####  

#### **U.S.SECURITIES AND EXCHANGE COMMISSION**

**Washington,D.C.  20549**

 

**FORM 10-QSB**

 
| **(Mark One)**                                                                                                                                                                                                                                                                                                                               |
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| **ý**                                                                                                                                                                                                                                                                                                                                   | **Quarterly Report Under  Section 13 or 15(d) of The Securities Exchange Act of 1934** |
|                                                                                                                                                                                                                                                                                                                                         |   |
| **For the quarterly period ended   March 26, 2004**                                                                                                                                                                                                                                                                                |
|                                                                                                                                                                                                                                                                                                                                         |   |
| **o**                                                                                                                                                                                                                                                                                                                                        | **Transaction Report Under  Section 13 or 15(d) of the Securities Exchange Act** |
|                                                                                                                                                                                                                                                                                                                                         |   |
| **For the transition period from                            to****                        ** |
|                                                                                                                                                                                                                                                                                                                                         |   |
| **Commission File Number   000-04169**                                                                                                                                                                                                                                                                                                  |

 

**SYS**

(Exact Name of Small Business Issuer as Specified in Its Charter)

 

| **California**                                                                      |   | **95-2467354**                        |
|-------------------------------------------------------------------------------------|--------|---------------------------------------|
| (State or Other Jurisdiction of  Incorporation or Organization)                     |   | (I.R.S. Employer  Identification No.) |
|                                                                                |   |                                  |
| **5050 Murphy Canyon Road, Suite 200, San Diego, California  92123**           |
| (Address of Principal Executive Offices)                                            |
|                                                                                |   |                                  |
| **(858) 715-5500**                                                                  |
| (Issuer’s Telephone Number, Including Area Code)                               |
|                                                                                |   |                                  |
|                                                                                |   |                                  |
| (Former Name, Former Address and Former Fiscal Year, if Changed Since  Last Report) |

 

Checkwhether the issuer: (1) filed all reports required to be filed bySection 13 or 15(d) of the Securities Exchange Act during the past 12months (or for such shorter period that the registrant was required to filesuch reports), and (2) has been subject to such filing requirements for thepast 90 days.

 

Yes  ý    No  o

 

Statethe number of shares outstanding of each of the issuer’s classes of commonequity, as of the latest practicable date:8,045,958 shares of commonstock, without par value, as of April 23, 2004.

 

TransitionalSmall Business Disclosure Format (check one):

 

Yes  o    No  ý

 

 

----

 

**TABLE OF CONTENTS**

 
| **PART I - FINANCIAL INFORMATION**                                       |                                                                                                                        |   |
|--------------------------------------------------------------------------|-----------------------------------------------------------------------------------------------------------------------------|--------|
|                                                                     |                                                                                                                        |   |
| Item 1. Financial Statements                                             |                                                                                                                        |
|                                                                     | Consolidated Balance Sheet (unaudited) March 26, 2004 and  June 30, 2003                                          |   |
|                                                                     | Consolidated Statements of Operations  (unaudited) Three and Nine Months Ended March 26, 2004 and  March 29, 2003 |   |
|                                                                     | Consolidated Statements of Cash Flows  (unaudited) Nine Months Ended March 26, 2004 and March 29, 2003            |   |
|                                                                     | Notes to Consolidated Financial Statements  (unaudited)                                                                     |   |
|                                                                     |                                                                                                                        |   |
| Item 2. Management’s Discussion and  Analysis or Plan of Operations |                                                                                                                        |
|                                                                     |                                                                                                                        |   |
|                                                                     | New Accounting Pronouncements                                                                                               |   |
|                                                                     | Description of Business                                                                                                     |   |
|                                                                     | Results of Operations                                                                                                       |   |
|                                                                     | Liquidity and Capital Resources                                                                                             |   |
|                                                                     | Critical Accounting Policies and Estimates                                                                                  |   |
|                                                                     |                                                                                                                        |   |
| Item 2a.   Factors Which May Affect Future Results                  |                                                                                                                        |
|                                                                     |                                                                                                                        |   |
| Item 3. Controls and Procedures                                          |                                                                                                                        |
|                                                                     |                                                                                                                        |   |
| **PART II - OTHER INFORMATION**                                          |                                                                                                                        |
|                                                                     |                                                                                                                        |   |
| Item 1. Legal Proceedings                                                |                                                                                                                        |
|                                                                     |                                                                                                                        |   |
| Item 2. Changes in Securities                                            |                                                                                                                        |
|                                                                     |                                                                                                                        |   |
| Item 3. Defaults Upon Senior Securities                                  |                                                                                                                        |
|                                                                     |                                                                                                                        |   |
| Item 4. Submission of Matters to a Vote of  Security Holders             |                                                                                                                        |
|                                                                     |                                                                                                                        |   |
| Item 5. Other Information                                                |                                                                                                                        |
|                                                                     |                                                                                                                        |   |
| Item 6. Exhibits and Reports on Form 8-K                                 |                                                                                                                        |
|                                                                     |                                                                                                                        |   |
| **SIGNATURES**                                                           |                                                                                                                        |   |
|                                                                          |                                                                                                                             |        |  |  |

 

2

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PART I

FINANCIAL INFORMATION

 

Item 1.                                     FinancialStatements

 

SYS

CONSOLIDATED BALANCE SHEET

(Unaudited)

 
|                                                                                                                                     |   | **March 26,  2004** |       | **June 30,  2003** |   |
|------------------------------------------------------------------------------------------------------------------------------------------|--------|--------------------------|------------|-------------------------|--------|
| ASSETS                                                                                                                                   |   |                     |       |                    |   |
| Current assets:                                                                                                                          |   | $                        | 3,916,000  |                    | $      | 19,000 |   |
| Cash                                                                                                                                     |   |                     |       |                    |   |
| Accounts receivables, net of allowance for  doubtful accounts of $58,000 and $28,000                                                     |   | 6,333,000                |       | 5,650,000               |   |
| Deferred tax assets                                                                                                                      |   | 302,000                  |       | 302,000                 |   |
| Income tax refund receivable                                                                                                             |   | —                   |       | 477,000                 |   |
| Inventory                                                                                                                                |   | 53,000                   |       | —                  |   |
| Other current assets                                                                                                                     |   | 129,000                  |       | 149,000                 |   |
| Total current assets                                                                                                                     |   | 10,733,000               |       | 6,597,000               |   |
|                                                                                                                                     |   |                     |       |                    |   |
| Furniture and equipment, less accumulated  depreciation and amortization of $1,113,000 and $937,000                                      |   | 667,000                  |       | 738,000                 |   |
| Capitalized software for internal use, net  of accumulated amortization of $32,000 and $17,000                                           |   | 70,000                   |       | 85,000                  |   |
| Other assets                                                                                                                             |   | 148,000                  |       | 251,000                 |   |
| Total assets                                                                                                                             |   | $                        | 11,618,000 |                    | $      | 7,671,000 |   |
|                                                                                                                                     |   |                     |       |                    |   |
| LIABILITIES AND STOCKHOLDERS’ EQUITY                                                                                                |   |                     |       |                    |   |
|                                                                                                                                     |   |                     |       |                    |   |
| Current liabilities:                                                                                                                     |   |                     |       |                    |   |
| Borrowings under bank line of credit                                                                                                     |   | $                        | —     |                    | $      | 638,000 |   |
| Current portion of working capital loan                                                                                                  |   | 153,000                  |       | 167,000                 |   |
| Accounts payable                                                                                                                         |   | 665,000                  |       | 1,398,000               |   |
| Accrued payroll and related taxes                                                                                                        |   | 1,620,000                |       | 932,000                 |   |
| Income taxes payable                                                                                                                     |   | 310,000                  |       | —                  |   |
| Other accrued liabilities                                                                                                                |   | 302,000                  |       | 266,000                 |   |
| Convertible notes payable                                                                                                                |   | 56,000                   |       | —                  |   |
| Current portion of capital lease  obligations                                                                                            |   | 33,000                   |       | 30,000                  |   |
| Total current liabilities                                                                                                                |   | 3,139,000                |       | 3,431,000               |   |
|                                                                                                                                     |   |                     |       |                    |   |
| Working capital loan, net of current  portion                                                                                            |   | —                   |       | 97,000                  |   |
| Convertible notes payable, net of current portion                                                                                        |   | 1,525,000                |       | 638,000                 |   |
| Convertible notes payable to related  parties, net of current portion                                                                    |   | 738,000                  |       | 362,000                 |   |
| Capital lease obligations, net of current  portion                                                                                       |   | 42,000                   |       | 64,000                  |   |
| Total liabilities                                                                                                                        |   | 5,444,000                |       | 4,592,000               |   |
| Stockholders’ equity:                                                                                                               |   |                     |       |                    |   |
| 9% preference stock, $1.00 par value;  2,000,000 shares authorized; 69,781 Series B shares issued and outstanding at  June 30, 2003 |   | —                   |       | 70,000                  |   |
| Common stock, no par value; 48,000,000  shares authorized; 7,318,140 and 5,525,790 shares issued                                         |   | 5,342,000                |       | 2,710,000               |   |
| Common stock to be issued for accrued  liability                                                                                         |   | —                   |       | 82,000                  |   |
| Retained earnings                                                                                                                        |   | 832,000                  |       | 217,000                 |   |
| Total stockholders’ equity                                                                                                          |   | 6,174,000                |       | 3,079,000               |   |
|                                                                                                                                     |   | $                        | 11,618,000 |                    | $      | 7,671,000 |   |

 

See accompanying Notes to Condensed Consolidated Financial Statements.

 

3

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SYS

CONSOLIDATED STATEMENTS OF OPERATIONS

(Unaudited)

 
|                                                                                               |   | **Three  months ended**  |            | **Nine  months ended**   |       |
|----------------------------------------------------------------------------------------------------|--------|--------------------------|-----------------|--------------------------|------------|
|                                                                                               |   | **March 26,  2004** |            | **March 29,  2003** | ** ** | **March 26,  2004** | ** ** | **March 29,  2003** | ** ** |
|                                                                                               |   |                     |            |                     |       |   |   |   |   |
| Revenues                                                                                           |   | $                        | 8,094,000  |                     | $          | 5,741,000 |   | $ | 23,304,000 |   | $ | 17,652,000 |   |
| Costs and expenses:                                                                                |   |                     |            |                     |       |   |   |   |   |
| Cost of revenues                                                                                   |   | 6,785,000                |            | 5,059,000                |       | 19,297,000 |   | 14,832,000 |   |
| General and administrative expenses                                                                |   | 840,000                  |            | 1,101,000                |       | 2,863,000 |   | 2,493,000 |   |
| Legal settlement                                                                                   |   | —                   |            | —                   |       | — |   | 941,000 |   |
|                                                                                               |   | 7,625,000                |            | 6,160,000                |       | 22,160,000 |   | 18,266,000 |   |
| Income (loss) from operations                                                                      |   | 469,000                  |            | (419,000                 | )          | 1,144,000 |   | (614,000 | ) |
|                                                                                               |   |                     |            |                     |       |   |   |   |   |
| Other (income) expenses:                                                                           |   | (4,000                   | )               | (2,000                   | )          | (35,000 | ) | (6,000 | ) |
| Interest income                                                                                    |   | 52,000                   |            | 56,000                   |       | 118,000 |   | 163,000 |   |
| Interest expense                                                                                   |   | 48,000                   |            | 54,000                   |       | 83,000 |   | 157,000 |   |
| Income (loss) from continuing operations  before income taxes                                      |   | 421,000                  |            | (473,000                 | )          | 1,061,000 |   | (771,000 | ) |
| Income tax provision (benefit) from  continuing operations                                         |   | 172,000                  |            | (189,000                 | )          | 442,000 |   | (308,000 | ) |
| Income (loss) from continuing operations                                                           |   | 249,000                  |            | (284,000                 | )          | 619,000 |   | (463,000 | ) |
| (Loss) from discontinued operations (less  applicable income tax benefit of $152,000 and $188,000) |   | —                   |            | (103,000                 | )          | — |   | (384,000 | ) |
| Net income (loss)                                                                                  |   | $                        | 249,000         |                     | $          | (387,000 | ) | $ | 619,000 |   | $ | (847,000 | ) |
|                                                                                               |   |                     |            |                     |       |   |   |   |   |
| Income (loss) from continuing operations                                                           |   | $                        | 249,000         |                     | $          | (284,000 | ) | $ | 619,000 |   | $ | (463,000 | ) |
| Dividend requirements                                                                              |   | —                   |            | 3,000                    |       | 4,000 |   | 6,000 |   |
| Net income (loss) applicable to common  stockholders attributable to continuing operations         |   | 249,000                  |            | (287,000                 | )          | 615,000 |   | (469,000 | ) |
| Net (loss) applicable to common  stockholders attributable to discontinued operations              |   | —                   |            | (103,000                 | )          | — |   | (384,000 | ) |
| Net income (loss) applicable to common  stockholders                                               |   | $                        | 249,000         |                     | $          | (390,000 | ) | $ | 615,000 |   | $ | (853,000 | ) |
|                                                                                               |   |                     |            |                     |       |   |   |   |   |
| Basic net income (loss) per common share  from continuing operations                               |   | $                        | 0.04       |                     | $          | (0.05 | ) | $ | 0.10  |   | $ | (0.09 | ) |
| Basic net (loss) per common share from  discontinued operations                                    |   | —                   |            | (0.02                    | )          | — |   | (0.08 | ) |
| Basic net income (loss) per common share                                                           |   | $                        | 0.04       |                     | $          | (0.07 | ) | $ | 0.10  |   | $ | (0.17 | ) |
|                                                                                               |   |                     |            |                     |       |   |   |   |   |
| Diluted net income (loss) per common share  from continuing operations                             |   | $                        | 0.03       |                     | $          | (0.05 | ) | $ | 0.09  |   | $ | (0.09 | ) |
| Diluted net (loss) per common share from  discontinued operations                                  |   | —                   |            | (0.02                    | )          | — |   | (0.08 | ) |
| Diluted net income (loss) per common share                                                         |   | $                        | 0.03            |                     | $          | (0.07 | ) | $ | 0.09  |   | $ | (0.17 | ) |

