**UNITED STATES**

**SECURITIES AND EXCHANGE COMMISSION**

**Washington,D.C. 20549**

 

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**FORM 10-Q**

 

**(Mark One)**

 

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

 

**For the quarterly period ended March 31,2006**

 

**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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**First Consulting Group, Inc.**

(Exact name of registrant as specified in itscharter)

 

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

 

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

(Address of principal executive offices,including zip code)

 

**(562) 624-5200**

(Registrant’s telephone number, includingarea code)

 

 

(Former name, former address and formerfiscal year, if changed since last report)

 

Indicate by check markwhether the registrant (1) has filed all reports required to be filed by Section 13or 15(d) of the Securities Exchange Act of 1934 during the preceding 12months (or for such shorter period that the registrant was required to filesuch reports), and (2) has been subject to such filing requirements forthe past 90 days. Yes  **ý**    No  **o**

 

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

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

 

**Indicate by check mark whether theregistrant is a shell company (as defined in Rule 12b-2 of the ExchangeAct).**Yes  o    No  ý

 

**Indicate the number of sharesoutstanding of each of the Registrant’s classes of common stock, as of thelatest practicable date.**

 
| **Common Stock, $.001 par value** | ** ** | **24,947,523**                        |
|-----------------------------------|------------|---------------------------------------|
| (Class)                           |       | (Outstanding at April 28,  2006) |

 

 

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**FirstConsulting Group, Inc.**

**Table ofContents**

 
| COVER PAGE                                                                                          |                                            |
|-----------------------------------------------------------------------------------------------------|-------------------------------------------------|
|                                                                                                |                                            |   |
| TABLE OF  CONTENTS                                                                                  |                                            |
|                                                                                                |                                            |   |
| PART I.                                                                                        | FINANCIAL INFORMATION                           |   |
|                                                                                                |                                            |   |
| ITEM 1. FINANCIAL STATEMENTS                                                                        |                                            |
|                                                                                                |                                            |   |
|                                                                                                | Consolidated Balance Sheets                     |   |
|                                                                                                |                                            |   |
|                                                                                                | Consolidated Statements of Operations           |   |
|                                                                                                |                                            |   |
|                                                                                                | Condensed Consolidated Statements of Cash Flows |   |
|                                                                                                |                                            |   |
|                                                                                                | Notes to Consolidated Financial Statements      |   |
|                                                                                                |                                            |   |
| ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION  AND RESULTS OF OPERATIONS |                                            |
|                                                                                                |                                            |   |
| ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISKS                                 |                                            |
|                                                                                                |                                            |   |
| ITEM 4. CONTROLS AND PROCEDURES                                                                     |                                            |
|                                                                                                |                                            |   |
| PART II. OTHER INFORMATION                                                                     |                                            |
|                                                                                                |                                            |   |
| ITEM 1. LEGAL PROCEEDINGS                                                                           |                                            |
|                                                                                                |                                            |   |
| ITEM 1A. RISK FACTORS                                                                               |                                            |
|                                                                                                |                                            |   |
| ITEM 2. UNREGISTERED SALES OF EQUITY  SECURITIES AND USE OF PROCEEDS                                |                                            |
|                                                                                                |                                            |   |
| ITEM 3. DEFAULTS UPON SENIOR SECURITIES                                                             |                                            |
|                                                                                                |                                            |   |
| ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF  SECURITY HOLDERS                                        |                                            |
|                                                                                                |                                            |   |
| ITEM 5. OTHER INFORMATION                                                                           |                                            |
|                                                                                                |                                            |   |
| ITEM 6. EXHIBITS                                                                                    |                                            |
|                                                                                                |                                            |   |
| SIGNATURES                                                                                          |                                            |
|                                                                                                |                                            |   |
| EXHIBIT INDEX                                                                                  |                                            |
|                                                                                                     |                                                 |  |  |  |

 

2

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# **PART I. FINANCIAL INFORMATION**

 

## **Item 1. Financial Statements**

 

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

 

### **Consolidated Balance Sheets**

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

 

 
| ** **                                                                                                                   | ** ** | **March 31,  2006** | ** ** | **December 30,  2005** | ** ** |
|------------------------------------------------------------------------------------------------------------------------------|------------|--------------------------|------------|-----------------------------|------------|
| ** **                                                                                                                   | ** ** | **(unaudited)**          | ** ** | ** **                  | ** ** |
| **ASSETS**                                                                                                                   | ** ** | ** **               | ** ** | ** **                  | ** ** |
| Current assets:                                                                                                              | ** ** | ** **               | ** ** | ** **                  | ** ** |
| Cash and cash equivalents                                                                                                    |       | $                        | 32,748     |                        | $          | 35,106 |   |
| Accounts receivable, less allowance of $1,574 and $1,633 as of March 31,  2006 and December 30, 2005, respectively |       | 21,581                   |       | 20,993                      |       |
| Unbilled receivables                                                                                                         |       | 15,298                   |       | 12,352                      |       |
| Prepaid expenses and other current assets                                                                                    |       | 4,087                    |       | 3,532                       |       |
| Total current assets                                                                                                         |       | 73,714                   |       | 71,983                      |       |
|                                                                                                                         |       |                     |       |                        |       |
| Property and equipment:                                                                                                      |       |                     |       |                        |       |
| Furniture, equipment, and leasehold improvements                                                                             |       | 3,509                    |       | 3,475                       |       |
| Information systems equipment and software                                                                                   |       | 31,291                   |       | 30,220                      |       |
|                                                                                                                         |       | 34,800                   |       | 33,695                      |       |
| Less accumulated depreciation and amortization                                                                               |       | 22,692                   |       | 21,365                      |       |
|                                                                                                                         |       | 12,108                   |       | 12,330                      |       |
|                                                                                                                         |       |                     |       |                        |       |
| Other assets:                                                                                                                |       |                     |       |                        |       |
| Executive benefit trust                                                                                                      |       | 10,141                   |       | 10,141                      |       |
| Long-term accounts receivable, net                                                                                           |       | 2,486                    |       | 1,661                       |       |
| Deferred contract costs                                                                                                      |       | 3,479                    |       | 3,476                       |       |
| Goodwill, net                                                                                                                |       | 18,159                   |       | 18,159                      |       |
| Intangibles, net                                                                                                             |       | 1,035                    |       | 1,228                       |       |
| Other                                                                                                                        |       | 2,712                    |       | 2,654                       |       |
|                                                                                                                         |       | 38,012                   |       | 37,319                      |       |
| Total assets                                                                                                                 |       | $                        | 123,834    |                        | $          | 121,632 |   |

 

 

The accompanying notes are anintegral part of these financial statements.

 

 

3

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

 

### **Consolidated Balance Sheets(Continued)**

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

 

 
| ** **                                                                                                                                                                                            | ** ** | **March 31,  2006** | ** ** | **December 30,  2005** | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|--------------------------|------------|-----------------------------|------------|
| ** **                                                                                                                                                                                            | ** ** | **(unaudited)**          | ** ** | ** **                  | ** ** |
| **LIABILITIES  AND STOCKHOLDERS’ EQUITY**                                                                                                                                                        | ** ** | ** **               | ** ** | ** **                  | ** ** |
| Current liabilities:                                                                                                                                                                                  | ** ** | ** **               | ** ** | ** **                  | ** ** |
| Accounts payable                                                                                                                                                                                      |       | $                        | 1,982      |                        | $          | 1,685 |   |
| Accrued liabilities                                                                                                                                                                                   |       | 4,583                    |       | 5,280                       |       |
| Accrued payroll and payroll taxes                                                                                                                                                                     |       | 1,746                    |       | 1,595                       |       |
| Accrued vacation                                                                                                                                                                                      |       | 6,208                    |       | 7,082                       |       |
| Accrued employee benefits                                                                                                                                                                             |       | 1,646                    |       | 2,741                       |       |
| Accrued severance                                                                                                                                                                                     |       | 471                      |       | 2,813                       |       |
| Accrued incentive compensation                                                                                                                                                                        |       | 1,809                    |       | 1,113                       |       |
| Customer advances                                                                                                                                                                                     |       | 8,000                    |       | 7,201                       |       |
| Accrued restructuring                                                                                                                                                                                 |       | 2,818                    |       | 3,204                       |       |
| Total current liabilities                                                                                                                                                                             |       | 29,263                   |       | 32,714                      |       |
| Non-current liabilities:                                                                                                                                                                              |       |                     |       |                        |       |
| Supplemental executive retirement plan                                                                                                                                                                |       | 9,531                    |       | 10,172                      |       |
| Total non-current liabilities                                                                                                                                                                         |       | 9,531                    |       | 10,172                      |       |
| Commitments  and contingencies                                                                                                                                                                        |       | —                   |       | —                      |       |
| Stockholders’  equity:                                                                                                                                                                           |       |                     |       |                        |       |
| Preferred Stock, $.001 par value; 9,500,000 shares authorized, no  shares issued and outstanding                                                                                                      |       | —                   |       | —                      |       |
| Series A Junior Participating Preferred Stock, $.001 par value;  500,000 shares authorized, no shares issued and outstanding                                                                     |       | —                   |       | —                      |       |
| Common Stock, $.001 par value; 50,000,000 shares authorized,  24,841,256 shares issued and outstanding at March 31, 2006 and  24,567,759 shares issued and outstanding at December 30, 2005 |       | 25                       |       | 25                          |       |
| Additional paid-in capital                                                                                                                                                                            |       | 92,975                   |       | 91,202                      |       |
| Deficit                                                                                                                                                                                               |       | (8,036                   | )          | (12,558                     | )          |
| Accumulated other comprehensive income                                                                                                                                                                |       | 76                       |       | 77                          |       |
| Total stockholders’ equity                                                                                                                                                                       |       | 85,040                   |       | 78,746                      |       |
| Total liabilities and stockholders’ equity                                                                                                                                                       |       | $                        | 123,834    |                        | $          | 121,632 |   |

 

 

The accompanying notes are anintegral part of these financial statements.

