##### Table of Contents



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 SEPTEMBER 30, 2006
 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 of Incorporation)
    
    (I.R.S. Employer Identification No.)
 60 FRONTAGE ROAD, ANDOVER, MASSACHUSETTS 01810-5498
 978-475-9090
 
 þ o
  o þ o
 o þ




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##### 



DYNAMICS RESEARCH CORPORATION
FORM 10-Q
For the Quarterly Period Ended September 30, 2006
Table of Contents
 PagePart I. Financial Information
    
    
    3Item 1. Financial Statements
    
    
    3Condensed Consolidated Balance Sheets as of September 30, 2006 (unaudited) and December 31, 2005 (audited)
    
    
    3Condensed Consolidated Statements of Operations for the three and nine months ended September 30, 2006 and 2005 (unaudited)
    
    
    4Condensed Consolidated Statements of Cash Flows for the nine months ended September 30, 2006 and 2005 (unaudited)
    
    
    5Notes to Condensed Consolidated Financial Statements (unaudited)
    
    
    6Item 2. Managements Discussion and Analysis of Financial Condition and Results of Operations
    
    
    18Item 3. Quantitative and Qualitative Disclosures About Market Risk
    
    
    26Item 4. Controls and Procedures
    
    
    26Part II. Other Information
    
    
    27Item 1. Legal Proceedings
    
    
    27Item 1A. Risk Factors
    
    
    27Item 2. Unregistered Sales of Equity Securities and Use of Proceeds
    
    
    29Item 6. Exhibits
    
    
    30Ex-10.1 Amendment to the 2000 Employee Stock Purchase PlanEx-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
  Special Note on Factors Affecting Future Results
  2




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##### Table of Contents



PART I. FINANCIAL INFORMATION
 
 Item 1. Condensed Consolidated Financial Statements
 DYNAMICS RESEARCH CORPORATION
 
 CONDENSED CONSOLIDATED BALANCE SHEETS
(dollars in thousands, except share data)
 September 30,
    
    
    December 31,2006
    
    
    2005(unaudited)
    
    
    (audited)AssetsCurrent assetsCash and cash equivalents
    
    $
    584
    
    
    $
    1,020Accounts receivable, net of allowances of $615 at
September 30, 2006 and $588 at December 31, 2005
    
    
    35,372
    
    
    
    32,894Unbilled expenditures and fees on contracts in process
    
    
    41,070
    
    
    
    60,210Prepaid expenses and other current assets
    
    
    2,308
    
    
    
    1,483Total current assets
    
    
    79,334
    
    
    
    95,607Noncurrent assetsProperty, plant and equipment, net
    
    
    11,869
    
    
    
    12,252Goodwill
    
    
    63,055
    
    
    
    63,055Intangible assets, net
    
    
    6,373
    
    
    
    8,480Other noncurrent assets
    
    
    7,046
    
    
    
    8,359Total noncurrent assets
    
    
    88,343
    
    
    
    92,146Total assets
    
    $
    167,677
    
    
    $
    187,753Liabilities and stockholders equityCurrent liabilitiesCurrent portion of long-term debt
    
    $
    
    
    
    $
    10,170Accounts payable
    
    
    20,268
    
    
    
    25,668Deferred taxes
    
    
    12,420
    
    
    
    19,825Accrued compensation and employee benefits
    
    
    15,094
    
    
    
    18,761Other accrued expenses
    
    
    3,741
    
    
    
    6,392Total current liabilities
    
    
    51,523
    
    
    
    80,816Long-term liabilitiesLong-term debt, less current portion
    
    
    21,692
    
    
    
    15,242Other long-term liabilities
    
    
    14,524
    
    
    
    17,508Total long-term liabilities
    
    
    36,216
    
    
    
    32,750Total liabilities
    
    
    87,739
    
    
    
    113,566Commitments and contingenciesStockholders equityPreferred stock, $0.10 par value; 5,000,000 shares
authorized; no shares issued and outstanding
    
    
    
    
    
    
    Common stock, $0.10 par value; 30,000,000 shares
authorized; 9,286,350 and 9,096,893 shares issued and
outstanding at September 30, 2006 and December 31, 2005,
respectively
    
    
    929
    
    
    
    910Capital in excess of par value
    
    
    46,882
    
    
    
    45,571Unearned compensation
    
    
    
    
    
    
    (1,850
    )Accumulated other comprehensive loss
    
    
    (10,768
    )
    
    
    (10,768
    )Retained earnings
    
    
    42,895
    
    
    
    40,324Total stockholders equity
    
    
    79,938
    
    
    
    74,187Total liabilities and stockholders equity
    
    $
    167,677
    
    
    $
    187,753
  3




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##### Table of Contents



DYNAMICS RESEARCH CORPORATION
 
 CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(unaudited)
(in thousands, except per share data)
 Three months ended
    
