** **

**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C. 20549-0001**

 

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**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, 2005** |
| ** **                               |
| **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 asSpecified 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** |

 

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Indicate by check mark whether the registrant (1) has filed all reportsrequired to be filed by Section 13 or 15(d) of the Securities Exchange Act of1934 during the preceding 12 months (or for such shorter period that theregistrant was required to file such reports), and (2) has been subject to thefiling 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 6, 2005, 27,611,281 of the registrant’s Common Stock, parvalue $.01 per share, were outstanding.

 

 

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**PEC SOLUTIONS, INC.**

**QUARTERLY REPORT ON FORM 10-Q FOR THE THREEMONTHS ENDED MARCH 31, 2005**

 

**TABLE OF CONTENTS**

 
| PART I. FINANCIAL INFORMATION                                                                       |
|-----------------------------------------------------------------------------------------------------|
| Item 1.                                                                                             | Financial Statements: |
|                                                                                                | Consolidated Balance Sheets — March 31, 2005 and December 31, 2004 |
|                                                                                                | Consolidated Statements of Income — Three  months ended March 31, 2005 and 2004 |
|                                                                                                | Consolidated Statements of Cash Flows —  Three months ended March 31, 2005 and 2004 |
|                                                                                                | Notes to Consolidated Financial Statements |
| Item 2. Management’s Discussion and  Analysis of Financial Condition and Results of Operations |
| Item 3. Qualitative and Quantitative  Disclosure about Market Risk                                  |
| Item 4. Controls and Procedures                                                                     |
| PART II. OTHER INFORMATION                                                                          |
| Item 1. Legal Proceedings                                                                           |
| Items 2-4.                                                                                          |
| Item 5.                                                                                             |
| Item 6. Exhibits                                                                                    |
| Signatures                                                                                          |

 

2

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**PART I - FINANCIAL INFORMATION**

 

**Item 1.            FinancialStatements**

 

**PEC SOLUTIONS, INC.**

### **CONSOLIDATEDBALANCE SHEETS**

(Dollars in thousands*)*

 
| ** **                                                                                                                                      | ** ** | **As of  March 31,  2005** | ** ** | **As of  December 31,  2004** | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------------------------|------------|----------------------------|------------|-------------------------------|------------|
| ** **                                                                                                                                      | ** ** | **(Unaudited)**            | ** ** | ** **                    | ** ** |
| **ASSETS**                                                                                                                                      |       |                       |       |                          |       |
| Current assets:                                                                                                                                 |       |                       |       |                          |       |
| Cash and cash equivalents                                                                                                                       |       | $                          | 24,732     |                          | $          | 17,599 |   |
| Short-term investments                                                                                                                          |       | 23,731                     |       | 11,819                        |       |
| Accounts receivable, net                                                                                                                        |       | 66,074                     |       | 64,003                        |       |
| Other current assets                                                                                                                            |       | 13,144                     |       | 16,098                        |       |
| Total current assets                                                                                                                            |       | 127,681                    |       | 109,519                       |       |
|                                                                                                                                            |       |                       |       |                          |       |
| Property and equipment, net                                                                                                                     |       | 25,166                     |       | 25,707                        |       |
| Investments                                                                                                                                     |       | 6,687                      |       | 18,522                        |       |
| Goodwill                                                                                                                                        |       | 78,871                     |       | 78,874                        |       |
| Intangibles, net                                                                                                                                |       | 14,373                     |       | 15,086                        |       |
| Other assets                                                                                                                                    |       | 5,395                      |       | 5,118                         |       |
| Total assets                                                                                                                                    |       | $                          | 258,173    |                          | $          | 252,826 |   |
|                                                                                                                                            |       |                       |       |                          |       |
| **LIABILITIES AND STOCKHOLDERS’ EQUITY**                                                                                                   |       |                       |       |                          |       |
|                                                                                                                                            |       |                       |       |                          |       |
| Current liabilities:                                                                                                                            |       |                       |       |                          |       |
| Accounts payable                                                                                                                                |       | $                          | 5,707      |                          | $          | 7,011 |   |
| Accrued expenses                                                                                                                                |       | 6,933                      |       | 5,363                         |       |
| Advance payments on contracts                                                                                                                   |       | 482                        |       | 448                           |       |
| Accrued payroll                                                                                                                                 |       | 6,627                      |       | 7,601                         |       |
| Accrued vacation                                                                                                                                |       | 5,024                      |       | 4,014                         |       |
| Other current liabilities                                                                                                                       |       | 13,297                     |       | 13,606                        |       |
| Total current liabilities                                                                                                                       |       | 38,070                     |       | 38,043                        |       |
|                                                                                                                                            |       |                       |       |                          |       |
| Long-term liabilities:                                                                                                                          |       |                       |       |                          |       |
| Supplemental retirement program  liability                                                                                                      |       | 1,708                      |       | 1,632                         |       |
| Deferred rent                                                                                                                                   |       | 2,289                      |       | 2,210                         |       |
| Deferred income tax payable                                                                                                                     |       | 656                        |       | 290                           |       |
| Long-term lease obligation                                                                                                                      |       | 23,298                     |       | 23,265                        |       |
| Total long-term liabilities                                                                                                                     |       | 27,951                     |       | 27,397                        |       |
| Total liabilities                                                                                                                               |       | 66,021                     |       | 65,440                        |       |
|                                                                                                                                            |       |                       |       |                          |       |
| Commitments and contingencies                                                                                                                   |       |                       |       |                          |       |
|                                                                                                                                            |       |                       |       |                          |       |
| Stockholders’ equity:                                                                                                                      |       |                       |       |                          |       |
| Undesignated capital stock,  10,000,000 shares authorized                                                                                       |       | —                     |       | —                        |       |
| Common stock, $0.01 par value,  75,000,000 shares authorized,  27,595,370 and 27,587,547 shares issued and  outstanding, respectively |       | 276                        |       | 276                           |       |
| Additional paid-in capital                                                                                                                      |       | 97,754                     |       | 97,654                        |       |
| Retained earnings                                                                                                                               |       | 94,227                     |       | 89,536                        |       |
| Accumulated other comprehensive  loss                                                                                                           |       | (105                       | )          | (80                           | )          |
| Total stockholders’ equity                                                                                                                 |       | 192,152                    |       | 187,386                       |       |
| Total liabilities and  stockholders’ equity                                                                                                |       | $                          | 258,173    |                          | $          | 252,826 |   |

 

See notes to consolidated financialstatements.

 

3

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**PEC SOLUTIONS, INC.**

**CONSOLIDATED STATEMENTS OF INCOME**

(Amounts in thousands, except pershare data)

 
| ** **                                                     | ** ** | **Three Months Ended** | ** ** |
|----------------------------------------------------------------|------------|------------------------|------------|
| ** **                                                     | ** ** | **March 31, 2005**     | ** ** | **March 31, 2004** | ** ** |
| ** **                                                     | ** ** | **(Unaudited)**        | ** ** |
| Revenues                                                       |       | $                      | 63,969     |   | $ | 40,369 |   |
| Operating costs and expenses:                                  |       |                   |       |   |   |
| Direct costs                                                   |       | 41,418                 |       | 24,623 |   |
| General and administrative  expenses                           |       | 12,453                 |       | 8,495 |   |
| Sales and marketing expenses                                   |       | 1,540                  |       | 1,127 |   |
| Amortization of intangibles                                    |       | 713                    |       | 213 |   |
| Total operating costs and  expenses                            |       | 56,124                 |       | 34,458 |   |
| Operating income                                               |       | 7,845                  |       | 5,911 |   |
| Investment and other income                                    |       | 529                    |       | 499 |   |
| Interest expense                                               |       | (672                   | )          | (667 | ) |
| Income before income taxes                                     |       | 7,702                  |       | 5,743 |   |
| Provision for income taxes                                     |       | 3,011                  |       | 2,155 |   |
| Net income                                                     |       | $                      | 4,691      |   | $ | 3,588 |   |
| Earnings per share:                                            |       |                   |       |   |   |
| Basic                                                          |       | $                      | 0.17       |   | $ | 0.13 |   |
| Diluted                                                        |       | $                      | 0.16       |   | $ | 0.12 |   |
| Weighted average shares used  in computing earnings per share: |       |                   |       |   |   |
| Basic                                                          |       | 27,591                 |       | 27,307 |   |
| Diluted                                                        |       | 29,187                 |       | 29,799 |   |

 

See notes to consolidated financial statements.

