**UNITED STATES**

**SECURITIESAND EXCHANGE COMMISSION**

**Washington, DC  20549**

 

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**FORM 10-Q**

 

**(MarkOne)**

 

ý           **QUARTERLY REPORT PURSUANT TO SECTION 13OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**

 

**For the quarterly period ended April 1, 2005**

 

**OR**

 

o           **TRANSITION REPORT PURSUANT TO SECTION 13OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**

 

**For the transition period from                to                **

 

**Commission File Number 0-23651**

 

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**FirstConsulting Group, Inc.**

(Exact name of registrant as specified in its charter)

 
| **Delaware**                                                  | ** ** | **95-3539020**                      |
|---------------------------------------------------------------|------------|-------------------------------------|
| (State or other jurisdiction ofincorporation or organization) | ** ** | (I.R.S. EmployerIdentification No.) |

 

**111 W. Ocean Blvd., 4th Floor, Long Beach, CA  90802**

(Address of principal executive offices including zip code)

 

**(562) 624-5200**

(Registrant’s telephone number, including area code)

 

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

 

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

 

**Indicate by check mark whether the registrant is anaccelerated filer (as defined in Rule 12b-2 of the Exchange Act).**Yes ý   Noo

 

Indicatethe number of shares outstanding of each of the issuer’s classes of commonstock, as of the latest practicable date.

 
| **Common Stock, $.001 par value** | ** ** | **24,343,250**                       |
|-----------------------------------|------------|--------------------------------------|
| (Class)                           |       | (Outstanding at April 29, 2005) |

 

 

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**First Consulting 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 |   |
|                                   |                                                                                                 |   |   |
|                                   |                                                                                                 | Condensed Consolidated Statements of Cash Flows |   |
|                                   |                                                                                                 |   |   |
|                                   |                                                                                                 | Notes to Consolidated Financial Statements |   |
|                                   |                                                                                                 |   |
|                                   | ITEM  2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF  OPERATIONS |   |
|                                   |                                                                                                 |   |
|                                   | ITEM  3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISKS                                 |   |
|                                   |                                                                                                 |   |
|                                   | ITEM 4. CONTROLS AND  PROCEDURES                                                                     |   |
|                                   |                                                                                                 |   |
| PART II.  OTHER  INFORMATION |                                                                                                 |
|                                   |                                                                                                 |   |
|                                   | ITEM 1. LEGAL PROCEEDINGS.                                                                           |   |
|                                   |                                                                                                 |   |
|                                   | ITEM  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**

 

## **Item1. Financial Statements**

 

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

 

### **ConsolidatedBalance Sheets**

**(in thousands, except share and per share data)**

 
| ** **                                                                                                                   | ** ** | **April 1,  2005** | ** ** | **December 31,  2004** | ** ** |
|------------------------------------------------------------------------------------------------------------------------------|------------|-------------------------|------------|-----------------------------|------------|
| ** **                                                                                                                   | ** ** | **(unaudited)**         | ** ** | ** **                  | ** ** |
| **ASSETS**                                                                                                                   | ** ** | ** **              | ** ** | ** **                  | ** ** |
| Current assets:                                                                                                              | ** ** | ** **              | ** ** | ** **                  | ** ** |
| Cash and cash equivalents                                                                                                    |       | $                       | 14,029     |                        | $          | 15,012 |   |
| Short-term investments                                                                                                       |       | 20,388                  |       | 25,309                      |       |
| Accounts receivable, less allowance of  $1,354 and $1,401 as of April 1, 2005 and December 31, 2004,  respectively |       | 24,596                  |       | 26,266                      |       |
| Unbilled receivables                                                                                                         |       | 14,020                  |       | 11,005                      |       |
| Deferred income taxes                                                                                                        |       | 7,869                   |       | 7,869                       |       |
| Prepaid expenses and other current assets                                                                                    |       | 3,818                   |       | 2,449                       |       |
| Current assets of discontinued operations                                                                                    |       | 174                     |       | 561                         |       |
| Total current assets                                                                                                         |       | 84,894                  |       | 88,471                      |       |
|                                                                                                                         |       |                    |       |                        |       |
| Property and equipment:                                                                                                      |       |                    |       |                        |       |
| Furniture, equipment, and leasehold  improvements                                                                            |       | 4,426                   |       | 4,144                       |       |
| Information systems equipment                                                                                                |       | 28,064                  |       | 27,016                      |       |
|                                                                                                                         |       | 32,490                  |       | 31,160                      |       |
| Less accumulated depreciation and  amortization                                                                              |       | 20,555                  |       | 19,331                      |       |
|                                                                                                                         |       | 11,935                  |       | 11,829                      |       |
|                                                                                                                         |       |                    |       |                        |       |
| Other assets:                                                                                                                |       |                    |       |                        |       |
| Executive benefit trust                                                                                                      |       | 9,344                   |       | 9,343                       |       |
| Long-term account receivable                                                                                                 |       | 3,353                   |       | 3,806                       |       |
| Deferred income taxes                                                                                                        |       | 4,188                   |       | 3,220                       |       |
| Goodwill, net                                                                                                                |       | 18,159                  |       | 17,259                      |       |
| Intangibles, net                                                                                                             |       | 2,056                   |       | 2,437                       |       |
| Notes receivable – stockholders                                                                                         |       | 406                     |       | 407                         |       |
| Long-term investments                                                                                                        |       | 325                     |       | 325                         |       |
| Other                                                                                                                        |       | 3,097                   |       | 3,302                       |       |
|                                                                                                                         |       | 40,928                  |       | 40,099                      |       |
| Total assets                                                                                                                 |       | $                       | 137,757    |                        | $          | 140,399 |   |

 

The accompanying notes are an integral partof these financial statements.

 

3

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

 

**Consolidated Balance Sheets (Continued)**

**(in thousands, except share and per share data)**

 
| ** **                                                                                                                                                                                           | ** ** | **April 1,  2005** | ** ** | **December 31,  2004** | ** ** |
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------------|------------|-----------------------------|------------|
| ** **                                                                                                                                                                                           | ** ** | **(unaudited)**         | ** ** | ** **                  | ** ** |
| **LIABILITIES AND STOCKHOLDERS’ EQUITY**                                                                                                                                                        | ** ** | ** **              | ** ** | ** **                  | ** ** |
| Current liabilities:                                                                                                                                                                                 | ** ** | ** **              | ** ** | ** **                  | ** ** |
| Accounts payable                                                                                                                                                                                     |       | $                       | 3,847      |                        | $          | 2,892 |   |
| Accrued liabilities                                                                                                                                                                                  |       | 10,599                  |       | 11,104                      |       |
| Accrued restructuring                                                                                                                                                                                |       | 1,512                   |       | 1,800                       |       |
| Accrued vacation                                                                                                                                                                                     |       | 7,434                   |       | 6,682                       |       |
| Accrued incentive compensation                                                                                                                                                                       |       | 1,387                   |       | 1,729                       |       |
| Customer advances                                                                                                                                                                                    |       | 7,282                   |       | 7,458                       |       |
| Current liabilities of discontinued operations                                                                                                                                                       |       | 26                      |       | 105                         |       |
| Total current liabilities                                                                                                                                                                            |       | 32,087                  |       | 31,770                      |       |
| Non-current liabilities:                                                                                                                                                                             |       |                    |       |                        |       |
| Accrued restructuring                                                                                                                                                                                |       | 2,861                   |       | 3,220                       |       |
| Supplemental executive retirement plan                                                                                                                                                               |       | 9,350                   |       | 9,094                       |       |
| Total non-current liabilities                                                                                                                                                                        |       | 12,211                  |       | 12,314                      |       |
| 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, 24,335,584 shares issued and outstanding at April 1,  2005 and 24,826,547 shares issued and outstanding at December 31, 2004 |       | 24                      |       | 25                          |       |
| Additional paid-in capital                                                                                                                                                                           |       | 90,096                  |       | 91,636                      |       |
| Retained earnings                                                                                                                                                                                    |       | 3,438                   |       | 4,727                       |       |
| Deferred compensation-stock incentive  agreements                                                                                                                                                    |       | (79                     | )          | (107                        | )          |
| Notes receivable-stockholders                                                                                                                                                                        |       | (240                    | )          | (286                        | )          |
| Accumulated other comprehensive income                                                                                                                                                               |       | 220                     |       | 320                         |       |
| Total stockholders’ equity                                                                                                                                                                      |       | 93,459                  |       | 96,315                      |       |
| Total liabilities and stockholders’ equity                                                                                                                                                      |       | $                       | 137,757    |                        | $          | 140,399 |   |

 

The accompanying notes are an integral partof these financial statements.

 

4

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

 

### **Consolidated Statements of Operations**

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

 
| ** **                                                    | ** ** | **Three Months Ended**  | ** ** |
|---------------------------------------------------------------|------------|-------------------------|------------|
| ** **                                                    | ** ** | **April 1,  2005** | ** ** | **March 26,  2004** | ** ** |
| ** **                                                    | ** ** | **(unaudited)**         | ** ** |
| Revenues before reimbursements                                |       | $                       | 68,144     |   | $ | 65,353 |   |
| Reimbursements                                                |       | 3,662                   |       | 3,980 |   |
| Total revenues                                                |       | 71,806                  |       | 69,333 |   |
|                                                          |       |                    |       |   |   |
| Cost of services before reimbursable  expenses                |       | 48,268                  |       | 44,531 |   |
| Reimbursable expenses                                         |       | 3,662                   |       | 3,980 |   |
| Total cost of services                                        |       | 51,930                  |       | 48,511 |   |
|                                                          |       |                    |       |   |   |
| Gross profit                                                  |       | 19,876                  |       | 20,822 |   |
|                                                          |       |                    |       |   |   |
| Selling expenses                                              |       | 6,758                   |       | 7,248 |   |
| General and administrative expenses                           |       | 14,739                  |       | 11,865 |   |
| Income (loss) from operations                                 |       | (1,621                  | )          | 1,709 |   |
| Other income (expense):                                       |       |                    |       |   |   |
| Interest income, net                                          |       | 230                     |       | 202 |   |
| Other expense, net                                            |       | —                  |       | (21 | ) |
| Expense for premium on repurchase of stock                    |       | —                  |       | (1,561 | ) |
| Income (loss) from continuing operations  before income taxes |       | (1,391                  | )          | 329 |   |
| Income tax provision (benefit)                                |       | (639                    | )          | 835 |   |
| Loss from continuing operations                               |       | (752                    | )          | (506 | ) |
| Loss on discontinued operations, net of tax  benefit          |       | (537                    | )          | (127 | ) |
| Net loss                                                      |       | $                       | (1,289     | ) | $ | (633 | ) |
|                                                          |       |                    |       |   |   |
| Basic net loss per share:                                     |       |                    |       |   |   |
| Loss from continuing operations, net of tax                   |       | $                       | (0.03      | ) | $ | (0.02 | ) |
| Loss on discontinued operations, net of tax                   |       | (0.02                   | )          | — |   |
| Net loss                                                      |       | $                       | (0.05      | ) | $ | (0.02 | ) |
| Diluted net loss per share:                                   |       |                    |       |   |   |
| Loss from continuing operations, net of tax                   |       | $                       | (0.03      | ) | $ | (0.02 | ) |
| Loss on discontinued operations, net of tax                   |       | (0.02                   | )          | — |   |
| Net loss                                                      |       | $                       | (0.05      | ) | $ | (0.02 | ) |
|                                                          |       |                    |       |   |   |
| Weighted average shares used in computing:                    |       |                    |       |   |   |
| Basic net loss per share                                      |       | 24,475                  |       | 25,422 |   |
| Diluted net loss per share                                    |       | 24,475                  |       | 25,422 |   |

 

The accompanying notes are an integral partof these financial statements.

 

5

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

 

### **Condensed Consolidated Statements ofCash Flows**

**(in thousands)**

 
| ** **                                                                   | ** ** | **Three Months Ended**  | ** ** |
|------------------------------------------------------------------------------|------------|-------------------------|------------|
| ** **                                                                   | ** ** | **April 1,  2005** | ** ** | **March 26,  2004** | ** ** |
| ** **                                                                   | ** ** | **(unaudited)**         | ** ** |
| Cash flows from operating activities:                                        |       |                    |       |   |   |
| Net loss:                                                                    |       | $                       | (1,289     | ) | $ | (633 | ) |
| Adjustments to reconcile net loss to net  cash used in operating activities: |       |                    |       |   |   |
| Depreciation and amortization                                                |       | 1,493                   |       | 1,109 |   |
| Premium on capital stock repurchase                                          |       | —                  |       | 1,561 |   |
| Intangible amortization                                                      |       | 381                     |       | 398 |   |
| Provision for bad debts, net of adjustments                                  |       | —                  |       | 116 |   |
| Loss on sale of assets                                                       |       | 2                       |       | — |   |
| Minority interest in net loss of subsidiary                                  |       | —                  |       | (14 | ) |
| Compensation from stock issuances                                            |       | 28                      |       | 26 |   |
| Interest income on notes receivable –  stockholders                     |       | (27                     | )          | (14 | ) |
| Changes in assets and liabilities,  excluding effect of acquisitions:        |       |                    |       |   |   |
| Accounts receivable                                                          |       | 1,670                   |       | 3,003 |   |
| Unbilled receivables                                                         |       | (3,015                  | )          | (3,141 | ) |
| Prepaid expenses and other                                                   |       | (1,369                  | )          | (1,034 | ) |
| Current assets of discontinued operations                                    |       | 387                     |       | — |   |
| Long term account receivable                                                 |       | 453                     |       | 613 |   |
| Other assets                                                                 |       | 205                     |       | (751 | ) |
| Accounts payable                                                             |       | 955                     |       | 751 |   |
| Accrued liabilities                                                          |       | (505                    | )          | (861 | ) |
| Current liabilities of discontinued  operations                              |       | (79                     | )          | — |   |
| Accrued restructuring                                                        |       | (647                    | )          | (2,303 | ) |
| Accrued vacation                                                             |       | 752                     |       | 244 |   |
| Accrued incentive compensation                                               |       | (342                    | )          | 116 |   |
| Customer advances                                                            |       | (176                    | )          | (1,468 | ) |
| Deferred income taxes                                                        |       | (968                    | )          | 508 |   |
| Supplemental executive retirement plan                                       |       | 255                     |       | 227 |   |
| Other                                                                        |       | (11                     | )          | 61 |   |
| Net cash used in operating activities                                        |       | (1,847                  | )          | (1,486 | ) |
| Cash flows from investing activities:                                        |       |                    |       |   |   |
| Proceeds from sale/maturity of investments                                   |       | 4,921                   |       | 8,766 |   |
| Purchase of property and equipment                                           |       | (1,619                  | )          | (1,992 | ) |
| Acquisition of business, net of cash  acquired                               |       | —                  |       | (2,383 | ) |
| Net cash provided by investing activities                                    |       | 3,302                   |       | 4,391 |   |
| Cash flows from financing activities:                                        |       |                    |       |   |   |
| Proceeds from issuance of capital stock,  net                                |       | 156                     |       | 729 |   |
| Proceeds from notes receivable and tax loan  payments                        |       | 7                       |       | 26 |   |
| Capital stock repurchase                                                     |       | (2,530                  | )          | (14,773 | ) |
| Net cash used in financing activities                                        |       | (2,367                  | )          | (14,018 | ) |
| Effect of exchange rate changes on cash and  cash equivalents                |       | (71                     | )          | 27 |   |
| Net change in cash and cash equivalents                                      |       | (983                    | )          | (11,086 | ) |
| Cash and cash equivalents at beginning of  period                            |       | 15,012                  |       | 26,826 |   |
| Cash and cash equivalents at end of period                                   |       | $                       | 14,029     |   | $ | 15,740 |   |
|                                                                         |       |                    |       |   |   |
| Cash paid during the period for:                                             |       |                    |       |   |   |
| Interest                                                                     |       | $                       | 42         |   | $ | 4 |   |
| Income taxes                                                                 |       | $                       | 127        |   | $ | 310 |   |

 

The accompanying notes are an integral partof these financial statements.

