**UNITED STATES**

 

**SECURITIES AND EXCHANGE 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 June 30, 2004** |
|                                          |
| **Or**                                        |
| ** **                                    |
|                                          | **o** | **Transition Report Pursuant to Section 13  or 15(d) of The Securities Exchange Act of 1934** |

 

**CommissionFile 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 telephonenumber, including area code: **(703) 679-4900**

 

Indicate by check markwhether the registrant (1) has filed all reports required to be filed bySection 13 or 15(d) of the Securities Exchange Act of 1934 during thepreceding 12 months (or for such shorter period that the registrant wasrequired to file such reports), and (2) has been subject to the filingrequirements for the past 90 days. Yes ý No o

 

Indicate by check markwhether the registrant is an accelerated filer (as defined in Rule 12b-2 of theExchange Act). Yes  ý   No o

 

As of August 9, 2004,27,459,178 shares of the registrant’s Common Stock, par value $.01 per share,were outstanding.

 

 

----

 

**PECSOLUTIONS, INC.**

**QUARTERLYREPORT ON FORM 10-Q FOR THE SIX MONTHS ENDED JUNE 30, 2004**

 

**TABLE OFCONTENTS**

 

 
| PART  I.  FINANCIAL INFORMATION                                                                |   |
|-----------------------------------------------------------------------------------------------------|--------|
| Item 1. Financial Statements:                                                                       |   |
| Consolidated  Balance Sheets - June 30, 2004 and December 31, 2003                        |   |
| Consolidated Statements of Income - Three and six months ended  June 30, 2004 and 2003         |   |
| Consolidated Statements of Cash Flows — Six months ended  June 30, 2004 and 2003          |   |
| Notes to Consolidated Financial Statements                                                          |   |
| Item 2. Management’s Discussion and  Analysis of Financial Condition and Results of Operations |   |
| Item 3. Qualitative and Quantitative  Disclosure about Market Risk                                  |   |
| Item 4.   Controls and Procedures                                                              |   |
| PART II. OTHER INFORMATION                                                                          |   |
| Item 1.   Legal Proceedings                                                                    |   |
| Items 2 – 3                                                                                    |   |
| Item 4.   Submission of Matters to a Vote of Security Holders                                  |   |
| Item 5.                                                                                             |   |
| Item 6.   Exhibits and Reports on Form 8-K                                                     |   |
| Signatures                                                                                          |   |

 

3

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**PART I: FINANC****IAL INFORMATION**

 

**ITEM 1. Fin****ancial Statements****.**

 

**PECSOLUTIONS, INC.**

**CONSOLIDATEDBALA****NCE SHEETS**

**(Dollarsin thousands)**

 
| ** **                                                                                                                           | ** ** | **As of  June 30,  2004** | ** ** | **As of  December 31,  2003** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------|------------|--------------------------------|------------|------------------------------------|------------|
| ** **                                                                                                                           | ** ** | **(Unaudited)**                | ** ** | ** **                         | ** ** |
| **ASSETS**                                                                                                                           |       |                           |       |                               |       |
| Current assets:                                                                                                                      |       |                           |       |                               |       |
| Cash  and cash equivalents                                                                                                           |       | $                              | 26,499     |                               | $          | 33,401 |   |
| Short-term  investments                                                                                                              |       | 21,726                         |       | 38,274                             |       |
| Accounts  receivable, net                                                                                                            |       | 50,700                         |       | 48,356                             |       |
| Other  current assets                                                                                                                |       | 9,043                          |       | 1,745                              |       |
| Total  current assets                                                                                                                |       | 107,968                        |       | 121,776                            |       |
|                                                                                                                                 |       |                           |       |                               |       |
| Property  and equipment, net                                                                                                         |       | 26,043                         |       | 26,674                             |       |
| Investments                                                                                                                          |       | 40,605                         |       | 37,587                             |       |
| Goodwill                                                                                                                             |       | 39,931                         |       | 16,932                             |       |
| Intangibles,  net                                                                                                                    |       | 9,933                          |       | 2,849                              |       |
| Other  assets                                                                                                                        |       | 4,774                          |       | 4,553                              |       |
| Total  assets                                                                                                                        |       | $                              | 229,254    |                               | $          | 210,371 |   |
|                                                                                                                                 |       |                           |       |                               |       |
| **LIABILITIES AND STOCKHOLDERS’ EQUITY**                                                                                        |       |                           |       |                               |       |
|                                                                                                                                 |       |                           |       |                               |       |
| Current  liabilities:                                                                                                                |       |                           |       |                               |       |
| Accounts  payable and accrued expenses                                                                                               |       | $                              | 8,381      |                               | $          | 5,576 |   |
| Advance  payments on contracts                                                                                                       |       | 1,262                          |       | 439                                |       |
| Retirement  plan contribution payable                                                                                                |       | 723                            |       | —                             |       |
| Accrued  payroll                                                                                                                     |       | 4,871                          |       | 5,503                              |       |
| Accrued  vacation                                                                                                                    |       | 3,794                          |       | 2,839                              |       |
| Other  current liabilities                                                                                                           |       | 6,499                          |       | 1,163                              |       |
| Total  current liabilities                                                                                                           |       | 25,530                         |       | 15,520                             |       |
|                                                                                                                                 |       |                           |       |                               |       |
| Long-term  liabilities:                                                                                                              |       |                           |       |                               |       |
| Supplemental  retirement program liability                                                                                           |       | 1,493                          |       | 1,417                              |       |
| Deferred  rent payable                                                                                                               |       | 2,004                          |       | 1,790                              |       |
| Long-term  lease obligation                                                                                                          |       | 23,161                         |       | 23,062                             |       |
| Total  long-term liabilities                                                                                                         |       | 26,658                         |       | 26,269                             |       |
| Total  liabilities                                                                                                                   |       | 52,188                         |       | 41,789                             |       |
|                                                                                                                                 |       |                           |       |                               |       |
| Commitments  and contingencies                                                                                                       |       |                           |       |                               |       |
|                                                                                                                                 |       |                           |       |                               |       |
| Stockholders’  equity:                                                                                                          |       |                           |       |                               |       |
| Undesignated  capital stock, 10,000,000 shares authorized                                                                            |       | —                         |       | —                             |       |
| Common  stock, $0.01 par value, 75,000,000 shares authorized, 27,443,938 and  27,303,041 shares issued and outstanding, respectively |       | 274                            |       | 273                                |       |
| Additional  paid-in capital                                                                                                          |       | 96,440                         |       | 95,219                             |       |
| Retained  earnings                                                                                                                   |       | 80,468                         |       | 73,140                             |       |
| Accumulated  other comprehensive loss                                                                                                |       | (116                           | )          | (50                                | )          |
| Total  stockholders’ equity                                                                                                     |       | 177,066                        |       | 168,582                            |       |
| Total  liabilities and stockholders’ equity                                                                                     |       | $                              | 229,254    |                               | $          | 210,371 |   |

 

See notes to consolidatedfinancial statements.