 

4

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**PEC SOLUTIONS, INC.**

**CONSOLIDATED STATEMENTS OF CASH FLOWS**

(Dollars in thousands)

 
| ** **                                                                                | ** ** | **Three Months Ending** | ** ** |
|-------------------------------------------------------------------------------------------|------------|-------------------------|------------|
| ** **                                                                                | ** ** | **March 31, 2005**      | ** ** | **March 31,**** 2004** | ** ** |
| ** **                                                                                | ** ** | **(Unaudited)**         | ** ** |
| Cash flows from operating  activities:                                                    |       |                    |       |   |   |
| Net income                                                                                |       | $                       | 4,691      |   | $ | 3,588 |   |
| Adjustments to reconcile net  income to  net cash provided  by operating activities: |       |                    |       |   |   |
| Depreciation and amortization                                                             |       | 754                     |       | 713 |   |
| Amortization of intangibles                                                               |       | 713                     |       | 213 |   |
| Amortization of bond premium  and discounts, net                                          |       | 12                      |       | 88 |   |
| (Gain) loss on sale of assets                                                             |       | 13                      |       | (4 | ) |
| Deferred rent payable                                                                     |       | 79                      |       | 95 |   |
| Deferred income taxes                                                                     |       | 362                     |       | (106 | ) |
| Bad debt expense                                                                          |       | —                  |       | 102 |   |
| Gain from investment in  building                                                         |       | (245                    | )          | (245 | ) |
| Non-cash charge related to  building                                                      |       | 33                      |       | 49 |   |
| Changes in operating assets and  liabilities:                                             |       |                    |       |   |   |
| Accounts receivable, net                                                                  |       | (2,071                  | )          | (3,872 | ) |
| Other current assets                                                                      |       | 3,426                   |       | (149 | ) |
| Other assets                                                                              |       | (69                     | )          | (57 | ) |
| Accounts payable                                                                          |       | (1,304                  | )          | (862 | ) |
| Accrued expenses                                                                          |       | 1,570                   |       | — |   |
| Advance payments on contracts                                                             |       | 35                      |       | 248 |   |
| Accrued payroll                                                                           |       | (974                    | )          | (2,448 | ) |
| Accrued vacation                                                                          |       | 1,010                   |       | 568 |   |
| Other current liabilities                                                                 |       | (647                    | )          | 2,274 |   |
| Supplemental retirement program  liability                                                |       | 74                      |       | 43 |   |
| Net cash provided by operating  activities                                                |       | 7,462                   |       | 238 |   |
| Cash flows from investing  activities:                                                    |       |                    |       |   |   |
| Purchases of property and  equipment                                                      |       | (125                    | )          | (293 | ) |
| Proceeds from sale of property  and equipment                                             |       | —                  |       | 4 |   |
| Purchases of short-term  investments                                                      |       | (4,066                  | )          | (13,023 | ) |
| Proceeds from sale of  short-term investments                                             |       | 3,900                   |       | 12,006 |   |
| Capitalized software                                                                      |       | (309                    | )          | (43 | ) |
| Purchase of long-term  investments                                                        |       | —                  |       | (10,616 | ) |
| Proceeds from sale of long-term  investments                                              |       | —                  |       | 8,641 |   |
| Distribution from building  investment                                                    |       | 172                     |       | 101 |   |
| Net cash used by investing  activities                                                    |       | (428                    | )          | (3,223 | ) |
| Cash flows from financing  activities:                                                    |       |                    |       |   |   |
| Proceeds from issuance of  common stock                                                   |       | 99                      |       | 71 |   |
| Net cash provided by financing  activities                                                |       | 99                      |       | 71 |   |
| Net (decrease) increase in cash                                                           |       | 7,133                   |       | (2,914 | ) |
| Cash and cash equivalents at  beginning of period                                         |       | 17,599                  |       | 33,401 |   |
| Cash and cash equivalents at  end of period                                               |       | $                       | 24,732     |   | $ | 30,487 |   |
|                                                                                      |       |                    |       |   |   |
| Income taxes paid                                                                         |       | $                       | 1,004      |   | $ | 12 |   |
| Interest paid                                                                             |       | $                       | 672        |   | $ | 667 |   |

 

See notes to consolidated financialstatements.

 

5

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**PEC SOLUTIONS, INC.**

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

**MARCH 31, 2005**

(*Unaudited*)

 

**1.  FinancialStatements**

 

The accompanying financial statements, except for the December 31, 2004balance sheet, are unaudited and have been prepared in accordance withaccounting standards generally accepted in the United States for interimfinancial information and the instructions to Form 10-Q and Article 10 ofRegulation S-X. Accordingly, certain information and footnote disclosuresnormally included in financial statements prepared in accordance withaccounting principles generally accepted in the United States have beenomitted. In the opinion of management, all adjustments, consisting of normallyrecurring accruals, considered necessary for a fair presentation, have beenincluded. It is suggested that these financial statements be read inconjunction with the Company’s audited financial statements as of December 31,2003 and 2004 and for each of the three years in the period ended December 31,2004 included in the Company’s Form 10-K/A, as filed with the Securities andExchange Commission on March 18, 2005. The results of operations for the threemonths ended March 31, 2005, are not necessarily indicative of the operatingresults to be expected for the full year. The financial statements for theperiod ended March 31, 2005 reflect the acquisitions of Integrated InformationTechnology Corporation (“IITC”) and AC Technologies, Inc. (“ACT”), on May 28,2004, and September 9, 2004, respectively, and therefore, the results may notbe meaningful when compared to the results for the period ended March 31, 2004.

 

**2.  Stock-based Compensation**

 

In December 2002, the FASB issued SFAS No. 148, *Accounting for Stock-Based Compensation—Transitionand Disclosure, an amendment of FASB Statement No. 123*. SFASNo. 148 provides alternative methods of transition for a voluntary changeto the fair market value-based method of accounting for stock-basedcompensation. The Company has not voluntarily adopted this change. In addition,SFAS No. 148 amends the disclosure requirements of SFAS No. 123 torequire prominent disclosures in both annual and interim financial statementsabout the method of accounting for stock-based employee compensation and theeffect of the method used on reported results. These amended disclosure requirements have been included below.

 

In December 2004, the FASB also issuedStatement No. 123 (Revised) “Share-Based Payment.” This Statementestablishes standards for the accounting for transactions in which an entityexchanges its equity instruments for goods or services. It also addressestransactions in which an entity incurs liabilities in exchange for goods orservices that are based on the fair value of the entity’s equity instruments orthat may be settled by the issuance of those equity instruments. This Statementrequires a public entity to measure the cost of employee services received inexchange for an award of equity instruments based on the grant-date fair valueof the award (with limited exceptions). That cost will be recognized over theperiod during which an employee is required to provide service in exchange forthe award—the requisite service period (usually the vesting period). Nocompensation cost is recognized for equity instruments for which employees donot render the requisite service. A public entity will initially measure thecost of employee services received in exchange for an award of liabilityinstruments based on its current fair value; the fair value of that award willbe re-measured subsequently at each reporting date through the settlement date.Changes in fair value during the requisite service period will be recognized ascompensation cost over that period. Statement No. 123R (“SFAS 123R”)is effective as of the beginning of the first annual reporting period thatbegins after June 15, 2005. In anticipation of the implementation ofSFAS 123R the Company accelerated the vesting of out-of-the-money stockoptions as of February 25, 2005. Therefore, these options will not be expensed in future periods. It wasestimated that this would reduce the amount of compensation expenses we wouldotherwise have been obligated to recognize in connection with these options infuture periods by approximately $8.4 million before taxes.

