**UNITEDSTATESSECURITIES AND EXCHANGE COMMISSION**

**Washington,D.C.  20549**

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**FORM 10-Q**

**(MarkOne)**

x                               **QUARTERLY REPORT PURSUANT TOSECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**

**For the quarterly period ended June 30, 2006**

**OR**

o                                  **TRANSITION REPORT PURSUANT TO SECTION13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**

**For the transition period from                  to                 **

**Commission File Number 0-23651**

**FirstConsulting Group, Inc.**

(Exact name of registrant as specified in its charter)

| **Delaware**                     |   | **95-3539020**       |
|----------------------------------|--------|----------------------|
| (State or other  jurisdiction of |   | (I.R.S. Employer     |
| incorporation or  organization)  |   | Identification  No.) |

 

**111 W. Ocean Blvd., 4****th**** Floor, Long Beach, CA  90802**(Address of principalexecutive offices, including zip code)

**(562) 624-5200**(Registrant’stelephone number, including area code)

 

(Former name, former address and former fiscal year, if changed sincelast report)

Indicate by check mark whether the registrant (1) has filed all reportsrequired to be filed by Section 13 or 15(d) of the Securities Exchange Act of1934 during the preceding 12 months (or for such shorter period that theregistrant was required to file such reports), and (2) has been subject to suchfiling requirements for the past 90 days. Yes **x** No **o**

**Indicateby check mark whether the registrant is a large accelerated filer, anaccelerated filer, or a non-accelerated filer. See definition of “accelerate filer and large accelerated filer” in Rule12b-2 of the Exchange Act.**

**Largeaccelerated filer**o                                           Acceleratedfilerx                                            Non-acceleratedfilero

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

**Indicate the number of shares outstanding of each of theRegistrant’s classes of common stock, as of the latest practicable date.**

| **Common Stock, $.001 par value** |   | **25,306,945**                  |
|-----------------------------------|--------|---------------------------------|
| (Class)                           |   | (Outstanding at  July 28, 2006) |

 

 

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**First Consulting Group, Inc**.

**Table ofContents**
| COVER PAGE                                                                                          |   |                                            |
|-----------------------------------------------------------------------------------------------------|--------|-------------------------------------------------|
|                                                                                                |   |                                            |   |   |
| TABLE OF CONTENTS                                                                                   |   |                                            |
|                                                                                                |   |                                            |   |   |
| PART  I.                                                                                            |   | FINANCIAL  INFORMATION                          |   |   |
|                                                                                                |   |                                            |   |   |
| ITEM  1. FINANCIAL STATEMENTS                                                                       |   |                                            |
|                                                                                                |   |                                            |   |   |
|                                                                                                |   | Consolidated  Balance Sheets                    |   |   |
|                                                                                                |   |                                            |   |   |
|                                                                                                |   | Consolidated Statements of Operations           |   |   |
|                                                                                                |   |                                            |   |   |
|                                                                                                |   | Condensed Consolidated Statements of Cash Flows |   |   |
|                                                                                                |   |                                            |   |   |
|                                                                                                |   | 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 RISKS                                |   |
|                                                                                                |   |                                            |   |   |
| 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                                                                                          |   |                                            |
|                                                                                                |   |                                            |   |   |
| EXHIBIT INDEX                                                                                       |   |                                            |
|                                                                                                     |        |                                                 |  |  |  |  |

 

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# **Part I.      Financial Information**

## **Item1. Financial Statements**

**First Consulting Group, Inc. and Subsidiaries**

### **Consolidated Balance Sheets(in thousands, except share and per share data)**

| ** **                                                                                                         | ** ** | **June 30,  2006** | ** ** | **December 30,  2005** | ** ** |
|--------------------------------------------------------------------------------------------------------------------|------------|-------------------------|------------|-----------------------------|------------|
| ** **                                                                                                         | ** ** | **(unaudited)**         | ** ** | ** **                  | ** ** |
| **ASSETS**                                                                                                         | ** ** | ** **              | ** ** | ** **                  | ** ** |
| Current assets:                                                                                                    | ** ** | ** **              | ** ** | ** **                  | ** ** |
| Cash and cash  equivalents                                                                                         |       | $                       | 42,851     |                        | $          | 35,106 |   |
| Accounts  receivable, less allowance of $1,489 and $1,633 as of June 30, 2006 and  December 30, 2005, respectively |       | 24,248                  |       | 20,993                      |       |
| Unbilled  receivables                                                                                              |       | 14,585                  |       | 12,352                      |       |
| Prepaid expenses  and other current assets                                                                         |       | 4,394                   |       | 3,532                       |       |
| Total current  assets                                                                                              |       | 86,078                  |       | 71,983                      |       |
|                                                                                                               |       |                    |       |                        |       |
| Property and equipment:                                                                                            |       |                    |       |                        |       |
| Furniture,  equipment, and leasehold improvements                                                                  |       | 4,470                   |       | 3,475                       |       |
| Information  systems equipment and software                                                                        |       | 30,427                  |       | 30,220                      |       |
|                                                                                                               |       | 34,897                  |       | 33,695                      |       |
| Less accumulated  depreciation and amortization                                                                    |       | 24,177                  |       | 21,365                      |       |
|                                                                                                               |       | 10,720                  |       | 12,330                      |       |
|                                                                                                               |       |                    |       |                        |       |
| Other assets:                                                                                                      |       |                    |       |                        |       |
| Executive  benefit trust                                                                                           |       | 10,261                  |       | 10,141                      |       |
| Long-term  accounts receivable, net                                                                                |       | 2,330                   |       | 1,661                       |       |
| Deferred  contract costs                                                                                           |       | 3,799                   |       | 3,476                       |       |
| Goodwill, net                                                                                                      |       | 18,159                  |       | 18,159                      |       |
| Intangibles, net                                                                                                   |       | 842                     |       | 1,228                       |       |
| Other                                                                                                              |       | 3,170                   |       | 2,654                       |       |
|                                                                                                               |       | 38,561                  |       | 37,319                      |       |
| Total assets                                                                                                       |       | $                       | 135,359    |                        | $          | 121,632 |   |

 

The accompanyingnotes are an integral part of these financial statements.

3

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**First Consulting Group, Inc. and Subsidiaries**

**Consolidated Balance Sheets (Continued)(in thousands, except share and per share data)**
| ** **                                                                                                                                                                                 | ** ** | **June 30,  2006** | ** ** | **December 30,  2005** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------------|------------|-----------------------------|------------|
| ** **                                                                                                                                                                                 | ** ** | **(unaudited)**         | ** ** | ** **                  | ** ** |
| **LIABILITIES AND STOCKHOLDERS’ EQUITY**                                                                                                                                              | ** ** | ** **              | ** ** | ** **                  | ** ** |
| Current  liabilities:                                                                                                                                                                      | ** ** | ** **              | ** ** | ** **                  | ** ** |
| Accounts payable                                                                                                                                                                           |       | $                       | 2,604      |                        | $          | 1,685 |   |
| Accrued liabilities                                                                                                                                                                        |       | 4,634                   |       | 5,280                       |       |
| Accrued payroll and payroll taxes                                                                                                                                                          |       | 2,913                   |       | 1,595                       |       |
| Accrued vacation                                                                                                                                                                           |       | 6,210                   |       | 7,082                       |       |
| Accrued employee benefits                                                                                                                                                                  |       | 2,964                   |       | 2,741                       |       |
| Accrued severance                                                                                                                                                                          |       | 16                      |       | 2,813                       |       |
| Accrued incentive compensation                                                                                                                                                             |       | 1,979                   |       | 1,113                       |       |
| Customer advances                                                                                                                                                                          |       | 10,147                  |       | 7,201                       |       |
| Accrued restructuring costs                                                                                                                                                                |       | 1,512                   |       | 3,204                       |       |
| Total current liabilities                                                                                                                                                                  |       | 32,979                  |       | 32,714                      |       |
| Non-current  liabilities:                                                                                                                                                                  |       |                    |       |                        |       |
| Supplemental executive retirement plan                                                                                                                                                     |       | 9,609                   |       | 10,172                      |       |
| Total non-current liabilities                                                                                                                                                              |       | 9,609                   |       | 10,172                      |       |
| Commitments and  contingencies                                                                                                                                                             |       | —                  |       | —                      |       |
| Stockholders’  equity:                                                                                                                                                                |       |                    |       |                        |       |
| Preferred Stock, $.001 par value; 9,500,000 shares  authorized, no shares issued and outstanding                                                                                           |       | —                  |       | —                      |       |
| Series A Junior Participating Preferred Stock, $.001  par value; 500,000 shares authorized, no shares issued and outstanding                                                               |       | —                  |       | —                      |       |
| Common Stock, $.001 par value; 50,000,000 shares  authorized, 25,249,548 shares issued and outstanding at June 30, 2006 and  24,567,759 shares issued and outstanding at December 30, 2005 |       | 25                      |       | 25                          |       |
| Additional paid-in capital                                                                                                                                                                 |       | 95,546                  |       | 91,202                      |       |
| Deficit                                                                                                                                                                                    |       | (2,875                  | )          | (12,558                     | )          |
| Accumulated other comprehensive income                                                                                                                                                     |       | 75                      |       | 77                          |       |
| Total stockholders’ equity                                                                                                                                                            |       | 92,771                  |       | 78,746                      |       |
| Total  liabilities and stockholders’ equity                                                                                                                                           |       | $                       | 135,359    |                        | $          | 121,632 |   |

 

The accompanyingnotes are an integral part of these financial statements.

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**First Consulting Group, Inc. and Subsidiaries**

**Consolidated Statements of Operations****(in thousands, except per share data)**
| ** **                                                            | ** ** | **Three Months Ended** | ** ** | **Six Months Ended** | ** ** |
|-----------------------------------------------------------------------|------------|----------------------------------|------------|--------------------------------|------------|
| ** **                                                            | ** ** | **(unaudited)**                  | ** ** | **(unaudited)**                | ** ** |
| ** **                                                            | ** ** | **June 30,  2006**          | ** ** | **July 1,  2005**         | ** ** | **June 30,  2006** | ** ** | **July 1,  2005** | ** ** |
| Revenues before  reimbursements                                       |       | $                                | 65,526     |                           | $          | 67,919 |   | $ | 132,212 |   | $ | 136,063 |   |
| Reimbursements                                                        |       | 3,491                            |       | 3,772                          |       | 7,270 |   | 7,434 |   |
| Total revenues                                                        |       | 69,017                           |       | 71,691                         |       | 139,482 |   | 143,497 |   |
|                                                                  |       |                             |       |                           |       |   |   |   |   |
| Cost of services  before reimbursable expenses                        |       | 47,086                           |       | 51,835                         |       | 95,679 |   | 104,325 |   |
| Reimbursable  expenses                                                |       | 3,491                            |       | 3,772                          |       | 7,270 |   | 7,434 |   |
| Total cost of services                                                |       | 50,577                           |       | 55,607                         |       | 102,949 |   | 111,759 |   |
|                                                                  |       |                             |       |                           |       |   |   |   |   |
| Gross profit                                                          |       | 18,440                           |       | 16,084                         |       | 36,533 |   | 31,738 |   |
|                                                                  |       |                             |       |                           |       |   |   |   |   |
| Selling expenses                                                      |       | 4,043                            |       | 7,094                          |       | 8,422 |   | 13,852 |   |
| General and  administrative expenses                                  |       | 9,274                            |       | 10,093                         |       | 18,449 |   | 20,610 |   |
| Income (loss) from operations                                         |       | 5,123                            |       | (1,103                         | )          | 9,662 |   | (2,724 | ) |
| Other income  (expense):                                              |       |                             |       |                           |       |   |   |   |   |
| Interest income, net                                                  |       | 425                              |       | 210                            |       | 763 |   | 440 |   |
| Other income (expense), net                                           |       | 2                                |       | (33                            | )          | (13 | ) | (33 | ) |
| Income (loss) from continuing operations before  income tax provision |       | 5,550                            |       | (926                           | )          | 10,412 |   | (2,317 | ) |
| Income tax  provision                                                 |       | 389                              |       | 6,000                          |       | 729 |   | 5,361 |   |
| Income (loss) from continuing operations                              |       | 5,161                            |       | (6,926                         | )          | 9,683 |   | (7,678 | ) |
| Loss on  discontinued operations, net of tax benefit                  |       | —                           |       | —                         |       | — |   | (537 | ) |
| Net income (loss)                                                     |       | $                                | 5,161      |                           | $          | (6,926 | ) | $ | 9,683 |   | $ | (8,215 | ) |
|                                                                  |       |                             |       |                           |       |   |   |   |   |
| Basic net income  (loss) per share:                                   |       |                             |       |                           |       |   |   |   |   |
| Income (loss)  from continuing operations, net of tax                 |       | $                                | 0.21       |                           | $          | (0.28 | ) | $ | 0.39 |   | $ | (0.32 | ) |
| Loss on discontinued  operations, net of tax                          |       | —                           |       | —                         |       | — |   | (0.02 | ) |
| Net income (loss)                                                     |       | $                                | 0.21       |                           | $          | (0.28 | ) | $ | 0.39 |   | $ | (0.34 | ) |
|                                                                  |       |                             |       |                           |       |   |   |   |   |
| Diluted net  income (loss) per share:                                 |       |                             |       |                           |       |   |   |   |   |
| Income (loss)  from continuing operations, net of tax                 |       | $                                | 0.20       |                           | $          | (0.28 | ) | $ | 0.38 |   | $ | (0.32 | ) |
| Loss on  discontinued operations, net of tax                          |       | —                           |       | —                         |       | — |   | (0.02 | ) |
| Net income (loss)                                                     |       | $                                | 0.20       |                           | $          | (0.28 | ) | $ | 0.38 |   | $ | (0.34 | ) |
|                                                                  |       |                             |       |                           |       |   |   |   |   |
| Weighted average  shares used in computing:                           |       |                             |       |                           |       |   |   |   |   |
| Basic net income (loss) per share                                     |       | 25,045                           |       | 24,343                         |       | 24,875 |   | 24,409 |   |
| Diluted net  income (loss) per share                                  |       | 25,790                           |       | 24,343                         |       | 25,350 |   | 24,409 |   |

 

The accompanyingnotes are an integral part of these financial statements.

