SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

 

Form 10-Q

 

(Mark One)
ý	Quarterly Report Pursuant to Section 13 or 15(d) of The Securities Exchange Act of 1934
For The Quarter Ended March 31, 2004
Or
o	Transition Report Pursuant to Section 13 or 15(d) of The Securities Exchange Act of 1934

 

Commission File Number 000-30271

 

PEC SOLUTIONS, INC.

(Exact Name of Registrant as Specified in its Charter)

 

DELAWARE		54-1339972
(State or other jurisdiction of incorporation or organization)		(I.R.S. Employer Identification No.)
12730 FAIR LAKES CIRCLE, FAIRFAX, VA		22033
(Address of principal executive offices)		(Zip Code)
Registrant’s telephone number, including area code:  (703) 679-4900

 

 

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 May 10, 2004, 27,345,552 of the registrant’s Common Stock, par value $.01 per share, were outstanding.

 

 

PEC SOLUTIONS, INC.

QUARTERLY REPORT ON FORM 10-Q FOR THE THREE MONTHS ENDED MARCH 31, 2004

 

TABLE OF CONTENTS

 

Item 1.	Financial Statements:
	Balance Sheets — March 31, 2004 and December 31, 2003
	Statements of Income — Three months ended March 31, 2004 and 2003
	Statements of Cash Flows — Three months ended March 31, 2004 and 2003
	Notes to 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
Item 4.	Controls and Procedures
PART II. OTHER INFORMATION
Item 1.	Legal Proceedings
Items 2-5
Item 6.	Exhibits and Reports on Form 8-K
Signatures

 

2

 

PART I - FINANCIAL INFORMATION

 

Item 1.            Financial Statements.

 

PEC SOLUTIONS, INC.

BALANCE SHEETS

(Dollars in thousands)

 

		As of March 31, 2004			As of December 31, 2003
		(Unaudited)
ASSETS
Current assets:
Cash and cash equivalents		$	30,487		$	33,401
Short-term investments		39,292			38,274
Accounts receivable, net		52,125			48,356
Other current assets		1,994			1,745
Total current assets		123,898			121,776
Property and equipment, net		26,317			26,674
Investments		39,681			37,587
Goodwill		16,932			16,932
Intangibles, net		2,637			2,849
Other assets		4,593			4,553
Total assets		$	214,058		$	210,371
LIABILITIES AND STOCKHOLDERS’ EQUITY
Current liabilities:
Accounts payable and accrued expenses		$	4,714		$	5,576
Advance payments on contracts		686			439
Accrued payroll		3,055			5,503
Accrued vacation		3,407			2,839
Other current liabilities		3,414			1,163
Total current liabilities		15,276			15,520
Long-term liabilities:
Supplemental retirement program liability		1,466			1,417
Deferred rent		1,884			1,790
Long-term lease obligation		23,111			23,062
Total long-term liabilities		26,461			26,269
Total liabilities		41,737			41,789
Commitments and contingencies
Stockholders’ equity:
Undesignated capital stock, 10,000,000 shares authorized		—			—
Common stock, $0.01 par value, 75,000,000 shares authorized, 27,311,371 and 27,303,041 shares issued and outstanding, respectively		273			273
Additional paid-in capital		95,314			95,219
Retained earnings		76,728			73,140
Accumulated other comprehensive income (loss)		6			(50		)
Total stockholders’ equity		172,321			168,582
Total liabilities and stockholders’ equity		$	214,058		$	210,371

 

See notes to financial statements.

 

3

 

PEC SOLUTIONS, INC.