 

See accompanying Notes to Condensed Consolidated Financial Statements.

 

4

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SYS

CONSOLIDATED STATEMENTS OF CASH FLOWS

(Unaudited)

 
|                                                                                                                  |   | **Nine  months ended**   | ** ** |
|-----------------------------------------------------------------------------------------------------------------------|--------|--------------------------|------------|
|                                                                                                                  |   | **March 26,  2004** |       | **March 29,  2003** | ** ** |
| Cash Flows From Operating Activities:                                                                                 |   |                     |       |   |   |
| Net income (loss) from continuing  operations                                                                         |   | $                        | 619,000    |   | $ | (463,000 | ) |
| Adjustments to reconcile net income to net  cash provided by (used in) operating activities of continuing operations: |   |                     |       |   |   |
| Depreciation and amortization                                                                                         |   | 191,000                  |       | 184,000 |   |
| Deferred income taxes                                                                                                 |   | —                   |       | (216,000 | ) |
| Impairment of goodwill                                                                                                |   | —                   |       | 84,000 |   |
| Issuance of stock for legal settlement                                                                                |   | —                   |       | 600,000 |   |
| Increase in allowance for doubtful accounts                                                                           |   | 30,000                   |       | — |   |
| Accretion of debt discount                                                                                            |   | —                   |       | 38,000 |   |
| Bonus expense in lieu of cash paid for  exercise of stock options                                                     |   | —                   |       | 14,000 |   |
| Changes in operating assets and  liabilities:                                                                         |   |                     |       |   |   |
| Contract receivables                                                                                                  |   | (713,000                 | )          | (468,000 | ) |
| Receivable from related party                                                                                         |   | —                   |       | 22,000 |   |
| Income tax refund receivable                                                                                          |   | 477,000                  |       | — |   |
| Other current assets                                                                                                  |   | (33,000                  | )          | (514,000 | ) |
| Inventory and other assets                                                                                            |   | 103,000                  |       | (138,000 | ) |
| Accounts payable                                                                                                      |   | (733,000                 | )          | 444,000 |   |
| Accrued payroll and related taxes                                                                                     |   | 856,000                  |       | 460,000 |   |
| Income taxes payable                                                                                                  |   | 310,000                  |       | — |   |
| Other accrued liabilities                                                                                             |   | 36,000                   |       | 192,000 |   |
| Net cash provided by operating activities  of continuing operations                                                   |   | 1,143,000                |       | 239,000 |   |
| Net cash used in discontinued operations                                                                              |   | —                   |       | (284,000 | ) |
| Net cash provided by (used in) operating  activities                                                                  |   | 1,143,000                |       | (45,000 | ) |
| Cash Flows From Investing Activities -  Acquisition of furniture and equipment                                        |   | (105,000                 | )          | (270,000 | ) |
| Cash Flows From Financing Activities:                                                                                 |   |                     |       |   |   |
| Net line of credit borrowings (payments)                                                                              |   | (638,000                 | )          | 138,000 |   |
| Payments of related party note payable                                                                                |   | —                   |       | (51,000 | ) |
| Payments of notes payable                                                                                             |   | (111,000                 | )          | (111,000 | ) |
| Payments of capital lease obligations                                                                                 |   | (19,000                  | )          | (43,000 | ) |
| Payments of dividends on preference stock                                                                             |   | (4,000                   | )          | (6,000 | ) |
| Cash paid due to call on preference stock                                                                             |   | (60,000                  | )          | — |   |
| Proceeds from convertible notes payable                                                                               |   | 1,600,000                |       | — |   |
| Proceeds from issuance of common stock                                                                                |   | 2,091,000                |       | 156,000 |   |
| Net cash provided by financing activities                                                                             |   | 2,859,000                |       | 83,000 |   |
| Net increase (decrease) in cash                                                                                       |   | 3,897,000                |       | (232,000 | ) |
| Cash at beginning of period                                                                                           |   | 19,000                   |       | 260,000 |   |
| Cash at end of period                                                                                                 |   | $                        | 3,916,000  |   | $ | 28,000 |   |
|                                                                                                                  |   |                     |       |   |   |
| Supplemental disclosure of cash flow data:                                                                            |   |                     |       |   |   |
| Interest paid                                                                                                         |   | $                        | 93,000     |   | $ | 99,000 |   |
| Income taxes paid                                                                                                     |   | $                        | 23,000     |   | $ | 81,000 |   |
| Supplemental disclosure of noncash  investing and financing activities:                                               |   |                     |       |   |   |
| Offset of subscriptions receivable from  Company officers with accrued compensation                                   |   |                     |       | $ | 45,000 |   |
| Common stock issued upon exercise of  convertible note                                                                |   | $                        | 281,000    |   |   |   |
| Common stock issued upon conversion of  preference stock                                                              |   | $                        | 10,000     |   |   |   |
| Common stock issued for accrued liability                                                                             |   | $                        | 82,000     |   |   |   |
| Common stock issued to ESOP as contribution                                                                           |   | $                        | 168,000    |   |   |   |

 

See accompanying Notes to Condensed Consolidated Financial Statements.

 

5

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##### SYS

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

##### March 26, 2004

#####  

(1)                                  General

 

In the opinion of the management, the unaudited financial informationin this report reflects all adjustments, consisting only of normal recurringaccruals, which are considered necessary for a fair presentation of theconsolidated financial position of SYS and subsidiaries as of March 26,2004 and June 30, 2003 and the consolidated results of operations and cashflows for the periods shown.  Certaininformation and footnote disclosures normally included in financial statementsprepared in conformity with accounting principles generally accepted in theUnited States of America have been condensed or omitted pursuant to SECregulations.  It is suggested that thesefinancial statements be read in conjunction with the audited financial statementsincluded in the Company’s Report on Form 10-KSB for the fiscal year endedJune 30, 2003.

 

The preparation of financial statements in conformity with generallyaccepted accounting principles requires 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.

 

The results of operations for the nine months ended March 26, 2004are not necessarily indicative of the results to be expected for the full yearending June 30, 2004.

 

The Company’s fiscal year is from July 1 throughJune 30.  The Company uses the5-4-4 weeks per period method for each quarter; periods one (July) and twelve(June) may vary slightly in the actual number of days due to the beginning andend of each fiscal year.

 

In fiscalyears prior to 2003, the Company identified and reported on two industrysegments, SYS Division and Testmasters Division.  The SYS Division works primarily as a contractor for U.S. defensecontractors and the U.S. Government, and the Testmasters Division primarilyprovided software testing services to industry.  The Company ceased reporting the Testmasters Division as asegment after the first quarter of 2003 as the business was included in theIntegrated Information Solutions (IIS) Division.  Effective June 30, 2003, the Company consolidated its Trainingbusiness with the Testmasters business and then sold the combined businesses asof the same date.  Additionally, during2003, the Company started the Walk Up Systems Division, which was discontinuedand wound down as of June 30, 2003. The condensed consolidated financial statements have been restated toreflect the results of operations sold or discontinued businesses asdiscontinued operations in accordance with SFAS No. 144.

 

Substantially all of the Company’s operations are conducted in theUnited States.

 

Certain amounts in the FY 2003 condensed consolidated financialstatements have been reclassified to conform to the FY 2004 presentation.

 

(2)                                  Stock-BasedCompensation

 

6

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The following table summarizes certain information regarding stock optionsissued under the SYS 1997 Incentive Stock Option and Restricted Stock Plan andthe SYS 2003 Stock Option Plan, as well as warrants issued for the nine monthperiod ended:

 
|                                                                           |   | **March 26,  2004**                   |   |
|--------------------------------------------------------------------------------|--------|--------------------------------------------|--------|
|                                                                           |   | **Options or  Exercise  Price Per  Share** |   | **Weighted  Average  Exercise  Price** | ** ** |
|                                                                           |   |                                       |   |   |   |
| Balance outstanding at beginning of period                                     |   | 1,846,350                                  |   | $ | 1.17 |   |
|                                                                           |   |                                       |   |   |   |
| Granted                                                                        |   | 378,750                                    |   | $ | 1.93 |   |
|                                                                           |   |                                       |   |   |   |
| Exercised                                                                      |   | (366,887                                   | )      | $ | 1.02 |   |
|                                                                           |   |                                       |   |   |   |
| Cancelled                                                                      |   | (177,028                                   | )      | $ | 1.08 |   |
| Balance outstanding at end of period                                           |   | 1,681,185                                  |   | $ | 1.39 |   |
|                                                                           |   |                                       |   |   |   |
| Price range at end of period                                                   |   | $0.63 to $2.30                             |   |   |   |
|                                                                           |   |                                       |   |   |   |
| Weighted average fair value of options and  warrants granted during the period |   | $                                          | 0.65   |   |   |   |
|                                                                                |        |                                            |        |  |  |  |  |

 

As allowed by SFAS No. 123, “Accounting for Stock-Based Compensation,”the company has chosen to continue to account for stock-based compensationusing the intrinsic value method prescribed in APB Opinion No. 25 and relatedinterpretations. Accordingly, compensation expense for stock options ismeasured as the excess, if any, of the fair market value of the company’s stockat the date of the grant over the exercise price of the related option.

