UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

 

WASHINGTON, D.C. 20549 - 0001

 

FORM 10-Q

 

 

 

PEC SOLUTIONS, INC.

(EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER)

 

 

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 the 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 Exchange Act). Yes  ý   No o

 

As of November 14, 2003, 27,212,466 of the registrant’s Common Stock, par value $.01 per share, were outstanding.

 

 

PEC SOLUTIONS, INC.

QUARTERLY REPORT ON FORM 10-Q FOR THE NINE MONTHS ENDED SEPTEMBER 30, 2003

 

TABLE OF CONTENTS

 

PART I.  FINANCIAL INFORMATION

Item 1. Financial Statements:

Consolidated Balance Sheets - September 30, 2003 and December 31, 2002

Consolidated Statements of Income - Three and nine months ended September 30, 2003 and 2002

Consolidated Statements of Cash Flows — Nine months ended September 30, 2003 and 2002

Notes to Consolidated Financial Statements

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

Item 3. Qualitative and Quantitative Disclosure about Market Risk

PART II. OTHER INFORMATION

Items 1 – 6

Signatures

 

2

 

PART I: FINANCIAL INFORMATION

 

ITEM 1: FINANCIAL STATEMENTS

 

PEC SOLUTIONS, INC.

CONSOLIDATED BALANCE SHEETS

(DOLLARS IN THOUSANDS)

 

		AS OF SEPTEMBER 30, 2003			AS OF DECEMBER 31, 2002
		(Unaudited)
ASSETS
Current assets:
Cash and cash equivalents		$	22,818		$	21,176
Short-term investments		40,958			35,551
Accounts receivable, net		49,511			52,974
Other current assets		2,547			3,452
Total current assets		115,834			113,153
Property and equipment, net		27,108			27,967
Investments		38,562			26,790
Goodwill		16,932			16,932
Intangibles, net		3,062			3,700
Other assets		4,478			3,749
Total assets		$	205,976		$	192,291
LIABILITIES AND STOCKHOLDERS’ EQUITY
Current liabilities:
Accounts payable and accrued expenses		$	7,627		$	8,415
Advance payments on contracts		471			1,070
Retirement plan contribution payable		1,581			—
Accrued payroll		3,356			6,836
Accrued vacation		3,021			2,562
Other current liabilities		1,211			935
Total current liabilities		17,267			19,818
Long-term liabilities:
Supplemental retirement program liability		1,454			966
Deferred rent payable		1,680			1,341
Long-term lease obligation		22,995			22,822
Total long-term liabilities		26,129			25,129
Total liabilities		43,396			44,947
Commitments and contingencies
Stockholders’ equity:
Undesignated capital stock, 10,000,000 shares authorized		—			—
Common stock, $0.01 par value, 75,000,000 shares authorized, 27,164,883 and 26,792,565 shares issued and outstanding, respectively		272			268
Additional paid-in capital		93,981			91,071
Retained earnings		68,471			56,046
Accumulated other comprehensive loss		(144		)	(41		)
Total stockholders’ equity		162,580			147,344
Total liabilities and stockholders’ equity		$	205,976		$	192,291

 

See notes to consolidated financial statements.

 

3

 

PEC SOLUTIONS, INC.

CONSOLIDATED STATEMENTS OF INCOME

(AMOUNTS IN THOUSANDS, EXCEPT PER SHARE DATA)

 

		THREE MONTHS ENDED						NINE MONTHS ENDED
		SEPTEMBER 30, 2003			SEPTEMBER 30, 2002			SEPTEMBER 30, 2003			SEPTEMBER 30, 2002
		(Unaudited)
Revenues		$	43,295		$	52,844		$	131,025		$	133,836
Operating costs and expenses:
Direct costs		25,821			30,359			78,503			78,789
General and administrative expenses		8,758			9,164			26,992			24,685
Sales and marketing expenses		1,250			1,205			4,331			4,246
Amortization of intangibles		213			175			638			556
Total operating costs and expenses		36,042			40,903			110,464			108,276
Operating income		7,253			11,941			20,561			25,560
Investment and other income		604			205			1,781			1,179
Interest expense		(664		)	(1		)	(1,986		)	(7		)
Income before income taxes		7,193			12,145			20,356			26,732
Provision for income taxes		2,751			4,743			7,786			10,439
Net income		$	4,442		$	7,402		$	12,570		$	16,293
Earnings per share:
Basic		$	0.16		$	0.28		$	0.46		$	0.62
Diluted		$	0.15		$	0.25		$	0.42		$	0.56
Weighted average shares used in computing earnings per share:
Basic		27,151			26,463			27,045			26,298
Diluted		29,978			29,566			29,811			29,176

 

See notes to consolidated financial statements.

 

4

 

PEC SOLUTIONS, INC.

CONSOLIDATED STATEMENTS OF CASH FLOWS

(DOLLARS IN THOUSANDS)

 

		NINE MONTHS ENDING
		SEPTEMBER 30, 2003			SEPTEMBER 30, 2002
		(Unaudited)
Cash flows from operating activities:
Net income		$	12,570		$	16,293
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation and amortization		2,096			1,094
Amortization of intangibles		638			556
Amortization of bond premium and discounts, net		164			(45		)
Write-off of capitalized software		—			289
Deferred rent		340			294
Bad debt expense		15			—
Deferred income taxes		(540		)	(339		)
(Gain) loss from investment in building		(708		)	69
Non-cash charge related to building		172			—
Other		(3		)	—
Changes in operating assets and liabilities:
Accounts receivable, net		3,448			(14,116		)
Other current assets		1,293			1,690
Other assets		(332		)	258
Accounts payable and accrued expenses		(789		)	8,311
Advance payments on contracts		(599		)	773
Retirement plan contribution payable		1,581			1,801
Accrued payroll		(3,481		)	(3,356		)
Accrued vacation		460			664
Other current liabilities		277			(1,828		)
Supplemental retirement program liability		487			(35		)
Net cash provided by operating activities		17,089			12,373
Cash flows from investing activities:
Purchases of property and equipment		(1,005		)	(1,009		)
Proceeds from sale of property and equipment		18
Purchases of short-term investments		(47,115		)	(68,734		)
Proceeds from sale of short-term investments		41,444			65,027
Purchase of assets		—			(5,890		)
Capitalized software		(493		)	(215		)
Purchases of long-term investments		(16,835		)	(18,743		)
Proceeds from sale of long-term investments		5,130			7,352
Distributions from building investment		640			—
Net cash used by investing activities		(18,216		)	(22,212		)
Cash flows from financing activities:
Proceeds from issuance of common stock		2,769			3,714
Payments on capital lease obligations		—			(50		)
Net cash provided by financing activities		2,769			3,664
Net increase in cash		1,642			(6,175		)
Cash and cash equivalents at beginning of period		21,176			30,436
Cash and cash equivalents at end of period		$	22,818		$	24,261
Income taxes paid		$	5,934		$	8,819
Interest paid		$	1,765		$	7
Non-cash transactions:
Common stock repurchased and retired in exchange for shares in cashless exercise of stock options		$	204		$	195