5

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**First Consulting Group, Inc. and Subsidiaries**

### **Condensed Consolidated Statements of CashFlows****(in thousands)**

| ** **                                                                            | ** ** | **Six Months Ended** | ** ** |
|---------------------------------------------------------------------------------------|------------|--------------------------------|------------|
| ** **                                                                            | ** ** | **(unaudited)**                | ** ** |
| ** **                                                                            | ** ** | **June 30, 2006**    | ** ** | **July 1, 2005** | ** ** |
| Cash flows from  operating activities:                                                |       |                           |       |   |   |
| Net income (loss):                                                                    |       | $                              | 9,683      |   | $ | (8,215 | ) |
| Adjustments to reconcile net income (loss) to net  cash used in operating activities: |       |                           |       |   |   |
| Depreciation and amortization                                                         |       | 3,604                          |       | 3,107 |   |
| Intangible amortization                                                               |       | 386                            |       | 689 |   |
| Provision for bad debts                                                               |       | (100                           | )          | — |   |
| Loss on sale/disposal of assets                                                       |       | 374                            |       | 2 |   |
| Stock-based compensation                                                              |       | 347                            |       | 38 |   |
| Interest income on notes receivable – stockholders                               |       | —                         |       | (39 | ) |
| Loss on operations of discontinued operations, net  of tax benefit                    |       | —                         |       | 537 |   |
| Change in assets and liabilities:                                                     |       |                           |       |   |   |
| Accounts receivable                                                                   |       | (3,155                         | )          | 4,761 |   |
| Unbilled receivables                                                                  |       | (2,233                         | )          | (3,308 | ) |
| Prepaid expenses and other current assets                                             |       | (862                           | )          | (1,251 | ) |
| Long term account receivable                                                          |       | (669                           | )          | 453 |   |
| Deferred contract costs                                                               |       | (323                           | )          | (260 | ) |
| Other assets                                                                          |       | (575                           | )          | — |   |
| Accounts payable                                                                      |       | 919                            |       | (177 | ) |
| Accrued liabilities                                                                   |       | (646                           | )          | (1,122 | ) |
| Accrued payroll and payroll taxes                                                     |       | 1,318                          |       | (168 | ) |
| Accrued vacation                                                                      |       | (872                           | )          | 992 |   |
| Accrued employee benefits                                                             |       | 223                            |       | 787 |   |
| Accrued severance                                                                     |       | (2,797                         | )          | — |   |
| Accrued incentive compensation                                                        |       | 866                            |       | (605 | ) |
| Customer advances                                                                     |       | 2,946                          |       | (9 | ) |
| Accrued restructuring costs                                                           |       | (1,692                         | )          | (1,064 | ) |
| Deferred income taxes                                                                 |       | —                         |       | 5,361 |   |
| Supplemental executive retirement plan                                                |       | (683                           | )          | 204 |   |
| Other                                                                                 |       | (113                           | )          | (146 | ) |
| Net cash provided by operating activities of  continuing operations                   |       | 5,946                          |       | 567 |   |
| Net cash used in operating activities of  discontinued operations                     |       | —                         |       | (427 | ) |
| Net cash provided by operating activities                                             |       | 5,946                          |       | 140 |   |
| Cash flows from  investing activities:                                                |       |                           |       |   |   |
| Proceeds from sale/maturity of investments                                            |       | —                         |       | 3,879 |   |
| Purchase of property and equipment                                                    |       | (2,410                         | )          | (3,197 | ) |
| Net cash provided by (used in) investing activities  of continuing operations         |       | (2,410                         | )          | 682 |   |
| Net cash provided by investing activities of  discontinued operations                 |       | —                         |       | 75 |   |
| Net cash provided by (used in) investing activities                                   |       | (2,410                         | )          | 757 |   |
| Cash flows from  financing activities:                                                |       |                           |       |   |   |
| Proceeds from issuance of capital stock, net                                          |       | 4,011                          |       | 807 |   |
| Proceeds from loan repayments                                                         |       | 45                             |       | 12 |   |
| Capital stock repurchase                                                              |       | —                         |       | (2,530 | ) |
| Net cash provided by (used in) financing activities                                   |       | 4,056                          |       | (1,711 | ) |
| Effect of exchange rate changes on cash and cash  equivalents                         |       | 153                            |       | (218 | ) |
| Net change in cash and cash equivalents                                               |       | 7,745                          |       | (1,032 | ) |
| Cash and cash  equivalents at beginning of period                                     |       | 35,106                         |       | 15,012 |   |
| Cash and cash  equivalents at end of period                                           |       | $                              | 42,851     |   | $ | 13,980 |   |
| Supplemental  disclosure of cash flow information                                     |       |                           |       |   |   |
| Cash paid during the period for interest                                              |       | $                              | 5          |   | $ | 51 |   |
| Cash paid during the period for income taxes, net of  refunds                         |       | $                              | 318        |   | $ | 173 |   |
| Supplemental  disclosure of non-cash investing and financing activities               |       |                           |       |   |   |
| Release from  escrow of common stock to complete acquisition of business              |       | $                              | —     |   | $ | 900 |   |

 

The accompanyingnotes are an integral part of these financial statements.

6

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**Notes to Consolidated Financial Statements**

**Note 1                    AccountingPolicies**

*Basisof Presentation*

       The accompanyingconsolidated balance sheet of First Consulting Group, Inc. (the “Company” or “FCG”)at June 30, 2006 and consolidated statements of operations and condensed consolidatedstatements of cash flows for the periods ended June 30, 2006 and July 1, 2005are unaudited.  These financialstatements reflect all adjustments, consisting of only normal recurring adjustments,which, in the opinion of management, are necessary to fairly present thefinancial position of the Company at June 30, 2006 and the results ofoperations for the three-month and six-month periods ended June 30, 2006 andJuly 1, 2005.  The results of operationsand cash flows for the three-month and six-month period ended June 30, 2006 arenot necessarily indicative of the results to be expected for the year endingDecember 29, 2006.  For more completefinancial information, these financial statements should be read in conjunctionwith the audited financial statements for the year ended December 30, 2005included in the Company’s Annual Report on Form 10-K.  Certain reclassifications have been made tothe 2005 financial statements to conform to the 2006 presentation.

*Principlesof Consolidation*

The consolidated financial statements include the accounts of theCompany and its subsidiaries.  Allmaterial intercompany accounts and transactions have been eliminated.

*Revised Presentation ofConsolidated Statements of Cash Flow*

The Company hasstated the operating, investing, and financing portions of the cash flows ofdiscontinued operations as separate lines within each such category for allperiods presented, while in prior reports, they were reported on a combinedbasis.

*Revised Presentation of CostClassification*

Commencing withthe first quarter of 2006, the Company has changed the way some expenses areclassified from general and administrative expense to cost of services. Management believes these changes better match the nature of the expense to itsexpense classification, and are consistent with other peer companies’reporting.  Historically, the Company hasonly included salary and benefits costs of client-serving staff, and costs ofsubcontractors in cost of services, a classification methodology emanating fromthe Company’s origins as a consulting firm. As the Company’s outsourcing business has evolved and developed datacenter and call center capabilities, and the Company has moved forward with anoffshore sourcing strategy, infrastructure costs of providing these serviceshave grown dramatically.  Since thesecosts have not been for staff or subcontractors, per the Company’ priordefinition of cost of services, they have been classified as general andadministrative.  The Company is nowclassifying these types of costs as cost of services.  This primarily affects the Company’soutsourcing businesses, its Software Services business, and its “Other”segment, where the costs of the shared service centers for both infrastructureand offshore sourcing are included. All costs in prior years have beenreclassified to be consistent with the fiscal year 2006 presentation.

*Stock-BasedCompensation*

Adoption of SFAS 123R

OnDecember 31, 2005, the Company adopted SFAS No. 123 (revised 2004),*“*Share-BasedPayment” (“SFAS 123R”) and related interpretations, which requires themeasurement and recognition of

7

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compensation expense forall share-based payment awards made to employees and directors, includingemployee stock options, based on estimated grant date fair values.  Previously, the Company elected to accountfor these share-based payment awards using the intrinsic-value method underAccounting Principles Board Opinion No. 25, “Accounting for Stock Issuedto Employees” (“APB 25”), and elected to only disclose the impact of expensingthe fair value of stock options in the notes to the financial statements.  Under the intrinsic-value method in APB 25,compensation cost is the excess, if any, of the quoted market price of thestock at the grant date over the amount an employee must pay to acquire thestock.  The Company grants options withan exercise price equal to the market value of the common stock on the date ofgrant, therefore no compensation expense was recognized related to thoseoptions for the six months ended July 1, 2005. Further, none of the grants contains any market or company-performanceconditions.

The Companyadopted SFAS 123R using the modified prospective transition method whichrequires applying the standard as of December 31, 2005 (“the adoption date”).The modified prospective transition method does not allow for the restatementof prior periods and accordingly, the results of operations for the quarterended June 30, 2006 and future periods will not be comparable to historicalresults of operations.  Under thistransition method, SFAS 123R applies to new equity awards and to equityawards modified, repurchased, or canceled after the adoption date.Additionally, compensation cost for the portion of awards granted prior to theadoption date for which the requisite service has not been rendered as of theadoption date shall be recognized as the requisite service is rendered. Thecompensation cost for that portion of awards shall be based on the grant datefair value of those awards as calculated in the prior period pro formadisclosures under SFAS No. 123, “Accounting for Stock-Based Compensation”(“SFAS 123”). Changes to the grant date fair value of equity awards grantedbefore the effective date are precluded.

Upon adoption ofSFAS 123R, the Company changed its method of attributing the value ofstock-based compensation expense from the multiple-option (i.e., accelerated)approach to the single-option (i.e., straight-line) method. Compensation expensefor share-based awards granted through December 30, 2005 will continue tobe subject to the accelerated multiple-option method, while compensationexpense for share-based awards granted on or after December 31, 2005 willbe recognized using a straight-line, or single-option method.  The Company recognizes these compensationcosts over the service period of the award, which is generally the optionvesting term of three to four years.

SFAS 123R requiresforfeitures to be estimated at the time of grant and revised, if necessary, insubsequent periods if actual forfeitures differ from those estimates in orderto derive the Company’s best estimate of awards ultimately expected to vest.Forfeitures have been estimated based on the Company’s historical experience.In the Company’s pro forma information required under SFAS 123 for the periodsprior to 2006, the Company accounted for forfeitures as they occurred.

Valuationand Expense Information under SFAS 123R

As a result ofadopting SFAS 123R, expense associated with stock-based compensation for thethree months and six months ended June 30, 2006 is $154,000 and $347,000,respectively, which had the effect of reducing basic and diluted earnings pershare by $0.01 in each case.  Stock-basedcompensation included $137,000 as a component of cost of services, $67,000 as acomponent of selling expense, and $143,000 as a component of general andadministrative expense for the six months ended June 30, 2006.  In addition, prior to the adoption of SFAS123R, the Company presented the tax benefit of stock option exercises asoperating cash flows.  Upon the adoptionof SFAS 123R, tax benefits resulting from tax deductions in excess of thecompensation cost recognized for those options are classified as financing cashflows.  For the first six months of 2006,there were no tax benefits resulting from tax deductions in excess of thecompensation cost recognized.  Becausethe Company maintained a full valuation allowance

8

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on its deferred taxassets, the Company did not recognize any tax benefit related to stock-basedcompensation expense for the six months ended June 30, 2006.

The Company hashistorically used the Black-Scholes option pricing model to value its optionsunder SFAS 123, and has elected to continue to do so under SFAS 123R.  The fair value of each option granted duringthe three months and six months ended June 30, 2006 was estimated on thedate of grant using such model with the following assumptions:

|                          | ** ** | **Three Months Ended  June 30 , 2006** | ** ** | **Six Months Ended  June 30 , 2006** | ** ** |
|--------------------------|------------|-----------------------------------------------------------------|------------|---------------------------------------------------------------|------------|
| Expected  volatility     |       | 40.0                                                            | %          | 40.0                                                          | %          |
| Risk-free  interest rate |       | 4.9                                                             | %          | 4.9                                                           | %          |
| Expected dividends       |       | —                                                          |       | —                                                        |       |

 

Expectedvolatilities are based on the Company’s historical volatility. The risk-freeinterest rate assumption is based upon observed interest rates appropriate forthe term of the Company’s employee stock options. The expected dividend yieldis zero as the Company does not expect to pay dividends in the future.  During the six months ended June 30, 2006,the Company issued its automatic annual option grant to its Board of Directorsfor 36,000 options, an additional automatic grant to a new member of the Boardof Directors for 24,000 options, and a grant in June 2006 to its new ChiefExecutive Officer for 500,000 options.

Stock option activity for the six months ended June 30, 2006 is asfollows:
| ** **                        | ** ** | **Shares** | ** ** | **Weighted Average  Exercise Price** | ** ** | **Weighted Average  Remaining  Contractual Life** | ** ** |
|-----------------------------------|------------|------------|------------|------------------------------------------------|------------|-------------------------------------------------------------|------------|
| Outstanding at  December 30, 2005 |       | 4,665,491  |       | $                                              | 7.43       |                                                        |       |   |
| Grants                            |       | 560,000    |       | $                                              | 8.89       |                                                        |       |   |
| Exercised                         |       | (683,859   | )          | $                                              | 5.86       |                                                        |       |   |
| Cancelled                         |       | (572,436   | )          | $                                              | 8.89       |                                                        |       |   |
| Outstanding at  June 30, 2006     |       | 3,969,196  |       | $                                              | 7.69       |                                                        | 5.80       |   |
|                              |       |       |       |                                           |       |                                                        |       |
| Exercisable at June 30,  2006     |       | 2,913,460  |       | $                                              | 7.83       |                                                        | 4.74       |   |

 

As of June 30, 2006, there was $1.6 million of total unrecognizedcompensation cost related to unvested stock options.  This cost is expected to be recognized over aweighted-average period of approximately 1.6 years.