 

Had compensation costs for the company’s stock options been determinedbased on the fair value method under SFAS No. 123, the company’s net income andearnings per share would have been as follows for the three and nine monthsended March 26, 2004 and March 29, 2003, respectively:

 

7

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|                                                                                                                         |   | **Three  months ended**  |    | **Nine  months ended**   |       |
|------------------------------------------------------------------------------------------------------------------------------|--------|--------------------------|---------|--------------------------|------------|
|                                                                                                                         |   | **March 26,  2004** |    | **March 29,  2003** | ** ** | **March 26,  2004** | ** ** | **March 29,  2003** | ** ** |
| Net income (loss) - applicable to common  stockholders - as reported - basic                                                 |   | $                        | 249,000 |                     | $          | (390,000 | ) | $ | 615,000 |   | $ | (853,000 | ) |
| Deduct total stock-based employee  compensation expense determined under fair value - based method for all  awards - basic   |   | 70,000                   |    | 60,000                   |       | 248,000 |   | 183,000 |   |
| Net income applicable to common stock - pro  forma - basic                                                                   |   | $                        | 179,000 |                     | $          | (450,000 | ) | $ | 367,000 |   | $ | (1,036,000 | ) |
| Net income (loss) - applicable to common  stockholders - as reported - diluted                                               |   | $                        | 277,000 |                     | $          | (390,000 | ) | $ | 671,000 |   | $ | (853,000 | ) |
| Deduct total stock-based employee  compensation expense determined under fair value - based method for all  awards - diluted |   | 70,000                   |    | 60,000                   |       | 248,000 |   | 183,000 |   |
| Net income applicable to common  stockholders - pro forma - diluted                                                          |   | $                        | 207,000 |                     | $          | (450,000 | ) | $ | 423,000 |   | $ | (1,036,000 | ) |
| Basic income per common share:                                                                                               |   |                     |    |                     |       |   |   |   |   |
| As reported                                                                                                                  |   | $                        | 0.04    |                     | $          | (0.07 | ) | $ | 0.10 |   | $ | (0.17 | ) |
| Pro forma                                                                                                                    |   | $                        | 0.03    |                     | $          | (0.08 | ) | $ | 0.06 |   | $ | (0.20 | ) |
| Diluted income per common share:                                                                                             |   |                     |    |                     |       |   |   |   |   |
| As reported                                                                                                                  |   | $                        | 0.03    |                     | $          | (0.07 | ) | $ | 0.09 |   | $ | (0.17 | ) |
| Pro forma                                                                                                                    |   | $                        | 0.02    |                     | $          | (0.08 | ) | $ | 0.05 |   | $ | (0.20 | ) |

 

(3)                                  NotesPayable

 

The Company had a $150,000 note payable to the Company’s CEO that waspaid in full as of June 30, 2003. This note carried interest at 10% and had a maturity date ofOctober 15, 2003.  As additionalconsideration, the note holder was granted warrants to purchase 250,000 sharesof common stock at a price of $1.00 per share, the market value of the Company’scommon stock at the grant date. The warrants vested immediately and werescheduled to expire 30 days after October 15, 2003. The warrants had afair value of $130,000 as of the date of issuance; accordingly, the Companydiscounted the note by $130,000 and accreted over the term of the note.  The Company recognized $54,400 and $64,800of additional interest expense in 2003 and 2002, respectively, related to theaccretion of this debt discount. The Company paid $74,595 of principal on thenote in fiscal 2003.

 

This note was paid in full as of June 30, 2003 and the CEOexercised the 250,000 warrants to

 

8

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purchase the common shares as discussed more fully in the Stockholders’Equity Note.

 

During FY 2002, the Company issued three-year convertible notes payablein exchange for $1,000,000 in cash to related and unrelated parties.  The notes bear interest at an annual rate of10%, are unsecured and mature on various dates starting November 8, 2004,which date can be extended by one year at the election of the note holder.  Each note has a conversion feature wherebythe noteholder can convert at any time the unpaid principal balance at the rateof $1.00 per share into the Company’s common stock, which represents the fairvalue of the common stock on the day the notes were issued. During fiscal year2004, convertible notes with a value of $281,000 were converted to commonstock, including a $225,000 note payable to the Company’s CEO (See Note 7).  Of the remaining $719,000 in notes, unlessthey are converted, $56,000 will be payable in the second quarter of fiscalyear 2005 and $663,000 will be payable in the second and third quarters offiscal year 2006. The Company deferred approximately $105,000 of expensesassociated with these notes payable, which are included in other assets and arebeing amortized over the life of the notes. As of March 26, 2004, the unamortized balance was $25,000.

 

During thequarter ended March 26, 2004, the Company completed a subscription offeringraising $3,200,000 for working capital and acquisition financing. The offeringconsisted of $50,000 units comprised of 50% common stock and 50% convertiblenotes.  The notes bear interest at 10%,are unsecured and mature on December 31, 2006.  The common stock was priced at $1.60 per share, which representedan approximate 15% discount to market at the time the financing was approved bythe Board.  This discount will beprorated to each of the two elements in the unit offering resulting in anadjusted relative fair value of common stock and convertible notes.  The discounted convertible notes will beratably accreted to the face value of the notes over the three-year maturityperiod.  The convertible notes may beconverted to common stock at any time during the three-year period at $2.20 pershare, a premium to market at the time of issuance.  The relative fair value conversion price, adjusted for thediscount discussed above, was also at a premium to market.

 

Certain units were sold to directors, officers and employees of theCompany.  As of March 26, 2004, thetotal principal balance of all convertible notes payable to related partiesamounted to $737,500.  Of this amount,$212,500 is from the FY 2002 offering and $525,000 is from the FY 2004 offering.

 

(4)                                  EarningsPer Share

 

Basic net income (loss) per common share is calculated by dividing netincome (loss) applicable to common stock by the weighted average number ofcommon shares outstanding during the period. The calculation of diluted net income (loss) per common share is similarto that of basic net income (loss) per common share, except that thedenominator is increased to include the number of additional common shares thatwould have been outstanding if all potentially dilutive common shares,principally those issuable upon the conversion of notes payable and theexercise of stock options and warrants, were issued during the period.

 

9

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The following table summarizes the calculation of basic and diluted netincome (loss) per common share for each period:

 
|                                                                                                                              |   | **Three  months ended**  |    | **Nine  months ended**   |       |
|-----------------------------------------------------------------------------------------------------------------------------------|--------|--------------------------|---------|--------------------------|------------|
|                                                                                                                              |   | **March 26,  2004** |    | **March 29,  2003** | ** ** | **March 26,  2004** | ** ** | **March 29,  2003** | ** ** |
| Numerators:                                                                                                                       |   |                     |    |                     |       |   |   |   |   |
| Income (loss) from continuing operations                                                                                          |   | $                        | 249,000 |                     | $          | (284,000 | ) | $ | 619,000 |   | $ | (463,000 | ) |
| Deduct - preference stock dividend  requirements applicable to continuing operations                                              |   | —                   |    | 3,000                    |       | 4,000 |   | 6,000 |   |
| Income (loss) applicable to common  stockholders from continuing operations - basic                                               |   | 249,000                  |    | (287,000                 | )          | 615,000 |   | (469,000 | ) |
| Add - interest on convertible notes, net of  tax effects                                                                          |   | 28,000                   |    | —                   |       | 56,000 |   | — |   |
| Income (loss) applicable to common  stockholders from continuing operations - diluted                                             |   | 277,000                  |    | (287,000                 | )          | 671,000 |   | (469,000 | ) |
|                                                                                                                              |   |                     |    |                     |       |   |   |   |   |
| Loss applicable to common stockholders from  discontinued operations                                                              |   | —                   |    | (103,000                 | )          | - |   | (384,000 | ) |
| Net income (loss) applicable to common  stockholders                                                                              |   | $                        | 277,000 |                     | $          | (390,000 | ) | $ | 671,000 |   | $ | (853,000 | ) |
|                                                                                                                              |   |                     |    |                     |       |   |   |   |   |
| Denominators:                                                                                                                     |   |                     |    |                     |       |   |   |   |   |
| Weighted average shares for basic net  income per common share                                                                    |   | 6,950,042                |    | 5,300,648                |       | 6,159,876 |   | 5,072,864 |   |
| Add effects of dilutive securities from  assumed exercise of stock options and warrants and application of treasury  stock method |   | 587,430                  |    | —                   |       | 527,467 |   | — |   |
| Add effects of the conversion of the  Company’s convertible promissory notes                                                 |   | 1,229,514                |    | —                   |       | 1,031,918 |   | — |   |
| Weighted average shares for diluted net  income (loss) per common share                                                           |   | 8,766,986                |    | 5,300,648                |       | 7,719,260 |   | 5,072,864 |   |
|                                                                                                                              |   |                     |    |                     |       |   |   |   |   |
| Basic net income (loss) per common share  from continuing operations                                                              |   | $                        | 0.04    |                     | $          | (0.05 | ) | $ | 0.10 |   | $ | (0.09 | ) |
| Basic net (loss) per common share from  discontinued operations                                                                   |   | —                   |    | $                        | (0.02      | ) | $ | — |   | $ | (0.08 | ) |
| Basic net income (loss) per common share                                                                                          |   | $                        | 0.04    |                     | $          | (0.07 | ) | $ | 0.10 |   | $ | (0.17 | ) |
|                                                                                                                              |   |                     |    |                     |       |   |   |   |   |
| Diluted net income (loss) per common share  from continuing operations                                                            |   | $                        | 0.03    |                     | $          | (0.05 | ) | $ | 0.09 |   | $ | (0.09 | ) |
| Diluted net loss per common Share from  discontinued operations                                                                   |   | -                        |    | (0.02                    | )          | $ | - |   | $ | (0.08 | ) |
| Diluted income (loss) per common share                                                                                            |   | $                        | 0.03    |                     | $          | (0.07 | ) | $ | 0.09 |   | $ | (0.17 | ) |

 

10

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Excluded fromthe table above in FY 2003 are the Company’s convertible promissory notes thatmay be converted into 1,000,000 shares of common stock and the assumed exerciseof stock options and warrants, calculated based on the treasury stock method,into 594,032 and 484,495 shares of common stock at the quarter and period ends,respectively, as these would be anti-dilutive due to the losses in those periods.Excluded from the treasury stock calculation in FY 2004 are 122,000 and 227,000shares of common stock at the quarter and period ends, respectively, as theseoptions were priced above the average stock price for the period and thereforewould be anti-dilutive.

 

11

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(5)                                  Lineof Credit and Working Capital Loan

 

The Company’s primary source of liquidity is its $2,000,000 revolvingline of credit facility under a loan agreement with Comerica Bank-Californiathat was renewed on January 28, 2004 and expires on December 28,2004.  The outstanding balance on theCompany’s revolving line of credit was zero at the end of the third quarter ofFY 2004, providing the Company with $2,000,000 of borrowing availability.  At the end of the same period in FY 2003,the line of credit balance was $138,000. The loan is collateralized by all ofthe Company’s assets including accounts receivable.  Comerica Bank-California advances funds to the Company of up to80% of the Company’s billed accounts receivable that are less than 90 daysold.  Comerica Bank-California chargesan interest rate of 0.25% over prime or 3.00% above Bank’s LIBOR, at theCompany’s option.  ComericaBank-California requires the Company to maintain certain covenants and atMarch 26, 2004 the Company was in compliance with all of those covenants.

 

At March 26, 2004, the Company had an outstanding balance of$153,000 under a $500,000 working capital loan provided by the same bank, whichexpires on January 31, 2005.  Theloan is collateralized by substantially all of the assets of the Company andbears interest at 0.75% above the prime rate.

 

(6)                                  LegalMatters

 

On March 19, 2003, the Company was served notice that it was namedin a lawsuit filed in the Superior Court of California, County of Orange, onMarch 10, 2003.  The lawsuit wasbrought by associates of former Company Chairman and Chief Executive Officer,Robert D. Mowry who had a relationship with Mowry through Big CanyonInvestments, Inc. and UniPrise, Inc. The Plaintiffs were George M. Colin, William Czapar, Dan Birdsall andBrian Patterson.

 

The Plaintiffs claimed to have suffered losses and sought damages of$980,000, plus interest, administrative fees and other consideration.  On April 21, 2004, the Superior Courtsustained the Company’s demurrer to the plaintiffs’ complaint and did not allowthe plaintiffs to further amend, thus ending the case.  The Company has requested that judgmententered against the plaintiffs, which Counsel anticipates will be granted as amatter of course.