    
    Nine months endedSeptember 30,
    
    
    September 30,2006
    
    
    2005
    
    
    2006
    
    
    2005Contract revenue
    
    $
    61,547
    
    
    $
    77,334
    
    
    $
    194,026
    
    
    $
    223,712Product sales
    
    
    1,614
    
    
    
    1,779
    
    
    
    4,626
    
    
    
    5,131Total revenue
    
    
    63,161
    
    
    
    79,113
    
    
    
    198,652
    
    
    
    228,843Cost of contract revenue
    
    
    53,756
    
    
    
    64,174
    
    
    
    169,054
    
    
    
    187,927Cost of product sales
    
    
    1,217
    
    
    
    1,242
    
    
    
    3,771
    
    
    
    3,948Selling, general and administrative expenses
    
    
    5,559
    
    
    
    6,722
    
    
    
    18,228
    
    
    
    19,429Amortization of intangible assets
    
    
    702
    
    
    
    760
    
    
    
    2,107
    
    
    
    2,279Total operating costs and expenses
    
    
    61,234
    
    
    
    72,898
    
    
    
    193,160
    
    
    
    213,583Operating income
    
    
    1,927
    
    
    
    6,215
    
    
    
    5,492
    
    
    
    15,260Interest expense, net
    
    
    (558
    )
    
    
    (1,061
    )
    
    
    (1,693
    )
    
    
    (3,193
    )Other income
    
    
    78
    
    
    
    119
    
    
    
    429
    
    
    
    2,221Income before provision for income taxes
    
    
    1,447
    
    
    
    5,273
    
    
    
    4,228
    
    
    
    14,288Provision for income taxes
    
    
    526
    
    
    
    2,136
    
    
    
    1,741
    
    
    
    5,787Income before cumulative effect of accounting
change
    
    
    921
    
    
    
    3,137
    
    
    
    2,487
    
    
    
    8,501Cumulative benefit of accounting change, net
of income taxes of $62
    
    
    
    
    
    
    
    
    
    
    84
    
    
    
    Net income
    
    $
    921
    
    
    $
    3,137
    
    
    $
    2,571
    
    
    $
    8,501Earnings per common shareBasicIncome before cumulative effect of
accounting change
    
    $
    0.10
    
    
    $
    0.35
    
    
    $
    0.27
    
    
    $
    0.97Cumulative benefit of accounting change
    
    
    
    
    
    
    
    
    
    
    0.01
    
    
    
    Net income
    
    $
    0.10
    
    
    $
    0.35
    
    
    $
    0.28
    
    
    $
    0.97DilutedIncome before cumulative effect of
accounting change
    
    $
    0.10
    
    
    $
    0.34
    
    
    $
    0.26
    
    
    $
    0.92Cumulative benefit of accounting change
    
    
    
    
    
    
    
    
    
    
    0.01
    
    
    
    Net income
    
    $
    0.10
    
    
    $
    0.34
    
    
    $
    0.27
    
    
    $
    0.92Weighted average shares outstandingBasic
    
    
    9,133,552
    
    
    
    8,846,245
    
    
    
    9,079,601
    
    
    
    8,761,800Diluted
    
    
    9,395,360
    
    
    
    9,264,137
    
    
    
    9,424,170
    
    
    
    9,208,054
  4




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##### Table of Contents



DYNAMICS RESEARCH CORPORATION
 
 CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(unaudited)
(in thousands)
 Nine months endedSeptember 30,2006
    
    
    2005Cash flows from operating activities:Net income
    
    $
    2,571
    
    
    $
    8,501Adjustments to reconcile net cash provided by operating activities
Depreciation
    
    
    2,425
    
    
    
    2,823Amortization of intangible assets
    
    
    2,107
    
    
    
    2,279Stock compensation expense, including cumulative effect of accounting change
    
    
    1,632
    
    
    
    621Non-cash interest expense
    
    
    166
    
    
    
    98Amortization of deferred gain on sale of building
    
    
    (507
    )
    
    
    Income from equity interest
    
    
    (169
    )
    
    
    (140
    )Tax benefit from stock options exercised
    
    
    
    
    
    
    457Deferred income taxes
    
    
    (6,866
    )
    
    
    1,135Gain on sale of investments and long-lived assets, net
    
    
    (193
    )
    
    
    (2,001
    )Change in operating assets and liabilities:Accounts receivable, net
    
    
    (2,478
    )
    
    
    9,058Unbilled expenditures and fees on contracts in process
    
    
    19,888
    
    
    
    (16,887
    )Prepaid expenses and other current assets
    
    
    (825
    )
    
    
    3,993Accounts payable
    
    
    (5,400
    )
    
    
    6,707Accrued payroll and employee benefits
    
    
    (3,667
    )
    