ProForma Information Under SFAS 123 For Periods Prior to 2006

For the periodsprior to 2006, the Company elected to apply APB 25 and related interpretationsin accounting for its stock-based compensation plans. The following is areconciliation of net loss per weighted average share had the Company adoptedthe fair value recognition provisions of SFAS 123 for the three and six monthsended July 1, 2005 (in thousands, except per share amounts):

9

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| ** **                                                                                                                                          | ** ** | **Three Months Ended  July 1, 2005** | ** ** | **Six Months Ended  July 1, 2005** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------------------|------------|----------------------------------------------------------|------------|--------------------------------------------------------|------------|
| Net loss                                                                                                                                            |       | $                                                        | (6,926     | )                                                      | $          | (8,215 | ) |
| Deduct:   Total stock-based employee  compensation expense determined under fair value method for all awards, net  of tax            |       | (439                                                     | )          | (680                                                   | )          |
| Add:        Amount  of such stock-based compensation expense included in net loss under APB 25,  net of tax |       | —                                                   |       | —                                                 |       |
| Pro forma net  loss                                                                                                                                 |       | $                                                        | (7,365     | )                                                      | $          | (8,895 | ) |
|                                                                                                                                                |       |                                                     |       |                                                   |       |
| Basic and  diluted loss per share             As  reported                         |       | $                                                        | (0.28      | )                                                      | $          | (0.34 | ) |
| Pro forma                                                                                                                                           |       | $                                                        | (0.30      | )                                                      | $          | (0.36 | ) |

 

*Basicand Diluted Net Income (Loss) Per Share*

Basic net income(loss) per share is based upon the weighted average number of common sharesoutstanding.  Diluted net income pershare is based on the assumption that stock options were exercised.  Dilution is computed by applying the treasurystock method. Under this method, options are assumed to be exercised at thebeginning of the period (or at the time of issuance, if later), and as if fundsobtained by the Company from such exercise were used by the Company to purchasecommon stock at the average market price during the period. Stock options arenot considered when computing diluted net loss per share as they are consideredanti-dilutive.

The following represents a reconciliation of basic and diluted netincome (loss) per share for the three months and six months ended June 30, 2006and July 1, 2005 (in thousands, except per share data):
| ** **                                                 | ** ** | **Three Months Ended** | ** ** | **Six Months Ended** | ** ** |
|------------------------------------------------------------|------------|----------------------------------|------------|--------------------------------|------------|
| ** **                                                 | ** ** | **June 30,  2006**          | ** ** | **July 1,  2005**         | ** ** | **June 30,  2006** | ** ** | **July 1,  2005** | ** ** |
|  Income (loss) from continuing operations             |       | $                                | 5,161      |                           | $          | (6,926 | ) | $ | 9,683 |   | $ | (7,678 | ) |
|  Loss on discontinued operations, net of tax  benefit |       | —                           |       | —                         |       | — |   | (537 | ) |
| Net income (loss)                                          |       | $                                | 5,161      |                           | $          | (6,926 | ) | $ | 9,683 |   | $ | (8,215 | ) |
|                                                       |       |                             |       |                           |       |   |   |   |   |
| Basic weighted  average number of shares outstanding       |       | 25,045                           |       | 24,343                         |       | 24,875 |   | 24,409 |   |
| Effect of  dilutive options and contingent shares          |       | 745                              |       | —                         |       | 475 |   | — |   |
| Diluted weighted average number of shares  outstanding     |       | 25,790                           |       | 24,343                         |       | 25,350 |   | 24,409 |   |
|                                                       |       |                             |       |                           |       |   |   |   |   |
| Basic per share:                                           |       |                             |       |                           |       |   |   |   |   |
| Income (loss)  from continuing operations                  |       | $                                | 0.21       |                           | $          | (0.28 | ) | $ | 0.39 |   | $ | (0.32 | ) |
| Loss on  discontinued operations, net of tax benefit       |       | —                           |       | —                         |       | — |   | (0.02 | ) |
| Net income (loss) per share                                |       | $                                | 0.21       |                           | $          | (0.28 | ) | $ | 0.39 |   | $ | (0.34 | ) |
|                                                       |       |                             |       |                           |       |   |   |   |   |
| Diluted per  share:                                        |       |                             |       |                           |       |   |   |   |   |
| Income (loss)  from continuing operations                  |       | $                                | 0.20       |                           | $          | (0.28 | ) | $ | 0.38 |   | $ | (0.32 | ) |
| Loss on  discontinued operations, net of tax benefit       |       | —                           |       | —                         |       | — |   | (0.02 | ) |
| Net income  (loss) per share                               |       | $                                | 0.20       |                           | $          | (0.28 | ) | $ | 0.38 |   | $ | (0.34 | ) |

 

For the three months ended June 30, 2006 and July 1, 2005, there were1,135,146 and 5,218,823 anti-dilutive outstanding stock options, respectively,excluded from the calculation of diluted income (loss) per share.  For the six months ended June 30, 2006 andJuly 1, 2005, there were 1,952,065 and

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5,231,175anti-dilutive outstanding stock options, respectively, excluded from thecalculation of diluted income (loss) per share.

*Use ofEstimates*

In preparingfinancial statements in conformity with accounting principles generallyaccepted in the United States of America, management is required to makeestimates and assumptions that affect the reported amounts of assets andliabilities, the disclosure of contingent assets and liabilities at the date ofthe financial statements, and the reported amounts of revenues and expensesduring the reporting period. Actual results could differ from thoseestimates.  On an ongoing basis, theCompany evaluates its estimates, including those related to revenue recognition,valuation of goodwill, stock-based compensation, long-lived and intangibleassets, other accrued liabilities, income taxes including the amount of taxasset valuation allowance required, restructuring costs, litigation anddisputes, and the allowance for doubtful accounts.

The Company basesits estimates on historical experience and on various other assumptions thatare believed to be reasonable under the circumstances, the results of whichform the basis for making judgments about the carrying values of assets andliabilities that are not readily apparent from other sources.  Such estimates are subject to a number ofassumptions, risks, and uncertainties, many of which are beyond the Company’scontrol.  The Company’s actual resultsmay differ from its estimates.

*Cash and Cash Equivalents*

For purposes ofreporting, cash and cash equivalents include cash and interest-earning depositsor securities purchased with original maturities of three months or less.

*New Accounting Standard –Accounting for Uncertainty in Income Taxes*

  In June 2006, the FASB issued FASBInterpretation No. 48, “Accounting for Uncertainty in Income Taxes” (“FIN 48”).  FIN 48 clarifies the application of SFAS No.109, “Accounting for Income Taxes”, by establishing a threshold condition thata tax position must meet for any part of the benefit of that position to berecognized in the financial statements. In addition to recognition, FIN 48 provides guidance concerningmeasurement, de-recognition, classification, and disclosure of taxpositions.  FIN 48 is effective forfiscal years beginning after December 15, 2006 and the Company will adopt FIN48 in the first quarter of 2007.  Managementhas not yet determined the impact that FIN 48 will have on its consolidatedfinancial statements or on the effective tax rate in future periods.

**Note 2                    Investments**

At June 30, 2006 and December 30, 2005, the Company had $325,000 ofnon-marketable equity investments, valued at the lower of cost or estimatedfair value, which were included within other assets.

**Note 3                    Long-TermReceivable**

At June 30, 2006, the Company carried a $2.3 million long-term accountreceivable.  Of this amount, $2.1 millionrepresents the discounted value of the deferral of one and one-half month’srevenue on an outsourcing contract which began in August 2005.  This payment has been deferred until thecurrent expiration date of the contract in December 2009.  The receivable was discounted using aninterest rate of 7% and the unamortized discount at June 30, 2006 was $593,000.

11

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**Note 4                    StockRepurchase**

On February 23,2005, the Company repurchased certain shares of the Company’s common stockwhich had been part of the consideration paid for the purchase of an entityacquired in fiscal year 2002 from the shareholders of that acquiredentity.  A total of 422,018 shares wererepurchased for approximately $2.5 million in cash.  The repurchased shares were subsequentlycancelled.

**Note 5                    Goodwilland Intangible Assets**

Under SFAS 142,the Company no longer amortizes its goodwill and is required to complete anannual impairment testing which is performed during the fourth quarter of eachyear.  The Company believes that the accounting assumptions and estimatesrelated to the annual goodwill impairment testing are critical because thesecan change from period to period.  Various assumptions, such as discountrates, and comparable company analysis are used in performing thesevaluations.  The impairment test requiresthe Company to forecast future cash flows, which involves significantjudgment.   Accordingly, if expectations of future operating resultschange, or if there are changes to other assumptions, estimates of the fairvalue of reporting units could change significantly resulting in a goodwillimpairment charge, which could have a significant impact on the consolidatedfinancial statements.  The Company performed an impairment test on each ofits components of goodwill as of the fourth quarter of fiscal year 2005 anddetermined that none of its goodwill was impaired.  As of June 30, 2006, the Company had $18.2million of goodwill and $842,000 of amortizable intangible assets recorded onits balance sheet.

There were no changes in the net carrying amounts of goodwill for thesix months ended June 30, 2006.  Theamounts of goodwill are as follows (in thousands):
|                                  | ** ** | **Health  Delivery  Services** | ** ** | **Health  Delivery  Outsourcing** | ** ** | **Life  Sciences** | ** ** | **Government  & Technology  Services** | ** ** | **Total**  | ** ** |
|----------------------------------|------------|--------------------------------|------------|-----------------------------------|------------|--------------------|------------|-------------------------------------------------|------------|------------|------------|
| Balance as of  December 30, 2005 |       | $                              | 3,225      |                              | $          | 5,193              |       | $                                               | 1,481      |       | $          | 8,260 | ** ** | **$** | **18,159** | ** ** |
| Acquired                         |       | —                         |       | —                            |       | —             |       | —                                          | ** ** | **—** | ** ** |
| Balance as of June 30,  2006     |       | $                              | 3,225      |                              | $          | 5,193              |       | $                                               | 1,481      |       | $          | 8,260 | ** ** | **$** | **18,159** | ** ** |

 

As of June 30, 2006, the Company had the following acquired intangibleassets (in thousands):

|                                  | ** ** | **Customer  Related** | ** ** |
|----------------------------------|------------|-----------------------|------------|
| Balance as of  December 30, 2005 |       | $                     | 1,228      |   |
| Amortization                     |       | (386                  | )          |
| Balance as of  June 30, 2006     |       | $                     | 842        |   |
| Amortization Period in  Years    |       | 4                     |       |

 

The following table summarizes the estimated remaining annual pretaxamortization expense for these assets (in thousands):

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| Fiscal Year          | ** ** | ** ** | ** ** |
|---------------------------|------------|------------|------------|
| 2006 (remainder  of year) |       | $          | 386        |   |
| 2007                      |       | 456        |       |
| Total                     |       | $          | 842        |   |

 

**Note 6                    RestructuringCosts**

**At June 30, 2006, the Company hadapproximately $1.5 million in restructuring accrual which related to facilityclosure costs incurred in prior years, primarily in the Life Sciencessegment.  In February 2006, the Companysigned an agreement with a landlord to return excess space.  As part of the agreement, the Company isrequired to make $2.9 million of payments to the landlord in equal installmentsover the last ten months of fiscal year 2006 in order to extinguish the Company’sobligations under the lease.**

**The restructuring cost liabilityactivity through June 30, 2006 is summarized as follows (in thousands):**
| Accrual balance at December  30, 2005 |   | $      | 3,204 |   |
|---------------------------------------|--------|--------|-------|--------|
| Cash payments                         |   | (1,692 | )     |
| Accrual balance at June  30, 2006     |   | $      | 1,512 |   |

 

**Note 7                    ComprehensiveIncome (Loss)**

Comprehensive income (loss), net of taxes, for the three months and sixmonths ended June 30, 2006 and July 1, 2005, is as follows (in thousands):
|                                          | ** ** | **Three Months Ended** | ** ** | **Six Months Ended** | ** ** |
|------------------------------------------|------------|----------------------------------|------------|--------------------------------|------------|
| ** **                               | ** ** | **June 30,  2006**          | ** ** | **July 1,  2005**         | ** ** | **June 30,  2006** | ** ** | **July 1,  2005** | ** ** |
| Net income  (loss)                       |       | $                                | 5,161      |                           | $          | (6,926 | ) | $ | 9,683 |   | $ | (8,215 | ) |
|                                     |       |                             |       |                           |       |   |   |   |   |
| Foreign currency  translation adjustment |       | 5                                |       | (290                           | )          | 10 |   | (390 | ) |
| Unrealized loss  on investments          |       | (6                               | )          | (1                             | )          | (12 | ) | (1 | ) |
| Other  comprehensive loss, net of tax    |       | (1                               | )          | (291                           | )          | (2 | ) | (391 | ) |
|                                     |       |                             |       |                           |       |   |   |   |   |
| Comprehensive income  (loss)             |       | $                                | 5,160      |                           | $          | (7,217 | ) | $ | 9,681 |   | $ | (8,606 | ) |

 

**Note 8                    DiscontinuedOperations**

OnDecember 7, 2004, the Company’s Board of Directors approved a plan to sell andexit its clinical and non-clinical Call Center Services (“CCS”) operation dueto recurring losses.  On February 2, 2005, the Company executed a definitiveagreement with the MPB Group, LLC, d/b/a The Beryl Companies.  FCGreceived 12 monthly payments of $12,500, totaling $150,000, for selectedcustomer contracts. The disposal plan consisted primarily of the termination ofnormal CCS activity, calculation of termination benefits for the existing CCSemployees, termination of a lease agreement, abandonment of property andequipment, collection of accounts receivable, and settlement of liabilities. Inaccordance with SFAS 144, “Accounting for the Impairment or Disposal ofLong-Lived Assets,” this disposal represents a discontinued operation.

SinceApril 1, 2005, there have been no remaining activities in this business.  A summary of results for CCS for the quarterended April 1, 2005 included revenues of $631,000 and a pre-tax loss of

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$866,000 which related tothe sales, operation, and wind-down of the business, including $276,000 relatedto severance costs for the remaining staff of 37 people.  This pretax loss resulted in a net loss of$537,000 after a 38% tax benefit.

**Note 9                    Disclosureof Segment Information**

For fiscal year2006, the Company has the following six reportable segments:

·                  Health DeliveryServices - the delivery of consulting and systems integration services tohealth delivery clients;

·                  Health DeliveryOutsourcing - the delivery of outsourcing services to health delivery clients;

·                  Life Sciences -the delivery of consulting and systems integration services to pharmaceuticaland other life sciences clients;

·                  Health Plan -the delivery of consulting and systems integration services and outsourcingservices to health plan clients;

·                  Government andTechnology Services - the delivery of consulting services to governmentclients, and the delivery of blended shore software development; and

·                  SoftwareProducts - the delivery of solutions involving the use of software to healthdelivery clients.

Additionally, theCompany has three shared service centers that provide services to multiplebusiness segments.  These shared servicecenters include FCG India, Integration Services, and InfrastructureServices.   The costs of these servicesare internally billed and reported in the individual business segments as costof services at a standard transfer cost.