 

See notes to consolidated financial statements.

 

5

 

PEC SOLUTIONS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

SEPTEMBER 30, 2003

(UNAUDITED)

1. Financial Statements

 

The accompanying consolidated financial statements, except for the December 31, 2002 balance sheet, are unaudited and have been prepared in accordance with accounting standards generally accepted in the United States for interim financial information and the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, certain information and footnote disclosures normally included in financial statements prepared in accordance with accounting principles generally in the United States have been omitted. In the opinion of management, all adjustments, consisting of normally recurring accruals, considered necessary for a fair presentation, have been included. It is suggested that these condensed financial statements be read in conjunction with the Company’s audited financial statements as of December 31, 2001 and 2002 and for each of the three years in the period ended December 31, 2002 included in the Company’s 2002 Form 10-K/A, as filed with the Securities and Exchange Commission. The results of operations for the nine months ended September 30, 2003, are not necessarily indicative of the operating results to be expected for the full year.

 

2. Stock-based Compensation

 

In December 2002, the FASB issued 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 market value based method of accounting for stock-based compensation. The Company does not presently expect to make such a voluntary change. In addition, SFAS No. 148 amends the disclosure requirements of SFAS No. 123 to require prominent disclosures in both annual and interim financial statements about the method of accounting for stock-based employee compensation and the effect of the method used on reported results. These amended disclosure requirements are applicable for financial statements issued for interim periods beginning after December 15, 2002, and have been included below.

 

The Company uses the Black-Scholes option-pricing model to determine the pro forma impact under SFAS No. 123 to the Company’s net income and earnings per share. The model utilizes certain information, such as the interest rate on a risk-free security maturing generally at the same time as the option being valued, and requires certain assumptions, such as the expected amount of time an option will be outstanding until it is exercised or it expires, to calculate the fair value of stock options granted.

 

This information and the assumptions used for the nine months ended September 30, 2003 and 2002 for the Company’s stock option and stock purchase plans are summarized as follows:

 

		STOCK OPTION PLAN						STOCK PURCHASE PLAN
		FOR THE NINE MONTHS ENDED
		SEPTEMBER 30, 2003			SEPTEMBER 30, 2002			SEPTEMBER 30, 2003			SEPTEMBER 30, 2002
Volatility		45.92		%	49.40		%	45.92		%	49.4		%
Risk-free interest rate		3.96		%	3.63		%	1.01		%	1.51		%
Dividend yield		0		%	0		%	0		%	0		%
Expected lives		10 years			10 years			0.50 years			0.50 years
Weighted average fair value per share at grant date		$	4.88		$	4.07		$	1.85		$	2.99

 

The Company continues to apply the provisions of APB 25 and provide the pro forma disclosures in accordance with the provisions of SFAS Nos. 123 and 148. Under APB 25, the Company has not recorded in net income any stock-based employee compensation cost associated with the Company’s stock option plan, as all options granted under the plan had an exercise price equal to the market value of the underlying common stock on the date of grant.

 

6

 

The following table illustrates the effect on net income and earnings per share if the Company had applied the fair value recognition provisions of SFAS No. 123 to its stock option and stock purchase plans:

 

 

3. Accounts Receivable

 

Accounts receivable consist of the following as of:

 

		SEPTEMBER 30, 2003			DECEMBER 31, 2002
		(Dollars in thousands)
Billed accounts receivable		$	36,154		$	45,411
Unbilled accounts receivable:
Amounts currently billable		10,994			5,856
Revenues recorded in excess of contract value or funding		3,146			3,099
Progress payments		(471		)	(1,070		)
		49,823			53,296
Allowance for doubtful accounts		(312		)	(322		)
Accounts receivable, net		$	49,511		$	52,974

 

Unbilled accounts receivable comprise recognized recoverable costs and accrued profits on contracts for which billings had not been presented to clients as of the balance sheet date. Revenues recorded in excess of contract value or funding are billable upon receipt of contractual amendments.  Management anticipates the collection of these amounts within 90 days of the balance sheet date. Payments to the Company on contracts with agencies and departments of the U.S. Government are subject to adjustment upon audit by the U.S. Government. All years subsequent to 2000 are subject to U.S. Government audit. Management believes the effect of audit adjustments, if any, on periods not yet audited, will not have a material effect on the financial statements.

 

During the nine months ended September 30, 2003, the Company had two customers that accounted for more that 10% of revenue.  EDS (Navy Marine Corps Intranet) accounted for 10.4% of revenue, or $13.6 million.  At September 30, 2003, there was $5.0 million due from EDS.  DEA (Special Projects Division) accounted for 10.4 % of revenue, or $13.6 million.  At September 30, 2003, there was $4.6 million due from DEA.  At September 30, 2003, there was $6.3 million due on a subcontract for the Company’s biometric identification system.  The Company filed a lawsuit in Federal Court against the prime contractor in September 2003 to recover full payment on this receivable and expects to receive full payment.  During the nine months ended September 30, 2002, the Company had two customers that accounted for more than 10% of revenue.  EDS (Navy Marine Corps Intranet) accounted for 17.4% of revenue, or $23.3 million.  At September 30, 2002, there was $3.7 million due from EDS.  The biometrics contract accounted for 13.0% of revenue, or $17.4 million.  At September 30, 2002, there was $14.4 million due from the prime contractor.