 

 

4

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

 

### **Consolidated Statements ofOperations**

**(inthousands, except per share data)**

 
| ** **                                                   | ** ** | **Three Months Ended** | ** ** |
|--------------------------------------------------------------|------------|----------------------------------|------------|
| ** **                                                   | ** ** | **(unaudited)**                  | ** ** |
| ** **                                                   | ** ** | **March 31,  2006**         | ** ** | **April 1,  2005** | ** ** |
| ** **                                                   | ** ** | ** **                       | ** ** | ** ** | ** ** |
| Revenues before reimbursements                               |       | $                                | 66,686     |   | $ | 68,144 |   |
| Reimbursements                                               |       | 3,779                            |       | 3,662 |   |
| Total revenues                                               |       | 70,465                           |       | 71,806 |   |
|                                                         |       |                             |       |   |   |
| Cost of services before reimbursable expenses                |       | 48,593                           |       | 52,490 |   |
| Reimbursable expenses                                        |       | 3,779                            |       | 3,662 |   |
| Total cost of services                                       |       | 52,372                           |       | 56,152 |   |
|                                                         |       |                             |       |   |   |
| Gross profit                                                 |       | 18,093                           |       | 15,654 |   |
|                                                         |       |                             |       |   |   |
| Selling expenses                                             |       | 4,379                            |       | 6,758 |   |
| General and administrative expenses                          |       | 9,175                            |       | 10,517 |   |
| Income (loss) from operations                                |       | 4,539                            |       | (1,621 | ) |
| Other income (expense):                                      |       |                             |       |   |   |
| Interest income, net                                         |       | 338                              |       | 230 |   |
| Other expense, net                                           |       | (15                              | )          | — |   |
| Income (loss) from continuing operations before income taxes |       | 4,862                            |       | (1,391 | ) |
| Income tax provision (benefit)                               |       | 340                              |       | (639 | ) |
| Income (loss) from continuing operations                     |       | 4,522                            |       | (752 | ) |
| Loss on discontinued operations, net of tax benefit          |       | —                           |       | (537 | ) |
| Net income (loss)                                            |       | $                                | 4,522      |   | $ | (1,289 | ) |
|                                                         |       |                             |       |   |   |
| Basic and diluted net income (loss) per share:               |       |                             |       |   |   |
| Income (loss) from continuing operations, net of tax         |       | $                                | 0.18       |   | $ | (0.03 | ) |
| Loss on discontinued operations, net of tax                  |       | —                           |       | (0.02 | ) |
| Net income (loss)                                            |       | $                                | 0.18       |   | $ | (0.05 | ) |
|                                                         |       |                             |       |   |   |
| Weighted average shares used in computing:                   |       |                             |       |   |   |
| Basic net income (loss) per share                            |       | 24,705                           |       | 24,475 |   |
| Diluted net income (loss) per share                          |       | 24,910                           |       | 24,475 |   |

 

 

The accompanying notes are anintegral part of these financial statements.

 

 

5

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

 

### **Condensed ConsolidatedStatements of Cash Flows**

**(in thousands)**

 
| ** **                                                                            | ** ** | **Three Months Ended** | ** ** |
|---------------------------------------------------------------------------------------|------------|----------------------------------|------------|
| ** **                                                                            | ** ** | **(unaudited)**                  | ** ** |
| ** **                                                                            | ** ** | **March 31,  2006**         | ** ** | **April 1,  2005** | ** ** |
| Cash flows from operating activities:                                                 |       |                             |       |   |   |
| Net income (loss):                                                                    |       | $                                | 4,522      |   | $ | (1,289 | ) |
| Adjustments to reconcile net income (loss) to net cash used in  operating activities: |       |                             |       |   |   |
| Depreciation and amortization                                                         |       | 1,752                            |       | 1,493 |   |
| Intangible amortization                                                               |       | 193                              |       | 381 |   |
| Provision for bad debts                                                               |       | (75                              | )          | — |   |
| Loss on sale of assets                                                                |       | 47                               |       | 2 |   |
| Stock-based compensation                                                              |       | 193                              |       | 1 |   |
| Loss on operations of discontinued operations, net of tax benefit                     |       | —                           |       | 537 |   |
| Change in assets and liabilities:                                                     |       |                             |       |   |   |
| Accounts receivable                                                                   |       | (513                             | )          | 1,670 |   |
| Unbilled receivables                                                                  |       | (2,946                           | )          | (3,015 | ) |
| Prepaid expenses and other                                                            |       | (555                             | )          | (1,369 | ) |
| Long term account receivable                                                          |       | (825                             | )          | 453 |   |
| Deferred contract costs                                                               |       | (3                               | )          | 137 |   |
| Other assets                                                                          |       | (95                              | )          | 68 |   |
| Accounts payable                                                                      |       | 297                              |       | 955 |   |
| Other accrued liabilities                                                             |       | (697                             | )          | (1,090 | ) |
| Accrued payroll and related tax                                                       |       | 151                              |       | (589 | ) |
| Accrued vacation                                                                      |       | (874                             | )          | 752 |   |
| Accrued employee benefits                                                             |       | (1,095                           | )          | 745 |   |
| Accrued severance                                                                     |       | (2,342                           | )          | 429 |   |
| Accrued incentive compensation                                                        |       | 696                              |       | (342 | ) |
| Customer advances                                                                     |       | 799                              |       | (176 | ) |
| Accrued restructuring costs                                                           |       | (386                             | )          | (647 | ) |
| Deferred income taxes                                                                 |       | —                           |       | (639 | ) |
| Supplemental executive retirement plan                                                |       | (641                             | )          | 255 |   |
| Other                                                                                 |       | (4                               | )          | (11 | ) |
| Net cash used in operating activities of continuing operations                        |       | (2,401                           | )          | (1,289 | ) |
| Net cash used in operating activities of discontinued operations                      |       | —                           |       | (596 | ) |
| Net cash used in operating activities                                                 |       | (2,401                           | )          | (1,885 | ) |
| Cash flows from investing activities:                                                 |       |                             |       |   |   |
| Proceeds from sale/maturity of investments                                            |       | —                           |       | 4,921 |   |
| Purchase of property and equipment                                                    |       | (1,603                           | )          | (1,619 | ) |
| Net cash provided by (used in) investing activities of continuing ops                 |       | (1,603                           | )          | 3,302 |   |
| Net cash provided by investing activities of discontinued ops                         |       | —                           |       | 38 |   |
| Net cash provided by (used in) investing activities                                   |       | (1,603                           | )          | 3,340 |   |
| Cash flows from financing activities:                                                 |       |                             |       |   |   |
| Proceeds from issuance of capital stock, net                                          |       | 1,593                            |       | 145 |   |
| Proceeds from notes receivable and tax loan payments                                  |       | 24                               |       | 7 |   |
| Capital stock repurchase                                                              |       | —                           |       | (2,519 | ) |
| Net cash provided by (used in) financing activities                                   |       | 1,617                            |       | (2,367 | ) |
| Effect of exchange rate changes on cash and cash equivalents                          |       | 29                               |       | (71 | ) |
| Net change in cash and cash equivalents                                               |       | (2,358                           | )          | (983 | ) |
| Cash and cash equivalents at beginning of period                                      |       | 35,106                           |       | 15,012 |   |
| Cash and cash equivalents at end of period                                            |       | $                                | 32,748     |   | $ | 14,029 |   |
| Supplemental disclosure of cash flow information                                      |       |                             |       |   |   |
| Cash paid during the year for interest                                                |       | $                                | 4          |   | $ | 42 |   |
| Cash paid (received) during the year for income taxes, net of refunds                 |       | $                                | (89        | ) | $ | 33 |   |
| Supplemental disclosure of non-cash investing and financing  activities               |       |                             |       |   |   |
| Release from escrow of common stock to complete acquisition of  business              |       | $                                | —     |   | $ | 900 |   |

 

The accompanying notes are anintegral part of these financial statements.

 

 

6

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### **Notes to Consolidated FinancialStatements**

### ** **

**Note 1   ****               ****Accounting Policies**

 

*Basis of Presentation*

 

The accompanying consolidated balance sheet of First Consulting Group, Inc.(the “Company” or “FCG”) at March 31, 2006 and consolidated statements ofoperations and consolidated statements of cash flows for the periods ended March 31,2006 and April 1, 2005 are unaudited. These financial statements reflectall adjustments, consisting of only normal recurring adjustments, which, in theopinion of management, are necessary to fairly present the financial positionof the Company at March 31, 2006 and the results of operations for thethree-month periods ended March 31, 2006 and April 1, 2005. Theresults of operations and cash flows for the three-month period ended March 31,2006 are not necessarily indicative of the results to be expected for the yearending December 29, 2006. For more complete financial information, thesefinancial statements should be read in conjunction with the audited financialstatements for the year ended December 30, 2005 included in the Company’sAnnual Report on Form 10-K. Certain reclassifications have been made tothe 2005 financial statements to conform to the 2006 presentation.

 

*Principles of Consolidation*

 

The consolidated financial statements include the accounts of theCompany and its subsidiaries. All material intercompany accounts andtransactions have been eliminated.

 

*RevisedPresentation of Consolidated Statements of Cash Flow*

 

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

 

*Revised Presentationof Cost Classification*

 

Commencingwith the first quarter of 2006, the Company has changed the way some expensesare classified from general and administrative expense to cost of services. Managementbelieves these changes better match the nature of the expense to its expenseclassification, and are consistent with other peer companies’ reporting. Historically,the Company has only included salary and benefits costs of client-servingstaff, and costs of subcontractors in cost of services, a classificationmethodology emanating from the Company’s origins as a consulting firm. As theCompany’s outsourcing business has evolved and developed data center and callcenter capabilities, and the Company has moved forward with an offshoresourcing strategy, infrastructure costs of providing these services have growndramatically. Since these costs have not been for staff or subcontractors, per theCompany’ prior definition of cost of services, they have been classified as generaland administrative. The Company is now classifying these types of costs as costof services. This primarily affects the Company’s outsourcing businesses, its SoftwareServices business, and its “Other” segment, where the costs of the sharedservice centers for both infrastructure and offshore sourcing are included.

 

*Stock-Based Compensation*

 

Adoption ofSFAS 123R

 

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

 

7

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compensation expense for allshare-based payment awards made to employees and directors, including employeestock options, based on estimated grant date fair values. Previously, theCompany elected to account for these share-based payment awards using theintrinsic-value method under Accounting Principles Board Opinion No. 25, “Accountingfor Stock Issued to Employees” (“APB 25”), and elected to only disclose theimpact of expensing the fair value of stock options in the notes to thefinancial statements. Under the intrinsic-value method in APB 25, compensationcost is the excess, if any, of the quoted market price of the stock at thegrant date over the amount an employee must pay to acquire the stock. The Companygrants options with an exercise price equal to the market value of the commonstock on the date of grant, therefore no compensation expense was recognizedrelated to those options for the three months ended April 1, 2005. Further,none of the grants contains any market or company-performance conditions.