Due to anorganizational change that the Company made which took effect at the beginningof 2006, the Technology Staffing Services (TSS) group has been moved fromGovernment and Technology Services to “Other.” FCG has reclassified previous segment reporting in accordance with SFAS131.  The history shown in the financial tables included with this releaseis now consistent with these changes.  This business is beingde-emphasized by the Company.  Althoughsome of the billable staff who were previously included in this business areahave been transferred to several of the Company’s other segments as part ofthis organizational change, it is impractical to reclassify the effect on thosesegments in prior years.  Additionally,the Health Delivery Sales group has been disbanded as a separate group servingboth Health Delivery Services and Health Delivery Outsourcing, with all sellingcosts now being contained within each individual unit.  FCG has reclassified such prior year costs toeach unit based on an estimate of the services provided to that unit by the HealthDelivery Sales group.

The Companyevaluates its segments’ performance based on revenues and operatingincome.  Certain selling and general andadministrative expenses (including corporate functions, occupancy relatedcosts, depreciation, professional development, recruiting, and marketing) aremanaged at the corporate level and allocated to each operating segment based oneither net revenues and/or actual usage. The Company does not manage or track most assets by segment.  As a result, interest and other charges arenot included in the tables below.

The followingsegment information is for the three months and six months ended June 30, 2006and July 1, 2005 (inthousands):

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**For the three months endedJune 30, 2006:**(in thousands)
|                                                | ** ** | **Health  Delivery  Services** | ** ** | **Health  Delivery  Outsourcing** | *** *** | ***Health  Delivery  Total*** | ** ** | **Life  Sciences** | ** ** | **Health  Plan** | ** ** | **Government  &  Technology  Services** | ** ** | **Software  Products** | ** ** | **Other** | ** ** | **Totals** | ** ** |
|------------------------------------------------|------------|--------------------------------|------------|-----------------------------------|--------------|-------------------------------|------------|--------------------|------------|------------------|------------|---------------------------------------------|------------|------------------------|------------|-----------|------------|------------|------------|
| Revenues before reimbursements                 |       | $                              | 13,881     |                              | $            | 26,780                        | * *   | *$*                | *40,661*   |             | $          | 8,339                                       |       | $                      | 7,410      |      | $          | 7,921      |       | $ | 787 |   | $ | 408 |   | **$** | **65,526** | ** ** |
| Reimbursements                                 |       | 1,958                          |       | 32                                | * *     | *1,990*                       | * *   | 188                |       | 938              |       | 355                                         |       | 18                     |       | 2         | ** ** | **3,491**  | ** ** |
| Total revenues                                 |       | 15,839                         |       | 26,812                            | * *     | *42,651*                      | * *   | 8,527              |       | 8,348            |       | 8,276                                       |       | 805                    |       | 410       | ** ** | **69,017** | ** ** |
| Cost  of services before reimbursable expenses |       | 8,388                          |       | 23,044                            | * *     | *31,432*                      | * *   | 4,545              |       | 5,302            |       | 4,865                                       |       | 670                    |       | 272       | ** ** | **47,086** | ** ** |
| Reimbursable expenses                          |       | 1,958                          |       | 32                                | * *     | *1,990*                       | * *   | 188                |       | 938              |       | 355                                         |       | 18                     |       | 2         | ** ** | **3,491**  | ** ** |
| Total cost of services                         |       | 10,346                         |       | 23,076                            | * *     | *33,422*                      | * *   | 4,733              |       | 6,240            |       | 5,220                                       |       | 688                    |       | 274       | ** ** | **50,577** | ** ** |
| Gross profit                                   |       | 5,493                          |       | 3,736                             | * *     | *9,229*                       | * *   | 3,794              |       | 2,108            |       | 3,056                                       |       | 117                    |       | 136       | ** ** | **18,440** | ** ** |
| Selling  expenses                              |       | 1,654                          |       | 270                               | * *     | *1,924*                       | * *   | 846                |       | 564              |       | 556                                         |       | 123                    |       | 30        | ** ** | **4,043**  | ** ** |
| General & administrative  expenses         |       | 2,336                          |       | 1,950                             | * *     | *4,286*                       | * *   | 2,076              |       | 1,014            |       | 1,019                                       |       | 247                    |       | 632       | ** ** | **9,274**  | ** ** |
| Income (loss) from operations                  |       | $                              | 1,503      |                              | $            | 1,516                         | * *   | *$*                | *3,019*    |             | $          | 872                                         |       | $                      | 530        |      | $          | 1,481      |       | $ | (253 | ) | $ | (526 | ) | **$** | **5,123** | ** ** |

**For the three months ended July 1, 2005:**(in thousands)
| ** **                                     | ** ** | **Health  Delivery  Services** | ** ** | **Health  Delivery  Outsourcing** | *** *** | ***Health  Delivery  Total*** | ** ** | **Life  Sciences** | ** ** | **Health  Plan** | ** ** | **Government  &  Technology  Services** | ** ** | **Software  Products** | ** ** | **Other** | ** ** | **Totals** | ** ** |
|------------------------------------------------|------------|--------------------------------|------------|-----------------------------------|--------------|-------------------------------|------------|--------------------|------------|------------------|------------|---------------------------------------------|------------|------------------------|------------|-----------|------------|------------|------------|
| Revenues  before reimbursements                |       | $                              | 17,097     |                              | $            | 28,659                        | * *   | *$*                | *45,756*   |             | $          | 8,844                                       |       | $                      | 4,121      |      | $          | 6,994      |       | $ | 593 |   | $ | 1,611 |   | **$** | **67,919** | ** ** |
| Reimbursements                                 |       | 2,532                          |       | 238                               | * *     | *2,770*                       |       | 224                |       | 546              |       | 110                                         |       | 32                     |       | 90        | ** ** | **3,772**  | ** ** |
| Total revenues                                 |       | 19,629                         |       | 28,897                            | * *     | *48,526*                      |       | 9,068              |       | 4,667            |       | 7,104                                       |       | 625                    |       | 1,701     | ** ** | **71,691** | ** ** |
| Cost  of services before reimbursable expenses |       | 10,531                         |       | 26,290                            | * *     | *36,821*                      |       | 4,851              |       | 3,200            |       | 3,953                                       |       | 976                    |       | 2,034     | ** ** | **51,835** | ** ** |
| Reimbursable  expenses                         |       | 2,532                          |       | 238                               | * *     | *2,770*                       |       | 224                |       | 546              |       | 110                                         |       | 32                     |       | 90        | ** ** | **3,772**  | ** ** |
| Total cost of services                         |       | 13,063                         |       | 26,528                            | * *     | *39,591*                      |       | 5,075              |       | 3,746            |       | 4,063                                       |       | 1,008                  |       | 2,124     | ** ** | **55,607** | ** ** |
| Gross profit (loss)                            |       | 6,566                          |       | 2,369                             | * *     | *8,935*                       |       | 3,993              |       | 921              |       | 3,041                                       |       | (383                   | )          | (423      | )          | **16,084** | ** ** |
| Selling  expenses                              |       | 2,232                          |       | 900                               | * *     | *3,132*                       |       | 1,879              |       | 606              |       | 600                                         |       | 132                    |       | 745       | ** ** | **7,094**  | ** ** |
| General  & administrative expenses         |       | 3,148                          |       | 1,632                             | * *     | *4,780*                       |       | 2,165              |       | 784              |       | 1,072                                       |       | 415                    |       | 877       | ** ** | **10,093** | ** ** |
| Income (loss) from operations                  |       | $                              | 1,186      |                              | $            | (163                          | )          | *$*                | *1,023*    |             | $          | (51                                         | )          | $                      | (469       | )         | $          | 1,369      |       | $ | (930 | ) | $ | (2,045 | ) | **$** | **(1,103** | **)** |

 

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**For the six months endedJune 30, 2006:**(in thousands)
|                                                | ** ** | **Health  Delivery  Services** | ** ** | **Health  Delivery  Outsourcing** | *** *** | ***Health  Delivery  Total*** | ** ** | **Life  Sciences** | ** ** | **Health  Plan** | ** ** | **Government  &  Technology  Services** | ** ** | **Software  Products** | ** ** | **Other** | ** ** | **Totals**  | ** ** |
|------------------------------------------------|------------|--------------------------------|------------|-----------------------------------|--------------|-------------------------------|------------|--------------------|------------|------------------|------------|---------------------------------------------|------------|------------------------|------------|-----------|------------|-------------|------------|
| Revenues before reimbursements                 |       | $                              | 29,276     |                              | $            | 54,213                        | * *   | *$*                | *83,489*   |             | $          | 16,086                                      |       | $                      | 14,233     |      | $          | 15,619      |       | $ | 1,745 |   | $ | 1,040 | ** ** | **$** | **132,212** | ** ** |
| Reimbursements                                 |       | 4,261                          |       | 69                                | * *     | *4,330*                       |       | 399                |       | 1,854            |       | 646                                         |       | 31                     |       | 10        | ** ** | **7,270**   | ** ** |
| Total revenues                                 |       | 33,537                         |       | 54,282                            | * *     | *87,819*                      |       | 16,485             |       | 16,087           |       | 16,265                                      |       | 1,776                  |       | 1,050     | ** ** | **139,482** | ** ** |
| Cost  of services before reimbursable expenses |       | 17,827                         |       | 47,090                            | * *     | *64,917*                      |       | 9,290              |       | 9,853            |       | 9,641                                       |       | 1,482                  |       | 496       | ** ** | **95,679**  | ** ** |
| Reimbursable expenses                          |       | 4,261                          |       | 69                                | * *     | *4,330*                       |       | 399                |       | 1,854            |       | 646                                         |       | 31                     |       | 10        | ** ** | **7,270**   | ** ** |
| Total cost of services                         |       | 22,088                         |       | 47,159                            | * *     | *69,247*                      |       | 9,689              |       | 11,707           |       | 10,287                                      |       | 1,513                  |       | 506       | ** ** | **102,949** | ** ** |
| Gross profit                                   |       | 11,449                         |       | 7,123                             | * *     | *18,572*                      |       | 6,796              |       | 4,380            |       | 5,978                                       |       | 263                    |       | 544       | ** ** | **36,533**  | ** ** |
| Selling  expenses                              |       | 3,774                          |       | 432                               | * *     | *4,206*                       |       | 1,729              |       | 1,037            |       | 1,130                                       |       | 241                    |       | 79        | ** ** | **8,422**   | ** ** |
| General & administrative  expenses         |       | 4,507                          |       | 3,833                             | * *     | *8,340*                       |       | 4,237              |       | 2,117            |       | 2,062                                       |       | 505                    |       | 1,188     | ** ** | **18,449**  | ** ** |
| Income (loss) from operations                  |       | $                              | 3,168      |                              | $            | 2,858                         | * *   | *$*                | *6,026*    |             | $          | 830                                         |       | $                      | 1,226      |      | $          | 2,786       |       | $ | (483 | ) | $ | (723 | ) | **$** | **9,662** | ** ** |

**For the six months ended July 1, 2005:**(in thousands)
|                                                | ** ** | **Health  Delivery  Services** | ** ** | **Health  Delivery  Outsourcing** | *** *** | ***Health  Delivery  Total*** | ** ** | **Life  Sciences** | ** ** | **Health  Plan** | ** ** | **Government  &  Technology  Services** | ** ** | **Software  Products** | ** ** | **Other** | ** ** | **Totals**  | ** ** |
|------------------------------------------------|------------|--------------------------------|------------|-----------------------------------|--------------|-------------------------------|------------|--------------------|------------|------------------|------------|---------------------------------------------|------------|------------------------|------------|-----------|------------|-------------|------------|
| Revenues before reimbursements                 |       | $                              | 33,166     |                              | $            | 59,395                        | * *   | *$*                | *92,561*   |             | $          | 17,559                                      |       | $                      | 8,131      |      | $          | 13,145      |       | $ | 1,130 |   | $ | 3,537 | ** ** | **$** | **136,063** | ** ** |
| Reimbursements                                 |       | 5,049                          |       | 370                               | * *     | *5,419*                       |       | 421                |       | 1,127            |       | 235                                         |       | 53                     |       | 179       | ** ** | **7,434**   | ** ** |
| Total revenues                                 |       | 38,215                         |       | 59,765                            | * *     | *97,980*                      |       | 17,980             |       | 9,258            |       | 13,380                                      |       | 1,183                  |       | 3,716     | ** ** | **143,497** | ** ** |
| Cost  of services before reimbursable expenses |       | 21,346                         |       | 53,225                            | * *     | *74,571*                      |       | 9,431              |       | 6,459            |       | 7,660                                       |       | 1,860                  |       | 4,344     | ** ** | **104,325** | ** ** |
| Reimbursable expenses                          |       | 5,049                          |       | 370                               | * *     | *5,419*                       |       | 421                |       | 1,127            |       | 235                                         |       | 53                     |       | 179       | ** ** | **7,434**   | ** ** |
| Total cost of services                         |       | 26,395                         |       | 53,595                            | * *     | *79,990*                      |       | 9,852              |       | 7,586            |       | 7,895                                       |       | 1,913                  |       | 4,523     | ** ** | **111,759** | ** ** |
| Gross profit (loss)                            |       | 11,820                         |       | 6,170                             | * *     | *17,990*                      |       | 8,128              |       | 1,672            |       | 5,485                                       |       | (730                   | )          | (807      | )          | **31,738**  | ** ** |
| Selling  expenses                              |       | 4,339                          |       | 1,710                             | * *     | *6,049*                       |       | 3,784              |       | 1,142            |       | 1,163                                       |       | 274                    |       | 1,440     | ** ** | **13,852**  | ** ** |
| General & administrative  expenses         |       | 6,335                          |       | 3,455                             | * *     | *9,790*                       |       | 4,645              |       | 1,524            |       | 2,122                                       |       | 776                    |       | 1,753     | ** ** | **20,610**  | ** ** |
| Income (loss) from operations                  |       | $                              | 1,146      |                              | $            | 1,005                         | * *   | *$*                | *2,151*    |             | $          | (301                                        | )          | $                      | (994       | )         | $          | 2,200       |       | $ | (1,780 | ) | $ | (4,000 | ) | **$** | **(2,724** | **)** |

 

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The “other” column includes reclassifications related to the charging outof the shared service centers described above, as well as the results of theremainder of the TSS business discussed above, with the net loss in that columnprimarily consisting of under absorption of shared service center or supportcosts into the segments, and a loss incurred by the TSS business.

