**UNITED STATES**

**SECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

 

**FORM 10-Q**

 
| **(Mark One)** |
|---------------------|
| ** **          |
| **ý**          | ** ** | **QUARTERLY REPORT PURSUANT TO SECTION 13 or 15(d) OF THE  SECURITIES EXCHANGE ACT OF 1934 FOR THE QUARTER ENDED APRIL 1, 2006** |
|                |   |   |
| **o**               | ** ** | **TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE  SECURITIES EXCHANGE ACT OF 1934** |

 

**Commission File Number**

**000-50080**

 

**SI International, Inc.**

(Exact name of registrant asspecified in its charter)

 

| **Delaware**                                                    | ** ** | **52-2127278**                        |
|-----------------------------------------------------------------|------------|---------------------------------------|
| (State or other jurisdiction of  incorporation or organization) |       | (I.R.S. Employer  Identification No.) |
|                                                            |       |                                  |
| **12012 Sunset Hills Road**                                     |       |                                  |
| **Reston. Virginia**                                            | ** ** | **20190-5869**                        |
| (Address of principal executive offices)                        |       | (Zip Code)                            |

 

Registrant’s telephone number, including area code: **(703) 234-7000**

 

----

 

Indicate by check mark whether the registrant (1) has filedall reports required to be filed by Section 13 or 15(d) of the SecuritiesExchange Act of 1934 during the preceding 12 months (or for such shorter periodthat the registrant was required to file such reports), and (2) has beensubject to such filing requirements for the past 90days.    ý  Yes    o  No

 

Indicate by check mark whether the registrant is a largeaccelerated filer, an accelerated filer, or a non-accelerated filer. Seedefinition of “accelerated filer and large accelerated filer” in Rule 12b 2 ofthe Exchange Act. (Check one):

 
| Large accelerated filer o |   | Accelerated filer ý |   | Non-accelerated filer o |
|---------------------------|--------|--------------------------|--------|-------------------------|

 

Indicate by check mark whether the registrant is a shellcompany (as defined in Rule 12b-2 of the Act.)    oYes  ý  No

 

As of May 1, 2006, 12,828,159 shares outstanding of the registrant’scommon stock.

 

 

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**SI INTERNATIONAL, INC.**

**FORM 10-Q**

# **INDEX**

 
| **PART I.**        | **FINANCIAL INFORMATION**                                                                                      | ** ** |
|--------------------|----------------------------------------------------------------------------------------------------------------|------------|
| ITEM 1             | Financial Statements                                                                                           |       |
|               | Consolidated Balance Sheets at April 1, 2006 (unaudited) and December  31, 2005                                |       |
|               | Consolidated Statements of Operations for the three months ended  April 1, 2006 and March 26, 2005 (unaudited) |       |
|               | Consolidated Statements of Cash Flows for the three months ended  April 1, 2006                                |       |
|               | and March 26, 2005 (unaudited)                                                                                 |       |
|               | Notes to Consolidated Financial Statements                                                                     |       |
| 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  1            | Legal  Proceedings                                                                                             |       |
| ITEM  1A.          | Risk  Factors                                                                                                  |       |
| ITEM 2             | Unregistered Sales of Equity Securities and Use of Proceeds                                                    |       |
| ITEM 3             | Defaults Upon Senior Securities                                                                                |       |
| ITEM 4             | Submission of Matters to a Vote of Security Holders                                                            |       |
| ITEM  5            | Other  Information                                                                                             |       |
| ITEM 6             | Exhibits                                                                                                       |       |
| Signatures         |                                                                                                           |
| Index  to Exhibits |                                                                                                           |

 

2

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## **PART I: FINANCIAL INFORMATION**

 

### **Item 1. Financial Statements**

 

**SIInternational, Inc. and Subsidiaries**

**ConsolidatedBalance Sheets**

**(Amountsin thousands, except share data)**

 
| ** **                                                                                                                                                                                                       | ** ** | **April 1,  2006** | ** ** | **December 31  2005** | ** ** |
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------------|------------|----------------------------|------------|
| ** **                                                                                                                                                                                                       | ** ** | **Unaudited**           | ** ** | ** **                 | ** ** |
| **Assets**                                                                                                                                                                                                       |       |                    |       |                       |       |
| **Current assets:**                                                                                                                                                                                              |       |                    |       |                       |       |
| Cash and cash equivalents                                                                                                                                                                                        |       | $                       | 13,256     |                       | $          | 26,160 |   |
| Marketable securities                                                                                                                                                                                            |       | —                  |       | 7,850                      |       |
| Accounts receivable, net                                                                                                                                                                                         |       | 89,790                  |       | 93,633                     |       |
| Deferred tax asset                                                                                                                                                                                               |       | 422                     |       | 422                        |       |
| Other current assets                                                                                                                                                                                             |       | 11,692                  |       | 6,276                      |       |
| Total current assets                                                                                                                                                                                             |       | 115,160                 |       | 134,341                    |       |
| **Property and equipment, net**                                                                                                                                                                                  |       | 6,304                   |       | 5,908                      |       |
| **Intangible assets, net**                                                                                                                                                                                       |       | 22,886                  |       | 16,483                     |       |
| **Other assets**                                                                                                                                                                                                 |       | 7,334                   |       | 5,655                      |       |
| **Goodwill**                                                                                                                                                                                                     |       | 220,440                 |       | 173,308                    |       |
| Total assets                                                                                                                                                                                                     |       | $                       | 372,124    |                       | $          | 335,695 |   |
| **Liabilities and stockholders’ equity**                                                                                                                                                                    |       |                    |       |                       |       |
| **Current liabilities:**                                                                                                                                                                                         |       |                    |       |                       |       |
| Current portion of long-term debt                                                                                                                                                                                |       | $                       | 1,293      |                       | $          | 1,000 |   |
| Accounts payable                                                                                                                                                                                                 |       | 15,773                  |       | 25,364                     |       |
| Accrued expenses and other current  liabilities                                                                                                                                                                  |       | 28,482                  |       | 29,674                     |       |
| Note payable – former owner of acquired  business                                                                                                                                                           |       | 2,280                   |       | 2,280                      |       |
| Total current liabilities                                                                                                                                                                                        |       | 47,828                  |       | 58,318                     |       |
| **Long-term debt, net of current portion**                                                                                                                                                                       |       | 127,634                 |       | 98,250                     |       |
| **Note payable—former owner of acquired  business**                                                                                                                                                         |       | 5,517                   |       | —                     |       |
| **Deferred income tax**                                                                                                                                                                                          |       | 6,173                   |       | 5,221                      |       |
| **Other long-term liabilities**                                                                                                                                                                                  |       | 7,424                   |       | 6,037                      |       |
| **Stockholders’ equity:**                                                                                                                                                                                   |       |                    |       |                       |       |
| **Common stock—**$0.01  par value per share; 50,000,000 shares authorized; 11,592,669 and 11,341,222  shares issued and outstanding as of April 1, 2006 and  December 31, 2005, respectively |       | 116                     |       | 114                        |       |
| Additional paid-in capital                                                                                                                                                                                       |       | 138,953                 |       | 133,843                    |       |
| Accumulated other comprehensive income                                                                                                                                                                           |       | 253                     |       | —                     |       |
| Retained earnings                                                                                                                                                                                                |       | 38,226                  |       | 33,912                     |       |
| Total stockholders’ equity                                                                                                                                                                                  |       | 177,548                 |       | 167,869                    |       |
| Total liabilities and stockholders’ equity                                                                                                                                                                  |       | $                       | 372,124    |                       | $          | 335,695 |   |

 

***See accompanying notes***

 

3

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**SIInternational, Inc. and Subsidiaries**

**ConsolidatedStatements of Operations**

**(Amountsin thousands, except per share data)**

**Unaudited**

 
| ** **                                  | ** ** | **Three Months Ended** | ** ** |
|---------------------------------------------|------------|----------------------------------|------------|
| ** **                                  | ** ** | **April 1,  2006**          | ** ** | **March 26,  2005** | ** ** |
|                                        |       |                             |       |   |   |
| Revenue                                     |       | $                                | 107,232    |   | $ | 83,717 |   |
| Costs and expenses:                         |       |                             |       |   |   |
| Direct costs                                |       | 66,609                           |       | 52,603 |   |
| Indirect costs                              |       | 30,546                           |       | 23,580 |   |
| Depreciation and amortization               |       | 548                              |       | 551 |   |
| Amortization of intangible assets           |       | 647                              |       | 457 |   |
| Total operating expenses                    |       | 98,350                           |       | 77,191 |   |
| Income from operations                      |       | 8,882                            |       | 6,526 |   |
| Other income (expense)                      |       | 30                               |       | (99 | ) |
| Interest expense                            |       | (1,782                           | )          | (1,097 | ) |
| Income before provision for income taxes    |       | 7,130                            |       | 5,330 |   |
| Provision for income taxes                  |       | 2,816                            |       | 2,106 |   |
| Net income                                  |       | $                                | 4,314      |   | $ | 3,224 |   |
|                                        |       |                             |       |   |   |
| Earnings per common share:                  |       |                             |       |   |   |
| Basic net income per common share           |       | $                                | 0.38       |   | $ | 0.29 |   |
| Diluted net income per common share         |       | $                                | 0.36       |   | $ | 0.28 |   |
|                                        |       |                             |       |   |   |
| Basic weighted-average shares outstanding   |       | 11,422                           |       | 11,063 |   |
| Diluted weighted-average shares outstanding |       | 11,899                           |       | 11,627 |   |

 

***See accompanying notes***

 

4

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**SIInternational, Inc. and Subsidiaries**

**ConsolidatedStatements of Cash Flows**

**(Amountsin thousands)**

**Unaudited**

 
| ** **                                                                                   | ** ** | **Three Months Ended** | ** ** |
|----------------------------------------------------------------------------------------------|------------|----------------------------------|------------|
| ** **                                                                                   | ** ** | **April 1,  2006**          | ** ** | **March 26,  2005** | ** ** |
| **Cash flows from operating activities:**                                                    |       |                             |       |   |   |
| Net income                                                                                   |       | $                                | 4,314      |   | $ | 3,224 |   |
| Adjustments to reconcile net income to net  cash provided by (used in) operating activities: |       |                             |       |   |   |
| Depreciation and amortization                                                                |       | 548                              |       | 551 |   |
| Amortization of intangible assets                                                            |       | 647                              |       | 457 |   |
| Stock-based compensation                                                                     |       | —                           |       | 32 |   |
| Change in fair value of interest rate swap                                                   |       | 253                              |       | — |   |
| Amortization of deferred financing costs                                                     |       | 194                              |       | 120 |   |
| Changes in operating assets and  liabilities, net of effect of acquisitions:                 |       |                             |       |   |   |
| Accounts receivable, net                                                                     |       | 14,465                           |       | 1,699 |   |
| Other current assets                                                                         |       | (4,790                           | )          | (976 | ) |
| Other assets                                                                                 |       | (1,389                           | )          | (454 | ) |
| Accounts payable and accrued expenses                                                        |       | (16,734                          | )          | 4,108 |   |
| Other long term liabilities                                                                  |       | 2,397                            |       | 732 |   |
| Net cash provided by (used in) operating  activities                                         |       | (95                              | )          | 9,493 |   |
| **Cash flows from investing activities:**                                                    |       |                             |       |   |   |
| Purchase of property and equipment                                                           |       | (461                             | )          | (172 | ) |
| Proceeds from sale of marketable securities                                                  |       | 7,850                            |       | 2,000 |   |
| Former owner payable                                                                         |       | (8,042                           | )          | — |   |
| Cash paid for business acquisitions, net of  cash assumed                                    |       | (45,943                          | )          | (71,288 | ) |
| Net cash used in investing activities                                                        |       | (46,596                          | )          | (69,460 | ) |
| **Cash flows from financing activities:**                                                    |       |                             |       |   |   |
| Proceeds from exercise of stock options                                                      |       | 3,734                            |       | 678 |   |
| Income tax benefit for stock option  exercises                                               |       | 880                              |       | — |   |
| Repayments under line of credit                                                              |       | —                           |       | (28,954 | ) |
| Proceeds from long-term debt                                                                 |       | 30,000                           |       | 100,000 |   |
| Repayments of long-term debt                                                                 |       | (323                             | )          | — |   |
| Payments of debt issuance costs                                                              |       | (476                             | )          | (3,160 | ) |
| Repayments of capital lease obligations                                                      |       | (28                              | )          | (25 | ) |
| Net cash provided by financing activities                                                    |       | 33,787                           |       | 68,539 |   |
| **Net change in cash and cash equivalents**                                                  |       | (12,904                          | )          | 8,572 |   |
| **Cash and cash equivalents, beginning of  period**                                          |       | 26,160                           |       | 3,754 |   |
| **Cash and cash equivalents, end of period**                                                 |       | $                                | 13,256     |   | $ | 12,326 |   |
| **Supplemental disclosures of cash flow  information:**                                      |       |                             |       |   |   |
| Cash payments for interest                                                                   |       | $                                | 1,791      |   | $ | 296 |   |
| Cash payments for income taxes                                                               |       | $                                | 1,915      |   | $ | 41 |   |