 

The Companyadopted SFAS 123R using the modified prospective transition method whichrequires applying the standard as of December 31, 2005 (“the adoption date”).The modified prospective transition method does not allow for the restatementof prior periods and accordingly, the results of operations for the quarterended March 31, 2006 and future periods will not be comparable tohistorical results of operations. Under this transition method, SFAS 123R appliesto new equity awards and to equity awards modified, repurchased, or canceledafter the adoption date. Additionally, compensation cost for the portion ofawards granted prior to the adoption date for which the requisite service hasnot been rendered as of the adoption date shall be recognized as the requisiteservice is rendered. The compensation cost for that portion of awards shall bebased on the grant date fair value of those awards as calculated in the priorperiod pro forma disclosures under SFAS No. 123, “Accounting forStock-Based Compensation” (“SFAS 123”). Changes to the grant date fair value ofequity awards granted before the effective date are precluded.

 

Upon adoptionof SFAS 123R, the Company changed its method of attributing the value ofstock-based compensation expense from the multiple-option (i.e., accelerated)approach to the single-option (i.e., straight-line) method. Compensationexpense for share-based awards granted through December 30, 2005 willcontinue to be subject to the accelerated multiple-option method, whilecompensation expense for share-based awards granted on or after December 31,2005 will be recognized using a straight-line, or single-option method. TheCompany recognizes these compensation costs over the service period of theaward, which is generally the option vesting term of three to four years.

 

SFAS 123Rrequires forfeitures to be estimated at the time of grant and revised, ifnecessary, in subsequent periods if actual forfeitures differ from thoseestimates in order to derive the Company’s best estimate of awards ultimatelyexpected to vest. Forfeitures have been estimated based on the Company’shistorical experience. In the Company’s pro forma information required underSFAS 123 for the periods prior to 2006, the Company accounted for forfeituresas they occurred.

 

Valuation and Expense Information under SFAS 123R

 

As a result ofadopting SFAS 123R, expense associated with stock-based compensation for thethree months ended March 31, 2006 is $193,000, which had the effect ofreducing basic and diluted earnings per share by $0.01 for the quarter. Stock-basedcompensation included $76,000 as a component of cost of services, $37,000 as acomponent of selling expense, and $80,000 as a component of general and administrativeexpense. In addition, prior to the adoption of SFAS 123R, the Company presentedthe tax benefit of stock option exercises as operating cash flows. Upon theadoption of SFAS 123R, tax benefits resulting from tax deductions in excess ofthe compensation cost recognized for those options are classified as financingcash flows. In the first quarter of 2006, there were no tax benefits resultingfrom tax deductions in excess of the compensation cost recognized. Because theCompany maintained a full valuation allowance on its deferred tax assets, theCompany did not recognize any tax benefit related to stock-based compensationexpense for the quarter ended March 26, 2006.

 

8

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The Companyhas historically used the Black-Scholes option pricing model to value itsoptions under SFAS 123, and has elected to continue to do so under SFAS 123R. Thefair value of each option granted during the three months ended March 31,2006 was estimated on the date of grant using such model with the followingassumptions:

 
| ** **              | ** ** | **Three Months Ended  March 31 , 2006** | ** ** |
|-------------------------|------------|------------------------------------------------------------------|------------|
| Expected volatility     |       | 40.0                                                             | %          |
| Risk-free interest rate |       | 4.7                                                              | %          |
| Expected dividends      |       | —                                                           |       |

 

Expectedvolatilities are based on the Company’s historical volatility. The risk-free interestrate assumption is based upon observed interest rates appropriate for the termof the Company’s employee stock options. The expected dividend yield is zero asthe Company does not expect to pay dividends in the future. During the threemonths ended March 31, 2006, the Company only issued its automatic annualoption grant to its Board of Directors for 36,000 options, and did not grantany options to its employees, although it does intend to do so in the future.

 

Stock option activity forthe three months ended March 31, 2006 is as follows:

 
| ** **                            | ** ** | **Shares** | ** ** | **Weighted Average  Exercise Price** | ** ** | **Weighted Average  Remaining  Contractual Life** | ** ** |
|---------------------------------------|------------|------------|------------|------------------------------------------------|------------|-------------------------------------------------------------|------------|
| Outstanding at December 30, 2005 |       | 4,665,491  |       | $                                              | 7.43       |                                                        |       |   |
| Grants                                |       | 36,000     |       | $                                              | 5.87       |                                                        |       |   |
| Exercised                             |       | (275,567   | )          | $                                              | 5.83       |                                                        |       |   |
| Cancelled                             |       | (397,789   | )          | $                                              | 8.74       |                                                        |       |   |
| Outstanding at March 31, 2006    |       | 4,028,135  |       | $                                              | 7.39       |                                                        | 5.32       |   |
|                                  |       |       |       |                                           |       |                                                        |       |
| Exercisable at March 31, 2006    |       | 3,367,519  |       | $                                              | 7.75       |                                                        | 4.83       |   |

 

Pro Forma Information Under SFAS 123 For Periods Prior to 2006

 

For theperiods prior to 2006, the Company elected to apply APB 25 and relatedinterpretations in accounting for its stock-based compensation plans. Thefollowing is a reconciliation of net loss per weighted average share had theCompany adopted the fair value recognition provisions of SFAS 123 for the threemonths ended April 1, 2005 (in thousands, except per share amounts):

 
| ** **                       | ** **                                                                                                      | ** **  | ** ** | **Three Months Ended  April 1, 2005** | ** ** |
|----------------------------------|-----------------------------------------------------------------------------------------------------------------|-------------|------------|-----------------------------------------------------------|------------|
| Net loss                         |                                                                                                            |        |       | $                                                         | (1,289     | ) |
| Deduct:                          | Total stock  based employee compensation expense determined under fair value method for  all awards, net of tax |        | (241       | )                                                         |
| Add:                             | Amount of  such stock-based expense included in net loss under APB 25                                           |        | —     |                                                      |
| Pro forma net loss               |                                                                                                            |        |       | $                                                         | (1,530     | ) |
|                             |                                                                                                            |        |       |                                                      |       |
| Basic and diluted loss per share |                                                                                                            | As reported |       | $                                                         | (0.05      | ) |
|                             |                                                                                                            | Pro forma   |       | $                                                         | (0.06      | ) |
|                                  |                                                                                                                 |             |            |                                                           |            |  |  |

 

9

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*Basic and Diluted Net Income(Loss) Per Share*

 

Basic netincome (loss) per share is based upon the weighted average number of commonshares outstanding. Diluted net income per share is based on the assumptionthat stock options were exercised. Dilution is computed by applying thetreasury stock method. Under this method, options are assumed to be exercisedat the beginning of the period (or at the time of issuance, if later), and asif funds obtained by the Company from such exercise were used by the Company topurchase common stock at the average market price during the period. Stockoptions are not considered when computing diluted net loss per share as theyare considered anti-dilutive.

 

The following represents areconciliation of basic and diluted net income (loss) per share for thethree-month periods ended March 31, 2006 and April 1, 2005 (inthousands, except per share data):

 
| ** **                                            | ** ** | **Three Months Ended**   | ** ** |
|-------------------------------------------------------|------------|------------------------------------|------------|
| ** **                                            | ** ** | **March 31,**

** 2006** | ** ** | **April 1,  2005** | ** ** |
|                                                  |       |                               |       |   |   |
| Income (loss) from continuing operations              |       | $                                  | 4,522      |   | $ | (752 | ) |
| Loss on discontinued operations, net of tax benefit   |       | —                             |       | (537 | ) |
| Net income (loss)                                     |       | $                                  | 4,522      |   | $ | (1,289 | ) |
|                                                  |       |                               |       |   |   |
| Basic weighted average number of shares outstanding   |       | 24,705                             |       | 24,475 |   |
| Effect of dilutive options and contingent shares      |       | 205                                |       | — |   |
| Diluted weighted average number of shares outstanding |       | 24,910                             |       | 24,475 |   |
| ** **                                            | ** ** | ** **                         | ** ** | ** ** | ** ** |
| Basic and diluted per share:                          |       |                               |       |   |   |
| Income (loss) from continuing operations              |       | $                                  | 0.18       |   | $ | (0.03 | ) |
| Loss on discontinued operations, net of tax benefit   |       | —                             |       | (0.02 | ) |
| Net income (loss) per share                           |       | $                                  | 0.18       |   | $ | (0.05 | ) |

 

For the three months ended March 31,2006 and April 1, 2005, there were 2,768,983 and 5,243,526 anti-dilutiveoutstanding stock options, respectively, excluded from the calculation of dilutedincome (loss) per share.

 

*Use of Estimates*

 

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

 

The Companybases its estimates on historical experience and on various other assumptionsthat are believed to be reasonable under the circumstances, the results ofwhich form the basis for making judgments about the carrying values ofassets and liabilities that are not readily apparent from other sources. Suchestimates are subject to a number of assumptions, risks, and uncertainties,many of which are beyond the Company’s control. The Company’s actual results may differfrom its estimates.

 

10

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*Cash andCash Equivalents*

 

For purposesof reporting, cash and cash equivalents include cash and interest-earningdeposits or securities purchased with original maturities of three months orless.

 

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

 

At March 31, 2006 and December 30,2005, the Company had $325,000 of non-marketable equity investments, valued atthe lower of cost or estimated fair value, which were included within otherassets.

 

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

 

At March 31, 2006, theCompany carried a $2.5 million long-term account receivable. Of this amount,$2.1 million represents the discounted value of the deferral of one and one-halfmonth’s revenue on an outsourcing contract which began in August 2005. Thispayment has been deferred until the current expiration date of the contract in December 2009.The receivable was discounted using an interest rate of 7% and the unamortizeddiscount at March 31, 2006 was $630,000.

