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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549
 FORM 10-Q þ
    
    QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
 For the quarterly period ended March 31, 2005 OR o
    
    TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
 For the transition period from       to Commission file number 000-02479 DYNAMICS RESEARCH CORPORATION  Massachusetts
    
    04-2211809(State or other Jurisdiction of
    
    (I.R.S. Employer Identification No.)Incorporation or Organization)
 60 Frontage RoadAndover, Massachusetts
    
    01810-5498(Address of Principal Executive Offices)
    
    (Zip Code)
 Registrants telephone number, including area code (978) 475-9090 Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by
Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for
such shorter period that the registrant was required to file such reports), and (2) has been
subject to such filing requirements for the past 90 days. Yes
þ No o. Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of
the Exchange Act). Yes þ No o. As of May 2, 2005, there were 8,919,646 shares of the Registrants Common Stock, $0.10 par value,
outstanding.




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DYNAMICS RESEARCH CORPORATION INDEX Page NumberPART I. FINANCIAL INFORMATIONItem 1. Consolidated Financial StatementsConsolidated Balance Sheets as of March 31, 2005 (unaudited) and December 31, 2004 (audited)
    
    
    3Consolidated Statements of Operations for the three months ended March 31, 2005 and 2004 (unaudited)
    
    
    4Consolidated Statement of Changes in Stockholders Equity and Comprehensive Income for the three months ended March 31, 2005 (unaudited)
    
    
    5Consolidated Statement of Changes in Stockholders Equity and Comprehensive Income for the three months ended March 31, 2004 (unaudited)
    
    
    6Consolidated Statements of Cash Flows for the three months ended March 31, 2005 and 2004 (unaudited)
    
    
    7Notes to Consolidated Financial Statements (unaudited)
    
    
    8Item 2. Managements Discussion and Analysis of Financial Condition and Results of Operations
    
    
    22Item 3. Quantitative and Qualitative Disclosures about Market Risk
    
    
    42Item 4. Controls and Procedures
    
    
    42PART II.OTHER INFORMATION
    
    
    44Item 1. Legal Proceedings
    
    
    44Item 6. Exhibits
    
    
    45Signatures
    
    
    46EX-31.1 SECTION 302 CERTIFICATION OF CEOEX-31.2 SECTION 302 CERTIFICATION OF CFOEX-32.1 SECTION 906 CERTIFICATION OF CEOEX-32.2 SECTION 906 CERTIFICATION OF CFO
  2




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Dynamics Research Corporation 
 
 March 31,
    
    
    December 31,2005
    
    
    2004(unaudited)
    
    
    (audited)AssetsCurrent assetsCash and cash equivalents
    
    $
    556
    
    
    $
    925Accounts receivable, net of allowances of $265 at March 31, 2005
and $396 at December 31, 2004
    
    
    37,290
    
    
    
    45,978Unbilled expenditures and fees on contracts in process
    
    
    51,773
    
    
    
    48,119Prepaid expenses and other current assets
    
    
    4,999
    
    
    
    5,668Total current assets
    
    
    94,618
    
    
    
    100,690Noncurrent assetsProperty, plant and equipment, net
    
    
    22,413
    
    
    
    22,139Goodwill
    
    
    63,055
    
    
    
    63,055Intangible assets, net
    
    
    10,765
    
    
    
    11,519Unbilled expenditures and fees on contracts in process
    
    
    5,385
    
    
    
    2,203Other noncurrent assets
    
    
    4,920
    
    
    
    5,528Total noncurrent assets
    
    
    106,538
    
    
    
    104,444Total assets
    
    $
    201,156
    
    
    $
    205,134Liabilities and stockholders equityCurrent liabilitiesCurrent portion of long-term debt
    
    $
    8,357
    
    
    $
    8,357Revolver
    
    
    9,550
    
    
    
    10,000Accounts payable
    
    
    18,690
    
    
    
    20,550Accrued payroll and employee benefits
    
    
    15,575
    
    
    
    17,914Deferred income taxes
    
    
    14,553
    
    
    
    15,418Other accrued expenses
    
    
    3,694
    
    
    
    4,447Discontinued operations
    
    
    264
    
    
    
    422Total current liabilities
    
    
    70,683
    
    
    
    77,108Long-term liabilitiesLong-term debt, less current portion
    
    
    49,396
    
    
    
    51,485Deferred income taxes
    
    
    1,113
    
    
    
    591Accrued pension liability
    
    
    10,457
    
    
    
    11,336Other long-term liabilities
    
    
    5,563
    
    
    
    3,296Total long-term liabilities
    
    
    66,529
    
    
    
    66,708Total liabilities
    
    
    137,212
    
    
    
    143,816Commitments and contingenciesStockholders equityPreferred stock, $0.10 par value, 5,000,000 shares authorized,
no shares issued
    
    
    
    
    
    
    Common stock, $0.10 par value, 30,000,000 shares authorized:8,880,900 shares at March 31, 2005 and 8,737,562 shares
at December 31, 2004
    
    
    888
    
    
    
    874Capital in excess of par value
    
    
    42,824
    
    
    
    40,849Unearned compensation
    
    
    (2,614
    )
    
    
    (1,572
    )Accumulated other comprehensive loss
    
    
    (8,136
    )
    
    
    (7,724
    )Retained earnings
    
    
    30,982
    
    
    
    28,891Total stockholders equity
    
    
    63,944
    
    
    
    61,318Total liabilities and stockholders equity
    
    $
    201,156
    
    
    $
    205,134
 The accompanying notes are an integral part of these unaudited consolidated financial statements. 3




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Dynamics Research Corporation 
 
 Three months endedMarch 31,2005
    
    
    2004Contract revenue
    
    $
    71,839
    
    
    $
    60,637Product sales
    
    
    1,703
    
    
    
    1,431Total revenue
    
    
    73,542
    
    
    
    62,068Cost of contract revenue
    
    
    60,806
    
    
    
    51,837Cost of product sales
    
    
    1,409
    
    
    
    1,141Selling, general and administrative expenses
    
    
    6,021
    
    
    
    5,335Amortization of intangible assets
    
    
    754
    
    
    
    381Total operating costs and expenses
    
    
    68,990
    
    
    
    58,694Operating income
    
    
    4,552
    
    
    
    3,374Interest expense, net
    
    
    (1,086
    )
    
    
    (213
    )Other income
    
    
    25
    
    
    
    381Income before provision for income taxes
    
    
    3,491
    
    
    
    3,542Provision for income taxes
    
    
    1,400
    
    
    
    1,498Net income
    
    $
    2,091
    
    
    $
    2,044Earnings per common shareBasic
    
    $
    0.24
    
    
    $
    0.24Diluted
    
    $
    0.23
    
    
    $
    0.23Weighted average shares outstandingWeighted average shares outstanding  basic
    
    
    8,695,638
    
    
    
    8,394,265Dilutive effect of options and restricted stock grants
    
    
    524,465
    
    
    
    608,862Weighted average shares outstanding  diluted
    
    
    9,220,103
    
    
    
    9,003,127
 The accompanying notes are an integral part of these unaudited consolidated financial statements. 4




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Dynamics Research Corporation 
 
 AccumulatedCommon stock
    
    
    Capital in
    
    
    
    
    
    
    otherIssued
    
    
    excess of
    
    
    Unearned
    
    
    comprehensive
    
    
    RetainedShares
    
    
    Par value
    
    
    par value
    
    
    compensation
    
    
    loss
    
    
    earnings
    
    
    TotalBalance December 31, 2004 (audited)
    
    
    8,737
    
    
    $
    874
    
    
    $
    40,849
    
    
    $
    (1,572
    )
    
    $
    (7,724
    )
    
    $
    28,891
    
    
    $
    61,318Issuance of common stock through stock options exercised
and employee stock purchase plan
    
    
    79
    
    
    
    8
    
    
    
    795
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    803Issuance of restricted stock
    
    
    76
    
    
    
    7
    
    
    
    1,268
    
    
    
    (1,275
    )
    
    
    
    
    
    
    
    
    
    
    Forfeiture of restricted stock
    
    
    (1
    )
    
    
    
    
    
    
    (12
    )
    
    
    9
    
    
    
    
    
    
    
    
    
    
    
    (3
    )Retirement of restricted stock
    
    
    (11
    )
    
    
    (1
    )
    
    
    (166
    )
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (167
    )Amortization of unearned compensation
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    224
    
    
    
    
    
    
    
    
    
    
    
    224Change in unrealized gain on investment in Lucent Technologies,
net of tax
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (412
    )
    
    
    
    
    
    
    (412
    )Tax benefit from stock options exercised and employee
stock purchase plan
    
    
    
    
    
    
    
    
    
    
    90
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    90Net income
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    2,091
    
    
    
    2,091Balance March 31, 2005
    
    
    8,880
    
    
    $
    888
    
    
    $
    42,824
    
    
    $
    (2,614
    )
    
    $
    (8,136
    )
    
    $
    30,982
    
    
    $
    63,944Comprehensive income is calculated as follows:Net income
    
    $
    2,091Change in unrealized gain on investment in Lucent
Technologies, net of tax
    
    
    (412
    )Comprehensive income
    
    $
    1,679
 The accompanying notes are an integral part of these unaudited consolidated financial statements. 5




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Dynamics Research Corporation 
 
 AccumulatedCommon stock
    
    
    Capital in
    
    
    
    
    
    
    otherIssued
    
    
    Treasury stock
    
    
    excess of
    
    
    Unearned
    
    
    comprehensive
    
    
    RetainedShares
    
    
    Par value
    
    
    Shares
    
    
    Par value
    
    
    par value
    
    
    compensation
    
    
    loss
    
    
    earnings
    
    TotalBalance December 31, 2003 (audited)
    
    
    9,822
    
    
    $
    982
    
    
    
    (1,379
    )
    
    $
    (138
    )
    
    $
    36,642
    
    
    $
    (797
    )
    
    $
    (7,556
    )
    
    $
    19,518
    
    
    $
    48,651Issuance of common stock through stock options
exercised and employee stock purchase plan
    
    
    52
    
    
    
    5
    
    
    
    
    
    
    
    
    
    
    
    596
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    601Issuance of restricted stock
    
    
    71
    
    
    
    7
    
    
    
    
    
    
    
    
    
    
    
    1,286
    
    
    
    (1,293
    )
    
    
    
    
    
    
    
    
    
    
    Forfeiture of restricted stock
    
    
    (10
    )
    
    
    (1
    )
    
    
    
    
    
    
    
    
    
    
    (91
    )
    
    
    92
    
    
    
    
    
    
    
    
    
    
    
    Repurchase and retirement of restricted stock
    
    
    (3
    )
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (36
    )
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (36
    )Amortization of unearned compensation, net of forfeiture
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    65
    
    
    
    
    
    
    
    
    
    
    
    65Tax benefit from stock options exercised
and employee stock purchase plan
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    99
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    99Net income
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    2,044
    
    
    
    2,044Balance March 31, 2004
    
    
    9,932
    
    
    $
    993
    
    
    
    (1,379
    )
    
    $
    (138
    )
    
    $
    38,496
    
    
    $
    (1,933
    )
    
    $
    (7,556
    )
    
    $
    21,562
    
    
    $
    51,424Comprehensive income is calculated as follows:Net income
    
    $
    2,044Adjustments to Accumulated other comprehensive loss
    
    
    Comprehensive income
    
    $
    2,044
 The accompanying notes are an integral part of these unaudited consolidated financial statements. 6




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Dynamics Research Corporation 
 
 Three months endedMarch 31,2005
    
    
    2004Operating activitiesNet income
    
    $
    2,091
    
    
    $
    2,044Adjustments to reconcile net cash provided by (used in) operating activitiesDepreciation
    
    
    942
    
    
    
    874Amortization of intangible assets
    
    
    754
    
    
    
    381Stock compensation expense
    
    
    224
    
    
    
    65Non-cash interest expense
    
    
    49
    
    
    
    31Investment income from equity interest
    
    
    (55
    )
    
    
    (59
    )Tax benefit from stock options exercised
    
    
    90
    
    
    
    99Deferred income taxes
    
    
    (76
    )
    
    
    (198
    )Loss on disposal of long-lived assets
    
    
    2
    
    
    
    Change in operating assets and liabilitiesAccounts receivable, net
    
    
    8,688
    
    
    
    3,771Unbilled expenditures and fees on contracts in process
    
    
    (7,041
    )
    
    
    (15,521
    )Prepaid expenses and other current assets
    
    
    669
    
    
    
    (1,100
    )Accounts payable
    
    
    493
    
    
    
    763Accrued payroll and employee benefits
    
    
    (2,339
    )
    
    
    405Other accrued expenses
    
    
    (1,572
    )
    
    
    131Net cash provided by (used in) continuing operations
    
    
    2,919
    
    
    
    (8,314
    )Net cash used in discontinued operations
    
    
    (158
    )
    
    
    (103
    )Net cash provided by (used in) operating activities
    
    
    2,761
    
    
    
    (8,417
    )Investing activitiesAdditions to property, plant and equipment
    
    
    (1,218
    )
    
    
    (1,157
    )Purchase of business
    
    
    (111
    )
    
    
    Dividends from equity investment
    
    
    60
    
    
    
    60Increase in other assets
    
    
    (125
    )
    
    
    (326
    )Net cash used in investing activities
    
    
    (1,394
    )
    
    
    (1,423
    )Financing activitiesNet borrowings (repayments) under revolving credit agreement
    
    
    (450
    )
    
    
    6,726Principal payments under loan agreements
    
    
    (2,089
    )
    
    
    (125
    )Proceeds from the exercise of stock options and issuance of common stock
    
    
    803
    
    
    
    565Net cash provided by (used in) financing activities
    
    
    (1,736
    )
    
    
    7,166Net decrease in cash and cash equivalents
    
    
    (369
    )
    
    
    (2,674
    )Cash and cash equivalents, beginning of period
    
    
    925
    
    
    
    2,724Cash and cash equivalents, end of period
    
    $
    556
    
    
    $
    50Supplemental informationCash paid for interest
    
    $
    1,004
    
    
    $
    167Cash paid (refunded) for income taxes, net
    
    $
    89
    
    
    $
    (457
    )
 The accompanying notes are an integral part of these unaudited consolidated financial statements. 7