STATEMENTS OF INCOME

(Amounts in thousands, except per share data)

 

		Three Months Ended
		March 31, 2004			March 31, 2003
		(Unaudited)
Revenues		$	40,369		$	43,466
Operating costs and expenses:
Direct costs		24,623			26,971
General and administrative expenses		8,495			9,159
Sales and marketing expenses		1,127			1,447
Amortization of intangibles		213			213
Total operating costs and expenses		34,458			37,790
Operating income		6,013			5,676
Investment and other income		499			637
Interest expense		(667		)	(660		)
Income before income taxes		5,743			5,653
Provision for income taxes		2,155			2,162
Net income		$	3,588		$	3,491
Earnings per share:
Basic		$	0.13		$	0.13
Diluted		$	0.12		$	0.12
Weighted average shares used in computing earnings per share:
Basic		27,307			26,935
Diluted		29,799			29,925

 

See notes to financial statements.

 

4

 

PEC SOLUTIONS, INC.

STATEMENTS OF CASH FLOWS

(Dollars in thousands)

 

		Three Months Ending
		March 31, 2004			March 31, 2003
		(Unaudited)
Cash flows from operating activities:
Net income		$	3,588		$	3,491
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation and amortization		713			665
Amortization of intangibles		213			213
Amortization of bond premium and discounts, net		88			(79		)
Gain on sale of assets		(4		)	—
Deferred rent payable		95			118
Deferred income taxes		(106		)	(172		)
Bad debt expense		102			—
Gain from investment in building		(245		)	(237		)
Non-cash charge related to building		49			64
Changes in operating assets and liabilities:
Accounts receivable, net		(3,872		)	2,962
Other current assets		(149		)	1,313
Other assets		(57		)	(94		)
Accounts payable and accrued expenses		(862		)	(3,202		)
Advance payments on contracts		248			696
Retirement plan contribution payable		—			647
Accrued payroll		(2,448		)	(3,351		)
Accrued vacation		568			636
Other current liabilities		2,274			842
Supplemental retirement program liability		43			86
Net cash provided by operating activities		238			4,598
Cash flows from investing activities:
Purchases of property and equipment		(293		)	(420		)
Proceeds from sale of property and equipment		4			—
Purchases of short-term investments		(13,023		)	(8,035		)
Proceeds from sale of short-term investments		12,006			11,414
Capitalized software		(43		)	—
Purchase of long-term investments		(10,616		)	(5,000		)
Proceeds from sale of long-term investments		8,641			1,271
Distribution from building investment		101			310
Net cash used by investing activities		(3,223		)	(460		)
Cash flows from financing activities:
Proceeds from issuance of common stock		71			1,052
Net cash provided by financing activities		71			1,052
Net (decrease) increase in cash		(2,914		)	5,190
Cash and cash equivalents at beginning of period		33,401			21,176
Cash and cash equivalents at end of period		$	30,487		$	26,366
Income taxes paid		$	12		$	2
Interest paid		$	667		$	660
Non-cash transactions:
Mature common stock repurchased and retired in exchange for shares in cashless exercise of stock options		—			$	197

 

See notes to financial statements.

 

5

 

PEC SOLUTIONS, INC.

NOTES TO FINANCIAL STATEMENTS

MARCH 31, 2004

(Unaudited)

 

1.  Financial Statements

 

The accompanying financial statements, except for the December 31, 2003 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 financial statements be read in conjunction with the Company’s audited financial statements as of December 31, 2002 and 2003 and for each of the three years in the period ended December 31, 2003 included in the Company’s Form 10-K, as filed with the Securities and Exchange Commission on March 15, 2004. The results of operations for the three months ended March 31, 2004, 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 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 March 31, 2004 and 2003 for the Company’s stock option plan are summarized as follows:

 

 

The Company continues to apply the provisions of APB 25 and provide the pro forma disclosures in accordance with the provisions of FAS 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 plan:

 

 

3.  Accounts Receivable

 

Accounts receivable consist of the following as of:

 

		March 31, 2004			December 31, 2003
		(Dollars in thousands)
Billed accounts receivable		$	38,696		$	32,100
Unbilled accounts receivable:
Amounts currently billable		13,729			12,033
Revenues recorded in excess of contract value or funding		2,500			4,776
Progress payments		(686		)	(439		)
		52,239			48,470
Allowance for doubtful accounts		(114		)	(114		)
Accounts receivable, net		$	52,125		$	48,356