 

4. Net Income Per Share

 

Basic and diluted earnings per share for the three months and nine months ended September 30, 2003 and 2002 were determined as follows:

 

		THREE MONTHS ENDED SEPTEMBER 30, 2002								NINE MONTHS ENDED SEPTEMBER 30, 2002
		(Dollars in thousands, except for per share amounts)
		NET INCOME			SHARES		PER SHARE			NET INCOME			SHARES		PER SHARE
Basic EPS		$	7,402		26,463,487		$	0.28		$	16,293		26,297,815		$	0.62
Effect of dilutive options		—			3,102,952		(0.03		)	—			2,877,685		(0.06		)
Diluted EPS		$	7,402		29,566,439		$	0.25		$	16,293		29,175,500		$	0.56

 

		THREE MONTHS ENDED SEPTEMBER 30, 2003								NINE MONTHS ENDED SEPTEMBER 30, 2003
		(Dollars in thousands, except for per share amounts)
		NET INCOME			SHARES		PER SHARE			NET INCOME			SHARES		PER SHARE
Basic EPS		$	4,442		27,151,268		$	0.16		$	12,570		27,045,458		$	0.46
Effect of dilutive options		—			2,826,607		(0.01		)	—			2,765,416		(0.04		)
Diluted EPS		$	4,442		29,977,875		$	0.15		$	12,570		29,810,874		$	0.42

 

7

 

5. Goodwill and Intangible Assets

 

The Company has recognized goodwill related to its acquisitions of Viking Technology, Inc. (“Viking”), Troy Systems, Inc. (“Troy”) and Vector Research, Inc. (“Vector”).  The Company only has one reporting unit.  Nonamortized intangible assets consist only of goodwill of $16.9 million.  The Company’s amortizable intangible assets include customer contracts and related relationships purchased in the acquisitions of Troy on November 20, 2001 and Vector on June 14, 2002.  The intangibles related to the Troy acquisition totaled $3.0 million and are amortized on a straight-line basis over a 4.5-year period.  The intangibles on the Vector purchase totaled $1.5 million and are being amortized on a straight-line basis over an 8.4-year period.  Total accumulated amortization as of September 30, 2003 was $1.5 million.  In accordance with the provisions of SFAS No. 142, the Company performed the appropriate annual impairment tests during the three months ended March 31, 2003 related to its stated goodwill, and determined that there was no impairment loss, and therefore no change was made to the carrying amount of goodwill.

 

Intangibles are amortized on a straight-line basis.  Estimated annual amortization expense for each of the five following calendar years is as follows:

 

Year ending December 31,		Amount
		(Dollars in thousands)
2003		$	851
2004		851
2005		851
2006		851
2007		296

 

6.  Investments

 

The Company has an ownership interest in an unconsolidated and affiliated company that owns an office building that the Company leases.  For the three and nine months ended September 30, 2003, the Company recorded income of $237,000 and $708,000, respectively, for its share of the affiliated company’s earnings..  It also received cash distributions of  $227,000 and $640,000, respectively from the investment.  For the three months and nine months ended September 30, 2002, the Company recorded losses of $20,000 and $69,000, respectively. There were no cash distributions for the three or nine months ended September 30, 2002.

 

7.  Other Comprehensive Gain (Loss)

 

Other comprehensive gain (loss), consisting of unrealized gains (losses) on investment securities was $1,000 and $(103,000), respectively, for the three months and nine months ended September 30, 2003, and $5,000 and  $(121,000), respectively, for the three months and nine months ended September 30, 2002.

 

8.  Contingencies

                                               

The Company is party to certain litigation and other legal proceedings arising in the ordinary course of business.  In the opinion of management, the outcome of such legal matters will not have a material adverse effect on the Company’s results of operations or financial condition.

 

On or after March 18, 2003, several purported class action complaints were filed against the Company and certain of its officers in the United States District Court for the Eastern District of Virginia.  The complaints allege that between October 22, 2002 and March 14, 2003, the defendants made, or were aware of false and misleading statements which had the effect of inflating the market price of the Company’s common stock, in violation of Sections 10(b) and 20(a) of the Securities Exchange Act of 1934.  The complaints were consolidated into a single action on June 13, 2003.  The consolidated complaint does not specify the amount of damages sought.  On September 8, 2003, the Company filed a motion to dismiss the consolidated complaint.  The Company believes that the plaintiffs’ claims are without merit, and intends to defend the cases vigorously.  In addition, a stockholder’s legal counsel sent a letter of demand that the Board of Directors investigate the same charges addressed in the class action suits.  The Board is addressing this request.

 

9.  Recent Pronouncements

 

In November 2002, the FASB’s Emerging Issues Task Force, or EITF, finalized EITF Issue 00-21, Revenue Arrangements with Multiple Deliverables. EITF 00-21 addresses how to determine whether an arrangement involving multiple deliverables contains more than one unit of accounting. It also addresses how arrangement consideration should be measured and allocated to the separate units of accounting in an arrangement. EITF 00-21 does not apply to deliverables in arrangements to the extent the accounting for such deliverables are within the scope of other existing higher-level authoritative accounting literature. The Company adopted the provisions of EITF 00-21 for new contracts entered into on or after July 1, 2003 with no material impact on its financial position, results of operations or cash flows.

 

8

 

In November 2002, FASB Interpretation No. 45, Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others, an Interpretation of FASB Statements No. 5, 57, and 107 and Rescission of FASB Interpretation No. 34, (FIN 45) was issued. FIN 45 clarifies the requirements of SFAS No. 5, “Accounting for Contingencies,” relating to guarantors’ accounting for, and disclosure of, the issuance of certain types of guarantees. The disclosure provisions of FIN 45 are applicable to interim or annual periods that ended after December 15, 2002, and did not have an impact on the September 30, 2003 financial statements. The provisions for initial recognition and measurement under FIN 45 are effective on a prospective basis for guarantees that are issued or modified after December 31, 2002. The initial recognition and measurement provisions under FIN 45 did not have any impact on the Company’s financial statements.

