** **

**U.S. SECURITIES ANDEXCHANGE COMMISSION**

**Washington,D.C.  20549**

 

**FORM 10-Q**

 
| **ý**                                                                                                                                         |       | **QUARTERLY REPORT PURSUANT TO SECTION 13 OR  15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**  |   |
|----------------------------------------------------------------------------------------------------------------------------------------------------|------------|---------------------------------------------------------------------------------------------------------|--------|
| ** **                                                                                                                                         |       |
| **For the  Quarter ended December 31, 2005**                                                                                                  | ** ** |
|                                                                                                                                               |       |
| **OR**                                                                                                                                             |       |
|                                                                                                                                               |       |
| **o**                                                                                                                                              |       | **TRANSITION REPORT PURSUANT TO SECTION 13 OR  15(d) OF THE SECURITIES EXCHANGE ACT OF 1934** |   |
|                                                                                                                                               |       |
| **For the  transition period  from         to         ** |       |

 

**Commissionfile number 1-11568**

 

**DYNTEK, INC.**

(Exact Name of Registrant asSpecified in its Charter)

 
| **Delaware**                     | ** ** | **95-4228470**       |
|----------------------------------|------------|----------------------|
| (State or other  jurisdiction of |       | (I.R.S  Employer     |
| incorporation  or organization)  |       | Identification  No.) |

 

**19700Fairchild Road, Suite 230**

**Irvine,CA  92612**

(Address of principal executiveoffices) (Zip code)

 

Registrant’s telephone number,including area code **(949) 271-6700**

 

Indicate by check whether the Registrant (1) hasfiled all reports required to be filed by Section 13 or 15(d) of theSecurities Exchange Act of 1934 during the preceding 12 months, (or for suchshorter period that the Registrant was required to file such reports), and (2) hasbeen subject to such filings requirements for the past 90 days.  Yes ý  Noo

 

Indicate by check mark whether the registrantis a large accelerated filter, an accelerated filer, or a non-acceleratedfiler.  See definition of “acceleratedfiler” in Rule 12b-2 of the Exchange Act. Large Acclerated Filer oAccelerated Filer o Non AcceleratedFiler ý

 

Indicate by check mark whether the Registrantis a shell company (as defined in Rule 12b-2 of the Exchange Act).Yes o  No ý

 

As of February 13, 2006, the number ofshares outstanding of the registrant’s Common Stock, $.0001 par value, was81,164,636.

 

 

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**DYNTEK,INC. AND SUBSIDIARIES**

**INDEX**

 
| **PART I – FINANCIAL INFORMATION**                                                         |                                                                                                                                                                         |
|------------------------------------------------------------------------------------------------------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|                                                                                                 |                                                                                                                                                                         |
| Item 1. Condensed Consolidated Financial  Statements                                                 |                                                                                                                                                                         |
|                                                                                                 |                                                                                                                                                                         |
| ** **                                                                                           | Condensed  Consolidated Balance Sheets – as of December 31, 2005 (unaudited)  and June 30, 2005                                                               | ** ** |
|                                                                                                 |                                                                                                                                                                         |
| ** **                                                                                           | Condensed  Consolidated Statements of Operations and Comprehensive Loss  (unaudited) - For the Three and Six Months Ended December 31, 2005 and  December 31, 2004 | ** ** |
|                                                                                                 |                                                                                                                                                                         |
|                                                                                                 | Condensed  Consolidated Statements of Cash Flows (unaudited) - For the  Six Months Ended December 31, 2005 and December 31, 2004                                   |   |
|                                                                                                 |                                                                                                                                                                         |
|                                                                                                 | Notes to Condensed Consolidated Financial  Statements (unaudited)                                                                                                            |   |
|                                                                                                 |                                                                                                                                                                         |
| Item 2.  Management’s Discussion and Analysis of Financial Condition and Results of  Operations |                                                                                                                                                                         |
| Item 3. Quantitative and Qualitative  Disclosures About Market Risk                                  |                                                                                                                                                                         |
| Item 4.  Controls and Procedures                                                                     |                                                                                                                                                                         |
|                                                                                                 |                                                                                                                                                                         |
| **PART II - OTHER INFORMATION**                                                                 |                                                                                                                                                                         |
| Item 1A. Risk Factors                                                                                |                                                                                                                                                                         |
| Item 4.  Submission of Matters to a Vote of Security Holders                                         |                                                                                                                                                                         |
| Item 6. Exhibits                                                                                     |                                                                                                                                                                         |
|                                                                                                 |                                                                                                                                                                         |
| **SIGNATURE**                                                                                        |                                                                                                                                                                         |

 

2

----

 

**1.****                                      PART 1– FINANCIAL INFORMATION**

 

**ITEM 1. CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**

 

**DYNTEK, INC. AND SUBSIDIARIES**

# **CONDENSEDCONSOLIDATED BALANCE SHEETS**

# (inthousands, except share data)

 
| ** **                                                                                                                                                                                               | ** ** | **December 31,  2005** | ** ** | **June 30, 2005** | ** ** |
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------------|------------|------------------------|------------|
| ** **                                                                                                                                                                                               | ** ** | **(unaudited)**             | ** ** | ** **             | ** ** |
| ASSETS                                                                                                                                                                                                   | ** ** | ** **                  | ** ** | ** **             | ** ** |
| CURRENT ASSETS:                                                                                                                                                                                          | ** ** | ** **                  | ** ** | ** **             | ** ** |
| Cash                                                                                                                                                                                                     |       | $                           | 244        |                   | $          | 963 |   |
| Cash – Restricted                                                                                                                                                                                   |       | 736                         |       | 334                    |       |
| Accounts  receivable, net of allowance for doubtful accounts of $480 and $618                                                                                                                            |       | 13,953                      |       | 17,894                 |       |
| Inventory                                                                                                                                                                                                |       | 811                         |       | 1,666                  |       |
| Prepaid  expenses and other current assets                                                                                                                                                               |       | 63                          |       | 75                     |       |
| Other  receivables                                                                                                                                                                                       |       | 636                         |       | 125                    |       |
| TOTAL  CURRENT ASSETS                                                                                                                                                                                    |       | 16,443                      |       | 21,057                 |       |
|                                                                                                                                                                                                     |       |                        |       |                   |       |
| RESTRICTED  CASH – over one year                                                                                                                                                                    |       | 747                         |       | 231                    |       |
|                                                                                                                                                                                                     |       |                        |       |                   |       |
| PROPERTY AND  EQUIPMENT, net of accumulated depreciation of $3,461 and $3,233                                                                                                                            |       | 904                         |       | 959                    |       |
|                                                                                                                                                                                                     |       |                        |       |                   |       |
| GOODWILL                                                                                                                                                                                                 |       | 18,767                      |       | 18,579                 |       |
|                                                                                                                                                                                                     |       |                        |       |                   |       |
| ACQUIRED  CUSTOMER LISTS, net of accumulated amortization of $10,761 and $9,609                                                                                                                          |       | 3,485                       |       | 4,637                  |       |
|                                                                                                                                                                                                     |       |                        |       |                   |       |
| DEFERRED  FINANCING COSTS, net of accumulated amortization of $767 and $476                                                                                                                              |       | 1,082                       |       | 1,002                  |       |
|                                                                                                                                                                                                     |       |                        |       |                   |       |
| DEPOSITS AND  OTHER ASSETS                                                                                                                                                                               |       | 939                         |       | 871                    |       |
|                                                                                                                                                                                                     |       | $                           | 42,367     |                   | $          | 47,336 |   |
| LIABILITIES  AND STOCKHOLDERS’ EQUITY                                                                                                                                                               |       |                        |       |                   |       |
|                                                                                                                                                                                                     |       |                        |       |                   |       |
| CURRENT  LIABILITIES:                                                                                                                                                                                    |       |                        |       |                   |       |
| Cash  overdraft                                                                                                                                                                                          |       | $                           | 307        |                   | $          | 1,274 |   |
| Accounts  payable                                                                                                                                                                                        |       | 6,668                       |       | 8,937                  |       |
| Line of  credit                                                                                                                                                                                          |       | 7,769                       |       | 4,697                  |       |
| Acquisition  indebtedness                                                                                                                                                                                |       | 1,931                       |       | 3,676                  |       |
| Accrued  expenses                                                                                                                                                                                        |       | 1,487                       |       | 2,564                  |       |
| Deferred  revenue                                                                                                                                                                                        |       | 1,125                       |       | 996                    |       |
| Notes  payable-accrued interest                                                                                                                                                                          |       | 329                         |       | 184                    |       |
| Notes  payable-current portion                                                                                                                                                                           |       | 5,979                       |       | 3,621                  |       |
| Current  liabilities of discontinued operations                                                                                                                                                          |       | 258                         |       | 329                    |       |
| TOTAL  CURRENT LIABILITIES                                                                                                                                                                               |       | 25,453                      |       | 26,278                 |       |
|                                                                                                                                                                                                     |       |                        |       |                   |       |
| DEFERRED  REVENUE                                                                                                                                                                                        |       | 803                         |       | 588                    |       |
| ACQUISITION  INDEBTEDNESS                                                                                                                                                                                |       | —                      |       | 644                    |       |
| LONG TERM  NOTES PAYABLE                                                                                                                                                                                 |       | 6,285                       |       | 6,371                  |       |
| TOTAL  LIABILITIES                                                                                                                                                                                       |       | 32,691                      |       | 33,881                 |       |
|                                                                                                                                                                                                     |       |                        |       |                   |       |
| COMMITMENTS  AND CONTINGENCIES                                                                                                                                                                           |       |                        |       |                   |       |
| STOCKHOLDERS’  EQUITY:                                                                                                                                                                              |       |                        |       |                   |       |
| Preferred  stock, $.0001 par value, 10,000,000 shares authorized; 0 and 583,124 shares  issued and outstanding as of December 31, 2005 and June 30, 2005,  respectively                        |       | —                      |       | 1                      |       |
| Class A  Common stock, $.0001 par value, 450,000,000 shares authorized; 81,164,636 and  75,426,764 shares issued and outstanding as of December 31, 2005 and June 30,  2005, respectively |       | 8                           |       | 5                      |       |
| Additional  paid-in capital                                                                                                                                                                              |       | 113,401                     |       | 109,551                |       |
| Common stock  to be issued in connection with acquisition (4,280,000 shares)                                                                                                                             |       | 1                           |       | 1,544                  |       |
| Accumulated  deficit                                                                                                                                                                                     |       | (103,583                    | )          | (97,646                | )          |
| TOTAL  STOCKHOLDERS’ EQUITY                                                                                                                                                                         |       | 9,826                       |       | 13,455                 |       |
| TOTAL  LIABILITIES AND STOCKHOLDERS’ EQUITY                                                                                                                                                         |       | $                           | 42,367     |                   | $          | 47,336 |   |

 

The accompanying notes are an integral part ofthese condensed consolidated financial statements.

 

3

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**DYNTEK,INC. AND SUBSIDIARIESCONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS AND COMPREHENSIVE INCOME(LOSS)(Unaudited)(in thousands, except per share data)**

 
| ** **                                                                 | ** ** | **Three Months Ended  December 31,** | ** ** | **Six Months Ended  December 31,** | ** ** |
|----------------------------------------------------------------------------|------------|-------------------------------------------|------------|-----------------------------------------|------------|
| ** **                                                                 | ** ** | **2005**                                  | ** ** | **2004**                                | ** ** | **2005** | ** ** | **2004** | ** ** |
| REVENUES:                                                                  | ** ** | ** **                                | ** ** | ** **                              | ** ** | ** ** | ** ** | ** ** | ** ** |
| Product  Revenues                                                          |       | $                                         | 12,428     |                                    | $          | 10,731 |   | $ | 28,583 |   | $ | 19,145 |   |
| Service  Revenues                                                          |       | 6,416                                     |       | 9,271                                   |       | 13,696 |   | 15,640 |   |
| Total  revenues                                                            |       | 18,844                                    |       | 20,002                                  |       | 42,279 |   | 34,785 |   |
|                                                                       |       |                                      |       |                                    |       |   |   |   |   |
| COST OF REVENUES:                                                          |       |                                      |       |                                    |       |   |   |   |   |
| Cost of  products                                                          |       | 11,039                                    |       | 8,641                                   |       | 25,191 |   | 15,601 |   |
| Cost of  services                                                          |       | 4,616                                     |       | 7,210                                   |       | 9,785 |   | 12,351 |   |
| Total cost  of revenues                                                    |       | 15,655                                    |       | 15,851                                  |       | 34,976 |   | 27,952 |   |
| GROSS PROFIT                                                               |       | 3,189                                     |       | 4,151                                   |       | 7,303 |   | 6,833 |   |
|                                                                       |       |                                      |       |                                    |       |   |   |   |   |
| OPERATING EXPENSES:                                                        |       |                                      |       |                                    |       |   |   |   |   |
| Selling                                                                    |       | 3,000                                     |       | 2,548                                   |       | 6,176 |   | 4,374 |   |
| General and  administrative                                                |       | 1,051                                     |       | 1,441                                   |       | 2,485 |   | 2,809 |   |
| Depreciation  and amortization                                             |       | 650                                       |       | 781                                     |       | 1,380 |   | 1,542 |   |
| Goodwill  Impairment                                                       |       | —                                    |       | 6,026                                   |       | — |   | 6,026 |   |
| Total  operating expenses                                                  |       | 4,701                                     |       | 10,796                                  |       | 10,041 |   | 14,751 |   |
|                                                                       |       |                                      |       |                                    |       |   |   |   |   |
| LOSS FROM OPERATIONS                                                       |       | (1,512                                    | )          | (6,645                                  | )          | (2,738 | ) | (7,918 | ) |
|                                                                       |       |                                      |       |                                    |       |   |   |   |   |
| OTHER INCOME (EXPENSE):                                                    |       |                                      |       |                                    |       |   |   |   |   |
| Gain on  marketable securities                                             |       | —                                    |       | —                                  |       | 54 |   | — |   |
| Interest  expense                                                          |       | (2,759                                    | )          | (402                                    | )          | (3,493 | ) | (675 | ) |
| Other income  (expense)                                                    |       | 1                                         |       | —                                  |       | — |   | (50 | ) |
| Interest  income                                                           |       | 15                                        |       | 2                                       |       | 24 |   | 11 |   |
| Total other  income (expense)                                              |       | (2,744                                    | )          | (400                                    | )          | (3,415 | ) | (714 | ) |
|                                                                       |       |                                      |       |                                    |       |   |   |   |   |
| LOSS FROM CONTINUING OPERATIONS                                            |       | $                                         | (4,256     | )                                       | $          | (7,045 | ) | $ | (6,153 | ) | $ | (8,632 | ) |
|                                                                       |       |                                      |       |                                    |       |   |   |   |   |
| DISCONTINUED OPERATIONS                                                    |       |                                      |       |                                    |       |   |   |   |   |
| Gain on disposal  of discontinued operations                               |       | —                                    |       | 41                                      |       | 216 |   | 1,676 |   |
|                                                                       |       |                                      |       |                                    |       |   |   |   |   |
| NET LOSS                                                                   |       | $                                         | (4,256     | )                                       | $          | (7,004 | ) | $ | (5,937 | ) | $ | (6,956 | ) |
|                                                                       |       |                                      |       |                                    |       |   |   |   |   |
| NET LOSS PER SHARE: Basic and Diluted                                      |       |                                      |       |                                    |       |   |   |   |   |
| Continuing  Operations                                                     |       | (.05                                      | )          | (.12                                    | )          | (.08 | ) | (.15 | ) |
| Discontinued  Operations                                                   |       | —                                    |       | —                                  |       | — |   | .03 |   |
|                                                                       |       | $                                         | (.05       | )                                       | $          | (.12 | ) | $ | (.08 | ) | $ | (.12 | ) |
| WEIGHTED  AVERAGE NUMBER OF SHARES USED IN COMPUTATION - Basic and Diluted |       | 81,164,636                                |       | 58,710,066                              |       | 78,823,629 |   | 58,570,482 |   |
|                                                                       |       |                                      |       |                                    |       |   |   |   |   |
| NET LOSS                                                                   |       | $                                         | (4,256     | )                                       | $          | (7,004 | ) | $ | (5,937 | ) | $ | (6,956 | ) |
|                                                                       |       |                                      |       |                                    |       |   |   |   |   |
| COMPREHENSIVE LOSS, NET OF TAX                                             |       |                                      |       |                                    |       |   |   |   |   |
| Change in  unrealized gain (loss) on available-for-sale- securities        |       | —                                    |       | (25                                     | )          | — |   | (37 | ) |
|                                                                       |       |                                      |       |                                    |       |   |   |   |   |
| COMPREHENSIVE LOSS                                                         |       | $                                         | (4,256     | )                                       | $          | (7,029 | ) | $ | (5,937 | ) | $ | (6,993 | ) |

 

The accompanying notes are anintegral part of these condensed consolidated financial statements.