 

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

 

This information and the assumptions used for March 31, 2005 and 2004for the Company’s stock option plan are summarized as follows:

 

 
| ** **                                           | ** ** | **Stock Option Plan** | ** ** |
|------------------------------------------------------|------------|-----------------------|------------|
| ** **                                           | ** ** | **March 31,**         | ** ** |
| ** **                                           | ** ** | **2005**              | ** ** | **2004** | ** ** |
| Volatility                                           |       | 75.1                  | %          | 82.1-84.2 | % |
| Risk-free interest rate                              |       | 3.81                  | %          | 3.1-3.3 | % |
| Dividend yield                                       |       | 0                     | %          | 0 | % |
| Expected lives                                       |       | 6.3 years             |       | 6.0-6.4 years |   |
| Weighted average fair value per share at  grant date |       | $                     | 9.83       |   | $ | 12.22 |   |
|                                                      |            |                       |            |  |  |  |  |

 

6

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The Company continues to apply the provisions of APB 25 and provide thepro forma disclosures in accordance with the provisions of FAS Nos. 123 and148. Under APB 25, the Company has not recorded in net income any stock-basedemployee compensation cost associated with the Company’s stock option plan, asall options granted under the plan had an exercise price equal to the marketvalue of the underlying common stock on the date of grant.

 

The following table illustrates the effect on net income and earningsper share if the Company had applied the fair value recognition provisions ofSFAS No. 123 to its stock option plan:

 
| ** **                                 | ** ** | **Quarter Ended March 31,** | ** ** |
|--------------------------------------------|------------|-----------------------------|------------|
| ** **                                 | ** ** | **2005**                    | ** ** | **2004** | ** ** |
| ** **                                 | ** ** | **(Dollars in thousands)**  | ** ** |
| Net income, as reported                    |       | $                           | 4,691      |   | $ | 3,588 |   |
| Pro forma compensation expense, net of tax |       | (5,624                      | )          | (1,572 | ) |
| Pro forma net income                       |       | $                           | (933       | ) | $ | 2,016 |   |
|                                       |       |                        |       |   |   |
| Net income (loss) per share:               |       |                        |       |   |   |
| Basic—as reported                     |       | $                           | 0.17       |   | $ | 0.13 |   |
| Basic—pro forma                       |       | $                           | (0.03      | ) | $ | 0.07 |   |
| Diluted—as reported                   |       | $                           | 0.16       |   | $ | 0.12 |   |
| Diluted—pro forma                     |       | $                           | (0.03      | ) | $ | 0.07 |   |

 

**3. Accounts Receivable**

 

Accounts receivable consist of the followingas of:

 
| ** **                                                | ** ** | **March 31,  2005**        | ** ** | **December 31,  2004** | ** ** |
|-----------------------------------------------------------|------------|----------------------------|------------|------------------------|------------|
| ** **                                                | ** ** | **(Dollars in thousands)** | ** ** |
| Billed accounts receivable                                |       | $                          | 52,707     |                   | $          | 51,381 |   |
| Unbilled accounts receivable:                             |       |                       |       |                   |       |
| Amounts currently billable                                |       | 12,756                     |       | 12,286                 |       |
| Revenues recorded in excess of  contract value or funding |       | 1,207                      |       | 898                    |       |
| Progress payments                                         |       | (482                       | )          | (448                   | )          |
|                                                      |       | 66,188                     |       | 64,117                 |       |
| Allowance for doubtful accounts                           |       | (114                       | )          | (114                   | )          |
| Accounts receivable, net                                  |       | $                          | 66,074     |                   | $          | 64,003 |   |

 

Unbilled accounts receivable comprise recognized recoverable costs andaccrued profits on contracts for which billings had not been presented toclients as of the balance sheet date. Revenues recorded in excess of contractvalue or funding are billable upon receipt of contractual amendments.  Management anticipates the collection ofthese amounts within 90 days of the balance sheet date. Payments to the Companyon contracts with agencies and departments of the Federal Government aresubject to adjustment upon audit by the Federal Government. PEC contracts aresubject to audit for all years subsequent to 2002, IITC all years subsequent to2001, and ACT contracts have not been audited. Management believes that audit adjustments, if any, on periods not yetaudited, will not have a material effect on the financial statements.

 

During the quarter ended March 31, 2004, the Special Project Divisionof the Drug Enforcement Agency accounted for 11% of the Company’s revenue, or$4.6 million.  At March 31, 2004, therewas $4.4 million due from the Special Project Division of the Drug EnforcementAgency.

 

During the quarter ended March 31, 2005, the Company did not have anyone customer who accounted for more than 10% of revenue.

 

At March 31, 2004, accounts receivable included $6.3 million due from asubcontract for the Company’s biometric identification system.  The Company filed a lawsuit in Federal courtagainst the prime contractor, NCS Pearson, in September 2003 to recover fullpayment on this receivable.  As of May 6,2005, the Company has received $4.1million of this receivable and continues topursue the balance of $2.2 million and expects to receive full payment.  See footnote 11 for further discussion.

 

7

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**4.  NetIncome Per Share**

 

Basic and diluted earnings per share for the three months ended March31, 2005 and 2004 were determined as follows:

 
| ** **                 | ** ** | **Three Months Ended March 31,  2005**                    | ** ** | **Three Months Ended March 31,  2004** | ** ** |
|----------------------------|------------|-----------------------------------------------------------|------------|----------------------------------------|------------|
| ** **                 | ** ** | **(Dollars in thousands, except  for per share amounts)** | ** ** |
| ** **                 | ** ** | **Net  Income**                                           | ** ** | **Shares**                             | ** ** | **Per Share** | ** ** | **Net  Income** | ** ** | **Shares** | ** ** | **Per Share** | ** ** |
| Basic EPS                  |       | $                                                         | 4,691      |                                   | 27,587,547 |   | $ | 0.17 |   | $ | 3,588 |   | 27,306,837 |   | $ | 0.13 |   |
| Effect of dilutive options |       | —                                                    |       | 1,599,122                              |       | (0.01 | ) | — |   | 2,492,001 |   | (0.01 | ) |
| Diluted EPS                |       | $                                                         | 4,691      |                                   | 29,186,669 |   | $ | 0.16 |   | $ | 3,588 |   | 29,798,838 |   | $ | 0.12 |   |

 

For the quarters ended March 31, 2005 and 2004, 1,823,084 and 1,659,167shares, respectively, attributable to outstanding stock options were excludedfrom the calculation of diluted earnings per share because the effect wasantidilutive.

 

**5. Acquisitions**

 

On May 28, 2004, the Company acquired all ofthe outstanding common shares of Integrated Information Technology Corporation(“IITC”).  The results of IITC’soperations have been included in the consolidated financial statements sincethat date.  IITC derives revenues fromproviding satellite communications engineering and information technologysolutions to the Federal Government.  Theaggregate purchase price was $34.0 million, including acquisition costs of $.8million.  The purchase was an all cashtransaction.  Approximately $3.6 millionis being held in escrow to be paid to IITC once certain conditions of the saleare met. These conditions are expected to be met by December 31, 2005.

 

The following table summarizes the estimatedfair values of the assets acquired and liabilities assumed at the date ofacquisition.  The fair value of theassets acquired and liabilities assumed has been based on preliminaryestimates, and may be revised when remaining aspects of the purchase priceallocation have been finalized.

 
| **(Dollars in thousands)**            | ** ** | **At May 28, 2004** | ** ** |
|---------------------------------------|------------|---------------------|------------|
| Current assets, including cash of $33 |       | $                   | 8,326      |   |
| Property and equipment                |       | 297                 |       |
| Intangible assets                     |       | 7,600               |       |
| Goodwill                              |       | 22,614              |       |
| Other assets                          |       | 154                 |       |
| Total assets acquired                 |       | 38,991              |       |
| Current liabilities                   |       | 4,968               |       |
| Long-term liabilities                 |       | 23                  |       |
| Total liabilities assumed             |       | 4,991               |       |
| Net assets acquired                   |       | $                   | 34,000     |   |

 

The $7.6 million of acquired intangibleassets was assigned to customer contracts and related relationships with aweighted-average useful life of 7.0 years. The transaction resulted in $22.6 million of goodwill, all of which isdeductible for tax purposes.