 

On January 17, 2003, the Financial Accounting Standards Board (FASB or the “Board”) issued FASB Interpretation No. 46, (FIN 46), “Consolidation of Variable Interest Entities”. The provisions will be the guidance that determines (1) whether consolidation is required under the “controlling financial interest” model of Accounting Research Bulletin No. 51 (ARB 51), “Consolidated Financial Statements” 51 (or other existing authoritative guidance) or, alternatively, (2) whether the variable interest model under FIN 46 should be used to account for existing and new entities. At this time, the Company does not have any entities that would be covered under FIN 46.

 

On May 31, 2003, the Financial Accounting Standards Board (FASB) issued FASB Statement No. 150 (FAS 150), Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity.  FAS 150 improves the accounting for certain financial instruments that, under previous guidance, issuers could account for as equity and requires that those instruments be classified as liabilities (or assets in certain circumstances) in statements of financial position.  FAS 150 also requires disclosures about alternative ways of settling the instruments and the capital structure of entities—all of whose shares are mandatorily redeemable. FAS 150 is generally effective for all financial instruments entered into or modified after May 31, 2003, and otherwise is effective at the beginning of the first interim period beginning after September 15, 2003.  The adoption of FAS 150 will not have any impact on the Company’s financial statements.

 

9

 

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

 

OVERVIEW

 

PEC Solutions is a professional services firm specializing in high-end solutions that help government organizations capitalize on the Internet and other advanced technologies. We migrate paper-intensive procedures to web-enabled processes using eGovernment solutions that help our clients enhance their productivity and improve the services they offer to the public. As a total solutions provider, we address the full technology lifecycle, including formulating technology strategies, creating business solutions, performing long-term operational management and continuing enhancement of the solution.

 

We derive substantially all of our revenues from fees for consulting services. We generate these fees from various types of contracts, including time and materials contracts, fixed-price contracts and cost-reimbursable contracts. During the three months and nine months ended September 30, 2003, revenues from these contract types were approximately 57%, 26% and 17%, and 57%, 24% and 19% respectively, of total revenues. We typically issue invoices monthly to manage outstanding accounts receivable balances. We recognize revenues on time and materials contracts as the services are provided. We recognize revenues on fixed-price contracts using the percentage of completion method as services are performed over the life of the contract, based on the costs we incur in relation to the total estimated costs. We recognize and make provisions for any anticipated contract losses at the time we know and can estimate them. Fixed-price contracts are attractive to clients and, while subject to increased risks, provide opportunities for increased margins. We recognize revenues on cost-reimbursable contracts as services are provided. These revenues are equal to the costs incurred in  providing these services plus a proportionate amount of the fee earned. We have historically recovered all of our costs on cost-reimbursable contracts, which means we have lower risk and our margins are lower on these contracts.

 

Our historical revenue growth is attributable to various factors, including an increase in the size and number of projects for existing and new clients. Existing clients from the previous year generated approximately 93% and 94% of our revenues in the three months and nine months ended September 30, 2003. As of September 30, 2003, we had 1,226 personnel.

 

In the three months and nine months ended September 30, 2003, we derived approximately 20% and 23%, respectively, of our revenues through relationships with prime contractors, who contract directly with the end-client and subcontract with us. In most of these engagements, we retain full responsibility for the end-client relationship and direct and manage the activities of our contract staff.

 

Our most significant expense is direct costs, which consist primarily of project personnel salaries and benefits, and direct expenses incurred to complete projects. Our direct costs as a percentage of revenues are also related to the utilization rate of our consulting personnel. We manage utilization by frequently monitoring project requirements and timetables. The number of consulting personnel assigned to a project will vary according to the size, complexity, duration and demands of the project.

 

General and administrative expenses consist primarily of costs associated with our executive management, finance and administrative groups, human resources, unassigned consulting personnel, personnel training, occupancy costs, depreciation and amortization, travel and all other branch and corporate costs.

 

Sales and marketing expenses include the costs of sales and marketing personnel and costs associated with marketing and bidding on future projects.

 

Investment and other income consist primarily of interest income earned on our cash, cash equivalents and marketable securities, as well as, income from the investment in our corporate headquarters building.

 

Interest expense is primarily related to the corporate headquarters building.

 

10

 

Results of Operations

 

The following table sets forth certain financial data as a percentage of revenues for the periods indicated.

 

		THREE MONTHS ENDED						NINE MONTHS ENDED
		SEPTEMBER 30, 2003			SEPTEMBER 30, 2002			SEPTEMBER 30, 2003			SEPTEMBER 30, 2002
		(Dollars in thousands)
Statement of Income:
Revenues		$	43,295		$	52,844		$	131,025		$	133,836
Direct costs		25,821			30,359			78,503			78,789
Gross profit (a)		17,474			22,485			52,522			55,047
Other operating costs and expenses:
General and administrative expenses		8,758			9,164			26,992			24,685
Sales and marketing expenses		1,250			1,205			4,331			4,246
Amortization of intangibles		213			175			638			556
Total other operating costs and expenses		10,221			10,544			31,961			29,487
Operating income		7,253			11,941			20,561			25,560
Investment and other income		604			205			1,781			1,179
Interest expense		(664		)	(1		)	(1,986		)	(7		)
Income before income taxes		7,193			12,145			20,356			26,732
Provision for income taxes		2,751			4,743			7,786			10,439
Net income		$	4,442		$	7,402		$	12,570		$	16,293
As a Percentage of Revenues:
Revenues		100.0		%	100.0		%	100.0		%	100.0		%
Direct costs		59.6			57.5			59.9			58.9
Gross profit (a)		40.4			42.5			40.1			41.1
Other operating costs and expenses:
General and administrative expenses		20.2			17.3			20.6			18.4
Sales and marketing expenses		2.9			2.3			3.3			3.2
Amortization of intangibles		0.5			0.3			0.5			0.4
Total other operating costs and expenses		23.6			19.9			24.4			22.0
Operating income		16.8			22.6			15.7			19.1
Investment and other income		1.4			0.4			1.4			0.9
Interest expense		(1.5		)	(0.0		)	(1.5		)	(0.0		)
Income before income taxes		16.7			23.0			15.6			20.0
Provision for income taxes		6.4			9.0			6.0			7.8
Net income		10.3		%	14.0		%	9.6		%	12.2		%

 

(a)  Gross profit represents revenues less direct costs, which consist primarily of project personnel salaries and benefits and direct expenses incurred to complete projects.