    
    (4,944
    )Other accrued expenses
    
    
    (2,835
    )
    
    
    131Other long-term liabilities
    
    
    (2,477
    )
    
    
    (3,574
    )Net cash provided by continuing operations
    
    
    3,372
    
    
    
    8,257Net cash used in discontinued operations
    
    
    
    
    
    
    (422
    )Net cash provided by operating activities
    
    
    3,372
    
    
    
    7,835Cash flows from investing activities:Additions to property, plant and equipment
    
    
    (2,063
    )
    
    
    (3,373
    )Purchase of business
    
    
    
    
    
    
    (128
    )Proceeds from sale of investments and long-lived assets
    
    
    214
    
    
    
    2,002Dividends from equity investment
    
    
    155
    
    
    
    60Increase in other assets
    
    
    (44
    )
    
    
    (156
    )Net cash used in investing activities
    
    
    (1,738
    )
    
    
    (1,595
    )Cash flow from financing activities:Net borrowings (repayments) under revolving credit agreement
    
    
    21,692
    
    
    
    (2,111
    )Principal payments under loan agreements
    
    
    (25,412
    )
    
    
    (6,268
    )Proceeds from the exercise of stock options and issuance of common stock
    
    
    1,574
    
    
    
    2,853Tax benefit from stock options exercised
    
    
    158
    
    
    
    Payments on deferred financing costs
    
    
    (82
    )
    
    
    Net cash used in financing activities
    
    
    (2,070
    )
    
    
    (5,526
    )Net decrease in cash and cash equivalents
    
    
    (436
    )
    
    
    714Cash and cash equivalents, beginning of period
    
    
    1,020
    
    
    
    925Cash and cash equivalents, end of period
    
    $
    584
    
    
    $
    1,639
  5




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##### Table of Contents



DYNAMICS RESEARCH CORPORATION
 
 NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
(dollars in thousands, except per share amounts)
 NOTE 1. BASIS OF PRESENTATION
  HMR HMR HMR HMR HMR
  NOTE 2. RECENT ACCOUNTING PRONOUNCEMENTS
   6
    Table of Contents   DYNAMICS RESEARCH CORPORATION
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
(dollars in thousands, except per share amounts)
     NOTE 3. SHAREHOLDERS EQUITY
 Earnings Per Share
    7




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DYNAMICS RESEARCH CORPORATION
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
(dollars in thousands, except per share amounts)
  Three Months Ended
    
    
    Nine Months EndedSeptember 30,
    
    
    September 30,2006
    
    
    2005
    
    
    2006
    
    
    2005Weighted average shares outstanding  Basic
    
    
    9,133,552
    
    
    
    8,846,245
    
    
    
    9,079,601
    
    
    
    8,761,800Dilutive effect of stock options and restricted stock grants
    
    
    261,808
    
    
    
    417,892
    
    
    
    344,569
    
    
    
    446,254Weighted average shares outstanding  Diluted
    
    
    9,395,360
    
    
    
    9,264,137
    
    
    
    9,424,170
    
    
    
    9,208,054
 Comprehensive Income
  Three Months Ended
    
    
    Nine Months EndedSeptember 30,
    
    
    September 30,2006
    
    
    2005
    
    
    2006
    
    
    2005Net income
    
    $
    921
    
    
    $
    3,137
    
    
    $
    2,571
    
    
    $
    8,501Adjustments to accumulated other comprehensive income:Change in unrealized gain (loss) on investments
available for sale
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (324
    )Reclassification adjustment of realized gain
included in net income
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (1,211
    )Adjustments to comprehensive income
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (1,535
    )Comprehensive income
    
    $
    921
    
    
    $
    3,137
    
    
    $
    2,571
    
    
    $
    6,966
 NOTE 4. SHARE-BASED COMPENSATION
   Pro forma Information for Periods Prior to the Adoption of SFAS 123R
  Three Months
    
    
    Nine MonthsEnded
    
    
    EndedSeptember 30,
    
    
    September 30,2005
    
    
    2005Net income, as reported
    
    $
    3,137
    
    
    $
    8,501Add: Share-based employee compensation
expense included in reported net
income, net of related tax effects
    
    
    121
    
    
    
    406Deduct: Total share-based employee
compensation expense determined under
the fair value based method for all
awards, net of related tax effects
    
    
    (256
    )
    
    
    (963
    )Pro forma net income
    
    $
    3,002
    
    
    $
    7,944
 8




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##### Table of Contents



DYNAMICS RESEARCH CORPORATION
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
(dollars in thousands, except per share amounts)
 Three Months
    
