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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

Form 10-Q

x      QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the Quarterly Period Ended March 31, 2011

or

o         TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from              to            

Commission File Number 0-22010

THOMAS GROUP, INC.

(Exact name of registrant as specified in its charter)

5221 North O’Connor Boulevard, Suite 500
Irving, TX 75039-3714
(Address of principal executive offices, including zip code)

(972) 869-3400
(Registrant’s telephone number, including area code)

NONE

(Former name, former address and former fiscal year, if changed since last report)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.  Yes x  No o

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).  Yes o  No o

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See definition of “large accelerated filer,” and “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.

Indicate by check mark whether the registrant is a shell company (as defined in Exchange Act Rule 12b-2 of the Exchange Act).  Yes o  No x

As of May 16, 2011, there were 2,226,553 shares of the registrant’s common stock outstanding.

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THOMAS GROUP, INC.

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PART I.  FINANCIAL INFORMATION

ITEM 1—Financial Statements

THOMAS GROUP, INC.

CONDENSED CONSOLIDATED BALANCE SHEETS

(in thousands, except share and per share amounts)

(Unaudited)

See accompanying notes to condensed consolidated financial statements

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THOMAS GROUP, INC.

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(In thousands, except per share data)

(Unaudited)

See accompanying notes to condensed consolidated financial statements.

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THOMAS GROUP, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(In thousands)

(Unaudited)

See accompanying notes to condensed consolidated financial statements.

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THOMAS GROUP, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

1.             Basis of Presentation—The unaudited condensed consolidated financial statements of Thomas Group, Inc. include all adjustments, which include only normal recurring adjustments, which are, in the opinion of management, necessary to present fairly our results of operations for the interim periods presented. The unaudited financial statements should be read in conjunction with the consolidated financial statements and notes thereto in our Form 10-K for the 2010 fiscal year, filed with the Securities and Exchange Commission. The results of operations for the three month period ended March 31, 2011 are not necessarily indicative of the results of operations for the entire year ending December 31, 2011.

2.             Liquidity— Our cash balance was $1,933,000 at March 31, 2011. Our available liquidity is limited to our existing working capital and cash flow that we will be able to generate from operations in 2011. We currently believe we have sufficient liquidity to sustain our operations at least through March 31, 2012. If circumstances change or we fail to meet our revenue expectations in our forecast for 2011 or we are unable to control our expenses as planned, we could be required to seek other sources of liquidity during 2011 or seek or implement alternative strategies. There can be no assurance that existing cash will be sufficient, that we will have access to the capital or credit markets if needed or that any of our strategies can be implemented on satisfactory terms, on a timely basis or at all to provide additional liquidity.

3.             Reverse Stock Split— Our Board of Directors and stockholders approved a 1-for-5 reverse split of our outstanding common stock that became effective at 6:01 pm ET, August 13, 2010. The new shares began trading on The Nasdaq Capital Market on August 16, 2010. As a result of the reverse stock split, every five shares of our issued and outstanding common stock, all treasury shares, and all unawarded or unvested shares under our approved stock plans were combined into one share. The reverse stock split did not change the number of authorized shares or par value of our common stock. All share and per share amounts have been adjusted to reflect the stock split for all periods presented.

4.             Earnings Per Share— Basic loss per share is based on the number of weighted average shares outstanding. Diluted loss per share includes the effect of dilutive securities such as stock options, stock warrants, and restricted stock awards expected to vest. The following table reconciles basic loss per share to diluted loss per share under the provisions of ASC 260, Earnings Per Share.

Diluted loss per share is the same as basic loss per share for the three month period ended March 31, 2011 because the effect of outstanding options and unvested restricted stock would have been antidilutive due to the net loss.

Stock options and unvested restricted stock awards outstanding that are not included in the diluted loss per share computation due to the antidilutive effects were approximately 45,040 for the three month period ended March 31, 2011, and 90,190 for the three month period ended March 31, 2010.

5.             Options and Restricted Stock Awards— Options to purchase shares of our common stock have been granted to directors, officers and employees. The majority of the options granted become exercisable at the rate of 33% per year and generally expire ten years after the date of grant. At March 31, 2011, options to purchase 40 shares of our common stock were outstanding and exercisable.

Since the adoption of our 2005 Omnibus Stock and Incentive Plan (the “2005 Omnibus Plan”), we have granted our employees restricted stock awards representing 176,000 shares of our common stock pursuant to that plan. The 176,000 shares covered by such awards have either vested or been forfeited by the award holders according to the terms of the respective awards. As

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THOMAS GROUP, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

of March 31, 2011, no awards remained outstanding and subject to restrictions. At March 31, 2011, 103,333 shares remain authorized and available for grant under the 2005 Omnibus Plan. The 2005 Omnibus Plan will terminate on December 20, 2015.