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DYNAMICS RESEARCH CORPORATION 
  NOTE 1. BASIS OF PRESENTATION The unaudited consolidated financial statements of Dynamics Research Corporation (DRC or
the company) and its subsidiary included herein have been prepared in accordance with
accounting principles generally accepted in the United States of America. The company
operated through the parent corporation and its wholly owned subsidiaries, HJ Ford
Associates, Inc. (HJ Ford), Andrulis Corporation (ANRULIS) and Impact Innovations Group
LLC (Impact Innovations) through December 31, 2004, at which time ANDRULIS and Impact
Innovations merged with and into the company. Effective January 1, 2005, the company
operates through the parent corporation and its wholly owned subsidiary, HJ Ford. In the opinion of management, all material adjustments that are of a normal and recurring
nature necessary for a fair presentation of the results for the periods presented have been
reflected. All material intercompany transactions and balances have been eliminated in
consolidation. The results of the three month period ended March 31, 2005 may not be
indicative of the results that may be expected for the year ended December 31, 2005. The
accompanying financial information should be read in conjunction with the consolidated
financial statements and notes thereto contained in the companys Annual Report on Form
10-K/A, Amendment No. 1 to Form 10-K, filed with the U.S. Securities and Exchange
Commission (SEC) for the year ended December 31, 2004. On September 1, 2004, the company acquired Impact Innovations from J3 Technology Services
Corp. (J3 Technology). Impact Innovations, based in the Washington, D.C. area, offers
solutions in business intelligence, enterprise software, application development,
information technology service management and other related areas. The results of this
acquired entity are included in the companys Consolidated Statements of Operations and of
Cash Flows for the three months ended March 31, 2005. The company has a 40% ownership interest in a small disadvantaged business, as defined by
the United States Government, which is accounted for using the equity method. This
ownership interest is reported as a component of Other noncurrent assets in the companys
Consolidated Balance Sheets. Earnings Per Share Basic earnings per share is computed by dividing net income by the weighted average number
of shares of common stock outstanding during the period. For periods in which there is net
income, diluted earnings per share is determined by using the weighted average number of
common and dilutive common equivalent shares outstanding during the period, unless the
effect is antidilutive. Restricted shares of common stock that are subject to the satisfaction of certain
conditions are treated as contingently issuable shares until the conditions are satisfied.
These shares are excluded from the basic earnings per share calculation and included in the
diluted earnings per share calculation. Due to their antidilutive effect, approximately 78,000 and 67,000 options to purchase
common stock were excluded from the calculation of diluted earnings per share for the first
quarters of 2005 and 2004, respectively. However, these options could become dilutive in
future periods. Stock-Based Compensation The company accounts for stock option plans under APB Opinion No. 25, Accounting for Stock
Issued to Employees, and related Interpretations. The following table illustrates the
effect on earnings per common share if the company had applied the fair value based method
of Statement of Financial Accounting Standards (SFAS) 8




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DYNAMICS RESEARCH CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) (Continued) No. 123, Accounting for Stock-Based Compensation(SFAS 123), to all outstanding and
unvested awards in each period for the purpose of recording expense for stock option
compensation (in thousands of dollars, except per share data). Three months endedMarch 31,2005
    
    
    2004Net income, as reported
    
    $
    2,091
    
    
    $
    2,044Deduct: Total stock-based employee
compensation determined under fair-value-based
method for all awards, net of related tax
effects
    
    
    (161
    )
    
    
    (412
    )Pro forma net income
    
    $
    1,930
    
    
    $
    1,632Net income per share:Basic, as reported
    
    $
    0.24
    
    
    $
    0.24Basic, pro forma
    
    $
    0.22
    
    
    $
    0.19Diluted, as reported
    
    $
    0.23
    
    
    $
    0.23Diluted, pro forma
    
    $
    0.21
    
    
    $
    0.18
 The weighted average fair values of options granted during the three months ended March 31,
2005 and 2004 were $12.08 and $10.88, respectively. The fair value of each option for the
companys plans is estimated on the date of the grant using the Black-Scholes
option-pricing model, with the following weighted average assumptions: Three months endedMarch 31,2005
    
    
    2004Expected volatility
    
    
    66.38
    %
    
    
    68.54
    %Dividend yield
    
    
    
    
    
    
    Risk-free interest rate
    
    
    3.87
    %
    
    
    3.44
    %Expected life in years
    
    
    6.5
    
    
    
    7.0
 Investment Available for Sale The company owns 672,518 shares of Lucent Technologies common stock (the Lucent shares)
which it received from the acquisition of Telica, in which DRC had an ownership interest,
by Lucent Technologies and , which are classified as available-for-sale securities as
permitted by SFAS No. 115, Accounting for Certain Investments in Debt and Equity Securities
(SFAS 115). The company has recorded the Lucent shares at fair values of $1.8 million
and $2.5 million at March 31, 2005 and December 31, 2004, respectively. The company
recognized a reduction of its unrealized gain of $0.4 million, net of taxes, resulting from
the decrease in the fair market value of the Lucent shares in the first quarter of 2005.
This amount is reported as a component of Accumulated other comprehensive loss in the
companys Consolidated Balance Sheets as of March 31, 2005. An additional 74,274 Lucent
shares are currently held in escrow for indemnification related to Lucents acquisition of
Telica. The company will record the fair value of the Lucent shares held in escrow at the
time that these shares, or any portion thereof, are issued. 9




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DYNAMICS RESEARCH CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) (Continued) Recent Accounting Pronouncements In December 2004, the FASB issued SFAS No. 123(R), Share-Based Payment(SFAS 123R).
SFAS 123R replaces SFAS No. 123, Accounting for Stock-Based Compensation(SFAS 123), and
supersedes Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to
Employees(APB 25). Under SFAS 123R, companies will be required to recognize
compensation costs related to share-based payment transactions to employees in their
financial statements. The amount of compensation cost will be measured using the
grant-date fair value of the equity or liability instruments issued. Additionally,
liability awards will be re-measured each reporting period. Compensation cost will be
recognized over the period that an employee provides service in exchange for the award.
The company is required to adopt the new standard in the first quarter of 2006. The
company historically has disclosed the pro forma effect of expensing its stock options as
prescribed by SFAS 123. The company is evaluating the different alternatives available for
applying the provisions of SFAS 123R, including guidance provided by the SEC in the
Commissions Staff Accounting Bulletin No. 107, and is currently assessing their effects on
its financial position and results of operations. Critical Accounting Policies There are business risks specific to the industries in which the company operates. These
risks include, but are not limited to, estimates of costs to complete contract obligations,
changes in government policies and procedures, government contracting issues and risks
associated with technological development. The preparation of financial statements
requires management to make estimates and assumptions that affect the reported amounts of
assets and liabilities and disclosure of contingent assets and liabilities at the date of
the financial statements. Estimates and assumptions also affect the amount of revenue and
expenses during the reported period. Actual results could differ from those estimates. The company believes the following accounting policies affect the more significant
judgments made and estimates used in the preparation of its consolidated financial
statements. Revenue Recognition The companys Systems and Services business segment provides its services pursuant to time
and materials, cost reimbursable and fixed-price contracts, including service-type
contracts. For time and materials contracts, revenue reflects the number of direct labor hours
expended in the performance of a contract multiplied by the contract billing rate, as well
as reimbursement of other billable direct costs. The risk inherent in time and materials
contracts is that actual costs may differ materially from negotiated billing rates in the
contract, which would directly affect operating income. For cost reimbursable contracts, revenue is recognized as costs are incurred and includes a
proportionate amount of the fee earned. Cost reimbursable contracts specify the contract
fee in dollars or as a percentage of estimated costs. The primary risk on a cost
reimbursable contract is that a government audit of direct and indirect costs could result
in the disallowance of certain costs, which would directly impact revenue and margin on the
contract. Historically, such audits have had no material impact on the companys revenue
and operating income. Under fixed-price contracts, other than service-type contracts, revenue is recognized
primarily under the percentage of completion method or, for certain short-term contracts,
by the completed contract method, in accordance with American Institute of Certified Public
Accountants Statement of Position 81-1, Accounting for Performance of Construction-Type and
Certain Production-Type Contracts(SOP 81-1). 10




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DYNAMICS RESEARCH CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) (Continued) Revenue from service-type fixed-price contracts is recognized ratably over the contract
period or by other appropriate output methods to measure service provided, and contract
costs are expensed as incurred. The risk to the company on a fixed-price contract is that
if estimates to complete the contract change from one period to the next, profit levels
will vary from period to period. For all types of contracts, the company recognizes anticipated contract losses as soon as
they become known and estimable. Out-of-pocket expenses that are reimbursable by the
customer are included in contract revenue and cost of contract revenue. Unbilled expenditures and fees on contracts in process are the amounts of recoverable
contract revenue that have not been billed at the balance sheet date. Generally, the
companys unbilled expenditures and fees relate to revenue that is billed in the month
after services are performed. In certain instances, billing is deferred in compliance with
contract terms, such as milestone billing arrangements and withholdings, or delayed for
other reasons. Billings which must be deferred more than one year from the balance sheet
date are classified as noncurrent assets. Costs related to certain United States
Government contracts, including applicable indirect costs, are subject to audit by the
government. Revenue from such contracts has been recorded at amounts the company expects
to realize upon final settlement. Unbilled expenditures and fees also include
subcontractor costs for which invoices have not been received and for which revenues have
not been recognized. The companys Metrigraphics business segment records revenue from product sales upon
transfer of title and risk of loss to the customer provided there is evidence of an
arrangement, fees are fixed or determinable, no significant obligations remain, collection
of the related receivable is reasonably assured and customer acceptance criteria have been
successfully demonstrated. Valuation Allowances The company provides for potential losses against accounts receivable and unbilled
expenditures and fees on contracts in process based on the companys expectation of a
customers ability to pay. These reserves are based primarily upon specific identification
of potential uncollectible accounts. In addition, payments to the company for performance
on United States Government contracts are subject to audit by the Defense Contract Audit
Agency. If necessary, the company provides an estimated reserve for adjustments resulting
from rate negotiations and audit findings. The company routinely provides for these items
when they are identified and can be reasonably estimated. Intangible and Other Long-lived Assets The company uses assumptions in establishing the carrying value, fair value and estimated
lives of intangible and other long-lived assets. Long-lived assets are reviewed for
impairment whenever events or changes in circumstances indicate that the asset carrying
value may not be recoverable. Recoverability is measured by a comparison of the assets
continuing ability to generate positive income from operations and positive cash flow in
future periods compared to the carrying value of the asset. If assets are considered to be
impaired, the impairment is recognized in the period of identification and is measured as
the amount by which the carrying value of the asset exceeds the fair value of the asset. The useful lives and related amortization of intangible assets are based on their estimated
residual value in proportion to the economic benefit consumed. The useful lives and
related depreciation of other long-lived assets are based on the companys estimate of the
period over which the asset will generate revenue or otherwise be used by the company. 11




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DYNAMICS RESEARCH CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) (Continued) Goodwill The company assesses goodwill for impairment at the segment level at least once each year
by applying a direct value-based fair value test. Goodwill could be impaired due to market
declines, reduced expected future cash flows, or other factors or events. Should the fair
value of goodwill, as determined by the company at any measurement date, fall below its
carrying value, a charge for impairment of goodwill would occur in that period. Business Combinations Since 2002, the company has completed three business acquisitions. The company determines
and records the fair values of assets acquired and liabilities assumed as of the dates of
acquisition. The company utilizes an independent specialist to determine the fair values
of identifiable intangible assets acquired in order to determine the portion of the
purchase price allocable to these assets. Deferred Taxes The company records a valuation allowance to reduce its deferred tax asset to the amount
that is more likely than not to be realized. The company has considered future taxable
income and ongoing prudent and feasible tax planning strategies in assessing the need for
the valuation allowance. In the event it is determined that the company would be able to
realize its deferred tax asset in excess of their net recorded amount, an adjustment to the
deferred tax asset would increase income in the period such determination was made.
Likewise, should the company determine it would not be able to realize all or part of its
net deferred tax asset in the future, an adjustment to the deferred tax asset would be
charged to income in the period such determination was made. The company determined that
no valuation allowance was required at March 31, 2005. Pensions Accounting and reporting for the companys pension plan requires the use of assumptions,
including but not limited to, discount rate, rate of compensation increases and expected
return on assets. If these assumptions differ materially from actual results, the
companys obligations under the pension plan could also differ materially, potentially
requiring the company to record an additional pension liability. An actuarial valuation of
the pension plan is performed each year. The results of this actuarial valuation are
reflected in the accounting for the pension plan upon determination. NOTE 2. BUSINESS ACQUISITION On September 1, 2004, the company completed the acquisition of Impact Innovations from J3
Technology for $53.4 million in cash, subject to adjustment based upon the value of
tangible net assets acquired in accordance with the provisions of the Equity Purchase
Agreement among the company, Impact Innovations and J3 Technology. The company used the
proceeds from the acquisition term loan portion of its new financing facility, entered into
on September 1, 2004, to finance the transaction. The company acquired all of the
outstanding membership interests of Impact Innovations, which constituted the government
contracts business of J3 Technology. Impact Innovations, based in the Washington, D.C.
area, offered solutions in business intelligence, enterprise software, application
development, information technology service management and other related areas. Its
customers include United States government intelligence agencies and various Department of
Defense agencies, as well as federal civilian agencies. The company believes that the
acquisition of Impact Innovations enhances its Capability Maturity Model Integration
(CMMI) Level 3 rating for software engineering core competency and enriches 12




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DYNAMICS RESEARCH CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) (Continued) DRCs business intelligence, business transformation and network engineering and operations
solution sets, while adding a number of key government defense and civilian customers to
the companys portfolio, including a new customer base in the intelligence community. As
part of this transaction, the company has paid $0.7 million for legal, audit and other
transaction costs related to the acquisition. The company also accrued $0.5 million for
exit costs, primarily related to the consolidation of one of the Impact Innovations
facilities into a DRC facility, including lease costs for the abandoned acquired facility. The purchase price was determined through negotiations with J3 Technology based upon the
companys access to new customers, customer relationships and cash flows. A portion of the
excess of purchase price over fair value of net assets acquired was allocated on a
preliminary basis to customer relationships, which the company estimates to have a useful
life of five years, based upon a preliminary independent appraisal. Accordingly, the
company is amortizing this intangible asset over five years, based upon the estimated
future cash flows of the individual contracts related to this asset. The balance of the
excess purchase price was recorded as goodwill. Finalization of the allocation of excess
of purchase price over the fair value of net assets acquired to identifiable intangible
assets and goodwill will be made after completion of the analysis of their fair values,
which the company expects to occur in the second quarter of 2005. The company has accrued
$0.5 million for additional cash consideration to the seller based upon the value of
tangible net assets acquired that were recorded at December 31, 2004. A change of $1.0
million in the allocation between the acquired identifiable intangible assets would result
in a change in annual amortization expense of approximately $0.2 million. An increase in
the useful life of the acquired identifiable intangible asset from five years to six years
would result in a decrease in annual amortization expense of approximately $0.4 million. A
decrease in the useful life of the identifiable intangible asset from five years to four
years would result in an increase in annual amortization expense of approximately $0.6
million. This sensitivity analysis assumes that any change would be allocated equally to
each financial reporting period. Any actual change to the value or useful life of the
customer relationships intangible asset would require analysis to calculate the new
estimated future cash flows of the individual contracts related to this asset in order to
determine the period amortization expense to be recorded. A summary of the transaction is
as follows (in thousands): Consideration:Cash
    
