Dynamics Research (DRCO)

 

UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

 

Form 10-K

 

 

 

Commission file number 000-02479

 

 

DYNAMICS RESEARCH CORPORATION

(Exact Name of Registrant as Specified in Its Charter)

 

 

Registrant’s telephone number, including area code

(978) 475-9090

 

 

Securities registered pursuant to Section 12(b) of the Act:

None

 

 

Securities registered pursuant to Section 12(g) of the Act:
Common Stock, $0.10 par value

 

 

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.  Yes o     No þ

 

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Exchange Act. Yes o     No þ

 

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

 

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.  o

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer (as defined in Rule 12b-2 of the Exchange Act).

Large accelerated filer o     Accelerated filer þ     Non-accelerated filer o

 

Indicate by check mark whether the registrant is a shell Company (as defined in Rule 12b-2 of the Exchange Act).  Yes o     No þ

 

The aggregate market value of the registrant’s common stock, $0.10 par value, held by nonaffiliates of the registrant as of June 30, 2006, was $98,325,095 based on the reported last sale price per share of $13.58 on that date on the Nasdaq Stock Market. As of March 1, 2007, 9,352,827 shares of the registrant’s common stock, $0.10 par value, were outstanding.

 

 

DOCUMENTS INCORPORATED BY REFERENCE

 

Portions of the registrant’s Proxy Statement involving the election of directors, which is expected to be filed within 120 days after the end of the registrant’s fiscal year, are incorporated by reference in Part III of this Report.

 

 

DYNAMICS RESEARCH CORPORATION

 

ANNUAL REPORT ON FORM 10-K FOR THE YEAR ENDED DECEMBER 31, 2006

 

 

FORWARD-LOOKING STATEMENTS

 

This Annual Report on Form 10-K (“Form 10-K”) contains forward-looking statements regarding future events and the future results of Dynamics Research Corporation (“DRC”) that are based on current expectations, estimates, forecasts, and projections about the industries in which DRC operates and the beliefs and assumptions of the management of DRC. Words such as “anticipates”, “believes”, “estimates”, “expects”, “intends”, “plans”, “projects”, and other similar expressions are intended to identify such forward-looking statements. These forward-looking statements are predictions of future events or trends and are not statements of historical matters. These statements are based on current expectations and beliefs of DRC and involve a number of risks, uncertainties, and assumptions that are difficult to predict. Therefore, actual results may differ materially and adversely from those expressed in any forward-looking statements. Readers are cautioned not to place undue reliance on these forward-looking statements, which speak only as of the date of this document or in the case of the statements incorporated by reference. Factors that might cause or contribute to such differences include, but are not limited to, those discussed in the Form 10-K under the section entitled “Risks Factors”. Except to the extent required by applicable law or regulation, DRC undertakes no obligation to revise or update publicly any forward-looking statements for any reason.

 

OVERVIEW

 

DRC provides information technology (“IT”), engineering, logistics and other consulting services to federal defense, civil and state agency customers. Founded in 1955 and headquartered in Andover, Massachusetts, DRC has approximately 1,500 employees, located throughout the United States (“U.S.”). DRC operates through its parent corporation and its wholly owned subsidiaries, H.J. Ford Associates, Inc. (“HJ Ford”) and DRC International Corporation. Unless the context otherwise requires, references in this Form 10-K to “DRC”, “we”, “us” or “our” refer to Dynamics Research Corporation and its subsidiaries.

 

Our core capabilities are focused on IT, engineering and technical subject matter expertise that pertain to the knowledge domains relevant to our core customers. More specifically, these solutions which are offered by our Systems and Services business segment, include design, development, operation and maintenance of business intelligence systems, business transformation services, engineering, defense program acquisition management services, training and performance support systems and services, automated case management systems and IT infrastructure services.

 

We strive to apply these processes and technologies to enhance the performance and cost effectiveness of a variety of mission-critical customer systems. We believe that one of our distinguishing competitive advantages is our ability to provide subject matter experts in disciplines such as logistics, engineering, IT, modeling, simulation and training systems to develop innovative solutions to customer challenges.

