******UNITEDSTATESSECURITIES AND EXCHANGE COMMISSION**

**Washington,D.C.  20549**

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**FORM 10-Q**
| **(Mark One)**                                                                                                                                                                                                                                    |       |                                                                                          |
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------------------------------------------------------------------------------|
| ** **                                                                                                                                                                                                                                        |       |                                                                                          |
| x                                                                                                                                                                                                                                                 | ** ** | **QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)  OF THE SECURITIES EXCHANGE ACT OF 1934**  |
|                                                                                                                                                                                                                                              | ** ** | ** **                                                                                    |
| **For the  quarterly period ended September 29, 2006**                                                                                                                                                                                            |
| ** **                                                                                                                                                                                                                                        |       | ** **                                                                                    |
| **OR**                                                                                                                                                                                                                                            |
| ** **                                                                                                                                                                                                                                        |       |                                                                                          |
| o                                                                                                                                                                                                                                                 | ** ** | **TRANSITION REPORT PURSUANT TO SECTION 13 OR  15(d) OF THE SECURITIES EXCHANGE ACT OF 1934** |
|                                                                                                                                                                                                                                              | ** ** | ** **                                                                                    |
| **For the  transition period from               to                   ** |

** **

**Commission File Number 0-23651**

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**First Consulting 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 principal executive offices, including zip code)

**(562)624-5200**

(Registrant’s telephone 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

**Indicate by check mark whether the registrant is a largeaccelerated filer, an accelerated filer, or a non-accelerated filer.  See definition of “accelerate filer and largeaccelerated filer” in Rule 12b-2 of the Exchange Act.**

**Largeaccelerated filer**o                                           Accelerated filer x                                            Non-accelerated filer x

**Indicate by check mark whether the registrant is a shellcompany (as defined in Rule 12b-2 of the Exchange Act). **YesoNo 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** |   | **25,752,590**                     |
|-----------------------------------|--------|------------------------------------|
| (Class)                           |   | (Outstanding at  October 27, 2006) |

 

 

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**FirstConsulting Group, Inc.Table of Contents**
| COVER PAGE                                                                                                |   |   |
|-----------------------------------------------------------------------------------------------------------|--------|--------|
| ** **                                                                                                |   |   |
| TABLE OF  CONTENTS                                                                                        |   |   |
| ** **                                                                                                |   |   |
| PART  I.  FINANCIAL INFORMATION                                                                      |   |   |
| ** **                                                                                                |   |   |
| ITEM 1. FINANCIAL STATEMENTS                                                                              |   |   |
| ** **                                                                                                |   |   |
| Consolidated Balance Sheets                                                                               |   |   |
| ** **                                                                                                |   |   |
| Consolidated Statements of  Operations                                                                    |   |   |
| ** **                                                                                                |   |   |
| Consolidated Statements of  Cash Flows                                                                    |   |   |
| ** **                                                                                                |   |   |
| First Consulting Group, Inc.  and Subsidiaries                                                            |   |   |
| ** **                                                                                                |   |   |
| 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                                                                                             |   |   |

 

2

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# **Part I.  Financial Information**

## **Item 1. Financial Statements**

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

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

| ** **                                                                                                              | ** ** | **September 29,  2006** | ** ** | **December 30,  2005** | ** ** |
|-------------------------------------------------------------------------------------------------------------------------|------------|------------------------------|------------|-----------------------------|------------|
| **ASSETS**                                                                                                              | ** ** | ** **                   | ** ** | ** **                  | ** ** |
| Current assets:                                                                                                         | ** ** | ** **                   | ** ** | ** **                  | ** ** |
| Cash and cash  equivalents                                                                                              |       | $                            | 51,196     |                        | $          | 35,106 |   |
| Short-term  investments                                                                                                 |       | 3,009                        |       | —                      |       |
| Accounts  receivable, less allowance of $1,650 and $1,633 as of September 29, 2006 and  December 30, 2005, respectively |       | 17,828                       |       | 20,993                      |       |
| Unbilled  receivables                                                                                                   |       | 15,272                       |       | 12,352                      |       |
| Prepaid expenses  and other current assets                                                                              |       | 3,444                        |       | 3,532                       |       |
| Total current  assets                                                                                                   |       | 90,749                       |       | 71,983                      |       |
|                                                                                                                    |       |                         |       |                        |       |
| Property and equipment:                                                                                                 |       |                         |       |                        |       |
| Furniture,  equipment, and leasehold improvements                                                                       |       | 4,691                        |       | 3,475                       |       |
| Information  systems equipment and software                                                                             |       | 31,247                       |       | 30,220                      |       |
|                                                                                                                    |       | 35,938                       |       | 33,695                      |       |
| Less accumulated  depreciation and amortization                                                                         |       | 25,186                       |       | 21,365                      |       |
|                                                                                                                    |       | 10,752                       |       | 12,330                      |       |
|                                                                                                                    |       |                         |       |                        |       |
| Other assets:                                                                                                           |       |                         |       |                        |       |
| Executive  benefit trust                                                                                                |       | 10,498                       |       | 10,141                      |       |
| Long-term  accounts receivable, net                                                                                     |       | 2,371                        |       | 1,661                       |       |
| Deferred contract  costs                                                                                                |       | 4,492                        |       | 3,476                       |       |
| Goodwill, net                                                                                                           |       | 18,159                       |       | 18,159                      |       |
| Intangibles, net                                                                                                        |       | 649                          |       | 1,228                       |       |
| Other                                                                                                                   |       | 2,908                        |       | 2,654                       |       |
|                                                                                                                    |       | 39,077                       |       | 37,319                      |       |
| Total assets                                                                                                            |       | $                            | 140,578    |                        | $          | 121,632 |   |

 

The accompanying notesare an integral part of these consolidated 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)****(unaudited)**
| ** **                                                                                                                                                                                      | ** ** | **September 29,            2006          ** | ** ** | **December 30,            2005          ** | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------------------------------------------------------------------------------------------------------------------------------------|------------|
| **LIABILITIES AND STOCKHOLDERS’ EQUITY**                                                                                                                                                   | ** ** | ** **                                                                                                                                           | ** ** | ** **                                                                                                                                          | ** ** |
| Current  liabilities:                                                                                                                                                                           | ** ** | ** **                                                                                                                                           | ** ** | ** **                                                                                                                                          | ** ** |
| Accounts payable                                                                                                                                                                                |       | $                                                                                                                                                    | 2,002      |                                                                                                                                                | $          | 1,685 |   |
| Accrued liabilities                                                                                                                                                                             |       | 3,985                                                                                                                                                |       | 5,280                                                                                                                                               |       |
| Accrued payroll and payroll taxes                                                                                                                                                               |       | 3,828                                                                                                                                                |       | 1,595                                                                                                                                               |       |
| Accrued vacation                                                                                                                                                                                |       | 6,135                                                                                                                                                |       | 7,082                                                                                                                                               |       |
| Accrued employee benefits                                                                                                                                                                       |       | 2,899                                                                                                                                                |       | 2,741                                                                                                                                               |       |
| Accrued severance                                                                                                                                                                               |       | 16                                                                                                                                                   |       | 2,813                                                                                                                                               |       |
| Accrued incentive compensation                                                                                                                                                                  |       | 1,874                                                                                                                                                |       | 1,113                                                                                                                                               |       |
| Customer advances                                                                                                                                                                               |       | 8,818                                                                                                                                                |       | 7,201                                                                                                                                               |       |
| Accrued restructuring costs                                                                                                                                                                     |       | 659                                                                                                                                                  |       | 3,204                                                                                                                                               |       |
| Total current liabilities                                                                                                                                                                       |       | 30,216                                                                                                                                               |       | 32,714                                                                                                                                              |       |
| Non-current  liabilities:                                                                                                                                                                       |       |                                                                                                                                                 |       |                                                                                                                                                |       |
| Supplemental executive retirement plan                                                                                                                                                          |       | 9,789                                                                                                                                                |       | 10,172                                                                                                                                              |       |
| Total non-current liabilities                                                                                                                                                                   |       | 9,789                                                                                                                                                |       | 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, 25,665,807 shares issued and outstanding at September 29, 2006  and 24,567,759 shares issued and outstanding at December 30, 2005 |       | 26                                                                                                                                                   |       | 25                                                                                                                                                  |       |
| Additional paid-in capital                                                                                                                                                                      |       | 97,213                                                                                                                                               |       | 91,202                                                                                                                                              |       |
| Retained earnings (deficit)                                                                                                                                                                     |       | 3,214                                                                                                                                                |       | (12,558                                                                                                                                             | )          |
| Accumulated other comprehensive income                                                                                                                                                          |       | 120                                                                                                                                                  |       | 77                                                                                                                                                  |       |
| Total stockholders’ equity                                                                                                                                                                 |       | 100,573                                                                                                                                              |       | 78,746                                                                                                                                              |       |
| Total liabilities  and stockholders’ equity                                                                                                                                                |       | $                                                                                                                                                    | 140,578    |                                                                                                                                                | $          | 121,632 |   |

 

The accompanyingnotes are an integral part of these consolidated financial statements.