 

We are involved in legal actions in the normal course of business,including audits and investigations by various governmental agencies thatresult from our work as a governmental contractor. We are named as defendantsin legal proceedings from time to time and we may assert claims from time totime.

 

(7)                                  Stockholders’Equity

 

During the first three quarters of FY 2004, there were 116,887 sharesof common stock issued due to the exercise of stock options for $123,627.  These options had exercise prices rangingfrom $0.625 to $1.57.

 

OnSeptember 9, 2003, the Board of Directors authorized management to callthe Company’s 69,781 shares of issued and outstanding 9% Series B Preferencestock.  The stockholders were offeredcash or an exchange for common stock using $1.75 as the per share price of thecommon stock.  These shareholdersreceived approximately $60,000 in cash and 5,969 shares of common stock

 

12

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with a market value of $10,000.

 

On September 29, 2003, the Company contributed 62,500 shares ofcommon stock to the Company’s Employee Stock Ownership Plan in accordance withthe matching provisions under the plan. These shares had a fair market value of $137,500.

 

On September 29, 2003, the Company issued 62,950 shares of commonstock to employees that participated in the Employee Stock Purchase Plan.  The period of performance was fromJanuary 1, 2003 to June 30, 2003. These shares had a fair market value of $138,490.

 

On October 16, 2003, Clifton L. Cooke, Jr., the Company’sPresident and CEO, exercised warrants to purchase 250,000 common shares at$1.00 per common share.  These shareshad a fair market value of $450,000.

 

On October 20, 2003, Clifton L. Cooke, Jr., the Company’sPresident and CEO, converted his $225,000 convertible notes at $1.00 per commonshare.  These shares had a fair marketvalue of $405,000.  During the thirdquarter, three other note holders chose to convert their notes valued at$56,250 at $1.00 per share.

 

On February 12, 2004, the Company issued 63,086 shares of commonstock to employees that participated in the Employee Stock Purchase Plan.  The period of performance was fromJuly 1, 2003 to December 31, 2003. These shares had a fair market value of $129,957 on the date of issuance.

 

As discussed in Note 3, the Company completed a subscription offeringraising $3,200,000 for working capital and acquisition financing. The offeringconsisted of $50,000 units comprised of 50% common stock and 50% convertiblenotes.  In connection with thisoffering, 1,000,005 shares of common stock were issued in exchange for $1.6million in cash.

 

(8)                                  SubsequentEvent

 

Subsequent to period end, on March 31, 2004, SYS acquired all ofthe outstanding stock of Polexis, Inc., a privately held, San Diego-basedprovider of advanced data management software, for approximately $6.5 millionin cash, stock, notes, and assumption of debt. The transaction was completedpursuant to an Agreement and Plan of Merger among SYS, Shadow ResearchInternational, Inc., a wholly owned subsidiary of SYS and Polexis, Inc. and thePolexis principal shareholders (“Agreement”). As a result of the acquisition,Polexis Inc. became a wholly owned subsidiary of SYS and, therefore, will beincluded in the consolidated financial results of SYS effective for periodssubsequent to March 31, 2004.

 

The merger consideration consisted of (i) $3,250,000 in cash, (ii)697,973 shares of SYS common stock with a value of $1,598,000 based on anaverage closing price of $2.29 prior to and after the closing, (iii) $1,375,000in unsecured subordinated convertible notes, and (iv) assumption of $325,000bank indebtedness.  Proceeds from therecently completed Subscription Offering were used to pay the cash portion of thetransaction.

 

The excess of the Company’s purchase price over the estimated fairvalue of the net assets acquired amounted to approximately $5.8 million, whichconsists of goodwill and other intangible assets.  An independent valuation will be performed to determine thepurchase price allocation based upon the fair value of the assets andliabilities acquired, at which time the allocation of purchase price

 

13

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may be revised. Management expects to complete the independentvaluation during the fourth quarter of FY 2004.

 

The following summary presentspro forma consolidated results of operations for the nine months ended March26, 2004 and March 29, 2003 as if the acquisition described above had occurredat the beginning of each fiscal year ending June 30, 2004 and 2003 and includesadjustments that were directly attributable to the transaction or were expectedto have a continuing impact on the Company.

 

The pro forma results areunaudited and for illustrative purposes only for the applicable periods, and donot purport to be indicative of the actual results which would have occurredhad the transaction been completed as of the beginning of the periods, nor arethey indicative of results of operations which may occur in the future. Thefollowing is also a reconciliation of GAAP (as reported) to pro forma financialresults for the nine months ended March 26, 2004 and March 29, 2003:

 
|                                 |   | **Nine  months ended March 26, 2004** |       | **Nine  months ended March 29, 2003** |   |
|--------------------------------------|--------|---------------------------------------|------------|---------------------------------------|--------|
|                                 |   | **As Reported**                       |       | **Pro forma  Adjustments**            |   | **Pro forma** |   | **As  Reported** |   | **Pro forma  Adjustments** |   | **Pro forma** |   |
|                                 |   |                                  |       |                                  |   |   |   |   |   |   |   |   |   |
| Revenues                             |   | $                                     | 23,304,000 |                                  | $      | 6,059,000 |   | $ | 29,363,000 |   | $ | 17,652,000 |   | $ | 5,877,438 |   | $ | 23,529,438 |   |
| Operating Income                     |   | $                                     | 1,144,000  |                                  | $      | 499,973 |   | $ | 1,643,973 |   | $ | (614,000 | ) | $ | 403,400 |   | $ | (210,600 | ) |
| Net income (loss)                    |   | $                                     | 615,000    |                                  | $      | 230,555 |   | $ | 845,555 |   | $ | (853,000 | ) | $ | 160,927 |   | $ | (692,073 | ) |
|                                 |   |                                  |       |                                  |   |   |   |   |   |   |   |   |   |
| Net income per common share:         |   |                                  |       |                                  |   |   |   |   |   |   |   |   |   |
| Basic                                |   | $                                     | 0.10       |                                  | $      | 0.02 |   | $ | 0.12 |   | $ | (0.17 | ) | $ | 0.05 |   | $ | (0.12 | ) |
| Diluted                              |   | $                                     | 0.09       |                                  | $      | 0.02 |   | $ | 0.11 |   | $ | (0.17 | ) | $ | 0.05 |   | $ | (0.12 | ) |
| Weighted average shares outstanding: |   |                                  |       |                                  |   |   |   |   |   |   |   |   |   |
| Basic                                |   | 6,159,876                             |       | 697,973                               |   | 6,857,849 |   | 5,072,864 |   | 697,973 |   | 5,770,837 |   |
| Diluted                              |   | 7,719,260                             |       | 1,290,645                             |   | 9,009,905 |   | 5,072,864 |   | 697,973 |   | 5,770,837 |   |

 

Item 2.                                     Management’sDiscussion and Analysis or Plan of Operations

 

To the extent that the information presented in this quarterly reportdiscusses financial projections, information or expectations about our businessplans, results of operations, products or markets, or otherwise makesstatements about future events, such statements are forward-looking.  Such forward-looking statements can beidentified by the use of words such as “intends”, “anticipates”, “believes”,“estimates”, “projects”, “forecasts”, “expects”, “plans” and “proposes”.  Although we believe that the expectationsreflected in these forward-looking statements are based on reasonableassumptions, there are a number of risks and uncertainties that could causeactual results to differ materially from such forward-looking statements.  These include, among others, the cautionarystatements in the “Factors Which May Affect Future Results” and “Management’s Discussionand Analysis or Plan of Operations” sections of this report.  These cautionary statements identifyimportant factors that could cause actual results to differ materially fromthose described in the forward-looking statements.

 

New AccountingPronouncements

 

InMay 2003, the Financial Accounting Standards Board (“FASB”) issued statement offinancial accounting standard (“SFAS”) 150, Accounting for Certain FinancialInstruments with Characteristics of Both Liabilities and Equity. SFAS 150requires that certain financial instruments, which under previous guidance wereaccounted for as equity, must now be accounted for as liabilities. Thefinancial instruments affected include mandatory redeemable stock, certainfinancial instruments that require or may require the issuer to buy back some ofits shares in exchange for cash or other assets and certain obligations thatcan be settled with shares of stock. SFAS 150 is effective for all financialinstruments entered into or modified after May 31, 2003, and otherwise iseffective at the beginning of the first interim period beginning afterJune 15, 2003. The Company adopted SFAS 150 effective July 1, 2003.The adoption of SFAS 150 did not have a material impact on the results ofoperations, financial position or liquidity of the Company.

 

InApril 2003, the FASB issued SFAS 149, Amendment of Statement 133 onDerivative Instruments and Hedging Activities, which amends and clarifiesfinancial accounting and reporting for derivative instruments, includingcertain derivative instruments embedded in other contracts and for hedgingactivities under SFAS 133. SFAS 149 is effective for contracts entered into ormodified after June 30, 2003. The adoption of SFAS 149 did not have amaterial impact on the results of operations, financial position or liquidityof the Company.

 

In July 2002, the FASB issued SFAS 146, Accounting forRestructuring Costs. SFAS 146 applies to costs associated with an exit activity(including restructuring) or with a disposal of long-lived assets. Thoseactivities can include eliminating or reducing product lines, terminatingemployees and contracts, and relocating plant facilities or personnel. UnderSFAS 146, a company will record a liability for a cost associated with an exitor disposal activity when that liability is incurred and can be measured atfair value.  SFAS 146 requires acompany to disclose information about its exit and disposal activities, therelated costs, and changes in those costs in the notes to the interim andannual financial statements that include the period in which an exit activityis initiated and in any subsequent period until the activity is completed.  SFAS 146 is effective prospectively for

 

14

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exit or disposal activities initiated after December 31, 2002. UnderSFAS 146, a company may not restate its previously issued financial statementsand SFAS 146 grandfathers the accounting for liabilities that a company hadpreviously recorded under Emerging Issues Task Force Issue 94-3. The adoptionof SFAS 146 did not have a material impact on our results of operations,financial position or liquidity.

 

InNovember 2002, the Emerging Issues Task Force (“EITF”) issued EITF IssueNo. 00-21, “Accounting for Revenue Arrangements with MultipleDeliverables.” EITF Issue No. 00-21 addresses how to determine whether arevenue arrangement involving multiple deliverables contains more than one unitof accounting for the purposes of revenue recognition and how the revenuearrangement consideration should be measured and allocated to the separateunits of accounting. EITF Issue No. 00-21 applies to revenue arrangementsentered into after June 15, 2003. The adoption of this statement did nothave a material impact on the Company’s financial condition or results ofoperations.

 

InJanuary 2003, the FASB issued Interpretation No. 46, *Consolidation of Variable Interest Entities*,which addresses the consolidation of certain entities (“variable interestentities”) in which an enterprise has a controlling financial interest throughother than voting interests. FIN No. 46 requires that a variable interestentity be consolidated by the holder of the majority of the expected risks andrewards associated with the activities of the variable interest entity. FIN 46was effective for VIE’s entered into prior to February 1, 2003 in periodsbeginning after June 15, 2003.  Theadoption of FIN 46 did not have a material impact on the Company’s financialcondition or results of operation.   InJanuary 2004, the FASB issued a revision to FIN 46, to clarify somerequirements and add new scope exceptions. The revised guidance is effective for the first reporting periodbeginning after December 15, 2003. The adoption of the provisions of FIN 46R did not have a material impacton the Company’s financial condition or results of operations.

 

In December 2003, the SEC issued Staff Accounting Bulletin (SAB)No. 104, “Revenue Recognition”  (SAB No.104), which codifies, revises and rescinds certain sections of SAB No. 101,  “Revenue Recognition”, in order to make thisinterpretive guidance consistent with current authoritative accounting andauditing guidance and SEC rules and regulations.  The changes noted in SAB No. 104 did not have a material effecton our consolidated results of operations, consolidated financial position orconsolidated cash flows.