*Detailof Health Delivery Outsourcing Revenues*

Health Delivery Outsourcing revenues before reimbursements includerevenues related to a major subcontractor on three projects in 2005, and oneproject in 2006.  The breakdown ofrevenue in Health Delivery Outsourcing is as follows (in thousands):
| ** **                     | ** ** | **Three Months Ended** | ** ** | **Six Months Ended** | ** ** |
|--------------------------------|------------|----------------------------------|------------|--------------------------------|------------|
| ** **                     | ** ** | **June 30,  2006**          | ** ** | **July 1,  2005**         | ** ** | **June 30,  2006** | ** ** | **July 1,  2005** | ** ** |
| Internally generated  revenues |       | $                                | 25,306     |                           | $          | 23,469 |   | $ | 51,437 |   | $ | 48,562 |   |
| Subcontractor revenues         |       | 1,474                            |       | 5,190                          |       | 2,776 |   | 10,833 |   |
| Revenues before reimbursements |       | $                                | 26,780     |                           | $          | 28,659 |   | $ | 54,213 |   | $ | 59,395 |   |

 

**Note 10                  IncomeTaxes**

The Company recorded a $729,000 tax provision for the six months endedJune 30, 2006 versus a $5.4 million tax provision for the six months ended July1, 2005.  The 7% tax provision for thesix months ended June 30, 2006 was for annual estimated current taxes payablefor U.S. federal alternative minimum tax and certain state and foreign incometaxes, as the Company’s net operating loss carryforwards offset most of thefederal and certain state tax liabilities. The tax provision for the six months ended July 1, 2005 primarilyconsisted of a $6.0 million tax asset valuation allowance.  The valuation allowance was recorded as aresult of the historical losses the Company had incurred, creating additionalnegative evidence as to the uncertainty of its ability to realize the deferredtax assets, as assessed per the guidance of the applicable tax accountingstandard, SFAS 109.

**Item2.  Management’s Discussion and Analysisof Financial Condition and Results of Operations**

THE FOLLOWINGMANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OFOPERATIONS CONTAINS FORWARD-LOOKING STATEMENTS WITHIN THE MEANING OF THEPRIVATE SECURITIES LITIGATION REFORM ACT OF 1995.  SUCH FORWARD-LOOKING STATEMENTS INVOLVE RISKSAND UNCERTAINTIES, INCLUDING THOSE SET FORTH IN PART II, ITEM 1A OF THIS REPORTAND CONTAINED IN OTHER REPORTS WE FILE WITH THE SECURITIES AND EXCHANGECOMMISSION.  OUR ACTUAL RESULTS COULDDIFFER MATERIALLY FROM THOSE ANTICIPATED IN THESE FORWARD-LOOKING STATEMENTS.

**Overview**

We provideservices primarily to providers, payors, government agencies, pharmaceutical,biogenetic, and other healthcare organizations in North America, Europe, andAsia.  We generate substantially all ofour revenues from fees for information technology outsourcing services andprofessional services.

We typically bill for our services on an hourly or fixed-fee basis asspecified by the agreement with a particular client.  For services billed on an hourly basis, inour consulting and systems integration businesses (“CSI”), fees are determinedby multiplying the amount of time expended on each assignment by the projecthourly rate for the staff members assigned to the engagement.  Fixed fees, including

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outsourcingfees, are established on a per-assignment or monthly basis and are based onseveral factors such as the size, scope, complexity and duration of anassignment, the number of our employees required to complete the assignment,and the volume of transactions or interactions. Revenues are generally recognized related to the level of servicesperformed, the amount of cost incurred on the assignment versus the estimatedtotal cost to complete the assignment, or on a straight-line basis over theperiod of performance of service. Additionally, we have been licensing an increased amount of our softwareproducts, generally in conjunction with the customization and implementation ofsuch software products.  Revenues fromour software licensing and maintenance were approximately 3.1% of our netrevenues in fiscal year 2005 and 4.3% of our net revenues for the six monthsended June 30, 2006.  We expect oursoftware licensing and related implementation revenues to continue to growincrementally during our 2006 fiscal year.

Provisions aremade for estimated uncollectible amounts based on our historicalexperience.  We may obtain payment inadvance of providing services.  Theseadvances are recorded as customer advances and reflected as a liability on ourbalance sheet until services are provided. Provisions for estimated losses on individual contracts are made in theperiod in which the loss first becomes known.

Out-of-pocketexpenses billed and reimbursed by clients are included in total revenues, andthen deducted to determine revenues before reimbursements (“net revenues”).  For purposes of analysis, all percentages inthis discussion are stated as a percentage of net revenues, since we believethat this is the more relevant measure of our business.

Cost of servicesprimarily consists of the salaries, bonuses, and related benefits ofclient-serving staff, subcontractor expenses, and infrastructure costs relatedto services provided to clients and in our offshore shared service center.  Selling expenses primarily consist of thesalaries, benefits, travel, and other costs of our sales force, as well asmarketing and market research expenses. General and administrative expenses primarily consist of costs tosupport our business such as non-billable travel, internal information systemsand infrastructure, salaries and expenses for executive management, financialaccounting and administrative personnel, and legal and other professionalservices.  As staff related costs arerelatively fixed in the short term, variations in our revenues and operatingresults in our CSI business can occur as a result of variations in billingmargins and utilization rates of our billable associates.

Our most significant expenses are our human resourceand related salary and benefit expenses. As of June 30, 2006, approximately 1,345 of our 2,391 employees arebillable consultants and software developers. Another 727 employees are part of our outsourcing business.  The salaries and benefits of such billablepersonnel staff and outsourcing related employees are recognized in our cost ofservices.  Most non-billable employeesalaries and benefits are recognized as a component of either selling orgeneral and administrative expenses. Approximately 13.3% of our workforce, or 319 employees, are classifiedas non-billable.  Our cost of services asa percentage of net revenues is directly related to several factors, including,but not limited to:

·                  Our staff utilization, which is theratio of total billable hours to available hours in a given period;

·                  The amount and timing of costincurred;

·                  Our ability to control costs on ouroutsourcing projects;

·                  The billed rate on time and materialcontracts; and

·                  The estimated cost to complete ournon-outsourcing fixed price contracts.

In our outsourcing contracts, a significant portion ofour revenues are fixed and allocated over the contract on a straight-linebasis, as we are required to provide a specified level of ongoingservices.  Also, certain revenues mayfluctuate under the contracts based on the volume of transactions we process or

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other measurements of service provided.  If we incur higher costs to provide therequired services or receive less revenue due to reduced transaction volumes orpenalties associated with service level failures, our gross profit can benegatively impacted.

In our CSI business,we manage staff utilization by monitoring assignment requirements andtimetables, available and required skills, and available staff hours per weekand per month.   Differences in personnelutilization rates can result from variations in the amount of non-billed time,which has historically consisted of training time, vacation time, time lost toillness and inclement weather, and unassigned time.  Non-billed time also includes time devoted toother necessary and productive activities such as sales support andinterviewing prospective employees. Unassigned time results from differences in the timing of the completionof an existing assignment and the beginning of a new assignment.  In order to reduce and limit unassigned time,we actively manage personnel utilization by monitoring and projecting estimatedengagement start and completion dates and matching staff availability withcurrent and projected client requirements. The number of people staffed on an assignment will vary according to thesize, complexity, duration, and demands of the assignment.  Assignment terminations, completions,inclement weather, and scheduling delays may result in periods in which staffmembers are not optimally utilized.  Anunanticipated termination of a significant assignment or an overall lengtheningof the sales cycle could result in a higher than expected number of unassignedstaff members and could cause us to experience lower margins.  In addition, entry into new market areas andthe hiring of staff in advance of client assignments have resulted and maycontinue to result in periods of lower staff utilization.

In response tocompetition and continued pricing and rate pressures, we have implemented aglobal sourcing strategy into our business operations, which includes thedeployment of offshore resources as well as resources that perform servicesremote from the client site.  We alsoincorporate larger numbers of variable cost or per diem staff in some of ourprojects.  We expect these strategies tocontinue to reduce cost of services through a combination of lower costattributable to offshore resources and higher leverage of resources thatperform services offsite or on a variable cost basis.  To the extent we pass through reduced coststo our clients related to offshore resources, the global sourcing strategy mayresult in lower revenues on a per engagement basis. However, we expect tooffset this potential revenue impact with improved competitive positioning inour markets, which could result in an increased number of engagements to offsetthe potential revenue impact.  Several ofour competitors employ both global sourcing and variable staffing strategies toprovide software development and other information technology services to theirclients, while at the same time reducing their cost structure and improving thequality of services they provide.  If weare unable to realize the perceived cost benefits of our strategies or if weare unable to receive high quality services from foreign employees, variablestaff employees, or subcontractors, our business may be adversely impacted andwe may not be able to compete effectively.

**Resultsof Operations for the Three Months Ended June 30, 2006 and July 1, 2005**

*Revenues. *Our net revenues were $65.5 million for thequarter ended June 30, 2006, a decrease of 3.5% from $67.9 million for thequarter ended July 1, 2005.  Our totalrevenues were $69.0 million for the quarter ended June 30, 2006, a decrease of3.7% from $71.7 million for the quarter ended July 1, 2005.  The decline in net revenues was primarily dueto decreases in Health Delivery Services and Health Delivery Outsourcing,offset by increases in Health Plan and Government and Technology Services.  The Health Delivery Services segment had themost significant decrease compared to the quarter ended July 1, 2005, $3.2million, or 18.8%, due to lower revenues from our consulting and implementationservices offerings.  The lower revenueswere attributable to the discontinuation of certain underperforming servicelines in late 2005 and a need to restructure our sales model in this area.  In Health Delivery Outsourcing, net revenuesdecreased by $1.9 million, or 6.6%, primarily due to the termination of twooutsourcing contracts during the fourth quarter of 2005, offset in large partby the receipt of new contracts.  In July2005, we announced the early termination for convenience by The New York andPresbyterian Hospital (“NYPH”) of our approximately $30 million per yearoutsourcing agreement, effective December 31,

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2005(the contract was executed in November 1999 and was originally scheduled toexpire in December 2006).  Also, inOctober 2005, we announced the mutually agreed termination of our outsourcingagreement with UMass Memorial Health Care (“UMMHC”) effective November 1, 2005,with certain transition services to be performed through December 31,2005.  In August 2005, however, we begana five-year IT outsourcing agreement with one client, and a three-yearagreement with another client. Outsourcing revenues in the second quarter of 2006 from these two newcontracts totaled $7.2 million, compared to $11.3 million for the twoterminated contracts in the second quarter of 2005.  The most significant offsetting increase inour net revenues was in Health Plan, which increased by $3.3 million, or 79.8%,due to an outsourcing engagement that began during the second quarter of 2005,and increased services revenue related to market acceptance of our blendedshore delivery model.  Government and TechnologyServices revenues increased by $927,000, or 13.3%, primarily due to growth inour Software Services business (formerly named Paragon Solutions, Inc.), whichcomprises the majority of the segment, and provides offshore softwaredevelopment services to independent software vendors.

In March 2006, wereceived a one year extension of one of our existing major outsourcingcontracts, University of Pennsylvania Health System (UPHS), and that contractis now set to expire in March 2007.  Wecurrently receive annual revenues of approximately $24 million from thiscontract.  We currently have noassurances that the contract will be extended past the one year renewal period,and UPHS still has the right to terminate the contract for convenience on 180days notice.  If we are unable to executea longer term renewal with UPHS or if we are unable to enter into newoutsourcing engagements, our Health Delivery Outsourcing revenues would beadversely impacted.  Revenues in ourbusiness units other than outsourcing are not expected to change significantlyfrom their levels at the end of the second quarter of 2006, with some modestgrowth expected to continue in the Health Plan and Government and TechnologyServices segments.  Growth in HealthDelivery Services and Outsourcing is highly dependent upon capturing marketshare through successfully restructuring our selling model and acceptance bythe health delivery market of our blended shore delivery model.  We expect our percentage mix of outsourcingrevenues in 2006 to be less than in prior years, primarily due to the loss ofrevenues associated with NYPH and UMMHC.

*Cost of Services. *Cost of services before reimbursable expenseswas $47.1 million for the quarter ended June 30, 2006, a decrease of 9.2% from$51.8 million for the quarter ended July 1, 2005.  The decrease was primarily due to a $3.2million decline in costs in the Health Delivery Outsourcing segment directlyrelated to the reduction in revenues described above.  Health Delivery Services cost decreased by$2.1 million as we reduced costs in that area, primarily through staffattrition and staff reductions in the fourth quarter of 2005, to improveprofitability.  Costs in Health Planincreased by $2.1 million and costs in Government and Technology Servicesincreased by $912,000 in order to serve the revenue growth in those segments.

*Gross Profit. *Grossprofit was $18.4 million, or 28.1% of net revenues, for the quarter ended June30, 2006, an increase of 14.6% from $16.1 million, or 23.7% of net revenues,for the quarter ended July 1, 2005.  Thisincrease was due to $1.4 million of additional gross profit in the HealthDelivery Outsourcing segment due to better performing contracts, and the marginassociated with the revenue increases in the Health Plan segment describedabove.  These increases were partiallyoffset by a decrease in gross profit in Health Delivery Services due to thedecline in revenue discussed above.

*Selling Expenses. *Selling expenses were $4.0 million for thequarter ended June 30, 2006, a decrease of 43.0% from $7.1 million for thequarter ended July 1, 2005.  Thisdecrease was primarily due to reductions in the sales force and marketingcosts.  Selling expenses as a percentageof net revenues decreased to 6.2% for the quarter ended June 30, 2006 from10.4% for the quarter ended July 1, 2005 for the same reasons.

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*General and Administrative Expenses. *General andadministrative expenses were $9.3 million for the quarter ended June 30, 2006,a decrease of 8.1% from $10.1 million for the quarter ended July 1, 2005.  This decrease was due to cost reductions thatoccurred during the latter part of fiscal year 2005.  As well as lower salary expense due to staffreductions, costs were also reduced in the areas of travel, recruiting,telecommunications, and office facilities. General and administrative expenses as a percentage of net revenuesdecreased slightly to 14.2% for the quarter ended June 30, 2006 from 14.9% forthe quarter ended July 1, 2005.