 

**Note 4   ****               ****Stock Repurchase**

 

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

 

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

 

Under SFAS142, the Company no longer amortizes its goodwill and is required to completean annual impairment testing which is performed during the fourth quarter ofeach year. The Company believes that the accounting assumptions and estimatesrelated to the annual goodwill impairment testing are critical because thesecan change from period to period. Various assumptions, such as discount rates,and comparable company analysis are used in performing these valuations. Theimpairment test requires the Company to forecast future cash flows, whichinvolves significant judgment.  Accordingly, if expectations of futureoperating results change, or if there are changes to other assumptions,estimates of the fair value of reporting units could change significantlyresulting in a goodwill impairment charge, which could have a significantimpact on consolidated financial statements. The Company performed animpairment test on each of its components of goodwill as of the fourth quarterof fiscal year 2005 and determined that none of its goodwill was impaired. Asof March 31, 2006 the Company has $18.2 million of goodwill and $1.0million of intangible assets recorded on its balance sheet.

 

11

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There were no changes in thenet carrying amounts of goodwill for the three months ended March 31, 2006.The amounts of goodwill are as follows (in thousands):

 
| ** **                           | ** ** | **Health  Delivery  Services** | ** ** | **Health  Delivery  Outsourcing** | ** ** | **Life  Sciences** | ** ** | **Government  & Technology  Services** | ** ** | **Total**  | ** ** |
|--------------------------------------|------------|--------------------------------|------------|-----------------------------------|------------|--------------------|------------|-------------------------------------------------|------------|------------|------------|
| Balance as of December 30, 2005 |       | $                              | 3,225      |                              | $          | 5,193              |       | $                                               | 1,481      |       | $          | 8,260 | ** ** | **$** | **18,159** | ** ** |
| Acquired                             |       | —                         |       | —                            |       | —             |       | —                                          | ** ** | **—** | ** ** |
| Balance as of March 31, 2006    |       | $                              | 3,225      |                              | $          | 5,193              |       | $                                               | 1,481      |       | $          | 8,260 | ** ** | **$** | **18,159** | ** ** |

 

As of March 31, 2006,the Company had the following acquired intangible assets (in thousands):

 

| ** **                           | ** ** | **Customer  Related** | ** ** |
|--------------------------------------|------------|-----------------------|------------|
| Balance as of December 30, 2005 |       | $                     | 1,228      |   |
|                                 |       |                  |       |
| Amortization                         |       | (193                  | )          |
|                                 |       |                  |       |
| Balance as of March 31, 2006    |       | $                     | 1,035      |   |
|                                 |       |                  |       |
| Amortization Period in Years         |       | 2 -4                  |       |

 

The following tablesummarizes the estimated remaining annual pretax amortization expense for theseassets (in thousands):

 

| **Fiscal Year**     | ** ** | ** ** | ** ** | ** ** |
|--------------------------|------------|------------|------------|------------|
| 2006 (remainder of year) |       | $          | 579        |       |
| 2007                     |       | 456        |       |
| Total                    |       | $          | 1,035      |       |

 

**Note 6   ****               ****Restructuring Costs**

 

**At March 31, 2006, the Company had approximately $2.8million in restructuring accrual which related to facility closure costsincurred in prior years, primarily in the Life Sciences segment. In February 2006,the Company signed an agreement with a landlord to return excess space to them.As part of the agreement, the Company is required to make $2.9 million ofpayments to the landlord in equal installments over the last ten months offiscal year 2006 in order to extinguish the Company’s obligations under thelease.**

** **

**The restructuring cost liability activity through March 31,2006 is summarized as follows (in thousands):**

** **
| Accrual balance at December 30, 2005 |   | $    | 3,204 |   |
|-------------------------------------------|--------|------|-------|--------|
| Cash payments                             |   | (386 | )     |
| Accrual balance at March 31, 2006    |   | $    | 2,818 |   |

 

12

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

 

Comprehensive income (loss),net of taxes, for the three months ended March 31, 2006 and April 1,2005, is as follows (in thousands):

 
| ** **                                    | ** ** | **Three Months Ended** | ** ** |
|-----------------------------------------------|------------|----------------------------------|------------|
| ** **                                    | ** ** | **March 31, 2006**     | ** ** | **April 1, 2005** | ** ** |
| Net income (loss)                             |       | $                                | 4,522      |   | $ | (1,289 | ) |
|                                          |       |                             |       |   |   |
| Foreign currency translation adjustment       |       | 5                                |       | (100 | ) |
| Unrealized loss on investments                |       | (6                               | )          | — |   |
| Other comprehensive income (loss), net of tax |       | (1                               | )          | (100 | ) |
|                                          |       |                             |       |   |   |
| Comprehensive income (loss)                   |       | $                                | 4,521      |   | $ | (1,389 | ) |

 

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

 

On December 7, 2004, the Company’s Board of Directors approved aplan to sell and exit its clinical and non-clinical Call Center Services (“CCS”)operation due to recurring losses. On February 2, 2005, the Companyexecuted a definitive agreement with the MPB Group, LLC, d/b/a The BerylCompanies. FCG received 12 monthly payments of $12,500, totaling $150,000, forselected customer contracts. The disposal plan consisted primarily of thetermination of normal CCS activity, calculation of termination benefits for theexisting CCS employees, termination of a lease agreement, abandonment ofproperty and equipment, collection of accounts receivable, and settlement ofliabilities. In accordance with SFAS 144, “Accounting for the Impairment orDisposal of Long-Lived Assets,” this disposal represents a discontinuedoperation.

 

SinceApril 1, 2005, there have been no remaining activities in this business. Asummary of results for CCS for the quarter ended April 1, 2005 includedrevenues of $631,000 and a pre-tax loss of $866,000 which related to the sales,operation, and wind-down of the business, including $276,000 related toseverance costs for the remaining staff of 37 people. This pretax loss resultedin a net loss of $537,000 after a 38% tax benefit.

 

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

 

For fiscalyear 2006, the Company has the following six reportable 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 andoutsourcing services to health plan clients;

•      Governmentand Technology Services - the delivery of consulting services to governmentclients, and the delivery of blended-shore software development; and

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

 

13

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Additionally,the Company has three shared service centers that provide services to multiplebusiness segments. These shared service centers include FCG India, IntegrationServices, and Infrastructure Services. The costs of these services areinternally billed and reported in the individual business segments as cost ofservices at a standard transfer cost.

 

Due to anorganizational change that the Company made which took effect at the beginningof 2006, the Technology Staffing Services (TSS) group has been moved fromGovernment and Technology Services to “Other.” FCG has reclassified previous segment reporting in accordance with SFAS131. The history shown in the financial tables included with this release isnow consistent with these changes. This business is being de-emphasized by theCompany. Although some of the billable staff who were previously included inthis business area have been transferred to several of the Company’s othersegments as part of this organizational change, it is impractical toreclassify the effect on those segments in prior years. Additionally, theHealth Delivery Sales group has been disbanded as a separate group serving bothHealth Delivery Services and Health Delivery Outsourcing, with all sellingcosts now being contained within each individual unit. FCG has reclassifiedsuch prior year costs to each unit based on an estimate of the servicesprovided to that unit by the Health Delivery Sales group.

 

The Companyevaluates its segments’ performance based on revenues and operating income. Certainselling and general and administrative expenses (including corporate functions,occupancy related costs, depreciation, professional development, recruiting,and marketing) are managed at the corporate level and allocated to eachoperating segment based on either net revenues and/or actual usage. The Companydoes not manage or track most assets by segment. As a result, interest andother charges are not included in the tables below.

 

14

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The followingsegment information is for the quarters ended March 31, 2006 and April 1,2005 (inthousands):

 

**For thethree months ended March 31, 2006:**

(in thousands)
| ** **                                     | ** ** | **Health  Delivery  Services** | ** ** | **Health  Delivery  Outsourcing** | ** ** | ***Health  Delivery  Total*** | ** ** | **Life  Sciences** | ** ** | **Health  Plan** | ** ** | **Government  &  Technology  Services** | ** ** | **Software  Products** | ** ** | **Other** | ** ** | **Totals** | ** ** |
|------------------------------------------------|------------|--------------------------------|------------|-----------------------------------|------------|-------------------------------|------------|--------------------|------------|------------------|------------|---------------------------------------------|------------|------------------------|------------|-----------|------------|------------|------------|
| Revenues before reimbursements                 |       | $                              | 15,395     |                              | $          | 27,433                        | * *   | *$*                | *42,828*   |             | $          | 7,747                                       |       | $                      | 6,823      |      | $          | 7,698      |       | $ | 958 |   | $ | 632 |   | **$** | **66,686** | ** ** |
| Reimbursements                                 |       | 2,303                          |       | 37                                | * *   | *2,340*                       |       | 211                |       | 916              |       | 291                                         |       | 13                     |       | 8         |       | **3,779**  | ** ** |
| Total  revenues                                |       | 17,698                         |       | 27,470                            | * *   | *45,168*                      |       | 7,958              |       | 7,739            |       | 7,989                                       |       | 971                    |       | 640       |       | **70,465** | ** ** |
| Cost of services before  reimbursable expenses |       | 9,439                          |       | 24,046                            | * *   | *33,485*                      |       | 4,745              |       | 4,551            |       | 4,776                                       |       | 812                    |       | 224       |       | **48,593** | ** ** |
| Reimbursable  expenses                         |       | 2,303                          |       | 37                                | * *   | *2,340*                       |       | 211                |       | 916              |       | 291                                         |       | 13                     |       | 8         |       | **3,779**  | ** ** |
| Total  cost of services                        |       | 11,742                         |       | 24,083                            | * *   | *35,825*                      |       | 4,956              |       | 5,467            |       | 5,067                                       |       | 825                    |       | 232       |       | **52,372** | ** ** |
| Gross  profit                                  |       | 5,956                          |       | 3,387                             | * *   | *9,343*                       |       | 3,002              |       | 2,272            |       | 2,922                                       |       | 146                    |       | 408       |       | **18,093** | ** ** |
| Selling  expenses                              |       | 2,120                          |       | 162                               | * *   | *2,282*                       |       | 883                |       | 473              |       | 574                                         |       | 118                    |       | 49        |       | **4,379**  | ** ** |
| General &  administrative expenses    |       | 2,171                          |       | 1,883                             | * *   | *4,054*                       |       | 2,161              |       | 1,103            |       | 1,043                                       |       | 258                    |       | 556       |       | **9,175**  | ** ** |
| Income (loss) from operations                  |       | $                              | 1,665      |                              | $          | 1,342                         | * *   | *$*                | *3,007*    |             | $          | (42                                         | )          | $                      | 696        |      | $          | 1,305      |       | $ | (230 | ) | $ | (197 | ) | **$** | **4,539** | ** ** |