4

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

### **Consolidated Statements of Operations(in thousands, except per share data)(unaudited)**

| ** **                                                            | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended** | ** ** |
|-----------------------------------------------------------------------|------------|----------------------------------|------------|---------------------------------|------------|
| ** **                                                            | ** ** | **September  29, 2006**     | ** ** | **September  30, 2005**    | ** ** | **September  29, 2006** | ** ** | **September  30, 2005** | ** ** |
| Revenues before  reimbursements                                       |       | $                                | 65,238     |                            | $          | 72,717 |   | $ | 197,450 |   | $ | 208,780 |   |
| Reimbursements                                                        |       | 3,326                            |       | 3,887                           |       | 10,596 |   | 11,321 |   |
| Total revenues                                                        |       | 68,564                           |       | 76,604                          |       | 208,046 |   | 220,101 |   |
|                                                                  |       |                             |       |                            |       |   |   |   |   |
| Cost of services  before reimbursable expenses                        |       | 47,044                           |       | 56,073                          |       | 142,723 |   | 160,398 |   |
| Reimbursable  expenses                                                |       | 3,326                            |       | 3,887                           |       | 10,596 |   | 11,321 |   |
| Total cost of services                                                |       | 50,370                           |       | 59,960                          |       | 153,319 |   | 171,719 |   |
|                                                                  |       |                             |       |                            |       |   |   |   |   |
| Gross profit                                                          |       | 18,194                           |       | 16,644                          |       | 54,727 |   | 48,382 |   |
|                                                                  |       |                             |       |                            |       |   |   |   |   |
| Selling expenses                                                      |       | 4,016                            |       | 7,621                           |       | 12,438 |   | 21,473 |   |
| General and  administrative expenses                                  |       | 8,930                            |       | 9,459                           |       | 27,379 |   | 30,069 |   |
| Income (loss) from operations                                         |       | 5,248                            |       | (436                            | )          | 14,910 |   | (3,160 | ) |
| Other income  (expense):                                              |       |                             |       |                            |       |   |   |   |   |
| Interest income, net                                                  |       | 646                              |       | 234                             |       | 1,409 |   | 674 |   |
| Other income (expense), net                                           |       | 653                              |       | (18                             | )          | 640 |   | (51 | ) |
| Income (loss) from continuing operations before  income tax provision |       | 6,547                            |       | (220                            | )          | 16,959 |   | (2,537 | ) |
| Income tax provision                                                  |       | 458                              |       | 20                              |       | 1,187 |   | 5,381 |   |
| Income (loss) from continuing operations                              |       | 6,089                            |       | (240                            | )          | 15,772 |   | (7,918 | ) |
| Loss on  discontinued operations, net of tax benefit                  |       | —                           |       | —                          |       | — |   | (537 | ) |
| Net income (loss)                                                     |       | $                                | 6,089      |                            | $          | (240 | ) | $ | 15,772 |   | $ | (8,455 | ) |
|                                                                  |       |                             |       |                            |       |   |   |   |   |
| Basic net income  (loss) per share:                                   |       |                             |       |                            |       |   |   |   |   |
| Income (loss)  from continuing operations, net of tax                 |       | $                                | 0.24       |                            | $          | (0.01 | ) | $ | 0.63 |   | $ | (0.33 | ) |
| Loss on  discontinued operations, net of tax                          |       | —                           |       | —                          |       | — |   | (0.02 | ) |
| Net income (loss)                                                     |       | $                                | 0.24       |                            | $          | (0.01 | ) | $ | 0.63 |   | $ | (0.35 | ) |
|                                                                  |       |                             |       |                            |       |   |   |   |   |
| Diluted net  income (loss) per share:                                 |       |                             |       |                            |       |   |   |   |   |
| Income (loss)  from continuing operations, net of tax                 |       | $                                | 0.23       |                            | $          | (0.01 | ) | $ | 0.62 |   | $ | (0.33 | ) |
| Loss on  discontinued operations, net of tax                          |       | —                           |       | —                          |       | — |   | (0.02 | ) |
| Net income (loss)                                                     |       | $                                | 0.23       |                            | $          | (0.01 | ) | $ | 0.62 |   | $ | (0.35 | ) |
|                                                                  |       |                             |       |                            |       |   |   |   |   |
| Weighted average  shares used in computing:                           |       |                             |       |                            |       |   |   |   |   |
| Basic net income (loss) per share                                     |       | 25,472                           |       | 24,468                          |       | 25,074 |   | 24,429 |   |
| Diluted net  income (loss) per share                                  |       | 26,229                           |       | 24,468                          |       | 25,643 |   | 24,429 |   |

 

The accompanying notesare an integral part of these consolidated financial statements.

5

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

### **Consolidated Statements of Cash Flows****(in thousands)(unaudited)**

| ** **                                                                                | ** ** | **Nine Months Ended** | ** ** |
|-------------------------------------------------------------------------------------------|------------|---------------------------------|------------|
| ** **                                                                                | ** ** | **September 29,  2006**    | ** ** | **September 30,  2005** | ** ** |
| Cash flows from  operating activities:                                                    |       |                            |       |   |   |
| Net income (loss):                                                                        |       | $                               | 15,772     |   | $ | (8,455 | ) |
| Adjustments to reconcile net income (loss) to net  cash provided by operating activities: |       |                            |       |   |   |
| Depreciation and amortization                                                             |       | 5,388                           |       | 4,765 |   |
| Intangible amortization                                                                   |       | 579                             |       | 971 |   |
| Provision for bad debts                                                                   |       | (99                             | )          | 336 |   |
| Loss on sale/disposal of assets                                                           |       | 473                             |       | 44 |   |
| Stock-based compensation                                                                  |       | 629                             |       | 43 |   |
| Interest income on notes receivable – stockholders                                   |       | —                          |       | (44 | ) |
| Loss on operations of discontinued operations, net  of tax benefit                        |       | —                          |       | 537 |   |
| Change in assets and liabilities:                                                         |       |                            |       |   |   |
| Accounts receivable                                                                       |       | 3,264                           |       | 6,725 |   |
| Unbilled receivables                                                                      |       | (2,920                          | )          | (4,791 | ) |
| Prepaid expenses and other current assets                                                 |       | 88                              |       | (3,762 | ) |
| Long term account receivable                                                              |       | (710                            | )          | 2,620 |   |
| Deferred contract costs                                                                   |       | (1,016                          | )          | (1,310 | ) |
| Other assets                                                                              |       | (397                            | )          | (31 | ) |
| Accounts payable                                                                          |       | 317                             |       | (710 | ) |
| Accrued liabilities                                                                       |       | (1,295                          | )          | 243 |   |
| Accrued payroll and payroll taxes                                                         |       | 2,233                           |       | 72 |   |
| Accrued vacation                                                                          |       | (947                            | )          | 568 |   |
| Accrued employee benefits                                                                 |       | 158                             |       | 1,081 |   |
| Accrued severance                                                                         |       | (2,797                          | )          | 446 |   |
| Accrued incentive compensation                                                            |       | 761                             |       | (355 | ) |
| Customer advances                                                                         |       | 1,617                           |       | (1,521 | ) |
| Accrued restructuring costs                                                               |       | (2,545                          | )          | (1,470 | ) |
| Deferred income taxes                                                                     |       | —                          |       | 5,361 |   |
| Supplemental executive retirement plan                                                    |       | (740                            | )          | 419 |   |
| Other                                                                                     |       | (97                             | )          | (154 | ) |
| Net cash provided by operating activities of  continuing operations                       |       | 17,716                          |       | 1,628 |   |
| Net cash used in operating activities of  discontinued operations                         |       | —                          |       | (469 | ) |
| Net cash provided by operating activities                                                 |       | 17,716                          |       | 1,159 |   |
| Cash flows from  investing activities:                                                    |       |                            |       |   |   |
| Proceeds from sale/maturity (purchase) of investments,  net                               |       | (3,009                          | )          | 17,439 |   |
| Purchase of property and equipment                                                        |       | (4,358                          | )          | (6,502 | ) |
| Net cash provided by (used in) investing activities  of continuing operations             |       | (7,367                          | )          | 10,937 |   |
| Net cash provided by investing activities of  discontinued operations                     |       | —                          |       | 113 |   |
| Net cash provided by (used in) investing activities                                       |       | (7,367                          | )          | 11,050 |   |
| Cash flows from  financing activities:                                                    |       |                            |       |   |   |
| Proceeds from issuance of capital stock, net                                              |       | 5,465                           |       | 862 |   |
| Collections of loan receivable                                                            |       | 61                              |       | 39 |   |
| Capital stock repurchase                                                                  |       | —                          |       | (2,530 | ) |
| Net cash provided by (used in) financing activities                                       |       | 5,526                           |       | (1,629 | ) |
| Effect of exchange rate changes on cash and cash  equivalents                             |       | 215                             |       | (209 | ) |
| Net change in cash and cash equivalents                                                   |       | 16,090                          |       | 10,371 |   |
| Cash and cash  equivalents at beginning of period                                         |       | 35,106                          |       | 15,012 |   |
| Cash and cash  equivalents at end of period                                               |       | $                               | 51,196     |   | $ | 25,383 |   |
|                                                                                      |       |                            |       |   |   |
| Supplemental  disclosure of cash flow information                                         |       |                            |       |   |   |
| Cash paid during the period for interest                                                  |       | $                               | 5          |   | $ | 57 |   |
| Cash paid during the period for income taxes, net of  refunds                             |       | $                               | 530        |   | $ | 470 |   |
| Supplemental  disclosure of non-cash investing and financing activities                   |       |                            |       |   |   |
| Release from escrow of common stock to complete  acquisition of business                  |       | $                               | —     |   | $ | 900 |   |
| Settlement of  officer loan receivable by repurchase of common stock                      |       | $                               | 82         |   | $ | 67 |   |

 

The accompanying notesare an integral part of these consolidated financial statements.

6

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### **First Consulting Group, Inc. andSubsidiaries**

### **Notes to ConsolidatedFinancial Statements**

**September29, 2006**

**Note 1                    Accounting Policies**

*Basisof Presentation*

The accompanying consolidated balance sheet of First Consulting Group,Inc. and subsidiaries (the “Company” or “FCG”) at September 29, 2006 andconsolidated statements of operations and consolidated statements of cash flowsfor the three-month and nine-month periods ended September 29, 2006 andSeptember 30, 2005 are unaudited.  Thesefinancial statements reflect all adjustments, consisting of only normalrecurring adjustments, which, in the opinion of management, are necessary tofairly present the financial position of the Company at September 29, 2006 andthe results of operations for the three-month and nine-month periods endedSeptember 29, 2006 and September 30, 2005. The results of operations and cash flows for the three-month andnine-month period ended September 29, 2006 are not necessarily indicative ofthe results to be expected for the year ending December 29, 2006.  For more complete financial information,these financial statements should be read in conjunction with the auditedfinancial statements for the year ended December 30, 2005 included in theCompany’s Annual Report on Form 10-K. Certain reclassifications have been made to the 2005 financialstatements 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 aglobal sourcing strategy, infrastructure costs of providing these services havegrown dramatically.  Since these costshad not been for staff or subcontractors, per the Company’s prior definition ofcost of services, they had been classified as general and administrative.  The Company is now classifying these types ofcosts as cost of services.  Thisprimarily affects the Company’s outsourcing businesses, its Software Servicesbusiness, and its “Other” segment, where the costs of the shared servicecenters for both infrastructure and offshore sourcing are included.  All costs in prior years have beenreclassified to be consistent with the fiscal year 2006 presentation.

7

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*Stock-BasedCompensation*

Restricted Stock

A summary of restricted stock activity for the nine months endedSeptember 29, 2006 is as follows:
|                                | ** ** | **Shares** | ** ** | **Weighted Average  Grant Date  Fair Value** | ** ** |
|--------------------------------|------------|------------|------------|-------------------------------------------------------------|------------|
| Balance at  December 30, 2005  |       | —     |       | —                                                      |       |
| Grants                         |       | 180,000    |       | $                                                           | 8.49       |   |
| Balance at September  29, 2006 |       | 180,000    |       | $                                                           | 8.49       |   |

 

In August, theCompany issued 180,000 shares of restricted stock awards with a vesting periodof five years to seven vice presidents and recognized $51,000 of compensationcosts during the three months ended September 29, 2006.  At September 29, 2006, there was $1.5 millionof total unrecognized compensation costs related to unvested stock, which isexpected to be recognized over a weighted average period of 4.8 years.

