**UNITED STATES****SECURITIES ANDEXCHANGE COMMISSION**

 

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

 

**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 SEPTEMBER 30, 2003** |
|                                               |   |
| **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 REGISTRANTAS SPECIFIED IN ITS CHARTER)

 

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

 

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

 

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

 

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

 

 

----

 

**PECSOLUTIONS, INC.**

**QUARTERLYREPORT ON FORM 10-Q FOR THE NINE MONTHS ENDED SEPTEMBER 30, 2003**

 

**TABLE OFCONTENTS**

 
| PART I.  FINANCIAL INFORMATION                                                                 |
|-----------------------------------------------------------------------------------------------------|
| Item 1. Financial Statements:                                                                       |
| Consolidated Balance Sheets - September 30, 2003 and  December 31, 2002                   |
| Consolidated Statements of Income - Three  and nine months ended September 30, 2003 and 2002   |
| Consolidated Statements of Cash Flows —  Nine months ended September 30, 2003 and 2002    |
| Notes to Consolidated Financial Statements                                                          |
| Item 2. Management’s Discussion and  Analysis of Financial Condition and Results of Operations |
| Item 3. Qualitative and Quantitative Disclosure  about Market Risk                                  |
| PART II. OTHER INFORMATION                                                                          |
| Items 1 – 6                                                                                    |
| Signatures                                                                                          |

 

2

----

 

**PART I: FINANCIAL INFORMATION**

 

**ITEM 1: FINANCIAL STATEMENTS**

 

**PECSOLUTIONS, INC.**

**CONSOLIDATED BALANCE SHEETS**

**(DOLLARSIN THOUSANDS)**

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

 

See notes to consolidatedfinancial statements.

 

3

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**PECSOLUTIONS, INC.**

**CONSOLIDATED STATEMENTS OF INCOME**

**(AMOUNTSIN THOUSANDS, EXCEPT PER SHARE DATA)**

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

 

See notes to consolidatedfinancial statements.

 

4

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**PECSOLUTIONS, INC.**

**CONSOLIDATEDSTATEMENTS OF CASH FLOWS**

**(DOLLARSIN THOUSANDS)**

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

 

See notes to consolidatedfinancial statements.

 

5

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**PECSOLUTIONS, INC.**

**NOTES TOCONSOLIDATED FINANCIAL STATEMENTS**

**SEPTEMBER 30,2003**

**(UNAUDITED)**

**1. Financial Statements**

 

The accompanying consolidated financialstatements, except for the December 31, 2002 balance sheet, are unauditedand have been prepared in accordance with accounting standards generallyaccepted in the United States for interim financial information and theinstructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, certaininformation and footnote disclosures normally included in financial statementsprepared in accordance with accounting principles generally in the UnitedStates have been omitted. In the opinion of management, all adjustments,consisting of normally recurring accruals, considered necessary for a fairpresentation, have been included. It is suggested that these condensedfinancial statements be read in conjunction with the Company’s auditedfinancial statements as of December 31, 2001 and 2002 and for each of thethree years in the period ended December 31, 2002 included in theCompany’s 2002 Form 10-K/A, as filed with the Securities and ExchangeCommission. The results of operations for the nine months endedSeptember 30, 2003, are not necessarily indicative of the operatingresults to be expected for the full year.

 

**2.Stock-based Compensation**

 

In December 2002, the FASB issued SFASNo. 148, “Accounting for Stock-Based Compensation—Transition andDisclosure, an amendment of FASB Statement No. 123.” SFAS No. 148provides alternative methods of transition for a voluntary change to the fairmarket value based method of accounting for stock-based compensation. TheCompany does not presently expect to make such a voluntary 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 disclosurerequirements are applicable for financial statements issued for interim periodsbeginning after December 15, 2002, and have been included below.

 

The Company uses the Black-Scholesoption-pricing model to determine the pro forma impact under SFAS No. 123to the Company’s net income and earnings per share. The model utilizes certaininformation, such as the interest rate on a risk-free security maturinggenerally at the same time as the option being valued, and requires certainassumptions, such as the expected amount of time an option will be outstandinguntil it is exercised or it expires, to calculate the fair value of stockoptions granted.

