##### Table of Contents



UNITED STATES
SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549
 FORM 10-Q [x]
    
    QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
 For the quarterly period ended March 31, 2004 OR [   ]
    
    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
[X]   No [  ]. Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Exchange Act). Yes
[X]  [  ]. As of April 30, 2004, there were 8,560,362 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, 2004 (unaudited) and December 31, 2003
(audited)
    
    
    3Consolidated
Statements of Operations for the three months ended March 31,
2004 and 2003 (unaudited)
    
    
    4Consolidated
Statement of Changes in Stockholders Equity and Comprehensive
Income for the three months ended March 31, 2004 (unaudited)
    
    
    5Consolidated
Statement of Changes in Stockholders Equity and Comprehensive
Income for the three months ended March 31, 2003 (unaudited)
    
    
    6Consolidated Statements of Cash Flows for the three months ended March 31, 2004 and 2003 (unaudited)
    
    
    7Notes Consolidated Financial Statements (unaudited)
    
    
    8Item 2.
    
    Managements Discussion and Analysis of Financial Condition and Results of Operations
    
    
    21Item 3.
    
    Quantitative and Qualitative Disclosures about Market Risk
    
    
    39Item 4.
    
    Controls and Procedures
    
    
    39PART II.
    
    OTHER INFORMATIONItem 1.
    
    Legal Proceedings
    
    
    42Item 6.
    
    Exhibits and Reports on Form 8-K
    
    
    44Signatures
    
    
    
    
    45Ex-31.1 Section 302 Certification CEOEx-31.2 Section 302 Certification CFOEx-32.1 Section 906 Certification CEOEx-32.2 Section 906 Certification CFO
  2




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##### Table of Contents



Dynamics Research Corporation 
   March 31,
    
    December 31,2004
    
    2003(unaudited)
    
    (audited)AssetsCurrent assetsCash and cash equivalents
    
    $
    50
    
    
    $
    2,724Accounts receivable, net of allowances of $343 and $321
at March 31, 2004 and December 31, 2003, respectively
    
    
    24,480
    
    
    
    28,251Unbilled expenditures and fees on contracts in process
    
    
    50,476
    
    
    
    34,257Prepaid expenses and other current assets
    
    
    3,245
    
    
    
    2,145Total current assets
    
    
    78,251
    
    
    
    67,377Noncurrent assetsProperty, plant and equipment, net
    
    
    20,955
    
    
    
    20,672Deferred income taxes
    
    
    2,340
    
    
    
    2,337Goodwill
    
    
    26,711
    
    
    
    26,711Intangible assets, net
    
    
    1,962
    
    
    
    2,343Other noncurrent assets
    
    
    1,924
    
    
    
    1,630Total noncurrent assets
    
    
    53,892
    
    
    
    53,693Total assets
    
    $
    132,143
    
    
    $
    121,070Liabilities and stockholders equityCurrent liabilitiesCurrent portion of long-term debt
    
    $
    500
    
    
    $
    500Notes payable and revolver
    
    
    15,226
    
    
    
    8,500Accounts payable
    
    
    14,812
    
    
    
    13,351Accrued payroll and employee benefits
    
    
    16,062
    
    
    
    15,657Deferred income taxes
    
    
    9,503
    
    
    
    9,698Other accrued expenses
    
    
    2,219
    
    
    
    2,371Discontinued operations
    
    
    823
    
    
    
    778Total current liabilities
    
    
    59,145
    
    
    
    50,855Long-term liabilitiesLong-term debt, less current portion
    
    
    7,625
    
    
    
    7,750Accrued pension liability
    
    
    12,030
    
    
    
    12,030Other long-term liabilities
    
    
    1,669
    
    
    
    1,386Discontinued operations
    
    
    250
    
    
    
    398Total long-term liabilities
    
    
    21,574
    
    
    
    21,564Total liabilities
    
    
    80,719
    
    
    
    72,419Commitments 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:Issued - 9,931,606 and 9,822,508 shares at March 31, 2004
and December 31, 2003, respectively
    
    
    993
    
    
    
    982Treasury stock -1,379,426 shares at both March 31, 2004
and December 31, 2003
    
    
    (138
    )
    
    
    (138
    )Capital in excess of par value
    
    
    38,496
    
    
    
    36,642Unearned compensation
    
    
    (1,933
    )
    
    
    (797
    )Accumulated other comprehensive loss
    
    
    (7,556
    )
    
    
    (7,556
    )Retained earnings
    
    
    21,562
    
    
    
    19,518Total stockholders equity
    
    
    51,424
    
    
    
    48,651Total liabilities and stockholders equity
    
    $
    132,143
    
    
    $
    121,070
 The accompanying notes are an integral part of these unaudited consolidated financial statements. 3




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##### Table of Contents



Dynamics Research Corporation 
    Three months endedMarch 31,2004
    
    2003Contract revenue
    
    $
    60,637
    
    
    $
    56,929Product sales
    
    
    1,431
    
    
    
    1,677Total revenue
    
    
    62,068
    
    
    
    58,606Cost of contract revenue
    
    
    51,837
    
    
    
    48,152Cost of product sales
    
    
    1,141
    
    
    
    1,253Selling, general and administrative expenses
    
    
    5,335
    
    
    
    5,781Amortization of intangible assets
    
    
    381
    
    
    
    455Total operating costs and expenses
    
    
    58,694
    
    
    
    55,641Operating income
    
    
    3,374
    
    
    
    2,965Interest expense, net
    
    
    (213
    )
    
    
    (277
    )Other income
    
    
    381
    
    
    
    42Income from continuing operations before provision for income taxes
    
    
    3,542
    
    
    
    2,730Provision for income taxes
    
    
    1,498
    
    
    
    1,098Income from continuing operations
    
    
    2,044
    
    
    
    1,632Loss from discontinued operations, net of tax benefit of $240 in 2003
    
    
    
    
    
    
    (357
    )Loss on disposal of discontinued operations, net of tax benefit of
$157 in 2003
    
    
    
    
    
    
    (233
    )Net income
    
    $
    2,044
    
    
    $
    1,042Earnings (loss) per common shareBasicIncome from continuing operations
    
    $
    0.24
    
    
    $
    0.20Loss from discontinued operations
    
    
    
    
    
    
    (0.04
    )Loss on disposal of discontinued operations
    
    
    
    
    
    
    (0.03
    )Net earnings per common share
    
    $
    0.24
    
    
    $
    0.13DilutedIncome from continuing operations
    
    $
    0.23
    
    
    $
    0.19Loss from discontinued operations
    
    
    
    
    
    
    (0.04
    )Loss on disposal of discontinued operations
    
    
    
    
    
    
    (0.03
    )Net earnings per common share
    
    $
    0.23
    
    
    $
    0.12Weighted average shares outstandingWeighted
average shares outstanding - basic
    
    
    8,394,265
    
    
    
    8,116,515Dilutive effect of options
    
    
    608,862
    
    
    
    529,402Weighted
average shares outstanding - diluted
    
    
    9,003,127
    
    
    
    8,645,917
 The accompanying notes are an integral part of these unaudited consolidated financial statements. 4




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##### Table of Contents



Dynamics Research Corporation 
     Common stockPreferred stock
    
    Issued
    
    Treasury stockShares
    
    Par value
    
    Shares
    
    Par value
    
    Shares
    
    Par valueBalance December 31, 2003 (audited)
    
    
    
    
    
    $
    
    
    
    
    9,822
    
    
    $
    982
    
    
    
    (1,379
    )
    
    $
    (138
    )Issuance of common stock through stock options
exercised and employee stock purchase plan
    
    
    
    
    
    
    
    
    
    
    52
    
    
    
    5
    
    
    
    
    
    
    
    Issuance of restricted stock
    
    
    
    
    
    
    
    
    
    
    71
    
    
    
    7
    
    
    
    
    
    
    
    Forfeiture of restricted stock
    
    
    
    
    
    
    
    
    
    
    (10
    )
    
    
    (1
    )
    
    
    
    
    
    
    Repurchase and retirement of restricted stock
    
    
    
    
    
    
    
    
    
    
    (3
    )
    
    
    
    
    
    
    
    
    
    
    Amortization of unearned compensation, net of forfeiture
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Tax benefit from stock options exercised
and employee stock purchase plan
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Net income
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Balance March 31, 2004
    
    
    
    
    
    $
    
    
    
    
    9,932
    
    
    $
    993
    
    
    
    (1,379
    )
    
    $
    (138
    )
   [Continued from above table, first column(s) repeated] AccumulatedCapital in
    
    
    
    
    
    otherexcess of
    
    Unearned
    
    comprehensive
    
    Retainedpar value
    
    compensation
    
    loss
    
    earnings
    
    TotalBalance December 31, 2003 (audited)
    
    $
    36,642
    
    
    $
    (797
    )
    
    $
    (7,556
    )
    
    $
    19,518
    
    
    $
    48,651Issuance of common stock through stock options
exercised and employee stock purchase plan
    
    
    596
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    601Issuance of restricted stock
    
    
    1,286
    
    
    
    (1,293
    )
    
    
    
    
    
    
    
    
    
    
    Forfeiture of restricted stock
    
    
    (91
    )
    
    
    92
    
    
    
    
    
    
    
    
    
    
    
    Repurchase and retirement of restricted stock
    
    
    (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
    
    $
    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. 5




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##### Table of Contents



Dynamics Research Corporation 
     Common stockPreferred stock
    
    Issued
    
    Treasury stockShares
    
    Par value
    
    Shares
    
    Par value
    
    Shares
    
    Par valueBalance December 31, 2002
    
    
    
    
    
    $
    
    
    
    
    9,544
    
    
    $
    954
    
    
    
    (1,379
    )
    
    $
    (138
    )Issuance of common stock through stock options
exercised and employee stock purchase plan
    
    
    
    
    
    
    
    
    
    
    55
    
    
    
    5
    
    
    
    
    
    
    
    Issuance of restricted stock
    
    
    
    
    
    
    
    
    
    
    23
    
    
    
    3
    
    
    
    
    
    
    
    Amortization of unearned compensation
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Net income
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Balance March 31, 2003
    
    
    
    
    
    $
    
    
    
    
    9,622
    
    
    $
    962
    
    
    
    (1,379
    )
    
    $
    (138
    )
   [Continued from above table, first column(s) repeated] AccumulatedCapital in
    
    
    