*Interest Income, Net.** ***Interest income, net of interest expense, was$425,000 for the quarter ended June 30, 2006, an increase of 102.4% from$210,000 for the quarter ended July 1, 2005, due to higher interest ratesearned on cash and investments.  Interestincome, net of interest expense as a percentage of net revenues increased to0.6% for the quarter ended June 30, 2006 from 0.3% for the quarter ended July1, 2005.

*Other Income (Expense), Net*.  Other income (expense) wasnegligible for the quarters ended June 30, 2006 and July 1, 2005.

*Income Taxes. *We recorded a $389,000 tax provision for thequarter ended June 30, 2006 versus $6.0 million for the quarter ended July 1,2005.  The 7% tax provision for thequarter ended June 30, 2006 was for annual estimated current taxes payable forU.S. federal alternative minimum tax and certain state and foreign incometaxes, as our net operating loss carryforwards offset most of the federal andcertain state tax liabilities.  The taxprovision for the quarter ended July 1, 2005 of $6.0 million consisted entirelyof a deferred tax asset valuation allowance. The valuation allowance was recorded as a result of the historicallosses we had incurred, creating additional negative evidence as to theuncertainty of our ability to realize our deferred tax assets, as assessed perthe guidance of the applicable tax accounting standard, SFAS 109.  We continue to expect that our tax provisionin fiscal 2006 will remain low, but that our long-term tax provision willreturn to levels consistent with full federal and state tax rates.

**Resultsof Operations for the Six Months Ended June 30, 2006 and July 1, 2005**

*Revenues. *Our net revenues were $132.2 million for thesix months ended June 30, 2006, a decrease of 2.8% from $136.1 million for thesix months ended July 1, 2005.  Our totalrevenues were $139.5 million for the six months ended June 30, 2006, a decreaseof 2.8% from $143.5 million for the six months ended July 1, 2005.  The decreases in net revenues were in HealthDelivery Outsourcing, Health Delivery Services, and Life Sciences, offset byincreases in Health Plan and Government and Technology Services.  The Health Delivery Outsourcing segment hadthe most significant decrease compared to the quarter ended July 1, 2005, $5.2million, or 8.7%, primarily due to the termination of two outsourcing contractsduring the fourth quarter of 2005, offset in large part by the receipt of newcontracts, as described above in *Results of Operations forthe Three Months Ended June 30, 2006 and July 1, 2005.*  Outsourcing revenues for the six months endedJune 30, 2006 from the two new contracts totaled $15.1 million, compared to$23.6 million for the two terminated contracts for the six months ended July 1,2005.  The net revenues in the HealthDelivery Services segment decreased $3.9 million, or 11.7% due to lowerrevenues from our consulting and implementation services offerings.  The most significant offsetting increase wasin Health Plan, which increased by $6.1 million, or 75.0%, due to anoutsourcing engagement that began during the second quarter of 2005, andincreased services revenue related to market acceptance of our blended shoredelivery model.  Government andTechnology Services revenues increased by $2.5 million, or 18.8%, primarily dueto growth in our Software Services business (formerly named Paragon Solutions, Inc.), which comprises the majorityof the segment, and provides offshore software development services toindependent software vendors.

*Cost of Services. *Cost of services before reimbursable expenseswas $95.7 million for the six months ended June 30, 2006, a decrease of 8.3%from $104.3 million for the six months ended July 1,

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2005.  The decrease was primarily due to a $6.1million decline in costs in the Health Delivery Outsourcing segment directlyrelated to the reduction in revenues described above.  Health Delivery Services cost decreased by$3.5 million as we reduced costs in that area, primarily through staffattrition and staff reductions in the fourth quarter of 2005, to improveprofitability.  Costs in Health Planincreased by $3.4 million and costs in Government and Technology Servicesincreased by $2.0 million in order to serve the revenue growth in thosesegments.

*GrossProfit. *Gross profit was $36.5 million, or 27.6% of netrevenues, for the six months ended June 30, 2006, an increase of 15.1% from$31.7 million, or 23.3% of net revenues, for the six months ended July 1,2005.  This increase was primarily due a$2.7 million increase in gross profit related to the revenue increase in theHealth Plan segment as described above, and a $1.0 million increase in grossprofit in Health Delivery Outsourcing due to better performing contracts.  Additionally, gross profit in our SoftwareProducts business improved by $1.0 million from a level of negative $730,000 topositive $263,000 due to additional revenues and cost reductions.

*Selling Expenses. *Selling expenses were $8.4 million for thesix months ended June 30, 2006, a decrease of 39.2% from $13.9 million for thesix months ended July 1, 2005.  Thisdecrease was primarily due to reductions in the sales force and marketingcosts.  Selling expenses as a percentageof net revenues also decreased to 6.4% for the six months ended June 30, 2006from 10.2% for the six months ended July 1, 2005 for the same reasons.

*General and Administrative Expenses. *General andadministrative expenses were $18.4 million for the six months ended June 30,2006, a decrease of 10.5% from $20.6 million for the six months ended July 1,2005.  This decrease was due to costreductions that occurred during the latter part of fiscal year 2005.  As well as lower salary expense due to staffreductions, costs were also reduced in the areas of travel, recruiting,telecommunications, and office facilities. General and administrative expenses as a percentage of net revenuesdecreased to 14.0% for the quarter ended June 30, 2006 from 15.1% for thequarter ended July 1, 2005.

*Interest Income, Net.** ***Interest income, net of interest expense, was$763,000 for the six months ended June 30, 2006, an increase of 73.4% from$440,000 for the six months ended July 1, 2005, due to higher interest ratesearned on cash and investments.  Interestincome, net of interest expense as a percentage of net revenues increased to0.6% for the six months ended June 30, 2006 from 0.3% for the six months endedJuly 1, 2005.

*Other Expense, Net*.  Other income (expense) wasnegligible for the six months ended June 30, 2006 and July 1, 2005.

*Income Taxes. *We recorded a $729,000 tax provision for thesix months ended June 30, 2006 versus a $5.4 million tax provision for the sixmonths ended July 1, 2005.  The 7% taxprovision for the six months ended June 30, 2006 was for annual estimatedcurrent taxes payable for U.S. federal alternative minimum tax and certainstate and foreign income taxes, as the net operating loss carryforwards offsetmost of the federal and certain state tax liabilities.  The tax provision for the six months endedJuly 1, 2005 of $5.4 million primarily consisted of a $6.0 million deferred taxasset valuation allowance.  The valuationallowance was recorded as a result of the historical losses we had incurred,creating additional negative evidence as to the uncertainty of our ability torealize our deferred tax assets, as assessed per the guidance of the applicabletax accounting standard, SFAS 109.

*Loss on Discontinued Operations*.  Thedisposition of our Coactive Call Center Service line had been accounted for asa discontinued operation.  During the sixmonths ended July 1, 2005, we incurred $866,000 of costs related to theoperation and wind-down of the business. These costs, net of a 38% tax

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benefit, resulted in anet loss of $537,000, compared to no loss on discontinued operations for thesix months ended June 30, 2006.

**Liquidityand Capital Resources**

At June 30, 2006, we had cash and investmentsavailable for sale of $42.9 million compared to $35.1 million at December 30,2005.  During the six months ended June30, 2006, we generated cash flow from continuing operations of $5.9 million whichprimarily consisted of $9.7 million of profit. We used $2.8 million to pay forseverance recorded during the fourth quarter of 2005.

Our days sales outstanding (DSO) of accountsreceivable increased to 39 days for the second quarter of 2006 from 34 days forthe fourth quarter of 2005.  The increasewas due to our outsourcing business becoming a smaller percentage of ourquarterly revenues in fiscal year 2006 compared to the fourth quarter of 2005after the winding down of two large outsourcing accounts.  We expect our DSO to remain at approximatelyits current level for the near future, subject to routine fluctuations.

In February 2006, we signed an agreement with alandlord to return excess office space to them. As part of the agreement, we are required to make $2.9 million ofpayments to the landlord in equal installments over the last ten months offiscal year 2006 in order to extinguish our obligation.  These payments are being charged againstamounts that have been accrued in prior years for facility closure costs, andthus affect cash flow in fiscal year 2006 without affecting pretax income.  The balance of this liability at June 30,2006 is $1.4 million.

We do not currently expect any significant cash flowchanges from our other areas of working capital such as prepaid expenses,accounts payable, and accrued liabilities; however, we are susceptible toongoing routine fluctuations in those areas.

During the six months ended June 30, 2006, our cashflow benefited from $4.0 million of stock option exercises, primarily by formeremployees.  Further, we usedapproximately $2.4 million of cash to purchase property and equipment,primarily information technology and related equipment, while incurring $4.0 millionof depreciation and amortization expense.

One of our new outsourcing accounts, which began inAugust 2005, had a net negative impact on cash of over $2 million for the sixmonths ended June 30, 2006, primarily due to the deferral of fees, transitioncosts, and capital expenditures agreed upon when the contract was originallysigned in the third quarter of 2005.  Thecash requirements related to this contract have largely been completed.

Our cash flow in fiscal year 2006 is highly dependenton our ability to continue to be profitable. Generally, we expect any pretax profitability in fiscal year 2006 tocontribute positively to cash flow.  Asignificant amount of income in 2006 or thereafter (approximately $20 million)is not expected to be subject to federal taxation or require any significantbook tax provision in our income statement due to the existence of netoperating loss carryforwards.  We continue to expect that our tax provisionin fiscal 2006 will remain low, but that our long-term tax provision willreturn to levels consistent with full federal and state tax rates.

As of June 30, 2006, thefollowing table summarizes our contractual commitments (in thousands):

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|                                     | ** ** | **Payments Due by Period** | ** ** |
|-------------------------------------|------------|-------------------------------------------|------------|
| **Contractual Obligation**     | ** ** | **Less than 1   Year**     | ** ** | **1 -3  Years** | ** ** | **3-5  Years** | ** ** | **More Than   5 Years** | ** ** | **Total** | ** ** |
| Operating  leases, net of subleases |       | $                                         | 6,109      |   | $ | 5,776 |   | $ | 1,893 |   | $ | 198 | ** ** | **$** | **13,976** | ** ** |
| Purchase  obligations               |       | 329                                       |       | 576 |   | — |   | — | ** ** | **905** | ** ** |
| **Total**                           | ** ** | **$**                                     | **6,438**  | ** ** | **$** | **6,352** | ** ** | **$** | **1,893** | ** ** | **$** | **198** | ** ** | **$** | **14,881** | ** ** |

Management believes that our existing cash and cashequivalents, together with funds generated from operations, will be sufficientto meet operating requirements for at least the next twelve months.  Our cash and cash equivalents are availablefor capital expenditures (which are projected at approximately $5 million for2006), upfront setup costs and deferred fees on new contracts, strategicinvestments, mergers and acquisitions, and other potential large-scale cashneeds that may arise.

We had a revolving line of credit, under which we wereallowed to borrow up to $7.0 million at an interest rate of the prevailingprime rate with an expiration of May 1, 2006. There was no outstanding balance under the line of credit at December30, 2005.  Due to repeated loan covenantviolations related to our quarterly losses in 2005, we elected to discontinuethe line of credit during the first quarter of 2006 rather than accept newrestrictive conditions to the credit line which were proposed by the bank.

**Critical Accounting Policies andEstimates**

The foregoingdiscussion and analysis of our financial condition and results of operations isbased upon our consolidated financial statements, which have been prepared inaccordance with accounting principles generally accepted in the UnitedStates.  The preparation of thesefinancial statements requires us to make estimates and assumptions that affectthe reported amounts of assets, liabilities, revenues and expenses, and relateddisclosure of contingent assets and liabilities.  On an ongoing basis, we evaluate our estimates,including those related to revenue recognition, cost to complete clientengagements, valuation of goodwill and long-lived and intangible assets,accrued liabilities, income taxes, restructuring costs, idle facilities,litigation and disputes, and the allowance for doubtful accounts.  We base our estimates on historicalexperience and on various other assumptions that we believe to be reasonableunder the circumstances, the results of which form the basis for makingjudgments about the carrying value of assets and liabilities that are not readilyapparent from other sources.  Our actualresults may differ from our estimates and we do not assume any obligation toupdate any forward-looking information.

Webelieve the following critical accounting policies reflect our more significantassumptions and estimates used in the preparation of our consolidated financialstatements.

***RevenueRecognition and Unbilled Receivables***

Revenues arederived primarily from information technology outsourcing services, consulting,and systems integration.  Revenues arerecognized on a time-and-materials, level-of-effort, percentage-of-completion,or straight-line basis.  Before revenuesare recognized, the following four criteria must be met: (a) persuasiveevidence of an arrangement exists; (b) delivery has occurred or servicesrendered; (c) the fee is fixed and determinable; and (d) collectability isreasonably assured.  We determine if thefee is fixed and determinable and collectability is reasonably assured based onour judgments regarding the nature of the fee charged for services rendered andproducts delivered.  Arrangements vary inlength from less than one year to seven years. The longer-term arrangements are generally level-of-effort or fixedprice arrangements.

Revenues fromtime-and-materials arrangements are generally recognized based upon contractedhourly billing rates as the work progresses. Revenues from level-of-effort arrangements are recognized based upon afixed price for the level of resources provided.  Revenues from fixed fee arrangements for 

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consulting and systemsintegration work are generally recognized on a rate per hour orpercentage-of-completion basis.  Wemaintain, for each of our fixed fee contracts, estimates of total revenue andcost over the contract term. For purposes of periodic financial reporting onthe fixed price consulting and system integration contracts, we accumulatetotal actual costs incurred to date under the contract. The ratio of thoseactual costs to our then-current estimate of total costs for the life of the contractis then applied to our then-current estimate of total revenues for the life ofthe contract to determine the portion of total estimated revenues that shouldbe recognized.  We follow this methodbecause reasonably dependable estimates of the revenues and costs applicable tovarious stages of a contract can be made.

Revenuesrecognized on fixed price consulting and system integration contracts aresubject to revisions as the contract progresses to completion.  If we do not accurately estimate the resourcesrequired or the scope of the work to be performed, do not complete our projectswithin the planned periods of time, or do not satisfy our obligations under thecontracts, then profit may be significantly and negatively affected.  Revisions in our contract estimates arereflected in the period in which the determination is made that facts andcircumstances dictate a change of estimate. Favorable changes in estimatesresult in additional revenues recognized, and unfavorable changes in estimatesresult in a reduction of recognized revenues. Provisions for estimated losseson individual contracts are made in the period in which the loss first becomesknown.  Some contracts include incentivesfor achieving either schedule targets, cost targets, or other definedgoals.  Revenues from incentive typearrangements are recognized when it is probable they will be earned.