 

***See accompanying notes***

 

5

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**SIInternational, Inc. and Subsidiaries**

 

**Notesto consolidated financial statements**

**(Unaudited)**

 

**1.****             Basisof Presentation**

 

The accompanying unaudited consolidated financialstatements of SI International, Inc. and its subsidiaries have been prepared inaccordance with accounting principles generally accepted in the United Statesfor interim financial information and with the instructions to Form 10-Qand Article 10 of Regulation S-X. Accordingly, they do not includeall of the information and footnotes required by accounting principlesgenerally accepted in the United States for complete financial statements. Inthe opinion of management, all adjustments (consisting of normal recurringaccruals) considered necessary for a fair presentation have been included.Operating results for the quarter ended April 1, 2006 are not necessarilyindicative of the results that may be expected for the year ending December 30,2006. For further information, refer to the financial statements and footnotesincluded in SI International’s Annual Report on Form 10-K for the yearended December 31, 2005. References to the “Company,” “we,” “us” and “our”refer to SI International, Inc. and its subsidiaries.

 

**2.****             Summaryof significant accounting policies:**

 

**Principles of consolidation**

 

The accompanying consolidated financial statementsinclude the accounts of the Company and its wholly owned subsidiaries. Allsignificant intercompany transactions and accounts have been eliminated inconsolidation.

 

**Use of estimates**

 

The preparation of financial statements inconformity with accounting principles generally accepted in the United Statesrequires management to make estimates and assumptions that affect the reportedamounts of assets and liabilities and disclosure of contingent assets andliabilities at the date of the financial statements and the reported amounts ofrevenues and expenses during the reporting period. Actual results could differfrom those estimates.

 

**Reporting periods**

 

The Company’s fiscal year is based on the calendaryear and ends each year on the Saturday nearest, but not falling after, December31 of that year. As a result, our fiscal year may be comprised of 52 or 53weeks. Typically, fiscal quarters also end on the Saturday nearest, but not fallingafter, the end of the calendar quarter. However, we will end those fiscalquarters presented in our Forms 10-Q (the first three fiscal quarters) on theSaturday which provides us with a 13 week quarter even if that Saturday fallsafter the end of the calendar quarter. As a result, in the future, if ourfiscal year comprises 53 weeks, the first three quarters shall each becomprised of 13 weeks and the fourth quarter shall be comprised of 14 weeks.

 

As a result of this policy, we ended our firstquarter on April 1, 2006 to provide us with a 13 week quarter.

 

**Cash and cash equivalents**

 

We consider cash on deposit and all highly liquidinvestments with original maturities of three months or less to be cash andcash equivalents.

 

**Revenue Recognition**

 

Our accounting policy regarding revenue recognitioncomplies with the following criteria: (1) a contract has been executed; (2) the contract price is fixed anddeterminable; (3) delivery of services or products has occurred; and (4)collectibility is considered probable and can be reasonably estimated. Compliancewith these criteria may require us to make significant judgments and estimates.

 

6

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**Significant customers**

 

Revenue generated from contracts with theFederal government or prime contractors doing business with the Federalgovernment accounted for a significant percent of revenues in the fiscalquarters ending April 1, 2006 and March 26, 2005.

 
| ** **                 | ** ** | **Three Months Ended** | ** ** |
|----------------------------|------------|------------------------|------------|
| ** **                 | ** ** | **April 1,  2006**     | ** ** | **March 26,  2005** | ** ** |
|                       |       |                   |       |   |   |
| Department  of Defense     |       | 48.0                   | %          | 49.0 | % |
| Federal  civilian agencies |       | 50.2                   |       | 48.9 |   |
| Commercial  entities       |       | 1.8                    |       | 2.1 |   |
| Total revenue              |       | 100.0                  | %          | 100.0 | % |

 

For the three months ended April 1, 2006 and March26, 2005, we had one contract that generated more than 10% of our revenue. Forthe three months ended April 1, 2006 and March 26, 2005, our C4I2TSR contractwith the U.S. Air Force Space Command represented approximately 19.3% and 17.9%of our revenue, respectively.

 

**Deferred financing costs**

 

Costs incurred in establishing our credit facilityare deferred and amortized as interest expense over the term of the relateddebt using the effective interest method. These deferred costs are reflected asa component of other assets in the accompanying consolidated balance sheets.The deferred financing costs consist of the following (in thousands):

 
| ** **                | ** ** | **April 1,  2006** | ** ** | **December 31,  2005** | ** ** |
|---------------------------|------------|--------------------|------------|-----------------------------|------------|
| Deferred  loan costs      |       | $                  | 5,451      |                        | $          | 4,975 |   |
| Accumulated  amortization |       | (1,736             | )          | (1,542                      | )          |
|                      |       | $                  | 3,715      |                        | $          | 3,433 |   |

 

**Intangible assets**

 

Intangible assets from acquisitions, which consistprimarily of contractual customer relationships, are amortized utilizing anaccelerated method over 6 to 14 years, based on their estimated useful lives. Theaccumulated amortization of intangible assets is $3.6 million and $3.0 million,respectively, as of April 1, 2006 and December 31, 2005. Amortization expenseis estimated to be $3.1 million, $2.8 million, $2.5 million, $2.2 million and$2.2 million for the years 2006, 2007, 2008, 2009 and 2010, respectively.

 

**Fair value of financial instruments**

 

The Company’s financial instruments consistprimarily of cash and cash equivalents, accounts receivable, accounts payable,credit facilities, and notes payable. In management’s opinion, the carryingamounts of these financial instruments approximate their fair values at April 1,2006 and December 31, 2005.

 

**Stock-based compensation**

 

Effective January 1, 2006, the Company adopted theprovisions of SFAS No. 123R using the modified prospective transition method. Dueto the use of the modified prospective method, prior interim periods and fiscalyears will not reflect any restated amounts. As disclosed in the stock optionplans, the Company accelerated the vesting of unvested stock options previouslyawarded to employees, officers and directors in December 2005. The Company hadno unvested stock options on January 1, 2006. The Company issued insignificantstock options in the quarter ended April 1, 2006. Accordingly, no stockcompensation expense was recognized during the first quarter.

 

7

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Prior to the adoption of SFAS No. 123R, the Companyaccounted for stock-based compensation using the intrinsic value method prescribedin APB Opinion No. 25 and related interpretations. Accordingly, compensationexpense for stock options was measured as the excess, if any, of the fairmarket value of the Company’s stock at the date of the grant over the exerciseprice of the related option. The following table illustrates the effect on netincome and earnings per share if the compensation costs for the Company’s stockoptions had been determined based on SFAS No. 123.

 
| ** **                                                                                                                              | ** ** | **Three Months Ended** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------|------------|----------------------------------|------------|
| ** **                                                                                                                              | ** ** | **April 1,**                | ** ** | **March 26,** | ** ** |
| ** **                                                                                                                              | ** ** | **2006**                         | ** ** | **2005** | ** ** |
|                                                                                                                                    |       |                             |       |   |   |
| Net income - as reported                                                                                                                |       | $                                | 4,314      |   | $ | 3,224 |   |
|                                                                                                                                    |       |                             |       |   |   |
| Add: total stock-based employee  compensation expense as reported under intrinsic value method (APB No. 25)  for all awards, net of tax |       | —                           |       | 19 |   |
|                                                                                                                                    |       |                             |       |   |   |
| Deduct: Total stock-based compensation expense  determined under fair value based method (SFAS No. 123) for all awards, net  of tax     |       | —                           |       | (642 | ) |
|                                                                                                                                    |       |                             |       |   |   |
| Net income - pro forma                                                                                                                  |       | 4,314                            |       | 2,601 |   |
|                                                                                                                                    |       |                             |       |   |   |
| Basic earnings per share - as reported                                                                                                  |       | 0.38                             |       | 0.29 |   |
|                                                                                                                                    |       |                             |       |   |   |
| Diluted earnings per share - as reported                                                                                                |       | 0.36                             |       | 0.28 |   |
|                                                                                                                                    |       |                             |       |   |   |
| Basic earnings per share - pro forma                                                                                                    |       | 0.38                             |       | 0.24 |   |
|                                                                                                                                    |       |                             |       |   |   |
| Diluted earnings per share - pro forma                                                                                                  |       | 0.36                             |       | 0.22 |   |
|                                                                                                                                         |            |                                  |            |  |  |  |  |

 

The fair value of each option is estimated on thedate of grant using the Black-Scholes option-pricing model with the followingassumptions used for grants during the fiscal periods ended April 1, 2006and March 26, 2005:

 
| ** **                      | ** ** | **Fiscal Year**        | ** ** |
|---------------------------------|------------|-----------------------------|------------|
| ** **                      | ** ** | **April 1, 2006** | ** ** | **Mar. 26, 2005** | ** ** |
| Risk-free interest rate         |       | 4.72                        | %          | 4.00 | % |
| Expected life of options        |       | 5 years                     |       | 7 years |   |
| Expected stock price volatility |       | 44                          | %          | 50 | % |
| Expected dividend yield         |       | 0                           | %          | 0 | % |

 

The risk-free interest is based on U.S. Treasuryyields in effect at the time of grant over the expected term of the option. Theexpected life of options is derived from the Company’s historical optionexercise data. The expected stock price volatility is based on the historicalvolatility of the Company’s common stock.

 

As of April 1, 2006, the total remainingunrecognized compensation expense related to unvested options was $0.2 millionwhich will be recognized over the weighted average period of 4 years.

 

Prior to the adoption of SFAS No. 123R, the Companypresented all tax benefits related to the exercise of stock options asoperating cash flows in the consolidated statement of cash flows. SFAS No. 123Rrequires the cash flows resulting from the tax benefits generated from taxdeductions in excess of the compensation costs recognized for those options tobe classified as financing cash flows.