    
    
    otherexcess of
    
    Unearned
    
    comprehensive
    
    Retainedpar value
    
    compensation
    
    loss
    
    earnings
    
    TotalBalance December 31, 2002
    
    $
    33,844
    
    
    $
    (816
    )
    
    $
    (6,881
    )
    
    $
    12,846
    
    
    $
    39,809Issuance of common stock through stock options
exercised and employee stock purchase plan
    
    
    451
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    456Issuance of restricted stock
    
    
    204
    
    
    
    (207
    )
    
    
    
    
    
    
    
    
    
    
    Amortization of unearned compensation
    
    
    
    
    
    
    49
    
    
    
    
    
    
    
    
    
    
    
    49Net income
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    1,042
    
    
    
    1,042Balance March 31, 2003
    
    $
    34,499
    
    
    $
    (974
    )
    
    $
    (6,881
    )
    
    $
    13,888
    
    
    $
    41,356Comprehensive income is calculated as follows:Net income
    
    
    
    
    
    $
    1,042Adjustments to Accumulated other comprehensive loss
    
    
    
    
    
    
    Comprehensive income
    
    
    
    
    
    $
    1,042
 The accompanying notes are an integral part of these unaudited consolidated financial statements. 6




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Dynamics Research Corporation 
    Three months endedMarch 31,2004
    
    2003Operating activitiesNet income
    
    $
    2,044
    
    

    $
    1,042Loss from discontinued operations
    
    
    
    
    
    
    (357
    )Loss on disposal of discontinued operations
    
    
    
    
    
    
    (233
    )Income from continuing operations
    
    
    2,044
    
    
    
    1,632Adjustments to reconcile net cash provided by (used in) operating activitiesDepreciation
    
    
    874
    
    
    
    800Non-cash interest expense
    
    
    31
    
    
    
    37Investment income from equity interest
    
    
    (59
    )
    
    
    (3
    )Stock compensation expense
    
    
    65
    
    
    
    49Tax benefit from stock options exercised
    
    
    99
    
    
    
    Amortization of intangible assets
    
    
    381
    
    
    
    455Deferred income taxes
    
    
    (198
    )
    
    
    (69
    )Change in operating assets and liabilitiesAccounts receivable, net
    
    
    3,771
    
    
    
    1,188Unbilled expenditures and fees on contracts in process
    
    
    (15,521
    )
    
    
    (1,468
    )Prepaid expenses and other current assets
    
    
    (1,100
    )
    
    
    (910
    )Accounts payable
    
    
    763
    
    
    
    (856
    )Accrued payroll and employee benefits
    
    
    405
    
    
    
    1,157Other accrued expenses
    
    
    131
    
    
    
    (471
    )Net cash provided by (used in) continuing operations
    
    
    (8,314
    )
    
    
    1,541Net cash provided by (used in) discontinued operations
    
    
    (103
    )
    
    
    851Net cash provided by (used in) operating activities
    
    
    (8,417
    )
    
    
    2,392Investing activitiesAdditions to property, plant and equipment
    
    
    (1,157
    )
    
    
    (833
    )Dividends from equity investment
    
    
    60
    
    
    
    Increase in other assets
    
    
    (326
    )
    
    
    (79
    )Net cash used in investing activities
    
    
    (1,423
    )
    
    
    (912
    )Financing activitiesNet borrowings (repayments) under revolving credit agreement and notes payable
    
    
    6,726
    
    
    
    (644
    )Principal payments under mortgage agreement
    
    
    (125
    )
    
    
    (125
    )Proceeds from the exercise of stock options and issuance of common stock
    
    
    565
    
    
    
    456Net cash provided by (used in) financing activities
    
    
    7,166
    
    
    
    (313
    )Net increase (decrease) in cash and cash equivalents
    
    
    (2,674
    )
    
    
    1,167Cash and cash equivalents, beginning of period
    
    
    2,724
    
    
    
    1,076Cash and cash equivalents, end of period
    
    $
    50
    
    
    $
    2,243Supplemental informationCash paid for interest
    
    $
    167
    
    
    $
    248Cash paid (refunded) for income taxes, net
    
    $
    (457
    )
    
    $
    461
 The accompanying notes are an integral part of these unaudited consolidated financial statements. 7




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##### Table of Contents



DYNAMICS RESEARCH CORPORATION 
  NOTE 1. BASIS OF PRESENTATION The unaudited consolidated financial statements of Dynamics Research
Corporation (DRC or the company) and its subsidiaries included herein
have been prepared in accordance with accounting principles generally
accepted in the United States of America. 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. Certain amounts in previously
issued financial statements have been reclassified to conform to current
presentation. The results of the three month period ended March 31, 2004
may not be indicative of the results that may be expected for the year
ended December 31, 2004. 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, filed with
the U.S. Securities and Exchange Commission (SEC) for the year ended
December 31, 2003. 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 (Loss) Per Share Basic earnings (loss) per share is computed by dividing net income (loss)
by the weighted average number of shares of common stock outstanding
during the period. For periods in which there is net income, diluted
earnings (loss) 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
(loss) per share calculation and included in the diluted earnings (loss) per
share calculation. Due to their antidilutive effect, approximately 67,000 and 100,000
options to purchase common stock were excluded from the calculation of
diluted earnings per share for the first quarters of 2004 and 2003,
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 of net income per common share
as if the company had applied the fair value based method of Statement of
Financial Accounting Standards (SFAS) 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 31,2004
    
    2003Net income, as reported
    
    $
    2,044
    
    
    $
    1,042Deduct: Total stock-based employee
compensation determined under fair-value-based
method for all awards, net of related tax
effects
    
    
    (412
    )
    
    
    (593
    )Pro forma net income
    
    $
    1,632
    
    
    $
    449Net earnings per share:Basic, as reported
    
    $
    0.24
    
    
    $
    0.13Basic, pro forma
    
    $
    0.19
    
    
    $
    0.06Diluted, as reported
    
    $
    0.23
    
    
    $
    0.12Diluted, pro forma
    
    $
    0.18
    
    
    $
    0.05
 8




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##### Table of Contents



DYNAMICS RESEARCH CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) (continued) The weighted average fair values of options granted were $10.88 and $8.33
in the first quarters of 2004 and 2003, 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 31,2004
    
    2003Expected volatility
    
    
    68.54
    %
    
    
    55.72
    %Dividend yield
    
    
    
    
    
    
    Risk-free interest rate
    
    
    3.44
    %
    
    
    4.02
    %Expected life in years
    
    
    7.0
    
    
    
    8.06
 Recent Accounting Pronouncements In December 2003, the staff of the Securities and Exchange Commission
issued Staff Accounting Bulletin (SAB) No. 104 (SAB 104). SAB 104
revises or rescinds certain portions of the interpretative guidance
related to revenue recognition as previously interpreted in SAB No. 101,
Revenue Recognition in Financial Statements(SAB 101). The
implementation of the interpretative guidance in SAB 104 has not had any
effect on the companys financial position, results of operations or cash
flows. In December 2003, the Financial Accounting Standards Board (FASB)
issued SFAS No. 132R (SFAS 132R), a revision of its original SFAS No.
132, Employers Disclosures About Pensions and Other Postretirement
Benefits(SFAS 132). SFAS 132R revises employers disclosures about
pension plans and other postretirement benefit plans. It does not change
the measurement or recognition of those plans required by SFAS No. 87,
Employers Accounting for Pensions, SFAS No. 88, Employers Accounting
for Settlements and Curtailments of Defined Benefit Pension Plans and for
Termination Benefitsand SFAS No. 106, Employers Accounting for
Postretirement Benefits Other Than Pensions. SFAS 132R retains the
disclosure requirements contained in SFAS 132 and requires additional
disclosures about the assets, obligations, cash flows and net periodic
benefit cost of defined benefit pension plans and other defined benefit
postretirement plans. The company adopted this statement for the year
ended December 31, 2003. In May 2003, the Emerging Issues Task Force (EITF) reached a consensus
on EITF Issue No. 00-21, Revenue Arrangements with Multiple Deliverables
(EITF 00-21). EITF 00-21 addresses when an arrangement with multiple
deliverables should be divided into separate units of accounting. The
company adopted the consensus in the third quarter of 2003. The impact
of adopting EITF 00-21 did not have a material impact on the companys
financial position, results of operations or cash flows. In May 2003, the FASB issued SFAS No. 150, Accounting for Certain
Financial Instruments with Characteristics of Both Liabilities and Equity
(SFAS 150). SFAS 150 requires issuers to classify as liabilities (or
assets in some circumstances) three classes of freestanding financial
instruments that embody obligations for the issuer. Generally, SFAS 150
is effective for financial instruments entered into or modified after May
31, 2003 and is otherwise effective at the beginning of the first interim
period beginning after June 15, 2003. The company adopted the provisions
of SFAS 150 on July 1, 2003. The company did not have any financial
instruments within the scope of SFAS 150 at March 31, 2004, and,
accordingly, the adoption of SFAS 150 did not have a material effect on
its financial position, results of operations or cash flows. 9