We account forcertain of our outsourcing contracts using EITF 00-21, “Accounting for RevenueArrangements with Multiple Deliverables,” which addresses how to account forarrangements that involve the delivery or performance of multiple products,services, and/or rights to use assets. Revenue arrangements with multiple deliverables are divided intoseparate units of accounting if the deliverables in the arrangement meet thefollowing criteria: (1) the delivered item has value to the customer on astandalone basis; (2) there is objective and reliable evidence of the fairvalue of undelivered items; and (3) delivery of any undelivered item isprobable.  Arrangement consideration isallocated among the separate units of accounting based on their relative fairvalues, with the amount allocated to the delivered item being limited to theamount that is not contingent on the delivery of additional items or meetingother specified performance conditions.

In our outsourcing contracts, a significant portion of our revenues arefixed and allocated over the contract on a straight-line basis, as we arerequired to provide a specified level of services subject to certainperformance measurements.  Also, certainrevenues may fluctuate under the contracts based on the volume of transactionswe process or other measurements of service provided.  If we incur higher costs to provide therequired services or receive lower revenues due to reduced transaction volumesor penalties associated with service level failures, our gross profit can benegatively impacted.

On certain contracts, or elements of contracts, costs are incurredsubsequent to the signing of the contract, but prior to the rendering ofservice and associated recognition of revenue. Where such costs are incurred and realization of those costs is eitherpaid for upfront or guaranteed by the contract, those costs are deferred andlater expensed over the period of recognition of the related revenue.  At June 30, 2006, we had deferred $3.8million of unamortized costs which are included in non-current assets.

As part of ourongoing operations to provide services to our customers, incidental expenses,which are generally reimbursable under the terms of the contracts, are billedto customers. These expenses are recorded as both revenues and direct cost ofservices in accordance with the provisions of EITF 01-14, “Income StatementCharacterization of Reimbursements Received for ‘Out-of-Pocket’ ExpensesIncurred,” and include expenses such as airfare, mileage, hotel stays,out-of-town meals, and telecommunication charges.

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Software licenseand maintenance revenues comprised approximately 4.3% of our net revenues forthe six months ended June 30, 2006. Additionally, we realized additional revenues from the implementation ofour software.  We recognize softwarerevenues in accordance with the provisions of the American Institute ofCertified Public Accountants Statement of Position (“SOP”) 97-2, “SoftwareRevenue Recognition”, as amended by SOP 98-9, “Modification of SOP 97-2,Software Revenue Recognition, With Respect to Certain Transactions”, and inaccordance with the Securities and Exchange Commission Staff Accounting Bulletin(“SAB”) No. 104, “Revenue Recognition”. We license software undernon-cancelable license agreements and provide related professional services,including consulting, training, and implementation services, as well as ongoingcustomer support and maintenance.  Mostof our software license fee revenues are from arrangements which includeimplementation services that are essential to the functionality of our softwareproducts, and are recognized using contract accounting, including thepercentage-of-completion methodology, over the period of the implementation.

In those morelimited cases where our software arrangements do not include services essentialto the functionality of the product, license fee revenues are recognized whenthe software product has been shipped, provided a non-cancelable licenseagreement has been signed, there are no uncertainties surrounding productacceptance, the fees are fixed or determinable and collection of the relatedreceivable is considered probable. We do not generally offer rights of returnor acceptance clauses to our customers. In situations where we do providerights of return or acceptance clauses, revenue is deferred until the clauseexpires. Typically, our software license fees are due within a twelve-monthperiod from the date of shipment. If the fee due from the customer is not fixedor determinable, including payment terms greater than twelve months fromshipment, revenue is recognized as payments become due and all other conditionsfor revenue recognition have been satisfied. In software arrangements thatinclude rights to multiple software products, specified upgrades, maintenanceor services, we allocate the total arrangement fee among the deliverables usingthe fair value of each of the deliverables determined using vendor-specificobjective evidence. Vendor-specific objective evidence of fair value isdetermined using the price charged when that element is sold separately. Insoftware arrangements in which we have fair value of all undelivered elementsbut not of a delivered element, we use the residual method to record revenue.Under the residual method, the fair value of the undelivered elements isdeferred and the remaining portion of the arrangement fee is allocated to thedelivered element(s) and is recognized as revenue. In software arrangements inwhich we do not have vendor-specific objective evidence of fair value of allundelivered elements, revenue is deferred until fair value is determined or allelements have been delivered, or is spread over the term of an arrangement as asubscription.

Revenues fromtraining and consulting services are recognized as services are provided tocustomers. Revenues from maintenance contracts are deferred and recognizedratably over the term of the maintenance agreements. Revenues for customersupport and maintenance that are bundled with the initial license fee aredeferred based on the fair value of the bundled support services and recognizedratably over the term of the agreement; fair value is based on the renewal ratefor continued support arrangements.

Unbilledreceivables of $14.6 million represent revenues recognized for servicesperformed that were not billed at the balance sheet date.  The majority of these amounts are billed inthe subsequent month; however, certain unbillable amounts arising fromcontracts occur when revenues recognized exceed allowable billings inaccordance with the contractual agreements. Such unbillable amounts most often become billable upon reaching certainproject milestones stipulated per the contract, or in accordance with thepercentage of completion methodology.  Asof June 30, 2006, we had unbillable amounts of approximately $2.6 million,which were generally expected to be billed within one year.

We had a long-termreceivable at June 30, 2006 and December 30, 2005 of $2.3 million and $1.7million.  Of the long-term receivables of$1.7 million at December 30, 2005, $1.3 million was created in August 2005through the deferral until 2009 of the first month of fees of a new outsourcingcontract.  In 

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January 2006, anadditional amount of approximately $800,000 related to this contract wasdeferred until 2009.  Both deferrals werein accordance with the terms of the contract executed with this client in July2005.

Customer advancesare comprised of payments from customers for which services have not yet beenperformed or prepayments against work in process. These unearned revenues aredeferred and recognized as future contract costs are incurred and as contractservices are rendered.

***Allowance forDoubtful Accounts***

We maintain anallowance for doubtful accounts for estimated losses resulting from theinability of our clients to make required payments. This allowance is based onthe amount and aging of our accounts receivable, creditworthiness of ourclients, historical collection experience, current economic trends, and changesin client payment patterns.  If thefinancial condition of our clients was to deteriorate, resulting in animpairment of their ability to make payments, additional allowances would berequired.  Our bad debt losses havegenerally been moderate due to the size and quality of our customers; however,we have recently incurred some bad debt losses in our growing Software Servicessegment due to the lower credit quality of our clients in that segment.  Should one of our larger clients unexpectedlybecome unable to pay us, our allowance would have to increase significantly.

***Deferred Income Taxes***

We account for income taxes in accordance with SFAS109, “Accounting for Income Taxes,” which requires recognition of deferred taxassets and liabilities for the expected future tax consequences of events thathave been included in the financial statements which differ from our taxreturns.  We use significant estimates indetermining what portion of our deferred tax asset is more likely than not tobe realized.  Prior to fiscal year 2003,our net deferred tax assets had historically consisted primarily of the taxbenefit related to restructuring costs for facility closures, supplemental executiveretirement plan contributions, and other accrued liabilities such as accruedvacation pay, which are not deductible for tax purposes until paid.

During fiscal year 2003, we generated additionaldeferred tax assets for net operating loss carryforwards which were created byour pretax losses, combined with the fact that we were outside the period it isallowable to carry back losses, and recorded a valuation allowance of $5.8million in the fourth quarter of that year. During the fourth quarter of fiscal year 2004, we re-evaluated ourrequirement for a valuation allowance after having completed a full year inwhich we recorded taxable income in each quarter, and reversed $3.0 million ofthe valuation allowance taken in fiscal year 2003.

During the first six months of 2005, we incurred apretax loss from continuing operations of $2.3 million.  Based on such performance, we increased ourdeferred tax asset valuation allowance during the second quarter of 2005 by $6.0million.  Additionally, in the fourthquarter of 2005, after having incurred losses in each quarter of the fiscalyear, we increased our valuation allowance by another $8.2 million such that wenow have a full valuation allowance against all of our tax assets.

This valuation allowance does not, in any way, limitour ability to use our deferred tax assets, primarily loss carryforwards, tooffset taxable income in the future.  Aswell as not being subject to federal taxation other than the Alternative MinimumTax, a significant amount (approximately $20 million) of any future pretaxincome from the beginning of fiscal year 2006 and thereafter will not require asignificant tax provision in the income statement.  Additionally, if at some point in the future,the realization of any of our deferred tax assets is considered more likelythan not based on successive years of generating taxable income, we willreverse all or a portion of any existing valuation allowance at that time.  Our valuation allowance for deferred incometaxes has been a particularly volatile estimate over the 

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past several years, as our level of income and losshas fluctuated, requiring us to reassess the likelihood of realization of ourtax assets.

***Goodwill and Intangible Assets***

Under SFAS 142, weno longer amortize our goodwill and are required to complete an annualimpairment testing which we perform during the fourth quarter of eachyear.  We believe that the accounting assumptions and estimates related tothe annual goodwill impairment testing are critical because these can changefrom period to period.  We use various assumptions, such as discountrates, and comparable company analysis in performing these valuations.  The impairment test requires us to forecastour future cash flows, which involves significant judgment.   Accordingly,if our expectations of future operating results change, or if there are changesto other assumptions, our estimate of the fair value of our reporting unitscould change significantly resulting in a goodwill impairment charge, whichcould have a significant impact on our consolidated financial statements. We performed an impairment test on each of our components of goodwill as of thefourth quarter of fiscal year 2005 and determined that none of our goodwill wasimpaired.  As of June 30, 2006, we have$18.2 million of goodwill and $842,000 of intangible assets recorded on ourbalance sheet (see Note 5 of the Notes to Consolidated Financial Statementsincluded in this report).

***Recent Accounting Pronouncements***

In June 2006, theFASB issued FASB Interpretation No. 48, “Accounting for Uncertainty in IncomeTaxes” (see New Accounting Standard in Note 1 in Item 1 of this report).

InDecember 2004, the FASB enacted SFAS 123R which we adopted in the firstquarter of 2006 (see Stock-Based Compensation in Note 1 in Item 1 of thisreport).

## **Item3.  Quantitative and QualitativeDisclosures about Market Risks**

Our financialinstruments include cash and cash equivalents (i.e., short-term and long-termcash investments), accounts receivable, unbilled receivables, and accountspayable.  Only the cash and cashequivalents which totaled $42.9 million at June 30, 2006 present us with marketrisk exposure resulting primarily from changes in interest rates.  Basedon this balance, a change of one percent in the interest rate would cause achange in interest income for the annual period of approximately$429,000.  Our objective in maintaining these investments is theflexibility obtained in having cash available for payment of accruedliabilities and acquisitions.

## **Item4.  Controls and Procedures**

We maintaindisclosure controls and procedures that are designed to ensure that informationrequired to be disclosed in our Exchange Act reports is recorded, processed,summarized, and reported within the time periods specified in the Securitiesand Exchange Commission’s rules and forms, and that such information isaccumulated and communicated to our management, including our Chief ExecutiveOfficer and Chief Financial Officer, as appropriate, to allow for timelydecisions regarding required disclosure. In designing and evaluating thedisclosure controls and procedures, management is required to apply itsjudgment in evaluating the cost-benefit relationship of possible controls andprocedures.  Our disclosure controls andprocedures are designed to provide a reasonable level of assurance of reachingour desired disclosure control objectives.

As required by SEC Rule13a-15(b), we carried out an evaluation, under the supervision and with theparticipation of our management, including our Chief Executive Officer and ourChief Financial Officer, of the effectiveness of the design and operation ofour disclosure controls and procedures as of

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the end of the quartercovered by this report. Based on the foregoing and except as noted below, ourChief Executive Officer and Chief Financial Officer concluded that ourdisclosure controls and procedures were effective, and were operating at thereasonable assurance level.

As previously disclosed inItem 9A to our Annual Report on Form 10-K for the fiscal year ended December30, 2005 (“2005 10-K”), our Chief Executive Officer and Chief Financial Officerconcluded that our disclosure controls and procedures were not effective as ofthe end of the 2005 year because we did not maintain effective controls overthe determination and reporting of our provision for income taxes, and we had a“material weakness” in internal controls as defined in Audit Standard No. 2adopted by the Public Company Accounting Oversight Board.  The material weakness was related to theinaccurate identification and recording of state tax net operating losses(NOLs) during fiscal years 2000 through 2004, resulting in excess state taxcontingency reserves accumulating on our balance sheet and $1.3 million ofhigher cumulative tax expense over those periods.  The proper procedure for estimating the statedeferred tax assets and the related contingency reserves is to use the incomeof each of our subsidiaries and the tax rates for each state jurisdiction inwhich such subsidiary operates in performing the calculations.  In preparing the 2005 10-K, we applied theproper procedure, which resulted in management identifying the excess taxcontingency reserve for the first time. The 2005 10-K correctly states our 2005 income tax expense and werestated our previously issued consolidated financial statements for the 2001through 2004 fiscal years to account for the inaccuracies that we identified inpreparing the 2005 10-K. As a result of the inaccuracies in tax accountingdescribed above, management concluded that our controls were not effectivebecause there were not sufficient personnel in our corporate tax department whowere qualified and trained to properly calculate state deferred tax assets andcontingency reserves.  Since thecalculation of state NOLs and the related accounting is performed on a once peryear basis after all tax returns are filed for the previous year, the initialtesting to confirm that the material weakness described above and in Item 9A ofour 2005 10-K has been remediated will occur in late 2006.  We have recently hired a new tax directorwith experience in calculating deferred tax assets, and in applying SFAS 109, “Accountingfor Income Taxes,” who will begin employment in late August, and will performthe appropriate detailed analysis on an ongoing basis starting in fiscal year2006.

Except asdescribed above, there has been no change in our internal controls overfinancial reporting during our most recent fiscal quarter that has materiallyaffected, or is reasonably likely to materially affect, our internal controlsover financial reporting.