    $
    53,399Accrued estimated additional cash consideration
    
    
    473Transaction costs
    
    
    726Exit costs
    
    
    469Total consideration
    
    
    55,067Preliminary allocation of consideration to assets
acquired/(liabilities assumed):Working capital
    
    
    6,768Property and equipment
    
    
    562Other noncurrent assets
    
    
    57Long-term liabilities
    
    
    (164
    )Preliminary total fair value of net tangible assets acquired
    
    
    7,223Preliminary excess of consideration over fair value of net
tangible assets acquired
    
    
    47,844Preliminary allocation of excess consideration to identifiable
intangible assets:Customer relationships
    
    
    11,500Preliminary allocation of excess consideration to goodwill
    
    $
    36,344
 13




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DYNAMICS RESEARCH CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) (Continued) The activity for the three months ended March 31, 2005, related to the exit costs accrued in
connection with the acquisition of Impact Innovations is as follows (in thousands): Balance at December 31, 2004
    
    $
    393Expenditures charged against accrual
    
    
    (69
    )Balance at March 31, 2005
    
    $
    324
 The following pro forma results of operations for the three month periods ended March 31,
2004 have been prepared as though the acquisition of Impact Innovations had occurred on
January 1, 2004. These pro forma results include adjustments for interest expense and
amortization of deferred financing costs on the acquisition term loan used to finance the
transaction, amortization expense for the identifiable intangible asset recorded and the
effect of income taxes. This pro forma information does not purport to be indicative of the
results of operations that would have been attained had the acquisition been made as of
January 1, 2004, or of results of operations that may occur in the future (in thousands,
except per share data): Three monthsendedMarch 31, 2004Revenue
    
    $
    73,938Net income
    
    $
    1,945Earnings per shareBasic
    
    $
    0.23Diluted
    
    $
    0.22
 NOTE 3. GOODWILL AND INTANGIBLE ASSETS Components of the companys identifiable intangible assets, customer relationships, are as
follows (in thousands): March 31,
    
    
    December 31,2005
    
    
    2004Cost
    
    $
    14,200
    
    
    $
    14,200Less accumulated amortization
    
    
    3,435
    
    
    
    2,681$
    10,765
    
    
    $
    11,519
 The company recorded amortization expense for its identifiable intangible assets of $0.8
million and $0.4 million for the three months ended March 31, 2005 and 2004, respectively.
Estimated amortization expense for the identifiable intangible assets recorded by the
company as of March 31, 2005 is as follows (in thousands): Remainder of 2005
    
    $
    2,3532006
    
    $
    2,7872007
    
    $
    2,5812008
    
    $
    2,0212009
    
    $
    1,023
 There were no changes in the carrying amount of goodwill during the three months ended
March 31, 2005. 14




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DYNAMICS RESEARCH CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) (Continued) NOTE 4. INCOME TAXES At both March 31, 2005 and December 31, 2004, deferred taxes on unbilled receivables
totaled approximately $17 million. Concurrent with an ongoing audit of the companys 2003
and 2002 federal income tax returns, the Internal Revenue Service (IRS) has challenged
the deferral of income for tax purposes related to the companys unbilled accounts
receivable (which are reported under the caption Unbilled expenditures and fees on
contracts in process in both current and noncurrent assets in the companys Consolidated
Balance Sheets), including the applicability of a Letter Ruling issued by the IRS to the
company in January 1976, which granted to the company deferred tax treatment of its
unbilled receivables. While the outcome of the audit is not known,
the company may incur interest expense, the companys deferred
tax liabilities may be reduced and income tax payments may be increased substantially in
2005 and beyond. NOTE 5. BUSINESS SEGMENT, GEOGRAPHIC, MAJOR CUSTOMER AND RELATED PARTY INFORMATION The company has two reportable business segments: Systems and Services, and Metrigraphics. The Systems and Services segment provides technical and information technology solutions to
government customers. These solutions include the design, development, operation and
maintenance of business intelligence systems, business transformation services, defense
program acquisition management services, training and performance support systems and
services, automated case management systems and information technology (IT)
infrastructure services. The Metrigraphics segment develops and builds components for original equipment
manufacturers in the computer peripheral device, medical electronics, telecommunications
and other industries, with the focus on the custom design and manufacture of miniature
electronic parts that are intended to meet high precision requirements through the use of
electroforming, thin film deposition and photolithography technologies. The company evaluates performance and allocates resources based on operating income (loss).
The operating income (loss) for each segment includes amortization of intangible assets
and selling, general and administrative expenses directly attributable to the segment. All
corporate operating expenses, including depreciation of corporate assets, are allocated
between the segments based on segment revenues. Corporate assets are primarily comprised
of cash and cash equivalents, the companys corporate headquarters facility in Andover,
Massachusetts, the PeopleSoft-based enterprise business system, any deferred tax assets,
certain corporate prepaid expenses and other current assets, and valuation allowances. Results of operations information for the companys business segments for the three month
period ended March 31, 2005 and 2004 are as follows (in thousands): Three months endedMarch 31,2005
    
    
    2004RevenueSystems and Services
    
    $
    71,839
    
    
    $
    60,637Metrigraphics
    
    
    1,703
    
    
    
    1,431$
    73,542
    
    
    $
    62,068Operating income (loss)Systems and Services
    
    $
    4,551
    
    
    $
    3,468Metrigraphics
    
    
    1
    
    
    
    (94
    )$
    4,552
    
    
    $
    3,374
 15




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DYNAMICS RESEARCH CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) (Continued) Asset information for the companys business segments and a reconciliation of segment
assets to the corresponding consolidated amounts as of March 31, 2005 and December 31, 2004
is as follows (in thousands): March 31,
    
    
    December 31,2005
    
    
    2004Segment assetsSystems and Services
    
    $
    175,890
    
    
    $
    179,973Metrigraphics
    
    
    1,767
    
    
    
    1,859Total segment assets
    
    
    177,657
    
    
    
    181,832Corporate assets
    
    
    23,499
    
    
    
    23,302$
    201,156
    
    
    $
    205,134
 Revenue is attributed to geographic areas based on the customers location. The company
does not have locations outside the United States; however, in rare instances, it may have
contracts with sales representatives located in foreign countries and provide services at
customer locations outside the United States. Domestic revenues consistently represent
approximately 98% to 99% of the companys consolidated revenues. Revenues from Department of Defense (DoD) customers accounted for approximately 76% and
80% of total revenues in the three months ended March 31, 2005 and 2004, respectively.
Information related to revenues earned from two significant DoD customers is as follows
(dollars in thousands): Percentage of revenuesThree months ended
    
    
    Accounts receivableMarch 31,
    
    
    March 31,
    
    
    December 31,2005
    
    
    2004
    
    
    2005
    
    
    2004Customer A
    
    
    15
    %
    
    
    18
    %
    
    $
    51
    
    
    $
    77Customer B
    
    
    10
    %
    
    
    11
    %
    
    $
    1,780
    
    
    $
    2,410
 The company had no other customer in the first quarter of either 2005 or 2004 that
accounted for more than 10% of revenues. The company has a 40% interest in HMR Tech, which it accounts for using the equity method
of accounting. This interest was acquired as a result of the companys May 31, 2002
acquisition of HJ Ford Associates, Inc. Accordingly, HMR Tech is considered a related
party for all periods subsequent to May 31, 2002. Revenues from HMR Tech for the three
months ended March 31, 2005 and 2004, were approximately $240,000 and $97,000,
respectively. The amounts due from HMR Tech included in accounts receivable at March 31,
2005 and December 31, 2004, were approximately $138,000 and $192,000, respectively. NOTE 6. FINANCING ARRANGEMENTS On September 1, 2004, the company entered into a new secured financing agreement (the
facility) with a bank group to restructure and increase the companys credit facilities
to $100.0 million, inclusive of the current mortgage on the companys Andover,
Massachusetts corporate headquarters, which had a balance of $7.9 million at closing (the
term loan). The facility provides for a $55.0 million, five-year term loan (the
acquisition term loan) with a seven-year amortization schedule for the acquisition of
Impact Innovations and a $37.0 million, five-year revolving credit agreement for working
capital (the revolver). The bank group, led by Brown Brothers 16




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DYNAMICS RESEARCH CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) (Continued) Harriman & Co. as a lender and as administrative agent (when acting in such capacity, the
Administrative Agent), also includes KeyBank National Association, Banknorth, NA and
Fleet National Bank, a Bank of America company. The facility replaces the companys
previous $50.0 million revolving credit agreement. All of the obligations of the company and its subsidiaries under the facility are secured
by a security interest in substantially all of the assets of the company and its
subsidiaries granted to the Administrative Agent. The agreement requires financial
covenant tests to be performed against the companys annual results beginning with the
results for the year ending December 31, 2005, that, if met, would result in the release of
all collateral securing the facility except for the mortgage that secures the term loan.
If the companys results do not meet specific financial ratio requirements, the company and
its subsidiaries will be required to perfect the security interest granted to the
Administrative Agent in all of the government contracts of the company and its
subsidiaries. On an ongoing basis, the facility requires the company to meet certain financial covenants,
including maintaining a minimum net worth and certain cash flow and debt coverage ratios.
The covenants also limit the companys ability to incur additional debt, pay dividends,
purchase capital assets, sell or dispose of assets, make additional acquisitions or
investments, or enter into new leases, among other restrictions. In addition, the facility
provides that the bank group may accelerate payment of all unpaid principal and all accrued
and unpaid interest under the facility, upon the occurrence and continuance of certain
events of default, including, among others, the following:  
    Any failure by the company and its subsidiaries to make any payment of principal,
interest and other sums due under the facility within three calendar days of the date
when such payment is due;
    Any breach by the company or any of its subsidiaries of certain covenants,
representations and warranties;
    Any default and acceleration of any indebtedness owed by the company or any of its
subsidiaries to any person (other than the bank group) which is in excess of
$1,000,000;
    Any final judgment against the company or any of its subsidiaries in excess of
$1,000,000 which has not been insured to the reasonable satisfaction of the
Administrative Agent;
    Any bankruptcy (voluntary or involuntary) of the company or any of its subsidiaries; and
    Any material adverse change in the business or financial condition of the company and its subsidiaries; or
    Any change in control of the company. Acquisition term loan The company used $53.4 million of the $55.0 million of proceeds from the acquisition term
loan to complete the acquisition of Impact Innovations. The company repaid $1.6 million of
the original $55.0 million financed on September 1, 2004. The facility requires quarterly
principal payments on the acquisition term loan of approximately $2 million, with a final
payment of approximately $16 million on September 1, 2009. The company has the option of selecting an interest rate for the acquisition term loan
equal to either: (a) the then applicable London Inter-Bank Offer Rate (the LIBOR Rate)
plus 1.75% to 3.25% per annum, depending on the companys most recently reported leverage
ratio; or (b) the base rate as announced from time to time by the Administrative Agent (the
Base Rate) plus up to 0.50% per annum, depending on the companys most recently reported
leverage ratio. For those portions of the acquisition term loan accruing at the LIBOR
Rate, the company has the option of selecting interest periods of 30, 60, 90 or 180 days. Term loan The company has a ten-year term loan as amended and restated on September 1, 2004, which is
secured by a mortgage on the companys headquarters in Andover, Massachusetts. The
agreement requires quarterly principal payments of $125,000, with a final payment of $5.0
million due on May 1, 2010. The company has the option of selecting an interest rate for
the term loan equal to either: (a) the then applicable LIBOR Rate plus 1.50% to 3.00% per
annum, depending on the companys most recently reported leverage ratio; or (b) the Base
Rate plus up to 17




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DYNAMICS RESEARCH CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) (Continued) 0.50% per annum, depending on the companys most recently reported leverage ratio. For
those portions of the term loan accruing at the LIBOR Rate, the company has the option of
selecting interest periods of 30, 60, 90 or 180 days. Revolver The revolver has a five-year term and is available to the company for general corporate
purposes, including strategic acquisitions. The fee on the unused portion of the revolver
ranges from 0.25% to 0.50% per annum, depending on the companys leverage ratio, and is
payable quarterly in arrears. The company has the option of selecting an annual interest
rate for the revolver equal to either: (a) the then applicable LIBOR Rate plus 1.50% to
3.00% per annum, depending on the companys most recently reported leverage ratio; or (b)
the Base Rate plus up to 0.50% per annum, depending on the companys leverage ratio. For
those portions of the revolver accruing at the LIBOR rate, the company has the option of
selecting interest periods of 30, 60, 90 or 180 days. The revolver matures on September 1,
2009. The excess cash flow recapture provisions described below
require that additional payments under these provisions be applied
first to the outstanding balance of the revolver. Accordingly, the
company has classified the outstanding balance of the revolver as a
current liability in its Consolidated Balance Sheets. Excess cash flow recapture In addition to the principal payments required on the acquisition term loan and the term
loan, the company will also make annual payments by February 15 of each year, commencing in
2006. The additional payment amount is equal to 50.0% of the companys excess cash flow,
defined as EBITDA (earnings before interest, taxes, depreciation and amortization) plus net
decreases in working capital or less net increases in working capital, minus interest
expense and principal payments on the acquisition term loan and term loan, capital
expenditures, and all cash taxes and cash dividends paid for the most recently completed
fiscal year, commencing with the year ending December 31, 2005. Each payment will be
applied: first, to the outstanding balance of the revolver, provided the outstanding
balance on the last day of the fiscal year compared with the outstanding balance of the
revolver on the last day of the previous fiscal year does not already reflect such a
reduction; second, to the outstanding principal balance of the acquisition term loan; and
lastly, to the outstanding principal balance of the term loan. Outstanding borrowings The companys outstanding debt at March 31, 2005 and December 31, 2004, was as follows
(dollars in thousands): Outstanding
    
    
    Interestprincipal
    
    
    rate
    
    
    Interest rate option and election dateMarch 31, 2005Acquisition term loan
    
    $
    50,128
    
    
    
    5.99
    %
    
    90-day LIBOR Rate option elected on February 1, 2005Term loan
    
    
    7,625
    
    
    
    5.74
    %
    
    90-day LIBOR rate option elected on February 1, 2005Revolver (portion)
    
    
    2,550
    
    
    
    6.25
    %
    
    Base Rate option; election date not applicableRevolver (portion)
    
    
    7,000
    
    
    
    5.75
    %
    
    30-day LIBOR Rate option elected on March 7, 2005$
    67,303December 31, 2004Acquisition term loan
    
    $
    52,092
    
    
    