On March 1, 2008, the Compensation and Corporate Governance Committee of our Board of Directors (the “Compensation Committee”) and our Board of Directors, upon the Compensation Committee’s recommendation, approved a new incentive compensation plan titled the 2008 Omnibus Stock and Incentive Plan for Thomas Group, Inc. (the “2008 Omnibus Plan”). The 2008 Omnibus Plan provides a means for us to grant awards to officers, employees or consultants in the form of options, restricted shares, performance awards and stock appreciation rights. A total of 200,000 shares of our common stock was reserved for issuance pursuant to awards to be made under the 2008 Omnibus Plan. The 2008 Omnibus Plan received stockholder approval at our 2008 Annual Meeting of Stockholders, held on June 26, 2008. At March 31, 2011, 20,000 shares remain authorized and available for grant under the 2008 Omnibus Plan. The 2008 Omnibus Plan will terminate on March 1, 2018.

On March 15, 2011, an award entitling Mr. McGrath to receive up to an aggregate of 60,000 shares of restricted stock was granted to Mr. McGrath under the 2008 Omnibus Plan. The award vests in installments of 15,000 shares at the end of each calendar quarter, contingent upon his being employed by the company at the end of such calendar quarter. On March 31, 2011, the first 15,000 shares vested and were issued to Mr. McGrath.

The restricted share awards were valued on the date of grant using the closing price of our common stock on The Nasdaq Capital Market on that date. Compensation expense is recognized over the applicable period of service.

6.             Significant Clients— We had three clients who each accounted for more than 10% of our revenue in the three month period ended March 31, 2011. Four other clients each accounted for more than 10% of our revenue in the three month period ended March 31, 2010.

There were no other clients from whom revenue exceeded 10% of total revenue in the three month periods ended March 31, 2011 and 2010, respectively.

7.             Concentration of Credit Risk— Financial instruments that potentially subject us to concentrations of credit risk consist primarily of trade receivables. We encounter a certain amount of credit risk as a result of a concentration of receivables among a few significant customers. The trade receivables (in dollars and as a percentage of accounts receivable) from such significant customers are set forth below:

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THOMAS GROUP, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

8.             Supplemental Disclosure of Cash Flow Information

9.             Geographical Data—We provide services within one industry segment and conduct our business primarily in North America and Europe with only occasional activities elsewhere. Information regarding these areas follows:

10.           Property and Equipment

There were no investments in property and equipment during the three month period ended March 31, 2011.

11.           Stockholders’ Equity

On March 15, 2011, an award entitling Mr. McGrath to receive up to an aggregate of 60,000 shares of restricted stock was granted to Mr. McGrath with vesting of 15,000 shares at the end of each calendar quarter, contingent upon his being employed by the company at the end of such calendar quarter. On March 31, 2011, the first 15,000 shares vested and were issued to Mr. McGrath.

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THOMAS GROUP, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

These shares were issued from treasury stock at a historical average cost of $35.12 per share. This led to a decrease in our treasury stock and additional paid-in capital of $0.5 million.

Options

A summary of the status of our stock options issued to employees for the three month period ended March 31, 2011 is presented below. As of March 31, 2011, there were no unvested stock options or remaining stock-based compensation costs related to outstanding stock options.

Restricted Stock

A summary of the restricted stock award activity for the three month period ended March 31, 2011 is presented below.

(1)                              Authorized awards are future rights to shares, usually subject to conditions. Grants are authorized awards for which there is a mutual understanding of the key terms and conditions applicable to the award. Vested shares are shares on which all restrictions have lapsed under the terms of the award and that have been issued to the holder and constitute outstanding common stock. A holder of vested shares has all rights, powers and privileges of a holder of unrestricted shares of our common stock.

(2)                              Authorized awards of 60,000 shares consisting of fully restricted shares were approved and granted to Mr. McGrath on March 15, 2011. Of the 60,000 shares, 15,000 shares vested on March 31, 2011.

At March 31, 2011 there was approximately $61,000 of stock based compensation costs related to unvested restricted stock awards to be recognized over the performance period of the remainder of 2011. For 2011 these awards were valued at $1.51 per share.

12.           Income Taxes— We follow ASC 740, Income Taxes, which requires use of the asset and liability method of accounting for deferred income taxes and providing deferred income taxes for all significant temporary differences and ASC 740-10-25, Income Taxes — Recognition, which prescribes a comprehensive model for how companies should recognize, measure, present, and disclose in their financial statements uncertain tax positions taken or expected to be taken on a tax return.

Income tax expense of $0.02 million for the three month period ended March 31, 2011 reflected an effective tax rate of 34%, compared to income tax expense of $1.6 million, or an effective tax rate of 97%, for the three month period ended March 31, 2010. In the first quarter of 2010, our cumulative losses began to exceed our cumulative earnings. Additionally, we are not currently profitable and we determined that as of March 31, 2010 it was no longer probable that we will recover our deferred tax asset. Thus, we established a valuation allowance to completely offset the deferred tax asset. The combined tax effect was to cause a deferred income tax expense for the first quarter of 2010 of $1.6 million. If we are able to return to sustained profitability, and when we can comply with all the requirements of ASC 740-10-25, we should be able to recover all or part of our deferred tax asset.

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THOMAS GROUP, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

We had approximately $23,000 in state taxes payable at March 31, 2011.

Subsequent to quarter end, we received notice from the Internal Revenue Service (“IRS”) that it will audit our corporate tax returns for the year ending December 31, 2009. In response to a request from the IRS, in conjunction with this audit of our 2009 tax returns, we agreed to extend the deadline for assessments related to our tax returns for the year ending December 31, 2007.  We do not anticipate any material impact on our financial statements as a result of this audit process.