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DYNAMICS RESEARCH CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) (continued) In April 2003, the FASB issued SFAS No. 149, Amendment of Statement 133
on Derivative Instruments and Hedging Activities(SFAS 149). SFAS 149
amends and clarifies financial accounting and reporting for derivative
instruments and hedging activities under SFAS No. 133, Accounting for
Derivative Instruments and Hedging Activities(SFAS 133), for decisions
made: (a) as part of the Derivative Implementation Group process that
requires amendment to SFAS 133; (b) in connection with other FASB
projects dealing with financial instruments; and (c) in connection with
the implementation issues raised related to the application of the
definition of derivative. SFAS 149 is effective for contracts entered
into or modified after June 30, 2003 and for designated hedging
relationships after June 30, 2003. SFAS 149 is required to be applied
prospectively. The company does not currently have any derivative
instruments and, accordingly, the adoption of SFAS 149 has not had any
effect on its financial position, results of operations or cash flows. In January 2003, the FASB issued FASB Interpretation No. (FIN) 46,
Consolidation of Variable Interest Entities, an interpretation of ARB No.
51 (FIN 46). In December 2003, the FASB issued FIN No. 46R (FIN
46R), to clarify some of the provisions of FIN 46 and to exempt certain
entities from its requirements. The primary objectives of FIN 46 are to
provide guidance on the identification of entities for which control is
achieved through means other than through voting rights (variable
interest entities) and how to determine when and which business
enterprise should consolidate the variable interest entity. This new
model for consolidation applies to an entity in which either: (a) the
equity investors (if any) do not have a controlling financial interest;
or (b) the equity investment at risk is insufficient to finance that
entitys activities without receiving additional subordinated financial
support from other parties. In addition, FIN 46 requires that both the
primary and all other enterprises with a significant variable interest in
a variable interest entity make additional disclosures. FIN 46 was
effective immediately for variable interest entities created after
January 31, 2003. FIN 46 had previously been effective for interim
periods beginning after June 15, 2003, for variable interests in place
prior to February 1, 2003; however, on October 10, 2003, the FASB issued
a statement deferring the implementation of FIN 46 for these variable
interests until the first reporting period beginning after December 15,
2003. The company acquired, as part of the May 31, 2002 purchase of HJ
Ford Associates, Inc., a 40% ownership interest in a small disadvantaged
business, as defined by the United States Government, which has been
accounted for using the equity method. The company has provided a
guarantee of the businesss line of credit, under which its maximum
exposure is $0.2 million. The company has evaluated this investment and
determined that it does not fall under the scope of FIN 46. Accordingly,
the company will continue to account for this investment under the equity
method, with no impact on the companys financial position, results of
operations or cash flows as a result of the adoption of FIN 46. The
company currently has no other investments subject to the provisions of
FIN 46. In December 2002, the FASB issued SFAS No. 148, Accounting for
Stock-Based Compensation-Transition and Disclosure-An Amendment of SFAS
No. 123(SFAS 148). SFAS 148 amends SFAS 123 to provide alternative
methods of transition for a voluntary change to the fair-value-based
method of accounting for stock-based employee compensation. SFAS 148
also amends the disclosure requirements of SFAS 123 to require prominent
disclosures in interim financial statements in addition to the annual
disclosures about the effect the fair value method would have had on
reported results. As permitted by SFAS 148, the company continues to
apply the disclosure-only alternative adopted under SFAS 123 to account
for its stock option grants to employees, under which compensation
expense is not typically recognized. The company adopted the interim
disclosure provisions of SFAS 148 in its Form 10-Q for the quarterly
period ended March 31, 2003. In November 2002, the FASB issued FIN No. 45, Guarantors Accounting and
Disclosure Requirements for Guarantees, Including Indirect Guarantees of
Indebtedness of Others, an Interpretation of SFAS No. 5, 57, and 107 and
Rescission of FASB Interpretation No. 34(FIN 45). FIN 45 clarifies
the requirements relating to the guarantors accounting for, and
disclosure of, the issuance of certain types of guarantees. FIN 45
requires that, upon issuance of a guarantee, the company recognize a
liability for the fair value of the obligation it assumes under that
guarantee. The company adopted the annual disclosure provisions of FIN
45 in the year ended December 31, 2002. The company adopted the
provisions for initial recognition and measurement and interim
disclosures during the first quarter of 2003. The adoption of FIN 45 did
not have a material effect on the companys financial position, results
of operations or cash flows. 10




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DYNAMICS RESEARCH CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) (continued) In April 2002, the FASB issued SFAS No. 145, Rescission of FASB
Statements No. 4, 44 and 64, Amendment of FASB Statement No. 13 and
Technical Corrections(SFAS 145). SFAS 145 rescinds SFAS No. 4,
Reporting Gains and Losses from Extinguishment of Debt, SFAS No. 44,
Accounting for Intangible Assets of Motor Carriersand SFAS No. 64,
Extinguishment of Debt Made to Satisfy Sinking-Fund Requirements. SFAS
145 also amends SFAS No. 13, Accounting for Leases, to eliminate the
inconsistency in the required accounting for sale-leaseback transactions
and other existing authoritative pronouncements to make various technical
corrections, clarify meanings or describe their applicability under
changed conditions. The company adopted the provisions of SFAS 145 on
January 1, 2003. The adoption of SFAS 145 did not have a material effect
on the companys financial position, results of operations or cash flows. 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 provides its services under
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 could differ materially from negotiated billing rates in the
contract, which directly affects 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 under the percentage of completion method, on the basis of
costs incurred in relation to estimated total costs to complete the
contract. Under service-type contracts, costs incurred are not
indicative of progression toward completion of the contract. 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 actual costs exceed the
estimated costs to complete the contract, then profit is eroded or losses
are incurred. 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. 11




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DYNAMICS RESEARCH CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) (continued) Unbilled expenditures and fees on contracts in process primarily
represent the amounts of recoverable contract revenue that have not been
billed at the balance sheet date. Most of 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. Costs related to 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. At March 31, 2004,
unbilled expenditures and fees also included subcontractor costs for the
month of March 2004, for which invoices had not been received and for
which revenues were not recognized, estimated at $3.1 million. The
comparable amount included in unbilled expenditures and fees at December
31, 2003, was $2.4 million. The related liabilities were recorded as
accounts payable. Valuation Allowances The company provides for potential losses against specifically identified
accounts receivable and unbilled expenditures and fees on contracts in
process based on the companys expectation of a customers inability 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. Goodwill The company assesses goodwill for impairment at the segment level at
least once each year by applying a 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. Deferred Taxes The company records a valuation allowance to reduce its deferred tax
assets 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 assets 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. 12




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DYNAMICS RESEARCH CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) (continued) 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 is performed each year. The results
of this actuarial valuation are reflected in the accounting for the
pension plan upon determination. NOTE 2. DISCONTINUED OPERATIONS 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, in the first quarter of 2003, the
company recorded charges aggregating $1.1 million before taxes as a loss
on the disposal of discontinued operations. The components of these
charges were $0.3 million of professional fees and $0.8 million of exit
costs, comprised of $0.5 million for severance costs for approximately 45
Encoder Division employees and $0.3 million for future lease costs, net
of contractual sublease income from GSI for the Encoder facility. During
the first quarter of 2003, the company recognized, on a cash basis, $0.7
million received as the final royalty payment associated with the 1999
sale of its discontinued Telecommunications Fraud control business, which
was recorded against the loss on the disposal of discontinued operations.
This income, net of the $1.1 million of charges described above,
resulted in a loss on the disposal of discontinued operations of $0.4
million before taxes, or a loss of $0.2 million, net of $0.2 million of
income tax benefit. The companys loss from discontinued operations, net
of taxes, was $0.4 million, or $0.04 per diluted share, in the first
quarter of 2003. The activity for the three months ended March 31, 2004, related to the
companys exit cost accrual is as follows (in thousands): Balance
    
    
    
    
    
    Adjustments
    
    Expenditures
    
    BalanceDecember 31,
    
    
    
    
    
    for changes
    
    charged against
    
    March 31,2003
    
    Provision
    
    in estimate
    
    accrual
    
    2004Severance
    
    $
    74
    
    
    $
    
    
    
    $
    
    
    
    $
    
    
    
    $
    74Lease
    
    
    932
    
    
    
    
    
    
    
    
    
    
    
    (148
    )
    
    
    784$
    1,006
    
    
    $
    
    
    
    $
    
    
    
    $
    (148
    )
    
    $
    858
 In addition to the exit cost accruals described above, liabilities of
discontinued operations also include $67,000 related to liabilities of
the Encoder Division not assumed by GSI in the purchase transaction. The balance sheet captions for discontinued operations include the
following (in thousands): March 31,
    
    December 31,2004
    
    2003Current liabilitiesAccrued payroll and employee benefits
    
    $
    74
    
    
    $
    74Other accrued expenses
    
    
    749
    
    
    
    704Total current liabilities
    
    $
    823
    
    
    $
    778Long-term liabilitiesOther long-term liabilities
    
    $
    250
    
    
    $
    398
 13




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DYNAMICS RESEARCH CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) (continued) The lease on the Encoder facility will expire in August 2005;
accordingly, lease payments and payments for other associated costs will
be made and charged to the accrual through that date. The difference
between the fair value of the total lease costs and the total cash
payments will be charged to discontinued operations as expense through
the expiration of the lease term, including sublease income initially
estimated at the time the accrual was recorded, but not subsequently
realized. NOTE 4. GOODWILL AND INTANGIBLE ASSETS Components of the companys identifiable intangible assets are as follows
(in thousands): March 31, 2004
    
    December 31, 2003Accumulated
    
    
    
    
    
    AccumulatedCost
    
    amortization
    
    Cost
    
    amortizationCustomer relationships
    
    $
    2,700
    
    
    $
    1,360
    
    
    $
    2,700
    
    
    $
    1,187Non-competition agreements
    
    
    1,740
    
    
    
    1,118
    
    
    
    1,740
    
    
    
    910$
    4,440
    
    
    $
    2,478
    
    
    $
    4,440
    
    
    $
    2,097
 The company recorded amortization expense for its identifiable intangible
assets of $0.4 million and $0.5 million for the three months March 31,
2004 and 2003, respectively. Estimated amortization expense on the
companys identifiable intangible assets for the remainder of the current
year and each of the four subsequent years is as follows (in thousands): Remainder of 2004
    
    $
    1,1402005
    
    $
    4892006
    
    $
    1662007
    
    $
    167Thereafter
    
    $
    
 There were no changes in the carrying amount of goodwill during the three
months ended March 31, 2004, as illustrated in the table below (in
thousands): Systems andServices
    
    Metrigraphics
    
    TotalBalance at December 31, 2003
    
    $
    26,711
    
    
    $
    
    
    
    $
    26,711Purchase accounting adjustments on prior period acquisitions
    
    
    
    
    
    
    
    
    
    
    Balance at March 31, 2004
    
    $
    26,711
    
    
    $
    
    
    
    $
    26,711
 NOTE 5. STOCK PLANS The company has stock option plans that are administered by the Compensation Committee of the Board of Directors (the Committee) and
the companys Chief Executive Officer. The companys 2003 Incentive Plan allows the company to grant incentive
stock options, non-qualified stock options, stock appreciation rights,
awards of nontransferable shares of restricted common stock and deferred
grants of common stock to directors or key employees of the company. 14