 

Our business growth strategy is focused on three national priority markets: national defense and intelligence, public safety and legislated citizen services. Within these markets we are focused on six strategic business areas: C4ISR (Command, control, communications, computing, intelligence, surveillance and reconnaissance), logistics, readiness, military space, public security and citizen services. Our strategy leverages six solution sets where we have strong competencies and a record of meeting our customers’ most difficult challenges. These repeatable, proven, cost effective solutions are acquisition management services, training and performance support, business transformation, business intelligence, IT infrastructure services and automated case management.

 

Our growth strategy is balanced, supplementing organic growth with the acquisition of businesses with additional or complementary capabilities, providing access to new customers. Consistent with this strategy, we have completed three business acquisitions since 2002.

 

In addition to government systems and services, we have one other business segment, the Metrigraphics Division, which develops and produces components for original equipment manufacturers in the computer peripheral device, medical electronics, telecommunications and other industries. Manufacturing core capabilities are focused on the custom design and manufacture of miniature electronics parts that are designed to meet ultra-high precision requirements through the use of electroforming, thin film deposition and photolithography technologies. We do not view Metrigraphics as a strategic business component.

 

Financial data and other information about our operating segments can be found in the section titled “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in Part II, Item 7, and in Note 12 of the “Notes to Consolidated Financial Statements” in Part II, Item 8 on this Form 10-K. Unless otherwise indicated, all financial information contained in this Form 10-K refers to continuing operations.

 

We maintain an Internet site at http://www.drc.com. Our Form 10-K, Quarterly Reports on Form 10-Q and Current Reports on Form 8-K and all amendments to these reports are available free of charge through our website by clicking on the “Investor Relations” page and selecting “SEC Filings”. The public may read and copy any materials we file with the Securities and Exchange Commission (“SEC”) at the SEC’s Public Reference Room at 100F Street, NE, Washington, DC 20549. The public may also obtain information on the operation of the Public Reference Room by calling the SEC at 1-800-SEC-0330. The SEC maintains an Internet site (http://www.sec.gov) that contains reports, proxy and information statements and other information

regarding issuers that file electronically with the SEC. We do not intend that the information contained on our website be deemed a part of this Form 10-K or to be deemed filed with the SEC.

 

MARKETS

 

Our Systems and Services business, which accounted for 97.6% of total revenue in 2006, is focused on providing technical and IT services to government customers. The government market is composed of three sectors: national defense and intelligence, federal civilian agencies, and state and local governments.

 

According to a report published in March 2006 by INPUT, Inc. (“INPUT”) a leading research firm specializing in the market for government contractors, the federal market demand for vendor-furnished information systems and services is estimated to increase from $63.3 billion in fiscal 2006 to $80.5 billion in fiscal 2011, a compound annual growth rate of 5.0%. For fiscal 2007, INPUT projects the contracted portion of the federal IT budget will increase $0.7 billion, or 1.1%, compared with fiscal 2006.

 

Significant changes are underway in the Federal Professional Services industry, especially in the defense related marketplace. First, federal deficits and funding needs related to the war in Iraq are impacting program funding decisions which have caused delays, cancellations and cutbacks. Second, the need for more effective and efficient utilization of available funds has resulted in the initiation of government programs aimed at this objective. As a result there is an increase in demand for business transformation, lean/six sigma, training, engineering and business intelligence solutions to support these programs. Third, Advisory and Assistance Services defense program work is increasingly being set aside for small businesses. And fourth, large agency multiple award sponsored contracts are increasingly being utilized as a preferred procurement method, replacing General Services Administration (“GSA”) contracts.

 

We believe the factors driving growth in the federal civilian agencies sector include homeland security needs, an ongoing need for systems modernization, and, as in the defense sector, government workforce ceilings. These factors have caused, and are expected to continue to cause, federal civilian agencies to turn to contractors on an increasing basis to fill their needs for IT services.

 

In the state and local government sector, there is a need for states to continue to modernize child welfare systems and Medicare management systems, areas where our Automated Case Management solution fits well. We have considerable experience in providing IT expertise in the health and human services areas. We believe the primary factors driving growth in this sector are infrastructure modernization and expansion, the migration of information and training to web-based applications and cost-sharing incentives to facilitate data exchange with federal agencies, which generally have large and burdensome caseloads. These agencies must maintain extensive records, report program data, eliminate errors and work toward a more responsive management. Yet the information systems of many of these agencies are antiquated, in some cases more than twenty years old, and have limited data interfacing and reporting capabilities.

