##### 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 June 30, 2004 OR  o TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d)OF THE SECURITIES
EXCHANGE ACT OF 1934 For the transition period from            to Commission file number 000-02479 DYNAMICS RESEARCH CORPORATION (Exact Name of Registrant as Specified in Its Charter) 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 o. Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Exchange Act). Yes x No o. As of July 29, 2004, there were 8,640,618 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 June 30, 2004 (unaudited)
and December 31, 2003 (audited)
    
    
    3Consolidated Statements of Operations for the three months
ended June 30, 2004 and 2003 (unaudited)
    
    
    4Consolidated Statements of Operations for the six months
ended June 30, 2004 and 2003 (unaudited)
    
    
    5Consolidated Statement of Changes in Stockholders Equity
and Comprehensive Income for the three and six months ended
June 30, 2004 (unaudited)
    
    
    6Consolidated Statement of Changes in Stockholders Equity
and Comprehensive Income for the three and six months ended
June 30, 2003 (unaudited)
    
    
    7Consolidated Statements of Cash Flows for the six months
ended June 30, 2004 and 2003 (unaudited)
    
    
    8Notes to Consolidated Financial Statements (unaudited)
    
    
    9Item 2.
    
    Managements Discussion and Analysis of Financial Condition
and Results of Operations
    
    
    23Item 3.
    
    Quantitative and Qualitative Disclosures about Market Risk
    
    
    43Item 4.
    
    Controls and Procedures
    
    
    43PART II.
    
    OTHER INFORMATIONItem 1.
    
    Legal Proceedings
    
    
    46Item 4.
    
    Submission of Matters to a Vote of Security Holders
    
    
    47Item 6.
    
    Exhibits and Reports
on Form 8-K
    
    
    48Signatures
    
    
    
    
    49EX-31.1 Section 302 CEO CertificationEX-31.2 Section 302 CFO CertificationEX-32.1 Section 906 CEO CertificationEX-32.2 Section 906 CFO Certification




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##### Table of Contents



Dynamics Research Corporation
Consolidated Balance Sheets
(in thousands, except share data) June 30,
    
    December 31,2004
    
    2003(unaudited)
    
    (audited)AssetsCurrent assetsCash and cash equivalents
    
    $
    145
    
    
    $
    2,724Accounts receivable, net of allowances of $347 and $321
at June 30, 2004 and December 31, 2003, respectively
    
    
    39,178
    
    
    
    28,251Unbilled expenditures and fees on contracts in process
    
    
    45,161
    
    
    
    34,257Prepaid expenses and other current assets
    
    
    2,722
    
    
    
    2,145Total current assets
    
    
    87,206
    
    
    
    67,377Noncurrent assetsProperty, plant and equipment, net
    
    
    21,068
    
    
    
    20,672Deferred income taxes
    
    
    2,342
    
    
    
    2,337Goodwill
    
    
    26,711
    
    
    
    26,711Intangible assets, net
    
    
    1,581
    
    
    
    2,343Other noncurrent assets
    
    
    1,981
    
    
    
    1,630Total non current assets
    
    
    53,683
    
    
    
    53,693Total assets
    
    $
    140,889
    
    
    $
    121,070Liabilities and stockholders equityCurrent liabilitiesCurrent portion of long-term debt
    
    $
    500
    
    
    $
    500Notes payable and revolver
    
    
    20,887
    
    
    
    8,500Accounts payable
    
    
    15,749
    
    
    
    13,351Accrued payroll and employee benefits
    
    
    14,628
    
    
    
    15,657Deferred income taxes
    
    
    10,081
    
    
    
    9,698Other accrued expenses
    
    
    2,399
    
    
    
    2,371Discontinued operations
    
    
    635
    
    
    
    778Total current liabilities
    
    
    64,879
    
    
    
    50,855Long-term liabilitiesLong-term debt, less current portion
    
    
    7,500
    
    
    
    7,750Accrued pension liability
    
    
    12,030
    
    
    
    12,030Other long-term liabilities
    
    
    1,728
    
    
    
    1,386Discontinued operations
    
    
    99
    
    
    
    398Total long-term liabilities
    
    
    21,357
    
    
    
    21,564Total liabilities
    
    
    86,236
    
    
    
    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 - 10,007,719 and 9,822,508 shares at June 30, 2004
and December 31, 2003, respectively
    
    
    1,001
    
    
    
    982Treasury stock-1,379,426 shares at both June 30, 2004
and December 31, 2003
    
    
    (138
    )
    
    
    (138
    )Capital in excess of par value
    
    
    39,538
    
    
    
    36,642Unearned compensation
    
    
    (1,953
    )
    
    
    (797
    )Accumulated other comprehensive loss
    
    
    (7,556
    )
    
    
    (7,556
    )Retained earnings
    
    
    23,761
    
    
    
    19,518Total stockholders equity
    
    
    54,653
    
    
    
    48,651Total liabilities and stockholders equity
    
    $
    140,889
    
    
    $
    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
Consolidated Statements of Operations
(unaudited)
(in thousands, except share and per share data) Three months endedJune 30,2004
    
    2003Contract revenue
    
    $
    63,065
    
    
    $
    60,309Product sales
    
    
    1,885
    
    
    
    1,829Total revenue
    
    
    64,950
    
    
    
    62,138Cost of contract revenue
    
    
    54,158
    
    
    
    50,851Cost of product sales
    
    
    1,359
    
    
    
    1,282Selling, general and administrative expenses
    
    
    4,935
    
    
    
    6,109Amortization of intangible assets
    
    
    381
    
    
    
    423Total operating costs and expenses
    
    
    60,833
    
    
    
    58,665Operating income
    
    
    4,117
    
    
    
    3,473Interest expense, net
    
    
    (361
    )
    
    
    (237
    )Other income
    
    
    56
    
    
    
    38Income from continuing operations before provision for income taxes
    
    
    3,812
    
    
    
    3,274Provision for income taxes
    
    
    1,613
    
    
    
    1,316Income from continuing operations
    
    
    2,199
    
    
    
    1,958Loss from discontinued operations, net of tax benefit of $574 in 2003
    
    
    
    
    
    
    (856
    )Net income
    
    $
    2,199
    
    
    $
    1,102Earnings (loss) per common shareBasicIncome from continuing operations
    
    $
    0.26
    
    
    $
    0.24Loss from discontinued operations
    
    
    
    
    
    
    (0.11
    )Net earnings per common share
    
    $
    0.26
    
    
    $
    0.13DilutedIncome from continuing operations
    
    $
    0.24
    
    
    $
    0.23Loss from discontinued operations
    
    
    
    
    
    
    (0.10
    )Net earnings per common share
    
    $
    0.24
    
    
    $
    0.13Weighted average shares outstandingWeighted average shares outstanding  basic
    
    
    8,461,945
    
    
    
    8,181,314Dilutive effect of options
    
    
    557,194
    
    
    
    504,706Weighted average shares outstanding  diluted
    
    
    9,019,139
    
    
    
    8,686,020
 The accompanying notes are an integral part of these unaudited consolidated financial statements. 4




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##### Table of Contents



Dynamics Research Corporation
Consolidated Statements of Operations
(unaudited)
(in thousands, except share and per share data) Six months endedJune 30,2004
    
    2003Contract revenue
    
    $
    123,702
    
    
    $
    117,238Product sales
    
    
    3,316
    
    
    
    3,506Total revenue
    
    
    127,018
    
    
    
    120,744Cost of contract revenue
    
    
    105,995
    
    
    
    99,003Cost of product sales
    
    
    2,500
    
    
    
    2,535Selling, general and administrative expenses
    
    
    10,270
    
    
    
    11,890Amortization of intangible assets
    
    
    762
    
    
    