 

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

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

 

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

 

6

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The following table illustrates the effect onnet income and earnings per share if the Company had applied the fair valuerecognition provisions of SFAS No. 123 to its stock option and stockpurchase plans:

 

|                                        |   | **FOR THE THREE MONTHS ENDED**                    |          | **FOR THE NINE MONTHS ENDED** |   |
|---------------------------------------------|--------|---------------------------------------------------|---------------|-------------------------------|--------|
|                                        |   | **SEPTEMBER 30,  2003**                      |          | **SEPTEMBER 30,  2002**  |   | **SEPTEMBER 30,  2003** |   | **SEPTEMBER 30,  2002** |   |
|                                        |   | **(In thousands, except for per share  amounts)** |          |
| Net income, as  reported                    |   | $                                                 | 4,442         |                          | $      | 7,402 |   | $ | 12,570 |   | $ | 16,293 |   |
| Pro forma  compensation expense, net of tax |   | (1,056                                            | )             | (921                          | )      | (3,449 | ) | (1,956 | ) |
|                                        |   |                                              |          |                          |   |   |   |   |   |
| Pro forma net  income                       |   | $                                                 |  

3,386 |                          | $      | 6,481 |   | $ | 9,121 |   | $ | 14,336 |   |
|                                        |   |                                              |          |                          |   |   |   |   |   |
| Net income per  share:                      |   |                                              |          |                          |   |   |   |   |   |
| Basic—as  reported                     |   | $                                                 | 0.16          |                          | $      | 0.28 |   | $ | 0.46 |   | $ | 0.62 |   |
| Basic—pro forma                        |   | $                                                 | 0.12          |                          | $      | 0.24 |   | $ | 0.34 |   | $ | 0.55 |   |
| Diluted—as  reported                   |   | $                                                 | 0.15          |                          | $      | 0.25 |   | $ | 0.42 |   | $ | 0.56 |   |
| Diluted—pro  forma                     |   | $                                                 | 0.11          |                          | $      | 0.22 |   | $ | 0.31 |   | $ | 0.49 |   |

 

**3. Accounts Receivable**

 

Accounts receivable consist of the followingas of:

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

 

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

 

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

 

**4. Net Income Per Share**

 

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

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

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

 

7

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**5. Goodwill and Intangible Assets**

 

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

 

Intangibles are amortized on a straight-linebasis.  Estimated annual amortizationexpense for each of the five following calendar years is as follows:

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

 

**6. Investments**

 

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

 

**7.  Other Comprehensive Gain (Loss)**

 

Othercomprehensive gain (loss), consisting of unrealized gains (losses) oninvestment securities was $1,000 and $(103,000), respectively, for the threemonths and nine months ended September 30, 2003, and $5,000 and  $(121,000), respectively, for the threemonths and nine months ended September 30, 2002.

 

**8.  Contingencies**

                                                

The Company is party to certain litigation and other legal proceedingsarising in the ordinary course of business. In the opinion of management, the outcome of such legal matters will nothave a material adverse effect on the Company’s results of operations orfinancial condition.

 

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

 

**9. Recent Pronouncements**

 

InNovember 2002, the FASB’s Emerging Issues Task Force, or EITF, finalizedEITF Issue 00-21, *Revenue Arrangements withMultiple Deliverables*. EITF 00-21 addresses how to determine whetheran arrangement involving multiple deliverables contains more than one unit ofaccounting. It also addresses how arrangement consideration should be measuredand allocated to the separate units of accounting in an arrangement. EITF 00-21does not apply to deliverables in arrangements to the extent the accounting forsuch deliverables are within the scope of other existing higher-levelauthoritative accounting literature. The Company adopted the provisions of EITF00-21 for new contracts entered into on or after July 1, 2003 with nomaterial impact on its financial position, results of operations or cash flows.

 

8

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

 

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

 

OnMay 31, 2003, the Financial Accounting Standards Board (FASB) issued FASBStatement No. 150 (FAS 150), *Accounting forCertain Financial Instruments with Characteristics of both Liabilities andEquity*.  FAS 150 improves theaccounting for certain financial instruments that, under previous guidance,issuers could account for as equity and requires that those instruments beclassified as liabilities (or assets in certain circumstances) in statements offinancial position.  FAS 150 alsorequires disclosures about alternative ways of settling the instruments and thecapital structure of entities—all of whose shares are mandatorily redeemable.FAS 150 is generally effective for all financial instruments entered into ormodified after May 31, 2003, and otherwise is effective at the beginningof the first interim period beginning after September 15, 2003.  The adoption of FAS 150 will not have anyimpact on the Company’s financial statements.