    Nine MonthsEnded
    
    EndedSeptember 30,
    
    September 30,2005
    
    2005Earnings per common share:As reported:Basic
    
    $
    0.35
    
    
    $
    0.97Diluted
    
    $
    0.34
    
    
    $
    0.92Pro forma:Basic
    
    $
    0.34
    
    
    $
    0.91Diluted
    
    $
    0.32
    
    
    $
    0.86
 Impact of the Adoption of SFAS 123R
   Three Months
    
    
    Nine MonthsEnded
    
    
    EndedSeptember 30,
    
    
    September 30,2006
    
    
    2006Stock options
    
    $
    181
    
    
    $
    538ESPP
    
    
    94
    
    
    
    319Impact on operating income
    
    
    275
    
    
    
    857Cumulative effect of accounting change
    
    
    
    
    
    
    (146
    )Impact after cumulative effect of accounting change
    
    $
    275
    
    
    $
    711Impact on net income
    
    $
    (233
    )
    
    $
    (548
    )Impact on earnings per common share:Basic
    
    $
    (0.03
    )
    
    $
    (0.06
    )Diluted
    
    $
    (0.02
    )
    
    $
    (0.06
    )
  Three Months
    
    
    Nine MonthsEnded
    
    
    EndedSeptember 30,
    
    
    September 30,2006
    
    
    2006Cost of products and services
    
    $
    297
    
    
    $
    897Selling, general and administrative
    
    
    303
    
    
    
    881Cumulative effect of accounting change
    
    
    
    
    
    
    (146
    )Total share-based compensation expense
    
    $
    600
    
    
    $
    1,632
 9




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##### Table of Contents



DYNAMICS RESEARCH CORPORATION
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
(dollars in thousands, except per share amounts)
 Valuation Assumptions
  Three Months Ended
    
    Nine Months EndedSeptember 30,
    
    September 30,2006 (1)
    
    2005 (1)
    
    2006 (1)
    
    2005Stock Options:Risk-free interest rate
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    3.87
    %Dividend yield
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Volatility
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    66.38
    %Expected life in years
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    6.5ESPP:Risk-free interest rate
    
    
    4.99
    %
    
    
    3.48
    %
    
    
    4.77
    %
    
    
    2.68
    %Dividend yield
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Volatility
    
    
    21.37
    %
    
    
    34.40
    %
    
    
    27.14
    %
    
    
    32.77
    %Expected life in months
    
    
    3.0
    
    
    
    3.0
    
    
    
    3.0
    
    
    
    3.0
 
 (1)
    
    During the three months ended September 30, 2006 and 2005 and the nine months ended September
30, 2006, the Company did not grant any stock option awards. Share-Based Payment Award Activity
  Stock Options
    
    
    Restricted StockWeighted
    
    
    
    
    
    
    WeightedAwards
    
    
    Average
    
    
    Awards
    
    
    AverageOutstanding
    
    
    Exercise Price
    
    
    Outstanding
    
    
    Fair ValueBalance at June 30, 2006
    
    
    1,159,775
    
    
    $
    8.47
    
    
    
    232,971
    
    
    $
    13.14Granted
    
    
    
    
    
    $
    
    
    
    
    
    
    
    $
    Exercised/Vested
    
    
    (6,729
    )
    
    $
    8.45
    
    
    
    (4,526
    )
    
    $
    15.88Cancelled
    
    
    (3,851
    )
    
    $
    18.09
    
    
    
    (4,997
    )
    
    $
    15.18Balance at September 30, 2006
    
    
    1,149,195
    
    
    $
    8.44
    
    
    
    223,448
    
    
    $
    13.04Balance at December 31, 2005
    
    
    1,239,393
    
    
    $
    8.49
    
    
    
    221,816
    
    
    $
    13.60Granted
    
    
    
    
    
    $
    
    
    
    
    69,900
    
    
    $
    14.30Exercised/Vested
    
    
    (50,297
    )
    
    $
    6.97
    
    
    
    (46,933
    )
    
    $
    16.89Cancelled
    
    
    (39,901
    )
    
    $
    12.46
    
    
    
    (21,335
    )
    
    $
    14.07Balance at September 30, 2006
    
    
    1,149,195
    
    
    $
    8.44
    
    
    
    223,448
    
    
    $
    13.04Balance at June 30, 2005
    
    
    1,376,113
    
    
    $
    8.76
    
    
    
    222,719
    
    
    $
    13.75Granted
    
    
    
    
    
    $
    
    
    
    
    18,280
    
    
    $
    15.62Exercised/Vested
    
    
    (109,870
    )
    
    $
    9.96
    
    
    
    
    
    
    $
    Cancelled
    
    
    (14,517
    )
    
    $
    18.47
    
    
    
    (15,717
    )
    
    $
    18.01Balance at September 30, 2005
    
    
    1,251,726
    
    
    $
    8.54
    
    
    
    225,282
    
    
    $
    13.61Balance at December 31, 2004
    
    
    1,499,105
    
    
    $
    8.71
    
    
    