13.           Financing Agreement— As of March 31, 2011, we had a note payable of $21,000 for insurance premiums for 2011.

14.           Recently Issued Accounting Pronouncements— None.

15.           Related Party Transactions— The Third Amendment to Michael McGrath’s employment contract which was effective March 1, 2011 provides that, in addition to his salary for the portion of his time devoted to his roles of Executive Chairman, President and Chief Executive Officer, he is to receive 50% of the revenue attributable to any time he personally spends providing consulting services to our clients. The Third Amendment provides that payments for these consulting services by Mr. McGrath are to be paid to Decisions Decisions, L.L.C., an entity which is owned by Mr. McGrath. For the quarter ended March 31, 2011, these payments totaled $14,000.

This payment was in addition to the salary paid to Mr. McGrath for the portion of his time devoted to his roles of Executive Chairman, President and Chief Executive Officer.

16.           Commitments— On March 3, 2011, the Compensation and Corporate Governance Committee of our Board of Directors adopted a retention pay program for certain of our officers and employees in order to help preserve the continuity of our operations and management. Under the retention pay program, each eligible employee will be entitled to receive a lump sum payment if we terminate his or her employment for any reason other than cause. The amount of the lump sum payment payable to an employee under the retention pay program will be based on the employee’s role and other facts, but it will not exceed an amount equal to six months of his or her annual base salary or annual minimum compensation (as applicable), at the time of termination. The payment will be in lieu of any cash severance payments otherwise payable under any other arrangement with the employee during the period of the retention pay program.

The retention pay program remains in effect through the end of 2012. At that time the program will expire and no payments under this program will be payable for any officer or employee whose employment is terminated after that date. The maximum payments under the Retention Plan (based on current compensation amounts) are approximately $546,000.

17.           Other Income— Other income for the first quarter of 2011 included insurance reimbursements and the reversal of the prior accrual related to the lawsuit with Earle Steinberg, our former President and CEO. The lawsuit was settled in March 2011 for a total cost to us of approximately $110,000. The final settlement was paid in March 2011.

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ITEM 2—Management’s Discussion and Analysis of Financial Condition and Results of Operations

“Safe Harbor” Statement Under The Private Securities Litigation Reform Act:

Various sections contained or incorporated by reference in this Quarterly Report on Form 10-Q include forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, Section 21E of the Securities Exchange Act of 1934 and the Private Securities Litigation Reform Act of 1995. Forward-looking statements may be identified by the context of the statement and generally arise when we are discussing our beliefs, estimates or expectations. Such statements may contain the words “believe,” “anticipate,” “expect,” “estimate,” “intend,” “project,” “could,” “should,” “may,” “will be,” “will likely continue,” “will likely result,” or words or phrases of similar meaning. These statements are not historical facts or guarantees of future performance but instead represent only our belief at the time the statements were made regarding future events. In particular, statements under Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations contain forward-looking statements, including but not limited to statements regarding our expectations regarding the sufficiency of our liquidity sources and the expected impact of legal proceedings with which we may become involved. All forward-looking statements are based largely on the expectations of management and are subject to a number of risks and uncertainties which may cause actual results and outcomes to differ materially from what we express or forecast in these forward-looking statements. In evaluating these statements, you should consider the risks and uncertainties discussed under Item 1A. Risk Factors in our Annual Report on Form 10-K for the fiscal year ended December 31, 2010, as well as the following list of some but not all of the factors that could cause actual results or events to differ materially from anticipated results or events:

·                  the possibility that we may not generate cash flow from operations sufficient to enable us to meet our cash needs over time;

·                  difficulty in obtaining new consulting engagements that generate revenues sufficient to allow us to return to profitability;

·                  the use by the U.S. government of continuing resolutions for the first half of the fiscal year ending September 30, 2011 and its failure to pass a definitive budget for the remainder of the current fiscal year until April 2011;

·                  uncertainties created by the ongoing debate as how to reduce the current U.S. government deficit and the US government debt level;

·                  a prolonged weak economic recovery or further downturn;

·                  the possibility that we may not be able to retain key personnel or to attract necessary replacements to enable our recovery;

·                  an inability to attract, hire, develop, train and retain experienced consultants necessary to meet client needs;

·                  disruption in our relationships with customers;

·                  an inability to successfully sustain sufficient cost containment initiatives;

·                  the competitive environment of the industry in which we operate;

·                  the possibility of being delisted from The Nasdaq Capital Market as a result of our failure to maintain compliance with applicable listing standards; and

·                  the potential for receiving a “going concern” opinion from our independent public accounting firm if our business does not improve during 2011.

These forward-looking statements and such risks, uncertainties and other factors speak only as of the date of this Quarterly Report on Form 10-Q, and we expressly disclaim any obligation or undertaking to disseminate any updates or revisions to any forward-looking statement contained herein, to reflect any change in our expectations with regard thereto, or any other change in events, conditions or circumstances on which any such statement is based.