 

4

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**PECSOLUTIONS, INC.**

**CONSOLIDATED STATEMENTSOF INCOME**

**(Amountsin thousands, except per share data)**

 
| ** **                                                     | ** ** | **Three Months Ended**  | ** ** | **Six Months Ended**    | ** ** |
|----------------------------------------------------------------|------------|-------------------------|------------|-------------------------|------------|
| ** **                                                     | ** ** | **June 30,  2004** | ** ** | **June 30,  2003** | ** ** | **June 30,  2004** | ** ** | **June 30,  2003** | ** ** |
| ** **                                                     | ** ** | **(Unaudited)**         | ** ** |
| Revenues                                                       |       | $                       | 44,504     |                    | $          | 44,265 |   | $ | 84,873 |   | $ | 87,731 |   |
| Operating  costs and expenses:                                 |       |                    |       |                    |       |   |   |   |   |
| Direct  costs                                                  |       | 27,113                  |       | 25,711                  |       | 51,736 |   | 52,682 |   |
| General  and administrative expenses                           |       | 9,591                   |       | 9,074                   |       | 17,985 |   | 18,233 |   |
| Sales  and marketing expenses                                  |       | 1,397                   |       | 1,635                   |       | 2,524 |   | 3,082 |   |
| Goodwill  and intangible amortization                          |       | 303                     |       | 212                     |       | 516 |   | 425 |   |
| Total  operating costs and expenses                            |       | 38,404                  |       | 36,632                  |       | 72,761 |   | 74,422 |   |
| Operating  income                                              |       | 6,100                   |       | 7,633                   |       | 12,112 |   | 13,309 |   |
| Investment  and other income                                   |       | 555                     |       | 540                     |       | 952 |   | 1,177 |   |
| Interest  expense                                              |       | (669                    | )          | (662                    | )          | (1,336 | ) | (1,322 | ) |
| Income  before income taxes                                    |       | 5,986                   |       | 7,511                   |       | 11,728 |   | 13,164 |   |
| Provision  for income taxes                                    |       | 2,246                   |       | 2,873                   |       | 4,400 |   | 5,035 |   |
| Net  income                                                    |       | $                       | 3,740      |                    | $          | 4,638 |   | $ | 7,328 |   | $ | 8,129 |   |
| Earnings  per share:                                           |       |                    |       |                    |       |   |   |   |   |
| Basic                                                          |       | $                       | 0.14       |                    | $          | 0.17 |   | $ | 0.27 |   | $ | 0.30 |   |
| Diluted                                                        |       | $                       | 0.13       |                    | $          | 0.16 |   | $ | 0.25 |   | $ | 0.27 |   |
| Weighted  average shares used in computing earnings per share: |       |                    |       |                    |       |   |   |   |   |
| Basic                                                          |       | 27,341                  |       | 27,047                  |       | 27,324 |   | 26,991 |   |
| Diluted                                                        |       | 28,963                  |       | 29,491                  |       | 28,981 |   | 29,720 |   |

 

See notes to consolidatedfinancial statements.

 

5

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**PECSOLUTIONS, INC.**

**CONSOLIDATED STATEMENTSOF CASH FLOWS**

**(Dollarsin thousands)**

 
| ** **                                                                                          | ** ** | **Six Months Ending**   | ** ** |
|-----------------------------------------------------------------------------------------------------|------------|-------------------------|------------|
| ** **                                                                                          | ** ** | **June 30,  2004** | ** ** | **June 30,  2003** | ** ** |
| ** **                                                                                          | ** ** | **(Unaudited)**         | ** ** |
| Cash  flows from operating activities:                                                              |       |                    |       |   |   |
| Net  income                                                                                         |       | $                       | 7,328      |   | $ | 8,129 |   |
| Adjustments  to reconcile net income to net cash provided by operating activities:                  |       |                    |       |   |   |
| Depreciation  and amortization                                                                      |       | 1,374                   |       | 1,441 |   |
| Amortization  of intangibles                                                                        |       | 515                     |       | 425 |   |
| Amortization  of bond premium and discounts, net                                                    |       | 178                     |       | 52 |   |
| Gain  on sale of assets                                                                             |       | (4                      | )          | — |   |
| Deferred  rent payable                                                                              |       | 215                     |       | 237 |   |
| Deferred  income taxes                                                                              |       | 348                     |       | (310 | ) |
| Bad  debt expense                                                                                   |       | 102                     |       | — |   |
| Gain  from investment in building                                                                   |       | (482                    | )          | (471 | ) |
| Non-cash  charge related to building                                                                |       | 99                      |       | 128 |   |
| Changes  in operating assets and liabilities:                                                       |       |                    |       |   |   |
| Accounts  receivable, net                                                                           |       | 4,311                   |       | 6,329 |   |
| Other  current assets                                                                               |       | (7,150                  | )          | 531 |   |
| Other  assets                                                                                       |       | (106                    | )          | (184 | ) |
| Accounts  payable and accrued expenses                                                              |       | 579                     |       | (1,807 | ) |
| Advance  payments on contracts                                                                      |       | 287                     |       | (472 | ) |
| Retirement  plan contribution payable                                                               |       | 642                     |       | 1,112 |   |
| Accrued  payroll                                                                                    |       | (2,227                  | )          | (2,712 | ) |
| Accrued  vacation                                                                                   |       | 591                     |       | 704 |   |
| Other  current liabilities                                                                          |       | 5,080                   |       | 42 |   |
| Supplemental  retirement program liability                                                          |       | 71                      |       | 308 |   |
| Net  cash provided by operating activities                                                          |       | 11,751                  |       | 13,482 |   |
| Cash  flows from investing activities:                                                              |       |                    |       |   |   |
| Purchases  of property and equipment                                                                |       | (318                    | )          | (722 | ) |
| Proceeds  from sale of property and equipment                                                       |       | 4                       |       | — |   |
| Purchases  of short-term investments                                                                |       | (16,881                 | )          | (21,818 | ) |
| Proceeds  from sale of short-term investments                                                       |       | 33,240                  |       | 27,160 |   |
| Purchase  of business, net of cash acquired                                                         |       | (33,024                 | )          | — |   |
| Capitalized  software                                                                               |       | (387                    | )          | (193 | ) |
| Purchases  of long-term investments                                                                 |       | (13,616                 | )          | (7,079 | ) |
| Proceeds  from sale of long-term investments                                                        |       | 10,630                  |       | 1,628 |   |
| Distributions  from building investment                                                             |       | 487                     |       | 413 |   |
| Net  cash used by investing activities                                                              |       | (19,865                 | )          | (611 | ) |
| Cash flows from  financing activities:                                                              |       |                    |       |   |   |
| Proceeds  from issuance of common stock                                                             |       | 1,212                   |       | 2,296 |   |
| Net  cash provided by financing activities                                                          |       | 1,212                   |       | 2,296 |   |
| Net  increase (decrease) in cash                                                                    |       | (6,902                  | )          | 15,167 |   |
| Cash  and cash equivalents at beginning of period                                                   |       | 33,401                  |       | 21,176 |   |
| Cash  and cash equivalents at end of period                                                         |       | $                       | 26,499     |   | $ | 36,343 |   |
| Income  taxes paid                                                                                  |       | $                       | 5,157      |   | $ | 3,059 |   |
| Interest  paid                                                                                      |       | $                       | 1,336      |   | $ | 1,322 |   |
| Non-cash  transactions:                                                                             |       |                    |       |   |   |
| Common  stock repurchased and retired in exchange for shares in cashless exercise of  stock options |       | $                       | 318        |   | $ | 197 |   |

 

See notes to consolidatedfinancial statements.

 

6

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**PECSOLUTIONS, INC.**

**NOTES TOCONSOLIDATED****FINANCIAL STATEMENTS**

**JUNE 30,2004**

**(Unaudited)**

 

**1.Financial Statements**

 

The accompanyingconsolidated financial statements, except for the December 31, 2003balance sheet, are unaudited and have been prepared in accordance with accountingstandards generally accepted in the United States for interim financialinformation and the instructions to Form 10-Q and Article 10 of RegulationS-X. Accordingly, certain information and footnote disclosures normallyincluded in financial statements prepared in accordance with accountingprinciples generally in the United States have been omitted. In the opinion ofmanagement, all adjustments, consisting of normally recurring accruals,considered necessary for a fair presentation, have been included. It issuggested that these financial statements be read in conjunction with theCompany’s audited financial statements as of December 31, 2002 and 2003,and for each of the three years in the period ended December 31, 2003included in the Company’s Form 10-K, as filed with the Securities and ExchangeCommission on March 15, 2004. The results of operations for the six monthsended June 30, 2004, are not necessarily indicative of the operatingresults to be expected for the full year.