 

On September 9, 2004, the Company acquiredall of the outstanding common shares of AC Technologies, Inc. (“ACT”).  The results of ACT’s operations have beenincluded in the consolidated financial statements since that date.  ACT specializes in software engineering andnetworking services to the Federal Government. The aggregate purchase price was $51.4 million, including acquisitioncosts of $4.7 million.  The purchaseprice included $16.9 million of cash used to retire ACT debt.  The purchase was an all cashtransaction.  Approximately $6.6 millionis being held in escrow to be paid to ACT once the conditions of the sale aremet. These conditions are expected to be met by December 31, 2005.

 

8

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The following table summarizes the estimatedfair values of the assets acquired and liabilities assumed at the date ofacquisition.  The fair value of theassets acquired and liabilities assumed has been based on preliminaryestimates, and may be revised when remaining aspects of the purchase priceallocation have been finalized.

 
| **(Dollars in thousands)**               | ** ** | **At September 9, 2004** | ** ** |
|------------------------------------------|------------|--------------------------|------------|
| Current assets, including cash of $1,575 |       | $                        | 11,261     |   |
| Property and equipment                   |       | 366                      |       |
| Intangible assets                        |       | 6,400                    |       |
| Goodwill                                 |       | 39,325                   |       |
| Other assets                             |       | 34                       |       |
| Total assets acquired                    |       | 57,386                   |       |
| Current liabilities                      |       | 22,908                   |       |
| Long-term liabilities                    |       | 22                       |       |
| Total liabilities assumed                |       | 22,930                   |       |
| Net assets acquired                      |       | $                        | 34,456     |   |

 

The $6.4 million of acquired intangibleassets was assigned to customer contracts and related relationships with aweighted-average useful life of 7.0 years. The transaction resulted in $39.3 million of goodwill, all of which isdeductible for tax purposes.

 

Unauditedpro forma results of operations as if the acquisitions had occurred at thebeginning of each period presented are as follows:

 
| **(Dollars in thousands)**                                     | ** ** | **Three Months Ended  March 31, 2005** | ** ** |
|----------------------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                                     | ** ** | ** **                                  | ** ** |
| Revenues                                                       |       | $                                           | 63,969     |   |
|                                                           |       |                                        |       |
| Net Income                                                     |       | $                                           | 4,691      |   |
|                                                           |       |                                        |       |
| Earnings per share:                                            |       |                                        |       |
| Basic                                                          |       | $                                           | 0.17       |   |
| Diluted                                                        |       | $                                           | 0.16       |   |
|                                                           |       |                                        |       |
| Weighted average shares used in computing  earnings per share: |       |                                        |       |
| Basic                                                          |       | 27,591                                      |       |
| Diluted                                                        |       | 29,187                                      |       |

 
| **(Dollars in thousands)**                                     | ** ** | **Three Months Ended  March 31, 2004** | ** ** |
|----------------------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                                     | ** ** | ** **                                  | ** ** |
| Revenues                                                       |       | $                                           | 61,621     |   |
|                                                           |       |                                        |       |
| Net Income                                                     |       | $                                           | 5,075      |   |
|                                                           |       |                                        |       |
| Earnings per share:                                            |       |                                        |       |
| Basic                                                          |       | $                                           | 0.18       |   |
| Diluted                                                        |       | $                                           | 0.17       |   |
|                                                           |       |                                        |       |
| Weighted average shares used in computing  earnings per share: |       |                                        |       |
| Basic                                                          |       | 27,307                                      |       |
| Diluted                                                        |       | 29,799                                      |       |

 

The pro forma consolidated results of operationsinclude adjustments to give effect to amortization of intangibles and otheradjustments, together with related income tax effects.  The unaudited pro forma information is notnecessarily indicative of the results of operations that would have occurredhad the purchase been made at the beginning of the periods presented or thefuture results of the combined operations.

 

9

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**6.  Othercurrent assets**

 

Othercurrent assets consisted of the following:
| ** **                                          | ** ** | **March 31,  2005**        | ** ** | **December 31,  2004** | ** ** |
|-----------------------------------------------------|------------|----------------------------|------------|------------------------|------------|
| ** **                                          | ** ** | **(Dollars in thousands)** | ** ** |
| Accounts receivable-other                           |       | 194                        |       | 623                    |       |
| Prepaid expenses                                    |       | 1,341                      |       | 1,392                  |       |
| Travel advances                                     |       | 67                         |       | 101                    |       |
| Deferred income taxes-current                       |       | 1,295                      |       | 1,283                  |       |
| Escrow-amounts related to IITC and ACT  acquisition |       | 10,246                     |       | 12,616                 |       |
| Inventory                                           |       | 1                          |       | 64                     |       |
| Other current assets                                |       | —                     |       | 19                     |       |
|                                                |       | $                          | 13,144     |                   | $          | 16,098 |   |
|                                                     |            |                            |            |                        |            |  |  |

 

**7.  Goodwill and Intangible Assets**

 

The Company has recognized goodwill related to its acquisitions ofViking Technology, Inc. (“Viking”), Troy Systems, Inc. (“Troy”), VectorResearch, Inc. (“Vector”), IITC, and ACT. Non-amortized intangible assetsconsist only of goodwill of $78.9 million. The Company’s amortizable intangible assets include customer contractsand related relationships purchased in the acquisitions of Troy on November 20,2001; Vector on June 14, 2002; IITC on May 28, 2004; and ACT on September 9,2004.  The intangibles related to theTroy acquisition totaled $3.0 million and are amortized on a straight-linebasis over a 4.5-year period.  Theintangibles on the Vector purchase totaled $1.5 million and are being amortizedon a straight-line basis over an 8.4-year period.   The intangibles on the IITC acquisitiontotaled $7.6 million and are being amortized on a straight-line basis over a7.0-year period.  The intangibles on theACT acquisition totaled $6.4 million and are being amortized on a straight-linebasis over a 7.0-year period.  Total accumulatedamortization as of March 31, 2005 was $4.1 million.  In accordance with the provisions of SFAS No.142, the Company performed the appropriate annual impairment tests during thequarter ended March 31, 2005 related to its stated goodwill, and determinedthat there was no impairment loss. Therefore, no change was made to the carrying amount of goodwill.

 

Amortization expense was $713,000 for the three months ended March 31,2005 and $213,000 for the three months ended March 31, 2004.  Intangibles are amortized on a straight-linebasis.

 

Estimated amortization expense for each of the five succeeding calendaryears based on the intangible assets as of December 31, 2004 is as follows inthousands:

 
| **Year ending December 31,** | ** ** | **Amount**                  | ** ** |
|------------------------------|------------|-----------------------------|------------|
| ** **                   | ** ** | **(Dollars in  thousands)** | ** ** |
| 2005                         |       | $                           | 2,851      |   |
| 2006                         |       | 2,459                       |       |
| 2007                         |       | 2,179                       |       |
| 2008                         |       | 2,179                       |       |
| 2009                         |       | 2,179                       |       |
|                              |            |                             |            |  |

 

**8. Investments**

 

The Company has an ownership interest in an unconsolidated andaffiliated company that owns an office building that the Company leases.  For the three months ended March 31, 2005,the Company recorded income of $245,000 for its share of the affiliated company’searnings and received cash distributions of $172,000 from the investment.  For the three months ended March 31, 2004,the Company recorded income of $245,000 and cash distributions of $101,000.