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# **Part II. Other Information**

## **Item1.  Legal Proceedings.**

From time to time,we may be involved in claims or litigation that arise in the normal course ofbusiness. We are not currently a party to any legal proceedings, which, ifdecided adversely to us, would have a material adverse effect on our business,financial condition, or results of operations.

## **Item1A.  Risk Factors.**

Except as setforth below, there have been no material changes from risk factors aspreviously disclosed in response to Item 1A in Part I of our 2005 10-K.

The following arematerial changes to the risk factors previously disclosed in our 2005 10-K.

1.  The first risk factor which appears on page11 of the 2005 10-K is changed in its entirety as follows:

*Many factors may cause our netrevenues, operating results, and cash flows to fluctuate and possibly decline.*

Our net revenues,operating results, and cash flows may fluctuate significantly because of anumber of factors, many of which are outside of our control.  Thesefactors may include:

·                                          Ourability to achieve and maintain profitability in each of our business segments;

·                                          Ourability in our Health Delivery business unit to generate a pipeline of businessand provide consistent service quality with a restructured sales organizationand new business unit leader;

·                                          Theloss of one or more significant clients in any of our business segments,including any failure to secure renewals for any of our large outsourcingcontracts or any early termination of any significant contracts;

·                                          Theability of our new chief executive officer and the remainder of the currentmanagement team to effectively manage our operations;

·                                          Ourability to realize our deferred tax assets through future pretax earnings;

·                                          Useof offsite and offshore resources on our engagements and adoption of a blended shoredelivery model in the healthcare IT industry;

·                                          Theroll-off or completion of significant projects in any of our business segments;

·                                          Fluctuationsin market demand for our services which affect associate hiring andutilization;

·                                          Delaysor increased expenses in securing and completing client engagements;

·                                          Timingand collection of fees and payments;

·                                          Thefinancial performance and credit worthiness of our clients;

·                                          Timingof new client engagements in any of our business segments;

·                                          Increasedcompetition and pricing pressures;

·                                          Budgetingand other capital expenditure decisions of our clients;

·                                          Ourability to anticipate changing customer demands and preferences;

·                                          Ourability to incorporate the use of variable labor staffing into our projects;

·                                          Theloss of key personnel and other employees;

·                                          Changesin our, and our competitors’, business strategy, pricing, and billing policies;

·                                          Thetiming of certain general and administrative expenses;

·                                          Costsassociated with integrating acquired operations;

·                                          Costsassociated with the disposition of certain assets;

·                                          Impairmentof goodwill from our acquisitions;

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·                                          Variabilityin the number of billable days in each quarter;

·                                          Thewrite-off of client billings;

·                                          Returnof fees for work deemed unsatisfactory by a client or claims or litigationresulting from the same;

·                                          Servicelevel credits and penalties associated with our outsourcing engagements;

·                                          Entryinto fixed price engagements and engagements where some fees are contingentupon the client realizing a certain return on investment for a project;

·                                          Availabilityof foreign net operating losses and other credits against our earnings;

·                                          Impacton our business and clients relating to force majeure events, including recenthurricanes in the Southeast and potential pandemic or epidemic disease;

·                                          Internationalcurrency fluctuations;

·                                          Expensesrelated to the issuance of stock options to our employees; and

·                                          Thefixed nature of a substantial portion of our expenses, particularly personneland related costs, depreciation, office rent, and occupancy costs.

One or more of theforegoing factors may cause our operating expenses to be unexpectedly high orresult in a decrease in our revenues during any given period.  Inaddition, we bill certain of our services on a fixed-price basis, and anyassignment delays or expenditures of time beyond that projected for theassignment could result in write-offs of client receivables (both unbilled andbilled).  Significant write-offs could materially adversely affect ourbusiness, financial condition, and results of operations.  Our businessalso has significant collection risks.  If we are unable to collect ourreceivables in a timely manner, our business and financial condition could alsosuffer.  If these or any other variables or unknowns were to cause ashortfall in revenues or earnings or otherwise cause a failure to meet publicmarket expectations, our business could be adversely affected.

Finally, wereported positive earnings in both of the first and second quarters of2006.  However, we also reported a netloss for the year ended December 30, 2005.  As a result, we cannot assureyou that we will achieve or maintain positive earnings in the future.  Ifwe are unable to achieve sustained profitability on a quarterly or annualbasis, the market price of our common stock could be adversely affected and ourfinancial condition would suffer.

2.  The second risk factor which appears on page12 of the 2005 10-K is changed in its entirety as follows:

*We are dependent on ouroutsourcing engagements for a significant part of our revenues.*

Net revenues fromour outsourcing relationships, for the quarter ended June 30, 2006, representedapproximately 40.9% of our consolidated net revenues.  The substantialmajority of these revenues are received from three large outsourcing accountsthat signed long-term agreements with us.  In the first quarter of 2006,we received a one year extension of one of our existing major outsourcingcontracts, University of Pennsylvania Health System (UPHS), and that contractis now set to expire in March 2007.  We currently have no assurances thatthe contract will be extended past the one year renewal period, and UPHSretains the right to terminate the contract at its discretion upon 180 daysnotice. The loss of any of our remaining three large outsourcing relationships,including a failure to gain renewal of any of these contracts or a longer termrenewal at UPHS, could have a material adverse impact on our business andresults of operations.  Further, if we are unable to successfully closeand implement the new outsourcing relationships that we are pursuing (includingthe renewal of our existing outsourcing clients, both large and small), ourbusiness and results of operations will be materially adversely impacted.

We recognizerevenue from certain service elements of our outsourcing agreements on astraight-line basis over the life of the contract.  Since we typicallyincur greater costs and expenses during the early phase of those serviceelements (which have straight-line revenue recognition) than we do in thesubsequent years of those elements, we believe our profitability is lowerduring the early stages of our 

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outsourcingengagements.  In addition, if we are unable to manage costs as planned inthe later stages of an outsourcing engagement, our profitability could likewisebe lower.  In general, income from our outsourcing contracts issusceptible to changes in the mix of newer versus older contracts, and to theimpact of cost fluctuations from quarter to quarter without a compensatingchange in revenues.  If we fail to meet our public market expectations orotherwise experience a shortfall in our net income due to these fluctuations,our business could be adversely affected and the price of our stock maydecline.

In many of ouroutsourcing engagements, the clients have fully outsourced their informationtechnology staff and functions to us.  In all of our outsourcingrelationships, we generally enter into detailed service level agreements, whichestablish performance levels and standards for our services.  If we failto meet these performance levels or standards, our clients may receive monetaryservice level credits from us or, if we experience persistent failures, ourclients may have a right to terminate the outsourcing contract for cause andhave no obligation to pay us any termination fees.  Our anticipatedrevenues and profitability from our outsourcing engagements could besignificantly reduced if we are unable to satisfy our performance levels orstandards, or if we are unable to improve our delivery costs as planned on suchengagements. Additionally, our outsourcing contracts can be terminated at theconvenience of our clients upon the payment of a termination fee.

In addition, manyof our outsourcing agreements require that we invest significant amounts oftime and resources in order to win the engagement, transition the client’sinformation technology department to our management, and complete the initialtransformation of our client’s information technology functioning to provideimproved service at a lower cost and meet agreed-upon service levels. Often, we recover this investment through payments over the life of theoutsourcing agreement.  If we are unable to achieve agreed-upon servicelevels or otherwise breach the terms of our outsourcing agreements, the clientsmay have rights to terminate our agreements for cause and we may be unable torecover our investments.  In addition, our pricing for many of theseagreements generally assume that we can reduce and manage costs so as toachieve desired margins and recoup our investments.  Any failure by us toeffectively reduce and manage costs and/or recover these investments couldreduce our outsourcing revenues, which would have a material adverse effect onour financial condition, results of operations, and price of our common stock.

Our outsourcingengagements may also require that we hire part or all of a client’s informationtechnology personnel.  We cannot assure you that we will be able to retainthese individuals, and effectively hire additional personnel as needed to meetthe obligations of our contract.  Any failure by us to retain theseindividuals or otherwise satisfy our contractual obligations could have amaterial adverse effect on the profitability of our outsourcing business andour reputation as an information technology services outsourcing provider.

Finally, wecontinue to pursue the outsourcing of discrete information technology servicesfor clients.  The amount of time and resources required to win clientengagements for our outsourcing business is significant, and we may not win thenumber or type of client engagements that we anticipate.  If we fail tomeet our objective to secure new outsourcing engagements, or fail to secure newoutsourcing engagements on acceptable commercial terms, we will not experiencethe growth in this business that we have anticipated.

3.  The 11th risk factor which appears on page 17of the 2005 10-K is changed in its entirety as follows:

*The loss of our key clientservice employees and executive officers could negatively affect us.*

Our performancedepends on the continued service of our executive officers, senior managers,and key employees.  In particular, we depend on such persons to secure newclients and engagements and to manage our business and affairs.  The lossof such persons could result in the disruption of our

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business, longer ordelayed sales cycles, and could have a material adverse effect on our businessand results of operations.  We have not entered into long-term employmentcontracts with any of our employees and do not maintain key employee life insurance.

On June 27, 2006,Larry R. Ferguson was appointed as our chief executive officer, and as a memberof the board of directors.  If our current management team is unable toeffectively manage and maintain our business through the transition in management,our business could be adversely impacted.

## **Item2.  Unregistered Sales of EquitySecurities and Use of Proceeds.**

None.

## **Item3.  Defaults Upon Senior Securities.**

None.

## **Item4.  Submission of Matters to a Vote ofSecurity Holders.**

We held our 2006Annual Meeting of Stockholders on June 1, 2006.  The stockholderselected the Board’s nominees as directors to serve three-year terms expiring atthe 2009 Annual Meeting of Stockholders by the votes indicated:
| Nominee               | ** ** | **Votes in  Favor** | ** ** | **Votes  Against** | ** ** | **Abstentions** | ** ** |
|-----------------------|------------|--------------------------|------------|--------------------|------------|-----------------|------------|
| Ronald V.  Aprahamian |       | 22,758,166               |       | 145,017            |       | 0               |       |
| Michael P.  Downey    |       | 22,487,286               |       | 415,897            |       | 0               |       |
| Cora M. Tellez        |       | 22,542,112               |       | 361,071            |       | 0               |       |

The stockholders also ratified our selection of GrantThornton LLP as our independent auditors for the year ending December 29,2006, with 22,559,578 votes cast in favor, 303,436 votes cast against and40,169 votes abstaining from the proposal.

## **Item5.  Other Information.**

None.

## **Item6.  Exhibits.**

| Item     | ** ** | **Description**                                                              |
|----------|------------|------------------------------------------------------------------------------|
| 3.1 (1)  |       | Certificate of Incorporation of the Company                                  |
| 3.2 (2)  |       | Certificate of Designation of Series A Junior  Participating Preferred Stock |
| 3.3 (3)  |       | Bylaws of the Company                                                        |
| 4.1 (4)  |       | Specimen Common Stock Certificate                                            |
| 11.1 (5) |       | Statement of computation of per share earnings                               |
| 31.1     |       | Rule 13a-14(a)/Rule 15d-14(a) Certification of the  Chief Executive Officer. |
| 31.2     |       | Rule 13a-14(a)/Rule 15d-14(a) Certification of the  Chief Financial Officer. |
| 32.1     |       | Section 1350 Certification of the Chief Executive  Officer.                  |
| 32.2     |       | Section 1350 Certification of the Chief Financial  Officer.                  |

 

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(1)          Incorporatedby reference to Exhibit 3.1 to FCG’s Form S-1 Registration Statement (No.333-41121) originally filed on November 26, 1997 (the “Form S-1”).

33

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(2)          Incorporatedby reference to Exhibit 99.1 to FCG’s Current Report on Form 8-K dated December9, 1999.

(3)          Incorporatedby reference to Exhibit 3.3 to FCG’s Form S-1.

(4)          Incorporatedby reference to Exhibit 4.1 to FCG’s Form S-1.

(5)          SeeNote 1 of Notes to Consolidated Financial Statements, “Basic and Diluted NetIncome (Loss) Per Share.”

34

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# **SIGNATURES**

Pursuant to therequirements of the Securities and Exchange Act of 1934, the registrant hasduly caused this report to be signed on its behalf by the undersigned thereuntoduly authorized.
|                      |   | FIRST CONSULTING GROUP, INC.              |
|----------------------|--------|-------------------------------------------|
|                 |   |                                      |
|                 |   |                                      |
| Date: August 9, 2006 |   | /s/LARRY R. FERGUSON                      |   |
|                 |   | Larry R. Ferguson                         |
|                 |   | Chief Executive Officer                   |
|                 |   |                                      |
|                 |   |                                      |
| Date: August 9, 2006 |   | /s/THOMAS A WATFORD                       |   |
|                 |   | Thomas A. Watford                         |
|                 |   | Chief Operating Officer and Interim Chief |
|                 |   | Financial Officer                         |
|                      |        |                                           |  |  |

35

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# **EXHIBITINDEX**

| Item     | ** ** | **Description**                                                              |
|----------|------------|------------------------------------------------------------------------------|
| 3.1 (1)  |       | Certificate of Incorporation of the Company                                  |
| 3.2 (2)  |       | Certificate of Designation of Series A Junior  Participating Preferred Stock |
| 3.3 (3)  |       | Bylaws of the Company                                                        |
| 4.1 (4)  |       | Specimen Common Stock Certificate                                            |
| 11.1 (5) |       | Statement of computation of per share earnings                               |
| 31.1     |       | Rule 13a-14(a)/Rule 15d-14(a) Certification of the  Chief Executive Officer  |
| 31.2     |       | Rule 13a-14(a)/Rule 15d-14(a) Certification of the  Chief Financial Officer  |
| 32.1     |       | Section 1350 Certification of the Chief Executive  Officer                   |
| 32.2     |       | Section 1350 Certification of the Chief Financial  Officer                   |

 

----

(1)          Incorporatedby reference to Exhibit 3.1 to FCG’s Form S-1 Registration Statement (No.333-41121) originally filed on November 26, 1997 (the “Form S-1”).

(2)          Incorporatedby reference to Exhibit 99.1 to FCG’s Current Report on Form 8-K dated December9, 1999.

(3)          Incorporatedby reference to Exhibit 3.3 to FCG’s Form S-1.

(4)          Incorporatedby reference to Exhibit 4.1 to FCG’s Form S-1.

(5)          SeeNote 1 of Notes to Consolidated Financial Statements, “Basic and Diluted NetIncome (Loss) Per Share.”

36

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