    192,408
    
    
    $
    12.90Granted
    
    
    15,000
    
    
    $
    18.57
    
    
    
    109,080
    
    
    $
    16.41Exercised/Vested
    
    
    (163,241
    )
    
    $
    9.25
    
    
    
    (36,836
    )
    
    $
    16.16Cancelled
    
    
    (99,138
    )
    
    $
    11.90
    
    
    
    (39,370
    )
    
    $
    16.05Balance at September 30, 2005
    
    
    1,251,726
    
    
    $
    8.54
    
    
    
    225,282
    
    
    $
    13.61
 10




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##### Table of Contents



DYNAMICS RESEARCH CORPORATION
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
(dollars in thousands, except per share amounts)
  Three Months
    
    Nine MonthsEnded
    
    EndedSeptember 30,
    
    September 30,2006
    
    2006Amounts realized or received from stock option exercises:Cash proceeds received
    
    $
    57
    
    
    $
    350Intrinsic value realized
    
    $
    31
    
    
    $
    203Income tax benefit realized
    
    $
    
    
    
    $
    138
    Options Outstanding
    
    
    Options ExercisableWeighted
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    WeightedWeighted
    
    
    Average
    
    
    
    
    
    
    
    
    
    
    Weighted
    
    
    AverageAverage
    
    
    Remaining
    
    
    
    
    
    
    
    
    
    
    Average
    
    
    RemainingRange of
    
    Number
    
    
    Exercise
    
    
    Contractual
    
    
    Intrinsic
    
    
    Number
    
    
    Exercise
    
    
    Contractual
    
    
    IntrinsicExercise Prices
    
    of Options
    
    
    Price
    
    
    Life
    
    
    Value
    
    
    of Options
    
    
    Price
    
    
    Life
    
    
    Value$3.13  $7.50
    
    
    344,060
    
    
    $
    5.08
    
    
    
    2.96
    
    
    $
    1,676
    
    
    
    344,060
    
    
    $
    5.08
    
    
    
    2.96
    
    
    $
    1,676$7.51  $13.68
    
    
    721,609
    
    
    $
    8.90
    
    
    
    4.52
    
    
    
    784
    
    
    
    181,609
    
    
    $
    8.80
    
    
    
    4.06
    
    
    
    238$13.69  $18.60
    
    
    63,526
    
    
    $
    17.10
    
    
    
    6.68
    
    
    
    
    
    
    
    41,191
    
    
    $
    17.69
    
    
    
    5.94
    
    
    
    $18.61  $24.50
    
    
    20,000
    
    
    $
    21.83
    
    
    
    4.10
    
    
    
    
    
    
    
    20,000
    
    
    $
    21.83
    
    
    
    4.10
    
    
    
    1,149,195
    
    
    $
    8.44
    
    
    
    4.16
    
    
    $
    2,460
    
    
    
    586,860
    
    
    $
    7.69
    
    
    
    3.55
    
    
    $
    1,914
 NOTE 5. SUPPLEMENTAL BALANCE SHEET INFORMATION
  September 30,
    
    
    December 31,2006
    
    
    2005Property, plant and equipment, net:Machinery and equipment
    
    $
    32,394
    
    
    $
    31,307Leasehold improvements
    
    
    1,917
    
    
    
    1,011Property, plant and equipment
    
    
    34,311
    
    
    
    32,318Less accumulated depreciation
    
    
    (22,442
    )
    
    
    (20,066
    )Property, plant and equipment, net
    
    $
    11,869
    
    
    $
    12,252Other noncurrent assets:Deferred tax asset
    
    $
    3,377
    
    
    $
    3,916Unbilled expenditures and fees on contracts in process
    
    
    801
    
    
    
    1,549Equity investments
    
    
    733
    
    
    
    719Other
    
    
    2,135
    
    
    
    2,175Other noncurrent assets
    
    $
    7,046
    
    
    $
    8,359
 11




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##### Table of Contents



DYNAMICS RESEARCH CORPORATION
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
(dollars in thousands, except per share amounts)
 September 30,
    
    
    December 31,2006
    
    
    2005Accrued compensation and employee benefits:Accrued pension liability
    
    $
    2,000
    
    
    $
    5,818Accrued vacation
    
    
    4,819
    
    
    
    4,705Other
    
    
    8,275
    
    
    
    8,238Accrued compensation and employee benefits
    
    $
    15,094
    
    
    $
    18,761Other accrued expenses:Accrued income taxes
    
    $
    
    
    
    $
    2,433Other
    
    
    3,741
    
    
    
    3,959Other accrued expenses
    
    $
    3,741
    
    
    $
    6,392Other long-term liabilities:Deferred gain on sale of building
    
    $
    5,577
    
    
    $
    6,158Accrued pension liability
    
    
    4,466
    
    
    