 

**For thethree months ended April 1, 2005:**

(in thousands)
| ** **                                     | ** ** | **Health  Delivery  Services** | ** ** | **Health  Delivery  Outsourcing** | ** ** | ***Health  Delivery  Total*** | ** ** | **Life  Sciences** | ** ** | **Health  Plan** | ** ** | **Government  &  Technology  Services** | ** ** | **Software  Products** | ** ** | **Other** | ** ** | **Totals** | ** ** |
|------------------------------------------------|------------|--------------------------------|------------|-----------------------------------|------------|-------------------------------|------------|--------------------|------------|------------------|------------|---------------------------------------------|------------|------------------------|------------|-----------|------------|------------|------------|
| Revenues  before reimbursements                |       | $                              | 16,069     |                              | $          | 30,736                        | * *   | *$*                | *46,805*   |             | $          | 8,715                                       |       | $                      | 4,010      |      | $          | 6,151      |       | $ | 537 |   | $ | 1,926 |   | **$** | **68,144** | ** ** |
| Reimbursements                                 |       | 2,517                          |       | 132                               | * *   | *2,649*                       |       | 197                |       | 581              |       | 125                                         |       | 21                     |       | 89        |       | **3,662**  | ** ** |
| Total  revenues                                |       | 18,586                         |       | 30,868                            | * *   | *49,454*                      |       | 8,912              |       | 4,591            |       | 6,276                                       |       | 558                    |       | 2,015     |       | **71,806** | ** ** |
| Cost of services before  reimbursable expenses |       | 10,815                         |       | 26,935                            | * *   | *37,750*                      |       | 4,580              |       | 3,259            |       | 3,707                                       |       | 884                    |       | 2,310     |       | **52,490** | ** ** |
| Reimbursable  expenses                         |       | 2,517                          |       | 132                               | * *   | *2,649*                       |       | 197                |       | 581              |       | 125                                         |       | 21                     |       | 89        |       | **3,662**  | ** ** |
| Total  cost of services                        |       | 13,332                         |       | 27,067                            | * *   | *40,399*                      |       | 4,777              |       | 3,840            |       | 3,832                                       |       | 905                    |       | 2,399     |       | **56,152** | ** ** |
| Gross  profit                                  |       | 5,254                          |       | 3,801                             | * *   | *9,055*                       |       | 4,135              |       | 751              |       | 2,444                                       |       | (347                   | )          | (384      | )          | **15,654** | ** ** |
| Selling  expenses                              |       | 2,107                          |       | 810                               | * *   | *2,917*                       |       | 1,905              |       | 536              |       | 563                                         |       | 142                    |       | 695       |       | **6,758**  | ** ** |
| General &  administrative expenses    |       | 3,187                          |       | 1,823                             | * *   | *5,010*                       |       | 2,480              |       | 740              |       | 1,050                                       |       | 361                    |       | 876       |       | **10,517** | ** ** |
| Income  (loss) from operations                 |       | $                              | (40        | )                                 | $          | 1,168                         | * *   | *$*                | *1,128*    |             | $          | (250                                        | )          | $                      | (525       | )         | $          | 831        |       | $ | (850 | ) | $ | (1,955 | ) | **$** | **(1,621** | **)** |

 

15

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The “other” column includes reclassifications related to the chargingout of the shared service centers described above, as well as the results ofthe remainder of the TSS business discussed above, with the net loss in thatcolumn primarily consisting of under absorption of shared service center orsupport costs into the segments, and a loss incurred by the TSS business.

 

*Detail of Health DeliveryOutsourcing Revenues*

 

Health Delivery Outsourcingrevenues before reimbursements include revenues related to a majorsubcontractor on three projects in 2005, and one project in 2006. The breakdownof revenue in Health Delivery Outsourcing is as follows (in thousands):

 
| ** **                     | ** ** | **Three Months Ended** | ** ** |
|--------------------------------|------------|----------------------------------|------------|
| ** **                     | ** ** | **March 31,  2006**         | ** ** | **April 1,  2005** | ** ** |
| Internally generated revenues  |       | $                                | 26,131     |   | $ | 25,093 |   |
| Subcontractor revenues         |       | 1,302                            |       | 5,643 |   |
|                           |       |                             |       |   |   |
| Revenues before reimbursements |       | $                                | 27,433     |   | $ | 30,736 |   |

 

## ** **

**Note 10 ****               ****Income Taxes**

 

                The Company recorded a $340,000 tax provisionfor the quarter ended March 31, 2006 versus a $639,000 tax benefit for thequarter ended April 1, 2005. The 7% tax provision for the quarter ended March31, 2006 was for estimated current taxes payable for U.S. federal alternativeminimum tax and certain state and foreign income taxes, as the Company's netoperating loss carryforwards offset most of the federal and certain state taxliabilities. The 46% tax benefit in the quarter ended April 1, 2005 was basedon full taxation of the then anticipated profit for fiscal year as whole.

 

## **Item 2. Management’s Discussion andAnalysis of Financial Condition and Results of Operations**

 

THE FOLLOWINGMANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OFOPERATIONS CONTAINS FORWARD-LOOKING STATEMENTS WITHIN THE MEANING OF THEPRIVATE SECURITIES LITIGATION REFORM ACT OF 1995. SUCH FORWARD-LOOKINGSTATEMENTS INVOLVE RISKS AND UNCERTAINTIES, INCLUDING THOSE SET FORTH IN PART II,ITEM 1A OF THIS REPORT AND CONTAINED IN OTHER REPORTS WE FILE WITH THESECURITIES AND EXCHANGE COMMISSION. OUR ACTUAL RESULTS COULD DIFFER MATERIALLYFROM THOSE ANTICIPATED IN THESE FORWARD-LOOKING STATEMENTS.

 

**Overview**

 

We provideservices primarily to providers, payors, government agencies, pharmaceutical,biogenetic, and other healthcare organizations in North America, Europe, andAsia. We generate substantially all of our revenues from fees for informationtechnology outsourcing services and professional services.

 

We typically bill for our services on anhourly or fixed-fee basis as specified by the agreement with a particularclient. 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 the staffmembers assigned to the engagement. Fixed fees, including outsourcing fees, areestablished on a per-assignment or monthly basis and are based on severalfactors such as the size, scope, complexity and duration of an assignment, thenumber of our employees required to complete the assignment, and the volume oftransactions or interactions. Revenues are generally recognized related to thelevel of services performed, the amount of cost incurred on the assignmentversus the estimated total cost to complete the assignment, or on astraight-line basis over the period of performance of service. Additionally, wehave been licensing an increased amount of our software products, generally inconjunction with the customization and implementation of such software products.Revenues from our software licensing and maintenance were approximately 2.7% ofour net revenues in fiscal year 2005 and 4.6% of our net revenues in the firstquarter of fiscal year 2006. We expect our software licensing revenues tocontinue to grow incrementally during our 2006 fiscal year. We also expect ourservices revenues associated with the implementation of our software productsto continue to become a more significant part of our overall servicesrevenues.

 

16

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Provisions aremade for estimated uncollectible amounts based on our historical experience. Wemay obtain payment in advance of providing services. These advances arerecorded as customer advances and reflected as a liability on our balance sheetuntil services are provided. Provisions for estimated losses on individualcontracts are made in the period in which the loss first becomes known.

 

Out-of-pocketexpenses billed and reimbursed by clients are included in total revenues, andthen deducted to determine revenues before reimbursements (“net revenues”). Forpurposes of analysis, all percentages in this discussion are stated as apercentage of net revenues, since we believe that this is the more relevantmeasure of our business.

 

Cost ofservices primarily consists of the salaries, bonuses, and related benefits ofclient-serving staff, subcontractor expenses, and infrastructure costs relatedto services provided to clients and in our offshore shared service center. Sellingexpenses primarily consist of the salaries, benefits, travel, and other costsof our sales force, as well as marketing and market research expenses. Generaland administrative expenses primarily consist of costs to support our businesssuch as non-billable travel, internal information systems and infrastructure,salaries and expenses for executive management, financial accounting andadministrative personnel, and legal and other professional services. As staffrelated costs are relatively fixed in the short term, variations in ourrevenues and operating results in our CSI business can occur as a result ofvariations in billing margins and utilization rates of our billable associates.

 

Our most significant expenses are our humanresource and related salary and benefit expenses. As of March 31, 2006,approximately 1,342 of our 2,394 employees are billable consultants andsoftware developers. Another 746 employees are part of our outsourcingbusiness. The salaries and benefits of such billable personnel staff andoutsourcing related employees are recognized in our cost of services. Mostnon-billable employee salaries and benefits are recognized as a component ofeither selling or general and administrative expenses. Approximately 12.8% ofour workforce, or 306 employees, are classified as non-billable. Our cost ofservices as a percentage of net revenues is directly related to severalfactors, including, but not limited to:

 

•      Our staffutilization, which is the ratio of total billable hours to available hours in agiven period;

•      The amount andtiming of cost incurred;

•      Our ability tocontrol costs on our outsourcing projects;

•      The billed rateon time and material contracts; and

•      The estimatedcost to complete our non-outsourcing fixed price contracts.

 

In our outsourcing contracts, a significantportion of our revenues are fixed and allocated over the contract on astraight-line basis, as we are required to provide a specified level of ongoingservices. Also, certain revenues may fluctuate under the contracts basedon the volume of transactions we process or other measurements of serviceprovided. If we incur higher costs to provide the required services or receiveless revenue due to reduced transaction volumes or penalties associated withservice level failures, our gross profit can be negatively impacted.