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Current Market Conditions

The U.S. and worldwide economies are undergoing unprecedented upheaval, turmoil and uncertainty due in part to the curtailment or reduction of credit available to both individuals and to businesses. It is difficult to predict the impact that these conditions will have on our operations. Even the experts are having difficulty agreeing upon the appropriate remedies for or the expected duration of this situation.

We are in the business of helping clients improve profitability and reduce costs. While we expect the current economic environment to make our recovery more difficult in some respects, we believe that successful companies will have to focus more efforts on reducing costs and improving profitability as achieving revenue growth and obtaining external funding become more challenging. We believe that the nature of our product and service offerings and the value proposition that we offer to our clients place us in a strong position to help those companies accelerate and magnify their internal efforts to reduce costs and improve profitability.

Prospective clients are more cautious in making commitments to new engagements and may delay the commencement of projects. This has made our efforts to grow our revenue more difficult than we had anticipated.

Overview

We are a professional services firm that executes and implements process improvements and culture change management operations strategies to produce improved operational and financial performance for our clients globally. We are a Delaware corporation founded in 1978 and headquartered in Irving, Texas.

Through our proprietary Process Value Management™, or PVM™, methodology, our consultants refine processes throughout an organization to give our clients a competitive advantage that increases revenues, lowers costs, and generates cash. With our more than 30 years of change management experience, innovation, and knowledge leadership, we have demonstrated our ability to apply this methodology in hundreds of clients in both the private and the public sectors. We strive to provide measurable results for clients during our engagements, not just reports for actions to be implemented by the client following our departure from the client.

Process Value Management is our proprietary methodology to identify, prioritize, and quantify the amount and timing of cross-functional business improvement opportunities. The PVM approach and methodology is designed to help an organization increase overall effectiveness by focusing on performance drivers throughout the organization like speed (cycle time), quality (first pass yield), and productivity. The PVM approach and methodology is widely applicable to almost all types of enterprises, including government entities, military organizations, for-profit companies in many industries, and not-for-profit enterprises, to help drive sustainable improvements in operations and reduced costs.

For marketing purposes, we are organized into two business units, the Government Business Unit and the Commercial Business Unit.  Our practice leaders and principals are responsible for sales and marketing to prospective clients.

The Commercial Business Unit focuses on sales to aerospace firms, to industrial clients, to transportation firms, and to healthcare entities including hospitals, medical practices and pharmaceutical firms.

The Government Business unit is focused on sales to U.S. government agencies, to all branches of the military, and to state and local government entities.

In the future we may create additional practices as we see potential market opportunities, or we may combine or eliminate practices in response to market conditions.

Through the years, we have developed a number of service offerings that employ the PVM approach and methodology to drive productivity improvements within multiple areas of our clients’ enterprises. We currently focus our marketing on specific solutions in;

·                  Operations, Improvement and Cost Reduction,

·                  Culture and Change Management,

·                  Business Decision Processes,

·                  Product and Service Innovation,

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·                  Physician Practice Management (in healthcare), and

·                  Supply Chain Management.

Historically, most of our clients have been large, diversified commercial or government enterprises in North America, Europe, South America and Asia.  For several years prior to April 2008, the majority of our revenue was derived from engagements with the U.S. Navy, both directly and through an intermediary.

In 2010, we focused on diversifying our client base by delivering our solutions in North America, both to the U.S. government and to commercial entities. Beginning November 2010, we concentrated our sales focus on government related organizations, although we will continue to pursue commercial business on an opportunistic basis for the short term.

In 2011, we continue to focus on diversifying our client base by delivering our solutions in North America, both to the U.S. government and to commercial entities. We also may engage in some business in Europe, and perhaps elsewhere, on an opportunistic basis.

While we believe our methodologies are applicable to any organization, we have developed a significant amount of subject matter expertise relevant to specific industries and governmental entities. Consequently, we can leverage our consultants’ prior executive experiences to obtain business and determine appropriate client project teams. Our goal is to diversify our business among our various practice areas. We are actively pursuing new business in each of these areas.

We perform services and provide solutions for clients pursuant to contracts that typically have terms of two weeks to one year or longer. We are compensated for our professional services and solutions in one or more of three ways:

·                  fixed fees,

·                  task-based fees, or

·                  incentive fees.

Our fee type and structure for each client engagement depends on a number of variables, including the size of the client, the complexity and geographic dispersion of its business, the extent of the opportunity for us to improve the client’s processes and other factors. Some of our contracts are cancellable with little notice. We do not report bookings or backlog because we believe the uncertainties associated with cancellable contracts, particularly in our commercial business, may render such information misleading.

The majority of our revenue is derived from fixed fee and task-based fee contracts.

Fixed fee revenue is recognized on the proportional performance model (which approximates the percentage completion method), based on direct labor hours expended and, when applicable, the completed performance model. In order to calculate the completion ratio on a given project, time and effort to date are divided by the total estimated time and effort for the entire project. This ratio is then multiplied by the total fixed fee to be earned on the project, resulting in the amount of revenue earned to date. A few of our fixed fee contracts, primarily assessments, are recognized using the completed contract performance model as these contracts are generally one to six weeks in duration and conclude with a presentation or agreed upon deliverable to the clients’ management. Revenues attributable to fixed fees were 49% of consolidated revenue for the three month period ended March 31, 2011, and 92% of consolidated revenue for the three month period ended March 31, 2010.