    878Total operating costs and expenses
    
    
    119,527
    
    
    
    114,306Operating income
    
    
    7,491
    
    
    
    6,438Interest expense, net
    
    
    (574
    )
    
    
    (514
    )Other income
    
    
    437
    
    
    
    80Income from continuing operations before provision for income taxes
    
    
    7,354
    
    
    
    6,004Provision for income taxes
    
    
    3,111
    
    
    
    2,414Income from continuing operations
    
    
    4,243
    
    
    
    3,590Loss from discontinued operations, net of tax benefit of $814 in 2003
    
    
    
    
    
    
    (1,213
    )Loss on disposal of discontinued operations, net of tax benefit of
$157 in 2003
    
    
    
    
    
    
    (233
    )Net income
    
    $
    4,243
    
    
    $
    2,144Earnings (loss) per common shareBasicIncome from continuing operations
    
    $
    0.50
    
    
    $
    0.44Loss from discontinued operations
    
    
    
    
    
    
    (0.15
    )Loss on disposal of discontinued operations
    
    
    
    
    
    
    (0.03
    )Net earnings per common share
    
    $
    0.50
    
    
    $
    0.26DilutedIncome from continuing operations
    
    $
    0.47
    
    
    $
    0.42Loss from discontinued operations
    
    
    
    
    
    
    (0.14
    )Loss on disposal of discontinued operations
    
    
    
    
    
    
    (0.03
    )Net earnings per common share
    
    $
    0.47
    
    
    $
    0.25Weighted average shares outstandingWeighted average shares outstanding  basic
    
    
    8,428,105
    
    
    
    8,160,932Dilutive effect of options
    
    
    570,234
    
    
    
    487,927Weighted average shares outstanding  diluted
    
    
    8,998,339
    
    
    
    8,648,859
 The accompanying notes are an integral part of these unaudited consolidated financial statements. 5




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##### Table of Contents



Dynamics Research Corporation
Consolidated Statement of Changes in Stockholders Equity and Comprehensive Income
Three and six months ended June 30, 2004
(unaudited)
(in thousands) Common stockPreferred stock
    
    Issued
    
    Treasury stock
    
    Capital in
    
    
    
    
    
    Accumulatedotherexcess of
    
    Unearned
    
    comprehensive
    
    RetainedShares
    
    Par value
    
    Shares
    
    Par value
    
    Shares
    
    Par value
    
    par value
    
    compensation
    
    loss
    
    earnings
    
    TotalThree months ended June 30, 2004Balance March 31, 2004
    
    
    
    
    
    $
    
    
    
    
    9,932
    
    
    $
    993
    
    
    
    (1,379
    )
    
    $
    (138
    )
    
    $
    38,496
    
    
    $
    (1,933
    )
    
    $
    (7,556
    )
    
    $
    21,562
    
    
    $
    51,424Issuance of common stock through stock options
exercised and employee stock purchase plan
    
    
    
    
    
    
    
    
    
    
    69
    
    
    
    7
    
    
    
    
    
    
    
    
    
    
    
    778
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    785Issuance of restricted stock
    
    
    
    
    
    
    
    
    
    
    17
    
    
    
    2
    
    
    
    
    
    
    
    
    
    
    
    284
    
    
    
    (286
    )
    
    
    
    
    
    
    
    
    
    
    Forfeiture of restricted stock
    
    
    
    
    
    
    
    
    
    
    (10
    )
    
    
    (1
    )
    
    
    
    
    
    
    
    
    
    
    (121
    )
    
    
    122
    
    
    
    
    
    
    
    
    
    
    
    Repurchase and retirement of restricted stock
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Amortization of unearned compensation, net of forfeiture
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    144
    
    
    
    
    
    
    
    
    
    
    
    144Tax benefit from stock options exercised
and employee stock purchase plan
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    101
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    101Net income
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    2,199
    
    
    
    2,199Balance June 30, 2004
    
    
    
    
    
    $
    
    
    
    
    10,008
    
    
    $
    1,001
    
    
    
    (1,379
    )
    
    $
    (138
    )
    
    $
    39,538
    
    
    $
    (1,953
    )
    
    $
    (7,556
    )
    
    $
    23,761
    
    
    $
    54,653Six months ended June 30, 2004Balance December 31, 2003 (audited)
    
    
    
    
    
    $
    
    
    
    
    9,822
    
    
    $
    982
    
    
    
    (1,379
    )
    
    $
    (138
    )
    
    $
    36,642
    
    
    $
    (797
    )
    
    $
    (7,556
    )
    
    $
    19,518
    
    
    $
    48,651Issuance of common stock through stock options
exercised and employee stock purchase plan
    
    
    
    
    
    
    
    
    
    
    121
    
    
    
    12
    
    
    
    
    
    
    
    
    
    
    
    1,374
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    1,386Issuance of restricted stock
    
    
    
    
    
    
    
    
    
    
    88
    
    
    
    9
    
    
    
    
    
    
    
    
    
    
    
    1,570
    
    
    
    (1,579
    )
    
    
    
    
    
    
    
    
    
    
    Forfeiture of restricted stock
    
    
    
    
    
    
    
    
    
    
    (20
    )
    
    
    (2
    )
    
    
    
    
    
    
    
    
    
    
    (212
    )
    
    
    214
    
    
    
    
    
    
    
    
    
    
    
    Repurchase and retirement of restricted stock
    
    
    
    
    
    
    
    
    
    
    (3
    )
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (36
    )
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (36
    )Amortization of unearned compensation, net of forfeiture
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    209
    
    
    
    
    
    
    
    
    
    
    
    209Tax benefit from stock options exercised
and employee stock purchase plan
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    200
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    200Net income
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    4,243
    
    
    
    4,243Balance June 30, 2004
    
    
    
    
    
    $
    
    
    
    
    10,008
    
    
    $
    1,001
    
    
    
    (1,379
    )
    
    $
    (138
    )
    
    $
    39,538
    
    
    $
    (1,953
    )
    
    $
    (7,556
    )
    
    $
    23,761
    
    
    $
    54,653
 Three
    
    Sixmonths
    
    monthsended
    
    endedJune 30, 2004Comprehensive income is calculated as follows:Net income
    
    $
    2,199
    
    
    $
    4,243Adjustments to Accumulated other comprehensive loss
    
    
    
    
    
    
    Comprehensive income
    
    $
    2,199
    
    
    $
    4,243
 The accompanying notes are an integral part of these unaudited consolidated financial statements. 6




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##### Table of Contents



Dynamics Research Corporation
Consolidated Statement of Changes in Stockholders Equity and Comprehensive Income
Three and six months ended June 30, 2003
(unaudited)
(in thousands) Common stock
    
    
    
    
    
    
    
    AccumulatedPreferred stock
    
    Issued
    
    Treasury stock
    
    Capital inexcess of
    
    Unearned
    
    othercomprehensive
    
    RetainedShares
    
    Par value
    
    Shares
    
    Par value
    
    Shares
    
    Par value
    
    par value
    
    compensation
    
    loss
    
    earnings
    
    TotalThree months ended June 30, 2003Balance March 31, 2003
    
    
    
    
    
    $
    
    
    
    
    9,622
    
    
    $
    962
    
    
    
    (1,379
    )
    
    $
    (138
    )
    
    $
    34,499
    
    
    $
    (974
    )
    
    $
    (6,881
    )
    
    $
    13,888
    
    
    $
    41,356Issuance of common stock through stock options
exercised and employee stock purchase plan
    
    
    
    
    
    
    
    
    
    
    50
    
    
    
    5
    
    
    
    
    
    
    
    
    
    
    
    410
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    415Issuance of restricted stock
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    23
    
    
    
    (23
    )
    
    
    
    
    
    
    
    
    
    
    Amortization of unearned compensation
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    64
    
