**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

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**FORM 10-K**

x                              ANNUALREPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIESEXCHANGE ACT OF 1934

**FORTHE YEAR ENDED DECEMBER 31, 2006.**

**OR**

** ̈**                                 TRANSITIONREPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIESEXCHANGE ACT OF 1934

**Forthe transition period from *                 *to *                 ***

**Commission filenumber: 0-22010**

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| **THOMAS GROUP, INC.**                                  |
|---------------------------------------------------------|
| (Exact name of  registrant as specified in our charter) |

 

| **Delaware**                                                    |   | **72-0843540**                        |
|-----------------------------------------------------------------|--------|---------------------------------------|
| (State or other  jurisdiction of incorporation or organization) |   | (I.R.S. Employer  Identification No.) |

 

| **5221 North O’Connor Boulevard,  Suite 500, Irving, Texas** |   | **75039-3714** |
|------------------------------------------------------------------------|--------|----------------|
| (Address of  principal executive offices)                              |   | (Zip Code)     |

 

| **(972) 869-3400**                                         |
|------------------------------------------------------------|
| (Registrant’s  telephone number, including area code) |

 

**Securitiesregistered pursuant to Section 12(b) of the Act:**

| **Title of each class**                                                                            |   | **Name of  each exchange on which registered**       |
|----------------------------------------------------------------------------------------------------|--------|------------------------------------------------------|
| Common stock, par  value $.01 per share  Rights to purchase common stock, par value $.01 per share |   | The Nasdaq Stock  Market LLC  (NASDAQ Global Market) |

 

**Securitiesregistered pursuant to Section 12(g) of the Act:**none

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Indicate by check mark ifthe registrant is a well-known seasoned issuer, as defined in Rule 405 ofthe Securities Act. Yes o  No x

Indicate by check mark ifthe registrant is not required to file reports pursuant to Section 13 or Section 15(d) ofthe Exchange Act. Yes o No x

Indicate by check markwhether the registrant (1) has filed all reports required to be filed by Section 13or 15(d) of the Securities Exchange Act of 1934 during the preceding 12months and (2) has been subject to such filing requirements for the past90 days. Yes x  No o

Indicate by check mark ifdisclosure of delinquent filers pursuant to Item 405 ofRegulation S-K is not contained herein, and will not be contained, to thebest of registrant’s knowledge, in definitive proxy or information statementsincorporated by reference in Part III of this Form 10-Kor any amendment to this Form 10-K. o

Indicate by checkmark whether the registrant is a large accelerated filer, an accelerated filer,or a non-accelerated filer.

| Large Accelerated filer o | Accelerated  Filer o | Non-accelerated  filer x |
|--------------------------------|---------------------------|-------------------------------|

 

Indicate by check markwhether the registrant is a shell company (as defined in Rule 12b-2of the Exchange Act). Yes o No x

As of June 30, 2006,the last business day of the registrant’s most recently completed second fiscalquarter, the aggregate market value of the voting stock held by non-affiliatesof the registrant was $43,247,270 based on the Nasdaq Capital Market closingprice of $14.02. Effective November 6, 2006, our commonstock has been listed on The Nasdaq Global Market under the symbol ’’TGIS.’’

As of April 3,2007, there were 10,939,242 shares of the registrant’s common stockoutstanding.
| Documents incorporated by reference                                                                                                                                                                                                                          | ** ** | **Part** |
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|----------|
| Portions of the  registrant’s definitive proxy statement pertaining to the 2007 Annual Meeting  of Stockholders to be filed on or before April 30, 2007 are incorporated  by reference into Part III of this Annual Report on Form 10-K. |       | III      |

 

 

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**TABLEOF CONTENTS**
|                                             | ** **                                                                                                               | **Page** |
|---------------------------------------------|--------------------------------------------------------------------------------------------------------------------------|----------|
| **PART I**                             |                                                                                                                     |     |
| ** **                                  | Explanatory Note                                                                                                         | 1        |
| Item 1.                                | Business                                                                                                                 | 3        |
| Item 1A.                               | Risk  Factors                                                                                                            | 11       |
| Item 1B.                               | Unresolved  Staff Comments                                                                                               | 21       |
| Item 2.                                | Properties                                                                                                               | 21       |
| Item 3.                                | Legal Proceedings                                                                                                        | 21       |
| Item 4.                                | Submission  of Matters to a Vote of Security Holders                                                                     | 22       |
| **PART II**                            |                                                                                                                     |     |
| Item 5.                                | Market  for Registrant’s Common Equity, Related Stockholder Matters and Issuer  Purchases of Equity Securities | 23       |
| Item 6.                                | Selected  Financial Data                                                                                                 | 27       |
| Item 7.                                | Management’s  Discussion and Analysis of Financial Condition and Results of Operations                              | 29       |
| Item 7A.                               | Quantitative  and Qualitative Disclosure About Market Risk                                                          | 48       |
| Item 8.                                | Financial  Statements and Supplementary Data                                                                             | 49       |
| Item 9.                                | Changes in  and Disagreements with Accountants on Accounting and Financial Disclosure                                    | 49       |
| Item 9A.                               | Controls and  Procedures                                                                                                 | 49       |
| Item 9B.                               | Other Information                                                                                                        | 50       |
| **PART III**                           |                                                                                                                     |     |
| Item 10.                               | Directors,  Executive Officers and Corporate Governance                                                                  | 51       |
| Item 11.                               | Executive  Compensation                                                                                                  | 51       |
| Item 12.                               | Security  Ownership of Certain Beneficial Owners and Management and Related Stockholder  Matters          | 51       |
| Item 13.                               | Certain  Relationships and Related Transactions and Director Independence                                                | 51       |
| Item 14.                               | Principal  Accounting Fees and Services                                                                                  | 51       |
| **PART IV**                            |                                                                                                                     |     |
| Item 15.                               | Exhibits  and Financial Statement Schedules                                                                         | 52       |
|                                        | Signatures                                                                                                               | 54       |
| Index to  Consolidated Financial Statements | F-1                                                                                                                      |

 

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**EXPLANATORY NOTE**

As previously announced on February 2, 2007, ourBoard of Directors, with concurrence and oversight by our Audit Committee,which is comprised solely of independent directors, initiated a review of ourhistorical stock option practices and related accounting during the period 1988to 2006. This voluntary review was initiated in connection with our assessmentof our historical capitalization documentation and not in response to anyspecific concerns from within Thomas Group about option practices or anyinquiry from the Securities and Exchange Commission or any other regulatoryagency. The review was conducted with the assistance of our outside legalcounsel and specially-retained forensic accountants. Based on the preliminaryfindings of this review, on March 15, 2007, our Board of Directors, AuditCommittee and management concluded that we would need to restate our financialstatements and related footnote disclosures for fiscal years ending December 31,2002 through 2005 and the first three quarters of the 2006 fiscal year. TheAudit Committee and the Board of Directors further concluded on March 15,2007 that our previously issued financial statements and related auditors’reports for the years 2002 through 2005, and our previously issued financialstatements for the first three quarters of 2006, should no longer be reliedupon.

The investigation has now been completed and our Boardof Directors received a report on the results of that investigation on March 30,2007 from our outside counsel and specially-retained forensic accountants.Please see “Review of Stock Option Grant Practices” in Item 7. Management’sDiscussion and Analysis of Financial Condition and Results of Operations andNote 19 to our Consolidated Financial Statements for a discussion relatedto our investigation. We have self reported the internal investigation and therestatement to the Securities and Exchange Commission and intend to cooperatewith any informational or other requests from the SEC.

We have not amended and wedo not intend to amend any of our other previously filed Annual Reports on Form 10-Kor Quarterly Reports on Form 10-Q for the periods affected by therestatement, as we present elsewhere herein (i) restated financial data foreach of the first three quarters of the fiscal year ended December 31,2006 and each of the quarters in the fiscal year ended December 31, 2005,and, (ii) restated financial statements for each of the fiscal years endedDecember 31, 2005 and 2004, and (iii) restated selected consolidatedfinancial data for the fiscal years ended December 31, 2003 and 2002. SeeItem 7—Management’s Discussion and Analysis of Financial Condition and Resultsof Operations and Notes 18 and 19 to the Consolidated Financial Statementsincluded in this Annual Report on Form 10-K.

**SPECIAL NOTEREGARDING FORWARD-LOOKING STATEMENTS**

Various sectionscontained or incorporated by reference in this Annual Report on Form 10-Kinclude forward-looking statements within the meaning of Section 27A ofthe Securities Act of 1933, Section 21E of the Securities Exchange Act of1934 and the Private Securities Litigation Reform Act of 1995. Forward-lookingstatements may be identified by the context of the statement and generallyarise when we are discussing our beliefs, estimates or expectations. Suchstatements may contain the words “believe,” “anticipate,” “expect,” “estimate,”“intend,” “project,” “could,” “may,” “will be,” “will likely continue,” “willlikely result,” or words or phrases of similar meaning. These statements arenot historical facts or guarantees of future performance but instead representonly our belief at the time the statements were made regarding future events. Inparticular, statements under Item 1. Business, Item 1A Risk Factors and Item 7.Management’s Discussion and Analysis of Financial Condition and Results ofOperations contain forward-looking statements. These forward-looking statementsare based largely on the expectations of management and are subject to a numberof risks and uncertainties which may cause actual results and outcomes todiffer materially from what we express or forecast in these forward-lookingstatements. In evaluating these statements, you should consider the risks anduncertainties discussed under Item 1A Risk Factors and Item 7 Management’sDiscussion and Analysis of Financial Condition and Results of 

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Operations,as well as the following list of some but not all of the factors that could causeactual results or events to differ materially from anticipated results orevents:

·       adisruption in our relationships with major customers;

·       difficultyin expanding our commercial sector business;

·       thecompetitive environment of the industry in which we operate;

·       customeracceptance of our Process Value Management approach; and

·       aninability to attract, hire, develop, train and retain experienced Resultants.

These forward-looking statements and such risks,uncertainties and other factors speak only as of the date of this Annual Reporton Form 10-K, and we expressly disclaim any obligation orundertaking to disseminate any updates or revisions to any forward-lookingstatement contained herein, to reflect any change in our expectations withregard thereto, or any other change in events, conditions or circumstances onwhich any such statement is based.

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**PART I**

**ITEM1.**                *Business*.

**Overview**

We are an operations andprocess improvement services firm headquartered in Irving, Texas providingprocess improvement solutions to enhance business efficiency, competitivenessand financial performance. We develop and employ methodologies to transform theprocesses, procedures and people within our clients’ organizations to enablemore efficient and seamless operations. Our methodologies address businessprocesses throughout the ‘‘Extended Enterprise.’’ Extended Enterprise is a termwe use to describe the full spectrum of a client’s value chain from itssuppliers, through its internal operations, and to its customers. Historically,we have successfully applied our methodologies in engagements for bothgovernment entities and Global and Fortune 1000 companies in a number ofindustries. During the past three years, however, we have been engagedprimarily by various government entities to implement our operations managementsolutions.

Asspecialists in operations and process improvement , we create and implementoperations management solutions to remove barriers, increase productivity,improve cultures and enable our clients to improve and sustain performance asmeasured by the following:

·       totalcycle time;

·       costsavings;

·       time-to-market;

·       productyields;

·       deliverylead times;

·       inventoryturns;

·       operationaland administrative productivity; and

·       return on assets.

To deliver thesesolutions, we utilize our staff of professionals, whom we refer to as ‘‘ResultantsTM,’’and who average over 25 years of business experience. To manage our clientengagements, our Resultants typically leverage our Process Value Management, orPVM, approach, which often incorporates our proprietary Total Cycle Time®, or TCT®, methodology along with otherindustry-accepted process improvement methodologies such as Kaizan, Lean, SixSigma and Theory of Constraints. PVM is used to manage client engagements,identify process inefficiencies and implement change within our clients inorder to achieve a total transformation to what we refer to as the ‘‘ProcessManaged Enterprise.’’ A Process Managed Enterprise is one in which managementfocus and systems are centered on customers and managed around processes.

Thefollowing principles guide us when we assess, architect, implement and delivercontinuous improvements to transform our clients into Process ManagedEnterprises:

·       Allbusinesses are made up of a series of linked processes, from the initialbusiness concept through all its applied resources and its end customer.

·       Allprocesses, left unmanaged, naturally deteriorate over time.

·       Peopleworking in cross-functional teams and focusing on customer needs are what makeprocesses effective.

·       Operationalchange is achieved by employing a combination of our proprietary methodologiesand industry best practices, and is implemented using a metrics-driven approachwithout additional capital expenditure by the client.

·       Theclient is the final arbiter of the value of the process.

·       Thetransformation to the Process Managed Enterprise must deliver short-termoperating results as well as continuous, long-term, systemic businessenhancements.

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**Industry Background**

Businesses operate in increasingly complexenvironments. Markets are becoming progressively larger and more global,offering companies the opportunity to expand their presence but also exposingthem to increased competition and operational uncertainties. As a result, manycompanies will frequently evaluate their business processes in order to manage changeand risk, reduce costs, increase productivity, improve quality and drive higherprofitability in order to be more competitive within their respectiveindustries and the global marketplace. In order to best accomplish these goals,we believe both management and business systems must be focused on customers’needs and the processes that strengthen the customers’ perception of value.These goals are typically achieved by increasing resource utilization, reducingcycle time, reducing procurement inefficiencies and reducing costs.

Similar to commercial enterprises, government entitiescompete for scarce budget resources and are seeking methods by which todecrease inefficiencies, thereby saving taxpayer dollars and reducing burdenson under-staffed agencies. As a result, many government entities are choosingto bring private industry best practices to federal programs in an effort toimprove efficiency.

Commercial enterprises andgovernment entities frequently lack the internal strategic expertise or the dedicatedstaff necessary to address operational challenges and implement correctivesolutions. In an effort to streamline operations and achieve higher returns oninvestment, companies and government entities are turning to consultants withspecialized operational expertise and experience. We believe firms employingsenior professionals with executive management experience are well-positionedto help large organizations and government entities solve complex businesschallenges and improve and sustain operational performance.

**CompetitiveStrengths**

We believe the followingfactors are strengths of our company and provide us with key competitiveadvantages:

***Experienced Professional Staff***

We believe our mostimportant asset is the knowledge base and experience of our Resultants. It isour policy to be highly selective in our hiring practices and to employseasoned executives with extensive management experience. Our Resultantsaverage 25 years of business experience and approximately 70% have held seniormanagement positions with previous employers, with almost half being formerCEOs or CFOs. Our Resultants’ backgrounds in executive management roles allowthem to better relate to the business challenges faced by our clients’ seniormanagement. Our Resultants are critical to developing long-term clientrelationships, which can span multiple engagements. We believe that theirexpertise and experience significantly improve our ability to effectivelymarket our capabilities, implement operational improvements and deliver returnon investment to our clients.

***Emphasis on Results***

The success of each clientengagement is defined by our ability to deliver measurable results. Our resultscan be measured by our clients’ productivity improvements, which are deriveddirectly from the operational changes we implement, and by our clients’ costsavings and return on investment that ultimately result from these productivityimprovements. In appropriate client situations, we are willing to base aportion of our fees on achieving desired results. These incentive fees arebased on predetermined client-specific measures, such as the achievement ofspecified process improvements, cost reductions or designated goals. We believethis demonstrates confidence in our ability to deliver positive results to ourclients.

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***Focus onImplementation and Continuous Improvement***

We stress a hands-onimplementation of process improvements and focus on the institutionalization ofchanges that improve the efficiency of our clients’ businesses and processes.We apply our process improvement methodologies throughout our clients’ ExtendedEnterprises in close cooperation with our clients’ management to effectivelyeliminate process barriers, thereby improving cycle time, quality or ‘‘firstpass yield’’ (that is, doing it right the first time) and overall operationalperformance. As part of each client engagement, we conduct knowledge managementsessions, which provide our clients with essential information, training andskills necessary to sustain continuous improvement. In contrast, we believemany of our competitors often leave their clients with a written assessment orreport, but generally do not work with company management to actually implementthe changes. Our Resultants not only identify and analyze a client’s criticalbusiness processes, but also implement and institutionalize processimprovements into a client’s day-to-day business practices in an effort toprovide lasting, transformational results.

***Reputation***

We have built a reputationas a leader in providing operational process improvement solutions that solvecomplex business problems. Through our client successes, we have established astrong reputation for our expertise in delivering collaborative,cross-functional results across the Extended Enterprise. We believe ourindustry reputation along with a high level of client referrals helps us sourcenew engagements and is evidence of the value we offer to our clients.

**Operations and Process Improvement Solutions**

We specialize inimplementing solutions that achieve measurable and sustainable resultsincluding reductions in cost and improved financial performance. We manage ourclient engagements by applying our PVM approach, a holistic approach thatdefines the steps necessary to improve strategic business processes, assessestheir linkages and efficiencies, and prescribes short- and long-termenhancement programs.

OurResultants specialize in operational process improvement solutions that can beapplied to clients in a variety of industries. Our process improvementsolutions address product development, resource utilization, procurement, cycletime, customer service, operations logistics, inventory turns and otherbusiness challenges. Specific examples of our solutions to these businesschallenges include:

·       *ProductDevelopment / Cycle Time Reductions.*In a competitive environment,the time required to get a product to market can significantly affect a company’smarket position. We deliver operations management solutions that identifybarriers in the product development process and implement efficiencies thatreduce cycle time and speed product development. Reducing the time required toget a product to market can increase customer satisfaction, lower costs andenhance our clients’ ability to respond timely to evolving market conditions.

·       *Procurement and Sourcing.*Inefficiencies in procurement andsourcing tend to increase costs. We work with our clients to achieve measurablesavings by addressing the entire procurement process including contractnegotiations, vendor selection, contract compliance, consumption patterns,total cost of ownership, performance measurement, knowledge transfer andmake-versus-buy decisions. Implementation of our solutions has enabled many ofour clients to achieve substantial savings in a wide variety of spendcategories including office supplies, telecommunications, technology hardware,software and services, insurance, printing services, travel and otherindustry-specific categories. *OperationsLogistics.*Inefficiencieswithin enterprises, particularly those with complex business processes, oftenresult from a lack of coordination among business units or other functionalgroups. Our solutions address these inefficiencies by improving operationslogistics across the Extended Enterprise, and include business processreengineering, identification of facility inefficiencies with respect topeople, parts and layout, as well as operational testing, 

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evaluation, implementation and training. Our operationslogistics engagements often lead to significant productivity improvement andcost savings.

**Growth Strategy**

Our strategy to grow ourbusiness includes the following:

***Attract, Hire,Develop, Train and Retain Highly Qualified Senior Resultants***

We are in the consultingservices industry and rely heavily on the quality of our professionals to driveour success. We believe attracting, hiring, developing, training and retainingexperienced professionals significantly improves our ability to achieve desiredclient results, and the quality of our Resultants is critical to both ourindustry reputation and our success in obtaining new business. We believe ourculture and the opportunity to work collaboratively on interesting assignmentsattracts high-quality Resultants and leads to low attrition rates. We invest inour Resultants’ career progression by providing training and developmentprograms designed to match their skill sets with the needs of our clients.

***Leverage Our TrackRecord of Success***

We have built a trackrecord of client satisfaction through the efficient and successful completionof complex projects for our government and large commercial clients. As aresult, we have established a solid reputation and many of our clients continueto serve as excellent references for us. As a key element of our future growth,we intend to leverage our reputation with existing and past clients to win newbusiness and seek repeat business opportunities with existing and formerclients, many of which have multiple operating divisions. We will continue toexpand efforts to promote our successes and to utilize our Resultants’ uniqueexperience and skill sets to secure new client engagements.

***Expand Sales andMarketing***

We believe theproliferation of global markets and complex business environments will continueto drive demand for process improvement expertise, significantly enhancing themarket opportunity for our solutions. To adequately address clientopportunities on a wider scale, we intend to invest in our sales and marketingas a means of accelerating our market presence, increasing our reputation as aknowledge leader and securing new client engagements. We intend to continuebuilding upon the strength of our brand and further promote awareness through avariety of traditional sales and marketing activities such as knowledgesessions, white papers, press interviews and conference speaking engagements.We continually update the content and functionality of our website.Collectively, we believe these programs will help clarify and differentiate ourcapabilities from our competition.

As an example, wecurrently have alliances with established academic programs, including TheWharton School of the University of Pennsylvania. Through these programs, wepublish white papers and host knowledge sessions and events with senior-levelexecutive attendees, which reinforce our subject-matter expertise in the fieldof operations and process improvement services. The content of these events istypically focused on addressing key business and operational challenges facedby large companies and generally produce a number of quality sales leads. Webelieve the synergy of our operational expertise combined with the strategicand technical skills of these partners will reinforce our position as knowledgeleaders in the minds of potential clients and greatly improve our ability tomarket our services.

***Target RepeatClient Engagements***

We intend to leverage ourprior engagement successes with existing and former clients to identifyadditional opportunities to apply our solutions and experiences. We believeclients for whom we have helped realize cost savings or return on investmentare likely to realize the economic benefit potential from our solutions andwill be more likely to engage us in follow-on programs.

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***Focus on Additional Business Opportunities in theCommercial Sector***

Historically, we haveserved both government and commercial clients. Recently, we have successfullyprovided our operations management solutions primarily to the governmentsector. However, we are dedicated to growing our commercial client base andexpect to deploy additional sales personnel, marketing resources and Resultantsin the future.

**Clients**

Wehave delivered operations and process improvement solutions to approximately375 clients since our inception in 1978. Historically, most of our clients havebeen large, diversified commercial or government enterprises in North America, Europe, and Asia. Duringthe last three years, however, our engagements have involved primarily variousgovernment entities. We have also served international clients in previousyears from our former offices in Switzerland, Sweden, Germany, Singapore, Chinaand Hong Kong. Currently, we are focused on delivering our solutions in NorthAmerica. In some instances, we provide solutions to the same organization underseparate contract agreements. While we believe our methodologies are applicableto any industry, we have developed a significant amount of subject-matterexpertise relevant to specific industries, including automotive, aviation,distribution, government, healthcare, manufacturing, semiconductor, textilesand transportation. Consequently, we can leverage our Resultants’ priorexecutive experiences to obtain business and determine appropriate clientproject teams. Following is a list of a number of clients in various industriesfor whom the Company has provided solutions since its inception in 1978:
| **Aerospace**      | ** ** | **Distribution**       | ** ** | **Mechanical Engineering**     |
|--------------------|------------|------------------------|------------|--------------------------------|
| Aerostructures     |       | ProSource              |       | ABB                            |
| Bombardier         |       | W.W. Grainger          |       | Alstom Power                   |
| Delta Air Lines    |       |                   |       | Dresser Waukesha               |
| Gulfstream         | ** ** | **Electronics**        |       | Dresser-Rand                   |
| ITT Cannon         |       | ABB                    |       | GEA                            |
| LSG Sky Chefs      |       | Berg                   |       | Hilti                          |
| Lufthansa Cargo    |       | EDS                    |       | Schindler                      |
| Lufthansa Technik  |       | Euclid-Hitachi         |       |                           |
| McDonnell Douglass |       | Flat Panel Display     | ** ** | **Medical Equipment Supplies** |
| TRW                |       | GTE Control Devices    |       | Boston Scientific              |
| Vought Aircraft    |       | Gemplus                |       | Siemens Medical                |
| ** **         |       | Johnson Electric       |       | GE Medical                     |
| **Automotive**     |       | Motorola               |       |                           |
| Adam Opel          |       | Osram                  |       |                           |
| Audi               |       | Philips                | ** ** | **Specialty Retail**           |
| Delco              |       | Texas Instruments      |       | Tuesday Morning                |
| Delphi             |       | Western Digital        |       |                           |
| Detroit Diesel     |       | Yuasa Exide Batteries  | ** ** | **Semiconductor**              |
| GM                 |       |                   |       | Alcatel Mietec                 |
| GM DELCO           | ** ** | **Healthcare**         |       | AMI Microsystems               |
| GM/Warranty        |       | Centura                |       | ASM Lithography                |
| Meritor            |       | Mallinckrodt           |       | AT&T Semiconductor         |
| Osram              |       | Pfizer                 |       | Cypress Semiconductor          |
| Pep Boys           |       |                   |       | Fairchild Semiconductor        |
| Robert Bosch       | ** ** | **Government**         |       | Ford Microelectronics          |
| Saab               |       | FAA                    |       | Hewlett Packard                |
| Siemens            |       | CACI                   |       | Hyundai                        |
|               |       | City of Garland, Texas |       | IBM                            |

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| **Apparel Manufacturer**         |       | United States Army           |       | LG Semiconductor                    |
|----------------------------------|------------|------------------------------|------------|-------------------------------------|
| Brandix                          |       | United States Navy           |       | NCR                                 |
| Esquel Group                     |       |                         |       | National Semiconductor              |
| Heely’s                     | ** ** | **Manufacturing/Industrial** |       | Matra MHS                           |
| Lanka Equities                   |       | Breguet                      |       | Motorola                            |
| Tristate Holdings                |       | Dover                        |       | Philips Semiconductor               |
|                             |       | Emerson                      |       | Rockwell                            |
| **Banking, Financial Services,** |       | Kimberly Clark               |       | Signetics                           |
| **Insurance**                    |       | VIAD                         |       | ST Microelectronics                 |
| DG Bank                          |       | Leeds & Northrup         |       | Taiwan Semiconductor                |
| Forethought Insurance            |       | Moore                        |       | Trilogy                             |
| Olivetti                         |       | Pawnee Industries            |       |                                |
| Sun Life Financial               |       | Pinnacle-lvey                | ** ** | **Telecommunications**              |
|                             |       | Radium                       |       | Allen Telecom                       |
| **Chemical**                     |       | Robert Bosch                 |       |                                |
| Heraeus                          |       | Siemens                      | ** ** | **Transportation**                  |
| Shipley                          |       | Stewart and Stevenson        |       | Alstom                              |
|                             |       | Teledyne                     |       | Amtrak                              |
| **Consumer Products**            |       | Thrall                       |       | Bombardier                          |
| Fossil                           |       | Xerox                        |       | Burlington Northern Santa Fe        |
| Givaudan                         |       |                         |       |                                |
| HengAn                           |       |                         | ** ** | **Utilities**                       |
| Hillenbrand                      |       |                         |       | PECO                                |
| Kodak                            |       |                         |       | Siemens                             |
| Polaroid                         |       |                         |       | Southern Indiana Gas & Electric |
| Rand McNally                     |       |                         |       |                                |
| Robert Bosch                     |       |                         |       |                                |
| Rubbermaid                       |       |                         |       |                                |

 

**ContractualArrangements**

We perform services and provide solutions for clientspursuant to contracts that generally have terms of three months to one year. Weare compensated for our professional services and solutions in one or more ofthree ways: fixed fees, task-based fees or incentive fees. The majority of ourrevenue is derived from fixed fee and task-based fee contracts. Our fee typeand structure for each client engagement is dependant on a number of variables,including size of the client, the complexity and geographic dispersion of itsbusiness, the level of the opportunity for us to improve the client’s processesand other factors. Our contracts are generally cancellable by the client upon30 days’ notice.

We are working in several divisions of the Navy, eachgoverned by a separate contractual agreement. However, contracts related tothese engagements are executed within the United States government’s budgetcycle and are fully funded for up to one year at a time and may be renewedannually for successive one-year periods over the remaining life of the engagement.Since we began working with the Navy in 1997, we have never had a prematuretermination. For our engagements with the Navy, we contract either directlywith the government through our listing with the General ServicesAdministration, or GSA, or we use an intermediary that acts as a primecontractor providing contracting and administrative services. Currently, weutilize CACI, Inc.-Federal, a wholly owned subsidiary of CACIInternational, Inc., or CACI, as an intermediary. In these instances, CACIplays a limited role in contract execution, and does not provide any clientconsulting services. We are in the third year of a three year contract withCACI. We anticipate entering into a similar contract with substantially similarterms upon expiration of the current contract. If we are unable to reachagreement with CACI as a future intermediary, we will seek other intermediariesor utilize our existing GSA agreement to contract with the Navy.

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Fixed fee revenue is recognized on a percentage ofcompletion method, based on direct labor hours expended. In order to calculatethe completion ratio on a given project, time and effort to date are divided bythe total estimated time and effort for the entire project. This ratio is thenmultiplied by the total fixed fee to be earned on the project, resulting in theamount of revenue earned to date. Revenues attributable to fixed fees were 8%,4% and 10% of consolidated revenue for the years ended December 31, 2006,2005, and 2004, respectively.

Task-based fees are recognized as revenue when thetask is completed or the deliverable is received by the client. Typically,task-based revenue recognition involves the delivery of a report, minutes orsome other evidence of completion. Revenues attributable to task-based fees were91%, 96% and 89% of consolidated revenue for the years ended December 31,2006, 2005, and 2004, respectively.

Incentive fees are tied to improvements in a varietyof client performance measures typically involving cycle time, assetutilization and productivity. Incentive fee revenue is recognized in the periodin which the related client improvements are achieved. Our incentive feeagreements with our clients define in advance performance improvement standardsthat form the basis of our incentive fees earned. Incentive fees are affectedby our clients’ business performance and prevailing economic conditions.Revenues attributable to incentive fees were 0%, 0% and 1%, for the years endedDecember 31, 2006, 2005, and 2004, respectively. As of April 3, 2007,we had no contractual agreements for incentive fees.

Reimbursement revenue represents the client’srepayment of our mutually agreed upon travel expenses as incurred. All billabletravel expenses are submitted to and approved by the client. Revenues attributableto reimbursement were 1%, 0% and 1%, for the years ended December 31,2006, 2005, and 2004, respectively.

In our business undercommitment, also known as backlog, we include signed client contracts andfunded government contract commitments with terms generally ranging from threemonths to one year. In 2006 and 2005, a portion of our backlog includedprojects that were funded as a specific line item in the United Statesgovernment’s budget, as opposed to inclusion in a general category. Budgetingin this manner was considered equivalent to full funding; therefore, thesecommitments are included in backlog. Backlog at December 31, 2006, was$16.1 million. Backlog at December 31, 2005 and 2004 was $14.5million and $22.5 million, respectively.

**FinancialInformation About Segments and Geographic Areas**

Financial informationabout our segments and information related to the geographic areas in which weoperate appears in Note 12 to our Consolidated Financial Statements included inthis report.

**Competition**

The consulting servicesindustry in which we operate is highly competitive and significantlyfragmented. We compete with a large number of diverse service providers,including business operations consulting firms, such as Huron Consulting Group,financial consulting firms, such as FTI Consulting, Inc., managementconsulting firms, such as McKinsey & Company, accounting firms,technical and economic advisory firms, regional and specialty consulting firmsand internal professional resources of existing and potential clients. Inaddition, since there are relatively low barriers to entry into the consultingservices market, we expect new entrants into our operations managementconsulting field to result in continued and additional future competition. Someof our competitors have significantly greater financial resources, professionalstaffs, industry expertise, and name recognition than we do. Competitivepressures could reduce our market share or require us to reduce the price ofour services and solutions, either of which could harm our business and resultsof operations. Furthermore, there can be no assurance we will be able tocompete successfully with our existing or new competitors. Our PVM approach andproprietary methodologies are trade secrets not capable of being patented, andthere can be no assurance our competitors will not acquire or developsubstantially similar methodologies or our clients will not adopt 

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ourmethodologies without our assistance. Therefore, there can be no assurance wewill not be subject to competition from others using substantially similarmethodologies. However, we believe our competitive strengths differentiate usfrom competitors.

**Employees**

At December 31, 2006, we had a total of 155employees, consisting of 107 full-time Resultants, 11 part-time Resultants, 13sales and marketing employees and 24 administrative employees. Our employeesare not represented by a labor union and are not subject to any collectivebargaining agreement. We consider our employee relations to be good.

We are highly selective in our hiring of Resultants.We recruit primarily experienced professionals with operational expertise. Webelieve these highly sought after professionals choose to work for us becauseof the credentials, experience and reputation of our Resultants, theopportunity to work on a diverse range of matters and our strong reputation. Wealso develop and support our Resultants in their career progression throughtraining and development programs designed to match the skill sets of our Resultantswith the needs of our clients. We believe our attractiveness as an employer isreflected in our low turnover rate among Resultants.

Our compensation plan includes competitive basesalary, incentives and benefits. The Compensation and Corporate GovernanceCommittee of our Board of Directors, at its discretion, determines theincentives to be granted to our officers and our equity-based compensationoffered to any of our employees. Our chief executive officer and seniormanagement determine performance compensation for our Resultants, commissionsfor our sales professionals and any other non-equity incentives granted toemployees.

We have entered intonondisclosure and non-competition agreements with our current and formeremployees. There can be no assurance the agreements will deter any of ouremployees from disclosing confidential information to third parties or fromusing such information to compete with us in the future.

**IntellectualProperty**

We are dedicated to providing industry leadingoperations and process improvement solutions to our clients and fostering aculture of continuous learning for our Resultants. Our PVM approach andproprietary methodologies have been developed at great expense, have requiredconsiderable effort on the part of skilled professionals and are consideredtrade secrets. Therefore, only in certain circumstances will we grant clients alimited license to make internal use of certain of our proprietarymethodologies. We maintain our trade secrets in strict confidence and includenondisclosure provisions as part of our standard engagement. Despite ourefforts to protect proprietary trade secrets from unauthorized use ordisclosure, such as use of nondisclosure and non-competition agreements withour current and former employees, our current or former employees or others mayattempt to disclose, obtain or use our trade secrets. Since our PVM approachand proprietary methodologies and solutions are trade secrets not capable ofbeing patented, there can be no assurance that our competitors will not acquireor develop substantially similar methodologies or that our clients will notadopt our methodologies without our assistance.

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We have secured federalregistration for the service marks Total Cycle Time® and TCT®. These registrations expire fromAugust 2012 to May 2015. We have secured federal service markregistration for several other marks important to our business. We have alsomade appropriate filings in several European countries securing protection ofour marks in those countries. We consider each of these service marks to besignificant to our business.

**AvailableInformation**

We are required to filereports with the Securities and Exchange Commission (“SEC”) pursuant toSection 13 or 15(d) of the Securities Exchange Act of 1934.Thepublic may read and copy any materials filed with the SEC by us at the SEC’sPublic Reference Room at 450 Fifth Street, NW, Washington, DC 20549. Thepublic may obtain information on the operation of the Public ReferenceRoom by calling the SEC at 1-800-SEC-0330. Our filingswith the SEC are submitted electronically and can be accessed via the SEC’swebsite at: *http://www.sec.gov*.

**Company Website**

Information about us canbe obtained by accessing our website at: *http://www.thomasgroup.com*.Our website contains an investor information section which provides links toour SEC reports and filings. Such reports and filings are available free ofcharge as soon as reasonably practical after such material is electronicallyfiled with or furnished to the SEC. We are not incorporating theinformation on that website into this report, and the website and theinformation appearing on the website are not included in, and are not part of,this report.

**ITEM 1A.**        *Risk Factors*.

**Risk Factors**

***We derive ourrevenue from a limited number of engagements and our revenue could be adverselyaffected by the loss of a significant client or the cancellation of asignificant engagement.***

We derive, and expect tocontinue to derive, a significant portion of our revenue from a limited numberof engagements, primarily with government entities. From year to year, revenuefrom one or more individual clients may exceed 10% of our revenue for suchperiod. Revenue from projects with the United States Navy (“Navy”)  totaled $54.3 million, or 91% ofrevenue, $40.1 million, or 95% of revenue, and $24.4 million, or 81%of revenue, for the years ended December 31, 2006, 2005, and 2004,respectively. We are working in several divisions of the Navy, each governed bya separate contractual agreement. We either contract directly with the Navy orwe use an intermediary who acts as a prime contractor providing contracting andadministrative services. Our direct contract engagements with the Navy arereported as one client representing $24.8 million, or 42% of revenue,$13.0, or 30% of revenue, and $9.8 million, or 33% of revenue, for theyears ended December 31, 2006, 2005, and 2004, respectively. Our engagementsthrough our contracting intermediary are reported as one client representing$29.1 million, or 49% of revenue, $27.9 million, or 65% of revenue,and $14.5 million, or 48% of revenue, during the years ended December 31,2006, 2005 and 2004, respectively. If we lose any major clients or if any ofour significant engagements is reduced in scope or cancelled, we would lose asignificant amount of revenue. In general, the volume of work we perform forany particular client varies from year to year due to the specific engagementnature of our business. A client accounting for a significant portion of ourrevenue in one year may not comprise a significant portion of our revenue inthe following year due to completion of the project, early termination of theproject or a reduction of the scope of our engagement in the following year.