 

### Description of Business

 

Overview

 

SYS Technologies (“SYS or “the Company”) has provided engineering,technical, financial and management services to commercial and U.S. governmentcustomers since 1966. It currently has several multiple-year management andengineering service contracts with the U.S. Navy and General ServicesAdministration at various locations across the country.

 

The Companydelivers these services through three divisions all of which are classified asone segment under the provisions of SFAS No. 131, as follows:

 

•                  EnterpriseSolutions Division

•                  IntegratedInformation Solutions Division

 

15

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•                  SystemsManagement and Engineering Division

 

Our revenues have grown internally by establishing new business unitswith experienced senior executives who have the ability to grow these businessunits and expand our customer base. We expect that this trend willcontinue.  At the same time we willevaluate acquisition opportunities and make acquisitions if the transactionsare in line with our strategy of increasing our core competencies and expandingour customer base.

 

Our operatingmargins are affected by the mix of contract types (cost reimbursement, fixed-priceor time and materials) as well as the mix of prime contracts versussubcontracts. Significant portions of our contracts are time and materials andcost reimbursement contracts. We are reimbursed for labor hours at negotiatedhourly billing rates and other direct expenses under time and materialscontracts and reimbursed for all actual costs, plus a fee, or profit, underreimbursement contracts. The financial risks under these contracts aregenerally lower than those associated with other types of contracts, andmargins are also typically lower than those on fixed-price contracts. The U.S.government also has awarded us fixed-price contracts. Such contracts carryhigher financial risks because we must deliver the products, systems orcontract services at a cost below the fixed contract value in order to earn aprofit. Of our total year to date revenues from our government business in2004, approximately 33 % were generated by time and materials contracts,approximately 63% were generated by cost reimbursement contracts andapproximately 4% were generated by fixed-price contracts.

 

Enterprise Solutions Division (ESD)

 
|                           |   | **Three  months ended**  |      | **Nine  months ended**   |   |
|--------------------------------|--------|--------------------------|-----------|--------------------------|--------|
|                           |   | **March 26,  2004** |      | **March 29,  2003** |   | **March 26,  2004** |   | **March 29,  2003** |   |
| Revenue for ESD                |   | $                        | 4,491,000 |                     | $      | 3,262,000 |   | $ | 13,170,000 |   | $ | 10,313,000 |   |
| Percent of revenue for Company |   | 55                       | %         | 57                       | %      | 57 | % | 58 | % |
|                                |        |                          |           |                          |        |  |  |  |  |  |  |  |  |

 

ESD is based in Oxnard, California and is adjacent to major Navyactivities, which includes the Port Hueneme Division of the Naval SurfaceWarfare Center, the Naval Facilities Expeditionary Logistics Center and theNaval Air Warfare Center.

 

ESD performs engineering services, operational analysis and informationtechnology services in support of Navy customers.  Engineering services are in support of combat systems, ships,auxiliary systems, components and equipment.  Operational analysis and services include a full range of businessfunctions performed both at the Company’s facilities for analysis and on thecustomer site for direct support. Information technology services providerequirements determination and analysis, software development, anddocumentation development as well as on-site administration, training and helpdesk operations as a subcontractor to a large Navy prime Information Technologycontractor.

 

Revenues increased approximately 38% and 28% for the three and ninemonth periods in FY 2004, as compared to the same periods of FY 2003.  The primary reason for the increase inrevenues is additional tasking on existing contracts.  During the nine month period ended March 26, 2004, thelargest increases were on the UNREP and NMCI contracts described below.

 

16

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ESD had revenue of $13,171,000 or 57% of the Company’s revenue for thefirst three quarters of FY 2004.  Someof this Division’s major contracts include:

 

•             U.S.Navy Underway Replenishment (UNREP) prime contract that has been held by theCompany since 1982.

 

•             Management,Planning, Analytical and Administrative (MPAA) prime contract, which supportsthe U.S. Navy’s Port Hueneme Division, Naval Surface Warfare Center.

 

•             NavyMarine Corps Intranet (NMCI) subcontract for information technology services.

 

The MPAA contract’s third option year expired on January 31,2004.  On January 26, 2004, thecompany received a 60-day extension on the MPAA contract plus a clean up periodthrough June 30, 2004.  The Companywas informed that the final option year on the MPAA contract would not beexercised and that the government would instead issue a new one year contractthat would be set aside for a small business with a three year revenue averageof under $6 million.  Since the Companydoes not qualify for that small business rating, it teamed with a smallbusiness that could comply with that rating. The Company was notified on March 31, 2004 that its team did notwin the contract; however, the company that was the announced contract winnerwas subsequently disqualified.  If theCompany’s team does not win this contract, the Company will try to move workcurrently being performed on the MPAA contract to other contracts held by theCompany.  Regardless of the outcome ofthis new contract, the Company does not expect to retain all of the workpresently being performed under the MPAA contract in 2005, which may result ina loss of revenue.  ThroughMarch 26, 2004, this contract accounted for $4.0 million or approximately17% of the Company’s revenue.

 

Integrated Information Solutions Division (IISD)

 
|                           |   | **Three  months ended**  |      | **Nine  months ended**   |   |
|--------------------------------|--------|--------------------------|-----------|--------------------------|--------|
|                           |   | **March 26,  2004** |      | **March 29,  2003** |   | **March 26,  2004** |   | **March 29,  2003** |   |
| Revenue for IISD               |   | $                        | 2,141,000 |                     | $      | 1,254,000 |   | $ | 6,036,000 |   | $ | 3,636,000 |   |
| Percent of revenue for Company |   | 26                       | %         | 22                       | %      | 26 | % | 21 | % |
|                                |        |                          |           |                          |        |  |  |  |  |  |  |  |  |

 

IISD is based in San Diego, California.  This division provides Command, Control, Communication, Computer,Intelligence, Surveillance and Reconnaissance (C4ISR) system engineeringservices and solutions, which includes such activities as providing our TheAssessment Profiling System (TAPS) Decision Support System to manage theInformation Operations Campaign by the 8th Army in Korea; providingtechnical and managerial personnel to design, develop and fabricate integratedsensors and communications devices in the Integrated Circuit FabricationFacility at SPAWAR Systems Center in San Diego; develop new communicationsarchitectures for combining strategic and tactical communications and datalinks into a single composite network; and support SPAWAR Headquartersassessments of FORCENet related capabilities and programs.

 

The customer base includes Space and Naval Warfare Systems Command(SPAWAR) Headquarters, SPAWAR Systems Center San Diego, Naval Air SystemsCommand (NAVAIR), Defense Advanced Research Programs Agency (DARPA), as well asnumerous operational 

 

17

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commands and other DOD industry partners such as Boeing and BritishAerospace Corporation.  The IISpersonnel work closely with Office of Naval Research, Assistant Secretary ofthe Navy for Research, Development and Acquisition, Advanced Research andDevelopment Activity, Chief of Naval Operations, Naval Warfare DevelopmentCommand, Joint Forces Command, and other services and Joint Agencies.

 

Revenues increased approximately 71% and 66% for the three and ninemonth periods in FY 2004, as compared to the same periods of FY 2003.  The primary reason for the increase inrevenues is additional tasking on existing contracts.  During the nine month period ended March 26, 2004, thelargest increases were on the SPAWAR and SAIC contracts described below.

 

IISD had revenue of $6,036,000 or 26% of the Company’s revenue for thefirst three quarters of FY 2004.  Someof this Division’s major contracts include:

 

•             Primecontract with SPAWAR Systems Center’s Joint and National Systems Division.  Subcontractors on this contract includeNorthrup-Grumman, Boeing, Lucent, SAIC, and BAE.

 

•             Subcontractwith Science Applications International Corporation (SAIC) on its SPAWARSystems Engineering & Integration contract.

 

•             Primecontract with SPAWAR Systems Center’s Information Assurance and EngineeringDivision.  Subcontractors on thiscontract are Science Applications International Corporation, Booz—Allen &Hamilton, Inc, American Systems Corporation, Galaxy Scientific Corporation andNathan Kunes, Inc.

 

Systems Engineering and Management Division (SEMD)

 
|                           |   | **Three  months ended**  |      | **Nine  months ended**   |   |
|--------------------------------|--------|--------------------------|-----------|--------------------------|--------|
|                           |   | **March 26,  2004** |      | **March 29,  2003** |   | **March 26,  2004** |   | **March 29,  2003** |   |
| Revenue for SEMD               |   | $                        | 1,462,000 |                     | $      | 1,309,000 |   | $ | 4,098,000 |   | $ | 3,787,000 |   |
| Percent of revenue for Company |   | 18                       | %         | 23                       | %      | 18 | % | 21 | % |
|                                |        |                          |           |                          |        |  |  |  |  |  |  |  |  |

 

SEMD is based in Arlington, Virginia with a second office located inChesapeake, Virginia.  A third office iscurrently being established in San Antonio, Texas.

 

SEMD performs Department of Defense Acquisition Program Management, NavyCombat System Safety Engineering, Communications and other InformationTechnology Engineering and Support Services, Port Engineering for shipequipment installations, training, and Budgeting and Financial Management.  Typical systems supported are:  Battle Force Tactical Training (BFTT), FiberOptic Data Multiplex System (FODMS), and the Combat System Operating SequencingSystem (CSOSS).

 

Revenues increased approximately 12% and 8% for the three and ninemonth periods in FY 2004, as compared to the same periods of FY 2003.  The primary reason for the increase inrevenues is additional tasking on existing contracts.  During the nine month period ended March 

 

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26, 2004, the largest increases were on the GSA contracts describedbelow.

 

SEMD had revenue of $4,098,000 or 18%of the Company’s revenue for the first three quarters of FY2004.  Some of this Division’s majorcontracts include:

 

•             Subcontractfor the Naval Sea Systems Command’s Professional Support Services MultipleAward Contract (NAVSEA MAC).

 

•             Technicalsupport under a GSA contract to the Battle Force Tactical Training (BFTT)program for Naval Sea Systems Command.

 

General Services Administration Contracts

 

The Company has three contracts from the General ServicesAdministration (GSA).  These threecontracts are for Information Technology, Financial and Business Solutions andProfessional Engineering Services. These contracts, which are time and material based, have proven to be ameans to develop new customers and these contracts are registered in the GSAAdvantage System.  The GSA AdvantageSystem is an on-line service provided by GSA that lists the price schedules forall registered companies. Revenues of $ 4,594,000 from those contracts are includedwithin the divisional revenues noted above.

 

### Results of Operations

 

The followingtable sets forth certain items, including consolidated revenues for the threeand nine-month periods ended for fiscal years 2004 and 2003 (in thousands):

 
|                                |   | **Three Months  Ended** |   | **Nine  Months Ended** |   |
|-------------------------------------|--------|-------------------------|--------|------------------------|--------|
|                                |   | **Mar. 26  2004**       |   | **%**                  |   | **Mar. 29  2003** |   | **%** |   | **Mar. 26  2004** |   | **%** |   | **Mar. 29  2003** |   | **%** |   |
| Revenues                            |   | $                       | 8,094  |                   | 100.0  |   | $ | 5,741 |   | 100.0 |   | $ | 23,304 |   | 100.0 |   | $ | 17,652 |   | 100.0 |   |
| Costs and expenses:                 |   |                    |   |                   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Cost of revenues                    |   | 6,785                   |   | 83.8                   |   | 5,059 |   | 88.1 |   | 19,297 |   | 82.8 |   | 14,832 |   | 84.0 |   |
| General and Administrative expenses |   | 840                     |   | 10.4                   |   | 1,101 |   | 19.2 |   | 2,863 |   | 12.3 |   | 2,493 |   | 14.1 |   |
| Legal settlement                    |   | —                  |   | —                 |   | — |   |   |   |   |   |   |   | 941 |   | 5.3 |   |
| Totals                              |   | 7,625                   |   | 94.2                   |   | 6,160 |   | 107.3 |   | 22,160 |   | 95.1 |   | 18,266 |   | 103.5 |   |
| Income (loss) from operations       |   | 469                     |   | 5.8                    |   | (419 | ) | (7.3 | ) | 1,144 |   | 4.9 |   | (614 | ) | (3.5 | ) |
|                                     |        |                         |        |                        |        |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

Revenues increased approximately 41% and 32% for the three and ninemonth periods for FY 2004, as compared to the same periods of FY 2003. As discussedpreviously, each division had an increase in revenues and the primary reasonfor the increase in revenues is additional tasking on existing contracts.