    5,328Other
    
    
    4,481
    
    
    
    6,022Other long-term liabilities
    
    $
    14,524
    
    
    $
    17,508
 NOTE 6. INVESTMENT AVAILABLE FOR SALE
   NOTE 7. GOODWILL AND INTANGIBLE ASSETS
  September 30, 2006
    
    
    December 31, 2005Accumulated
    
    
    
    
    
    
    AccumulatedCost
    
    
    Amortization
    
    
    Cost
    
    
    AmortizationCustomer relationships
    
    $
    12,800
    
    
    $
    (6,427
    )
    
    $
    14,200
    
    
    $
    (5,720
    )Non-competition agreements
    
    
    
    
    
    
    
    
    
    
    1,740
    
    
    
    (1,740
    )$
    12,800
    
    
    $
    (6,427
    )
    
    $
    15,940
    
    
    $
    (7,460
    )
  Remainder of 2006
    
    $
    7022007
    
    $
    2,6022008
    
    $
    2,0382009
    
    $
    1,031
 12




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##### Table of Contents



DYNAMICS RESEARCH CORPORATION
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
(dollars in thousands, except per share amounts)
  NOTE 8. INCOME TAXES
   NOTE 9. DEFINED BENEFIT PENSION PLAN
  Three Months Ended
    
    
    Nine Months EndedSeptember 30,
    
    
    September 30,2006
    
    
    2005
    
    
    2006
    
    
    2005Interest cost
    
    $
    1,002
    
    
    $
    959
    
    
    $
    3,006
    
    
    $
    2,953Expected return on plan assets
    
    
    (1,262
    )
    
    
    (1,139
    )
    
    
    (3,786
    )
    
    
    (3,305
    )Recognized actuarial loss
    
    
    440
    
    
    
    334
    
    
    
    1,320
    
    
    
    1,127Net periodic benefit cost
    
    $
    180
    
    
    $
    154
    
    
    $
    540
    
    
    $
    775
  NOTE 10. FINANCING ARRANGEMENTS
  13




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##### Table of Contents



DYNAMICS RESEARCH CORPORATION
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
(dollars in thousands, except per share amounts)
   
    
    Any failure by the Company and its subsidiaries to make any payment of principal, interest and other sums
due under the 2006 facility within three (3) calendar days of the date when the 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 Brown Brothers Harriman & Co. as administrative agent;
    
    Any bankruptcy (voluntary or involuntary) of the Company or any of its subsidiaries;
    
    Any material adverse change in the business or financial condition of the Company and its subsidiaries; or
    
    A change in control of the Company, as described in the 2006 facility.
  Outstanding
    
    
    InterestPrincipal
    
    
    Rate
    
    
    Interest Rate Option and Election DateDecember 31, 2005Acquisition term loan
    
    $
    23,100
    
    
    
    6.17
    %
    
    180-day LIBOR rate option elected on August 1, 2005Acquisition term loan
    
    
    2,312
    
    
    
    7.25
    %
    
    Base Rate option elected on December 30, 2005Total Debt
    
    
    25,412Less: Current portion of long-term debt
    
    
    (10,170
    )Long-term debt
    
    $
    15,242
 NOTE 11. BUSINESS SEGMENT, MAJOR CUSTOMERS AND RELATED PARTY INFORMATION
 Business Segment
   14




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##### Table of Contents



DYNAMICS RESEARCH CORPORATION
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
(dollars in thousands, except per share amounts)
     Three Months Ended
    
    
    Nine Months EndedSeptember 30,
    
    
    September 30,2006
    
    
    2005
    
    
    2006
    
    
    2005Revenues from external customersSystems and Services
    
    $
    61,547
    
    
    $
    77,334
    
    
    $
    194,026
    
    
    $
    223,712Metrigraphics
    
    
    1,614
    
    
    
    1,779
    
    
    
    4,626
    
    
    
    5,131$
    63,161
    
    
    $
    79,113
    
    
    $
    198,652
    
    
    $
    228,843Gross profitSystems and Services
    
    $
    7,791
    
    
    $
    13,160
    
    
    $
    24,972
    
    
    $
    35,785Metrigraphics
    
    
    397
    
    
    
    537
    
    
    
    855
    
    
    
    1,183$
    8,188
    
    
    $
    13,697
    
    
    $
    25,827
    
    
    $
    36,968Operating incomeSystems and Services
    
    $
    1,806
    
    
    $
    5,959
    
    
    $
    5,465
    
    
    $
    14,949Metrigraphics
    
    
    121
    
    
    
    256
    
    
    
    27
    
    
    