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***If we are unable toattract, hire, develop, train and retain experienced Resultants and salesprofessionals, our competitive position and financial performance could suffer.***

Our business consists primarily of the delivery ofprofessional services and solutions and our success depends upon the efforts,abilities and project execution of our business consultants, whom we callResultantsTM. OurResultants have highly specialized skills. If key Resultants leave and we areunable to replace them with suitable candidates, we could experience difficultyin managing the affected client engagements. Professionals with requisitecredentials and experience qualified to be our Resultants are in great demandand we face significant competition for these professionals from ourcompetitors, academic institutions, government entities, research firms andother organizations, including our clients. In addition, we rely on our salesprofessionals to develop business opportunities and client relationships. Weface significant competition for these sales professionals from ourcompetitors. Competing employers for both Resultants and sales professionalsmay be able to offer greater compensation and benefits or more attractivelifestyle choices, career paths or geographic locations than we do.

Typically, our Resultantshave close relationships with the clients they serve. Our agreements with ourclients typically include non-solicitation arrangements. If a client hires oneof our Resultants in violation of the non-solicitation provisions, we willconsider any legal remedies we may have on a case-by-case basis. However, wemay decide preserving cooperation and a professional relationship with ourclients, or other concerns, outweigh the benefits of any possible legalrecovery. Therefore, we may determine not to pursue legal action. Furthermore,our employment agreements with our employees, including Resultants and salesprofessionals, typically include non-competition provisions. However, manystates, including Texas, generally interpret non-competition clauses narrowly.Therefore, if a Resultant or salesperson leaves and goes into business incompetition with us or joins a competitor, we may not have reasonably availablelegal recourse and our client relationships could suffer. Our inability toattract, hire, develop, train and retain Resultants or sales professionalscould limit our ability to accept or complete engagements and adversely affectour competitive position and financial performance.

***A significantportion of our revenue is derived from government client engagements and thisexposes us to various risks inherent in government contracts and the governmentcontracting process.***

We perform work forvarious government entities and agencies. Revenue from Navy contractsconstituted 91% of our revenue during the fiscal year ended December 31,2006. As a result, our business is susceptible to special risks inherent ingovernment contracts and the government contracting process, including thefollowing:

·       Governmententities fund projects annually through congressionally appropriated moniespursuant to the government budgeting cycle beginning on October 1 of eachyear. While our government engagements are often planned and executed asmulti-year projects, the initial contract term is typically one year or less,running through the next September 30 after the contract is signed, andcontains options to annually extend the term through the end of the project.Extensions are generally awarded each October 1 through the end of theproject in conjunction with the government budgeting cycle. Our governmentclients reserve the right to change the scope of or terminate these projectswith limited notice for lack of approved funding and at their convenience.Occasionally, congressional approval for appropriations extends beyond October 1.In such a case, we typically obtain short-term extensions to fund the projectuntil congressional approval is obtained.

·       Ourgovernment clients reserve the right to audit our contract costs, includingallocated indirect costs, and conduct inquiries and investigations of ourbusiness practices with respect to our government contracts. Such an audit mayresult in prospective adjustments to previously agreed rates for our work andaffect our future margins.

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·       Ifa government client discovers improper or illegal activities in the course ofaudits or investigations, we may become subject to civil and criminal penaltiesand administrative sanctions, which may include termination of contracts,forfeiture of profits, suspension of payments, fines and suspensions ordebarment from doing business with related or other government entities. Ourinternal controls may not prevent or detect all improper or illegal activities.

·       Governmentcontracts, and the proceedings surrounding them, are often subject to moreextensive scrutiny and publicity than commercial contracts. The number andterms of new government contracts signed can be affected significantly bypolitical and economic factors, such as pending elections and revisions togovernment tax policies. Negative publicity related to our governmentcontracts, regardless of its accuracy, may damage our business by affecting ourability to compete for new contracts.

·       Asour government contract business continues to grow, we may become subject tostringent diversity requirements imposed under various government procurementregulations. We may have difficulty finding suitable professionals to enable usto comply with such regulations due to the unique experience qualifications forour Resultants.

·       Manyof our government clients are affected by the timing and duration of militaryconflicts in which the United States is involved. Funds intended for futurecontract renewals could be re-appropriated and may not be available for ourservices and solutions as a result of the fiscal needs of other areas of themilitary during times of conflict.

·       Governmentpersonnel who make decisions with respect to the award of military and othergovernment contracts move in and out of such decision-making positions. We mustexpend significant effort educating such decision makers about our business andcapabilities, and developing and maintaining relationships with decision makersat appropriate levels within our client organizations. If we fail tosuccessfully identify, educate and maintain relationships with appropriatedecision makers within our clients’ organizations, our ability to compete fornew contracts, and therefore our business generally, may suffer.

The impact of any of theoccurrences or conditions described above could affect not only our businesswith the particular government entity involved, but also other related andunrelated government entities. Depending on the size of the project or themagnitude of the costs, penalties or negative publicity involved, any of theseoccurrences or conditions could have a material adverse effect on our businessand results of operations.

***Our engagements with clients may be terminated by ourclients on short notice.***

The majority of ourcontracts can be terminated by our clients without cause, with short notice(typically 30 days) and without penalty. When contracts are terminatedunexpectedly, the costs associated with the lost revenue may not be reduced ina timely manner. Following an unexpected termination, we may not be able torapidly deploy our Resultants to other projects, which would result inunder-utilization of resources. In addition, because much of our work isproject-based rather than recurring in nature, we may not be able to replacecancelled contracts and maintain our utilization rates with new business.Consequently, our revenue and results of operations in subsequent periods maybe lower than expected.

***Failure to maintainstrong relationships with our contracting intermediary could result in lessfavorable contract terms and a decline in our revenue.***

We derive substantialrevenue from government engagements in which we utilize a contractingintermediary, CACI, Inc.-Federal, a wholly owned subsidiary of CACIInternational, Inc., or CACI. Although we also contract directly with thefederal government through our listing with the General 

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ServicesAdministration, we evaluate, on a project-by-project basis, whether to use anintermediary such as CACI to act as a prime contractor and provide contractingand administrative services. We are in the third year of a three-year contractwith CACI. We expect to continue to use intermediaries as prime contractors forcertain contracts when appropriate in the foreseeable future. In such cases, wewill enter into agreements with such intermediaries that define the terms ofour arrangement such as payment terms and specific deliverables. Future termswith contracting intermediaries may be less favorable than the terms underwhich we currently operate. Financial difficulties of an intermediary couldcause a delay in remission of government funds to us and force us to seek otherintermediaries.

***We derive a portionof our revenue from contracts awarded through a competitive bidding process. Ifwe are unable to win new awards consistently over any extended period, ourbusiness could be adversely affected.***

A portion of our contractsare awarded through a competitive bidding process. The competitive biddingprocess increases competition and pricing pressure, and we may be required todecrease our profit margins on our professional services and solutions in orderto win a contract over our competitors. If we are unable to win new contractawards consistently over any extended period or if the proportion of ourcontracts obtained through a competitive bidding process increases, ourbusiness will be adversely affected and cause our results of operations todiffer materially from those anticipated. In addition, upon the expiration of acontract, if the client requires further services and solutions of the typeprovided by the contract, there may be a competitive re-bidding process. Therecan be no assurance that we will win any particular bid, or that we will beable to replace business lost upon expiration or completion of a contract. Thetermination or non-renewal of any of our significant contracts could cause ourresults of operations to differ materially from those anticipated.

***We enter intofixed, task-based and incentive fee engagements with our clients and unexpectedcosts, delays or failures to achieve anticipated cost reductions or performanceimprovements could make our contracts less profitable.***

We charge for ourprofessional services and solutions based on monthly fixed fee arrangements,task-based fees or incentive fees. Fixed fee contracts require us to price ourcontracts by estimating our expenditures in advance. Our ability to properlyestimate the costs and timing for completing client projects is critical to theprofitability of our fixed fee contracts. Task-based contracts also require usto estimate our expenditures in advance, and an appropriate billing amount isassigned to each completed task or deliverable based on the estimated cost foreach specific task or deliverable. Incentive fees are based on client-specificmeasures, such as the achievement of specified process improvements, costreductions or designated goals. We must estimate our costs to deliver suchclient-specific measures and design the incentive calculation accordingly toachieve our desired profit margin. Our cost, pricing and margin estimatesreflect our professional judgment regarding our costs and the efficiencies ofour Resultants and processes. Any increased or unexpected costs, delays orfailures to achieve anticipated cost reductions or performance improvements inconnection with the performance of these engagements, including delays causedby factors outside our control, could make these contracts less profitable orunprofitable, which would have an adverse effect on our results of operations.Furthermore, incentive fees are affected by the client’s business performanceand prevailing economic conditions, both of which are beyond our control, whichmay cause variability in revenue and profit margins earned on such contractsand may limit our ability to forecast future revenue.

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***Our revenue andoperating results may fluctuate significantly from quarter to quarter, andfluctuations in operating results could cause our stock price to decline.***

Our revenue andoperating results may vary significantly from quarter to quarter due to anumber of factors. In future quarters, operating results may be below theexpectations of market analysts or investors, and the price of our common stockmay decline. Factors that could cause quarterly fluctuations include:

·       thebeginning and ending of significant contracts during a quarter;

·       thenumber, size and scope of our ongoing engagements;

·       variationsin the amount of revenue attributable to incentive fees;

·       ourability to recruit and retain qualified professionals;

·       theextent to which our Resultants can be reassigned efficiently from oneengagement to another;

·       fluctuationsin demand for our professional services and solutions resulting from budgetcuts, project delays, cyclical downturns or similar events;

·       theoccurrence and duration of conflicts involving the United States military,which could cause delays or changes in program operations related to ourgovernment clients;

·       clients’decisions to divert resources to other projects;

·       collectibilityof receivables; and

·       reductionsin the prices of services and solutions offered by our competitors.

***Our profitability will suffer if we are not able tomaintain our pricing and utilization rates and control our costs.***

Our profitabilityis largely a function of the fees we are able to charge for our services andsolutions and the efficiency with which we are able to utilize our Resultants.Accordingly, if we are not able to maintain the pricing for our services andsolutions or an appropriate utilization rate for our Resultants withoutcorresponding cost reductions, our profitability will suffer. Pricing for ourprofessional services and solutions is affected by a number of factors, including:

·       ourclients’ perceptions of our ability to add value through our services andsolutions;

·       introductionof new services or solutions by us or our competitors;

·       pricingpolicies of our competitors; and

·       marketdemand for our services and solutions and general economic conditions.

Our utilizationrates are also affected by a number of factors, including:

·       thenumber and size of our client engagements;

·       unanticipatedchanges in the duration or scope of client engagements;

·       ourability to transition Resultants from completed projects to new engagements;

·       ourability to forecast demand for our services and solutions and thereby maintainan appropriate headcount in each area of expertise; and

·       ourability to manage attrition.

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***A significant or prolonged economic downturn couldhave a material adverse effect on our results of operations.***

Our results of operationsare affected by the level of business activity of our clients, which in turn isaffected by the level of economic activity in the industries and markets theyserve. Budgets for consulting services typically decrease during times ofadverse economic conditions. A decline in the level of business activity of ourclients could affect our ability to secure new client engagements, increase thelikelihood of existing client engagement contract cancellations and reduce ourutilization rates, which would have a material adverse impact on our ability togenerate revenue and our operating results. For example, during the generaleconomic slowdown in 2001 and 2002, our industry averaged an approximate 35%decrease in revenue. As a result, during the third quarter of 2001 through andincluding the third quarter of 2002, we were not profitable. Although currenteconomic conditions have improved over previous periods, future economicdownturns could cause some clients to reduce or defer their expenditures forconsulting services. We have implemented and will continue to implementcost-savings initiatives to manage our expenses as a percentage of revenue; however,current and future savings initiatives may not be sufficient to maintain ourmargins if the economic environment should weaken for a prolonged period.

***The consultingservices industry is highly competitive and actions by competitors could renderour services and solutions less competitive, causing revenue and profit marginto decline.***

The consultingservices industry in which we operate is highly competitive and significantlyfragmented. We compete with a large number of diverse service providers, includingbusiness operations consulting firms, financial consulting firms, managementconsulting firms, accounting firms, technical and economic advisory firms,regional and specialty consulting firms and internal professional resources ofexisting and potential clients. In addition, since there are relatively lowbarriers to entry into the consulting services market, we expect new entrantsinto our operations management consulting field to result in continued andadditional future competition. Some of our competitors have significantlygreater financial resources, professional staffs, industry-specific expertiseand name recognition than we do. Competitive pressures could reduce our marketshare or require us to reduce the price of our services and solutions, eitherof which could harm our business and results of operations. In addition, ourability to compete depends on a number of factors outside of our control,including:

·       theprices at which others offer competitive services, including aggressive price competitionand discounting on individual engagements;

·       theability of our competitors to undertake more extensive marketing campaigns;

·       theextent, if any, to which our competitors develop proprietary tools that improvetheir ability to compete;

·       theability of our clients and potential clients to perform the servicesthemselves; and

·       theextent of our competitors’ responsiveness to client needs.

We may not be able tocompete effectively on these or other factors. If we are unable to competeeffectively, our market position, and therefore our revenue and results ofoperations, could decline.

***It may be difficultfor us to differentiate the professional services and solutions we offer to ourclients from those offered by our competitors.***

Many of our competitorsoffer consulting services of a nature similar to those provided by ourResultants. Although we strive to differentiate our services and solutions byusing experienced professionals to deliver improvements using our proprietaryPVM approach, there can be no guarantee potential clients will find suchdifferentiation persuasive. If we cannot effectively differentiate our services

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andsolutions from those offered by our competitors, our sales efforts could beadversely affected, and therefore our revenue and our results of operationscould decline.

***We must continuallyenhance our services and solutions to meet the changing needs of our clients orface the possibility of losing future business to competitors.***

Our future success willdepend in part upon our ability to enhance existing services and solutions andto introduce new services and solutions to meet the requirements of our clientsin a rapidly developing and evolving market. For example, certain clients mayrequire a different methodology from what our Resultants typically utilize. Insuch cases, we may have to train our Resultants to utilize differentmethodologies. Some of our competitors have significantly greater financialresources, professional staffs and expertise in certain methodologies than wedo. Our competitors may be able to respond more quickly to changes in clientrequirements. If we are unable to anticipate or respond adequately to ourclients’ needs, our revenue could decline and our results of operations couldsuffer.

***Maintaining our reputation is critical to our futuresuccess.***

We have investedsignificant time and resources in building our reputation and name recognition.Our ability to gain market acceptance of the Thomas Group brand and to securenew engagements depends heavily on our reputation and our ability to providehigh quality, reliable and cost-effective services and solutions. Some of ourengagements come from former or existing clients or from referrals by former orexisting clients. Consequently, if we fail to perform our services andsolutions in a manner meeting our clients’ expectations, our reputation may bedamaged and our ability to attract new business or new Resultants, ourcompetitive position and our results of operations could suffer.

***If we are unable togrow or if we fail to manage growth successfully our revenue and results ofoperations could be adversely affected.***

Any failure on our part tomanage growth successfully could adversely affect our revenue and results ofoperations. We expect to grow our operations by expanding into other areas ofthe government and by strengthening our position in the commercial sector.Expanding our position in these areas will likely require extensive managementattention and may increase our overall selling, general and administrativeexpenses. We also may expand by hiring additional Resultants, eitherindividually or as members of existing groups, or acquiring complementarybusinesses. These activities could result in the diversion of management’stime, attention and resources from managing and marketing our company. We alsocould encounter difficulties in integrating persons from other firms withdiverse professional backgrounds, experiences and organizational cultures intoour own organization. Expansion creates new and increased management andtraining responsibilities for our employees. Expansion also increases demandson our internal systems, procedures and controls and on our managerial,administrative, financial, marketing and other resources. If we do not managegrowth effectively, our business, financial condition and results of operationscould be adversely affected.

***Our engagements could result in professionalliability, which could be very costly and damage our reputation.***

Our engagements typicallyaddress complex business challenges which require us to exercise professionaljudgment. As a result, we are subject to the risk of professional liability. Ifa client questions the quality of our work, the client could bring a lawsuit torecover damages or contest its obligation to pay our fees. Litigation allegingthat we performed negligently or breached our obligations to a client couldexpose us to significant legal liabilities and, regardless of the merits oroutcome, could be very costly and could distract our management and damage ourreputation. Although our engagement agreements typically include provisionsdesigned to limit our exposure to legal claims, they may not protect us undersome circumstances. In addition, we carry professional liability insurance tocover many of these types of 

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claims,but policy limits and breadth of coverage may be inadequate to cover anyparticular claim or all claims plus the cost of our legal defense. For example,we provide services and solutions on engagements in which the impact on aclient may substantially exceed the limits of our errors and omissionsinsurance coverage. If we are found to have professional liability with respectto work performed on such an engagement, we may not have sufficient insuranceto cover the entire liability. Liability in excess of our insurance limitswould have to be borne directly by us and could seriously harm ourprofitability, financial position and reputation.

***Inability to protect intellectual property could harmour competitive position and financial performance.***

We have only a limitedability to protect our intellectual property rights, which are important to oursuccess. Our PVM approach and proprietary methodologies are trade secrets notcapable of being patented, and there can be no assurance our competitors willnot acquire or develop substantially similar methodologies or our clients willnot adopt our methodologies without our assistance. Despite our efforts toprotect our proprietary trade secrets from unauthorized use or disclosure, suchas use of nondisclosure and non-competition agreements with our current andformer employees, our current or former employees or others may attempt todisclose, obtain or use our trade secrets. The steps we have taken to protectour proprietary trade secrets may not prevent misappropriation, particularly inforeign countries where laws or law enforcement practices may not protectintellectual property rights as fully as in the United States. The unauthorizeduse of our trade secrets or use of substantially similar methodologies andsolutions by our competitors or others could harm our competitive position andfinancial performance.

***If we fail tomaintain adequate internal control over financial reporting, if we are unableto timely complete our assessment of the effectiveness of our internal controlover financial reporting, or if our independent registered public accountingfirm cannot attest to our assessment of our internal control over financialreporting, we may be subject to regulatory sanctions and a loss of publicconfidence and the trading price of our stock could be negatively impacted.***

Effective internalcontrols are necessary for us to provide reliable financial reports andeffectively detect and prevent fraud. Pursuant to Section 404 of theSarbanes-Oxley Act of 2002, which we refer to as Section 404, undercurrently published SEC rules, beginning with our fiscal year ending December 31,2007, we will be required to perform an assessment of the effectiveness of ourinternal control over financial reporting and publicly disclose the assessmentin our Annual Report on Form 10-K for the year ending December 31,2007. Attestation by our auditor will be required for the year ended December 31,2008. We expect to dedicate significant management, financial and otherresources in connection with our compliance with Section 404 in 2007. Weexpect these efforts to include a review of our existing internal controlstructure. We cannot be certain at this time that we will be able to complywith all of our reporting obligations and successfully complete the procedures,certification and attestation requirements of Section 404 by the time thatwe are required to file our 2007 Annual Report. If we fail to achieve andmaintain the adequacy of our internal controls and do not address anydeficiencies that may be identified by our auditors, we may not be able toconclude, on an ongoing basis, that we have effective internal controls overfinancial reporting in accordance with the Sarbanes-Oxley Act of 2002.Moreover, effective internal controls are necessary for us to produce reliablefinancial reports and are important to help prevent fraud. As a result, ourfailure to satisfy the requirements of Section 404 on a timely basis couldresult in the loss of investor confidence in the reliability of our financialstatements, which in turn could harm our business and negatively impact thetrading price of our common stock.

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***Operatinginternationally exposes us to special risks and factors that could negativelyimpact our business or operations and could result in increased expenses anddeclining profit margin.***

We currentlyoperate primarily in the United States and have minimal operations in Asia;however, in the future, we may expand our international operations. If ourrevenue from international operations does not exceed the expense associatedwith establishing and maintaining our international operations, our results ofoperations could suffer. International operations create special risks,including the following:

·       locallegal and regulatory requirements, such as import/export controls, contentrequirements, trade restrictions, tariffs and foreign taxes, sanctions, dataprivacy laws and labor regulations, may impair our ability to operateefficiently or expatriate foreign profits;

·       enforcingagreements with clients and collecting accounts receivable may be moredifficult in certain foreign jurisdictions;

·       foreignintellectual property laws may make enforcement of our intellectual propertyrights in foreign countries more difficult;

·       increasedcompetition from local consultants may hamper our marketing and salesopportunities in certain locations;

·       generaleconomic and political conditions in the foreign countries in which we operatecould have an adverse impact on our earnings from operations in thosecountries;

·       fluctuationsin currency exchange rates, may affect demand for our services and solutionsand may adversely affect the profitability in United States dollars of servicesand solutions provided by us in foreign markets where payment for our servicesis made in the local currency; and

·       moreburdensome employee benefit requirements may impair our ability to maintainappropriate gross profit margins.

***Certainparticipants in our 401(k) plan may have rescission rights with respect toshares of our common stock purchased by such participants.***

We filed a RegistrationStatement on Form S-8 registering the acquisition of our commonstock pursuant to our 401(k) plan on September 21, 2006. Prior tosuch registration, the acquisition of common stock pursuant to our 401(k) planby plan participants may have been subject to the registration requirements ofthe Securities Act of 1933 or applicable state securities laws and may not havequalified for an available exemption from such requirements. Federal securitieslaws generally provide for a one-year rescission right for an investor whoacquires unregistered securities in a transaction that is subject toregistration and for which no exemption was available. As such, an investor successfullyasserting a rescission right during the one-year time period has the right torequire an issuer to repurchase the securities acquired by the investor at theprice paid by the investor for the securities (or if such security has beendisposed of, to receive damages with respect to any loss on such disposition),plus interest from the date of acquisition. These rights may apply to certainparticipants in our 401(k) plan. From July 2005 through September 21,2006, participants in our 401(k) plan purchased interests in our commonstock fund representing approximately 14,950 shares of our common stock atprices ranging from $3.06 to $18.15 per share. We have notified theseparticipants of their potential rescission rights, and we have agreed, incertain circumstances, to settle certain rescission claims in cash. Based onour current stock price, we believe our current potential liability forrescission claims is not material to our financial condition or results ofoperations; however, our potential liability could become material in thefuture if our stock price were to fall below participants’ acquisition pricesfor their interest in our stock fund during the one-year period following theunregistered acquisitions.

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***We may not continue to pay dividends.***

Our current dividendpolicy provides for the payment of an aggregate annual cash dividend of $0.40on each outstanding share of common stock, payable quarterly at a rate of $0.10per share. The determination of future cash dividends, if any, will be at thediscretion of our Board of Directors after taking into account various factors,including our financial condition, results of operations, cash flow, the levelof our capital expenditures, restrictive covenants in our credit facility,future business prospects and any other matters that our Board of Directorsdeems relevant. There can be no assurance that we will continue to paydividends at this rate or at all in the future.

***We may needadditional capital in the future, and this capital may not be available to us.The raising of additional capital may dilute stockholders’ ownership in us.***

We may need toraise additional funds through public or private debt or equity financings inorder to:

·       expandour international operations;

·       developnew services and solutions;

·       respondto competitive pressures; or

·       pursuestrategic acquisitions.

Any additional capitalraised through the sale of equity may dilute stockholders’ ownership percentagein us. We believe that existing cash resources, the amounts available under ourcredit facility and cash generated from current operations will be sufficientto satisfy our operating cash needs at least through December 31, 2007.Any future decreases in our operating income, cash flow, or stockholders’equity may impair our future ability to raise additional funds to financeoperations. Any additional financing we may need may not be available on termsfavorable to us, or at all.

***Our certificate ofincorporation, bylaws, stockholder rights plan, Delaware law and arrangementswe have with certain significant stockholders may discourage an acquisition ofour company.***

Provisions of ourcertificate of incorporation, bylaws and Delaware law could make it moredifficult for a third party to acquire us, even if doing so would be beneficialto our stockholders. We have also adopted a stockholder rights plan which couldalso have the effect of making it more difficult for a third party to acquire,or of discouraging a third party from acquiring, a majority of our outstandingstock. We have entered into an agreement with two of our directors andsignificant stockholders, General John T. Chain, Jr. and Mr. EdwardP. Evans, which grants General Chain the right to designate two nominees to ourBoard of Directors as long he owns greater than 15% of our outstanding commonstock and Mr. Evans the right to designate one nominee to our Board ofDirectors as long as he owns greater than 15% of our outstanding common stock.These contractual obligations could make it difficult for a third party to gaincontrol of our Board of Directors in the event of an acquisition. In addition,these directors and significant stockholders currently have and may continue tohave a significant ownership interest in our common stock which could make itdifficult for a third party to acquire a majority of our outstanding commonstock.

***We have selfreported our internal investigation into our stock option practices and therelated restatement to the Securities and Exchange Commission.***

We are subject to theoversight of  the Securities and ExchangeCommission (“SEC”) and other regulatory agencies.   As a result of the investigation and ourrestatement, we could become subject to administrative or other legalproceedings by those agencies, in which case we may be required to pay fines orotherwise be subject to other penalties. In connection with our restatement webelieve that we have made appropriate judgments in concluding the correctaccounting measurement dates for stock option 

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grants;however,  the SEC may disagree with themanner in which we have accounted for the financial impact of past stock optiongrant measurement date errors. There is a risk that any SEC inquiry could leadto circumstances in which we may have to further restate our prior financialstatements, amend prior SEC filings, or otherwise take other actions notcurrently contemplated. We have self reported the internal investigation andthe restatement to the SEC and intend to cooperate with any informational or otherrequests from the SEC.

**ITEM1B.****       *UnresolvedStaff Comments.***

None.

**ITEM2.****                *Properties.***

We believe thefollowing facilities are adequate for our current needs:

·       Welease approximately 26,000 square feet of office space at our principalexecutive office in Irving, Texas under a lease which expires in March 2012.

·       Welease approximately 6,000 square feet of office space in Troy, Michigan under alease which expires on March 31, 2007.

·       Welease approximately 12,000 square feet of office space in Reston, Virginiaunder a lease which expires on October 31, 2007.

·       Welease space for our office in Hong Kong under a month-to-month lease.

**ITEM 3.**                *Legal Proceedings.*

Due to declining revenue of our European subsidiaries,we filed for insolvency of our wholly-owned subsidiary headquartered inFrankfurt, Germany in 2002 and our wholly-owned subsidiary in Zug, Switzerlandin 2005. During 2005, a suit was filed against our subsidiary in Switzerland bythe German insolvency administrator to recover approximately $0.3 millionrelated to an intercompany receivable between the two entities. Due to theinsolvency of the Swiss entity, the suit was dismissed during the fourthquarter of 2005. We believe any future legal action related to the closure ofour German and Swiss subsidiaries would not have a material impact on ourfinancial position, results of operations or cash flows in future years.

During the third quarter of 2003, we became aware ofpast circumstances involving a former employee that management believed would resultin future litigation or settlement costs. As such, we recorded a $150,000contingent liability related to the matter. On December 17, 2003, weentered into a settlement agreement with this former employee resulting in$121,160 payable to the former employee in two installments, due December 17,2003 in the amount of $21,160 and January 5, 2004 in the amount of$100,000. We made both installment payments. In addition to the settlementpayments, as part of the settlement agreement, we entered into a consultingagreement whereby we paid our former employee $84,640, in five equal monthlyinstallments of $16,928 beginning January 2004 with the final paymentbeing made in May 2004. Our former employee provided reports related tothe financial strength and other conditions of the Asian marketplace asperformance under the consulting agreement, and no obligation to this formeremployee remained after the final payment was made in 2004.

We have self reported the internal investigation intoour historical stock option practices and related restatement to the Securitiesand Exchange Commission and intend to cooperate with any informational or otherrequests from the SEC.

We may become subject tovarious claims and other legal matters, such as collection matters initiated byus in the ordinary course of conducting our business. We believe neither suchclaims and legal matters 

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nor thecost of prosecuting and/or defending such claims and legal matters will have amaterial adverse effect on our consolidated results of operations, financialcondition or cash flows. No material claims are currently pending; however, noassurances can be given that future claims, if any, may not be material.

**ITEM4.****                *Submission of Matters to a Vote of Security Holders.***

On December 12, 2006, a special meeting of ourstockholders was held to consider and vote upon a proposal to approve, adoptand ratify the 2005 Omnibus Stock and Incentive Plan for Thomas Group, Inc.,which we refer to as the 2005 Plan, and to consider and vote upon a proposal toapprove and ratify certain awards made under the 2005 Omnibus Stock andIncentive Plan to James T. Taylor, our President and Chief Executive Officer,David English, our Chief Financial Officer, and Terry Stinson, our President,North America—Commercial, which we refer to collectively as the Awards.  At the special meeting, 7,128,559 shares werevoted in favor of the 2005 Plan, 551,965 shares were voted against the 2005 Plan and 700 shares were withheld.Also at the special meeting, 7,124,391 shares were voted in favor of theAwards,  556,133 shares were votedagainst the Awards and 700 shares were withheld.

The 2005 Plan is an equity-based compensation plan weuse to attract and retain qualified employees and independent contractors whoare essential to our success. The 2005 Plan was authorized by our Board ofDirectors on December 20, 2005. On December 20, 2005 and December 23,2005, stockholders who collectively owned approximately 67% of our common stockprovided their written approval and adoption of the 2005 Plan. In order tocomply with provisions of our certificate of incorporation, the special meetingwas held to obtain formal approval of the 2005 Plan at a meeting ofstockholders.

On December 20, 2005, December 23, 2005 and April 27,2006, the Compensation and Corporate Governance Committee of our Board ofDirectors, with General John T. Chain, Jr. abstaining, granted restrictedshare awards to James T. Taylor, our President and Chief Executive Officer,David English, our Chief Financial Officer and Terry D. Stinson, our PresidentCommercial Operations. The special meeting was held also to obtain formalstockholder approval of the Awards at a meeting of stockholders.

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**PART II**

**ITEM 5.     *Market for Registrant’sCommon Equity, Related Stockholder Matters and Issuer Purchases of EquitySecurities.***

**Market forRegistrant’s Common Equity**

Ourcommon stock was quoted on the OTC Bulletin Board (OTCBB) under the symbol “TGIS.OB”during 2004 and through December 22, 2005. Beginning December 23,2005, our common stock was listed in The Nasdaq Capital Market under the symbol“TGIS.”  Since November 6, 2006, our commonstock has been listed on The Nasdaq Global Market under the symbol “TGIS.”  The stock prices set forth belowrepresent the highest and lowest sales prices per share of our common stock asreported by the OTC Bulletin Board through December 22, 2005. Stock pricesset forth beginning December 23, 2005, through December 31, 2006,represent the highest and lowest sales prices per share for the indicatedquarters as reported on The Nasdaq Capital Market and The Nasdaq Global Market:

| **Quarter Ended**   | ** ** | ** ** | ** ** | **Dividend** | ** ** | **High** | ** ** | **Low** | ** ** |
|--------------------------|------------|------------|------------|--------------|------------|----------|------------|---------|------------|
| December 31,  2006  |       |       | $          | 0.100        |       |     | $          | 17.65   |       | $ | 10.01 |   |
| September 30,  2006 |       |       | $          | 0.075        |       |     | $          | 16.00   |       | $ | 7.72 |   |
| June 30,  2006      |       |       | $          | 0.075        |       |     | $          | 14.28   |       | $ | 7.30 |   |
| March 31,  2006     |       |       | $          | 0.050        |       |     | $          | 10.50   |       | $ | 6.82 |   |
| December 31, 2005   |       |       | $          | 0.050        |       |     | $          | 9.25    |       | $ | 5.32 |   |
| September 30,  2005 |       |       | —     |         |       | $        | 6.97       |    | $          | 2.55 |   |
| June 30,  2005      |       |       | —     |         |       | $        | 3.23       |    | $          | 1.77 |   |
| March 31, 2005      |       |       | —     |         |       | $        | 2.00       |    | $          | 1.25 |   |

 

**Holders of Record**

As of December 31,2006, there were approximately 95 holders of record of ourcommon stock.

**Dividends**

On December 12, 2006, we revised our dividendpolicy to provide for an increased annual cash dividend of $0.40 per share,payable quarterly at a rate of $0.10 per share. Payment of future cashdividends will be at the discretion of our Board of Directors after taking intoaccount various factors, including our financial condition, results of operations,cash flow, the level of our capital expenditures, restrictive covenants in ourcredit facility, future business prospects and any other matters that our Boardof Directors deems relevant.

Prior to 2005, we had paid no dividends tostockholders. On December 20, 2005, we adopted a policy under which wewould pay an aggregate annual cash dividend of $0.20 on each outstanding shareof common stock, payable quarterly at a rate of $0.05 per share. On June 20,2006, our Board of Directors amended our dividend policy to increase the annualdividend to $0.30 per share, payable quarterly at a rate of $0.075 per share.

We paid dividends of $0.075 per share on July 14,2006, and October 13, 2006, and $0.05 per share on January 13, 2006,and April 13, 2006.

Information regarding ourequity compensation plans is set forth in Item 12 in Part III of thisAnnual Report on Form 10-K, which information is incorporated hereinby reference.

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**Recent Sale ofUnregistered Securities; Use of Proceeds from Registered Securities**

***Restricted StockAwards***

*Net Profit BasedRestricted Stock Awards*

On December 20, 2005,the Committee, with General John T. Chain, Jr. abstaining, granted netprofit restricted share awards (i) for 300,000 restricted shares to JamesT. Taylor, the Company’s President and Chief Executive Officer, and (ii) for50,000 restricted shares to David English, the Company’s Chief FinancialOfficer. On April 27, 2006, the Committee, with General John T. Chain, Jr.abstaining, granted a net profit restricted share award for 50,000 restrictedshares to Terry D. Stinson, the Company’s newly appointed President NorthAmerica Region—Commercial. We refer to these awards collectively as the “NetProfit Awards.”  The restrictions onone-third of the restricted shares granted to each officer will lapse (that is,such restricted shares will become “vested”) on the last day of each fiscalyear in which the Company achieves at least a 15% increase in the Company’sannual profit when compared to the greater of (a) the annual profit for2005 or (b) the annual profit for the preceding year. The percentageincrease in annual profit will be calculated by dividing (x) the excess(if any) of the annual profit for the current year over the greater of (1) theannual profit for the year 2005 and (2) the annual profit for thepreceding year; by (y) the greater of (1) or (2). At each timerestricted shares become vested, the Company will deliver to the appropriateparticipant 40% of such vested shares, and will continue to hold the remaining60% of vested shares until the participant’s termination of full timeemployment (the “Retention Period”), at which time all such retained vestedshares will be delivered to such participant. At December 31, 2006, noshares had vested under the net profit awards, pending certification of thefinancial statements by our registered public accounting firm.

*Share PriceRestricted Stock Award*

On December 23, 2005, the Committee, with GeneralJohn T. Chain, Jr. abstaining, granted a share price restricted shareaward for 300,000 shares of restricted stock to James T. Taylor, the Company’sPresident and Chief Executive Officer. We refer to this award as the “SharePrice Award.”  The restricted sharesbecome “available shares” in 20,000 share increments based upon the highest “quarterlyprice” achieved during the term of such award. The “quarterly price” for aquarter will be equal to the lowest closing price per share of the Company’sstock during any given calendar quarter, beginning with the quarter ending December 31,2005. The 20,000 restricted shares become available shares if there is a “quarterlyprice” of at least $6.00, and an additional 20,000 restricted shares becomeavailable for every $1 increase (above $6.00) in the quarterly price so that,if the quarterly price reaches $20, all of the shares will become availableshares. As of December 31, 2006, 100,000 restricted shares have becomeavailable shares since the date of the Share Price Award. On December 23,2010 (the fifth anniversary of the date of grant), if the award has notpreviously terminated, the restrictions on all restricted shares which havebecome available shares will lapse.