 

RESULTS OF OPERATIONS FOR THE THREE MONTHS ENDED SEPTEMBER 30, 2003 COMPARED WITH THE THREE MONTHS ENDED SEPTEMBER 30, 2002

 

REVENUES. For the three months ended September 30, 2003, our total revenues decreased by 18.1%, or $9.5 million over the same period last year.  Services to new clients represent approximately 7% of revenues.  Revenues were adversely impacted by the late passage and signing of the 2003 Federal civilian agency budgets.  We also saw a reduction in revenue from the EDS (Navy Marine Corps Intranet) contract during the current period versus last year, as the program went from its initial engineering phase into a production phase.  In addition, during the third quarter 2002 we received quick response orders in the amount of $13.1 million for our mobile biometric solutions related to the hiring of airport security personnel.

 

DIRECT COSTS. For the three months ended September 30, 2003, direct costs decreased by 14.9%, or $4.5 million, over the same period last year.  Direct costs increased as a percentage of revenues for the period ended September 30, 2003, to 59.6% as compared to 57.5% in the same period last year as a result of a change in contract mix and a lower labor utilization rate.  The rate for 2003 is in line with our historical rate whereas 2002 was higher due to the concentrated effort on the mobile biometric work.

 

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GROSS PROFIT. Gross profit decreased by 22.3% to $17.5 million in the three months ended September 30, 2003 from $22.5 million in the three months ended September 30, 2002. Gross profit as a percentage of revenues decreased to 40.4% in the three months ended September 30, 2003 from 42.5% in the three months ended September 30, 2002, as a result of decreased labor utilization, changes in contract mix and the concentrated effort on the mobile biometric work in 2002.

 

GENERAL AND ADMINISTRATIVE EXPENSES. General and administrative expenses decreased 4.4% to $8.8 million in the three months ended September 30, 2003 from $9.2 million in the three months ended September 30, 2002.  Our total general and administrative headcount was 115 personnel as of September 30, 2003 compared to 126 personnel as of September 30, 2002.

 

SALES AND MARKETING. Sales and marketing expenses increased 3.7% in the three months ended September 30, 2003 from the three months ended September 30, 2002, both years had approximately $1.2 million in sales and marketing costs. This slight increase was due to an increase in our marketing efforts.

 

AMORTIZATION OF INTANGIBLES.  For the three months ended September 30, 2003 and September 30, 2002, we incurred $213,000 and $175,000, respectively, of amortization expense related to the $4.5 million of intangibles we recorded in connection with the value of contracts and customer relationships acquired in the November 2001 acquisition of Troy, and the June 2002 acquisition of Vector.

 

INVESTMENT AND OTHER INCOME.  For the three months ended September 30, 2003, we earned $367,000 of interest income and net gains on sales of securities.  We also had $ 237,000 of income from our investment in our corporate headquarters building.  For the three months ended September 30, 2002, we had $225,000 of interest income and net losses on sales of securities.  We also had a $20,000 loss from the investment in our corporate headquarters building.  The increase in the gain from the investment in our corporate headquarters building was a result of the building going into operation in December 2002.

 

INTEREST EXPENSE.   For the three months ended September 30, 2003, we incurred interest expense of $664,000 principally related to our corporate headquarters building.  For the three months ended September 30, 2002, we incurred $1,000 of interest expense, there was no interest expense related to the corporate headquarters building during this period of time.

 

OPERATING INCOME. Operating income decreased 39.3% to $7.3 million in the three months ended September 30, 2003 from $11.9 million in the three months ended September 30, 2002. This decrease was due primarily to the concentration of the quick response for our mobile biometric solutions related to the hiring of airport security personnel in the third quarter of 2002.

 

RESULTS OF OPERATIONS FOR THE NINE MONTHS ENDED SEPTEMBER 30, 2003 COMPARED WITH THE NINE MONTHS ENDED SEPTEMBER 30, 2002

 

REVENUES. For the nine months ended September 30, 2003, our total revenues decreased by 2.1%, or $2.8 million over the same period last year.  Services to new clients represent approximately 6% of revenues.  Revenues were adversely impacted by the late passage and signing of the 2003 Federal civilian agency budgets.  We saw a reduction in revenue from the EDS (Navy Marine Corps Intranet) contract during the period versus last year as the program went from its initial engineering phase into a production phase.  In addition, during the third quarter 2002 we received quick response orders of $13.1 million for our mobile biometric solutions related to the hiring of airport security personnel

 

DIRECT COSTS. For the nine months ended September 30, 2003, direct costs decreased by 0.4%, or $300,000, over the same period last year.  Direct costs increased as a percentage of revenues for the period ended September 30, 2003, to 59.9% as compared to 58.9% in the same period last year, primarily due to the delays related to the passage and signing of the Federal civilian agency budgets and the associated lack of new project startups during this period.  New project startups increase revenues and allow for the recovery of increases in labor costs, which for us go into effect January 1^st of each year.  The increase also was impacted by lower labor utilization, which was related to the concentration of the quick response for our mobile solutions related to the hiring of airport security personnel in 2002.

 

GROSS PROFIT. Gross profit decreased by 4.6% to $52.5 million in the nine months ended September 30, 2003 from $55.0 million in the nine months ended September 30, 2002. Due to the factors described above in “Revenues” and “Direct Costs”, gross profit as a percentage of revenues decreased to 40.1% in the nine months ended September 30, 2003 from 41.1% in the nine months ended September 30, 2002.   As previously indicated, revenues were impacted by the late passage and signing of the 2003 Federal civilian agency budgets and to the concentrated effort for the quick response for our mobile solutions related to the hiring of airport security personnel in 2002.