 

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 quarter ended March 31, 2004, the Company had one customer that accounted for more than 10% of revenue.  For the quarter, the Special Project Division of the Drug Enforcement Agency accounted for 11%, or $4.6 million.  At March 31, 2004, there was $4.4 million due from the Special Project Division of the Drug Enforcement Agency.  At March 31, 2004, there was $6.3 million due from 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 quarter ended March 31, 2003, the Company had two customers that each accounted for more than 10% of revenue.  For the quarter, EDS (Navy Marine Corps Intranet) accounted for 13%, or $5.7 million, and the Special Project Division of the Drug Enforcement Agency accounted for 11%, or $4.7 million of revenue.  At March 31, 2003 there was $5.0 million due from EDS and $3.7 million due from the Special Project Division of the Drug Enforcement Agency.

 

7

 

4.  Net Income Per Share

 

Basic and diluted earnings per share for the three months ended March 31, 2004 and 2003 were determined as follows:

 

		Three Months Ended March 31, 2004								Three Months Ended March 31, 2003
		(Dollars in thousands, except for per share amounts)
		Net								Net
		Income			Shares		Per Share			Income			Shares		Per Share
Basic EPS		$	3,588		27,306,837		$	0.13		$	3,491		26,934,667		$	0.13
Effect of dilutive options		—			2,492,001		(0.01		)	—			2,990,474		(0.01		)
Diluted EPS		$	3,588		29,798,838		$	0.12		$	3,491		29,925,141		$	0.12

 

For the quarters ended March 31, 2004 and 2003, 1,659,167 and 1,319,699 shares, respectively, attributable to outstanding stock options were excluded from the calculation of diluted earnings per share because the effect was antidilutive.

 

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.  Non-amortized intangible assets consist only of goodwill in the amount 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 March 31, 2004 was $1.9 million.  In accordance with the provisions of SFAS No. 142, the Company performed the appropriate annual impairment tests during the quarter ended March 31, 2004 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.

 

Amortization expense for the three months ended March 31, 2004 and 2003 was $213,000 for both periods.  Intangibles are amortized on a straight-line basis.

 

Estimated amortization expense for each of the five succeeding calendar years based on the intangible assets as of December 31, 2003 is as follows in thousands:

 

 

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 months ended March 31, 2004, the Company recorded income of $245,000 for its share of the affiliated company’s earnings and received cash distributions of $101,000 from the investment.  For the three months ended March 31, 2003, the Company recorded income of $237,000 and cash distributions of $310,000.

 

7.  Other Comprehensive Loss

 

Other comprehensive loss, consisting of unrealized gains (losses) on securities was $6,000 for the three months ended March 31, 2004 and $(111,000) for the three months ended March 31, 2003.

 

8.  Contingencies

 

In the ordinary course of business, the Company may be party to various legal proceedings.  In the opinion of management, the Company’s liability, if any, in all pending litigation or other legal proceedings will not have a material effect upon the financial condition, results of operations or liquidity of the Company.

 

8

 

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 stock, in violation of Sections 10(b) and 20(a) of the Securities Exchange Act of 1934.  The complaints were consolidated into a single class action on June 13, 2003.  The class action was dismissed by the court on January 28, 2004.  Plaintiffs have filed notice of appeal.  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 suit.  The Board concluded after its investigation and based on its business judgment to reject the demand letter.

 

On September 11, 2003, the Company instituted a lawsuit in the United States District Court for the District of Minnesota against NCS Pearson, Inc. for improperly withholding the payment of funds owed to the Company under a subcontract.  The Company is seeking recovery of $6.3 million in unpaid receivables plus interest and costs.  The proceedings are moving according to schedule.