    
    
    
    
    
    
    
    
    
    
    64Tax benefit from stock options exercised
and employee stock purchase plan
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    33
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    33Net income
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    1,102
    
    
    
    1,102Balance June 30, 2003
    
    
    
    
    
    $
    
    
    
    
    9,672
    
    
    $
    967
    
    
    
    (1,379
    )
    
    $
    (138
    )
    
    $
    34,965
    
    
    $
    (933
    )
    
    $
    (6,881
    )
    
    $
    14,990
    
    
    $
    42,970Six months ended June 30, 2003Balance December 31, 2002
    
    
    
    
    
    $
    
    
    
    
    9,544
    
    
    $
    954
    
    
    
    (1,379
    )
    
    $
    (138
    )
    
    $
    33,844
    
    
    $
    (816
    )
    
    $
    (6,881
    )
    
    $
    12,846
    
    
    $
    39,809Issuance of common stock through stock options
exercised and employee stock purchase plan
    
    
    
    
    
    
    
    
    
    
    105
    
    
    
    10
    
    
    
    
    
    
    
    
    
    
    
    861
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    871Issuance of restricted stock
    
    
    
    
    
    
    
    
    
    
    23
    
    
    
    3
    
    
    
    
    
    
    
    
    
    
    
    227
    
    
    
    (230
    )
    
    
    
    
    
    
    
    
    
    
    Amortization of unearned compensation
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    113
    
    
    
    
    
    
    
    
    
    
    
    113Tax benefit from stock options exercised
and employee stock purchase plan
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    33
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    33Net income
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    2,144
    
    
    
    2,144Balance June 30, 2003
    
    
    
    
    
    $
    
    
    
    
    9,672
    
    
    $
    967
    
    
    
    (1,379
    )
    
    $
    (138
    )
    
    $
    34,965
    
    
    $
    (933
    )
    
    $
    (6,881
    )
    
    $
    14,990
    
    
    $
    42,970
 Three
    
    Sixmonths
    
    monthsended
    
    endedJune 30, 2003Comprehensive income is calculated as follows:Net income
    
    $
    1,102
    
    
    $
    2,144Adjustments to Accumulated other comprehensive loss
    
    
    
    
    
    
    Comprehensive income
    
    $
    1,102
    
    
    $
    2,144
 The accompanying notes are an integral part of these unaudited consolidated financial statements. 7




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Dynamics Research Corporation
Consolidated Statements of Cash Flows
(unaudited)
(in thousands) Six months endedJune 30,2004
    
    2003Operating activitiesNet income
    
    $
    4,243
    
    
    $
    2,144Loss from discontinued operations
    
    
    
    
    
    
    (1,213
    )Loss on disposal of discontinued operations
    
    
    
    
    
    
    (233
    )Income from continuing operations
    
    
    4,243
    
    
    
    3,590Adjustments to reconcile net cash provided by (used in) operating activitiesDepreciation
    
    
    1,772
    
    
    
    1,559Non-cash interest expense
    
    
    54
    
    
    
    75Investment income from equity interest
    
    
    (113
    )
    
    
    (63
    )Stock compensation expense
    
    
    209
    
    
    
    113Tax benefit from stock options exercised
    
    
    200
    
    
    
    33Amortization of intangible assets
    
    
    762
    
    
    
    878Deferred income taxes
    
    
    378
    
    
    
    (386
    )Loss on disposal of long-lived assets
    
    
    4
    
    
    
    Change in operating assets and liabilitiesAccounts receivable, net
    
    
    (10,927
    )
    
    
    1,658Unbilled expenditures and fees on contracts in process
    
    
    (9,972
    )
    
    
    (1,131
    )Prepaid expenses and other current assets
    
    
    (21
    )
    
    
    (2,014
    )Accounts payable
    
    
    910
    
    
    
    1,036Accrued payroll and employee benefits
    
    
    (1,029
    )
    
    
    541Other accrued expenses
    
    
    370
    
    
    
    (621
    )Net cash provided by (used in) continuing operations
    
    
    (13,160
    )
    
    
    5,268Net cash provided by (used in) discontinued operations
    
    
    (442
    )
    
    
    315Net cash provided by (used in) operating activities
    
    
    (13,602
    )
    
    
    5,583Investing activitiesAdditions to property, plant and equipment
    
    
    (2,182
    )
    
    
    (3,228
    )Dividends from equity investment
    
    
    60
    
    
    
    Proceeds from the sale of assets
    
    
    10
    
    
    
    Increase in other assets
    
    
    (352
    )
    
    
    (301
    )Net cash used in continuing operations
    
    
    (2,464
    )
    
    
    (3,529
    )Net cash provided by discontinued operations
    
    
    
    
    
    
    2,950Net cash used in operating activities
    
    
    (2,464
    )
    
    
    (579
    )Financing activitiesNet borrowings (repayments) under revolving credit agreement and notes payable
    
    
    12,387
    
    
    
    (4,644
    )Principal payments under mortgage agreement
    
    
    (250
    )
    
    
    (250
    )Proceeds from the exercise of stock options and issuance of common stock
    
    
    1,350
    
    
    
    871Net cash provided by (used in) financing activities
    
    
    13,487
    
    
    
    (4,023
    )Net increase (decrease) in cash and cash equivalents
    
    
    (2,579
    )
    
    
    981Cash and cash equivalents, beginning of period
    
    
    2,724
    
    
    
    1,076Cash and cash equivalents, end of period
    
    $
    145
    
    
    $
    2,057Supplemental informationCash paid for interest
    
    $
    429
    
    
    $
    459Cash paid for income taxes, net of refunds
    
    $
    258
    
    
    $
    1,312
 The accompanying notes are an integral part of these unaudited consolidated financial statements. 8




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##### Table of Contents



DYNAMICS RESEARCH CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) 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 and six-month periods
ended June 30, 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 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 66,000 and 98,000 options
to purchase common stock were excluded from the calculation of diluted
earnings per share for the second quarters of 2004 and 2003,
respectively. Approximately 66,000 and 198,000 options to purchase
common stock were excluded from the calculation of diluted income per
share for the six months ended June 30, 2004 and 2003, respectively, as
their effect would be antidilutive. However, these options could become
dilutive in future periods. Stock-Based Compensation The company accounts for stock option plans under APB Opinion No. 25,
Accounting for Stock Issued to Employees, and related Interpretations.
The following table illustrates the effect on net income per common share
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 9




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DYNAMICS RESEARCH CORPORATION  stock option compensation (in thousands of dollars, except per share
data). Three Months Ended
    
    Six Months EndedJune 30,
    
    June 30,2004
    
    2003
    
    2004
    
    2003Net income, as reported
    
    $
    2,199
    
    
    $
    1,102
    
    
    $
    4,243
    
    
    $
    2,144Deduct: Total
stock-based employee
compensation
determined under
fair-value-based
method for all awards,
net of related tax
effects
    
    
    (133
    )
    
    
    (519
    )
    
    
    (213
    )
    
    
    (1,000
    )Pro forma net income
    
    $
    2,066
    
    
    $
    583
    
    
    $
    4,030
    
    
    $
    1,144Net income per share:Basic, as reported
    
    $
    0.26
    
    
    $
    0.13
    
    
    $
    0.50
    
    
    $
    0.26Basic, pro forma
    
    $
    0.24
    
    
    $
    0.07
    
    
    $
    0.48
    
    
    $
    0.14Diluted, as reported
    
    $
    0.24
    
    
    $
    0.13
    
    
    $
    0.47
    
    
    $
    0.25Diluted, pro forma
    
    $
    0.23
    
    
    $
    0.07
    
    
    $
    0.45
    
    
    $
    0.14
 The weighted average fair values of options granted were $11.12 and $8.48
in the first quarters of 2004 and 2003, respectively. The weighted
average fair values of options granted were $11.18 and $8.21 in the six
months ended June 30, 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 Ended
    