 

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

 

**OVERVIEW**

 

PEC Solutions is a professional services firmspecializing in high-end solutions that help government organizationscapitalize on the Internet and other advanced technologies. We migratepaper-intensive procedures to web-enabled processes using eGovernment solutionsthat help our clients enhance their productivity and improve the services theyoffer to the public. As a total solutions provider, we address the fulltechnology lifecycle, including formulating technology strategies, creatingbusiness solutions, performing long-term operational management and continuingenhancement of the solution.

 

We derive substantially all of our revenuesfrom fees for consulting services. We generate these fees from various types ofcontracts, including time and materials contracts, fixed-price contracts andcost-reimbursable contracts. During the three months and nine months endedSeptember 30, 2003, revenues from these contract types were approximately57%, 26% and 17%, and 57%, 24% and 19% respectively, of total revenues. Wetypically issue invoices monthly to manage outstanding accounts receivablebalances. We recognize revenues on time and materials contracts as the servicesare provided. We recognize revenues on fixed-price contracts using thepercentage of completion method as services are performed over the life of thecontract, based on the costs we incur in relation to the total estimated costs.We recognize and make provisions for any anticipated contract losses at thetime we know and can estimate them. Fixed-price contracts are attractive toclients and, while subject to increased risks, provide opportunities forincreased margins. We recognize revenues on cost-reimbursable contracts asservices are provided. These revenues are equal to the costs incurred in  providing these services plus aproportionate amount of the fee earned. We have historically recovered all ofour costs on cost-reimbursable contracts, which means we have lower risk and ourmargins are lower on these contracts.

 

Our historical revenue growth is attributableto various factors, including an increase in the size and number of projectsfor existing and new clients. Existing clients from the previous year generatedapproximately 93% and 94% of our revenues in the three months and nine monthsended September 30, 2003. As of September 30, 2003, we had 1,226personnel.

 

In the three months and nine months endedSeptember 30, 2003, we derived approximately 20% and 23%, respectively, ofour revenues through relationships with prime contractors, who 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 primarily of project personnel salaries and benefits, and directexpenses incurred to complete projects. Our direct costs as a percentage ofrevenues are also related to the utilization rate of our consulting personnel.We manage utilization by frequently monitoring project requirements andtimetables. The number of consulting personnel assigned to a project will varyaccording to the size, complexity, duration and demands of the project.

 

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

 

Sales and marketing expenses include thecosts of sales and marketing personnel and costs associated with marketing andbidding on future projects.

 

Investment and other income consist primarilyof interest income earned on our cash, cash equivalents and marketablesecurities, as well as, income from the investment in our corporateheadquarters building.

 

Interest expense is primarily related to thecorporate headquarters building.

 

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**Results of Operations**

 

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

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

 

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(a)  Gross profit representsrevenues less direct costs, which consist primarily of project personnelsalaries and benefits and direct expenses incurred to complete projects.

 

**RESULTS OF OPERATIONS FOR THE THREE MONTHSENDED SEPTEMBER 30, 2003 COMPARED WITH THE THREE MONTHS ENDEDSEPTEMBER 30, 2002**

 

REVENUES. For the three months endedSeptember 30, 2003, our total revenues decreased by 18.1%, or $9.5 millionover the same period last year. Services to new clients represent approximately 7% of revenues.  Revenues were adversely impacted by the latepassage and signing of the 2003 Federal civilian agency budgets.  We also saw a reduction in revenue from theEDS (Navy Marine Corps Intranet) contract during the current period versus lastyear, as the program went from its initial engineering phase into a productionphase.  In addition, during the thirdquarter 2002 we received quick response orders in the amount of $13.1 millionfor our mobile biometric solutions related to the hiring of airport securitypersonnel.

 

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

 

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

 

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

 

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

 

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

 

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

 

INTEREST EXPENSE.   For the three months ended September 30, 2003, we incurredinterest expense of $664,000 principally related to our corporate headquartersbuilding.  For the three months endedSeptember 30, 2002, we incurred $1,000 of interest expense, there was nointerest expense related to the corporate headquarters building during thisperiod of time.