Task-based fees are recognized as revenue when the relevant task is completed, usually on a monthly basis. Revenues attributable to task-based fees were 47% of consolidated revenue for the three month period ended March 31, 2011, and 0% of consolidated revenue for the three month period ended March 31, 2010.

Incentive fees are tied to improvements in a variety of client performance measures typically involving cycle time, asset utilization and productivity. Incentive fee revenue is recognized in the period in which the related client improvements are achieved and we obtain the client’s acceptance. Our incentive fee agreements with our clients define in advance the performance improvement standards that will form the basis for the payment of incentive fees. In order to mitigate the risk of disputes arising over the achievement of performance improvements, which drive incentive fees, we obtain customer agreement to these achievements prior to recognizing revenue. Typically these contracts are for commercial customers and they provide for a base fee and an additional incentive fee earned according to a formula specified in the applicable contract. Incentive fees are affected by our clients’ business performance and prevailing economic conditions. We did not have any revenues attributable to incentive fees for the three month periods ended March 31, 2011, and March 31, 2010. As of March 31, 2011, we had no contracts that provided for incentive fees.

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Reimbursement revenue represents repayment by our clients of our mutually agreed upon travel expenses as incurred. All billable travel expenses are submitted to and approved by the client. Revenues attributable to reimbursement were 4% of consolidated revenue for the three month period ended March 31, 2011, and 8% of consolidated revenue for the three month period ended March 31, 2010. For some clients, the fixed fee or task-based fee is inclusive of travel. In these cases, the travel expense is included in cost of sales.

Consulting contracts typically are awarded by both government entities and private organizations on the basis of sole-source negotiations, that is, direct negotiation between the client and a single vendor such as Thomas Group, or on the basis of competitive bidding, generally in response to a Request for Proposal, or RFP. Whenever possible, we prefer to work under sole source contract arrangements. Competitive bids can require extensive time, effort and cost to submit a qualified bid, and the outcome is unpredictable. In many competitive bid situations, we compete against far larger companies with far greater resources to devote to the proposal process. In some cases, we team with another company that has capabilities complementary to ours in order to increase the competitiveness of our bid. In some other cases, we use an intermediary who has the capability to respond more effectively in this process.

Contracts related to U.S. government engagements often are executed within the U.S. government’s budget cycle and may be fully funded for up to one year at a time. They may be renewed annually for successive one-year periods if the life of the engagement extends beyond one fiscal year. For our engagements with the U.S. government, we contract either directly with the government through our listing with the General Services Administration or we use an intermediary that acts as a prime contractor providing contracting and administrative services for the majority of our government programs.

Cost of sales represents the direct costs involved in providing services and solutions to our clients. The components include, but are not limited to, direct labor and benefit costs, support costs such as telecommunications and computer costs, travel costs and other costs incurred in providing services and solutions to our clients.

Selling, general and administrative expenses include the costs of all labor and other goods and services necessary for our selling and marketing efforts, human resource support, accounting and finance services, legal and other professional services, facilities and equipment, information technology and telecommunications support and services, and other corporate functions. Selling, general and administrative expenses also include depreciation and amortization on the fixed assets used to support these functions.

Critical Accounting Policies

General— The preparation of financial statements in conformity with U.S. generally accepted accounting principles requires management to make estimates and assumptions that affect the amounts reported in the accompanying financial statements and related notes. Management bases its estimates and assumptions on historical experience, observance of industry trends and various other sources of information and factors. Actual results could differ from these estimates. Critical accounting policies are defined as those that are reflective of significant judgments and uncertainties, and potentially could result in materially different results under different assumptions and conditions.

Revenue Recognition— Revenue is recognized when realizable and earned generally as services and solutions are provided over the life of a contract. Fixed fee revenue is recognized using a proportional performance model (which approximates the percentage completion method), based on direct labor hours expended and, when applicable, the completed performance model. Task-based, or deliverable-based, fees are recognized when the relevant task or deliverable is completed. Incentive fee revenue is recognized in the period in which the related improvements are achieved. Our incentive fee agreements with our clients define in advance the performance improvement standards that will form the basis of our incentive fees earned. We do not recognize incentive fee revenue until the client has agreed that performance improvements have in fact been achieved.

Unbilled Receivables— Although fixed fee revenue recognition generally coincides with billings, as an accommodation to our clients, we may structure fee billings in a different pattern. In such instances, amounts collectible for services provided but not yet billed are represented in unbilled receivables.

Deferred Revenue— We occasionally receive advance payments of a portion of our fees. Advance payments are classified as deferred revenue upon receipt and recorded as revenue when earned.