 

10

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**9. Other current liabilities**

 

Other current liabilities consisted of the following:

 
| ** **                                        | ** ** | **March 31,  2005**        | ** ** | **December 31,  2004** | ** ** |
|---------------------------------------------------|------------|----------------------------|------------|------------------------|------------|
| ** **                                        | ** ** | **(Dollars in thousands)** | ** ** |
| Employees stock purchase plan payable             |       | $                          | 344        |                   | $          | 8 |   |
| Amounts due related to IITC and ACT  acquisitions |       | 10,163                     |       | 12,563                 |       |
| Employee benefits payable                         |       | 510                        |       | 376                    |       |
| Payroll taxes payable                             |       | 891                        |       | 602                    |       |
| Income taxes payable                              |       | 1,361                      |       | —                 |       |
| Deferred rent-current portion                     |       | 27                         |       | 31                     |       |
| Capital lease-current portion                     |       | 1                          |       | 2                      |       |
| Other current liabilities                         |       | —                     |       | 24                     |       |
|                                              |       | $                          | 13,297     |                   | $          | 13,606 |   |

 

**10. Other Comprehensive Loss**

 

Other comprehensive loss, consisting of unrealized losses onsecurities, was $26,000 for the three months ended March 31, 2005 and $56,000for the three months ended March 31, 2004.

 

**11. Contingencies**

 

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

 

On September 11, 2003, the Companyinstituted a lawsuit in the United States District Court of Minnesota againstNCS Pearson, Inc. for improperly withholding the payment of funds owed tothe Company under a subcontract. The Company was seeking recovery of$6.3 million in unpaid receivables plus interest and costs. OnNovember 4, 2004, the District Court granted the defendant’s motion tostay the proceedings pending the outcome of dispute resolution procedures amongNCS Pearson, PEC and the Government. The judge stated that NCS Pearson and PECpossessed a commonality of position against the Government and indicated thatadjudication of PEC’s claim was premature at that time. We appealed the stay tothe U.S. Court of Appeals for the Eight Circuit. After the appeal was filed, inDecember 2004, NCS Pearson settled its dispute with the Government, andsubsequently paid the Company approximately $4.1 million. On February 3,2005, the Company filed a motion in the District Court asking the judge to liftthe stay and reopen our case against NCS Pearson.   On April 5, 2005, the District Court vacatedits own November 4, 2004 order and granted our motion to recommenceproceedings.  The Eighth Circuit, onMarch 30, 2005, granted our motion to dismiss our appeal of the November 4,2004 order, without prejudice, for lack of jurisdiction.  On April 5, 2005, the District Court ordereda recommencement of proceedings and vacated its November 4, 2004 order.  A settlement conference before a courtmagistrate is scheduled for June 16, 2005.

 

**12**.  **SubsequentEvents**

 

As described in the Company’s Schedule 14D-9,filed with the SEC on May 3, 2005, PS Merger Sub, Inc., (“Purchaser”)  a Delaware corporation and a wholly-ownedsubsidiary of Nortel Networks Inc., (“Nortel”) a Delaware corporation, hascommenced a tender offer to purchase all of the outstanding shares of Companycommon stock at a purchase price of $15.50 per share, net to the seller incash, without interest thereon, upon the terms and subject to the conditionsset forth in the Offer to Purchase, dated May 3, 2005, and the related Letterof Transmittal.  The tender offer isdescribed in greater detail in the Tender Offer Statement on Schedule TO filedby Nortel and Purchaser with the SEC on May 3, 2005.

 

11

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**Item 2.            Management’sDiscussion and Analysis of Financial Condition and Results of Operations**

 

**Overview**

 

PEC Solutions, Inc. (www.pec.com) is a professional services firmspecializing in high-end solutions that help government clients harness thepower of the Internet and other advanced technologies to improve missionperformance. We specialize in Web-Enabling Government® by providing secure, interoperabletechnology solutions for clients in homeland security, law enforcement,intelligence, defense, and civilian agencies within the Federal Government andat state and local levels.  As a totalsolutions provider, we address the full technology lifecycle, includingformulating technology strategies, creating business solutions, performinglong-term operational management and continuing enhancement of the solution.

 

We derive substantially all of our revenues from fees for consultingservices, primarily from contracts with the Federal Government. We generatethese fees from contracts with various payment arrangements, including time andmaterials contracts, fixed-price contracts and cost-reimbursable contracts.During the three months ended March 31, 2005, revenues from these contracttypes were approximately 69%, 13% and 18%, respectively, of total revenues.During the three months ended March 31, 2004, revenues from these contracttypes were approximately 60%, 19% and 21%, respectively, of total revenues. Wetypically issue invoices monthly to manage outstanding accounts receivablebalances. We recognize revenues on time and materials contracts based on actualhours delivered at the contracted billable hourly rate plus the cost ofmaterials incurred.  We recognizerevenues on fixed-price contracts using the percentage-of-completion methodbased on costs we incurred in relation to total estimated costs. However, ifthe contract has a service element, we recognize revenue for the serviceelement on a straight-line basis over the term of the contract.  We recognize revenues on cost-type contractsto the extent of costs incurred plus a proportionate amount of fee earned.

 

On occasion, we enter into contracts that include the delivery of acombination of two or more of our service offerings.  Typically, such multiple-element arrangementsincorporate the design, development or modification of systems and an ongoingobligation to manage, staff, maintain, host or otherwise run solutions andsystems provided to the client.  Suchcontracts are divided into separate units of accounting and the totalarrangement fee is allocated to each unit based on its relative fairvalue.  Revenue is recognized separately,and in accordance with our revenue recognition policy, for each element.

 

In certain limited circumstances, revenues are recognized beforecontract amendments have been finalized. Prior to agreeing to commence work as directed by a customer and inadvance of the receipt of the written modification or amendment to the existingcontract, the Company requires the completion of an internal memo that assessesthe probability of the modification or amendment being executed in a timelyfashion and the Company’s ability to subsequently collect payment from thecustomer.

 

The fees under certain government contracts may be increased ordecreased in accordance with cost or performance incentive provisions thatmeasure actual performance against established targets or other criteria.  Such incentive fee awards or penalties areincluded in revenue at the time the amounts can be reasonably determined.  Provisions for anticipated contract lossesare 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 newclients. Existing clients from the previous year generated in excess of 99% ofour revenues in the three months ended March 31, 2005.

 

In the three months ended March 31, 2005, we derived approximately 25%of our revenues through relationships with prime contractors, which contractdirectly with the end-client and subcontract with us. In most of theseengagements we retain full responsibility for the end-client relationship anddirect and manage the activities of our contract staff.

 

Our most significant expense is direct costs, which consist primarilyof project personnel salaries and benefits, and direct expenses incurred tocomplete projects. Our direct costs as a percentage of revenues are also relatedto the utilization rate of our consulting personnel. We manage utilization byfrequently monitoring project requirements and timetables. The number ofconsulting personnel assigned to a project will vary according to the size,complexity, duration and demands of the project.   As of March 31, 2005, we had 1,740personnel.

 

General and administrative expenses consist primarily of costsassociated with our executive management, finance and administrative groups,human resources, unassigned consulting personnel, personnel training, occupancycosts, depreciation and amortization, travel and all other branch and corporatecosts.

 

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

 

Investment and other income consists primarily of interest incomeearned on our cash, cash equivalents and marketable securities, and income fromour investment in the limited liability company that owns the corporateheadquarters office building.

 

12

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Interest expense is primarily associated with the corporateheadquarters office building.