 

6

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### **Notes to Consolidated FinancialStatements**

 

**Note 1****            AccountingPolicies**

 

*Basisof Presentation*

 

Theaccompanying consolidated balance sheet of First Consulting Group, Inc.(the “Company” or “FCG”) at April 1, 2005 and consolidated statements ofoperations and condensed consolidated statements of cash flows for the periodsended April 1, 2005 and March 26, 2004 are unaudited.  These financial statements reflect alladjustments, consisting of only normal recurring adjustments, which, in theopinion of management, are necessary to fairly present the financial positionof the Company at April 1, 2005 and the results of operations and cashflows for the three-month periods ended April 1, 2005 and March 26,2004.  The results of operations and cashflows for the three-month period ended April 1, 2005 are not necessarilyindicative of the results to be expected for the year ending December 30,2005.  For more complete financialinformation, these financial statements should be read in conjunction with theaudited financial statements for the year ended December 31, 2004 includedin the Company’s Annual Report on Form 10-K.  Certain reclassifications have been made tothe 2004 financial statements to conform to the 2005 presentation.

 

*Principlesof Consolidation*

 

Theconsolidated financial statements include the accounts of the Company and itssubsidiaries.  All material intercompanyaccounts and transactions have been eliminated.

 

*Stock-BasedCompensation*

 

The Company accounts forstock-based employee compensation using the intrinsic value method asprescribed by APB Opinion No. 25, “Accountingfor Stock Issued to Employees,” and has adopted the disclosureprovisions of Statement of Financial Accounting Standards No. 123, “Accounting for Stock-Based Compensation”**(“SFAS No. 123”), andStatement of Financial Accounting Standards No. 148, “Accounting for Stock-Based Compensation –Transition and Disclosure – an amendment of SFAS No. 123”**(“SFAS No. 148”).  SFAS No. 123 requires pro formadisclosures of net income (loss) and net income (loss) per share as if the fairvalue method of accounting for stock-based awards had been applied. Under thefair value method, compensation cost is recorded based on the value of theaward at the grant date and is recognized over the service period.

 

The following table presentsthe pro forma net loss had compensation costs been determined using the fairvalue at the date of grant for awards under the plan in accordance with SFAS No. 123(in thousands, except per share data):

 
| ** **                                                                                                              | ** **  | ** ** | **Three Months Ended**  | ** ** |
|-------------------------------------------------------------------------------------------------------------------------|-------------|------------|-------------------------|------------|
| ** **                                                                                                              | ** **  | ** ** | **April 1,  2005** | ** ** | **March 26,  2004** | ** ** |
| Net loss, as reported                                                                                                   |        |       | $                       | (1,289     | ) | $ | (633 | ) |
| Deduct: Total stock based employee  compensation expense determined under fair value method for all awards, net  of tax |        | (241       | )                       | (453       | ) |
| Pro forma net loss                                                                                                      |        |       | $                       | (1,530     | ) | $ | (1,086 | ) |
|                                                                                                                    |        |       |                    |       |   |   |
| Basic and diluted loss per share                                                                                        | As reported |       | $                       | (0.05      | ) | $ | (0.02 | ) |
|                                                                                                                    | Pro forma   |       | $                       | (0.06      | ) | $ | (0.04 | ) |

 

7

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*Basicand Diluted Net Income (Loss) Per Share*

 

Basic net income (loss) per share is based upon the weighted averagenumber of common shares outstanding. Diluted net income per share is based on the assumption that stockoptions were exercised.  Dilution iscomputed by applying the treasury stock method. Under this method, options areassumed to be exercised at the beginning of the period (or at the time ofissuance, if later), and as if funds obtained by the Company from such exercisewere used by the Company to purchase common stock at the average market priceduring the period. Stock options are not considered when computing diluted net lossper share as they are considered anti-dilutive.

 

Thefollowing represents a reconciliation of basic and diluted net loss per sharefor the three-month periods ended April 1, 2005 and March 26, 2004(in thousands, except per share data):

 
| ** **                                                       | ** ** | **Three Months Ended**  | ** ** |
|------------------------------------------------------------------|------------|-------------------------|------------|
| ** **                                                       | ** ** | **April 1,  2005** | ** ** | **March 26,  2004** | ** ** |
|                                                             |       |                    |       |   |   |
| Loss from continuing operations                                  |       | $                       | (752       | ) | $ | (506 | ) |
| Loss on discontinued operations, net of tax  benefit             |       | (537                    | )          | (127 | ) |
| Net loss                                                         |       | $                       | (1,289     | ) | $ | (633 | ) |
|                                                             |       |                    |       |   |   |
| Basic and diluted weighted average number of  shares outstanding |       | 24,475                  |       | 25,422 |   |

 
| ** **                                           | ** ** | **Three  Months Ended** | ** ** |
|------------------------------------------------------|------------|-------------------------|------------|
| ** **                                           | ** ** | **April 1,  2005** | ** ** | **March 26,  2004** | ** ** |
| Basic and diluted per share:                         |       |                    |       |   |   |
| Loss from continuing operations                      |       | $                       | (0.03      | ) | $ | (0.02 | ) |
| Loss on discontinued operations, net of tax  benefit |       | (0.02                   | )          | — |   |
| Net loss per share                                   |       | $                       | (0.05      | ) | $ | (0.02 | ) |

 

Forthe three months ended April 1, 2005 and March 26, 2004, there were5,243,526 and 5,242,036 anti-dilutive outstanding stock options, respectively,excluded from the calculation of diluted loss per share.

 

*Use ofEstimates*

 

In preparing financial statements in conformity with accounting principles generally accepted in the United States of America, management is required to make estimates and assumptions that affect the reported amounts of assets and liabilities, the disclosure of contingent assets and liabilities at the date of the financial statements, and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.  On an on-going basis, the Company evaluates its estimates, including those related to revenue recognition, valuation of goodwill and long-lived and intangible assets, accrued liabilities, income taxes including the amount of tax asset valuation allowance required, restructuring costs, litigation and disputes, and the allowance for doubtful accounts.

 

The Company uses significant estimates in the calculation of its incometax provision by estimating whether it will have sufficient future taxableincome to realize its deferred tax assets. Therecan be no assurances that the Company’s taxable income will be sufficient torealize such deferred tax assets and the Company will continue to evaluate itsvaluation allowance on an ongoing basis.

 

8

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The Company bases its estimates on historical experience and on variousother assumptions that are believed to be reasonable under the circumstances,the results of which form the basis for making judgments about the carryingvalues of assets and liabilities that are not readily apparent from othersources.  The Company’s actual resultsmay differ from its estimates.

 

**Note 2****           ****Investments**

 

AtApril 1, 2005, the Company had approximately $20.4 million in short-terminvestments.  Such investments were heldprimarily in commercial paper, money market investments, and tax-exemptgovernment securities.  Net unrealizedgains and losses on investments were immaterial at April 1, 2005.  Additionally, the Company had $0.3 million ofnon-marketable equity investments, valued at the lower of cost or estimatedfair value, which were included in long-term investments.

 

**Note 3****           ****Long-Term Account Receivable**

 

AtApril 1, 2005, the Company carried a long-term account receivable ofapproximately $3.4 million from a single client.  The receivable is related to an outsourcingcontract and is scheduled to be collected over the next 21 months.

 

**Note 4****           ****Business Acquisitions**

 

*FCG Infrastructure Services (FCGIS)*

 

OnMay 31, 2002, the Company acquired a controlling interest of 52.35% in CodigentSolutions Group, Inc., renamed FCG Infrastructure Services, Inc.(FCGIS), a provider of value added information technology solutions tohospitals and other healthcare delivery organizations, for $2.6 million incash.  On January 30, 2004, the Company purchased the remaining47.65% minority interest in FCGIS from five remaining individual stockholdersfor approximately $2.4 million in cash.  Additionally, the Companydeposited 591,328 shares of FCG common stock into an escrow account, with one-fourthof such shares to be released to those same stockholders in four separateincrements upon successful fulfillment by FCGIS of certain revenue andprofitability targets for the six-month periods ended June 25, 2004, December 31,2004, July 1, 2005, and December 30, 2005.  If such targets werenot fulfilled for any of the six-month periods, the shares in escrow for thatperiod would revert to FCG.

 

Theacquisition was accounted for using the purchase method of accounting and theallocation of the $5.0 million non-contingent purchase price (net of cashacquired of $392,000) is as follows (in thousands):

 
| Accounts receivable       |   | $     | 784    |   |
|---------------------------|--------|-------|--------|--------|
| Fixed assets and software |   | 557   |   |
| Intangible assets         |   | 604   |   |
| Goodwill                  |   | 3,254 |   |
| Accrued liabilities       |   | (397  | )      |
| Assumed long-term debt    |   | (194  | )      |
| Net assets acquired       |   | $     | 4,608  |   |

 

The$3.9 million of excess over book value was allocated between goodwill andintangible assets of $3.3 million and $0.6 million, respectively.  Suchamounts are non-deductible for tax purposes.

 

Forthe six-month periods ended June 25, 2004 and December 31, 2004,FCGIS met the revenue and profitability targets, and 295,664 contingent shareswere released to the former FCGIS stockholders, thus adding $1.8 million togoodwill.  In February 2005, the Company negotiated an earlyconclusion to

 

9

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its escrow agreement related to shares ofcommon stock issued in the purchase of FCGIS, where half of the remaining295,664 shares in escrow were released and the other half were forfeited backto the Company.  The shares released further increased goodwill by another$900,000 to a total of $6.1 million of goodwill related to the acquisition.

 

Additionally,on February 23, 2005, the Company repurchased most of the stock which hadbeen previously and currently released from escrow for its current fair marketvalue.  A total of 422,018 shares were repurchased for approximately $2.5million in cash and cancelled.

 

**Note 5****           ****Goodwill and Intangible Assets**

 

Goodwill is evaluated for impairment annually, pursuant to SFAS 142, orif an event occurs or circumstances change that may reduce the fair value ofthe reporting unit below its book value. The impairment test is conducted atthe reporting unit level by comparing the fair value of the reporting unit withits carrying value. Fair value is determined by using a market approachvaluation model based on revenue multiples or a discounted cash flowapproach.  The Company uses variousassumptions in the valuation, such as discount rates, and comparable companyanalysis in performing these valuations. If the carrying value exceeds the fair value, goodwill may be impaired.If this occurs, the fair value of the reporting unit is then allocated to itsassets and liabilities in a manner similar to a purchase price allocation inorder to determine the implied fair value of the reporting unit goodwill. Thisimplied fair value is then compared with the carrying amount of the reportingunit goodwill, and if it is less, the Company would then recognize animpairment loss.  In addition, theCompany evaluates intangible assets with definite lives pursuant to SFAS 142,to determine whether adjustment to these amounts or estimated useful lives arerequired based on current events and circumstances.

 

In the first quarter of 2005, the Company reorganized its businesssegments.  In accordance with SFAS 142,the goodwill formerly attributed to the Meditech Service Center segment wasdivided between the Health Delivery Services and Health Delivery Outsourcingsegments based on the relative fair values of parts of the previous MeditechService Center being reorganized into those business units, and is shownhistorically on this restated basis in the following schedule.

 

Thechanges in the net carrying amounts of goodwill for the three months ended April 1,2005 are as follows (in thousands):

 
| ** **                           | ** ** | **Health  Delivery  Services** | ** ** | **Health  Delivery  Outsourcing** | ** ** | **Life  Sciences** | ** ** | **Government  & Technology  Services** | ** ** | **Other** | ** ** | **Total** | ** ** |
|--------------------------------------|------------|--------------------------------|------------|-----------------------------------|------------|--------------------|------------|--------------------------------------------|------------|-----------|------------|-----------|------------|
| Balance as of December 26, 2003 |       | $                              | 1,051      |                              | $          | 3,228              |       | $                                          | 1,477      |      | $          | 8,260     |       | $ | 1,442 |   | $ | 15,458 |   |
| Acquired                             |       | 1,701                          |       | 1,538                             |       | —             |       | —                                     |       | —    |       | 3,239     |       |
| Impaired                             |       | —                         |       | —                            |       | —             |       | —                                     |       | (1,442    | )          | (1,442    | )          |
| Currency translation adjustment      |       | —                         |       | —                            |       | 4                  |       | —                                     |       | —    |       | 4         |       |
| Balance as of December 31, 2004 |       |                           | 2,752      |                              |       | 4,766              |       |                                       | 1,481      |      |       | 8,260     |       |   | — |   |   | 17,259 |   |
| Acquired                             |       | 473                            |       | 427                               |       | —             |       | —                                     |       | —    |       | 900       |       |
| Balance as of April 1, 2005     |       | $                              | 3,225      |                              | $          | 5,193              |       | $                                          | 1,481      |      | $          | 8,260     |       | $ | — |   | $ | 18,159 |   |

 

10

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The $900,000 of additional goodwill in the first quarter of 2005relates to a final earn out payment to the previous owners of a business whichwas the substantial portion of the Meditech Service Center segment.