 

8

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**Earnings per share**

 

Basic earnings per share is computed by dividingreported earnings available to common stockholders by the weighted averagenumber of shares outstanding without consideration of common stock equivalentsor other potentially dilutive securities. Diluted earnings per share giveseffect to common stock equivalents and other potentially dilutive securitiesoutstanding during the period.

 

The following details the computation of net income per common share(in 000s):

 
| ** **                                  | ** ** | **Three Months Ended** | ** ** |
|---------------------------------------------|------------|----------------------------------|------------|
| ** **                                  | ** ** | **April 1,  2006**          | ** ** | **March 26,  2005** | ** ** |
|                                        |       |                             |       |   |   |
| Net Income – Basic and Diluted         |       | $                                | 4,314      |   | $ | 3,224 |   |
|                                        |       |                             |       |   |   |
| **Weighted average share calculation:**     |       |                             |       |   |   |
|                                        |       |                             |       |   |   |
| Basic weighted average shares outstanding   |       | 11,422                           |       | 11,063 |   |
| Treasury stock effect of stock options      |       | 477                              |       | 564 |   |
|                                        |       |                             |       |   |   |
| Diluted weighted average shares outstanding |       | 11,899                           |       | 11,627 |   |
|                                             |            |                                  |            |  |  |  |  |

 

**Reclassifications**

 

Certain prior year balances have beenreclassified to conform to the presentation of the current year.

 

**New accounting pronouncements**

 

InDecember 2004, the FASB issued FASB StatementNo. 123(R) (revised 2004), *Share Based Payment.*Statement 123(R) addresses the accounting for share-based paymenttransactions in which an enterprise receives employee services in exchange for(a) equity instruments of the enterprise or (b) liabilities that arebased on the fair value of the enterprise’s equity instruments or that may besettled by the issuance of such equity instruments. Statement123(R) requires an entity to recognize the grant-date fair-value of stockoptions and other equity-based compensation issued to employees in the incomestatement. The revised Statement generally requires an entity account for thosetransactions using the fair-value-based method, and eliminates the intrinsicvalue method of accounting in APB Opinion No. 25, *Accountingfor Stock Issued to Employees*, which was permitted under Statement123, as originally issued. The revised Statement requires entities to discloseinformation about the nature of the share-based payment transactions and theeffects of those transactions on the financial statements. Statement123(R) is effective for the Company as of its fiscal year beginningJanuary 1, 2006. All public companies must use either the modified prospectiveor the modified retrospective transition method.

 

EffectiveJanuary 1, 2006, the Company adopted the provisions of SFAS No. 123R using themodified prospective transition method. Since the Company accelerated unvestedstock options previously awarded to employees, officers and directors onDecember 13, 2005, no stock compensation expense was recognized as of April 1,2006. However, had we adopted Statement 123(R) in prior periods, the impact ofthat standard would have approximated the impact of Statement 123 as describedin the disclosure of pro forma net income and earnings per share in theStock-Based Compensation section of this note to our consolidated financialstatements. Statement 123(R) also requires the benefits of tax deductions inexcess of recognized compensation cost to be reported as a financing cash flow,rather than as an operating cash flow as required under current literature.This requirement will reduce net operating cash flows and increase netfinancing cash flows in periods after adoption.

 

InJuly 2005, the FASB issued an Exposure Draft of a proposed Interpretation, *Accounting for Uncertain Tax Positions – anInterpretation of FASB Statement No. 109*. The proposedInterpretation (if adopted in its current form) would apply to all open taxpositions accounted for in accordance with FAS 109, *Accounting for Income Taxes,* including those acquired in

 

9

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business combinations. Underthe proposed Interpretation, the recognition of a tax benefit would occur whenit is “probable” that the position would be sustained upon audit. As a resultof comment letters received, the Board decided to change the threshold forinitial recognition to "more-likely-than-not". The proposedInterpretation would be effective as of the first annual period beginning afterDecember 15, 2006. It is not certain that the Interpretation will be adoptedwith the current effective date. Management is in the process of determiningthe effect of this proposal on its financial statements.

 

**3.****             Acquisitions:**

 

On February 27, 2006, we closed the acquisition ofZen Technology, Inc., or Zen, a Virginia corporation pursuant to a StockPurchase Agreement dated February 8, 2006 (the “Zen Agreement”). Zen is aprovider of critical IT services, specializing in managed network services,information assurance, software development and systems engineering, databaseand systems administration and IT consulting to various U.S. Governmentagencies.  Zen’s largest clients include the Missile Defense Agency (MDA),Department of Defense’s Washington Headquarters Services (WHS), FederalCommunications Commission (FCC), the Pension Benefit Guaranty Corporation(PBGC), and the Federal Trade Commission (FTC).

 

Pursuant to the terms of the Zen Agreement weacquired all of the outstanding capital stock of Zen for $60 million in cash,of which we are withholding $6 million for 15 months in order to securepost-closing indemnity obligations of the sellers. The amount of imputedinterest on the Zen Note Payable is approximately $.5 million. The purchaseprice is subject to a two-way adjustment based upon whether the working capitalof Zen as of the closing date was above or below the target working capitalspecified in the Zen Agreement. Each of the parties to the Zen Agreement hasmade customary representations and warranties and agreed to certainindemnification obligations. The transaction was funded through cash-on-hand, asubordinated Seller’s Note in the amount of $6 million, and borrowing from ournewly amended credit facility, which is described below. The purchase price isalso subject to adjustment as a result of certain tax elections. Zen’s trailingtwelve months revenue ended November 30, 2005, was approximately $38 million(unaudited).

 

Approximately $47.5 million of the purchaseconsideration has been allocated to goodwill based primarily on the excess ofthe purchase price over the estimated fair value of net assets acquired andapproximately $6.9 million and $0.2 million of the purchase price has beenassigned to identifiable Intangible assets of contractual customerrelationships and non-compete agreements, respectively. Each customerrelationship, which includes each customer’s contract, is being amortized on anaccelerated basis over its useful life of 9 years. The non-compete agreementsare amortized on a straight-line basis over a 3-year period.

 

The total purchase price paid, including transactioncosts of $0.5 million, has been preliminarily allocated as follows (inthousands):

 
| Cash and cash equivalents              |   | 2,542   |   |
|----------------------------------------|--------|---------|--------|
| Accounts  receivable                   |   | 10,623  |   |
| Other  current assets                  |   | 128     |   |
| Property and  equipment                |   | 491     |   |
| Accounts  payable and accrued expenses |   | (12,661 | )      |
| Other long  term liabilities           |   | (41     | )      |
| Intangible  assets                     |   | 7,050   |   |
| Goodwill                               |   | 47,535  |   |
| Total  consideration                   |   | 55,667  |   |

 

Similarly,in the first quarter of 2005, we completed the purchase of ShenandoahElectronic Intelligence, Inc. (SEI). SEI provides critical businessprocess outsourcing primarily for the Department of Homeland Security (DHS),including services such as: data and records management; applicationsprocessing; file and mail management; analytical support services; and secureoptical card processing.

 

OnFebruary 9, 2005, the acquisition of SEI closed pursuant to the terms of thedefinitive stock purchase agreement. The purchase price was $75 million incash, subject to certain adjustments totaling approximately $0.6 million. Aswith the

 

10

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acquisition of Zen, the SEItransaction was funded through cash-on-hand and borrowings under the CreditAgreement. The purchase price was subject to adjustment as a result of certaintax elections under Section 338(h)(10) of the tax code. The definitive stockpurchase agreement also provided that the SEI stockholders retained certainnon-operating assets and contingent accounts receivable.

 

Approximately$52.6 million of the purchase consideration has been allocated to goodwillbased primarily on the excess of the purchase price over the estimated fairvalue of net assets acquired, and approximately $12.2 million of the purchaseprice has been assigned to identifiable intangible assets on the basis ofcontractual customer relationships. The contractual customer relationships arebeing amortized using an accelerated method over their estimated remaining lifeof 14 years.

 

Thefollowing unaudited proforma combined condensed statements of operations (inthousands, except per share) set forth the consolidated results of operationsof the Company for the three months ended April 1, 2006 and March 26,2005 as if the above described acquisitions had occurred at the beginning ofeach period presented. This unaudited proforma information does not purport tobe indicative of the actual financial position or the results that wouldactually have occurred if the combination had been in effect for the threemonths ended April 1, 2006 and March 26, 2005.

 
| ** **                  | ** ** | **Three Months Ended** | ** ** |
|-----------------------------|------------|------------------------|------------|
| ** **                  | ** ** | **April 1, 2006**      | ** ** | **March 26, 2005** | ** ** |
| Revenue                     |       | $                      | 114,701    |   | $ | 100,971 |   |
| Net income                  |       | $                      | 4,362      |   | $ | 3,542 |   |
| Diluted  earnings per share |       | $                      | 0.37       |   | $ | 0.30 |   |

 

Inaccordance with the purchase accounting method, the operations of the SEI andZen have been included in the Company’s statement of operations since theirrespective dates of acquisition.

 

**4.****             Accountsreceivable:**

 

Accounts receivable consists of the following(in thousands):

 
| ** **                                                                                         | ** ** | **April 1, 2006** | ** ** | **December 31, 2005** | ** ** |
|----------------------------------------------------------------------------------------------------|------------|-------------------|------------|-----------------------|------------|
|                                                                                               |       |              |       |                  |       |
| Billed accounts receivable                                                                         |       | $                 | 41,518     |                  | $          | 47,939 |   |
| Unbilled accounts receivable:                                                                      |       |              |       |                  |       |
| Currently billable                                                                                 |       | 42,409            |       | 40,094                |       |
| Unbilled retainages and milestone payments expected  to be billed within the next 12 months        |       | 5,807             |       | 5,546                 |       |
| Indirect costs incurred and charged to  cost-plus contracts in excess of provisional billing rates |       | 1,544             |       | 1,563                 |       |
| Total unbilled accounts receivable                                                                 |       | 49,760            |       | 47,203                |       |
| Allowance for doubtful accounts                                                                    |       | (1,488            | )          | (1,509                | )          |
| Accounts receivable, net                                                                           |       | $                 | 89,790     |                  | $          | 93,633 |   |

 

The currently billable amounts included asunbilled accounts receivable as of April 1, 2006 represent amounts that arebilled during the following quarter of the current year. They are billings forservices rendered prior to quarter-end, which are billed once necessary billingdata has been collected and an invoice is produced.

 

11

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**5.****             Propertyand equipment:**

 

Property and equipment consist of thefollowing (in thousands):

 
| ** **                                           | ** ** | **April 1, 2006** | ** ** | **December 31, 2005** | ** ** |
|------------------------------------------------------|------------|-------------------|------------|-----------------------|------------|
| Computers  and equipment                             |       | $                 | 9,163      |                  | $          | 8,691 |   |
| Software                                             |       | 2,723             |       | 2,623                 |       |
| Furniture  and fixtures                              |       | 2,528             |       | 2,356                 |       |
| Leasehold  improvements                              |       | 2,169             |       | 1,581                 |       |
|                                                 |       | 16,583            |       | 15,251                |       |
| Less—Accumulated  depreciation and amortization |       | (10,279           | )          | (9,343                | )          |
| Property and  equipment, net                         |       | $                 | 6,304      |                  | $          | 5,908 |   |

 

Property and equipment includes assets financedunder capital lease obligations of approximately $243,000 and $273,000, net of accumulatedamortization, as of April 1, 2006 and December 31, 2005, respectively.