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DYNAMICS RESEARCH CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) (continued) The companys 2000 Incentive Plan (the 2000 Plan) allows the company to
grant incentive stock options, nonqualified stock options, stock
appreciation rights, awards of nontransferable shares of restricted
common stock and deferred grants of common stock. The companys
Executive Long Term Incentive Program (the ELTIP), implemented under
the provisions of the 2000 Plan, provides incentives to program
participants through a combination of stock options and restricted stock
grants, which vest fully in seven years. The ELTIP allows for
accelerated vesting contingent upon the companys achievement of specific
financial performance goals. The companys 2000 Employee Stock Purchase Plan allows eligible employees
to purchase the companys common stock through accumulated payroll
deductions at a price per share of 85% of the lower of the fair market
value price per share on the first or last day of each three month
offering period. Participating employees may elect to have up to 10% of
base pay withheld and applied toward the purchase of such shares. The companys 1995 Stock Option Plan for Non-employee Directors provides
for each outside director to receive options to purchase shares of common
stock at the first annual meeting at which the director is elected and at
each subsequent annual meeting, provided he or she remains an eligible
director and meets certain other independence criteria. NOTE 6. 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 services to government customers. The segment is comprised of
five operating groups that provide similar services and are subject to
similar regulations. These services included the design, development,
operation and maintenance of information technology systems, engineering
services, complex logistics planning systems and services, defense
program administrative support services, simulation, modeling, training
systems and services, and custom built electronic test equipment and
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 are allocated between the segments based on
segment revenues, including depreciation. Sales between segments
represent less than 1% of total revenues and are accounted for at cost.
Corporate assets are primarily comprised of cash and cash equivalents,
the companys corporate headquarters facility in Andover, Massachusetts,
the deferred tax asset, certain corporate prepaid expenses and other
current assets, and valuation allowances. 15




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DYNAMICS RESEARCH CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) (continued) Results of operations information for the companys business segments for
the three month periods ended March 31, 2004 and 2003, are as follows (in
thousands): Three months endedMarch 31,2004
    
    2003RevenueSystems and Services
    
    $
    60,637
    
    
    $
    56,929Metrigraphics
    
    
    1,431
    
    
    
    1,677$
    62,068
    
    
    $
    58,606Operating income (loss)Systems and Services
    
    $
    3,468
    
    
    $
    2,823Metrigraphics
    
    
    (94
    )
    
    
    142$
    3,374
    
    
    $
    2,965
 Asset information for the companys business segments and a
reconciliation of segment assets to the corresponding consolidated
amounts as of March 31, 2004 and December 31, 2003 is as follows (in
thousands): March 31,
    
    December 31,2004
    
    2003Segment assetsSystems and Services
    
    $
    108,730
    
    
    $
    98,274Metrigraphics
    
    
    1,855
    
    
    
    2,004Total segment assets
    
    
    110,585
    
    
    
    100,278Corporate assets
    
    
    21,558
    
    
    
    20,792$
    132,143
    
    
    $
    121,070
 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% of the companys consolidated
revenues. Revenues from Department of Defense (DoD) customers accounted for 80.3%
and 77.2% of total revenues in the first quarters of 2004 and 2003,
respectively. Revenues earned from one significant DoD contract in the
Systems and Services segment accounted for approximately 18% and 17% of
the companys total revenues in the first quarters of 2004 and 2003,
respectively, with an accounts receivable balance of approximately $9,000
at March 31, 2004. This customer had no outstanding accounts receivable
balance at December 31, 2003. A second significant contract in the
Systems and Services segment comprised approximately 11% of the companys
total revenues in the first quarters of both 2004 and 2003. This
customer had accounts receivable balances of $2.9 million and $1.6
million at March 31, 2004 and December 31, 2003, respectively. The
company had no other customer that accounted for more than 10% of
revenues in the first quarter of either 2004 or 2003. The company has a 40% interest in HMR Tech, a small disadvantaged
business, as defined by the United States government, 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. (HJ Ford). 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, 2004, were approximately $97,000. The
company did not recognize any revenues from HMR Tech in the first quarter
of 2003. The amounts due from HMR Tech included in accounts receivable
at March 31, 2004 and December 31, 2003, were approximately $196,000 and
$501,000, respectively. Related party transactions and amounts included
in accounts receivable are on standard pricing and contractual terms and
manner of settlement for services of similar types at comparable volumes. 16




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DYNAMICS RESEARCH CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) (continued) NOTE 7. FINANCING ARRANGEMENTS The company had outstanding debt of $23.3 million at March 31, 2004,
comprised of $8.1 million on the mortgage on the companys headquarters
facility in Andover, Massachusetts and $15.2 million under the companys
revolving credit agreement. The companys outstanding debt of $16.8
million at December 31, 2003, was comprised of $8.3 million on the
mortgage on the companys headquarters facility and $8.5 million under
the companys revolving credit agreement. On December 26, 2002, the company entered into an installment payment
agreement in connection with the purchase of its enterprise business
system software. The company made the first payment on January 26, 2003,
and the second and final payment of $0.6 million on January 26, 2004.
The company had recorded the liability using an imputed interest rate of
3.38%, which was its effective borrowing rate at December 31, 2002. This
purchase commitment is included as a component of Other accrued
expenses in the companys Consolidated Balance Sheet as of December 31,
2003. The company obtained a $50.0 million revolving credit agreement (the
Revolver), effective June 28, 2002. This Revolver replaced the
companys former revolving credit facility. The Revolver has a
three-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%, depending on the
companys most recently reported leverage ratio, and is payable quarterly
in arrears. The company has the option to elect a fixed 30, 60 or 90 day
term, at an interest rate of LIBOR plus 2.0% to 3.0%, depending on the
companys most recently reported leverage ratio, or to pay the base rate
on any outstanding balance. Interest on the outstanding principal
balance of the Revolver is payable monthly under the base rate option or
at the end of the elected term for the LIBOR rate option. At March 31,
2004, the outstanding principal balance under the Revolver was $15.2
million, with $2.7 million borrowed at the base rate of 4.0%, $8.5
million borrowed at 3.11% under a 90 day LIBOR option elected on March
15, 2004 and $4.0 million borrowed at 3.09% under a 30 day LIBOR option
elected on March 12, 2004. The weighted average interest rate on the
$15.2 million outstanding at March 31, 2004, was 3.26%. At December 31,
2003, the outstanding principal balance under the Revolver was $8.5
million. The interest rate on $7.5 million of this outstanding amount
was 3.17% under the 60 day LIBOR rate option elected on December 15,
2003. The interest rate on the remaining $1.0 million principal amount
outstanding was 3.16% under the 30 day LIBOR rate option elected on
December 15, 2003. The company has a 10 year mortgage loan (the Mortgage), dated June 12,
2000, as amended and restated on June 28, 2002, on its corporate office
facility in Andover, Massachusetts. The agreement requires quarterly
principal payments of $125,000, with a final payment of $5.0 million due
in May 2010. Interest on the Mortgage accrues at the rate of LIBOR plus
2.0%. The interest rate on the Mortgage under the 90 day LIBOR option,
elected at January 12, 2004, was 3.14%, which was effective at March 31,
2004. The companys outstanding principal balance on the Mortgage was
$8.1 million and $8.3 million at March 31, 2004 and December 31, 2003,
respectively. The Revolver and Mortgage agreements, as currently amended, require 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 loan agreements contain a
subjective acceleration clause, allowing the lender to require payment
upon the occurrence of a material adverse change in the companys
financial position. On December 23, 2003, the Revolver was amended to increase the capital
expenditure limits in 2003 and 2004 to $9.0 million and $7.0 million,
respectively, to allow for adjustments to the scheduled renovations of
the companys Andover, Massachusetts corporate office facility and the
companys investment in its new enterprise business system. On March 26,
2003, the tangible net worth covenant of the Revolver was amended to base
the covenant on total net worth and to exclude any adjustments to
Accumulated other comprehensive loss from the covenant calculation.
Management believes the company was in compliance with the Revolver and
Mortgage agreements on March 31, 2004. 17




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DYNAMICS RESEARCH CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) (continued) NOTE 8. 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 31,2004
    
    2003Interest cost
    
    $
    977
    
    
    $
    674Expected return on plan assets
    
    
    (979
    )
    
    
    (586
    )Recognized actuarial loss
    
    
    327
    
    
    
    212Net periodic benefit cost
    
    $
    325
    
    
    $
    300
 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. As previously disclosed in its Annual Report on Form 10-K for
the year ended December 31, 2003, the company expects to contribute
$3,725,000 to its pension plan in 2004. As of March 31, 2004, $416,461 of such
contributions had been made. NOTE 9. CONTINGENCIES 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. The company has continuing business
relationships with this business and has provided a guarantee of the
businesss line of credit in the principal amount of $0.2 million. The
companys guarantee obligation is supported by a right of indemnification
from the other shareholders of this business. At March 31, 2004, there
was no outstanding balance under this line of credit. 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 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
Investigative Service, the General Accounting office, the Department of
Justice and 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 the 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. 18




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DYNAMICS RESEARCH CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) (continued) 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 in substantial part upon the actions and
omissions of the former employees which gave rise to the criminal cases
against them. In the civil action, the United States Attorney is
asserting on behalf of the government claims against the company 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
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 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 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. On September 5, 2002, Genesis Tactical Group LLC (Genesis) asserted a
cross-claim against Lockheed Martin Corporation (Lockheed) in the State
of New York Supreme Court, County of Onondaga, seeking $50.0 million in
damages and against the company seeking $35.0 million in damages. These
cross-claims arise out of a suit filed on July 30, 2003, by Lockheed
against Tactical Communications Group LLC, Genesis and the company in the
State of New York Supreme Court, County of Onondaga. The Lockheed suit
relates to a contract for services that was sold to Genesis by the
company pursuant to an asset purchase agreement in 2001. By the terms of
the asset purchase agreement, the companys liability to Genesis is
limited to $300,000, other than for intentional misrepresentation,
willful breach or fraud. Lockheed and Genesis have settled their
outstanding issues, including a software ownership issue, and filed a
stipulation of dismissal with prejudice. The Genesis claim for $35.0
million against the company was related to the software ownership issue
that was settled in favor of Genesis. Lockheeds settlement demand to
the company was $496,000 plus interest. The company believes that
$312,000 of the demanded amount is for extra work and materials procured
by Lockheed from Genesis and disputes the balance due to other mutually
agreed contract changes between Lockheed and Genesis. The company
expects to continue to defend against any and all claims by Lockheed
and/or Genesis. While the company believes that the possibility of a
material adverse effect on the companys business, financial position,
results of operations and cash flows is remote, there can be no assurance
as to the outcome. 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 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. 19