 

GENERAL AND ADMINISTRATIVE EXPENSES. General and administrative expenses increased 9.3% to $27.0 million in the nine months ended September 30, 2003 from $24.7 million in the nine months ended September 30, 2002. Facility costs increased in the current period over last year due to the opening of new headquarters office in Fairfax, Virginia and an office in Washington, D.C.  Our total general and administrative headcount was 115 employees as of September 30, 2003 compared to 126 employees as of September 30, 2002.

 

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SALES AND MARKETING. Sales and marketing expenses increased 2.0% to $4.3 million in the nine months ended September 30, 2003 from $4.2 million in the nine months ended September 30, 2002. This increase was due to a modest increase in our marketing efforts.

 

AMORTIZATION OF INTANGIBLES.  For the nine months ended September 30, 2003 and September 30, 2002, we incurred $638,000 and $556,000, respectively, of amortization of expense related to the $4.5 million of intangibles we recorded in connection with the value of contracts and customer relationships acquired in the November 2001 acquisition of Troy, and the June 2002 acquisition of Vector.

 

INVESTMENT AND OTHER INCOME.  For the nine months ended September 30, 2003, we earned $1.1 million of interest income and net gains on sales of securities.  We also had  $708,000 of income from our investment in our corporate headquarters building.  For the nine months ended September 30, 2002, we had $1.2 million of interest income and net losses on sales of securities.  We also had a $69,000 loss from the investment in our corporate headquarters building.   The increase in the gain from the investment in our corporate headquarters building was a result of the building going into operation in December 2002.

 

INTEREST EXPENSE.   For the nine months ended September 30, 2003, we incurred interest expense of $2.0 million principally related to our corporate headquarters building.  For the nine months ended September 30, 2002, we incurred $7,000 of interest expense, there was no interest expense related to the corporate headquarters building during this period of time.

 

OPERATING INCOME. Operating income decreased 19.6% to $20.6 million in the nine months ended September 30, 2002 from $25.6 million in the nine months ended September 30, 2002, due to the factors discussed above, including the late passage and signing of the 2003 Federal civilian agency budgets and the concentration of the quick response for our mobile biometric solutions related to the hiring of airport personnel in 2002.

 

Our revenues and operating results may be subject to significant variation from quarter to quarter depending on a number of factors, including the progress of contracts, revenues earned on contracts, the number of billable days in a quarter, the timing of the pass-through of other direct costs, the commencement and completion of contracts during any particular quarter, the schedule of the government agencies for awarding contracts, the term of each contract that we have been awarded and general economic conditions. Because a significant portion of our expenses, such as personnel and facilities costs, are fixed in the short term, successful contract performance and variation in the volume of activity as well as in the number of contracts commenced or completed during any quarter may cause significant variations in operating results from quarter to quarter.

 

The federal government’s fiscal year ends September 30. If a budget for the next fiscal year has not been approved by that date, our clients may have to suspend engagements that we are working on until a budget has been approved. Such suspensions may cause us to realize lower revenues until these engagements are reinstated or new engagements are awarded.  Further, a change in Presidential administrations and in senior government officials may affect the rate at which the federal government purchases technology, although we have not seen an impact with the 2001 change in administration.

 

As a result of the factors above, period-to-period comparisons of our revenues and operating results may not be meaningful. You should not rely on these comparisons as indicators of future performance as no assurances can be given that quarterly results will not fluctuate, causing a material adverse effect on our operating results and financial condition.

 

Liquidity and Capital Resources

 

Net cash provided by operating activities was $17.1 million for the nine months ended September 30, 2003. Cash provided by operating activities was primarily from net income, adjusted for working capital changes, which were principally decreases in accounts receivable.

 

Net cash used by investing activities was $18.2 million for the nine months ended September 30, 2003. During the nine months ended September 30, 2003, we purchased $1.0 million of property and equipment $5.6 million of net short-term investments and $11.7 million of net long-term investments, invested $0.5 million in capitalized software, while receiving $0.6 million of distributions from the investment in our building joint venture.

 

Net cash provided by financing activities was $2.8 million from the sale of common stock to employees upon the exercise of their stock options and purchase of stock through the employee stock purchase plan for the nine months ended September 30, 2003.

 

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We expect to retain future earnings, if any, for use in the operation and expansion of our business and do not anticipate paying any cash dividends in the foreseeable future.

 

We maintain a $10.0 million line of credit with Bank of America, bearing interest at the one month LIBOR Rate plus 250 basis points per annum, which expires on June 30, 2005. As of September 30, 2003, we had no borrowings outstanding under the line of credit. As of September 30, 2003, we had outstanding $2.8 million in letters of credit in lieu of rent deposits.

 

Under some of our fixed-price contracts, we receive advance payments for work to be performed in future months. If we do not perform the work, the unearned portion of these advances will be returned to our clients. At September 30, 2003, our accounts receivable turnover rate, net of advance payments on contracts, was approximately four times per year.

 

Recent Accounting Pronouncements

 

In November 2002, the FASB’s Emerging Issues Task Force, or EITF, finalized EITF Issue 00-21, Revenue Arrangements with Multiple Deliverables. EITF 00-21 addresses how to determine whether an arrangement involving multiple deliverables contains more than one unit of accounting. It also addresses how arrangement consideration should be measured and allocated to the separate units of accounting in an arrangement. EITF 00-21 does not apply to deliverables in arrangements to the extent the accounting for such deliverables are within the scope of other existing higher-level authoritative accounting literature. We adopted the provisions of EITF 00-21 for new contracts entered into on or after July 1, 2003 with no material impact on our financial position, results of operations or cash flows.

 

In November 2002, FASB Interpretation No. 45, Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others, an Interpretation of FASB Statements No. 5, 57, and 107 and Rescission of FASB Interpretation No. 34, (FIN 45) was issued. FIN 45 clarifies the requirements of SFAS No. 5, “Accounting for Contingencies,” relating to guarantors’ accounting for, and disclosure of, the issuance of certain types of guarantees. The disclosure provisions of FIN 45 are applicable to interim or annual periods that end after December 15, 2002, and did not have an impact on the September 30, 2003 financial statements. The provisions for initial recognition and measurement under FIN 45 are effective on a prospective basis for guarantees that are issued or modified after December 31, 2002. The initial recognition and measurement provisions under FIN 45 did not have any impact on our financial statements.