    Six Months EndedJune 30,
    
    June 30,2004
    
    2003
    
    2004
    
    2003Expected volatility
    
    
    69.88
    %
    
    
    65.47
    %
    
    
    69.88
    %
    
    
    60.81
    %Dividend yield
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Risk-free interest rate
    
    
    4.39
    %
    
    
    3.94
    %
    
    
    4.29
    %
    
    
    3.94
    %Expected life in years
    
    
    7.00
    
    
    
    7.98
    
    
    
    7.00
    
    
    
    7.98
 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 these disclosure provisions
for the year ended December 31, 2003. 10




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##### Table of Contents



DYNAMICS RESEARCH CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) (continued) 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 adoption
of EITF 00-21 did not have a material effect 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 June 30, 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
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 had provided a
guarantee of the businesss line of credit, under which its maximum
exposure was $0.2 million. On April 1, 2004, the company was released as
guarantor for this line of credit. 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. 11




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##### Table of Contents



DYNAMICS RESEARCH CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) (continued) 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. The adoption of these disclosure
provisions did not have a material effect on the companys financial
position, results of operations or cash flows. 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. 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
pursuant to time and materials, cost reimbursable and fixed price
contracts, including service-type contracts. For time and materials contracts, revenue reflects the number of direct
labor hours expended in the performance of a contract multiplied by the
contract billing rate, as well as reimbursement of other billable direct
costs. The risk inherent in time and materials contracts is that actual
costs could differ materially from negotiated billing rates in the
contract, which directly affects operating income. 12




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DYNAMICS RESEARCH CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) (continued) 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 related to 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 as services are performed, primarily using the percentage of
completion method, or, for certain short-term contracts, by the
completed contract method, in accordance with American Institute of Certified Public Accountants
Statement of Position 81-1, Accounting for Performance of
Construction-Type and Certain Production-Type Contracts (SOP 81-1). Revenue from service-type fixed price
contracts is recognized ratably over the contract period or by other
appropriate output methods to measure service provided, and contract
costs are expensed as incurred. The risk to the company related to 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 primarily
represent the amounts of recoverable contract revenue that have not been
billed at the balance sheet date. Generally, the companys unbilled
expenditures and fees relate to revenue that is billed in the month after
services are performed. In certain instances, billing is deferred in
compliance with contract terms, such as milestone billing arrangements
and withholdings or delayed for other reasons. In 2004, the company
encountered delays in billing activity related to the start-up of its
PeopleSoft-based enterprise business system. 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 June 30, 2004, unbilled expenditures
and fees also included subcontractor costs for the month of June 2004,
for which invoices had not been received and for which revenues were not
recognized, estimated at $3.3 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. 13




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DYNAMICS RESEARCH CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) (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. 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 14




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##### Table of Contents



DYNAMICS RESEARCH CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) (continued) 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, in the three months ended March
31, 2003 and the six months ended June 30, 2003. The company did not
record any charges related to this disposal in the three months ended
June 30, 2003. The companys loss from discontinued operations, net of taxes, was $0.9
million, or $0.10 per diluted share, and $1.2 million, or $0.14 per
diluted share, in the three and six months ended June 30, 2003,
respectively. The second-quarter loss included one month of operating
loss from the Encoder Division and an accrual of $1.1 million for future
lease costs of the Encoder facility, net of estimated sublease income
from GSI. The six-month loss included four months of operating loss for
the Encoder Division and the aforementioned charge for accrued lease
costs. The company did not record any charges for discontinued
operations in either the three or six months ended June 30, 2004. The activity for the three and six months ended June 30, 2004, related to
the companys exit cost accrual is as follows (in thousands): Three months ended June 30, 2004Balance
    
    
    
    
    
    Adjustments
    
    Expenditures
    
    BalanceMarch 31,
    
    
    
    
    
    for changes
    
    charged against
    
    June 30,2004
    
    Provision
    
    in estimate
    
    accrual
    
    2004Severance
    
    $
    74
    
    
    $
    
    
    
    $
    
    
    
    $
    (74
    )
    
    $
    Lease
    
    
    784
    
    
    
    
    
    
    
    
    
    
    
    (64
    )
    
    
    720$
    858
    
    
    $
    
    
    
    $
    
    
    
    $
    (138
    )
    
    $
    720
 Six months ended June 30, 2004Balance
    
    
    
    
    
    Adjustments
    
    Expenditures
    
    BalanceDecember 31,
    
    
    
    
    
    for changes
    
    charged against
    
    June 30,2003
    
    Provision
    
    in estimate
    
    accrual
    
    2004Severance
    
    $
    74
    
    
    $
    
    
    
    $
    
    
    
    $
    (74
    )
    
    $
    Lease
    
    
    932
    
    
    
    
    
    
    
    
    
    
    
    (212
    )
    
    
    720$
    1,006
    
    
    $
    
    
    
    $
    
    
    
    $
    (286
    )
    
    $
    720
 In addition to the exit cost accruals described above, liabilities of
discontinued operations also include approximately $14,000 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): June 30,
    
    December 31,2004
    
    2003Current liabilities
Accrued payroll and employee benefits
    
    $
    
    
    
    $
    74Other accrued expenses
    
    
    635
    
    
    
    704Total current liabilities
    
    $
    635
    
    
    $
    778Long-term liabilities
Other long-term liabilities
    
    $
    99
    
    
    $
    398
 15




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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 3. GOODWILL AND INTANGIBLE ASSETS Components of the companys identifiable intangible assets are as follows
(in thousands): June 30, 2004
    
    December 31, 2003Accumulated
    
    
    
    
    
    AccumulatedCost
    
    amortization
    
    Cost
    
    amortizationCustomer relationships
    
    $
    2,700
    
    
    $
    1,532
    
    
    $
    2,700
    
    
    $
    1,187Non-competition agreements
    
    
    1,740
    
    
    
    1,327
    
    
    
    1,740
    
    
    
    910$
    4,440
    
    
    $
    2,859
    
    
    $
    4,440
    
    
    $
    2,097
 The company recorded amortization expense for its identifiable intangible
assets of $0.4 million and $0.4 million for the three months June 30,
2004 and 2003, respectively, and $0.8 million and $0.9 million for the
six months then ended. 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
    
    $
    7592005
    
    $
    4892006
    
    $
    1662007
    
    $
    167Thereafter
    
    $
    
 There were no changes in the carrying amount of goodwill during the six
months ended June 30, 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 June 30, 2004
    
    $
    26,711
    
    
    $
    
    
    
    $
    26,711
 NOTE 4. STOCK PLANS The company has stock option plans that are administered by the
Compensation Committee of the Board of Directors 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. 16




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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 5. BUSINESS SEGMENT, GEOGRAPHIC, MAJOR CUSTOMER AND RELATED PARTY
INFORMATION The company has two reportable business segments: Systems and Services,
and Metrigraphics. The Systems and Services segment provides technical and information
technology services to government customers. The segment was 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. On July 1, 2004, the company announced that it had sharpened
its government customer focus by consolidating and realigning its
operations to better facilitate the execution of its recently developed
business growth strategy, better address the needs of its customers and
further strengthen the delivery of its solutions-based services.
Accordingly, effective July 1, 2004, the company has consolidated its five Systems and Services
segment operating groups into two organizations. The two new
organizations encompass all of the capabilities of the five former
groups. This realignment will not impact the companys business
segments, as the new groups both provide solutions-based services and are
subject to similar regulations. 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 new PeopleSoft-based enterprise business system, the deferred tax asset, certain
corporate prepaid expenses and other current assets, and valuation
allowances. 17