 

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

 

Overview

 

PEC Solutions, Inc. (www.pec.com) is a professional services firm specializing in high-end solutions that help government clients harness the power of the Internet and other advanced technologies to improve mission performance. We specialize in Web-Enabling Government® by providing secure, interoperable technology solutions for clients in homeland security, law enforcement, intelligence, defense, and civilian agencies within the Federal Government and at state and local levels.  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, primarily from contracts with the Federal Government. We generate these fees from contracts with various payment arrangements, including time and materials contracts, fixed-price contracts and cost-reimbursable contracts. During the three months ended March 31, 2004, revenues from these contract types were approximately 60%, 19% and 21%, respectively, of total revenues. During the three months ended March 31, 2003, revenues from these contract types were approximately 57%, 23% and 20%, respectively, of total revenues. We typically issue invoices monthly to manage outstanding accounts receivable balances. We recognize revenues on time and materials contracts based on actual hours delivered at the contracted billable hourly rate plus the cost of materials incurred.  We recognize revenues on fixed-price contracts using the percentage-of-completion method based on costs we incurred in relation to total estimated costs. However, if the contract has a service element, we recognize revenues on a straight-line basis over the term of the contract.  We recognize revenues on cost-type contracts to the extent of costs incurred plus a proportionate amount of fee earned.

 

On occasion, we enter into contracts that include the delivery of a combination of two or more of our service offerings.  Typically, such multiple-element arrangements incorporate the design, development or modification of systems and an ongoing obligation to manage, staff, maintain, host or otherwise run solutions and systems provided to the client.  Such contracts are divided into separate units of accounting and the total arrangement fee is allocated to each unit based on its relative fair value.  Revenue is recognized separately, and in accordance with our revenue recognition policy, for each element.

 

In certain limited circumstances, revenues are recognized before contract amendments have been finalized.  Prior to agreeing to commence work as directed by a customer and in advance of the receipt of the written modification or amendment to the existing contract, the Company requires the completion of an internal memo that assesses the probability of the modification or amendment being executed in a timely fashion and the Company’s ability to subsequently collect payment from the customer.

 

The fees under certain government contracts may be increased or decreased in accordance with cost or performance incentive provisions that measure actual performance against established targets or other criteria.  Such incentive fee awards or penalties are included in revenue at the time the amounts can be reasonably determined.  Provisions for anticipated contract losses are recognized at the time they become known.

 

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 greater than 98% of our revenues in the three months ended March 31 2004.

 

9

 

In the three months ended March 31, 2004, we derived approximately 20% of our revenues through relationships with prime contractors, which contract directly with the end-client and subcontract with us. In most of these engagements, with the exception of the EDS (NMCI) subcontract, 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.   As of March 31, 2004, we had 1,215 personnel.

 

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.

 

Other income (loss) consists primarily of interest income earned on our cash, cash equivalents and marketable securities, and income from our investment in the limited liability corporation that owns the corporate headquarters office building and the interest expense associated with that building.

 

Results of Operations

 

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

 

		Three Months Ended
		March 31, 2004			March 31, 2003
		(Dollars in thousands)
Statements of Income:
Revenues		$	40,369		$	43,466
Direct costs		24,623			26,971
Gross profit(a)		15,746			16,495
Other operating costs and expenses:
General and administrative expenses		8,495			9,159
Sales and marketing expenses		1,127			1,447
Amortization of intangibles		213			213
Total other operating costs and expenses		9,835			10,819
Operating income		5,911			5,676
Investment and other income		499			637
Interest expense		(667		)	(660		)
Income before income taxes		5,743			5,653
Provision for income taxes		2,155			2,162
Net income		$	3,588		$	3,491
As a Percentage of Revenues:
Revenues		100.0		%	100.0		%
Direct costs		61.0			62.0
Gross profit (a)		39.0			38.0
Other operating costs and expenses:
General and administrative expenses		21.0			21.1
Sales and marketing expenses		2.8			3.3
Amortization of intangibles		0.5			0.5
Total other operating costs and expenses		24.3			24.9
Operating income		14.7			13.1
Investment and other income		1.2			1.4
Interest expense		(1.7		)	(1.5		)
Income before income taxes		14.2			13.0
Provision for income taxes		5.3			5.0
Net income		8.9		%	8.0		%