 

**2. Stock-based Compensation**

 

In December 2002, theFASB issued SFAS No. 148, *Accountingfor Stock-Based Compensation—Transition and Disclosure, an amendment of FASBStatement No. 123*. SFAS No. 148 provides alternativemethods of transition for a voluntary change to the fair market value-basedmethod of accounting for stock-based compensation. The Company does notpresently expect to make such a voluntary change. In addition, SFASNo. 148 amends the disclosure requirements of SFAS No. 123 to requireprominent disclosures in both annual and interim financial statements about themethod of accounting for stock-based employee compensation and the effect ofthe method used on reported results. These amended disclosure requirements havebeen included below.

 

The Company uses theBlack-Scholes option-pricing model to determine the pro forma impact under SFASNo. 123 to the Company’s net income and earnings per share. The modelutilizes certain information, such as the interest rate on a risk-free securitymaturing generally at the same time as the option being valued, and requirescertain assumptions, such as the expected amount of time an option will beoutstanding until it is exercised or it expires, to calculate the fair value ofstock options granted.

 

This information and theassumptions used for the six months ended June 30, 2004 and 2003 for theCompany’s stock option and stock purchase plans are summarized as follows:

 
| ** **                                           | ** ** | **Stock Option Plan**  | ** ** | **Stock Purchase Plan** | ** ** |
|------------------------------------------------------|------------|------------------------|------------|-------------------------|------------|
| ** **                                           | ** ** | **June 30, 2004** | ** ** | **June 30, 2003**  | ** ** | **June 30, 2004** | ** ** | **June 30, 2003** | ** ** |
|                                                 |       |                   |       |                    |       |   |   |   |   |
| Volatility                                           |       | 80.4-84.2              | %          | 84.1-90.1               | %          | 43.1 | % | 105.7 | % |
| Risk-free interest rate                              |       | 3.09-3.99              | %          | 2.76-3.04               | %          | 1.68 | % | 0.98 | % |
| Dividend yield                                       |       | 0                      | %          | 0                       | %          | 0 | % | 0 | % |
| Expected lives                                       |       | 6.0-6.6 years          |       | 5.0-5.9 years           |       | 0.50 years |   | 0.50 years |   |
|                                                 |       |                   |       |                    |       |   |   |   |   |
| Weighted average fair value per share at  grant date |       | $                      | 10.22      |                    | $          | 15.54 |   | $ | 10.22 |   | $ | 15.54 |   |
|                                                      |            |                        |            |                         |            |  |  |  |  |  |  |  |  |

 

The Company continues toapply the provisions of APB 25 and provide the pro forma disclosures inaccordance with the provisions of FAS Nos. 123 and 148. Under APB 25, the Companyhas not recorded in net income any stock-based employee compensation costassociated with the Company’s stock option plan, as all options granted underthe plan had an exercise price equal to the market value of the underlyingcommon stock on the date of grant.

 

7

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The following tableillustrates the effect on net income and earnings per share if the Company hadapplied the fair value recognition provisions of SFAS No. 123 to its stockoption and stock purchase plans:

 
| ** **                                 | ** ** | **Three Months Ended**                           | ** ** | **Six Months Ended**   | ** ** |
|--------------------------------------------|------------|--------------------------------------------------|------------|------------------------|------------|
| ** **                                 | ** ** | **June 30, 2004**                           | ** ** | **June 30, 2003** | ** ** | **June 30, 2004** | ** ** | **June 30, 2003** | ** ** |
| ** **                                 | ** ** | **(In thousands, except for per share amounts)** | ** ** |
| Net income, as reported                    |       | $                                                | 3,740      |                   | $          | 4,638 |   | $ | 7,328 |   | $ | 8,129 |   |
| Pro forma compensation expense, net of tax |       | (1,319                                           | )          | (1,182                 | )          | (2,510 | ) | (2,400 | ) |
|                                       |       |                                             |       |                   |       |   |   |   |   |
| Pro forma net income                       |       | $                                                | 2,421      |                   | $          | 3,456 |   | $ | 4,818 |   | $ | 5,729 |   |
|                                       |       |                                             |       |                   |       |   |   |   |   |
| Net income (loss) per share:               |       |                                             |       |                   |       |   |   |   |   |
| Basic—as reported                     |       | $                                                | 0.14       |                   | $          | 0.17 |   | $ | 0.27 |   | $ | 0.30 |   |
| Basic—pro forma                       |       | $                                                | 0.09       |                   | $          | 0.13 |   | $ | 0.18 |   | $ | 0.21 |   |
| Diluted—as reported                   |       | $                                                | 0.13       |                   | $          | 0.16 |   | $ | 0.25 |   | $ | 0.27 |   |
| Diluted—pro forma                     |       | $                                                | 0.08       |                   | $          | 0.12 |   | $ | 0.17 |   | $ | 0.19 |   |

 

**3.Accounts Receivable**

 

Accounts receivableconsist of the following as of:

 
| ** **                                                | ** ** | **June 30, 2004**      | ** ** | **December 31,  2003** | ** ** |
|-----------------------------------------------------------|------------|-----------------------------|------------|-----------------------------|------------|
| ** **                                                | ** ** | **(Dollars in  thousands)** | ** ** |
| Billed  accounts receivable                               |       | $                           | 38,978     |                        | $          | 32,100 |   |
| Unbilled  accounts receivable:                            |       |                        |       |                        |       |
| Amounts  currently billable                               |       | 12,783                      |       | 12,033                      |       |
| Revenues  recorded in excess of contract value or funding |       | 315                         |       | 4,776                       |       |
| Progress  payments                                        |       | (1,262                      | )          | (439                        | )          |
|                                                      |       | 50,814                      |       | 48,470                      |       |
| Allowance  for doubtful accounts                          |       | (114                        | )          | (114                        | )          |
| Accounts  receivable, net                                 |       | $                           | 50,700     |                        | $          | 48,356 |   |

 

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

 

At June 30, 2004, there was $6.3 million due from a subcontractfor the Company’s biometric identification system.  The Company filed a lawsuit in Federal courtagainst the prime contractor in September 2003 to recover full payment onthis receivable and expects to receive full payment.

 

During the six months ended June 30, 2004, the Company had onecustomer that accounted for more that 10% of revenue.  For the six months ended June 30, 2004,the Special Project Division of the Drug Enforcement Agency accounted for 12.2%of revenue, or $10.3 million.  AtJune 30, 2004, there was $3.3 million due from the Special ProjectDivision of the Drug Enforcement Agency. During the six months ended June 30, 2003, the Company had onecustomer that accounted for more than 10% of revenue.  For the six months ended June 30, 2003,EDS (Navy Marine Corps Intranet) accounted for 11.7% of revenue, or $10.3million.  At June 30, 2003, therewas $6.3 million due from EDS.

 

**4. NetIncome Per Share**

 

Basic and diluted earnings per share for the three months andsix months ended June 30, 2004 and 2003 were determined as follows:

 
| ** **                  | ** ** | **Three Months Ended  June 30, 2004**                          | ** ** | **Six Months Ended  June 30, 2004** | ** ** |
|-----------------------------|------------|---------------------------------------------------------------------|------------|------------------------------------------|------------|
| ** **                  | ** ** | **(Dollars in  thousands, except for share and per share amounts)** | ** ** |
| ** **                  | ** ** | **Net  Income**                                                     | ** ** | **Shares**                               | ** ** | **Per Share** | ** ** | **Net  Income** | ** ** | **Shares** | ** ** | **Per Share** | ** ** |
| Basic  EPS                  |       | $                                                                   | 3,740      |                                     | 27,340,750 |   | $ | 0.14 |   | $ | 7,328 |   | 27,323,725 |   | $ | 0.27 |   |
| Effect  of dilutive options |       | —                                                              |       | 1,622,081                                |       | (0.01 | ) | — |   | 1,656,920 |   | (0.02 | ) |
| Diluted  EPS                |       | $                                                                   | 3,740      |                                     | 28,962,831 |   | $ | 0.13 |   | $ | 7,328 |   | 28,980,645 |   | $ | 0.25 |   |