 

In our CSIbusiness, we manage staff utilization by monitoring assignment requirements andtimetables, available and required skills, and available staff hours per weekand per month. Differences in personnel utilization rates can result fromvariations in the amount of non-billed time, which has historically consistedof training time, vacation time, time lost to illness and inclement weather,and unassigned time. Non-billed time also includes time devoted to othernecessary and productive activities such as sales support and interviewingprospective employees. Unassigned time results from differences in the timingof the completion of an existing assignment and the beginning of a newassignment. In order to reduce and limit unassigned time, we actively managepersonnel utilization by monitoring and

 

17

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projecting estimated engagementstart and completion dates and matching staff availability with current andprojected client requirements. The number of people staffed on an assignmentwill vary according to the size, complexity, duration, and demands of theassignment. Assignment terminations, completions, inclement weather, andscheduling delays may result in periods in which staff members are notoptimally utilized. An unanticipated termination of a significant assignment oran overall lengthening of the sales cycle could result in a higher thanexpected number of unassigned staff members and could cause us to experiencelower margins. In addition, entry into new market areas and the hiring of staffin advance of client assignments have resulted and may continue to resultin periods of lower staff utilization.

 

In response tocompetition and continued pricing and rate pressures, we have implemented aglobal sourcing strategy into our business operations, which includes thedeployment of offshore resources as well as resources that perform servicesremote from the client site. We also incorporate larger numbers of variablecost or per diem staff in some of our projects. We expect these strategies tocontinue to reduce cost of services through a combination of lower costattributable to offshore resources and higher leverage of resources that perform servicesoffsite or on a variable cost basis. To the extent we pass through reducedcosts to our clients related to offshore resources, the global sourcingstrategy may result in lower revenues on a per engagement basis. However, weexpect to offset this potential revenue impact with improved competitivepositioning in our markets, which could result in an increased number ofengagements to offset the potential revenue impact. Several of our competitorsemploy both global sourcing and variable staffing strategies to providesoftware development and other information technology services to theirclients, while at the same time reducing their cost structure and improving thequality of services they provide. If we are unable to realize the perceivedcost benefits of our strategies or if we are unable to receive high qualityservices from foreign employees, variable staff employees, or subcontractors,our business may be adversely impacted and we may not be able tocompete effectively.

 

**Results of Operations for theThree Months Ended March 31, 2006 and April 1, 2005**

 

*Revenues.*Our net revenues decreased to $66.7 millionfor the quarter ended March 31, 2006, a decrease of 2.1% from $68.1million for the quarter ended April 1, 2005. Our total revenues decreasedto $70.5 million for the quarter ended March 31, 2006, a decrease of 1.9%from $71.8 million for the quarter ended April 1, 2005. The decreases innet revenues were in Health Delivery Outsourcing and Life Sciences, offset by increasesin Health Plan and Government and Technology Services. The Health DeliveryOutsourcing segment had the most significant decrease, $3.3 million, or 10.7%, primarilydue to the termination of two outsourcing contracts during the fourth quarterof 2005, offset in large part by the receipt of new contracts. In July 2005,we announced the early termination for convenience by The New York andPresbyterian Hospital (“NYPH”) of our approximately $30 million per yearoutsourcing agreement, effective December 31, 2005 (the contract wasexecuted in November 1999 and was originally scheduled to expire in December 2006).Also, in October 2005, we announced the mutually agreed termination of ouroutsourcing agreement with UMass Memorial Health Care (“UMMHC”) effective November 1,2005, with certain transition services to be performed through December 31,2005. In August 2005, however, we began a five-year IT outsourcingagreement with one client, and a three-year agreement with another client. Outsourcingrevenues in the first quarter of 2006 from these two new contracts totaled $7.9million. In Life Sciences, net revenues decreased by $1.0 million, or 11.1%,primarily due to the completion of certain projects where we performed non-FirstDocsoftware work, as our focus is now on selling and servicing FirstDoc softwareclients. The most significant offsetting increase was in Health Plan, which increasedby $2.8 million, or 70.1%, due to the receipt of a significant outsourcingcontract which began during the second quarter of 2005, and increased servicesrevenue related to market acceptance of our onshore/offshore delivery model. Governmentand Technology Services increased by $1.5 million, or 25.2%, primarily due togrowth in our Software Services business (formerly named Paragon Solutions, Inc.),which comprises the majority of the segment, and provides offshore softwaredevelopment services to independent software vendors.

 

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In March 2006,we received a one year extension of one of our existing major outsourcingcontracts, University of Pennsylvania Health System (UPHS), and that contractis now set to expire in March 2007. We currently receive annual revenuesof approximately $24 million from this contract. During the current extensionperiod, we intend to negotiate in good faith with UPHS on pricing and servicelevels applicable to the one year extension, and until then, current pricingand service levels apply. We currently have no assurances that the contractwill be extended past the one year renewal period, and UPHS still has the rightto terminate the contract for convenience on 180 days notice. If we are unableto execute a longer term renewal with UPHS or if we are unable to enter intonew outsourcing engagements, our Health Delivery Outsourcing revenues would beadversely impacted. Revenues in our business units other than outsourcing arenot expected to change significantly from their levels at the end of the firstquarter of 2006, with some modest growth expected to continue in the HealthPlan and Government and Technology Services segments. Growth in Health DeliveryServices and Outsourcing is highly dependent upon capturing market sharethrough acceptance by the health delivery market of our blended shore deliverymodel. Overall, if we do not otherwise convert potential opportunities in ouroutsourcing pipeline, we expect our percentage mix of outsourcing revenues in2006 to be less than in prior years, primarily due to the loss of revenuesassociated with NYPH and UMMHC.

 

*Cost of Services.*Cost of services before reimbursable expensesdecreased to $48.6 million for the quarter ended March 31, 2006, a decreaseof 7.4% from $52.5 million for the quarter ended April 1, 2005. The decreasewas primarily due to a $2.9 million decline in personnel and other costs in theHealth Delivery Outsourcing segment related to the reduction in revenuesdescribed above. Health Delivery Services cost decreased by $1.4 million as wereduced costs in that area, primarily through staff attrition, to improveprofitability. Costs in Health Plan increased by $1.3 million and costs inGovernment and Technology Services increased by $1.1 million in order to servethe revenue growth in those segments.

 

*Gross Profit.*Grossprofit increased to $18.1 million, or 27.1% of net revenues, for the quarterended March 31, 2006, an increase of 15.6% from $15.7 million, or 23.0% ofnet revenues, for the quarter ended April 1, 2005. This increase was dueto increases in gross profit in Health Plan and Government and TechnologyServices related to the increases in revenues in those businesses describedabove, and in Health Delivery Services related higher labor utilization rates, partlyoffset by a decrease in gross profit in Life Sciences, due to the combinationof the decrease in revenue described above, and increased costs related tocompleting a large custom software development contract.

 

The gross profit of Health DeliveryOutsourcing, approximately 12.3% during the first quarter of 2006, is lower ona percentage basis than gross profit in our other business segments. While thegross profit percentage in this segment remained steady year over year for the firstquarter, the significantly lower portion of our revenue mix coming from ourHealth Delivery Outsourcing segment was a major contributing factor to ouroverall gross profit percentage increase to 27.1% from 23.0% of net revenues,due to the lower gross profit nature of outsourcing business.

 

*Selling Expenses.*Selling expenses decreased to $4.4 millionfor the quarter ended March 31, 2006, a decrease of 35.2% from $6.8million for the quarter ended April 1, 2005. This decrease was primarilydue to reductions in the size of the sales force, and also to cuts in marketingcosts. Selling expenses as a percentage of net revenues decreased to 6.6% forthe quarter ended March 31, 2006 from 9.9% for the quarter ended April 1,2005 for the same reasons.

 

*General and AdministrativeExpenses.*General andadministrative expenses decreased to $9.2 million for the quarter ended March 31,2006, a decrease of 12.8% from $10.5 million for the quarter ended April 1,2005. This decrease was due to cost reductions which occurred during fiscalyear 2005. As well as lower salary expense due to staff reductions, costs werealso reduced in the areas of travel, recruiting, telecommunications, and officespace. General and administrative expenses as a percentage of

 

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net revenues decreased to 13.8% for thequarter ended March 31, 2006 from 15.4% for the quarter ended April 1,2005.

 

*Interest Income, Net.*Interest income, net of interest expense,increased to $338,000 for the quarter ended March 31, 2006, an increase of47.0% from $230,000 for the quarter ended April 1, 2005, due to higherinterest rates earned on cash and investments, partially offset by the slightlyreduced level of cash and investments on which interest is earned. Interestincome, net of interest expense as a percentage of net revenues increasedslightly to 0.5% for the quarter ended March 31, 2006 from 0.3% for thequarter ended April 1, 2005.

 

*Other Income (Expense),Net*. Other income(expense) was negligible for the quarters ended March 31, 2006 and April 1,2005.

 

*Income Taxes.*We recorded a $340,000 tax provision for thequarter ended March 31, 2006 versus a $639,000 tax benefit for the quarterended April 1, 2005. The 7% tax provision for the quarter ended March 31,2006 was for estimated current taxes payable for U.S. federal alternativeminimum tax and certain state and foreign income taxes, as the net operatingloss carryforwards offset most of the federal and certain state tax liabilities.The 46% tax benefit in the quarter ended April 1, 2005 was based on fulltaxation of the then anticipated profit for fiscal year as a whole.

 

*Loss on DiscontinuedOperations*. Thedisposition of our Coactive Call Center Service line in the first quarter offiscal year 2005 has been accounted for as a discontinued operation, and therewere no remaining activities in this business during the quarter ended March 31,2006. During the quarter ended April 1, 2005, we incurred $866,000 ofcosts related to the operation and wind-down of the business. These costs, netof a 38% tax benefit, resulted in a net loss of $537,000.

 

**Liquidity and Capital Resources**

 

During the quarter ended March 31, 2006,we used cash flow for continuing operations of $2.4 million. We used $2.8million to pay for severance recorded during the fourth quarter of 2005. Further,we used approximately $1.6 million of cash to purchase property and equipment,primarily information technology and related equipment. At March 31, 2006,we had cash and investments available for sale of $32.7 million compared to$35.1 million at December 30, 2005. One of our new outsourcing accounts,which began in August 2005, had a net negative impact on cash of over $2million for the quarter ended March 31, 2006, primarily due to thedeferral of fees, transition costs, and capital expenditures agreed upon whenthe contract was originally signed in the third quarter of 2005. During thefirst quarter of 2006, our cash flow benefited from $1.6 million of stockoption exercises, primarily by recently terminated employees.

 

In February 2006, we signed an agreementwith a landlord to return excess space to them. As part of the agreement,we are required to make $2.9 million of payments to the landlord in equalinstallments over the last ten months of fiscal year 2006 in order toextinguish our obligation. These payments will be charged against amounts thathave been accrued in fiscal year 2005 and prior years for facility closurecosts, and thus will affect cash flow in fiscal year 2006 without affectingpretax income.