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 compensation expense for all share-based paymentawards made to employees and directors, including employee stock options, basedon estimated grant date fair values. Previously, the Company elected to account for these share-based paymentawards using the intrinsic-value method under Accounting Principles BoardOpinion No. 25, “Accounting for Stock Issued to Employees” (“APB 25”), andelected to only disclose the impact of expensing the fair value of stockoptions 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 nine months ended September 30, 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 September 29, 2006 and future periods will not be comparable tohistorical results of operations.  Underthis transition method, SFAS 123R applies to new equity awards and toequity awards 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 of SFAS123R, the Company changed its method of attributing the value of stock-basedcompensation expense from the multiple-option (i.e., accelerated) approach tothe single-option (i.e., straight-line) method. Compensation expense forshare-based awards granted through December 30,

8

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2005 will continue to besubject to the accelerated multiple-option method, while compensation expensefor share-based awards granted on or after December 31, 2005 will berecognized using a straight-line, or single-option method.  The Company recognizes these compensationcosts over the service period of the award, which is generally the option vestingterm 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 nine months ended September 29, 2006 is $230,000 and $578,000,respectively, which had the effect of reducing basic and diluted earnings per shareby $0.01 for the three-month period and $0.02 for the nine-month period.  Stock-based compensation included $187,000 asa component of cost of services, $97,000 as a component of selling expense, and$294,000 as a component of general and administrative expense for the ninemonths ended September 29, 2006.  Inaddition, prior to the adoption of SFAS 123R, the Company presented the taxbenefit of stock option exercises as operating cash flows.  Upon the adoption of SFAS 123R, tax benefitsresulting from tax deductions in excess of the compensation cost recognized forthose options are classified as financing cash flows.  For the first nine months of 2006, there wereno tax benefits resulting from tax deductions in excess of the compensationcost recognized.  Because the Companymaintained a full valuation allowance on its deferred tax assets, the Companydid not recognize any tax benefit related to stock-based compensation expensefor the nine months ended September 29, 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 nine months ended September 29, 2006 was estimated on thedate of grant using such model with the following assumptions:
|                         | ** ** | **Three Months Ended  September 29, 2006** | ** ** | **Nine Months Ended  September 29, 2006** | ** ** |
|-------------------------|------------|----------------------------------------------------------------|------------|---------------------------------------------------------------|------------|
| Expected volatility     |       | N/A                                                            |       | 55.0                                                          | %          |
| Risk-free interest rate |       | N/A                                                            |       | 4.9                                                           | %          |
| Expected dividends      |       | —                                                         |       | —                                                        |       |

 

Expected volatilities arebased on the Company’s historical volatility. The risk-free interest rateassumption is based upon observed interest rates appropriate for the term ofthe Company’s employee stock options. The expected dividend yield is zero asthe Company does not expect to pay dividends in the future.  During the nine months ended September 29,2006, the Company issued its automatic annual stock option grant to its Boardof Directors for 36,000 shares, an additional stock option grant to a newmember of the Board of Directors for 24,000 shares, and a stock option grant inJune 2006 to its new Chief Executive Officer for 500,000 shares.

9

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Stock option activity for the nine months ended September 29, 2006 is as follows:
|                                    | ** ** | **Shares** | ** ** | **Weighted Average  Exercise Price** | ** ** | **Weighted Average  Remaining  Contractual Life (Years)** | ** ** |
|------------------------------------|------------|------------|------------|------------------------------------------------|------------|--------------------------------------------------------------------------|------------|
| ** **                         | ** ** | ** ** | ** ** | ** **                                     | ** ** | ** **                                                               | ** ** |
| Outstanding at  December 30, 2005  |       | 4,665,491  |       | $                                              | 7.43       |                                                                     |       |   |
| Grants                             |       | 560,000    |       | $                                              | 8.89       |                                                                     |       |   |
| Exercised                          |       | (928,475   | )          | $                                              | 5.95       |                                                                     |       |   |
| Cancelled                          |       | (623,177   | )          | $                                              | 8.82       |                                                                     |       |   |
| Outstanding at  September 29, 2006 |       | 3,673,839  |       | $                                              | 7.78       |                                                                     | 5.73       |   |
|                               |       |       |       |                                           |       |                                                                     |       |
| Exercisable at  September 29, 2006 |       | 2,738,082  |       | $                                              | 7.88       |                                                                     | 4.72       |   |

 

As of September 29, 2006, there was $2.3 million of total unrecognizedcompensation cost related to unvested stock options.  This cost is expected to be recognized over aweighted-average period of approximately 1.5 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 nine monthsended September 30, 2005 (in thousands, except per share amounts):
|                                                                                                                                                                                                                                                                                                                                                       | ** ** | **Three Months Ended  September 30, 2005** | ** ** | **Nine Months Ended  September 30, 2005** | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|----------------------------------------------------------------|------------|---------------------------------------------------------------|------------|
| ** **                                                                                                                                                                                                                                                                                                                                            | ** ** | ** **                                                     | ** ** | ** **                                                    | ** ** |
| Net loss                                                                                                                                                                                                                                                                                                                                              |       | $                                                              | (240       | )                                                             | $          | (8,455 | ) |
| Deduct:Total  stock-based employee compensation expense determined under fair value method  for all awards, net of tax                                                                                                                                                                                                                                |       | (147                                                           | )          | (827                                                          | )          |
| Add:Amount  of such stock-based compensation expense included in net loss under APB 25,  net of tax                                                                                                                                                                                                                                                   |       | —                                                         |       | —                                                        |       |
| Pro forma net  loss                                                                                                                                                                                                                                                                                                                                   |       | $                                                              | (387       | )                                                             | $          | (9,282 | ) |
|                                                                                                                                                                                                                                                                                                                                                  |       |                                                           |       |                                                          |       |
| Basic  and diluted loss per share      As reported                                                                                                                                                                                                                                                                           |       | $                                                              | (0.01      | )                                                             | $          | (0.35 | ) |
|                                                         Pro  forma |       | $                                                              | (0.02      | )                                                             | $          | (0.38 | ) |

 

*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 nine months ended September29, 2006 and September 30, 2005 (in thousands, except per share data):

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| ** **                                             | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended** | ** ** |
|--------------------------------------------------------|------------|----------------------------------|------------|---------------------------------|------------|
| ** **                                             | ** ** | **September  29, 2006**     | ** ** | **September  30, 2005**    | ** ** | **September  29, 2006** | ** ** | **September  30, 2005** | ** ** |
| Income (loss) from  continuing operations              |       | $                                | 6,089      |                            | $          | (240 | ) | $ | 15,772 |   | $ | (7,918 | ) |
| Loss on discontinued  operations, net of tax benefit   |       | —                           |       | —                          |       | — |   | (537 | ) |
| Net income  (loss)                                     |       | $                                | 6,089      |                            | $          | (240 | ) | $ | 15,772 |   | $ | (8,455 | ) |
|                                                   |       |                             |       |                            |       |   |   |   |   |
| Basic weighted average  number of shares outstanding   |       | 25,472                           |       | 24,468                          |       | 25,074 |   | 24,429 |   |
| Effect of dilutive  options and contingent shares      |       | 757                              |       | —                          |       | 569 |   | — |   |
| Diluted weighted  average number of shares outstanding |       | 26,229                           |       | 24,468                          |       | 25,643 |   | 24,429 |   |
|                                                   |       |                             |       |                            |       |   |   |   |   |
| Basic per share:                                       |       |                             |       |                            |       |   |   |   |   |
| Income (loss) from  continuing operations              |       | $                                | 0.24       |                            | $          | (0.01 | ) | $ | 0.63 |   | $ | (0.33 | ) |
| Loss on discontinued  operations, net of tax benefit   |       | —                           |       | —                          |       | — |   | (0.02 | ) |
| Net income  (loss) per share                           |       | $                                | 0.24       |                            | $          | (0.01 | ) | $ | 0.63 |   | $ | (0.35 | ) |
|                                                   |       |                             |       |                            |       |   |   |   |   |
| Diluted per share:                                     |       |                             |       |                            |       |   |   |   |   |
| Income (loss) from  continuing operations              |       | $                                | 0.23       |                            | $          | (0.01 | ) | $ | 0.62 |   | $ | (0.33 | ) |
| Loss on discontinued  operations, net of tax benefit   |       | —                           |       | —                          |       | — |   | (0.02 | ) |
| Net income (loss) per  share                           |       | $                                | 0.23       |                            | $          | (0.01 | ) | $ | 0.62 |   | $ | (0.35 | ) |

 

For the three months ended September 29, 2006 and September 30, 2005,there were 1,288,392 and 5,075,785 anti-dilutive outstanding stock options,respectively, excluded from the calculation of diluted income (loss) pershare.  For the nine months endedSeptember 29, 2006 and September 30, 2005, there were 2,003,147 and 5,179,378anti-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,management evaluates its estimates, including those related to revenuerecognition, valuation of goodwill, stock-based compensation, long-lived andintangible assets, other accrued liabilities, income taxes including the amountof tax asset valuation allowance required, restructuring costs, litigation anddisputes, and the allowance for doubtful accounts.

Management basesits estimates on historical experience and on various other assumptions thatare believed to be reasonable under the circumstances, the results of which formthe 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.

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*New Accounting Standards*

Considering the Effectsof Prior Year Misstatements when Quantifying Misstatements in Current YearFinancial Statements

In September 2006,the Securities and Exchange Commission issued Staff Accounting Bulletin 108, “Consideringthe Effects of Prior Year Misstatements when Quantifying Misstatements inCurrent Year Financial Statements” (“SAB 108”).  SAB 108 requires thatregistrants utilize both an income statement assessment and a balance sheetassessment (“dual approach”) to evaluate the quantitative effects of financialstatement misstatements.  SAB 108 permits the Company to initially applyits provisions either by i) restating prior financial statements as if the dualapproach had always been used or ii) recording the cumulative effect ofinitially applying the dual approach as adjustments to the carrying values ofassets and liabilities as of the beginning of the Company’s 2006 fiscal year,with an offsetting adjustment recorded to the opening balance of retained earnings. The guidance in SAB 108 must be applied to annual financial statements forfiscal years ending after November 15, 2006.  The Company’s adoption ofSAB 108 is not expected to have a material impact on the consolidatedfinancial statements.