 

8

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| ** **                  | ** ** | **Three Months Ended  June 30, 2003**                          | ** ** | **Six Months Ended  June 30, 2003** | ** ** |
|-----------------------------|------------|---------------------------------------------------------------------|------------|------------------------------------------|------------|
| ** **                  | ** ** | **(Dollars in  thousands, except for share and per share amounts)** | ** ** |
| ** **                  | ** ** | **Net  Income**                                                     | ** ** | **Shares**                               | ** ** | **Per Share** | ** ** | **Net  Income** | ** ** | **Shares** | ** ** | **Per Share** | ** ** |
| Basic  EPS                  |       | $                                                                   | 4,638      |                                     | 27,047,227 |   | $ | 0.17 |   | $ | 8,129 |   | 26,991,481 |   | $ | 0.30 |   |
| Effect  of dilutive options |       | —                                                              |       | 2,443,813                                |       | (0.01 | ) | — |   | 2,728,290 |   | (0.03 | ) |
| Diluted  EPS                |       | $                                                                   | 4,638      |                                     | 29,491,040 |   | $ | 0.16 |   | $ | 8,129 |   | 29,719,771 |   | $ | 0.27 |   |

 

Forthe three and six months ended June 30, 2004, 1,717,125 and 1,619,506shares, respectively, attributable to outstanding stock options were excludedfrom the calculation of diluted earnings per share because the effect wasantidilutive.

 

Forthe three and six months ended June 30, 2003, 1,200,945 and 328,511shares, respectively, attributable to outstanding stock options were excludedform the calculation of diluted earnings per share because the effect wasantidilutive.

 

**5. Acquisitions**

 

On May 28, 2004, the Company acquired all of the outstanding commonshares of Integrated Information Technology Corporation (“IITC”).  The results of IITC’s operations have beenincluded in the consolidated financial statements since that date.  IITC derives revenues from providingsatellite communications engineering and information technology solutions tothe Federal Government.  The aggregatepurchase price was $34.4 million, including acquisition costs of $0.8million.  The purchase was an all cashtransaction.

 

The following table summarizes the estimated fair values of the assetsacquired and liabilities assumed at the date of acquisition.  The fair value of the assets acquired andliabilities assumed has been based on preliminary estimates, and may be revisedwhen remaining aspects of the purchase price allocation have been finalized.

 
| **(Dollars  in thousands)**              | ** ** | **At May 28, 2004** | ** ** |
|------------------------------------------|------------|---------------------|------------|
| Current assets, including cash of $1,565 |       | $                   | 8,466      |   |
| Property and equipment                   |       | 293                 |       |
| Intangible assets                        |       | 7,600               |       |
| Goodwill                                 |       | 23,150              |       |
| Other assets                             |       | 154                 |       |
| Total assets acquired                    |       | 39,663              |       |
| Current liabilities                      |       | 5,064               |       |
| Total liabilities assumed                |       | 5,064               |       |
| Net assets acquired                      |       | $                   | 34,599     |   |

 

The $7.6 million of acquired intangible assets was assigned to customercontracts and related relationships with a weighted-average useful life of 7.0years.  The transaction resulted in $23.0million of goodwill, all of which is deductible for tax purposes.

 

9

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Unaudited pro forma results of operations as if the acquisition hasoccurred at the beginning of each period presented are as follows:

 
| ** **                                                     | ** ** | **Three Months Ended  June 30, 2003**     | ** ** | **Six Months Ended  June 30, 2003** | ** ** |
|----------------------------------------------------------------|------------|------------------------------------------------|------------|------------------------------------------|------------|
| ** **                                                     | ** ** | **(in thousands except shares and per share)** | ** ** |
| Revenues                                                       |       | $                                              | 52,524     |                                     | $          | 103,451 |   |
|                                                           |       |                                           |       |                                     |       |
| Net Income                                                     |       | $                                              | 5,087      |                                     | $          | 8,643 |   |
|                                                           |       |                                           |       |                                     |       |
| Earnings per share:                                            |       |                                           |       |                                     |       |
| Basic                                                          |       | $                                              | 0.19       |                                     | $          | 0.32 |   |
| Diluted                                                        |       | $                                              | 0.17       |                                     | $          | 0.29 |   |
|                                                           |       |                                           |       |                                     |       |
| Weighted average shares used in computing  earnings per share: |       |                                           |       |                                     |       |
| Basic                                                          |       | 27,047                                         |       | 26,991                                   |       |
| Diluted                                                        |       | 29,491                                         |       | 29,720                                   |       |
|                                                           |       |                                           |       |                                     |       |
| ** **                                                     | ** ** | **Three Months Ended  June 30, 2004**     | ** ** | **Six Months Ended  June 30, 2004** | ** ** |
| ** **                                                     | ** ** | **(in thousands except shares and per share**  | ** ** |
| Revenues                                                       |       | $                                              | 51,562     |                                     | $          | 100,442 |   |
|                                                           |       |                                           |       |                                     |       |
| Net Income                                                     |       | $                                              | 3,469      |                                     | $          | 7,403 |   |
|                                                           |       |                                           |       |                                     |       |
| Earnings per share:                                            |       |                                           |       |                                     |       |
| Basic                                                          |       | $                                              | 0.13       |                                     | $          | 0.27 |   |
| Diluted                                                        |       | $                                              | 0.12       |                                     | $          | 0.26 |   |
|                                                           |       |                                           |       |                                     |       |
| Weighted average shares used in computing  earnings per share: |       |                                           |       |                                     |       |
| Basic                                                          |       | 27,341                                         |       | 27,324                                   |       |
| Diluted                                                        |       | 28,963                                         |       | 28,981                                   |       |

 

The pro forma consolidated results of operations include adjustments togive effect to amortization of goodwill and other adjustments, together withrelated income tax effects.  Theunaudited pro forma information is not necessarily indicative of the results ofoperations that would have occurred had the purchase been made at the beginningof the periods presented or the future results of the combined operations.

 

**6. Other current assets**

 

Other current assets consisted of thefollowing:

 
| ** **                         | ** ** | **June 30,  2004**         | ** ** | **December 31,  2003** | ** ** |
|------------------------------------|------------|----------------------------|------------|------------------------|------------|
| ** **                         | ** ** | **(Dollars in thousands)** | ** ** |
| Accrued interest receivable        |       | $                          | 4          |                   | $          | 15 |   |
| Accounts receivable-other          |       | 161                        |       | —                 |       |
| Notes receivable employees-current |       | 1                          |       | 1                      |       |
| Prepaid expenses                   |       | 2,028                      |       | 930                    |       |
| Travel advances                    |       | 33                         |       | 12                     |       |
| Deferred income taxes-current      |       | 807                        |       | 787                    |       |
| Escrow-IITC acquisition            |       | 6,000                      |       | —                 |       |
| Inventory                          |       | 9                          |       | —                 |       |
|                               |       | $                          | 9,043      |                   | $          | 1,745 |   |

 

**7. Goodwill andIntangible Assets**

 

The Company has recognizedgoodwill related to its acquisitions of Viking Technology, Inc. (“Viking”),Troy Systems, Inc. (“Troy”), Vector Research, Inc. (“Vector”) and IITC.  Nonamortized intangible assets consist onlyof goodwill of $39.9 million.  TheCompany’s amortizable intangible assets include customer contracts and relatedrelationships purchased in the acquisitions of Troy on November 20, 2001;Vector on June 14, 2002; and IITC on May 28, 2004.  The intangibles related to the Troyacquisition totaled $3.0 million and are amortized on a straight-line basisover a 4.5-year period.  The intangibleson the Vector purchase totaled $1.5 million and are being amortized on astraight-line basis over an 8.4-year period. The intangibles on the IITC acquisition totaled $7.6 million and arebeing amortized on a straight-line basis over a 7.0-year period.  Total accumulated amortization as ofJune 30, 2004 was $2.2 million.  Inaccordance with the provisions of SFAS No. 142, the Company performed theappropriate annual impairment tests during the three months endedMarch 31, 2004 related to its stated goodwill, and determined that therewas no impairment loss, and therefore no change was made to the carrying amountof goodwill.