 

Cost of revenues include all direct costs such as labor and materialsand indirect costs such as subcontractors and overhead. The Company generallyrecognizes revenue as services are performed

 

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under contracts.  The cost ofrevenues is primarily direct labor with subcontracting and overhead as secondarycosts. Since direct labor is fully burdened, any increase or decrease in themix of direct labor to other direct costs from period to period will have asignificant impact on revenues and operating margins.

 

Historically, cost of revenues approximates 83% of revenues. For therecent quarter ended, cost of revenues were approximately 83.8% of revenues,which is a 4.9% decrease from the previous year’s same quarter.  The primary reason for the decrease is areduction in subcontractor costs in the current quarter.  Year to date cost of revenues wereapproximately 82.8% of revenues, which is a 1.6% decrease from the previousyear’s same period. The primary reason for the decrease is the same reductionin subcontractor costs as noted for the quarter.

 

General and administrative (G & A) expenses, which consistprincipally of corporate support, have increased by approximately $370,000 overthe same nine-month period from the prior year.  Although this is a 15% increase over the prior year’s costs,revenue increased 32% over this same period. The primary reasons for theincreased costs year to date were due to additional salaries, audit expenses,director fees and estimated accruals for certain expenses, which accounts forthe year to date increase.  For thequarter, G & A expenses decreased $261,000 as compared to the same quarterin the prior year.  The primary reasonfor the decrease is that the prior year quarter included costs associated witha terminated acquisition.

 

The increasedsalaries relate to key management personnel who are responsible for (i)executing on the Company’s growth strategy including the recent fund raisingand acquisition activities and  (ii)ensuring the Company’s ability to comply with the increased costs of being apublicly traded company under the recent Sarbanes-Oxley legislation. Auditexpenses have increased significantly and are expected to continue increasingas reporting and compliance obligations have been increased for both theCompany and the independent accountants. The estimated accruals are based on an incentive compensation plan putin place during the current fiscal year.

 

The Company’s interest expense decreased approximately 7% and 28% forthe three and nine month periods, respectively, for FY 2004, as compared to thesame periods of FY 2003.  Interestexpense decreased due to improvements in working capital resulting in less useof the Company’s line of credit with Comerica Bank-California.  Additionally, the accretion of a debtdiscount recorded as interest expense was ended in FY 2003.  The Company will incur additional interestexpense in future periods due to the notes associated with the subscriptionoffering.

 

Income from operations improved to $469,000 and $1,144,000 for thethird quarter and year to date in 2004 as compared to a loss from operations of($419,000) and ($614,000) for the same periods in the prior fiscal year. Thisimprovement is directly attributable to the elimination of losses fromdiscontinued operations and the legal settlement. Current year to dateoperating margins are 4.9%, which is representative of margins for a servicesbased defense contract business.

 

During the first three quarters of FY 2003, the Company had combinedlosses of approximately $384,000 in its Training Division and Walk-Up SystemsDivisions, after the applicable income tax benefit.  As these divisions were discontinued at the end of 2003, no suchlosses were incurred in 2004.  TheTraining Division was sold and the Walk-Up Systems Division was wound down.

 

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Income taxes reflect effective rates of 42% year to date in fiscal year2004, compared to tax benefits in the prior year due to the losses. The ratesin the current year reflect the expected tax provision rate for the full fiscalyear. The expected tax provision rates are impacted by estimated changes inannual book income and the estimated tax deductibility of certain operatingexpenses.

 

Net income is $249,000 and $619,000 for the third quarter and year todate in fiscal year 2004 as compared to a net loss of ($387,000) and ($847,000)for the same periods in the prior fiscal year. The improvement in net income isbased on the improved income from operations as discussed above.

 

Funded contract backlog (the Company has been awarded contracts whichhave been funded by the customer) was approximately $13,845,000 at the end ofthe third quarter of FY 2004 compared to $11,093,000 for the same quarter in FY2003. The amount of funded backlog at any one time will generally approximateone to two quarters of revenues.

 

Contracts undertaken by the Company may extend beyond one year.  Accordingly, portions are carried forwardfrom one year to the next as part of backlog. Because many factors affect the scheduling of projects, no assurance canbe given as to when revenue will be realized on projects included in ourbacklog.  Although funded backlogrepresents only business that is considered to be firm, we cannot guaranteethat cancellations or scope adjustments will not occur.  The majority of funded backlog representscontracts under the terms of which cancellation by the customer would entitlethe Company to all or a portion of our costs incurred and potential fees.

 

### Liquidity and CapitalResources

 

The Company had net accounts receivable of $6,333,000 at the end of thethird quarter of fiscal year 2004 and $4,860,000 for the same quarter ended infiscal year 2003. Revenues grew by 32% for the nine month period endedMarch 26, 2004 compared to the same period in the prior year, accountsreceivables grew by approximately the same amount.

 

Cash flow from operating activities was $1,143,000 as compared to($45,000) in the prior year. The increase in cash flow is attributable toincreased net income, an income tax refund of $477,000, accrued payroll andrelated taxes decreasing by $856,000, and accrued income taxes decreasing by$310,000. Net cash provided by financing activities of $2,859,000 includesproceeds from issuance of convertible notes payable of $1,600,000, and proceedsfrom issuances of common stock of $2,091,000, and payments on notes of$768,000, payment of dividends of $4,000, payment of $60,000 due to the call onthe preference stock.

 

The Company had accounts payable of $665,000 at the end of the thirdquarter of fiscal year 2004 and $1,398,000 for the same quarter in fiscal year2003.  At the end of the third quarterof fiscal year 2003, the Company had one invoice totaling $495,000 from onesubcontractor, which accounted for the majority of the significant differencebetween the two periods.

 

In the normal course of operating the business, short-term timingdifferences arise between when the Company pays its employees andsubcontractors and when the Company receives payment from its customers.Accordingly, the Company utilizes its revolving line of credit to fund thesedifferences.

 

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Details of contractual obligations at March 26, 2004 are asfollows:

 
|                               |   |      |      | **Payments  Due by Period** |   |
|------------------------------------|--------|-----------|-----------|-----------------------------|--------|
|                               |   | **Total** |      | **Less than  1 year**       |   | **1-3 years** |   | **4-5 years** |   | **After 5  years** |   |
| Long-Term debt                     |   | $         | 2,547,000 |                        | $      | 242,000 |   | $ | 2,305,000 |   | — |   | — |   |
| Operating leases                   |   | 2,330,000 |      | 625,000                     |   | 1,480,000 |   | 225,000 |   | — |   |
| Total contractual cash obligations |   | $         | 4,877,000 |                        | $      | 867,000 |   | $ | 3,785,000 |   | $ | 225,000 |   | — |   |
|                                    |        |           |           |                             |        |  |  |  |  |  |  |  |  |  |  |

 

The Company’s primary source of liquidity is its $2,000,000 revolvingline of credit facility under a loan agreement with Comerica Bank-Californiathat was renewed on January 28, 2004 and expires on December 28,2004.  The outstanding balance on theCompany’s revolving line of credit was zero at the end of the third quarter ofFY 2004, providing the Company with $2,000,000 of borrowing availability.  At the end of the same period in FY 2003,the line of credit balance was $138,000. The loan is collateralized by all ofthe Company’s assets including accounts receivable.  Comerica Bank-California advances funds to the Company of up to80% of the Company’s billed accounts receivable that are less than 90 days old.  Comerica Bank-California charges an interestrate of 0.25% over prime or 3.00% above Bank’s LIBOR, at the Company’soption.  Comerica Bank-Californiarequires the Company to maintain certain covenants and at March 26, 2004the Company was in compliance with all of those covenants.

 

Management believes that the Company will have sufficient cash flowfrom operations and funds available under the revolving credit agreement withComerica Bank-California to finance its operating and capital expenditurerequirements. However, to the extent that the Company pursues acquisitions toachieve its growth strategy, it may need to raise additional cash or otherforms of debt or equity financing. There can be no assurance that the Company will be able to obtainadditional debt or equity financing or obtain such financing on terms favorableto the Company and its existing investors.

 

Certain key factors, some of which are bank covenants and other ratiosused by management, indicating the Company’s financial condition include:

 
|                        |   | **March 26,  2004** |      | **June 30,  2003** |   |
|-----------------------------|--------|--------------------------|-----------|-------------------------|--------|
| Current ratio               |   | 3.42                     |      | 1.92                    |   |
| Debt to equity              |   | 0.88                     |      | 1.49                    |   |
| Stockholders’ equity   |   | $                        | 6,174,000 |                    | $      | 3,079,000 |   |
| Net working capital         |   | $                        | 7,594,000 |                    | $      | 3,166,000 |   |
| Debt to total assets        |   | 47                       | %         | 60                      | %      |
| Book value per common share |   | $                        | 0.84      |                    | $      | 0.57 |   |

 

The above factors are calculated as follows: The current ratio isderived by dividing total current assets by total current liabilities.  Debt to equity is calculated by dividingtotal liabilities (total current liabilities plus other liabilities) bystockholders’ equity.  Net workingcapital is total current assets less total current liabilities.  Debt to total assets is total liabilitiesdivided by total assets.  Book value percommon share is stockholders’ equity related to common shares divided by thenumber of common shares outstanding at the end of the period.

 

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CriticalAccounting Policies and Estimates

 

The Company’s discussion and analysis of its financial condition andresults of operations are based upon its consolidated financial statements,which have been prepared in accordance with accounting principles generallyaccepted in the United States.  Thepreparation of these financial statements requires management to make estimatesand judgments that affect the reported amounts of assets, liabilities, revenuesand expenses, and related disclosure of contingent liabilities.  On an ongoing basis, management evaluatesits estimates, including those that relate to revenues,  bad debts, inventory, intangible assets,income tax contingencies, stock based compensation and litigation.  Management bases its estimates on historicalexperience and on various other assumptions that are believed to be reasonableunder the circumstances, the results of which form the basis for making judgmentsabout the carrying values of assets and liabilities that are not readilyapparent from other sources.  Actualresults may differ from these estimates under different assumptions andconditions.  If actual resultssignificantly differ from management’s estimates, the Company’s financialcondition and results of operations could be materially impaired.

 

The Company believes the following critical accounting policies affectits more significant judgments and estimates used in the preparation of itsconsolidated financial statements.

 

Revenues are primarily derived from contracts with agencies of the U.S.Government.  Revenues on fixed-pricecontracts are recorded on the percentage completion method in the ratio thatcosts incurred bear to total estimated costs at completion.  Revenues on cost plus fixed fee contractsand time and material contracts, for which percentage-of-completion is notused, are generally recognized as work is performed and billed to the customer.  Contract costs, including indirect costs, oncertain U.S. Government contracts are subject to audit by the Defense ContractAudit Agency before final acceptance. Revenues have been recorded at amounts expected to be realized uponfinal settlement.

 

Our accounts receivables balances include unbilled receivables whichare comprised of work-in-process which will be billed in accordance withcontract terms and delivery schedules, as well as amounts billable upon finalexecution of contracts, contract completion, milestones or completion of rate negotiations.Payments to us for performance on certain of our U.S. Government contracts aresubject to audit by the DCAA, and are subject to government funding. We providea reserve against our receivables for estimated losses that may result fromrate negotiations, audit adjustments, and/or government funding availability.To the extent that actual adjustments due to rate negotiations, auditadjustments, or government funding availability differ from our estimates, ourrevenue may be impacted.  Historically,the Company has not incurred the adjustments discussed above.

 

Since the Company’s primary customer is the U.S. Government, theCompany historically has not recorded significant charges for bad debt.  Bad debts are recognized in the period inwhich they are identified.