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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 and six month periods ended June 30, 2004 and 2003, are as
follows (in thousands): Three Months Ended
    
    Six Months EndedJune 30,
    
    June 30,2004
    
    2003
    
    2004
    
    2003RevenueSystems and Services
    
    $
    63,065
    
    
    $
    60,309
    
    
    $
    123,702
    
    
    $
    117,238Metrigraphics
    
    
    1,885
    
    
    
    1,829
    
    
    
    3,316
    
    
    
    3,506$
    64,950
    
    
    $
    62,138
    
    
    $
    127,018
    
    
    $
    120,744Operating incomeSystems and Services
    
    $
    4,010
    
    
    $
    3,299
    
    
    $
    7,478
    
    
    $
    6,122Metrigraphics
    
    
    107
    
    
    
    174
    
    
    
    13
    
    
    
    316$
    4,117
    
    
    $
    3,473
    
    
    $
    7,491
    
    
    $
    6,438
 Asset information for the companys business segments and a
reconciliation of segment assets to the corresponding consolidated
amounts as of June 30, 2004 and December 31, 2003 is as follows (in
thousands): June 30,
    
    December 31,2004
    
    2003Segment assetsSystems and Services
    
    $
    117,707
    
    
    $
    98,274Metrigraphics
    
    
    1,892
    
    
    
    2,004Total segment assets
    
    
    119,599
    
    
    
    100,278Corporate assets
    
    
    21,290
    
    
    
    20,792$
    140,889
    
    
    $
    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 80.0%
and 77.7% of total revenues in the second quarters of 2004 and 2003,
respectively, and 80.1% and 77.5% of total revenues in the six months
then ended. Revenues earned from one significant DoD contract in the
Systems and Services segment accounted for approximately 17% of the
companys total revenues in both the three and six months ended June 30,
2004, and 18% in both of the comparable prior year periods. This
customer had no outstanding accounts receivable balance at either June
30, 2004, or December 31, 2003. A second significant contract in the
Systems and Services segment comprised approximately 13% and 11% of the
companys total revenues in the second quarters of 2004 and 2003,
respectively, and 12% of revenues in both six month periods. This
customer had accounts receivable balances of $7.7 million and $1.6
million at June 30, 2004 and December 31, 2003, respectively. The
company had no other customers that accounted for more than 10% of
revenues in either the three or six months ended June 30, 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 and six months ended June 30, 2004, were approximately $93,000
and $190,000, respectively. Revenues from HMR Tech were approximately
$40,000 for both the three and six months ended June 30, 2002, as 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 June 30, 2004 and December 31, 2003, were approximately $223,000 and
$501,000, respectively. 18




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DYNAMICS RESEARCH CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) (continued) NOTE 6. FINANCING ARRANGEMENTS The company had outstanding debt of $28.9 million at June 30, 2004,
comprised of $8.0 million on the mortgage on the companys headquarters
facility in Andover, Massachusetts and $20.9 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 PeopleSoft-based 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 June 30,
2004, the outstanding principal balance under the Revolver was $20.9
million, with $8.4 million borrowed at the base rate of 4.0% and $12.5
million borrowed at 3.11% under a 30-day LIBOR option elected on June 2,
2004. The weighted average interest rate on the $20.9 million
outstanding at June 30, 2004, was 3.47%. 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 ten-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 was 3.14% at June 30, 2004,
under the 90-day LIBOR option elected on April 12, 2004. The companys
outstanding principal balance on the Mortgage was $8.0 million and $8.3
million at June 30, 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 PeopleSoft-based 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 June 30, 2004. 19




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DYNAMICS RESEARCH CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) (continued) NOTE 7. DEFINED BENEFIT PENSION PLAN The components of net periodic benefit cost for the companys defined
benefit pension plan are below (in thousands): Three months ended
    
    Six months endedJune 30,
    
    June 30,2004
    
    2003
    
    2004
    
    2003Interest cost
    
    $
    977
    
    
    $
    823
    
    
    $
    1,954
    
    
    $
    1,497Expected return on plan assets
    
    
    (979
    )
    
    
    (715
    )
    
    
    (1,958
    )
    
    
    (1,301
    )Recognized actuarial loss
    
    
    327
    
    
    
    259
    
    
    
    654
    
    
    
    471Net periodic benefit cost
    
    $
    325
    
    
    $
    367
    
    
    $
    650
    
    
    $
    667
 The companys defined benefit pension plan is frozen. No credit is
earned for current service and no new participants are eligible to enter
the plan; accordingly, the net periodic benefit costs do not include any
charges for service cost. The company 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
June 30, 2004, $1.5 million of contributions had been made. The company
currently expects to contribute an additional $1.4 million to fund its
pension plan in 2004, for a total contribution of $2.9 million. The
reduction in the expected cash contribution in 2004 from the previously
disclosed estimate is a result of interest rate relief promulgated by the
Internal Revenue Service in April 2004, coupled with the finalization of
the companys contribution requirement calculation. NOTE 8. 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 had provided a guarantee of the
businesss line of credit, under which its maximum exposure was $0.2
million. On April 1, 2004, the company was released as guarantor for
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, as defined in these agreements,
within a certain period of time from the date of any change of control of
the company. As a defense contractor, the company is subject to many levels of audit
and review from various government agencies, including the Defense
Contract Audit Agency, various inspectors general, the Defense Criminal
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. 20




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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. The companys claim against Storage Engine, which filed for
reorganization under Chapter 11 of the United States Bankruptcy Code, has
survived the bankruptcy proceeding and remains a claim against Storage
Engine. 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. In connection with this settlement, the Genesis claim for $35.0 million against
the company was eliminated. 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. 21




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DYNAMICS RESEARCH CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) (continued) In the first half 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 half 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 respective
states legislature. NOTE 9. SUBSEQUENT EVENTS On August 2, 2004, the company announced that it signed a definitive
agreement to acquire the government division of Impact Innovations LLC
(Impact Innovations) for $53.4 million in cash,
subject to certain closing provisions. Impact Innovations
government group has annual revenues approximating $47 million and is
based in the Washington, D.C. area. The government group offers solutions in business intelligence, enterprise
software, application development, information technology service management
and other related areas. Its customers include United States government
intelligence agencies and various Department of Defense agencies, as well as
federal civilian agencies. In connection with the acquisition, the company
expects to amend its existing credit facility to provide for a $55.0 million
term loan and a $37.0 million revolver for working capital. The acquisition is
also subject to seller shareholder and regulatory approvals and completion of
the financing discussed below. On July 31, 2004, the company received a commitment letter from its bank
group to restructure and increase the companys credit facilities to
$100.0 million, inclusive of the current mortgage on the corporate
headquarters in Andover, Massachusetts. The secured financing agreement
will provide for a $55.0 million, five-year term loan with a seven-year
amortization schedule for the purchase of Impact Innovations government
division and a $37.0 million, five-year revolving credit agreement for
working capital. The bank group, led by Brown Brothers Harriman, also
includes KeyBank, Bank North and BancAmerica. Although the company has
received the commitment letter, there can be no assurance that the
transaction will be completed. 22




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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 is intended to leverage six solution sets where
DRC believes it has strong competencies and a record of meeting its
customers most difficult challenges. These solutions are
business intelligence, acquisition
managements, training, business transformation, child welfare case
management and network services management. 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 in selected markets; to achieve operational excellence; and
to become an employer of choice. On July 1, 2004, the company announced that it had sharpened its
government customer focus by consolidating and realigning its operations
to better facilitate the execution of its recently developed business
growth strategy, better address the needs of its customers and further
strengthen the delivery of its solutions-based services. Accordingly,
effective July 1, 2004, the company has consolidated its five Systems and Services segment
operating groups into two organizations. The two new organizations
encompass all of the capabilities of the five former groups. This
realignment will not impact the companys business segments, as the new
groups both provide solutions-based services and are subject to similar
regulations. 23