 

10

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Intangibles are amortizedon a straight-line basis.  Estimatedannual amortization expense for each of the five following calendar years is asfollows:

 

| **Year ending December 31,** | ** ** | **Amount**                  | ** ** |
|-----------------------------------|------------|-----------------------------|------------|
| ** **                        | ** ** | **(Dollars in  thousands)** | ** ** |
| 2004                              |       | $                           | 1,484      |   |
| 2005                              |       | 1,937                       |       |
| 2006                              |       | 1,544                       |       |
| 2007                              |       | 1,264                       |       |
| 2008                              |       | 1,264                       |       |
|                                   |            |                             |            |  |

 

**8.  Investments**

 

The Company has an ownership interest in an unconsolidated andaffiliated company that owns an office building that the Company leases.  For the three months and six months endedJune 30, 2004, the Company recorded other income of $237,000 and $482,000,respectively from this investment.  Italso received cash distributions of $386,000 and $487,000, respectively fromthe investment.  For the three months andsix months ended June 30, 2003, the Company recorded other income of$234,000 and $471,000, respectively.  Italso received cash distributions of $103,000 and $413,000, respectively fromthe investment.

 

**9.Other current liabilities**

 

Other current liabilities consisted of thefollowing:

 
| ** **                              | ** ** | **June 30,  2004**         | ** ** | **December 31,  2003** | ** ** |
|-----------------------------------------|------------|----------------------------|------------|------------------------|------------|
| ** **                              | ** ** | **(Dollars in thousands)** | ** ** |
| Employees stock purchase plan payable   |       | $                          | 10         |                   | $          | 10 |   |
| Amounts due related to IITC acquisition |       | 6,000                      |       | —                 |       |
| Employee benefits payable               |       | 57                         |       | 64                     |       |
| Payroll taxes payable                   |       | 432                        |       | 520                    |       |
| Income taxes payable                    |       | —                     |       | 569                    |       |
|                                    |       | $                          | 6,499      |                   | $          | 1,163 |   |

 

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

 

Other comprehensive gain (loss), consisting of unrealized gains(losses) on securities was $(122,000) and $(116,000), respectively, for thethree months and six months ended June 30, 2004, and $7,000 and  $(111,000), respectively, for the threemonths and six months ended June 30, 2003.

 

**11.**  **Contingencies**

 

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

 

On or after March 18, 2003, several purported class actioncomplaints were filed against the Company and certain of its officers in theUnited States District Court for the Eastern District of Virginia.  The complaints allege that betweenOctober 22, 2002 and March 14, 2003, the defendants made, or wereaware of false and misleading statements which had the effect of inflating themarket price of the Company’s common stock, in violation of Sections 10(b) and20(a) of the Securities Exchange Act of 1934. The complaints were consolidated into a single class action onJune 13, 2003.  The class action wasdismissed by the district court on January 28, 2004.  The plaintiffs filed an appeal with the U.S.Court of Appeals for the Fourth Circuit on June 30, 2004.  In addition, a stockholder’s legal counselsent a letter of demand that the Board of Directors investigate the same chargesaddressed in the class action suit.  TheBoard concluded, after its investigation and based on its business judgment, toreject the demand letter.

 

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

 

11

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

 

**Overview**

 

PEC Solutions, Inc.(www.pec.com) is a professional services firm specializing in high-endsolutions that help government clients harness the power of the Internet andother advanced technologies to improve mission performance. We specialize inWeb-Enabling Government® by providing secure, interoperable technologysolutions for clients in homeland security, law enforcement, intelligence,defense, and civilian agencies within the Federal Government and at state andlocal levels.  We enhance theirproductivity and improve the services they offer to the public.  As a total solutions provider, we address thefull technology lifecycle, including formulating technology strategies,creating business solutions, performing long-term operational management andcontinuing enhancement of the solution.

 

We derive substantiallyall of our revenues from fees for consulting services, primarily from contractswith the Federal Government.   Wegenerate these fees from contracts with various payment arrangements, includingtime and materials contracts, fixed-price contracts and cost-reimbursable contracts.During the three months and six months ended June 30, 2004, revenues fromthese contract types were approximately 60%, 16%, and 24%, and 60%, 18%, and22%, respectively, of total revenues. During the three months and six monthsended June 30, 2003, revenues from these contract types were approximately57%, 25% and 18%, and 61%, 20% and 19%, respectively, of total revenues.  We typically issue invoices monthly to manageoutstanding accounts receivable balances. We recognize revenues on time andmaterials contracts based on actual hours delivered at the contracted billablehourly rate plus the cost of materials incurred. We recognize revenues onfixed-price contracts using the percentage-of-completion method based on costswe incurred in relation to total estimated costs.  However, if the contract has a serviceelement, we recognize revenues on a straight-line basis over the term of thecontract.  We recognize revenues on cost-typecontracts to the extent of costs incurred plus a proportionate amount of feeearned.

 

On occasion, we enter intocontracts that include the delivery of a combination of two or more of ourservice offerings.  Typically, suchmultiple-element arrangements incorporate the design, development, or modificationof systems and an ongoing obligation to manage, staff, maintain, host, orotherwise run solutions and systems provided to the client.  Such contracts are divided into separateunits of accounting and the total arrangement fee is allocated to each unitbased on its relative fair value.  Inaccordance with our revenue recognition policy, revenue is recognizedseparately for each element.

 

In certain limitedcircumstances, revenues are recognized before contract amendments have beenfinalized.  Prior to agreeing to commencework as directed by a customer, and in advance of the receipt of the writtenmodification or amendments to the existing contract, the Company requires thecompletion of an internal memo that assesses the probability of themodification or amendment being executed in a timely fashion and the Company’sability to subsequently collect payment from the customer.

 

The fees under certaingovernment contracts may be increased or decreased in accordance with cost orperformance incentive provisions that measure actual performance againsttargets or other criteria.  Suchincentive fee awards or penalties are included in revenue at the time theamounts can be reasonably determined. Provisions for anticipated contract losses are recognized at the timethey become known.

 

Our historical revenuegrowth is attributable to various factors, including an increase in the sizeand number of projects for existing and new clients.  Existing clients from the previous yeargenerated greater than 98% of our revenues in the three months and six monthsended June 30, 2004.

 

In the three months andsix months ended June 30, 2004, we derived approximately 22% and 21%,respectively, of our revenues through relationships with prime contractors, whocontract directly 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 significantexpense is direct costs, which consist primarily of project personnel salariesand benefits, and direct expenses incurred to complete projects. Our directcosts as a percentage of revenues are also related to the utilization rate ofour consulting personnel. We manage utilization by frequently monitoringproject requirements and timetables. The number of consulting personnelassigned to a project will vary according to the size, complexity, duration,and demands of the project.  As ofJune 30, 2004, we had 1,557 personnel.

 

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

 

Sales and marketingexpenses include the costs of sales and marketing personnel, and costsassociated with marketing and bidding on future projects.

 

12

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Investment and otherincome consist primarily of interest income earned on our cash, cashequivalents and marketable securities, and income from our investment in thelimited liability corporation that owns our corporate headquarters officebuilding.

 

Interest expense isprimarily associated with the corporate headquarters office building.