Fair Value Measurements

InSeptember 2006, the FASB issued SFAS No. 157, “Fair ValueMeasurements” (“SFAS 157”), which provides guidance for using fair value tomeasure assets and liabilities.  SFAS 157will apply whenever another standard requires or permits assets or liabilitiesto be measured at fair value. The standard does not expand the use of fairvalue to any new circumstances.  SFAS 157is effective for financial statements issued for fiscal years beginning afterNovember 15, 2007.  The Company’sadoption of SFAS 157 is not expected to have a material impact on theconsolidated financial statements.

Accounting forUncertainty 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 tax positions.  FIN 48 is effective for fiscal years beginningafter December 15, 2006 and the Company will adopt FIN 48 in the first quarterof 2007.  Management has not yetdetermined the impact that FIN 48 will have on its consolidated financialstatements or on the effective tax rate in future periods.

**Note 2                    Investments**

At September 29, 2006 and December 30, 2005, the Company had $325,000of non-marketable equity investments, valued at the lower of cost or estimatedfair value, which were included within other assets.

**Note 3                    Long-Term Receivable**

AtSeptember 29, 2006, the Company carried $2.4 million in long-term accountsreceivable.  Of this amount, $2.2 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 September 29, 2006 was$555,000.

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**Note 4                    Stock Repurchase**

On February 23,2005, the Company repurchased certain shares of the Company’s common stock thathad been part of the consideration paid for the purchase of an entity acquiredin fiscal year 2002 from the shareholders of that acquired entity.  A total of 422,018 shares were repurchasedfor approximately $2.5 million in cash. The repurchased shares were subsequently cancelled.

**Note 5                    Goodwill and IntangibleAssets**

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 significant judgment.  Accordingly, if expectations of future operating results change, or ifthere are changes to other assumptions, estimates of the fair value ofreporting units could change significantly resulting in a goodwill impairmentcharge, which could have a significant impact on the consolidated financialstatements.  The Company performed an impairment test on each of itscomponents of goodwill as of the fourth quarter of fiscal year 2005 anddetermined that none of its goodwill was impaired.  As of September 29, 2006, the Company had$18.2 million of goodwill and $649,000 of amortizable intangible assetsrecorded on its balance sheet.

There were no changes in the net carrying amounts of goodwill for thenine months ended September 29, 2006. The amounts of goodwill are as follows (in thousands):
|                                   | ** ** | **Health  Delivery  Services** | ** ** | **Health  Delivery  Outsourcing** | ** ** | **Life  Sciences** | ** ** | **Software  Services** | ** ** | **Total**  | ** ** |
|-----------------------------------|------------|--------------------------------|------------|-----------------------------------|------------|--------------------|------------|------------------------|------------|------------|------------|
| Balance as of  December 30, 2005  |       | $                              | 3,225      |                              | $          | 5,193              |       | $                      | 1,481      |       | $          | 8,260 | ** ** | **$** | **18,159** | ** ** |
| Acquired                          |       | —                         |       | —                            |       | —             |       | —                 | ** ** | **—** | ** ** |
| Balance as of September  29, 2006 |       | $                              | 3,225      |                              | $          | 5,193              |       | $                      | 1,481      |       | $          | 8,260 | ** ** | **$** | **18,159** | ** ** |

 

As of September 29, 2006, the Company had the following acquiredintangible assets (in thousands):

|                                   | ** ** | **Customer  Related** | ** ** |
|-----------------------------------|------------|-----------------------|------------|
| Balance as of December  30, 2005  |       | $                     | 1,228      |   |
| Amortization                      |       | (579                  | )          |
| Balance as of September  29, 2006 |       | $                     | 649        |   |
| Amortization Period in Years      |       | 4                     |       |

 

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

| Fiscal Year          | ** ** | ** ** | ** ** |
|---------------------------|------------|------------|------------|
| 2006 (remainder of  year) |       | $          | 193        |   |
| 2007                      |       | 456        |       |
| Total                     |       | $          | 649        |   |

 

**Note 6                    Restructuring Costs**

**At September 29, 2006, the Company hadapproximately $659,000 of 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 ismaking $2.9 million of payments to the landlord in equal installments over thelast ten months of fiscal year 2006 in order to extinguish the Company’sobligations under the lease.**

**The restructuring cost liabilityactivity through September 29, 2006 is summarized as follows (in thousands):**
| Accrual balance at December  30, 2005  |   | $      | 3,204 |   |
|----------------------------------------|--------|--------|-------|--------|
| Cash payments                          |   | (2,545 | )     |
| Accrual balance at  September 29, 2006 |   | $      | 659   |   |

 

**Note 7                    Comprehensive Income (Loss)**

Comprehensive income (loss), net of taxes, for the three months andnine months ended September 29, 2006 and September 30, 2005, is as follows (inthousands):
|                                                | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended** | ** ** |
|------------------------------------------------|------------|----------------------------------|------------|---------------------------------|------------|
| ** **                                     | ** ** | **September  29, 2006**     | ** ** | **September  30, 2005**    | ** ** | **September  29, 2006** | ** ** | **September  30, 2005** | ** ** |
| Net income  (loss)                             |       | $                                | 6,089      |                            | $          | (240 | ) | $ | 15,772 |   | $ | (8,455 | ) |
|                                           |       |                             |       |                            |       |   |   |   |   |
| Foreign currency  translation adjustment       |       | 40                               |       | (34                             | )          | 50 |   | (424 | ) |
| Unrealized gain  (loss) on investments         |       | 5                                |       | 14                              |       | (7 | ) | 13 |   |
| Other  comprehensive income (loss), net of tax |       | 45                               |       | (20                             | )          | 43 |   | (411 | ) |
|                                           |       |                             |       |                            |       |   |   |   |   |
| Comprehensive income  (loss)                   |       | $                                | 6,134      |                            | $          | (260 | ) | $ | 15,815 |   | $ | (8,866 | ) |

**Note 8                    Discontinued Operations**

On December 7, 2004, theCompany’s Board of Directors approved a plan to sell and exit its clinical andnon-clinical Call Center Services (“CCS”) operation due to recurringlosses.  On February 2, 2005, the Company executed a definitive agreementwith the MPB Group, LLC, d/b/a The Beryl Companies.  FCG received 12monthly payments of $12,500, totaling $150,000, for selected customercontracts. The disposal plan consisted primarily of the termination of normalCCS 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

14

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with SFAS 144, “Accountingfor the Impairment or Disposal of Long-Lived Assets,” this disposal representsa discontinued operation.

Since April 1, 2005, there have been no remainingactivities in this business.  Asummary of results for CCS for the quarter ended April 1, 2005 includedrevenues of $631,000 and a pre-tax loss of $866,000 which related to the sales,operation, and wind-down of the business, including $276,000 related toseverance 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                    Disclosure of SegmentInformation**

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

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

·                  SoftwareServices - the delivery of blended shore software development; and

·                  Software Products - the delivery ofsolutions involving the use of software to health delivery clients.

Additionally, theCompany has three shared service centers that provide services to multiplebusiness segments.  These shared servicecenters include FCG India, Integration Services, and Infrastructure Services.   The costs of these services are internallybilled and reported in the individual business segments as cost of services ata standard transfer cost.

Due to anorganizational change that the Company made which took effect at the beginningof 2006, the Technology Staffing Services (TSS) group was moved from Governmentand Technology Services to “Other.”  FCGhas reclassified previous segment reporting in accordance with SFAS 131. This business is being de-emphasized by the Company.  Although some of the billable staff who werepreviously included in this business area have been transferred to several ofthe Company’s other segments as part of this organizational change, it isimpractical to reclassify the effect on those segments in prior years.  Additionally, the Health Delivery Sales groupwas disbanded as a separate group serving both Health Delivery Services andHealth Delivery Outsourcing, with all selling costs now being contained withineach individual segment.  FCG has reclassifiedsuch prior year costs to each segment based on an estimate of the servicesprovided to that unit by the Health Delivery Sales group.  The history shown in the financial tablesincluded in this note is consistent with this change.

Due to anotherorganizational change that the Company made which took effect at the beginningof the third quarter of 2006, the Government and Technology Services segmentwas split.  The Government group has beencombined into the Health Delivery Services segment and the remaining segmenthas been named Software Services.  Thehistory shown in the financial tables included in this note is consistent withthis change.

The Company evaluates itssegments’ performance based on revenues and operating income.  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

15

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Company does not manageor track most assets by segment.  As aresult, interest and other charges are not included in the tables below.

The following segmentinformation is for the three months and nine months ended September 29, 2006and September 30, 2005 (inthousands):

16

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**For the three months ended September 29, 2006:**(in thousands)
| ** **                                     | ** ** | **Health  Delivery  Services** | ** ** | **Health  Delivery  Outsourcing** | ** ** | **Health  Delivery  Total** | ** ** | **Life  Sciences** | ** ** | **Health  Plan** | ** ** | **Software  Services** | ** ** | **Software  Products** | ** ** | **Other** | ** ** | **Totals** | ** ** |
|------------------------------------------------|------------|--------------------------------|------------|-----------------------------------|------------|-----------------------------|------------|--------------------|------------|------------------|------------|------------------------|------------|------------------------|------------|-----------|------------|------------|------------|
| Revenues  before reimbursements                |       | $                              | 14,171     |                              | $          | 26,900                      | * *   | *$*                | *41,071*   |             | $          | 8,152                  |       | $                      | 8,074      |      | $          | 7,170      |       | $ | 472 |   | $ | 299 | ** ** | **$** | **65,238** | ** ** |
| Reimbursements                                 |       | 2,078                          |       | 32                                | * *   | *2,110*                     |       | 129                |       | 916              |       | 162                    |       | 8                      |       | 1         | ** ** | **3,326**  | ** ** |
| Total revenues                                 |       | 16,249                         |       | 26,932                            | * *   | *43,181*                    |       | 8,281              |       | 8,990            |       | 7,332                  |       | 480                    |       | 300       | ** ** | **68,564** | ** ** |
| Cost  of services before reimbursable expenses |       | 8,299                          |       | 23,307                            | * *   | *31,606*                    |       | 4,121              |       | 6,087            |       | 4,579                  |       | 638                    |       | 13        | ** ** | **47,044** | ** ** |
| Reimbursable  expenses                         |       | 2,078                          |       | 32                                | * *   | *2,110*                     |       | 129                |       | 916              |       | 162                    |       | 8                      |       | 1         | ** ** | **3,326**  | ** ** |
| Total cost of services                         |       | 10,377                         |       | 23,339                            | * *   | *33,716*                    |       | 4,250              |       | 7,003            |       | 4,741                  |       | 646                    |       | 14        | ** ** | **50,370** | ** ** |
| Gross profit                                   |       | 5,872                          |       | 3,593                             | * *   | *9,465*                     |       | 4,031              |       | 1,987            |       | 2,591                  |       | (166                   | )          | 286       | ** ** | **18,194** | ** ** |
| Selling  expenses                              |       | 1,642                          |       | 283                               | * *   | *1,925*                     |       | 990                |       | 562              |       | 501                    |       | 78                     |       | (40       | )          | **4,016**  | ** ** |
| General  & administrative expenses         |       | 2,602                          |       | 1,878                             | * *   | *4,480*                     |       | 1,815              |       | 994              |       | 886                    |       | 207                    |       | 548       | ** ** | **8,930**  | ** ** |
| Income (loss) from operations                  |       | $                              | 1,628      |                              | $          | 1,432                       | * *   | *$*                | *3,060*    |             | $          | 1,226                  |       | $                      | 431        |      | $          | 1,204      |       | $ | (451 | ) | $ | (222 | ) | **$** | **5,248** | ** ** |