 

Our days sales outstanding (DSO) of accountsreceivable increased to 39 days for the first quarter of 2006 from 34 days forthe fourth quarter of 2005. The increase was due to our outsourcing business becominga smaller percentage of overall revenues after the winding down of two large outsourcingaccounts. We do not currently expect any significant cash flow changes relatedto the other elements of the working capital cycle such as accounts payable andother accrued liabilities; however, we are susceptible to ongoing routinefluctuations in these areas.

 

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Our cash flow in fiscal year 2006 will behighly dependent on our ability to achieve profitability. Generally, we expect anypretax profitability in fiscal year 2006 to contribute positively to cash flow.A significant amount of any future income (approximately $20 million) is notexpected to be subject to federal taxation or require any significant book taxprovision in our income statement.

 

As of March 31, 2006, the followingtable summarizes our contractual commitments (in thousands):

 
| ** **                          | ** ** | **Payments Due by Period** | ** ** |
|-------------------------------------|------------|-------------------------------------------|------------|
| **Contractual Obligation**     | ** ** | **Less than 1  Year**           | ** ** | **1 -3  Years** | ** ** | **3-5  Years** | ** ** | **More Than  5 Years** | ** ** | **Total** | ** ** |
| Operating  leases, net of subleases |       | $                                         | 6,785      |   | $ | 6,485 |   | $ | 1,881 |   | $ | 374 | ** ** | **$** | **15,525** | ** ** |
|                                     |            |                                           |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

Management believes that our existing cashand cash equivalents, together with funds generated from operations, will besufficient to meet operating requirements for at least the next twelve months. Ourcash and cash equivalents are available for capital expenditures (which areprojected at approximately $7 million for 2006), upfront setup costs anddeferred fees on new contracts, strategic investments, mergers andacquisitions, and other potential large-scale cash needs that may arise.

 

We had a revolving line of credit, underwhich we were allowed to borrow up to $7.0 million at an interest rate of theprevailing prime rate with an expiration of May 1, 2006. There was nooutstanding balance under the line of credit at December 30, 2005. Due torepeated loan covenant violations related to our quarterly losses in 2005, weelected to discontinue the line of credit during the first quarter of 2006rather than accept new restrictive conditions to the credit line which wereproposed by the bank.

 

**CriticalAccounting Policies and Estimates**

 

The foregoingdiscussion and analysis of our financial condition and results of operations isbased upon our consolidated financial statements, which have been prepared inaccordance with accounting principles generally accepted in the United States. Thepreparation of these financial statements requires us to make estimates andassumptions that affect the reported amounts of assets, liabilities, revenuesand expenses, and related disclosure of contingent assets and liabilities. Onan ongoing 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 base our estimates on historical experienceand on various other assumptions that we believe to be reasonable under thecircumstances, the results of which form the basis for making judgmentsabout the carrying value of assets and liabilities that are not readilyapparent from other sources. Our actual results may differ from ourestimates and we do not assume any obligation to update any forward-lookinginformation.

 

We believe thefollowing critical accounting policies reflect our more significant assumptionsand estimates used in the preparation of our consolidated financial statements.

 

***Revenue Recognition and Unbilled Receivables***

 

Revenues arederived primarily from information technology outsourcing services, consulting,and systems integration. Revenues are recognized on a time-and-materials,level-of-effort, percentage-of-completion, or straight-line basis. Beforerevenues are recognized, the following four criteria must be met: (a) persuasiveevidence of an arrangement exists; (b) delivery has occurred or servicesrendered; (c) the fee is fixed and determinable; and (d) collectabilityis reasonably assured. We determine if the fee is fixed and determinable andcollectability is reasonably assured based on our judgments regarding thenature of the fee charged for services rendered and products delivered. Arrangementsvary in length from

 

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less than one year to sevenyears. The longer-term arrangements are generally level-of-effort or fixedprice arrangements.

 

Revenues fromtime-and-materials arrangements are generally recognized based upon contractedhourly billing rates as the work progresses. Revenues from level-of-effortarrangements are recognized based upon a fixed price for the level of resourcesprovided. Revenues from fixed fee arrangements for consulting and systemsintegration work are generally recognized on a rate per hour orpercentage-of-completion basis. We maintain, for each of our fixed fee contracts,estimates of total revenue and cost over the contract term. For purposes ofperiodic financial reporting on the fixed price consulting and systemintegration contracts, we accumulate total actual costs incurred to date underthe contract. The ratio of those actual costs to our then-current estimate oftotal costs for the life of the contract is then applied to our then-currentestimate of total revenues for the life of the contract to determine theportion of total estimated revenues that should be recognized. We follow thismethod because reasonably dependable estimates of the revenues and costsapplicable to various stages of a contract can be made.

 

Revenuesrecognized on fixed price consulting and system integration contracts aresubject to revisions as the contract progresses to completion. If we do notaccurately estimate the resources required or the scope of the work to beperformed, do not complete our projects within the planned periods of time, ordo not satisfy our obligations under the contracts, then profit may besignificantly and negatively affected. Revisions in our contract estimates arereflected in the period in which the determination is made that facts andcircumstances dictate a change of estimate. Favorable changes in estimates resultin additional revenues recognized, and unfavorable changes in estimates resultin a reduction of recognized revenues. Provisions for estimated losses onindividual contracts are made in the period in which the loss first becomesknown. Some contracts include incentives for achieving either schedule targets,cost targets, or other defined goals. Revenues from incentive type arrangementsare recognized when it is probable they will be earned.

 

We account forcertain of our outsourcing contracts using EITF 00-21, “Accounting for RevenueArrangements with Multiple Deliverables,” which addresses how to account forarrangements that involve the delivery or performance of multiple products,services, and/or rights to use assets. Revenue arrangements with 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 allocatedamong the separate units of accounting based on their relative fair values,with the amount allocated to the delivered item being limited to the amountthat is not contingent on the delivery of additional items or meeting otherspecified 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, certain revenues may fluctuate under thecontracts based on the volume of transactions we process or other measurementsof service provided. If we incur higher costs to provide the required servicesor receive lower revenues due to reduced transaction volumes or penaltiesassociated with service level failures, our gross profit can be negativelyimpacted.

 

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 incurredand realization of those costs is either paid for upfront or guaranteed by thecontract, those costs are deferred and later expensed over the period ofrecognition of the related revenue. At March 31, 2006, we had deferred $3.5million of unamortized costs which are included in non-current assets. One ofour recent contract awards includes approximately $400,000 of setup andtransition costs not yet incurred, so our deferred costs are expected toincrease in the second quarter of fiscal year 2006.

 

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As part ofour ongoing operations to provide services to our customers, incidentalexpenses, which are generally reimbursable under the terms of the contracts,are billed to customers. These expenses are recorded as both revenues anddirect cost of services in accordance with the provisions of EITF 01-14, “IncomeStatement Characterization of Reimbursements Received for ‘Out-of-Pocket’Expenses Incurred,” and include expenses such as airfare, mileage, hotel stays,out-of-town meals, and telecommunication charges.

 

Softwarelicense and maintenance revenues comprised approximately 4.6% of our netrevenues in the first quarter of 2006. Additionally, we realized additionalrevenues from the implementation of our software. We recognize softwarerevenues in accordance with the provisions of the American Institute ofCertified Public Accountants Statement of Position (“SOP”) 97-2, “SoftwareRevenue Recognition”, as amended by SOP 98-9, “Modification of SOP 97-2,Software Revenue Recognition, With Respect to Certain Transactions”, and inaccordance with the Securities and Exchange Commission Staff AccountingBulletin (“SAB”) No. 104, “Revenue Recognition”. We license software undernon-cancelable license agreements and provide related professional services,including consulting, training, and implementation services, as well as ongoingcustomer support and maintenance. Most of our software license fee revenues arefrom arrangements which include implementation services that are essential tothe functionality of our software products, and are recognized using contractaccounting, including the percentage-of-completion methodology, over the periodof the implementation.

 

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

 

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

 

Unbilledreceivables of $15.3 million represent revenues recognized for servicesperformed that were not billed at the balance sheet date. The majority of theseamounts are billed in the subsequent month; however, certain unbillable amountsarising from contracts occur when revenues recognized

 

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exceed allowable billings inaccordance with the contractual agreements. Such unbillable amounts most oftenbecome billable upon reaching certain project milestones stipulated per thecontract, or in accordance with the percentage of completion methodology. As ofMarch 31, 2006, we had unbillable amounts of approximately $3.3 million,which were generally expected to be billed within one year.

 

We had along-term receivable at March 31, 2006 and December 30, 2005 of $2.5 millionand $1.7 million. Of the long-term receivables of $1.7 million at December 30,2005, $1.3 million was created in August 2005 through the deferral until2009 of the first month of fees of a new outsourcing contract. An additionalamount of approximately $800,000 related to this contract was deferred in January 2006.

 

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

 

***Allowance for Doubtful Accounts***

 

                We maintainan allowance for doubtful accounts for estimated losses resulting from theinability of our clients to make required payments. This allowance is based onthe amount and aging of our accounts receivable, creditworthiness of ourclients, historical collection experience, current economic trends, and changesin client payment patterns. If the financial condition of our clients was todeteriorate, resulting in an impairment of their ability to make payments,additional allowances would be required. Our bad debt losses have generallybeen moderate due to the size and quality of our customers; however, we haverecently incurred some bad debt losses in our growing Software Services segmentdue to the lower credit quality of our clients in that segment, and have had toincrease our bad debt reserves accordingly. Our allowance for doubtful accountsis a particularly difficult estimate to make, because if one of our largerclients unexpectedly became unable to pay us, our allowance would have toincrease suddenly.

 

***Deferred Income Taxes***

 

We account for income taxes in accordancewith SFAS 109, “Accounting for Income Taxes,” which requires recognition ofdeferred tax assets and liabilities for the expected future tax consequences ofevents that have been included in the financial statements which differ fromour tax returns. We use significant estimates in determining what portion ofour deferred tax asset is more likely than not to be realized. Prior to fiscalyear 2003, our net deferred tax assets had historically consisted primarily ofthe tax benefit related to restructuring costs for facility closures,supplemental executive retirement plan contributions, and other accruedliabilities such as accrued vacation pay, which are not deductible for taxpurposes 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, and recorded a valuation allowanceof $5.8 million in the fourth quarter of that year. During the fourth quarterof fiscal year 2004, we re-evaluated our requirement for a valuation allowanceafter having completed a full year in which we recorded taxable income in eachquarter, and reversed $3.0 million of the valuation allowance taken in fiscalyear 2003.