 

13

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**Resultsof Operations**

 

The following table setsforth certain financial data as a percentage of revenues for the periodsindicated.

 
| ** **                                | ** ** | **THREE MONTHS ENDED**      | ** ** | **SIX MONTHS ENDED**    | ** ** |
|-------------------------------------------|------------|-----------------------------|------------|-------------------------|------------|
| ** **                                | ** ** | **JUNE 30,  2004**     | ** ** | **JUNE 30,  2003** | ** ** | **JUNE 30,  2004** | ** ** | **JUNE 30,  2003** | ** ** |
| ** **                                | ** ** | **(Dollars in  thousands)** | ** ** |
| Statement  of Income:                     |       |                        |       |                    |       |   |   |   |   |
| Revenues                                  |       | $                           | 44,504     |                    | $          | 44,265 |   | $ | 84,873 |   | $ | 87,731 |   |
| Direct  costs                             |       | 27,113                      |       | 25,711                  |       | 51,736 |   | 52,682 |   |
| Gross  profit (a)                         |       | 17,391                      |       | 18,554                  |       | 33,137 |   | 35,049 |   |
| Other  operating costs and expenses:      |       |                        |       |                    |       |   |   |   |   |
| General  and administrative expenses      |       | 9,591                       |       | 9,074                   |       | 17,985 |   | 18,233 |   |
| Sales  and marketing expenses             |       | 1,397                       |       | 1,635                   |       | 2,524 |   | 3,081 |   |
| Goodwill  and intangible amortization     |       | 303                         |       | 212                     |       | 516 |   | 426 |   |
| Total  other operating costs and expenses |       | 11,291                      |       | 10,921                  |       | 21,025 |   | 21,740 |   |
| Operating  income                         |       | 6,100                       |       | 7,633                   |       | 12,112 |   | 13,309 |   |
| Investment  and other income              |       | 555                         |       | 540                     |       | 952 |   | 1,177 |   |
| Interest  expense                         |       | (669                        | )          | (662                    | )          | (1,336 | ) | (1,322 | ) |
| Income  before income taxes               |       | 5,986                       |       | 7,511                   |       | 11,728 |   | 13,164 |   |
| Provision  for income taxes               |       | 2,246                       |       | 2,873                   |       | 4,400 |   | 5,035 |   |
| Net  income                               |       | $                           | 3,740      |                    | $          | 4,638 |   | $ | 7,328 |   | $ | 8,129 |   |
|                                      |       |                        |       |                    |       |   |   |   |   |
| As  a Percentage of Revenues:             |       |                        |       |                    |       |   |   |   |   |
| Revenues                                  |       | 100.0                       | %          | 100.0                   | %          | 100.0 | % | 100.0 | % |
| Direct  costs                             |       | 60.9                        |       | 58.1                    |       | 60.9 |   | 60.1 |   |
| Gross  profit (a)                         |       | 39.1                        |       | 41.9                    |       | 39.1 |   | 39.9 |   |
| Other  operating costs and expenses:      |       |                        |       |                    |       |   |   |   |   |
| General  and administrative expenses      |       | 21.6                        |       | 20.5                    |       | 21.2 |   | 20.8 |   |
| Sales  and marketing expenses             |       | 3.1                         |       | 3.7                     |       | 3.0 |   | 3.5 |   |
| Goodwill  and intangible amortization     |       | 0.7                         |       | 0.5                     |       | 0.6 |   | 0.5 |   |
| Total  other operating costs and expenses |       | 25.4                        |       | 24.7                    |       | 24.8 |   | 24.8 |   |
| Operating  income                         |       | 13.7                        |       | 17.2                    |       | 14.3 |   | 15.1 |   |
| Investment  and other income              |       | 1.2                         |       | 1.2                     |       | 1.1 |   | 1.4 |   |
| Interest  expense                         |       | (1.5                        | )          | (1.4                    | )          | (1.6 | ) | (1.5 | ) |
| Income  before income taxes               |       | 13.4                        |       | 17.0                    |       | 13.8 |   | 15.0 |   |
| Provision  for income taxes               |       | 5.0                         |       | 6.5                     |       | 5.2 |   | 5.7 |   |
| Net  income                               |       | 8.4                         | %          | 10.5                    | %          | 8.6 | % | 9.3 | % |

 

----

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

 

Our revenues and operatingresults may be subject to significant variation from quarter to quarterdepending on a number of factors, including the progress of contracts, revenuesearned on contracts, the number of billable days in a quarter, the timing ofthe pass-through of other direct costs, the commencement and completion ofcontracts during any particular quarter, the schedule of the governmentagencies for awarding contracts, the term of each contract that we have beenawarded, and general economic conditions. Because a significant portion of ourexpenses, such as personnel and facilities costs, are fixed in the short term,successful contract performance and variation in the volume of activity, aswell as in the number of contracts commenced or completed during any quarter,may cause significant variations in operating results from quarter to quarter.

 

The Federal Government’sfiscal year ends September 30. If a budget for the next fiscal year hasnot been approved by that date, our clients may have to suspend engagementsthat we are working on until a budget has been approved. Such suspensions maycause us to realize lower revenues in the fourth quarter of the year. Further,a change in presidential administrations and in senior government officials maynegatively affect the rate at which the Federal Government purchasestechnology.

 

As a result of the factorsabove, period-to-period comparisons of our revenues and operating results maynot be meaningful. You should not rely on these comparisons as indicators offuture performance as no assurances can be given that quarterly results willnot fluctuate, causing a material adverse effect on our operating results andfinancial condition.

 

14

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**Resultsof Operations for the Three Months Ended June 30, 2004 Compared with theThree Months Ended June 30, 2003**

 

*Revenues*. Revenues increased by 0.5% to$44.5 million for the three months ended June 30, 2004, from $44.3 millionfor the three months ended June 30, 2003. The 2004 revenues include approximately one month’s revenue from IITC,which was acquired on May 28, 2004.    Wecontinued to see a reduction in revenue from the EDS (Navy Marine CorpsIntranet) contract during the current period versus last year, as the programcontinues to move from its initial engineering phase into a production phase.

 

*DirectCosts*.Direct costs increased by 5.5% to $27.1 million for the three months endedJune 30, 2004, from $25.7 million for the three months ended June 30,2003.  Direct costs increased as apercentage of revenues to 60.9% in the three months ended June 30, 2004,from 58.1% for the period ended June 30, 2003.  This increase was associated with acombination of factors.  The inclusion ofapproximately one month’s direct costs from IITC, which reflects a higher ratioof direct costs than the civilian government business of PEC, and the change inPEC’s headcount from the year-ago quarter ended June 30, 2003.

 

15

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*GrossProfit*.Gross profit decreased by 6.3% to $17.4 million in the three months endedJune 30, 2004, from $18.6 million in the three months ended June 30,2003. Gross profit as a percentage of revenues decreased to 39.1% in the threemonths ended June 30, 2004, from 41.9% in the three months endedJune 30, 2003, because of the higher ratio of IITC direct costs and thechange in the EDS contract.

 

*Generaland Administrative Expenses*. General and administrative expenses increased 5.7% to $9.6million in the three months ended June 30, 2004, from $9.1 million in thethree months ended June 30, 2003, primarily due to our increase in headcount.  Our total general and administrativeheadcount increased to 148 personnel as of June 30, 2004, compared to 125personnel as of June 30, 2003.  The2004 headcount includes the addition of the IITC headcount as of May 28, 2004.

 

*Salesand Marketing*. Sales and marketing expenses decreased 14.6% to $1.4 million inthe three months ended June 30, 2004, from $1.6 million in the threemonths ended June 30, 2003. This decrease was due to a decrease in ourmarketing and proposal efforts during the quarter, which was related to ourclient’s deferral of program actions.

 

*Amortizationof Intangibles*.  For the three monthsended June 30, 2004 and June 30, 2003, we incurred $303,000 and$213,000, respectively, of amortization of expense related to the $12.1 millionof intangibles we recorded in connection with the value of contracts andcustomer relationships acquired in the November 2001 acquisition of Troy,the June 2002 acquisition of Vector, and the May 2004 acquisition of IITC.

 

*OperatingIncome*.Operating income decreased 20.1% to $6.1 million in the three months endedJune 30, 2004, from $7.6 million in the three months ended June 30,2003, due to the factors discussed above.