 

**6.****             Accruedexpenses and other current liabilities:**

 

Accrued expenses and other currentliabilities consist of the following (in thousands):

 
| ** **                                      | ** ** | **April 1,  2006** | ** ** | **December 31,  2005** | ** ** |
|-------------------------------------------------|------------|-------------------------|------------|-----------------------------|------------|
| Accrued vacation                                |       | $                       | 7,185      |                        | $          | 6,183 |   |
| Accrued compensation                            |       | 11,125                  |       | 9,638                       |       |
| Accrued bonus                                   |       | 962                     |       | 6,755                       |       |
| Other accrued liabilities                       |       | 9,210                   |       | 7,098                       |       |
| Accrued expenses and other current  liabilities |       | $                       | 28,482     |                        | $          | 29,674 |   |

 

**7.****             Debt:**

 

Debt consists of the following (in thousands):

 
| ** **                                                                                                                                                                                                                                                                                                                                                        | ** ** | **April 1,  2006** | ** ** | **December 31,  2005** | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------------|------------|-----------------------------|------------|
| Credit facilities:                                                                                                                                                                                                                                                                                                                                                |       |                    |       |                        |       |
| Line of credit bears interest at LIBOR plus  200 to 275 base points or a specified base rate plus 100 to 175 basis points,  interest due monthly, principal due February 9, 2010                                                                                                                                                                             |       | $                       | —     |                        | $          | — |   |
| Term loan, pursuant to the First Amendment,  as of April 1, 2006 bears interest at LIBOR plus 200 basis points or a  specified base rate plus 100 basis points, with twenty-one consecutive  quarterly principal and interest payments of $323,125 starting on March 31,  2006, with the unpaid principal of $122.8 million payment due on  February 9, 2011 |       | 128,927                 |       | 99,250                      |       |
| Total debt*                                                                                                                                                                                                                                                                                                                                                       |       | $                       | 128,927    |                        | $          | 99,250 |   |

 

----

*       Excludes approximately $8.3 million notepayable in connection with the Bridge and Zen acquisitions as described below.

 

On February 9, 2005, contemporaneously with theclosing of our acquisition of SEI, the Company entered into an Amended and RestatedCredit Agreement (the “Credit Agreement”) which increased its borrowing capacityto $160 million, which is comprised of a $60 million five-year revolving creditfacility and a $100 million six-year term loan facility. Additionally, theCredit Agreement provides that up to an additional $75 million in uncommittedincremental term loan funds are available to the Company upon its request atany time for up to two years from one or more of the lenders under the CreditAgreement. The annual maturity of long-term debt under the Credit Agreement was$1.0 million for each of the five fiscal years subsequent toDecember 31, 2005 and approximately $94.3 million thereafter.

 

12

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On February 27, 2006, contemporaneously with ourclosing the acquisition of Zen, we entered into a First Amendment to the CreditAgreement (the “First Amendment” together with the Credit Agreement the “AmendedCredit Agreement”). The funds borrowed under the First Amendment were used to(i) refinance the approximately $99.3 million in principal outstanding underthe then existing term loan under the Credit Agreement and to pay any and allfees and expenses related thereto; (ii) to finance the acquisition of Zen andpay any and all fees and expenses related thereto; and (iii) to provide forworking capital expenditures, and other general corporate uses.

 

The Company had approximately $129.3 million ofoutstanding long-term debt under our Amended Credit Agreement onFebruary 27, 2006 following the closing of our acquisition of Zen. TheCompany is required to repay $323,125 in consecutive quarterly paymentsstarting from March 31, 2006 through December 31, 2010, and a finalpayment of approximately $122.8 million on February 9, 2011. As with theprevious credit facilities, the Company is required to maintain compliance withfinancial and non-financial covenants including, maintaining certain leverageand fixed charge ratios, as well as certain annual limits on our capitalexpenditures. As of April 1, 2006, the Company was compliant with the financialcovenants under the Amended Credit Agreement.

 

In connection with the Credit Agreement, the Companyhad incurred approximately $3.2 million financing costs. With respect tothe First Amendment, the Company incurred approximately $0.5 million infinancing costs. Such costs associated with the Credit Agreement werecapitalized as deferred financing costs on the balance sheet and amortized overthe six year term of the Credit Agreement. Such costs associated with the FirstAmendment are being amortized over five year term of the First Amendment.

 

At the time the Company borrows funds under the AmendedCredit Agreement, it may choose from two interest rate options. The Company mayelect to have the borrowings bear interest at floating rates equal to LIBORplus a spread ranging from 200 to 275 basis points or an alternative base rateplus a spread ranging from 100 to 175 basis points. Under either the LIBOR oralternative base rate option, the exact interest rate spread will be determinedbased upon the Company’s leverage ratio as defined in the Amended CreditAgreement.

 

The Company entered into an Underwriting Agreementwith Wachovia Capital Markets, LLC (“Wachovia”) dated as of April 4, 2006. Underthe terms of the Underwriting Agreement, on April 4, 2006, SI Internationalissued and sold to Wachovia 1,200,000 shares of Company common stock, par value$0.01 per share.

 

With respect to the common stock issued and soldpursuant to the Underwriting Agreement, the Company registered the common stockby filing with the Securities and Exchange Commission a Registration Statementon Form S-3 (No. 333-113827) under the Securities Act of 1933. The publicoffering price for the common stock was $34.00 per share, and the Companyreceived proceeds from the sale of approximately $40.5 million after underwritingdiscounts and commission, but before other expenses relating to the sale. TheCompany used the net proceeds from the sale to pay down outstanding term debtunder the First Amendment.

 

The estimated amount of deferred loan originationfees to be written off in the second quarter 2006 are anticipated to beapproximately $1.0 million.

 

The Company also has outstanding a note payable inthe amount of $2.3 million, to be paid in June, 2006 for the acquisitionof Bridge, and a note payable in the amount of $6.0 million, to be paid in May,2007 for the acquisition of Zen. The amount of imputed interest in the Zen NotePayable is approximately $0.5 million.

 

**8.****             Commitmentsand contingencies:**

 

**Leases**

 

As of April 1, 2006, the Company has noncancelableoperating leases, primarily for real estate, that expire over the next sevenyears. Rental expense during the quarter ended April 1, 2006 was approximately $2.1million, compared to rental expense of approximately $1.9 million during thequarter ended March 26, 2005.

 

13

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**Contract cost audits**

 

Payments to the Company on government costreimbursable contracts are based on provisional, or estimated indirect rates,which are subject to audit on an annual basis by the Defense Contract AuditAgency (DCAA). The cost audits result in the negotiation and determination ofthe final indirect cost rates that the Company may use for theperiod(s) audited. The final rates, if different from the provisionalrates, may create an additional receivable or liability for the Company. TheCompany’s revenue recognition policy calls for revenue recognized on all costreimbursable government contracts to be recorded at actual rates unlesscollectibility is not reasonably assured. To the extent the indirect ratedifferential creates a liability for the Company, the differential isrecognized as a reduction to revenue when identified.

 

**Litigation and claims**

 

We are a party to litigation and legal proceedingsthat we believe to be a part of the ordinary course of our business. While wecannot predict the ultimate outcome of these matters, we currently believe thatany ultimate liability arising out of these proceedings will not have amaterial adverse effect on our financial position. We may become involved inother legal and governmental, administrative or contractual proceedings in thefuture.

 

The SEI acquisition agreement provides for apurchase price adjustment based upon the working capital of SEI as of theclosing date.  Subsequent to the closing date, we received a payment of$1.6 million in connection with services performed prior to the closing datethat SEI had not previously billed, and was not authorized to bill, itscustomer as of the closing date.  The SEI selling stockholders have assertedthat they are entitled to a credit in connection with the calculation ofworking capital adjustment in an amount equal to the amount received by us forthis post-closing payment.  We believe that, in accordance with GAAP, theSEI selling stockholders should not receive the benefit of the post-closingpayment.  In accordance with the terms of the SEI acquisition agreement,the parties have jointly submitted the issue to an independent accounting firmfor resolution.  We anticipate that this matter will be resolved beforethe end of 2006.

 

**9.****            ****Stockholders’ equity:**

 

**Stock option plans**

 

In 2002, the Company adopted the 2002 StockIncentive Plan, or the Plan, to grant stock options to purchase up to 1,600,000shares of its common stock to its employees and employees of its affiliates. InMarch 2004, the Board of Directors increased the number of reserved sharesby 160,000, so that the total number of reserved shares totaled 1,760,000. InMarch 2005, the Board of Directors increased the number of reserved sharesby an additional 160,000 so that the total number of reserved shares totaled1,920,000.

 

In April 2005, the Board of Directors voted toadopt the 2002 Amended and Restated Omnibus Stock Incentive Plan (the “Amendedand Restated Plan”) and the Amended and Restated Plan was approved by ourstockholders at the annual meeting of stockholders held in June 2005. TheAmended and Restated Plan amends and restates the Plan by (i) increasingthe number of shares of common stock reserved and available under the Plan by1,000,000 shares to a total share allocation of 2,920,000, (ii) permittingthe grant of deferred shares, performance shares and performance units,(iii) prohibiting repricing of options without prior stockholder approval,(iv) limiting the number of shares of common stock and performance unitssubject to awards a participant may receive in any calendar year to 300,000 and500,000, respectively, and adding other administrative provisions to complywith the performance-based compensation exception to the deduction limit ofSection 162(m) of the Internal Revenue Code of 1986, as amended;(v) eliminating the provision that previously provided for an automaticincrease in the number of shares reserved for issuance under the Amended andRestated Plan each fiscal year by a number equal to the lesser of 160,000shares and an amount determined by the Board of Directors, (vi) providingthat non-qualified stock option grants will be priced at one hundred percent(100%) of fair market value; (vii) providing for minimum vesting periodsof stock bonus awards, restricted common stock awards, stock appreciationrights, deferred shares, and other stock awards subject to the possibleacceleration of the vesting schedule at the discretion of the administrator;(viii) providing that future amendments to the Amended and Restated Planthat increase the number of shares allocated, modify participationrequirements, or materially

 

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increase benefits accruing tothe participants under the Plan will be subject to stockholder approval; and(ix) making other technical changes to the Plan.

 

On December 13, 2005, the Board of Directors announcedthe accelerated vesting of unvested stock options previously awarded toemployees, officers and directors as of December 7, 2005 in light of newaccounting regulations that came into effect on January 1, 2006. Based onthe Statement of Financial Accounting Standards No. 123R, “Share-BasedPayment” (SFAS 123R), the Board took the action to accelerate the unvestedstock with the belief that it was in the best interest of stockholders, as itwill reduce the Company’s reported compensation expense in future periods.