 

**For the three months ended September 30, 2005:**(in thousands)
| ** **                                     | ** ** | **Health  Delivery  Services** | ** ** | **Health  Delivery  Outsourcing** | ** ** | **Health  Delivery  Total** | ** ** | **Life  Sciences** | ** ** | **Health   Plan** | ** ** | **Software  Services** | ** ** | **Software  Products** | ** ** | **Other** | ** ** | **Totals** | ** ** |
|------------------------------------------------|------------|--------------------------------|------------|-----------------------------------|------------|-----------------------------|------------|--------------------|------------|------------------------|------------|------------------------|------------|------------------------|------------|-----------|------------|------------|------------|
| Revenues  before reimbursements                |       | $                              | 16,947     |                              | $          | 35,265                      | * *   | *$*                | *52,212*   |                   | $          | 7,272                  |       | $                      | 4,938      |      | $          | 6,199      |       | $ | 823 |   | $ | 1,273 | ** ** | **$** | **72,717** | ** ** |
| Reimbursements                                 |       | 2,497                          |       | 198                               | * *   | *2,695*                     |       | 318                |       | 701                    |       | 113                    |       | 9                      |       | 51        | ** ** | **3,887**  | ** ** |
| Total revenues                                 |       | 19,444                         |       | 35,463                            | * *   | *54,907*                    |       | 7,590              |       | 5,639                  |       | 6,312                  |       | 832                    |       | 1,324     | ** ** | **76,604** | ** ** |
| Cost  of services before reimbursable expenses |       | 11,071                         |       | 31,488                            | * *   | *42,559*                    |       | 4,249              |       | 3,398                  |       | 3,669                  |       | 898                    |       | 1,300     | ** ** | **56,073** | ** ** |
| Reimbursable  expenses                         |       | 2,497                          |       | 198                               | * *   | *2,695*                     |       | 318                |       | 701                    |       | 113                    |       | 9                      |       | 51        | ** ** | **3,887**  | ** ** |
| Total cost of services                         |       | 13,568                         |       | 31,686                            | * *   | *45,254*                    |       | 4,567              |       | 4,099                  |       | 3,782                  |       | 907                    |       | 1,351     | ** ** | **59,960** | ** ** |
| Gross profit                                   |       | 5,876                          |       | 3,777                             | * *   | *9,653*                     |       | 3,023              |       | 1,540                  |       | 2,530                  |       | (75                    | )          | (27       | )          | **16,644** | ** ** |
| Selling  expenses                              |       | 2,772                          |       | 1,718                             | * *   | *4,490*                     |       | 1,543              |       | 606                    |       | 533                    |       | 126                    |       | 323       | ** ** | **7,621**  | ** ** |
| General  & administrative expenses         |       | 3,015                          |       | 1,873                             | * *   | *4,888*                     |       | 2,239              |       | 638                    |       | 937                    |       | 308                    |       | 449       | ** ** | **9,459**  | ** ** |
| Income (loss) from operations                  |       | $                              | 89         |                              | $          | 186                         | * *   | *$*                | *275*      |                   | $          | (759                   | )          | $                      | 296        |      | $          | 1,060      |       | $ | (509 | ) | $ | (799 | ) | **$** | **(436** | **)** |

 

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**For the nine months ended September 29, 2006:**(in thousands)
| ** **                                    | ** ** | **Health  Delivery  Services** | ** ** | **Health  Delivery  Outsourcing** | ** ** | **Health  Delivery  Total** | ** ** | **Life  Sciences** | ** ** | **Health  Plan** | ** ** | **Software  Services** | ** ** | **Software  Products** | ** ** | **Other** | ** ** | **Totals**  | ** ** |
|-----------------------------------------------|------------|--------------------------------|------------|-----------------------------------|------------|-----------------------------|------------|--------------------|------------|------------------|------------|------------------------|------------|------------------------|------------|-----------|------------|-------------|------------|
| Revenues before reimbursements                |       | $                              | 45,725     |                              | $          | 81,113                      | * *   | *$*                | *126,838*  |             | $          | 24,238                 |       | $                      | 22,307     |      | $          | 20,511      |       | $ | 2,217 |   | $ | 1,339 | ** ** | **$** | **197,450** | ** ** |
| Reimbursements                                |       | 6,720                          |       | 101                               | * *   | *6,821*                     |       | 528                |       | 2,770            |       | 427                    |       | 39                     |       | 11        | ** ** | **10,596**  | ** ** |
| Total revenues                                |       | 52,445                         |       | 81,214                            | * *   | *133,659*                   |       | 24,766             |       | 25,077           |       | 20,938                 |       | 2,256                  |       | 1,350     | ** ** | **208,046** | ** ** |
| Cost of services before reimbursable expenses |       | 27,722                         |       | 70,397                            | * *   | *98,119*                    |       | 13,411             |       | 15,940           |       | 12,624                 |       | 2,120                  |       | 509       | ** ** | **142,723** | ** ** |
| Reimbursable expenses                         |       | 6,720                          |       | 101                               | * *   | *6,821*                     |       | 528                |       | 2,770            |       | 427                    |       | 39                     |       | 11        | ** ** | **10,596**  | ** ** |
| Total cost of services                        |       | 34,442                         |       | 70,498                            | * *   | *104,940*                   |       | 13,939             |       | 18,710           |       | 13,051                 |       | 2,159                  |       | 520       | ** ** | **153,319** | ** ** |
| Gross profit                                  |       | 18,003                         |       | 10,716                            | * *   | *28,719*                    |       | 10,827             |       | 6,367            |       | 7,887                  |       | 97                     |       | 830       | ** ** | **54,727**  | ** ** |
| Selling expenses                              |       | 5,571                          |       | 715                               | * *   | *6,286*                     |       | 2,719              |       | 1,599            |       | 1,476                  |       | 319                    |       | 39        | ** ** | **12,438**  | ** ** |
| General & administrative expenses         |       | 7,613                          |       | 5,711                             | * *   | *13,324*                    |       | 6,052              |       | 3,111            |       | 2,444                  |       | 712                    |       | 1,736     | ** ** | **27,379**  | ** ** |
| Income  (loss) from operations                |       | $                              | 4,819      |                              | $          | 4,290                       | * *   | *$*                | *9,109*    |             | $          | 2,056                  |       | $                      | 1,657      |      | $          | 3,967       |       | $ | (934 | ) | $ | (945 | ) | **$** | **14,910** | ** ** |

**For thenine months ended September 30, 2005:**(in thousands)
| ** **                                    | ** ** | **Health  Delivery  Services** | ** ** | **Health  Delivery  Outsourcing** | ** ** | **Health  Delivery  Total** | ** ** | **Life  Sciences** | ** ** | **Health  Plan** | ** ** | **Software  Services** | ** ** | **Software  Products** | ** ** | **Other** | ** ** | **Totals**  | ** ** |
|-----------------------------------------------|------------|--------------------------------|------------|-----------------------------------|------------|-----------------------------|------------|--------------------|------------|------------------|------------|------------------------|------------|------------------------|------------|-----------|------------|-------------|------------|
| Revenues before reimbursements                |       | $                              | 53,436     |                              | $          | 94,660                      | * *   | *$*                | *148,096*  |             | $          | 24,831                 |       | $                      | 13,069     |      | $          | 16,021      |       | $ | 1,953 |   | $ | 4,810 | ** ** | **$** | **208,780** | ** ** |
| Reimbursements                                |       | 7,578                          |       | 568                               | * *   | *8,146*                     |       | 739                |       | 1,828            |       | 316                    |       | 62                     |       | 230       | ** ** | **11,321**  | ** ** |
| Total revenues                                |       | 61,014                         |       | 95,228                            | * *   | *156,242*                   |       | 25,570             |       | 14,897           |       | 16,337                 |       | 2,015                  |       | 5,040     | ** ** | **220,101** | ** ** |
| Cost of services before reimbursable expenses |       | 34,080                         |       | 84,713                            | * *   | *118,793*                   |       | 13,680             |       | 9,857            |       | 9,666                  |       | 2,758                  |       | 5,644     | ** ** | **160,398** | ** ** |
| Reimbursable expenses                         |       | 7,578                          |       | 568                               | * *   | *8,146*                     |       | 739                |       | 1,828            |       | 316                    |       | 62                     |       | 230       | ** ** | **11,321**  | ** ** |
| Total cost of services                        |       | 41,658                         |       | 85,281                            | * *   | *126,939*                   |       | 14,419             |       | 11,685           |       | 9,982                  |       | 2,820                  |       | 5,874     | ** ** | **171,719** | ** ** |
| Gross profit                                  |       | 19,356                         |       | 9,947                             | * *   | *29,303*                    |       | 11,151             |       | 3,212            |       | 6,355                  |       | (805                   | )          | (834      | )          | **48,382**  | ** ** |
| Selling expenses                              |       | 7,446                          |       | 3,428                             | * *   | *10,874*                    |       | 5,327              |       | 1,748            |       | 1,361                  |       | 400                    |       | 1,763     | ** ** | **21,473**  | ** ** |
| General & administrative expenses         |       | 10,181                         |       | 5,328                             | * *   | *15,509*                    |       | 6,884              |       | 2,162            |       | 2,228                  |       | 1,084                  |       | 2,202     | ** ** | **30,069**  | ** ** |
| Income  (loss) from operations                |       | $                              | 1,729      |                              | $          | 1,191                       | * *   | *$*                | *2,920*    |             | $          | (1,060                 | )          | $                      | (698       | )         | $          | 2,766       |       | $ | (2,289 | ) | $ | (4,799 | ) | **$** | **(3,160** | **)** |

 

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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 support costsinto 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 one projectin 2006.  The breakdown of revenue inHealth Delivery Outsourcing is as follows (in thousands):
| ** **                      | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended** | ** ** |
|---------------------------------|------------|----------------------------------|------------|---------------------------------|------------|
| ** **                      | ** ** | **September 29,  2006**     | ** ** | **September 30,  2005**    | ** ** | **September 29,  2006** | ** ** | **September 30,  2005** | ** ** |
| Internally  generated revenues  |       | $                                | 25,511     |                            | $          | 30,165 |   | $ | 76,948 |   | $ | 78,727 |   |
| Subcontractor  revenues         |       | 1,389                            |       | 5,100                           |       | 4,165 |   | 15,933 |   |
| Revenues before  reimbursements |       | $                                | 26,900     |                            | $          | 35,265 |   | $ | 81,113 |   | $ | 94,660 |   |

 

**Note 10                  Income Taxes**

The Company recorded a $1.2 million tax provision for the nine monthsended September 29, 2006 versus a $5.4 million tax provision for the ninemonths ended September 30, 2005.  The 7%tax provision for the nine months ended September 29, 2006 is for annualestimated current taxes payable for U.S. federal alternative minimum tax andcertain state and foreign income taxes, as the Company’s net operating losscarryforwards offset most of the federal and certain state taxliabilities.  The tax provision for thenine months ended September 30, 2005 primarily consisted of a $6.0 million taxasset valuation allowance.  The valuationallowance was recorded as a result of the historical losses the Company hadincurred, creating additional negative evidence as to the uncertainty of the Company’sability to realize its deferred tax assets, as assessed per the guidance of theapplicable tax accounting standard, SFAS 109.