 

4

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**DYNTEK,INC. AND SUBSIDIARIESCONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS**(Unaudited)(in thousands)

 
| ** **                                                                   | ** ** | **Six Months Ended   December 31,** | ** ** |
|------------------------------------------------------------------------------|------------|------------------------------------------|------------|
| ** **                                                                   | ** ** | **2005**                                 | ** ** | **2004** | ** ** |
| CASH FLOWS FROM OPERATING ACTIVITIES:                                        |       |                                     |       |   |   |
| Net  loss-Continuing operations                                              |       | $                                        | (6,153     | ) | $ | (8,632 | ) |
| Adjustments  to reconcile net loss to net cash used in operating activities: |       |                                     |       |   |   |
| Depreciation  and amortization                                               |       | 1,380                                    |       | 1,455 |   |
| Non-cash  interest                                                           |       | 2,371                                    |       | 201 |   |
| Employee  option expense                                                     |       | 205                                      |       | — |   |
| Write-down  of capitalized software costs                                    |       | —                                   |       | 82 |   |
| Gain in  marketable securities                                               |       | (54                                      | )          | (34 | ) |
| Impairment  of goodwill                                                      |       | —                                   |       | 6,026 |   |
|                                                                         |       |                                     |       |   |   |
| Changes in  operating assets and liabilities:                                |       |                                     |       |   |   |
| Accounts  receivable                                                         |       | 3,894                                    |       | (781 | ) |
| Inventory                                                                    |       | 855                                      |       | (524 | ) |
| Accrued  interest                                                            |       | 145                                      |       | (108 | ) |
| Prepaid  expenses and other current assets                                   |       | 12                                       |       | — |   |
| Other  receivables                                                           |       | (511                                     | )          | — |   |
| Deposits and  other assets                                                   |       | (68                                      | )          | 108 |   |
| Accounts  payable                                                            |       | (2,269                                   | )          | 704 |   |
| Deferred  revenue                                                            |       | 344                                      |       | 16 |   |
| Accrued  expenses                                                            |       | (1,077                                   | )          | (972 | ) |
| Restricted  cash                                                             |       | (918                                     | )          | 155 |   |
| Total  adjustments                                                           |       | 4,316                                    |       | 6,334 |   |
| NET CASH  USED IN CONTINUING OPERATIONS                                      |       | (1,837                                   | )          | (2,304 | ) |
| NET CASH  PROVIDED BY (USED IN) DISCONTINUED OPERATIONS                      |       | 145                                      |       | (1,539 | ) |
| NET CASH USED IN OPERATING ACTIVITIES                                        |       | (1,692                                   | )          | (3,843 | ) |
|                                                                         |       |                                     |       |   |   |
| CASH FLOWS FROM INVESTING ACTIVITIES:                                        |       |                                     |       |   |   |
| Cash from  disposition of marketable securities                              |       | 54                                       |       | — |   |
| Cash paid  for acquisitions                                                  |       | (2,530                                   | )          | (6,036 | ) |
| Cash  received from Redrock acquisition                                      |       | —                                   |       | 405 |   |
| Cash  received from ITI acquisition                                          |       | —                                   |       | 106 |   |
| Other notes  receivable                                                      |       | —                                   |       | (130 | ) |
| Capital  expenditures                                                        |       | (173                                     | )          | (203 | ) |
| NET CASH  USED IN INVESTING ACTIVITIES                                       |       | (2,649                                   | )          | (5,858 | ) |
|                                                                         |       |                                     |       |   |   |
| CASH FLOWS FROM FINANCING ACTIVITIES:                                        |       |                                     |       |   |   |
| Cash  overdraft                                                              |       | (967                                     | )          | — |   |
| Proceeds  from debt financing                                                |       | 2,500                                    |       | 4,775 |   |
| Deferred  financing costs                                                    |       | (371                                     | )          | — |   |
| Net proceeds  under line of credit                                           |       | 3,072                                    |       | 2,431 |   |
| Principal  payments                                                          |       | (605                                     | )          | — |   |
| NET CASH  PROVIDED BY FINANCING ACTIVITIES                                   |       | 3,622                                    |       | 7,206 |   |
| NET INCREASE (DECREASE) IN CASH                                              |       | (719                                     | )          | (2,495 | ) |
| CASH AT BEGINNING OF PERIOD                                                  |       | 963                                      |       | 2,810 |   |
| CASH AT END OF PERIOD                                                        |       | $                                        | 244        |   | $ | 315 |   |

 

The accompanying notes are anintegral part of these condensed consolidated financial statements.

 

5

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**DYNTEK, INC. AND SUBSIDIARIES**

# **CONSOLIDATEDSTATEMENTS OF CASH FLOWS**

 

(UNAUDITED)

(in thousands, except share data)

 
| ** **                                                              | ** ** | **Six Months Ended   December 31,** | ** ** |
|-------------------------------------------------------------------------|------------|------------------------------------------|------------|
| ** **                                                              | ** ** | **2005**                                 | ** ** | **2004** | ** ** |
| SUPPLEMENTAL DISCLOSURE OF CASH FLOW  INFORMATION:                      | ** ** | ** **                               | ** ** | ** ** | ** ** |
|                                                                    |       |                                     |       |   |   |
| Cash paid  for interest                                                 |       | $                                        | 558        |   | $ | 360 |   |
|                                                                    |       |                                     |       |   |   |
| SUPPLEMENTAL  DISCLOSURE OF NON-CASH FINANCING AND INVESTING ACTIVITIES |       |                                     |       |   |   |
| Debt  discount issued in connection with convertible debt               |       | $                                        | —     |   | $ | (34 | ) |
| Issuance of  stock in connection with convertible debt                  |       | —                                   |       | 40 |   |
|                                                                    |       |                                     |       |   |   |
| Acquisition  of Redrock Communications Solutions, Inc. in 2004:    |       |                                     |       |   |   |
| Cash paid to  shareholders                                              |       | 763                                      |       | 2,750 |   |
| Gross cash  acquired                                                    |       | —                                   |       | 405 |   |
| Contingent  consideration                                               |       | —                                   |       | 750 |   |
|                                                                    |       |                                     |       |   |   |
| Acquisition  of Integration Technologies, Inc. in 2004:            |       |                                     |       |   |   |
| Cash paid to  shareholders                                              |       | —                                   |       | 2,500 |   |
| Gross cash  acquired                                                    |       | —                                   |       | 106 |   |
|                                                                    |       |                                     |       |   |   |
| Acquisition  of AMR in 2004:                                            |       |                                     |       |   |   |
| Cash paid to  shareholders                                              |       | —                                   |       | 786 |   |

 

The accompanying notes are anintegral part of these condensed consolidated financial statements.

 

6

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**DYNTEK,INC. & SUBSIDIARIESNOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTSDecember 31, 2005(UNAUDITED)**

 

**1.****             ****BASIS OF PRESENTATION**

 

The accompanyingunaudited condensed consolidated financial statements of DynTek, Inc. andits subsidiaries (“DynTek”, “Company”, or “we”) have been prepared inaccordance with accounting principles generally accepted in the United Statesof America, for interim financial statements and pursuant to the instructionsto Form 10-Q and Article 10 of Regulation S-X.  Accordingly, they do not include all of theinformation and disclosures required for annual financial statements.  These condensed consolidated financial statementsshould be read in conjunction with the consolidated financial statements andrelated footnotes for the year ended June 30, 2005 included in the Form 10-Kfor the year then ended.

 

The accompanyingcondensed consolidated financial statements reflect all adjustments, which, inthe opinion of management consist of normal recurring items that are necessaryfor a fair presentation in conformity with accounting principles generallyaccepted in the United States of America.  Preparing condensed consolidated financial statements requiresmanagement to make estimates and assumptions that affect the reported amountsof assets, liabilities, revenues and expenses. The results of operations for any interim period are not necessarilyindicative of the results attainable for a full fiscal year.**                                 **

 

**2.****             ****LIQUIDITY AND FINANCIAL CONDITION**

 

TheCompany incurred a net loss of $5,937,000 for the six months ended December 31,2005, which includes $3,956,000 of non-cash charges resulting from $1,380,000of depreciation and amortization; $205,000 in stock-based compensation; and$2,371,000 in non-cash interest charges. At December 31, 2005, the Company had a working capital deficiencyof approximately $9,160,000.  

 

The Company’snew management team instituted certain measures to reduce the amount of cashthat the Company has been using in its operating activities. More specifically,the Company has announced a planned annual reduction in its general andadministrative overhead expenses by approximately $1,600,000 for the fiscalyear ended June 30, 2006, and has concentrated its revenue generatingactivities on providing high-end IT services, which has traditionally been thecore competency of the business. The Company has also attempted to defer cashoutlays by restructuring payments due under the Laurus Note and 9% Notes.  However, the combination of continuingoperating losses and the cash required to be paid under existing debtobligations has severely impacted the Company’s ability to sustain and grow itsbusiness.  As described below, theCompany has completed certain financing transactions and subsequent to thereporting period signed a term sheet for up to $6.7 million in newfinancing.  The Company is also in theprocess of attempting to raise capital from other sources wherever possible,however, there can be no assurance that the Company will close its currentproposed financing transactions or secure sufficient capital to sustain itsoperations at all. These matters raise substantial doubt about the Company’sability to continue as a going concern. The Company needs to restructure its debtand/or obtain new capital in the third quarter of fiscal year 2006 in order tocontinue as a going concern .

 

In August 2005, the Company entered intoa series of related agreements with New England Technology Finance, LLC (“NETF”),an affiliate of Global Technology Finance. The new credit facility is comprised of two primary components:  (1) an Asset Purchase and LiabilityAssumption Agreement (the “APLA”), under which NETF agreed to finance certainof the Company’s qualified product purchases under an arrangement that providesfor the assignment of accounts receivable (resulting from the sale of suchproducts to customers) and for NETF to assume the liability for payment toproduct vendors; and (2) an Asset Purchase Agreement (the “APA”), underwhich NETF purchased $7,500,000 of qualified accounts receivable (services andproducts), with recourse.  The proceedsreceived under the APA were used to repay in full the $4,800,000 balance on ourcredit line with Textron, for acquisition debt, and general corporatepurposes.  In addition to the accountsreceivable purchased on August 8, 2005, NETF may purchase up to 80% ofadditional qualified accounts receivable in the future on the same terms.  As of December 31, 2005, the balance onthe APA account was approximately $7,156,000.

 

The Company believes that the NETF APLAfacility has enabled it to more effectively manage its liquidity because thefacility is structured to provide the flexibility of matching the timing ofcash outflows for product purchases to cash amounts collected fromcustomers.  The financing fee under thefacility is calculated on a monthly basis depending on gross margin on suchproducts, and days sales outstanding. The Company may also use the APA facilityas a general financing arrangement for certain product and servicesreceivables.  

 

InOctober 2005, the Company raised gross proceeds of $2,500,000, upon itsissuance of notes to certain investors (the “Bridge Notes”).  The proceeds were used to pay acquisitiondebt and for working capital.  Intereston unpaid principal under the Bridge Notes is 12% per annum through March 1,2006, 14% from March 1, 2006 to April 1, 2006, 16% from April 1,2006 to May 1, 2006, 18% from May 1, 2006 to June 1, 2006, and20% from June 1, 2006 until the maturity date, December 31,2006.  

 

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As described in Note 4, the Company paid$3,000,000 to the sellers of Redrock Communication Solutions (“Redrock”) aspartial consideration for the acquisition of such business in October 2004,and paid $850,000 in contingent consideration in July 2005.  In October 2005, the Company paid anadditional $650,000 in contingent consideration upon the resolution andsettlement of a litigation matter brought against the former Redrockshareholders/sellers by a former Redrock employee, as described in Note 4,together with a settlement amount of $120,000 payable over 24 months, less$26,000 of fees and expenses incurred by the Company in connection with suchlitigation.

 

As described in Note 4, the Company paid$2,500,000 to the sellers of Integration Technologies, Inc. (“ITI”) aspartial consideration for the acquisition of ITI in October 2004. TheCompany accrued an additional $2,845,748 of contingent consideration, of which$270,993 was paid in August 2005. In September 2005, the Company entered into promissory notes (the “ITINotes”) with three former shareholders of ITI, including the Company’s currentchief executive officer, Casper Zublin, Jr., to defer an aggregate of$2,574,735 in payments due in connection with the acquisition of ITI.  Principal payments are due quarterly, withthe balance due July 31, 2006.  In September 2005,the Company paid $643,684 in principal pursuant to the ITI Notes, with aremaining unpaid balance of $1,931,051 at December 31, 2005. 

 

On October 26, 2005, the Company amendedits Restated Secured Convertible Term Note (the “Laurus Note”), to deferprincipal payments from December 2005 until March 2006. In exchange,the Company was required to decrease the exercise price of warrants issued inconnection with the Laurus Note from $.65 per share to $.25 per share.  Laurus entered into this transaction toassist the Company in alleviating its immediate liquidity constraints.  This transaction deferred approximately$831,249 in aggregate payments originally due through March 2006 (Note 6).

 

On October 26, 2005, the Company amendedits 9% Subordinated Convertible Notes (the “9% Notes”) with a majority of theholders thereof, to defer $1,893,629 in principal due under the 9% Notes until January 2007.  In exchange for the deferral, the Company (i) reducedthe conversion price under the 9% Notes from $.65 to $.22 per share, and (ii) reducedthe exercise price of warrants held by the holders of the 9% Notes from $.50 to$0.22 per share (Note 6).

 

In November 2005, the Company announcedits intention to offer up to $15,000,000 of shares of common stock inconnection with a rights offering (the “Rights Offering”), pursuant to which itintended to distribute non-transferable subscription rights to purchase sharesof common stock upon the effectiveness of a registration statement tostockholders of record as of a specified record date.  Each subscription right would have entitledeach stockholder to purchase two (2) shares of common stock for each shareof common stock owned as of the record date. The price for each share purchased in the rights offering was expectedto be $.10 per share.  On January 6,2006, the Company announced revised terms of the anticipated Rights Offering toreduce the aggregate amount of the offering to approximately $8,100,000.  On January 31, 2006, the Companyannounced that it was no longer pursuing the Rights Offering and that it wouldwithdraw the registration statement related to the Rights Offering, whichregistration statement was withdrawn on February 3, 2006.