 

A summary of option activity under the plan as ofApril 1, 2006, is presented below:

 
| ** **                            | ** ** | ** **  | ** ** | ** **      | ** ** | **Weighted-**      | ** ** |
|---------------------------------------|------------|-------------|------------|-----------------|------------|--------------------|------------|
| ** **                            | ** ** | ** **  | ** ** | **Shares**      | ** ** | **average**        | ** ** |
| ** **                            | ** ** | **Options** | ** ** | **exercisable** | ** ** | **exercise price** | ** ** |
| Outstanding  at December 31, 2005     |       | 1,750,937   |       |            |       | 20.29              |       |
| 2006 grants                           |       | 10,000      |       |            |       | 32.55              |       |
| 2006  exercise                        |       | (251,497    | )          |            |       | (16.77             | )          |
| 2006  forfeitures                     |       | (10,888     | )          |            |       | (21.28             | )          |
| Balance,  April 1, 2006               |       | 1,498,552   |       |            |       | $                  | 21.18      |   |
| Options  exercisable at April 1, 2006 |       |        |       | 1,491,052       |       | $                  | 21.12      |   |

 

The following table shows the number of optionsoutstanding, the weighted average exercise price, the weighted averageremaining life, and the options exercisable for each range of exercise pricesof options outstanding at April 1, 2006.

 
| ** ** | ** ** | **Number of  Options  Outstanding** | ** ** | **Range of  Exercise  Price** | ** **         | **Weighted  Avg. Exercise  Price** | ** ** | **Weighted  Average  Remaining Life** | ** ** | **Options  Exercisable** | ** ** | **Weighted  Avg. Exercise  Price** | ** ** |
|------------|------------|------------------------------------------|------------|------------------------------------|--------------------|-----------------------------------------|------------|--------------------------------------------|------------|--------------------------|------------|-----------------------------------------|------------|
|       |       | 84,007                                   |       | $                                  | 1.58 – 9.27   |                                    | $          | 8.91                                       |       | 2.4                      |       | 84,007                                  |       | $ | 8.91 |   |
|       |       | 376,214                                  |       | $                                  | 10.81 – 14.00 |                                    | $          | 13.80                                      |       | 6.6                      |       | 376,214                                 |       | $ | 13.80 |   |
|       |       | 321,554                                  |       | $                                  | 16.40 – 19.26 |                                    | $          | 16.70                                      |       | 7.8                      |       | 321,554                                 |       | $ | 16.70 |   |
|       |       | 202,788                                  |       | $                                  | 20.55 – 26.60 |                                    | $          | 25.68                                      |       | 8.7                      |       | 202,788                                 |       | $ | 25.68 |   |
|       |       | 347,303                                  |       | $                                  | 26.80 – 29.87 |                                    | $          | 28.11                                      |       | 9.0                      |       | 347,303                                 |       | $ | 28.11 |   |
|       |       | 166,125                                  |       | $                                  | 30.46 – 32.83 |                                    | $          | 31.00                                      |       | 9.6                      |       | 158,625                                 |       | $ | 30.92 |   |
|       |       | 561                                      |       | $                                  | 556.26             |                                    | $          | 556.26                                     |       | 1.8                      |       | 561                                     |       | $ | 556.26 |   |
| Total      |       | 1,498,552                                |       |                               |               |                                    |       |                                       |       | 1,491,052                |       |                                    |       |

 

Each stock option grant establishes the vestingschedule applicable to the grant. The weighted-average remaining contractuallife of the stock options outstanding and exercisable as of April 1, 2006was 7.8 years with the maximum contractual term of 10 years.

 

The weighted-average grant-date fair value ofoptions granted during the quarters ended April 1, 2006 and March 26, 2005 were$14.76 and $15.47, respectively. The total intrinsic value of options exercisedduring the quarters ended April 1, 2006, and March 26, 2005 was $4.0 millionand $0.9 million, respectively. The total intrinsic value of optionsoutstanding and exercisable as of April 1, 2006 was $20.9 million.

 

**Stock repurchase program**

 

The Company’s Board of Directors authorized therepurchase of up to 300,000 shares of its common stock up to an aggregatemaximum dollar amount of $8 million.  The Company has approximately 11.6million shares outstanding as of April 1, 2006.  Timing and volume of anypurchases will be guided by management’s assessment of market conditions,securities law limitations, the number of shares of common stock outstanding,and alternative, potentially higher value uses for cash resources.  Therepurchase plan may be suspended or discontinued at any time without priornotice.

 

**Item 2.****    Management’sDiscussion and Analysis of Financial Condition and Results of Operations**

 

*The following discussion and analysis should be read in conjunctionwith the consolidated financial statements and related notes included elsewherein this Form 10-Q. This discussion and analysis contains forward-lookingstatements that involve known and unknown risks, uncertainties, and otherfactors that may cause our actual results, level of activity, performance orachievements to be materially different from any future results, levels ofactivity, performance or achievements expressed or implied by suchforward-looking statements. In some cases, you can identify these statements byforward-looking words such as “anticipate,” “believe,” “could,” “estimate,” “expect,”“intend,” “may,” “plan,” “potential,” “should,” “will,” and “would” or similarwords. You should read statements that contain these words carefully becausethey discuss our future expectations, contain projections of our future resultsof operations or of our financial position, or state other forward-lookinginformation. We believe that it is important to communicate our futureexpectations to our investors. However, there may be events in the future thatwe are not able to predict accurately or control. In particular, statementsthat we make in this section relating to the sufficiency of anticipated sourcesof capital to meet our cash requirements are forward- looking statements. Ouractual results could differ materially from those anticipated in these forward-lookingstatements for many reasons, including as a*

 

15

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*result of some of the factors described below, elsewhere in this Form10-Q and in the section entitled “Risk Factors” in our Form 10-K for the fiscalyear ended December 31, 2005. You should not place undue reliance on theseforward-looking statements, which apply only as of the date of the filing ofthis Form 10-Q.*

 

*The Company’s fiscal year is based on the calendar year and ends eachyear on the Saturday nearest, but not falling after, December 31 of that year. Typically,fiscal quarters also end on the Saturday nearest, but not falling after, theend of the calendar quarter. However, in order to ensure that the fiscalquarters presented in this Form 10-Q include 13 weeks, we ended the firstquarter on Saturday, April 1, 2006. Similarly, we will end future fiscalquarters on the Saturday which provides us with a 13 week quarter to comparewith the previous year’s quarterly results even if that Saturday falls afterthe end of the calendar quarter. As a result, our fiscal year may be comprisedof 52 or 53 weeks.*

 

*References to the “Company,” “we,” “us” and “our” refer to SIInternational, Inc. and its subsidiaries.*

 

**Overview**

 

We are, first and foremost, a provider ofinformation technology and network solutions (IT) to the Federal Government.Our clients include the U.S. Air Force, U.S. Army, U.S. Navy, Department ofState, Missile Defense Agency, Department of Homeland Security, Department ofEnergy, Department of Agriculture, National Institutes of Health, FederalRetirement Thrift Investment Board, National Guard Bureau, and the Intelligencecommunity. We combine our technology and industry expertise to provide a fullspectrum of state-of-the-practice solutions and services, from design anddevelopment to implementation and operations, which assist our clients inachieving mission success. We believe that our company is distinguishable fromour peers within the federal IT sector in several important respects.

 

We employ a “Rapid Response • Rapid DeploymentTM” methodology that enablesthe rapid standing up of innovative solutions and the incorporation ofadditional capabilities in rapid succession. This capability allows us torespond to urgent IT imperatives quickly, often in a matter of months, andwithin a well defined budget. We can, therefore, provide solutions for currentIT needs, while establishing a platform for advancing long-termtransformational objectives. We possess a proven ability to respond to highpriority information technology and network needs through innovation, and anenviable reputation for timely delivery of robust solutions on assignmentswhere failure is not an option. Our Mission Critical, Mission Accomplishedsolutions enable clients to respond to new mandates, expand the scope of theirmissions, and reengineer underlying business processes. We have a demonstratedability of turning troubled IT projects into winning outcomes and realizedexceptional growth from high-quality client engagements. We also utilize matureand proven processes to manage and market large-scale ID/IQ contracts, such asC4I2TSR. We employ a diverse, innovative team that effectively utilizes smallbusiness partners’ unique skills and expertise for mission critical ITprojects.

 

For the fiscal quarters ended April 1, 2006 andMarch 26, 2005, we received 98.2% and 97.9%, respectively, of our revenues fromservices we provided to various departments and agencies of the FederalGovernment, both directly and through other prime contractors, and 1.8% and 2.1%,respectively, of our total revenues from work performed for commercialentities. The following table shows our revenues from the client groups listedas a percentage of total revenue. Revenue data for the DoD includes revenuegenerated from work performed under engagements for both the DoD and theIntelligence community.

 
| ** **                | ** ** | **Three Months Ended** | ** ** |
|---------------------------|------------|----------------------------------|------------|
| ** **                | ** ** | **April 1,  2006**          | ** ** | **March 26,  2005** | ** ** |
|                      |       |                             |       |   |   |
| Department of Defense     |       | 48.0                             | %          | 49.0 | % |
| Federal civilian agencies |       | 50.2                             | %          | 48.9 | % |
| Commercial entities       |       | 1.8                              | %          | 2.1 | % |
|                      |       |                             |       |   |   |
| Total revenue             |       | 100.0                            | %          | 100.0 | % |

 

16

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As a result of the Zen acquisition, we believe thatthe percentage of our revenue attributable to the DoD and federal civilianagencies should increase, and the percentage of our revenue attributable tocommercial entities, including international commercial operations, shoulddecrease marginally.

 

We have derived a substantial majority of ourrevenues from governmental contracts under which we act as a prime contractor.We also provide services indirectly as a subcontractor. The following tableshows our revenues as prime contractor and as subcontractor as a percentage ofour total revenue for the following periods:

 
| ** **             | ** ** | **Three Months Ended** | ** ** |
|------------------------|------------|----------------------------------|------------|
| ** **             | ** ** | **April 1,  2006**          | ** ** | **March 26,  2005** | ** ** |
|                   |       |                             |       |   |   |
| Prime contract revenue |       | 77.4                             | %          | 77.6 | % |
| Subcontract revenue    |       | 22.6                             | %          | 22.4 | % |
| Total revenue          |       | 100.0                            | %          | 100.0 | % |

 

As a result of the Zen acquisition, we believe thepercentage of our prime contract revenue may increase marginally.

 

Our services are provided to clients pursuant to threetypes of contracts: cost reimbursable, time and materials and fixed pricecontracts. The following table shows our revenues from each of these types ofcontracts as a percentage of our total revenue for the following periods:

 
| ** **         | ** ** | **Three Months Ended** | ** ** |
|--------------------|------------|----------------------------------|------------|
| ** **         | ** ** | **April 1,  2006**          | ** ** | **March 26,  2005** | ** ** |
|               |       |                             |       |   |   |
| Cost reimbursable  |       | 31.8                             | %          | 34.2 | % |
| Time and materials |       | 41.2                             | %          | 47.2 | % |
| Fixed price        |       | 27.0                             | %          | 18.6 | % |
| Total              |       | 100.0                            | %          | 100.0 | % |

 

As a result of the acquisition of Zen, we anticipatethat during fiscal year 2006 that the percentage of our revenue attributable totime and materials and fixed price contracts may increase marginally.

 

Under cost reimbursable contracts, we are reimbursedfor costs that are determined to be reasonable, allowable and allocable to thecontract, and paid a fee representing the profit margin negotiated between usand the contracting agency, which may be fixed or performance based. Under costreimbursable contracts we recognize revenues and an estimate of applicable feesearned as costs are incurred. We consider fixed fees under cost reimbursablecontracts to be earned in proportion to the allowable costs incurred inperformance of the contract. For performance-based fees under cost reimbursablecontracts, we recognize the relevant portion of the expected fee to be awardedby the client at the time such fee can be reasonably estimated, based onfactors such as our prior award experience and communications with the clientregarding performance. In general, cost reimbursable contracts are the leastprofitable of our government contracts.

 

Under time and materials contracts, we arereimbursed for labor at fixed hourly rates and generally reimbursed separatelyfor allowable materials, costs and expenses. To the extent that our actuallabor costs under a time and materials contract are higher or lower than thebilling rates under the contract, our profit under the contract may either begreater or less than we anticipated or we may suffer a loss under the contract.We recognize revenues under time and materials contracts by multiplying thenumber of direct labor hours expended by the contract billing rates and addingthe effect of other billable direct costs. In general, we realize a higherprofit margin on work performed under time and materials contracts than costreimbursable contracts.