 

Asof April 1, 2005, the Company had the following acquired intangible assetsrecorded (in thousands):

 
| ** **                           | ** ** | **Software and  Software  Development** | ** ** | **Customer   Related** | ** ** | **Non-Compete  Agreements** | ** ** | **Total** | ** ** |
|--------------------------------------|------------|-----------------------------------------|------------|------------------------|------------|-----------------------------|------------|-----------|------------|
| Balance as of December 26, 2003 |       | $                                       | 763        |                   | $          | 2,858                       |       | $         | 179        |   | $ | 3,800 |   |
| Acquired                             |       | —                                  |       | 300                    |       | —                      |       | 300       |       |
| Amortization                         |       | (543                                    | )          | (981                   | )          | (139                        | )          | (1,663    | )          |
| Balance as of December 31, 2004 |       |                                    | 220        |                   |       | 2,177                       |       |      | 40         |   |   | 2,437 |   |
| Amortization                         |       | (88                                     | )          | (264                   | )          | (29                         | )          | (381      | )          |
| Balance as of April 1, 2005     |       | $                                       | 132        |                   | $          | 1,913                       |       | $         | 11         |   | $ | 2,056 |   |
| Amortization Period in Years         |       | 2 -3                                    |       | 2 -4                   |       | 2 -3                        |       |      |       |

 

Thefollowing table summarizes the estimated annual pretax amortization expense forthese assets (in thousands):

 
| **Fiscal Year**          | ** ** | ** ** | ** ** |
|--------------------------|------------|------------|------------|
| 2005 (remainder of year) |       | $          | 828        |   |
| 2006                     |       | 772        |       |
| 2007                     |       | 456        |       |
| Total                    |       | $          | 2,056      |   |

 

**Note 6****           ****Restructuring, Severance, andImpairment Costs**

 

**At April 1,2005, the Company had approximately $4.4 million in restructuring accrual whichrelated to restructuring, severance, and impairment costs incurred in the prioryears, primarily in the Life Sciences segment. The remaining accrual entirely consists of costs related to vacatedleases, net of estimated sublease payments.**

 

**Therestructuring liability activity through April 1, 2005 is summarized asfollows (in thousands):**

 
| ** **                                | ** ** | **Facilities/Other  Related Costs** | ** ** |
|-------------------------------------------|------------|-------------------------------------|------------|
| Accrual balance at December 31, 2004 |       | $                                   | 5,020      |   |
| Cash payments                             |       | (647                                | )          |
| Accrual balance at April 1, 2005     |       | $                                   | 4,373      |   |

 

**Note 7****           ****Comprehensive Income (Loss)**

 

Comprehensiveincome (loss), net of taxes, for the three months ended April 1, 2005 and March 26,2004, is as follows (in thousands):

 

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| ** **                                     | ** ** | **Three Months Ended**  | ** ** |
|------------------------------------------------|------------|-------------------------|------------|
| ** **                                     | ** ** | **April 1,  2005** | ** ** | **March 26,  2004** | ** ** |
| Net loss                                       |       | $                       | (1,289     | ) | $ | (633 | ) |
|                                           |       |                    |       |   |   |
| Foreign currency translation adjustment        |       | (100                    | )          | 82 |   |
| Unrealized gain on investments                 |       | —                  |       | 10 |   |
| Other comprehensive income (loss), net of  tax |       | (100                    | )          | 92 |   |
|                                           |       |                    |       |   |   |
| Comprehensive loss                             |       | $                       | (1,389     | ) | $ | (541 | ) |

 

**Note 8****            Discontinued****Operations**

 

On December 7, 2004, the Company’s Boardof Directors approved a plan to sell and exit its clinical and non-clinicalCall Center Services (CCS) operation due to recurring losses.  On February 2,2005, the Company executed a definitive agreement with the MPB Group, LLC,d/b/a The Beryl Companies.  FCG will receive 12 monthly payments totaling$150,000 for selected customer contracts. The disposal plan consisted primarilyof the termination of normal CCS activity, calculation of termination benefitsfor the existing CCS employees, termination of a lease agreement, abandonmentof property and equipment, collection of accounts receivable, and settlement ofliabilities.

 

In accordance with SFAS 144, “Accounting forthe Impairment or Disposal of Long-Lived Assets,” this disposal represents adiscontinued operation.  Accordingly, the accompanying consolidatedfinancial statements and notes reflect the results of operations and financialposition of the CCS division as a discontinued operation for all periodspresented.

 

A summary of results for CCS for the quarter ended April 1, 2005included revenues of $631,000 and a pre-tax loss of $866,000 which related tothe sales, operation, and wind-down of the business.  The pre-tax loss, net of a 38% tax benefit,resulted in a net loss of $537,000, compared to a loss of $127,000, net of a38% tax benefit for the quarter ended March 26, 2004.  The current quarter’s net loss included$276,000 related to severance costs for the remaining staff of 37 people.  Further, in accordance with SFAS 146, “Accountingfor Costs Associated with Exit or Disposal Activities”, the Company recorded anaccrual for the remaining lease payments on the CCS leased property in theamount of $89,000.

 

**Note 9****           ****Disclosure of Segment Information**

 

In the first quarter of 2005, the Company reorganized its previoussegment reporting in accordance with SFAS 131 and had the following changes inits reporting:

 

•      TheMeditech Service Center segment has been split between Health Delivery Servicesand Health Delivery Outsourcing.  Aninsignificant portion of the Meditech Service Center has also been included inthe Software Products segment;

•      TheHealth Delivery Services (previously Health Delivery) and Health DeliveryOutsourcing segments, while still reported separately, are now combined with acommon sales group, Health Delivery Sales into a total Health Delivery segment;

•      TheGovernment and Technology Services (GTS) segment has been created by combiningthe Paragon Solutions, Inc. (our software development business) andTechnology Staffing Services groups, which used to be included within OtherBusiness, with the government healthcare business unit, which used to be partof Health Delivery;

•      SoftwareProducts (SWP) has been created by adding the Cyberview product that used to bein the Meditech Service Center segment to the existing SWP business line, whichused to be included within Other Business, and primarily involves the FirstGatewaysproduct.

 

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For fiscal year 2005, the Company has the following six reportableoperating segments:

 

•      HealthDelivery Services - the delivery of consulting and systems integration servicesto health delivery clients;

•      HealthDelivery Outsourcing - the delivery of outsourcing services to health deliveryclients;

•      LifeSciences - the delivery of consulting and systems integration services topharmaceutical and other life sciences clients;

•      HealthPlan - the delivery of consulting and systems integration services to healthplan clients;

•      Governmentand Technology Services - the delivery of consulting services to governmentclients, the delivery of blended offshore software development, and the deliveryof technology staff augmentation services; and

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

 

Additionally, the Company has three shared service centers that provideservices to multiple business segments. These shared service centers include FCG India, Integration Services,and Infrastructure Services.   The costsof these services are internally billed and reported in the individual businesssegments as cost of services at a standard transfer cost.

 

The Company evaluates its segments’ performance based on revenues andoperating income.  Certain selling andgeneral and administrative expenses (including corporate functions, occupancyrelated costs, depreciation, professional development, recruiting, andmarketing), are managed at the corporate level and allocated to each operatingsegment based on either net revenues and/or actual usage.  The Company does not manage or track mostassets by segment.  As a result, interestand other charges are not included in the tables below.

 

13

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The following segment information is for the quarters ended April 1,2005 and March 26, 2004 (in thousands):

 

**For the three months ended April 1, 2005:**

(in thousands)

 
| ** **                                    | ** ** | **Health  Delivery  Services** | ** ** | **Health  Delivery  Sales** | ** ** | **Health  Delivery  Outsourcing** | *** *** | **Health  Delivery  Total** | ** ** | **Life  Sciences** | ** ** | **Health  Plan** | ** ** | **Government  &  Technology  Services** | ** ** | **Software  Products** | ** ** | **Other** | ** ** | **Totals** | ** ** |
|-----------------------------------------------|------------|--------------------------------|------------|-----------------------------|------------|-----------------------------------|--------------|-----------------------------|------------|--------------------|------------|------------------|------------|---------------------------------------------|------------|------------------------|------------|-----------|------------|------------|------------|
| Revenues before reimbursements                |       | $                              | 16,043     |                        | $          | —                            |         | $                           | 30,762     | * *           | *$*        | *46,805*         |       | $                                           | 8,715      |                   | $          | 4,010     |       | $          | 8,077      |   | $ | 537 |   | $ | — | ** ** | **$** | **68,144** | ** ** |
| Reimbursements                                |       | 2,517                          |       | —                      |       | 132                               | * *     | *2,649*                     |       | 197                |       | 581              |       | 214                                         |       | 21                     |       | —    | ** ** | **3,662**  | ** ** |
| Total revenues                                |       | 18,560                         |       | —                      |       | 30,894                            | * *     | *49,454*                    |       | 8,912              |       | 4,591            |       | 8,291                                       |       | 558                    |       | —    | ** ** | **71,806** | ** ** |
| Cost of services before reimbursable expenses |       | 10,799                         |       | —                      |       | 25,567                            | * *     | *36,366*                    |       | 4,480              |       | 3,259            |       | 4,833                                       |       | 884                    |       | (1,554    | **)**      | **48,268** | ** ** |
| Reimbursable expenses                         |       | 2,517                          |       | —                      |       | 132                               | * *     | *2,649*                     |       | 197                |       | 581              |       | 214                                         |       | 21                     |       | —    | ** ** | **3,662**  | ** ** |
| Total cost of services                        |       | 13,316                         |       | —                      |       | 25,699                            | * *     | *39,015*                    |       | 4,677              |       | 3,840            |       | 5,047                                       |       | 905                    |       | (1,554    | **)**      | **51,930** | ** ** |
| Gross profit                                  |       | 5,244                          |       | —                      |       | 5,195                             | * *     | *10,439*                    |       | 4,235              |       | 751              |       | 3,244                                       |       | (347                   | )          | 1,554     | ** ** | **19,876** | ** ** |
| Selling expenses                              |       | 1,127                          |       | 1,324                       |       | 466                               | * *     | *2,917*                     |       | 1,905              |       | 536              |       | 873                                         |       | 142                    |       | 385       | ** ** | **6,758**  | ** ** |
| General & administrative expenses    |       | 3,180                          |       | —                      |       | 3,214                             | * *     | *6,394*                     |       | 2,580              |       | 740              |       | 1,702                                       |       | 361                    |       | 2,962     | ** ** | **14,739** | ** ** |
| Income (loss) from operations                 |       | $                              | 937        |                        | $          | (1,324                            | )            | $                           | 1,515      | * *           | *$*        | *1,128*          |       | $                                           | (250       | )                      | $          | (525      | )          | $          | 669        |   | $ | (850 | ) | $ | (1,793 | **)** | **$** | **(1,621** | **)** |

 

**For the three months ended March 26, 2004:**

(inthousands)

 
| ** **                                    | ** ** | **Health  Delivery  Services** | ** ** | **Health  Delivery  Sales** | ** ** | **Health  Delivery  Outsourcing** | *** *** | **Health  Delivery  Total** | ** ** | **Life  Sciences** | ** ** | **Health  Plan** | ** ** | **Government  &  Technology  Services** | ** ** | **Software  Products** | ** ** | **Other** | ** ** | **Totals** | ** ** |
|-----------------------------------------------|------------|--------------------------------|------------|-----------------------------|------------|-----------------------------------|--------------|-----------------------------|------------|--------------------|------------|------------------|------------|---------------------------------------------|------------|------------------------|------------|-----------|------------|------------|------------|
| Revenues before reimbursements                |       | $                              | 17,358     |                        | $          | —                            |         | $                           | 27,119     | * *           | *$*        | *44,477*         |       | $                                           | 8,867      |                   | $          | 4,248     |       | $          | 7,361      |   | $ | 384 |   | $ | 16 | ** ** | **$** | **65,353** | ** ** |
| Reimbursements                                |       | 2,384                          |       | —                      |       | 100                               | * *     | *2,484*                     |       | 226                |       | 580              |       | 145                                         |       | 70                     |       | 475       | ** ** | **3,980**  | ** ** |
| Total revenues                                |       | 19,742                         |       | —                      |       | 27,219                            | * *     | *46,961*                    |       | 9,093              |       | 4,828            |       | 7,506                                       |       | 454                    |       | 491       | ** ** | **69,333** | ** ** |
| Cost of services before reimbursable expenses |       | 9,704                          |       | —                      |       | 22,606                            | * *     | *32,310*                    |       | 5,054              |       | 2,438            |       | 4,746                                       |       | 656                    |       | (673      | **)**      | **44,531** | ** ** |
| Reimbursable expenses                         |       | 2,384                          |       | —                      |       | 100                               | * *     | *2,484*                     |       | 226                |       | 580              |       | 145                                         |       | 70                     |       | 475       | ** ** | **3,980**  | ** ** |
| Total cost of services                        |       | 12,088                         |       | —                      |       | 22,706                            | * *     | *34,794*                    |       | 5,280              |       | 3,018            |       | 4,891                                       |       | 726                    |       | (198      | **)**      | **48,511** | ** ** |
| Gross profit                                  |       | 7,654                          |       | —                      |       | 4,513                             | * *     | *12,167*                    |       | 3,813              |       | 1,810            |       | 2,615                                       |       | (272                   | )          | 689       | ** ** | **20,822** | ** ** |
| Selling expenses                              |       | 1,101                          |       | 1,369                       |       | 585                               | * *     | *3,055*                     |       | 2,488              |       | 876              |       | 667                                         |       | 70                     |       | 92        | ** ** | **7,248**  | ** ** |
| General & administrative expenses    |       | 2,570                          |       | —                      |       | 2,571                             | * *     | *5,141*                     |       | 2,984              |       | 644              |       | 1,382                                       |       | 157                    |       | 1,557     | ** ** | **11,865** | ** ** |
| Income (loss) from operations                 |       | $                              | 3,983      |                        | $          | (1,369                            | )            | $                           | 1,357      | * *           | *$*        | *3,971*          |       | $                                           | (1,659     | )                      | $          | 290       |       | $          | 566        |   | $ | (499 | ) | $ | (960 | **)** | **$** | **1,709** | ** ** |

 

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The “other” column consists of unallocated sharedservice center and support costs.  Forthe quarter ended April 1, 2005, there was a significant net loss in thiscolumn due to under utilization of both the infrastructure and integrationshared service centers.