 

The carrying value of the Company’s net deferred tax assets assumesthat the Company will be able to generate sufficient future taxable income,based on estimates and assumptions.  Ifthese estimates and assumptions change in the future, the Company may berequired to record valuation allowances against its deferred tax assetsresulting in additional income tax expenses.

 

In assessing the recoverability of the Company’s intangible assets, theCompany must make

 

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estimates of expected future cash flows and other factors to determinethe fair market value of the respective assets.  If these estimates and their related assumptions change in thefuture, the Company may be required to record impairment charges.  The Company adopted Statement of FinancialAccounting Standards No. 142, Goodwill and Other Intangible Assets, and will berequired to analyze its goodwill for impairment on an annual basis.  The Company recorded impairment charges forGoodwill in  FY 2003 of approximately$84,000.

 

Item 2a.                               FactorsWhich May Affect Future Results

 

Information contained in this Form 10-QSB should be studied carefullyby any shareholder or potential investor while considering the following riskfactors to the Company.

 

**We depend upon a single customer, the U.S. government, formost of our revenues, and a decrease in its demand for our services might harmour operating results.**

 

Asubstantial part of our business at the present time is with the U.S. Navy.Even though the level of business with this customer is growing and we havenegotiated multiple-year contracts that include option and award years, thereis no certainty that budget changes in Congress or the Department of Defense(“DoD”) will not seriously affect us. In addition, there is no certainty that the government will exerciseeach option or award year available on a contract.

 

**Most of our customers are government agencies subject tounique political and budgetary constraints and have special contractingrequirements that may affect our ability to obtain new government customers.**

 

Mostof our customers are government agencies, principally DoD agencies. Theseagencies often do not set their own budgets and therefore have little controlover the amount of money they can spend. In addition, these agencies experiencepolitical pressure that may dictate the manner in which they spend money. Dueto political and budgetary processes and other scheduling delays thatfrequently occur in the contract or bidding process, some government agencyorders may be canceled or substantially delayed, and the receipt of revenues orpayments may be substantially delayed.

 

Inaddition, future sales to government agencies will depend on our ability tomeet government contracting requirements, certain of which may be onerous orimpossible to meet, resulting in our inability to obtain a particular contract.Common requirements in government contracts include bonding; provisionspermitting the purchasing agency to modify or terminate at will the contractwithout penalty and provisions permitting the agency to perform investigationsor audits of our business practices.

 

**Any inability to adequately retain or protect our employees,customer relationships and proprietary technology could harm our ability tocompete.**

 

Our future success and ability to compete depends in part upon ouremployees, customer relationships, proprietary technology and trademarks, whichwe attempt to protect with a combination of patent, copyright, trademark and tradesecret claims, as well as with our confidentiality procedures and contractualprovisions. These legal protections afford only limited protection and aretime-consuming and expensive to obtain and/or maintain. Further, despite ourefforts, we may be unable to prevent third parties from soliciting ouremployees or customers or 

 

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infringing upon or misappropriating our intellectual property.  Our employees, customer relationships andintellectual property may not be adequate to provide us with a competitiveadvantage or to prevent competitors from entering the markets for our productsand services. Additionally, our competitors could independently developnon-infringing technologies that are competitive with, and equivalent orsuperior to, our technology. Monitoring infringement and/or misappropriation ofintellectual property can be difficult, and there is no guarantee that we woulddetect any infringement or misappropriation of our proprietary rights. Even ifwe do detect infringement or misappropriation of our proprietary rights,litigation to enforce these rights could cause us to divert financial and otherresources away from our business operations.

 

**The departure of certain key personnel could harm thefinancial condition of the Company.**

 

Clifton L. Cooke, Jr., Michael W. Fink, Linda E. Gagnon, Edward M.Lake, Kenneth D. Regan and Charles E. Vandeveer, are intimately involved in ourbusiness and some have day-to-day relationships with critical customers. SYS isnot able to afford additional staff to supplement these key personnel.Competition for highly skilled business, product development, technical andother personnel is intense, and there can be no assurance that we will besuccessful in recruiting new personnel or in retaining our existing personnel.A failure on our part to retain the services of these key personnel could havea material adverse effect on our operating results and financial condition. Wedo not maintain key man life insurance on any of our employees.

 

**We face numerous competitors.**

 

We have many competitors with comparable characteristics andcapabilities that compete for the same group of customers. Our competitors arecompetent and experienced and are continuously working to take projects awayfrom us. Some of our competitors have greater financial, technical, marketingand other resources than we do. Our ability to compete effectively may beadversely affected by the ability of these competitors to devote greaterresources to the sales and marketing of their products and services than areavailable to us.

 

**We must comply with numerous GovernmentRegulations.**

 

The Company could become liable for penalties under various procurementrules and regulations.  Changes ingovernment regulations could harm our operating results.  Our business must comply with and isaffected by various government regulations. Among the most significant regulations are:

 

•                  theFederal Acquisition Regulations, and agency regulations supplemental to theFederal Acquisition Regulations, which comprehensively regulate the formation,administration and performance of government contracts;

 

•                  theTruth in Negotiations Act, which requires certification and disclosure of allcost and pricing data in connection with contract negotiations;

 

•                  governmentaccounting regulations, which impose accounting requirements that govern ourright to reimbursement under certain cost-based government contracts; and

 

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•                  laws,regulations and executive orders restricting the use and dissemination ofinformation classified for national security purposes and the exportation ofcertain products and technical data.

 

## **Accuracy of Indirect Billing Rates is critical.**

 

The Company’s indirect billing rates are approved at least annually bythe Defense Contract Audit Agency (DCAA). These rates can differ from the Company’s actual indirect rates.  The Company budgets to have its actualindirect rates as close as possible to its DCAA approved indirect rates atfiscal year end.  If the actual indirectrates at year-end are materially different from the DCAA approved indirectrates, the Company would have to recognize that difference at year-end, whichcould affect the Company’s results of operations.

 

## **We Rely on Subcontractors.**

 

The Company regularly employs subcontractors to assist us in satisfyingour contractual obligations. If these subcontractors fail to adequately performtheir contractual obligations, our prime contract performance and our abilityto obtain future business could be materially and adversely impacted.

 

Our performance of government contracts may involve the issuance ofsubcontracts to other companies upon which we rely to perform all or a portionof the work we are obligated to deliver to our customers.  There is a risk that we may have disputeswith subcontractors concerning a number of issues including the quality andtimeliness of work performed by the subcontractor, customer concerns about thesubcontractor, our decision not to extend task orders or issue new task ordersunder a subcontract, or our hiring of former personnel of a subcontractor.  A failure by one or more of oursubcontractors to satisfactorily deliver on a timely basis the agreed-uponsupplies and/or perform the agreed-upon services may materially and adverselyimpact our ability to perform our obligations as a prime contractor.  In extreme cases, such subcontractorperformance deficiencies could result in the government terminating ourcontract for default.  A defaulttermination could expose us to liability for excess costs of procurement by thegovernment and have a material adverse effect on our ability to compete forfuture contracts and task orders.

 

## **Security Clearances are necessary.**

 

If the Company cannot obtain the necessary security clearances, we maynot be able to perform classified work for the government and our revenues maysuffer.  Certain government contractsrequire our facilities and some of our employees, to maintain securityclearances.  If we lose or are unable toobtain required security clearances, the client can terminate the contract ordecide not to renew it upon its expiration. As a result, to the extent we cannot obtain the required security clearancesfor our employees working on a particular contract, we may not derive therevenue anticipated from the contract, which, if not replaced with revenue fromother contracts, could seriously harm our operating results.

 

Security breaches in sensitive government systems could result in theloss of clients and negative publicity. Many of the systems we develop involve managing and protectinginformation involved in national security and other sensitive governmentfunctions.  A security breach in one of 

 

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these systems could cause serious harm to our business, could result innegative publicity and could prevent us from having further access to suchcritically sensitive systems or other similarly sensitive areas for othergovernment clients.

 

**There are risks associated with our planned growth.**

 

Weplan to grow the Company’s revenues and profits by adding to our existingcustomer base through internal growth and by the acquisition of othergovernment services or technology related companies.  Over the past twoyears we have hired senior management personnel capable of establishing newbusiness units within the Company.  The San Diego Operations Division wasestablished during FY 2001 and has grown steadily since inception.  TheEast Coast Operations Division was established during FY 2002 and has alsogrown steadily since inception.  Both of these divisions were started withno assurance that they would develop into successful business units. Rapid expansion through internal growth has required additional capitalresources.  We plan to continue this approach to building our governmentservices business.  There can be no assurance that this approach willresult in increased profitability in the future.

 

Managementbelieves that SYS can grow through the acquisition of other government servicesor technology related companies as part of a “roll-up” strategy.  Theacquisition of other companies is uncertain and contains a variety of businessrisks, including:  cultural differences, the retention of key personnel,competition, protection of intellectual property, profitability, industrychanges and others.  Although we do nothave an agreement to acquire any specific company at this time, we intend toattempt to expand our operations through the acquisition of other companies.Acquisitions and attempted acquisitions may place a strain on our limitedpersonnel, financial and other resources. Our ability to manage this growth,should it occur, will require expansion of our capabilities andpersonnel.  We may not be able to find qualified personnel to filladditional positions or be able to successfully manage a larger organization.

 

Wehave very limited assets upon which to rely for adjusting to businessvariations and for growing new businesses. While we are likely to look for newfunding to assist in the acquisition of other profitable businesses, it isuncertain whether such funds will be available. Our substantial reliance on ourrevolving line of credit with Comerica Bank - California imposes certain limitationson us. If we are to grow and expand our operations, we will need to raisesignificant amounts of additional capital. There can be no assurance that wewill be successful in raising a sufficient amount of additional capital, or ifwe are successful, that we will be able to raise capital on reasonable terms.If we do raise additional capital, our existing shareholders may incursubstantial and immediate dilution.

 

**There are a large number of shares that maybe available for future sale, and the sale of these shares may depress themarket price of our common stock.**

 

Asof March 26, 2004, we had issued 7,318,140 shares of common stock,convertible promissory notes that may be converted into 1,446,023 sharesof common stock at prices ranging from $1.00 to $2.20 per share, and 2,500warrants to purchase common stock at a price of $1.00 per share. In addition,the Company has issued 1,684,500 exercisable stock options for the acquisitionof shares of common stock at various prices. The sale of shares issued upon any conversion of our outstandingconvertible notes or the exercise of outstanding options or warrants couldadversely affect the market price of our common stock.

 

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**There is a limited market for our common stock.**

 

Ourcommon stock is traded in the Over-the-Counter Bulletin Board market, and thismay cause delays in the timing of transactions and reductions in the number andquality of securities analysts’ reporting on the Company and the extent of ourcoverage in the media. Trading in our common stock has been sporadic, and atpresent, there is a limited market for it. There can be no assurance that astronger market will develop. Even if such a market does develop, it may not besustained.  There are no analystscurrently covering the Company.

 

**Future sales of our common stock by existing shareholdersunder Rule 144 could decrease the trading price of our common stock.**

 

Asof March 26, 2004, a total of 3,378,137 shares of our outstanding commonstock were “restricted securities” and could be sold in the public markets onlyin compliance with Rule 144 adopted under the Securities Act of 1933 or otherapplicable exemptions from registration. Rule 144 provides that a personholding restricted securities for a period of one year may thereafter sell, inbrokerage transactions, an amount not exceeding in any three-month period thegreater of either (i) 1% of the issuer’s outstanding common stock or (ii) theaverage weekly trading volume in the securities during a period of fourcalendar weeks immediately preceding the sale. Persons who are not affiliatedwith the issuer and who have held their restricted securities for at least twoyears are not subject to the volume limitation. Possible or actual sales of ourcommon stock by present shareholders under Rule 144 could have a depressiveeffect on the price of our common stock.