 

On February 17, 2006, the Company signeda term sheet with B. Riley & Co., Inc. and Lloyd I. Miller, IIIpursuant to which B. Riley & Co., Inc. and Mr. Miller agreedto negotiate the prospective purchase of Senior Secured Notes in the aggregateprincipal amount of approximately $6.7 million and Junior Secured ConvertibleNotes in the aggregate principal amount of $3 million.  Proceeds from the debt financing would beused to pay the outstanding principal and accrued interest under the LaurusNote, in an aggregate amount of approximately $6.7 million and for generalworking capital.  The new debt financingis contingent upon certain secured and unsecured creditors of approximately$10.7 million agreeing to negotiated settlements acceptable to thepurchasers.  In addition, the Companyengaged Network 1 Financial Securities Inc. to act as placement agent forprivate placements of common stock

 

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solely to accredited investors in an aggregate amount of up to $4.5million.  The conversion price for theJunior Secured Convertible Notes would be equal to the price paid for ourcommon stock in the proposed private placements.  Definitive terms of the restructured debt andprivate placements have not been determined and are subject to ongoingnegotiations.  The Company has not enteredinto any binding agreements regarding its proposed recapitalization plan andthere can be no assurance that it will consummate the proposed recapitalizationplan on favorable terms, or at all, and there continues to be substantial doubtabout the Company’s ability to continue as a going concern.

 

**3.****             ****SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES**

 

A.           Principlesof Consolidation - The consolidated financial statements include the accountsof the Company and its wholly-owned subsidiaries. All significant inter-companytransactions have been eliminated.

 

B.             RevenueRecognition.  The Company applies therevenue recognition principles set forth under SOP 97-2 and SAB 104 withrespect to all revenue.  The Companyadheres strictly to the criteria set forth in paragraph .08 of SOP 97-2 andoutlined in SAB 104 which provides for revenue to be recognized when (i) persuasiveevidence of an arrangement exists, (ii) delivery has occurred, (iii) thevendor’s fee is fixed or determinable, and (iv) collect ability isprobable.

 

*Computer Hardware Product Revenues*

 

TheCompany requires its hardware product sales to be supported by a writtencontract or other evidence of a sale transaction that clearly indicates theselling price to the customer, shipping terms, payment terms (generally 30days) and refund policy, if any. Since the Company’s hardware sales aresupported by a contract or other document that clearly indicates the terms ofthe transaction, and the selling price is fixed at the time the sale isconsummated, the Company records revenue on these sales at the time in which itreceives a confirmation that the goods were tendered at their destination whenshipped “FOB destination,” or upon confirmation that shipment has occurred whenshipped “FOB shipping point.”  

 

*SoftwareProduct Revenues*

 

TheCompany makes substantially all of its software product sales as a reseller oflicenses, which may include a post contract customer support arrangement andaccess to product and upgrades, and enhancements that are provided exclusivelyby the manufacturer following delivery and the customer’s acceptance of thesoftware product. The Company does not presently sell any software that itdevelops internally.  Any responsibilityfor technical support and access to upgrades and enhancements to these softwareproducts are solely the responsibility of the software manufacturer, whicharrangement is known to the customer at the time the sale is consummated.  With respect to delivery, the Companyrequires that the customer has received transfer of the software or, at aminimum, an authorization code (“key”) to permit access to the product.  If a software license is delivered to thecustomer, but the license term has not begun, the Company does not record therevenue prior to inception of the license term. 

 

TheCompany requires its software product sales to be supported by a writtencontract or other evidence of a sale transaction, which generally consists of acustomer purchase order or on-line authorization.  These forms of evidence clearly indicate theselling price to the customer, shipping terms, payment terms (generally 30days) and refund policy, if any. The selling prices of these products are fixedat the time the sale is consummated. 

 

Forproduct sales, the Company applies the factors discussed in Emerging IssuesTask Force Issue “EITF” 99-19 in determining whether to recognize productrevenues on a gross or net basis.  In asubstantial majority of transactions, the Company (i) acts as principal; (ii) takestitle to the products; and (iii) has the risks and rewards of ownership,including the risk of loss for collection, delivery or returns.  For these transactions, the Companyrecognizes revenues based on the gross amounts billed to customers.  In certain circumstances, based on an analysisof the factors set forth in EITF 99-19, the Company has determined that it wasacting as an agent, and therefore recognizes revenues on a net basis.  For the six months ended December 31,2005,  no revenues were recognized on anet basis.

 

9

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*ITServices Revenue*

 

TheCompany generally bills its customers for professional IT services based onhours of time spent on any given assignment at its hourly billing rates. As itrelates to delivery of these services, the Company recognizes revenue underthese arrangements as the work is completed and the customer has indicatedacceptance of services by approving a work order milestone or completionorder.   For certain engagements, theCompany enters fixed bid contracts, and recognizes revenue as phases of theproject are completed and accepted by the client.  For its seat management services, the Companyenters unit-price contracts (e.g., price per user for seat management), andrecognizes revenue based on number of units multiplied by the agreed-uponcontract unit price per month.

 

*BPOServices Revenue*

 

Forbusiness process outsourcing (“BPO”) services, which primarily includes theCompany’s child support service contracts in the states of Kansas and Nebraska,the Company provides services under a fixed price (flat monthly fee) contract,and recognizes revenue as the services are provided and billed.  In the state of North Carolina, the Companyhas one contract subject to revenue-sharing related to child support services.  Under that contract a fee from amountscollected is shared by the Company with the county on a percentage basis, andrevenue is recognized monthly in arrears as a percentage of the total amount ofcollections received.

 

C.             Cash andCash Equivalents – The Company considers all highly liquid temporary cashinvestments with an original maturity of three months or less when purchased,to be cash equivalents.

 

D.            Allowance for Doubtful Accounts - The Companyhas a policy of reserving for uncollectible accounts based on its best estimateof the amount of probable credit losses in its existing accounts receivable.The Company periodically reviews its accounts receivable to determine whetheran allowance is necessary based on an analysis of past due accounts and otherfactors that may indicate that the realization of an account may be in doubt.Account balances deemed to be uncollectible are charged to the allowance afterall means of collection have been exhausted and the potential for recovery isconsidered remote.

 

E.              Property andEquipment - Property and equipment is stated at cost and is depreciated on astraight-line basis over the estimated useful lives of the assets. Leaseholdimprovements are amortized over the term of their respective leases or servicelives of the improvements, whichever is shorter.

 

F.              Income(loss) per Common Share – Basic earnings per share has been calculated basedupon the weighted average number of common shares outstanding. Convertiblepreferred stock, convertible debt, options and warrants have been excluded ascommon stock equivalents in the diluted earnings per share because they areanti-dilutive.  The aggregate number ofpotential common stock equivalents outstanding as of December 31, 2005 was51,200,407.  

 

Total outstanding stock, options, convertiblepreferred stock, convertible debt and warrants are as follows:

 
| ** **           | ** ** | **As of December 31,** | ** ** |
|----------------------|------------|-----------------------------|------------|
| ** **           | ** ** | **2005**                    | ** ** | **2004** | ** ** |
| Common stock         |       | 81,164,636                  |       | 58,989,235 |   |
| Options and warrants |       | 27,094,757                  |       | 26,859,990 |   |
| Convertible debt     |       | 24,105,650                  |       | 17,269,115 |   |
| Preferred Stock      |       | —                      |       | 1,511,493 |   |
|                 |       | 132,365,043                 |       | 104,629,833 |   |

 

G.             Estimates -The Company’s financial statements and accompanying notes are prepared inaccordance with accounting principles generally accepted in the United States.Preparing financial statements requires management to make estimates andassumptions that affect the reported amounts of assets, liabilities, revenue,and expenses. These estimates and assumptions 

 

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are affected by management’s application ofaccounting policies. Critical accounting policies include revenue recognition,impairment of goodwill, and accounting for discontinued operations.

 

H.            Stock BasedCompensation – Prior to July 1, 2005, the Company accounted for employeestock transactions in accordance with Accounting Principle Board, APB Opinion No. 25,“Accounting for Stock Issued to Employees.” The Company has adopted the proforma disclosure requirements of Statement of Financial Accounting Standards No. 123,“Accounting For Stock-Based Compensation.”

 

Effective July 1, 2005, the Companyadopted FASB Statement of Financial Accounting Standard (“SFAS”) No. 123R “ShareBased Payment”.  This statement is arevision of SFAS Statement No. 123, andsupersedes APB Opinion No. 25, and its related implementationguidance. SFAS 123R addresses all forms of share based payment (“SBP”) awardsincluding shares issued under employee stock purchase plans, stock options,restricted stock and stock appreciation rights. Under SFAS 123R, SBP awardsresult in a cost that will be measured at fair value on the awards’ grant date,based on the estimated number of awards that are expected to vest that willresult in a charge to operations. Consequently, during the six months ended December 31, 2005, theCompany recognized $205,000 in expenses, which represents the fair value ofstock option awards that the Company elected to accelerate vesting during thatperiod.

 

For the six months ended December 31,2004, the Company had applied APB Opinion No. 25, “Accounting for StockIssued to Employees.”  As required underSFAS No. 148, “Accounting for Stock-based Compensation – Transition andDisclosure,” the following table presents pro- forma net income and basic anddiluted earnings per share as if the fair value-based method had been appliedto all awards during that period. 

 
| ** **                                                                                          | ** ** | **Six Months Ended  December 31,** | ** ** |
|-----------------------------------------------------------------------------------------------------|------------|-----------------------------------------|------------|
| **(in thousands except per share  data)**                                                           | ** ** | **2004**                                | ** ** |
| Net Loss                                                                                            |       | $                                       | (6,956     | ) |
| Stock-based  employee compensation cost, net of tax effect, under fair value accounting             |       | (70                                     | )          |
| Pro-forma  net loss under Fair Value Method                                                         |       | $                                       | (7,026     | ) |
| Loss per  share                                                                                     |       |                                    |       |
| Basic                                                                                               |       | $                                       | (0.15      | ) |
| Diluted                                                                                             |       | $                                       | (0.15      | ) |
| Per share  stock-based employee compensation cost, net of tax effect, under fair value  accounting: |       |                                    |       |
| Pro-forma  loss share basic                                                                         |       | (0.15                                   | )          |
| Pro-forma  loss share diluted                                                                       |       | $                                       | (0.15      | ) |

 

The fair value of all options granted wasestimated at the date of grant using the Black-Scholes option valuationmodel.  The Black-Scholes optionvaluation model was developed for use in estimating the fair value of traded optionsthat have no vesting restrictions and are fully transferable.  Because the Company’s stock options havecharacteristics significantly different from those of traded options, andbecause changes in the subjective input assumptions can materially affect thefair value estimate, in management’s opinion, the existing models do notnecessarily provide a reliable single measure of the fair value estimate of itsstock options. In calculating the fair values of the stock options, the followingassumptions were used:

 
| ** **                                | ** ** | **Fiscal 2005** | ** ** |
|-------------------------------------------|------------|-----------------|------------|
| Dividend yield                            |       | —          |       |
| Weighted average expected life            |       | 8.8 years       |       |
| Weighted average risk-free  interest rate |       | 1.35            | %          |
| Expected volatility                       |       | 35              | %          |

 

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L.              Fair Valueof Financial Instruments - The carrying amounts reported in the balance sheetfor cash, trade receivables, accounts payable and accrued expenses approximatefair value based on the short-term maturity of these instruments.  The carrying amounts of notes receivableapproximate fair value as such instruments feature contractual interest ratesthat are consistent with current market rates of interest. The carrying amountsof notes payable approximate fair value because the effective yields of suchinstruments, which includes the effect of contractual interest rates takentogether with discounts resulting from the concurrent issuances of common stockpurchase warrants, are consistent with current market rates of interest.

 

M.         Goodwill -Goodwill represents the excess of the purchase price over the fair value of netassets acquired in business combinations (Note 4).  SFAS 142, Goodwill and Other Intangible Assets, requires that goodwill betested for impairment at the reporting unit level (operating segment or onelevel below an operating segment) on an annual basis (June 30thfor the Company) and between annual tests when circumstances indicate that therecoverability of the carrying amount of goodwill may be in doubt. Applicationof the goodwill impairment test requires judgment, including the identificationof reporting units, assigning assets and liabilities to reporting units,assigning goodwill to reporting units, and determining the fair value.Significant judgments required to estimate the fair value of reporting unitsinclude estimating future cash flows, determining appropriate discount ratesand other assumptions. Changes in these estimates and assumptions couldmaterially affect the determination of fair value and/or goodwill impairmentfor each reporting unit.   

 

N.            ComprehensiveIncome (Loss) – Comprehensive income (loss) is comprised of net income (loss)and all changes to the statements of stockholders’ equity, except for changesthat relate to investments made by stockholders, changes in paid-in capital anddistributions.  

 

O.            Inventory -Inventory consist primarily of finished goods, which are recorded at the lowerof cost or market. 

 

P.              New AccountingStandards

 

In December 2004, the FASB issuedStatement of Financial Accounting Standard (“SFAS”) No. 153 “Exchanges of Nonmonetary Assets”.  This Statement amends Opinion 29 toeliminate the exception for non-monetary exchanges of similar productive assetsand replaces it with a general exception for exchanges of non-monetary assetsthat do not have commercial substance. A non-monetary exchange has commercial substanceif the future cash flows of the entity are expected to change significantly asa result of the exchange. The provisions of this Statement, which is to beapplied prospectively, are effective for non-monetary asset exchanges occurringin fiscal periods beginning after June 15, 2005. The adoption of thispronouncement did not have a material effect on the Company’s financialstatements. 

 

EITFIssue 04-8, “The Effect of Contingently Convertible Instruments on DilutedEarnings per Share.”  The EITF reached aconsensus that contingently convertible instruments, such as contingentlyconvertible debt, contingently convertible preferred stock, and other suchsecurities should be included in diluted earnings per share (if dilutive)regardless of whether the market price trigger has been met.  The consensus became effective for reportingperiods ending after December 15, 2004. The adoption of this pronouncement does not currently have an effect onthe Company’s financial statements because the inclusion of common stockequivalents in earnings per share is anti-dilutive.

 

InSeptember 2005, the FASB ratified the Emerging Issues Task Force’s (“EITF”)Issue No. 05-7, “Accounting for Modifications to Conversion OptionsEmbedded in Debt Instruments and Related Issues,” which addresses whether amodification to a conversion option that changes its fair value affects therecognition of interest expense for the associated debt instrument after themodification and whether a borrower should recognize a beneficial conversionfeature, not a debt extinguishment if a debt modification increases theintrinsic value of the debt (for example, the modification reduces theconversion price of the debt).  In September 2005,the FASB also ratified the EITF’s Issue No. 05-8, “Income Tax Consequencesof Issuing Convertible Debt with a Beneficial Conversion Feature,” whichdiscusses whether the issuance of convertible debt with a

 

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beneficialconversion feature results in a basis difference arising from the intrinsicvalue of the beneficial conversion feature on the commitment date (which istreated recorded in the shareholder’s equity for book purposes, but as aliability for income tax purposes), and, if so, whether that basis differenceis a temporary difference under FASB Statement No. 109, “Accounting forIncome Taxes.”  The Company is currentlyin the process of evaluating the effect that the adoption of this pronouncementmay have on its financial statements. 