Deferred Taxes— Income taxes are calculated using the asset and liability method required by ASC 740-10-25, Income Taxes. Deferred income taxes are recognized for the tax consequences resulting from timing differences by applying enacted statutory tax rates applicable to future years. These timing differences are associated with differences between the financial and the tax basis of existing assets and liabilities. Under ASC 740-10, a statutory change in tax rates will be recognized immediately in deferred taxes and income. Net deferred taxes are recorded both as a current deferred income tax asset and as other long-term liabilities based upon the

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classification of the related timing difference. A valuation allowance is recognized if, based on the weight of available evidence, it is more likely than not that some portion or all of a deferred tax asset will not be realized. All available evidence, both positive and negative, is considered when determining the need for a valuation allowance. Judgment is used in considering the relative impact of negative and positive evidence. The weight given to the potential effect of negative and positive evidence is commensurate with the extent to which it can be objectively verified. In accordance with ASC 740-10, evidence, such as operating results during the most recent three-year period, is given more weight than our expectations of future profitability, which are inherently uncertain.

In assessing the realizability of deferred tax assets, we considered whether it is more likely than not that some portion or all of the deferred tax assets will not be realized. In the first quarter of 2010, our cumulative losses began to exceed our cumulative earnings. Our analyses of the positive and negative evidence indicate that it is more likely than not that all of the net deferred tax asset will not be realized, and a full valuation allowance is required. Additionally, we are not currently profitable and we determined as of March 31, 2010 it was no longer probable that we will recover our deferred tax asset. The combined tax effect was to cause an income tax expense for the first quarter of 2010 of $1.6 million. Until we can demonstrate that we have returned to profitability, we will not be able to book a deferred income tax asset resulting from losses incurred in each period.

At March 31, 2011, we increased our valuation allowance by $0.2 million to a total of $3.9 million, of which $58,000 is subject to the limitations of Section 382 of the Internal Revenue Code.

For the first quarter of 2011 we incurred income tax expense of $0.02 million compared to an income tax expense of $1.6 million in the same quarter of last year. At March 31, 2011, we booked a net operating loss of $0.9 million which is available to carry forward. As of March 31, 2011, we had a $9.1 million net operating loss to carry forward, of which $2.8 million is subject to the limitations of Section 382 of the Internal Revenue Code.

We also follow the guidance under ASC 740-10-25, which prescribes a comprehensive model for how companies should recognize, measure, present, and disclose in their financial statements uncertain tax positions taken or expected to be taken on a tax return. Tax law is subject to varied interpretation, and whether a tax position will ultimately be sustained may be uncertain. Under ASC 740-10-25, tax positions are initially recognized in the financial statements when it is more likely than not that the position will be sustained upon examination by the tax authorities. Such tax positions are initially and subsequently measured as the largest amount of tax benefit that is greater than 50% likely of being realized upon ultimate settlement with the tax authority assuming full knowledge of the position and all relevant facts. ASC 740-10-25 also requires additional disclosures about unrecognized tax benefits associated with uncertain income tax positions and a reconciliation of the change in the unrecognized benefit. In addition, ASC 740-10-25 requires interest to be recognized on the full amount of deferred benefits for uncertain tax positions. An income tax penalty is recognized as expense when the tax position does not meet the minimum statutory threshold to avoid the imposition of a penalty. As of March 31, 2011, we did not have any liabilities or associated interest under ASC 740-10-25.

Stock Based Compensation— We account for stock based compensation arrangements in accordance with the provisions of ASC 718, Stock Compensation. ASC 718-30 requires us to measure all stock based compensation awards at the grant date using a fair value method and to record expense in the financial statements over the requisite service period of the award. We estimate the fair value of options using the Black-Scholes method, which considers a risk-free interest rate, volatility, expected life, forfeitures, and dividend rates. We use the U.S. 10-year Treasury Bond yield to estimate the risk-free interest rate; and, our estimate of volatility is based on our historical stock price for a period of at least or equal to the expected life of award. Our estimate of forfeitures considers the term of the awards granted and historical forfeiture experience and our estimate of the expected life of awards is based on the anticipated time the award is held. The restricted stock awards are valued on the date of grant using the closing price of our common stock on the Nasdaq Capital Market on that date. Performance share awards are expensed over the applicable year(s) of service at the closing price on the Nasdaq Capital Market on the date when there is mutual understanding of the key terms and conditions affecting the performance award for the year(s).

Recently Issued Accounting Pronouncements— None

Results of Operations

The following table sets forth the percentages of revenue for the identified items in our consolidated statements of operations:

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Three Month Period Ended March 31, 2011 Compared to the Three Month Period Ended March 31, 2010

Revenue—In the first quarter of 2011, total revenues decreased $0.9 million, or 54%, to $0.8 million from $1.7 million in the first quarter of 2010. Task-based revenue was 0.4 million, or 47% of revenue, in the first quarter of 2011. There was no task-based revenue in the first quarter of 2010. Fixed fee revenue was $0.4 million, or 49% of revenue, in the first quarter of 2011, compared to $1.5 million, or 92% of revenue, in the first quarter of 2010. Reimbursement revenues were $0.03 million, or 4% of revenue, in the first quarter of 2011, compared to $0.1 million, or 8% of revenue, in the first quarter of 2010. There was no incentive revenue in the first quarter of 2011 or 2010. As of May 16, 2011, we had no active incentive-based contracts.