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DYNAMICS RESEARCH CORPORATION
MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS (continued) RECENT DEVELOPMENTS On August 2, 2004, the company announced that it signed a definitive
agreement to acquire the government division of Impact Innovations LLC
(Impact Innovations) for $53.4 million in cash,
subject to certain closing provisions. Impact Innovations
government group has annual revenues approximating $47 million and is
based in the Washington, D.C. area. The government group offers solutions in business intelligence, enterprise
software, application development, information technology service management
and other related areas. Its customers include United States government
intelligence agencies and various Department of Defense agencies, as well as
federal civilian agencies. In connection with the acquisition, the company
expects to amend its existing credit facility to provide for a $55.0 million
term loan and a $37.0 million revolver for working capital. The acquisition is
also subject to seller shareholder and regulatory approvals and completion of
the financing discussed below. On July 31, 2004, the company received a commitment letter from its bank
group to restructure and increase the companys credit facilities to
$100.0 million, inclusive of the current mortgage on the corporate
headquarters in Andover, Massachusetts. The secured financing agreement
will provide for a $55.0 million, five-year term loan with a seven-year
amortization schedule for the purchase of Impact Innovations government
division and a $37.0 million, five-year revolving credit agreement for
working capital. The bank group, led by Brown Brothers Harriman, also
includes KeyBank, Bank North and BancAmerica. The company expects
to complete the financing in late August 2004. Although the company has
received the commitment letter, there can be no assurance that the
transaction will be completed. RESULTS OF OPERATIONS
THREE AND SIX MONTHS ENDED JUNE 30, 2004 AND 2003 Revenues The company reported revenues of $64.9 million in the second quarter of
2004, compared to $62.1 million in the same prior year period. The
companys revenues for the six months ended June 30, 2004, were $127.0
million, compared to $120.7 million in the same prior year period. Contract revenues for the Systems and Services segment increased 4.6%, to
$63.0 million, in the second quarter of 2004, from $60.3 million in the
comparable prior year period. Contract revenues were $123.7 million and
$117.2 million, respectively, in the first six months of 2004 and 2003.
Defense revenues grew 7.6%, or $3.7 million, in the second quarter of
2004, from $48.2 million in the second quarter of 2003. Defense revenues
were $101.7 million and $93.5 million in the six months ended June 30,
2004 and 2003, respectively. The increase in defense revenues in both
the current year three and six-month periods is attributable to
internally generated growth, primarily in the C4ISR (Command, control,
communications, computing, intelligence, surveillance and
reconnaissance), readiness and logistics markets. Revenues from federal civilian agencies were $7.1 million for the quarter
ended June 30, 2004, a decrease of 22.2% from the $9.1 million reported
in the same prior year quarter. Revenues from federal civilian agencies
in the six months ended June 30, 2004 and 2003, were $13.6 million and
$18.1 million, respectively. The decrease in federal civilian agency
revenues is primarily the result of the completion late in 2003 of the
companys quality assurance work at the Bureau of Citizenship and
Immigration Services and delays in new contract awards by this agency.
The company continues to await new contract awards by agencies in this
sector and is pursuing business opportunities in this area. State and local government revenues increased to $3.9 million in the
second quarter of 2004, from $2.9 million in the second quarter of 2003,
resulting from the commencement of work on a new multi-year software
development contract with the State of Ohio. State and local government
revenues were $8.3 million and $5.5 million in the six month periods
ended June 30, 2004 and 2003, respectively. The increase in the current
year was due to the new Ohio contract, as well as higher
revenues from training and network management services with health and
human services customers. 24




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DYNAMICS RESEARCH CORPORATION
MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS (continued) Product sales for the Metrigraphics segment increased by $0.1 million, to
$1.9 million, in the second quarter of 2004, from $1.8 million in the
same quarter of 2003. Product sales for this segment decreased by $0.2
million, to $3.3 million, in the first half of 2004, compared to the same
prior year period. This segments increase in the second quarter of 2004
is due in part to an overall improvement in order levels, combined with
an acceleration of orders by one customer from the third quarter to the
second quarter. The company expects 2004 revenues for this segment to be
comparable to 2003 revenues. However, the company remains concerned that
further economic weakness could increase the adverse effect on this
segment. Gross margin Gross margins were 14.5% and 16.1% in the second quarters of 2004 and
2003, respectively, and 14.6% and 15.9% in the six months then ended. The companys Systems and Services segments gross margin on contract
revenues decreased to 14.1% in the second quarter of 2004, from 15.7% in
the comparable prior year quarter. The segments gross margin for the
six months ended June 30, 2004, also decreased, to 14.3%, compared to
15.6% in the same prior year period. The decrease in both current year
periods 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 in both the
three and six-month periods ended June 30, 2004, to 27.9% and 24.6%,
respectively, compared to 29.9% and 27.7% in the same prior year
periods. However, the segments gross margin in the second quarter of the current year reflected
improved performance in comparison to the first quarter, and is consistent with
higher revenues in the second quarter. Despite these increased
revenues, gross margin declined in the current year, compared to the same prior
year periods. This decrease is primarily attributable to product mix. The
company remains concerned that further economic weakness in this sector could
exert additional downward pressure on this segments gross margin. Selling, general and administrative expenses Selling, general and administrative expenses for the second quarter of
2004 were $5.0 million, a decrease of $1.1 million, compared to $6.1
million in the same prior year quarter. Selling, general and
administrative expenses also decreased in the six months ended June 30,
2004, by $1.6 million, to $10.3 million, compared to $11.9 million in the
six months ended June 30, 2003. 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 of $0.4 million in the second quarters of both 2004
and 2003, and $0.8 million and $0.9 million in the six months ended June
30, 2004 and 2003, respectively, relates to intangible assets acquired in
the companys 2002 purchases of Andrulis Corporation and HJ Ford
Associates, Inc. Operating income The company reported operating income of $4.1 million, or 6.3% of
revenues, and $3.4 million, or 5.6% of revenues, in the second quarters
of 2004 and 2003, respectively. The companys operating income in the
six months ended June 30, 2004 and 2003, was $7.5 million, or 5.9% of
revenues, and $6.4 million, or 5.3% of revenues, respectively. The
increase in both operating income and margin in the current year periods
is primarily attributable to reduced selling, general and administrative
expenses. 25




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DYNAMICS RESEARCH CORPORATION
MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS (continued) Interest income and expense Interest income increased to approximately $24,000 in the second quarter
of 2004, from approximately $12,000 in the comparable prior year period.
Interest income in the six months ended June 30, 2004, was approximately
$31,000, an increase from the amount reported for the same prior year
period, which approximated $18,000. Interest expense increased by
approximately $136,000, to approximately $385,000, in the second quarter
of 2004, compared to the same prior year period. Interest expense for
the six months ended June 30, 2004, approximated $606,000, an increase of
approximately $73,000 from the same prior year period. The increase in
interest expense in both current year periods is primarily attributable
to the higher outstanding principal balance on the companys revolving
credit facility during the second quarter of 2004. Borrowings during the
first half of 2004 have been used to support the start-up of the companys new PeopleSoft-based enterprise business system,
which was placed into service on January 1, 2004. Income tax provision The company recorded income tax provisions of $3.1 million, or 42.3% of
pre-tax income, and $2.4 million, or 40.2% of pre-tax income, in the
first six months of 2004 and 2003, respectively. The increase in the
2004 tax rate reflects changes in estimates during 2003 for
non-deductible expenses. 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, for $3.3 million in cash, subject to post-closing
adjustments related to a valuation of the net assets of the Encoder
Division and the assumption by GSI of certain of DRCs liabilities with
respect to the assets acquired. 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, in the three months ended March 31, 2003 and the six
months ended June 30, 2003. The company did not record any charges
related to this disposal in the three months ended June 30, 2003. The companys loss from discontinued operations, net of taxes, was $0.9
million, or $0.10 per diluted share, and $1.2 million, or $0.14 per
diluted share, in the three and six months ended June 30, 2003,
respectively. The second-quarter loss included one month of operating
loss from the Encoder Division and an accrual of $1.1 million for future
lease costs of the Encoder facility, net of estimated sublease income
from GSI. The six-month loss included four months of operating loss for
the Encoder Division and the aforementioned charge for accrued lease
costs. The company did not record any charges for discontinued
operations in either the three or six months ended June 30, 2004. 26