 

*Detailof Health Delivery Outsourcing Revenues*

 

HealthDelivery Outsourcing revenues before reimbursements include revenues related toa major subcontractor on several projects. The breakdown of revenue in Health Delivery Outsourcing is as follows(in thousands):

 
| ** **                     | ** ** | **Three Months Ended**  | ** ** |
|--------------------------------|------------|-------------------------|------------|
| ** **                     | ** ** | **April 1,  2005** | ** ** | **March 26,  2004** | ** ** |
| Internally generated revenues  |       | $                       | 25,119     |   | $ | 21,656 |   |
| Subcontractor revenues         |       | 5,643                   |       | 5,463 |   |
| Revenues before reimbursements |       | $                       | 30,762     |   | $ | 27,119 |   |

 

**Note 10****         ****Line of Credit**

 

The Company has a revolving line of credit expiring on May 1,2006, under which it is allowed to borrow up to $7.0 million at the prevailingprime rate.  There was no outstandingbalance under the line of credit at April 1, 2005.

 

**Note 11****          Capital Stock Repurchase From MajorStockholder**

 

On February27, 2004, the Company repurchased all outstanding shares of FCG common stockheld by David S. Lipson, one of the Company’s directors and the former CEO ofIntegrated Systems Consulting Group, Inc. (ISCG).  The Company acquired ISCG in December1998.  The Company also purchased anyin-the-money options to purchase FCG common stock held by Mr. Lipson.  The aggregate purchase price for the sharesand options held by Mr. Lipson was $15.1 million.  As a result of the transaction, Mr. Lipsonresigned from the Company’s Board of Directors.

 

The Company’s purchase of Mr. Lipson’s ownership interest includedall of the 1,962,400 outstanding shares of common stock of FCG held by Mr. Lipson,together with 32,000 in-the-money options to purchase shares of common stock ofFCG.  The aggregate purchase price forthe shares and the options represented a premium of approximately 11% over theclosing price of FCG’s common stock on February 26, 2004.

 

In the first quarter of 2004, the Company recorded a charge of $1.6million without any tax benefit, which charge is based on the premium includedin the purchase consideration.  From atax perspective, no amounts of the purchase price are allocable to any of therestrictive covenants agreed to by Mr. Lipson in the repurchase agreement.

 

Other material terms of the transaction were as follows:

 

•   The purchase pricewas comprised of cash, a portion of which Mr. Lipson used to repay in fullindebtedness owed by Mr. Lipson to the Company of approximately $0.3million.

•   In the event theCompany were to enter into negotiations regarding a change in controltransaction prior to February 27, 2005 and subsequently announce publiclya definitive agreement for or consummate a change in control transaction priorto August 27, 2005, the Company would pay to Mr. Lipson, upon theclosing of such change in control of the

 

15

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Company, an amount equal to the differencebetween $7.50 per share and the change in control transaction price per share,if such change in control price per share amount is higher.

•   Mr. Lipson issubject to a five year non-compete agreement, a mutual non-disparagementagreement, a non-solicitation agreement and a standstill agreement.  The parties agreed that no amounts of thepurchase price would be allocated to these covenants for tax purposes.

•   Mr. Lipsonalso granted to the Board of Directors of the Company an irrevocable proxy forany of the Company’s securities that he owns or acquires after the closing ofthe Company’s purchase in this transaction.

•   The Company and Mr. Lipsonexecuted a mutual release of claims.

 

16

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## **Item 2. Management’s Discussion and Analysis of Financial Condition and Resultsof Operations**

 

THE FOLLOWING MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIALCONDITION AND RESULTS OF OPERATIONS CONTAINS FORWARD-LOOKING STATEMENTS WITHINTHE MEANING OF THE PRIVATE SECURITIES LITIGATION REFORM ACT OF 1995.  SUCH FORWARD-LOOKING STATEMENTS INVOLVE RISKSAND UNCERTAINTIES, INCLUDING THOSE SET FORTH BELOW UNDER THE CAPTION “RISKSRELATING TO OUR BUSINESS,” AND OTHER REPORTS WE FILE WITH THE SECURITIES ANDEXCHANGE COMMISSION.  OUR ACTUAL RESULTSCOULD DIFFER MATERIALLY FROM THOSE ANTICIPATED IN THESE FORWARD-LOOKINGSTATEMENTS.

 

## **Overview**

 

We provide services primarily to providers, payors, governmentagencies, pharmaceutical, biogenetic, and other healthcare organizations inNorth America, Europe, and Asia.  Wegenerate substantially all of our revenues from fees for information technologyoutsourcing services and professional services.

 

Wetypically bill for our services on an hourly or fixed-fee basis as specified bythe agreement with a particular client. For services billed on an hourly basis, in our consulting and systemsintegration businesses (“CSI”), fees are determined by multiplying the amountof time expended on each assignment by the project hourly rate for theconsultant(s) assigned to the engagement. Fixed fees, including outsourcing fees, are established on aper-assignment or monthly basis and are based on several factors such as thesize, scope, complexity and duration of an assignment, the number of ouremployees required to complete the assignment, and the volume of transactionsor interactions.  Revenues are generallyrecognized related to the level of services performed, the amount of costincurred on the assignment versus the estimated total cost to complete the assignment,or on a straight-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% of our total revenues in the first quarter of2005, and we expect our software licensing revenues to continue to growincrementally during our 2005 fiscal year. We also expect our services revenues associated with the implementationof our software products to continue to become a more significant part of ouroverall services revenues.

 

Provisions are made for estimated uncollectible amounts based on ourhistorical experience.  We may obtainpayment in advance of providing services. These advances are recorded as customer advances and reflected as aliability on our balance sheet.

 

Out-of-pocket expenses billed and reimbursed by clients are included intotal revenues, and then deducted to determine revenues before reimbursements (“netrevenues”).  For purposes of analysis,all percentages in this discussion are stated as a percentage of net revenues,since we believe that this is the more relevant measure of our business.

 

Cost of services primarily consists of the salaries, bonuses, andrelated benefits of client-serving consultants and outsourcing associates, andsubcontractor expenses.  Selling expensesprimarily consist of the salaries, benefits, travel, and other costs of oursales force, as well as marketing and market research expenses.  General and administrative expenses primarilyconsist of the costs attributable to the support of our client-servingprofessionals such as non-billable travel, office space occupancy, informationsystems and infrastructure, salaries and expenses for executive management,financial accounting and administrative personnel, expenses for firm andbusiness unit governance meetings, recruiting fees, professional developmentand training, and legal and other professional services.  As associate related costs are relativelyfixed in the short term, variations in our revenues and operating results inour CSI

 

17

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business can occur as a resultof variations in billing margins and utilization rates of our billableassociates.

 

Our mostsignificant expenses are our human resource and related salary and benefitexpenses.  As of April 1, 2005,approximately 1,282 of our 2,434 employees are billable consultants.  Another 800 employees are part of ouroutsourcing business.  The salaries andbenefits of such billable consultants and outsourcing related employees arerecognized in our cost of services.  Mostnon-billable employee salaries and benefits are recognized as a component ofeither selling or general and administrative expenses.  Approximately 14% of our workforce, or 352employees, are classified as non-billable. Our cost of services as a percentage of revenues is directly related toseveral factors, including, but not limited to:

 

•      Ourconsultant 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

•      Theestimated cost to complete our non-outsourcing fixed price contracts.

 

In ouroutsourcing contracts, a significant portion of our revenues are fixed andallocated over the contract on a straight-line basis, as we are required toprovide a specified level of services subject to certain performancemeasurements.  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 CSI business, we manage consultant utilization by monitoringassignment requirements and timetables, available and required skills, andavailable consultant hours per week and per month.   Differences in personnel utilization ratescan result from variations in the amount of non-billed time, which hashistorically consisted of training time, vacation time, time lost to illnessand inclement weather, and unassigned time. Non-billed time also includes time devoted to other necessary andproductive activities such as sales support and interviewing prospectiveemployees.  Unassigned time results fromdifferences in the timing of the completion of an existing assignment and thebeginning of a new assignment.  In orderto reduce and limit unassigned time, we actively manage personnel utilizationby monitoring and projecting estimated engagement start and completion datesand matching consultant availability with current and projected clientrequirements.  The number of consultantsstaffed on an assignment will vary according to the size, complexity, duration,and demands of the assignment.  Assignment terminations, completions,inclement weather, and scheduling delays may result in periods in whichconsultants are not optimally utilized. An unanticipated termination of a significant assignment or an overalllengthening of the sales cycle could result in a higher than expected number ofunassigned consultants and could cause us to experience lower margins.  In addition, entry into new market areas andthe hiring of consultants in advance of client assignments have resulted andmay continue to result in periods of lower consultant utilization.

 

In response to competition and continued pricing and rate pressures, wehave implemented a global sourcing strategy into our business operations, whichincludes the deployment of offshore resources as well as resources that performservices remote from the client site.  Wealso incorporate larger numbers of variable cost or per diem staff in some ofour projects.  We expect these strategiesto result in improved 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

 

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impact with improvedcompetitive positioning in our markets, which could result in an increasednumber of engagements to offset the potential revenue impact.  Several of our competitors employ both globalsourcing and variable staffing strategies to provide software development andother information technology services to their clients, while at the same timereducing their cost structure and improving the quality of services theyprovide.  If we are unable to realize theperceived cost benefits of our recently implemented strategies or if we areunable to receive high quality services from foreign employees, variable staffemployees or subcontractors, our business may be adversely impacted and we maynot be able to compete effectively.

 

**Resultsof Operations for the Three Months Ended April 1, 2005 and March 26,2004**

 

*Revenues. *Our net revenues increased to $68.1 millionfor the quarter ended April 1, 2005, an increase of 4.3% from $65.4million for the quarter ended March 26, 2004.  Our total revenues increased to $71.8 millionfor the quarter ended April 1, 2005, an increase of 3.6% from $69.3 millionfor the quarter ended March 26, 2004. The increases were in HealthDelivery Outsourcing and Government and Technology Services, offset bydecreases in Health Delivery Services, Health Plan and Life Sciences. TheHealth Delivery Outsourcing segment had the most significant increase, $3.6million or 13.4%, partly due to the award of a new outsourcing engagement inlate 2004. The most significant offsetting decrease was in Health DeliveryServices, which declined by $1.3 million or 7.6%, due to delays in closing newcontracts involving the adoption of our blended shore delivery model in theHealth Delivery Services segment. Overall, we anticipate that our revenues in the near future will growmoderately from those of the first quarter of 2005, exclusive of the potentialfor growth in the outsourcing market.  Inoutsourcing, we are pursuing several opportunities which, if we are successful,could significantly increase our revenues later in fiscal year 2005 or in futureyears although there can be no assurances in that regard.  Additionally, we have several existingoutsourcing contracts up for renewal over the next 12 to 24 months, which wemust successfully retain in order to avoid an offsetting decline in our revenues.

 

* Cost of Services. *Cost of services before reimbursable expenses increased to $48.3million for the quarter ended April 1, 2005, an increase of 8.4% from$44.5 million for the quarter ended March 26, 2004.  The increase was primarily due to $3.0million of additional costs in the Health Delivery Outsourcing segment toservice the increased revenues noted above. Additionally, we increased costs in Health Delivery Services over thepast year to support what had been a growing level of revenues prior to anunexpected decline in the first quarter of fiscal year 2005.  We also increased Health Plan costs as aninvestment in developing new business offerings in both information technologyand business process outsourcing.

 

*GrossProfit. *Gross profit decreased to$19.9 million, or 29.2% of net revenues, for the quarter ended April 1,2005, a decrease of 4.5% from $20.8 million, or 31.9% of net revenues, for thequarter ended March 26, 2004.  Thedecrease was primarily due to a reduction in the Health Delivery Servicessegment gross profit, falling from 44.1% in the first quarter of 2004 to 32.7%in the first quarter of 2005.  Thisdecrease was due to the unexpected decline in revenue in the first quarter offiscal year 2005, while cost of services had increased over the past year inline with what had previously been growing revenues in that segment. Inaddition, the gross profits of Health Delivery Outsourcing, approximately 16.9%during the first quarter of 2005, is generally lower on a percentage basis thangross profits in our other business segments. While gross profit in this segment has remained steady year over year,the growth we have experienced in our Health Delivery Outsourcing segment hasresulted in an overall lower gross profit percentage due to the lower grossprofit nature of outsourcing business. Given our current mix of outsourcing and non-outsourcing revenues, ouroverall gross profit percentage is not expected to change significantly in thenear future.  However, we expectoutsourcing to contribute an increasing proportion of our total revenues, whichwe expect will result in our gross profit percentage decliningincrementally.  In addition, a suddendownturn in demand in one or more of our segments or an inability to controlcosts on our fixed price projects could negatively affect our gross profitpercentage.

 

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Wehave recently extended our agreement with a major outsourcing client.  This was originally a 5-year agreement,with just over two years remaining, and was extended for an additional threeyears to expire on June 30, 2010. As part of the extension, the client has advised us to replace a majorinfrastructure subcontractor.  Therelated subcontract specifies that we are required to pay the subcontractor atermination fee of up to $900,000. Depending on the timing and outcome of contract negotiations, we may berequired to pay such fee and charge some or all of it to expense, withoutoffsetting revenue, in the quarter ending July 1, 2005.  We would expect to earn higher margins overthe remainder of the contract as a result, however, by reducing our cost ofservices.