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DYNAMICS RESEARCH CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) (continued) In
the first quarter of 2004 and the year ended December 31, 2003, approximately 91% and 93%,
respectively, 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 first quarter of 2004 and the year ended December 31, 2003, sales to agencies of state and
local governments comprised approximately 7% and 5%, 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 states legislatures. 20




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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, engineering and other services focused
on defense, public safety and citizen services for federal, state and
local governments. DRCs core capabilities are focused on information
technology, engineering and technical subject matter expertise that
pertain to the knowledge domains relevant to the companys core
customers. The company has two reportable business segments: Systems and Services,
and Metrigraphics. The Systems and Services segment provides technical
and information technology services to government customers. These
services include logistics information systems; business transformation;
design, development, operation and maintenance of information technology
systems; engineering services; defense acquisition management services;
modeling and simulation; decision support; training systems and services;
automated case management; and custom-built electronic test equipment and
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 developing
relationships with customers in defense, public safety and state citizen
services markets whose missions are focused on one or more of these six
strategic business areas: C4ISR (command, control, communications,
computing, intelligence, surveillance and reconnaissance), logistics,
readiness, military space, homeland security and health and human
services. The strategy leverages six solution sets where DRC believes it
has strong competencies and a record of meeting its customers most
difficult challenges. These repeatable, proven, cost effective solutions
are acquisitions management; training; business transformation; child
welfare case management; network management; and decision support
systems. DRC has a balanced organic and acquisition growth strategy aimed at
gaining market segment leadership and penetrating new market segments,
with specific focus on sustained organic growth. This strategy is
intended to achieve four key objectives: to increase shareholder value;
to grow sales in selected markets; to achieve operational excellence; and
to become an employer of choice. 21




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DYNAMICS RESEARCH CORPORATION
MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS (continued) RESULTS OF OPERATIONS
THREE MONTHS ENDED MARCH 31, 2004 AND 2003 Revenues The company reported revenues of $62.1 million in the first quarter of
2004, an increase of $3.5 million, or 5.9%, from $58.6 million in the
same prior year period. The increase in revenues is attributable to
internally generated growth. Contract revenues for the Systems and Services segment increased 6.5%, to
$60.6 million, in the first quarter of 2004, compared to $56.9 million in
the same prior year period. Defense revenues grew 10.1%, or $4.6
million, in the first quarter of 2004, from $45.3 million in the
comparable prior year period. Revenues from federal civilian agencies
were $6.5 million for the quarter ended March 31, 2004, a decrease of
28.2% from the $9.0 million reported in the comparable prior year period.
The increase in defense revenues is attributable to internally generated
growth, primarily in the readiness and logistics markets. The decrease
in federal civilian agency revenues is primarily the result of the
completion of the companys quality assurance work at the Bureau of
Citizenship and Immigration Services and the delays in new contract
awards by this agency. The company continues to await new contract
awards by agencies in this sector and to pursue business opportunities in
this area. State and local government revenues were $4.3 million in the
first quarter of 2004, an increase of 65.0% from the comparable prior
year period. This increase is principally attributable to increases in
training and network management services with health and human services
customers. A recently awarded fixed price systems development contract
with the State of Ohio, with a total value of $30 million over a three year period, is projected to generate incremental revenues
aggregating $5 million over the last three quarters of 2004. Product sales for the Metrigraphics segment decreased 14.7%, to $1.4
million in the first quarter of 2004, from $1.7 million in the same
quarter of 2003. The decrease reflects the continuing weak economic
conditions in the manufacturing sector. The company remains concerned
that further economic weakness could increase its adverse effect on this
segment. Gross margin Gross margins were 14.6% and 15.7% in the first quarters of 2004 and
2003, respectively. The companys Systems and Services segments gross margin on contract
revenues decreased to 14.5% in the first quarter of 2004, from 15.4% in
the comparable prior year quarter. The decrease in the current quarter
is primarily attributable to increased subcontractor costs and
amortization and maintenance expenses related to the implementation of
the companys new PeopleSoft-based enterprise business system, which was
placed into service on January 1, 2004. These factors were partially
offset by efficiencies realized from the integration of recent
acquisitions into the companys operations, primarily facility
consolidation and lower overhead as a percentage of revenues. The Metrigraphics segments gross margin on product sales decreased to
20.3% in the first quarter of 2004, from 25.3% in the first quarter of
the prior year. This decrease is primarily attributable to the
under-absorption of fixed costs resulting from this segments lower
revenues. The company expects that 2004 revenues in the aggregate for
this segment will be comparable to 2003. Selling, general and administrative expenses Selling, general and administrative expenses for the first quarter of
2004 were $5.3 million, a decrease of $0.5 million, compared to $5.8
million in the same prior year quarter. This decrease is primarily
attributable to reduced legal and marketing costs, partially offset by
costs related to the implementation of the companys new PeopleSoft-based
enterprise business system. Amortization of intangible assets Amortization expense totaled $0.4 million and $0.5 million in the three
months ended March 31, 2004 and 2003, respectively, and relates to
intangible assets acquired in the companys 2002 purchases of Andrulis
Corporation and HJ Ford Associates, Inc. 22




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DYNAMICS RESEARCH CORPORATION
MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS (continued) Operating income The company reported operating income of $3.5 million, or 5.4% of
revenues, and $3.0 million, or 5.1% of revenues, in the first quarters of
2004 and 2003, respectively. The increase in operating margin is
primarily attributable to reduced selling, general and administrative
expenses coupled with reduced intangible amortization costs. Interest income and expense Interest income increased to approximately $7,000 in the first quarter of
2004, from approximately $6,000 in the comparable prior year period.
Interest expense decreased by approximately $63,000, to approximately
$220,000, in the first quarter of 2004, compared to the same prior year
period. The decrease in interest expense in the current year is
primarily attributable to the higher outstanding principal balance on the
companys revolving credit facility during the first quarter of 2003
related to the acquisition of Andrulis Corporation. Borrowings during
the first quarter of 2004 have been used to support the companys focus
on the implementation of its new PeopleSoft-based enterprise business
system, which was placed into service on January 1, 2004. This focus has
resulted in a temporary increase in the companys outstanding accounts
receivable balances and receivables days sales outstanding (DSO),
necessitating the additional borrowings. Management believes that this
is a function of temporary resource allocation and system start-up.
However, the increased borrowings could result in higher interest expense
charges in subsequent periods. Income tax provision The company recorded income tax provisions of $1.5 million, or 42.3% of
pre-tax income, and $1.1 million, or 40.2% of pre-tax income, for the
first three months of 2004 and 2003, respectively. The increase in the
2004 tax rate reflects changes in estimates during 2003 for
non-deductible expenses, state income taxes and state tax credits. Discontinued operations 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, in the first quarter of 2003, the
company recorded charges aggregating $1.1 million before taxes as a loss
on the disposal of discontinued operations. The components of these
charges were $0.3 million of professional fees and $0.8 million of exit
costs, comprised of $0.5 million for severance costs for approximately 45
Encoder Division employees and $0.3 million for future lease costs, net
of contractual sublease income from GSI for the Encoder facility. During
the first quarter of 2003, the company recognized, on a cash basis, $0.7
million received as the final royalty payment associated with the 1999
sale of its discontinued Telecommunications Fraud control business, which
was recorded against the loss on the disposal of discontinued operations.
This income, net of the $1.1 million of charges described above,
resulted in a loss on the disposal of discontinued operations of $0.4
million before taxes, or a loss of $0.2 million, net of $0.2 million of
income tax benefit. The companys loss from discontinued operations, net
of taxes, was $0.4 million, or $0.04 per diluted share, in the first
quarter of 2003. Backlog The
companys funded backlog was $145.8 million at March 31, 2004 and
$123.9 million at December 31, 2003. The funded backlog generally is
subject to possible termination at the convenience of the customer. The company has a number of multi-year contracts with
agencies of the United States and state governments on which actual
funding generally occurs on an annual basis. A portion of the companys
funded backlog is based on annual purchase contracts and subject to
annual governmental approval or appropriations legislation, and the
amount of funded backlog as of any date can be affected by the timing of
order receipts and deliveries. Backlog does not necessarily equate to
future revenues. 23




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DYNAMICS RESEARCH CORPORATION
MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS (continued) LIQUIDITY AND CAPITAL RESOURCES At March 31, 2004 and December 31, 2003, the company had cash and cash
equivalents aggregating $50,000 and $2.7 million, respectively. The
decrease in cash and cash equivalents is primarily the result of $8.4
million of net cash used in operating activities, including $0.1 million
used in discontinued operations, and $1.2 million of capital
expenditures. These amounts were partially offset by $6.7 million of
additional borrowings under the companys revolving credit facility and
$0.6 million of proceeds from the exercise of stock options and
participation in the companys employee stock purchase plan. Cash used in operating activities totaled $8.4 million, and is primarily
attributable to increased unbilled expenditures and fees on contracts in
process totaling $15.7 million, partially off set by $2.0 million of net
income, depreciation and amortization expenses aggregating $1.3 million,
$3.8 million of reductions to accounts receivable and $1.1 million of
increases to prepaid expenses and other current assets. DSO was 106 at March 31, 2004 and 89 at December 31, 2003. These amounts
exclude subcontractor costs accrued, for which revenues were not
recognized, described below. As anticipated and discussed in the
companys most recent Annual Report on Form 10-K, this increase in
receivables (as reported under the captions Accounts receivable, net of
allowances and Unbilled expenditures and fees on contracts in process)
and DSO is a function of temporary resource allocation and start-up of
the companys PeopleSoft-based enterprise business system, and has no
indication of collectibility concerns. The company expects DSO to
decline to 85 or below by the end of 2004. At March 31, 2004 and December 31, 2003, unbilled expenditures and fees
on contracts in process included subcontractor costs for the month of
December, for which invoices had not been received and for which revenues
were not recognized, estimated at $3.1 million and $2.4 million,
respectively. Related liabilities were recorded as accounts payable. Cash used for investing activities totaled $1.4 million, and is primarily
attributable to $1.2 million of capital expenditures, including $0.6
million related to the implementation of the companys new enterprise
business system and $0.5 million for facility renovation and fit-up
costs. The company has a revolving credit facility (the Revolver), entered
into on June 28, 2002. The Revolver has a three-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% depending on the companys most recently
reported leverage ratio, and is payable quarterly in arrears. The
company has the option to elect on a fixed 30, 60 or 90 day term, at an
interest rate of LIBOR plus 2.0% to 3.0%, depending on the companys most
recently reported leverage ratio, or to pay the base rate on any
outstanding balance. Interest on the Revolvers outstanding principal
balance is payable monthly under the base rate option or at the end of
the elected term for the LIBOR rate option. At March 31, 2004, the
outstanding principal balance under the Revolver was $15.2 million, with
$2.7 million borrowed at the base rate of 4.0%, $8.5 million borrowed at
3.11% under a 90 day LIBOR option elected on March 15, 2004, and $4.0
million borrowed at 3.09% under a 30 day LIBOR option elected on March
12, 2004. The weighted average interest rate on the outstanding
principal balance was 3.26% at March 31, 2004. The company has a 10-year mortgage loan (the Mortgage), dated June 12,
2000, as amended and restated on June 28, 2002, on the corporate office
facility in Andover, Massachusetts. The outstanding principal balance of
the Mortgage was $8.1 million at March 31, 2004. The agreement requires
quarterly principal payments of $125,000, with a final payment of $5.0
million in May 2010. Interest on the Mortgage accrues at the rate of
LIBOR plus 2.0%. The interest rate on the Mortgage at March 31, 2004,
was 3.14% under the 90 day LIBOR option, elected on January 12, 2004. 24