 

**Our directors and executive officers beneficially ownapproximately 37.4% of our stock, including stock options and warrantsexercisable within 60 days of March 26, 2004; their interests couldconflict with yours; significant sales of stock held by them could have anegative effect on our stock price; shareholders may be unable to exercisecontrol.**

 

Asof March 26, 2004, our executive officers, directors and affiliatedpersons were the beneficial owners of approximately 54.4% of our common stock,including stock options exercisable within 60 days of March 26, 2004. As aresult, our executive officers, directors and affiliated persons will havesignificant ability to:

 

• elect or defeat the election of ourdirectors;

• amend or prevent amendment of our articles of incorporation or bylaws;

• effect or prevent a merger, sale of assets or other corporate transaction;and

• control the outcome of any other matter submitted to the shareholders forvote.

 

As a result of their ownership and positions, our directors andexecutive officers, collectively, are able to significantly influence allmatters requiring shareholder approval, including the election of directors andapproval of significant corporate transactions. In addition, sales ofsignificant amounts of shares held by our directors and executive officers, orthe prospect of these sales, could adversely affect the market price of ourcommon stock. Management’s stock ownership may discourage a potentialacquiror from making a tender offer or otherwise attempting to obtain controlof us, which in turn could reduce our stock price or prevent our shareholdersfrom realizing a premium over our stock price.

 

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**Our common stock is subject to “penny stock”rules.**

 

Our common stock is classified as a penny stock by the Securities andExchange Commission. This classification severely and adversely affects themarket liquidity for our common stock. The Commission has adopted Rule 15g-9,which establishes the definition of a “penny stock,” for the purposes relevantto us, as any equity security that has a market price of less than $5.00 pershare or with an exercise price of less than $5.00 per share, subject tocertain exceptions. For any transaction involving a penny stock, unless exempt,the rules require: (i) that a broker or dealer approve a person’s account fortransactions in penny stocks; and (ii) the broker or dealer receive from theinvestor a written agreement to the transaction, setting forth the identity andquantity of the penny stock to be purchased. In order to approve a person’saccount for transactions in penny stocks, the broker or dealer must (i) obtainfinancial information and investment experience objectives of the person; and(ii) make a reasonable determination that the transactions in penny stocks aresuitable for that person and the person has sufficient knowledge and experiencein financial matters to be capable of evaluating the risks of transactions inpenny stocks. The broker or dealer must also deliver, prior to any transactionin a penny stock, a disclosure schedule prepared by the Commissionrelating to the penny stock market, which, in highlight form, sets forth (i)the basis on which the broker or dealer made the suitability determination and(ii) that the broker or dealer received a signed, written agreement from theinvestor prior to the transaction. Disclosure also has to be made about therisks of investing in penny stocks in public offerings and secondary tradingand about the commissions payable to the broker-dealer and registeredrepresentative, current quotations for the securities and the rights andremedies available to an investor in cases of fraud in penny stocktransactions. Finally, monthly statements have to be sent disclosing recentprice information for the penny stock held in the account and information onthe limited market in penny stocks.

 

Item 3.                                     Controls andProcedures

 

The Company maintains certain disclosure controls and procedures thatare designed to ensure that information required to be disclosed in theCompany’s Exchange Act reports is recorded, processed, summarized and reportedwithin the time periods specified by the Securities and Exchange Commission andthat such information is accumulated and communicated to the Company’smanagement, including Clifton L. Cooke, Jr., the Company’s Chief ExecutiveOfficer, and Edward M. Lake, the Company’s Chief Financial Officer, asappropriate, to permit timely decisions regarding required disclosure.  In designing and evaluating the disclosurecontrols and procedures, the Company’s management recognizes that any controlsand procedures, no matter how well designed and implemented, can provide onlyreasonable assurance of achieving the desired control objectives, andmanagement’s duties require it to make its best judgment in evaluating thecost-benefit relationship of potential controls and procedures.

 

The Company and its management, including its Chief Executive Officerand Chief Financial Officer, engage in a variety of procedures to evaluate theeffectiveness of the design and implementation of the Company’s disclosurecontrols and procedures.

 

As noted in the Company’s Form 10-KSB for the year ended June 30,2003, the Company’s recent rapid growth has outpaced the growth of theCompany’s control systems.  Inconnection with our year-end audit, senior management and our Audit Committeehave been informed by our independent auditors that they had identified“material weaknesses” (as defined under standards established by the AmericanInstitute of Certified Public Accountants) relating to deficiencies in the 

 

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systems and processes used in the preparation of the financialstatements and the lack of proper management review.

 

Mr. Cooke and Mr. Lake determined that these material weaknesses,together with certain other deficiencies, if not addressed, could result in accountingerrors and impair our ability to accurately report our financial results in atimely manner.

 

Management has taken the following steps to remedy these deficiencies:

 

•                                          Duringthe fourth quarter of FY 2003, a new independent director was elected to ourBoard of Directors who has an extensive financial background and in FY 2004this Director was named the Chairman of the Audit Committee;

 

•                                          TheAudit Committee established a reporting timetable whereby Management mustreport to the Audit Committee all corrective actions taken and scheduledquarterly updates on the controls and procedures;

 

•                                          Managementimplemented procedures to ensure improved monitoring of our IT systems,segregation of duties and documentation for transactional authorization and approvals;

 

•                                          Updatedwritten policies and procedures have been completed to standardize and improveprocesses, including procedures relating to systems, finance policies andinternal controls;

 

•                                          Managementis developing internal control and internal audit checklists that we will beimplementing in the fourth quarter;

 

Management will continue to monitor and evaluate further improvements.

 

Based uponthat evaluation and the steps noted above, Messrs. Cooke and Lake concludedthat as of March 26, 2004, the Company’s disclosure controls andprocedures were reasonably effective in timely alerting them to materialinformation relating to the Company required to be included in its periodicfilings with the Securities and Exchange Commission.

 

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PART II - OTHER INFORMATION

 

Item 1.                                     LegalProceedings

 

On March 19, 2003, the Company was served notice that it was namedin a lawsuit filed in the Superior Court of California, County of Orange, onMarch 10, 2003.  The lawsuit wasbrought by associates of former Company Chairman and Chief Executive Officer,Robert D. Mowry who had a relationship with Mowry through Big CanyonInvestments, Inc. and UniPrise, Inc. The Plaintiffs were George M. Colin, William Czapar, Dan Birdsall andBrian Patterson.

 

The Plaintiffs claimed to have suffered losses and sought damages of$980,000, plus interest, administrative fees and other consideration.  On April 21, 2004, the Superior Courtsustained the Company’s demurrer to the plaintiffs’ complaint and did not allowthe plaintiffs to further amend, thus ending the case.  The Company has requested that judgmententered against the plaintiffs, which Counsel anticipates will be granted as amatter of course.

 

We are involved in legal actions in the normal course of business,including audits and investigations by various governmental agencies thatresult from our work as a governmental contractor. We are named as defendantsin legal proceedings from time to time and we may assert claims from time totime.

 

Item 2.                                     Changesin Securities

 

During the first three quarters of FY 2004, there were 116,887 sharesof common stock issued due to the exercise of stock options for $123,627.  These options had exercise prices rangingfrom $0.625 to $1.57.

 

OnSeptember 9, 2003, the Board of Directors authorized management to callthe Company’s 69,781 shares of issued and outstanding 9% Series B Preferencestock.  The stockholders were offeredcash or an exchange for common stock using $1.75 as the per share price of thecommon stock.  These shareholdersreceived approximately $60,000 in cash and 5,969 shares of common stock with amarket value of $10,000.

 

On September 29, 2003, the Company contributed 62,500 shares ofcommon stock to the Company’s Employee Stock Ownership Plan in accordance withthe matching provisions under the plan. These shares had a fair market value of $137,500.

 

On September 29, 2003, the Company issued 62,950 shares of commonstock to employees that participated in the Employee Stock Purchase Plan.  The period of performance was fromJanuary 1, 2003 to June 30, 2003. These shares had a fair market value of $138,490.

 

On October 16, 2003, Clifton L. Cooke, Jr., the Company’sPresident and CEO, exercised warrants to purchase 250,000 common shares at$1.00 per common share.  These shareshad a fair market value of $450,000.

 

On October 20, 2003, Clifton L. Cooke, Jr., the Company’sPresident and CEO, converted his $225,000 convertible notes at $1.00 per commonshare.  These shares had a fair marketvalue of $405,000.  During the thirdquarter, three other note holders chose to convert their notes valued at$56,250 at $1.00 per share.

 

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On February 12, 2004, the Company issued 63,086 shares of commonstock to employees that participated in the Employee Stock Purchase Plan.  The period of performance was fromJuly 1, 2003 to December 31, 2003. These shares had a fair market value of $129,957 on the date of issuance.

 

As discussed in Note 3 of the Notes to Consolidated FinancialStatements, the Company completed a subscription offering raising $3,200,000for working capital and acquisition financing. The offering consisted of$50,000 units comprised of 50% common stock and 50% convertible notes.  In connection with this offering, 1,000,005shares of common stock were issued in exchange for $1.6 million in cash.

 

Subsequent to period end, on March 31, 2004, SYS acquired all ofthe outstanding stock of Polexis, Inc., a privately held, San Diego-basedprovider of advanced data management software, for approximately $6.5 millionin cash, stock, notes, and assumption of debt. The transaction was completedpursuant to an Agreement and Plan of Merger among SYS, Shadow ResearchInternational, Inc., a wholly owned subsidiary of SYS and Polexis, Inc. and thePolexis principal shareholders (“Agreement”). As a result of the acquisition,Polexis Inc. became a wholly owned subsidiary of SYS and, therefore, will beincluded in the consolidated financial results of SYS effective for periodssubsequent to March 31, 2004.

 

The merger consideration consisted of (i) $3,250,000 in cash, (ii)697,973 shares of SYS common stock with a value of $1,598,000 based on anaverage closing price of $2.29 prior to and after the closing, (iii) $1,375,000in unsecured subordinated convertible notes, and (iv) assumption of $325,000bank indebtedness.  Proceeds from therecently completed Subscription Offering were used to pay the cash portion ofthe transaction.

 

The excess of the Company’s purchase price over the estimated fairvalue of the net assets acquired amounted to approximately $5.8 million, whichconsists of goodwill and other intangible assets.  An independent valuation will be performed to determine thepurchase price allocation based upon the fair value of the assets andliabilities acquired, at which time the allocation of purchase price may berevised. Management expects to complete the independent valuation during thefourth quarter of FY 2004.

 

Item 3.                                     DefaultsUpon Senior Securities

 

None.

 

Item 4.                                     Submissionof Matters to a Vote of Securities Holders

 

None

 

Item 5.                                     OtherInformation

 

None

 

Item 6.                                     Exhibitsand Reports on Form 8-K

 

(a)          List of exhibits

 

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31.1                           Certification of ChiefExecutive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of2002.

31.2                           Certification of ChiefFinancial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of2002.

32.1                           Certification of ChiefExecutive Officer pursuant to Section 906 of the Sarbanes-Oxley Act of2002.

32.2                           Certification of ChiefFinancial Officer pursuant to Section 906 of the Sarbanes-Oxley Act of2002.

 

(b)         Reports on Form 8-K

 

On a report dated December 10, 2003, the Company stated that uponthe recommendation of its Audit Committee, it had elected to engage KPMG LLP(“KPMG”) to serve as the Company’s principal public accountants for fiscal year2004.

 

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SIGNATURES

 

In accordance with the requirements of the Exchange Act, the registrantcaused this report to be signed on its behalf by the undersigned, thereuntoduly authorized.

 

 
|   | SYS                     |
|--------|-------------------------|
|   | (Registrant)            |
|   |                    |
|   |                    |
| Date:  |  May 10, 2004      |   | /s/ Clifton L. Cooke, Jr. |   |
|   | Clifton L. Cooke, Jr.   |
|   | Chief Executive Officer |
|   |                    |
|   |                    |
| Date:  |  May 10, 2004      |   | /s/ Edward M. Lake |   |
|   | Edward M. Lake          |
|   | Chief Financial Officer |

 

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