 

*Selling Expenses. *Selling expenses decreased to $6.8 millionfor the quarter ended April 1, 2005, a decrease of 6.8% from $7.2 millionfor the quarter ended March 26, 2004. This decrease was primarily due to a reduction in our sales force,primarily in the Life Sciences segment. Selling expenses as a percentage of net revenues decreased to 9.9% forthe quarter ended April 1, 2005 from 11.1% for the quarter ended March 26,2004.

 

*General and Administrative Expenses. *General andadministrative expenses increased to $14.7 million for the quarter ended April 1,2005, an increase of 24.2% from $11.9 million for the quarter ended March 26,2004.  Almost the entire increase was dueto non-salary costs.  The mostsignificant increase was in infrastructure costs of approximately $1.1 millionrelated to facilities and equipment needed to directly support our growingoutsourcing business.  Further, weincurred approximately $500,000 more in travel costs during the first quarterof fiscal year 2005 than in the first quarter of 2004.  Finally, we experienced higher costs in anumber of other areas including severance, rent in our growing offshore sharedservice centers, and outside professional services such as audit, legal, andconsulting costs.  Generaland administrative expenses as a percentage of net revenues increased to 21.6%for the quarter ended April 1, 2005 from 18.2% for the quarter ended March 26,2004.  After having experienced somesignificant growth quarter-to-quarter over the past year for the items notedabove, we expect the ongoing level of general and administrative expenses to beconsistent with their current level in the near future.

 

*Interest Income, Net.** ***Interest income, net of interest expense,remained constant at $0.2 million for the quarters ended April 1, 2005 andMarch 26, 2004, respectively. Interest income net of interest expense as a percentage of net revenuesremained at 0.3% for the quarters ended April 1, 2005 and March 26,2004, respectively.

 

*Other Expense, Net*.  Other expense was negligiblefor the quarters ended April 1, 2005 and March 26, 2004,respectively.

 

*Expensefor Premium on Repurchase of Stock*.  In the first quarter of 2004, we repurchased1.96 million shares of our stock and certain options from a major stockholderat a premium to the then current market price (see Note 11 of Notes toConsolidated Financial Statements).  Theaggregate purchase price for the shares and the options represented a premiumof approximately 11% to market.  As aresult, we recorded a pretax charge of approximately $1.6 million (without anytax benefit) for such premium included in the purchase consideration.

 

*Income Taxes. *We recorded a $0.6 million tax benefit forthe quarter ended April 1, 2005 versus a $0.8 million tax provision forthe quarter ended March 26, 2004. The 46% tax benefit in the quarter ended April 1, 2005 is based onan anticipated profit for fiscal year 2005 as a whole, which management expectswill incur a tax provision at the 46% rate. The provision for income taxes for the quarter ended March 26, 2004was $0.8 million despite the existence of a pretax loss, due to thenondeductibility of the premium on the repurchase of stock described above.

 

*Loss on Discontinued Operations*.  Thedisposition of our Coactive Call Center Service line has been accounted for asa discontinued operation.  During thequarter ended April 1, 2005, we incurred

 

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$866,000 of costs related to the operationand wind-down of the business.  Thesecosts, net of a 38% tax benefit, resulted in a net loss of $537,000, comparedto a net loss from the operations of this discontinued operation of $127,000 inthe first quarter of 2004.

 

**Liquidityand Capital Resources**

 

During the three months ended April 1, 2005, we used cash flow foroperations of $1.8 million to fund our operating losses and $2.5 million torepurchase shares of our common stock from the previous owners of FCGInfrastructure Services, Inc. (formerly Codigent Solutions Group, Inc.).  Further, we used approximately $1.6 millionof cash to purchase property and equipment, primarily information technologyand related equipment.  Combined billedand unbilled accounts receivables increased by $1.3 million as days salesoutstanding increased from 37 days at the end of the fourth quarter of 2004 to41 days at the end of the first quarter of 2005.  At April 1, 2005, we had cash and investmentsavailable for sale of $34.4 million compared to $40.3 million at December 31,2004.

 

On February27, 2004, we repurchased all outstanding shares and certain stock options froma major stockholder (see Note 11 of Notes to Consolidated FinancialStatements).  The aggregate purchaseprice for the shares and options was $14.8 million in cash, and cancellation ofa note owed to us by the stockholder in the amount of $0.3 million.  In addition, in the event we were to announceor consummate a change in control transaction prior to the first anniversary ofthis transaction, or if we were to enter into negotiations regarding a changein control transaction prior to the first anniversary and subsequently announcepublicly a definitive agreement for or consummate a change in control transactionwithin the 18 months following the closing of this repurchase transaction, wewould pay to this former stockholder, upon the closing of such change incontrol, an amount equal to the difference between $7.50 per share and thechange in control transaction price per share, if such change in control priceper share amount was higher.

 

On October 1, 2003, we entered into an unsecured loan agreementwith White Plains Hospital Center requiring us to provide interest freefinancing of up to $4.08 million if our system implementation at the hospitalresults in an increase in the hospital’s accounts receivable balance or daysoutstanding during a 150-day period following the completion of the systemimplementation.  Any amounts borrowedduring this 150-day period are payable 90 days after the borrowingdate.  There was no outstanding balanceunder this unsecured loan agreement at April 1, 2005.  We do not currently expect to make any loansunder this agreement, however, this could require temporary use of cash duringfiscal year 2005.  Since our loans wouldbe unsecured, we cannot guarantee that the hospital will repay our loans on atimely basis, if at all.  If our loansare not repaid or repaid in a timely manner, our financial condition would beimpacted negatively.

 

We have a revolving line of credit, under which we are allowed toborrow up to $7.0 million at an interest rate of the prevailing prime rate withan expiration of May 1, 2006.  Therewas no outstanding balance under the line of credit at April 1, 2005.

 

As of April 1,2005, the following table summarizes our contractual and other commitments (inthousands):

 
| ** **                         | ** ** | **Payments Due by Period** | ** ** |
|------------------------------------|------------|----------------------------|------------|
| **Contractual Obligations**        | ** ** | **Less than 1  Year**      | ** ** | **1 -3  Years** | ** ** | **3-5  Years** | ** ** | **Total** | ** ** |
| Operating leases, net of subleases |       | $                          | 4,727      |   | $ | 8,159 |   | $ | 1,382 |   | $ | 14,268 |   |
| Purchase obligations               |       | 310                        |       | — |   | — |   | 310 |   |
| Total                              |       | $                          | 5,037      |   | $ | 8,159 |   | $ | 1,382 |   | $ | 14,578 |   |

 

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Management believes that our existing cash and investments, togetherwith funds generated from operations, will be sufficient to meet operatingrequirements for at least the next twelve months.  Our cash and investments are available forcapital expenditures (which are projected to be approximately $8.0 million for2005), strategic investments, mergers and acquisitions, and other potentiallarge-scale cash needs that may arise.

 

**Critical Accounting Policies and Estimates**

 

The foregoing discussion and analysis of ourfinancial condition and results of operations is based upon our consolidatedfinancial statements, which have been prepared in accordance with accountingprinciples generally accepted in the United States.  The preparation of these financial statementsrequires us to make estimates and assumptions that affect the reported amountsof assets, liabilities, revenues and expenses, and related disclosure ofcontingent assets and liabilities.  On anon-going basis, we evaluate our estimates, including those related to revenuerecognition, cost to complete client engagements, valuation of goodwill andlong-lived and intangible assets, accrued liabilities, income taxes,restructuring costs, idle facilities, litigation and disputes, and theallowance for doubtful accounts.  We baseour estimates on historical experience and on various other assumptions that webelieve to be reasonable under the circumstances, the results of which form thebasis for making judgments about the carrying value of assets and liabilitiesthat are not readily apparent from other sources.  Our actual results may differ from ourestimates and we do not assume any obligation to update any forward-lookinginformation.

 

We believe the following critical accountingpolicies reflect our more significant assumptions and estimates used in thepreparation of our consolidated financial statements.

 

***Revenue Recognition andUnbilled Receivables***

 

Revenues are derived primarily frominformation technology outsourcing services, consulting, and systemsintegration.  Revenues are recognized ona time-and-materials, level-of-effort, percentage-of-completion, orstraight-line basis.  Before revenues arerecognized, the following four criteria must be met: (a) persuasive evidence ofan arrangement exists; (b) delivery has occurred or services rendered; (c) thefee is fixed and determinable; and (d) collectibility is reasonablyassured.  We determine if the fee isfixed and determinable and collectibility is reasonably assured based on ourjudgments regarding the nature of the fee charged for services rendered andproducts delivered.  Arrangements rangein length from less than one year to seven years.  The longer-term arrangements are generallylevel-of-effort or fixed price arrangements.

 

Revenues from time-and-materials arrangementsare generally recognized based upon contracted hourly billing rates as the workprogresses.  Revenues fromlevel-of-effort arrangements are recognized based upon a fixed price for thelevel of resources provided.  Revenuesfrom fixed fee arrangements for consulting and systems integration work aregenerally recognized on a rate per hour or percentage-of-completion basis.  We maintain, for each of our fixed feecontracts, estimates of total revenue and cost over the contract term. Forpurposes of periodic financial reporting on the fixed price consulting andsystem integration contracts, we accumulate total actual costs incurred to dateunder the contract. The ratio of those actual costs to our then-currentestimate of total costs for the life of the contract is then applied to ourthen-current estimate of total revenues for the life of the contract todetermine the portion of total estimated revenues that should berecognized.  We follow this methodbecause reasonably dependable estimates of the revenues and costs applicable tovarious stages of a contract can be made.

 

Revenues recognized on fixed price consultingand system integration contracts are subject to revisions as the contractprogresses to completion.  If we do notaccurately estimate the resources required or the scope of the work to beperformed, do not complete our projects within the planned periods of time,

 

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or do not satisfy our obligations under the contracts, then profit maybe significantly and negatively affected. Revisions in our contract estimates are reflected in the period in whichthe determination is made that facts and circumstances dictate a change ofestimate. Favorable changes in estimates result in additional revenuesrecognized, and unfavorable changes in estimates result in a reduction ofrecognized revenues. Provisions for estimated losses on individual contractsare made in the period in which the loss first becomes known.  Some contracts include incentives forachieving either schedule targets, cost targets, or other definedgoals.  Revenues from incentive typearrangements are recognized when it is probable they will be earned.

 

We account for certain of our outsourcingcontracts using EITF 00-21, “Accounting for Revenue Arrangements with MultipleDeliverables,” which addresses how to account for arrangements that involve thedelivery or performance of multiple products, services, and/or rights to useassets.  Revenue arrangements with multipledeliverables are divided into separate units of accounting if the deliverablesin the arrangement meet the following criteria: (1) the delivered item hasvalue to the customer on a standalone basis; (2) there is objective andreliable evidence of the fair value of undelivered items; and (3) deliveryof any undelivered item is probable. Arrangement consideration is allocated among the separate units ofaccounting based on their relative fair values, with the amount allocated tothe delivered item being limited to the amount that is not contingent on thedelivery of additional items or meeting other 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 less revenue due to reduced transaction volumes orpenalties 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 April 1, 2005, we had deferred $1.3million of unamortized deferred costs.

 

As part of our on-going operations to provideservices to our customers, incidental expenses, which are generallyreimbursable under the terms of the contracts, are billed to customers. Theseexpenses are recorded as both revenues and direct cost of services inaccordance 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 license and maintenance revenuescomprised approximately 3% of our net revenues in the first quarter of2005.  Additionally, we realizedsubstantial additional revenue from the implementation of our software.  We recognize software revenues in accordancewith the provisions of the American Institute of Certified Public AccountantsStatement of Position (“SOP”) 97-2, “Software Revenue Recognition”, as amendedby SOP 98-4, “Deferral of the Effective Date of a Provision of SOP 97-2,Software Revenue Recognition” and SOP 98-9, “Modification of SOP 97-2, SoftwareRevenue Recognition, With Respect to Certain Transactions”, and in accordancewith the Securities and Exchange Commission Staff Accounting Bulletin (SAB)No. 104, “Revenue Recognition”. We license software under non-cancelablelicense agreements and provide related professional services, includingconsulting, training, and implementation services, as well as ongoing customersupport and maintenance.  Most of oursoftware license fee revenues are from arrangements which includeimplementation services that are

 

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essential to the functionality of our software products, and arerecognized using contract accounting, including the percentage-of-completionmethodology, over the period of the implementation.

 

In those more limited cases where oursoftware arrangements do not include services essential to the functionality ofthe product, license fee revenues are recognized when the software product hasbeen shipped, provided a non-cancelable license agreement has been signed,there are no uncertainties surrounding product acceptance, the fees are fixedor determinable and collection of the related receivable is consideredprobable. We do not generally offer rights of return or acceptance clauses to ourcustomers. In situations where we do provide rights of return or acceptanceclauses, revenue is deferred until the clause expires. Typically, our softwarelicense fees are due within a twelve-month period from the date of shipment. Ifthe fee due from the customer is not fixed or determinable, including paymentterms greater than twelve months from shipment, revenue is recognized aspayments become due and all other conditions for revenue recognition have beensatisfied. In software arrangements that include rights to multiple softwareproducts, specified upgrades, maintenance or services, we allocate the totalarrangement fee among the deliverables using the fair value of each of thedeliverables determined using vendor-specific objective evidence. Vendor-specificobjective evidence of fair value is determined using the price charged whenthat element is sold separately. In software arrangements in which we have fairvalue of all undelivered elements but not of a delivered element, we use theresidual method to record revenue. Under the residual method, the fair value ofthe undelivered elements is deferred and the remaining portion of thearrangement fee is allocated to the delivered element(s) and is recognized asrevenue. In software arrangements in which we do not have vendor-specificobjective evidence of fair value of all undelivered elements, revenue isdeferred until fair value is determined or all elements have been delivered.

 

Revenues from training and consultingservices are recognized as services are provided to customers. Revenues frommaintenance contracts are deferred and recognized ratably over the term of themaintenance agreements. Revenues for customer support and maintenance that arebundled with the initial license fee are deferred based on the fair value ofthe bundled support services and recognized ratably over the term of theagreement; fair value is based on the renewal rate for continued supportarrangements.