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DYNAMICS RESEARCH CORPORATION
MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS (continued) On December 26, 2002, the company entered into an installment payment
agreement in connection with the purchase of its enterprise business
system software. The company made the first payment on January 26, 2003,
and the second and final payment of $0.6 million on January 26, 2004.
The company had recorded the liability using an imputed interest rate of
3.38%, which was its effective borrowing rate at December 31, 2002. This
purchase commitment is included as a component of Other accrued expenses
in the companys Consolidated Balance Sheet as of December 31, 2003. The Revolver and Mortgage agreements, as currently amended, require the
company to meet certain financial covenants including maintaining a
minimum net worth, cash flow and debt coverage ratios, and 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 Revolver and Mortgage agreements contain a subjective
acceleration clause allowing the lender to require payment upon the
occurrence of a material adverse change. On December 23, 2003, the Revolver was amended to increase the capital
expenditure limits in 2003 and 2004 to $9.0 million and $7.0 million,
respectively, to allow for adjustments to the scheduled renovations of
the companys Andover, Massachusetts corporate headquarters and the
companys investment in its new enterprise business system. On March 26,
2003, the tangible net worth covenant of the Revolver was amended to base
the covenant on total net worth and to exclude any adjustments to
Accumulated other comprehensive loss from the covenant calculation.
Management believes the company was in compliance with the Revolver and
Mortgage agreements amounts on March 31, 2004. Cash provided by financing activities was comprised of $6.7 million of
net borrowings under the companys revolving credit agreement
and $0.6
million of cash proceeds from the exercise of stock options and issuance
of shares under the employee stock purchase plan. These amounts were
partially offset by $0.1 million of principal payments under the
companys Mortgage agreement. 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. Selective acquisitions are an
important component of the companys 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s capital expenditures, excluding business
acquisitions, are expected to be in the range of $6 million to $7 million
in 2004, primarily for facilities infrastructure consolidation and
improvements. The companys need for, cost of, and access to funds are dependent on
future operating results, the companys growth and acquisition activity,
as well as conditions external to the company. The company will continue
to consider acquisition opportunities that align with its strategic
objectives, along with the possibility of utilizing the credit facility
as a source of financing. 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 the
remainder of 2004 and for the foreseeable future and that it will be able
to obtain replacement financing on competitive terms when the Revolver
expires on June 27, 2005. However, the development of adverse economic
or business conditions could significantly affect the need for and
availability of capital resources. 25




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DYNAMICS RESEARCH CORPORATION
MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS (continued) The companys contractual obligations as of March 31, 2004 consist of the
following (in thousands): Less than
    
    Two to three
    
    Four to fiveone year
    
    years
    
    years
    
    Thereafter
    
    TotalRevolver
    
    $
    15,226
    
    
    $
    
    
    
    $
    
    
    
    $
    
    
    
    $
    15,226Long-term debt
    
    
    500
    
    
    
    1,000
    
    
    
    1,000
    
    
    
    5,625
    
    
    
    8,125Operating leases
    
    
    4,618
    
    
    
    4,938
    
    
    
    3,182
    
    
    
    2,948
    
    
    
    15,686Total contractual obligations
    
    $
    20,344
    
    
    $
    5,938
    
    
    $
    4,182
    
    
    $
    8,573

    
    
    $
    39,037
 In addition, the company previously disclosed in its Annual Report on
Form 10-K for the year ended December 31, 2003, that it expected to
contribute $3,725,000 to its pension plan in 2004. As of March 31, 2004, $416,461 of such
contributions had been made. COMMITMENTS AND CONTINGENCIES 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. The company has continuing business
relationships with this business and has provided a guarantee of the
businesss line of credit in the principal amount of $0.2 million. The
companys obligation is supported by a right of indemnification from the
other shareholders of this business. At March 31, 2004, there was no
outstanding principal balance under this line of credit. 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 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
Investigative Service, the General Accounting office, the Department of
Justice and 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 the 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 26




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DYNAMICS RESEARCH CORPORATION
MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS (continued) United States District Court for the District of Massachusetts based in
substantial part upon the actions and omissions of the former employees
which gave rise to the criminal cases against them. In the civil action,
the United States Attorney is asserting on behalf of the government
claims against the company 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 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 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 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. On September 5, 2002, Genesis Tactical Group LLC (Genesis) asserted a
cross-claim against Lockheed Martin Corporation (Lockheed) in the State
of New York Supreme Court, County of Onondaga, seeking $50.0 million in
damages and against the company seeking $35.0 million in damages. These
cross-claims arise out of a suit filed on July 30, 2003, by Lockheed
against Tactical Communications Group LLC, Genesis and the company in the
State of New York Supreme Court, County of Onondaga. The Lockheed suit
relates to a contract for services that was sold to Genesis by the
company pursuant to an asset purchase agreement in 2001. By the terms of
the asset purchase agreement, the companys liability to Genesis is
limited to $300,000, other than for intentional misrepresentation,
willful breach or fraud. Lockheed and Genesis have settled their
outstanding issues, including a software ownership issue, and filed a
stipulation of dismissal with prejudice. The Genesis claim for $35.0
million against the company was related to the software ownership issue
that was settled in favor of Genesis. Lockheeds settlement demand to
the company was $496,000 plus interest. The company believes that
$312,000 of the demanded amount is for extra work and materials procured
by Lockheed from Genesis and disputes the balance due to other mutually
agreed contract changes between Lockheed and Genesis. The company
expects to continue to defend against any and all claims by Lockheed
and/or Genesis. While the company believes that the possibility of a
material adverse effect on the companys business, financial position,
results of operations and cash flows is remote, there can be no assurance
as to the outcome. 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 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. In
the first quarter of 2004 and the year ended December 31, 2003, approximately 91% and 93%,
respectively, 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 first quarter of 2004 and the year ended December 31, 2003, sales to agencies of state and
local governments comprised approximately 7% and 5%, 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 states legislatures. 27




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DYNAMICS RESEARCH CORPORATION
MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS (continued) CRITICAL ACCOUNTING POLICIES Use of Estimates 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. Management must make use of
estimates in the areas discussed below. Revenue Recognition The companys systems and services business provides its services under
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 differ materially from negotiated billing rates in the contract,
which directly affects operating income. For cost reimbursable contracts, revenue is recognized as costs are
incurred and include 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 under the percentage of completion method, on the basis of
costs incurred in relation to estimated total costs to complete the
contract. Under service-type contracts, costs incurred are not
indicative of progression toward completion of the contract. 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 actual costs exceed the
estimated costs to complete the contract, then profit is eroded or losses
are incurred. 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. Most of 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. Costs related
to 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. At March 31, 2004, unbilled expenditures and fees
also included subcontractor costs for the month of March, for which
invoices had not been received and for which revenues were not
recognized, estimated at $3.1 million. The comparable amount included in
unbilled expenditures and fees at December 31, 2003, was $2.4 million.
The related liabilities were recorded as accounts payable. Valuation Allowances The company provides for potential losses against specifically identified
accounts receivable and unbilled expenditures and fees on contracts in
process based on the companys expectation of a customers inability 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. 28




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DYNAMICS RESEARCH CORPORATION
MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS (continued) 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. Goodwill The company assesses goodwill for impairment at the segment level at
least once each year by applying a 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. Deferred Taxes The company records a valuation allowance to reduce its deferred tax
assets 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 assets 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 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 2003, the staff of the Securities and Exchange Commission
issued Staff Accounting Bulletin (SAB) No. 104 (SAB 104). SAB 104
revises or rescinds certain portions of the interpretative guidance
related to revenue recognition as previously interpreted in SAB No. 101,
Revenue Recognition in Financial Statements(SAB 101). The
implementation of the interpretative guidance in SAB 104 has not had any
effect on the companys financial position, results of operations or cash
flows. 29