 

OPERATING INCOME. Operating income decreased39.3% to $7.3 million in the three months ended September 30, 2003 from$11.9 million in the three months ended September 30, 2002. This decreasewas due primarily to the concentration of the quick response for our mobilebiometric solutions related to the hiring of airport security personnel in thethird quarter of 2002.

 

**RESULTS OF OPERATIONS FOR THE NINE MONTHSENDED SEPTEMBER 30, 2003 COMPARED WITH THE NINE MONTHS ENDEDSEPTEMBER 30, 2002**

 

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

 

DIRECT COSTS. For the nine months endedSeptember 30, 2003, direct costs decreased by 0.4%, or $300,000, over thesame period last year.  Direct costsincreased as a percentage of revenues for the period ended September 30,2003, to 59.9% as compared to 58.9% in the same period last year, primarily dueto the delays related to the passage and signing of the Federal civilian agencybudgets and the associated lack of new project startups during thisperiod.  New project startups increaserevenues and allow for the recovery of increases in labor costs, which for usgo into effect January 1st of each year.  The increase also was impacted by lowerlabor utilization, which was related to the concentration of the quick responsefor our mobile solutions related to the hiring of airport security personnel in2002.

 

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

 

GENERAL AND ADMINISTRATIVE EXPENSES. Generaland administrative expenses increased 9.3% to $27.0 million in the nine monthsended September 30, 2003 from $24.7 million in the nine months endedSeptember 30, 2002. Facility costs increased in the current period overlast year due to the opening of new headquarters office in Fairfax, Virginiaand an office in Washington, D.C.  Ourtotal general and administrative headcount was 115 employees as ofSeptember 30, 2003 compared to 126 employees as of September 30,2002.

 

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SALES AND MARKETING. Sales and marketingexpenses increased 2.0% to $4.3 million in the nine months endedSeptember 30, 2003 from $4.2 million in the nine months endedSeptember 30, 2002. This increase was due to a modest increase in ourmarketing efforts.

 

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

 

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

 

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

 

OPERATING INCOME. Operating income decreased19.6% to $20.6 million in the nine months ended September 30, 2002 from$25.6 million in the nine months ended September 30, 2002, due to thefactors discussed above, including the late passage and signing of the 2003Federal civilian agency budgets and the concentration of the quick response forour mobile biometric solutions related to the hiring of airport personnel in2002.

 

Our revenues and operating results may besubject to significant variation from quarter to quarter depending on a numberof factors, including the progress of contracts, revenues earned on contracts,the number of billable days in a quarter, the timing of the pass-through ofother direct costs, the commencement and completion of contracts during anyparticular quarter, the schedule of the government agencies for awardingcontracts, the term of each contract that we have been awarded and generaleconomic conditions. Because a significant portion of our expenses, such aspersonnel and facilities costs, are fixed in the short term, successfulcontract performance and variation in the volume of activity as well as in thenumber of contracts commenced or completed during any quarter may causesignificant variations in operating results from quarter to quarter.

 

The federal government’s fiscal year endsSeptember 30. If a budget for the next fiscal year has not been approvedby that date, our clients may have to suspend engagements that we are workingon until a budget has been approved. Such suspensions may cause us to realizelower revenues until these engagements are reinstated or new engagements areawarded.  Further, a change inPresidential administrations and in senior government officials may affect therate at which the federal government purchases technology, although we have notseen an impact with the 2001 change in administration.

 

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

 

**Liquidityand Capital Resources**

 

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

 

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

 

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

 

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

 

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

 

Under some of our fixed-price contracts, wereceive advance payments for work to be performed in future months. If we donot perform the work, the unearned portion of these advances will be returnedto our clients. At September 30, 2003, our accounts receivable turnoverrate, net of advance payments on contracts, was approximately four times peryear.

 

**RecentAccounting Pronouncements**

 

In November 2002, the FASB’s Emerging Issues Task Force, or EITF,finalized EITF Issue 00-21, *RevenueArrangements with Multiple Deliverables*. EITF 00-21 addresses how todetermine whether an arrangement involving multiple deliverables contains morethan one unit of accounting. It also addresses how arrangement considerationshould be measured and allocated to the separate units of accounting in anarrangement. EITF 00-21 does not apply to deliverables in arrangements to theextent the accounting for such deliverables are within the scope of otherexisting higher-level authoritative accounting literature. We adopted theprovisions of EITF 00-21 for new contracts entered into on or after July 1,2003 with no material impact on our financial position, results of operationsor cash flows.