 

On January 17, 2003, the Financial Accounting Standards Board (FASB or the “Board”) issued FASB Interpretation No. 46, (FIN 46), “Consolidation of Variable Interest Entities”. The provisions will be the guidance that determines (1) whether consolidation is required under the “controlling financial interest” model of Accounting Research Bulletin No. 51 (ARB 51), “Consolidated Financial Statements” 51 (or other existing authoritative guidance) or, alternatively, (2) whether the variable interest model under FIN 46 should be used to account for existing and new entities. At this time, we do not have any entities that would be covered under FIN 46.

 

On May 31, 2003, the Financial Accounting Standards Board (FASB) issued FASB Statement No. 150 (FAS 150), Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity.  FAS 150 improves the accounting for certain financial instruments that, under previous guidance, issuers could account for as equity and requires that those instruments be classified as liabilities (or assets in certain circumstances) in statements of financial position.  FAS 150 also requires disclosures about alternative ways of settling the instruments and the capital structure of entities—all of whose shares are mandatorily redeemable. FAS 150 is generally effective for all financial instruments entered into or modified after May 31, 2003, and otherwise is effective at the beginning of the first interim period beginning after September 15, 2003.  The adoption of FAS 150 will not have any impact on our financial statements.

 

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SPECIAL NOTE REGARDING FORWARD LOOKING STATEMENTS

 

The matters discussed in this Form 10-Q include forward-looking statements that involve risks or uncertainties. While forward-looking statements are sometimes presented with numerical specificity, they are based on various assumptions made by management regarding future circumstances over many of which we have little or no control. Forward-looking statements may be identified by words including “anticipate,” “believe,” “estimate,” “expect” and similar expressions. We caution readers that forward-looking statements, including without limitation, those relating to our future business prospects, revenues, working capital, liquidity, and income, are subject to certain risks and uncertainties that would cause actual results to differ materially from those indicated in the Forward-Looking Statements. Factors that could cause actual results to differ from Forward-Looking Statements include the concentration of our revenues from government clients, risks involved in contracting with the government, difficulties we may have in attracting, retaining and managing professional and administrative staff, fluctuations in quarterly results, risks related to acquisitions, risks related to competition and our ability to continue to win and perform efficiently on contracts, and other risks and factors identified from time to time in our reports filed with the SEC, including those identified under the section entitled “Risk Factors” in our Registration Statement on Form 10-K/A (SEC File No. 000-30271) as amended which hereby is incorporated by reference. Should one or more of these risks or uncertainties materialize, or should underlying assumptions prove incorrect, actual results may vary materially from those anticipated, estimated or projected.

 

ITEM 3. QUALITATIVE AND QUANTITATIVE DISCLOSURE ABOUT MARKET RISK

 

We invest our cash in a variety of financial instruments, including U.S. Treasury and Agency obligations, money market instruments of domestic and foreign issuers denominated in U.S. dollars of commercial paper, bankers’ acceptances, certificates of deposit, euro-dollar time deposits and variable rate issues, corporate note and bonds, asset-backed securities, repurchase agreements, municipal notes and bonds and auction rate preferred securities.

 

Investments in both fixed and floating rate interest earning instruments carry a degree of interest rate risk. Fixed securities may have their fair market value adversely impacted because of a rise in interest rates, while floating rare securities may produce less income than expected if interest rates fall. Due in part to these factors, our future investment income may fall short of expectations because of changes in interest rates or we may suffer losses in principal if forced to sell securities which have seen a decline in market value because of changes in interest rates.  A 10% change in interest rates could have approximately a $150,000 impact on our interest income.

 

Our investments are made in accordance with an investment policy approved by the Board of Directors. Under this policy, no investment securities can have maturities exceeding two years and the average duration of the portfolio cannot exceed twelve months.

 

ITEM  4.  Controls and Procedures

 

Our management, under the supervision and with the participation of David C. Karlgaard, our Chief Executive Officer, and Stuart R. Lloyd, our Chief Financial Officer, performed an evaluation of the effectiveness of the design and operation of our disclosure controls and procedures as of the end the quarter covered by this report.  Based on that evaluation, Messrs. Karlgaard and Lloyd concluded that our disclosure controls and procedures were effective.  There have been no significant changes in our internal controls or in other factors that could significantly affect internal controls subsequent to their evaluation.

 

15

 

PART II – OTHER INFORMATION

 

ITEM 1. LEGAL PROCEEDINGS

 

On or after March 18, 2003, several purported class action complaints were filed against us and certain of our officers in the United States District Court for the Eastern District of Virginia.  The complaints allege that between October 22, 2002 and March 14, 2003, the defendants made, or were aware of false and misleading statements which had the effect of inflating the market price of our stock, in violation of Sections 10(b) and 20(a) of the Securities Exchange Act of 1934.  The complaints were consolidated into a single action on June 13, 2003.  The consolidated complaint does not specify the amount of damages sought.  On September 8, 2003, the Company filed a motion to dismiss the consolidated complaint.  We believe that the plaintiffs’ claims are without merit, and we intend to defend the cases vigorously.  In addition, a stockholder’s legal counsel sent a letter of demand that the Board of Directors investigate the same charges addressed in the class actions suits.  The Board is addressing this request.

 

ITEM 2. CHANGES IN SECURITIES AND USE OF PROCEEDS

 

In April 2000, we commenced and completed a firm commitment underwritten initial public offering of 3,000,000 shares of our common stock at a price of $9.50 per share. The shares were registered with the Securities and Exchange Commission pursuant to a registration statement on Form S-1 (No. 333-95331), which was declared effective on April 19, 2000. The public offering was underwritten by a syndicate of underwriters led by Donaldson, Lufkin & Jenrette Securities Corporation; Chase Securities Inc.; Legg Mason Wood Walker, Incorporated; and DLJDIRECT Inc. as their representatives. After deducting underwriting discounts and commissions of approximately $2 million and expenses of approximately $0.9 million, we received net proceeds of $25.6 million.