**Note 11                  Sale of Cyberview**

On August 21, 2006, the Company sold its Cyberview software product andrelated intellectual property and service contracts to Medisolv, Inc.  The proceeds from the transaction wererecognized by the Company as other income. The Company recognized $691,000 of other income before taxes for thequarter ended September 29, 2006. Revenues from Cyberview for the three and nine months ended September29, 2006 were $112,000 and $595,000, respectively.

**Note 12                  Health Plan OutsourcingContract**

In April 2006, the Company began a $12 million outsourcing contract inthe Health Plan segment.  This contractrequires the Company to complete a system implementation prior to beginning theoperations phase of the contract.  Theimplementation phase of this contract is being accounted for as deferred cost,and all revenue from the implementation will be recognized over the period ofoutsourcing operations.  As a result, theCompany will receive approximately $5 million of cash which will be accountedfor as a customer advance prior to earning revenue on the contract, anddeferred costs on the balance sheet will increase substantially.  As of September 29, 2006, there wereapproximately $1.2 million of deferred revenues and $1.1 million of deferredcosts related to this project.

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## **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 provide servicesprimarily 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 typicallybill for our services on an hourly or fixed-fee basis as specified by theagreement with a particular client.  Forservices billed on an hourly basis, in our consulting and systems integrationbusinesses (“CSI”), fees are determined by multiplying the amount of timeexpended on each assignment by the project hourly rate for the staff membersassigned to the engagement.  Fixed fees,including outsourcing fees, are established on a per-assignment or monthly basisand are based on several factors such as the size, scope, complexity andduration of an assignment, the number of our employees required to complete theassignment, and the volume of transactions or interactions.  Revenues are generally recognized related tothe level of services performed, the amount of cost incurred on the assignmentversus the estimated total cost to complete the assignment, or on astraight-line basis over the period of performance of service.  Additionally, we have been licensing anincreased amount of our software products, generally in conjunction with thecustomization and implementation of such software products.  Revenues from our software licensing andmaintenance were approximately 3.1% of our net revenues in fiscal year 2005 and4.2% of our net revenues for the nine months ended September 29, 2006.  We expect our software licensing and relatedimplementation revenues to continue to grow incrementally in the near future.

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

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CSI business can occur asa result of variations in billing margins and utilization rates of our billableassociates.

Our most significant expenses are our human resourceand related salary and benefit expenses. As of September 29, 2006, approximately 1,514 of our 2,612 employees arebillable consultants and software developers. Another 733 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 14.0% of our workforce, or 365 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:

·                  Ourstaff utilization, which is the ratio of total billable hours to availablehours in a given period;

·                  Theamount and timing of cost incurred;

·                  Ourability to control costs on our outsourcing projects;

·                  Thebilled rate on time and material contracts; and

·                  The estimatedcost to complete our non-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 orother measurements of service provided. If we incur higher costs to provide the required services or receiveless revenue due to reduced transaction volumes or penalties associated withservice level failures, our gross profit can be negatively impacted.

In our CSIbusiness, 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

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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 deliver quality services, our business may be adversely impactedand we may not be able to compete effectively.

**Resultsof Operations for the Three Months Ended September 29, 2006 and September 30,2005**

*Revenues. *Our net revenues were $65.2 million for thequarter ended September 29, 2006, a decrease of 10.3% from $72.7 million forthe quarter ended September 30, 2005. Our total revenues were $68.6 million for the quarter ended September29, 2006, a decrease of 10.5% from $76.6 million for the quarter endedSeptember 30, 2005.  The decline in netrevenues was primarily due to decreases in Health Delivery Outsourcing andHealth Delivery Services, offset by increases in Health Plan and SoftwareServices.  The Health DeliveryOutsourcing segment had the most significant decrease compared to the quarterended September 30, 2005, $8.4 million, or 23.7%, primarily due to thetermination of two outsourcing contracts (New York Presbyterian Hospital (“NYPH”)and UMass Memorial Health Care (“UMMHC”)) at the end of the fourth quarter of2005.  This decline was partially offsetby the award of new contracts at Continuum Health Partners and Centura Healthin the third quarter of 2005.  Outsourcingrevenues in the third quarter of 2005 for the two terminated contracts totaled$10.9 million, while outsourcing revenues in the third quarter of 2006 from thetwo new contracts totaled $7.4 million, compared to revenues of $4.0 million inthe third quarter of 2005.  Additionally,during the third quarter of 2005, there was a one-time $1.0 millionpass-through revenue item related to transitioning out subcontractor servicesat University Hospitals Health System (“UHHS”) in Cleveland, Ohio.

In Health Delivery Services, net revenues decreased by $2.8 million, or16.4%, due to lower revenues from our consulting and implementationservices.  The lower revenues wereattributable to the discontinuation of certain underperforming service lines inlate 2005 and a need to restructure our sales model in this area to improve oursales effectiveness.

The most significant offsetting increase in our net revenues was inHealth Plan, which increased by $3.1 million, or 63.5%, due to marketacceptance of our blended shore delivery model by mid-size and large healthplans.  Software Services (formerly namedParagon Solutions, Inc.) revenues increased by $971,000, or 15.7%, due togeneral growth in providing offshore software development services toindependent software vendors.  LifeSciences revenue grew by $880,000, or 12.1%, due to unusual weakness inrevenues in that segment during the latter half of 2005.

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 have no assurances that thecontract will be extended past the one year renewal period, and UPHS still hasthe right to terminate the contract for convenience on 180 days notice.  The renewal process is currently beingcompetitively bid and it is anticipated that a vendor of choice decision willbe made in the fourth quarter of 2006. If we are unable to execute a longer term renewal with UPHS or if we areunable to enter into new outsourcing engagements, our Health DeliveryOutsourcing revenues would be adversely impacted.  Revenues in our business units other thanoutsourcing are not expected to change significantly from their levels at theend of the third quarter of 2006, with some modest growth expected to continuein the Health Plan and Software Services segments.  Growth in Health Delivery Services andOutsourcing is highly dependent upon capturing market share throughsuccessfully restructuring our selling model and acceptance by the healthdelivery market of our blended shore delivery model.

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*Cost of Services. *Cost of services before reimbursable expenseswas $47.0 million for the quarter ended September 29, 2006, a decrease of 16.1%from $56.1 million for the quarter ended September 30, 2005.  The decrease was primarily due to an $8.2million decline in costs in the Health Delivery Outsourcing segment directlyrelated to the reduction in revenues described above.  Health Delivery Services costs decreased by$2.8 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 $2.7 million and costs in Software Services increased by $910,000in order to serve the revenue growth in those segments.

*GrossProfit. *Gross profitwas $18.2 million, or 27.9% of net revenues, for the quarter ended September29, 2006, an increase of 9.3% from $16.6 million, or 22.9% of net revenues, forthe quarter ended September 30, 2005. This increase was due to $1.0 million of additional gross profit in theLife Sciences segment due to the revenue increase in that segment, and themargin associated with the revenue increases in the Health Plan segmentdescribed above.

*Selling Expenses. *Selling expenses were $4.0 million for thequarter ended September 29, 2006, a decrease of 47.3% from $7.6 million for thequarter ended September 30, 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 September 29, 2006 from10.5% for the quarter ended September 30, 2005 for the same reasons.  We expect to invest increased amounts insales and marketing costs over the next several quarters, which may affectprofitability.

*General and Administrative Expenses. *General andadministrative expenses were $8.9 million for the quarter ended September 29,2006, a decrease of 5.6% from $9.5 million for the quarter ended September 30,2005.  This decrease was due to reducedbad debt and office facilities expenses. General and administrative expenses as a percentage of net revenuesincreased to 13.7% for the quarter ended September 29, 2006 from 13.0% for thequarter ended September 30, 2005.

*Interest Income, Net.** ***Interest income, net of interest expense, was$646,000 for the quarter ended September 29, 2006, an increase of 176.1% from$234,000 for the quarter ended September 30, 2005, due to higher interest ratesearned on higher cash and investments balances. Interest income, net of interest expense, as a percentage of netrevenues increased to 1.0% for the quarter ended September 29, 2006 from 0.3%for the quarter ended September 30, 2005.

*Other Income (Expense), Net*.  Other income (expense) was$653,000 for the quarter ended September 29, 2006, compared to a negligibleamount for the quarter ended September 30, 2005.  In August 2006, we sold our Cyberviewsoftware product assets to Medisolv, Inc. and generated $691,000 of otherincome before taxes for the quarter ended September 29, 2006.

*IncomeTaxes. *We recorded a $458,000 tax provision for thequarter ended September 29, 2006, compared to a $20,000 tax provision for thequarter ended September 30, 2005.  The 7%tax provision for the quarter ended September 29, 2006 was for annual estimatedcurrent taxes payable for U.S. federal alternative minimum tax and certainstate and foreign income taxes, as our net operating loss carryforwards offsetmost of the federal and certain state tax liabilities.  The tax provision for the quarter endedSeptember 30, 2005 of $20,000 reflects a minor adjustment to achieve anestimated effective annual tax benefit rate of 24.4% for 2005 (exclusive of avaluation allowance). We continue to expect that our tax provision in fiscal2006 will remain low, but that our long-term tax provision will return tolevels consistent with full federal and state tax rates.

