures which are designed with the objective of providing reasonable assurance that: (1) our transactions are properly authorized; (2) our assets are safeguarded against unauthorized or improper use; and (3) our transactions are properly recorded and reported, all to permit the preparation of our financial statements in conformity with generally accepted accounting principles. However, any control system, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of the control system are met.

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        Scope of the Controls Evaluation.    The CEO's and the CFO's evaluation of our Disclosure Controls and our Internal Controls included a review of the controls' objectives and design, the controls' implementation by the Company and the effect of the controls on the information generated for use in this report. This type of evaluation will be done on a quarterly basis so that the conclusions concerning controls effectiveness can be reported in our Quarterly and Annual Reports. Our Internal Controls are also evaluated on an ongoing basis by other personnel in our finance and accounting department.

        Among other matters, the Company sought in our evaluation to determine whether there were any "significant deficiencies" or "material weaknesses" in our Internal Controls, or whether the Company had identified any acts of fraud involving personnel who have a significant role in our Internal Controls. This information was important both for the Controls Evaluation generally and because the 13a-14 Certifications require that the CEO and the CFO disclose that information to our Board's Audit Committee and to our independent auditors. In the professional auditing literature, "significant deficiencies" are control issues that could have a significant adverse effect on the ability to record, process, summarize and report financial data in the financial statements. A "material weakness" is defined in the auditing literature as a particularly serious reportable condition where the internal control does not reduce to a relatively low level the risk that misstatements caused by error or fraud may occur in amounts that would be material in relation to the financial statements and not be detected within a timely period by employees in the normal course of performing their assigned functions.

        Changes in Internal Controls.    There were no significant changes in our Internal Controls or in other factors that could significantly affect these controls subsequent to the date of the Evaluation Date, nor were there any significant deficiencies or material weaknesses in our Internal Controls. Accordingly, no corrective actions were required or undertaken.

        Conclusions.    Based on the Controls Evaluation, as described above, the CEO and the CFO have concluded that as of the Evaluation Date, the Company's Disclosure Controls and Internal Controls were adequate, effective and designed to ensure that material information relating to the Company and our consolidated subsidiaries was made known to them by others within those entities, particularly during the period when the Company's periodic reports are being prepared.

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PART II

ITEM 1. LEGAL PROCEEDINGS

        We are sometimes a party to litigation incidental to our business. We believe that these routine legal proceedings will not have a material adverse effect on our financial position. We maintain insurance in amounts, with coverage and deductibles, that we believe are reasonable.

ITEM 2. CHANGES IN SECURITIES AND USE OF PROCEEDS

        None.

ITEM 3. DEFAULTS UPON SENIOR SECURITIES

        Not applicable as our Company does not have any senior securities issued or outstanding.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

        Not applicable as there were no matters submitted to our company's stockholders during the quarterly period ended March 31, 2004.

ITEM 5. OTHER INFORMATION

        None.

ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K

(a)

Exhibits

(b)

Reports on Form 8-K



1.

A Form 8-K was filed with the SEC on February 11, 2004 relating to the announcement of our fourth quarter and full year 2003 financial results.



2.

A Form 8-K/A was filed with the SEC on March 18, 2004 relating to the announcement that the Company was revising the fourth quarter and full year 2003 financial results.

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SIGNATURES

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

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