 

17

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Under fixed price contracts, we perform specifictasks for a fixed price. Compared to cost reimbursable and time and materialscontracts, fixed price contracts generally offer higher profit marginopportunities but involve greater financial risk because we bear the impact ofcost overruns in return for the full benefit of any cost savings. We generallydo not undertake complex, high-risk work, such as long-term softwaredevelopment, under fixed price terms. Fixed price contracts may include eithera product delivery or specific service performance over a defined period.Revenue on fixed price contracts that provide for the Company to renderservices throughout a period is recognized as earned according to contractterms as the service is provided on a proportionate performance basis. While asubstantial number of these contracts are generally less than six months induration, we have several multi-year contracts of this type in which thecustomer has the option to extend the contractual term beyond the current term.

 

If we anticipate a loss on a contract, we providefor the full amount of anticipated loss at the time of that determination.

 

Our most significant expense is direct cost, whichconsists primarily of direct labor costs for program personnel and directexpenses incurred to complete contracts, including cost of materials andsubcontract efforts. Our ability to predict accurately the number and types ofpersonnel, their salaries, and other costs, can have a significant impact onour direct cost.

 

The allowance of certain direct and indirect costsin federal contracts is subject to audit by the client, usually through theDCAA. Certain indirect costs are charged to contracts and paid by the clientusing provisional, or estimated, indirect rates, which are subject to laterrevision, based on the government audits of those costs.

 

**Recent Events**

 

*Stock Issuance.*TheCompany entered into an Underwriting Agreement with Wachovia Capital Markets,LLC (“Wachovia”) dated as of April 4, 2006. Under the terms of the UnderwritingAgreement, on April 4, 2006, SI International issued and sold to Wachovia1,200,000 shares of Company common stock, par value $0.01 per share.

 

Withrespect to the common stock issued and sold pursuant to the UnderwritingAgreement, the Company registered the common stock by filing with theSecurities and Exchange Commission a Registration Statement on Form S-3 (No.333-113827) under the Securities Act of 1933. The public offering price for thecommon stock was $34.00 per share, and the Company received proceeds from thesale of approximately $40.5 million after underwriting discounts andcommission, but before other expenses relating to the sale. The Company used thenet proceeds from the sale to pay down outstanding term debt under the FirstAmendment. The estimated amount of deferred loan origination fees to be writtenoff in the second quarter 2006 are anticipated to be approximately $1.0million. 

 

*Zen Acquisition.  *On February 27, 2006, we closed theacquisition of Zen. Zen is a provider of critical IT services, specializing inmanaged network services, information assurance, software development andsystems engineering, database and systems administration and IT consulting tovarious U.S. Government agencies.  Zen’s largest clients include theMissile Defense Agency (MDA), Department of Defense’s Washington HeadquartersServices (WHS), Federal Communications Commission (FCC), the Pension BenefitGuaranty Corporation (PBGC), and the Federal Trade Commission (FTC).  As aresult of our acquisition of Zen, we gained approximately 275 employees, ofwhich approximately 50% hold security clearances.  The acquisition of Zenprovides additional scale with existing customers as well as diversificationwith new government customers.

 

Pursuant to the terms of the Zen Agreement weacquired all of the outstanding capital stock of Zen for $60 million in cash,of which we are withholding $6 million for 15 months in order to securepost-closing indemnity obligations of the sellers.  The purchase price issubject to a two-way adjustment based upon whether the working capital of Zenas of the closing date was above or below the target working capital specifiedin the Zen Agreement.  Each of the parties to the Zen Agreement has madecustomary representations and warranties and agreed to certain indemnificationobligations.   The transaction was funded through cash-on-hand, asubordinated Seller’s Note in the amount of $6 million, and borrowing from ournewly amended credit facility, which is described below. We expect theacquisition to be accretive to earnings.  Zen’s trailing twelve monthsrevenue ended November 30, 2005, was approximately $38 million (unaudited).

 

*Amendment to Credit Facility.*   On February 27, 2006, weentered into the First Amendment to the credit agreement. The First Amendmentprovides new terms and conditions with respect to the term loan portion of theCredit Agreement and increased the available term loan amount to approximately$129.3 million from approximately $99.3 million. The funds borrowed under thenew term loan were used to (a) refinance the initial term loan; (b) tofinance the acquisition of Zen; and (c) to provide for working capital,capital expenditures and other general corporate purposes. The First Amendmentamended the leverage ratio that requires us to maintain a ratio of funded debtto consolidated EBITDA for such period as follows:

 

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| **Period**                                                                       | ** ** | **New Maximum Ratio** | ** ** | **Prior Maximum Ratio** | ** ** |
|----------------------------------------------------------------------------------|------------|---------------------------------|------------|-----------------------------------|------------|
| First Amendment Effective Date through  fiscal quarter ending June 30, 2006 |       | 3.75 to 1.00                    |       | 3.50 to 1.00                      |       |
| July 1, 2006 through fiscal quarter  ending June 29, 2007              |       | 3.50 to 1.00                    |       | 3.25 to 1.00                      |       |
| June 30, 2007 through fiscal quarter  ending June 27, 2008             |       | 3.00 to 1.00                    |       | 3.00 to 1.00                      |       |
| June 28, 2008 and thereafter                                                |       | 2.75 to 1.00                    |       | 2.75 to 1.00                      |       |

 

Theseratios will be calculated in accordance with the definitions and termscontained in the Amended Credit Agreement, which may be different thancalculations pursuant to GAAP. As of April 1, 2006, the Company was compliantwith the financial covenants under the Amended Credit Agreement.

 

*NVC Contract Award.*   On January 31, 2006, in arecompetition for our expiring National Visa Center, or NVC, contract, we wereawarded the successor contract for the NVC contract by the Department of State.Under the contract, we anticipate performing over 20 million immigrant visatransactions each year at the NVC in Portsmouth, New Hampshire and at theKentucky Consular Center in Williamsburg, Kentucky. The prime contract has aone-year base period and four one-year options with a potential value ofapproximately $84 million, inclusive of the options. The prior NVC contractgenerated 9.1% of our total revenues in fiscal 2005 and 9.2% of our totalrevenues in fiscal 2004.

 

*Acceleration of Vesting of StockOptions.*  On December 13, 2005, the Company announced that our Board of Directorsapproved the accelerated vesting of unvested stock options previously awardedto employees, officers and directors as of December 7, 2005 in light ofnew accounting regulations that came into effect on January 1, 2006. Basedon the Statement of Financial Accounting Standards No. 123R, “Share-BasedPayment” (SFAS 123R), the Board took the action to accelerate the unvestedstock with the belief that it is in the best interest of stockholders, as itwill reduce the Company’s reported compensation expense in future periods.

 

**Liquidity and Capital Resources**

 

*General.*   Short-term liquidityrequirements are created by our use of funds for working capital, capitalexpenditures, and the need to provide debt service. We expect to meet theserequirements through a combination of cash flow from operations and borrowingsunder our Amended Credit Agreement.

 

We anticipate that our long-term liquidityrequirements, including any further acquisitions, will be funded through acombination of cash flow from operations, borrowings under our Amended CreditAgreement, additional secured or unsecured debt or the issuance of common orpreferred stock, each of which may be initially funded through borrowings underour Amended Credit Agreement.

 

*Cash and Cash Equivalents.*   We consider cash on deposit andall highly liquid investments with original maturities of three months or lessto be cash and cash equivalents. Cash and cash equivalents, includingmarketable securities, as of the end of three months ending April 1, 2006 andMarch 26, 2005 was $13.3 million and $12.3 million, respectively.

 

*Cash Flow.*   The following table sets forthour sources and uses of cash for the three months ended April 1, 2006 and March26, 2005.

 
|                                                 |   | **Three Months Ended** |    |
|------------------------------------------------------|--------|----------------------------------|---------|
|                                                 |   | **April 1,  2006**          |    | **March 26,  2005** |   |
|                                                 |   | **(in thousands)**          |    |
| Net cash provided by (used in) operations            |   | $                                | (95     | ) | $ | 9,493 |   |
| Net cash used in investing activities                |   | (46,596                          | )       | (69,460 | ) |
| Net cash provided by (used in) financing  activities |   | 33,787                           |    | 68,539 |   |
| Net (decrease) increase in cash                      |   | $                                | (12,904 | ) | $ | 8,572 |   |

 

Our operating cash flow is primarily affected by theoverall profitability of our contracts, our ability to invoice and collect fromour clients in a timely manner, and our ability to manage our vendor payments.We bill most of our clients monthly after services are rendered. Cash used inoperations in the three months ended April 1, 2006 was attributable to netincome of $4.3 million, plus depreciation, amortization and other non-cashitems of $1.6 million, and an increase in working capital and

 

19

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otheroperating assets and liabilities of $6.0 million. Cash provided by operationsin the three months ended March 26, 2005 was attributable to net income of$3.2 million, depreciation, amortization, and other non-cash items of $1.2million, and a decrease in working capital and other operating assets andliabilities of $5.1 million.

 

Our cash flow used in investing activities consistsprimarily of capital expenditures, the purchase and sale of marketablesecurities, and acquisitions. In the three months ended April 1, 2006, we paid$45.9 million for business acquisitions, net of cash assumed, repaid a contractsettlement to a former owner for $8.0 million, and purchased capital assetstotaling $0.5 million. We partially offset the cash use with $7.8 million ofproceeds from the sale of marketable securities. During the three months endedMarch 26, 2005, we paid $71.3 million for business acquisitions, net of cashassumed, invested $0.2 million in capital assets, and we partially offset thecash use with $2.0 million of proceeds from the sale of marketable securities.

 

Our cash flow provided by financing activitiesconsists primarily of borrowings under and payments on our credit facility.Cash provided by financing activities for the three months ended April 1, 2006 wasattributable to proceeds of $30.0 million from the term loan portion of ourcredit facility, proceeds of $3.7 million from the exercise of stock options,and a $0.9 million income tax benefit for the stock option exercises. Cashprovided by financing activities was partially offset by payment of debtissuance fees of $0.5 million, partial repayment of the term loan portion ofour credit facility of $0.3 million, and $28,000 of capital lease payments. Cashprovided by financing activities for the three months ended March 26, 2005 wasattributable to $100.0 million of long term debt provided by our creditfacility, $29.0 million in debt repayment, and $0.7 million provided byproceeds from the exercise of stock options, partially offset by $3.2 millionof payments related to debt issuance costs and $25,000 of capital leasepayments.

 

**Results of Operations**

 

The following table sets forth certain itemsfrom our consolidated statements of operations as a percentage of revenues forthe periods indicated.