    5.41
    %
    
    90-day LIBOR Rate option elected on November 1, 2004Term loan
    
    
    7,750
    
    
    
    5.16
    %
    
    90-day LIBOR Rate option elected on November 1, 2004Revolver
    
    
    10,000
    
    
    
    5.28
    %
    
    30-day LIBOR Rate option elected on December 1, 2004$
    69,842
 18




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DYNAMICS RESEARCH CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) (Continued) NOTE 7. DEFINED BENEFIT PENSION PLAN The components of net periodic benefit cost for the companys defined benefit pension plan
are below (in thousands): Three months endedMarch 31,2005
    
    
    2004Interest cost
    
    $
    1,000
    
    
    $
    977Expected return on plan assets
    
    
    (1,081
    )
    
    
    (979
    )Recognized actuarial loss
    
    
    400
    
    
    
    327Net periodic benefit cost
    
    $
    319
    
    
    $
    325
 The companys defined benefit pension plan is frozen. No credit is earned for current
service and no new participants are eligible to enter the plan; accordingly, the net
periodic benefit costs do not include any charges for service cost. The company currently
expects to contribute $4.5 million in 2005 to fund its pension plan. Of this amount, $0.9
million had been contributed as of March 31, 2005. NOTE 8. DISCONTINUED OPERATIONS EXIT COST ACCRUAL On May 2, 2003, the company completed the sale of its Encoder Division assets and certain
liabilities to GSI Lumonics Inc. (GSI) in Billerica, Massachusetts. In connection with
this transaction, the company accrued $0.8 million of exit costs primarily relating to lease
costs, net of estimated sublease income. The lease on the Encoder facility expires in
August 2005. The activity for the three months ended March 31, 2005, related to this
accrual is as follows (in thousands): Balance at December 31, 2004
    
    $
    422Expenditures charged against accrual
    
    
    (158
    )Balance at March 31, 2005
    
    $
    264
 NOTE 9. CONTINGENCIES The company has change of control agreements with certain of its employees that provide them
with benefits should their employment with the company be terminated other than for cause or
their disability or death, or if they resign for good reason, as defined in these agreements,
within a certain period of time from the date of any change of control of the company. 19




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DYNAMICS RESEARCH CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) (Continued) As a defense contractor, the company is subject to many levels of audit and review from various
government agencies, including the Defense Contract Audit Agency, various inspectors general,
the Defense Criminal Investigation Service, the Government Accountability Office, the
Department of Justice and other congressional committees. Both related to and unrelated to its
defense industry involvement, the company is, from time to time, involved in audits, lawsuits,
claims, administrative proceedings and investigations. The company accrues for liabilities
associated with these activities when it becomes probable that future expenditures will be made
and such expenditures can be reasonably estimated. The companys evaluation of the likelihood
of expenditures related to these matters is subject to change in future periods, depending on
then current events and circumstances, which could have material adverse effects on the
companys business, financial position, results of operations and cash flows. As previously disclosed, on October 26, 2000, two former company employees were indicted and
charged with, among other violations, wire fraud and a conspiracy scheme to defraud the United
States Air Force out of approximately $10 million through kickbacks and overcharging for
computer components and services. The former employees collected the kickbacks and overcharges
through separate and independent businesses. The company received no money from their scheme.
When notified by the government of the employees conspiracy, the company fired the two
employees and voluntarily cooperated with the governments investigation. The company was not
charged in the criminal case. Both former employees pled guilty and were sentenced to prison.
The company believes that the government has recovered a substantial portion of the defrauded
funds from the co-conspirators. Notwithstanding the companys efforts to settle any claims
against the company arising from the co-conspirators scheme, on October 9, 2003, the United
States Attorney filed a civil complaint against the company in the United States District Court
for the District of Massachusetts based upon the False Claims Act and the Anti-Kickback Act, in
addition to certain common law and equitable claims. The United States Attorney seeks to
recover up to three times its actual damages and penalties under the False Claims Act and
double damages and penalties under the Anti-Kickback Act and to recover costs and interest.
The company has filed a third party complaint, as part of the United States Attorneys civil
action, including an affirmative multiple damage claim for unfair and deceptive practices,
against Storage Engine, Inc. (Storage Engine), formerly known as ECCS, Inc., and its
president and director. The complaint alleges that Storage Engine directly benefited from the
kickback scheme alleged by the United States Attorney. Storage Engine, a supplier of computer
components for the United States Air Force, made payments to the companys two former employees
through separate and independent businesses. Storage Engine and its president have denied the
allegations. The companys claim against Storage Engine, which filed for reorganization under
Chapter 11 of the United States Bankruptcy Code, presently remains in effect as a claim against
Storage Engine. The company disputes the claims of the U.S. Attorney, believes it has
substantive defenses, and intends to vigorously defend itself. The company and the United
States Attorney have agreed to non-binding mediation of this matter. However, the outcome of
such litigation, if unfavorable, could have a material adverse effect on the companys
business, financial position, results of operations and cash flows. In 2002, a dispute arose between Genesis Tactical Group LLC (Genesis), Lockheed Martin
Corporation (Lockheed) and DRC related to a contract for services to Lockheed which DRC sold
to Genesis in 2001. In the first quarter of 2005, Genesis, Lockheed and the company settled
the outstanding issues related to this dispute. The settlement did not have a material effect
on the companys business, financial position, results of operations or cash flows. The company has provided documents in response to a previously disclosed grand jury subpoena
issued on October 15, 2002 by the United States District Court for the District of
Massachusetts, directing the company to produce specified documents dating back to 1996. The
subpoena relates to an investigation, currently focused on the period from 1996 to 1999, by the
Antitrust Division of the Department of Justice into the bidding and procurement activities
involving the company and several other defense contractors who have received similar subpoenas
and may also be subjects of the investigation. Although the company is cooperating in the
investigation, it does not have a sufficient basis to predict 20




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DYNAMICS RESEARCH CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) (Continued) the outcome of the investigation. Should the company be found to have violated the antitrust
laws, the matter could have a material adverse effect on the companys business, financial
position, results of operations and cash flows. On February 3, 2004, a
suit was filed in the Circuit Court for the County of Fairfax,
Virginia against the company by Cushman & Wakefield of
Virginia, Inc. (Cushman & Wakefield), a real estate broker that the company maintains it had not retained, claiming breach
of contract and nonpayment of a commission fee related to an office lease. On January 12,
2005, a judgment of $407,000 was entered against the company. The real estate broker retained
by the company for such office lease has indemnified the company from any such claims.
However, the company may also be liable for Cushman &
Wakefields legal costs, against which the
companys broker may not indemnify the company. The company and its real estate broker are
considering their options for appeal. The company has recorded a reserve for costs related to
this matter. While the company believes it has accrued sufficient amounts for these costs, it
is possible that an additional liability could be incurred which could have a material adverse
effect on the companys business, financial position, results of operations and cash flows. In both the three months ended March 31, 2005 and the year ended December 31, 2004,
approximately 89% of the companys revenues were derived from sales to United States
Government agencies, primarily the Department of Defense. All of the companys United
States Government contracts are subject to termination for convenience in accordance with
government regulations. In the three months ended March 31, 2005 and the year ended
December 31, 2004, sales to agencies of state and local governments comprised approximately
8% and 7%, respectively, of revenues. Many of the contracts the company has won are
multi-year efforts. In accordance with state laws, funding must be approved annually by
the respective states legislature. 21




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DYNAMICS RESEARCH CORPORATION 
 Item 2. MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF
OPERATIONS FORWARD-LOOKING STATEMENTS Certain statements in this quarterly report constitute forward-looking statements which
involve known risks, uncertainties and other factors which may cause the actual results,
performance or achievements of Dynamics Research Corporation (DRC or the company) to be
materially different from any future results, performance or achievements expressed or
implied by such forward-looking statements. Such factors include the Factors That May
Affect Future Results set forth in Managements Discussion and Analysis of Financial
Condition and Results of Operations, which is included in this report. Precautionary
statements made herein should be read as being applicable to all related forward-looking
statements whenever they appear in this report. OVERVIEW DRC, founded in 1955, and headquartered in Andover, Massachusetts, provides information
technology (IT), engineering and other services focused on defense, public safety and
citizen services for federal, state and local governments. The companys core capabilities
are focused on information technology, engineering and technical subject matter expertise
that pertain to the knowledge domains of the companys core customers. The companys strategy is comprised of four key objectives: (a) to increase shareholder
value; (b) to grow revenues in selected markets; (c) to achieve operational excellence; and
(d) to be an employer of choice. Operating margin and cash generation improvement
initiatives support the companys shareholder value objective. DRC has a balanced growth
strategy aimed at organic growth in its existing markets and penetrating new market
segments through acquisition. The company has completed three business acquisitions since
2002. The companys initiatives related to its employer of choice objective include
professional development programs, performance-based compensation programs and competitive
benefit programs. The company has two reportable business segments: Systems and Services, and Metrigraphics.
The Systems and Services segment provides technical and information technology solutions
to government customers. These solutions include the design, development, operation and
maintenance of business intelligence systems, business transformation services, defense
program acquisition management services, training and performance support systems and
services, automated case management systems and IT infrastructure services. Revenues in
this segment are reported in the caption Contract revenue in the companys Consolidated
Statements of Operations. The Metrigraphics segment develops and builds components for
original equipment manufacturers (OEM) in the computer peripheral device, medical
electronics, telecommunications and other industries, with the focus on the custom design
and manufacture of miniature electronic parts that meet high precision requirements through
the use of electroforming, thin film deposition and photolithography technologies.
Revenues in this segment are reported in the caption Product sales in the companys
Consolidated Statements of Operations. The companys business growth strategy is focused on three national priority markets:
national defense, citizen services and citizen security. Within these markets there are
six strategic business areas on which the company focuses its efforts: C4ISR (Command,
control, communications, computing, intelligence, surveillance and reconnaissance),
logistics, readiness, military space, citizen security and legislated citizen services.
Because these markets address the mission critical functions of government, the company
expects that they will be funded regardless of economic cycle. The strategy leverages six
solution sets where DRC has strong competencies and a record of meeting its customers most
difficult challenges. These repeatable, proven, cost-effective solutions are acquisition
management services, training and performance support, business transformation, business
intelligence, IT infrastructure services and automated case management. 22




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BUSINESS ACQUISITION On September 1, 2004, the company completed the acquisition of Impact Innovations Group LLC
(Impact Innovations) from J3 Technology Services Corp. Impact Innovations, based in the
Washington, D.C. area, offers solutions in business intelligence, enterprise software,
application development, information technology service management and other related areas.
The results of this acquired entity are included in the companys Consolidated Statements
of Operations and of Cash Flows for the three months ended March 31, 2005. RESULTS OF OPERATIONS Operating results (in thousands) and expressed as a percentage of total revenues for the
three month periods ended March 31, 2005 and 2004 are as follows: Three months ended
    
    
    Three months endedMarch 31, 2005
    
    
    March 31, 2004% of
    
    
    
    
    
    
    % of$ thousands
    
    
    revenues
    
    
    $ thousands
    
    
    revenuesContract revenue (Systems and Services)
    
    $
    71,839
    
    
    
    97.7
    %
    
    $
    60,637
    
    
    
    97.7
    %Product sales (Metrigraphics)
    
    
    1,703
    
    
    
    2.3
    %
    
    
    1,431
    
    
    
    2.3
    %Total revenue
    
    
    73,542
    
    
    
    100.0
    %
    
    
    62,068
    
    
    
    100.0
    %Gross profit/margin on contract revenue (1)
    
    
    11,033
    
    
    
    15.4
    %
    
    
    8,800
    
    
    
    14.5
    %Gross profit/margin on product sales (1)
    
    
    294
    
    
    
    17.3
    %
    
    
    290
    
    
    
    20.3
    %Total gross profit/margin (1)
    
    
    11,327
    
    
    
    15.4
    %
    
    
    9,090
    
    
    
    14.6
    %Selling, general and administrative expenses
    
    
    6,021
    
    
    
    8.2
    %
    
    
    5,335
    
    
    
    8.6
    %Amortization of intangible assets
    
    
    754
    
    
    
    1.0
    %
    
    
    381
    
    
    
    0.6
    %Operating income
    
    
    4,552
    
    
    
    6.2
    %
    
    
    3,374
    
    
    
    5.4
    %Interest expense, net
    
    
    (1,086
    )
    
    
    (1.5
    )%
    
    
    (213
    )
    
    
    (0.3
    %)Other income (expense), net
    
    
    25
    
    
    
    
    
    
    
    381
    
    
    
    0.6
    %Income before provision for income taxes
    
    $
    3,491
    
    
    
    4.7
    %
    
    $
    3,542
    
    
    
    5.7
    %
   (1)
    
    These amounts represent a percentage of contract revenues, product sales and total
revenues, respectively. Revenues The company reported revenues of $73.5 million and $62.1 million in the first quarters of
2005 and 2004, respectively. The revenues for the three months ended March 31, 2005
represent an increase of $11.4 million, or 18.5%, from the same prior year period. Contract revenues (Systems and Services segment) Contract revenues in the companys Systems and Services segment were $71.8 million and
$60.7 million in the 23




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three months ended March 31, 2005 and 2004, respectively. The increase in the current year
was primarily attributable to revenues added through the acquisition of Impact Innovations.
The companys contract revenue in the first quarters of 2005 and 2004 was earned from the
following sectors (in thousands): Three months endedMarch 31,2005
    
    
    2004Defense and intelligence agencies
    
    $
    56,014
    
    
    $
    49,813Federal civilian agencies
    
    
    9,215
    
    
    
    6,462State and local government agencies
    
    
    5,694
    
    
    
    4,336Other
    
    
    916
    
    
    
    26$
    71,839
    
    
    $
    60,637
 The increase in revenues from both defense and intelligence agencies and federal civilian
agencies in the current year was primarily attributable to revenues added through
acquisition. Revenues from state and local government agencies increased primarily due to $3.6 million
of revenues from the companys $30 million, three and one-half year contract with the State
of Ohio to design, develop and install an automated child welfare case management system.
Work under this contract began in the second quarter of 2004. Despite a high level of
bookings in the first quarter of 2005 and a growing new business
pipeline, extensions in procurement schedules and contract award
delays, coupled with a very competitive Washington area employment
market, have dampened organic growth in the first quarter. The
companys new business awards in the first quarter of 2005
totaled approximately $8 million, compared to approximately
$18 million in the same prior year quarter. The company believes
the delays relate, directly or indirectly, to funding needs for the
war in Iraq. Revenues by contract type as a percentage of Systems and Services segment revenues were as
follows: Three months endedMarch 31,2005
    