    311$
    1,927
    
    
    $
    6,215
    
    
    $
    5,492
    
    
    $
    15,260
 Major Customers
   Three Months Ended September 30,
    
    
    Nine Months Ended September 30,2006
    
    
    2005
    
    
    2006
    
    
    2005$
    
    
    %
    
    
    $
    
    
    %
    
    
    $
    
    
    %
    
    
    $
    
    
    %Air Force Aeronautical Systems Center
    
    $
    12,754
    
    
    
    20
    %
    
    $
    12,450
    
    
    
    16
    %
    
    $
    39,467
    
    
    
    20
    %
    
    $
    34,932
    
    
    
    15
    %
  September 30,
    
    
    December 31,2006
    
    
    2005Air Force Aeronautical Systems Center
    
    $
    2,516
    
    
    $
    4,740
  15




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##### Table of Contents



DYNAMICS RESEARCH CORPORATION
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
(dollars in thousands, except per share amounts)
 Related Party
 HMR HMR HMR HMR HMR HMR
 NOTE 12. COMMITMENTS AND CONTINGENCIES
     16




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##### Table of Contents



DYNAMICS RESEARCH CORPORATION
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
(dollars in thousands, except per share amounts)
  NOTE 13. SUBSEQUENT EVENTS
   17




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##### Table of Contents



Item 2. Managements Discussion and Analysis of Financial Condition and Results of Operations
  Overview
     18




---



##### Table of Contents



Results of Operations
  Three Months Ended September 30,2006
    
    2005$ millions
    
    %
    
    $ millions
    
    %Contract revenue
    
    $
    61.5
    
    
    
    97.4
    %
    
    $
    77.3
    
    
    
    97.8
    %Product sales
    
    $
    1.6
    
    
    
    2.6
    %
    
    $
    1.8
    
    
    
    2.2
    %Total revenue
    
    $
    63.2
    
    
    
    100.0
    %
    
    $
    79.1
    
    
    
    100.0
    %Gross profit on contract revenue (1)
    
    $
    7.8
    
    
    
    12.7
    %
    
    $
    13.2
    
    
    
    17.0
    %Gross profit on product sales (1)
    
    $
    0.4
    
    
    
    24.6
    %
    
    $
    0.5
    
    
    
    30.2
    %Total gross profit (1)
    
    $
    8.2
    
    
    
    13.0
    %
    
    $
    13.7
    
    
    
    17.3
    %Selling, general and administrative
    
    $
    5.6
    
    
    
    8.8
    %
    
    $
    6.7
    
    
    
    8.5
    %Amortization of intangible assets
    
    $
    0.7
    
    
    
    1.1
    %
    
    $
    0.8
    
    
    
    1.0
    %Operating income
    
    $
    1.9
    
    
    
    3.1
    %
    
    $
    6.2
    
    
    
    7.9
    %Interest expense, net
    
    $
    (0.6
    )
    
    
    (0.9
    )%
    
    $
    (1.1
    )
    
    
    (1.3
    )%Other income, net
    
    $
    0.1
    
    
    
    0.1
    %
    
    $
    0.1
    
    
    
    0.2
    %Provision for income taxes
    
    $
    0.5
    
    
    
    0.8
    %
    
    $
    2.1
    
    
    
    2.7
    %Net income
    
    $
    0.9
    
    
    
    1.5
    %
    
    $
    3.1
    
    
    
    4.0
    %
 Nine Months Ended September 30,2006
    
    2005$ millions
    
    %
    
    $ millions
    
    %Contract revenue
    
    $
    194.0
    
    
    
    97.7
    %
    
    $
    223.7
    
    
    
    97.8
    %Product sales
    
    $
    4.6
    
    
    
    2.3
    %
    
    $
    5.1
    
    
    
    2.2
    %Total revenue
    
    $
    198.7
    
    
    
    100.0
    %
    
    $
    228.8
    
    
    
    100.0
    %Gross profit on contract revenue (1)
    
    $
    25.0
    
    
    
    12.9
    %
    
    $
    35.8
    
    
    
    16.0
    %Gross profit on product sales (1)
    
    $
    0.9
    
    
    
    18.5
    %
    
    $
    1.2
    
    
    
    23.1
    %Total gross profit (1)
    
    $
    25.8
    
    
    
    13.0
    %
    
    $
    37.0
    
    
    
    16.2
    %Selling, general and administrative
    
    $
    18.2
    
    
    
    9.2
    %
    
    $
    19.4
    
    
    
    8.5
    %Amortization of intangible assets
    
    $
    2.1
    
    
    
    1.1
    %
    
    $
    2.3
    
    
    
    1.0
    %Operating income
    
    $
    5.5
    
    
    
    2.8
    %
    
    $
    15.3
    
    
    
    6.7
    %Interest expense, net
    
    $
    (1.7
    )
    
    
    (0.9
    )%
    
    $
    (3.2
    )
    
    
    (1.4
    )%Other income, net
    
    $
    0.4
    
    
    
    0.2
    %
    
    $
    2.2
    
    
    