 

*Investmentand Other Income*.  For the three monthsended June 30, 2004, we earned $317,000 of interest income, and had$237,000 of income from our investment in our corporate headquartersbuilding.  For the three months endedJune 30, 2003, we had $306,000 of interest income and net gains on salesof securities and $234,000 of income from our investment in our corporateheadquarters office building.

 

*InterestExpense*.   For the three months ended June 30,2004 and 2003, we incurred interest expense of $669,000 and $662,000,respectively, principally related to our corporate headquarters officebuilding.

 

**Resultsof Operations for the Six Months Ended June 30, 2004, Compared with theSix Months Ended June 30, 2003**

 

*Revenues*. Revenues decreased by 3.3% to $84.9 million for the six months endedJune 30, 2004, from $87.7 million for the six months ended June 30,2003.  We saw a reduction in revenue fromthe EDS (Navy Marine Corps Intranet) contract during the current period versuslast year, as the program went from its initial engineering phase into aproduction phase.  These revenues alsoinclude approximately $3.0 million of revenue from IITC, which was acquired onMay 28, 2004.

 

*DirectCosts*.Direct costs decreased by 1.8% to $51.7 million for the six months endedJune 30, 2004, from $52.7 million for the six months ended June 30,2003.  Direct costs increased as apercentage of revenues to 60.9% in the six months ended June 30, 2004,from 60.1% for the six months ended June 30, 2003.  This increase was associated with acombination of factors.  The inclusion ofapproximately one month’s direct costs from IITC, which reflects a higher ratioof direct costs than the civilian government business of PEC, and the change inPEC’s headcount for the six months ended June 30, 2004, compared to thesix months ended June 30, 2003.

 

*GrossProfit*.Gross profit decreased by 5.5% to $33.1 million in the six months endedJune 30, 2004, from $35.0 million in the six months ended June 30,2003. Gross profit as a percentage of revenues decreased to 39.1% in the sixmonths ended June 30, 2004, from 39.9% in the six months endedJune 30, 2003, because of the higher ratio of IITC direct costs and thechange in the EDS contract.

 

*Generaland Administrative Expenses*. General and administrative expenses decreased 1.4% to $18.0million in the six months ended June 30, 2004, from $18.2 million in thesix months ended June 30, 2003.  Ourtotal general and administrative headcount increased to 148 personnel as ofJune 30, 2004, compared to 125 personnel as of June 30, 2003.  This included the addition of the IITC headcountas of May 28, 2004.   Excluding the IITCheadcount, we had a decrease in the general and administrative headcount.

 

16

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*Salesand Marketing*. Sales and marketing expenses decreased 18.1% to $2.5 million inthe six months ended June 30, 2004, from $3.1 million in the six monthsended June 30, 2003. This decrease was due to a decrease in our marketingand proposal efforts during the period, which was related to our client’sdeferral of program actions.

 

*Amortizationof  Intangibles*. For the six months ended June 30, 2004 and June 30, 2003, weincurred $516,000 and $426,000, respectively, of amortization of expenserelated to the $12.1 million of intangibles we recorded in connection with thevalue of contracts and customer relationships acquired in theNovember 2001 acquisition of Troy, the June 2002 acquisition ofVector, and the May 2004 acquisition of IITC.

 

*OperatingIncome*.  Operating income decreased 9.0% to $12.1million in the six months ended June 30, 2004, from $13.3 million in thesix months ended June 30, 2003, due to the factors discussed above.

 

*Investmentand Other Income*.  For the six months endedJune 30, 2004, we earned $571,000 of interest income, and had   $482,000 of income from our investment inour corporate headquarters building.  Forthe six months ended June 30, 2003, we had $706,000 of interest income andnet gains on sales of securities and $471,000 gain from the investment in ourcorporate headquarters building.

 

*InterestExpense*.   Forthe six months ended June 30, 2004 and 2003, we incurred interest expenseof $1.3 million, respectively, principally related to our corporateheadquarters building.

 

**Liquidityand Capital Resources**

 

We currently expect tomeet our short-term and long-term cash requirements through funds generatedfrom operations.  Net cash provided byoperating activities was $11.8 million for the six months ended June 30,2004. Cash provided by operating activities is primarily driven by net income,adjusted for working capital changes, which were principally changes inaccounts receivable.

 

Net cash used by investingactivities was $19.9 million for the six months ended June 30, 2004.During the six months ended June 30, 2004, we had $0.3 million of netpurchases of property and equipment, $3.0 million of net long-term investments,invested $0.4 million in capitalized software, $33.0 million used to purchaseIITC, while selling $16.3 million of net short-term investments and receiving$0.5 million of distributions from the investment in our building jointventure.

 

Net cash provided byfinancing activities was $1.2 million from the sale of common stock toemployees upon the exercise of their stock options and purchase of stockthrough the employee stock purchase plan for the six months ended June 30,2004.

 

17

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We expect to retain futureearnings, if any, for use in the operation and expansion of our business and donot anticipate paying any cash dividends in the foreseeable future.

 

We maintain a $10.0million line of credit with Bank of America, bearing interest at the LIBOR Rateplus 250 basis points per annum, which expires on June 30, 2005. As ofJune 30, 2004, we had no borrowings outstanding under the line of credit.As of June 30, 2004, we had outstanding $2.6 million in letters of creditin lieu of rent deposits.

 

Under some of ourfixed-price contracts, we receive advance payments for work to be performed infuture months. If we do not perform the work, the unearned portion of theseadvances will be returned to our clients. At June 30, 2004, our accountsreceivable turnover rate, net of advance payments on contracts, wasapproximately four times a year.

 

**Recent Accounting Pronouncements**

 

None.

 

18

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**SPECIALNOTE REGARDING FORWARD LOOKING STATEMENTS**

 

The foregoing Management’sDiscussion  and Analysis of FinancialCondition and Results of Operations section of this Form 10-Q includes“forward-looking statements” within the meaning of the Federal PrivateSecurities Litigation Reform Act of 1995. While forward-looking statements are sometimes presented with numericalspecificity, they are based on various assumptions made by management regardingfuture circumstances over many of which we have little or no control.Forward-looking statements may be identified by words including “anticipate,”“believe,” “estimate,” “expect” and similar expressions. We caution readersthat forward-looking statements, including without limitation, those relatingto our future business prospects, revenues, working capital, liquidity, andincome, are subject to certain risks and uncertainties that would cause actualresults to differ materially from those indicated in the forward-lookingstatements. Factors that could cause actual results to differ fromforward-looking statements include the concentration of our revenues fromgovernment clients, risks involved in contracting with the U.S. Government andwith state and local governments, difficulties we may have in attracting,retaining and managing professional and administrative staff, fluctuations inquarterly results, risks related to acquisitions, risks related to competitionand our ability to continue to win and perform efficiently on contracts, andother risks and factors identified from time to time in our reports filed withthe SEC, including those identified under the section entitled “RiskFactors” in our Annual Report on Form 10-K for the year ended December 31,2003, which hereby is incorporated by reference.  Should one or more of these risks oruncertainties materialize, or should underlying assumptions prove incorrect,actual results may vary materially from those anticipated, estimated, or projected.

 

**Item 3****.****          ****Qualitative andQuantitative Disclosure About Market Risk****.**

 

We invest our cash in avariety of financial instruments, including U.S. Treasury and agencyobligations, money market instruments of domestic and foreign issuersdenominated in U.S. dollars consisting of commercial paper, bankers’acceptances, certificates of deposit, euro-dollar time deposits and variablerate issues, corporate note and bonds, asset-backed securities, repurchaseagreements, municipal notes and bonds, and auction rate preferred securities.

 

Investments in both fixedand floating rate interest-earning instruments carry a degree of interest raterisk. Fixed securities may have their fair market value adversely impactedbecause of a rise in interest rates, while floating rare securities may produceless income than expected if interest rates fall. Due in part to these factors,our future investment income may fall short of expectations because of changesin interest rates, or the Company may suffer losses in principal if forced tosell securities which have seen a decline in market value because of changes ininterest rates.  A 10% change in interestrates could have approximately a $150,000 impact on our interest income.