    
    2004Time and materials
    
    
    55
    %
    
    
    62
    %Cost reimbursable
    
    
    20
    %
    
    
    22
    %Fixed price, including service-type contracts
    
    
    25
    %
    
    
    16
    %100
    %
    
    
    100
    %Prime contract
    
    
    70
    %
    
    
    71
    %Sub-contract
    

    
    30
    %
    
    
    29
    %100
    %
    
    
    100
    %
 The companys contracts with the Internal Revenue Service, the Air Force Electronic Systems
Center and the Aeronautical Systems Center, which provided approximately $12 million, $31
million and $47 million, respectively, of revenues in 2004, are subject to re-competition
in 2005. The company has submitted a proposal for a prime contract with the Internal
Revenue Service. It is currently anticipated that the 2005 competitions with the Air Force
Electronic Systems Center and the Aeronautical Systems Center will restrict prime contract
awards to small businesses. DRC expects to participate in the competitions as a
sub-contractor to qualified small businesses. The company currently
anticipates that awards on these contracts will occur in the second
half of 2005, with the transition of task orders to the new
contracts occurring in 2006. Regarding the change-over in 2006, the
company anticipates that approximately $33 million of low margin
sub-contractor pass-through revenues will move from DRC to small
business prime contractors. The company also anticipates that a
successful re-competition will enable DRC to retain and preserve
profits on substantially all
of its labor base currently supporting these customers, resulting in
an increase in profit margins. Product sales (Metrigraphics segment) Product sales for the Metrigraphics segment increased by $0.3 million, or 19.0%, in the
first quarter of 2005, compared to the same prior year quarter. This increase reflects the
overall improvement in order levels and a strengthening in the segments market in recent
periods. 24




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Funded backlog The companys funded backlog was $186.3 million at March 31, 2005, $165.0 million at
December 31, 2004 and $145.8 million at March 31, 2004. Included in the companys funded
backlog at March 31, 2005 and December 31, 2004, were $28.1 million and $30.9 million,
respectively, of funded backlog attributable to Impact Innovations. The company expects
that substantially all of its backlog will generate revenue during the subsequent twelve
month period. The funded backlog generally is subject to possible termination at the
convenience of the contracting party. A portion of the companys funded backlog is based
on annual purchase contracts and subject to annual governmental approvals or appropriations
legislation. The amount of backlog as of any date may be affected by the timing of order
receipts and associated deliveries. Gross margin The companys total gross margins were 15.4% and 14.6% for the first quarters of 2005 and
2004, respectively. The overall improvement in gross margin in 2005 is primarily the
result of lower employee benefit and other indirect overhead costs as a percentage of
revenues. The companys gross margins on contract revenues were 15.4% and 14.5% in the first quarters
of 2005 and 2004, respectively. The improvement in 2005 is primarily attributable to lower
indirect overhead costs as a percentage of revenues. The companys gross margins on product sales were 17.3% and 20.3% in the first quarters of
2005 and 2004, respectively. The decrease in margin performance in 2005 is primarily
attributable to changes in product mix and higher costs associated with sales to
international customers. Selling, general and administrative expenses Selling, general and administrative expenses increased from $5.3 million in the first
quarter of 2004, to $6.0 million in the first quarter of 2005. Costs have increased
primarily due to the addition of staff and administrative expenses associated with the
acquisition of Impact Innovations on September 1, 2004. In the first quarter, selling,
general and administrative expenses included charges of $0.1 million and $0.3 million for
2005 and 2004, respectively, which were related to deferred compensation. These charges
were offset by similar credits to other income in the same periods. Amortization of intangible assets Amortization expense of $0.8 million in the first quarter of 2005 relates to intangible
assets acquired in the companys 2004 purchase of Impact Innovations and the companys 2002
purchases of Andrulis Corporation and HJ Ford Associates, Inc. Amortization expense
related to the companys 2002 acquisitions was $0.4 million in the first quarter of 2004. Operating income (loss) The companys operating income was $4.6 million in the first quarter of 2005 and $3.4
million in the first quarter of 2004. The increase in operating income in the current
year, compared to the same prior year period, is primarily attributable to the inclusion of
Impact Innovations, which was acquired on September 1, 2004. Impact Innovations reported
revenues of $11.4 million in the first quarter of 2005. 25




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Segment operating income (loss) includes amortization of intangible assets and selling,
engineering and administrative expenses directly attributable to the segment. All
corporate operating expenses, including depreciation of corporate assets, are allocated
between the segments based on segment revenues. Operating income for the Systems and
Services segment was $4.6 million in the three months ended March 31, 2005, compared to
$3.5 million in the same prior year period. The Metrigraphics
segment reported essentially break-even results in the first quarter of 2005, and an operating loss of $0.1 million in the
first quarter of 2004. Interest income and expense The company incurred interest expense totaling $1.1 million in the first quarter of 2005
and $0.2 million in the first quarter of 2004. The increase in interest expense in the
current year is primarily attributable to the acquisition loan used to fund the September
1, 2004 acquisition of Impact Innovations and higher interest rates. The interest rates on
the companys current financing vehicles are variable. These vehicles are described in
detail in the Liquidity and Capital Resources section below. The weighted average
interest rates on the companys outstanding borrowings were 5.94% and 3.22% at March 31,
2005 and 2004, respectively. An increase in one percentage point in the companys rates
would result in approximately $0.7 million of additional interest expense on an annual
basis. The company is focused on debt reduction in order to reduce its interest expense in
subsequent periods. The company recorded approximately $10,000 and $7,000 of interest income in the first
quarters of 2005 and 2004, respectively. Other income, net The company recorded net other income of approximately $25,000 and $0.4 million in the
three month periods ended March 31, 2005 and 2004, respectively. Included in these amounts
are income of $0.1 million and $0.3 million, respectively, related to investments held in a
rabbi trust associated with the companys deferred compensation plan. These credits were
offset by similar charges to selling, general and administrative expenses in the same
periods. Income tax provision The company recorded income tax provisions of $1.4 million, or 40.1% of pre-tax income, and
$1.5 million, or 42.3% of pre-tax income, in the first three months of 2005 and 2004,
respectively. The reduction in the 2005 tax rate reflects changes in estimates during 2004
for non-deductible expenses. The 2005 rate was unchanged from the 2004 year-end rate. LIQUIDITY AND CAPITAL RESOURCES At March 31, 2005 and December 31, 2004, the company had cash and cash equivalents
aggregating $0.6 million and $0.9 million, respectively. The decrease in cash and cash
equivalents is primarily the result of $1.7 million used in financing activities, including
$2.5 million of net principal payments on the companys
borrowings and $1.4 million
used in investing activities, including $1.2 million of capital expenditures. These
amounts were partially offset by $2.8 million of cash provided by operating activities,
including $0.2 million of cash used for discontinued operations. Operating activities Cash used in operating activities totaled $2.8 million for the three months ended March 31,
2005, and is primarily attributable to $2.1 million of net income, depreciation and
amortization expenses aggregating $1.7 million and $8.7 million of decreases in accounts
receivable. These amounts were partially offset by a $7.0 million increase in unbilled
expenditures and fees on contracts in process and decreases of $2.3 million in accrued
payroll and employee benefits and $1.6 million in other accrued expenses. Stock compensation expense increased to $0.2 million in the first quarter of 2005, from
$0.1 million in the comparable prior year quarter. The company has realigned its approach
to equity compensation by increasing its 26




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use of restricted stock awards and reducing its use of stock option awards. As a result,
higher non-cash expense was recorded in the current year, and will continue to be recorded
in subsequent periods. Non-cash amortization expense of the companys acquired intangible assets was $0.8 million
and $0.4 million in the first quarters of 2005 and 2004, respectively. As a result of the
companys recent business acquisition, the company anticipates that non-cash expense for
the amortization of intangible assets will remain at this quarterly level throughout 2005. At both March 31, 2005 and December 31, 2004, deferred taxes on unbilled receivables
totaled approximately $17 million. Concurrent with an ongoing audit of the companys 2003
and 2002 federal income tax returns, the Internal Revenue Service (IRS) has challenged
the deferral of income for tax purposes related to the companys unbilled accounts
receivable (which are reported under the caption Unbilled expenditures and fees on
contracts in process in both current and noncurrent assets in the companys Consolidated
Balance Sheets), including the applicability of a Letter Ruling issued by the IRS to the
company in January 1976, which granted to the company deferred tax treatment of its
unbilled receivables. While the outcome of the audit is not known,
the company may incur interest expense, the companys deferred
tax liabilities may be reduced and income tax payments may be increased substantially in
2005 and beyond. Total accounts receivable and current and noncurrent unbilled expenditures and fees on
contracts in process were $94.4 million and $96.3 million at March 31, 2005 and December
31, 2004, respectively. Billed accounts receivable decreased $8.7 million in the first
quarter of 2005, while unbilled amounts increased $7.0 million in the aggregate. The decrease in billed receivables was due to strong cash collections in the first quarter
of 2005. Collection delays encountered in the fourth quarter of 2004 with the U.S. Defense
Finance and Accounting Services and the General Services Administration improved
significantly in the first quarter of 2005. Regarding unbilled receivables, $3.6 million of the increase related to costs incurred on
the companys contract with the State of Ohio (the Ohio contract), for which payment is
contractually deferred. Total unbilled receivables on this contract were $11.8 million at
March 31, 2005 and $8.2 million at December 31, 2004. As noted in the companys most
recent 10-K filing with the SEC, the State of Ohio and the company have agreed to negotiate
accelerated payment terms on the contract. The outcome of such negotiations is uncertain
at this time. Total accounts receivable (including unbilled amounts) days sales outstanding, or DSO, was
116 at March 31, 2005 and 111 at December 31, 2004. The Ohio contract receivable balance
accounted for 14 days of the companys DSO at March 31, 2005, and 9 days of the companys
DSO at December 31, 2004, which accounted for the entire increase in total DSO. An
increase of $3.4 million in unbilled costs on contracts other than the Ohio contract was
offset by the decrease in billed receivables noted above. Investing activities The company used $1.4 million of cash in investing activities, primarily comprised of
capital expenditures aggregating $1.2 million, including $0.9 for renovations to the
companys Andover, Massachusetts corporate headquarters. The companys capital
expenditures, excluding business acquisitions, if any, are expected to approximate $5 to $6
million in 2005, primarily for facilities and infrastructure consolidation and improvement. The company believes that selective acquisitions are an important component of its growth
strategy. The company may acquire, from time to time, firms or properties that are aligned
with the companys core capabilities and which complement the companys customer base. The
company will continue to consider acquisition opportunities that align with its strategic
objectives, along with the possibility of utilizing the credit facility, described below,
as a source of financing. 27




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Financing activities The company used $1.7 million of cash in financing activities, including $2.5 million of
net principal payments on the companys borrowings. These payments were partially
offset by $0.8 million of proceeds from the exercise of stock options and issuance of
shares under the employee stock purchase plan. On September 1, 2004, the company entered into a new secured financing agreement (the
facility) with a bank group to restructure and increase the companys credit facilities
to $100.0 million, inclusive of the current mortgage on the companys Andover,
Massachusetts corporate headquarters, which had a balance of $7.9 million at closing (the
term loan). The facility provides for a $55.0 million, five-year term loan (the
acquisition term loan) with a seven-year amortization schedule for the acquisition of
Impact Innovations and a $37.0 million, five-year revolving credit agreement for working
capital (the revolver). The bank group, led by Brown Brothers Harriman & Co. as a lender
and as administrative agent (when acting in such capacity, the Administrative Agent),
also includes KeyBank National Association, Banknorth, NA and Fleet National Bank, a Bank
of America company. The company used $53.4 million of the $55.0 million of proceeds from the acquisition term
loan to complete the acquisition of Impact Innovations. The company repaid $1.6 million of
the original $55.0 million financed on September 1, 2004. The facility requires quarterly
principal payments on the acquisition term loan of approximately $2 million, with a final
payment of approximately $16 million on September 1, 2009. At March 31, 2005, the
outstanding principal balance on the acquisition term loan was $50.1 million. The company has a ten-year term loan as amended and restated on September 1, 2004, with an
outstanding principal balance of $7.6 million at March 31, 2005, which is secured by a
mortgage on the companys headquarters in Andover, Massachusetts. The agreement requires
quarterly principal payments of $125,000, with a final payment of $5.0 million due on May
1, 2010. The revolver has a five-year term and is available to the company for general corporate
purposes, including strategic acquisitions. The fee on the unused portion of the revolver
ranges from 0.25% to 0.50% per annum, depending on the companys leverage ratio, and is
payable quarterly in arrears. At March 31, 2005, the outstanding principal balance on the
revolver was $9.6 million. The excess cash flow recapture provisions described below
require that additional payments under these provisions be applied
first to the outstanding balance of the revolver. Accordingly, the
company has classified the outstanding balance of the revolver as a
current liability in its Consolidated Balance Sheets. All of the obligations of the company and its subsidiaries under the facility are secured
by a security interest in substantially all of the assets of the company and its
subsidiaries granted to the Administrative Agent. The agreement requires financial
covenant tests to be performed against the companys annual results beginning with the
results for the year ending December 31, 2005, that, if met, would result in the release of
all collateral securing the facility except for the mortgage that secures the term loan.
If the companys results do not meet specific financial ratio requirements, the company and
its subsidiaries will be required to perfect the security interest granted to the
Administrative Agent in all of the government contracts of the company and its
subsidiaries. On an ongoing basis, the facility requires the company to meet certain financial covenants,
including maintaining a minimum net worth and certain cash flow and debt coverage ratios.
The covenants also limit the companys ability to incur additional debt, pay dividends,
purchase capital assets, sell or dispose of assets, make additional acquisitions or
investments, or enter into new leases, among other restrictions. In addition, the facility
provides that the bank group may accelerate payment of all unpaid principal and all accrued
and unpaid interest under the 28