    1.0
    %Provision for income taxes
    
    $
    1.7
    
    
    
    0.9
    %
    
    $
    5.8
    
    
    
    2.5
    %Net income
    
    $
    2.6
    
    
    
    1.3
    %
    
    $
    8.5
    
    
    
    3.7
    %
 
 (1)
    
    These amounts represent a percentage of contract revenues, product sales and total revenues,
respectively. Revenues
  19




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##### Table of Contents



Contract Revenues
  Three Months Ended
    
    Nine months endedSeptember 30,
    
    September 30,2006
    
    2005
    
    2006
    
    2005National defense and intelligence agencies
    
    $
    50.6
    
    
    $
    64.0
    
    
    $
    159.0
    
    
    $
    180.0Federal civilian agencies
    
    $
    6.6
    
    
    $
    6.8
    
    
    $
    23.0
    
    
    $
    24.6State and local government agencies
    
    $
    4.0
    
    
    $
    5.9
    
    
    $
    11.2
    
    
    $
    17.0Other
    
    $
    0.4
    
    
    $
    0.6
    
    
    $
    0.8
    
    
    $
    2.2Total contract revenue
    
    $
    61.5
    
    
    $
    77.3
    
    
    $
    194.0
    
    
    $
    223.7
  HMR HMR
  20




---



##### Table of Contents



Three Months Ended
    
    
    Nine months endedSeptember 30,
    
    
    September 30,2006
    
    
    2005
    
    
    2006
    
    
    2005Time and materials
    
    
    64
    %
    
    
    55
    %
    
    
    62
    %
    
    
    56
    %Cost reimbursable
    
    
    17
    %
    
    
    21
    %
    
    
    19
    %
    
    
    20
    %Fixed price, including service type contracts
    
    
    19
    %
    
    
    24
    %
    
    
    19
    %
    
    
    24
    %100
    %
    
    
    100
    %
    
    
    100
    %
    
    
    100
    %Prime contract
    
    
    67
    %
    
    
    68
    %
    
    
    68
    %
    
    
    68
    %Sub-contact
    
    
    33
    %
    
    
    32
    %
    
    
    32
    %
    
    
    32
    %100
    %
    
    
    100
    %
    
    
    100
    %
    
    
    100
    %
 Product Sales
  Funded Backlog
   Gross Profit
   21




---



##### Table of Contents



Selling, general and administrative expenses
  Amortization of intangible assets
  Interest expense, net
  Other income, net
 HMR HMR
 Income tax provision
  22




---



##### Table of Contents



LIQUIDITY AND CAPITAL RESOURCES
  Operating activities
       Investing activities
  23




---



##### Table of Contents



Financing activities
       RECENT ACCOUNTING PRONOUNCEMENTS
  24




---



##### Table of Contents



25




---



##### Table of Contents



Item 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
   
 Item 4. CONTROLS AND PROCEDURES
  26




---



##### Table of Contents



PART II. OTHER INFORMATION
 
 Item 1. LEGAL PROCEEDINGS
   
 Item 1A. RISK FACTORS
  Our Contracts and Subcontracts with Government Agencies are Subject to a Competitive Bidding
Process and to Termination Without Cause by the Government.
   HMR HMR
 27




---



##### Table of Contents



We Are Involved in Various Litigation Matters Which, If Not Resolved in Our Favor, Could Harm Our
Business.
   28




---



##### Table of Contents



Item 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS
  ApproximateTotal Number
    
    
    Dollar Valueof Shares
    
    
    of Shares thatPurchased as
    
    
    May Yet BePart of
    
    
    PurchasedTotal Number
    
    
    Average
    
    
    Publicly
    
    
    Under theof Shares
    
    
    Price Paid
    
    
    Announced
    
    
    ProgramsPeriod
    
    Purchased
    
    
    Per Share
    
    
    Programs
    
    
    (in millions)July 1, 2006 to July 31, 2006
    
    
    333
    
    
    $
    13.46
    
    
    
    
    
    
    $
    August 1, 2006 to August 31, 2006
    
    
    860
    
    
    
    13.45
    
    
    
    
    
    
    
    September 1, 2006 to September 30, 2006
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Total
    
    
    1,193
    
    
    $
    13.45
    
    
    
    
    
    
    $
    
  29




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##### Table of Contents



Item 6. EXHIBITS
  10.1
    
    Amendment, effective November 1, 2006, to the 2000 Employee Stock Purchase Plan of the Company.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.
 30




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##### Table of Contents



DYNAMICS RESEARCH CORPORATION
(Registrant)Date: November 8, 2006
    
    /s/ David KeleherDavid KeleherSenior Vice President and Chief Financial Officer/s/ Francis MurphyFrancis MurphyVice President, Corporate Controller and ChiefAccounting Officer
 31