North America region revenue decreased $0.6 million, or 42%, to $0.8 million in the first quarter of 2011, compared to $1.3 million in the first quarter of 2010. The decrease in North America revenues for the first quarter of 2011 compared to the first quarter of 2010 is due primarily to a decrease in our commercial business. The increase in task-based revenue, which is associated with our government contracts, is due primarily to new business generated. The decrease in fixed fee revenue, which is associated with our commercial contracts, is due primarily to having a lower volume of commercial contracts, along with the contracts having a lower contract value for the three month period ended March 31, 2011 compared to the three month period ended March 31, 2010. Reimbursable revenues, which also are associated with our commercial contracts, decreased due to the decrease in commercial activity.

We had no revenue in the Europe region in the first quarter of 2011 compared to $0.3 million in the first quarter of 2010, due to completion of contracts. Although we discontinued our Europe operations in 2006, we maintain a strategic relationship in Europe through which we may periodically obtain business.

Gross Profit— Gross profit margins were 41% of revenue, or $0.3 million, in the first quarter of 2011, compared to 31%, or $0.5 million, in the first quarter of 2010. Costs of sales consists of direct labor, travel, and other direct costs incurred by our consultants to provide services to our clients and to complete client related projects, including training. The increase in the quarterly gross margins is related to the variable cost model for staffing consulting projects, minimized bench costs, and the decreased use of outside consultants during the first quarter of 2011.

Selling, General and Administrative Expenses— SG&A costs for the first quarter of 2011 were $1.1 million, compared to $2.0 million in the first quarter of 2010. The $0.9 million decrease is related primarily to a $0.5 million decrease in payroll costs due to employee furloughs and the decline in the number of employees, a $0.1 million decrease in stock-based compensation expense, a $0.1 million decrease in sales commissions and employee bonus, and a $0.2 million decrease in other costs due to a decline in activity as compared to the same period in 2010.

Other Income— Other income for the first quarter of 2011 included insurance reimbursements and the reversal of the prior accrual related to the lawsuit with Earle Steinberg, our former President and CEO. The lawsuit was settled in March 2011 for a total cost to us of approximately $110,000. The final settlement was paid in March 2011.

Income Tax Expense (Benefit)— For the first quarter of 2011 we incurred income tax expense of $0.02 million compared to $1.6 million during the first quarter of 2010. In the first quarter of 2010, our cumulative losses began to exceed our cumulative earnings. Additionally, we are not currently profitable, and we determined as of the end of March 2010 it was no longer probable that we will recover our deferred tax asset. The combined tax effect resulted in an income tax expense of $1.6 million for the first quarter of 2010. The effect is to increase the net loss as well as the loss per share compared to prior quarters. If we are able to return to sustained profitability and when we can comply with all of the requirements of ASC 740-10-25, we should be able to recover all or part of our deferred tax asset.

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Subsequent to quarter end, we received notice from the Internal Revenue Service (“IRS”) that it will audit our corporate tax returns for the year ending December 31, 2009. In response to a request from the IRS, in conjunction with this audit of our 2009 tax returns, we agreed to extend the deadline for assessments related to our tax returns for the year ending December 31, 2007. We do not anticipate any material impact on our financial statements as a result of this audit process.

Liquidity and Capital Resources

Cash and cash equivalents decreased by $1.1 million during the first quarter of 2011 compared to a $1.6 million decrease during the first quarter of 2010. The major components of these changes are discussed below.

Cash Flows from Operating Activities— For the first quarter of 2011, net cash used in operating activities was $1.1 million compared to $1.6 million for the first quarter of 2010. This decrease in net cash used by operating activities is due primarily to the decrease in net loss for the first quarter of 2011.

Cash Flows from Investing Activities— There were no investing activities for the first quarter of 2011 or 2010.

Cash Flows from Financing Activities— There was no cash used for financing activities for the first quarter of 2011 compared to $0.02 million related to the purchase of stock under our stock repurchase plan during the first quarter of 2010.

Our Liquidity Plan— Our ability to generate cash from operations is determined primarily by our ability to generate substantial new revenue. Our ability to generate this required new revenue will be affected by prevailing economic conditions, among other factors. In recent periods we have taken steps to reduce our costs in many areas, and we will continue to do so to the maximum extent we believe is prudent. If future cash flows and capital resources are insufficient to meet our obligations and commitments, we may be forced to reduce or delay activities and capital expenditures, obtain additional equity capital, take other steps to refinance our business or consider other alternative strategies.

We currently believe that our available working capital of $2.3 million and cash balance of $1,933,000 at March 31, 2011 is sufficient to provide the necessary resources for us in 2011. Our available liquidity is limited to our existing working capital and cash flow that we will be able to generate from operations in 2011. We currently believe we have sufficient liquidity to sustain our operations at least through March 31, 2012. If circumstances change or we fail to meet our revenue expectations in our forecast for 2011 or we are unable to control our expenses as planned, we could be required to seek other sources of liquidity during 2011 or seek or implement alternative strategies. There can be no assurance that existing cash will be sufficient, that we will have access to the capital or credit markets if needed or that any of our strategies can be implemented on satisfactory terms, on a timely basis or at all to provide additional liquidity.

Inflation— Although our operations are influenced by general economic conditions, we do not believe inflation had a material effect on the results of operations during the three month periods ended March 31, 2011 or 2010. However, there can be no assurance our business will not be affected by inflation in the future.