 

**4.****             ****BUSINESS ACQUISITIONS**

 

**RedrockCommunications Solutions, Inc. (“Redrock”)**

 

On September 29,2004, the Company entered into a Stock Purchase Agreement (the “RedrockAgreement”) by and among the Company and the two holders of record (the “Sellers”)of the outstanding shares of Redrock, to acquire all of the outstanding CommonStock of Redrock for purchase consideration consisting of $4,500,000 in cash,including an earn-out cash payment of $1,500,000 due July 31, 2005 (the “Earn-OutPayment”), and $500,000 of the Company’s common stock at a price of $.63 pershare.

 

After the transaction closed, a formeremployee of Redrock claimed that he was owed up to one-third (1/3) of theoutstanding shares of Redrock at the time of the Company’s acquisition ofRedrock (the “Redrock Dispute”).  TheRedrock Agreement provides an indemnification for the benefit of the Company bythe Sellers with respect to Redrock’s capital structure, its securitiesthen-outstanding, and the Sellers’ ownership of Redrock shares. 

 

In August 2005, the Company paid$850,000 of the Earn-Out Payment, withholding the remaining portion pendingresolution of the Redrock Dispute.  In October 2005,the Sellers and the former employee of Redrock entered into a settlementagreement, and the Company paid the remaining $650,000 of the Earn-Out Paymentto the Sellers, plus $120,000 in a settlement amount to the former employee ofRedrock payable over 24 months, less $26,000 in fees and expenses incurred bythe Company in connection with such litigation, terminated the former employeeof Redrock, and obtained a release in connection with the Redrock Dispute.  

 

**Integration Technologies Inc.**

 

On October 14, 2004, the Company enteredinto an Agreement and Plan of Merger (the “Merger Agreement”), by and among theCompany, ITI Acquisition Corp., a California corporation and wholly ownedSubsidiary of the Company (“Merger Sub”), Integration Technologies, Inc.,a California corporation (“ITI”), the shareholders of ITI (the “ITIShareholders”) and Casper Zublin, Jr., in his capacity as the shareholderrepresentative (the “Representative”).                                                

 

On October 18, 2004, the Merger Sub wasmerged into ITI with ITI becoming a wholly-owned subsidiary of the Company (the“Merger”).  The consideration paid or payable to the ITI Shareholders in connectionwith the Merger is comprised of: (i) an initial cash payment of$2,500,000; (ii) an earn-out cash payment up to a maximum amount of$1,500,000, based upon ITI’s EBITDA for the period between July 1, 2004through June 30, 2005; (iii) a earn-out cash payment up to a maximumamount of $1,500,000, based upon ITI’s revenue for the period between July 1,2004 through June 30, 2005; and (iv) an aggregate number of wholeshares of Company common stock  based onthe average closing sale price per share (the “Share Price”) of such commonstock for the 30 trading days prior to June 28, 2005 (the “ShareConsideration”).  The Share Price was$.36 and the value of 4,280,000 shares, the maximum number of shares to beissued under the Merger Agreement, was $1,544,252.  In the event the number of shares issuable asStock Consideration was so limited, the Company agreed to pay the differencebetween the share value and $2,140,000 to the Shareholders in cash.  The resulting cash adjustment was $595,748(the “Cash Adjustment”).

 

In February 2005, the Company and theITI Shareholders entered into a Satisfaction and Release Agreement based onperformance of the ITI business through January 31, 2005, the performanceof certain former ITI employees who had undertaken additional responsibilitiesat the Company, and the opportunity for the Company to consolidate the ITIoperations with Redrock and other operations of the Company.  Based on these considerations and therevenues and EBITDA from the ITI business through such date, the Company agreedto pay the amount of $2,250,000 to the Shareholders in satisfaction of theearn-out cash payments (the “ITI Earn-Out Payment”).  The ITI Earn-Out Payment and Cash Adjustmentequaled an aggregate of $2,845,748.  In August 2005,the Company paid $270,993 of this amount to two ITI Shareholders who arecurrently employees of the Company.  

 

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In September 2005, the Company enteredinto promissory notes with the three remaining ITI Shareholders (the “ITI Notes”),including the Company’s current chief executive officer, Casper Zublin, Jr.,to pay an aggregate of $2,574,735. Principal payments are due quarterly beginning in September 2005,with the balance due on July 31, 2006. The ITI Notes bear interest at a rate of 8.9%.  The interest on Mr. Zublin’s note ispayable in shares of the Company’s Common Stock.  The Company paid $643,684 in principal dueunder the ITI Notes in September 2005, with a remaining aggregate balanceof $1,931,051.  

 

**5.**              **RESTRICTED CASH**

 

Restricted cash includes cash received inconnection with maintenance agreements that are restricted and will becomeavailable to the Company as revenue is earned and recognized under the terms ofthe respective agreements, which are three years.  Approximately $747,000 is classified as anon-current asset.  

 

**6.****              NOTES PAYABLE**

 

**9% Subordinated Convertible Note**

 

OnOctober 15, 2004, the Company entered into a 9% Senior SubordinatedConvertible Note Purchase Agreement with certain investors in which it issuedan aggregate of $4,438,775 in principal amount of the Company’s SeniorSubordinated Convertible Notes (the “9% Notes”), bearing 9% interest at perannum with a maturity of three years.  Interest payments are due quarterlyon the first day of each calendar quarter. Principal payments are due in monthly installments of $145,844 beginningJuly 1, 2005 with any remaining principal due on October 15,2007.  The 9% Notes were convertible intoshares of the Company’s common stock at a conversion price of $.65 per share,subject to certain adjustments.  At December 31,2005, the net carrying value of these notes amounted to $2,993,637 includingunamortized discounts of approximately $339,595. 

 

Amortization of the debt discount inconnection with issuance of the 9% Notes amounted to $94,770 during the sixmonths ended December 31, 2005 and is included as a component of interestexpense in the accompanying condensed consolidated statement ofoperations.  Contractual interest expenseon the 9% Notes for the six months ended December 31, 2005 amounted to$179,178 and is also included as a component of interest expense in theaccompanying condensed consolidated statement of operations. 

 

On October 26, 2005, the Company amendedthe 9% Notes with a majority of the holders thereof, and deferred all paymentsof principal due under the 9% Notes until January 2007.  In exchange for the deferral, the Company (i) reducedthe conversion price under the 9% Notes from $.65 to $.22 per share, (ii) reducedthe exercise price of warrants held by the holders of the 9% Notes from $.50 to$0.22 per share, and (iii) increased the number of shares exercisableunder the 9% Notes by an aggregate of 491,400 shares. This transaction deferredapproximately $1,893,629 in aggregate principal payments otherwise due andpayable through January 2007.

 

The Company accounted for the modification ofthe 9% Notes in accordance with SFAS 15. Accordingly, the Company recorded a non-cash interest charge of$1,742,853, which represents the incremental number of shares issuable uponconversion of the 9% Notes by having reduced the conversion price from $.65 to$.22, multiplied by $.20, the closing price of the Company’s common stock on October 26,2005.  The Company also recorded anon-cash interest charge in the amount of $168,768, which represents theincrease in the fair value of the common stock purchase warrants held by theholders of the 9% Notes that resulted from reducing their exercise price from$.50 to $.22 as of the date of the modification.

 

**Laurus Funds Note**

 

On November 15, 2004, the Companyentered into an Amended and Restated Secured Convertible Term Note with LaurusMaster Fund, LTD (the “Laurus Note”). The Laurus Note is 

 

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convertible into the Company’s common stock at the option of LaurusFunds at a conversion price of $0.65 per share.  The Laurus Note issubordinated to the Company’s working capital credit facility; however,substantially all other assets of the Company have been pledged as security forthis obligation.  At December 31,2005, the remaining principal on the Laurus Note amounted to $6,649,999.

 

The Laurus Note provides for interest payableat the greater of the prime rate plus 1% per annum or 4% per annum. Principal payments are due in twenty-four monthly installments of $277,083beginning December 1, 2005. Any pre-payments of principal that the Companymay choose to make under the Laurus Note prior to its maturity are subject to a2% prepayment premium.  

 

In connection with this transaction, theCompany also issued to Laurus Funds a five-year amended and restated warrant topurchase 1,046,150 shares of the Company’s common stock, exercisable at $0.65per share (the “Laurus Warrant”) 

 

In accordance with APB 14, the Companyallocated $6,551,000 of the proceeds to the Laurus Notes and $98,982 of theproceeds to the Laurus Warrant (including the effect of note amendments).  Accretion of the aforementioned discount(including the effect of note amendments) amounted to $33,876 for the sixmonths ended December 31, 2005, and is included as a component of interestexpense in the accompanying statement of operations. Contractual interestexpense on the Laurus Notes amounted to $253,671 for the six months ended December 31,2005 and is also included as a component of interest expense in theaccompanying statement of operations

 

On October 26, 2005, the Company amendedthe Laurus Note, and deferred principal payments from December 2005 until March 2006in return for a decrease in the exercise price of warrants issued in connectionwith issuance of the Laurus Note from $.65 per share to $.25 per share.  Laurus entered this transaction to assist theCompany in alleviating its immediate liquidity constraints.  This transaction deferred approximately$831,249 in aggregate payments otherwise due and payable through March 2006.

 

The Company accounted for the modification ofthe Laurus Note in accordance with SFAS 15 “Accounting by Debtors and Creditorsfor Troubled Debt Restructurings” (“SFAS 15”). Accordingly, there has been no change in the carrying value of theLaurus Note since the amendment affects only the timing of the payments and notthe aggregate amount of the liability. The Company also recorded a non-cash interest charge in the amount of$49,851, which represents the increase in the fair value of the common stockpurchase warrants held by Laurus that resulted from reducing their exerciseprice from $.65 to $.25 as of the date of the modification.

 

**Bridge Notes**

 

On October 26, 2005, the Company enteredinto a Note Purchase Agreement, whereby it obtained an aggregate loan of$2,500,000 from two shareholders of the Company pursuant to two SecuredPromissory Notes (the “Bridge Notes”), each in the original principal amount of$1,250,000.  The Bridge Notes bearinterest at 12% per annum until March 1, 2006, with the interest rateincreasing 2% each month until June 1, 2006, and then remaining constantat 20% until maturity, December 31, 2006. The Company is required to redeem the Bridge Notes on the earlier of (i) theclosing of a rights offering to record holders of the Company’s common stock inan aggregate amount of $15,000,000 or more; (ii) the stated maturity date,December 31, 2006; or (iii) an event of default. Payment of principaland interest under the Bridge Notes is secured by a lien to substantially allthe assets of the Company, which lien is subordinated to the perfected securityinterests held be existing secured lenders. The carrying value of the Bridge Notes is approximately equal to itsfair value due to its short maturity and the fact that the contractual interestrate is approximately equal to the effective rate of interest that wouldprevail for instruments with similar credit risk.

 

In connectionwith the issuance of the Notes, DynTek issued warrants to purchase shares of itscommon stock (the “Warrants”).  TheWarrants are exercisable for an aggregate 1,000,000 shares of its common stockat an exercise price equal to the greater of $0.10 per share of the price pershare at which common stock is sold in any rights offering to record holders ofits common stock.  The Warrants expire onOctober 26, 2015.  The company recorded a$150,000 discount on the notes based on the rotative fair value of the notes andthe warrants.

 

**Line of Credit**

 

In August 2005, the Company terminatedits credit facility agreement with an agency of Textron Financial Corporation (“Textron”).  The Textron facility provided a fullnotification factoring facility for up to $7,000,000 of working capital.  Eligible accounts receivable expected to becollected within 90 days were purchased with recourse, with a holdback amountof 15%.  Interest was charged on theoutstanding balance at the prime rate plus 2.0% (8.25% at June 30,2005).  Additionally, a 0.15% discountfee was charged at the time of purchase. In August 2005, the Company terminated this agreement, and paid theentire balance then outstanding of approximately $4,800,000.

 

On August 8, 2005, the Company enteredinto a series of related agreements with New England Technology Finance, LLC (“NETF”),an affiliate of Global Technology Finance, which is a provider of structuredfinancing solutions to technology companies that operates in partnership withCredit Suisse First Boston, CIT Group, Inc. and others, that togetherprovided a new working capital credit facility.

 

15

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The new credit facility is comprised of twoprimary components:  (1) an AssetPurchase and Liability Assumption Agreement (the “APLA”), under which NETFagreed to finance certain of the Company’s qualified product purchases under anarrangement that provides for the Company to assign accounts receivable(resulting from product sales to customers) and for NETF to assume theliability for payment to product vendors; and (2) an Asset Purchase Agreement (the “APA”), under which NETFpurchased $7,500,000 of qualified accounts receivables (both services andproducts).  These agreements are securedby the Company’s accounts receivables that are transferred under the respectiveagreements.  The agreements also containcertain provisions that allow NETF to return the liability to the Company ifcustomers have not paid in 150 days. The proceeds received under the APA wereused to repay in full the $4,800,000 balance on the credit line with Textron,for acquisition debt, and general corporate purposes.  In addition to the accounts receivablepurchased on August 8, 2005, NETF may purchase up to 80% of additionalqualified accounts receivable in the future on the same terms.  At December 31, 2005, a balance ofapproximately $7,156,000 was outstanding under the APA facility.

 

**7.**              **ACQUISITION INDEBTEDNESS**

 

Acquisition indebtednessincludes $1,931,051 of accrued contingent consideration payable to three of thesellers of ITI (see Note 4).

 

**8.****              STOCKHOLDERS’EQUITY**

 

On August 14, 2005, the Company’s then outstanding Series Apreferred stock automatically converted into shares of its Class A CommonStock, at a rate of 2.5 common shares for each preferred share, pursuant to theterms of the Series A preferred stock certificate of designations.  During the six months ended December 31,2005, all remaining shares of the Company’s Series A Preferred Stock wereexchanged or automatically converted into 1,457,827 shares of the Company’sCommon Stock, including common shares issued for fractional shares.

 

**9.****              COMMITMENTS,CONTINGENCIES, AND OTHER AGREEMENTS**

 

WestconSettlement

 

On April 7, 2003Westcon, Inc. filed a breach of contract complaint in the Supreme Court ofNew York State, County of Westchester. The complaint arose from the Company’sfailure to make payments within the terms of the reseller agreement.  The Company does not dispute the amount dueof $ 413,000 and has negotiated payment terms. The remaining balance due Westcon under this settlement, which isincluded in accounts payable, amounts to $87,000 at December 31, 2005 andis payable on demand.

 

Separation Agreement with Former ChiefExecutive Officer 

 

On May 26, 2005, the Company and StevenJ. Ross, its then Chairman and Chief Executive Officer entered into aSeparation Agreement and General Release (“Separation Agreement”).  The Separation Agreement provides for themutual termination of an Employment Agreement, dated July 1, 2004, betweenthe Company and Mr. Ross, pursuant to which Mr. Ross was employed asPresident and Chief Executive Officer of the Company.  The Separation Agreement also provides forsalary continuation for Mr. Ross based on his then current annual salaryof $440,000 through May 31, 2006, a portion of his bonus under theEmployment Agreement not to exceed $110,000, and continuation of insurancebenefits through May 31, 2006.  TheSeparation Agreement contains a mutual release, as well as certainnon-solicitation and non-competition covenants by Mr. Ross in favor of theCompany.

 

Contract Management Services Agreement 

 

As of March 1,2004, the Company entered into a series of agreements with Young Williams, P.C.Under the services agreement, Young Williams will manage certain contracts ofthe Company pursuant to which it provides child support services.  The Company agreed to pay Young Williams afee of 12% of revenues under the contracts, and the Company will remainresponsible for the operating expenses related to the contracts managed byYoung Williams for the current term and option year extensions of eachcontract.  The management fee paid toYoung Williams was $218,000 for the six months ended 

 

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December 31, 2005. In the event of contract renewals past thecurrent terms and option years, Young Williams will have the right to bid thecontracts. If Young Williams is awarded a new contract, it will pay the Company4% of revenues under each such contract during the awarded term through February 2010.  