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**Resultsof Operations for the Nine Months Ended September 29, 2006 and September 30,2005**

*Revenues. *Our net revenues were $197.5 million for thenine months ended September 29, 2006, a decrease of 5.4% from $208.8 millionfor the nine months ended September 30, 2005. Our total revenues were $208.0 million for the nine months endedSeptember 29, 2006, a decrease of 5.5% from $220.1 million for the nine monthsended September 30, 2005.  The decreasesin net revenues were in Health Delivery Outsourcing and Health DeliveryServices, partially offset by increases in Health Plan and SoftwareServices.  The Health DeliveryOutsourcing segment had the most significant decrease compared to the ninemonths ended September 30, 2005, $13.5 million, or 14.3%, primarily due to thetermination of two outsourcing contracts at the end of the fourth quarter of2005.  Outsourcing revenues for the ninemonths ended September 30, 2005 from the two terminated contracts totaled $34.5million.  Revenues from two new contractswhich began in August 2005 were $22.5 million for the nine months endedSeptember 29, 2006 compared to only two months of revenue recognized of $4.0million for the nine months ended September 30, 2005.

The net revenues in the Health Delivery Services segment decreased $7.7million, or 14.4% due to lower revenues from our consulting and implementationservices offerings.  The most significantoffsetting increase was in Health Plan, which increased by $9.2 million, or70.7%, due to market acceptance of our blended shore delivery model.  Software Services revenues increased by $4.5million, or 28.0%, primarily due to general growth in providing offshoresoftware development services to independent software vendors.

*Cost of Services. *Cost of services before reimbursable expenseswas $142.7 million for the nine months ended September 29, 2006, a decrease of11.0% from $160.4 million for the nine months ended September 30, 2005.  The decrease was primarily due to a $14.3million decline in costs in the Health Delivery Outsourcing segment directlyrelated to the reduction in revenues described above.  Health Delivery Services costs decreased by$6.4 million as we reduced costs in that area, primarily through staff attritionand staff reductions in the fourth quarter of 2005, to improveprofitability.  Costs in Health Planincreased by $6.1 million and costs in Software Services increased by $3.0million in order to serve the revenue growth in those segments.

*GrossProfit. *Gross profitwas $54.7 million, or 27.7% of net revenues, for the nine months endedSeptember 29, 2006, an increase of 13.1% from $48.4 million, or 23.2% of netrevenues, for the nine months ended September 30, 2005.  This increase was primarily due to a $3.2million increase in gross profit related to the revenue increase in the HealthPlan segment as described above, and a $1.5 million increase in gross profit inSoftware Services due to better performing contracts.  Additionally, gross profit in our SoftwareProducts business improved by $902,000 from a level of negative $805,000 topositive $97,000, primarily due to cost reductions.

*Selling Expenses. *Selling expenses were $12.4 million for thenine months ended September 29, 2006, a decrease of 42.1% from $21.5 millionfor the nine months ended September 30, 2005. This decrease was primarily due to reductions in the sales force andmarketing costs.  Selling expenses as apercentage of net revenues also decreased to 6.3% for the nine months endedSeptember 29, 2006 from 10.3% for the nine months ended September 30, 2005 forthe same reasons.

*General and Administrative Expenses. *General andadministrative expenses were $27.4 million for the nine months ended September29, 2006, a decrease of 8.9% from $30.1 million for the nine months endedSeptember 30, 2005.  This decrease wasdue to cost reductions that occurred during the latter part of fiscal year2005.  As well as lower salary expensedue to staff reductions, costs were also reduced in the areas of travel,recruiting, telecommunications, and office facilities.  General and administrative expenses as apercentage of net revenues decreased to 13.9% for the nine months endedSeptember 29, 2006 from 14.4% for the nine months ended September 30, 2005.

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*Interest Income, Net.** ***Interest income, net of interest expense, was$1.4 million for the nine months ended September 29, 2006, an increase of109.1% from $674,000 for the nine months ended September 30, 2005, due tohigher interest rates earned on higher cash and investments balances.  Interest income, net of interest expense, asa percentage of net revenues increased to 0.7% for the nine months endedSeptember 29, 2006 from 0.3% for the nine months ended September 30, 2005.

*Other Expense, Net*.  Other income (expense) was$640,000 for the nine months ended September 29, 2006 compared to a negligibleamount for the nine months ended September 30, 2005.  In August 2006, we sold our Cyberviewsoftware product assets to Medisolv, Inc. and generated $691,000 of otherincome before taxes for the nine months ended September 29, 2006.

*Income Taxes. *We recorded a $1.2 million tax provision forthe nine months ended September 29, 2006, compared to a $5.4 million taxprovision for the nine months ended September 30, 2005.  The 7% tax provision for the nine monthsended September 29, 2006 was for annual estimated current taxes payable forU.S. federal alternative minimum tax and certain state and foreign incometaxes, as the net operating loss carryforwards offset most of the federal andcertain state tax liabilities.  The taxprovision for the nine months ended September 30, 2005 of $5.4 millionprimarily consisted of a $6.0 million deferred tax asset valuationallowance.  The valuation allowance wasrecorded as a result of the historical losses we had incurred, creatingadditional negative evidence as to the uncertainty of our ability to realizeour deferred tax assets, as assessed per the guidance of the applicable taxaccounting standard, SFAS 109.

*Loss on Discontinued Operations*.  Thedisposition of our Coactive Call Center Service line had been accounted for asa discontinued operation.  During thenine months ended September 30, 2005, we incurred $866,000 of costs related tothe operation and wind-down of the business. These costs, net of a 38% tax benefit, resulted in a net loss of$537,000, compared to no loss on discontinued operations for the nine monthsended September 29, 2006.

**Liquidityand Capital Resources**

At September 29, 2006, we had cash and investmentsavailable for sale of $54.2 million compared to $35.1 million at December 30,2005.  During the nine months endedSeptember 29, 2006, we generated cash flow from continuing operations of $17.7million which primarily consisted of $15.8 million of profit.

Our days sales outstanding (DSO) of accountsreceivable was 34 days for the third quarter of 2006, the same as the fourthquarter of 2005.  We expect our DSO toremain at approximately its current level for the near future, subject toroutine fluctuations.

 In February2006, we signed an agreement with a landlord to return excess office space tothem.  As part of the agreement, we arerequired 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 ourobligation.  These payments are beingcharged against amounts that have been accrued in prior years for facilityclosure costs, and thus affect cash flow in fiscal year 2006 without affectingpretax income.  The balance of thisliability at September 29, 2006 is $659,000.

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 nine months ended September 29, 2006, ourcash flow benefited from $5.5 million of stock option exercises, primarily byformer employees.

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Further, we used approximately $4.4 million of cash topurchase property and equipment, primarily information technology and relatedequipment, while incurring $5.4 million of depreciation and amortization.  During the third quarter of 2006, we madecommitments of approximately $2 million for leasehold improvements and furnitureto move and expand our office in Bangalore, India.  Approximately $800,000 of this capital wasspent in the third quarter of 2006, with approximately $1.2 million expected tobe spent in the fourth quarter of the year. Additionally, we expect to incur several months of duplicate rent and atermination fee of approximately $300,000 during the fourth quarter of 2006.

One of our new outsourcing accounts, which began inAugust 2005, had a net negative impact on cash of over $2 million for the ninemonths ended September 29, 2006, primarily due to the deferral of fees,transition costs, and capital expenditures agreed upon when the contract wasoriginally signed in the third quarter of 2005. The initial cash requirements related to this contract have beencompleted.

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 $25 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 September 29, 2006,the following table summarizes our contractual commitments (in thousands):
|                                     | ** ** | **Payments Due by Period** | ** ** |
|-------------------------------------|------------|-------------------------------------------|------------|
| **Contractual Obligation**     | ** ** | **Less than 1  Year**           | ** ** | **1 -3  Years** | ** ** | **3-5  Years** | ** ** | **Total** | ** ** |
| Operating  leases, net of subleases |       | $                                         | 5,004      |   | $ | 4,992 |   | $ | 1,829 | ** ** | **$** | **11,825** | ** ** |
| Purchase  obligations               |       | 1,529                                     |       | 412 |   | — | ** ** | **1,941** | ** ** |
| **Total**                           | ** ** | **$**                                     | **6,533**  | ** ** | **$** | **5,404** | ** ** | **$** | **1,829** | ** ** | **$** | **13,766** | ** ** |

 

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 $6 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 ourestimates, including those related to revenue recognition, cost to completeclient engagements, valuation of goodwill and long-lived and intangible assets,accrued liabilities, income taxes, restructuring costs, idle

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facilities, litigationand 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 notreadily apparent from other sources.  Ouractual results may differ from our estimates and we do not assume anyobligation to update 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 forconsulting and systems integration work are generally recognized on a rate perhour or percentage-of-completion basis. We maintain, for each of our fixed fee contracts, estimates of totalrevenue and cost over the contract term. For purposes of periodic financialreporting on the fixed price consulting and system integration contracts, weaccumulate total actual costs incurred to date under the contract. The ratio ofthose actual costs to our then-current estimate of total costs for the life ofthe contract is then applied to our then-current estimate of total revenues forthe life of the contract to determine the portion of total estimated revenuesthat should be recognized.  We followthis method because reasonably dependable estimates of the revenues and costsapplicable to various 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 theresources required or the scope of the work to be performed, do not completeour projects within the planned periods of time, or do not satisfy ourobligations under the contracts, then profit may be significantly andnegatively affected.  Revisions in ourcontract estimates are reflected in the period in which the determination ismade that facts and circumstances dictate a change of estimate. Favorablechanges in estimates result in additional revenues recognized, and unfavorablechanges in estimates result in a reduction of recognized revenues. Provisionsfor estimated losses on individual contracts are made in the period in whichthe loss first becomes known.  Somecontracts include incentives for achieving either schedule targets, costtargets, or other defined goals. Revenues from incentive type arrangements are recognized when it isprobable 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

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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 September 29, 2006, we had deferred $4.5million of unamortized costs which are included in non-current assets.

In April 2006, we began a $12 million outsourcing contract in theHealth Plan segment.  This contractrequires us to complete a system implementation prior to beginning theoperations phase of the contract.  Theimplementation phase of this contract is being accounted for as deferred cost,and all revenue from the implementation will be recognized over the period ofoutsourcing operations.  As a result, wewill receive approximately $5 million of cash which will be accounted for as acustomer advance prior to our beginning to earn revenue on the contract, andour deferred costs on the balance sheet will increase substantially.

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.

Software licenseand maintenance revenues comprised approximately 4.2% of our net revenues forthe nine months ended September 29, 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 AccountingBulletin (“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

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than twelve months fromshipment, revenue is recognized as payments become due and all other conditionsfor revenue recognition have been satisfied. In software arrangements that includerights to multiple software products, specified upgrades, maintenance orservices, 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 $15.3 million represent revenues recognized for servicesperformed that were not billed as of September 29, 2006.  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 the percentageof completion methodology.  As ofSeptember 29, 2006, we had unbillable amounts of approximately $2.9 million,which were generally expected to be billed within one year.