 

Unbilled receivables represent revenuesrecognized for services performed that were not billed at the balance sheetdate.  The majority of these amounts arebilled in the subsequent month. Unbillable amounts arising from contracts occurwhen revenues recognized exceed allowable billings in accordance with thecontractual agreements.  Such unbillableamounts most often become billable upon reaching certain project milestonesstipulated per the contract, or in accordance with the percentage completionmethodology.  As of April 1, 2005,we had unbillable revenues included in current unbilled receivables ofapproximately $5.3 million, which were generally expected to be billed withinone year.  In addition, we had along-term account receivable at April 1, 2005, and December 31, 2004of $3.4 million and $3.8 million, respectively, on a single major outsourcingcontract with a term of seven years.  Thelong-term receivable will be billed and collected over the remaining two yearsof the contract through contractual billings that will exceed the amounts to beearned as revenues.

 

Customer advances are comprised of payments from customers for whichservices have not yet been performed or prepayments against work in process.These unearned revenues are deferred and recognized as future contract costsare incurred and as contract services are rendered.

 

***Allowance for Doubtful 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

 

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trends, andchanges in client payment patterns.  Ifthe financial condition of our clients was to deteriorate, resulting in animpairment of their ability to make payments, additional allowances would berequired.

 

***Deferred IncomeTaxes***

 

Weaccount for income taxes in accordance with SFAS No. 109, “Accounting forIncome Taxes,” which requires recognition of deferred tax assets andliabilities for the expected future tax consequences of events that have beenincluded in the financial statements which differ from our tax returns.  We use significant estimates in determiningwhat portion of our deferred tax asset is more likely than not to berealized.  Our net deferred tax assetshave historically consisted primarily of the tax benefit related torestructuring costs for facility closures, supplemental executive retirementplan contributions, and other accrued liabilities such as accrued vacation pay,which are not deductible for tax purposes until paid.  During fiscal year 2003, we generatedadditional deferred tax assets for net operating loss carryforwards which werecreated by our pretax losses combined with the fact that we were outside theperiod it is allowable to carry back losses. Taking into account our then-recent history of cumulative losses, werecorded a valuation allowance of $5.5 million in the fourth quarter of fiscalyear 2003.  Together with a full valuationallowance of $5.5 million we had already taken against the net operating losscarryforwards of companies we had previously acquired, we had a valuationallowance of $11.0 million against a total deferred tax asset of $21.6 million.

 

During the fourth quarter of fiscal year 2004, were-evaluated our requirement for a valuation allowance after having completed afull year in which we recorded taxable income in each quarter.  At that time, we determined that it was morelikely than not we would realize an additional $3.0 million of our deferred taxassets, of which $11.1 million were left unreserved.  During the first quarter of 2005, we incurreda pretax loss from continuing operations of $1.4 million.  Based on management’s belief that this lossis due to unanticipated short-term issues, and is not indicative of a change inexpected overall trends in our business over the next several years, noadjustment was made to the valuation allowance in the first quarter of2005.  However, there is no guaranteethat our taxable income will be sufficient to realize such remaining netdeferred tax assets, and we will continue to evaluate the appropriateness foran additional valuation allowance on an ongoing basis, particularly in light ofthe results in the first quarter of fiscal year 2005.  Additionally, if at some point in the future,the realization of a greater amount of our deferred tax assets is consideredmore likely than not, we will reverse all or a portion of the existingvaluation allowance at that time.

 

***Goodwill andIntangible Assets***

 

Under SFAS No 142, we no longer amortize ourgoodwill and are required to complete an annual impairment testing during thefourth quarter of each year.  We believethat the accounting assumptions and estimates related to the annual goodwillimpairment testing are critical because these can change from period toperiod.  The impairment test requires usto forecast our future cash flows, which involves significant judgment.  Accordingly, if our expectations of futureoperating results change, or if there are changes to other assumptions, ourestimate of the fair value of our reporting units could change significantlyresulting in a goodwill impairment charge, which could have a significantimpact on our consolidated financial statements.  As of April 1, 2005, we have $18.2million of goodwill and $2.1 million of intangible assets recorded on ourbalance sheet (see Note 5 of the Notes to Consolidated Financial Statements).

 

***Recent AccountingPronouncements***

 

In December 2004, the FinancialAccounting Standards Board (“FASB”) enacted Statement of Financial AccountingStandards 123 (revised 2004) (“SFAS 123R”), “Share-Based Payment” which

 

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replaces Statement of Financial Accounting Standards No. 123 (“SFAS 123”),“Accounting for Stock-Based Compensation” and supersedes APB OpinionNo. 25 (“APB 25”), “Accounting for Stock Issued to Employees.” SFAS 123R requires the measurement of all share-based payments toemployees, including grants of employee stock options, using a fair-value-basedmethod and the recording of such expense in the consolidated statements ofincome. The accounting provisions of SFAS 123R were originally planned to be effective forall quarterly reporting periods beginning after June 15, 2005.  In April 2005, the Securities andExchange Commission adopted a revision to SFAS 123R to make the accountingprovisions applicable to all fiscal year reporting periods commencing after June 15,2005.  As a result, we are now requiredto adopt SFAS 123R commencing in the first quarter of 2006.

 

Upon the adoption of SFAS 123R, the pro formadisclosures previously permitted under SFAS 123 no longer will be analternative to financial statement recognition. Although we have not yet determinedour method of adoption or whether the adoption of SFAS 123R willresult in amounts that are similar to the current pro forma disclosures underSFAS 123, we are evaluating the requirements under SFAS 123R andwe expect that the adoption will have an adverse impact on our reportedearnings and net income per share.

 

**Risks Relating to Our Business**

 

Before deciding to invest in us or tomaintain or increase your investment, you should carefully consider the risksdescribed below, in addition to the other information contained in thisreport.  The risks and uncertaintiesdescribed below are not the only ones facing our company.  Additional risks and uncertainties notpresently known to us or that we currently deem immaterial may also affect ourbusiness operations.  If any of theserisks are realized, our business, financial condition or results of operationscould be seriously harmed.  In thatevent, the market price for our common stock could decline and you may lose allor part of your investment.

 

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

 

Our net revenues, operating results, and cashflows may fluctuate significantly because of a number of factors, many of whichare outside of our control.  Thesefactors may include:

 

•      Our ability toachieve and maintain profitability in each of our business segments;

•      The loss of oneor more significant clients in any of our business segments, including anyfailure to secure renewals for any of our large outsourcing contracts;

•      Use of offsiteand offshore resources on our engagements;

•      The roll-off orcompletion of significant projects in any of our business segments;

•      Fluctuations inmarket demand for our services which affect associate hiring and utilization;

•      Our ability torealize our deferred tax assets through future pretax earnings;

•      Delays orincreased expenses in securing and completing client engagements;

•      Timing andcollection of fees and payments;

•      Timing of newclient engagements in any of our business segments;

•      Increasedcompetition and pricing pressures;

•      Our ability toanticipate changing customer demands and preferences;

•      Our ability toincorporate the use of variable labor staffing into our projects;

•      The loss of keypersonnel and other employees;

•      Changes in our,and our competitors’, business strategy, pricing and billing policies;

•      The timing ofcertain general and administrative expenses;

•      Costsassociated with integrating acquired operations;

 

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•      Costsassociated with the disposition of certain assets and the winding down of ourcall center service business;

•      Impairment ofgoodwill from our acquisitions;

•      Variability inthe number of billable days in each quarter;

•      The write-offof client billings;

•      Return of feesfor work deemed unsatisfactory by a client or claims or litigation resultingfrom the same;

•      Service levelcredits and penalties associated with our outsourcing engagements;

•      Entry intofixed price engagements and engagements where some fees are contingent upon theclient realizing a certain return on investment for a project;

•      Availability offoreign net operating losses and other credits against our earnings;

•      Internationalcurrency fluctuations;

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

•      The fixednature of a substantial portion of our expenses, particularly personnel andrelated costs, depreciation, office rent, and occupancy costs.

 

One or more of the foregoing factors maycause our operating expenses to be unexpectedly high or result in a decrease inour revenue 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 couldmaterially adversely affect our business, financial condition, and results ofoperations.  Our business also hassignificant collection risks.  If we areunable to collect our receivables in a timely manner, our business andfinancial condition could also suffer. If these or any other variables or unknowns were to cause a shortfall inrevenues or earnings or otherwise cause a failure to meet public marketexpectations, our business could be adversely affected.

 

We adopted EITF 00-21 in the first quarter of2003, which affects the way we recognize revenue on long-term outsourcingagreements. The adoption of EITF 00-21 results in separating our outsourcingcontracts into multiple elements and separately accounting for each element,rather than accounting for all elements together as a group.  As a result, we now recognize revenue from certainservice elements of our outsourcing agreements on a straight-line basis overthe life of the contract, rather than on a percentage of completion basis.  Since we typically incur greater costs andexpenses during the early phase of the service elements (which now havestraight-line revenue recognition) than we do in the later years of thoseelements, we believe our net income is lower during the early stages of ouroutsourcing engagements.  In addition, ifwe are unable to manage costs as planned in the later stages of an outsourcingengagement, our net income will likewise be negatively impacted.  In general, income from our outsourcingcontracts will be less stable in the future, since it will be more susceptibleto changes in the mix of newer versus older contracts, and to the impact of costfluctuations from quarter to quarter without a compensating change inrevenue.  If we fail to meet our publicmarket expectations or otherwise experience a shortfall in our net income dueto these fluctuations, our business could be adversely affected and the priceof our stock may decline.

 

Finally, we reported a net loss for the firstquarter of 2005.  As a result, we cannotassure you that we will achieve or maintain positive earnings in thefuture.  If we are unable to achieveprofitability on a quarterly or annual basis, the market price of our commonstock could be adversely affected and our financial condition would suffer.

 

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

 

Net revenues from our outsourcing relationships,for the quarter ended April 1, 2005, represented approximately 45.1% ofour consolidated net revenues.  Thesubstantial majority of these revenues are

 

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received from four largeoutsourcing accounts that have signed long-term agreements with us.  However, the loss of any of our outsourcingrelationships, including a failure to gain renewal of any of these contracts(several of which are due to expire in the next 12 to 24 months), could have anadverse impact on our business and results of operations.  In each of these engagements, the clientshave fully outsourced their information technology staff and functions tous.  In all of our outsourcingrelationships, we generally enter into detailed service level agreements, whichestablish performance levels and standards for our services.  If we fail to meet these performance levelsor standards, our clients may receive monetary service level credits from usor, if we experience persistent failures, our clients may have a right toterminate the outsourcing contract for cause and have no obligation to pay usany termination fees.  Our anticipatedrevenues and profitability from our outsourcing engagements could besignificantly reduced if we are unable to satisfy our performance levels orstandards, or if we are unable to improve our delivery costs as planned on suchengagements.  Additionally, ouroutsourcing contracts can be terminated at the convenience of our clients uponthe payment of a termination fee.

 

In addition, many of our outsourcingagreements require that we invest significant amounts of time and resources inorder to win the engagement, transition the client’s information technologydepartment to our management, and complete the initial transformation of ourclient’s information technology functioning to provide improved service at alower cost and meet agreed-upon service levels. Often, we recover this investment through payments over the life of theoutsourcing agreement.  If we are unableto achieve agreed-upon service levels or otherwise breach the terms of ouroutsourcing agreements, the clients may have rights to terminate our agreementsfor cause and we may be unable to recover our investments.  Any failure by us to recover these investmentscould reduce our outsourcing revenue, which would have a material adverseeffect on our financial condition, results of operations, and price of ourcommon stock.

 

Our outsourcing engagements may also requirethat we hire part or all of a client’s information technology personnel.  We cannot assure you that we will be able toretain these individuals, and effectively hire additional personnel as neededto meet the obligations of our contract. Any failure by us to retain these individuals or otherwise satisfy ourcontractual obligations could have a material adverse effect on theprofitability of our outsourcing business and our reputation as an informationtechnology services outsourcing provider.

 

Finally, we are expanding our outsourcingbusiness to perform discrete information technology services for clients.  The amount of time and resources required towin client engagements for our outsourcing business is significant, and we maynot win the number or type of client engagements that we anticipate.  If we fail to meet our objective to securenew outsourcing engagements, or fail to secure new outsourcing engagements onacceptable commercial terms, we will not experience the growth in this businessthat we have anticipated.

 

*The length of time required to engage aclient and to complete an assignment may be unpredictable and could negativelyimpact our net revenues and operating results.*

 

The timing of securing our client engagementsand service fulfillment is difficult to predict with any degree ofaccuracy.  Prior engagement cycles arenot necessarily an indication of the timing of future client engagements orrevenues.  The length of time required tosecure a new client engagement or complete an assignment often depends onfactors outside our control, including:

 

•      Existinginformation systems at the client site;

•      Changes or theanticipation of changes in the regulatory environment affecting healthcare andpharmaceutical organizations;

•      Changes in themanagement or ownership of the client;

•      Budgetarycycles and constraints;

 

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•      Changes in theanticipated scope of engagements;

•      Availability ofpersonnel and other resources; and

•      Consolidationin the healthcare and pharmaceutical industries.

 

Prior to client engagements, we typicallyspend a substantial amount of time and resources (1) identifying strategic orbusiness issues facing the client, (2) defining engagement objectives, (3)gathering information, (4) preparing proposals, and (5) negotiatingcontracts.  Our failure to procure anengagement after spending such time and resources could materially adverselyaffect our business, financial condition, and results of operations.  We may also be required to hire newassociates before securing a client engagement. If clients defer committing to new assignments for any length of time orfor any reason we could be required to maintain a significant number ofunder-utilized associates which could adversely affect our operating resultsand financial condition during any given period.  Further, our outsourcing business has verylong sales and contract lead times, requiring us to spend a substantial amountof time and resources in attempting to secure each outsourcing engagement.  We cannot predict whether the investment oftime and resources will result in a new outsourcing engagement or, if theengagement is secured, that the engagement will be on terms favorable to us.