 

**10.****       DISCONTINUED OPERATIONS**

 

During 2003, the Company disposed of itsnon-emergency transportation business. At December 31, 2005, the total remaining liabilities ofdiscontinued operations was $258,000.  

 

Effective March 1, 2003, the Companyentered into an Asset Purchase Agreement with First Transit, Inc. (the “FirstTransit Agreement”), pursuant to which the Company sold to First Transit, Inc.certain specific assets relating to its former non-emergency transportationbrokerage services previously business. The assets sold consisted of the Company’s interests in three contractsto provide non-emergency transportation related services and related assetsused in connection with performance of such contracts by the Company as well asthe assumption of all vendor and services sub-contract agreements relating tothe contracts. The purchase price consisted of $6,450,000 cash payments and upto $1,750,000 to be paid in the event that First Transit, Inc. is able toobtain an extension of the Illinois Department of Public Aid contract for aperiod of up to three years beyond May 31, 2004, under certain specifiedconditions.  As part of the First TransitAgreement, the Company agreed not to compete with First Transit in the businessthat was sold.  The Company receivedpayments of $216,000 during the six-month period ended December 31, 2005from the extension of the Illinois Department of Public Aid contract.  There can be no assurance that the Companywill obtain any additional payments as a result of additional extensions, ifany, in any future periods.

 

**11.****       BUSINESS SEGMENTS**

 

The Company’soperations include two segments – Information Technology (“IT”) Services andBusiness Process Outsourcing Services. The Information Technology Services segment provides a range ofspecialized IT infrastructure services, including, system architectural design,legacy systems integration, network engineering, applications infrastructure,network security solutions, remote access implementation, help desk support andoperational support, primarily to mid-market commercial companies and state andlocal government entities. In conjunction with these service offerings, it alsosells hardware and software to its customers. Operations are distributed primarily among five states: California(including the principal executive office), New York, Michigan, Florida, andNevada, with employees situated in locations that are convenient to clientsites.   

 

The BusinessProcess Outsourcing segment contracts outsourced program operations for stategovernment agencies in several areas including the privatization of childsupport enforcement services. The Company’s business process outsourcingcustomers have included various governmental departments in the states of NorthCarolina, Kansas and Nebraska.  Typicallythese contracts are for multi-year periods of performance, with options torenew for additional periods. Such contracts are generally awarded throughcompetitive procurements. Payment is based on either fixed-price, fixed-unit-price based on contractual allocations, revenue sharing, or a combination ofthe above.   

 

The Company’sreportable segments are business units that offer different services andcontract types and are managed separately due to the expertise and differentmanaged key factors in each area. Since the Business Process Outsourcingbusiness segment was acquired as a unit, management has retained separatereporting and review criteria for that unit. The following table providesactual selected financial data for our business segments (in thousands):

 

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| ** **                                | ** ** | **Reportable  Business Segments**   | ** ** |
|-------------------------------------------|------------|-------------------------------------|------------|
| ** **                                | ** ** | **Business****Process Outsourcing** | ** ** | **Information Technology Services** | ** ** | **Total** | ** ** |
| Three months ended December 31, 2005 |       |                                |       |   |   |   |   |
| Sales                                     |       | $                                   | 964        |   | $ | 17,880 |   | $ | 18,884 |   |
| Depreciation and amortization  expense    |       | —                              |       | 650 |   | 650 |   |
| Goodwill impairment                       |       | —                              |       | — |   | — |   |
| Income (loss) from operations             |       | 69                                  |       | (1,581 | ) | (1,512 | ) |
| Interest expense                          |       | —                              |       | 2,759 |   | 2,759 |   |
| Total assets                              |       | 367                                 |       | 42,000 |   | 42,367 |   |
| Capital expenditures                      |       | —                              |       | 98 |   | 98 |   |
|                                      |       |                                |       |   |   |   |   |
| Three months ended December 31, 2004 |       |                                |       |   |   |   |   |
| Sales                                     |       | $                                   | 2,201      |   | $ | 17,801 |   | $ | 20,002 |   |
| Depreciation and amortization  expense    |       | 116                                 |       | 655 |   | 781 |   |
| Goodwill impairment                       |       | 5,837                               |       | 189 |   | 6,026 |   |
| Loss from operations                      |       | (5,363                              | )          | (1,283 | ) | (6,645 | ) |
| Interest expense                          |       | —                              |       | 402 |   | 402 |   |
| Total assets                              |       | 9,985                               |       | 38,887 |   | 48,872 |   |
| Capital expenditures                      |       | 27                                  |       | 140 |   | 167 |   |
|                                      |       |                                |       |   |   |   |   |
| Six months ended December 31, 2005   |       |                                |       |   |   |   |   |
| Sales to external customers               |       | $                                   | 1,949      |   | $ | 40,329 |   | $ | 42,279 |   |
| Depreciation and amortization expense     |       | 35                                  |       | 1,345 |   | 1,380 |   |
| Goodwill impairment                       |       | —                              |       | — |   | — |   |
| Income (loss) from operations             |       | 115                                 |       | (2,853 | ) | (2,738 | ) |
| Interest expense                          |       | —                              |       | (3,493 | ) | (3,493 | ) |
| Total assets                              |       | 367                                 |       | 42,000 |   | 42,367 |   |
| Capital expenditures                      |       | —                              |       | 173 |   | 173 |   |
|                                      |       |                                |       |   |   |   |   |
| Six months ended December 31, 2004   |       |                                |       |   |   |   |   |
| Sales to external customers               |       | $                                   | 4,877      |   | $ | 29,908 |   | $ | 34,785 |   |
| Depreciation and amortization expense     |       | 233                                 |       | 1,309 |   | 1,542 |   |
| Goodwill impairment                       |       | 5,837                               |       | 189 |   | 6,026 |   |
| Income (loss) from operations             |       | (5,684                              | )          | (2,234 | ) | (7,918 | ) |
| Interest expense                          |       | —                              |       | 675 |   | 675 |   |
| Total assets                              |       | 9,985                               |       | 38,887 |   | 48,872 |   |
| Capital expenditures                      |       | 27                                  |       | 176 |   | 203 |   |

 

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**12.****       SUBSEQUENT EVENTS**

 

In November 2005, the Company announcedits intention to offer up to $15,000,000 of shares of common stock inconnection with a rights offering (the “Rights Offering”), pursuant to which itintended to distribute non-transferable subscription rights to purchase sharesof common stock upon the effectiveness of a registration statement tostockholders of record as of a specified record date.  Each subscription right would have entitledeach stockholder to purchase two (2) shares of common stock for each shareof common stock owned as of the record date. The price for each share purchased in the rights offering was expectedto be $.10 per share.  On January 6,2006, the Company announced revised terms of the anticipated Rights Offering toreduce the aggregate amount of the offering to approximately $8,100,000.  On January 31, 2006, the Companyannounced that it was no longer pursuing the Rights Offering and that it wouldwithdraw the registration statement related to the Rights Offering, which registrationstatement was withdrawn on February 3, 2006.

 

On February 17, 2006, the Company signeda term sheet with B. Riley & Co., Inc. and Lloyd I. Miller, IIIpursuant to which B. Riley & Co., Inc. and Mr. Miller agreedto negotiate the purchase of Senior Secured Notes in the aggregate principalamount of approximately $6.7 million and Junior Secured Convertible Notes inthe aggregate principal amount of $3 million. Proceeds from the debt financing would be used to pay the outstandingprincipal and accrued interest under the Secured Convertible Term Note held byLaurus Master Fund, Ltd., in an aggregate amount of approximately $6.7 millionand for general working capital.  The newdebt financing is contingent upon certain secured and unsecured creditors of approximately$10.7 million agreeing to negotiated settlements acceptable to thepurchasers.  In addition, the Companyengaged Network 1 Financial Securities Inc. to act as placement agent forprivate placements of common stock solely to accredited investors in anaggregate amount of up to $4.5 million. The conversion price for the Junior Secured Convertible Notes would beequal to the price paid for the Company’s common stock in the proposed privateplacements.  Definitive terms of therestructured debt and private placements have not been determined and aresubject to ongoing negotiations.  TheCompany has not entered into any binding agreements regarding its proposedrecapitalization plan and there can be no assurance that the Company willconsummate its proposed recapitalization plan on favorable terms, or at all.

 

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**ITEM2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITIONS AND RESULTS OFOPERATIONS**

 

The following discussion and analysis of ourresults of operations and financial position should be read in conjunction withour audited consolidated financial statements and related notes included in ourAnnual Report on Form 10-K for the year ended June 30, 2005 and theunaudited consolidated financial statements and related notes included in thisQuarterly Report on Form 10-Q. Depending upon the context, the termsDynTek, “we,” “our,” and “us,” refers to either DynTek alone, or DynTek and itssubsidiaries.

 

**Forward-Looking Statements**

 

This report contains “forward-lookingstatements” within the meaning of such term in Section 27A of theSecurities Act of 1933, Section 21E of the Securities Exchange Act of1934, and the Private Securities Litigation Reform Act of 1995. We wish tocaution readers not to place undue reliance on any such forward-lookingstatements, each of which speaks only as of the date made. Forward-lookingstatements involve known and unknown risks, uncertainties and other factorswhich could cause actual financial or operating results, performance orachievements expressed or implied by such forward-looking statements not tooccur or be realized. Such statements are subject to certain risks anduncertainties that could cause actual results to differ materially fromhistorical results and those presently anticipated or projected. See below, anda discussion of such risks and factors discussed in Item 1 (Business) of Part Iand Item 7 (Management’s Discussion and Analysis of Financial Condition andResults of Operations) of Part II of our Annual Report on Form 10-Kfor the fiscal year ended June 30, 2005 as filed with the Securities andExchange Commission, and Part II, Item 1A of this Form 10-Q. Forward-lookingstatements made in this Form 10-Q generally are based on our bestestimates of future results, performances or achievements, predicated uponcurrent conditions and the most recent results of the companies involved andtheir respective industries. Forward-looking statements may be identified bythe use of forward-looking terminology such as “may,” “will,” “could,” “should,”“project,” “expect,” “believe,” “estimate,” “anticipate,” “intend,” “continue,”“potential,” “endeavor,”  “opportunity”or similar terms, variations of those terms or the negative of those terms orother variations of those terms or comparable words or expressions. Readersshould carefully review those risks, as well as additional risks described inthis report and other documents we file from time to time with the Securitiesand Exchange Commission. Potential risks and uncertainties include, among otherthings, such factors as:

 

•                        Ourability to reach target markets for services and products and our ability toretain current and attract future customers;

 

•                        Ourability to attract and retain professional staff, successfully integrateacquired companies into our operations, and our ability to acquire additionalcompanies, if any;

 

•                        Marketacceptance, revenues and profitability of our current and future products andservices;

 

•                        Ourability to finance and sustain operations, including the ability to fund,maintain, replace and/or extend the 9% Notes, the Bridge Notes, and/or theLaurus Funds Note, when due, respectively, or to replace such instruments withalternative financing;

 

•                        Ourability to raise equity capital or debt in the future, despite historicallosses from operations;

 

•      Ourability to fund operations and continue as a going concern in the absence ofdebt restructuring and/or infusion of capital in the third quarter of fiscal2006.

 

•                        Generaleconomic conditions in the United States and elsewhere, as well as the economicconditions affecting the industries in which we operate, our customers andsuppliers;

 

•                        Politicaland regulatory matters that affect the industries in which we operate;

 

•                        Ourcontinued ability to trade on the NASD bulletin board; and

 

•                        Otherrisks detailed in our filings with the Securities and Exchange Commission.

 

The Company has no obligation to publicly release the results of anyrevisions to any forward-looking statements to reflect anticipated orunanticipated events or circumstances occurring after the date of suchstatements.

 

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**Business Overview**

 

DynTek, Inc.provides professional information technology (“IT”) services and sales ofrelated products to mid-market commercial businesses, state and localgovernment agencies, and educational institutions. We operate our businessprimarily through our subsidiary, DynTek Services, Inc.

 

We provide a broad rangeof multi-disciplinary IT solutions that address the critical business needs ofour clients, including IT security, converged networking (includingvoice-over-internet-protocol “VOIP”), application infrastructure, and accessinfrastructure. Our primary operations are located in four of the top tenlargest IT spending states: California, New York, Florida, and Michigan. Wedeliver complex infrastructure technology solutions through teams ofprofessional consultants in close geographic proximity to our clients. Membersof our technical and consulting services team have advanced certifications withleading vendor-manufacturers, including Microsoft, Cisco, McAfee and Citrix. Asa professional services firm and value-added reseller of hardware and softwarefrom leading manufacturers, we help organizations assess, design, build,implement, manage and support their technology infrastructure.

 

We believe that our services-led approach,combined with expertise in multi-disciplinary practice areas such as ITsecurity, converged networking (VOIP), application infrastructure, and accessinfrastructure, will continue to provide the platform we need to capture anincreasing share of our target markets. Our strategy allows our clients to relyon DynTek as their primary IT vendor. Additionally, we believe that ourmulti-disciplinary capabilities help differentiate us from our competitors inthe markets in which we compete.

 

We recognize revenue from sales of productsand services. Services are primarily provided to the client at hourly ratesthat are established for each of our employees or third-party contractors basedupon their skill level, experience and the type of work performed. We alsoprovide project management and consulting work which are billed either by anagreed upon fixed fee or hourly rates, or a combination of both. The majorityof our services are provided under purchase orders with commercial customers orbid contracts with government entities. (See “Revenue Recognition,” below.)

 

Costs of services consist primarily ofsalaries of services personnel and related expenses incurred in providing suchservices, and the cost of outsourced service labor. Costs of products consistof our cost of products purchased and sold to our customers. Selling, generaland administrative expenses consist primarily of salaries and benefits ofpersonnel responsible for administrative, finance, sales and marketing activitiesand all other corporate overhead expenses. Corporate overhead expenses includerent, telephone and internet charges, insurance premiums, accounting and legalfees, and other general administrative expenses. Selling, general andadministrative costs also include a calculation of the fair value of employeestock options and other share-based payment awards calculated pursuant to SFAS No. 123R.

 

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**Results of Operations**

** **

The following table setsforth, for the periods indicated, the relative percentages that certain incomeand expense items bear to net sales. 

 
| ** **                                    | ** ** | **Six Months Ended  Dec. 31,** | ** ** |
|-----------------------------------------------|------------|-----------------------------------------------|------------|
| ** **                                    | ** ** | **2005**                                      | ** ** | **2004** | ** ** |
| Product  Revenue                              |       | 68                                            | %          | 55 | % |
| Service  Revenue-Information Technology       |       | 28                                            | %          | 31 | % |
| Service  Revenue-Business Process Outsourcing |       | 4                                             | %          | 14 | % |
|                                          |       |                                          |       |   |   |
| Cost of  Products                             |       | 88                                            | %          | 81 | % |
| Cost of  Service-Information Technology       |       | 71                                            | %          | 45 | % |
| Cost of  Service-Business Process Outsourcing |       | 94                                            | %          | 36 | % |
|                                          |       |                                          |       |   |   |
| Gross profit                                  |       | 17                                            | %          | 19 | % |
|                                          |       |                                          |       |   |   |
| SG &  A                              |       | 20                                            | %          | 21 | % |
|                                          |       |                                          |       |   |   |
| Loss from  continuing operations              |       | (14                                           | )%         | (25 | )% |
| Gain (loss)  from discontinued operations     |       | —                                        |       | 5 | % |
| Net income  (loss)                            |       | (14                                           | )%         | (20 | )% |

 

***Sixmonths ended December 31, 2005 and December 31, 2004***

*** ***

**Revenues.**For the six months ended December 31,2005, our revenues increased to approximately $42,279,000 from approximately$34,785,000 for the six months ended December 31, 2004. This $7,494,000increase, or 22%, is principally attributable to an increase of $4,852,000 fromnew businesses we acquired as of August and October 2004, which nowcomprise our Southwest Region; an increase of $5,570,000 in IT Services segmentrevenues from our other regions; less a decrease of $2,928,000 in sales fromour BPO business, which is being de-emphasized.