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DYNAMICS RESEARCH CORPORATION
MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS (continued) Backlog The companys funded
backlog was $123.4 million and $118.5 million at June 30,
2004 and 2003, respectively, 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 for 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. LIQUIDITY AND CAPITAL RESOURCES At June 30, 2004 and December 31, 2003, the company had cash and cash
equivalents aggregating $145,000 and $2.7 million, respectively. The
decrease in cash and cash equivalents is primarily the result of $13.6
million of net cash used in operating activities, including $0.4 million
used in discontinued operations, and $2.2 million of capital
expenditures. These amounts were partially offset by $12.4 million of
additional borrowings under the companys revolving credit facility and
$1.3 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 $13.6 million, and is primarily
attributable to $10.9 million of increased accounts receivable, $10.0
million of increases in unbilled expenditures and fees on contracts in
process, and $1.0 million of reduced accrued payroll and employee
benefits. These amounts were partially offset by $4.2 million of net
income, depreciation and amortization expenses aggregating $2.5 million
and $0.9 million of increased accounts payable. The companys days sales outstanding, or DSO, was 114 at June 30, 2004
and 89 at December 31, 2003. These amounts include the amounts reported
under the captions Accounts receivable, net of allowances and Unbilled
expenditures and fees on contracts in process with the exception of
subcontractor costs accrued, for which revenues were not recognized,
described below. As reported in the companys Annual
Report on Form 10-K for the year ended December 31, 2003, and Quarterly
Report on Form 10-Q for the quarterly period ended March 31,
2004, the company encountered start-up delays in billing activity in the first
quarter of 2004, related to the implementation of its PeopleSoft-based
enterprise business system. Progress was made in the second quarter; the
company generated invoices totaling $70 million, well in excess of second
quarter revenues, and compared to invoices totaling $47 million generated in
the first quarter of 2004. However, delayed timing of cash collections
resulted in an increase in DSO, from 106 days at March 31, 2004 to 114 days at
June 30, 2004. The company has no indication of concerns of collectibility. At June 30, 2004 unbilled expenditures and fees on contracts in process
included subcontractor costs for the month of June, for which invoices
had not been received and for which revenues were not recognized,
estimated at $3.3 million. The corresponding amount recorded at December
31, 2003, was $2.4 million. Related liabilities were recorded as
accounts payable. Cash used for investing activities totaled $2.5 million, and is primarily
attributable to $2.2 million of capital expenditures, including $0.9
million for renovations to the companys Andover, Massachusetts corporate
headquarters and $0.7 million related to the implementation of the
companys new PeopleSoft-based enterprise business system. 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 June 30, 2004, the
outstanding principal balance under the Revolver was $20.9 million, with
$8.4 million borrowed at the base rate of 4.0% and $12.5 million borrowed
at 3.11% under a 30-day LIBOR option elected on June 2, 2004. The
weighted average interest rate on the outstanding principal balance was
3.47% at June 30, 2004. 27




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DYNAMICS RESEARCH CORPORATION
MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS (continued) The company has a ten-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 $8.0 million at June 30, 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 June 30, 2004, was
3.14% under the 90-day LIBOR option, elected on April 12, 2004. On December 26, 2002, the company entered into an installment payment
agreement in connection with the purchase of its PeopleSoft-based 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 PeopleSoft-based 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 June 30, 2004. On July 31, 2004, the company received a commitment letter from its bank
group to restructure and increase the companys credit facilities to
$100.0 million, inclusive of the current mortgage on the corporate
headquarters in Andover, Massachusetts. The secured financing agreement
will provide for a $55.0 million, five-year term loan with a seven-year
amortization schedule for the purchase of Impact Innovations government
division and a $37.0 million, five-year revolving credit agreement for
working capital. This financing is intended to replace the Revolver,
which expires on June 27, 2005. The bank group, led by Brown Brothers Harriman, also
includes KeyBank, Bank North and BancAmerica. The company expects
to complete the financing in late August. Although the company has
received the commitment letter, there can be no assurance that the
transaction will be completed. Cash provided by financing activities was comprised of $12.4 million of
net borrowings under the companys revolving credit agreement and $1.3
million of cash proceeds from the exercise of stock options and issuance
of shares under the employee stock purchase plan. The company has
increased its borrowings under the revolving credit agreement to support
its temporary resource allocation related to the start-up of the
companys new PeopleSoft-based enterprise business system. This resource allocation was
necessary to address billing issues encountered during the system
implementation; these issues have been identified and are being
addressed. The companys proceeds from financing activities were
partially offset by $0.3 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. The company believes that
selective acquisitions are an important component of its growth strategy.
The company may acquire, from time to time, firms or properties that are
aligned with the companys core capabilities and which complement the
companys customer base. The company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. 28




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DYNAMICS RESEARCH CORPORATION
MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS (continued) 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 at or prior to
the expiration of the Revolver
on June 27, 2005. However, the development of adverse economic
or business conditions could significantly affect the need for and
availability of capital resources. The companys contractual obligations as of June 30, 2004 consist of the
following (in thousands): Less than
    
    Two to three
    
    Four to fiveone year
    
    years
    
    years
    
    Thereafter
    
    TotalRevolver
    
    $
    20,887
    
    
    $
    
    
    
    $
    
    
    
    $
    
    
    
    $
    20,887Long-term debt
    
    
    500
    
    
    
    1,000
    
    
    
    1,000
    
    
    
    5,500
    
    
    
    8,000Operating leases
    
    
    4,595
    
    
    
    4,433
    
    
    
    3,119
    
    
    
    2,599
    
    
    
    14,746Total contractual obligations
    
    $
    25,982
    
    
    $
    5,433
    
    
    $
    4,119
    
    
    $
    8,099
    
    
    $
    43,633
 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 June 30, 2004, $1.5
million of contributions had been made. The company currently expects to
contribute an additional $1.4 million to fund its pension plan in 2004,
for a total contribution of $2.9 million. The reduction in the expected
cash contribution in 2004 from the previously disclosed estimate is a
result of interest rate relief promulgated by the Internal Revenue Service
in April 2004, coupled with the finalization of the companys
contribution requirement calculation. COMMITMENTS AND CONTINGENCIES The company has entered into an agreement to acquire the government
division of Impact Innovations LLC (Impact Innovations)
for $53.4
million in cash, subject to certain closing provision. Impact
Innovations government group has annual revenues approximating
$47 million and is based in the Washington, D.C.
area. The government group offers solutions in business intelligence, enterprise
software, application development, information technology service management
and other related areas. Its customers include United States government
intelligence agencies and various Department of Defense agencies, as well as
federal civilian agencies. In connection with the acquisition, the company
expects to amend its existing credit facility to provide for a $55.0 million
term loan and a $37.0 million revolver for working capital. The acquisition is
also subject to seller shareholder and regulatory approvals. There
can be no assurance that the acquisition or the financing will be
completed. 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 had provided a guarantee of the
businesss line of credit, under which its maximum exposure was $0.2
million. On April 1, 2004, the company was released as guarantor for
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, as defined in these agreements,
within a certain period of time from the date of any change of control of
the company. 29