 

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

 

10

 

Results of Operations for the Three Months Ended March 31, 2004 Compared with the Three Months Ended March 31, 2003

 

Revenues.  Revenues decreased by 7.1% to $40.4 million for the three months ended March 31, 2004 from $43.5 million for the three months ended March 31, 2003.  Revenues were adversely impacted by the approximate $700,000 reduction taken at the end of the quarter on one of our state and local contracts, based on the customer’s indication that they would be restructuring the contract.  Based on the current negotiations and under contract accounting we made this reduction of revenue in the current quarter.  We also saw a reduction in revenue from the first quarter 2003 under the EDS (Navy Marine Corps Intranet) subcontract as the program continued to ramp down from its initial engineering phase into a production phase.

 

Direct Costs. Direct costs decreased by 8.7% to $24.6 million for the three months ended March 31, 2004 from $27.0 million for the three months ended March 31, 2003.  Direct costs decreased as a percentage of revenues to 61.0% for the period ended March 31, 2004 from 62.0% for the period ended March 31, 2003.  This decrease was primarily due to the change in our headcount of billable personnel, and lower other direct costs.

 

Gross Profit. Gross profit decreased by 4.5% to $15.7 million in the three months ended March 31, 2004 from $16.5 million in the three months ended March 31, 2003. Gross profit as a percentage of revenues increased to 39.0 % in the three months ended March 31, 2004 from 38.0% in the three months ended March 31, 2003, because direct costs decreased at a faster rate than revenue decreased.

 

General and Administrative Expenses. General and administrative expenses decreased 7.2% to $8.5 million in the three months ended March 31, 2004 from $9.2 million in the three months ended March 31, 2003.  Our total general and administrative headcount decreased to 118 employees as of March 31, 2004 compared to 123 employees as of March 31, 2003.

 

Sales and Marketing. Sales and marketing expenses decreased 22.1% to $1.1 million in the three months ended March 31, 2004, from $1.4 million in the three months ended March 31, 2003. This decrease was due to a decrease in our marketing and proposal efforts during the quarter, which was related to our clients budget actions.

 

Amortization of Intangibles.  For each of the three month periods ended March 31, 2004 and March 31, 2003,  we incurred $213,000 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.

 

Operating Income. Operating income increased 4.1% to $5.9 million in the three months ended March 31, 2004 from $5.7 million in the three months ended March 31, 2003, due to the factors discussed above.

 

Investment and Other Income.  For the three months ended March 31, 2004, we earned $254,000 of interest income, and had $245,000 of income from our investment in our corporate headquarters building.   For the three months ended March 31, 2003, we had $400,000 of interest income and net losses on sales of securities.  We also had a $237,000 gain from the investment in our corporate headquarters building.

 

Interest Expense.  For the three months ended March 31, 2004 and 2003, we incurred interest expense of $667,000 and $660,000, respectively, principally related to our corporate headquarters building.

 

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 in the fourth quarter of the year. Further, a change in presidential administrations and in senior government officials may negatively affect the rate at which the Federal Government purchases technology.

 

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 possible material adverse effect on our operating results and financial condition.

 

11

 

Liquidity and Capital Resources

 

We currently expect to meet our short-term and long-term cash requirements through funds generated from operations.  Net cash provided by operating activities was $238,000 for the three months ended March 31, 2004. Cash provided by operating activities is primarily driven by net income, adjusted for working capital changes, which are principally changes in accounts receivable.

 

Net cash used by investing activities was $3.2 million for the three months ended March 31, 2004. During the three months ended March 31, 2004, we had $0.3 million of net purchases of property and equipment, $1.0 million of net short-term investments and $2.0 million of net long-term investments and invested $0.04 million in capitalized software, while receiving $0.1 million of distributions from the investment in the entity that owns our headquarters building.  Investing activity is primarily driven by investments in short and long-term securities.

 

For the three months ended March 31, 2004, net cash provided by financing activities was $71,000 and is primarily derived from payments received from employees in connection with the exercise of stock options.