The restricted shares granted to Mr. Taylor bythe award agreement do not constitute issued and outstanding common stock forany corporate purposes, and Mr. Taylor has no rights, powers or privilegesof a holder of unrestricted shares, until such time as such shares become availableshares. After such time, Mr. Taylor shall have all rights, powers andprivileges of a holder of unrestricted shares, including the right to receivedividends or distributions, except the right to receive and transfer suchshares until they have vested in accordance with the terms of the awardagreement.

24

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Basedon the lowest closing price per share of the Company’s stock of $10.15, 40,000awards were earned in the three months ended December 31, 2006. Restrictedshares granted under the award have become available shares**asfollows:

| **Quarter Ended**   | ** ** | ** ** | ** ** | **Lowest Closing  Price** | ** ** | **Available  Shares** | ** ** |
|--------------------------|------------|------------|------------|--------------------------------|------------|-----------------------|------------|
| March 31,  2006     |       |       | $          | 6.97                           |       |                  | 20,000     |   |
| June 30,  2006      |       |       | $          | 7.46                           |       |                  | 20,000     |   |
| September 30,  2006 |       |       | $          | 8.38                           |       |                  | 20,000     |   |
| December 31,  2006  |       |       | $          | 10.15                          |       |                  | 40,000     |   |
| **Total**                | ** ** | ** ** | ** ** |                           |       | **100,000**           |       |

 

No consideration was paidfor the shares and there were no proceeds to the Company from the award.Because the issuance of the shares was made in a private transaction with theCompany’s President and CEO the issuance did not involve a public offering and,therefore, was exempt from registration pursuant to Section 4(2) ofthe Securities Act of 1933, as amended.

***Sales prior to registration of plan interests insecurities offered under employee benefit plans on Form S-8***

We filed a RegistrationStatement on Form S-8 registering the acquisition of our commonstock pursuant to our 401(k) plan on September 21, 2006. Prior tosuch registration, the acquisition of common stock pursuant to our 401(k) planby plan participants may have been subject to the registration requirements ofthe Securities Act of 1933 or applicable state securities laws and may not havequalified for an available exemption from such requirements. Federal securitieslaws generally provide for a one-year rescission right for an investor whoacquires unregistered securities in a transaction that is subject toregistration and for which no exemption was available. As such, an investorsuccessfully asserting a rescission right during the one-year time period hasthe right to require an issuer to repurchase the securities acquired by theinvestor at the price paid by the investor for the securities (or if suchsecurity has been disposed of, to receive damages with respect to any loss onsuch disposition), plus interest from the date of acquisition. These rights mayapply to certain participants in our 401(k) plan. From July 2005through September 21, 2006, participants in our 401(k) plan purchasedinterests in our common stock fund representing approximately14,950 shares of our common stock at prices ranging from $3.06 to $18.15per share. We have notified these participants that they may have rescissionrights, and we have agreed, in certain circumstances, to settle certainrescission claims in cash. Based on our current stock price, we believe thatour current potential liability for rescission claims is not material to ourfinancial condition or results of operations; however, our potential liabilitycould become material in the future if our stock price were to fall belowparticipants’ acquisition prices for their interest in our stock fund duringthe one-year period following the unregistered acquisitions.

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**Stockholder ReturnPerformance Graph**

**Thefollowing graph sets forth our total stockholder return as compared to TheNASDAQ Stock Market (US) Index and an index of companies having a marketcapitalization of $100.0 million to $150.0 million, over the period beginning January 1,2001 and ending December 31, 2006. The total stockholder return assumes$100 invested at the beginning of the period in our common stock.  We chose an index of companies having a marketcapitalization of $100.0 million to $150.0 million for the following reasons:this is the historical market capitalization range for our common stock, thestock price performance for companies in that range tends to react to marketforces in a similar fashion, and we have no true public company peer group.**

**COMPARE 5-YEARCUMULATIVE TOTAL RETURN AMONG THOMAS GROUP, INC.NASDAQ MARKET INDEX AND PEER GROUP INDEX**

****

| ** **               | ** ** | **2001** | ** ** | **2002** | ** ** | **2003** | ** ** | **2004** | ** ** | **2005** | ** ** | **2006** | ** ** |
|--------------------------|------------|----------|------------|----------|------------|----------|------------|----------|------------|----------|------------|----------|------------|
| Thomas  Group, Inc. |       | 100.00   |       | 20.00    |       | 60.00    |       | 60.00    |       | 366.53   |       | 689.61   |       |
| Peer Group Index         |       | 100.00   |       | 74.89    |       | 114.05   |       | 118.85   |       | 109.69   |       | 111.94   |       |
| NASDAQ Market Index      |       | 100.00   |       | 69.75    |       | 104.88   |       | 113.70   |       | 116.19   |       | 128.12   |       |

 

ASSUMES $100INVESTED ON  JAN. 1, 2001ASSUMES  DIVIDEND REINVESTEDFISCAL YEAR ENDING Dec. 31, 2006*Data Source: Hemscott Data., Richmond, VA*

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**ITEM6.****                *Selected Financial Data*.**

***Pleasesee “Review of Stock Option Grant Practices” in Item 7. Management’s Discussionand Analysis of Financial Condition and Results of Operations and Note 19 toour Consolidated Financial Statements for a discussion related to therestatement of our financial statements and related footnote disclosures forthe fiscal years ending December 31, 2002 through 2005.***

The following table presents our selected consolidatedfinancial information, which reflects the restatement,  and should be read in conjunction with ourconsolidated financial statements and the related notes and “Management’sDiscussion and Analysis of Financial Condition and Results of Operations”included elsewhere in this Annual Report on Form 10-K. Historical operatingand statistical information may not be indicative of our future performance.

The table below contains selected consolidatedfinancial information prepared based on our audited consolidated financialstatements for each of the fiscal years in the five-year period ended December 31,2006. The financial statements for each of the fiscal years ended December 31,2006, 2005, 2004 and 2003 have been audited by Hein & Associates LLP,an independent registered public accounting firm. The financial statements forthe fiscal year ended December 31, 2002 are based upon financialstatements that were originally audited by Ernst & Young LLP, anindependent registered public accounting firm, but which now reflect therestatement described herein, and are therefore unaudited.

Ouraudited financial statements included herein and the following selectedhistorical financial data for the five-year period ended on that date reflectthe effects of our reclassification of the assets, liabilities and results ofoperations of our operations in Switzerland as discontinued operations. Suchoperations were liquidated in 2005.

| ** **                                                                                                                                                                                    | ** ** | **Year Ended December 31,**              | ** ** | ** **     |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|---------------------------------------------------------|------------|----------------|
| ** **                                                                                                                                                                                    | ** ** | **2006**                                                | ** ** | **2005**       | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** | ** ** |
| ** **                                                                                                                                                                                    | ** ** | ** **                                              | ** ** | **(Restated)** | ** ** | **(Restated)** | ** ** | **(Restated)** | ** ** | **(Restated)** | ** ** | ** ** |
| ** **                                                                                                                                                                                    | ** ** | **In thousands, except share data** | ** ** | ** **     |
| Revenue                                                                                                                                                                                       |       | $                                                       | 59,478     |           | $ | 43,062 |   | $ | 30,020 |   | $ | 30,275 |   | $ | 20,215 |   |   |
| Operating expenses                                                                                                                                                                            |       | 44,571                                                  |       | 34,793         | (a) | 27,428 |   | 27,217 |   | 30,370 | (c) |   |
| Operating income  (loss)                                                                                                                                                                      |       | 14,907                                                  |       | 8,269          |   | 2,592 |   | 3,058 |   | (10,155 | ) |   |
| Other income  (expense), net                                                                                                                                                                  |       | 362                                                     |       | (13            | ) | (279 | ) | (628 | ) | (871 | ) |   |
| Income (loss) from  continuing operations before income taxes                                                                                                                                 |       | 15,269                                                  |       | 8,256          |   | 2,313 |   | 2,430 |   | (11,026 | ) |   |
| Income taxes  (benefit)                                                                                                                                                                       |       | 3,764                                                   |       | 311            |   | (21 | ) | (343 | )(b) | (286 | )(d) |   |
| Income (loss) from  continuing operations before the cumulative effect of a change in accounting  principle                                                                                   |       | 11,505                                                  |       | 7,945          |   | 2,334 |   | 2,773 |   | (10,740 | ) |   |
| Gain (loss) on  discontinued operations, net of related income tax expense (benefit) effect  of $0, $58, $(44), $(184), and $263 for the years 2006, 2005, 2004, 2002 and  2002, respectively |       | 1                                                       |       | (1,212         | ) | (893 | ) | (2,106 | ) | 2,984 |   |   |
| Income (loss)  before the cumulative effect of a change in accounting principle                                                                                                               |       | 11,506                                                  |       | $              | 6,733 |   | $ | 1,441 |   | $ | 667 |   | $ | (7,756 | ) |   |
| Cumulative effect  of a change in accounting principle, net of related income tax benefit of  $0.5                                                                                            |       | —                                                  |       | (10            | ) | — |   | — |   | — |   |   |
| Net income (loss)                                                                                                                                                                             |       | $                                                       | 11,506     |           | $ | 6,723 |   | $ | 1,441 |   | $ | 667 |   | $ | (7,756 | ) |   |

 

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| ** **                                                                  | ** ** | **Year Ended December 31,**              | ** ** | ** **     |
|-----------------------------------------------------------------------------|------------|---------------------------------------------------------|------------|----------------|
| ** **                                                                  | ** ** | **2006**                                                | ** ** | **2005**       | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** | ** ** |
| ** **                                                                  | ** ** | ** **                                              | ** ** | **(Restated)** | ** ** | **(Restated)** | ** ** | **(Restated)** | ** ** | **(Restated)** | ** ** | ** ** |
| ** **                                                                  | ** ** | **In thousands, except share data** | ** ** | ** **     |
| Per share of common stock:                                                  |       |                                                    |       |           |   |   |   |   |   |   |   |   |
| Basic earnings per share:                                                   |       |                                                    |       |           |   |   |   |   |   |   |   |   |
| Income (loss) from  continuing operations                                   |       | $                                                       | 1.06       |           | $ | 0.76 |   | $ | 0.25 |   | $ | 0.29 |   | ($1.94 | ) |   |
| Gain (loss) on  discontinued operations, net of tax                         |       | —                                                  |       | (0.12          | ) | (0.10 | ) | (0.22 | ) | 0.54 |   |   |
| Cumulative effect  of a change in accounting principles, net of tax benefit |       | —                                                  |       | —         |   | — |   | — |   | — |   |   |
| Net income (loss)                                                           |       | $                                                       | 1.06       |           | $ | 0.64 |   | $ | 0.15 |   | $ | 0.07 |   | ($1.40 | ) |   |
| Diluted earnings per share:                                                 |       |                                                    |       |           |   |   |   |   |   |   |   |   |
| Income (loss) from  continuing operations                                   |       | $                                                       | 1.04       |           | $ | 0.75 |   | $ | 0.22 |   | $ | 0.28 |   | ($1.94 | ) |   |
| Gain (loss) on  discontinued operations, net of tax                         |       | —                                                  |       | (0.12          | ) | (0.08 | ) | (0.21 | ) | 0.54 |   |   |
| Cumulative effect  of a change in accounting principles, net of tax benefit |       | —                                                  |       | —         |   | — |   | — |   | — |   |   |
| Net Income (loss)                                                           |       | $                                                       | 1.04       |           | $ | 0.63 |   | $ | 0.14 |   | $ | 0.07 |   | ($1.40 | ) |   |
| Dividends per share:                                                        |       | $                                                       | 0.30       |           | $ | 0.05 |   | $ | — |   | $ | — |   | $ | — |   |   |
| Weighted average shares:                                                    |       |                                                    |       |           |   |   |   |   |   |   |   |   |
| Basic                                                                       |       | 10,812,117                                              |       | 10,512,703     |   | 9,658,131 |   | 9,555,662 |   | 5,538,520 |   |   |
| Diluted                                                                     |       | 11,065,088                                              |       | 10,702,375     |   | 10,548,922 |   | 10,169,575 |   | 5,538,520 |   |   |
|                                                                             |            |                                                         |            |                |  |  |  |  |  |  |  |  |  |  |  |  |  |

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(a)           Includes $0.6 million in lossesrelated to renewal of a contract subleasing excess office space to a thirdparty.

(b)           Includes the reversal of $0.2 millionof foreign income taxes payable.

(c)            Includes $1.3 million ofrestructuring charges for insolvency proceedings related to our subsidiarylocated in Germany.

(d)          Includes $0.9 million of federalincome tax refunds.

| ** **                                           | ** ** | **Year ended December 31,** | ** ** |
|------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                           | ** ** | **2006**                                   | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** |
| **Balance  Sheet Data**                              |       |                                       |       |   |   |   |   |   |   |   |   |
| Working capital                                      |       | $                                          | 16,787     |   | $ | 8,188 |   | $ | 3,084 |   | $ | 2,535 |   | $ | 3,222 |   |
| Total assets                                         |       | $                                          | 23,466     |   | $ | 13,031 |   | $ | 6,549 |   | $ | 7,440 |   | $ | 11,692 |   |
| Long-term  obligations, including current maturities |       | $                                          | 103        |   | $ | 274 |   | $ | 1,412 |   | $ | 4,286 |   | $ | 6,398 |   |
| Total stockholders’  equity                     |       | $                                          | 18,663     |   | $ | 8,494 |   | $ | 2,489 |   | $ | 713 |   | $ | 9 |   |

 

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**ITEM 7.**                *Management’s Discussion and Analysis of Financial Condition and Resultsof Operations*.

*The following discussion of our financial conditionand results of operations should be read in conjunction with our consolidatedfinancial statements and the related notes appearing elsewhere or incorporatedby reference in this Annual Report on Form 10-K. This discussioncontains forward-looking statements. Actual results could differmaterially from the results discussed in the forward-looking statements.Please see “Special Note Regarding Forward-Looking Statements” and “RiskFactors” for a discussion of some of the uncertainties, risks and assumptionsassociated with these statements.*

**Overview**

We are an operations and process improvement servicesfirm headquartered in Irving, Texas that provides process improvement solutionsthat enhance business efficiency, competitiveness and financial performance. Wedevelop and employ methodologies to transform the processes, procedures andpeople within our clients’ organizations to enable more efficient and seamlessoperations. Our methodologies address business processes throughout the “ExtendedEnterprise.” Extended Enterprise is a term we use to describe the full spectrumof a client’s value chain from its suppliers, through its internal operations,and to its customers.

As specialists inoperations and process improvement, we create and implement process improvementsolutions that remove barriers, increase productivity, improve cultures andenable our clients to improve and sustain operational performance as measuredby the following:

·       totalcycle time;

·       time-to-market;

·       deliveringlead times;

·       operationaland administrative productivity;

·       costsavings;

·       productyields;

·       inventoryturns; and

·       returnon assets.

To deliver these solutions, we utilize our staff ofprofessionals, whom we refer to as “ResultantsTM,” who average over25 years of business experience. To manage our client engagements, ourResultants typically leverage our Process Value Management, or PVM, approach,which incorporates our proprietary Total Cycle Time®, or TCT®, methodology along with other industry-acceptedprocess improvement methodologies. PVM is used to manage client engagements,identify process inefficiencies and implement change within our clients inorder to achieve a total transformation to what we refer to as the “ProcessManaged Enterprise.” A Process Managed Enterprise is one in which managementfocus and systems are centered on customers and managed around processes.

We have delivered operations and process improvementsolutions to approximately 375 clients since our inception in 1978.Historically, most of our clients have been large, diversified commercial orgovernment enterprises in North America,Europe, and Asia. During the last three years, however, our engagementshave involved primarily various government entities. We have also servedinternational clients in previous years from our former offices in Switzerland,Sweden, Germany, Singapore, China and Hong Kong. Currently, we are focused ondelivering our solutions in North America. In some instances, we providesolutions to the same organization under separate contract agreements. While webelieve our methodologies are applicable to any industry, we have developed asignificant amount of subject-matter 

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expertise relevant tospecific industries, including automotive, aviation, distribution, government,healthcare, manufacturing, semiconductor, textiles and transportation.

We generally derive our revenue from fees for theimplementation of business operations improvement programs delivered by ourResultants. Total revenue consists of fees and other billings derived fromfixed fees, task-based fees, incentive fees and reimbursed travel expenses. Ourfee type and structure for each client engagement is dependant on a number ofvariables, including the size of the client, the complexity and geographicdispersion of its business, the level of the opportunity for us to improve theclient’s processes and other factors.

Fixed fee revenue is recognized on a percentage ofcompletion method, based on direct labor hours expended. In order to calculatethe completion ratio on a given project, time and effort to date are divided bythe total estimated time and effort for the entire project. This ratio is thenmultiplied by the total fixed fee to be earned on the project, resulting in theamount of revenue earned to date. Revenues attributable to fixed fees were 8%,4% and 10% of consolidated revenue for the years ended December 31, 2006,2005, and 2004, respectively.

Task-based fees are recognized as revenue when thetask is completed or the deliverable is received by the client. Typically,task-based revenue recognition involves the delivery of a report, minutes orsome other evidence of completion. Revenues attributable to task-based feeswere 91%, 96% and 89% of consolidated revenue for the years ended December 31,2006, 2005, and 2004, respectively.

Incentive fees are tied to improvements in a varietyof client performance measures typically involving cycle time, assetutilization and productivity. Incentive fee revenue is recognized in the periodin which the related client improvements are achieved. Our incentive feeagreements with our clients predefine performance improvement standards thatform the basis of our incentive fees earned. Incentive fees are affected by ourclients’ business performance and prevailing economic conditions, both of whichare out of our control, and may cause variability in revenue and profit marginsearned on such engagements. We do not recognize revenue until the client hasagreed that performance improvements have in fact been achieved. Revenuesattributable to incentive fees were 0%, 0% and 1%, for the years ended December 31,2006, 2005, and 2004, respectively. As of April 3, 2007, we had no contractualagreements for incentive fees.

Reimbursement revenue represents the client’srepayment of our mutually agreed upon travel expenses as incurred. All billabletravel expenses are submitted to and approved by the client. Revenuesattributable to reimbursement were 1%, 0% and 1%, for the years ended December 31,2006, 2005, and 2004, respectively.

Cost of sales represents the direct costs involved inproviding services and solutions to our clients. The components include, butare not limited to, direct labor and benefit costs, support costs such as telecommunicationsand computer costs, travel costs and other costs incurred in providing servicesand solutions to our clients.

Selling, general and administrative expenses includethe costs of all labor and other goods and services necessary for our sellingand marketing efforts, human resource support, accounting and finance services,legal and other professional services, facilities and equipment, informationtechnology and telecommunications support and services, and other corporatefunctions. Selling, general and administrative expenses also includedepreciation and amortization on the fixed assets used to support thesefunctions.

In addition, during the last three years, we have usedcash generated from operating activities to eliminate debt incurred in 2001 and2002. We repurchased all of our outstanding warrants in September 2005,and, in December 2005, we instituted our first annual dividend policy,which was 

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subsequently increased to$0.30 per share annually in June 2006 and $0.40 per share annually in December 2006.

Sublease losses and income arise from the subleasecontracts we maintain with subtenants in our Reston, VA and Troy, MI offices.Losses are generally the result of a subtenant defaulting on a lease or at thetermination of a lease in which we anticipate that the future subtenant incomewill not be sufficient to recoup our costs associated with the subleased officespace. Sublease income is recognized generally upon the termination of asublease in which we, as a result of the termination, are able to avoid futureanticipated costs previously recognized as sublease losses.

In addition to ourUnited States operations, we have operations in the Asia/Pacific region.Some of our revenue related transactions are denominated in the local currency wherethe client is located. The majority of our operating expenses for oursubsidiaries are denominated in the local currency of the subsidiary.Therefore, we are exposed to currency fluctuation risks. See Item 7A, “Quantitativeand Qualitative Disclosure About Market Risk.”

**Critical AccountingPolicies and Estimates**

The preparation offinancial statements in conformity with U.S. generally accepted accountingprinciples requires management to make estimates and assumptions that affectthe amounts reported in the accompanying financial statements and relatednotes. Management bases its estimates and assumptions on historical experience,observance of industry trends and various other sources of information andfactors. Actual results could differ from these estimates. Critical accountingpolicies are defined as those that are reflective of significant judgments anduncertainties, and potentially could result in materially different resultsunder different assumptions and conditions.

***Revenue Recognition***

Revenue is recognized whenrealizable and earned generally as services and solutions are provided over thelife of a contract. Fixed fee revenue is recognized using a percentagecompletion method, based on direct labor hours expended. Task-based, ordeliverable-based, fees are recognized when the task or deliverable iscompleted and delivered to the client. Incentive fee revenue is recognized inthe period in which the related improvements are achieved. Our incentive feeagreements with our clients define in advance the performance improvementstandards that will form the basis of our incentive fees earned. We do notrecognize revenue until the client has agreed that performance improvementshave in fact been achieved.

***Unbilled Receivables***

Although fixed fee revenuerecognition generally coincides with billings, as an accommodation to ourclients, we may structure fee billings to increase in the latter stages of aprogram. In such instances, amounts collectible for services and solutionsprovided but not yet billed are represented in unbilled receivables.

***Deferred Taxes***

Income taxes are calculated using the asset andliability method required by FASB Statement No. 109, “Accounting forIncome Taxes.” Deferred income taxes are recognized for the tax consequencesresulting from timing differences by applying enacted statutory tax ratesapplicable to future years. These timing differences are associated withdifferences between the financial and the tax basis of existing assets andliabilities. Under FAS No. 109, a statutory change in tax rates will berecognized immediately in deferred taxes and income. Net deferred taxes arerecorded both as a current deferred income tax asset and as other long-termliabilities based upon the classification of the related timing difference. Avaluation allowance is 

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recognized if, based onthe weight of available evidence, it is more likely than not that some portionor all of a deferred tax asset will not be realized. All available evidence,both positive and negative, is considered when determining the need for avaluation allowance. Judgment is used in considering the relative impact ofnegative and positive evidence. The weight given to the potential effect ofnegative and positive evidence is commensurate with the extent to which it canbe objectively verified. In accordance with Statement of Financial AccountingStandards No. 109, *Accounting forIncome Taxes,*evidence, such as operating results during the mostrecent three-year period, is given more weight than our expectations of futureprofitability, which are inherently uncertain.

In addition to timing differences arising fromoperating assets and liabilities, we also record deferred tax assets for thetax benefits of net operating losses and foreign tax credits. For United Statesfederal tax purposes, at December 31, 2002, we had net operating loss (“NOL”)carryovers of approximately $4.2 million. Under the Section 382limitation, discussed below, $0.7 million was used to offset United Statestaxable income in 2003. In 2004, $0.2 million expired under Section 382,but an $8.1 million in United States net operating loss was generated,resulting in a balance of $11.4 million at December 31, 2004. In2005, we used $8.1 million of the net operating loss to offset UnitedStates taxable income and used $0.2 million of the net operating losscarryforward limited under Section 382, resulting in a net operating losscarryforward balance of $3.1 million at December 31, 2005. In2006,  we used $0.2 million of the netoperating loss carryforward balance of $2.9 million at December 31, 2006. Wehad unused foreign tax credit carryovers of $0.8 million, on December 31,2002. These credits were converted to deductions and amended returns were filedfor the appropriate years, leaving approximately $3,000 in foreign tax creditswhich were utilized in 2005. In Asia, we used our remaining $0.7 millionof net operating loss carryovers to offset taxable income in 2004.

In assessing the realizability of deferred tax assets,we considered whether it is more likely than not that some portion or all ofthe deferred tax assets will not be realized. Due to the uncertainty of ourability to utilize our net deferred tax assets, primarily due to the Section 382limitation discussed above, we provided a valuation allowance of $1.4 millionagainst net deferred tax assets of $1.4 million, leaving a net deferred taxasset of approximately $33,000 at September 30, 2006. At December 31,2006, after further evaluation of operating results of the most recentthree-year period and comparison of all positive and negative evidence, wedetermined that a valuation allowance was only appropriate on approximately$117,000 of the NOL carryforward, due to annual limitations under Section 382.Therefore, we removed $1.5 million of the valuation allowance, which decreasedincome tax expense and increased assets.

If future analyses of thepositive and negative evidence indicates that it is more likely than not thatsome portion or all of the net deferred tax asset will not be realized, a partialor full valuation allowance may be required, which could have a negative on netincome in the period that it becomes more likely than not that deferred taxassets will not be realized.

***Accumulated Other Comprehensive Loss***

Translation of thefinancial statements of our operations in Europe and Asia resulted inaccumulated translation adjustments of approximately $682,000 at December 31,2004 that was required to be carried on the balance sheet as a separatecomponent of stockholders’ equity. During 2005, we liquidated our subsidiariesin Switzerland resulting in a reclassification of a $713,000 accumulated othercomprehensive loss to the income statement. The remaining gain of $31,000relates to our subsidiary in Hong Kong which is currently under liquidation.Upon substantially complete liquidation of our investment in our Hong Kongsubsidiary, $31,000 will be reclassified as a non-cash gain included inoperations for the year then ended.

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**Review of StockOption Grant Practices**

As previously announced on February 2, 2007, ourBoard of Directors, with concurrence and oversight by our Audit Committee,which is comprised solely of independent directors, initiated a review of ourhistorical stock option practices and related accounting during the period 1988to 2006. This voluntary review was initiated in connection with our assessmentof our historical capitalization documentation and not in response to anyspecific concerns from within Thomas Group about option practices or anyinquiry from the Securities and Exchange Commission or any other regulatoryagency. The review was conducted with the assistance of our outside legalcounsel and specially-retained forensic accountants. Based on the preliminaryfindings of this review, on March 15, 2007, our Board of Directors, AuditCommittee and management concluded that we would need to restate our financialstatements and related footnote disclosures for fiscal years ending December 31,2002 through 2005 and the first three quarters of the 2006 fiscal year. The AuditCommittee and the Board of Directors further concluded on March 15, 2007that our previously issued financial statements and related auditors’ reportsfor the years 2002 through 2005, and previously issued financial statements forthe first three quarters of 2006, should no longer be relied upon.

The investigation has now been completed and our Boardof Directors received a report on the results of that investigation on March 30,2007, from our outside counsel and specially-retained forensic accountants. Atthat time, such counsel and accountants also submitted recommendations for proposed remedial measures to theBoard, which are outlined below. Those proposals did not include any remedialmeasures pertaining to our directors or senior management team. Except as notedbelow, those recommendations are now being reviewed by the Board for possibleimplementation. After consideration of the report, the Board affirmed itsconfidence in our senior management team and their continued ability to signcertifications with respect to our periodic SEC reports and our financialstatements. We have self reported the internal investigation and therestatement to the Securities and Exchange Commission and intend to cooperatewith any informational or other requests from the SEC.

During the course of the investigation, theinvestigation team reviewed available electronic and hard copy documentationand conducted interviews of selected current and former officers, directors andemployees.

The following background pertaining to our historicalstock option grant practices was confirmed through the investigation.

From our initial public offering in August 1993to January 2003, our historical stock option granting process hasgenerally reflected a lack of either Board or Compensation Committeeauthorization for specific option grants, although a few instances exist whereour Board or Compensation Committee took appropriate granting action underDelaware law and our option plans. Instead, from August 1993 to January 2003,we ran a CEO-centric option granting process with additional participation bythe President from time to time and with minimal oversight by either our Boardor Compensation Committee—particularly with respect to grants to rank and fileemployees. Our current and former Board members who were interviewed generallyrecalled periodic discussions concerning option grants to senior executives anddirectors, but, except for the instances noted above, there is a general lackof confirmatory written evidence in our records that would evidence thesediscussions. We last issued stock options in January 2003.

Our CEOs and/or Presidents through January 2003thought they had the apparent authority to grant options. Although theinvestigation discovered 1992 Board resolutions purporting to delegateauthority to the CEO and President to grant stock options, it does not appearfrom the investigation that the CEOs and/or Presidents acted pursuant to suchdelegation but instead acted based on their perceived apparent authorityresulting from their positions as senior officers of Thomas Group.

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During the review period, we granted options under thefollowing circumstances: (i) grants to new employees at or near startdates; (ii) grants as part of an annual review process; (iii) grantsto employees on their fifth and tenth year anniversaries; (iv) grants thatwere awarded to a key group of officers and employees; (v) grants made inconnection with business developed through the Company’s CEO center; (vi) periodicgrants to directors for Board service; and (vii) grants made periodicallyto employees for other reasons. Documents identified pursuant to which CEOsprior to 2003 made option grants include notices of grant awards, stock optionagreements, memos, notes and emails directing employees to document thegranting of stock options.

Based on our historical process deficiencies notedabove, we have concluded that we will be required to adjust the accountingmeasurement dates for certain of our stock option grants as more fullydiscussed below. In addition to the process deficiencies noted above thatallowed grants to be made without proper stock option plan or Delawarestatutory approval, our investigation also identified some evidence that could beconstrued as manipulative for certain option grants and option exercises,including the following:(i) evidence of possible rearward selection ofcertain grant dates and exercise prices, including due to administrative delaysin initiation and/or finalization of stock option terms; (ii) the use ofan incorrect calculation to determine exercise prices under two of our stockoption plans; (iii) evidence of the extension of expiration dates ofcertain stock option grants not properly accounted for; (iv) evidence thata limited number of rank and file employees were allowed to exercise optionsafter expiration dates and (v) evidence of the possible rearward selectionof an exercise date in one case. Notwithstanding the foregoing, theinvestigation team concluded that the totality of the information obtained andreviewed does not indicate that (i) stock option grants were intentionallyback-dated on a widespread basis in order to obtain more favorable pricing fordirectors, officers or employees or (ii) option exercises wereintentionally manipulated on a widespread basis. The investigation team alsoconcluded that our internal control over financial reporting and our legalprocesses in connection with stock option grants and exercises have beenineffective.

In connection with the investigation, theinvestigation team has made the following recommendations with respect toproposed remedial measures: (i) establish modified accounting measurementdates for option grants not properly authorized by either Board or CompensationCommittee resolutions, which we did in connection with the restatement; (ii) inorder to correct the lack of complete legal documentation, adopt resolutionsratifying all prior option grants that may not have been previously authorizedby specific Board or Compensation Committee resolutions, which resolutions wereadopted by the Board on March 30, 2007; (iii) adopt and document aneffective system of internal control over financial reporting that govern ourstock option granting and/or other equity award processes; and (iv) adoptwritten equity granting practices and procedures that provide for option grantsor other equity awards only by our Compensation Committee, consisting ofoutside independent directors, and that equity awards be made only on aquarterly basis during a meeting of the Compensation Committee.

Based upon the results of the investigation, we havedetermined that we will establish an accounting measurement date for each grantin accordance with the earliest evidence that the recipient of the grant aswell as the number of shares subject to such award were set with finality asdescribed in more detail below. We have also concluded that, on balance, ourprocess deficiencies and lack of historical documentation of certain stockoption grants should not preclude us from concluding, from an accountingperspective, that such options had been properly granted or that such stockoptions should be accounted for on a date other than the purported date ofgrant reflected in our stock option administration software. For stock optiongrants that were not otherwise evidenced by specific Board or CompensationCommittee action, we have determined that it is appropriate to rely uponancillary documentation that was found in our files and records, when suchdocumentation confirms stock options had been granted.This conclusion issupported by Hein & Associates, our independent public accountingfirm. This conclusion is also supported by the SEC’s published September 2006guidance, which generally indicates that the accounting for stock options 

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may depend on the factsand circumstances surrounding a company’s stock option grant practices whendefinitive documentation is not available.

In conducting thereview of our stock option practices, the investigation team reviewed allavailable documentation, including but not limited to corporate minute books,Board of Directors’ packages, employment offer letters, employment agreements,notices of stock option grants, stock option agreements and personnel files. Wehave focused on the identified documentation and other evidence that maysupport a determination that a stock option grant was awarded with finality,even if such documentation is not sufficient to otherwise support a conclusionthat all necessary legal steps have been taken to authorize such an award. Inparticular, we have focused on correspondence or agreements with employees thatindicate the employees knew stock option awards were outstanding. We have alsorelied upon internal documents that indicate we recognized the awards wereoutstanding. Where ancillary documentation exists for a stock option grant andis dated, we have determined to use the date of earliest supportingdocumentation in establishing a revised measurement date. We have used the followingdocuments in establishing revised measurement dates:

·       Offerletters

·       Noticesof grant awards

·       Section 16filings

·       Stockoption grant lists

·       Companyworksheets prepared to support earnings per share calculations

·       Othercorrespondence to employees recognizing existence of outstanding stock optiongrants

·       Directorand officer questionnaires listing outstanding stock option grants

In connection with the investigation, our Board ofDirectors, with the approval of our Audit Committee, has determined that thecumulative non-cash stock-based compensation expense adjustment was materialand that our consolidated financial statements for each of the first threequarters of fiscal year ended December 31, 2006, each of the quarters inthe fiscal year ended December 31, 2005 and the fiscal years ended December 31,2005 and 2004 as well as the selected consolidated financial data for thefiscal years ended December 31, 2003 and 2002 should be restated to recordadditional stock-based compensation expense resulting from stock optionsgranted during 1993 to 2003 that were incorrectly accounted for under GAAP, andrelated income tax effects.

We also analyzed the impact of our investigationrelated to Internal Revenue Code Section 162(m), which provides for a $1million tax deduction cap on compensation awarded to certain top executivesthat is not considered performance-based. After completing our analysis, wedetermined that Section 162(m) may apply to option exercises in 2006for 180,649 shares held by James T. Taylor, our CEO, which, when combined withother applicable employee remuneration, will be limited to a tax deduction of$1 million in 2006. We estimate the non-deductible amount for 2006 to beapproximately $654,000, which will result in increased taxes of approximately$241,000.