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facility, upon the occurrence and continuance of certain events of default, including,
among others, the following:  
    Any failure by the company and its subsidiaries to make any payment of principal,
interest and other sums due under the facility within three calendar days of the date
when such payment is due;
    Any breach by the company or any of its subsidiaries of certain covenants,
representations and warranties;
    Any default and acceleration of any indebtedness owed by the company or any of its
subsidiaries to any person (other than the bank group) which is in excess of
$1,000,000;
    Any final judgment against the company or any of its subsidiaries in excess of
$1,000,000 which has not been insured to the reasonable satisfaction of the
Administrative Agent;
    Any bankruptcy (voluntary or involuntary) of the company or any of its subsidiaries; and
    Any material adverse change in the business or financial condition of the company and its subsidiaries; or
    Any change in control of the company. In addition to the principal payments required on the acquisition term loan and the term
loan, the company will also make annual payments by February 15 of each year, commencing in
2006. The additional payment amount is equal to 50.0% of the companys excess cash flow,
defined as EBITDA (earnings before interest, taxes, depreciation and amortization) plus net
decreases in working capital or less net increases in working capital, minus interest
expense and principal payments on the acquisition term loan and term loan, capital
expenditures, and all cash taxes and cash dividends paid for the most recently completed
fiscal year, commencing with the year ending December 31, 2005. Each payment will be
applied: first, to the outstanding balance of the revolver, provided the outstanding
balance on the last day of the fiscal year compared with the outstanding balance of the
revolver on the last day of the previous fiscal year does not already reflect such a
reduction; second, to the outstanding principal balance of the acquisition term loan; and
lastly, to the outstanding principal balance of the term loan. The companys results of operations, cash flows and financial condition are subject to
certain trends, events and uncertainties, including demands for capital to support growth,
economic conditions, government payment practices and contractual matters. The companys
need for, cost of and access to funds are depending on future operating results, the
companys growth and acquisition activity, and conditions external to the company. Based upon its present business plan and operating performance, the company believes that
cash provided by operating activities, combined with amounts available for borrowing under
the revolver, will be adequate to fund the capital requirements of its existing operations
during 2005 and for the foreseeable future. In the event that the companys current
capital resources are not sufficient to fund requirements, the company believes its access
to additional capital resources would be sufficient to meet its needs. However, the
development of adverse economic or business conditions could significantly affect the need
for and availability of capital resources. Commitments The companys contractual obligations as of March 31, 2005 consist of the following (in
thousands): Payments due by periodLess than
    
    
    Two to three
    
    
    Four to fiveTotal
    
    
    one year
    
    
    years
    
    
    years
    
    
    ThereafterRevolver
    
    $
    9,550
    
    
    $
    9,550
    
    
    $
    
    
    
    $
    
    
    
    $
    Long-term debt
    
    
    57,753
    
    
    
    8,357
    
    
    
    16,714
    
    
    
    27,557
    
    
    
    5,125Operating leases
    
    
    20,921
    
    
    
    4,982
    
    
    
    6,298
    
    
    
    4,385
    
    
    
    5,256Total contractual obligations
    
    $
    88,224
    
    
    $
    22,889
    
    
    $
    23,012
    
    
    $
    31,942
    
    
    $
    10,381
 29




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The amounts above related to the revolver and long-term debt do not include interest
payments on any outstanding principal balance, because the interest rates on the companys
financing arrangements are not fixed. Additionally, the amounts above exclude the effect
on the schedule of payments of the application of any annual February 15 payments, as
described above, to the outstanding principal balances of either the acquisition term loan
or the term loan (reported under the caption Long-term debt in the table above), as these
amounts are not fixed. The amounts above related to operating leases include payments on facilities that the
company either no longer occupies or is in the process of abandoning, for which the company
is contractually obligated. At March 31, 2005, the company had recorded a current liability of $4.7 million that
represents the amount it expects to contribute to fund its pension plan within one year of
that date. This amount is not included in the table above. CONTINGENCIES The company has change of control agreements with certain of its employees that provide them
with benefits should their employment with the company be terminated other than for cause or
their disability or death, or if they resign for good reason, as defined in these agreements,
within a certain period of time from the date of any change of control of the company. As a defense contractor, the company is subject to many levels of audit and review from various
government agencies, including the Defense Contract Audit Agency, various inspectors general,
the Defense Criminal Investigation Service, the Government Accountability Office, the
Department of Justice and other congressional committees. Both related to and unrelated to its
defense industry involvement, the company is, from time to time, involved in audits, lawsuits,
claims, administrative proceedings and investigations. The company accrues for liabilities
associated with these activities when it becomes probable that future expenditures will be made
and such expenditures can be reasonably estimated. The companys evaluation of the likelihood
of expenditures related to these matters is subject to change in future periods, depending on
then current events and circumstances, which could have material adverse effects on the
companys business, financial position, results of operations and cash flows. On October 9, 2003, the United States Attorney filed a civil complaint against the company in
the United States District Court for the District of Massachusetts based in substantial part
upon the actions and omissions of two former employees which gave rise to criminal cases
against them. The United States Attorney seeks to recover up to three times its actual damages
and penalties under the False Claims Act and double damages and penalties under the
Anti-Kickback Act and to recover costs and interest. The company disputes the claims, believes
it has substantive defenses, and intends to vigorously defend itself. However, the outcome of
such litigation, if unfavorable, could have a material adverse effect on the companys
business, financial position, results of operations and cash flows. The company and the United
States Attorney have agreed to non-binding mediation of this matter. 30




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In 2002, a dispute arose between Genesis Tactical Group LLC (Genesis), Lockheed Martin
Corporation (Lockheed) and DRC related to a contract for services to Lockheed which DRC sold
to Genesis in 2001. In the first quarter of 2005, Genesis, Lockheed and the company settled
the outstanding issues related to this dispute. The settlement did not have a material effect
on the companys business, financial position, results of operations or cash flows. The company has provided documents in response to a previously disclosed grand jury subpoena
issued on October 15, 2002 by the United States District Court for the District of
Massachusetts, directing the company to produce specified documents dating back to 1996. The
subpoena relates to an investigation, currently focused on the period from 1996 to 1999, by the
Antitrust Division of the Department of Justice into the bidding and procurement activities
involving the company and several other defense contractors who have received similar subpoenas
and may also be subjects of the investigation. Although the company is cooperating in the investigation, it does not have a
sufficient basis to predict the outcome of the investigation. Should the company be found to
have violated the antitrust laws, the matter could have a material adverse effect on the
companys business, financial position, results of operations and cash flows. On February 3, 2004, a
suit was filed in the Circuit Court for the County of Fairfax,
Virginia against the company by Cushman & Wakefield of
Virginia, Inc. (Cushman & Wakefield), a real estate broker that the company maintains it had not retained, claiming breach
of contract and nonpayment of a commission fee related to an office lease. On January 12,
2005, a judgment of $407,000 was entered against the company. The real estate broker retained
by the company for such office lease has indemnified the company from any such claims.
However, the company may also be liable for Cushman &
Wakefields legal costs, against which the
companys broker may not indemnify the company. The company and its real estate broker are
considering their options for appeal. The company has recorded a reserve for costs related to
this matter. While the company believes it has accrued sufficient amounts for these costs, it
is possible that an additional liability could be incurred which could have a material adverse
effect on the companys business, financial position, results of operations and cash flows. In both the three months ended March 31, 2005 and the year ended December 31, 2004,
approximately 89% of the companys revenues were derived from sales to United States
Government agencies, primarily the Department of Defense. All of the companys United
States Government contracts are subject to termination for convenience in accordance with
government regulations. In the three months ended March 31, 2005 and the year ended
December 31, 2004, sales to agencies of state and local governments comprised approximately
8% and 7%, respectively, of revenues. Many of the contracts the company has won are
multi-year efforts. In accordance with state laws, funding must be approved annually by
the respective states legislature. CRITICAL ACCOUNTING POLICIES There are business risks specific to the industries in which the company operates. These
risks include, but are not limited to, estimates of costs to complete contract obligations,
changes in government policies and procedures, government contracting issues and risks
associated with technological development. The preparation of financial statements
requires management to make estimates and assumptions that affect the reported amounts of
assets and liabilities and disclosure of contingent assets and liabilities at the date of
the financial statements. Estimates and assumptions also affect the amount of revenue and
expenses during the reported period. Actual results could differ from those estimates. The company believes the following accounting policies affect the more significant
judgments made and estimates used in the preparation of its consolidated financial
statements. Revenue Recognition The companys Systems and Services business segment provides its services pursuant to time
and materials, cost reimbursable and fixed-price contracts, including service-type
contracts. For time and materials contracts, revenue reflects the number of direct labor hours
expended in the performance of a contract multiplied by the contract billing rate, as well
as reimbursement of other billable direct costs. The risk inherent in time and materials
contracts is that actual costs may differ materially from negotiated billing rates in the
contract, which would directly affect operating income. For cost reimbursable contracts, revenue is recognized as costs are incurred and includes a
proportionate amount of the fee earned. Cost reimbursable contracts specify the contract
fee in dollars or as a percentage of estimated costs. The primary risk on a cost
reimbursable contract is that a government audit of direct and indirect costs could result
in the disallowance of certain costs, which would directly impact revenue and margin on the
contract. Historically, such audits have had no material impact on the companys revenue
and operating income. 31




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Under fixed-price contracts, other than service-type contracts, revenue is recognized
primarily under the percentage of completion method or, for certain short-term contracts,
by the completed contract method, in accordance with American Institute of Certified Public
Accountants Statement of Position 81-1, Accounting for Performance of Construction-Type and
Certain Production-Type Contracts(SOP 81-1). Revenue from service-type fixed-price contracts is recognized ratably over the contract
period or by other appropriate output methods to measure service provided, and contract
costs are expensed as incurred. The risk to the company on a fixed-price contract is that
if estimates to complete the contract change from one period to the next, profit levels
will vary from period to period. For all types of contracts, the company recognizes anticipated contract losses as soon as
they become known and estimable. Out-of-pocket expenses that are reimbursable by the
customer are included in contract revenue and cost of contract revenue. Unbilled expenditures and fees on contracts in process are the amounts of recoverable
contract revenue that have not been billed at the balance sheet date. Generally, the
companys unbilled expenditures and fees relate to revenue that is billed in the month
after services are performed. In certain instances, billing is deferred in compliance with
contract terms, such as milestone billing arrangements and withholdings, or delayed for
other reasons. Billings which must be deferred more than one year from the balance sheet
date are classified as noncurrent assets. Costs related to certain United States
Government contracts, including applicable indirect costs, are subject to audit by the
government. Revenue from such contracts has been recorded at amounts the company expects
to realize upon final settlement. Unbilled expenditures and fees also include
subcontractor costs for which invoices have not been received and for which revenues have
not been recognized. The companys Metrigraphics business segment records revenue from product sales upon
transfer of title and risk of loss to the customer provided there is evidence of an
arrangement, fees are fixed or determinable, no significant obligations remain, collection
of the related receivable is reasonably assured and customer acceptance criteria have been
successfully demonstrated. Valuation Allowances The company provides for potential losses against accounts receivable and unbilled
expenditures and fees on contracts in process based on the companys expectation of a
customers ability to pay. These reserves are based primarily upon specific identification
of potential uncollectible accounts. In addition, payments to the company for performance
on United States Government contracts are subject to audit by the Defense Contract Audit
Agency. If necessary, the company provides an estimated reserve for adjustments resulting
from rate negotiations and audit findings. The company routinely provides for these items
when they are identified and can be reasonably estimated. Intangible and Other Long-lived Assets The company uses assumptions in establishing the carrying value, fair value and estimated
lives of intangible and other long-lived assets. Long-lived assets are reviewed for
impairment whenever events or changes in circumstances indicate that the asset carrying
value may not be recoverable. Recoverability is measured by a comparison of the assets
continuing ability to generate positive income from operations and positive cash flow in
future periods compared to the carrying value of the asset. If assets are considered to be
impaired, the impairment is recognized in the period of identification and is measured as
the amount by which the carrying value of the asset exceeds the fair value of the asset. 32




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The useful lives and related amortization of intangible assets are based on their estimated
residual value in proportion to the economic benefit consumed. The useful lives and
related depreciation of other long-lived assets are based on the companys estimate of the
period over which the asset will generate revenue or otherwise be used by the company. Goodwill The company assesses goodwill for impairment at the segment level at least once each year
by applying a direct value-based fair value test. Goodwill could be impaired due to market
declines, reduced expected future cash flows, or other factors or events. Should the fair
value of goodwill, as determined by the company at any measurement date, fall below its
carrying value, a charge for impairment of goodwill would occur in that period. Business Combinations Since 2002, the company has completed three business acquisitions. The company determines
and records the fair values of assets acquired and liabilities assumed as of the dates of
acquisition. The company utilizes an independent specialist to determine the fair values
of identifiable intangible assets acquired in order to determine the portion of the
purchase price allocable to these assets. Deferred Taxes The company records a valuation allowance to reduce its deferred tax asset to the amount
that is more likely than not to be realized. The company has considered future taxable
income and ongoing prudent and feasible tax planning strategies in assessing the need for
the valuation allowance. In the event it is determined that the company would be able to
realize its deferred tax asset in excess of their net recorded amount, an adjustment to the
deferred tax asset would increase income in the period such determination was made.
Likewise, should the company determine it would not be able to realize all or part of its
net deferred tax asset in the future, an adjustment to the deferred tax asset would be
charged to income in the period such determination was made. Pensions Accounting and reporting for the companys pension plan requires the use of assumptions,
including but not limited to, discount rate, rate of compensation increases and expected
return on assets. If these assumptions differ materially from actual results, the
companys obligations under the pension plan could also differ materially, potentially
requiring the company to record an additional pension liability. An actuarial valuation of
the pension plan is performed each year. The results of this actuarial valuation are
reflected in the accounting for the pension plan upon determination. RECENT ACCOUNTING PRONOUNCEMENTS In December 2004, the FASB issued SFAS No. 123(R), Share-Based Payment(SFAS 123R).
SFAS 123R replaces SFAS No. 123, Accounting for Stock-Based Compensation(SFAS 123), and
supersedes Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to
Employees(APB 25). Under SFAS 123R, companies will be required to recognize
compensation costs related to share-based payment transactions to employees in their
financial statements. The amount of compensation cost will be measured using the
grant-date fair value of the equity or liability instruments issued. Additionally,
liability awards will be re-measured each reporting period. Compensation cost will be
recognized over the period that an employee provides service in exchange for the award.
The company is required to adopt the new standard in the first quarter of 2006. The 33