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DYNAMICS RESEARCH CORPORATION
MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS (continued) As a defense contractor, the company is subject to many levels of audit
and review from various government agencies, including the Defense
Contract Audit Agency, various inspectors general, the Defense Criminal
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. The companys claim against Storage Engine, which filed for
reorganization under Chapter 11 of the United States Bankruptcy Code, has
survived the bankruptcy proceeding and remains a claim against Storage
Engine. 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. In connection with this settlement, the Genesis claim for $35.0 million against
the company was eliminated. 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. 30




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DYNAMICS RESEARCH CORPORATION
MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS (continued) 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 half 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 half 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 respective
states legislature. 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 primarily under the percentage of completion method,
or, for certain short-term contracts, by the completed contract
method, in accordance with American
Institute of Certified Public Accountants Statement of Position 81-1,
Accounting for Performance of Construction-Type and Certain
Production-Type Contracts (SOP 81-1). 31




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DYNAMICS RESEARCH CORPORATION
MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS (continued) Revenue
from service-type fixed price contracts is recognized ratably over the
contract period or by other appropriate output methods to measure service
provided, and contract costs are expensed as incurred. The risk to the
company related to 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. Generally, the companys unbilled expenditures and fees
relate to revenue that is billed in the month after services are
performed. In certain instances, billing is deferred in compliance with
contract terms, such as milestone billing arrangements and withholdings, or delayed for other reasons. In 2004, the company encountered delays in
billing activity related to the start-up of its PeopleSoft-based enterprise
business system. 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 June
30, 2004, unbilled expenditures and fees also included subcontractor
costs for the month of June, for which invoices had not been received and
for which revenues were not recognized, estimated at $3.3 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. 32




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DYNAMICS RESEARCH CORPORATION
MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS (continued) 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. 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 these disclosure provisions
for the year ended December 31, 2003. The adoption of these
disclosure provisions did not have a material effect on the
companys financial position, results of operations or cash
flows. 33




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DYNAMICS RESEARCH CORPORATION
MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS (continued) 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 June 30, 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
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 had provided a
guarantee of the businesss line of credit, under which its maximum
exposure was $0.2 million. On April 1, 2004, the company was released as
guarantor for this line of credit. 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. 34




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DYNAMICS RESEARCH CORPORATION
MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS (continued) 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 Quarterly Reports on Form 10-Q and 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. 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 the first half of 2004 and in 2003, approximately 91% and 93% 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. 35




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DYNAMICS RESEARCH CORPORATION
MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS (continued) 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. 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. 36




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DYNAMICS RESEARCH CORPORATION
MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS (continued) 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. 37




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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 2002 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. 38




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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. 39




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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 80% and
78% of our total revenue in the first half of 2004 and in 2003,
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. 40




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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 PeopleSoft-based 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 PeopleSoft-based 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 and does vary relative
to revenue, a decrease in revenue may cause a significant variation in
our operating results. 41




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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 August 2004, we announced that we had entered into a definitive
agreement to acquire the government division of Impact Innovations LLC
for $53.4 million in cash. There can be no assurance that we will
complete this transaction. In 2002, we acquired HJ Ford Associates, Inc.
and Andrulis Corporation. We may seek to continue to expand our
operations through mergers, acquisitions or strategic alliances with
businesses that will complement our existing business. However, we may
not be able to find attractive candidates, or enter into acquisitions on
terms that are favorable to us, or successfully integrate the operations
of companies that we acquire. In addition, we may compete with other
companies for these acquisition candidates, which could make an
acquisition more expensive for us. If we are able to 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. 42




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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 June 30, 2004 would result in a $0.3 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 June 30, 2004. While we have
previously identified internal control weaknesses, which are discussed below, our
current 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. 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. Prior
to filing our Annual Report on Form 10-K for the year ended December 31, 2003, 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 related 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 suggested the need for the company
to review its GAAP training procedures and strengthen its accounting
resources. 43




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The company concurred with Grant Thorntons finding, recorded liabilities and
related assets of $2.4 million at December 31, 2003, and 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 this policy. In 2004, the company believes that it has
significantly strengthened its accounting resources by adding two highly
experienced professionals to its existing staff and conducting a training
program on internal controls. In April 2004, the company hired an Assistant
Controller for Financial Reporting, and, in June 2004, appointed a new
Corporate Controller and Chief Accounting Officer with extensive experience in
COSO-compliant internal control implementation, complex enterprise systems
implementation and transaction processing and general accounting practices.
The former Corporate Controller and Chief Accounting Officer has assumed
responsibility for business control matters, such as forecasting and business
transaction review. The company will continue to seek and identify
opportunities to strengthen staff skills through training. In 2004, the
companys training will be primarily focused on internal controls, current tax
law changes and procedures related to the implementation of the companys new
PeopleSoft-based enterprise business system. The second significant 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. 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. Both the
company and Grant Thornton expect the implementation of the companys new
enterprise business system, which was placed into service in January
2004, to assist in resolving this deficiency. The company encountered start-up delay in billing activity in the first quarter
of 2004 related to the system implementation. In the second quarter of 2004,
the company generated invoices totaling $70 million, well in excess of second
quarter revenues, compared to $47 million invoiced in the first quarter of
2004, and as a result, anticipates reduced receivables in the second half of
2004. The company placed its PeopleSoft-based enterprise business
system into service effective January 1, 2004. The company has realized
benefits resulting from the new enterprise business system, including a
reduction in the number of adjusting journal entries required during the
close, easier reconciliation of financial applications and a shortened
close schedule, which provides additional time for both reconciliation
and value-added analysis. During the first half 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
have been created, 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. 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. The second significant deficiency related to our quarterly and year-end closing
procedures and consolidation. The third significant deficiency related to the
level of SEC and GAAP experience of our personnel responsible for accounting
and financial reporting. The measures discussed above, as well as those
discussed in the companys other periodic reports filed with the Commission,
were designed to address the significant deficiencies identified, and we
believe these measures serve to further strengthen our internal controls over
financial reporting. 44




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While we continue to address
the effectiveness 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 are 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. 45




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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. The companys claim against Storage Engine, which filed for
reorganization under Chapter 11 of the United States Bankruptcy Code, has
survived the bankruptcy proceeding and remains a claim against Storage
Engine. 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. In connection with this settlement, the Genesis claim for $35.0 million against
the company was eliminated. 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 46




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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. 
 Item 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS  (a)
    
    The Annual Meeting of Stockholders of the company was held on
May 13, 2004.(b)
    
    Proxies representing 7,430,259 shares were received
(total shares outstanding as of the Record Date were
8,337,703). The results of the voting at the Annual Meeting as
to the approval of a proposal to fix the number of directors at
six and to elect two Class II directors (Dr. Francis J. Aguilar
and Mr. John S. Anderegg) for the term of three years are set
below: Fix the number of directors at six and elect Dr. Aguilar and Mr.
Anderegg: (i)
    
    Dr. Aguilar
Votes for
Votes withheld
    
    7,324,401
114,536(ii)
    
    Mr. Anderegg
Votes for
Votes withheld
    
    7,327,431
111,506
 In each case, there were no shares abstaining and no broker
non-voting shares cast. 47




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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 June 30, 2004:  (1)
    
    Current Report on Form 8-K, filed on May 5, 2004, relating to the
press release of the companys financial results for the quarter ended
March 31, 2004. 48




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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: August 9 , 2004
    /s/ David KeleherDavid KeleherSenior Vice President and Chief Financial Officer /s/ Francis MurphyFrancis MurphyCorporate Controller and Chief Accounting Officer 49




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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
 50