Wehave determined that the cumulative, pre-tax, non-cash stock-based compensationexpense resulting from revised measurement dates was approximately$2.1 million during the period from our initial public offering in August 1993through December 31, 2006. The adjustments relate to options coveringapproximately 1.9 million shares. We recorded additional stock-basedcompensation expense of $5,532, $48,567 and $53,722 for the fiscal yearsended December 31, 2006, 2005 and 2004, respectively, and$2.0 million for fiscal years ending prior to fiscal 2002. Previouslyreported total revenues were not impacted by our restatement. The table belowreflects the cumulative effect on our stockholders’ equity 

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during the period from our initial public offering in August 1993through December 31, 2006 (in thousands):

| Decrease in  cumulative net income and retained earnings:                  |   |   |   |   |   |
|----------------------------------------------------------------------------|--------|--------|--------|--------|--------|
| Stock-based  compensation expense                                          |   | $      | (2,119 | )      |   |   |
| Estimated tax  related penalties and interest on underpayment deficiencies |   | (101   | )      |   |   |
| Decrease in  pretax profit                                                 |   | (2,220 | )      |   |   |
| Income tax  benefit, net                                                   |   | 111    |   |   |   |
| Decrease in  cumulative net income and retained earnings                   |   |   |   | $      | (2,109 | ) |
| Increase to additional paid-in capital:                                    |   |   |   |   |   |
| Stock-based  compensation expense                                          |   | 2,119  |   |   |   |
| Increase in  additional paid-in capital                                    |   |   |   | 2,119  |   |
| Increase in  stockholders’ equity at December 31, 2006           |   |   |   | $      | 10     |   |
|                                                                            |        |        |        |        |        |  |  |

 

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Thetable below reflects the breakdown by year of the cumulative adjustment toretained earnings. Our consolidated financial statements included in previouslyfiled periodic reports with the SEC for such periods have not been amended. Theconsolidated financial statements included in this Annual Report on Form 10-Khave been restated.(in thousands)

| ** **                                   | ** ** | ** ** | ** ** | **Stock-based  compensation  expense** | ** ** | **Estimated taxes,  Interest and  penalties(1)** | ** ** | **Income  tax  benefit,  net** | ** ** | **Total  adjustments** | ** ** | ** ** | ** ** |
|----------------------------------------------|------------|------------|------------|----------------------------------------|------------|------------------------------------------------------------|------------|--------------------------------|------------|------------------------|------------|------------|------------|
| Years ended December 31,                |       |       |       |                                   |       |                                                       |       |                           |       |                   |       |       |       |   |   |   |   |   |   |   |   |   |   |   |   |
| 1993                                         |       |       |       |                                   |       |                                                       | $          | (84                            | )          |                   |       | $          | —     |   |   |   | $ | — |   |   |   | $ | (84 | ) |   |   |   |   |   |
| 1994                                         |       |       |       |                                   |       |                                                       | (187       | )                              |       |                   | —     |       |       |   | — |   |   |   | (187 | ) |   |   |   |   |   |
| 1995                                         |       |       |       |                                   |       |                                                       | (362       | )                              |       |                   | —     |       |       |   | — |   |   |   | (362 | ) |   |   |   |   |   |
| 1996                                         |       |       |       |                                   |       |                                                       | (196       | )                              |       |                   | —     |       |       |   | — |   |   |   | (196 | ) |   |   |   |   |   |
| 1997                                         |       |       |       |                                   |       |                                                       | (312       | )                              |       |                   | —     |       |       |   | — |   |   |   | (312 | ) |   |   |   |   |   |
| 1998                                         |       |       |       |                                   |       |                                                       | (29        | )                              |       |                   | —     |       |       |   | — |   |   |   | (29 | ) |   |   |   |   |   |
| 1999                                         |       |       |       |                                   |       |                                                       | (225       | )                              |       |                   | —     |       |       |   | — |   |   |   | (225 | ) |   |   |   |   |   |
| 2000                                         |       |       |       |                                   |       |                                                       | (170       | )                              |       |                   | —     |       |       |   | — |   |   |   | (170 | ) |   |   |   |   |   |
| Cumulative effect at  December 31, 2001 |       |       |       |                                   |       |                                                       | (1,891     | )                              |       |                   | —     |       |       |   | — |   |   |   | (1,891 | ) |   |   |   |   |   |
|                                              |            |            |            |                                        |            |                                                            |            |                                |            |                        |            |            |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

| ** **                                   | ** ** | **Net  income (loss)  As reported** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | **Net  income (loss)  As restated** | ** ** |
|----------------------------------------------|------------|-----------------------------------------------|------------|------------|------------|------------|------------|------------|------------|------------|------------|-----------------------------------------------|------------|
| Years ended  December 31,               |       |                                          |       |       |       |       |       |       |       |       |       |                                          |       |   |   |   |   |   |   |   |   |   |   |   |   |
| 2002                                         |       |                                          | $          | (7,718     | )          |       |       | (49        | )          |       |       | —                                        |       |   |   | 11 |   |   |   | (38 | ) |   |   | $ | (7,756 | ) |   |
| 2003                                         |       |                                          | $          | 712        |       |       |       | (71        | )          |       |       | —                                        |       |   |   | 26 |   |   |   | (45 | ) |   |   | $ | 667 |   |   |
| 2004                                         |       |                                          | $          | 1,475      |       |       |       | (54        | )          |       |       | —                                        |       |   |   | 20 |   |   |   | (34 | ) |   |   | $ | 1,441 |   |   |
| 2005                                         |       |                                          | $          | 6,752      |       |       |       | (49        | )          |       |       | —                                        |       |   |   | 20 |   |   |   | (29 | ) |   |   | $ | 6,723 |   |   |
| 2006                                         |       |                                          |       |       |       |       | (5         | )          |       |       | (101       | )                                             |       |   | 34 |   |   |   | (72 | ) |   |   |   |   |   |
| Cumulative effect  at December 31, 2006 |       |                                          |       |       |       |       | $          | (2,119     | )          |       |       | $                                             | (101       | ) |   |   | $ | 111 |   |   |   | $ | (2,109 | ) |   |   |   |   |   |
|                                              |            |                                               |            |            |            |            |            |            |            |            |            |                                               |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

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(1)          Estimatedtaxes, interest and penalties on stock options for which a revised measurementdate resulted in a non-qualified, or discounted stock option.

In connection with the restatement of our consolidatedfinancial statements discussed above, we assessed the impact of the findings ofour internal investigation into our historical stock option grant practices andother tax matters on our reported income tax benefits and deductions, includingincome tax deductions previously taken for cash and stock-based executivecompensation under the provisions of Section 162(m). In connection withthat assessment, we determined that no adjustments were required to our (i) incometax expense previously reported in our Consolidated Statements of Income; (ii) taxbenefits on stock option exercises previously reported in our ConsolidatedStatements of Cash Flows and Consolidated Statement of Changes in Stockholders’Equity or (iii) deferred tax assets previously reported in ourConsolidated Balance Sheets.

We have recorded $101,230 of income tax benefit in ourConsolidated Statements of Income for the year ended December 31, 2006 andin our Consolidated Balance Sheets at December 31, 2006 to recognizedeferred income tax assets on stock-based compensation relating to unexercisedstock options. This amount is not included in the tables above because it is afourth quarter 2006 estimate, and not part of the restatement.

Section 409A of the Internal Revenue Code (“Section 409A”)provides that option holders with options granted with a below-market exerciseprice, to the extent the options were not vested as of 

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December 31, 2004,may be subject to adverse Federal income tax consequences. Holders of theseoptions will likely be required to recognize taxable income at the date ofvesting for those options vesting after December 31, 2004, rather thanupon exercise, on the difference between the amount of the fair market value ofour common stock on the date of vesting and the exercise price, plus anadditional 20 percent penalty tax and interest on any income tax to bepaid. To the extent this process is available to affected employees, we havedecided to follow the IRS Settlement Offer issued in February 2007 to paypenalty and interest to the IRS on behalf of the employees and potentiallygross-up employees for tax costs. The IRS offer only applies to optionexercises by rank and file employees in 2006.

Certain grants of stockoptions made during the period under investigation were priced below fairmarket value, rather than at fair market value. Consequently, certain grants intendedto be classified as ISOs, requiring pricing at no less than fair market valueon the date of grant, should have been classified as nonqualified stockoptions, or NQs. Given the significant differences in the tax treatment betweenISOs and NQs, we underreported or underwithheld certain payroll taxes for thoseoptions which were exercised during the period through 2006. We have recordedcertain tax liabilities related to these issues in the period of exercise withrelated penalties and interest charged in subsequent periods, except forperiods closed by the statute of limitations where no liability is recorded. Weintend to pursue a negotiated settlement with the IRS as soon as practicable;however, there can be no assurance that we will settle these issues for amountsconsistent with the estimated liabilities we have recorded. In the aggregate,the financial impact of these tax errors was approximately $0.1 million and areincluded in the adjustment.

**Results ofOperations**

Thefollowing sets forth certain operating data as a percentage of revenue for theperiods presented:

| ** **                                                                                           | ** ** | **Percentage of Revenue For Year  Ended December 31,** | ** ** |
|------------------------------------------------------------------------------------------------------|------------|--------------------------------------------------------------------------------------|------------|
| ** **                                                                                           | ** ** | **2006**                                                                             | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                                                                                           | ** ** | ** **                                                                           | ** ** | **(Restated)** | ** ** | **(Restated)** | ** ** |
| Revenue                                                                                              |       | 100.0                                                                                | %          |   | 100.0 | % |   |   | 100.0 | % |   |
| Cost of sales                                                                                        |       | 47.0                                                                                 | %          |   | 47.9 | % |   |   | 50.0 | % |   |
| Gross profit                                                                                         |       | 53.0                                                                                 | %          |   | 52.1 | % |   |   | 50.0 | % |   |
| Selling, general  and administrative                                                                 |       | 27.9                                                                                 | %          |   | 32.9 | % |   |   | 41.4 | % |   |
| Operating income                                                                                     |       | 25.1                                                                                 | %          |   | 19.2 | % |   |   | 8.6 | % |   |
| Interest income  (expense), net                                                                      |       | 0.6                                                                                  | %          |   | (0.2 | )% |   |   | (0.9 | )% |   |
| Other income, net                                                                                    |       | —                                                                               |       |   | 0.2 | % |   |   | — |   |   |
| Income from  continuing operations before income taxes                                               |       | 25.7                                                                                 | %          |   | 19.2 | % |   |   | 7.7 | % |   |
| Income taxes  (benefit)                                                                              |       | 6.4                                                                                  | %          |   | 0.8 | % |   |   | (0.1 | )% |   |
| Income from  continuing operations before the cumulative effect of a change in accounting  principle |       | 19.3                                                                                 | %          |   | 18.4 | % |   |   | 7.8 | % |   |
| Loss on discontinued  operations, net of tax                                                         |       | —                                                                               |       |   | 2.8 | % |   |   | 3.0 | % |   |
| Income before  cumulative effect of a change in accounting principle, net of tax                     |       | 19.3                                                                                 | %          |   | 15.6 | % |   |   | 4.8 | % |   |
| Cumulative effect  of a change in accounting principle, net of tax                                   |       | —                                                                               |       |   | 0.0 | % |   |   | — |   |   |
| Net income                                                                                           |       | 19.3                                                                                 | %          |   | 15.6 | % |   |   | 4.8 | % |   |

 

***Years Ended December 31, 2006 and 2005***

*Revenue*

Total revenue increased $16.4 million, or 38%, to$59.5 million in 2006, from $43.1 million in 2005. The increase inrevenue is primarily attributable to our efforts in securing additionalcontracts for services with current and previous customers. Typically, ourinitial customer engagement consists of a paid 

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assessment followed by alonger, more extensive program. During 2005, we completed 4 assessments leadingto longer term programs in 2006, benefiting both revenue and gross margins in2006. Additionally, we completed 4 assessments in 2006 that led to additionalassessments or programs starting within 2006. During 2006, we recorded revenueson 36 assessments and programs from 17 different customers compared to 22assessments and programs with 12 different customers during 2005. There were 5 assessmentscompleted or started in 2006 that, as of December 31, 2006, had not yetled to a subsequent assessment or program.

Fixed fee revenues increased $3.0 million, or 176%, to$4.6 million, or 8% of revenue, in 2005 from to $1.6 million, or 4%of revenue, in 2005. The increase in fixed fee revenues is attributable to therise in the number of active commercial contracts. During 2006, we derivedfixed fee revenues from 19 assessments and programs from 12 differentcustomers, versus 9 programs and assessments from 8 different customers in2005. In 2006, we recorded fixed fee revenues from 3 customers with multipleengagements, versus 1 customer with multiple engagements in 2005.

Task based revenues increased $13.0 million, or31%, to $54.3 million, or 91% of revenue, in 2006, from$41.3 million, or 96% of revenue, in 2005. The increase in task basedrevenues relates primarily to the number of active programs with theUnited States government. During 2006, we derived task based revenues on17 assessments and programs from 5 customers, versus 13 assessments andprograms from 3 customers in 2005. In 2006 and 2005, we had multipleengagements with each of our task based customers.

Incentive fee revenue was $0, or 0%, of revenue in2006, compared to $0.1 million, or 0% of revenue, in 2005. Although wecontinue to offer a portion of our fees contingent on performance basedmetrics, our more recent customers have preferred fixed fee arrangements.

Reimbursement revenues increased $0.5 million, 400%,to $0.6 million, or 1% of revenues, from $0.1 million, or 0%, in 2005. Theincrease in the number of commercial contracts is also solely responsible for theincrease in reimbursement revenues.

North America region revenue increased$16.3 million, or 38%, to $59.4 million in 2006, from$43.0 million in 2005. Revenues from United States governmentcontracts increased $13.0 million, or 31%, to $54.3 million from$41.3 million in 2005. Revenues from contracts with commercial clients inthe United States increased $3.4 million, or 200%, to $5.1 millionfrom $1.7 million in 2005.

Our Europe region generated no revenue in 2006 or2005. We have no significant continuing involvement in our former Europeoperations and all prior activity is included in discontinued operations.

Our Asia/Pacific regionrevenue increased to $71,000 in 2006 from $29,000 in 2005. The increase is dueto training programs initiated in the first quarter of 2006 and an assessmentwith one customer completed over the second and third quarters of 2006,compared to no revenue from training classes and incentive fees finalized fromone customer in 2005. We currently retain limited sales and marketingoperations in Asia.

*Gross Profit*

Gross profit for 2006increased $9.1 million to $31.5 million, or 53% of revenue, from$22.4 million, or 52% of revenue, in 2005. Costs of sales consists ofdirect labor, travel, and other direct costs incurred by our Resultants toprovide services to our clients and to complete client related projects,including training. The improvement in gross profit margin is primarilyattributable to a higher ratio of fixed fee and task based programs toassessments completed, the consolidation of several large task based programsresulting in higher utilization of our Resultants assigned to these programs,and our ability to match our hiring pace with the resource needs of ourassessments and programs. At December 31, 2006, we had 118 full and parttime Resultants and 3 active contractors serving on active assessments andprograms for our clients compared to 114 full and part time Resultants and 3contractors at December 31, 2005.

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*Selling, Generaland Administrative*

Selling, general andadministrative expense for 2006 increased $3.1 million, or 23%, to$16.6 million from $13.5 million in 2005. The increase iscomprised  primarily of $1.2 millionin stock based compensation costs, $0.4 million in sales commissions andincentive compensation, $0.5 million related to staffing levels in supportfunctions necessary to accommodate our growth, $0.2 million in advertising andmarketing related activities, $0.2 million in office and equipment rental, and$0.6 in legal costs.

*Sublease Losses*

During June 2006, we terminated a portion of ourTroy, Michigan office lease and our related sublease agreement resulting in again of $16,000. As of December 31, 2006, the remaining sublease lossliability was approximately $96,000 and consisted entirely of amounts relatedto our Reston, Virginia sublease.

During the first quarterof 2005, we recorded a $0.6 million charge relating to subleasing excessoffice capacity in Reston, Virginia, at market rates. The charge is based onthe shortfall between future sublease income and costs expected to be incurredunder our leases with our landlords. This action accounted for$0.6 million, or $0.06 per diluted share for the year ended December 31,2005 (See the accompanying Note 11 of the Consolidated FinancialStatements included herein).

*DiscontinuedOperations*

In 2005, we disposed ofour operations in Switzerland. Although we maintained only minimal S,G&Acosts in Switzerland, the operations had not produced significant revenue fortwo years. It was determined the cost of maintaining an office was no longerprudent, and the operations were disposed of by filing for insolvency with theSwiss insolvency court. During the fourth quarter of 2005, we determined theliquidation of our investment in our Swiss entity was substantially complete,triggering the non-cash reclassification of $713,000 in accumulated translationloss adjustments to the income statement. These adjustments represent foreigncurrency losses incurred prior to 2001, which were required to be reported as aseparate component of stockholders’ equity titled “Accumulated othercomprehensive loss”. This reclassification had no effect on equity for 2005 asthe amount was previously recorded as a direct reduction of equity. Thepresentation of all periods reflect the Swiss operations as discontinuedoperations. For the year 2005, the effect of the discontinued Swiss operationwas $1.2 million, net of tax, or $0.12 per diluted share, compared to$0.9 million, net of tax, or $0.08 per diluted share, for the year 2004(See the accompanying Note 2 of the Consolidated Financial Statementsincluded herein).

*Income Taxes*

During 2006, we recorded income tax expense of$3.9 million compared to $0.3 million during 2005. Our effective taxrate for 2006 was 25%, compared to 4% in 2005. The increase in tax expense andresulting effective rate is due primarily to the utilization of significantNOLs outstanding during 2005 no longer available in 2006, offset by certainreductions in our deferred tax asset valuation allowance.

At December 31, 2001, we determined, basedprimarily on our recent history of operating losses in the United States,that we could no longer consider the recovery of our net deferred tax assets asmore likely than not. Accordingly, our net deferred tax assets were reduced bya valuation allowance adjustment. While a valuation allowance was required forour net deferred tax assets, as discussed below, the assets remained availablefor use in the future, subject to the limitations described above, to offset futureincome tax liabilities should sufficient amounts of United States andforeign income be generated in the carryforward period.

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Beginning in 2001, we had provided a valuationallowance for the full amount of the net deferred tax assets. During the threemonths ended March 31, 2006, we determined that future sources of taxableincome, the reversing of temporary differences and other tax planningstrategies will be sufficient to realize certain components of our deferred taxasset. Therefore, approximately $0.3 million of the deferred tax assetvaluation allowance was removed during the three months ended March 31,2006. There were no reductions in the deferred tax asset valuation allowancefor the three months periods ended June 30, 2006, September 30, 2006.At December 31, 2006, after furtherevaluation of operating results of the most recent three-year period andcomparison of all positive and negative evidence, we determined that avaluation allowance was only appropriate on approximately $117,000 of the NOLcarryforward, due to annual limitations under Section 382. Therefore, weremoved $1.5 million of the valuation allowance during the three months endedDecember 31, 2006.

Although our statutory tax rate is approximately 38%,our removal of this portion of our deferred tax asset valuation allowancereduced income tax expense in the first and fourth quarters of 2006 resultingin an effective tax rate of 28% for the quarter ended March 31, 2006, 0%for the quarter ended December 31, 2006 and 26% for the year ended December 31,2006.

We continue to provide avaluation allowance of approximately $117,000 against our net deferred taxassets against net operating loss carryforwards subject to annual limitationunder Section 382 of the Internal Revenue Code of 1986, as amended. Whilethe factors listed above were considered in assessing the sufficiency of avaluation allowance, there is no assurance an adjustment to the valuationallowance would not need to be made in the future if information about futureyears change. Any change in the valuation allowance would impact our income taxprovision and net income in the period in which such a determination is made.

***Years Ended December 31, 2005 and 2004***

*Revenue*

Total revenue increased $13.1 million, or 44%, to$43.1 million in 2005, from $30.0 million in 2004. Typically, ourinitial customer engagement consists of an initial paid assessment followed bya longer, more extensive program. The increase in fixed fee revenue in 2005primarily relates to approximately 7 programs and extensions signed with theUnited States government and one commercial program in the third andfourth quarter of 2004. These contracts were signed and started in 2004 andextended in 2005, thus contributing to the revenue growth in the 2004 and 2005.We also completed 2 assessments during 2004 that led to higher revenue programsin 2005.

Fixed fee revenues decreased $0.5 million, or 24%, to$1.6 million from $2.1 million in 2004. The decrease in revenue is attributableto the decrease in the number of active commercial contracts. During 2005, wederived fixed fee revenues on 9 programs and assessments from 8 differentcustomers in 2005, versus revenues on 19 assessments and programs from 13different customers in 2004. In 2005, we recorded revenue from 1 customer withmultiple engagements, versus 4 customers with multiple engagements in 2004.

Task based revenues increased $14.5 million, or 54%,to $41.3 million in 2005 from $26.8 million in 2004. During 2005, we derivedtask based revenues on 13 assessments and programs from 3 customers, versus 11assessments and programs from 3 customers in 2004. In 2005 and 2004, we hadmultiple engagements with each of our task based customers.

Incentive fee revenue was $0.1 million, or 0.5%of revenue, in 2005, compared to $0.3 million, or 1% of revenue, in 2004.Although we continue to offer a portion of our fees contingent on performance basedmetrics, our more recent customers have preferred fixed fee arrangements. Incentiverevenues during 2005 and 2004 were derived from one customer.

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Reimbursements were $0.1 million, or 0.5% ofrevenue, in 2005, compared to $0.1 million, or 0.5% of revenue, in 2004.The increase in the number of commercial contracts is solely responsible foryear-over-year fluctuations in reimbursement revenues.

North America region revenue increased$14.1 million, or 48%, to $43.0 million in 2005, from$28.9 million in 2004. United States government contracts increased$14.5 million, or 54%, to $41.3 million from $26.8 million in2004. Contracts from commercial clients in the United States and Canadadecreased $0.4 million, or 19%, to $1.7 million from$2.1 million in 2004.

Europe region revenue is included in discontinuedoperations and decreased $10,000 or 100%, to $0 from $10,000 in 2004. We haveno significant continuing involvement in our former operations in Europe.

Asia/Pacific regionrevenue decreased $1.1 million, or 99%, to $29,000 in 2005, from$1.1 million in 2004. The decrease is attributable to the completion ofprograms in 2004 that were not renewed or replaced in 2005.

*Gross Profit*

Gross profit for 2005increased to $22.4 million and 52% of revenue, from $15.0 million and50% of revenue in 2004. The improvement in gross profit is attributableprimarily to increased revenue, maintaining full utilization of our directlabor and strict control over costs.

*Selling, Generaland Administrative*

Selling, general and administrativeexpense for 2005 increased $1.1 million, or 9%, to $13.5 million from$12.4 million in 2004. The increase is composed primarily of a$0.5 million increase in selling costs and a $0.6 million increase instock-based compensation expense attributable to the increase in thevalue of our stock during the year.

*Sublease Losses*

During the first quarterof 2005, we recorded a $0.6 million charge relating to subleasing excessoffice capacity, at market rates. The charge is based on the shortfall betweenfuture sublease income and costs expected to be incurred under our leases withour landlords. This action accounted for $0.6 million, or $0.06 perdiluted share for the year ended December 31, 2005 (See theaccompanying Note 11 of the Consolidated Financial Statements includedherein).

*DiscontinuedOperations*

In 2005, we disposed ofour operations in Switzerland. Although we maintained only minimal selling,general and administrative costs in Switzerland, the operations had notproduced significant revenue for two years. It was determined the cost ofmaintaining an office was no longer prudent, and the operations were disposedof by filing for insolvency with the Swiss insolvency court. During the fourthquarter of 2005, we determined the liquidation of our investment in our Swissentity was substantially complete, triggering the non-cash reclassification of$713,000 in accumulated translation loss adjustments to the income statement.These adjustments represent foreign currency losses incurred prior to 2001,which were required to be reported as a separate component of stockholders’equity titled “Accumulated other comprehensive loss”. This reclassification hadno effect on equity for the quarter or for the year as the amount waspreviously recorded as a direct reduction of equity. The presentation of allprior periods is revised to reflect the Swiss operations as discontinuedoperations. For the year 2005, the effect of the discontinued Swiss operationwas $1.2 million, net of tax, or $0.12 per diluted share, compared to$0.9 million, net of tax, or $0.08 per diluted share, for the year 2004(See the accompanying Note 2 of the Consolidated Financial Statementsincluded herein).

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*Cumulative Effectof a Change in Accounting Principle*

We adopted FASB Statement No. 123(R),“Share-based Payments” on October 1, 2005. FAS No. 123(R) whicheliminates the ability to account for stock-based compensation using theintrinsic value provisions of Accounting Principles Board Opinion No. 25and instead requires such compensation to be valued using a fair-value-basedmethod. We applied FAS No. 123(R) using the Modified ProspectiveApplication method. Under this method, compensation cost is recognized on orafter the adoption date for the portion of the outstanding equity and liabilityawards for which the requisite service has not yet been rendered. The fairvalue of certain liability awards are required to be adjusted to fair value atthe date of adoption, and such adjustment is to be recognized in the incomestatement, net of any related tax effect, as a cumulative effect of a change inaccounting principle. The adjustment to the liability awards was recorded inthe fourth quarter of 2005 as a cumulative effect of a change in accountingprinciple and totaled $10,000, net of tax (See the accompanyingNote 1(c) of the Consolidated Financial Statements).

*Income Taxes*

Our effective tax rate for 2005 was 4%, compared to 3%in 2004. The change in our effective tax rate is related primarily to taxrefunds received in 2004 that did not recur in 2005. The refunds are the resultof converting foreign tax credits to deductions prior to their expiration, andfiling amended tax returns to obtain the refunds.

At December 31, 2001, we determined, basedprimarily on our recent history of operating losses in the United States,that we could no longer consider the recovery of our net deferred tax assets asmore likely than not. Accordingly, our net deferred tax assets were reduced bya valuation allowance adjustment. While a valuation allowance was required forour net deferred tax assets, as discussed above, the assets remained availablefor use in the future, subject to the limitations described above, to offsetfuture income tax liabilities should sufficient amounts of United Statesand foreign income be generated in the carryforward period.

Consistent with ourposition beginning December 31, 2001, we recorded no income tax expensefor income offset by NOL carryforwards previously subject to valuation reserve.

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***Quarterly Results***

The following table setsforth certain unaudited operating results for each of the four quarters in thetwo years ended December 31, 2006. This information has been prepared onthe same basis as the audited financial statements and, in the opinion of theCompany, includes all adjustments (consisting of normal recurring adjustments)necessary for a fair presentation of the information for the periods presented.

| ** **                  | ** ** | **2006**                                                    | ** ** | **2005**                                      | ** ** |
|-----------------------------|------------|-------------------------------------------------------------|------------|-----------------------------------------------|------------|
| ** **                  | ** ** | **For the Three Months Ended**               | ** ** | **For the Three Months Ended** | ** ** |
| ** **                  | ** ** | **Mar. 31**                                            | ** ** | **June 30**                              | ** ** | **Sept. 30** | ** ** | **Dec. 31** | ** ** | **Mar. 31** | ** ** | **June 30** | ** ** | **Sept. 30** | ** ** | **Dec. 31** | ** ** |
| ** **                  | ** ** | **(Restated)**                                              | ** ** | **(Restated)**                                | ** ** | **(Restated)** | ** ** | ** ** | ** ** | **(Restated)** | ** ** | **(Restated)** | ** ** | **(Restated)** | ** ** | **(Restated)** | ** ** |
| ** **                  | ** ** | **In thousands, except per share data** | ** ** |
| Revenue                     |       |                                                        | $          | 13,296                                        |       |   |   | $ | 15,570 |   |   |   | $ | 15,859 |   |   | $ | 14,753 |   |   | $ | 7,908 |   |   |   | $ | 11,668 |   |   |   | $ | 11,786 |   |   |   | $ | 11,700 |   |   |
| Gross profit                |       |                                                        | 6,398      |                                          |       |   | 8,428 |   |   |   | 8,732 |   |   | 7,949 |   |   | 3,670 |   |   |   | 6,826 |   |   |   | 6,553 |   |   |   | 5,377 |   |   |
| Operating income            |       |                                                        | 2,962      |                                          |       |   | 4,047 |   |   |   | 4,352 |   |   | 3,546 |   |   | 6 |   |   |   | 3,547 |   |   |   | 2,721 |   |   |   | 1,995 |   |   |
| Net income (loss)           |       |                                                        | 2,176      |                                          |       |   | 2,544 |   |   |   | 2,976 |   |   | 3,810 |   |   | (134 | )(b) |   |   | 3,127 |   |   |   | 2,654 |   |   |   | 1,076 |   |   |
| Earnings (loss) per  share: |       |                                                        |       |                                          |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Basic                       |       |                                                        | $          | 0.20                                          |       |   |   | $ | 0.24 |   |   |   | $ | 0.27 |   |   | $ | 0.35 |   |   | $ | (0.01 | ) |   |   | $ | 0.29 |   |   |   | $ | 0.25 |   |   |   | $ | 0.10 |   |   |
| Diluted                     |       |                                                        | $          | 0.20                                          |       |   |   | $ | 0.23 |   |   |   | $ | 0.27 |   |   | $ | 0.34 |   |   | $ | (0.01 | ) |   |   | $ | 0.29 |   |   |   | $ | 0.25 |   |   |   | $ | 0.10 |   |   |
| Weighted average shares:    |       |                                                        |       |                                          |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Basic                       |       |                                                        | 10,667     |                                          |       |   | 10,722 |   |   |   | 10,921 |   |   | 10,994 |   |   | 10,077 |   |   |   | 10,655 |   |   |   | 10,655 |   |   |   | 10,655 |   |   |
| Diluted                     |       |                                                        | 10,880     |                                          |       |   | 10,978 |   |   |   | 11,084 |   |   | 11,176 |   |   | 10,077 |   |   |   | 10,952 |   |   |   | 10,784 |   |   |   | 10,810 |   |   |
| Stock Price(a):             |       |                                                        |       |                                          |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| High                        |       |                                                        | $          | 10.50                                         |       |   |   | $ | 14.28 |   |   |   | $ | 16.00 |   |   | $ | 17.65 |   |   | $ | 2.00 |   |   |   | $ | 3.23 |   |   |   | $ | 6.97 |   |   |   | $ | 9.25 |   |   |
| Low                         |       |                                                        | $          | 6.82                                          |       |   |   | $ | 7.30 |   |   |   | $ | 7.72 |   |   | $ | 10.01 |   |   | $ | 1.25 |   |   |   | $ | 1.77 |   |   |   | $ | 2.55 |   |   |   | $ | 5.32 |   |   |
| Close                       |       |                                                        | $          | 8.05                                          |       |   |   | $ | 14.02 |   |   |   | $ | 10.27 |   |   | $ | 15.04 |   |   | $ | 1.93 |   |   |   | $ | 3.03 |   |   |   | $ | 5.35 |   |   |   | $ | 8.20 |   |   |

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(a)              The stock prices set forth above represent the highestand lowest sales prices per share of our common stock as reported by the OTCBulletin Board through December 22, 2005. Stock prices set forth beginningDecember 23, 2005, through December 31, 2006, represent the highestand lowest sales prices per share as reported on The Nasdaq Capital Market andas reported on The Nasdaq Global Market on and after November 6, 2006.

(b)             Includes $0.6 million related to losseson a sublease contract for excess office space.

***Liquidity and Capital Resources***

Cash provided by operating activities increased$1.1 million, to $7.4 million in 2006, compared to $6.3 millionin 2005. The increase in 2006 is attributable primarily to a $3.3 millionincrease in net profits offset by a $0.7 increase in trade accounts receivableand a $1.5 million reduction in operating liabilities. During the latterpart of 2005, we experienced abnormal growth in our accounts receivablebalances due to the timing of the contracting cycles of our larger U.S.government clients. Decreases in operating liabilities are due primarily toreductions in sublease related liabilities, while other components of ouroperating liabilities remained relatively constant.

Net cash used in investing activities increased$260,000 to $467,000 in 2006, from $167,000 in 2005. The increase is a resultof capital expenditures made to replace aging computer equipment and software,and updates to our audio visual office equipment. Capital expenditures in 2005and 2004 consisted primarily of computer hardware and software upgrades.

Net cash used in financing activities decreased$0.9 million to $1.9 million in 2006 from $2.8 million in 2005. In2006, we paid dividends of $2.7 million, which were offset by proceeds of$0.8 million in cash and tax benefits from option exercises. In 2005, weeliminated our subordinated and bank debt totaling $1.8 million,repurchased all outstanding warrants for $1.3 million, and received$0.3 million upon the exercise of stock warrants and options.

In January and October of1999, we announced two stock repurchase plans for up to 250,000 and500,000 shares, respectively, to be purchased on the open market. In August 2000,we announced an additional stock repurchase plan of up to 750,000 sharesto be purchased on the open market. During 1999, 

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wepurchased 289,150 shares at an average price of $8.41 per share. During2000, we purchased 596,300 shares at an average price of $7.96 per share.During 2001, we purchased 109,100 shares at an average price of $5.11 pershare. We have not repurchased stock since October 23, 2001 and505,450 shares remain available to be repurchased under the plans.

*$5.5 million CreditFacility with JPMorgan Chase Bank, N.A.*

On December 15, 2006,we entered into a credit agreement with JPMorgan Chase Bank, N.A. Thesenior secured revolving credit facility will be used for ongoing workingcapital needs and general corporate purposes. At December 31, 2006, we hada zero balance on such credit facility. This credit facility will mature on March 31,2009, at which time it will terminate and all outstanding amounts shall be dueand payable. The obligations under the senior secured revolving credit facilityare secured by first priority liens on all of our accounts and proceedsthereof.

We may prepay all loans under the senior securedrevolving credit facility at any time without premium or penalty (other thancustomary LIBOR breakage costs and payment of accrued interest), subject tocertain notice requirements. Amounts borrowed and repaid under the seniorsecured revolving credit facility may be reborrowed. Indebtedness under thesenior secured revolving credit facility bears interest at our option at eitherthe bank’s reference rate minus 1.50% or LIBOR plus 1.25%. We incur quarterlycommitment fees based on the unused amount of the credit facilities.

The creditagreement for the senior secured revolving credit facility contains variouscovenants that, among other restrictions, limit our ability to:

·       incuradditional indebtedness;

·       createliens;

·       sellour assets or consolidate or merge with or into other companies;

·       makeloans, extend guarantees or enter into other certain investments;

·       engagein transactions with affiliates; and

·       makecapital expenditures.

The credit agreement for the senior secured revolvingcredit facility also contains a covenant requiring us to maintain minimumlevels of tangible net worth (as defined in the credit agreement).

Each of thefollowing will be an event of default under the senior secured revolving creditfacility:

·       failureto pay any principal, interest, fees, expenses or other amounts when due;

·       failureto observe any agreement, obligation, or covenant in the credit agreement,subject to cure periods for certain failures;

·       certainjudgments against us or any of our subsidiaries, in excess of certainallowances;

·       certainbankruptcy or insolvency events involving us or our subsidiaries;

·       achange in control not consented to by the bank; and

·       thefailure of any representation or warranty to be true and correct when made.

We believe that the senior revolving credit facilitywill provide adequate liquidity based on our current growth strategies and costcontrol measures. We also believe that cash flows provided by operatingactivities will be sufficient to service debt payments as they become due.

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In March 2007, wesigned an amendment to the credit facility that increases the capitalexpenditures we can make in compliance with the terms of the credit agreement.The capital expenditure limit was increased to $1.0 million for the year endingDecember 31, 2007 from the original limit of $0.5 million annually.Effective January 1, 2008, the annual limit reverts to $0.5 million.

*Former CreditFacility with Bank of America, N.A.*

On August 16, 2004, we signed a $5.5 millionrevolving line of credit with Bank of America, N.A., replacing Comerica bank asour senior lender. We paid $55,000 as a commitment fee to obtain the financing.All our inventory, chattel paper, accounts, equipment and general intangiblessecured the credit facility. The line of credit was subject to a borrowing basecalculated as a percentage of our eligible United States trade accountsreceivable less than 90 days old. The credit facility maturedAugust 21, 2006, and bore interest at the prime rate, or LIBOR plus 2.5%,if elected, to be paid monthly. The unused portion of the line of credit boreinterest at an annual rate of 0.375%, and was paid quarterly. The creditagreement contained financial and non-financial covenants, that if breached,would have accelerated of the amounts owed under the credit facility. OnFebruary 7, 2005, we signed an amendment to the credit facility with Bankof America, N.A. allowing, but not requiring, us to make regularly scheduledpayments of principal of $0.1 million each month against General Chain’ssubordinated debt so long as we were not in default on any agreement with Bankof America, N.A. On May 27, 2005, we signed an amendment to our loanagreement eliminating the over advance provisions from the original agreementthat we had never used, removing all restrictions on repayment of subordinateddebt and changing the financials covenants.

At the facility’s maturityon August 21, 2006, we were in compliance with all of our debt covenantsand our outstanding balance on the line of credit was zero, and had not beendrawn on since it was paid in full on June 2, 2005.

*SubordinatedFinancing*

In2002, we issued two promissory notes to our current Chairman of the Board,General John T. Chain, Jr. The notes were subordinated to our seniorlender, and their terms were as follows:

| **Name**                         | ** ** | ** ** | ** ** | **Issue  Date** | ** ** | **Date  Funded** | ** ** | **Date  Retired** | ** ** | **Principal &  Interest  Maturity  Date** | ** ** | **Semi-Annual  Interest  Payment  Dates** | ** ** | **Interest  Rate** | ** **          | **Original  Principal  Amount** | ** ** |
|----------------------------------|------------|------------|------------|-----------------|------------|------------------|------------|-------------------|------------|----------------------------------------------------|------------|-------------------------------------------|------------|--------------------|---------------------|---------------------------------|------------|
| General John T.  Chain, Jr. |       | 3/29/02    |       | 4/4/02          |       | 4/26/05          |       |              | 4/1/06     |                                               |       | Oct 1/Apr 1                               |       |               | Prime + 6 | %                               |       | $ | 1,000,000 |   |
| General John T.  Chain, Jr. |       | 5/31/02    |       | 5/28/02         |       | 6/9/05           |       |              | 6/1/06     |                                               |       | Dec 1/Jun 1                               |       |               | Prime + 6 | %                               |       | $ | 400,000 |   |

 

On February 7, 2005,we signed an amendment to the credit facility with Bank of America, N.A.allowing, but not requiring, us to make regularly scheduled payments ofprincipal of $0.1 million each month against General Chain’s subordinateddebt so long as we are not in default on any agreement with Bank of America,N.A. We made four payments of $0.1 million each to General Chain againstthe subordinated note dated May 31, 2002, retiring this note onApril 26, 2005. We made one payment of $0.1 million to General Chainagainst the subordinated note dated March 29, 2002. On May 27, 2005,we signed an amendment to our credit agreement, removing any restrictions onthe repayment of subordinated debt. On June 9, 2005, we repaid theremaining balance of $0.9 million.