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DYNAMICS RESEARCH CORPORATION
MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS (continued) In December 2003, the Financial Accounting Standards Board (FASB)
issued SFAS No. 132R (SFAS 132R), a revision of its original SFAS No.
132, Employers Disclosures About Pensions and Other Postretirement
Benefits(SFAS 132). SFAS 132R revises employers disclosures about
pension plans and other postretirement benefit plans. It does not change
the measurement or recognition of those plans required by SFAS No. 87,
Employers Accounting for Pensions, SFAS No. 88, Employers Accounting
for Settlements and Curtailments of Defined Benefit Pension Plans and for
Termination Benefitsand SFAS No. 106, Employers Accounting for
Postretirement Benefits Other Than Pensions. SFAS 132R retains the
disclosure requirements contained in SFAS 132 and requires additional
disclosures about the assets, obligations, cash flows and net periodic
benefit cost of defined benefit pension plans and other defined benefit
postretirement plans. The company adopted this statement for the year
ended December 31, 2003. In May 2003, the Emerging Issues Task Force (EITF) reached a consensus
on EITF Issue No. 00-21, Revenue Arrangements with Multiple Deliverables
(EITF 00-21). EITF 00-21 addresses when an arrangement with multiple
deliverables should be divided into separate units of accounting. The
company adopted the consensus in the third quarter of 2003. The impact
of adopting EITF 00-21 did not have a material impact on the companys
financial position, results of operations or cash flows. In May 2003, the FASB issued SFAS No. 150, Accounting for Certain
Financial Instruments with Characteristics of Both Liabilities and Equity
(SFAS 150). SFAS 150 requires issuers to classify as liabilities (or
assets in some circumstances) three classes of freestanding financial
instruments that embody obligations for the issuer. Generally, SFAS 150
is effective for financial instruments entered into or modified after May
31, 2003 and is otherwise effective at the beginning of the first interim
period beginning after June 15, 2003. The company adopted the provisions
of SFAS 150 on July 1, 2003. The company did not have any financial
instruments within the scope of SFAS 150 at March 31, 2004, and,
accordingly, the adoption of SFAS 150 did not have a material effect on
its financial position, results of operations or cash flows. In April 2003, the FASB issued SFAS No. 149, Amendment of Statement 133
on Derivative Instruments and Hedging Activities(SFAS 149). SFAS 149
amends and clarifies financial accounting and reporting for derivative
instruments and hedging activities under SFAS No. 133, Accounting for
Derivative Instruments and Hedging Activities(SFAS 133), for decisions
made: (a) as part of the Derivative Implementation Group process that
requires amendment to SFAS 133; (b) in connection with other FASB
projects dealing with financial instruments; and (c) in connection with
the implementation issues raised related to the application of the
definition of derivative. SFAS 149 is effective for contracts entered
into or modified after June 30, 2003 and for designated hedging
relationships after June 30, 2003. SFAS 149 is required to be applied
prospectively. The company does not currently have any derivative
instruments and, accordingly, the adoption of SFAS 149 has not had any
effect on its financial position, results of operations or cash flows. In January 2003, the FASB issued FASB Interpretation No. (FIN) 46,
Consolidation of Variable Interest Entities, an interpretation of ARB No.
51 (FIN 46). In December 2003, the FASB issued FIN No. 46R (FIN
46R), to clarify some of the provisions of FIN 46 and to exempt certain
entities from its requirements. The primary objectives of FIN 46 are to
provide guidance on the identification of entities for which control is
achieved through means other than through voting rights (variable
interest entities) and how to determine when and which business
enterprise should consolidate the variable interest entity. This new
model for consolidation applies to an entity in which either: (a) the
equity investors (if any) do not have a controlling financial interest;
or (b) the equity investment at risk is insufficient to finance that
entitys activities without receiving additional subordinated financial
support from other parties. In addition, FIN 46 requires that both the
primary and all other enterprises with a significant variable interest in
a variable interest entity make additional disclosures. FIN 46 was
effective immediately for variable interest entities created after
January 31, 2003. FIN 46 had previously been effective for interim
periods beginning after June 15, 2003, for variable interests in place
prior to February 1, 2003; however, on October 10, 2003, the FASB issued
a statement deferring the implementation of FIN 46 for these variable
interests until the first reporting period beginning after December 15,
2003. The company acquired, as part of the May 31, 2002 purchase of HJ 30




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DYNAMICS RESEARCH CORPORATION
MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS (continued) Ford Associates, Inc., a 40% ownership interest in a small disadvantaged
business, as defined by the United States Government, which has been
accounted for using the equity method. The company has provided a
guarantee of the businesss line of credit, under which its maximum
exposure is $0.2 million. The company has evaluated this investment and
determined that it does not fall under the scope of FIN 46. Accordingly,
the company will continue to account for this investment under the equity
method, with no impact on the companys financial position, results of
operations or cash flows as a result of the adoption of FIN 46. The
company currently has no other investments subject to the provisions of
FIN 46. In December 2002, the FASB issued SFAS No. 148, Accounting for
Stock-Based Compensation-Transition and Disclosure-An Amendment of SFAS
No. 123(SFAS 148). SFAS 148 amends SFAS 123 to provide alternative
methods of transition for a voluntary change to the fair-value-based
method of accounting for stock-based employee compensation. SFAS 148
also amends the disclosure requirements of SFAS 123 to require prominent
disclosures in interim financial statements in addition to the annual
disclosures about the effect the fair value method would have had on
reported results. As permitted by SFAS 148, the company continues to
apply the disclosure-only alternative adopted under SFAS 123 to account
for its stock option grants to employees, under which compensation
expense is not typically recognized. The company adopted the interim
disclosure provisions of SFAS 148 in its Form 10-Q for the quarterly
period ended March 31, 2003. In November 2002, the FASB issued FIN No. 45, Guarantors Accounting and
Disclosure Requirements for Guarantees, Including Indirect Guarantees of
Indebtedness of Others, an Interpretation of SFAS No. 5, 57, and 107 and
Rescission of FASB Interpretation No. 34(FIN 45). FIN 45 clarifies
the requirements relating to the guarantors accounting for, and
disclosure of, the issuance of certain types of guarantees. FIN 45
requires that, upon issuance of a guarantee, the company recognize a
liability for the fair value of the obligation it assumes under that
guarantee. The company adopted the annual disclosure provisions of FIN
45 in the year ended December 31, 2002. The company adopted the
provisions for initial recognition and measurement and interim
disclosures during the first quarter of 2003. The adoption of FIN 45 did
not have a material effect on the companys financial position, results
of operations or cash flows. In April 2002, the FASB issued SFAS No. 145, Rescission of FASB
Statements No. 4, 44 and 64, Amendment of FASB Statement No. 13 and
Technical Corrections(SFAS 145). SFAS 145 rescinds SFAS No. 4,
Reporting Gains and Losses from Extinguishment of Debt, SFAS No. 44,
Accounting for Intangible Assets of Motor Carriersand SFAS No. 64,
Extinguishment of Debt Made to Satisfy Sinking-Fund Requirements. SFAS
145 also amends SFAS No. 13, Accounting for Leases, to eliminate the
inconsistency in the required accounting for sale-leaseback transactions
and other existing authoritative pronouncements to make various technical
corrections, clarify meanings or describe their applicability under
changed conditions. The company adopted the provisions of SFAS 145 on
January 1, 2003. The adoption of SFAS 145 did not have a material effect
on the companys financial position, results of operations or cash flows. FACTORS THAT MAY AFFECT FUTURE RESULTS You should carefully consider the risks described below and the
information in our Annual Report on Form 10-K for the year ended December
31, 2003, filed with the Securities and Exchange Commission (SEC) on
March 15, 2004, as well as our Current Reports on Form 8-K filed with the
SEC, 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. 31




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DYNAMICS RESEARCH CORPORATION
MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS (continued) Our Revenue is Highly Dependent on the Department of Defense and Other
Federal Agencies. Decreases in Their Budgets, Changes in Program
Priorities or Military Base Closures Could Affect Our Results. In 2003 and 2002, approximately 93% and 89% of our revenue, respectively,
was derived from United States government agencies, primarily the
Department of Defense. 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
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. 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 our
business, financial condition, results of operations and cash flows. 32




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DYNAMICS RESEARCH CORPORATION
MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS (continued) 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 are 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 2003 and 2002, the company derived $42.4 million
and $17.1 million, respectively, of revenue from a small business set
aside contract held by its HJ Ford Associates, Inc. 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 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 and the U.S.
Army Aviation and Missile Command, which represented revenues of
approximately $15 million and $6 million, respectively, in the year ended
December 31, 2003, 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 and
Cost Adjustments 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
General Accounting 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. 33




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DYNAMICS RESEARCH CORPORATION
MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS (continued) The federal government audits and reviews our performance on contracts,
pricing practices, cost structure and compliance with applicable laws,
regulations and standards. Like most government contractors, the
companys contract costs are audited and reviewed on a continual basis.
Although audits have been completed on the companys incurred contract
costs through 2001 for the parent company, and through 2000 for our
Andrulis Corporation and HJ Ford Associates, Inc. subsidiaries, audits
for costs incurred or work performed subsequent to these dates remains
ongoing and, for much of our work in recent years, have not yet
commenced. In addition, non-audit reviews by the government may still be
conducted on all of our government contracts. An audit of the companys
work, including an audit of work performed by the companies we have
acquired or may acquire, could result in a substantial adjustment to our
revenues because any costs found to be improperly allocated to a specific
contract will not be reimbursed, and revenues we have already recognized
may need to be refunded. If a government audit uncovers improper or
illegal activities, we may be subject to civil and criminal penalties and
administrative sanctions, including termination of contracts, forfeiture
of profits, suspension of payments, fines and suspension or debarment
from doing business with federal government agencies. In addition, our
reputation could suffer serious harm if allegations of impropriety were
made against us. 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. 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. 34




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DYNAMICS RESEARCH CORPORATION
MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS (continued) 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 cause 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 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. Additionally, 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. If We Are Unable to Effectively and Efficiently Eliminate the Significant
Deficiencies That Have Been Identified in Our Internal Controls and
Procedures, There Could Be a Material Adverse Effect On Our Operations or
Financial Results In March 2004, our management and Audit Committee were notified by our
independent accountants, Grant Thornton LLP, of two significant
deficiencies in our internal controls and procedure regarding, first, the
accrual of subcontractor work performed and, second, our manually
intensive financial reporting process. In 2003, our management and Audit
Committee were notified by our then engaged independent accountants, KPMG
LLP, of three significant deficiencies relating to contract initiation
and set-up for certain fixed price contracts, inefficiencies in our
quarterly and year-end closing procedures and consolidation and the level
of SEC and generally accepted accounting principles, or GAAP, experience
of our personnel responsible for accounting and financial reporting.
Although we are committed to addressing these 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 significant deficiencies.
Our inability to successfully eliminate these significant deficiencies
could have a material adverse effect on our business, financial
condition, results of operations and cash flows. 35




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DYNAMICS RESEARCH CORPORATION
MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS (continued) 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. 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. Our Business is Highly Concentrated and a Significant Portion of Our
Revenue is Derived From a Few Customers. Our revenue from contracts with the Department of Defense, either as
prime contractor or subcontractor, accounted for approximately 78% and
80% of our total revenue in 2003 and 2002, respectively. Within the
Department of Defense, certain individual programs account for a
significant portion of our United States Government business. We cannot
provide any assurance that any of these programs will continue as such or
will continue at current levels. A decrease in orders from the
Department of Defense or any of these customers would have an adverse
effect on our profitability, and the loss of any large customer could
have a material adverse effect on our business, financial condition,
results of operations and cash flows. We May Be Subject to Product Liability Claims. Our precision manufactured products are generally designed to operate as
important components of complex systems or products. Defects in our
products 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. Like other
manufacturing companies, we may be subject to claims for alleged
performance issues related to our products. 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. 36