 

| ** **                               | ** ** | **Three Months Ended** | ** ** |
|------------------------------------------|------------|----------------------------------|------------|
| ** **                               | ** ** | **April 1,  2006**          | ** ** | **March 26,  2005** | ** ** |
|                                     |       |                             |       |   |   |
| Revenue                                  |       | 100.0                            | %          | 100.0 | % |
| Costs and expenses:                      |       |                             |       |   |   |
| Direct costs                             |       | 62.1                             |       | 62.8 |   |
| Indirect costs                           |       | 28.5                             |       | 28.2 |   |
| Depreciation                             |       | 0.5                              |       | 0.7 |   |
| Amortization                             |       | 0.6                              |       | 0.5 |   |
|                                     |       |                             |       |   |   |
| Total operating expenses                 |       | 91.7                             |       | 92.2 |   |
| Income from operations                   |       | 8.3                              |       | 7.8 |   |
| Other income (expense)                   |       | 0.0                              |       | (0.1 | ) |
| Interest expense                         |       | (1.7                             | )          | (1.3 | ) |
| Income before provision for income taxes |       | 6.6                              |       | 6.4 |   |
| Provision for income taxes               |       | 2.6                              |       | 2.5 |   |
| Net income                               |       | 4.0                              | %          | 3.9 | % |

 

**Three months ended April 1, 2006 comparedwith three months ended March 26, 2005**

 

*Revenue.*Forthe three months ended April 1, 2006, our revenues increased 28.1% to $107.2 millionfrom $83.7 million for the three months ended March 26, 2005. Revenuesfrom work under Federal Government contracts increased 28.6% to $105.3 millionfor the three months ended April 1, 2006 from $81.9 million for the threemonths ended March 26, 2005. Thisincrease was attributable to the acquisition of Zen and SEI in the firstquarter of 2006 and 2005, respectively, new contract awards, successfulrecompetition wins on existing programs, new contracts from and growth withinexisting programs in our four focus areas: Federal IT Modernization, DefenseTransformation, Homeland Defense, and Mission-Critical Outsourcing. Commercialrevenues increased 7.6% to $1.9 million in the three months ended April 1, 2006from $1.8 million in the three months ended March 26, 2005. However, wecontinue to focus primarily onopportunities for the Federal Government.

 

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*Direct costs.*Directcosts include direct labor and other direct costs such as materials andsubcontracts. Generally, changes in direct costs are correlated to changes inrevenue as resources are consumed in the production of that revenue. For thethree months ended April 1, 2006, direct costs increased 26.6% to $66.6 millionfrom $52.6 million for the three months ended March 26, 2005. Thisincrease was attributable primarily to the increase in revenue. As a percentageof revenue, direct costs were 62.1% for the three months ended April 1, 2006 ascompared to 62.8% for the three months ended March 26, 2005.

 

*Indirect costs.*Indirectcosts include facilities, selling, bid and proposal, indirect labor, fringebenefits and other discretionary costs. For the three months ended April 1,2006, indirect costs increased 29.5% to $30.5 million from $23.6 millionfor the three months ended March 26, 2005. This $7.0 million increase was primarily attributable to theexpected growth of support functions necessary to facilitate and administer thegrowth in direct costs as well as the integration of Zen. As apercentage of revenue, indirect costs were 28.5% for the three months ended April1, 2006 as compared to 28.2% for the three months ended March 26, 2005.

 

*Depreciation.*Forthe three months ended April 1, 2006, depreciation expense was $548,000, aslight decrease compared to $551,000 for the three months ended March 26, 2005.However, as a percentage of revenue, depreciation expense was 0.5% for thethree months ended April 1, 2006 compared to 0.7% for the three months ended March26, 2005.

 

*Amortization of intangible assets.*Forthe three months ended April 1, 2006, amortization of intangible assets was $647,000,compared to $457,000 for the three months ended March 26, 2005. The contractual customer relationships arebeing amortized using an accelerated method over their estimated remaininglives. As a percentage of revenue, amortization of intangible assets was 0.6%for the three months ended April 1, 2006 compared to 0.5% for the three monthsended March 26, 2005.

 

*Income fromoperations.*For the three months ended April 1, 2006,income from operations increased 36.1% to $8.9 million from $6.5 millionfor the three months ended March 26, 2005. This increase was attributableprimarily to increased revenues. As a percentage of revenue, income fromoperations was 8.3% for the three months ended April 1, 2006 compared to 7.8%for the three months ended March 26, 2005.

 

*Interest expense.*Interestexpense increased 62.4% to $1.8 million for the three months ended April 1,2006 from $1.1 million for the three months ended March 26, 2005. This increase was attributable primarily toincreased borrowings under our amended credit facility made in connection withthe acquisition of Zen and other cash flow needs. As a percentage ofrevenue, interest expense was 1.7% for the three months ended April 1, 2006 ascompared to 1.3% for the three months ended March 26, 2005. We anticipate interest expense to remain atthe same levels throughout the rest of fiscal year 2006 as compared to the sameperiods in 2005 due to the $40 million early debt repayment.

 

*Provision for incometaxes.*The provision for income taxes was $2.8 millionin the three months ended April 1, 2006, compared to $2.1 million for thethree months ended March 26, 2005. Our firstquarters of 2006 and 2005 tax provision, represents an estimated annualeffective tax rate of 39.5%. Our estimated annual effective tax rate is greaterthan the federal statutory rate of 34% due primarily to state income taxes.

 

**Off-Balance Sheet Arrangements**

 

As of April 1, 2006, we have no off-balance sheetarrangements that are reasonably likely to have a current or future materialeffect on our financial condition, revenues, or expenses, result of operations,liquidity, capital expenditures, or capital resources.

 

**Critical Accounting Policies and Estimates**

 

Our significant accounting policies are described inNote 2 to our accompanying consolidated financial statements. We considerthe accounting policies related to revenue recognition to be critical to theunderstanding of our results of operations. Our critical accounting policiesalso include the areas where we have made what we consider to be particularlydifficult, subjective or complex judgments in making estimates, and where theseestimates can significantly impact our financial results under differentassumptions and conditions. We prepare our financial statements in conformitywith accounting principles

 

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generallyaccepted in the United States. As such, we are required to make certain estimates,judgments and assumptions that we believe are reasonable based upon theinformation available. These estimates, judgments and assumptions affect thereported amounts of assets and liabilities at the date of the financialstatements and the reported amounts of revenue and expenses during the periodspresented. Actual results could be different from these estimates.

 

*Revenue Recognition*

 

We recognize revenue under its contracts when acontract has been executed, the contract price is fixed and determinable,delivery of services or products has occurred, and collectibility of thecontract price is considered probable and can be reasonably estimated. Revenueis earned under cost reimbursable, time and materials and fixed pricecontracts. Direct contract costs are expensed as incurred.

 

Under cost reimbursable contracts, we are reimbursedfor allowable costs, and paid a fee, which may be fixed or performance-based.Revenues on cost reimbursable contracts are recognized as costs are incurredplus an estimate of applicable fees earned. We consider fixed fees under costreimbursable contracts to be earned in proportion of the allowable costsincurred in performance of the contract. For cost reimbursable contracts thatinclude performance based fee incentives, we recognize the relevant portion ofthe expected fee to be awarded by the customer at the time such fee can bereasonably estimated, based on factors such as our prior award experience andcommunications with the customer regarding performance.

 

Revenue on time and materials contracts arerecognized based on direct labor hours expended at contract billing rates andadding other billable direct costs.

 

Fixed price contracts may include either a productdelivery or specific service performance throughout a period. For fixed pricecontracts that are based on unit pricing, we recognize revenue for the numberof units delivered in any given fiscal period. For fixed price contracts thatare based on the proportionate performance method and involve a specified numberof similar acts, we recognize revenue based on the proportion of those actscompleted compared to the number of total specified acts required by thecontract. For fixed price contracts that are based on the proportionateperformance method and involve a specified number of defined but not similaracts, we recognize revenue based on the proportion of the project’s percentagetotal costs incurred compared to the estimated total costs associated with theentire transaction. For fixed price contracts that provide for the delivery ofa specific product with related customer acceptance provisions, revenues andassociated contract costs are recognized upon product delivery and customeracceptance.

 

Our contracts with agencies of the government aresubject to periodic funding by the respective contracting agency. Funding for acontract may be provided in full at inception of the contract or ratablythroughout the contract as the services are provided. In evaluating theprobability of funding for purposes of assessing collectibility of the contractprice, we consider our previous experiences with our customers, communicationswith our customers regarding funding status, and our knowledge of availablefunding for the contract or program. If funding is not assessed as probable,revenue recognition is deferred until realization is deemed probable.

 

Contract revenue recognition inherently involvesestimation, including the contemplated level of effort to accomplish the tasksunder contract, the cost of the effort, and an ongoing assessment of progresstoward completing the contract. From time to time, as part of the normalmanagement processes, new information comes to light that requires revisions toestimated total costs or revenues expected. The cumulative impact of any revisionsto estimates and the full impact of anticipated losses on any type of contractare recognized in the period in which they become known.

 

The allowance of certain costs under governmentcontracts is subject to audit by the government. Certain indirect costs arecharged to contracts using provisional or estimated indirect rates, which aresubject to later revision based on government audits of those costs. Managementis of the opinion that costs subsequently disallowed, if any, would not besignificant.

 

*Stock Based Compensation*

 

In December 2004, the FASB issued FASBStatement No. 123(R) (revised 2004), *ShareBased Payment.* Statement 123(R) addresses the accounting forshare-based payment transactions in which an enterprise receives employeeservices in exchange for (a) equity instruments of the enterprise or(b) liabilities that are based on the fair value of the enterprise’sequity instruments or that may be settled by the issuance of such equityinstruments. Statement 123(R) requires an entity to recognize thegrant-date fair-value of stock options and other equity-based compensationissued to employees in the income statement. The revised Statement generallyrequires that an entity account for those transactions using thefair-value-based method, and eliminates the intrinsic value method ofaccounting in APB Opinion No. 25, *Accountingfor Stock Issued to Employees*, which was permitted under Statement123, as originally issued. The revised Statement requires entities to discloseinformation about the nature of the share-based payment transactions and theeffects of those transactions on the financial statements. Statement

 

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123(R) iseffective for the Company beginning January 1, 2006. All public companies mustuse either the modified prospective or the modified retrospective transitionmethod. (See “—Recent Events” above for a discussion of changes to our StockOption programs.)

 

Effective January 1, 2006, the Company adopted theprovisions of SFAS No. 123R using the modified prospective transition method.Due to the use of the modified prospective transition method, prior interimperiods and fiscal years will not reflect any restated amounts. As disclosed inthe stock option plans, the Company accelerated the vesting of unvested stockoptions previously awarded to employees, officers and directors in December2005. The Company had no unvested stock options on January 1, 2006. The Companyissued insignificant stock options in the quarter ended April 1, 2006.Accordingly, no stock compensation expense was recognized during the firstquarter. Prior to the adoption of SFAS No. 123R, the Company accounted forstock-based compensation using the intrinsic value method prescribed in APBOpinion No. 25 and related interpretations.

 

**Item 3. Quantitative andQualitative Disclosures About Market Risk.**

 

We are exposed to certain financial market risks,the most predominant being fluctuations in interest rates for borrowings underour credit facility. Interest rate fluctuations are monitored by our managementas an integral part of our overall risk management program, which recognizesthe unpredictability of financial markets and seeks to reduce the potentiallyadverse effect on our results of operations. As part of this strategy, we mayuse interest rate swap arrangements to manage or hedge our interest rate risk.We do not use derivative financial instruments for speculative or tradingpurposes.

 

As of April 1, 2006, we had approximately $128.9million outstanding under our Amended Credit Agreement. A 1% change in interestrates would have resulted in our interest expense fluctuating by approximately$322,000 for the three months ended April 1, 2006.

 

Effective February 14, 2006, an interest swapagreement came into effect which reduced our exposure associated with themarket volatility of floating LIBOR interest rates. This agreement has anotional principal amount of $30.0 million and, as of April 1, 2006,had a rate ranging from 4.05% to 4.74%. This agreement is a hedge against termdebt, which bears interest at LIBOR plus a margin which has a current overallrate of 6.97%. At stated monthly intervals the difference between the intereston the floating LIBOR-based debt and the interest calculated in the swapagreement are settled in cash.