*Our Liquidity Plan*

As a result of net cash provided by operations, wereduced our debt by $4.5 million in 2003, $2.4 million in 2004 and$1.8 million in 2005, we have had no senior or subordinated debt sinceJune 9, 2005. Our ability to reduce debt and generate cash from operationsis due primarily to revenue increases, cost saving measures such as downsizingand subleasing facilities, and more aggressive collection policies. 

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Our ability to maintaingross margins, control costs and generate cash flow from operations in thefuture will determine our ability to make payments on debts as they become dueand to remain in future compliance with debt covenants. We regularly evaluateour business to enhance our liquidity position.

Our performance will also be affected by prevailingeconomic conditions. Many of these factors are beyond our control. Recentconflicts throughout the world involving the United States military couldpotentially have an adverse affect on our liquidity due to the highconcentration of United States government contracts, which could result indelays in program operations. If future cash flows and capital resources areinsufficient to meet our debt obligations and commitments, we may be forced toreduce or delay activities and capital expenditures, obtain additional equitycapital or restructure or refinance our debt.

We believe the bank debtfacility described above provides adequate liquidity based on our currentgrowth strategies and cost control measures. We also believe cash flowsprovided by operating activities will be sufficient to service debt payments asthey become due. In the event revenue growth exceeds anticipated levels, we maybe required to seek additional financing.

*Inflation*

Although our operationsare influenced by general economic conditions, we do not believe inflation hada material effect on the results of operations during the years ended December 31,2006, 2005 or 2004. However, there can be no assurance our business will not beaffected by inflation in the future.

*Other*

As discussed in “Review ofStock Option Grant Practices” above, as a result of our internal investigationinto our stock option grant practices, we restated certain of our previouslyfiled consolidated financial statements and recorded cumulative adjustments fornon-cash stock-based compensation expense totaling $2.2 million. Whilethese expenses are non-cash, the tax related impacts are expected to requirethe use of cash. At December 31, 2006, we have recorded approximately$101,000 of additional taxes, penalty and interest payable related to theexercise of certain incentive stock options. We also expect to pay approximately$46,000 in penalty and interest taxes related to revised measurement datesunder Section 409A. This amount is expected to be paid in April 2007,and we expect to fund this payment from cash flows from operating activities.

***Off-Balance Sheet Arrangements***

At December 31, 2006, and 2005, we had noobligations that would qualify to be disclosed as off-balance sheetarrangements.

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***Contractual Obligations***

Wehave had contractual obligations with various creditors for the purpose ofproviding working capital and financing specific assets. The amounts of ourcontractual obligations at December 31, 2006, as well as the maturity ofthese commitments are as follows:

| ** **                                              | ** ** | ** ** | ** ** | **Payment due in** | ** ** |
|---------------------------------------------------------|------------|------------|------------|------------------------------|------------|
| ** **                                              | ** ** | ** ** | ** ** | **in thousands**        | ** ** |
| **Contractual Obligations**                        | ** ** | ** ** | ** ** | **Total**                    | ** ** | **2007** | ** ** | **2008-2009** | ** ** | **2010-2011** | ** ** | **Later Years** | ** ** |
| Long-term debt  obligations                             |       | $          | —     |                         | $          | — |   |   | $ | — |   |   |   | $ | — |   |   |   | $ | — |   |   |
| Capital lease  obligations                              |       | —     |       | —                       |       |   | — |   |   |   | — |   |   |   | — |   |   |
| Operating lease  obligations                            |       | 3,979      |       | 1,306                        |       |   | 1,554 |   |   |   | 1,089 |   |   |   | 30 |   |   |
| Purchase  obligations                                   |       | —     |       | —                       |       |   | — |   |   |   | — |   |   |   | — |   |   |
| Dividends Payable                                       |       | 19         |       | —                       |       |   | — |   |   |   | 19 |   |   |   | — |   |   |
| Long-Term Rent  Reserve for Operating Lease Obligations |       | 84         |       | (8                           | )          |   | (8 | ) |   |   | (8 | ) |   |   | 108 |   |   |
| Total                                                   |       | $          | 4,082      |                         | $          | 1,298 |   |   | $ | 1,546 |   |   |   | $ | 1,100 |   |   |   | $ | 138 |   |   |
|                                                         |            |            |            |                              |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

*Long-termdebt obligations:*   At December 31, 2006, wehad no long-term debt obligations. We continue to have availability under our$5.5 million line of credit with JPMorgan Chase, N.A.

*Capitallease obligations:*   At December 31, 2006, wehad no capital lease obligations.

*Operatinglease obligations:*   Operating lease obligationsconsist of office rental commitments for our offices in Irving, Texas; Troy,Michigan, and Reston, Virginia. Various equipment leases for copiers, postagemeters and laptop computers are maintained under operating leases.

*Purchase obligations:*   AtDecember 31, 2006, we had no legally binding purchase obligations forgoods or services.

**ITEM 7A.   *Quantitative and Qualitative Disclosure About Market Risk.***

We invest cash balances in excess of operatingrequirements in short-term securities, generally with maturities of 90 daysor less. Our credit agreement provides for borrowings, which bear interest atthe prime rate, or LIBOR plus 1.25%, if elected. Since January 1, 1994,the prime rate has fluctuated between 9.5% and 4% and the 1-year LIBORrate has fluctuated between 7.5% and 1.2%. Based on the volatility of the primerate in recent years, a five-percentage point increase in interest rates wouldhave resulted in $0 of additional interest expense in 2006. Through March 27,2007, we had no borrowings or repayments on our revolving line of credit. Theoutstanding balance at March 27, 2007 was $0.

Due to our foreign operations in Asia, we are exposedto transaction adjustments with respect to foreign currency. Our functionalcurrency is the United States dollar. Under United States dollarfunctional currency, the financial statements of foreign subsidiaries areremeasured from the recording currency to the United States dollar. Theresulting remeasurement adjustment is recorded as foreign exchange gain or lossin the statement of operations. There is no translation adjustment to theseparate component of stockholders’ equity or adjustment to comprehensiveincome. We incurred foreign exchange losses of $2,000 and $9,000 for the yearsended December 31, 2006 and 2005, respectively. At December 31, 2006,the effect of a 10% increase in foreign exchange rates would have resulted in a$644 foreign currency exchange loss on our non-United States denominatedassets and a $10 foreign exchange gain on the Company’s non-United Statesdenominated liabilities. As such, the net effect of a 10% increase in theCompany’s foreign exchange rates, at December 31, 2006, would have been a$634 foreign currency exchange loss. The Company believes that operating underUnited States dollar functional currency, combined with transactingbusiness in countries with traditionally stable currencies mitigates the effectof 

48

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any near-term foreigncurrency transaction adjustments on the Company’s financial position, resultsof operations and cash flows.

The Company has notengaged in foreign currency hedging transactions nor does the Company have anyderivative financial instruments. However, going forward, the Company willassess the need to enter into hedging transactions to limit its risk due tofluctuations in exchange rates.

**ITEM 8.   *Financial Statements and Supplementary Data.***

See Index to ConsolidatedFinancial Statements on page F-1. Supplementary quarterly financialinformation for us is included in Item 7, “Management’s Discussion andAnalysis of Financial Condition and Results of Operations.”

**ITEM 9.   *Changes in and Disagreements with Accountants on Accounting andFinancial Disclosure.***

Not applicable.

**ITEM 9A.   *Controls and Procedures.***

Based on the evaluation ofour disclosure controls and procedures as of the end of the period covered bythis annual report,our Chief Executive Officer and our Chief Financial Officerhave concluded that, in their judgment, our disclosure controls and proceduresare effective to ensure that information required to be disclosed by theCompany, including its subsidiaries, in the reports it files, or submits underthe Securities Exchange Act of 1934, as amended, the “Exchange Act”, isrecorded, processed, summarized, and reported within the time periods specifiedin the Securities and Exchange Commission’s rules and forms. Managementnecessarily applied its judgment in assessing the costs and benefits of suchcontrols and procedures, which, by their nature, can provide only reasonableassurance regarding management’s control objectives. The design of any systemof controls and procedures is based in part upon certain assumptions about thelikelihood of future events. There can be no assurance that any design willsucceed in achieving our stated goals under all potential future conditions,regardless of how remote.

*Extension ofCompliance Date for Management’s Report on Internal Control Over FinancialReporting*

This Annual Report on Form 10-K does notinclude a report of management’s assessment regarding internal control overfinancial reporting or an attestation report of our registered publicaccounting firm due to a transition period established by the rules of theSecurities and Exchange Commission for non-accelerated filers, as defined in Rule 12b-2under the Exchange Act. We will be required to include a report of management’sassessment regarding internal control over financial reporting beginning withour annual report for the fiscal year ending December 31, 2007 and anattestation report of our registered public accounting firm beginning with ourannual report for the fiscal year ending December 31, 2008.

Under the internal control reporting provisions of theExchange Act, management will be responsible for establishing and maintainingadequate internal control over financial reporting as defined in Exchange Act Rule 13a-15(f) .Internal control over financial reporting is a process designed to providereasonable assurance regarding the reliability of financial reporting and thepreparation of financial statements for external purposes in accordance withaccounting principles generally accepted in the United States of America.

Our internal control over financial reporting includesthose policies and procedures that (i) pertain to the maintenance ofrecords that, in reasonable detail, accurately and fairly reflect ourtransactions and dispositions of our assets; (ii) provide reasonableassurance that transactions are recorded as necessary to permit preparation ofour financial statements in accordance with U.S. generally acceptedaccounting principles, and that receipts and expenditures are being made onlyin accordance with authorizations of 

49

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our management anddirectors; and (iii) provide reasonable assurance regarding prevention ortimely detection of unauthorized acquisition, use, or disposition of our assetsthat could have a material effect on our financial statements.

Because of inherent limitations, internal control overfinancial reporting may not prevent or detect misstatements. Also, projectionsof any evaluation of effectiveness to future periods are subject to the riskthat controls may become inadequate because of changes in conditions, or thatthe degree of compliance with the policies or procedures may deteriorate.

Prior to the extended deadline in 2007, managementwill conduct an evaluation of the effectiveness of internal control overfinancial reporting based on the framework in Internal Control—IntegratedFramework issued by the Committee of Sponsoring Organizations of the TreadwayCommission. Based on this evaluation, management will determine whether ourinternal control over financial reporting is effective.

There were no changes in our internal control overfinancial reporting during our last fiscal quarter that have materiallyaffected, or are reasonably likely to materially affect, our internal controlover financial reporting.

In connection with theinvestigation into our stock option practices, the investigation team concludedthat our internal control over financial reporting and our legal processes inconnection with stock option grants and exercises have been ineffective. As aresult, the investigation team has made the following recommendations withrespect to proposed remedial measures: (i) establish modified accountingmeasurement dates for option grants not properly authorized by either Board orCompensation Committee resolutions, which we did in conjunction with therestatement; (ii) in order to correct the lack of complete legal documentation,adopt resolutions ratifying all prior option grants that may not have beenpreviously authorized by specific Board of Compensation Committee resolutions,which resolutions were adopted by the Board on March 30, 2007; (iii) adoptand document an effective system of internal control over financial reportingthat govern our stock option granting and/or other equity award processes; and (iv) adoptwritten equity granting practices and procedures that provide for option grantsor other equity awards only by our Compensation Committee, consisting ofoutside independent directors, and that equity awards be made only on aquarterly basis during a meeting of the Compensation Committee. Please see “Reviewof Stock Option Grant Practices” in Item 7. Management’s Discussion andAnalysis of Financial Condition and Results of Operations and Note 19 toour Consolidated Financial Statements for a discussion related to ourinvestigation.

**ITEM 9B.   *Other Information.***

There was no information required to be disclosed in areport on Form 8-K in the fourth quarter of 2006 which was notreported.

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**PART III**

**ITEM10.****         *Directorsand Executive Officers of the Registrant.***

The information requiredby this Item 10 is incorporated herein by reference from our Proxy Statementfor our 2007 Annual Meeting of Stockholders, which will be filed on or before April 30,2007.

**ITEM11.****         *ExecutiveCompensation.***

The discussion under “ExecutiveCompensation” in our Proxy Statement for our 2007 Annual Meeting isincorporated herein by reference.

**ITEM12.****         *SecurityOwnership of Certain Beneficial Owners and Management.***

The discussion under “Security Ownership of CertainBeneficial Owners and Management” in our Proxy Statement for our 2007 AnnualMeeting is incorporated herein by reference.

The following tableprovides information related to the number of shares to be issued upon exerciseof all outstanding options, warrants and rights and the number of sharesavailable for future issuance under our equity compensation plans at December 31,2006.

**EQUITYCOMPENSATION PLAN INFORMATION**

| ** **                                                  | ** ** | **(a)**    | ** ** | **(b)**                                                                                                                                                              | ** ** | **(c)**                                                                                                     | ** ** |
|-------------------------------------------------------------|------------|------------|------------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------------------------------------------------------------------------------------------------|------------|
| **Plan Category**                                      | ** ** | ** ** | ** ** | **Number of securities to be  to be issued upon exercise  of outstanding options,  warrants and rights** | ** ** | **Weighted-average  exercise price of  outstanding options,  warrants and rights** | ** ** | **Number of securities  remaining available for  future issuance under  equity compensation plans  (excluding securities  reflected in column (a))** | ** ** |
| Equity  compensation plans approved by security holders     |       |       | 1,056,248  | (1)(2)                                                                                                                                                               |       |                                                                                                        | $          | 3.07 |   |   |   | 684,712 |   |   |
| Equity  compensation plans not approved by security holders |       |       | —     |                                                                                                                                                                 |       |                                                                                                        | —     |   |   |   | — |   |   |
| Total                                                       |       |       | 1,056,248  |                                                                                                                                                                 |       |                                                                                                        | $          | 3.07 |   |   |   | 684,712 |   |   |
|                                                             |            |            |            |                                                                                                                                                                      |            |                                                                                                             |            |  |  |  |  |  |  |  |  |  |

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(1)          These plans include theThomas Group, Inc. 1988, 1992 and 1997 Stock Option Plans and theNon-Employee Director Plan and the 2005 Omnibus Restricted Stock and IncentivePlan.

(2)          Thenumber of shares is subject to adjustments for changes resulting from stockdividends, stock splits, recapitalizations and similar events.

**ITEM13.****         *CertainRelationships and Related Transactions.***

The discussion under “CertainRelationships and Related Transactions” in our Proxy Statement for our 2007Annual Meeting is incorporated herein by reference.

**ITEM14.****         *PrincipalAccounting Fees and Services.***

The discussion under “Principal Accounting Fees andServices” in our Proxy Statement for our 2007 Annual Meeting is incorporatedherein by reference.

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**PART IV**

**ITEM 15.**         *Exhibits and Financial Statement Schedules.*
| (a)(1) |   | See  “Index to Consolidated Financial Statements” on page F-1 of this  Annual Report on Form 10-K.                                                                                         |
|--------|--------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| (a)(2) |   | The financial statement schedules required by this  item are included in the accompanying notes to the consolidated financial  statements beginning on page F-7 of this Annual Report on  Form 10-K. |
| (a)(3) |   | Documents filed as part of this Annual Report on  Form 10-K are listed sequentially by subsection in the  Exhibit Index at Part IV, Item 15(b).                                                 |
| (b)    |   | Documents filed as part of this Annual Report on  Form 10-K are listed sequentially by subsection in the following  Exhibit Index.                                                                   |

 
| Exhibit   Number | ** ** | **Description**                                                                                                                                                                                                                                                                                                |
|------------------|------------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 3.1              |       | Amended  and Restated Certificate of Incorporation of Thomas Group, Inc. filed  July 10, 1998, with the State of Delaware Office of the Secretary of  State (filed as Exhibit 3.1 to our Annual Report on Form 10-K  dated March 12, 1999 and incorporated herein by reference). |
| 3.2              |       | Amended and Restated By-Laws dated May 30, 2001  (filed as Exhibit 3.2 to our Quarterly Report on Form 10-Q  dated August 10, 2001 and incorporated herein by reference).                                                                                                             |
| 4.1              |       | Specimen Certificate evidencing Common Stock (filed  as Exhibit 4.1 to our 1993 Registration Statement on Form S-1  (file No. 33-64492) and incorporated herein by reference).                                                                                                        |
| 4.2              |       | Rights Agreement dated July 9, 1998 (filed as  Exhibit 4 to our Current Report on Form 8-K dated  July 16, 1998 and incorporated herein by reference).                                                                                                                                |
| 4.3              |       | Amendment No. 1 to Rights Agreement dated  March 1, 1999 (filed as Exhibit 4.4 to our Annual Report on  Form 10-K dated March 12, 1999 and incorporated herein by  reference).                                                                                              |
| 4.4              |       | Amendment No. 2 to Rights Agreement dated August 12,  1999 (filed as Exhibit 4.5 to our Quarterly Report on Form 10-Q  dated August 16, 1999 and incorporated herein by reference).                                                                                         |
| 4.5              |       | First Amendment to Rights Agreement, dated  September 13, 2002, between Thomas Group, Inc. and Computershare  Trust Company, as rights agent (filed as Exhibit 99.7 to our  Current Report on Form 8-K dated October 3, 2002 and  incorporated herein by reference).             |
| 4.6              |       | Second Amendment to Rights Agreement, dated  October 17, 2002, between Thomas Group, Inc. and Computershare Trust  Company, as rights agent (filed as Exhibit 99.7 to our Current  Report on Form 8-K/A dated October 23, 2002 and incorporated  herein by reference).           |
| 4.7              |       | Registration Rights Agreement, dated  October 17, 2002, by and between Thomas Group, Inc. and Edward P.  Evans (filed as Exhibit 99.4 to our Current Report on Form 8-K/A  dated October 23, 2002 and incorporated herein by reference).                                         |
| 4.8              |       | Registration Rights Agreement, dated  September 20, 2002, by and between Thomas Group, Inc. and John T.  Chain, Jr. (filed as Exhibit 99.4 to our Current Report  Form 8-K dated October 3, 2002 and incorporated herein by  reference).                                    |
| 10.1             |       | Amended and Restated Note and Warrant Purchase  Agreement by and between Thomas Group, Inc., John T. Chain, Jr. and  Edward P. Evans (filed as Exhibit 99.1 to our Current Report on  Form 8-K/A dated October 23, 2002 and incorporated herein by  reference).                       |
| 10.2             |       | Credit Agreement dated December 15, 2006  between Thomas Group, Inc. and JPMorgan Chase, N.A. (filed as  Exhibit 10.5 to our Current Report on Form 8-K dated  December 15, 2006).                                                                                                    |

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| 10.3  |   | Loan  Agreement dated July 21, 2004 between Bank of America, N.A. and Thomas  Group, Inc. (filed as Exhibit 99.1 to our Current Report on  Form 8-K dated August 20, 2004 and incorporated herein by  reference).                                  |
|-------|--------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.4  |   | Amendment No. 1 to Loan Agreement dated  February 7, 2005 between Bank of America, N.A. and Thomas  Group, Inc. (filed as Exhibit 10.33 to our Annual Report  Form 10-K dated March 30, 2005 and incorporated herein by  reference).          |
| 10.5  |   | Amendment No. 2 to Loan Agreement dated  May 27, 2005 between Bank of America, N.A. and the Company.(filed as  Exhibit 10.27 to our Annual Report on Form 10-K dated  March 31, 2006 and incorporated herein by reference).                             |
| 10.6  |   | Amended and Restated Employment Agreement between Thomas  Group, Inc. and James T. Taylor dated February 14, 2007 (filed as  Exhibit 10.1 to our Current Report on Form 8-K dated  February 20, 2007 and incorporated herein by reference).             |
| 10.7  |   | Employment Agreement between Thomas Group, Inc.  and David English, dated November 7, 2005 (filed as Exhibit 10.1  to our Quarterly Report Form 10-Q dated November 10,  2005 and incorporated herein by reference).                               |
| 10.8  |   | 2005 Omnibus Stock and Incentive Plan for Thomas  Group, Inc. dated December 19, 2005, as amended December 23,  2005 (filed as Exhibit 10.1 to our Current Report on Form 8-K  dated December 27, 2005 and incorporated herein by reference). |
| 10.9  |   | Net Profit Restricted Share Award agreement for  James T. Taylor dated December 20, 2005 (filed as Exhibit 10.2  to our Current Report on Form 8-K dated December 27,  2005 and incorporated herein by reference).                                      |
| 10.10 |   | Net Profit Restricted Share Award agreement for  David English dated December 20, 2005 (filed as Exhibit 10.3  to our Current Report on Form 8-K dated December 27,  2005 and incorporated herein by reference).                                        |
| 10.11 |   | Share Price Restricted Share Award agreement for  James T. Taylor dated December 23, 2005 (filed as Exhibit 10.4  to our Current Report on Form 8-K dated December 27,  2005 and incorporated herein by reference).                                     |
| 10.12 |   | Net Profit Restricted Share Award agreement for  Terry Stinson dated April 27,2006 (filed as Exhibit 10.5  to our Current Report Form 8-K/A dated December 15, 2006  and incorporated herein by reference).                                             |
| 10.13 |   | Letter Agreement between Thomas Group, Inc. and  Terry Stinson dated January 3, 2007 (filed as Exhibit 10.1 to our  Current Report on Form 8-K dated January 9, 2007 and  incorporated herein by reference).                                            |
| *21   |   | Subsidiaries of the Company.                                                                                                                                                                                                                                                     |
| *23   |   | Consent of Hein & Associates LLP.                                                                                                                                                                                                                                  |
| *31.1 |   | Certification pursuant to Section 302 of the  Sarbanes-Oxley Act of 2002                                                                                                                                                                                                    |
| *31.2 |   | Certification pursuant to Section 302 of the  Sarbanes-Oxley Act of 2002.                                                                                                                                                                                                   |
| *32.1 |   | Certification pursuant to Section 906 of the  Sarbanes-Oxley Act of 2002.                                                                                                                                                                                                   |
| *32.2 |   | Certification pursuant to Section 906 of the  Sarbanes-Oxley Act of 2002.                                                                                                                                                                                                   |

 

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*                    Filed herewith

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**SIGNATURES**

Pursuantto the requirements of Section 13 or 15(d) of the SecuritiesExchange Act of 1934, we have duly caused this Form 10-K to besigned on our behalf by the undersigned, thereunto duly authorized, in the Cityof Irving, State of Texas, on April 6, 2007.

|        | THOMAS GROUP, INC. |
|--------|--------------------|
|   | By:                |   | /s/ JAMES T.  TAYLOR |
|   |               |   | James  T. Taylor |
|   |               |   | *Chief Executive Officer and President* |

 

**POWER OF ATTORNEY**

Each individual whose signature appears belowconstitutes and appoints James T. Taylor such person’s true and lawfulattorneys-in-fact and agents with full power of substitution andre-substitution, for such person and in such person’s name, place, and stead,in any and all capacities, to sign any and all amendments to this Form 10-Kand to file the same with all exhibits thereto, and all documents inconnection therewith, with the Securities and Exchange Commission, grantingunto such attorneys-in-fact and agents, and each of them, full power andauthority to do and perform each and every act and thing requisite andnecessary to be done in and about the premises, as fully to all intents andpurposes as such person might or could do in person, hereby ratifying andconfirming all that such attorneys-in-fact and agents or any of them, or theirsubstitute or substitutes, may lawfully do or cause to be done by virtuehereof.

Pursuant to the requirements of Section 13or 15(d) of the Securities Exchange Act of 1934, this Form 10-Khas been signed by the following persons on behalf of the Registrant in thecapacities and on the dates indicated.

Pursuantto the requirements of Section 13 or 15(d) of the SecuritiesExchange Act of 1934, this Form 10-K has been signed by thefollowing persons on behalf of the Registrant in the capacities and on thedates indicated.

|                             | **Signature** | ** **                                        | ** ** | ** **         | **Capacity** | ** ** | ** ** | ** ** | **Date** | ** ** |
|-----------------------------|---------------|---------------------------------------------------|------------|--------------------|--------------|------------|------------|------------|----------|------------|
| /s/ JAMES T. TAYLOR         |          | Chief Executive  Officer, President, and Director |       | April 6, 2007 |
| James T. Taylor             |          | (Principal Executive  Officer)                    |       |               |
| /s/ DAVID ENGLISH           |          | Vice President,  Chief Financial Officer,         |       | April 6, 2007 |
| David English               |          | Treasurer, and Secretary                          |       |               |
|                        |          | (Principal Financial  Officer)                    |       |               |
| /s/ JOHN T. CHAIN, JR. |          | Chairman of the  Board                            |       | April 6, 2007 |
| John T. Chain, Jr.     |          |                                              |       |               |
| /s/ EDWARD P. EVANS         |          | Director                                          |       | April 6, 2007 |
| Edward P. Evans             |          |                                              |       |               |
| /s/ DORSEY R. GARDNER       |          | Director                                          |       | April 6, 2007 |
| Dorsey R. Gardner           |          |                                              |       |               |
| /s/ DAVID B. MATHIS         |          | Director                                          |       | April 6, 2007 |
| David B. Mathis             |          |                                              |       |               |

 

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**ANNUAL REPORT ON FORM 10-KITEM 8, and 15(a)(1) and (c)LIST OF FINANCIAL STATEMENTSCERTAIN EXHIBITSFINANCIAL STATEMENTSYEAR ENDED DECEMBER 31, 2006THOMAS GROUP, INC.IRVING, TEXAS**

**FORM 10-K—ITEM15(a)(1)Thomas Group, Inc.INDEX TO CONSOLIDATED FINANCIAL STATEMENTS**

Thefollowing consolidated financial statements of Thomas Group, Inc. areincluded in response to Item 8:
| Report of Independent  Registered Public Accounting Firm                                                                           |   | F-2 |   |
|------------------------------------------------------------------------------------------------------------------------------------|--------|-----|--------|
| Consolidated Balance Sheets as of December 31,  2006, and 2005                                                                |   | F-3 |   |
| Consolidated Statements of Operations for the fiscal  years ended December 31, 2006, 2005 and 2004                            |   | F-4 |   |
| Consolidated Statements of Stockholders’ Equity for  the fiscal years ended December 31, 2006, 2005 and 2004   |   | F-5 |   |
| Consolidated Statements of Cash Flows for the fiscal  years ended December 31, 2006, 2005 and 2004                            |   | F-6 |   |
| Notes  to Consolidated Financial Statements                                                                                        |   | F-7 |   |

 

F-1

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**REPORT OFINDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM**

To the Board of Directors and StockholdersThomas Group, Inc.Irving, TX

We have audited the accompanying consolidated balancesheets of Thomas Group, Inc. as of December 31, 2006 and 2005, andthe related consolidated statements of operations, stockholders’ equity(deficit) and cash flows for each of the three years in the period ended December 31,2006. These financial statements are the responsibility of Thomas Group, Inc.’smanagement. Our responsibility is to express an opinion on these financialstatements based on our audits.

We conducted our audit in accordance with thestandards of the Public Company Accounting Oversight Board(United States). Those standards require that we plan and perform theaudit to obtain reasonable assurance about whether the financial statements arefree of material misstatement. An audit includes examining, on a test basis,evidence supporting the amounts and disclosures in the financial statements. Anaudit also includes assessing the accounting principles used and significantestimates made by management, as well as evaluating the overall financialstatement presentation. We believe that our audits provide a reasonable basisfor our opinion.

In our opinion, the consolidated financial statementsreferred to above present fairly, in all material respects, the financialposition of Thomas Group, Inc. at December 31, 2006 and 2005 and theconsolidated results of operations and cash flows of Thomas Group, Inc.for each of the three years in the period ended December 31, 2006, inconformity with U.S. generally accepted accounting principles.

Asdescribed in Note 19 to the financial statements, the consolidated balancesheet as of December 31, 2005 and the related consolidated statements ofoperations, stockholders’ equity (deficit) and cash flows for each of the twoyears ended December 31, 2005 have been restated to record additionalstock-based compensation and related tax effects resulting from errors inaccounting for stock option grants under generally accepted accountingprinciples.
| */s/ HEIN &  ASSOCIATES LLP* |
|--------------------------------------------|
| Dallas, Texas                              |
| March 30, 2007                        |

 

F-2

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**THOMASGROUP, INC. CONSOLIDATED BALANCE SHEETS**

| ** **                                                                                                                                                                                                               | ** ** | **December 31,**                               | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                                                                                                                                                                                                               | ** ** | **2006**                                            | ** ** | **2005** | ** ** |
| ** **                                                                                                                                                                                                               | ** ** | ** **                                          | ** ** | **(Restated)** | ** ** |
| ** **                                                                                                                                                                                                               | ** ** | **In thousands,  except share data** | ** ** |
| **ASSETS**                                                                                                                                                                                                               |       |                                                |       |   |   |
| Current Assets                                                                                                                                                                                                           |       |                                                |       |   |   |
| Cash and cash equivalents                                                                                                                                                                                                |       | $                                                   | 8,484      |   | $ | 3,481 |   |
| Trade accounts receivable, net of allowance of $137  at December 31, 2006, and 2005, respectively                                                                                                              |       | 12,318                                              |       | 8,382 |   |
| Unbilled receivables                                                                                                                                                                                                     |       | 352                                                 |       | 305 |   |
| Other current assets                                                                                                                                                                                                     |       | 333                                                 |       | 282 |   |
| Current assets to be disposed                                                                                                                                                                                            |       | —                                              |       | 1 |   |
| Total Current Assets                                                                                                                                                                                                     |       | 21,487                                              |       | 12,451 |   |
| Property and  equipment, net of accumulated depreciation of $2,144 and $1,800 at December 31,  2006, and 2005, respectively                                                                                    |       | 616                                                 |       | 493 |   |
| Deferred tax  asset, net of allowance of $117 and $1,880, respectively                                                                                                                                                   |       | 1,294                                               |       | — |   |
| Other assets                                                                                                                                                                                                             |       | 69                                                  |       | 87 |   |
|                                                                                                                                                                                                                     |       | $                                                   | 23,466     |   | $ | 13,031 |   |
| **LIABILITIES  AND STOCKHOLDERS’ EQUITY**                                                                                                                                                                           |       |                                                |       |   |   |
| Current Liabilities                                                                                                                                                                                                      |       |                                                |       |   |   |
| Accounts payable and accrued liabilities                                                                                                                                                                                 |       | $                                                   | 1,611      |   | $ | 1,269 |   |
| Accrued wages and benefits                                                                                                                                                                                               |       | 1,889                                               |       | 2,326 |   |
| Income taxes payable                                                                                                                                                                                                     |       | 106                                                 |       | 52 |   |
| Dividends payable                                                                                                                                                                                                        |       | 1,094                                               |       | 533 |   |
| Current liabilities to be disposed                                                                                                                                                                                       |       | —                                              |       | 83 |   |
| Total Current Liabilities                                                                                                                                                                                                |       | 4,700                                               |       | 4,263 |   |
| Other long-term  obligations                                                                                                                                                                                             |       | 103                                                 |       | 274 |   |
| Total Liabilities                                                                                                                                                                                                        |       | 4,803                                               |       | 4,537 |   |
| Commitments and  Contingencies (Notes 11 and 13)                                                                                                                                                               |       |                                                |       |   |   |
| Stockholders’ Equity                                                                                                                                                                                                |       |                                                |       |   |   |
| Common stock, $.01 par value; 25,000,000 shares  authorized; 13,490,630 and 13,209,119 shares issued and 10,936,754 and  10,655,243 shares outstanding at December 31, 2006, and 2005,  respectively |       | $                                                   | 135        |   | $ | 132 |   |
| Additional paid-in capital                                                                                                                                                                                               |       | 30,476                                              |       | 28,533 |   |
| Retained earnings                                                                                                                                                                                                        |       | 10,480                                              |       | 2,257 |   |
| Accumulated other comprehensive gain                                                                                                                                                                                     |       | 31                                                  |       | 31 |   |
| Treasury stock, 2,553,876 shares at  December 31, 2006, and 2005, respectively, at cost                                                                                                                        |       | (22,459                                             | )          | (22,459 | ) |
| Total Stockholders’ Equity                                                                                                                                                                                          |       | 18,663                                              |       | 8,494 |   |
|                                                                                                                                                                                                                     |       | $                                                   | 23,466     |   | $ | 13,031 |   |

 

See accompanying notes to consolidated financial statements.

F-3

----

**THOMASGROUP, INC. CONSOLIDATED STATEMENTS OF OPERATIONS**

| ** **                                                                                                                                                                            | ** ** | **Year Ended December 31,**              | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|---------------------------------------------------------|------------|
| ** **                                                                                                                                                                            | ** ** | **2006**                                                | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                                                                                                                                                                            | ** ** | ** **                                              | ** ** | **(Restated)** | ** ** | **(Restated)** | ** ** |
| ** **                                                                                                                                                                            | ** ** | **In thousands, except share data** | ** ** |
| Consulting  revenue before reimbursements                                                                                                                                             |       | $                                                       | 58,843     |   | $ | 42,966 |   | $ | 29,928 |   |
| Reimbursements                                                                                                                                                                        |       | 635                                                     |       | 96 |   | 92 |   |
| Total revenue                                                                                                                                                                         |       | 59,478                                                  |       | 43,062 |   | 30,020 |   |
| Cost of sales  before reimbursable expenses                                                                                                                                           |       | 27,336                                                  |       | 20,540 |   | 14,908 |   |
| Reimbursable  expenses                                                                                                                                                                |       | 635                                                     |       | 96 |   | 92 |   |
| Total cost of  sales                                                                                                                                                                  |       | 27,971                                                  |       | 20,636 |   | 15,000 |   |
| Gross profit                                                                                                                                                                          |       | 31,507                                                  |       | 22,426 |   | 15,020 |   |
| Selling, general  and administrative                                                                                                                                                  |       | 16,616                                                  |       | 13,547 |   | 12,428 |   |
| Sublease losses                                                                                                                                                                       |       | (16                                                     | )          | 610 |   | — |   |
| Operating income                                                                                                                                                                      |       | 14,907                                                  |       | 8,269 |   | 2,592 |   |
| Interest income  (expense), net                                                                                                                                                       |       | 362                                                     |       | (13 | ) | (279 | ) |
| Income from  continuing operations before income taxes                                                                                                                                |       | 15,269                                                  |       | 8,256 |   | 2,313 |   |
| Income tax  expense (benefit)                                                                                                                                                         |       | 3,764                                                   |       | 311 |   | (21 | ) |
| Income from  continuing operations before the cumulative effect of a change in accounting  principle                                                                                  |       | 11,505                                                  |       | 7,945 |   | 2,334 |   |
| Gain (loss) on  discontinued operations, net of related tax expense effect of $0 and $58 for  the years 2006 and 2005, respectively, and tax benefit effect of $44 for the  year 2004 |       | 1                                                       |       | (1,212 | ) | (893 | ) |
| Income before the  cumulative effect of a change in accounting principle                                                                                                              |       | 11,506                                                  |       | 6,733 |   | 1,441 |   |
| Cumulative effect  of a change in accounting principle, net of related income tax benefit                                                                                             |       | —                                                  |       | (10 | ) | — |   |
| Net income                                                                                                                                                                            |       | $                                                       | 11,506     |   | $ | 6,723 |   | $ | 1,441 |   |
| Earnings per share:                                                                                                                                                                   |       |                                                    |       |   |   |   |   |
| Basic:                                                                                                                                                                                |       |                                                    |       |   |   |   |   |
| Income from  continuing operations                                                                                                                                                    |       | $                                                       | 1.06       |   | $ | 0.76 |   | $ | 0.25 |   |
| Loss on  discontinued operations, net of tax effect                                                                                                                                   |       | —                                                  |       | (0.12 | ) | (0.10 | ) |
| Cumulative effect  of a change in accounting principle, net of tax effect                                                                                                             |       | —                                                  |       | — |   | — |   |
| Net income                                                                                                                                                                            |       | $                                                       | 1.06       |   | $ | 0.64 |   | $ | 0.15 |   |
| Diluted:                                                                                                                                                                              |       |                                                    |       |   |   |   |   |
| Income from  continuing operations                                                                                                                                                    |       | $                                                       | 1.04       |   | $ | 0.75 |   | $ | 0.22 |   |
| Loss on discontinued  operations, net of tax effect                                                                                                                                   |       | —                                                  |       | (0.12 | ) | (0.08 | ) |
| Cumulative effect  of a change in accounting principle, net of tax effect                                                                                                             |       | —                                                  |       | — |   | — |   |
| Net Income                                                                                                                                                                            |       | $                                                       | 1.04       |   | $ | 0.63 |   | $ | 0.14 |   |
| Weighted average shares:                                                                                                                                                              |       |                                                    |       |   |   |   |   |
| Basic                                                                                                                                                                                 |       | 10,812,117                                              |       | 10,512,703 |   | 9,658,131 |   |
| Diluted                                                                                                                                                                               |       | 11,065,088                                              |       | 10,702,375 |   | 10,548,922 |   |

 

See accompanying notes to consolidated financial statements.