 

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

 

**Item  4****.  Controlsand Procedures.**

 

Our management, under the supervision and with the participation ofDavid C. Karlgaard, our Chief Executive Officer, and Stuart R. Lloyd, our ChiefFinancial Officer, performed an evaluation of the design and operation of ourdisclosure controls and procedures (as defined in Rule 13a-15 under theSecurities Exchange Act of 1934).  Basedon that evaluation, Messrs. Karlgaard and Lloyd concluded that as ofJune 30, 2004, our disclosure controls and procedures were effective.  There has been no change in the Company’sinternal controls over financial reporting that occurred during the quarterended June 30, 2004, that has materially affected, or is likely tomaterially affect, the Company’s internal control over financial reporting.

 

19

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**PART II****– OTHERINFORMATION**

 

**Item 1****.  LegalProceedings.**

 

On or after March 18, 2003, several purported class actioncomplaints were filed against us and certain of our officers in the UnitedStates District Court for the Eastern District of Virginia.  The complaints allege that betweenOctober 22, 2002 and March 14, 2003, the defendants made, or wereaware of, false and misleading statements which had the effect of inflating themarket price of our stock, in violation of Sections 10(b) and 20(a) of theSecurities Exchange Act of 1934.  Thecomplaints were consolidated into a single class action on June 12,2003.  The class action was dismissed bythe district court on January 28, 2004. The plaintiffs filed an appeal with the U.S. Court of Appeals for theFourth Circuit on June 30, 2004.  Inaddition, a stockholder’s legal counsel sent a letter of demand that the Boardof Directors investigate the same charges addressed in the class actionsuit.  The Board concluded, after itsinvestigation and based on its business judgment, to reject the demand letter.

 

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

 

**Item 2. Cha****nges In Securities and Use of Proceeds****.**

 

None.

 

**Item 3. Defaults Upon Senior Securities.**

 

None.

 

**Item 4.  S**ubmissionof Matters to a Vote of Security Holders.

 

The Company held itsAnnual Meeting of Stockholders on May 19, 2004 (the “Annual Meeting”).  Set forth below is a brief description ofeach matter voted upon at the Annual Meeting and the number of votes cast for,withheld or against, the number of abstentions and broker on-votes with respectto each matter.

 

(a)  *Electionof Class II directors. *Thethree directors proposed by the Board of Directors for re-election at theAnnual Meeting were elected to new, three-year terms by the following vote:

 

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| **Name of Director** | ** ** | **Votes For** | ** ** | **Authority Withheld** | ** ** | **Broker Non-Votes** | ** ** |
|----------------------|------------|---------------|------------|------------------------|------------|----------------------|------------|
| Paul  G. Rice        |       | 25,673,563    |       | 53,042                 |       | 0                    |       |
| Frank  J. Carr       |       | 25,673,563    |       | 53,042                 |       | 0                    |       |
| Zimri  C. Putney     |       | 25,673,563    |       | 53,042                 |       | 0                    |       |

 

Our remaining directors,Dr. David C. Karlgaard, Dr. Alan H. Harbitter, Stuart R. Lloyd, B. Gary Dando,R. Jerry Grossman, and John W. Melchner, were not up for election, and theirterms of office as directors continued after the Annual Meeting.

 

(b) *Ratification of the appointment ofPricewaterhouseCoopers LLP (“PWC”) as our independent auditors. *The appointment of PWC wasratified at the Annual Meeting by the following vote*:* votes for:24,935,037; votes against: 727,255; abstentions: 11,271; broker non-votes: 0.

 

**Item 5****. Other Information.**

 

None.

 

21

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**Item 6****.  Exhibitsand Reports on Form 8-K.**

 

**(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 Severance  Plan and Letter Agreement between the 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 Severance  Plan and Letter Agreement between the 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 Severance  Plan and Letter Agreement between the 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 the Registrant                           |
|                |       |                                                                                                                        |
| 10.15**             |       | Amendment No. 3 to  Office Lease Agreement between Building IV Associates L.P. and the Registrant                           |
|                |       |                                                                                                                        |
| 10.16**             |       | Office Lease Agreement  between Building VI L.C. and the Registrant                                                         |
|                |       |                                                                                                                        |
| 10.17***            |       | First Amendment to Lease  Agreement between Building VI L.C.  and  the Registrant                                      |

 

22

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| 10.18***    |   | Second Amendment to  Lease Agreement between Building VI L.C. and the Registrant                                        |
|-------------|--------|-------------------------------------------------------------------------------------------------------------------------|
|        |   |                                                                                                                    |
| 10.19***    |   | Operating Agreement  between Building VI Investment L.C. and the Registrant                                             |
|        |   |                                                                                                                    |
| 10.20***    |   | First Amendment to  Operating Agreement between Building VI Investment L.C. and the Registrant                          |
|        |   |                                                                                                                    |
| 10.21***    |   | Bank of America  Financing and Security Agreement                                                                       |
|        |   |                                                                                                                    |
| 10.22***    |   | Bank of America  Promissory Note                                                                                        |
|        |   |                                                                                                                    |
| 10.23*****  |   | Amended and Restated  Bank of America Revolving Credit Note                                                             |
|        |   |                                                                                                                    |
| 10.24*****  |   | Amendment to Restated  Bank of America Financing and Security Agreement                                                 |
|        |   |                                                                                                                    |
| 10.25*****  |   | Key Executive Severance  Plan and Letter Agreement between Registrant and Christos Bratiotis, dated  July 23, 2003 |
|        |   |                                                                                                                    |
| 10.26*****  |   | Key Executive Severance  Plan and Letter Agreement between Registrant and John T. Forbus, dated  July 23, 2003     |
|        |   |                                                                                                                    |
| 10.27****** |   | Key Executive Severance  Plan and Letter Agreement between Registrant and Charles E. Owlett, dated  July 23, 2003  |
|        |   |                                                                                                                    |
| 31.1        |   | Section 302  Certification of Chief Executive Officer                                                              |
|        |   |                                                                                                                    |
| 31.2        |   | Section 302  Certification of Chief Financial Officer                                                              |
|        |   |                                                                                                                    |
| 32.1        |   | Section 906  Certification of Chief Executive Officer                                                              |
|        |   |                                                                                                                    |
| 32.2        |   | Section 906  Certification of Chief Financial Officer                                                              |

 

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

 

********                                 **Incorporatedherein by reference to the Company’s Annual Report on Form 10K/A for the yearended December 31, 2000, filed on April 19, 2001.

 

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

 

**********                   **Incorporatedherein by reference to the Company’s Annual Report on Form 10-K for the yearended December 31, 2001, filed on March 29, 2002.

 

***********            **Incorporatedherein by reference to the Company’s Quarterly Report on Form 10Q for thequarter ended June 30, 2003, filed on August 14, 2003.

 

******      Incorporated herein by reference to the Company’s Quarterly Reporton Form 10-Q for the quarter ended September 30, 2003, filed onNovember 14, 2003.

 

(b)         Reports on Form 8-K

 

On April 20, 2004, wefiled a Current Report on Form 8-K, accompanying a press release announcing ourfinancial results for the quarter ended March 31, 2004.

 

On June 1, 2004, wefiled a Current Report on Form 8-K, accompanying a press release announcing thepurchase of IITC on May 28, 2004, and a copy of the Stock Purchase Agreement.

 

23

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**SIGNATURES**

 

Pursuant to therequirements of the Securities Exchange Act of 1934, the Company has dulycaused this report to be signed on its behalf by the undersigned thereunto dulyauthorized.

 

 
|                       | BY: /s/ STUART R. LLOYD                                                  |
|----------------------------|--------------------------------------------------------------------------|
| DATE: AUGUST 9,  2004 | Stuart R. Lloyd                                                          |
|                       | Chief Financial Officer,  Senior Vice President, Treasurer and  Director |
|                       | (Principal Financial and  Accounting Officer)                            |

 

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