 

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

 

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This valuation allowance does not, in anyway, limit our ability to use our deferred tax assets, primarily losscarryforwards, to offset taxable income in the future. As well as not beingsubject to federal taxation other than the Alternative Minimum Tax, asignificant amount (approximately $20 million) of any future pretax income willnot require a significant tax provision in the income statement. Additionally,if at some point in the future, the realization of any of our deferred taxassets is considered more likely than not based on successive years ofgenerating taxable income, we will reverse all or a portion of any existingvaluation allowance at that time. Our valuation allowance for deferred incometaxes has been a particularly volatile estimate over the past several years, asour level of income and loss has fluctuated, requiring us to reassess thelikelihood of realization of our tax assets.

 

***Goodwill and Intangible Assets***

 

Under SFAS142, we no longer amortize our goodwill and are required to complete an annualimpairment testing which we perform during the fourth quarter of each year.We believe that the accounting assumptions and estimates related to the annualgoodwill impairment testing are critical because these can change from periodto period. We use various assumptions, such as discount rates, and comparablecompany analysis in performing these valuations. The impairment test requiresus to forecast our future cash flows, which involves significant judgment.  Accordingly,if our expectations of future operating results change, or if there are changesto other assumptions, our estimate of the fair value of our reporting unitscould change significantly resulting in a goodwill impairment charge, whichcould have a significant impact on our consolidated financial statements. Weperformed an impairment test on each of our components of goodwill as of thefourth quarter of fiscal year 2005 and determined that none of our goodwill wasimpaired. As of March 31, 2006, we have $18.2 million of goodwill and $1.0million of intangible assets recorded on our balance sheet (see Note 5 of the Notesto Consolidated Financial Statements included in this report).

 

***Recent Accounting Pronouncements***

 

In December 2004,the FASB enacted SFAS 123R which we adopted in the first quarter of 2006 (seeStock-Based Compensation in Note 1 in Item 1 of this report).

 

In May 2005,the FASB issued SFAS 154, “Accounting Changes and Error Corrections - AReplacement of APB Opinion No. 20 and FASB Statement No. 3.”  SFAS 154 requires that all voluntary changesin accounting principles and changes required by a new accounting pronouncementthat do not include specific transition provisions be applied retrospectivelyto prior periods’ financial statements, unless it is impracticable to do so. ThisStatement is effective for accounting changes and corrections of errors made infiscal years beginning after December 15, 2005. Management does notbelieve that its adoption of SFAS 154 will have a significant effect on itsfinancial statements.

 

In November 2005,the FASB issued FASB Staff Position (FSP) SFAS 115-1 and SFAS 124-1, “TheMeaning of Other-Than-Temporary Impairment and Its Application to CertainInvestments.”  This FSP provides guidanceon determining if an investment is considered to be impaired, if the impairmentis other-than-temporary and the measurement of an impairment loss. It alsoincludes accounting considerations subsequent to the recognition of another-than-temporary impairment and requires certain disclosures aboutunrealized losses that have not been recognized as other-than-temporaryimpairments. The guidance in this FSP amends SFAS 115, “Accounting for CertainInvestments in Debt and Equity Securities”, and is effective for reportingperiods beginning after December 15, 2005. We previously accounted forinvestments in accordance with this guidance, and therefore, the adoption ofthis FSP will not have a material impact on the results of operations orfinancial position.

 

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## **Item 3.  Quantitative and Qualitative Disclosures aboutMarket Risks**

 

Our financialinstruments include cash and cash equivalents (i.e., short-term and long-termcash investments), accounts receivable, unbilled receivables, and accountspayable. Only the cash and cash equivalents which totaled $32.7 million at March 31,2006 present us with market risk exposure resulting primarily from changes ininterest rates. Based on this balance, a change of one percent in the interestrate would cause a change in interest income for the annual period ofapproximately $327,000. Our objective in maintaining these investments is theflexibility obtained in having cash available for payment of accruedliabilities and acquisitions.

 

## **Item 4.  Controls and Procedures**

 

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

 

As required by SEC Rule 13a-15(b),we carried out an evaluation, under the supervision and with the participationof our management, including our Chief Executive Officer and our ChiefFinancial Officer, of the effectiveness of the design and operation of ourdisclosure controls and procedures as of the end of the quarter covered by thisreport. Based on the foregoing and except as noted below, our Chief ExecutiveOfficer and Chief Financial Officer concluded that our disclosure controls andprocedures were effective, and were operating at the reasonable assurancelevel.

 

As previously disclosed inItem 9A to our Annual Report on Form 10-K for the fiscal year ended December 30,2005 (“2005 10-K”), our Chief Executive Officer and Chief Financial Officerconcluded that our disclosure controls and procedures were not effective as ofthe end of the 2005 year because we did not maintain effective controls overthe determination and reporting of our provision for income taxes, and we had a“material weakness” in internal controls as defined in Audit Standard No. 2adopted by the Public Company Accounting Oversight Board. The material weaknesswas related to the inaccurate identification and recording of state tax netoperating losses (NOLs) during fiscal years 2000 through 2004, resulting inexcess state tax contingency reserves accumulating on our balance sheet and$1.3 million of higher cumulative tax expense over those periods. The properprocedure for estimating the state deferred tax assets and the related contingencyreserves is to use the income of each of our subsidiaries and the tax rates foreach state jurisdiction in which such subsidiary operates in performing thecalculations. In preparing the 2005 10-K, we applied the proper procedure,which resulted in management identifying the excess tax contingency reserve forthe first time. The 2005 10-K correctly states our 2005 income tax expense andwe restated our previously issued consolidated financial statements for the2001 through 2004 fiscal years to account for the inaccuracies that weidentified in preparing the 2005 10-K. As a result of the inaccuracies in taxaccounting described above, management concluded that our controls were noteffective because there were not sufficient personnel in our corporate taxdepartment who were qualified and trained to properly calculate state deferredtax assets and contingency reserves. Since the calculation of state NOLs andthe related accounting is performed on a once per year basis after all taxreturns are filed for the previous year, the initial testing to confirm thatthe material weakness described above and in Item 9A of our 2005 10-K has beenremediated will occur in late 2006. As indicated in our 2005 10-K, we areactively searching for a new tax director with

 

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experience in calculating deferred tax assets, andin applying SFAS 109, “Accounting for Income Taxes,” who will perform theappropriate detailed analysis on an ongoing basis starting in fiscal year 2006.

 

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

 

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# **PART II.  OTHER INFORMATION**

 

## **Item 1.  Legal Proceedings.**

 

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

 

## **Item 1A.  Risk Factors.**

 

There havebeen no material changes from risk factors as previously disclosed in responseto Item 1A in Part I of our Annual Report on Form 10-K for the fiscalyear ended December 30, 2005.

 

## **Item 2.  Unregistered Sales of Equity Securities andUse of Proceeds.**

 

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 (December 31, 2005 – January 27, 2006) |       | 0                                                |       | $                                                | 0.00       |                                                                                              | n/a        |                                                                                                                | n/a        |   |
| Month #2 (January 28, 2006 – February 24, 2006) |       | 0                                                |       | $                                                | 0.00       |                                                                                              | n/a        |                                                                                                                | n/a        |   |
| Month #3 (February 25, 2006 – March 31, 2006)   |       | 2,070                                            |       | $                                                | 6.76       |                                                                                              | n/a        |                                                                                                                | n/a        |   |
| **Total**                                                      | ** ** | **2,070**                                        | ** ** | **$**                                            | **6.76**   | ** **                                                                                        | **n/a**    | ** **                                                                                                          | **n/a**    | ** ** |

 

On March 3,2006, we repurchased a total of 2,070 shares of common stock from one of ournon-Section 16 officer vice presidents in private transactions, for atotal purchase price of $13,993. All shares were purchased at the closing priceof our common stock on Nasdaq National Market on the date of purchase, or $6.76per share. Of the total purchase price, $13,992 of such amount was applied tooutstanding loan that such vice president had with us. The remaining amount ofthe purchase price paid to the applicable vice presidents was intended to coverthe individuals’ estimated capital gains tax on the sale. The loan was made inconnection with restricted stock purchase agreements between FCG and this vicepresident that were entered into prior to December 2000, when weeliminated a requirement that our vice presidents purchase and hold commonstock of FCG.

 

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

 

None.

 

## **Item 4.  Submission of Matters to a Vote of SecurityHolders.**

 

None.

 

## **Item 5.  Other Information.**

 

None.

 

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## **Item 6. 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.                            |       |

----

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

 

(2)   Incorporated by reference to Exhibit 99.1to FCG’s Current Report on Form 8-K dated December 9, 1999.

 

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

 

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

 

(5)   See Note 1 of Notes to ConsolidatedFinancial Statements, “Basic and Diluted Net Income (Loss) Per Share.”

 

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# **SIGNATURES**

 

Pursuant tothe requirements of the Securities and Exchange Act of 1934, the registrant hasduly caused this report to be signed on its behalf by the undersigned thereuntoduly authorized.

 
|                     | FIRST  CONSULTING GROUP, INC.             |
|--------------------------|------------------------------------------------|
|                     |                                           |
|                     |                                           |
| Date: May 10,  2006 | /s/STEVEN  HECK                                |
|                     | Steven Heck                                    |
|                     | President  and Interim Chief Executive Officer |
|                     |                                           |
|                     |                                           |
| Date: May 10,  2006 | /s/THOMAS A.  WATFORD                          |
|                     | Thomas A.  Watford                             |
|                     | Executive  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)   Incorporated by reference to Exhibit 3.1to FCG’s Form S-1 Registration Statement (No. 333-41121) originallyfiled on November 26, 1997 (the “Form S-1”).

 

(2)   Incorporated by reference to Exhibit 99.1to FCG’s Current Report on Form 8-K dated December 9, 1999.

 

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

 

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

 

(5)   See Note 1 of Notes toConsolidated Financial Statements, “Basic and Diluted Net Income (Loss) PerShare.”

 

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