F-4

----

**THOMASGROUP, INC. CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY**

| ** **                                                                                          | ** ** | ** **                                              | ** ** | ** **     | ** ** | **Retained**     | ** ** | **Accumulated**   | ** ** | ** **              | ** ** | ** ** | ** **         |
|-----------------------------------------------------------------------------------------------------|------------|---------------------------------------------------------|------------|----------------|------------|------------------|------------|-------------------|------------|-------------------------|------------|------------|--------------------|
| ** **                                                                                          | ** ** | ** **                                              | ** ** | **Additional** | ** ** | **Earnings**     | ** ** | **Other**         | ** ** | ** **              | ** ** | ** ** | ** **         |
| ** **                                                                                          | ** ** | **Common Stock**                                   | ** ** | **Paid-In**    | ** ** | **(Accumulated** | ** ** | **Comprehensive** | ** ** | **Treasury Stock** | ** ** | ** ** | ** **         |
| ** **                                                                                          | ** ** | **Shares**                                              | ** ** | **Amount**     | ** ** | **Capital**      | ** ** | **Deficit)**      | ** ** | **Income (Loss)**  | ** ** | **Shares** | ** **         | **Amount** | ** ** | **Total** | ** ** |
| ** **                                                                                          | ** ** | **In thousands, except share data** | ** ** |
| **Balance as of January 1, 2004 (Restated)**                                                   |       | 12,109,538                                              |       |           | $          | 121              |       |              |       | $                       | 28,074     |       |               |   | $ | (4,237 | ) |   |   | $ | (786 | ) |   | 2,553,876 |   | $ | (22,459 | ) | $ | 713 |   |
| Exercise of stock options for 132,284 shares of  common stock                                  |       | 132,284                                                 |       |           | 1          |             |       |              | 51         |                    |       |       |               |   |   |   |   |   |   |   |   |   |   | 52 |   |
| Amortization of non-employee stock compensation                                                     |       |                                                    |       |           |       |             |       |              | 131        |                    |       |       |               |   |   |   |   |   |   |   |   |   |   | 131 |   |
| Discounted common stock options under employee stock  option plans                                  |       |                                                    |       |           |       |             |       |              | 48         |                    |       |       |               |   |   |   |   |   |   |   |   |   |   | 48 |   |
| Comprehensive income:                                                                               |       |                                                    |       |           |       |             |       |              |       |                    |       |       |               |   |   |   |   |   |   |   |   |   |   |   |   |
| Foreign currency translation adjustment reclassified  to net loss, net of tax (Note 1(q))      |       |                                                    |       |           |       |             |       |              |       |                    |       |       |               |   |   |   | 104 |   |   |   |   |   |   | 104 |   |
| Net Income                                                                                          |       |                                                    |       |           |       |             |       |              |       |                    |       |       | 1,441              |   |   |   |   |   |   |   |   |   |   | 1,441 |   |
| Total Comprehensive Income                                                                          |       |                                                    |       |           |       |             |       |              |       |                    |       |       |               |   |   |   |   |   |   |   |   |   |   | 1,545 |   |
| **Balance as of December 31, 2004 (Restated)**                                                 |       | 12,241,822                                              |       |           | 122        |             |       |              | 28,304     |                    |       |       | (2,796             | ) |   |   | (682 | ) |   | 2,553,876 |   | (22,459 | ) | 2,489 |   |
| Exercise of stock options for 97,499 shares of  common   stock                                 |       | 97,499                                                  |       |           | 1          |             |       |              | 35         |                    |       |       |               |   |   |   |   |   |   |   |   |   |   | 36 |   |
| Exercise of stock warrants for 869,798 shares of  common stock                                 |       | 869,798                                                 |       |           | 9          |             |       |              | 252        |                    |       |       |               |   |   |   |   |   |   |   |   |   |   | 261 |   |
| Repurchase of stock warrants                                                                        |       |                                                    |       |           |       |             |       |              | (113       | )                       |       |       | (1,137             | ) |   |   |   |   |   |   |   |   |   | (1,250 | ) |
| Deferred compensation from restricted stock grants                                                  |       |                                                    |       |           |       |             |       |              | 18         |                    |       |       |               |   |   |   |   |   |   |   |   |   |   | 18 |   |
| Discounted common stock options under employee  stock option plans                             |       |                                                    |       |           |       |             |       |              | 37         |                    |       |       |               |   |   |   |   |   |   |   |   |   |   | 37 |   |
| Dividends                                                                                           |       |                                                    |       |           |       |             |       |              |       |                    |       |       | (533               | ) |   |   |   |   |   |   |   |   |   | (533 | ) |
| Comprehensive income:                                                                               |       |                                                    |       |           |       |             |       |              |       |                    |       |       |               |   |   |   |   |   |   |   |   |   |   |   |   |
| Foreign currency translation adjustment reclassified  to net loss, net of tax (Note 1(q)) |       |                                                    |       |           |       |             |       |              |       |                    |       |       |               |   |   |   | 713 |   |   |   |   |   |   | 713 |   |
| Net Income                                                                                          |       |                                                    |       |           |       |             |       |              |       |                    |       |       | 6,723              |   |   |   |   |   |   |   |   |   |   | 6,723 |   |
| Total Comprehensive Income                                                                          |       |                                                    |       |           |       |             |       |              |       |                    |       |       |               |   |   |   |   |   |   |   |   |   |   | 7,436 |   |
| **Balance as of December 31, 2005 (Restated)**                                                 |       | 13,209,119                                              |       |           | 132        |             |       |              | 28,533     |                    |       |       |    2,257 |   |   |   |      31 |   |   | 2,553,876 |   | (22,459 | ) |    8,494 |   |
| Exercise of stock options for 281,511 shares of  common stock                                  |       | 281,511                                                 |       |           | 3          |             |       |              | 409        |                    |       |       |               |   |   |   |   |   |   |   |   |   |   | 412 |   |
| Deferred compensation from restricted stock grants                                                  |       |                                                    |       |           |       |             |       |              | 1,180      |                    |       |       |               |   |   |   |   |   |   |   |   |   |   | 1,180 |   |
| Discounted common stock options under employee stock  option plans                                  |       |                                                    |       |           |       |             |       |              | (47        | )                       |       |       |               |   |   |   |   |   |   |   |   |   |   | (47 | ) |
| Tax benefit of options exercised                                                                    |       |                                                    |       |           |       |             |       |              | 401        |                    |       |       |               |   |   |   |   |   |   |   |   |   |   | 401 |   |
| Dividends                                                                                           |       |                                                    |       |           |       |             |       |              |       |                    |       |       | (3,283             | ) |   |   |   |   |   |   |   |   |   | (3,283 | ) |
| Net Income                                                                                          |       |                                                    |       |           |       |             |       |              |       |                    |       |       | 11,506             |   |   |   |   |   |   |   |   |   |   | 11,506 |   |
| **Balance  as of December 31,   2006**                                                         |       | 13,490,630                                              |       |           | $          | 135              |       |              |       | $                       | 30,476     |       |               |   | $ | 10,480 |   |   |   | $ | 31 |   |   | 2,553,876 |   | $ | (22,459 | ) | $ | 18,663 |   |

 

See accompanying notes to consolidated financial statements.

F-5

----

**THOMAS GROUP, INC. CONSOLIDATED STATEMENTS OF CASHFLOWS**

| ** **                                                                              | ** ** | **Year Ended December 31,** | ** ** |
|-----------------------------------------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                                                              | ** ** | **2006**                                   | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                                                                              | ** ** | ** **                                 | ** ** | **(Restated)** | ** ** | **(Restated)** | ** ** |
| ** **                                                                              | ** ** | **In thousands of dollars** | ** ** |
| **Cash Flows from Operating  Activities:**                                              |       |                                       |       |   |   |   |   |   |   |   |   |
| Net income                                                                              |       | $                                          | 11,506     |   |   | $ | 6,723 |   |   |   | $ | 1,441 |   |   |
| Adjustments to  reconcile net income to net cash provided by operating activities: |       |                                       |       |   |   |   |   |   |   |   |   |
| Depreciation                                                                            |       | 346                                        |       |   | 285 |   |   |   | 449 |   |   |
| Amortization                                                                            |       | 19                                         |       |   | 19 |   |   |   | 19 |   |   |
| (Gain)/loss on disposal of assets                                                       |       | (2                                         | )          |   | 72 |   |   |   | — |   |   |
| Bad debt                                                                                |       | —                                     |       |   | 59 |   |   |   | 116 |   |   |
| (Gain)/loss on subleases                                                                |       | (16                                        | )          |   | 510 |   |   |   | — |   |   |
| Cumulative translation adjustment                                                       |       | —                                     |       |   | 713 |   |   |   | 104 |   |   |
| Cumulative effect of a change in accounting  principle                                  |       | —                                     |       |   | 11 |   |   |   | — |   |   |
| Stock based compensation expense                                                        |       | 1,180                                      |       |   | 18 |   |   |   | 131 |   |   |
| Discounted stock option grant expense net of cancellations                              |       | (47                                        | )          |   | 37 |   |   |   | 48 |   |   |
| Other                                                                                   |       | 5                                          |       |   | 1 |   |   |   | 8 |   |   |
| Change in operating assets and liabilities:                                             |       |                                       |       |   |   |   |   |   |   |   |   |
| (Increase) decrease in trade accounts receivable                                        |       | (3,936                                     | )          |   | (3,241 | ) |   |   | (1,703 | ) |   |
| (Increase) decrease in unbilled receivables                                             |       | (48                                        | )          |   | (314 | ) |   |   | 285 |   |   |
| (Increase) decrease in deferred tax asset                                               |       | (1,294                                     | )          |   | — |   |   |   | — |   |   |
| (Increase) decrease in other assets                                                     |       | (52                                        | )          |   | 130 |   |   |   | (36 | ) |   |
| Increase (decrease) in accounts payable and accrued  liabilities                        |       | (353                                       | )          |   | 1,237 |   |   |   | (217 | ) |   |
| Increase (decrease) in income taxes payable                                             |       | 54                                         |       |   | 32 |   |   |   | (59 | ) |   |
| Net cash provided  by operating activities                                              |       | 7,362                                      |       |   | 6,292 |   |   |   | 586 |   |   |
| **Cash  Flows From Investing Activities:**                                              |       |                                       |       |   |   |   |   |   |   |   |   |
| Proceeds from  sale of assets                                                           |       | 5                                          |       |   | 1 |   |   |   | — |   |   |
| Capital  expenditures                                                                   |       | (472                                       | )          |   | (167 | ) |   |   | (42 | ) |   |
| Net cash used in  investing activities                                                  |       | (467                                       | )          |   | (166 | ) |   |   | (42 | ) |   |
| **Cash Flows From Financing Activities:**                                               |       |                                       |       |   |   |   |   |   |   |   |   |
| Issuance of  common stock                                                               |       | 3                                          |       |   | 10 |   |   |   | 1 |   |   |
| Proceeds from  exercise of stock options                                                |       | 409                                        |       |   | 35 |   |   |   | 51 |   |   |
| Proceeds from  exercise of stock warrants                                               |       | —                                     |       |   | 252 |   |   |   | — |   |   |
| Repurchase of  stock warrants                                                           |       | —                                     |       |   | (1,250 | ) |   |   | — |   |   |
| Repayment of  related party indebtedness                                                |       | —                                     |       |   | (1,400 | ) |   |   | — |   |   |
| Repayments of  debt and other long-term obligations                                     |       | —                                     |       |   | (11 | ) |   |   | (2,806 | ) |   |
| Dividends                                                                               |       | (2,703                                     | )          |   | — |   |   |   | — |   |   |
| Tax effect of  option exercises                                                         |       | 401                                        |       |   | — |   |   |   | — |   |   |
| Net advances  (repayments)—line of credit                                          |       | —                                     |       |   | (430 | ) |   |   | 430 |   |   |
| Net cash used in  financing activities                                                  |       | (1,890                                     | )          |   | (2,794 | ) |   |   | (2,324 | ) |   |
| Effect of  exchange rate changes on cash                                                |       | (2                                         | )          |   | 6 |   |   |   | (1 | ) |   |
| Net change in  cash                                                                     |       | 5,003                                      |       |   | 3,338 |   |   |   | (1,781 | ) |   |
| Cash and cash  equivalents                                                              |       |                                       |       |   |   |   |   |   |   |   |   |
| Beginning of period                                                                     |       | 3,481                                      |       |   | 143 |   |   |   | 1,924 |   |   |
| End of period                                                                           |       | $                                          | 8,484      |   |   | $ | 3,481 |   |   |   | $ | 143 |   |   |

 

See accompanying notes to consolidated financial statements.

F-6

----

**THOMAS GROUP, INC.NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 2005**

**Note 1 *Summary of Significant Accounting Policies***

(a)   *The Company*—ThomasGroup, Inc. (the ”Company”) is an operations and processimprovement services firm headquartered in Irving, Texas providing processimprovement solutions to enhance business efficiency, competitiveness andfinancial performance. The Company develops and employs methodologies totransform the processes, procedures and people within its clients’organizations to enable more efficient and seamless operations. Our specific methodology in our core product isknown as PVM and focuses on reducing the time spent on revenue-producing,product development and administrative processes, resulting in operational andfinancial improvements.

The Company was incorporated under the laws ofthe State of Delaware in June 1978.

(b)   *Basis of Presentation*—The accompanyingconsolidated financial statements include the accounts of the Company and ourwholly owned subsidiaries. All significant intercompany transactions andbalances have been eliminated. Certain amounts from prior years have beenreclassified to conform to the 2006 presentation.

(c)   *Accounting Changes*—We adopted theprovisions of FASB Statement No. 123(R), “Share-Based Payments” on October 1,2005. We applied the provisions of FAS 123(R) using the modifiedprospective application method. Under this method, the difference between theaccumulated deferred compensation costs of liability awards using fair value asdefined in FASB Statement No. 123, “Accounting for Stock-BasedCompensation,” and the accumulated deferred compensation costs using theintrinsic method under APB Opinion No. 25, “Accounting for StockIssued to Employees” is recorded as a cumulative effect of a change inaccounting principle in the period of the change. We recorded $10,000, net oftax, on October 1, 2005, related to this change in accounting principle.Financial statements for periods prior to 2005 are presented as previouslyreported, and adoption of FAS 123(R) had no effect on beginningretained earnings.

(d)   *Earnings Per Share*—Earnings per commonshare is presented in accordance with the provisions of the FASB Statement No. 128,“Earnings Per Share”, which requires the presentation of “basic” and “diluted”earnings per share. Basic earnings (loss) per share is based on the weightedaverage shares outstanding. Diluted earnings (loss) per share includes theeffect of dilutive securities such as stock options and warrants.

F-7

----

Thefollowing table reconciles basic earnings per share to diluted earnings pershare under the provisions of FAS 128.

| ** **                             | ** ** | **Income  (Numerator)**                                          | ** ** | **Shares  (Denominator)** | ** ** | **Per Share  Amount** | ** ** |
|----------------------------------------|------------|------------------------------------------------------------------|------------|---------------------------|------------|----------------------------|------------|
| ** **                             | ** ** | **In thousands, except per share data** | ** ** |
| **Year  Ended December 31, 2006** |       |                                                             |       |                      |       |                       |       |   |   |   |   |   |   |
| Basic earnings  per share              |       |                                                             | $          | 11,506                    |       |                       |       | 10,812 |   |   |   | $ | 1.06 |   |   |
| Effect of  dilutive securities:        |       |                                                             |       |                      |       |                       |       |   |   |   |   |   |   |
| Options                                |       |                                                             | —     |                      |       |                       | 253        |   |   |   | (0.02 | ) |   |
| Diluted earnings  per share            |       |                                                             | $          | 11,506                    |       |                       |       | 11,065 |   |   |   | $ | 1.04 |   |   |
| **Year Ended December 31, 2005**  |       |                                                             |       |                      |       |                       |       |   |   |   |   |   |   |
| Basic earnings  per share              |       |                                                             | $          | 6,723                     |       |                       |       | 10,513 |   |   |   | $ | 0.64 |   |   |
| Effect of  dilutive securities:        |       |                                                             |       |                      |       |                       |       |   |   |   |   |   |   |
| Options                                |       |                                                             | —     |                      |       |                       | 189        |   |   |   | (0.01 | ) |   |
| Diluted earnings  per share            |       |                                                             | $          | 6,723                     |       |                       |       | 10,702 |   |   |   | $ | 0.63 |   |   |
| **Year Ended December 31, 2004**  |       |                                                             |       |                      |       |                       |       |   |   |   |   |   |   |
| Basic earnings  per share              |       |                                                             | $          | 1,441                     |       |                       |       | 9,658 |   |   |   | $ | 0.15 |   |   |
| Effect of  dilutive securities:        |       |                                                             |       |                      |       |                       |       |   |   |   |   |   |   |
| Options and warrants                   |       |                                                             | —     |                      |       |                       | 891        |   |   |   | (0.01 | ) |   |
| Diluted earnings per  share            |       |                                                             | $          | 1,441                     |       |                       |       | 10,549 |   |   |   | $ | 0.14 |   |   |

 

Total stock options and warrants outstanding in 2006,2005 and 2004 not included in the diluted earnings per share computation due totheir antidilutive effects are approximately 35,000, 205,000, and 1,313,000,respectively. Such options and warrants are excluded due to exercise pricesexceeding the average market value of our common stock in 2006, 2005 and 2004.

(e)   *Management’s Estimates and Assumptions—*Thepresentation of financial statements in conformity with U.S. generallyaccepted accounting principles require management to make estimates andassumptions that affect the reported amounts of assets and liabilities anddisclosure of contingent assets and liabilities at the date of the financialstatements and the reported amounts of revenues and expenses during thereporting period. Actual results could differ from those estimates. We review allsignificant estimates affecting the financial statements on a recurring basisand record the effect of any necessary adjustments prior to issuance of thefinancial statements. We consider revenue recognition, the allowance for baddebt, the valuation allowance for deferred taxes, and accumulated othercomprehensive loss to be the most significant estimates.

(f)    *Warrants*—During 2002, we issued a WarrantPurchase Agreement exercisable for 434,899 shares of common stock toGeneral John T. Chain, Jr., Chairman of our Board of Directors, inconsideration for a note in the amount of $1.0 million. The warrant wasissued with an exercise price of $0.30 per share and an expiration date of September 20,2007. This warrant was valued at $0.30 based on the Black-Scholes model.On February 16, 2005, General Chain exercised his outstanding warrant infull. We received cash in the amount of the purchase price from General Chain,and on February 23, 2005, we issued 434,899 shares of unregisteredcommon stock to General Chain. A Warrant Purchase Agreement exercisable for434,899 shares of common stock was also issued during 2002 to Mr. EdwardP. Evans, a stockholder, in consideration for a note in the amount of$1.0 million. The warrant was issued with an exercise price of $0.30 pershare and an expiration date of October 17, 2007. This warrant was valuedat $0.30 based on the Black-Scholes model. On February 14, 2005, Mr. Evansexercised his outstanding warrant in full. We received the purchase price from Mr. Evans,and on February 23, 2005, we issued 434,899 shares of unregisteredcommon stock to Mr. Evans.

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On November 26, 2002, a Warrant PurchaseAgreement exercisable for 397,443 shares of common stock was issued toComerica Bank, our former senior lender, in consideration for amending ourcredit facility. The warrant was issued with an exercise price of $0.30 and anexpiration date of November 26, 2007. This warrant was valued at $0.37based on the Black Scholes model. The total fair value of the warrant issued in2002 was allocated between the warrant and the related debt based on therelative fair value of each. The portion attributable to the warrant was$284,000 and initially recorded as a reduction, or “discount,” of the relateddebt and a corresponding increase in additional paid in capital. The discountwas accreted to interest expense over the life of the debt. Interest expense of$99,000 and $185,000 was recorded related to these warrants in 2003 and 2002,respectively. As of December 31, 2003, the discount had been fullyaccreted. On September 27, 2005, we repurchased the warrant for$1.25 million cash, or $3.145 per share, which represented a 37% discountfrom the market price on that date.

(g)   *Advertising—*We expense the costs ofadvertising as incurred. Advertising expense was $0.1 million for each ofthe years ended December 31, 2006, 2005, and 2004, respectively.

(h)   *Property and Equipment*—Property andequipment are stated at cost less accumulated depreciation. We recordimpairment losses on long-lived assets used in operations when events andcircumstances indicate the assets might be impaired and the undiscounted cashflows estimated to be generated by those assets are less than the carryingamounts of those assets.

Depreciationis calculated on an accelerated declining balance or straight-line basis overthe estimated useful lives of the various assets as follows:

| Furniture and  fixtures |   | 5-7 Years  |   |
|-------------------------|--------|-----------------|--------|
| Equipment               |   | 3-7 Years  |   |
| Leasehold  improvements |   | 2-10 Years |   |
| Computer software       |   | 3 Years    |   |

 

(i)    *Capitalized Software Development Costs*—Wecapitalized $0.3 million during 2002 and $0.3 during 2001 of certainsoftware development costs, once technological feasibility was achieved.Capitalization of software development costs ceased when the product wasavailable for sale. Software development costs incurred prior to achievingtechnological feasibility were charged to selling, general and administrativeexpense. Amortization of previously capitalized software development costs were$0, $20,000, and $0.2 million in 2006, 2005, and 2004, respectively.Unamortized software development costs were $0, $0, and $37,000 at December 31,2006, 2005, and 2004, respectively. During 2005, we recorded a $17,000 loss onthe disposal of those assets.

(j)    *Revenue*—We generally derive our revenuefrom fees for the implementation of business operations improvement programsdelivered by our Resultants. Total revenue consists of fees and other billingsderived from fixed fees, task-based fees, incentive fees and reimbursed travelexpenses. Our fee type and structure for each client engagement is dependant ona number of variables, including the size of the client, the complexity andgeographic dispersion of its business, the level of the opportunity for us toimprove the client’s processes and other factors.

Fixed fee revenue is recognized on the proportionalperformance model (which approximates the percentage completion method), basedon direct labor hours expended and, when applicable, the completed performancemodel. In order to calculate the completion ratio on a given project, time andeffort to date are divided by the total estimated time and effort for theentire project. This ratio is then multiplied by the total fixed fee to beearned on the project, resulting in the amount of revenue earned to date. Task-basedfees are recognized as revenue when the relevant task is completed ordeliverable is received by the client using the completed performance model.Typically, task-based revenue recognition involves the delivery of a report,minutes or some other evidence of completion. Incentive fees are tied to 

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improvements in a varietyof client performance measures typically involving cycle time, assetutilization and productivity. Incentive fee revenue is recognized in the periodin which the related client improvements are achieved. Our incentive feeagreements with our clients define in advance the performance improvementstandards that will form the basis for the payment of incentive fees. In orderto mitigate the risk of disputes arising over the achievement of performanceimprovements, which drive incentive fees, we obtain customer agreement to theseachievements prior to recognizing revenue. As of April 7, 2007, we had nocontractual agreements for incentive fees.

(k)   *Unbilled Receivables—*Although fixed feerevenue recognition generally coincides with billings we may structure feebillings to increase in the latter stages of a program. In such instances,revenues recognized for services provided are represented in unbilledreceivables.

(l)    *Deferred Revenue*—We occasionally receiveadvance payments of a portion of our fees. Advance payments are classified asdeferred revenue upon receipt and recorded as revenue when earned.

(m)  *Income Taxes*—Wefollow SFAS No. 109, “Accounting for Income Taxes,” which requires use ofthe asset and liability method of accounting for deferred income taxes andproviding deferred income taxes for all significant temporary differences.

As part of the process of preparing consolidatedfinancial statements, we are required to estimate income taxes in each of thejurisdictions in which we operate. This process involves estimating actualcurrent tax payable and related tax expense together with assessing temporarydifferences resulting from differing treatment of certain items, such asdepreciation, for tax and accounting purposes. These differences can result indeferred tax assets and liabilities, which are included within the consolidatedbalance sheets.

Deferred income taxes are provided for temporarydifferences between the financial statement and income tax basis of assets andliabilities. Provisions are made for estimated domestic and foreign incometaxes, less available tax credits and deductions, which may be incurred on theremittance of our share of foreign subsidiaries’ undistributed earnings.

We must then assess the likelihood of recovering ourdeferred tax assets from future taxable income and, to the extent we believe itis more likely than not (a likelihood of more than 50%) that some portion orall of the deferred tax assets will not be realized, a valuation allowance mustbe established. We consider all available evidence, both positive and negative,to determine whether, based on the weight of the evidence, a valuationallowance is needed. Evidence used includes information about our currentfinancial position and results of operations for the current and precedingyears, as well as all currently available information about future years,including our anticipated future performance, the reversal of deferred taxliabilities and tax planning strategies.

Beginning in 2001, we had provided a valuationallowance for the full amount of our net deferred tax assets. During the threemonths ended March 31, 2006, we determined the future sources of taxableincome, the reversing of temporary differences and other tax planningstrategies will be sufficient to realize certain components of our deferred taxasset. Therefore, approximately $0.3 million of the deferred tax assetvaluation allowance was removed during the three months ended March 31,2006. Although our statutory tax rate is approximately 38%, the removal of thisportion of our deferred tax asset valuation allowance reduced income taxexpense by 10 percentage points, resulting in an effective tax rate of 28% forthe quarter ended March 31, 2006.

At December 31, 2006, after further evaluation ofoperating results of the most recent three-year period and comparison of allpositive and negative evidence, we determined that a valuation allowance wasonly appropriate on approximately $117,000 of the NOL carryforward, due toannual limitations under Section 382. Therefore, we removed $1.5 millionof the valuation allowance, which decreased income tax expense and increasedassets.

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In July 2006, the FASB issued FIN 48, “Accountingfor Uncertainty in Income Taxes,” or FIN 48, which is effective for us as ofthe interim reporting period beginning January 1, 2007. The validity ofany tax position is a matter of tax law, and generally there is no controversyabout recognizing the benefit of a tax position in a company’s financialstatements when the degree of confidence is high that the tax position will besustained upon examination by a taxing authority. The tax law is subject tovaried interpretation, and whether a tax position will ultimately be sustainedmay be uncertain. Under FIN 48, the impact of an uncertain income tax positionon the income tax provision must be recognized at the largest amount that ismore-likely-than-not to be sustained upon audit by the relevant taxingauthority. An uncertain income tax position will not be recognized if it hasless than a 50% likelihood of being sustained. FIN 48 also requires additionaldisclosures about unrecognized tax benefits associated with uncertain incometax positions and a reconciliation of the change in the unrecognized benefit.In addition, FIN 48 requires interest to be recognized on the full amount ofdeferred benefits for uncertain tax positions. An income tax penalty isrecognized as expense when the tax position does not meet the minimum statutorythreshold to avoid the imposition of a penalty. We continue to evaluate theimpact of FIN 48 on our consolidated financial statements. We are evaluatingour tax positions and anticipate that the interpretation will not have asignificant impact on our results of operations.

(n)   *Cash and Cash Equivalents*—Cash equivalentsconsist of highly liquid investments with original maturities of three monthsor less.

(o)   *Accounts Receivable and Allowance for DoubtfulAccounts*—We record trade receivables related to billings to ourclients for operations and process improvement services. Trade receivablesnormally have terms of 30 to 60 days. We have no interest provision forpast due trade accounts receivable. Trade accounts receivable are consideredpast due when the amount due is still uncollected at the time the terms per thetrade receivable have expired. An allowance for doubtful accounts is providedwhen necessary and is evaluated periodically on a client-by-client basis. Forthe years ended December 31, 2006, and 2005, there were no receivableswritten off against the allowance.

(p)   *Concentration of Credit Risk*—Financialinstruments that potentially subject us to concentrations of credit riskconsist solely of trade receivables for which the carrying value equals fairvalue as determined by actual billings, offset by any applicable reserves orallowances. We encounter a certain amount of credit risk as a result of aconcentration of unsecured receivables among a few significant clients.Accounts receivable from our largest client, CACI, INC.—FEDERAL (formerlyknown as CACI AB, Inc. and previously Acton Burnell, Inc.), a wholly-ownedsubsidiary of CACI International Inc. (www.caci.com), totaled $4.8 millionand $5.0 million, or 38% and 59% of accounts receivable at December 31,2006, and 2005, respectively. Accounts receivable from another client, theUnited States Navy, totaled $5.8 and $2.8 million, or 46% and 33%, ofaccounts receivable at December 31, 2006, and 2005, respectively. As of December 31,2006, and 2005, there were no reserves or allowances assessed on thereceivables from either CACI or the Navy.

We currently maintain limited operations in Asia wherepotential economic turmoil may result in significant fluctuations in the valueof certain foreign currencies versus the United States dollar. We mayexperience difficulties expanding our operations or may encounter othercollection issues if economic conditions should change. There were nosignificant concentrations of credit risk in these foreign operations as of December 31,2006.

(q)   *Foreign Currency Translation*—Our reportingand functional currency is the United States dollar. UnderUnited States dollar functional currency, the financial statements offoreign subsidiaries are remeasured from the recording currency to theUnited States dollar. Monetary assets such as cash, accounts receivableand most liabilities are remeasured at the period end exchange rate. All otherassets, liabilities and stockholders’ equity are remeasured based on thehistorical rate at the time of the transaction. The resulting remeasurementadjustment is recorded as foreign exchange gain or loss in the 

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statement of operations.Revenue and expense transactions are remeasured at the average exchange ratefor the period. The resulting remeasurement adjustment is recorded as foreignexchange gain or loss in the statement of operations. We recorded a $3,000remeasurement loss, a $7,000 remeasurement gain, and an $8,000 remeasurementloss for the years ending December 31, 2006, 2005, and 2004, respectively.There is no translation adjustment to the separate component of stockholders’equity or adjustment to comprehensive income.

Prior to the change of our reporting and functionalcurrency to the United States dollar, all adjustments resulting from thetranslation of foreign currency financial statements were recorded and reportedas a separate component of stockholders’ equity titled “Accumulated othercomprehensive loss.” Generally accepted accounting principles require theseamounts to be reclassified to the income statement and recorded as a non-cashcharge to operations upon discontinuance of the operations causing suchcurrency adjustments. At the beginning of 2005, the accumulation of prior years’translation adjustments of approximately $682,000 included in accumulated othercomprehensive loss related primarily to our Swiss operations in Europe of$713,000. During 2005 we liquidated our subsidiaries in Switzerland, and as aresult, reclassified $713,000 from other accumulated comprehensive loss to theincome statement. The resulting reclassification was recorded as a non-cashcharge to operations for the year then ended. We reclassified approximately$713,000, $104,000 and $7,000 to selling, general and administrative expenseduring the years 2005, 2004, and 2003, respectively, as a result of thesubstantial liquidation of certain foreign subsidiaries. No amounts werereclassified during 2006.

(r)    *Comprehensive Income*—Comprehensive incomeincludes all changes in equity except those resulting from investments bystockholders and distributions to stockholders.

(s)    *Stockholder Rights Plan*—On July 9,1998, we announced the adoption of a Stockholder Rights Plan, intended toprotect us from unfair or coercive takeover attempts. The grant of the rightswas made to stockholders of record as of July 20, 1998. Periodically, theStockholder Rights Plan is amended to exempt certain transactions fromtriggering the rights. During 2002, the Stockholder Rights Plan was amended, ontwo separate occasions, regarding the conversion of two $1.0 millionsubordinated notes to common stock.

(t)    *Stock Appreciation Rights (“SAR”)*—EffectiveApril 8, 2003 we entered into a SARs agreement with James T. Taylor, ourcurrent President and CEO ,  granting him99,351 SARs at a price of $0.42 per SAR. The SARs were exercisable in full orin part immediately upon grant and entitled Mr. Taylor to a cash paymentequal to the fair market value (defined as the last reported sale price of ourcommon stock on the Nasdaq Capital Market on the last business day of thequarter immediately preceding the quarter in which an exercise occurs) of ashare of common stock of the Company over $0.42 per share. On September 25,2006, Mr. Taylor notified us of his election to exercise the SARs in theirentirety, subject to review by our Audit Committee of the Board of Directors (“Committee”).On October 25, 2006, the Audit Committee determined the closing price of$14.02 on June 30, 2006, as reported on the Nasdaq Capital Market was thefair market value for purposes of this SAR exercise, and approved payment tothe SAR holder under the terms of the agreement. On October 25, 2006,$1.35 million was paid to Mr. Taylor under the terms of the agreement,less required withholding taxes.

Prior to October 1, 2005, we accounted for theSARs under the intrinsic value method specified in APB Opinion No. 25 “Accountingfor Stock Issued to Employees” and related Interpretations. Effective October 1,2005, we adopted the fair value recognition provisions of FASB Statement No. 123(R),“Share-Based Payments”, requiring us to value the liability attributableto the SARs using a fair value pricing model. Using the Black-Scholesoption pricing model, we recorded the fair value of the SARs liability,classified as a current liability based upon the immediate exercisability ofthe SARs, of $1.2 million and $782,000 at June 30, 2006, and December 31,2005, respectively. Under FAS 123(R), any difference between the amountcarried as a liability and the actual settlement amount is to be recorded inthe period the SARs are settled. Therefore, upon receiving notice of SARexercise from Mr. Taylor in the 

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third quarter of 2006, anadditional liability of $175,000 was recorded, representing the differencebetween fair value as defined in FAS 123(R) at June 30, 2006, and theamount due to Mr. Taylor, which was calculated as the closing stock priceof $14.02 at June 30, 2006, less the exercise price of $0.42.

The total amount recorded for SARs expense was$569,000 and $673,000 for the years ended December 31, 2006, and 2005,respectively.

There were no additional SARs issued during the yearended December 31, 2006, and no SARs were outstanding and exercisable at December 31,2006.

(u)   *Stock Based Compensation*—Wegrant incentive and non-qualified stock options and had reserved3,550,000 shares of common stock for issuance under our stock optionplans, of which 684,712 remain authorized and available for grant. Options topurchase shares of our common stock have been granted to directors, officersand employees. The majority of the options granted become exercisable at therate of 20% per year, and generally expire ten years after the date of grant.

On December 12, 2006,  at a special meeting of stockholders,stockholders owning approximately 65% of the outstanding stock of Thomas Groupvoted to approve the 2005 Omnibus Stock and Incentive Plan (“2005 Plan”) andthe awards thereunder. This approval allowed 1,000,000 shares to becomeavailable for awards as options, SARs, restricted shares or performance awards.Under this plan, 650,000 restricted stock awards (the “Awards”) wereinitially granted to employees in 2005 with vesting occurring over a three tofive year period, dependent on achieving various profit levels and market priceper share. During the year ended December 31, 2006, an additional 50,000restricted stock awards were granted to employees. The Awards automaticallyterminate and expire on the earlier of (i) the date on which allrestricted shares have become vested shares, or (ii) the date the Holder’sfull-time employment with us is terminated for any reason, and upon the date ofsuch separation all restricted shares which have not previously vested will bepermanently forfeited. The 2005 Plan will terminate on December 20,2015. Shares are not delivered to the Holder until all restrictions on theshares have lapsed under the terms of the individual award.