 

Our product salesincreased from $19,145,000 during the six months ended December 31, 2005to $28,583,000 during the six months ended December 31, 2005. The increaseresulted primarily from the increase in product sales of network communicationsequipment and software in the Southwest Region, including voice-over-internetprotocol (“VOIP”) products, and the sales of other networking and computerequipment and software products in our other regions.

 

Our services revenuesdecreased from $15,640,000 during the six months ended December 31, 2004to $13,696,000 during the same period in 2005, a decrease of $1,944,000. Thisdecrease resulted from a $2,928,000 decrease in service revenues from ourBusiness Process Outsourcing (“BPO”) segment, offset by a 984,000 increase inIT service revenues. Our BPO services revenues decreased from approximately$4,877,000 during the six months ended December 31, 2004 to $1,949,000during the six months ended December 31, 2005 as we are no longer pursuingopportunities in that segment due to its relatively lower margin rates. Servicerevenues from our Information Technology Services segment increased from$10,763,000 in the six months ended December 31, 2004, to $11,747,000 inthe six months ended December 31, 2005, or an increase of 9%, dueprimarily to increased billings for higher-end services.

 

The following table setsforth for the periods presented information derived from our consolidatedstatements of operations (in thousands): 

 
| ** **    | ** ** | **For the Six Months ended December 31** | ** ** |
|---------------|------------|------------------------------------------------------------------------|------------|
| **REVENUES**  | ** ** | **2005**                                                               | ** ** | **2004** | ** ** | **Percentage  change** | ** ** | **Amount** | ** ** |
| ***Product*** |       | $                                                                      | 28,583     |   | 19,145 |   | 49 | % | 9,438 |   |
| *** ***  |       |                                                                   |       |   |   |   |   |   |   |
| ***Service*** |       | 13,696                                                                 |       | 15,640 |   | (12 | )% | (1,946 | ) |
| *** ***  |       |                                                                   |       |   |   |   |   |   |   |
| ***Total***   |       | 42,279                                                                 |       | 34,785 |   | 22 | % | 7,494 |   |
|               |            |                                                                        |            |  |  |  |  |  |  |  |

 

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Our customersare primarily state and local government entities and mid-sized corporations indiversified industries. For the six months ended December 31, 2005, 58% ofour revenues were derived from commercial clients, compared to 34% fromgovernment agencies and 8% from educational institutions.

 

**Grossprofit.**Gross profit increasedfrom $6,833,000 in the six months ended December 31, 2004 to $7,303,000 inthe six months ended December 31, 2005, an increase of 7%. Gross marginfor the six months ended December 31, 2005 was 17%, compared to 20% for thesimilar period in the prior fiscal year. While our services margin increasedsignificantly, from 21% to 29%, our product margin decreased from 17% to 12%.Services margin increased primarily due to an increase in the overall level ofutilization with respect to consultants throughout the company, a greater mixof higher-end services, and a lower percentage of BPO services. The decrease inoverall product gross margin is primarily the result of having consummatedseveral large, lower-margin product sales under contracts with certain stateand local government clients and fewer vendor rebates that were received duringthe six months ended December 31, 2005. Although we have improved ourservice margins, and will seek opportunities to make further improvements, ourproduct margins in particular are subject to competitive pricing pressures andfluctuate from period to period depending on the mix of products we provide. Weintend to meet the challenges of aggressive price reductions and discountpricing by certain product suppliers by focusing our offerings aroundrelatively higher margin practice areas, including security solutions, VOIP,and access infrastructure. There can be no assurance, however, that we will beable to improve profit margins, especially for our sale of products, andcompete profitably in all areas, given the intense competition that exists inthe IT industry.

 

**Selling,general and administrative expenses.**Generaland administrative expenses decreased to approximately $2,485,000 for the sixmonths ended December 31, 2005, from approximately $2,809,000 for the sixmonths ended December 31, 2004. As a percent of revenues, general andadministrative expenses decreased from 8% to 6%. This decrease is primarily theresult of reduced costs from restructuring and re-organization by newmanagement.

 

Selling costs increasedto approximately $6,176,000 for the six months ended December 31, 2005from $4,374,000 in the six months ended December 31, 2004. The increasewas primarily due to the addition of sales and business development personnelfrom the integration of the Redrock and ITI businesses, a $205,000 expense foremployee stock options vested by sales personnel during the period, andincreased sales commissions and other expenses commensurate with approximately$7,494,000 in higher revenues during the 2005 period.

 

**Depreciationand amortization expense.**Depreciation andamortization expense decreased to approximately $1,380,000 for the six-monthperiod ended December 31, 2005, from approximately $1,542,000 during thesame period in the prior year. The decrease is primarily due to loweramortization of customer lists from acquisitions completed in late 2004.

 

**Interestexpense.**Interest expense for thesix months ended December 31, 2005 increased to $3,493,000, as compared to$675,000 for the six months ended December 31, 2004. This increase isprimarily due to $1,742,853 in non-cash interest charges resulting from thereduction in the conversion price of our 9% Notes, $168,768 in non-cash interestcharges resulting from the reduction in warrant exercise prices for our 9%Notes, and $49,851 in non-cash interest charges resulting from the reduction inwarrant exercise price for the Laurus Note. The increase also includescontractual interest due on notes that we entered into in January and October 2004,the bridge note entered into in November 2005, an increase in the averageborrowings under our credit facility, and the amortization of deferredfinancing fees.

 

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The following table sets forth operatingexpenses for the periods presented from information derived from ourconsolidated statements of operations (in thousands):

 
| ** **                                    | ** ** | **For the Six Months ended  December 31,** | ** ** |
|-----------------------------------------------|------------|---------------------------------------------------------------------|------------|
| ** **                                    | ** ** | ** **                                                          |
| **OPERATING**                                 | ** ** | **Dollars**                                                         | ** ** | **Percentage of  Revenues** | ** ** |
| **EXPENSES**                                  | ** ** | **2005**                                                            | ** ** | **2004** | ** ** | **2005** | ** ** | **2004** | ** ** |
| ***Selling***                                 |       | 6,176                                                               |       | 4,374 |   | 15 | % | 13 | % |
| *** ***                                  |       |                                                                |       |   |   |   |   |   |   |
| ***General & Administrative(1)***    |       | 2,485                                                               |       | 2,809 |   | 6 | % | 8 | % |
| *** ***                                  |       |                                                                |       |   |   |   |   |   |   |
| ***Depreciation & Amortization(1)*** |       | 1,380                                                               |       | 1,542 |   | 3 | % | 4 | % |
| *** ***                                  |       |                                                                |       |   |   |   |   |   |   |
| ***Total***                                   |       | 10,041                                                              |       | 8,682 |   | 24 | % | 25 | % |

 

**Netloss.**Our net loss for the sixmonths ended December 31, 2005 was $5,937,000 compared to a net loss of$6,956,000 for the six months ended December 31, 2004. The net loss duringthe six months ended December 31, 2005 includes depreciation andamortization expense of $1,380,000, non-cash option expense of $205,000, andinterest expense of $3,493,000 (including a non-cash portion of $2,374,000). Thenet loss in the 2004 period included a gain from discontinued operations of$1,676,000 and a goodwill impairment expense of $6,026,000.

 

***DiscontinuedOperations.***Income from discontinuedoperations was $216,000 for the six months ended December 31, 2005compared to income of $1,676,000 for the six months ended December 31,2004. The 2004 period included a one-time gain from the resolution of certainliabilities associated with a discontinued transportation services business inthe State of Virginia. The 2005 period includes a payment from First Transitrelating to a contract extension related to assets sold in connection with ourformer non-emergency transportation brokerage services in Illinois.

 

24

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**Results of Operations**

** **

The following table setsforth, for the periods indicated, the relative percentages that certain incomeand expense items bear to net sales. 

 
| ** **                                    | ** ** | **Three Months  Ended Dec. 31,** | ** ** |
|-----------------------------------------------|------------|-------------------------------------------------|------------|
| ** **                                    | ** ** | **2005**                                        | ** ** | **2004** | ** ** |
| Product  Revenue                              |       | 66                                              | %          | 54 | % |
| Service  Revenue-Information Technology       |       | 29                                              | %          | 35 | % |
| Service  Revenue-Business Process Outsourcing |       | 5                                               | %          | 11 | % |
|                                          |       |                                            |       |   |   |
| Cost of  Products                             |       | 89                                              | %          | 81 | % |
| Cost of  Service-Information Technology       |       | 68                                              | %          | 74 | % |
| Cost of  Service-Business Process Outsourcing |       | 93                                              | %          | 90 | % |
|                                          |       |                                            |       |   |   |
| Gross profit                                  |       | 17                                              | %          | 21 | % |
|                                          |       |                                            |       |   |   |
| SG &  A                              |       | 21                                              | %          | 20 | % |
| Interest  expense                             |       | 15                                              | %          | 2 | % |
| Loss from  continuing operations              |       | (23                                             | )%         | (35 | )% |
| Gain (loss)  from discontinued operations     |       | —                                          |       | — |   |
| Net income  (loss)                            |       | (23                                             | )%         | (35 | )% |

*** ***

***Threemonths ended December 31, 2005 and December 31, 2004***

*** ***

**Revenues.**For the three months ended December 31,2005, our revenues decreased to approximately $18,844,000 from approximately$20,002,000 for the three months ended December 31, 2004. This $1,158,000decrease, or 6%, is principally attributable to a $1,232,000 decrease inrevenues from our Business Process Outsourcing business, which is being de-emphasized.

 

Our product salesincreased from $10,731,000 during the three months ended December 31, 2004to $12,428,000 during the three months ended December 31, 2005. The 16%increase resulted primarily from the increase in product sales of networkcommunications equipment and software, including voice-over-internet protocol (“VOIP”)products, and the sales of other networking and computer equipment and softwareproducts in all of our business regions.

 

Our services revenuesdecreased from $9,271,000 during the three months ended December 31, 2004to $6,416,000 during the same period in 2005. This decrease resulted primarilyfrom a decrease of approximately $1,232,000 from discontinued business processoutsourcing services, and a decrease of IT services segment revenues ofapproximately $2,175,000 in our Southwest Region. This decrease was primarilydue to a reorganization of the region during the period, and a decrease inbillable days in the December quarter in 2005. Services revenues from ourBusiness Process Outsourcing (“BPO”) segment decreased from $2,201,000 to$964,000 during the same period, as we de-emphasized that segment and did notpursue additional BPO services business.

 

The following table setsforth for the periods presented information derived from our consolidatedstatements of operations (in thousands): 

 
| ** **    | ** ** | **For the Three Months ended December 31** | ** ** |
|---------------|------------|--------------------------------------------------------------------------|------------|
| **REVENUES**  | ** ** | **2005**                                                                 | ** ** | **2004** | ** ** | **Percentage  change** | ** ** | **Amount** | ** ** |
| ***Product*** |       | $                                                                        | 12,428     |   | 10,731 |   | 16 | % | 1,697 |   |
| *** ***  |       |                                                                     |       |   |   |   |   |   |   |
| ***Service*** |       | 6,416                                                                    |       | 9,271 |   | (31 | )% | (2,855 | ) |
| *** ***  |       |                                                                     |       |   |   |   |   |   |   |
| ***Total***   |       | 18,844                                                                   |       | 20,002 |   | (6 | )% | (1,158 | ) |
|               |            |                                                                          |            |  |  |  |  |  |  |  |

 

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Our customersare primarily state and local government entities and mid-sized corporations indiversified industries. For the three months ended December 31, 2005, 68%of our revenues were derived from commercial clients, compared to 28% fromgovernment agencies and 4% from educational institutions.

 

**Grossprofit.**Gross profit decreasedfrom $4,151,000 in the quarter ended December 31, 2004 to $3,189,000 inthe quarter ended December 31, 2005, a decrease of 23%. Gross margin decreasedfrom 21% for the three months ended December 31, 2004 to 17% for the threemonths ended December 31, 2005. While our services margin increased from 22% to28%, our product margin decreased from 19% to 11%. Services margin increasedprimarily due to a greater mix of higher-end services, and an increasedproportion of IT services, relative to lower-margin BPO services. The decreasein overall product gross margin is primarily the result of having consummatedseveral large, lower-margin product sales during the quarter, together withfewer vendor rebates that were received during the December quarter in2005, compared to the December quarter in 2004. Although we have improvedour service margins, and will seek opportunities to make further improvements,our product margins in particular are subject to competitive pricing pressuresand fluctuate from quarter to quarter depending on the mix of products weprovide. We intend to meet the challenges of aggressive price reductions anddiscount pricing by certain product suppliers by focusing our offerings aroundrelatively higher margin practice areas, including security solutions, VOIP,and access infrastructure. There can be no assurance, however, that we will beable to improve profit margins, especially for our sale of products, andcompete profitably in all areas, given the intense competition that exists inthe IT industry.

 

**Selling,general and administrative expenses.**Generaland administrative expenses decreased by 27%, to approximately $1,051,000 forthe three months ended December 31, 2005, from approximately $1,441,000for the three months ended December 31, 2004. As a percent of revenues,general and administrative expenses decreased from 7% to 6%. This decrease isprimarily the result of reduced costs from restructuring and re-organization bynew management.

 

Selling expensesincreased to approximately $3,000,000 for the three months ended December 31,2005 from $2,548,000 in the three months ended December 31, 2004. Theincrease was primarily due to additional sales and business developmentpersonnel employed during the 2005 period.

 

**Depreciationand amortization expense.**Depreciation andamortization expense decreased to approximately $650,000 for the three-monthperiod ended December 31, 2005, from approximately $781,000 during thesame period in the prior year. The decrease is primarily due to loweramortization of customer lists from acquisitions completed in late 2004.

 

**Interestexpense.**Interest expense for thethree months ended December 31, 2005 increased to $2,759,000, as comparedto $402,000 for the three months ended December 31, 2004. The increaseincludes non-cash charges of $2,374,000 incurred in connection with reductionin the conversion price of our 9% Notes, and reductions in the exercise pricesof warrants issued to holders of 9% Notes and the Laurus Notes, and theamortization of deferred financing fees. The increase also includes contractualinterest due on notes that we entered into in January and October 2004,a bridge loan in November 2005, and an increase in the average borrowingsunder our credit facility.