 

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

 

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

 

OnMay 31, 2003, the Financial Accounting Standards Board (FASB) issued FASBStatement No. 150 (FAS 150), *Accounting forCertain Financial Instruments with Characteristics of both Liabilities andEquity*.  FAS 150 improves theaccounting for certain financial instruments that, under previous guidance,issuers could account for as equity and requires that those instruments beclassified as liabilities (or assets in certain circumstances) in statements offinancial position.  FAS 150 alsorequires disclosures about alternative ways of settling the instruments and thecapital structure of entities—all of whose shares are mandatorily redeemable.FAS 150 is generally effective for all financial instruments entered into ormodified after May 31, 2003, and otherwise is effective at the beginningof the first interim period beginning after September 15, 2003.  The adoption of FAS 150 will not have anyimpact on our financial statements.

 

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**SPECIALNOTE REGARDING FORWARD LOOKING STATEMENTS**

 

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

 

**ITEM 3.QUALITATIVE AND QUANTITATIVE DISCLOSURE ABOUT MARKET RISK**

 

We invest our cash in a variety of financialinstruments, including U.S. Treasury and Agency obligations, money marketinstruments of domestic and foreign issuers denominated in U.S. dollars ofcommercial paper, bankers’ acceptances, certificates of deposit, euro-dollartime deposits and variable rate issues, corporate note and bonds, asset-backedsecurities, repurchase agreements, municipal notes and bonds and auction ratepreferred securities.

 

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

 

Our investments are made in accordance withan investment policy approved by the Board of Directors. Under this policy, noinvestment securities can have maturities exceeding two years and the averageduration of the portfolio cannot exceed twelve months.

 

**ITEM  4. Controls and Procedures**

 

Ourmanagement, under the supervision and with the participation of David C.Karlgaard, our Chief Executive Officer, and Stuart R. Lloyd, our ChiefFinancial Officer, performed an evaluation of the effectiveness of the designand operation of our disclosure controls and procedures as of the end thequarter covered by this report.  Basedon that evaluation, Messrs. Karlgaard and Lloyd concluded that our disclosurecontrols and procedures were effective. There have been no significant changes in our internal controls or inother factors that could significantly affect internal controls subsequent totheir evaluation.

 

15

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**PART II – OTHER INFORMATION**

 

**ITEM 1.LEGAL PROCEEDINGS**

 

On or afterMarch 18, 2003, several purported class action complaints were filedagainst us and certain of our officers in the United States District Court forthe Eastern District of Virginia.  Thecomplaints allege that between October 22, 2002 and March 14, 2003,the defendants made, or were aware of false and misleading statements which hadthe effect of inflating the market price of our stock, in violation of Sections10(b) and 20(a) of the Securities Exchange Act of 1934.  The complaints were consolidated into asingle action on June 13, 2003. The consolidated complaint does not specify the amount of damagessought.  On September 8, 2003, theCompany filed a motion to dismiss the consolidated complaint.  We believe that the plaintiffs’ claims arewithout merit, and we intend to defend the cases vigorously.  In addition, a stockholder’s legal counselsent a letter of demand that the Board of Directors investigate the samecharges addressed in the class actions suits. The Board is addressing this request.

 

**ITEM 2. CHANGES IN SECURITIES AND USE OFPROCEEDS**

 

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

 

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

 

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

 

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

 

**ITEM 3. DEFAULTS UPON SENIOR SECURITIES**

 

None

 

**ITEM 4. SUBMISSION OF MATTERS TO VOTE OFSECURITY HOLDERS**

 

None

 

 

**ITEM 5. OTHER INFORMATION**

 

None

 

16

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**ITEM 6 (A) EXHIBITS**

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

 

17

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

 

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

 

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

 

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

 

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

 

***********  **Incorporatedherein by reference to the Company’s Quarterly Report Form 10Q/A filed onMay 14, 2003.

 

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

 

(b) None

 

18

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**SIGNATURES**

 

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

 

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

 

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