 

**Results of Operations**

 

The following table sets forth certain financial data and such data asa percentage of revenues for the periods indicated. The period ended March 31,2005, reflects the acquisitions of IITC and ACT on May 28, 2004, and September9, 2004, respectively.

 
| ** **                                | ** ** | **Three Months Ended**     | ** ** |
|-------------------------------------------|------------|----------------------------|------------|
| ** **                                | ** ** | **March 31,  2005**        | ** ** | **March 31,  2004** | ** ** |
| ** **                                | ** ** | **(Dollars in thousands)** | ** ** |
| Statements of Income:                     |       |                       |       |   |   |
| Revenues                                  |       | $                          | 63,969     |   | $ | 40,369 |   |
| Direct costs                              |       | 41,418                     |       | 24,623 |   |
| Gross profit(a)                           |       | 22,551                     |       | 15,746 |   |
| Other operating costs and  expenses:      |       |                       |       |   |   |
| General and administrative  expenses      |       | 12,453                     |       | 8,495 |   |
| Sales and marketing expenses              |       | 1,540                      |       | 1,127 |   |
| Amortization of intangibles               |       | 713                        |       | 213 |   |
| Total other operating costs and  expenses |       | 14,706                     |       | 9,835 |   |
| Operating income                          |       | 7,845                      |       | 5,911 |   |
| Investment and other income               |       | 529                        |       | 499 |   |
| Interest expense                          |       | (672                       | )          | (667 | ) |
| Income before income taxes                |       | 7,702                      |       | 5,743 |   |
| Provision for income taxes                |       | 3,011                      |       | 2,155 |   |
| Net income                                |       | $                          | 4,691      |   | $ | 3,588 |   |
|                                      |       |                       |       |   |   |
| As a Percentage of Revenues:              |       |                       |       |   |   |
|                                      |       |                       |       |   |   |
| Revenues                                  |       | 100.0                      | %          | 100.0 | % |
| Direct costs                              |       | 64.7                       |       | 61.0 |   |
| Gross profit (a)                          |       | 35.3                       |       | 39.0 |   |
| Other operating costs and  expenses:      |       |                       |       |   |   |
| General and administrative  expenses      |       | 19.5                       |       | 21.0 |   |
| Sales and marketing expenses              |       | 2.4                        |       | 2.8 |   |
| Amortization of intangibles               |       | 1.1                        |       | 0.5 |   |
| Total other operating costs and  expenses |       | 23.0                       |       | 24.3 |   |
| Operating income                          |       | 12.3                       |       | 14.7 |   |
| Investment and other income               |       | 0.8                        |       | 1.2 |   |
| Interest expense                          |       | (1.1                       | )          | (1.7 | ) |
| Income before income taxes                |       | 12.0                       |       | 14.2 |   |
| Provision for income taxes                |       | 4.7                        |       | 5.3 |   |
| Net income                                |       | 7.3                        | %          | 8.9 | % |

 

----

(a)   Grossprofit represents revenues less direct costs, which consist primarily ofproject personnel salaries and benefits and direct expenses incurred tocomplete projects.

 

Our revenues and operating results may be subject to significantvariation from quarter to quarter depending on a number of factors, including theprogress of contracts, revenues earned on contracts, the number of billabledays in a quarter, the timing of the pass-through of other direct costs, thecommencement and completion of contracts during any particular quarter, theschedule of the government agencies for awarding contracts, the term of eachcontract that we have been awarded and general economic conditions. Because asignificant portion of our expenses, such as personnel and facilities costs,are fixed in the short term, successful contract performance and variation inthe volume of activity as well as in the number of contracts commenced orcompleted during any quarter may cause significant variations in operatingresults from quarter to quarter.

 

The Federal Government’s fiscal year ends September 30. If a budget forthe next fiscal year has not been approved by that date, our clients may haveto 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 quarterof the year. Further, a change in presidential administrations and in seniorgovernment officials may negatively affect the rate at which the FederalGovernment purchases technology.

 

13

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

 

**Results of Operations for the Three Months Ended March 31, 2005Compared with the Three Months Ended March 31, 2004**

 

*Revenues*.  Revenues increased by 58.4% to $64.0 million**for the three months ended March 31, 2005, from $40.4million for the three months ended March 31, 2004.  Revenues benefited from the acquisitions ofIITC and ACT during 2004.

 

*Direct Costs.* Directcosts increased by 68.3% to $41.4 million for the three months ended March 31,2005, from $24.6 million for the three months ended March 31, 2004.  Direct costs increased as a percentage ofrevenues to 64.7% for the period ended March 31, 2005, from 61.0% for theperiod ended March 31, 2004.  Thisincrease was principally attributable to the different cost models of IITC andACT.

 

*Gross Profit*. Grossprofit increased by 43.9% to $22.6 million in the three months ended March 31,2005, from $15.7 million in the three months ended March 31, 2004. Gross profitas a percentage of revenues decreased to 35.3% in the three months ended March31, 2005, from 39.0% in the three months ended March 31, 2004, because directcosts increased at a faster rate than revenues.

 

Gross profit was impacted as previously indicated by the difference incost models of our acquired subsidiaries.

 

*General and Administrative Expenses*.General and administrative expenses increased 47.1% to $12.5 million in thethree months ended March 31, 2005, from $8.5 million in the three months endedMarch 31, 2004.  Our total general andadministrative headcount increased to 190 employees as of March 31, 2005,compared to 118 employees as of March 31, 2004. This increase in headcount was principally related to the acquisitionsof IITC and ACT in the second and third quarters, respectively, of 2004.  Retention bonuses related to the acquisitionsof IITC and ACT amounted to approximately $0.5 million in the first quarter of2005, with no such costs in the first quarter of 2004.

 

*Sales and Marketing*.Sales and marketing expenses increased 36.4% to $1.5 million in the threemonths ended March 31, 2005, from $1.1 million in the three months ended March31, 2004.  The increase was principallyrelated to the acquisitions of IITC and ACT in the second and third quarters,respectively, of 2004.

 

*Amortization of Intangibles*.  For the three months ended March 31, 2005, weincurred $0.7 million of amortization expense related to the $18.5 million ofintangibles we recorded in connection with the value of contracts and customerrelationships acquired in the November 2001 acquisition of Troy, the June 2002acquisition of Vector, the May 2004 acquisition of IITC, and the September 2004acquisition of ACT.  This compares to$0.2 million in the first quarter of 2004.

 

*Operating Income*.Operating income increased 32.2% to $7.8 million in the three months endedMarch 31, 2005, from $5.9 million in the three months ended March 31, 2004, dueto the factors discussed above.

 

*Investment and Other Income.*  For the three months ended March 31, 2005, weearned $0.3 million of interest income, and had $0.2 million of income from ourinvestment in our corporate headquarters building.   For the three months ended March 31, 2004,we had $0.3 million of interest income and net losses on sales ofsecurities.  We also had a $0.3 milliongain from the investment in our corporate headquarters building.

 

*Interest Expense. *For each of thethree months ended March 31, 2005 and 2004, we incurred interest expense of$0.7 million, principally related to our corporate headquarters building.

 

14

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**Liquidity and Capital Resources**

 

We currently expect to meet our short-term and long-term cashrequirements through funds generated from operations.  Net cash provided by operating activities was$7.5 million for the three months ended March 31, 2005. Cash provided byoperating activities is primarily driven by net income, adjusted for workingcapital changes, which are principally changes in accounts receivable.

 

Net cash used by investing activities was $0.4 million for the threemonths ended March 31, 2005. During the three months ended March 31, 2005, wehad $0.1 million of net purchases of property and equipment, $0.2 million ofnet short-term investments, and invested $0.3 million in capitalized software,while receiving $0.2 million of distributions from the investment in the entitythat owns our headquarters building. Investing activity is primarily driven by investments in short andlong-term securities.

 

For the three months ended March 31, 2005, net cash provided byfinancing activities was $0.1 million and was primarily derived from paymentsreceived from employees in connection with the exercise of stock options.

 

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

 

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 ofMarch 31, 2005, we had no borrowings outstanding under the line of credit. Asof March 31, 2005, we had outstanding $2.2 million in letters of credit in lieuof rent deposits.

 

Under some of our fixed-price contracts, we receive advance paymentsfor work to be performed in future months. If we do not perform the work, theunearned portion of these advances will be returned to our clients. At March31, 2005, our accounts receivable turnover rate, net of advance payments oncontracts, was approximately four times a year.