We had a long-termreceivable at September 29, 2006 and December 30, 2005 of $2.4 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 January 2006, an additionalamount of approximately $800,000 related to this contract was deferred until2009.  Both deferrals were in accordancewith the terms of the contract executed with this client in July 2005.

Customeradvances are comprised of payments from customers for which services have notyet been performed or prepayments against work in process. These unearnedrevenues are deferred and recognized as future contract costs are incurred andas contract services 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.

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***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, supplementalexecutive retirement plan contributions, and other accrued liabilities such asaccrued vacation 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 periodallowable 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 our requirementfor a valuation allowance after having completed a full year in which werecorded taxable income in each quarter, and reversed $3.0 million of thevaluation allowance taken in fiscal year 2003.

During the first six months of 2005, we incurred a pretaxloss 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$6.0 million.  Additionally, in thefourth quarter of 2005, after having incurred losses in each quarter of thefiscal year, we increased our valuation allowance by another $8.2 million suchthat we now 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 AlternativeMinimum Tax, a significant amount (approximately $25 million) of any futurepretax income from the beginning of fiscal year 2006 and thereafter will notrequire a significant 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 likely thannot based on successive years of generating taxable income, we will reverse allor a portion of any existing valuation allowance at that time.  Our valuation allowance for deferred incometaxes has been a particularly volatile estimate over the past several years, asour level of income and loss has fluctuated, requiring us to reassess thelikelihood of realization of our tax assets.

***Goodwill and Intangible Assets***

Under SFAS 142, weno longer amortize our goodwill and are required to complete an annual impairmenttesting which we perform during the fourth quarter of each year.  Webelieve that the accounting assumptions and estimates related to the annualgoodwill impairment testing are critical because these can change from periodto period.  We use various assumptions, such as discount rates, andcomparable 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 September 29, 2006, wehave $18.2 million of goodwill and $649,000 of intangible assets recorded onour balance sheet (see Note 5 of the Notes to Consolidated Financial Statementsincluded in this report).

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***Recent Accounting Pronouncements***

In September 2006,the Securities and Exchange Commission issued Staff Accounting Bulletin 108, “Consideringthe Effects of Prior Year Misstatements when Quantifying Misstatements inCurrent Year Financial Statements” (see New Accounting Standards in Note 1 inItem 1 of this report).

InSeptember 2006, the FASB issued SFAS No. 157, “Fair ValueMeasurements” (see New Accounting Standards in Note 1 in Item 1 of thisreport).

In June 2006, theFASB issued FASB Interpretation No. 48, “Accounting for Uncertainty in IncomeTaxes” (see New Accounting Standards 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 financial instrumentsinclude cash and cash equivalents (i.e., short-term and long-term cashinvestments), accounts receivable, unbilled receivables, and accountspayable.  Only the cash and cashequivalents which totaled $51.2 million at September 29, 2006 present us withmarket risk exposure resulting primarily from changes in interest rates. Based on this balance, a change of one percent in the interest rate would causea change in interest income for the annual period of approximately$512,000.  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 of ourdisclosure controls and procedures as of the end of the quarter covered by thisreport. Based on the foregoing and except as noted below, our Chief ExecutiveOfficer and Chief Financial Officer concluded that our disclosure controls andprocedures were effective, and were operating at the reasonable assurancelevel.

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

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million of higher cumulativetax expense over those periods.  Theproper procedure for estimating the state deferred tax assets and the relatedcontingency reserves is to use the income of each of our subsidiaries and thetax rates for each state jurisdiction in which such subsidiary operates inperforming the calculations.  Inpreparing the 2005 10-K, we applied the proper procedure, which resulted in managementidentifying the excess tax contingency reserve for the first time.  The 2005 10-K correctly states our 2005income tax expense and we restated our previously issued consolidated financialstatements for the 2001 through 2004 fiscal years to account for theinaccuracies that we identified in preparing the 2005 10-K. As a result of theinaccuracies in tax accounting described above, management concluded that ourcontrols were not effective because there were not sufficient personnel in ourcorporate tax department who were qualified and trained to properly calculatestate deferred tax assets and contingency reserves.  Since the calculation of state NOLs and therelated accounting is performed on a once per year basis after all tax returnsare filed for the previous year, the initial testing to confirm that thematerial weakness described above and in Item 9A of our 2005 10-K has beenremediated will occur in late 2006.  Wehave recently hired a new tax director with experience in calculating deferredtax assets, and in applying SFAS 109, “Accounting for Income Taxes,” who beganemployment in late August, and will perform the appropriate detailed analysison an ongoing basis starting in fiscal year 2006.

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 and toItem 1A in Part II of our Form 10-Q for the fiscal quarter ended June 30, 2006.

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 (and in Item 1A in Part II of our Form 10-Q for the fiscalquarter ended June 30, 2006) 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 relatively new business unit leader;

·                                          Theloss of one or more significant clients in any of our business segments, includingany failure to secure renewals for any of our large outsourcing contracts inHealth Delivery 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 blendedshore delivery 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;

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·                                          Costsassociated with the disposition of certain assets;

·                                          Impairmentof goodwill from our acquisitions;

·                                          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;

·                                          Internationalcurrency fluctuations;

·                                          Expensesrelated to the issuance of restricted stock or 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 each of the three quarters for the nine monthsended September 29, 2006.  However, wealso reported a net loss for the year ended December 30, 2005.  As aresult, we cannot assure you that we will achieve or maintain positive earningsin the future.  If we are unable to achieve sustained profitability on aquarterly or annual basis, the market price of our common stock could beadversely affected and our financial condition would suffer.

2.  The second risk factor which appears on page12 of the 2005 10-K (and in Item 1A in Part II of our Form 10-Q for the fiscalquarter ended June 30, 2006) 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 September 29, 2006,represented approximately 41.2% of our consolidated net revenues.  Thesubstantial majority of these revenues are received from three largeoutsourcing accounts that signed long-term agreements with us.  In thefirst quarter of 2006, we received a one year extension of one of our existingmajor outsourcing contracts, University of Pennsylvania Health System (UPHS),and that contract is now set to expire in March 2007.  We currently haveno assurances that the contract will be extended past the one year renewalperiod, and UPHS retains the right to terminate the contract at its discretionupon 180 days notice. In addition, the renewal process is currently beingcompetitively bid and we have no assurances that our proposal will be deemedcompetitive or successful against the multiple service providers that areexpected to compete for the new contract. 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

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(including the renewal ofour existing outsourcing clients, both large and small), our business andresults of operations will be materially adversely impacted.

We recognize revenuefrom certain service elements of our outsourcing agreements on a straight-linebasis over the life of the contract.  Since we typically incur greatercosts and expenses during the early phase of those service elements (which havestraight-line revenue recognition) than we do in the subsequent years of thoseelements, we believe our profitability is lower during the early stages of ouroutsourcing engagements.  In addition, if we are unable to manage costs asplanned in the later stages of an outsourcing engagement, our profitabilitycould likewise be lower.  In general, income from our outsourcingcontracts is susceptible to changes in the mix of newer versus older contracts,and to the impact 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 our outsourcingengagements, the clients have fully outsourced their information technologystaff and functions to us.  In all of our outsourcing relationships, wegenerally enter into detailed service level agreements, which establishperformance levels and standards for our services.  If we fail to meetthese performance levels or standards, our clients may receive monetary servicelevel credits from us or, if we experience persistent failures, our clients mayhave a right to terminate the outsourcing contract for cause and have noobligation to pay us any termination fees.  Our anticipated revenues andprofitability from our outsourcing engagements could be significantly reducedif we are unable to satisfy our performance levels or standards, or if we areunable to improve our delivery costs as planned on such engagements.Additionally, our outsourcing contracts can be terminated at the convenience ofour 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 client engagementsfor our outsourcing business is significant, and we may not win the number ortype of client engagements that we anticipate.  If we fail to meet ourobjective 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.

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

Repurchase of Securities
| **Period**                                            | ** ** | **Total number of  shares  purchased** | ** ** | **Average price  paid per share** | ** ** | **Total shares purchased  as part of publicly  announced programs** | ** ** | **Maximum number of  shares that may yet  be purchased under  the program** | ** ** |
|-------------------------------------------------------|------------|--------------------------------------------------|------------|--------------------------------------------------|------------|---------------------------------------------------------------------------------------------------|------------|---------------------------------------------------------------------------------------------------------------------|------------|
|  Month #1 (July 1, 2006 – July 28, 2006)    |       | 0                                                |       | $                                                | 0.00       |                                                                                              | N/A        |                                                                                                                | N/A        |   |
| Month #2 (July  29, 2006 – August 25, 2006)      |       | 8,357                                            |       | $                                                | 8.49       |                                                                                              | N/A        |                                                                                                                | N/A        |   |
| Month #3 (August  26, 2006 – September 29, 2006) |       | 0                                                |       | $                                                | 0.00       |                                                                                              | N/A        |                                                                                                                | N/A        |   |
| **Total**                                             | ** ** | **8,357**                                        | ** ** | **$**                                            | **8.49**   | ** **                                                                                        | **N/A**    | ** **                                                                                                          | **N/A**    | ** ** |

 

On August 8, 2006,we repurchased a total of 8,357 shares of common stock from one of ournon-Section 16 officer vice presidents in private transactions, for a totalpurchase price of $70,951.  All shareswere purchased at the closing price of our common stock on Nasdaq NationalMarket on the date of purchase, or $8.49 per share.  Of the total purchase price, $67,836 of suchamount was applied to outstanding loan that such vice president had withus.  The remaining amount of the purchaseprice paid to the applicable vice president was intended to cover theindividual’s estimated capital gains tax on the sale.  The loan was made in connection withrestricted stock purchase agreements between FCG and this vice president thatwere entered into prior to December 2000, when we eliminated a requirement thatour vice presidents purchase and hold common stock of FCG.

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

None.

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

None.

## **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”).

(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.”

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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: November  8, 2006 |   | /s/LARRY R. FERGUSON                       |   |
|                    |   | Larry R.  Ferguson                         |
|                    |   | Chief Executive  Officer                   |
|                    |   |                                       |
|                    |   |                                       |
| Date: November  8, 2006 |   | /s/THOMAS A WATFORD                        |   |
|                    |   | Thomas A.  Watford                         |
|                    |   | Chief Operating  Officer and Interim Chief |
|                    |   | Financial Officer                          |

 

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# **Exhibit Index**

| 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”).

(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.”

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