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company historically has disclosed the pro forma effect of expensing its stock options as
prescribed by SFAS 123. The company is evaluating the different alternatives available for
applying the provisions of SFAS 123R, including guidance provided by the SEC in the
Commissions Staff Accounting Bulletin No. 107, and is currently assessing their effects
on its financial position and results of operations. FACTORS THAT MAY AFFECT FUTURE RESULTS You should carefully consider the risks described below before deciding to invest in
shares of our common stock. These are risks and uncertainties we believe are most
important for you to consider. Additional risks and uncertainties not presently known
to us, or which we currently deem immaterial, or which are similar to those faced by
other companies in our industry or business in general, may also impair our business
operations. If any of the following risks or uncertainties actually occurs, our
business, financial condition, results of operations or cash flows would likely
suffer. In that event, the market price of our common stock could decline. Our Revenue is Highly Concentrated on the Department of Defense and Other Federal
Agencies, and a Significant Portion of Our Revenue is Derived From a Few Customers.
Decreases in Their Budgets, Changes in Program Priorities or Military Base Closures
Could Affect Our Results. In both the three months ended March 31, 2005 and the year ended December 31, 2004,
approximately 89% of our revenue was derived from United States government agencies.
Within the Department of Defense, certain individual programs account for a
significant portion of our United States Government business. Our revenue from
contracts with the Department of Defense, either as a prime contractor or
subcontractor, accounted for approximately 76% of our total revenue in the three
months ended March 31, 2005, and approximately 78% of our total revenue in the year
ended December 31, 2004. We cannot provide any assurance that any of these programs
will continue as such or will continue at current levels. Our revenue could be
adversely affected by significant changes in defense spending during periods of
declining United States defense budgets. Among the effects of this general decline
has been increased competition within a consolidating defense industry. Under procedures established by the Base Reduction and Closure Act, the Department of
Defense has announced its intention to select in 2005 certain military bases for
closure. In 2003, the Department of Defense published an initial list of bases from
which it is expected the final selections will be made. Hanscom Air Force Base and
other installations at which the company does business were included on the initial
list for consideration. Should a base be selected for closure at which the company
has significant business, the companys business, financial condition, results of
operations and cash flows could be adversely affected. It is not possible for us to predict whether defense budgets will increase or decline
in the future. Further, changing missions and priorities in the defense budget may
have adverse effects on our business. Funding limitations could result in a
reduction, delay or cancellation of existing or emerging programs. We anticipate
there will continue to be significant competition when our defense contracts are
re-bid, as well as significant competitive pressure to lower prices, which may reduce
profitability in this area of our business, which would adversely affect our business,
financial condition, results of operations and cash flows. We Must Bear the Risk of Various Pricing Structures Associated With Government
Contracts. We historically have derived a substantial portion of our revenue from contracts and
subcontracts with the United States Government. A significant portion of our federal
and state government contracts are 34




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undertaken on a time and materials nature, with fixed hourly rates that are intended
to cover salaries, benefits, other indirect costs of operating the business and
profit. The pricing of such contracts is based upon estimates of future costs and
assumptions as to the aggregate volume of business that we will perform in a given
business division or other relevant unit. Alternatively, we undertake various government projects on a fixed-price basis, as
distinguished from billing on a time and materials basis. Under a fixed-price
contract, the government pays an agreed upon price for our services or products, and
we bear the risk that increased or unexpected costs may reduce our profits or cause us
to incur a loss. Significant cost overruns can occur if we fail to:  
    adequately estimate the resources required to complete a project;
    properly determine the scope of an engagement; or
    complete our contractual obligation in a manner consistent with the project plan. For fixed price contracts, we must estimate the costs necessary to complete the
defined statement of work and recognize revenue or losses in accordance with such
estimates. Actual costs may vary materially from the estimates made from time to
time, necessitating adjustments to reported revenue and net income. Underestimates of
the costs associated with a project could adversely affect our overall profitability
and could have a material adverse effect on our business, financial condition, results
of operations and cash flows. While we endeavor to maintain and improve contract
profitability, we cannot be certain that any of our existing or future time and
materials or fixed-price projects will be profitable. The companys revenues earned
under fixed price contracts has increased as a percentage of total revenues from
approximately 16% in the three months ended March 31, 2004, to approximately 25% in
the three months ended March 31, 2005. A substantial portion of our United States Government business is as a subcontractor.
In such circumstances, we generally bear the risk that the prime contractor will meet
its performance obligations to the United States Government under the prime contract
and that the prime contractor will have the financial capability to pay us amounts due
under the subcontract. The inability of a prime contractor to perform or make
required payments to us could have a material adverse effect on the companys
business, financial condition, results of operations and cash flows. Our Contracts and Subcontracts with Government Agencies Are Subject to a
Competitive Bidding Process and to Termination Without Cause by the Government. A significant portion of our federal and state government contracts are renewable on
an annual basis, or are subject to the exercise of contractual options. Multi-year
contracts often require funding actions by the United States Government, state
legislature or others on an annual or more frequent basis. As a result, our business
could experience material adverse consequences should such funding actions or other
approvals not be taken. Recent federal regulations and renewed congressional interest in small business set
aside contracts is likely to influence decisions pertaining to contracting methods for
many of the companys customers. These regulations require more frequent review and
certification of small business contractor status, so as to ensure that companies
competing for contracts intended for small business are qualified as such at the time
of the competition. In the years ended December 31, 2004 and 2003, the company
derived $43.6 million and $42.4 million, respectively, of revenue from a small
business set aside contract held by its HJ Ford subsidiary and due for re-competition
in 2005. The customer has currently indicated that the re-competition will continue
to be set aside, or reserved, to include only prime contractors that qualify as small
businesses under regulations established by the Small Business Administration. The
company will strive to retain its 35




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current work by moving work to other contract vehicles to the extent possible and by
partnering with firms that will qualify as small businesses. To the extent these
efforts are not successful, the companys business, financial condition, results of
operations and cash flows could be adversely affected. The companys contracts with the Internal Revenue Service, Air Force Electronic
Systems Center and Aeronautical Systems Center are subject to re-competition in 2005. Governmental awards of contracts are subject to regulations and procedures that permit
formal bidding procedures and protests by losing bidders. Such protests may result in
significant delays in the commencement of expected contracts, the reversal of a
previous award decision or the reopening of the competitive bidding process, which
could have a material adverse effect on our business, financial condition, results of
operations and cash flows. Because of the complexity and scheduling of contracting with government agencies, from
time to time we may incur costs before receiving contractual funding by the United
States Government. In some circumstances, we may not be able to recover such costs in
whole or in part under subsequent contractual actions. Failure to collect such
amounts may have material adverse consequences on our business, financial condition,
results of operations and cash flows. In addition, the United States Government has the right to terminate contracts for
convenience. If the government terminated contracts with us, we would generally
recover costs incurred up to termination, costs required to be incurred in connection
with the termination and a portion of the fee earned commensurate with the work we
have performed to termination. However, significant adverse effects on our indirect
cost pools may not be recoverable in connection with a termination for convenience.
Contracts with state and other governmental entities are subject to the same or
similar risks. We Are Subject to a High Level of Government Regulations and Audits Under Our
Government Contracts and Subcontracts. As a defense contractor, we are subject to many levels of audit and review, including
by the Defense Contract Audit Agency, various inspectors general, the Defense Criminal
Investigative Service, the Government Accountability Office, the Department of Justice
and congressional committees. These audits, reviews and the pending grand jury
investigation and civil suit in the United States District Court for the District of
Massachusetts could result in the termination of contracts, the imposition of fines or
penalties, the withholding of payments due to us or the prohibition from participating
in certain United States government contracts for a specified period of time. Any
such action could have a material adverse effect on our business, financial condition,
results of operations and cash flows. Loss of Key Personnel Could Limit Our Growth. We are dependent on our ability to attract and retain highly skilled technical
personnel. Many of our technical personnel may have specific knowledge and experience
related to various government customer operations and these individuals would be
difficult to replace in a timely fashion. In addition, qualified technical personnel
are in high demand worldwide and are likely to remain a limited resource. The loss of
services of key personnel could impair our ability to perform required services under
some of our contracts, to retain such business after the expiration of the existing
contract, or to win new business in the event that we lost the services of individuals
who have been identified in a given proposal as key personnel in the proposal. Any of
these situations could have a material adverse effect on our business, financial
condition, results of operations and cash flows. 36




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Our Failure to Obtain and Maintain Necessary Security Clearances May Limit Our
Ability to Perform Classified Work for Government Clients, Which Could Harm Our
Business. Some government contracts require us to maintain facility security clearances, and
require some of our employees to maintain individual security clearances. If our
employees lose or are unable to obtain security clearances on a timely basis, or we
lose a facility clearance, the government client can terminate the contract or decide
not to renew the contract upon its expiration. As a result, to the extent that we
cannot obtain the required security clearances for our employees working on a
particular contract, or we fail to obtain them on a timely basis, we may not derive
the revenue anticipated from the contract, which could have a material adverse effect
on our business, financial condition, results of operations and cash flows. Security Breaches in Sensitive Government Systems Could Harm Our Business. Many of the systems we develop, install and maintain involve managing and protecting
information involved in intelligence, national security, and other sensitive or
classified government functions. A security breach in one of these systems could
cause serious harm to our business, damage our reputation, and prevent us from being
eligible for further work on sensitive or classified systems for federal government
clients. We could incur losses from such a security breach that could exceed the
policy limits under our errors and omissions and product liability insurance. Damage
to our reputation or limitations on our eligibility for additional work resulting from
a security breach in one of our systems could have a material adverse effect on our
business, financial condition, results of operations and cash flows. Our Employees May Engage in Misconduct or Other Improper Activities, Which Could
Harm Our Business. We are exposed to the risk that employee fraud or other misconduct could occur.
Misconduct by employees could include intentional failures to comply with federal
government procurement regulations, engaging in unauthorized activities, or falsifying
time records. Employee misconduct could also involve the improper use of our clients
sensitive or classified information, which could result in regulatory sanctions
against us and serious harm to our reputation. It is not always possible to deter
employee misconduct, and the precautions we take to prevent and detect this activity
may not be effective in controlling unknown or unmanaged risks or losses, which could
have a material adverse effect on our business, financial condition, results of
operations and cash flows. We Are Involved in Various Litigation Matters Which, If Not Resolved in Our Favor,
Could Harm Our Business. On October 26, 2000, two former company employees were indicted and charged with
conspiracy to defraud the United States, and wire fraud, among other charges, arising
out of a scheme to defraud the 37




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United States out of approximately $10 million. Both men subsequently pled guilty to
the principal charges against them. On October 9, 2003, the United States Attorneys
office filed a civil complaint in the District Court of Massachusetts against the
company based in substantial part upon the actions and omissions of the former
executives that gave rise to the criminal cases against them. In the civil action,
the United States is asserting claims against the company based on the False Claims
Act and the Anti-Kickback Act, in addition to certain common law and equitable claims.
The United States seeks to recover up to three times its actual damages and penalties
under the False Claims Act, and double damages and penalties under the Anti-Kickback
Act. The United States also seeks to recover its costs and interest in this action.
The company believes it has substantive defenses to these claims and intends to
vigorously defend itself. However, the outcome of this litigation and other
proceedings to which the company is a part, if unfavorable, could have a material
adverse effect on the companys business, financial position, results of operations
and cash flows. The Antitrust Division of the Department of Justice is engaged in an
investigation, currently focused on the period from 1996 to 1999, into bidding and
procurement activities involving the company and several other defense contractors who
may also be subjects of the investigation. Although the company is cooperating in the
investigation, it does not have a sufficient basis to predict the outcome of the
investigation. Should the company be found to have violated antitrust laws, the
matter could have a material adverse effect on the companys business, financial
position, results of operations and cash flows. On February 3, 2004, a
suit was filed in the Circuit Court for the County of Fairfax,
Virginia against the company by Cushman & Wakefield of
Virginia, Inc. (Cushman & Wakefield), a real estate broker that the company maintains it had not
retained, claiming breach of contract and nonpayment of a commission fee related to an
office lease. On January 12, 2005, a judgment of $407,000 was entered against the
company. The real estate broker retained by the company for such office lease has
indemnified the company from any such claims. However, the company may also be liable
for Cushman & Wakefields legal costs, against which the companys broker may not indemnify
the company. The company and its real estate broker are considering their options for
appeal. The company has recorded a reserve for costs related to this matter. While
the company believes it has accrued sufficient amounts for these costs, it is possible
that an additional liability could be incurred which could have a material adverse
effect on the companys business, financial position, results of operations and cash
flows. If We Are Unable to Effectively and Efficiently Eliminate the Material Weaknesses
and Significant Deficiencies in Our Internal Controls and Procedures, We May Not Be
Able to Accurately Report Our Financial Results. As a Result, Current and Potential
Stockholders Could Lose Confidence in Our Financial Reporting, Which Would Harm Our
Business and the Trading Price of Our Stock. Effective internal controls are necessary for us to provide reliable financial
reports. If we cannot provide reliable financial reports, our business and operating
results could be harmed. We have in the past discovered, and may in the future
discover, areas of our internal control over financial reporting that need
improvement. At December 31, 2004, the company disclosed four material weaknesses related to
internal controls, and in the past has disclosed significant deficiencies. Refer to
Item 9A of our Annual Report on Form 10-K/A for the year ended December 31, 2004, and
to Item 4 of this Quarterly Report on Form 10-Q, for additional information on these
weaknesses and deficiencies. Based on managements assessment, management has
concluded that, as of December 31, 2004, the companys internal control over financial
reporting was not effective as a result of the effect of these material weaknesses. Although we are committed to addressing these material weaknesses and significant
deficiencies, we cannot assure you that we will be able to successfully implement the
revised controls and procedures or that our revised controls and procedures will be
effective in remedying all of the identified material weaknesses and significant
deficiencies. Any failure to implement and maintain improvements in the internal
control over our financial reporting, or difficulties encountered in the
implementation of improvements in our internal control over financial reporting, could
cause us to fail to meet our reporting obligations. Any failure to improve our
internal controls to address identified weaknesses could also cause investors to lose
confidence in our reported financial information, which could have a negative impact
on the trading price of our stock. We Operate in Highly Competitive Markets and May Have Difficulties Entering New
Markets. The markets for our services are highly competitive. The government contracting
business is subject to intense competition from numerous companies, many of which have
significantly greater financial, technical and marketing resources than we do. The
principal competitive factors are prior performance, previous experience, technical
competence and price. 38




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Competition in the market for our commercial products is also intense. There is a
significant lead-time for developing such business, and it involves substantial
capital investment including development of prototypes and investment in manufacturing
equipment. Principal competitive factors are product quality, the ability to
specialize our engineering in order to meet our customers specific system
requirements and price. Our precision products business has a number of competitors,
many of which have significantly greater financial, technical and marketing resources
than we do. Competitive pressures in our government and commercial businesses could
have a material adverse effect on our business, financial condition, results of
operations and cash flows. In our efforts to enter new markets, including commercial markets and United States
Government agencies other than the Department of Defense, we generally face
significant competition from other companies that have prior experience with such
potential customers, as well as significantly greater financial, technical and
marketing resources than we have. As a result, we may not achieve the level of
success that we expect in our efforts to enter such new markets. We May Be Subject to Product or Service Liability Claims. Our products and services are generally designed to operate as important components of
complex systems or products. Defects in our products and services could cause our
customers product or systems to fail or perform below expectations. Although we
attempt to contractually limit our liability for such defects or failures, we cannot
assure you that our attempts to limit our liability will be successful. We may be
subject to claims for alleged performance issues related to our products or services.
Such claims, if made, could damage our reputation and could have a material adverse
effect on our business, financial condition, results of operations and cash flows. Economic Events May Affect Our Business Segments. Many of our precision products are components of commercial products. Factors that
affect the production and demand for such products, including economic events both
domestically and in other regions of the world, competition, technological change and
production disruption, could adversely affect demand for our products. Many of our
products are incorporated into capital equipment, such as machine tools and other
automated production equipment, used in the manufacture of other products. As a
result, this portion of our business may be subject to fluctuations in the
manufacturing sector of the overall economy. An economic recession, either in the
United States or elsewhere in the world, could have a material adverse effect on the
rate of orders received by the commercial division. Significantly lower production
volumes resulting in under-utilization of our manufacturing facilities would adversely
affect our business, financial condition, results of operations and cash flows. Our Products and Services Could Become Obsolete Due to Rapid Technological Changes
in the Industry. We offer sophisticated products and services in areas in which there have been and are
expected to continue to be significant technological changes. Many of our products
are incorporated into sophisticated machinery, equipment or electronic systems.
Technological changes may be incorporated into competitors products that may
adversely affect the market for our products. If our competitors introduce superior
technologies or products, we cannot assure you that we will be able to respond quickly
enough to such changes or to offer services that satisfy our customers requirements
at a competitive price. Further, we cannot provide any assurance that our research
and product development efforts will be successful or result in new or improved
products that may be required to sustain our market position. 39