 

**Recent Accounting Pronouncements**

 

In December 2004, the FASB also issuedStatement No. 123(Revised) “Share-Based Payment.” This Statementestablishes standards for the accounting for transactions in which an entityexchanges its equity instruments for goods or services. It also addressestransactions in which an entity incurs liabilities in exchange for goods orservices that are based on the fair value of the entity’s equity instruments orthat may be settled by the issuance of those equity instruments. This Statementrequires a public entity to measure the cost of employee services received inexchange for an award of equity instruments based on the grant-date fair valueof the award (with limited exceptions). That cost will be recognized over theperiod during which an employee is required to provide service in exchange forthe award—the requisite service period (usually the vesting period). Nocompensation cost is recognized for equity instruments for which employees donot render the requisite service. A public entity will initially measure thecost of employee services received in exchange for an award of liabilityinstruments based on its current fair value; the fair value of that award willbe re-measured subsequently at each reporting date through the settlement date.Changes in fair value during the requisite service period will be recognized ascompensation cost over that period. Statement No. 123R (“SFAS 123R”)is effective as of the beginning of the first annual reporting period thatbegins after June 15, 2005. In anticipation of the implementation ofSFAS 123R, the Company accelerated the vesting of all out-of-the-moneystock options as of February 25, 2005, therefore these options will not beexpensed in future periods. It was estimated that this would reduce the amountof compensation expenses that the Company would otherwise have been obligatedto recognize in connection with these options by approximately $8.4 millionbefore taxes.

 

15

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**SPECIAL NOTE REGARDING FORWARD LOOKINGSTATEMENTS**

 

The foregoing Management’s Discussion and Analysis of FinancialCondition and Results of Operations section of this Form 10-Q includes “forward-lookingstatements” within the meaning of the Federal Private Securities LitigationReform Act of 1995. While forward-looking statements are sometimes presentedwith numerical specificity, they are based on various assumptions made bymanagement regarding future circumstances over many of which we have little orno control. Forward-looking statements may be identified by words including “anticipate,”“believe,” “estimate,” “expect” and similar expressions. We caution readersthat forward-looking statements, including without limitation, those relatingto our future business prospects, revenues, working capital, liquidity, andincome, are subject to certain risks and uncertainties that would cause actualresults to differ materially from those indicated in the forward-lookingstatements. Factors that could cause actual results to differ fromforward-looking statements include the concentration of our revenues fromgovernment clients, risks involved in contracting with the U.S. Government andwith state and local governments, difficulties we may have in attracting,retaining and managing professional and administrative staff, fluctuations inquarterly results, risks related to acquisitions, risks related to competitionand our ability to continue to win and perform efficiently on contracts, andother risks and factors identified from time to time in our reports filed withthe SEC, including those identified under the section entitled “Risk Factors”in our Annual Report on Form 10-K/A for the year ended December 31, 2004 whichhereby is incorporated by reference. Should one or more of these risks oruncertainties materialize, or should underlying assumptions prove incorrect,actual results may vary materially from those anticipated, estimated orprojected.

 

**Item 3.            Qualitativeand Quantitative Disclosure About Market Risk**

 

We invest our cash in a variety of financial instruments, includingU.S. Treasury and agency obligations, money market instruments of domestic andforeign issuers denominated in U.S. dollars consisting of commercial paper,bankers’ acceptances, certificates of deposit, euro-dollar time deposits andvariable 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 earninginstruments carry a degree of interest rate risk. Fixed securities may havetheir fair market value adversely impacted because of a rise in interest rates,while floating rate securities may produce less income than expected ifinterest rates fall. Due in part to these factors, our future investment incomemay fall short of expectations because of changes in interest rates or we maysuffer losses in principal if we are forced to sell securities which have seena decline in market value because of changes in interest rates.  A 10% change in interest rates could haveapproximately a $70,000 impact on our interest income.

 

16

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

 

## **Item4.            Controls and Procedures**

## ** **

Our management under the direction and with the participation of DavidC. Karlgaard, our Chief Executive Officer, and Stuart R. Lloyd, our ChiefFinancial Officer, performed an evaluation of the design and operation of ourdisclosure controls and procedures (as defined in Rule 13a-15 under theSecurities Exchange Act of 1934).  Basedon that evaluation, Messrs. Karlgaard and Lloyd concluded that as of March 31,2005, our disclosure controls and procedures are effective.  There have been no changes in our internalcontrols or in other factors that could significantly affect internal controlssubsequent to their evaluation.

 

**PART II – OTHER INFORMATION**

 

**Item 1.            LegalProceedings**

 

On September 11, 2003, the Companyinstituted a lawsuit in the United States District Court of Minnesota againstNCS Pearson, Inc. for improperly withholding the payment of funds owed tothe Company under a subcontract. The Company was seeking recovery of$6.3 million in unpaid receivables plus interest and costs. OnNovember 4, 2004, the District Court granted the defendant’s motion tostay the proceedings pending the outcome of dispute resolution procedures amongNCS Pearson, PEC and the Government. The judge stated that NCS Pearson and PECpossessed a commonality of position against the Government and indicated thatadjudication of PEC’s claim was premature at that time. We appealed the stay tothe U.S. Court of Appeals for the Eight Circuit. After the appeal was filed, inDecember 2004, NCS Pearson settled its dispute with the Government, andsubsequently paid the Company approximately $4.1 million. OnFebruary 3, 2005, the Company filed a motion in the District Court askingthe judge to lift the stay and reopen our case against NCS Pearson. On April 5,2005, the District Court vacated its own November 4, 2004 order and granted ourmotion to recommence proceedings.  TheEighth Circuit, on March 30, 2005, granted our motion to dismiss our appeal ofthe November 4, 2004 order, without prejudice, for lack of jurisdiction.  On April 5, 2005, the District Court ordereda recommencement of proceedings and vacated its November 4, 2004 order.  A settlement conference before a courtmagistrate is scheduled for June 16, 2005.

 

**Item 2.            Changesin Securities and Use of Proceeds**

 

None.

 

**Item 3.            Defaults Upon Senior Securities**

 

None.

 

**Item 4.            Submission of Matters to a Voteof Security Holders**

 

None.

 

**Item 5.            OtherInformation**

 

As described in the Company’s Schedule 14D-9,filed with the SEC on May 3, 2005, PS Merger Sub, Inc., (“Purchaser”) aDelaware corporation and a wholly-owned subsidiary of Nortel Networks Inc., (“Nortel”)a Delaware corporation, has commenced a tender offer to purchase all of theoutstanding shares of Company common stock at a purchase price of $15.50 pershare, net to the seller in cash, without interest thereon, upon the terms andsubject to the conditions set forth in the Offer to Purchase, dated May 3,2005, and the related Letter of Transmittal. The tender offer is described in greater detail in the Tender OfferStatement on Schedule TO filed by Nortel and Purchaser with the SEC on May 3,2005.