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DYNAMICS RESEARCH CORPORATION
MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS (continued) 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. 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. We have recently 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. The implementation
of the companys new enterprise business system has caused certain delays
in billing and collection of accounts receivable, which are currently
being addressed by us. 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; 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, a decrease in revenue may cause a significant variation in
our operating results. 37




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DYNAMICS RESEARCH CORPORATION
MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS (continued) We May Not Make or Complete Future Mergers, Acquisitions or Strategic
Alliances or Investments. In 2002, we acquired HJ Ford Associates, Inc. and Andrulis Corporation
and 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 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. 38




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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 Mortgage
and Revolver, where interest payments are tied to either the LIBOR or
prime rate. At any time, a sharp rise in interest rates could have an
adverse effect on net interest expense as reported in the companys
Consolidated Statements of Operations. A one full percentage point
increase in the interest rate on the balance of the Mortgage and Revolver
at March 31, 2004 would result in a $0.2 million increase in interest
expense per year. The company does not currently hedge these interest
rate exposures. The company presently has no investments 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 We strive to maintain disclosure controls and procedures that are
designed to ensure that information required to be disclosed in our
Securities and Exchange Act of 1934 reports is recorded, processed,
summarized and reported within the time periods specified in rules and
forms of the Securities and Exchange Commission, or SEC, and that such
information is accumulated and communicated to our management, including
our chief executive officer and chief financial officer, as appropriate,
to allow timely decisions regarding required disclosure. In designing
and evaluating the disclosure controls and procedures, management
recognizes that any controls and procedures, no matter how well designed
and operated, can provide only reasonable assurance of achieving the
desired control objectives, and management necessarily is required to
apply its judgment in evaluating the cost-benefit relationship of
possible controls and procedures. Our company carried out an evaluation, under the supervision and with the
participation of its chief executive officer and chief financial officer,
pursuant to Rule 13a-15 promulgated under the Securities Exchange Act of
1934, as amended, of the effectiveness of the design and operation of its
disclosure controls and procedures as of March 31, 2004. While we have
identified internal control weaknesses, which are discussed below, our
evaluation indicated that these weaknesses did not impair the
effectiveness of our overall disclosure controls and procedures and we
have concluded that the companys disclosure controls and procedures are
effective to ensure that information required to be disclosed in the
reports that the company files or submits under the Securities Exchange
Act of 1934 is recorded, processed, summarized and reported as specified
in the SECs rules and forms. 2003 Assessment In evaluating our internal controls we sought to determine whether there
were any significant deficiencies under standards established by the
American Institute of Certified Public Accountants, or AICPA. In 2004,
our management and Audit Committee were notified by our engaged
accountants, Grant Thornton LLP (Grant Thornton), of the existence of
two significant deficiencies. The first significant deficiency relates to the companys accounting
policy regarding the recognition of liabilities for subcontractor work
performed but not invoiced. Under the companys accounting policy, at
the end of each reporting period, the companys recognition of
liabilities for un-invoiced subcontractor work performed was deferred
until the following accounting period, which is not consistent with
generally accepted accounting principles, or GAAP. Grant Thornton recommended that the company develop policies and
procedures to estimate and capture this data and record the amounts in
the proper period. This condition also suggests the need for the company
to review its GAAP training procedures and strengthen its accounting
resources. 39




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This deficiency relates to recognition of liabilities and assets for
subcontractor work performed in the last month of a reporting period.
The companys policy was to recognize the liabilities and the related
assets in the month following the end of the reporting period, coincident
with the recognition of related costs and revenues, when known and
determinable, and generally when invoices were received. The company
concurred with Grant Thorntons finding, recoded liabilities and related
assets of $2.4 million at December 31, 2003, and has revised its policy
to record the liabilities and related assets in the period in which the
services are performed. The company continues to recognize costs and
revenues consistent with its policy. In addition, the company continues
to assess opportunities to strengthen its accounting capabilities beyond
the progress made in 2003. In April 2004, the company hired an Assistant
Controller for Financial Reporting, who is expected to further enhance
the depth and breadth of the companys accounting staff. The second deficiency relates to the companys manually intensive
financial reporting process, which can limit the time for internal
review. Although Grant Thornton did not note any material adjustments as
a result of this condition, the potential for errors exists. Both the
company and Grant Thornton expect the implementation of the companys new
enterprise business system to assist in resolving this deficiency. Grant Thornton recommended that the company consider updating its current
accounting and reporting system to a more automated system so that
management will have adequate time to analyze, record and review account
balances for accuracy, and that senior management reevaluate the current
organizational structure to determine if additional resources are
necessary. The company placed its PeopleSoft-based enterprise business
system into service effective January 1, 2004, and is undergoing full
implementation in the first half of 2004. The company anticipates
implementation of this system will substantially mitigate this
deficiency.
In the first quarter of 2004, the company experienced certain challenges
inherent in the implementation of a new enterprise business system. The
company continues to work through these transitional issues. During the first quarter of 2004, in conjunction with both the
installation of the new PeopleSoft-based enterprise business system and
the companys preparation for the attestation requirements proscribed by
Section 404 of the Sarbanes-Oxley Act of 2002, the company has begun to
undertake an extensive review and documentation of its existing internal
control structure. As a result of this endeavor, many policies and
procedures were modified or formalized. The company continues its
efforts to strengthen its internal controls. Additionally, the company
plans to assess regularly the quantity and effectiveness of its resources
and to continue to invest in its employees in an effort to improve the
effectiveness of both the individual employees and the overall
organization. 2002 Assessment In 2003, our management and Audit Committee were notified by our then
engaged accountants, KPMG LLP, of the existence of three significant
deficiencies relating to our operations for the year ended December 31,
2002. These significant deficiencies were not believed to be material
weaknesses, either individually or in the aggregate. The first significant deficiency related to contract initiation and
set-up for certain fixed price contracts. During its audit of the year
ended December 31, 2002, KPMG noted that the company had seven fixed
price contracts that qualified as service-type contracts which should
have been accounted for on a proportional performance basis using an
output method, rather than under the percentage-of-completion method
provided for by AICPA Statement of Position 81-1, Accounting for
Construction-Type Contracts. Accordingly, the company instituted
additional controls intended to ensure that new contracts are reviewed at
inception and that the appropriate method of revenue recognition is
applied. The second significant deficiency related to our quarterly and year-end
closing procedures and consolidation. KPMG noted findings related to
financial systems and processes including, among other things, monthly
operational review of results by the chief operating officer; a
pre-closing review of critical items with the auditors; the establishment
of daily close meetings with all general accounting personnel and
business controllers; the assignment of standard journal numbers for all
standard journal entries; the consolidation and reduction in the number
of bank accounts; the review and sign-off of all material account
reconciliations by the responsible supervisor or controller; and the
implementation, effective January 1, 2004, of the companys new
PeopleSoft-based enterprise business system for contract and financial
management, as described above. 40




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The third significant deficiency related to the level of SEC and GAAP
experience of our personnel responsible for accounting and financial
reporting. In 2003, the company added staff intended to strengthen its
skills and experience in this area, including an External Reporting
Manager, a new General Accounting Manager, an addition to the tax
accounting staff, several additions to the general accounting staff and
an addition to the internal audit staff of an internal controls oversight
position. While we have taken or begun to take the foregoing steps in order to
address the efficacy of our disclosure controls and procedures, the
adequacy of the steps we have taken to date and the steps we are still in
the process of completing is subject to continued management review
supported by confirmation and testing by our internal and external
auditors. Other than the foregoing matters, since the date of the evaluation,
supervised by our management, there have been no changes to our internal
controls over financial reporting that have materially affected, or are
reasonably likely to materially affect, our internal controls over
financial reporting. 41




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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
Investigative Service, the General Accounting office, the Department of
Justice and 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 the 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 in substantial part upon the actions and
omissions of the former employees which gave rise to the criminal cases
against them. In the civil action, the United States Attorney is
asserting on behalf of the government claims against the company 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
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 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 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. On September 5, 2002, Genesis Tactical Group LLC (Genesis) asserted a
cross-claim against Lockheed Martin Corporation (Lockheed) in the State
of New York Supreme Court, County of Onondaga, seeking $50.0 million in
damages and against the company seeking $35.0 million in damages. These
cross-claims arise out of a suit filed on July 30, 2003, by Lockheed
against Tactical Communications Group LLC, Genesis and the company in the
State of New York Supreme Court, County of Onondaga. The Lockheed suit
relates to a contract for services that was sold to Genesis by the
company pursuant to an asset purchase agreement in 2001. By the terms of
the asset purchase agreement, the companys liability to Genesis is
limited to $300,000, other than for intentional misrepresentation,
willful breach or fraud. Lockheed and Genesis have settled their
outstanding issues, including a software ownership issue, and filed a
stipulation of dismissal with prejudice. The Genesis claim for $35.0
million against the company was related to the software ownership issue
that was settled in favor of Genesis. Lockheeds settlement demand to
the company was $496,000 plus interest. The company believes that
$312,000 of the demanded amount is for extra work and materials procured
by Lockheed from Genesis and disputes the balance due to other mutually
agreed contract changes between Lockheed and Genesis. The company will
continue to defend against any and all 42




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claims by Lockheed and/or Genesis. While the company believes that the
possibility of a material adverse effect on the companys business,
financial position, results of operations and cash flows is remote, there
can be no assurance as to the outcome. 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 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. 43




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DYNAMICS RESEARCH CORPORATION 
 Item 6. EXHIBITS AND REPORTS ON FORM 8-K (a) 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 200231.2
    
    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 200232.1
    
    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 200232.2
    
    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
 (b) The following report on Form 8-K was furnished during the quarterly period
ended March 31, 2004:  (1)
    
    Current Report on Form 8-K, filed on February 25, 2004, relating to
the press release of the companys financial results for the quarter and
year ended December 31, 2003. 44




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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 7, 2004
    
    /s/ David KeleherDavid KeleherVice President and Chief Financial Officer/s/ Donald B. LevisDonald B. LevisCorporate Controller and Chief Accounting Officer
 45




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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
 46