 

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

 

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 March 31, 2004, we had no borrowings outstanding under the line of credit. As of March 31, 2004, we had outstanding $2.6 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 March 31, 2004, our accounts receivable turnover rate, net of advance payments on contracts, was approximately three times a year.

 

SPECIAL NOTE REGARDING FORWARD LOOKING STATEMENTS

 

The foregoing Management’s Discussion and Analysis of Financial Condition and Results of Operations section of  this Form 10-Q includes “forward-looking statements” within the meaning of the Federal Private Securities Litigation Reform Act of 1995. 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 U.S. Government and with state and local governments, 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 Annual Report on Form 10-K for the year ended December 31, 2003 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 consisting of commercial paper, bankers’ acceptances, certificates of deposit, euro-dollar time deposits and variable rate issues, corporate notes 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 rate 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 we are 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.

 

12

 

Our investments are made in accordance with an investment policy approved by our 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 direction 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 design and operation of our disclosure controls and procedures (as defined in Rule 13a-15 under the Securities Exchange Act of 1934).  Based on that evaluation, Messrs. Karlgaard and Lloyd concluded that as of March 31, 2004, our disclosure controls and procedures are effective.  There have been no changes in our internal controls or in other factors that could significantly affect internal controls subsequent to their evaluation.

 

 

 

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 class action on June 13, 2003.  The class action was dismissed by the court on January 28, 2004.  Plaintiffs have filed notice of appeal.  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 suit.  The Board concluded after its investigation and based on its business judgment to reject the demand letter.

 

On September 11, 2003, we instituted a lawsuit in the United States District Court for the District of Minnesota against NCS Pearson, Inc. for improperly withholding the payment of funds owed to us under a subcontract.  We are seeking recovery of $6.3 million in unpaid receivables plus interest and costs.  The proceedings are moving according to schedule.

 

 

Item 2.            Changes in Securities and Use of Proceeds.

 

None.

 

Item 3.            Defaults Upon Senior Securities.

 

None.

 

Item 4.            Submission of Matters to a Vote of Security Holders.

 

None.

 

Item 5.            Other Information.

 

None.

 

13

 

Item 6.            Exhibits and Reports on Form 8-K.

 

(a)     Exhibits.

 

 

14

 

 

*		Incorporated herein by reference to the Company’s Registration Statement on Form S-1(No. 333-95331), as amended.
**		Incorporated herein by reference to the Company’s Annual Report on Form 10-K/A for the year ended December 31, 2000, filed on April 19, 2001.
***		Incorporated herein by reference to the Company’s Quarterly Report on Form 10-Q for the quarter ended
		June 30, 2001, filed August 13, 2001.
****		Incorporated herein by reference to the Company’s Annual Report on Form 10-K for the year ended December 31, 2001, filed on March 29, 2002.
*****		Incorporated herein by reference to the Company’s Quarterly Report on Form 10-Q for the quarter ended June 30, 2003, filed on August 14, 2003.
******		Incorporated herein by reference to the Company’s Quarterly Report on Form 10-Q for the quarter ended September 30, 2003, filed on November 14, 2003.

 

(b)     Reports on Form 8-K.

 

On January 22, 2004, we filed a Current Report on Form 8-K accompanying a press release pre-announcing certain financial results for the quarter and year ended December 31, 2003.

 

On February 10, 2004, we filed a Current Report on Form 8-K accompanying a press release announcing our financial results for the quarter and year ended December, 31, 2003.

 

On February 11, 2004, we filed  a Current Report on Form 8-K accompanying a transcript of the prepared remarks provided during the earnings conference call held at 5:30 pm (EST), February 10, 2004, with respect to the results for the quarter and year ended December 31, 2003.

 

15

 

Signatures

 

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

 

		BY:	/s/ STUART R. LLOYD
			Stuart R. Lloyd
			Chief Financial Officer, Senior Vice President and Director (Principal Financial and Accounting Officer)

 

May 10, 2004

 

16