 

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** **

**Item 6.    Exhibits**

 

(a)   Exhibits

 
| **Number** | ** ** | **Exhibit Description**                                                                                                                                                                                                                                                                                                        |
|------------|------------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|       |       |                                                                                                                                                                                                                                                                                                                           |
| 3.1*       |       | Certificate of Incorporation                                                                                                                                                                                                                                                                                                   |
|       |       |                                                                                                                                                                                                                                                                                                                           |
| 3.2*       |       | By-Laws                                                                                                                                                                                                                                                                                                                        |
|       |       |                                                                                                                                                                                                                                                                                                                           |
| 10.1**     |       | Agreement  and Plan of Merger, dated April 25, 2005, by and among Nortel Networks  Inc., PS Merger Sub, Inc. and the Company                                                                                                                                                                                         |
|       |       |                                                                                                                                                                                                                                                                                                                           |
| 10.2**     |       | Stockholder  Agreement, dated April 25, 2005, by and among Nortel Nortel Networks  Inc., PS Merger Sub, Inc., and David C. Karlgaard, the David C.  Karlgaard Revocable Trust, the David C. Karlgaard and Marilyn E. Karlgaard  Trust, the Karlgaard Family Foundation and the Karlgaard Charitable Remainder  Trust |
|       |       |                                                                                                                                                                                                                                                                                                                           |
| 10.3**     |       | Non-Competition  and Commitment Agreement dated April 25, 2005, by and between the  Company and David C. Karlgaard                                                                                                                                                                                                        |
|       |       |                                                                                                                                                                                                                                                                                                                           |
| 10.4*      |       | Employment Agreement between the Company  and David C. Karlgaard, dated January 1, 2000                                                                                                                                                                                                                                        |
|       |       |                                                                                                                                                                                                                                                                                                                           |
| 10.5***    |       | Key Executive Severance Plan and Letter  Agreement between the Company and David C. Karlgaard, dated July 23, 2003                                                                                                                                                                                                             |
|       |       |                                                                                                                                                                                                                                                                                                                           |
| 10.6**     |       | Stockholder  Agreement, dated April 25, 2005, by and among Nortel Nortel Networks  Inc., PS Merger Sub, Inc., and Paul G. Rice, the Paul G. Rice Grantor  Retained Annuity Trust, and the Rice Family Foundation                                                                                                     |
|       |       |                                                                                                                                                                                                                                                                                                                           |
| 10.7**     |       | Non-Competition  and Commitment Agreement dated April 25, 2005, by and between PEC  Solutions, Inc. and Paul G. Rice                                                                                                                                                                                                      |
|       |       |                                                                                                                                                                                                                                                                                                                           |
| 10.8*      |       | Employment Agreement between the Company  and Paul G. Rice, dated January 1, 2000                                                                                                                                                                                                                                              |
|       |       |                                                                                                                                                                                                                                                                                                                           |
| 10.9***    |       | Key Executive Severance Plan and Letter  Agreement between the Company and Paul G. Rice, dated July 23, 2003                                                                                                                                                                                                                   |
|       |       |                                                                                                                                                                                                                                                                                                                           |
| 10.10**    |       | Stockholder  Agreement, dated April 25, 2005, by and among Nortel Nortel Networks  Inc., PS Merger Sub, Inc., and Alan H. Harbitter, the Harbitter CRUT DTD  10 15 01, the Harbitter Family Foundation, and the Alan Harris Harbitter and  Lisa Jan Harbitter Grantor Retained Annuity Trust                         |
|       |       |                                                                                                                                                                                                                                                                                                                           |
| 10.11**    |       | Non-Competition  and Commitment Agreement dated April 25, 2005, by and between PEC  Solutions, Inc. and Alan H. Harbitter                                                                                                                                                                                                 |
|       |       |                                                                                                                                                                                                                                                                                                                           |
| 10.12*     |       | Employment Agreement between the Company  and Alan H. Harbitter, dated January 1, 2000                                                                                                                                                                                                                                         |
|       |       |                                                                                                                                                                                                                                                                                                                           |
| 10.13***   |       | Key Executive Severance Plan and Letter  Agreement between the Company and Alan H. Harbitter, dated July 23, 2003                                                                                                                                                                                                              |
|       |       |                                                                                                                                                                                                                                                                                                                           |
| 10.14*     |       | Employment Agreement between the Company  and Stuart R. Lloyd, dated December 31, 1998, as amended September 30,  2003***                                                                                                                                                                                                      |
|       |       |                                                                                                                                                                                                                                                                                                                           |
| 10.15***   |       | Key Executive Severance Plan and Letter  Agreement between Company and Christos Bratiotis, dated July 23, 2003                                                                                                                                                                                                                 |
|       |       |                                                                                                                                                                                                                                                                                                                           |
| 10.16      |       | Key Executive Severance Plan and Letter  Agreement between Company and Robert L. Veschi, dated April 4, 2005                                                                                                                                                                                                                   |
|       |       |                                                                                                                                                                                                                                                                                                                           |
| 10.17*     |       | 2000 Stock Incentive Plan                                                                                                                                                                                                                                                                                                      |
|       |       |                                                                                                                                                                                                                                                                                                                           |
| 10.18*     |       | 2000 Employee Stock Purchase Plan                                                                                                                                                                                                                                                                                              |
|       |       |                                                                                                                                                                                                                                                                                                                           |
| 10.19*     |       | Nonqualified Executive Supplemental  Retirement Program Agreement dated December 1998                                                                                                                                                                                                                                          |
|       |       |                                                                                                                                                                                                                                                                                                                           |
| 10.20*     |       | 1995 Nonqualified Stock Option Plan                                                                                                                                                                                                                                                                                            |

 

18

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| 10.21*      |   | 1987 Stock Option Agreement, as amended                                                                                                                                                    |
|-------------|--------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|        |   |                                                                                                                                                                                       |
| 10.22*****  |   | Amended and Restated Bank of America  Revolving Credit Note                                                                                                                                |
|        |   |                                                                                                                                                                                       |
| 10.25*****  |   | Amended and Restated Bank of America  Financing and Security Agreement                                                                                                                     |
|        |   |                                                                                                                                                                                       |
| 10.26****   |   | Amended and Restated Operating Agreement of  Building VII Associates L.C., by and among Building VII Investment, L.C., PEC  Solutions, Inc. and Building VII, Inc. dated December 12, 2002 |
|        |   |                                                                                                                                                                                       |
| 10.27****** |   | Office Lease Agreement between the Company  and Building VII Associates L.C., dated February 5, 2001, as amended****                                                                       |
|        |   |                                                                                                                                                                                       |
| 10.28*      |   | Office Lease Agreement between Building V  Associates L.P. and the Company, dated April 1, 1998                                                                                            |
|        |   |                                                                                                                                                                                       |
| 10.29*      |   | Office Lease Agreement between Building IV  Associates L.P. and the Company, dated May 17, 1999, as amended******                                                                          |
|        |   |                                                                                                                                                                                       |
| 31.1        |   | Section 302 Certification of Chief  Executive Officer                                                                                                                                      |
|        |   |                                                                                                                                                                                       |
| 31.2        |   | Section 302 Certification of Chief  Financial Officer                                                                                                                                      |
|        |   |                                                                                                                                                                                       |
| 32.1        |   | Section 906 Certification of Chief  Executive Officer                                                                                                                                      |
|        |   |                                                                                                                                                                                       |
| 32.2        |   | Section 906 Certification of Chief  Financial Officer                                                                                                                                      |
|        |   |                                                                                                                                                                                       |

 

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| *      |   | Filed as an exhibit to the Company’s Registration Statement on Form  S-1 (No. 333-95331), as amended, and incorporated by reference herein.                                                  |
|--------|--------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                                                              |
| **     |   | Filed as an exhibit to the Company’s Current Report on Form 8-K,  filed with the SEC on April 29, 2005 and incorporated by reference herein.                                                 |
|   |   |                                                                                                                                                                                              |
| ***    |   | Filed as an exhibit to the Company’s Quarterly Report on Form 10-Q  for the quarter ended September 30, 2003, filed with the SEC on November 14,  2003 and incorporated by reference herein. |
|   |   |                                                                                                                                                                                              |
| ****   |   | Filed as an exhibit to the Company’s Quarterly Report on Form 10-Q  for the quarter ended June 30, 2001, filed with the SEC on August 13, 2001  and incorporated by reference herein.        |
|   |   |                                                                                                                                                                                              |
| *****  |   | Filed as an exhibit to the Company’s Quarterly Report on Form 10-Q  for the quarter ended June 30, 2003, filed with the SEC on August 14, 2003  and incorporated by reference herein.        |
|   |   |                                                                                                                                                                                              |
| ****** |   | Filed as an exhibit to the Company’s Annual Report on Form 10-K/A for  the year ended December 31, 2000, filed with the SEC on April 19, 2001 and  incorporated by reference herein.         |

 

19

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**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 theundersigned thereunto duly authorized.

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

 

May 6, 2005

 

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