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Our Financing Requirements May Increase and We Could Have Limited Access to
Capital Markets. While we believe that our current resources and access to capital markets are adequate
to support operations over the near term and foreseeable future, we cannot assure you
that these circumstances will remain unchanged. Our need for capital is dependent on
operating results and may be greater than expected. Our ability to maintain our
current sources of debt financing depends on our ability to remain in compliance with
certain covenants contained in our financing agreements, including, among other
requirements, maintaining a minimum total net worth and minimum cash flow and debt
coverage ratios. If changes in capital markets restrict the availability of funds or
increase the cost of funds, we may be required to modify, delay or abandon some of our
planned expenditures, which could have a material adverse effect on our business,
financial condition, results of operations and cash flows. Accounting System Upgrades and Conversions May Delay Billing and Collections of
our Accounts Receivable. In 2004, we installed a new enterprise business system, and from time to time, we may
be required to make changes to that system as we integrate businesses or upgrade to
new technologies. Future accounting system conversions and upgrades could cause
delays in billing and collection of accounts receivable under our contracts, which
could adversely affect our business, financial condition, results of operations and
cash flows. Our Quarterly Operating Results May Vary Significantly From Quarter to
Quarter. Our revenue and earnings may fluctuate from quarter to quarter depending on a number
of factors, including:  
    the number, size and timing of client projects commenced and completed during a quarter;
    bid and proposal efforts undertaken;
    progress on fixed-price projects during a given quarter;
    employee productivity and hiring, attrition and utilization rates;
    accuracy of estimates of resources required to complete ongoing projects;
    the trend in interest rates; and
    general economic conditions. Demand for our products and services in each of the markets we serve can vary
significantly from quarter to quarter due to revisions in customer budgets or
schedules and other factors beyond our control. In addition, because a high
percentage of our expenses is fixed and does not vary relative to revenue, a decrease
in revenue may cause a significant variation in our operating results. Additionally,
at March 31, 2005, the company had $67.3 million of outstanding debt, or approximately
51% of its invested capital at that date. We May Not Make or Complete Future Mergers, Acquisitions or Strategic Alliances or
Investments. In 2004, we acquired Impact Innovations Group LLC, and in 2002, we acquired HJ Ford
Associates, Inc. and Andrulis Corporation. We may seek to continue to expand our
operations through mergers, acquisitions or strategic alliances with businesses that
will complement our existing business. However, we may not be able to find attractive
candidates, or enter into acquisitions on terms that are favorable to us, or
successfully integrate the operations of companies that we acquire. In addition, we
may compete with other companies for these acquisition candidates, which could make an
acquisition more expensive for us. If we are able to 40




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successfully identify and complete an acquisition or similar transaction, it could
involve a number of risks, including, among others:  
    the difficulty of assimilating the acquired operations and personnel;
    the potential disruption of our ongoing business and diversion of resources
and management time;
    the potential failure to retain key personnel of the acquired business;
    the difficulty of integrating systems, operations and cultures; and
    the potential impairment of relationships with customers as a result of
changes in management or otherwise arising out of such transactions. We cannot assure you that any acquisition will be made, that we will be able to obtain
financing needed to fund such acquisitions and, if any acquisitions are so made, that
the acquired business will be successfully integrated into our operations or that the
acquired business will perform as expected. In addition, if we were to proceed with
one or more significant strategic alliances, acquisitions or investments in which the
consideration consists of cash, a substantial portion of our available cash could be
used to consummate the strategic alliances, acquisitions or investments. The
financial impact of acquisitions, investments and strategic alliances could have a
material adverse effect on our business, financial condition, results of operations
and cash flows and could cause substantial fluctuations in our quarterly and annual
operating results. The Market Price of Our Common Stock May Be Volatile. The market price of securities of technology companies historically has faced
significant volatility. The stock market in recent years has also experienced
significant price and volume fluctuations that often have been unrelated or
disproportionate to the operating performance of particular companies. Many factors
that have influenced trading prices will vary from period to period, including:  
    decreases in our earnings and revenue or quarterly operating results;
    changes in estimates by analysts;
    market conditions in the industry;
    announcements and new developments by competitors; and
    regulatory reviews. Any of these events could have a material adverse effect on the market price of our
common stock. 41




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DYNAMICS RESEARCH CORPORATION 
 Item 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK The company is subject to interest rate risk associated with our acquisition term loan,
term loan and revolver, where interest payments are tied to either the LIBOR or prime rate.
The interest rate on the acquisition term loan was 5.99% at March 31, 2005, under the
90-day LIBOR Rate option elected on February 1, 2005. The interest rate on the term loan
was 5.74% at March 31, 2005, under the 90-day LIBOR Rate option elected on February 1,
2005. The interest rate on $2.6 million of the revolver was 6.25% at March 31, 2005, under
the Base Rate option. The interest rate on the remaining $7.0 million of the revolvers
outstanding balance at March 31, 2005 was 5.75%, under the 30-day LIBOR Rate option
elected on March 7, 2005. At any time, a modest rise in interest rates could have an
adverse effect on net income as reported in the companys Consolidated Statements of
Operations. An increase of one full percentage point in the interest rate on the companys
acquisition term loan, term loan and revolver would result in increases in annual interest
expense aggregating $0.7 million. The company presently has no investments in debt securities and, accordingly, no exposure
to market interest rates on investments. The company has no significant exposure to foreign currency fluctuations. Foreign sales,
which are nominal, are primarily denominated in United States dollars. 
 Item 4. CONTROLS AND PROCEDURES Our principal executive officer and principal financial officer, based on their evaluation
of our disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and
15d-15(e)) as of the end of the period covered by this Quarterly Report on Form 10-Q, have
concluded that our disclosure controls and procedures are effective for ensuring that
information required to be disclosed by us in the reports that we file or submit under the
Securities Exchange Act of 1934 is recorded, processed, summarized and reported within the
time periods specified in the SECs rules and forms. In our Annual Report on Form 10-K/A, Amendment No. 1 to Form 10-K, for the year ended
December 31, 2004, we identified and disclosed four material weaknesses in internal
control over financial reporting in the following areas: Information Technology Access Controls. Design and assignment of PeopleSoft
access profiles did not limit access to assigned duties in several system modules. Also,
controls in place to establish access did not function as intended. While we are not
aware of any evidence that this control deficiency resulted in financial statement error,
the potential exists that errors could occur that would not be prevented or detected. Evidence of Compliance with Approval Authority Policy. Testing of the operating
effectiveness of the companys approval controls in many process areas indicated that
required approvals were not consistently documented. While we are not aware of any
evidence of transactions that were inconsistent with managements intent, the possibility
exists that such transactions could occur without detection and result in financial
statement error. Evidence of the Performance of Review Controls. In several instances either: (1)
the companys internal control design did not require review controls, (2) testing
indicated that required reviews were not consistently documented; or (3) managements
design of controls did not require documented evidence, such as signatures, of reviews
performed. Lack of review and the inability to demonstrate that reviews were performed
creates the potential that undetected errors could occur. 42




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Assessment of the Effectiveness of Internal Controls. The scope, testing and
evaluation of test results of managements assessment of the effectiveness of internal
controls were insufficient in these areas: footnote disclosures, fixed assets, accounts
receivable and information technology controls. Also, the basis for evaluating test
exceptions was not adequately documented. To remediate these material weaknesses, the personnel responsible for these areas have
been working to identify and define their remediation plans. After individual remediation
plans are complete, they are reviewed and approved by our senior management. It is
anticipated that senior management and the companys Board of Directors will receive
regular updates on the progress of each of these personnel toward complete and effective
remediation. Currently, these remediation plans include approximately 50 tasks in the
aggregate to correct these weaknesses. Of these tasks, several immaterial changes and one
material change have been implemented. This material change involves the transition of
payroll processing and purchases related to selling, general and administrative functions
from the companys subsidiaries to the corporate offices in Andover, Massachusetts. There have been no other changes in the companys internal control over financial
reporting that occurred during the companys first quarter of 2005 that have materially
affected or are reasonably likely to materially affect the companys internal control over
financial reporting. The company will continue to include reports on its progress in these areas in its
quarterly filings with the SEC. 43




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DYNAMICS RESEARCH CORPORATION 
 PART II. OTHER INFORMATION 
 Item 1. LEGAL PROCEEDINGS As a defense contractor, the company is subject to many levels of audit and review from various
government agencies, including the Defense Contract Audit Agency, various inspectors general,
the Defense Criminal Investigation Service, the Government Accountability Office, the
Department of Justice and other congressional committees. Both related to and unrelated to its
defense industry involvement, the company is, from time to time, involved in audits, lawsuits,
claims, administrative proceedings and investigations. The company accrues for liabilities
associated with these activities when it becomes probable that future expenditures will be made
and such expenditures can be reasonably estimated. The companys evaluation of the likelihood
of expenditures related to these matters is subject to change in future periods, depending on
then current events and circumstances, which could have material adverse effects on the
companys business, financial position, results of operations and cash flows. On October 9, 2003, the United States Attorney filed a civil complaint against the company in
the United States District Court for the District of Massachusetts based in substantial part
upon the actions and omissions of two former employees which gave rise to criminal cases
against them. The United States Attorney seeks to recover up to three times its actual damages
and penalties under the False Claims Act and double damages and penalties under the
Anti-Kickback Act and to recover costs and interest. The company disputes the claims, believes
it has substantive defenses, and intends to vigorously defend itself. However, the outcome of
such litigation, if unfavorable, could have a material adverse effect on the companys
business, financial position, results of operations and cash flows. The company and the United
States Attorney have agreed to non-binding mediation of this matter. In 2002, a dispute arose between Genesis Tactical Group LLC (Genesis), Lockheed Martin
Corporation (Lockheed) and DRC related to a contract for services to Lockheed which DRC sold
to Genesis in 2001. In the first quarter of 2005, Genesis, Lockheed and the company settled
the outstanding issues related to this dispute. The settlement did not have a material effect
on the companys business, financial position, results of operations or cash flows. The company has provided documents in response to a previously disclosed grand jury subpoena
issued on October 15, 2002 by the United States District Court for the District of
Massachusetts, directing the company to produce specified documents dating back to 1996. The
subpoena relates to an investigation, currently focused on the period from 1996 to 1999, by the
Antitrust Division of the Department of Justice into the bidding and procurement activities
involving the company and several other defense contractors who have received similar subpoenas
and may also be subjects of the investigation. Although the company is cooperating in the
investigation, it does not have a sufficient basis to predict the outcome of the investigation.
Should the company be found to have violated the antitrust laws, the matter could have a
material adverse effect on the companys business, financial position, results of operations
and cash flows. On February 3, 2004, a
suit was filed in the Circuit Court for the County of Fairfax,
Virginia against the company by Cushman & Wakefield of
Virginia, Inc. (Cushman & Wakefield), a real estate broker that the company maintains it had not retained, claiming breach
of contract and nonpayment of a commission fee related to an office lease. On January 12,
2005, a judgment of $407,000 was entered against the company. The real estate broker retained
by the company for such office lease has indemnified the company from any such claims.
However, the company may also be liable for Cushman &
Wakefields legal costs, against which the
companys broker may not indemnify the company. The company and its real estate broker are
considering their options for appeal. The company has recorded a reserve for costs related to
this matter. While the company believes it has accrued sufficient amounts for these costs, it
is possible that an additional liability could be incurred which could have a material adverse
effect on the companys business, financial position, results of operations and cash flows. 44




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DYNAMICS RESEARCH CORPORATION 
 Item 6. EXHIBITS The following Exhibits are filed or furnished, as applicable, herewith: 31.1
    
    Certification of the Chief Executive Officer pursuant to Rule
13a-14(a) under the Securities Exchange Act of 1934, as adopted
pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.31.2
    
    Certification of the Chief Financial Officer pursuant to Rule
13a-14(a) under the Securities Exchange Act of 1934, as adopted
pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.32.1
    
    Certification of the Chief Executive Officer pursuant to 18 U.S.C.
Section 1350, as adopted pursuant to Section 906 of the
Sarbanes-Oxley Act of 2002.32.2
    
    Certification of the Chief Financial Officer pursuant to 18 U.S.C.
Section 1350, as adopted pursuant to Section 906 of the
Sarbanes-Oxley Act of 2002.
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SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has
duly caused this report to be signed on its behalf by the undersigned thereunto duly
authorized. DYNAMICS RESEARCH CORPORATION(Registrant)Date:
May 10, 2005
    
    /s/ David KeleherDavid KeleherSenior Vice President and Chief Financial Officer/s/ Francis MurphyFrancis MurphyVice President, Corporate Controller and Chief Accounting Officer
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EXHIBIT INDEX ExhibitNumber
    
    Exhibit Name
    
    Location31.1
    
    Certification of the Chief Executive
Officer pursuant to Rule 13a-14(a)
under the Securities Exchange Act of
1934, as adopted pursuant to Section
302 of the Sarbanes-Oxley Act of
2002.
    
    Filed herewith31.2
    
    Certification of the Chief Financial
Officer pursuant to Rule 13a-14(a)
under the Securities Exchange Act of
1934, as adopted pursuant to Section
302 of the Sarbanes-Oxley Act of
2002.
    
    Filed herewith32.1
    
    Certification of the Chief Executive
Officer pursuant to 18 U.S.C.
Section 1350, as adopted pursuant to
Section 906 of the Sarbanes-Oxley
Act of 2002.
    
    Furnished herewith32.2
    
    Certification of the Chief Financial
Officer pursuant to 18 U.S.C.
Section 1350, as adopted pursuant to
Section 906 of the Sarbanes-Oxley
Act of 2002.
    
    Furnished herewith
 47