 

The primary purposes of this offering were to create a public market for our common stock, to improve the incentive mechanism for our professionals through stock options, to obtain additional equity capital and to facilitate future access to public markets. We have used the net proceeds from this offering for general corporate purposes, including working capital. We have also used a portion of the net proceeds to acquire three businesses that are complementary to ours, and may use the remaining proceeds for this purpose.

 

On August 28, 2000, we acquired all of the outstanding capital stock of Viking for $2 million cash plus the assumption of debt in a business combination accounted for as a purchase. Viking is a provider of integrated software and advanced technology solutions for state and local law enforcement, fire and emergency medical service agencies. On November 20, 2001, we acquired all of the outstanding capital stock of Troy for $15.3 million cash plus common stock valued at $3.0 million (103,065 shares).  Troy derives revenue from system development, networking, engineering, integration services, and information systems security and its primary customer is the federal government.  On September 14, 2002, we acquired the assets of Vector, which consisted of their contracts with federal government agencies, for $5.7 million cash plus the assumption of $100,000 in liabilities.  Vector provided technology development and engineering services to the federal government.

 

Management will have broad discretion in the allocation of the remaining net proceeds from the sale of stock.  We have no current plans, agreements or commitments for, and are not currently engaged in any negotiations with respect to, any such transaction. Pending their use, the proceeds of this offering have been invested in short-term, investment grade, interest-bearing securities.

 

ITEM 3. DEFAULTS UPON SENIOR SECURITIES

 

None

 

ITEM 4. SUBMISSION OF MATTERS TO VOTE OF SECURITY HOLDERS

 

None

 

 

ITEM 5. OTHER INFORMATION

 

None

 

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ITEM 6 (A) EXHIBITS

 

EXHIBIT NUMBER		EXHIBIT DESCRIPTION
3.1*		Certificate of Incorporation
3.2*		By-Laws
10.1*		Office Lease Agreement between Building IV Associates L.P. and the Registrant
10.2*		Amendment No. 1 to Office Lease Agreement between Building IV Associates L.P. and the Registrant
10.3*		Office Lease Agreement between Building V Associates L.P. and the Registrant
10.4*		Employment Agreement between the Registrant and David C. Karlgaard, dated January 1, 2000
10.4.1******		Key Executive Severence Plan between Registrant and David C. Karlgaard, dated July 23, 2003
10.5*		Employment Agreement between the Registrant and Paul G. Rice, dated January 1, 2000
10.5.1******		Key Executive Severence Plan between Registrant and Paul G. Rice, dated July 23, 2003
10.6*		Employment Agreement between the Registrant and Alan H. Harbitter, dated January 1, 2000
10.6.1******		Key Executive Severence Plan between Registrant and Alan H. Harbitter, dated July 23, 2003
10.7*		Employment Agreement between the Registrant and Stuart R. Lloyd, dated December 31, 1998
10.7.1		Amendment to Employment Agreement between the Registrant and Stuart R. Lloyd, dated September 30, 2003
10.8*		2000 Stock Incentive Plan
10.9*		1995 Nonqualified Stock Option
10.10*		1987 Stock Option Agreement, as amended
10.11*		Nonqualified Executive Supplemental Retirement Program Agreement dated December 1998
10.12*		2000 Employee Stock Option Plan
10.13*		Amended and Restated Loan Agreement between the Registrant and NationsBank, N.A.
10.14**		Amendment No. 2 to Office Lease Agreement between Building IV Associates L.P. and PEC Solutions, Inc.
10.15**		Amendment No. 3 to Office Lease Agreement between Building IV Associates L.P. and PEC Solutions, Inc.
10.16**		Office Lease Agreement between Building VI L.C. and PEC Solutions, Inc.
10.17***		First Amendment to Lease Agreement between Building VI L.C.  and PEC Solutions, Inc.

 

17

 

10.18***		Second Amendment to Lease Agreement between Building VI L.C. and PEC Solutions, Inc.
10.19***		Operating Agreement between Building VI Investment L.C. And PEC Solutions, Inc.
10.20***		First Amendment to Operating Agreement between Building VI Investment L.C. and PEC Solutions, Inc.
10.21***		Bank of America Financing and Security Agreement
10.22***		Bank of America Promissory Note
10.23***		Bank of America Revolving Note
10.24*****		Amendment to Bank of America Promissory Note
10.25*****		Amendment to Bank of America Revolving Note
10.26******		Amended and Restated Bank of America Revolving Credit Note
10.27******		Amended and Restated Bank of America Financing and Security Agreement
10.28******		Key Executive Severance Plan between Registrant and Christos Bratiotis, dated July 23, 2003
10.29******		Key Executive Severance Plan between Registrant and John T. Forbus, dated July 23, 2003
10.30		Key Executive Severance Plan between Registrant and Charles E. Owlett, dated July 23, 2003
21.1****		Subsidiaries of PEC Solutions, Inc.

 

*                               Incorporated herein by reference to the Company’s Registration Statement on Form S-1, No. 333-95331.

 

**                        Incorporated herein by reference to the Company’s Annual Report on Form 10K/A filed on April 19, 2001.

 

***                 Incorporated herein by reference to the Company’s Quarterly Report on Form 10-Q for the quarter ended September 30, 2001, filed August 13, 2001.

 

****          Incorporated herein by reference to the Company’s Annual Report on Form 10-K filed on March 29, 2002.

 

*****   Incorporated herein by reference to the Company’s Quarterly Report Form 10Q/A filed on May 14, 2003.

 

******  Incorporated herein by reference to the Company’s Quarterly Report Form 10Q filed on August 14, 2003.

 

(b)  None

 

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SIGNATURES

 

PURSUANT TO THE REQUIREMENTS OF THE SECURITIES EXCHANGE ACT OF 1934, THE REGISTRANT HAS DULY CAUSED THIS REPORT TO BE SIGNED ON ITS BEHALF BY THE UNDERSIGNED THEREUNTO DULY AUTHORIZED.

 

 

	BY: /s/ STUART R. LLOYD
DATE: NOVEMBER 14, 2003	STUART R. LLOYD
	CHIEF FINANCIAL OFFICER, SENIOR VICE PRESIDENT AND DIRECTOR
	(PRINCIPAL FINANCIAL AND ACCOUNTING OFFICER)

 

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