 

*We may be negatively impacted if ourinvestments in products and emerging service lines are unsuccessful.*

 

We have publicly announced our strategy toincrease our investment in product development, including further investment inFirstDoc® as well as investment in FirstGatewaysTM.  These investments are in addition tocontinuing our investments in other emerging service lines and products.  We typically do not capitalize the cost ofour product development activities and do not anticipate capitalizing expectedinvestments this year.  As a result, ourfinancial results may be adversely impacted by such increased investment in theshort term.  If such product developmentactivities or investment in our emerging service lines do not result inrelevant offerings, we will not achieve desired levels of return on theseinvestments.  As a result, our businessand results of operations could be adversely affected.

 

*If we are unable to generate additionalrevenue from our existing clients, our business may be negatively affected.*

 

Our success depends, to a significant extent,on obtaining additional engagements from our existing clients.  A substantial portion of our revenues isderived from additional services provided to our existing clients.  The loss of a small number of clients, areduction in the number of engagements with these clients, or the failure tosecure renewals from any of our outsourcing clients may result in a materialdecline in revenues and cause us to fail to meet public market expectations ofour financial performance and operating results.  If we fail to generate additional revenuesfrom our existing clients, it may materially adversely affect our business,financial condition, and results of operations.

 

*If we fail to meet client expectations in theperformance of our services, our business could suffer.*

 

Our services often involve assessing and/orimplementing complex information systems and software, which are critical toour clients’ operations.  Our failure tomeet client expectations in the performance of our services, including thequality, cost and timeliness of our services, may damage our reputation in thehealthcare and pharmaceutical industries and adversely affect our ability toattract and retain clients.  If a clientis not satisfied with our services, we will generally spend additional humanand other resources at our own expense to ensure client satisfaction.  Such expenditures will typically result in alower margin on such engagements and could materially adversely affect ourbusiness, financial condition, and results of operations.

 

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Further, in the course of providing ourservices, we will often recommend the use of software and hardwareproducts.  These products may not performas expected or contain defects.  If thisoccurs, our reputation could be damaged and we could be subject toliability.  We attempt contractually tolimit our exposure to potential liability claims; however, such limitations maynot be effective.  A successful liabilityclaim brought against us may adversely affect our reputation in the healthcareand pharmaceutical industries and could have a material adverse effect on ourbusiness, financial condition, and results of operations.  Although we maintain professional liabilityinsurance, such insurance may not provide adequate coverage for successfulclaims against us.

 

*We may be unable to attract and retain asufficient number of qualified employees.*

 

Our business is labor-intensive and requireshighly skilled employees.  Many of ourassociates possess extensive expertise in the healthcare, insurance,pharmaceutical, information technology and consulting fields.  To serve a growing client base, we mustcontinue to recruit and retain qualified personnel with expertise in each ofthese areas.  We must also seek certainemployees that are willing to work on a variable or per diem basis.  Competition for such personnel is intense andwe compete for such personnel with management consulting firms, healthcare andpharmaceutical organizations, software firms, and other businesses.  Many of these entities have substantiallygreater financial and other resources than we do, or can offer more attractivecompensation packages to candidates, including salary, bonuses, stock, andstock options.  If we are unable torecruit and retain a sufficient number of qualified personnel to serve existingand new clients, our ability to expand our client base or services and to offerour services at competitive rates could be impaired and our business wouldsuffer.

 

*The loss of our key client service employeesand executive officers could negatively affect us.*

 

Our performance depends on the continuedservice of our executive officers, senior managers, and key employees.  In particular, we depend on such persons tosecure new clients and engagements and to manage our business and affairs.  The loss of such persons could result in thedisruption of our business, longer or delayed sales cycles, and could have amaterial adverse effect on our business and results of operations.  Generally, we have not entered into long-termemployment contracts with any of our employees and do not maintain key employeelife insurance.

 

*We could be negatively impacted if we fail tosuccessfully integrate the businesses we acquire.*

 

We have grown, in part, by acquiringcomplementary businesses that could enhance our capability to serve thehealthcare and pharmaceutical industries. All acquisitions involve risks that could materially and adverselyaffect our business and operating results. These risks include:

 

•      Distractingmanagement from our business;

•      Losing keypersonnel and other employees;

•      Losing clients;

•      Costs, delays,and inefficiencies associated with integrating acquired operations andpersonnel;

•      The impairmentof acquired assets and goodwill;

•      Acquiring thecontingent and other liabilities of the businesses we acquire; and

•      Not realizingthe intended or expected benefits of the acquisitions.

 

In addition, acquired businesses may notenhance our services, provide us with increased client opportunities, or resultin the growth that we anticipate. Furthermore, integrating acquired operations is a complex,time-consuming, and expensive process. Combining acquired operations with us may result in lower overalloperating margins, greater stock price volatility, and quarterly earnings fluctuations.  Cultural incompatibilities, careeruncertainties, and other factors associated with such acquisitions may

 

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also result in the loss of employees and clients.  Failing to acquire and successfully integratecomplementary practices, or failing to achieve the business synergies or otheranticipated benefits, could materially adversely affect our business andresults of operations.

 

In February 2005, we sold substantiallyall of the call center service agreements of Coactive Systems Corporation, acompany we acquired in 2003.  We haveincurred costs to dispose of such assets, and we expect to incur additionalcosts to wind down the call center service operations.  This transaction has also involved significantmanagement time and attention.  If we arenot able to timely and effectively wind down these operations, furthermanagement time and attention will continue to be dedicated to this task, andwe may incur greater wind down costs that we have anticipated.

 

*Continued or increased employee turnovercould negatively affect our business.*

 

We have experienced employee turnover as aresult of:

 

•      Dependence onlateral hiring of associates;

•      Travel demandsimposed on our associates;

•      Loss ofemployees to competitors and clients; and

•      Reductions inforce as certain areas of our business have seen less demand.

 

Continued or increased employee turnovercould materially adversely affect our business, financial condition, andresults of operations.  In addition, manyof our associates develop strong business relationships with our clients.  We depend on these relationships to generateadditional assignments and engagements. The loss of a substantial number of associates could erode our clientbase and decrease our revenues.

 

*If we are unable to manage shifts in marketdemand or growth in our business, our business may be negatively impacted.*

 

Our business has historically grown rapidly,and though our overall revenues have remained flat for the past several years,we have experienced growth and increased demand in certain areas of ourbusiness.  In response to shifts inmarket demand and in an effort to better align our business with our markets,we restructured our organization and hired persons with appropriate skills,including salespersons, and reduced our workforce in practice areasexperiencing less demand.  We have alsohired employees willing to work on a variable or per diem basis in order tobetter manage project costs and general and administrative expense associatedwith underutilized resources.  Thesemarket conditions and restructuring efforts have placed new and increaseddemands on our management personnel.  Ithas also placed significant and increasing demands on our financial, technicaland operational resources, and on our information systems.  If we are unable to manage growth effectivelyor if we experience business disruptions due to shifts in market demand, orgrowth or restructuring, our operating results will suffer.  To manage any future growth, we must extendour financial reporting and information management systems to our multiple andinternational office locations and traveling employees, and develop andimplement new procedures and controls to accommodate new operations, services andclients.  Increasing operational andadministrative demands may make it difficult for our senior managers to engagein business development activities and their other day-to-day responsibilities.  Further, the addition of new employees andoffices to offset any increasing demands may impair our ability to maintain ourservice delivery standards and corporate culture.  In addition, we have in the past changed, andmay in the future change, our organizational structure and businessstrategy.  Such changes may result inoperational inefficiencies and delays in delivering our services.  Such changes could also cause a disruption inour business and could cause a material adverse effect on our financialcondition and results of operations.

 

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*Changes in the healthcare and pharmaceuticalindustries or the economy in general could negatively impact our revenues.*

 

We derive a substantial portion of ourrevenues from clients in the healthcare industry.  As a result, our business, financialcondition, and results of operations are influenced by conditions affectingthis industry, particularly any trends towards consolidation among healthcareand pharmaceutical organizations.  Suchconsolidation may reduce the number of existing and potential clients for ourservices.  In addition, the resultingorganizations could have greater bargaining power, which could erode thecurrent pricing structure for our services and decrease our revenues.  The reduction in the size of our targetmarket or our failure to maintain our pricing goals could have a materialadverse effect on our business, financial condition, and results ofoperations.  Finally, each of the marketswe serve is highly dependent upon the health of the overall economy.  Our clients in each of these markets haveexperienced significant cost increases and pressures in recent years.  Our services are targeted at relieving thesecost pressures; however, any continuation or acceleration of current marketconditions could greatly impact our ability to secure or retain engagements,the loss of which could have a material adverse effect on our business andfinancial condition.

 

A substantial portion of our revenues hasalso come from companies in the pharmaceutical industry.  Our revenues are, in part, linked to thepharmaceutical industry’s research and development and technologyexpenditures.  Should any of thefollowing events occur in the pharmaceutical industry, our business could benegatively affected in a material way:

 

•      Continuedadverse changes to the industry’s general economic environment;

•      Continuedconsolidation of companies; or

•      A decrease inpharmaceutical companies’ research and development or technology expenditures.

 

A trend in the pharmaceutical industry is forcompanies to outsource either large information technology-dependent projectsor their information systems staff.  Webenefit when pharmaceutical companies outsource to us, but may lose significantfuture business when pharmaceutical companies outsource to ourcompetitors.  If this outsourcing trendslows down or stops, or if pharmaceutical companies direct their business awayfrom us, our financial condition and results of operations could be impacted ina materially adverse way.

 

*Our international operations createspecialized risks that can negatively affect us.*

 

We are subject to many risks as a result ofthe services we provide to our international clients or services we may providethrough subcontractors or employees that are located outside of the U.S.  We have business operations and employeeslocated in India, Vietnam, and throughout Europe.  Our international operations are subject to avariety of risks, including:

 

•      Increasing anduncertain labor costs and high turnover rates;

•      Difficulties increating market demand for our offshore services based on perceived qualityissues and potential political risk;

•      Difficulties increating international market demand for our other services;

•      Unfavorablepricing and price competition;

•      Difficulties andcosts of tailoring our services to each individual country’s healthcare andpharmaceutical market needs;

•      Currencyfluctuations;

•      Recruiting andhiring employees, and other employment issues unique to internationaloperations, including ability to secure work visas for foreign employees in theU.S.;

 

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•      Changes inavailability of, and requirements for, the types of work visas we may seek forour foreign employees working in the U.S.;

•      Additional costs,including income tax equalization, associated with foreign employees coming towork in the U.S.;

•      Longer paymentcycles in some countries and difficulties in collecting international accountsreceivable;

•      Terroristattacks;

•      Difficulties inenforcing contractual obligations and intellectual property rights;

•      Adverse taxconsequences;

•      Increased costsassociated with maintaining international marketing efforts and offices;

•      Governmentregulations and restrictions;

•      Adverse changesin regulatory requirements; and

•      Economic orpolitical instability.

 

We perform services in Europe for ourinternational pharmaceutical clients.  Wecannot assure you that we will be able to become profitable in our Europeanoperations, which may materially adversely affect our financial condition,results of operations, and price for our common stock.

 

Our acquisition of Paragon Solutions, Inc. in2003 provided us a means to implement our global sourcing strategy to providesoftware development and other information technology services to ourclients.  If we are unable to realizeperceived cost benefits of such a strategy or if we are unable to receive highquality services from foreign employees or subcontractors, our business may beadversely impacted. Further, our international operations in Vietnam and Indiasubject our business to a variety of risks and uncertainties unique tooperating businesses in these countries, including the risk factors discussedabove.

 

Any one or all of these factors may causeincreased operating costs, lower than anticipated financial performance, andmay materially adversely affect our business, financial condition, and resultsof operations.

 

*If we do not compete effectively in thehealthcare and pharmaceutical information services industries, our businesswill be negatively impacted.*

 

The market for healthcare and pharmaceuticalinformation technology consulting is very competitive.  We have competitors that provide some or allof the services we provide.  For example,in strategic consulting services, we compete with international, regional, andspecialty consulting firms such as Bearing Point (formerly KPMG Consulting),the Capgemini Group, IBM Global Consulting Services, Wipro Technologies, andAccenture.

 

In integration and co-management services, wecompete with:

 

•      Informationsystem vendors such as McKesson, Siemens Medical Solutions, Cerner Corporation,and IBM Global Systems;

•      Service groupsof computer equipment companies;

•      Systemsintegration companies such as Affiliated Computer Services (“ACS”), ElectronicData Systems Corporation, Perot Systems Corporation, SAIC, the Capgemini Group,and Computer Sciences Corporation;

•      Clients’internal information management departments;

•      Otherconsulting firms such as Accenture, Healthlink, and Computer SciencesCorporation’s consulting division; and

•      Otherhealthcare and pharmaceutical consulting and outsourcing firms, includingSuperior Consultant, which has recently been acquired by ACS.

 

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In e-health and e-commerce related services,we compete with the traditional competitors outlined above, as well as newerinternet product and service companies. We also compete with companies that provide software development,information technology consulting and outsourcing, and other integration andmaintenance services, such as Wipro Technologies, Cognizant TechnologySolutions Corporation, and Tata Technologies Limited.

 

Several of our competitors employ a globalsourcing strategy to provide software development and other informationtechnology services to their clients, while at the same time reducing theircost structure and improving the quality of services they provide.  If we are unable to realize the perceivedcost benefits of our recently implemented global sourcing strategy or if we areunable to receive high quality services from foreign employees orsubcontractors, our business may be adversely impacted and we may not be ableto compete effectively.

 

Many of our competitors have significantlygreater financial, human, and marketing resources than us.  As a result, such competitors may be able torespond more quickly to new or emerging technologies and changes in customerdemands, or to devote greater resources to the development, promotion, sale,and support of their products and services than we do.  In addition, as healthcare organizationsbecome larger and more complex, our larger competitors may be better able toserve the needs of such organizations. If we do not compete effectively with current and future competitors, wemay be unable to secure new and renewed client engagements, or we may berequired to reduce our rates in order to compete effectively.  This could result in a reduction in our revenues,resulting in lower earnings or operating losses, and otherwise materiallyadversely affecting our business, financial condition, and results ofoperations.