Commitments and Off-Balance Sheet Arrangements— On March 3, 2011, the Compensation and Corporate Governance Committee of our Board of Directors adopted a retention pay program for certain of our officers and employees in order to help preserve the continuity of our operations and management. Under the retention pay program, each eligible employee will be entitled to receive a lump sum payment if we terminate his or her employment for any reason other than cause. The amount of the lump sum payment payable to an employee under the retention pay program will be based on the employee’s role and other facts, but it will not exceed an amount equal to six months of his or her annual base salary or annual minimum compensation (as applicable), at the time of termination. The payment will be in lieu of any cash severance payments otherwise payable under any other arrangement with the employee during the period of the retention pay program.

The retention pay program remains in effect through the end of 2012. At that time the program will expire and no payments under this program will be payable for any officer or employee whose employment is terminated after that date. The maximum payments under the Retention Plan (based on current compensation amounts) are approximately $546,000.

As of March 31, 2011, we had no other material commitments for capital expenditures or any obligations that would qualify to be disclosed as off-balance sheet arrangements.

ITEM 3—Quantitative and Qualitative Disclosure About Market Risk

There have been no material changes in circumstances affecting our exposure to interest rate or foreign exchange rate risk since December 31, 2010.

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ITEM 4—Controls and Procedures

Based on the evaluation of our disclosure controls and procedures as of the end of the period covered by this quarterly report, Michael McGrath, our Executive Chairman, President and Chief Executive Officer, and Frank Tilley, our Vice President and Chief Financial Officer, have concluded that, as of March 31, 2011, in their judgment, our disclosure controls and procedures are effective to ensure that information required to be disclosed by us, including our subsidiaries, in the reports we file, or submit under the Securities Exchange Act of 1934, as amended, is recorded, processed, summarized, and reported within the time periods specified in the Securities and Exchange Commission’s rules and forms. Our disclosure controls and procedures include controls and procedures designed to ensure that information required to be disclosed in reports filed or submitted under the Exchange Act is accumulated and communicated to our management, including our Executive Chairman, President and Chief Executive Officer and Vice President and Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosure. Management necessarily applied its judgment in assessing the costs and benefits of such controls and procedures, which, by their nature, can provide only reasonable assurance regarding management’s control objectives.

There were no changes in our internal controls over financial reporting during our last fiscal quarter that have materially affected, or are reasonably likely to materially affect, our internal controls over financial reporting.

PART II—OTHER INFORMATION

ITEM 1—Legal Proceedings

Effective December 21, 2009, Earle Steinberg was removed from his role as CEO and President. His employment agreement (the “Agreement”) provided for payment of his salary for six months following separation, under certain circumstances. We ceased making such payments to Mr. Steinberg as of February 1, 2010 and disputed our continuing liability for the unpaid amount under the Agreement. On May 24, 2010, Mr. Steinberg filed suit against us in the District Court of Dallas County claiming breach of this Agreement and asserting a total claim of $206,000 plus attorney’s fees.    We settled the lawsuit in March 2011 for a total cost to us of approximately $110,000. The final settlement was paid in March 2011.

We may become subject to various claims and other legal matters, such as collection matters initiated by us in the ordinary course of conducting our business. We believe neither such claims and legal matters nor the cost of prosecuting and/or defending such claims and legal matters will have a material adverse effect on our consolidated results of operations, financial condition or cash flows. No material claims are currently pending; however, no assurances can be given that future claims, if any, will not be material.

ITEM 1A—Risk Factors

We are currently not in compliance with the Nasdaq rules for continued listing on The Nasdaq Capital Market and are at risk of being delisted, which may decrease the liquidity of our common stock and subject us to the SEC’s penny stock rules.

On April 18, 2011, we received a Nasdaq Staff Determination Letter stating that we no longer meet the minimum Market Value of Publicly Held Shares (“MVPHS”) requirement set forth in Listing Rule 5550(a)(5) of The Nasdaq Stock Market (the “Rule”). The Rule requires that we maintain a MVPHS of at least $1 million. We have until October 17, 2011 to regain compliance with the Rule by maintaining a minimum MVPHS of $1 million for at least ten consecutive business days. If we do not regain compliance with the Rule by such date, we will receive written notification that our securities are subject to delisting from The Nasdaq Capital Market. At that time, we may appeal the delisting determination to a hearings panel.

Unless there is a substantial improvement in our performance in the meantime, at some future date we may also be notified that we are in non-compliance with other Nasdaq rules for continued listing.

Our failure to maintain our Nasdaq listing may decrease the liquidity of our common stock and subject us to the SEC’s penny stock rules.

There have been no other material changes from the information previously reported under Item 1A of our Annual Report on Form 10-K for the fiscal year ended December 31, 2010.

ITEM 2—Unregistered Sales of Equity Securities and Use of Proceeds

None.

ITEM 3—Defaults Upon Senior Securities

None.

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ITEM 4— Removed and Reserved

ITEM 5—Other Information

None.

ITEM 6—Exhibits

*              Filed herewith

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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.

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Thomas Group, Inc.

Form

Exhibit Index

*              Filed herewith

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