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Priorto October 1, 2005, we accounted for our stock option plans under therecognition and measurement provisions of APB Opinion No. 25, “Accountingfor Stock Issued to Employees,” and related Interpretations. No stock-basedemployee compensation cost was initially reflected in net income for the threeor nine month periods ending September 30, 2005, as all options grantedunder those plans had an exercise price equal to the market value of theunderlying common stock on the date of grant. However, as part of therestatement resulting from the Review of Stock Option Granting Procedures, thefinancial statements for the three and nine month periods ending September 30,2005 now include amounts to reflect stock based employee compensation. Pleasesee Note 19 to our Consolidated Financial Statements. Effective October 1,2005, we adopted the fair value recognition provisions of FASB Statement No. 123(R),“Share-Based Payment,” which revises FASB Statement No. 123, “Accountingfor Stock-Based Compensation” using the modified prospective applicationmethod. Under the modified prospective application method of adoption selectedby us under the provisions of FASB Statement No. 148, “Accounting forStock-Based Compensation—Transition and Disclosure,” compensation costrecognized in the nine months ended September 30, 2006, is the same aswould have been recognized had the recognition provisions of FAS 123 beenapplied from our original effective date. Results for prior years have not beenrestated. The fair value of stock options were estimated at the date of grantusing the Black-Scholes model and the restricted stock awards were estimatedusing the binomial lattice method. Both pricing models use a risk-free interestrate based on the U.S. 10-year Treasury Bond yield. Beginning in October 2005,with the adoption of FAS 123(R), the expected lives of stock options andgrants are estimated using the term of the awards granted and historicalexperience. The expected lives of the restricted stock awards are based on theanticipated time to maturity of the individual awards, typically between oneand five years. This information is summarized as follows:

| ** **               | ** ** | **2006** | ** ** | **2005** | ** ** | **2004** | ** ** |
|--------------------------|------------|----------|------------|----------|------------|----------|------------|
| Dividend yield           |       |     | 2          | %        |       |     | 3          | % |   |   | 0 | % |   |
| Expected  volatility     |       |     | 73         | %        |       |     | 65         | % |   |   | 85 | % |   |
| Risk free  interest rate |       |     | 5          | %        |       |     | 4          | % |   |   | 3 | % |   |
| Expected life (years)    |       |     | 5          |     |       |     | 5          |   |   |   | 5 |   |   |

 

Thefollowing table illustrates the effect on net income and earnings per share forthe years ended December 31, 2005, and 2004, respectively, if the fairvalue based method had been applied to all outstanding and unvested awards.

| ** **                                                                                                        | ** ** | **Year Ended December 31,** | ** ** |
|-------------------------------------------------------------------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                                                                                        | ** ** | **2005**                                   | ** ** | **2004** | ** ** |
| ** **                                                                                                        | ** ** | **(Restated)**                             | ** ** | **(Restated)** | ** ** |
| ** **                                                                                                        | ** ** | **In thousands of dollars** | ** ** |
| Net income, as  reported                                                                                          |       |                                       | $          | 6,723 |   |   |   | $ | 1,441 |   |   |
| Add: Stock-based  employee compensation expense                                                                   |       |                                       | 17         |   |   |   | — |   |   |
| Deduct: Total  stock-based compensation adjusted for stock option cancellations                                   |       |                                       | (12        | ) |   |   | (6 | ) |   |
| Deduct: Total  stock-based employee compensation expense determined under fair value  based method for all awards |       |                                       | (73        | ) |   |   | (128 | ) |   |
| Pro forma  net income                                                                                        |       |                                       | $          | 6,655 |   |   |   | $ | 1,307 |   |   |
| Earnings (loss)  per share                                                                                        |       |                                       |       |   |   |   |   |   |   |
| As reported:                                                                                                      |       |                                       |       |   |   |   |   |   |   |
| Basic                                                                                                             |       |                                       | $          | 0.64 |   |   |   | $ | 0.15 |   |   |
| Diluted                                                                                                           |       |                                       | $          | 0.63 |   |   |   | $ | 0.14 |   |   |
| Pro forma:                                                                                                   |       |                                       |       |   |   |   |   |   |   |
| Basic                                                                                                             |       |                                       | $          | 0.64 |   |   |   | $ | 0.14 |   |   |
| Diluted                                                                                                           |       |                                       | $          | 0.62 |   |   |   | $ | 0.12 |   |   |

 

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We recognized stock based compensation expense of $1.8million, or $0.16 per diluted share,  and$0.7 million, or $0.06 per diluted share, for the years ended December 31,2006, and 2005, respectively.

(v)   *Recent AccountingPronouncements*—On November 10, 2005, the FASB issuedStaff Position No. 123(R)-3 (“FSP 123R-3”), ‘‘TransitionElection Related to Accounting for the Tax Effects of Share-Based PaymentAwards.” We elected not to adopt the alternative transition method provided inFSP 123R-3, which provides an alternative (and simplified) method tocalculate the pool of excess income tax benefits upon the adoption of SFAS No. 123(R),and chose the transition method presented in FAS 123(R).

In January 2006, we adopted SFAS No. 154, “AccountingChanges and Error Corrections”, a replacement of APB Opinion No. 20 andSFAS No. 3 (“SFAS 154”). SFAS 154 requires retrospective application forvoluntary changes in accounting principles unless it is impracticable to do so.In addition, SFAS 154 requires a change in depreciation method to be accountedfor as a change in estimate, not as a change in accounting principle aspreviously required by APB 20. However, a change in depreciation methods mustcontinue to be justified by its preferability and related disclosures must beprovided. We do not expect any material impact upon adoption of thispronouncement.

In June 2006, the FASB issued FIN 48, “Accountingfor Uncertainty in Income Taxes,” an interpretation of FASB Statement No. 109“Accounting for Income Taxes” (“FIN 48”). This interpretation prescribes arecognition threshold and measurement attribute for the financial statementrecognition and measurement of a tax position taken or expected to be taken ina tax return and requires disclosure for uncertain tax positions for which itis “reasonably possible” the amount of unrecognized tax benefits will changesignificantly within one year. This interpretation also provides guidance onde-recognition, classification, interest and penalties, accounting in interimperiods, disclosure and transition. We must adopt FIN 48 in fiscal year 2007. Wedo not expect any material impact upon adoption of this pronouncement.

In September 2006,the Securities and Exchange Commission issued Staff Accounting Bulletin No. 108(“SAB 108”), “Considering the Effects of Prior Year Misstatements whenQuantifying Misstatements in Current Year Financial Statements.” SAB 108 providesguidance regarding the consideration given to prior year misstatements whendetermining materiality in current year financial statements and is effectivefor fiscal years ending after November 15, 2006. We do not expect anymaterial impact upon adoption of this SEC ruling.

**Note 2 *Discontinued Operations***

In the second quarter of 2005, we committed to an exitplan related to our wholly owned subsidiary in Switzerland. This action wastaken in response to declining revenue and cash flows from the operations ofthis subsidiary during 2004 and 2005. All existing revenue contracts of thissubsidiary were completed in the second quarter of 2004, and the subsidiary hadno significant assets or operations. Selling efforts during 2004 and the firstquarter of 2005 were unsuccessful and, as a result, management decided toliquidate the Swiss subsidiary. Approximately $178,000 was accrued for costsexpected to be incurred during the last half of 2005 and was classified as acurrent liability at September 30, 2005, based on the expected completiondate of the liquidation, and included in selling, general and administrativeexpenses for the second quarter of 2005. The accrual was comprised of $108,000in compensation and benefits, $9,000 in losses on disposal of assets, $34,000in legal and accounting costs and $27,000 in other administrative costs. Duringthe year ended December 31, 2005, approximately $143,000 in cash was paidrelated to exit activities.

In December 2005, we liquidated the remaininginvestment in our Swiss subsidiaries and will have no significant continuinginvolvement in Switzerland. We eliminated the operations and cash flows of theSwiss subsidiaries from ongoing operations, and have presented the results ofthe Swiss subsidiaries as discontinued operations for all periods. We accruedapproximately $165,000 for obligations as of 

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December 31, 2005.The accrual was comprised of $95,000 in compensation and benefits, $27,000 inlegal and accounting costs and $43,000 in other administrative costs. For theyear ended December 31, 2006, approximately $156,000 in cash was paidrelated to exit activities.

Thepresentation of all prior periods is revised to reflect the Swiss operations asdiscontinued operations.

| ** **                     | ** ** | **Discontinued Operations  for the Year Ended** | ** ** |
|--------------------------------|------------|---------------------------------------------------------------------|------------|
| ** **                     | ** ** | **2006**                                                            | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                     | ** ** | **(in thousands)**                                             | ** ** |
| Assets to be  disposed         |       |                                                                | $          | — |   |   | $ | 1 |   | $ | 32 |   |
| Liabilities to be  disposed    |       |                                                                | $          | — |   |   | $ | 83 |   | $ | 69 |   |
| Revenues                       |       |                                                                | $          | — |   |   | $ | — |   | $ | 10 |   |
| Gain/(loss)  before income tax |       |                                                                | $          | 1 |   |   | $ | (1,270 | ) | $ | (937 | ) |
| Net loss                       |       |                                                                | $          | 1 |   |   | $ | (1,212 | ) | $ | (893 | ) |
| Earnings per  share:           |       |                                                                |       |   |   |   |   |   |   |
| Basic                          |       |                                                                | $          | — |   |   | $ | (0.12 | ) | $ | (0.10 | ) |
| Diluted                        |       |                                                                | $          | — |   |   | $ | (0.12 | ) | $ | (0.08 | ) |

 

**Note 3 *Financing Agreement and Liquidity***

On December 15, 2006, weentered into a credit agreement with JPMorganChase Bank, N.A. This credit agreement forms the basis of a $5.5 millionrevolving line of credit maturing March 31, 2009. Interest on theoutstanding amount under the credit facility is payable either quarterly or atthe end of the applicable LIBOR interest period elected by the Company, at arate equal to, at our option, either (i) the bank’s prime rate thencurrently in effect minus 1.5% or (ii) the LIBOR rate plus 1.25%. Ourobligations under the credit facility are secured by a security interest in ouraccounts and related collateral as well as a security interest in our equityownership of all subsidiaries. The credit agreement limits our ability to,among other things, make certain distributions and dividends, incur liens,dispose of our assets and consummate any merger, certain acquisitions and otherbusiness combination transactions. We are also required to meet certainfinancial covenants under the credit agreement, including maintaining a minimumtangible net worth as defined in the credit agreement.

Prior to August 31, 2006, and during 2005 and2004, we utilized a $5.5 million revolving line of credit with Bank ofAmerica, N.A. During 2003, we utilized a credit facility with our former seniorlender, Comerica Bank. Total interest expense under bank credit facilities was$0, $4,000 and $135,000 for 2006, 2005 and 2004, respectively. We incurredcommitment fees on the unused portion of the credit facility in 2006, 2005 and2004, totaling $13,000, $21,000 and $9,000, respectively, at an interest rateof 0.375%. The credit facility contained no provision for unused commitmentfees in 2003.

Total interest expense for 2006 was $27,000, comprisedof $14,000 related to our credit facility and $13,000 for interest on taxpenalties related to the review of our historical stock option grantingprocedures.

Total interest expense for 2005 was $92,000, comprisedof $25,000 related to bank debt and $60,000 for related party debt, and $7,000to other parties.

Total interest expense for 2004 was $289,000,comprised of $143,000 related to bank debt and $145,000 for related party debt,and $1,000 to other parties.

For the year ended December 31,2006, we had no borrowings or repayments on our current or former creditfacility and we had no outstanding balance on our current credit facility as ofDecember 31, 2006. At December 31, 2005 and 2004, the outstanding balance on the former line of credit was $0 and 

F-16

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$0.4 million, respectively, classified as a currentliability, and we were in compliance with all of our debt covenants.

**Note 4 *Other Assets***

| ** **                                                          | ** ** | **December 31,**                  | ** ** |
|---------------------------------------------------------------------|------------|----------------------------------------|------------|
| ** **                                                          | ** ** | **2006**                               | ** ** | **2005** | ** ** |
| ** **                                                          | ** ** | **In thousands  of dollars** | ** ** |
| Prepaid expenses                                                    |       | $                                      | 223        |   | $ | 246 |   |
| Current  receivables                                                |       | 88                                     |       | 16 |   |
| Income tax  receivable                                              |       | 53                                     |       | 50 |   |
| Investment in  Texas Stadium Suite, net of accumulated amortization |       | 38                                     |       | 57 |   |
|                                                                |       | 402                                    |       | 369 |   |
| Less current portion                                                |       | (333                                   | )          | (282 | ) |
|                                                                |       | $                                      | 69         |   | $ | 87 |   |

 

**Note 5 *Property and Equipment***

| ** **                                      | ** ** | **December 31,**                  | ** ** |
|-------------------------------------------------|------------|----------------------------------------|------------|
| ** **                                      | ** ** | **2006**                               | ** ** | **2005** | ** ** |
| ** **                                      | ** ** | **In thousands of  dollars** | ** ** |
| Equipment                                       |       | $                                      | 972        |   | $ | 875 |   |
| Furniture and  fixtures                         |       | 561                                    |       | 561 |   |
| Leasehold  improvements                         |       | 910                                    |       | 747 |   |
| Computer software                               |       | 317                                    |       | 110 |   |
|                                            |       | 2,760                                  |       | 2,293 |   |
| Less accumulated  depreciation and amortization |       | (2,144                                 | )          | (1,800 | ) |
|                                            |       | $                                      | 616        |   | $ | 493 |   |

 

During the year ended December 31, 2005, weidentified approximately $6.0 million in fixed assets with relatedaccumulated depreciation of approximately $6.0 million, which were nolonger utilized. We recorded a loss of $73,706 upon disposal of these assets.Also during the year, we purchased all our equipment being leased under capitalleases, resulting in a gain of $800.

Depreciation fromequipment under capital leases totaled $0, $7,000, and $6,000 for the yearsended December 31, 2006, 2005, and 2004, respectively.

**Note 6 *Accounts Payable andAccrued Liabilities***

| ** **                 | ** ** | **December 31,**                  | ** ** |
|----------------------------|------------|----------------------------------------|------------|
| ** **                 | ** ** | **2006**                               | ** ** | **2005** | ** ** |
| ** **                 | ** ** | **In thousands of  dollars** | ** ** |
| Accounts payable  trade    |       | $                                      | 471        |   | $ | 358 |   |
| Accrued travel             |       | 495                                    |       | 436 |   |
| Other accrued  liabilities |       | 645                                    |       | 475 |   |
|                       |       | $                                      | 1,611      |   | $ | 1,269 |   |

 

F-17

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**Note 7 *Accrued Wages and Benefits***

| ** **                             | ** ** | **December 31,**                  | ** ** |
|----------------------------------------|------------|----------------------------------------|------------|
| ** **                             | ** ** | **2006**                               | ** ** | **2005** | ** ** |
| ** **                             | ** ** | **In thousands of  dollars** | ** ** |
| Accrued salaries  and benefits         |       | $                                      | 454        |   | $ | 336 |   |
| Stock  appreciation rights             |       | —                                 |       | 782 |   |
| Accrued bonuses  and sales commissions |       | 1,435                                  |       | 1,208 |   |
|                                   |       | $                                      | 1,889      |   | $ | 2,326 |   |

 

**Note 8 *Other Long-TermObligations***

| ** **                              | ** ** | **December 31,**                  | ** ** |
|-----------------------------------------|------------|----------------------------------------|------------|
| ** **                              | ** ** | **2006**                               | ** ** | **2005** | ** ** |
| ** **                              | ** ** | **In thousands of  dollars** | ** ** |
| Dividends on  unvested restricted stock |       | $                                      | 19         |   | $ | — |   |
| Sublease  obligations                   |       | —                                 |       | 413 |   |
| Deferred rent                           |       | 84                                     |       | — |   |
|                                    |       | 103                                    |       | 413 |   |
| Less current  portion                   |       | —                                 |       | (139 | ) |
|                                    |       | $                                      | 103        |   | $ | 274 |   |

 

**Note 9 *Income Taxes***

Thedomestic and foreign source components of income (loss) from continuingoperations before taxes are as follows:

| ** **       | ** ** | **Year Ended December 31,** | ** ** |
|------------------|------------|--------------------------------------------|------------|
| ** **       | ** ** | **2006**                                   | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **       | ** ** | **In thousands of dollars** | ** ** |
| Domestic sources |       | $                                          | 14,685     |   | $ | 8,480 |   | $ | (11,459 | ) |
| Foreign sources  |       | 584                                        |       | (224 | ) | 13,793 |   |
|             |       | $                                          | 15,269     |   | $ | 8,256 |   | $ | 2,334 |   |

 

In 2004, $13.7 million of intercompany bad debtfrom our foreign subsidiaries in Asia was recorded on the books of theUnited States parent company. Conversely, $13.7 million of debtforgiveness income was recorded by the respective subsidiaries in Asia. Notaxes are owed as a result of the debt forgiveness income due to net operatingloss carryforwards in the Asia subsidiaries which offset the income in 2004.

F-18

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Thereconciliation of income tax from continuing operations computed at theUnited States federal statutory tax rate to our effective income tax rateis as follows:

| ** **                                                                      | ** ** | **Year Ended December 31,** | ** ** |
|---------------------------------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                                                      | ** ** | **2006**                                   | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                                                                      | ** ** | **In thousands of dollars** | ** ** |
| Income taxes at  statutory rate                                                 |       | $                                          | 5,192      |   | $ | 2,819 |   | $ | 805 |   |
| Effect on taxes  resulting from:                                                |       |                                       |       |   |   |   |   |
| State taxes                                                                     |       | 385                                        |       | 87 |   | 68 |   |
| Utilization of federal and foreign net operating  losses, less benefit received |       | (199                                       | )          | (2,811 | ) | (734 | ) |
| Unbenefitted losses of foreign subsidiary                                       |       | —                                     |       | 76 |   | — |   |
| Effect of United States and foreign minimum  taxes                         |       | —                                     |       | (119 | ) | (11 | ) |
| United States federal tax refund                                           |       | —                                     |       | — |   | (34 | ) |
| Change in valuation allowance                                                   |       | (1,763                                     | )          | — |   | — |   |
| Non-deductible compensation and other                                           |       | 149                                        |       | 259 |   | (115 | ) |
| Income tax expense (benefit)                                                    |       | $                                          | 3,764      |   | $ | 311 |   | $ | (21 | ) |

 

Federal, state and foreign income tax expense(benefit) from continuing operations consists of the following:

| ** **                       | ** ** | **Year Ended  December 31,**     | ** ** |
|----------------------------------|------------|--------------------------------------------|------------|
| ** **                       | ** ** | **2006**                                   | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                       | ** ** | **In thousands of dollars** | ** ** |
| Current tax  expense (benefit):  |       |                                       |       |   |   |   |   |
| Federal                          |       | $                                          | 5,051      |   | 220 |   | $ | (102 | ) |
| State                            |       | 584                                        |       | 88 |   | 70 |   |
| Foreign                          |       | —                                     |       | 3 |   | 11 |   |
|                             |       | $                                          | 5,635      |   | $ | 311 |   | $ | (21 | ) |
| Deferred tax  expense (benefit): |       |                                       |       |   |   |   |   |
| Federal                          |       | (1,731                                     | )          | — |   | — |   |
| State                            |       | (140                                       | )          | — |   | — |   |
|                             |       | (1,871                                     | )          | — |   | — |   |
|                             |       | $                                          | 3,764      |   | $ | 311 |   | $ | (21 | ) |

 

F-19

----

Significantcomponents of our net deferred tax assets (liabilities) for federal and stateincome taxes are as follows:

| ** **                       | ** ** | **December 31,**                  | ** ** |
|----------------------------------|------------|----------------------------------------|------------|
| ** **                       | ** ** | **2006**                               | ** ** | **2005** | ** ** |
| ** **                       | ** ** | **In thousands of  dollars** | ** ** |
| Deferred tax assets:             |       |                                   |       |   |   |
| Current:                         |       |                                   |       |   |   |
| Accrued expenses                 |       | $                                      | 177        |   | $ | 340 |   |
| Allowance for doubtful accounts  |       | 15                                     |       | 47 |   |
| Net operation loss carryforwards |       | 59                                     |       | — |   |
| Deferred compensation            |       | 326                                    |       | — |   |
| Valuation allowance              |       | —                                 |       | (387 | ) |
| Net current deferred tax asset   |       | 577                                    |       | — |   |
| Non-current:                     |       |                                   |       |   |   |
| Accrued expenses                 |       | 57                                     |       | 48 |   |
| Minimum tax credit carryforward  |       | 197                                    |       | 105 |   |
| Net operating loss carryforward  |       | 1,081                                  |       | 1,234 |   |
| Deferred compensation            |       | 76                                     |       | 105 |   |
| Valuation allowance              |       | (117                                   | )          | (1,492 | ) |
|                             |       | 1,294                                  |       | — |   |
| Total deferred tax assets        |       | 1,871                                  |       | — |   |
| Deferred tax liabilities         |       | —                                 |       | — |   |
| Net deferred tax asset           |       | $                                      | 1,871      |   | $ | — |   |

 

At December 31, 2006, we had $2.9 million ofUnited States federal net operating loss carryforwards. These carryforwards are subject to a $0.2 million Section 382 annual limitationexpiring 2022. At December 31, 2006, we had approximately $2.4 millionof state net operating loss carryovers, expiring at various times.

At December 31, 2005, we had $3.1 million ofUnited States federal net operating loss carryforwards. These carryforwards are subject to a $0.2 million Section 382 annual limitationexpiring 2022. At December 31, 2005, we had approximately$1.1 million of state net operating loss carryovers, expiring at varioustimes. Due to liquidation proceedings related to our Asia and Europesubsidiaries, foreign net operating losses of $0.7 million and$2.5 million, respectively, were forfeited.

At December 31, 2004, we had $11.4 millionof United States federal net operating loss carryforwards, of which$3.3 million was subject to a $0.2 million Section 382 annuallimitation. At December 31, 2004, we had approximately $9.2 millionof state net operating loss carryovers, expiring at various times. We also hadapproximately $3.2 million in foreign net operating loss carryovers at December 31,2004 of which $0.7 million were in Asian subsidiaries and $2.5 millionwere in European subsidiaries. Due to liquidation proceedings and operatinglosses in these subsidiaries, the foreign net operating losses will beforfeited, and therefore no deferred tax asset was established for the foreignNOLs.

Beginning in 2001, we had provided a valuationallowance for the full amount of our net deferred tax assets. During the threemonths ended March 31, 2006, we determined the future sources of taxableincome, the reversing of temporary differences and other tax planningstrategies will be sufficient to realize certain components of our deferred taxasset. Therefore, approximately $0.3 million of the deferred tax assetvaluation allowance was removed during the three months ended March 31,2006. Although our statutory tax rate is approximately 38%, the removal of thisportion of our deferred tax asset valuation 

F-20

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allowance reduced incometax expense by 10 percentage points, resulting in an effective tax rate of 28%for the quarter ended March 31, 2006.

At December 31, 2006,after further evaluation of operating results of the most recent three-yearperiod and comparison of all positive and negative evidence, we determined thata valuation allowance was only appropriate on approximately $117,000 of the NOLcarryforward, due to annual limitations under Section 382. Therefore, weremoved $1.5 million of the valuation allowance, which decreased income taxexpense and increased assets.

**Note 10 *Employee Benefit Plans***

We sponsor a 401(k) retirementplan. We may match a portion of the participants’ contributions or make profit-sharingcontributions. Participants vest in our contributions ratably over five yearsand may join immediately. Matching contributions were $919,000, $739,000 and$535,000 for the years ending December 31, 2006, 2005, and 2004,respectively.

**Note 11 *Commitments and Contingencies***

**Operating leasecommitments**

We lease office space and various types of officeequipment under non-cancelable operating leases. Rent expense related to theseoperating leases totaled $1.7 million in 2006, $1.5 million in 2005,and $1.0 million for 2004.

In June 2006,we entered into a new lease agreement expanding our current office space inIrving, Texas. The new lease agreement became effective September 1, 2006,and expires on March 31, 2012. Minimum lease payments required undernon-cancelable operating lease arrangements subsequent to December 31,2006, are as follows:

| ** **                    | ** ** | **Operating Leases**                  | ** ** |
|-------------------------------|------------|--------------------------------------------|------------|
| ** **                    | ** ** | **In thousands of dollars** | ** ** |
| 2007                          |       |                                       | $          | 1,298 |   |   |
| 2008                          |       |                                       | 880        |   |   |
| 2009                          |       |                                       | 666        |   |   |
| 2010                          |       |                                       | 530        |   |   |
| 2011                          |       |                                       | 551        |   |   |
| Thereafter                    |       |                                       | 138        |   |   |
| Total minimum lease  payments |       |                                       | $          | 4,063 |   |   |

 

**Sublease losses**

*During June 2006, we terminateda portion of our Troy, Michigan office lease and our related sublease agreementresulting in a gain of $16,000.*

*On August 1,2006, we learned the subtenant of our Reston, Virginia office had filedbankruptcy under Chapter 7 of the U.S. Bankruptcy code on July 31, 2006.On September 28, 2006, we signed an occupancy agreement with thebankruptcy trustee. The terms provide rent payments by the bankruptcy trusteeat approximately the same monthly rate as the subtenant previously paid throughDecember 31, 2006. As of January 1, 2007, the subtenant no longeroccupies our office space. We will actively use the space to supplement ouroffice space needs through the end of the lease agreement ending October 31,2007. The remaining rent reserve balance of approximately $96,000 will beamortized ratably against rent expense until the expiration of the lease.*

F-21

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**Contingencies**

On January 3, 2007, the Compensation andCorporate Governance Committee of our Board of Directors granted a one-timecash award of $300,000 to Mr. Terry D. Stinson, President—CommercialOperations. This award was granted in recognition of Mr. Stinson’s pastand continuing efforts to grow our commercial sector business. The payment ofsuch award will be made on July 2, 2007 if, at the close of business on June 30,2007, Mr. Stinson has been continuously employed by us since January 4,2007.

In 2002, we filed for insolvency of our wholly-ownedsubsidiary headquartered in Frankfurt, Germany and in 2005, we filed forinsolvency of our wholly-owned subsidiary in Switzerland. During 2005, asuit was filed against our subsidiary in Switzerland by the German insolvencyadministrator to recover approximately $0.3 million related to anintercompany receivable between the two entities. Due to the insolvency of theSwiss entity, the suit was dismissed. We believe any future legal actionrelated to the closure of our German and Swiss subsidiaries would not have amaterial impact on our financial position, results of operations or cash flowsin future years.

We have self reported theinternal investigation into our historical stock option practices and relatedrestatement to the Securities and Exchange Commission and intend to cooperatewith any informational or other requests from the SEC. We have become subjectto various claims and other legal matters, such as collection matters initiatedby the Company, in the course of conducting our business. We believe neithersuch claims and other legal matters nor the cost of prosecuting and/ordefending such claims and other legal matters will have a material adverseeffect on our consolidated results of operations, financial condition or cashflows.

**Note 12 *Geographic and Major Customer Information***

**GeographicalInformation**

Weprovide services within one industry segment. During 2006, 2005, and 2004, weconducted business primarily in North America, and had limited operations inEurope and Asia/Pacific. In the fourth quarter of 2005, we liquidated ourremaining interest in our operations located in Switzerland and revised thepresentation of our financial results to reflect the discontinued operations.The geographical revenue and long-lived asset information below has beenrestated to reflect this change:

| ** **                                                    | ** ** | **North America** | ** ** | **Europe** | ** ** | **Asia/Pacific** | ** ** | **Total** | ** ** |
|---------------------------------------------------------------|------------|------------------------|------------|------------|------------|------------------|------------|-----------|------------|
| ** **                                                    | ** ** | **In thousands**  | ** ** |
| Year ended  December 31, 2006:                           |       |                   |       |       |       |             |       |      |       |   |   |   |   |   |   |
| Revenue                                                       |       |                   | $          | 59,407     |       |             |       | —    |       |   |   | $ | 71 |   |   | $ | 59,478 |   |
| Income/(loss)  from continuing operations before income taxes |       |                   | 15,422     |       |       |             | —     |      |       |   | (153 | ) |   | 15,269 |   |
| Long-lived assets                                             |       |                   | 685        |       |       |             | —     |      |       |   | — |   |   | 685 |   |
| Year ended  December 31, 2005:                           |       |                   |       |       |       |             |       |      |       |   |   |   |   |   |   |
| Revenue                                                       |       |                   | $          | 43,033     |       |             |       | —    |       |   |   | $ | 29 |   |   | $ | 43,062 |   |
| Income (loss)  from continuing operations before income taxes |       |                   | $          | 8,480      |       |             |       | —    |       |   |   | $ | (224 | ) |   | $ | 8,256 |   |
| Long-lived assets                                             |       |                   | $          | 580        |       |             |       | —    |       |   |   | — |   |   | $ | 580 |   |
| Year ended  December 31, 2004:                           |       |                   |       |       |       |             |       |      |       |   |   |   |   |   |   |
| Revenue                                                       |       |                   | $          | 28,930     |       |             |       | —    |       |   |   | $ | 1,090 |   |   | $ | 30,020 |   |
| Income (loss)  from continuing operations before income taxes |       |                   | $          | (11,480    | )          |             |       | —    |       |   |   | $ | 13,793 |   |   | $ | 2,313 |   |
| Long-lived assets                                             |       |                   | $          | 804        |       |             |       | —    |       |   |   | $ | 7 |   |   | $ | 811 |   |

 

F-22

----

**Major CustomerInformation**

During 2006, one client accounted for approximately$29.1 million or 50% of North America revenues and another clientaccounted for approximately $24.8 million or 42% of North Americarevenues. One client accounted for approximately $67,000 or 94% of Asia/Pacific2006 revenues.

During 2005, one client accounted for approximately$27.9 million or 65% of North America revenues and another clientaccounted for approximately $13.0 million or 30% of North Americarevenues. One client accounted for approximately $29,000 or 100% ofAsia/Pacific 2005 revenues.

During 2004, one client accounted for approximately$14.5 million or 50% of North America revenues and another client accountedfor approximately $9.8 million or 34% of North America revenues. Oneclient accounted for approximately $698,000 or 64% of Asia/Pacific 2004revenues and another client accounted for approximately $371,000 or 34% ofAsia/Pacific 2004 revenues.

There were no otherclients from whom revenue exceeded 10% of any one geographical region’srevenues in the years ended December 31, 2006, 2005, and 2004.

**Note 13 *Related Party Transactions***

In 2002, we issued two promissory notes totaling$1.4 million to our current Chairman of the Board, General John T. Chain, Jr.The notes were subordinated to our senior lender and matured in 2006. On February 7,2005, we signed an amendment to our credit facility with Bank of America, N.A.allowing, but not requiring, us to make regularly scheduled principal paymentsof $0.1 million each month against our subordinated debt to General Chainprovided we were not in default on any agreement with Bank of America, N.A. Wemade five payments of $0.1 million each, reducing the subordinated debtbalance to $0.9 million. On May 7, 2005, we signed an amendment tothe credit facility releasing the prohibition against repayment of subordinateddebt. On June 9, 2005, we repaid the remaining $0.9 million balance,including unpaid interest, of our then outstanding subordinated debt to Chain.Interest payments related to the subordinated debt were $112,508 and $141,520in 2005 and 2004, respectively.

A family member of James T. Taylor, our ChiefExecutive Officer and President, performed advertising and marketing servicesduring 2006, 2005 and 2004 for the Company. Fees and expenses paid for theseservices were approximately $13,000, $32,300, and $4,600 for 2006, 2005, and2004, respectively.

On February 14, 2005, Mr. Edward P. Evans, adirector of the Company, exercised his outstanding warrants in full. Wereceived the purchase price of $130,470 and on February 23, 2005, weissued 434,899 shares of unregistered common stock to Mr. Evans.

On February 16, 2005, General John T. Chain, Jr.,Chairman of the Board, exercised his outstanding warrants in full. We receivedthe purchase price of $130,470 and on February 23, 2005, we issued434,899 shares of unregistered common stock to General Chain.

On December 31, 2004, John R. Hamann, former CEOof the Company, exercised stock options for 97,399 shares of common stock.We received the purchase price of $36,038 and on January 4, 2005, weissued 97,399 shares of registered common stock to Mr. Hamann.

On February 19, 2004, we entered into aconsulting agreement with our former Asia region president, Mr. G. TobyMarion. Effective May 1, 2004, we agreed to pay $408,750, payable in nineinstallments of $43,750 per month beginning May 31, 2004 and oneinstallment of $15,000 payable in January 2005. Mr. Marion agreed toconsult and advise the Company on doing business in Asia. This agreementexpired January 31, 2005. Non-compete and other covenants were re-affirmedand carried into the consulting agreement. Under the terms of the agreement, wepaid $47,813 during 2005 and $393,750 during 2004.

F-23

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On January 12, 2004, we entered into a separationagreement with John R. Hamann, former CEO of the Company. As part of theseparation agreement between us and Mr. Hamann, the expiration date of his329,683 outstanding options was extended to January 12, 2005, whichcreated a new stock option issuance under generally accepted accountingprinciples. Under the new issuance, Mr. Hamann exercised129,683 options during 2004. We issued 32,284 shares of common stockduring 2004 related to these exercises. The remaining 97,399 shares wereissued on January 4, 2005, based on an exercise date of December 31,2004. The remaining 200,000 options expired on January 12, 2005, dueto their exercise price exceeding market value.

On December 31, 2003, we entered into aconsulting agreement with our former Chief Executive Officer, John R. Hamann.Effective January 13, 2004, we agreed to pay a total of $450,000 to Mr. Hamannin return for his services as an advisor to the Chairman of the Board andseeking out new business for the Company. Monthly payments of $37,500 were madeuntil expiration of this agreement on January 12, 2005. In addition, weagreed to pay Mr. Hamann a commission of five percent of the value on anynew U.S. commercial business for the Company from clients identified by Mr. Hamannprior to January 13, 2005, and which led to business under contract priorto July 13, 2005. Non-compete and other covenants were re-affirmed andcarried into the consulting agreement. Under the terms of the agreement, wepaid $13,846 and $436,154 for consulting services and $0 for commissions during2005 and 2004, respectively.

On December 17, 2003, we entered into settlementand consulting agreements with a former employee to provide services with regardsto the Asian marketplace. We paid a total of $0 and $184,640 during 2005 and2004, respectively.

On July 1, 2003, we entered into a consultingagreement with our Chairman, General John T. Chain, Jr. Under the terms ofthe contract, General Chain received $100,000 annually, in quarterlyinstallments, in return for his services with regards to sales, marketing andfinancial strategies. The agreement expired June 30, 2005. We madepayments under this agreement totaling $50,000 and $150,000 during 2005 and 2004, respectively.

Effective April 8,2003, we entered into a Stock Appreciation Rights (“SAR”) agreement with JohnR. Hamann, former CEO of the Company. Mr. Hamann’s agreement granted him170,317 SARs at a price of $0.42 per SAR. The SARs were exercisable infull or in part immediately upon grant and entitled Mr. Hamann to a cashpayment equal to the fair market value, as defined in the agreement, of a shareof common stock the Company over $0.42 per share. In the third quarter of 2004,Mr. Hamann exercised 42,400 SARs, for which we paid approximately$46,000. On December 31, 2004, Mr. Hamann exercised his remaining127,917 SARs, for which we paid approximately $144,000 on January 4,2005, in accordance with the SARs agreement.