 

In addition, historically, our investment positionshave been relatively small and short-term in nature. We have typically madeinvestments in a fund with an effective average maturity of fewer than 40 daysand a portfolio make-up consisting primarily of commercial paper and notes,variable rate instruments, and, to a lesser degree, overnight securities andbank instruments. Since our initial public offering, the Board of Directorsapproved an investment policy that requires us to invest in relativelyshort-term, high quality, and high liquidity obligations.

 

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**Item 4. Controls and Procedures.**

 

*Evaluation of Disclosure Controls and Procedures.* The Company performed an evaluation under thesupervision and with the participation of management, including the Company’sChief Executive Officer and Chief Financial Officer, of the design andoperation of the Company’s disclosure controls and procedures as of April 1,2006. Based upon the evaluation, the Company’s Chief Executive Officer andChief Financial Officer have concluded that, as of April 1, 2006, the Company’sdisclosure controls and procedures were effective.

 

*Changes in Internal Control Over Financial Reporting.*During the three months ended April 1, 2006,there were no changes in the Company’s internal control over financialreporting that has materially affected, or is reasonably likely to materiallyaffect, the Company’s internal control for financial reporting.

 

**PART II:  OTHER INFORMATION**

 

**Item 1. Legal Proceedings**

 

From time to time, the Company is involved inlitigation, claims and disputes that arise in the ordinary course of itsbusiness. In addition, the Company is subject to audit, review, andinvestigation by various agencies of the Federal government to determinecompliance with applicable federal statutes and regulations. As a Federalgovernment contractor, the Company is subject to audit by certain federalagencies to determine if the Company’s performance and administration of itsgovernment contracts are compliant with contractual requirements and applicablefederal statutes and regulations. While the Company cannot predict the ultimateoutcome of legal proceedings, government audits, investigations, claims anddisputes to which it is or may be subject, the Company currently believes,based upon information available to us as of the date of this filing, that anyultimate liability arising out of these matters will not have a materialadverse effect on our financial position, results of operations, or cash flows.

 

The SEI acquisition agreement provides for apurchase price adjustment based upon the working capital of SEI as of theclosing date.  Subsequent to the closing date, the Company received apayment of $1.6 million in connection with services performed prior to theclosing date that SEI had not previously billed, and was not authorized tobill, its customer as of the closing date.  The SEI sellingstockholders have asserted that they are entitled to a credit inconnection with the calculation of working capital adjustment in an amountequal to the amount received by the Company for thispost-closing payment.  The Company believes that, in accordancewith GAAP, the SEI selling stockholders should not receive the benefit ofthe post-closing payment.  In accordance with the terms of the SEIacquisition agreement, the parties have jointly submitted the issue to anindependent accounting firm for resolution.

 

**Item 1A. Risk Factors**

 

Thereare no material updates to the risk factors previously disclosed in our Form10-K for the year ended December 31, 2005.

 

**Item 2. Unregistered Sales of EquitySecurities and Use of Proceeds**

 

None.

 

**Item 3. Defaults Upon Senior Securities**

 

None.

 

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**Item 4. Submission of Matters To a Vote of Security Holders**

 

None.

 

**Item 5. Other Information**

 

None.

 

**Item 6. Exhibits**

 

Theexhibits required by this item are set forth on the Index to Exhibits attachedhereto.

 

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SIGNATURES

 

Pursuant to the requirements of the SecuritiesExchange Act of 1934, the registrant has duly caused this report to be signedon its behalf by the undersigned thereunto duly authorized.

 
|               | SI  INTERNATIONAL, INC.       |
|--------------------|-------------------------------|
|               |                          |
|               |                          |
|               | /s/  THOMAS E. DUNN           |   |
|               | Thomas  E. Dunn               |
|               | Executive  Vice President and |
|               | Chief  Financial Officer      |
|               |                          |
|               |                          |
| Date:  May 9, 2006 |                          |

 

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**INDEX TO EXHIBITS**

 
| **Exhibit No.** | ** ** | **Description**                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     |
|----------------------|------------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 2.1                  |       | Stock  Purchase Agreement among the Company, Shenandoah Electronic Intelligence,  Inc. (“SEI”), and the stockholders of SEI dated January 12, 2005 (filed as  Exhibit 99.1 to the Company’s Current Report on Form 8-K filed March 1, 2005  and incorporated by reference). (The appendices and exhibits have been  omitted pursuant to Item 601(b)(2) of Regulation S-K. SI International, Inc.  hereby undertakes to furnish supplementally to the Securities and Exchange  Commission copies of any omitted appendices and exhibits upon request by the  Securities and Exchange Commission).                                     |
| 2.2                  |       | Stock  Purchase Agreement among the Company, Zen Technology, Inc., and the  stockholders of Zen Technology, Inc. dated February 8, 2006 (filed as Exhibit  2.2 to the Company’s Annual Report on Form 10-K for the fiscal year ended  December 31, 2005 and filed March 15, 2006 and incorporated herein by  reference). (The appendices and exhibits have been omitted pursuant to Item  601(b)(2) of Regulation S-K. SI International, Inc., hereby undertakes to  furnish supplementally to the Securities and Exchange Commission copies of  any omitted appendices and exhibits upon request by the Securities and  Exchange Commission). |
| 3.1                  |       | Second  Restated Certificate of Incorporation (filed as Exhibit 3.1 to the Company’s  Registration Statement on Form S-1/A (File No. 333-87964) filed on October  25, 2002 (the “Third Amendment”) and incorporated herein by reference).                                                                                                                                                                                                                                                                                                                                                                                            |
| 3.2                  |       | Amended and  Restated Bylaws, as amended (filed as Exhibit 3.2 to the Company’s Current  Report on Form 8-K filed October 11, 2005 and incorporated herein by  reference).                                                                                                                                                                                                                                                                                                                                                                                                                                                                     |
| 4.1                  |       | Registration  Rights Agreement, as amended (filed as Exhibit 4.1 to the Third Amendment and  incorporated herein by reference).                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     |
| 4.2                  |       | Specimen  Certificate of our common stock (filed as Exhibit 4.2 to the Company’s  Registration Statement on Form S-1/A (File No. 333-87964) filed on November  5, 2002 (the “Fourth Amendment) and incorporated herein by reference).                                                                                                                                                                                                                                                                                                                                                                                                     |
| 4.3                  |       | Stock  Purchase Agreement, as amended (filed as Exhibit 4.3 to the Fifth Amendment  and incorporated herein by reference).                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          |
| 4.4                  |       | Amendment to  Stock Purchase Agreements (filed as Exhibit 4.4 to the Fourth Amendment and  incorporated herein by reference).                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       |
| 10.1                 |       | 2002 Amended  and Restated Omnibus Stock Incentive Plan (filed as Annex B to the Company’s  Proxy Statement on Schedule 14A for the 2005 Annual Meeting of Stockholders  filed on April 21, 2005 and incorporated herein by reference).                                                                                                                                                                                                                                                                                                                                                                                                        |
| 10.2                 |       | January 2001  Nonqualified Stock Option Plan (filed as Exhibit 10.2 to the Company’s  Registration Statement on Form S-1/A (File No. 333-87964) filed on June 24,  2002 (the “First Amendment) and incorporated herein by reference).                                                                                                                                                                                                                                                                                                                                                                                                     |
| 10.3                 |       | SI  International, Inc. 2001 Service Award Stock Option Plan (filed as Exhibit  10.3 to the First Amendment and incorporated herein by reference).                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  |
| 10.4                 |       | 1998 Stock  Option Plan (filed as Exhibit 10.5 to the First Amendment and incorporated  herein by reference).                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       |
| 10.5                 |       | Non-Qualified  Deferred Compensation Plan, as amended (filed as Exhibit 10.13 to the 2004  10-K and incorporated herein by reference).                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              |
| 10.6                 |       | Form of SI International,  inc. Stock Option Agreement Evidencing Grant of Stock Options Under the SI  International, inc. 2002 Amended and Restated Omnibus Stock Incentive Plan,  Including Notice of Stock Option Grant (filed as Exhibit 99.1 to the  Company’s Current Report on Form 8-K filed on March 17, 2005 and incorporated  herein by reference).                                                                                                                                                                                                                                                                                 |
| 10.7                 |       | Notice of  Stock Option Acceleration of Vesting (filed as Exhibit 10.1 to the Company’s  Current Report on Form 8-K filed on December 13, 2005 and incorporated herein  by reference).                                                                                                                                                                                                                                                                                                                                                                                                                                                         |
| 10.8                 |       | Amended and  Restated Credit Agreement, dated as of February 9, 2005 (filed as Exhibit  99.1 to the Company’s Current Report on Form 8-K filed February 15, 2005 and  incorporated herein by reference).                                                                                                                                                                                                                                                                                                                                                                                                                                       |
| 10.9                 |       | First  Amendment to Amended and Restated Credit Agreement, dated February 27, 2006  (filed as Exhibit 10.1 to the Company’s Current Report on Form 8-K filed  March 3, 2006 and incorporated herein by reference).                                                                                                                                                                                                                                                                                                                                                                                                                             |

 

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| **Exhibit No.** | ** ** | **Description**                                                                                                                                                                                    |
|----------------------|------------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.10                |       | Executive  Employment Agreement with S. Bradford Antle (filed as Exhibit 10.6 to the  Third Amendment and incorporated herein by reference).                                                       |
| 10.11                |       | Executive  Employment Agreement with Thomas E. Dunn (filed as Exhibit 10.8 to the Third  Amendment and incorporated herein by reference).                                                          |
| 10.12                |       | Executive  Employment Agreement with Thomas E. Lloyd (filed as Exhibit 10.9 to the Third  Amendment and incorporated herein by reference).                                                         |
| 10.13                |       | Executive  Employment Agreement with Ray J. Oleson (filed as Exhibit 10.10 to the Third  Amendment and incorporated herein by reference).                                                          |
| 10.14                |       | Executive  Employment Agreement with Paul R. Brubaker (filed as Exhibit 99.1 to the  Company’s Current Report on Form 8-K filed March 22, 2005 and incorporated  herein by reference).        |
| 10.15                |       | Executive  Employment Agreement with Harry D. Gatanas (filed as Exhibit 10.1 to the  Company’s Current Report on Form 8-K/A filed November 15, 2005 and  incorporated herein by reference).   |
| 10.16                |       | Executive  Employment Agreement with Marylynn Stowers (filed as Exhibit 10.1 to the  Company’s Current Report on Form 8-K/A filed February 2, 2006 and  incorporated herein by reference).    |
| 10.17                |       | Executive  Employment Agreement with P. Michael Becraft (filed as Exhibit 10.1 to the  Company’s Current Report on Form 8-K/A filed February 24, 2006 and  incorporated herein by reference). |
| 10.18                |       | Form of  Indemnification Agreement (filed as Exhibit 10.11 to the Third Amendment and  incorporated herein by reference).                                                                          |
| 10.19                |       | Consulting  Services Agreement with Walter J. Culver (filed as Exhibit 10.12 to the 2004  10-K and incorporated herein by reference).                                                              |
| 31.1                 |       | Certifications  of Chief Executive Officer and Chief Financial Officer pursuant to Rule  13a-14(a) as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of  2002 (*).                      |
| 32.1                 |       | Certifications  of Chief Executive Officer and Chief Financial Officer pursuant to 18 U.S.C.  Section 1350, as adopted pursuant to Section 906 of the Sarbanes Oxley Act of  2002 (*).             |

 

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* Indicates filed herewith.

 

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