 

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The following table sets forth operatingexpenses for the periods presented from information derived from ourconsolidated statements of operations (in thousands):

 
| ** **                                 | ** ** | **For the Three Months ended  December 31,** | ** ** |
|--------------------------------------------|------------|-----------------------------------------------------------------------|------------|
| ** **                                 | ** ** | ** **                                                            |
| **OPERATING**                              | ** ** | **Dollars**                                                           | ** ** | **Percentage of  Revenues** | ** ** |
| **EXPENSES**                               | ** ** | **2005**                                                              | ** ** | **2004** | ** ** | **2005** | ** ** | **2004** | ** ** |
| ***Selling***                              |       | 3,000                                                                 |       | 2,548 |   | 16 | % | 13 | % |
| *** ***                               |       |                                                                  |       |   |   |   |   |   |   |
| ***General & Administrative***    |       | 1,051                                                                 |       | 1,441 |   | 6 | % | 7 | % |
| *** ***                               |       |                                                                  |       |   |   |   |   |   |   |
| ***Depreciation & Amortization*** |       | 650                                                                   |       | 781 |   | 3 | % | 4 | % |
| *** ***                               |       |                                                                  |       |   |   |   |   |   |   |
| ***Total***                                |       | 4,701                                                                 |       | 4,770 |   | 25 | % | 24 | % |

 

**Netloss.**Our net loss for thethree months ended December 31, 2005 was $4,256,000 compared to a net lossof $7,004,000 for the three months ended December 31, 2004. The lossduring the three months ended December 31, 2005 includes interest expenseof $2,759,000 (including a non-cash portion of $2,374,000), and depreciationand amortization expense of $650,000. The net loss in the 2004 period includeda goodwill impairment charge of $6,026,000, interest expense of $402,000, anddepreciation and amortization expense of $781,000.

 

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**Liquidity and Capital Resources**

 

We measure our liquidity in a number of ways, as summarized in thefollowing table:

 
| ** **                                            | ** ** | **(Dollars in thousands)**    | ** ** |
|-------------------------------------------------------|------------|-----------------------------------------|------------|
| ** **                                            | ** ** | **As of  Dec. 31, 2005** | ** ** | **As of  June 30, 2005** | ** ** |
|                                                  |       |                                    |       |   |   |
| Cash and  cash equivalents                            |       | $                                       | 980        |   | $ | 1,297 |   |
|                                                  |       |                                    |       |   |   |
| Working  capital                                      |       | $                                       | (9,160     | ) | $ | (5,221 | ) |
|                                                  |       |                                    |       |   |   |
| Current  ratio                                        |       | .64:1                                   |       | .80:1 |   |
|                                                  |       |                                    |       |   |   |
| Notes  payable (current portion and accrued interest) |       | $                                       | 6,058      |   | $ | 3,805 |   |

 

Cash and cash equivalents generally consistof cash and money market funds. We consider all highly liquid investmentspurchased with maturities of three months or less to be cash equivalents. Suchinvestments are stated at cost, which approximates fair value, and areconsidered cash equivalents for purposes of reporting cash flows.

 

We incurred a net loss of $5,937,000 for thesix months ended December 31, 2005, which includes $3,956,000 of non-cashand/or non-recurring charges resulting from $2,371,000 in non-cash interestcharges; $1,380,000 of depreciation and amortization; and $205,000 in stockbased compensation. At December 31, 2005, the Company had a workingcapital deficiency of approximately $9,160,000.

 

InOctober 2005, we raised gross proceeds of $2,500,000, upon issuance ofnotes to certain investors (the “Bridge Notes”). The proceeds were used to payacquisition debt and for working capital. Interest on unpaid principal underthe Bridge Notes is 12% per annum through March 1, 2006, 14% from March 1,2006 to April 1, 2006, 16% from April 1, 2006 to May 1, 2006,18% from May 1, 2006 to June 1, 2006, and 20% from June 1, 2006until the maturity date, December 31, 2006.

 

In July 2005, we began making principalpayments of approximately $146,000 per month on our 9% Subordinated ConvertibleNotes (the “9% Notes”) due to certain investors. In October 2005, weamended a majority of 9% Notes to defer all payments of principal due undersuch 9% Notes until January 2007. In connection with such amendment, wereduced the conversion price of such notes from $.65 to $.22, and issued the 9%Note holders warrants to purchase shares of our common stock at $.22 per share.We incurred a non-cash interest expense of $1,742,853 in connection with thereduction of the conversion price, and a non-cash interest expense of $168,768in connection with a reduction in the exercise price of the warrants.

 

In October 2005, we amended our Amendedand Restated Secured Convertible Term Note (the “Laurus Note”), and deferredprincipal payments under the Laurus Note from December 2005 until March 2006in return for a reduction in the exercise price of warrants issued inconnection with issuance of the Laurus Note from $.65 per share to $.25 pershare. This transaction deferred aggregate payments of $831,249 in cashotherwise due and payable prior to March 2006. We incurred a non-cashinterest expense of $49,851 in connection with the reduction in the exerciseprice of the warrants.

 

In August 2005, we terminated our creditfacility agreement with an agency of Textron Financial Corporation (“Textron”).The Textron facility provided a full notification factoring facility for up to$7,000,000 of working capital. Eligible accounts receivable expected to becollected within 90 days were purchased with recourse, with a holdback amountof 15%. Interest was charged on the outstanding balance at the prime rate plus2.0% (8.25% at June 30, 2005). Additionally, a 0.15% discount fee wascharged at the time of purchase. As of June 30, 2005, $4,697,000 wasoutstanding on this facility. In August 2005, we terminated thisagreement, and paid the entire balance then outstanding of approximately$4,800,000.

 

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On August 8, 2005, we entered into aseries of related agreements with New England Technology Finance, LLC (“NETF”),an affiliate of Global Technology Finance, which is a provider of structuredfinancing solutions to technology companies that operates in partnership withCredit Suisse First Boston, CIT Group, Inc. and others, that togetherprovided a new working capital credit facility.

 

The new credit facility is comprised of twoprimary components:  (1) an AssetPurchase and Liability Assumption Agreement (the “APLA”), under which NETFagreed to finance certain of our qualified product purchases under anarrangement that provides for us to assign accounts receivable (resulting fromthe sale of such products to our customers) and for NETF to assume theliability for payment to product vendors; and (2) an Asset Purchase Agreement (the “APA”), under which NETFpurchased $7,500,000 of our qualified accounts receivables (services andproducts). The proceeds we received under the APA were used to repay in fullthe $4,800,000 balance on our credit line with Textron, for acquisition debt,and general corporate purposes. In addition to the accounts receivablepurchased on August 8, 2005, NETF may purchase up to 80% of our additionalqualified accounts receivable in the future on the same terms.

 

We believe that the NETF APLA facility willenable us to more effectively manage our liquidity. The facility is structuredto provide us with the flexibility of matching the timing of cash outflows forproduct purchases to cash amounts that we collect from our customers. Thefinancing fee under the facility is calculated on a monthly basis depending on ourgross margin on such products, and days sales outstanding, which fee weanticipate will be less than prior fees charged under our prior financingarrangement with Textron. We may also use the APA facility as a generalfinancing arrangement for certain product and services receivables.

 

In June 2005, Casper Zublin, Jr.was appointed as our Chief Executive Officer, and Robert Webber was appointedour President, at which time we re-evaluated our business strategy with respectto our BPO segment and our available capital resources. We have recently takencertain steps to conserve our capital resources, including a de-emphasis on theBPO segment and a projected reduction of our general and administrativeexpenses by approximately $1,600,000 from the year ended June 30, 2005 tothe year ended June 30, 2006. Total G&A expenses for the year ended June 30,2005 were approximately $7,045,000 for the twelve-month period. For the firstsix months of the twelve-month period ending June 30, 2006, G&Aexpenses were $2,485,000, or $4,970,000 on an annualized basis. Thus, webelieve that we will likely meet or exceed our projected G&A reductiontarget.

 

Despite these measures,  as well as attempts to reduce cashobligations through the restructuring of payments due under the Laurus Note and9% Notes, the combination of continuing operating losses and the cash requiredto be paid under existing debt obligations has severely impacted our ability tosustain and grow our business. These matters raise substantial doubt about ourability to continue as a going concern without a re-structuring of our debtand/or an infusion of capital.

 

In November 2005, we announced ourintention to offer up to $15,000,000 of shares of common stock in connectionwith a rights offering (the “Rights Offering”), pursuant to which we intendedto distribute non-transferable subscription rights to purchase shares of commonstock upon the effectiveness of a registration statement to stockholders ofrecord as of a specified record date. Each subscription right would haveentitled each stockholder to purchase two (2) shares of common stock foreach share of common stock owned as of the record date. The price for eachshare purchased in the rights offering was expected to be $.10 per share. On January 6,2006, we announced revised terms of the anticipated Rights Offering to reducethe aggregate amount of the offering to approximately $8,100,000. On January 31,2006, we announced that we were no longer pursuing the Rights Offering and thatwe would withdraw the registration statement related to the Rights Offering,which registration statement was withdrawn on February 3, 2006.

 

On February 17, 2006, we signed a termsheet with B. Riley & Co., Inc. and Lloyd I. Miller, IIIpursuant to which B. Riley & Co., Inc. and Mr. Miller agreedto negotiate the prospective purchase of Senior Secured Notes in the aggregateprincipal amount of approximately $6.7 million and Junior Secured ConvertibleNotes in the aggregate principal amount of $3 million. Proceeds from the debtfinancing would be used to pay the outstanding principal and accrued interestunder the Secured Convertible Term Note held by Laurus Master Fund, Ltd., in anaggregate amount of approximately $6.7 million and for general working capital.The new debt financing is contingent upon certain secured and unsecuredcreditors of approximately $10.7 million agreeing to negotiated settlementsacceptable to the purchasers. In addition, we engaged Network 1 FinancialSecurities Inc. to act as placement agent for private placements of commonstock solely to accredited investors in an aggregate amount of up to $4.5

 

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million. The conversion price for the Junior Secured Convertible Noteswould be equal to the price paid for our common stock in the proposed privateplacements. Definitive terms of the restructured debt and private placementshave not been determined and are subject to ongoing negotiations. We have notentered into any binding agreements regarding our proposed recapitalizationplan and there can be no assurance that we will consummate our proposedrecapitalization plan on favorable terms, or at all.

 

**ContractualObligations**

 
| ** **                    | ** ** | **Payments due by period** | ** ** |
|-------------------------------|------------|-------------------------------------------|------------|
| **(in thousands)**       |
| ** **                    | ** ** | **Total**                                 | ** ** | **Less  than 1  year** | ** ** | **1-3 years** | ** ** | **3-5  years** | ** ** | **More  than 5  years** | ** ** |
| *Contractual  Obligations*    | ** ** | ** **                                | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Convertible  Debt Obligations |       | 12,014                                    |       | 5,729 |   | 6,285 |   | — |   | — |   |
| Acquisition  Debt             |       | 1,931                                     |       | 1,931 |   | — |   | — |   | — |   |
| Operating  Lease Obligations  |       | 1,984                                     |       | 610 |   | 1,009 |   | 335 |   | 30 |   |
| Total                         |       | $                                         | 15,929     |   | $ | 8,270 |   | $ | 7,294 |   | $ | 335 |   | $ | 30 |   |
|                               |            |                                           |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

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**CriticalAccounting Policies and Estimates**

 

The Company’s financial statements andaccompanying notes are prepared in accordance with accounting principles generallyaccepted in the United States. Preparing financial statements requiresmanagement to make estimates and assumptions that affect the reported amountsof assets, liabilities, revenue, and expenses. These estimates and assumptionsare affected by management’s application of accounting policies. Criticalaccounting policies for us include revenue recognition, impairment of goodwill,and accounting for discontinued operations.

 

**Revenue Recognition.** We apply the revenuerecognition principles set forth under SOP 97-2 and SAB 104 with respect to allof our revenue. We adhere strictly to the criteria set forth in paragraph .08of SOP 97-2 and outlined in SAB 104 which provides for revenue to be recognizedwhen (i) persuasive evidence of an arrangement exists, (ii) delivery hasoccurred, (iii) the vendor’s fee is fixed or determinable, and (iv)collectability is probable. A summary of our revenue recognition policies, asthey relate to our specific revenue streams, is as follows:

 

*Computer Hardware Product Revenues*

 

We require our hardwareproduct sales to be supported by a written contract or other evidence of a saletransaction that clearly indicates the selling price to the customer, shippingterms, payment terms (generally 30 days) and refund policy, if any.

 

Since our hardware salesare supported by a contract or other document that clearly indicates the termsof the transaction, and our selling price is fixed at the time the sale isconsummated, we record revenue on these sales at the time in which we receive aconfirmation that the goods were tendered at their destination when shipped “FOBdestination,” or upon confirmation that shipment has occurred when shipped “FOBshipping point.”

 

*Software Product Revenues*

 

We make substantiallyall of our software product sales as a reseller of licenses, which may includea post contract customer support arrangement and access to product andupgrades, and enhancements that are provided exclusively by the manufacturerfollowing delivery and the customer’s acceptance of the software product. We donot presently sell any software that we develop internally. Any responsibilityfor technical support and access to upgrades and enhancements to these softwareproducts are solely the responsibility of the software manufacturer, whicharrangement is known to the customer at the time the sale is consummated. Withrespect to delivery, we require that the customer has received transfer of thesoftware or, at a minimum, an authorization code (“key”) to permit access tothe product. If a software license is delivered to the customer, but thelicense term has not begun, we do not record the revenue prior to inception ofthe license term.

 

We require our softwareproduct sales to be supported by a written contract or other evidence of a saletransaction, which generally consists of a customer purchase order or on-lineauthorization. These forms of evidence clearly indicate the selling price tothe customer, shipping terms, payment terms (generally 30 days) and refundpolicy, if any. The selling prices of these products are fixed at the time thesale is consummated.

 

For product sales, weapply the factors discussed in EITF 99-19 “Reporting Revenue Gross as aPrincipal versus Net as an Agent” in determining whether to recognize productrevenues on a gross or net basis. In a substantial majority of ourtransactions, we (i) act as principal; (ii) take title to theproducts; and (iii) have the risks and rewards of ownership, including therisk of loss for collection, delivery or returns. For these transactions, werecognize revenues based on the gross amounts billed to our customers. Incertain circumstances, based on an analysis of the factors set forth in EITF 99-19,we have determined that we were acting as an agent, and therefore recognize revenueson a net basis. During the six months ended December 31, 2005, no revenueswere recognized on a net basis.

 

*IT Services Revenue*

 

We generally bill ourcustomers for professional IT services based on hours of time that we spend onany given assignment at our hourly billing rates. As it relates to delivery ofthese services, we recognize revenue under these arrangements as the work iscompleted and the customer has indicated their

 

31

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acceptance of our servicesby approving a work order milestone or completion order. For certainengagements, we enter fixed bid contracts, and we recognize revenue as phasesof the project are completed and accepted by our client. For our seatmanagement services, we enter unit-price contracts (e.g., price per user forseat management), and we recognize revenue based on number of units multipliedby the agreed-upon contract unit price per month.

 

*BPO Services Revenue*

 

For our business processoutsourcing (“BPO”) services, which primarily include our child support servicecontracts in the states of Kansas and Nebraska, we provide services under afixed price (flat monthly fee) contract, and recognize revenue as the servicesare provided and billed. In the state of North Carolina, we have one contractsubject to revenue-sharing related to child support services. Under thatcontract a fee from amounts collected is shared with the county on a percentagebasis, and revenue is recognized monthly in arrears as a percentage of thetotal amount of collections received.

 

**Collectibility of Receivables.** Aconsiderable amount of judgment is required to assess the ultimate realizationof receivables, including assessing the probability of collection and thecurrent credit worthiness of our clients. Probability of collection is basedupon the assessment of the client’s financial condition through the review ofits current financial statements or credit reports.