F-24

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**Note 14 *Stock Based Awards***

**Options**

Asummary of the status of our stock options to employees as of December 31,2006, 2005, and 2004 and changes in the years then ended is presented below.

| ** **                                                 | ** ** | **2006**   | ** ** | **2005**   | ** ** | **2004**                               | ** ** |
|------------------------------------------------------------|------------|------------|------------|------------|------------|----------------------------------------|------------|
| **Common Option Shares**                         | ** ** | ** ** | ** ** | **Shares** | ** ** | **Weighted  Average  Exercise  Price** | ** ** | **Shares** | ** ** | **Weighted  Average  Exercise  Price** | ** ** | **Shares** | ** ** | **Weighted  Average  Exercise  Price** | ** ** |
| Outstanding at  beginning of year                          |       | 424,703    |       |       | $          | 4.74                                   |       |   | 936,516 |   |   | $ | 6.24 |   |   | 1,277,817 |   |   | $ | 4.93 |   |   |
| Adjustments                                                |       | 411,865    |       |       | 8.48       |                                   |       | 200 |   |   | 6.47 |   |   | — |   |   | — |   |   |
| Exercised                                                  |       | (400,045   | )          |       | 3.75       |                                   |       | (100 | ) |   | 0.94 |   |   | (229,683 | ) |   | 0.38 |   |   |
| Forfeited                                                  |       | (80,275    | )          |       | 9.45       |                                   |       | (511,913 | ) |   | 7.49 |   |   | (111,618 | ) |   | 3.29 |   |   |
| Outstanding at  end of year                                |       | 356,248    |       |       | $          | 9.12                                   |       |   | 424,703 |   |   | $ | 4.74 |   |   | 936,516 |   |   | $ | 6.24 |   |   |
| Options  exercisable at year-end                           |       | 356,248    |       |       | $          | 9.12                                   |       |   | 424,703 |   |   | $ | 4.74 |   |   | 804,929 |   |   | $ | 6.13 |   |   |
| Weighted average  grant-date fair value of options granted |       |       |       |       | $          | —                                 |       |   |   |   |   | $ | — |   |   |   |   |   | $ | — |   |   |
|                                                            |            |            |            |            |            |                                        |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

Thefollowing table summarizes information about stock options outstanding at December 31, 2006.

| ** **                                | ** ** | **Common Options** | ** ** | **Options Outstanding and Exercisable** | ** ** |
|-------------------------------------------|------------|-------------------------|------------|--------------------------------------------------------|------------|
| **Exercise Price**                   | ** ** | ** **              | ** ** | **Outstanding  and  Exercisable**                      | ** ** | **Weighted Average  Remaining  Contractual Life  (Years)** | ** ** | **Weighted Average  Exercise Price** | ** ** |
| $0.48 -    7.75            |       |                    | 15,994     |                                                   |       |   | 5.22 |   |   |   | $ | 1.00 |   |   |
|   8.63 -    9.44 |       |                    | 254,772    |                                                   |       |   | 1.30 |   |   |   | 9.18 |   |   |
|   9.50 -  12.88            |       |                    | 85,482     |                                                   |       |   | 2.05 |   |   |   | 11.87 |   |   |
| $0.48 - 12.88                        |       |                    | 356,248    |                                                   |       |   | 1.66 |   |   |   | $ | 9.12 |   |   |
|                                           |            |                         |            |                                                        |            |  |  |  |  |  |  |  |  |  |  |  |

 

The excess of market price over the exercise price wasapproximately $2.1 million for stock options outstanding and exercisableas of December 31, 2006. The market price over exercise price for stockoptions exercised in 2006 was approximately $2.3 million.

The excess of market price over the exercise price wasapproximately $1.7 million for stock options outstanding and exercisableas of December 31, 2005. The market price over exercise price for stockoptions exercised in 2005 was approximately $406,000.

The amount of cash received from the exercise of stockoptions during 2006 was approximately $412,000. The amount of cash receivedfrom the exercise of stock options during 2005 was approximately $94,000.

F-25

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Changesin our outstanding non-vested options during 2006 and 2005 were as follows:

| ** **                                        | ** ** | **Shares** | ** ** | **Weighted Average  Exercise Price** | ** ** |
|---------------------------------------------------|------------|------------|------------|------------------------------------------------|------------|
| Non-vested  options at the December 31, 2004 |       | 131,587    |       |                                           | $          | 6.94 |   |   |
| Adjustments                                       |       | 200        |       |                                           | 6.47       |   |   |
| Granted                                           |       | —     |       |                                           | —     |   |   |
| Vested                                            |       | (26,787    | )          |                                           | (1.59      | ) |   |
| Forfeited                                         |       | (105,000   | )          |                                           | (8.29      | ) |   |
| Non-vested  options at December 31, 2005     |       | —     |       |                                           | $          | — |   |   |
| Adjustments                                       |       | 26,556     |       |                                           | —     |   |   |
| Granted                                           |       | —     |       |                                           | —     |   |   |
| Vested                                            |       | (26,556    | )          |                                           |       |   |   |
| Forfeited                                         |       | —     |       |                                           | —     |   |   |
| Non vested options at  December 31, 2006     |       | —     |       |                                           | $          | — |   |   |

 

**Restricted Stock**

Under the 2005 Omnibus Stock and Incentive Plan, weare able to grant restricted stock. In 2006, we granted 50,000 performanceawards to employees under this plan. In 2005, we granted350,000 performance awards and 300,000 market awards to employeesunder this plan. The performance awards vest over 3 years and the marketawards become available and vest over 5 years. The fair value of theperformance awards is the excess of market price at grant date over theexercise price, of which is zero. The fair value of the market awards wasdetermined using a binomial lattice method. Shares are not delivered to theholder until all restrictions on the shares have lapsed under the terms of theindividual award.

Theawards are summarized below:

| ** **                                                          | ** ** | **2006**   | ** ** | **2005**   | ** ** |
|---------------------------------------------------------------------|------------|------------|------------|------------|------------|
| **Restricted Stock**                                           | ** ** | ** ** | ** ** | **Shares** | ** ** | **Weighted Average  Exercise Price** | ** ** | **Shares** | ** ** | **Weighted Average  Exercise Price** | ** ** |
| Outstanding  grants at beginning of year                            |       | 650,000    |       |       | $          | 0.00 |   |   | — |   |   | $ | — |   |   |
| Granted during  year                                                |       | 50,000     |       |       | 0.00       |   |   | 650,000 |   |   | 0.00 |   |   |
| Outstanding  grants at end of year                                  |       | 700,000    |       |       | $          | 0.00 |   |   | 650,000 |   |   | $ | 0.00 |   |   |
| Restricted stock  exercisable at year-end                           |       | —     |       |       | $          | — |   |   | — |   |   | $ | — |   |   |
| Weighted average  grant-date fair value of restricted stock granted |       |       |       |       | $          | 10.15 |   |   |   |   |   | $ | 7.71 |   |   |
|                                                                     |            |            |            |            |            |  |  |  |  |  |  |  |  |  |  |  |  |

 

Asummary of the status of the Company’s restricted stock awards to employees forthe year ended December 31, 2006 is presented below:

| ** **                                    | ** ** | **Fully Restricted(1)** | ** ** | **Available(2)** | ** ** | **Vested(3)** | ** ** | **Total** | ** ** |
|-----------------------------------------------|------------|------------------------------|------------|------------------|------------|---------------|------------|-----------|------------|
| Outstanding  grants at January 1, 2006   |       |                         | 650,000    |             |       |          | —     |      |       |   | — |   |   | 650,000 |   |
| Change in restricted status                   |       |                         | (100,000   | )                |       |          | 100,000    |      |       |   | — |   |   | — |   |
| Awards                                        |       |                         | 50,000     |             |       |          | —     |      |       |   | — |   |   | 50,000 |   |
| Forfeitures                                   |       |                         | —     |             |       |          | —     |      |       |   | — |   |   | — |   |
| Outstanding grants at  December 31, 2006 |       |                         | 600,000    |             |       |          | 100,000    |      |       |   | — |   |   | 700,000 |   |

----

(1)          Fully restricted sharesare registered in the Holder’s name, but are deposited with the Company,together with stock powers and other instruments of assignment, endorsed inblank. Fully restricted 

F-26

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shares do not constituteissued and outstanding common stock for any corporate purposes and the Holderhas no rights, powers or privileges of a Holder of unrestricted shares.

(2)          Available sharesconstitute issued and outstanding common stock and the Holder of availableshares has all rights, powers and privileges of a holder of unrestrictedshares, except that the holder has no right to receive Available Shares untilthe date on which they become Vested Shares. A change in restricted statusoccurs upon satisfaction of certain required conditions as specified under eachAward.

(3)          Vestedshares are shares on which all restrictions have lapsed under the terms of theAward, and are held by the Holder as unrestricted shares, constitute issued andoutstanding common stock and the Holder has all rights, powers and privilegesof a Holder of unrestricted Shares.

**Warrants**

During2002, we issued stock warrants to two stockholders and to our then seniorlender. All warrants held by our stockholders were exercised in February 2005.The warrant held by our former senior lender was cancelled in September 2005upon repurchase by us (See Note 1(f)). The warrants were exercisableupon issuance and expired five years after date of issuance. Changes in ouroutstanding warrants were as follows:

| ** **                                                  | ** ** | **2006**   | ** **    | **2005**   | ** ** | **2004**                               | ** ** |
|-------------------------------------------------------------|------------|------------|---------------|------------|------------|----------------------------------------|------------|
| **Warrants**                                                | ** ** | ** ** | ** **    | **Shares** | ** ** | **Weighted  Average  Exercise  Price** | ** ** | **Shares** | ** ** | **Weighted  Average  Exercise  Price** | ** ** | **Shares** | ** ** | **Weighted  Average  Exercise  Price** | ** ** |
| Outstanding at  beginning of year                           |       |       | —        |       |       |                                   | —     |   |   | $ | 0.30 |   | 1,267,241 |   | 1,317,241 |   |   | $ | 0.64 |   |   |
| Exercised                                                   |       |       | —        |       |       |                                   | —     |   |   | (0.30 | ) | (869,798 | ) | — |   |   | — |   |   |
| Cancelled                                                   |       |       | —        |       |       |                                   | —     |   |   | (0.30 | ) | (397,443 | ) | (50,000 | ) |   | (9.13 | ) |   |
| Expired                                                     |       |       |          |       |       |                                   |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Outstanding at  end of year                                 |       |       | —        |       |       |                                   | —     |   |   | $ | — |   | — |   | 1,267,241 |   |   | $ | 0.30 |   |   |
| Warrants  exercisable at year-end                           |       |       |   — |       |       |                                   | —     |   |   |        — |   | — |   | 1,267,241 |   |   | $ | 0.30 |   |   |
| Weighted average  grant-date fair value of warrants granted |       |       |          |       |       |                                   |       |   |   | $ | — |   |   |   |   |   |   | $ | — |   |   |
|                                                             |            |            |               |            |            |                                        |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

There were no outstanding warrants at December 31,2006 or 2005.

The total cash receivedfrom the exercise of warrants during 2005 was approximately $261,000.

F-27

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**Stock AppreciationRights**

EffectiveApril 8, 2003, we entered into two Stock Appreciation Rights (“SARs”) agreementswith John R. Haman, former CEO of the Company, and James T. Taylor, current CEOof the Company (See Note 1(t)). Changes in our outstanding SARs wereas follows:

| ** **                                              | ** ** | **2006**   | ** ** | **2005** | ** ** | **2004**                               | ** ** |
|---------------------------------------------------------|------------|------------|------------|----------|------------|----------------------------------------|------------|
| **SARs**                                                | ** ** | ** ** | ** ** | **SARs** | ** ** | **Weighted  Average  Exercise  Price** | ** ** | **SARs** | ** ** | **Weighted  Average  Exercise  Price** | ** ** | **SARs** | ** ** | **Weighted  Average  Exercise  Price** | ** ** |
| Outstanding at  beginning of year                       |       | 99,351     |       |     | $          | 0.42                                   |       |   | 99,351 |   |   | $ | 0.42 |   |   | 269,668 |   |   | $ | 0.42 |   |   |
| Granted                                                 |       | —     |       |     | —     |                                   |       | — |   |   | — |   |   | — |   |   | — |   |   |
| Exercised                                               |       | (99,351    | )          |     | $          | 0.42                                   |       |   | — |   |   | — |   |   | (170,317 | ) |   | 0.42 |   |   |
| Outstanding at  end of year                             |       | —     |       |     | —     |                                   |       | 99,351 |   |   | $ | 0.42 |   |   | 99,351 |   |   | 0.42 |   |   |
| SARs exercisable  at year-end                           |       | —     |       |     | $          | —                                 |       |   | 99,351 |   |   | $ | — |   |   | 99,351 |   |   | $ | 0.42 |   |   |
| Weighted average  grant-date fair value of SARs granted |       |       |       |     | $          | —                                 |       |   |   |   |   | $ | — |   |   |   |   |   | $ | — |   |   |
|                                                         |            |            |            |          |            |                                        |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

All outstanding SARs wereexercised in 2006. There were no SARs exercised in 2005.

**Note 15 *Supplemental Disclosure ofCash Flow Information***

| ** **                            | ** ** | **Year Ended  December 31,**     | ** ** |
|---------------------------------------|------------|--------------------------------------------|------------|
| ** **                            | ** ** | **2006**                                   | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                            | ** ** | **In thousands of dollars** | ** ** |
| Interest paid                         |       | $                                          | 17         |   | $ | 145 |   | $ | 301 |   |
| Income taxes paid                     |       | $                                          | 4,591      |   | $ | 202 |   | $ | 171 |   |
| Other non-cash  financing activities: |       |                                       |       |   |   |   |   |
| Dividends  declared                   |       | $                                          | 3,283      |   | $ | 533 |   | $ | — |   |

 

**Note 16 *Subsequent Events***

On March 15, 2007,our Board of Directors declared a $0.10 per share dividend, with a record dateof March 30, 2007 to be paid April 13, 2007.

F-28

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**Note 17 *Valuation and Qualifying Accounts***

Thefollowing table summarizes the activity of the allowance for doubtful accountsand the deferred tax asset valuation allowance:

| ** **                               | ** ** | **Year Ended December 31,** | ** ** |
|------------------------------------------|------------|--------------------------------------------|------------|
| ** **                               | ** ** | **2006**                                   | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                               | ** ** | **In thousands of dollars** | ** ** |
| Allowance for  doubtful accounts:        |       |                                       |       |   |   |   |   |
| Beginning balance                        |       | $                                          | 137        |   | $ | 114 |   | $ | 45 |   |
| Additions to expense                     |       | —                                     |       | 92 |   | 69 |   |
| Reductions of allowance                  |       | —                                     |       | (69 | ) | — |   |
| Ending balance                           |       | $                                          | 137        |   | $ | 137 |   | $ | 114 |   |
| Deferred tax  asset valuation allowance: |       |                                       |       |   |   |   |   |
| Beginning balance                        |       | $                                          | 1,880      |   | $ | 4,685 |   | $ | 4,507 |   |
| Additions to valuation allowance         |       |                                       |       | — |   | 178 |   |
| Reductions of valuation allowance        |       | (1,763                                     | )          | (2,805 | ) | — |   |
| Ending balance                           |       | $                                          | 117        |   | $ | 1,880 |   | $ | 4,685 |   |

 

**Note 18 *Selected QuarterlyFinancial Data (Unaudited)***

| ** **                                   | ** ** | **2006**                                                         | ** ** |
|----------------------------------------------|------------|------------------------------------------------------------------|------------|
| ** **                                   | ** ** | **For the Three Months Ended**               | ** ** |
| ** **                                   | ** ** | **Mar. 31  (Restated)**                                     | ** ** | **June 30  (Restated)** | ** ** | **Sept. 30  (Restated)** | ** ** | **Dec. 31** | ** ** |
| ** **                                   | ** ** | **In thousands, except per share data** | ** ** |
| Revenue                                      |       |                                                             | $          | 13,296 |   |   |   | $ | 15,570 |   |   |   | $ | 15,859 |   |   |   | $ | 14,753 |   |   |
| Gross profit                                 |       |                                                             | 6,398      |   |   |   | 8,428 |   |   |   | 8,732 |   |   |   | 7,949 |   |   |
| Operating income  from continuing operations |       |                                                             | 2,962      |   |   |   | 4,047 |   |   |   | 4,352 |   |   |   | 3,546 |   |   |
| Net income                                   |       |                                                             | 2,176      |   |   |   | 2,544 |   |   |   | 2,976 |   |   |   | 3,810 |   |   |
| Earnings per  share                          |       |                                                             |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Basic                                        |       |                                                             | $          | 0.20 |   |   |   | $ | 0.24 |   |   |   | $ | 0.27 |   |   |   | $ | 0.35 |   |   |
| Diluted                                      |       |                                                             | $          | 0.20 |   |   |   | $ | 0.23 |   |   |   | $ | 0.27 |   |   |   | $ | 0.34 |   |   |
| Weighted average  shares                     |       |                                                             |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Basic                                        |       |                                                             | 10,667     |   |   |   | 10,722 |   |   |   | 10,921 |   |   |   | 10,994 |   |   |
| Diluted                                      |       |                                                             | 10,880     |   |   |   | 10,978 |   |   |   | 11,084 |   |   |   | 11,176 |   |   |

 

| ** **                                   | ** ** | **2005**                                                         | ** ** |
|----------------------------------------------|------------|------------------------------------------------------------------|------------|
| ** **                                   | ** ** | **For the Three Months Ended**               | ** ** |
| ** **                                   | ** ** | **Mar. 31  (Restated)**                                     | ** ** | **June 30  (Restated)** | ** ** | **Sept. 30  (Restated)** | ** ** | **Dec. 31  (Restated)** | ** ** |
| ** **                                   | ** ** | **In thousands, except per share data** | ** ** |
| Revenue                                      |       |                                                             | $          | 7,908 |   |   |   | $ | 11,668 |   |   |   | $ | 11,786 |   |   |   | $ | 11,700 |   |   |
| Gross profit                                 |       |                                                             | 3,670      |   |   |   | 6,826 |   |   |   | 6,553 |   |   |   | 5,377 |   |   |
| Operating income  from continuing operations |       |                                                             | 6          |   |   |   | 3,547 |   |   |   | 2,721 |   |   |   | 1,995 |   |   |
| Net income (loss)                            |       |                                                             | (134       | ) |   |   | 3,127 |   |   |   | 2,654 |   |   |   | 1,076 |   |   |
| Earnings (loss)  per share                   |       |                                                             |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Basic                                        |       |                                                             | $          | (0.01 | ) |   |   | $ | 0.29 |   |   |   | $ | 0.25 |   |   |   | $ | 0.10 |   |   |
| Diluted                                      |       |                                                             | $          | (0.01 | ) |   |   | $ | 0.29 |   |   |   | $ | 0.25 |   |   |   | $ | 0.10 |   |   |
| Weighted average  shares                     |       |                                                             |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Basic                                        |       |                                                             | 10,077     |   |   |   | 10,655 |   |   |   | 10,655 |   |   |   | 10,655 |   |   |
| Diluted                                      |       |                                                             | 10,077     |   |   |   | 10,952 |   |   |   | 10,784 |   |   |   | 10,810 |   |   |

 

F-29

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**Note 19*Review of Stock Option Grant Practices***

As previously announced on February 2, 2007, ourBoard of Directors, with concurrence and oversight by our Audit Committee,which is comprised solely of independent directors, initiated a review of ourhistorical stock option practices and related accounting during the period 1988to 2006. This voluntary review was initiated in connection with our assessmentof our historical capitalization documentation and not in response to anyspecific concerns from within Thomas Group about option practices or anyinquiry from the Securities and Exchange Commission or any other regulatoryagency. The review was conducted with the assistance of our outside legalcounsel and specially-retained forensic accountants. Based on the preliminaryfindings of this review, on March 15, 2007, our Board of Directors, AuditCommittee and management concluded that we would need to restate our financialstatements and related footnote disclosures for fiscal years ending December 31,2002 through 2005 and the first three quarters of the 2006 fiscal year. TheAudit Committee and the Board of Directors further concluded on March 15,2007 that our previously issued financial statements and related auditors’reports for the years 2002 through 2005, and previously issued financialstatements for the first three quarters of 2006, should no longer be reliedupon.

The investigation has now been completed and our Boardof Directors received a report on the results of that investigation on March 30,2007 from our outside counsel and specially-retained forensic accountants. Atthat time, such counsel and accountants also submitted recommendations forproposed remedial measures to the Board, which are outlined below. Thoseproposals did not include any remedial measures pertaining to our directors orsenior management team. Except as noted below, those recommendations are nowbeing reviewed by the Board for possible implementation. After consideration ofthe report, the Board affirmed its confidence in our senior management team andtheir continued ability to sign certifications with respect to our periodic SECreports and our financial statements. We have self reported the internalinvestigation and the restatement to the Securities and Exchange Commission andintend to cooperate with any informational or other requests from the SEC.

During the course of the investigation, theinvestigation team reviewed available electronic and hard copy documentationand conducted interviews of selected current and former officers, directors andemployees.

The following background pertaining to our historicalstock option grant practices was confirmed through the investigation.

From our initial public offering in August 1993to January 2003, our historical stock option granting process hasgenerally reflected a lack of either Board or Compensation Committeeauthorization for specific option grants, although a few instances exist where ourBoard or Compensation Committee took appropriate granting action under Delawarelaw and our option plans. Instead, from August 1993 to January 2003, we ran aCEO-centric option granting process with additional participation by thePresident from time to time and with minimal oversight by either our Board orCompensation Committee—particularly with respect to grants to rank and fileemployees. Our current and former Board members who were interviewed generallyrecalled periodic discussions concerning option grants to senior executives anddirectors, but, except for the instances noted above, there is a general lackof confirmatory written evidence in our records that would evidence thesediscussions. We last issued stock options in January 2003.

Our CEOs and/or Presidents through January 2003thought they had the apparent authority to grant options. Although theinvestigation discovered 1992 Board resolutions purporting to delegateauthority to the CEO and President to grant stock options, it does not appearfrom the investigation that the CEOs and/or Presidents acted pursuant to suchdelegation but instead acted based on their perceived apparent authorityresulting from their positions as senior officers of Thomas Group.

F-30

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During the review period, we granted options under thefollowing circumstances: (i) grants to new employees at or near startdates;(ii) grants as part of an annual review process; (iii) grantsto employees on their fifth and tenth year anniversaries; (iv) grants thatwere awarded to a key group of officers and employees; (v) grants made inconnection with business developed through the Company’s CEO center; (vi) periodicgrants to directors for Board service; and (vii) grants made periodicallyto employees for other reasons. Documents identified pursuant to which CEOsprior to 2003 made option grants include notices of grant awards, stock optionagreements, memos, notes and emails directing employees to document thegranting of stock options.

Based on our historical process deficiencies notedabove, we have concluded that we will be required to adjust the accountingmeasurement dates for certain of our stock option grants as more fullydiscussed below. In addition to the process deficiencies noted above thatallowed grants to be made without proper stock option plan or Delawarestatutory approval, our investigation also identified some evidence that couldbe construed as manipulative for certain option grants and option exercises,including the following:(i) evidence of possible rearward selection ofcertain grant dates and exercise prices, including due to administrative delaysin initiation and/or finalization of stock option terms; (ii) the use ofan incorrect calculation to determine exercise prices under two of our stockoption plans; (iii) evidence of the extension of expiration dates ofcertain stock option grants not properly accounted for; (iv) evidence thata limited number of rank and file employees were allowed to exercise optionsafter expiration dates and (v) evidence of the possible rearward selectionof an exercise date in one case. Notwithstanding the foregoing, theinvestigation team concluded that the totality of the information obtained andreviewed does not indicate that (i) stock option grants were intentionallyback-dated on a widespread basis in order to obtain more favorable pricing fordirectors, officers or employees or (ii) option exercises wereintentionally manipulated on a widespread basis. The investigation team alsoconcluded that our internal control over financial reporting and our legalprocesses in connection with stock option grants and exercises have beenineffective.

In connection with the investigation, theinvestigation team has made the following recommendations with respect toproposed remedial measures: (i) establish modified accounting measurementdates for option grants not properly authorized by either Board or CompensationCommittee resolutions, which we did in connection with the restatement; (ii) inorder to correct the lack of complete legal documentation, adopt resolutionsratifying all prior option grants that may not have been previously authorizedby specific Board or Compensation Committee resolutions, which resolutions wereadopted by the Board on March 30, 2007; (iii) adopt and document aneffective system of internal control over financial reporting that govern ourstock option granting and/or other equity award processes; and (iv) adoptwritten equity granting practices and procedures that provide for option grantsor other equity awards only by our Compensation Committee, consisting ofoutside independent directors, and that equity awards be made only on aquarterly basis during a meeting of the Compensation Committee.

Based upon the results of the investigation, we havedetermined that we will establish an accounting measurement date for each grantin accordance with the earliest evidence that the recipient of the grant aswell as the number of shares subject to such award were set with finality as describedin more detail below. We have also concluded that, on balance, our processdeficiencies and lack of historical documentation of certain stock optiongrants should not preclude us from concluding, from an accounting perspective,that such options had been properly granted or that such stock options shouldbe accounted for on a date other than the purported date of grant reflected inour stock option administration software. For stock option grants that were nototherwise evidenced by specific Board or Compensation Committee action, we havedetermined that it is appropriate to rely upon ancillary documentation that wasfound in our files and records, when such documentation confirms stock optionshad been granted.This conclusion is supported by Hein & Associates,our independent public accounting firm. This conclusion is also supported bythe SEC’s published September 2006 guidance, which generally indicatesthat the accounting for stock options 

F-31

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may depend on the factsand circumstances surrounding a company’s stock option grant practices whendefinitive documentation is not available.

In conducting thereview of our stock option practices, the investigation team reviewed allavailable documentation, including but not limited to corporate minute books, Boardof Directors’ packages, employment offer letters, employment agreements,notices of stock option grants, stock option agreements and personnel files. Wehave focused on the identified documentation and other evidence that maysupport a determination that a stock option grant was awarded with finality,even if such documentation is not sufficient to otherwise support a conclusionthat all necessary legal steps have been taken to authorize such an award. Inparticular, we have focused on correspondence or agreements with employees thatindicate the employees knew stock option awards were outstanding. We have alsorelied upon internal documents that indicate we recognized the awards wereoutstanding. Where ancillary documentation exists for a stock option grant andis dated, we have determined to use the date of earliest supportingdocumentation in establishing a revised measurement date. We have used thefollowing documents in establishing revised measurement dates:

·       Offerletters

·       Noticesof grant awards

·       Section 16filings

·       Stockoption grant lists

·       Companyworksheets prepared to support earnings per share calculations

·       Othercorrespondence to employees recognizing existence of outstanding stock optiongrants

·       Directorand officer questionnaires listing outstanding stock option grants

In connection with the investigation, our Board ofDirectors, with the approval of our Audit Committee, has determined that thecumulative non-cash stock-based compensation expense adjustment was materialand that our consolidated financial statements for each of the first threequarters of fiscal year ended December 31, 2006, each of the quarters inthe fiscal year ended December 31, 2005 and the fiscal years ended December 31,2005 and 2004 as well as the selected consolidated financial data for thefiscal years ended December 31, 2003 and 2002 should be restated to recordadditional stock-based compensation expense resulting from stock optionsgranted during 1993 to 2003 that were incorrectly accounted for under GAAP, andrelated income tax effects.

We also analyzed the impact of our investigationrelated to Internal Revenue Code Section 162(m), which provides for a $1million tax deduction cap on compensation awarded to certain top executivesthat is not considered performance-based. After completing our analysis, wedetermined that Section 162(m) may apply to option exercises in 2006for 180,649 shares held by James T. Taylor, our CEO, which, when combined withother applicable employee remuneration, will be limited to a tax deduction of$1 million in 2006. We estimate the non-deductible amount for 2006 to beapproximately $654,000, which will result in increased taxes of approximately$241,000.

F-32

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Wehave determined that the cumulative, pre-tax, non-cash stock-based compensationexpense resulting from revised measurement dates was approximately$2.1 million during the period from our initial public offering in August 1993through December 31, 2006. The adjustments relate to options coveringapproximately 1.9 million shares. We recorded additional stock-basedcompensation expense of $5,532, $48,567 and $53,722 for the fiscal yearsended December 31, 2006, 2005 and 2004, respectively, and$2.0 million for fiscal years ending prior to fiscal 2002. Previouslyreported total revenues were not impacted by our restatement. The table belowreflects the cumulative effect on our stockholders’ equity during the periodfrom our initial public offering in August 1993 through December 31,2006 (in thousands):

| Decrease in  cumulative net income and retained earnings:                  |   |   |   |   |   |
|----------------------------------------------------------------------------|--------|--------|--------|--------|--------|
| Stock-based  compensation expense                                          |   | $      | (2,119 | )      |   |   |
| Estimated tax  related penalties and interest on underpayment deficiencies |   | (101   | )      |   |   |
| Decrease in  pretax profit                                                 |   | (2,220 | )      |   |   |
| Income tax  benefit, net                                                   |   | 111    |   |   |   |
| Decrease in  cumulative net income and retained earnings                   |   |   |   | $      | (2,109 | ) |
| Increase to additional paid-in capital:                                    |   |   |   |   |   |
| Stock-based  compensation expense                                          |   | 2,119  |   |   |   |
| Increase in  additional paid-in capital                                    |   |   |   | 2,119  |   |
| Increase in  stockholders’ equity at December 31, 2006           |   |   |   | $      | 10     |   |
|                                                                            |        |        |        |        |        |  |  |

 

F-33

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Thetable below reflects the breakdown by year of the cumulative adjustment toretained earnings. Our consolidated financial statements included in previouslyfiled periodic reports with the SEC for such periods have not been amended. Theconsolidated financial statements included in this Annual Report on Form 10-Khave been restated.(in thousands)

| ** **                                  | ** ** | ** ** | ** ** | **Stock-based  compensation  expense** | ** ** | **Estimated taxes,  Interest and  penalties(1)** | ** ** | **Income  tax  benefit,  net** | ** ** | **Total  adjustments** | ** ** | ** ** | ** ** |
|---------------------------------------------|------------|------------|------------|----------------------------------------|------------|------------------------------------------------------------|------------|--------------------------------|------------|------------------------|------------|------------|------------|
| Years ended December 31,               |       |       |       |                                   |       |                                                       |       |                           |       |                   |       |       |       |   |   |   |   |   |   |   |   |   |   |   |   |
| 1993                                        |       |       |       |                                   |       |                                                       | $          | (84                            | )          |                   |       | $          | —     |   |   |   | $ | — |   |   |   | $ | (84 | ) |   |   |   |   |   |
| 1994                                        |       |       |       |                                   |       |                                                       | (187       | )                              |       |                   | —     |       |       |   | — |   |   |   | (187 | ) |   |   |   |   |   |
| 1995                                        |       |       |       |                                   |       |                                                       | (362       | )                              |       |                   | —     |       |       |   | — |   |   |   | (362 | ) |   |   |   |   |   |
| 1996                                        |       |       |       |                                   |       |                                                       | (326       | )                              |       |                   | —     |       |       |   | — |   |   |   | (326 | ) |   |   |   |   |   |
| 1997                                        |       |       |       |                                   |       |                                                       | (196       | )                              |       |                   | —     |       |       |   | — |   |   |   | (196 | ) |   |   |   |   |   |
| 1998                                        |       |       |       |                                   |       |                                                       | (312       | )                              |       |                   | —     |       |       |   | — |   |   |   | (312 | ) |   |   |   |   |   |
| 1999                                        |       |       |       |                                   |       |                                                       | (29        | )                              |       |                   | —     |       |       |   | — |   |   |   | (29 | ) |   |   |   |   |   |
| 2000                                        |       |       |       |                                   |       |                                                       | (225       | )                              |       |                   | —     |       |       |   | — |   |   |   | (225 | ) |   |   |   |   |   |
| 2001                                        |       |       |       |                                   |       |                                                       | (170       | )                              |       |                   | —     |       |       |   | — |   |   |   | (170 | ) |   |   |   |   |   |
| Cumulative effect at December 31, 2001 |       |       |       |                                   |       |                                                       | (1,891     | )                              |       |                   | —     |       |       |   | — |   |   |   | (1,891 | ) |   |   |   |   |   |
|                                             |            |            |            |                                        |            |                                                            |            |                                |            |                        |            |            |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

| ** **                                   | ** ** | **Net  income (loss)  as reported** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | **Net  income (loss)  As restated** | ** ** |
|----------------------------------------------|------------|-----------------------------------------------|------------|------------|------------|------------|------------|------------|------------|------------|------------|-----------------------------------------------|------------|
| Years ended  December 31,               |       |                                          |       |       |       |       |       |       |       |       |       |                                          |       |   |   |   |   |   |   |   |   |   |   |   |   |
| 2002                                         |       |                                          | $          | (7,718     | )          |       |       | (49        | )          |       |       | —                                        |       |   |   | 11 |   |   |   | (38 | ) |   |   | $ | (7,756 | ) |   |
| 2003                                         |       |                                          | $          | 712        |       |       |       | (71        | )          |       |       | —                                        |       |   |   | 26 |   |   |   | (45 | ) |   |   | $ | 667 |   |   |
| 2004                                         |       |                                          | $          | 1,475      |       |       |       | (54        | )          |       |       | —                                        |       |   |   | 20 |   |   |   | (34 | ) |   |   | $ | 1,441 |   |   |
| 2005                                         |       |                                          | $          | 6,752      |       |       |       | (49        | )          |       |       | —                                        |       |   |   | 20 |   |   |   | (29 | ) |   |   | $ | 6,723 |   |   |
| 2006                                         |       |                                          |       |       |       |       | (5         | )          |       |       | (101       | )                                             |       |   | 34 |   |   |   | (72 | ) |   |   |   |   |   |
| Cumulative effect  at December 31, 2006 |       |                                          |       |       |       |       | $          | (2,119     | )          |       |       | $                                             | (101       | ) |   |   | $ | 111 |   |   |   | $ | (2,109 | ) |   |   |   |   |   |
|                                              |            |                                               |            |            |            |            |            |            |            |            |            |                                               |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

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(1)          Estimated taxes,interest and penalties on stock options for which a revised measurement dateresulted in a non-qualified, or discounted stock option.

In connection with the restatement of our consolidatedfinancial statements discussed above, we assessed the impact of the findings ofour internal investigation into our historical stock option grant practices andother tax matters on our reported income tax benefits and deductions, includingincome tax deductions previously taken for cash and stock-based executive compensationunder the provisions of Section 162(m). In connection with thatassessment, we determined that no adjustments were required to our (i) incometax expense previously reported in our Consolidated Statements of Income; (ii) taxbenefits on stock option exercises previously reported in our ConsolidatedStatements of Cash Flows and Consolidated Statement of Changes in Stockholders’Equity or (iii) deferred tax assets previously reported in ourConsolidated Balance Sheets.

We have recorded $101,230 of income tax benefit in ourConsolidated Statements of Income for the year ended December 31, 2006 andin our Consolidated Balance Sheets at December 31, 2006 to recognizedeferred income tax assets on stock-based compensation relating to unexercisedstock options. This amount is not included in the tables above because it is afourth quarter 2006 estimate, and not part of the restatement.

F-34

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Section 409A of the Internal Revenue Code (“Section 409A”)provides that option holders with options granted with a below-market exerciseprice, to the extent the options were not vested as of December 31, 2004,may be subject to adverse Federal income tax consequences. Holders of theseoptions will likely be required to recognize taxable income at the date ofvesting for those options vesting after December 31, 2004, rather thanupon exercise, on the difference between the amount of the fair market value ofour common stock on the date of vesting and the exercise price, plus anadditional 20 percent penalty tax and interest on any income tax to bepaid. To the extent this process is available to affected employees, we havedecided to follow the IRS Settlement Offer issued in February 2007 to paypenalty and interest to the IRS on behalf of the employees and potentiallygross-up employees for tax costs. The IRS offer only applies to optionexercises by rank and file employees in 2006.

Certain grants of stock options made during the periodunder investigation were priced below fair market value, rather than at fairmarket value. Consequently, certain grants intended to be classified as ISOs,requiring pricing at no less than fair market value on the date of grant,should have been classified as nonqualified stock options, or NQs. Given thesignificant differences in the tax treatment between ISOs and NQs, weunderreported or underwithheld certain payroll taxes for those options whichwere exercised during the period through 2006. We have recorded certain taxliabilities related to these issues in the period of exercise with relatedpenalties and interest charged in subsequent periods, except for periods closedby the statute of limitations where no liability is recorded. We intend topursue a negotiated settlement with the IRS as soon as practicable; however,there can be no assurance that we will settle these issues for amountsconsistent with the estimated liabilities we have recorded. In the aggregate,the financial impact of these tax errors was approximately $0.1 million and areincluded in the adjustment.

F-35

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