 

*If we fail to establish and maintainrelationships with vendors of software and hardware products, it could have anegative effect on our ability to secure engagements.*

 

We have a number of relationships withsoftware and hardware vendors.  Forexample, our Life Sciences business is highly dependent upon a non-exclusiverelationship with EMC Documentum, a vendor of document management softwareapplications with which we integrate our FirstDoc TM solution.    We often are engaged by vendors or theircustomers to implement or integrate vendor products based on our relationshipwith a particular vendor.  In addition,our clients may request that we host or operate a vendor application as part ofa hosting or outsourcing relationship, which may require the consent orcooperation of the vendor.  As a result,we believe that our relationship with vendors is important to our operations,including our sales, marketing, and support activities.  If we fail to maintain our relationships withthese vendors, or fail to establish additional new relationships, our businesscould be materially adversely affected.

 

*Our relationships with vendors of softwareand hardware products could have a negative impact on our ability to secureconsulting engagements.*

 

Our growing number of relationships withsoftware and hardware vendors could result in clients perceiving that we arenot independent from those software and hardware vendors.  Our ability to secure assessment and otherconsulting engagements is often dependent, in part, on our being independent ofsoftware and hardware solutions that we may review, analyze or recommend toclients.  If clients believe that we arenot independent of those software and hardware vendors, clients may not engageus for certain consulting engagements relating to those vendors, which couldreduce our revenues and materially adversely affect our business.

 

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*We may infringe the intellectual propertyrights of third parties.*

 

Our success depends, in part, on notinfringing patents, copyrights, and other intellectual property rights held byothers.  We do not know whether patentsheld or patent applications filed by third parties (i.e., in the area ofenterprise content management) may force us to alter our methods of businessand operation or require us to obtain licenses from third parties.  If we attempt to obtain such licenses, we donot know whether we will be granted licenses or whether the terms of thoselicenses will be fair or acceptable to us. Third parties may assert infringement claims against us in the future.  Such claims may result in protracted andcostly litigation, penalties, judgments, and fines that could adversely affectour business regardless of the merits of such claims.

 

*Our business is highly dependent on theavailability of business travel.*

 

Our associates and service providers oftenreside or work in cities or other locations that require them to travel to aclient’s site to perform and execute the client’s project.  As a result of the September 11, 2001terrorist attacks, air travel has become more time-consuming to businesstravelers due to increased security, flight delays, reduced flight schedules,and other variables.  If efficient andcost effective air travel becomes unavailable to our associates, or if domesticor international air travel is significantly reduced or halted, we may beunable to satisfactorily perform our client engagements on a timely basis,which could have a materially adverse impact on our business.  Further, if our associates refuse to utilizeair travel to perform their job functions for any reason, our business andreputation would be negatively affected.

 

*If we fail to keep pace with regulatory andtechnological changes, our business could be materially adversely affected.*

 

The healthcare and pharmaceutical industriesare subject to regulatory and technological changes that may affect theprocurement practices and operations of healthcare and pharmaceuticalorganizations.  During the past severalyears, the healthcare and pharmaceutical industries have been subject to anincrease in governmental regulation and reform proposals.  These reforms could increase governmentalinvolvement in the healthcare and pharmaceutical industries, lowerreimbursement rates or otherwise change the operating environment of ourclients.  Also, certain reforms that createpotential work for us could be delayed or cancelled.  Healthcare and pharmaceutical organizationsmay react to these situations by curtailing or deferring investments, includingthose for our services.  In addition, ifwe are unable to maintain our skill and expertise in light of regulatory ortechnological changes, our services may not be marketable to our clients and wecould lose existing clients or future engagements.  Finally, government regulations, particularlyHIPAA, may require our clients to impose additional contractual responsibilitieson us, which may make it more costly to perform certain of our engagements andsubject us to increased risk in the performance of these engagements, includingimmediate termination of an engagement.

 

Technological change in the network andapplication markets has created high demand for consulting, implementation, andintegration services.  If the pace oftechnological change were to diminish, we could experience a decrease in demandfor our services.  Any material decreasein demand would materially adversely affect our business, financial condition,and results of operations.

 

*We may be unable to effectively protect ourproprietary information and procedures.*

 

We must protect our proprietary information,including our proprietary methodologies, research, tools, software code, andother information.  To do this, we relyon a combination of copyright and trade secret laws and confidentialityprocedures to protect our intellectual property.  These steps may not protect our proprietaryinformation.  In addition, the laws ofcertain foreign countries do not protect or enforce proprietary rights to thesame extent, as do the laws of the United States.  We are currently

 

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providing our services to clients in international markets and havebusiness operations in Europe, India and Vietnam.  Our proprietary information may not beprotected to the same extent as provided under the laws of the United States,if at all.  The unauthorized use of ourintellectual property could have a material adverse effect on our business,financial condition, or results of operations.

 

*The price of our common stock may beadversely affected by market volatility.*

 

The trading price of our common stockfluctuates significantly.  Since ourcommon stock began trading publicly in February 1998, the reported saleprice of our common stock on the Nasdaq National Market has been as high as$29.13 and as low as $3.63 per share. This price may be influenced by many factors, including:

 

•      Our performanceand prospects;

•      The depth andliquidity of the market for our common stock;

•      Investorperception of us and the industries in which we operate;

•      Changes inearnings estimates or buy/sell recommendations by analysts;

•      Generalfinancial and other market conditions;

•      Domestic andinternational economic conditions; and

•      The other risksrelated to our business discussed above.

 

In addition, public stock markets haveexperienced extreme price and trading volume volatility.  This volatility has significantly affectedthe market prices of securities of many companies for reasons frequentlyunrelated to or disproportionately impacted by the operating performance ofthese companies.  These broad marketfluctuations may adversely affect the market price of our common stock.  As a result, we may be unable to raisecapital or use our stock to acquire businesses on attractive terms andinvestors may be unable to resell their shares of our common stock at or abovetheir purchase price.  Further, ifresearch analysts stop covering our company or reduce their expectations of us,our stock price could decline or the liquidity of our common stock may beadversely impacted, which could create difficulty for investors to resell theirshares of our common stock.

 

*If our stock price is volatile, we may becomesubject to securities litigation, which is expensive and could result in adiversion of resources.*

 

If our stock price experiences periods ofvolatility, our security holders may initiate securities class actionlitigation against us.  If we becomeinvolved in this type of litigation it could be very expensive and divert ourmanagement’s attention and resources, which could materially and adverselyaffect our business and financial condition.

 

*Our charter documents, Delaware law andstockholders rights plan will make it more difficult to acquire us and maydiscourage take-over attempts and thus depress the market price of our commonstock.*

 

Our Board of Directors has the authority toissue up to 9,500,000 shares of undesignated preferred stock, to determine thepowers, preferences, and rights and the qualifications, limitations, orrestrictions granted to or imposed upon any unissued series of undesignatedpreferred stock and to fix the number of shares constituting any series and thedesignation of such series, without any further vote or action by ourstockholders.  The preferred stock couldbe issued with voting, liquidation, dividend, and other rights superior to therights of our common stock.  Furthermore,any preferred stock may have other rights, including economic rights, senior toour common stock, and as a result, the issuance of any preferred stock coulddepress the market price of our common stock.

 

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In addition, our certificate of incorporationeliminates the right of stockholders to act without a meeting and does notprovide cumulative voting for the election of directors.  Our certificate of incorporation also providesfor a classified Board of Directors.  Theability of our Board of Directors to issue preferred stock and these otherprovisions of our certificate of incorporation and bylaws may have the effectof deterring hostile takeovers or delaying changes in control or management.

 

We are also subject to the provisions of Section 203of the Delaware General Corporation Law, which could delay or prevent a changein control of us, impede a merger, consolidation, or other business combinationinvolving us or discourage a potential acquirer from making a tender offer orotherwise attempting to obtain control. Any of these provisions, which may have the effect of delaying orpreventing a change in control, could adversely affect the market value of ourcommon stock.

 

In 1999, our Board of Directors adopted arights agreement that is intended to protect our stockholders’ interests in theevent we are confronted with coercive takeover tactics.  Pursuant to the stockholders rights plan, wedistributed “rights” to purchase up to 500,000 shares of our Series A JuniorParticipating Preferred Stock.  Undersome circumstances, these rights become the rights to purchase shares of ourcommon stock or securities of an acquiring entity at one-half the market value.  The rights are not intended to prevent ourtakeover, rather they are designed to deal with the possibility of unilateralactions by hostile acquirers that could deprive our Board of Directors andstockholders of their ability to determine our destiny and obtain the highestprice for our common stock.

 

## **Item 3. Quantitative and Qualitative Disclosures about Market Risks**

 

Our financial instruments include cash andcash equivalents (i.e., short-term and long-term cash investments), accountsreceivable, unbilled receivables, accounts payable, and a revolving line ofcredit.  Only the cash and cash equivalents which totaled $34.4 million atApril 1, 2005 present us with market risk exposure resulting primarilyfrom changes in interest rates.  Based on this balance, a change of onepercent in the interest rate would cause a change in interest income for theannual period of approximately $0.3 million.  Our objective in maintainingthese investments is the flexibility obtained in having cash available forpayment of accrued liabilities and acquisitions.

 

Our borrowings are primarily dependent uponthe prevailing prime rate.  As of April 1, 2005, we had no borrowingsunder our revolving line of credit and an available borrowing capacity of $7.0million.  See “Item 2. Management’s Discussion and Analysis of Financial Conditionand Results of Operations - Liquidity and Capital Resources.”  Theestimated fair value of borrowings under the revolving line is expected toapproximate its carrying value.

 

## **Item4.  Controls and Procedures**

 

We maintain disclosure controls and proceduresthat are designed to ensure that information required to be disclosed in ourExchange Act reports is recorded, processed, summarized, and reported withinthe time periods specified in the Securities and Exchange Commission’s rulesand forms, and that such information is accumulated and communicated to ourmanagement, including our Chief Executive Officer and Chief Financial Officer,as appropriate, to allow for timely decisions regarding required disclosure. Indesigning and evaluating the disclosure controls and procedures, management isrequired to apply its judgment in evaluating the cost-benefit relationship ofpossible controls and procedures.  Ourdisclosure controls and procedures are designed to provide a reasonable levelof assurance of reaching our desired disclosure control objectives.

 

As required by SEC Rule 13a-15(b), we carriedout an evaluation, under the supervision and with the participation of ourmanagement, including our Chief Executive Officer and our Chief FinancialOfficer, of the effectiveness of the design and operation of our disclosurecontrols and procedures as of

 

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the end of the quarter covered by this report. Based on the foregoing,our Chief Executive Officer and Chief Financial Officer concluded that ourdisclosure controls and procedures were effective, and were operating at thereasonable assurance level.

 

There has been no change in our internalcontrols over financial reporting during our most recent fiscal quarter thathas materially affected, or is reasonably likely to materially affect, ourinternal controls over financial reporting.

 

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# **PART II.  OTHER INFORMATION**

 

## **Item1.  Legal Proceedings.**

 

From time to time, we may be involved inclaims or litigation that arise in the normal course of business. We are notcurrently a party to any legal proceedings, which, if decided adversely to us,would have a material adverse effect on our business, financial condition, or resultsof operations.

 

## **Item 2. Unregistered Sales of Equity Securities and Use of Proceeds.**

 

(c) Repurchase ofSecurities

 
| **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 (January 1,  2005 – January 28, 2005)   |       | 0                                      |       | $                                 | 0.00       |                                                                | n/a        |                                                                        | n/a        |   |
| Month #2 (January 29,  2005 – February 25, 2005) |       | 434,167                                |       | $                                 | 5.97       |                                                                | n/a        |                                                                        | n/a        |   |
| Month #3 (February 26,  2005 – April 1, 2005)    |       | 0                                      |       | $                                 | 0.00       |                                                                | n/a        |                                                                        | n/a        |   |

 

OnFebruary 22, 2005, we repurchased a total of 12,149 shares of common stockfrom one of our non-Section 16 officer vice presidents, in a privatetransaction, for a total purchase price of $72,529.53.  All shares were purchased at the closingprice of our common stock on Nasdaq National Market on the date of purchase, or$5.97 per share.  Of the total purchaseprice, $67,294.20 of such amount was applied to an outstanding loan that suchvice president had with us.  Theremaining amount of the purchase price paid to the applicable vice presidentwas intended to cover the individual’s estimated capital gains tax on thesale.  The loan was made in connectionwith a restricted stock purchase agreement between FCG and this vice presidentthat was entered into prior to December 2000, when we eliminated therequirement that our vice presidents purchase and hold common stock of FCG.

 

OnFebruary 23, 2005, we negotiated an early conclusion to the escrowagreement related to shares of our common stock issued in connection with ourpurchase of the minority interest in Codigent Solutions Group, Inc. (renamedFCG Infrastructure Services, Inc.) from its five remaining stockholders.  In connection with this private transaction,we agreed to repurchase a total of 422,018 shares of common stock from the fiveindividuals for an aggregate purchase price of $2,519,447.46, or $5.97 pershare, based on the closing price of FCG common stock on February 22,2005.  In connection with this transaction,the five remaining stockholders also agreed to forgo the release of theremaining 147,830 shares held in the escrow account.  We cancelled these shares in February 2005,and they are no longer outstanding.

 

## **Item 3. Defaults Upon Senior Securities.**

 

None.

 

## **Item 4. Submission of Matters to a Vote of Security Holders.**

 

None.

 

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## **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 December 9,1999.

 

(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 the requirements of theSecurities and Exchange Act of 1934, the registrant has duly caused this reportto be signed on its behalf by the undersigned thereunto duly authorized.

 
|               | FIRST CONSULTING GROUP, INC.            |
|--------------------|-----------------------------------------|
|               |                                    |
|               |                                    |
| Date: May 11, 2005 | /s/LUTHER J. NUSSBAUM                   |   |
|               | Luther J. Nussbaum                      |
|               | Chairman of the Board and               |
|               | Chief Executive Officer                 |
|               |                                    |
|               |                                    |
| Date: May 11, 2005 | /s/THOMAS A WATFORD                     |   |
|               | Thomas A. Watford                       |
|               | Senior Vice President 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 December 9,1999.

 

(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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