 

**Goodwill**. SFAS 142, Goodwilland Other Intangible Assets, requires that goodwill be tested forimpairment at the reporting unit level (operating segment or one level below anoperating segment) on an annual basis (June 30th for theCompany) and between annual tests in certain circumstances. Application of thegoodwill impairment test requires judgment, including the identification ofreporting units, assigning assets and liabilities to reporting units, assigninggoodwill to reporting units, and determining the fair value. Significantjudgments required to estimate the fair value of reporting units includeestimating future cash flows, determining appropriate discount rates and otherassumptions. Changes in these estimates and assumptions could materially affectthe determination of fair value and/or goodwill impairment for each reporting unit.We have recorded goodwill in connection with the Company’s acquisitions, mostrecently the acquisitions of Redrock in September 2004 and ITI in October 2004,and recorded goodwill in the amount of $4,664,000 and $6,568,000, respectively.In these instances, goodwill was determined by comparing the purchase price andrelated transaction costs with the fair value of the net tangible assets andliabilities acquired.

 

**Recent Accounting Standards**

 

In December 2004, the FASB issuedStatement of Financial Accounting Standard (“SFAS”) No. 123R “Share BasedPayment”. This statement is a revision of SFAS Statement No. 123, “Accounting for Stock-Based Compensation” andsupersedes APB Opinion No. 25, Accounting for Stock Issued to Employees, and its relatedimplementation guidance. SFAS 123R addresses all forms of share based payment (“SBP”)awards including shares issued under employee stock purchase plans, stockoptions, restricted stock and stock appreciation rights. Under SFAS 123R, SBPawards result in a cost that will be measured at fair value on the awards’grant date, based on the estimated number of awards that are expected to vestthat will result in a charge to operations. This statement is effective for public entities that do not fileas small business issuers—as of the beginning of the first annual reportingperiod that begins after June 15, 2005. The Company began implementingthis policy for the three-month period ended September 30, 2005.

 

In December 2004, the FASB issuedStatement of Financial Accounting Standard (“SFAS”) No. 153 “Exchanges of Nonmonetary Assets”. ThisStatement amends Opinion No. 29 to eliminate the exception for nonmonetaryexchanges of similar productive assets and replaces it with a general exceptionfor exchanges of nonmonetary assets that do not have commercial substance. Anonmonetary exchange has commercial substance if the future cash flows of theentity are expected to change significantly as a result of the exchange. Theprovisions of this Statement, which is to be applied prospectively  are effective for nonmonetary asset exchangesoccurring in fiscal periods beginning after June 15, 2005. Earlierapplication is permitted for nonmonetary asset exchanges occurring in fiscalperiods beginning after June 15, 2004. The adoption of this pronouncementis not expected to have material effect on the Company’s financial statements.

 

Emerging Issues Task Force (“EITF”) Issue 04-8,“The Effect of Contingently Convertible Instruments on Diluted Earnings perShare.”  The EITF reached a consensusthat contingently convertible

 

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instruments, such as contingently convertible debt, contingentlyconvertible preferred stock, and other such securities should be included indiluted earnings per share (if dilutive) regardless of whether the market pricetrigger has been met. The consensus is effective for reporting periods endingafter December 15, 2004. The adoption of this pronouncement is notexpected to have material effect on the Company’s financial statements.

 

**ITEM3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK**

 

Market risk associated with adverse changesin financial and commodity market prices and rates could impact our financialposition, operating results or cash flows. We are exposed to market risk due tochanges in interest rates such as the prime rate and LIBOR. This exposure isdirectly related to our normal operating and funding activities. Historically,and as of December 31, 2005, we have not used derivative instruments orengaged in hedging activities.

 

The Laurus Funds convertible secured termnote exposes the Company to similar risks, and it requires interest to be paidat 1% over the prime rate. The table below provides information on the LaurusFunds Note as of December 31, 2005.

 
| ** **         | ** ** | **Principal Balance** | ** ** | **Interest Rate** | ** ** |
|--------------------|------------|----------------------------|------------|------------------------|------------|
| Laurus Funds  Note |       | $                          | 6,649,999  |                   | 7.75       | % |
|                    |            |                            |            |                        |            |  |

 

We have operatedprimarily in the United States. Accordingly, we have not had any significantexposure to foreign currency rate fluctuations.

 

**ITEM4. CONTROLS AND PROCEDURES**

 

An evaluation as of the end of the periodcovered by this quarterly report was performed under the supervision and withthe participation of the Company’s management, including its Chief ExecutiveOfficer, President and Chief Financial Officer, regarding the effectiveness ofthe design and operation of the Company’s disclosure controls and procedures. Basedon that evaluation, the Company’s Chief Executive Officer and President andChief Financial Officer, have concluded that the Company’s disclosure controlsand procedures are effective to ensure that the information required to bedisclosed in the Company filings or which it submits under the SecuritiesExchange Act is recorded, processed, summarized and reported within the timeperiods specified in the Securities and Exchange Commission’s rules andforms. There have been no changes in the Company’s internal controls overfinancial reporting that occurred during the six months ended December 31,2005 that have materially affected, or are reasonably likely to materiallyaffect, the Company’s internal control over financial reporting.

 

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**PART II- OTHER INFORMATION**

 

**ITEM 1A. RISKFACTORS**

 

Potential risks and uncertainties include,among other things, those factors discussed in Item 1 (Business) of Part Iand Item 7 (Management’s Discussion and Analysis of Financial Condition andResults of Operations) of Part II of our Annual Report on Form 10-Kfiled on September 29, 2005, Item 2 (Management’s Discussion and Analysisof Financial Condition and Results of Operations) of Part I of thisQuarterly Report on Form 10-Q, and as set forth below in this Item IA. Readersshould carefully review those risks, as well as additional risks described inother documents we file from time to time with the Securities and ExchangeCommission. We undertake no obligation to publicly release the results of anyrevisions to any forward-looking statements to reflect anticipated orunanticipated events or circumstances occurring after the date of suchstatements. The following risk factors include material changes to the riskfactors previously disclosed in our Form 10-K filed on September 29,2005, but are not a complete list of all of our risk factors.

 

***We will need additional capital in thefuture, or we will need to scale back operations***.

 

We will need capital in the future, and if itis not available on terms acceptable to us, or at all, we would have to scaleback operations and/or personnel costs. As of December 31, 2005, we hadcash and cash equivalents of approximately $980,000. We have recently takencertain steps to conserve our capital resources, including a reduction of ourgeneral and administrative expenses, and deferred certain principal paymentsunder our debt obligations. However, without additional increases in cash flowfrom operations, such reduction in our overhead would not be sufficient toovercome the projected shortage in working capital that we would experience inthe event that we are unable to restructure our existing indebtedness orreceive an infusion of capital during the third quarter of 2006. New financingtransactions could include issuing additional equity and/or debt securitieswhere appropriate. We anticipate using the proceeds of future financingtransactions (if any) to retire debt and fund our working capital needs. In theevent of any additional financing, any equity financing would likely result indilution to our existing stockholders and any debt financing may includerestrictive covenants. We currently have no binding commitments for newfinancing in place nor can we provide any assurance that we will be successfulin our efforts to raise additional capital in the future. If we are unable toraise additional capital during the third quarter of fiscal year 2006, we willneed to scale back our operations and personnel and/or divest assets tocontinue operations. Any such reductions or divestitures would materiallyimpact our operations. There can be no assurance that we will be successfulrestructuring our debt, reducing expenses as planned, selling assets, orraising additional capital and these matters raise substantial doubt about ourability to continue as a going concern.

 

***We have a history of operating losses and maynot be able to achieve long-term profitability.***

 

Since our inception in May 1989, we haveincurred substantial operating losses, and as of December 31, 2005, therewas substantial doubt about our ability to continue as a going concern. Duringthe six months ended December 31, 2005, we generated a net loss of$5,937,000. At December 31, 2005, we had an accumulated deficit of$103,583,000. There can be no assurance that our revenues will exceed ouroperating expenses and cost of revenues in the future.

 

***Dilution in ownership of our shares from theexercise or conversion of options, warrants, and convertible securities.***

 

There are a significant number of outstandingoptions, warrants, and convertible securities to acquire shares of our CommonStock and we may grant additional rights in the future. The holders of suchoptions, warrants, and convertible securities can be expected to exercise themat a time when our Common Stock is trading at a price higher than the exerciseprice of these outstanding options, warrants, and convertible securities. Ifthese options or warrants to purchase our Common Stock are exercised,convertible debt is converted or other equity interests are granted under our2001 or 2005 stock option plans or under other plans or agreements adopted inthe future, such equity interests will have a dilutive effect on your ownershipof Common Stock. The existence of such options, warrants, and convertiblesecurities may also adversely affect the terms on which we can obtainadditional financing.

 

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We intend to raise capital through offeringsof our Common Stock, securities convertible into our Common Stock, or rights toacquire such securities or our Common Stock. Such other rights to acquire ourCommon Stock may be issued at exercise prices or conversion rates that aresignificantly lower than the price at which you may have paid for our shares. Inaddition, the shares issuable upon exercise of certain of the warrants and uponconversion of our convertible debt may increase subject to anti-dilutiverights, which we granted to warrant and debt holders. We may also issue asignificant number of new options to purchase shares of our Common Stock, asthe number of authorized shares under our 2005 option plan was increased to30,000,000 by approval of the stockholders at our Annual Meeting on December 13,2005.

 

***New equity financings may result in a changein control of DynTek and may prevent our current stockholders from influencingsignificant corporate decisions.***

 

In the event we raise additional capitalthrough the sale of our Common Stock or securities convertible into shares ofour Common Stock, based upon the current market value of our Common Stock, wewill have to issue a significant number of shares to raise the capitalnecessary to fund current operations. In that case, the purchasers of suchshares or convertible securities may purchase enough shares to collectivelycontrol a majority of the voting power of our Common Stock, which would providesuch investors with the ability to control the election of our board ofdirectors and to control approval of other matters presented for considerationby our stockholders, including mergers, acquisitions, amendments to our charterand various corporate governance actions. Such new investors may have interestsdifferent than yours. The significant concentration of stock ownership mayadversely affect the trading price of our Common Stock due to investors’perception that conflicts of interest may exist or arise.

 

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**ITEM 4. SUBMISSION OF MATTERS TO A VOTE OFSECURITY HOLDERS**

 

Our Annual Meeting ofStockholders was held on December 13, 2005. At the Annual Meeting, therewas submitted to a vote of security holders the election of directors, anamendment to our Second Amended and Restated Certificate of Incorporation toauthorize our Board to effect a reverse stock split, an amendment to our SecondAmended and Restated Certificate of Incorporation to increase our authorizedcapital, an amendment to our 2005 Stock Incentive Plan to increase the numberof shares issuable under the plan, and ratification of our independentregistered public accounting firm. Proxies were solicited pursuant toRegulation 14A of the Securities Exchange Act of 1934. There was nosolicitation in opposition to the proposals listed in the proxy statement. 81,164,636share were outstanding. 60,864,660 shares voted.

 

Each director nominatedand all other proposals submitted to a vote passed, and the voting outcome ofeach proposal was as follows:

 

1.                                       Electionof the following four (4) directors to serve until the next annual meetingof stockholders or until their successors are elected and have qualified toserve as directors:

 
| **Name**                | ** ** | **For**    | ** ** | **Against or Withheld** | ** ** |
|-------------------------|------------|------------|------------|-------------------------|------------|
| Casper Zublin, Jr. |       | 59,448,824 |       | 1,415,836               |       |
| Robert I Webber         |       | 59,357,186 |       | 1,407,474               |       |
| Marshall Toplansky      |       | 59,448,739 |       | 1,415,921               |       |
| J. Michael Gullard      |       | 59,369,959 |       | 1,494,701               |       |

 

2.                                       Authorizationof the Board to amend our Second Amended and Restated Certificate ofIncorporation to effect a reverse stock split of the Company’s outstandingCommon Stock by a ratio of 1-for-10:

 

For:                           47,621,498                                          Against:  13,182,365                                      Abstain:  60,797

 

3.                                       Approvalof an amendment to the Company’s Second Amended and Restated Certificate ofIncorporation to increase the number of shares of our capital stock that theCompany would have the authority to issue from 160,000,000 shares to460,000,000 shares, and our Common Stock, $0.0001 par value per share, that theCompany would have authority to issue from 150,000,000 shares to 450,000,000shares:

 

For: 57,668,612               Against:  3,113,857                                            Abstain:  82,191

 

4.                                       Approvalof an amendment to the Company’s 2005 Stock Incentive Plan to (i) increasethe number of shares of Common Stock issuable thereunder by 25,000,000 shares,bringing the total number of shares issuable thereunder to 30,000,000, and (ii) increasethe total number of shares of Common Stock that may be acquired by any oneindividual pursuant to options or restricted stock awards granted under the2005 Stock Incentive Plan in any one calendar year from 1,500,000 shares to7,500,000 shares:

 

For:  30,574,605               Against:  3,351,415                                            Abstain:  286,998      BrokerNon-Vote:  26,651,642

 

5.                                       Ratificationof Marcum & Kliegman LLP as our independent registered publicaccounting firm for the fiscal year ending December 31, 2005:

 

For:                           60,144,404                                          Against:  612,000      Abstensions:  108,256

 

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| **ITEM 6.** |   | **EXHIBITS** |
|-------------|--------|--------------|

 

(a)          Exhibits.

 
| 31.1   |   | Certification  of Chief Executive Officer Pursuant to Rule 13a-14(d) / 15d-14(a) of  the Securities Exchange Act of 1934.                                 |
|--------|--------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                                     |
| 31.2   |   | Certification  of Chief Financial Officer Pursuant to Rule 13a-14(d) / 15d-14(a) of  the Securities Exchange Act of 1934.                                 |
|   |   |                                                                                                                                                                     |
| 32.1   |   | Certification  of Chief Executive Officer Pursuant to Rule 13a-14(b) / 15d-14(b) of  the Securities Exchange Act of 1934 and 18 U.S.C. Section 1350. |
|   |   |                                                                                                                                                                     |
| 32.2   |   | Certification  of Chief Financial Officer Pursuant to Rule 13a-14(b) / 15d-14(b) of  the Securities Exchange Act of 1934 and 18 U.S.C. Section 1350. |

 

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SIGNATURE

 

Pursuant to therequirements of the Securities Exchange Act of 1934, the registrant has dulycaused this report to be signed on its behalf by the undersigned, thereuntoduly authorized.

 

 
|   | DYNTEK, INC.                 |
|--------|------------------------------|
|   |                         |
|   |                         |
|   | By:                          |   | /s/ Casper Zublin, Jr. |   |
|   | Casper  Zublin, Jr.     |
|   | Chief  Executive Officer     |
|   |                         |
|   | Date: February 17, 2006 |

 

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**INDEX TO EXHIBITS**

 
| **Exhibit  Number** | ** ** | **Description**                                                                                                                                                          |
|---------------------|------------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 31.1                |       | Certification of Chief Executive Officer  Pursuant to Rule 13a-14(d) / 15d-14(a) of the Securities  Exchange Act of 1934.                                 |
|                |       |                                                                                                                                                                     |
| 31.2                |       | Certification of Chief Financial Officer  Pursuant to Rule 13a-14(d) / 15d-14(a) of the Securities  Exchange Act of 1934.                                 |
|                |       |                                                                                                                                                                     |
| 32.1                |       | Certification of Chief Executive Officer  Pursuant to Rule 13a-14(b) / 15d-14(b) of the Securities  Exchange Act of 1934 and 18 U.S.C. Section 1350. |
|                |       |                                                                                                                                                                     |
| 32.2                |       | Certification of Chief Financial Officer  Pursuant to Rule 13a-14(b) / 15d-14(b) of the Securities  Exchange Act of 1934 and 18 U.S.C. Section 1350. |

 

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