 

Our Metrigraphics Division represented 2.4% of total revenue in 2006. The Metrigraphics Division serves the commercial original equipment manufacturers market. This market includes manufacturers of computer peripheral devices and telecommunications and medical technology equipment. The Metrigraphics Division sells principally to commercial customers and is not considered strategically important to our future.

 

MAJOR CUSTOMERS

 

Our 2006 contract revenue delineated by market sector was derived 81.4% from the national defense and intelligence sector, 12.1% from federal civilian agencies, 6.0% from state and local governments, and 0.4% from other commercial customers. We had two customers in the past three years that accounted for more than 10% of total revenues. These customers, the U.S. Air Force Aeronautical Systems Center and the U.S. Air Force Electronic Systems Center, along with other customers, are more fully described by sector below.

 

National Defense and Intelligence Sector

 

U.S. Air Force customers constituted the largest component of our national defense and intelligence revenue in 2006, representing 45.4% of total revenue, while U.S. Navy revenue represented 16.4%, U.S. Army

revenue represented 10.3% and revenue from other agencies represented 7.4% of total revenue. Key capabilities that we offer to defense customers include business intelligence systems, business transformation services, acquisition management services, training and performance support systems and services, and IT infrastructure services. In addition, we develop, maintain and validate hardware and software for complex weapons systems. The work we perform for our major customers in this sector is described below.

 

Aeronautical Systems Center, U.S. Air Force Materiel Command

 

The Aeronautical Systems Center (“ASC”), headquartered at Wright-Patterson Air Force Base in Dayton, Ohio, is responsible for research, development, testing, evaluation and initial acquisition of aeronautical systems and related equipment for the Air Force. Major active programs supported include the C-17, F/A-22, F-16, B-1, B-2 Systems Groups, as well as the Reconnaissance Sensors, Propulsion and Tanker Systems Modernization Programs. Through a prime contract held by ^HMRTech/HJ Ford SBA JV, LLC (“^HMRTech/HJ Ford SBA JV”), a joint venture formed by ^HMRTech, LLC and our HJ Ford subsidiary, we provide technical and subject matter expertise supporting a number of the offices responsible for these programs.

 

Our Base Purchase Agreement contract with the ASC was subject to re-competition in 2006 as the Consolidated Acquisition of Professional Services (“CAPS”) contract. In April 2006, ^HMRTech/HJ Ford SBA JV was awarded a CAPS contract, under which task order competition is expected to be completed in 2007. We believe we are well positioned to retain our base of services provided by HJ Ford employees and compete for new business. With the first year re-competitions under the new CAPS contract estimated at 60% complete, annual revenue from the awards to date is anticipated to reach $24 million, growing by more than 10% over the last year of the preceding task order periods, excluding subcontractor revenue. The periods of performance for the task awards range from one to five years. The task orders include a mix of time and material and firm fixed price awards.

 

The new task order awards provide us with the opportunity to continue to expand our presence within the Wings, Groups and Squadrons at ASC and other key U.S. Air Force organizations at Wright-Patterson AFB, Ohio. CAPS is the primary contract vehicle for delivering multi-functional support including Consulting, Program Management, Logistics, Engineering, Financial Management, and Business Transformation services to a variety of ASC, U.S. Air Force Materiel Command, U.S. Air Force Research Laboratory customers and to other Wright-Patterson Air Force Base organizations.

 

Also, related to the new CAPS contract structure, work performed by other contractor team members on these programs, which under the predecessor contract was passed-through our revenue and cost of sales, will be contracted directly between ^HMRTech/HJ Ford SBA JV and the subcontractor and will no longer be included in our financial results. The total annual effect of eliminating the revenue and cost of sales pass-through, estimated at $28 million, prior to the re-competitions, is not included in the $24 million of revenues we have anticipated under the new CAPS contract.

 

U.S. Air Force Electronic Systems Center

 

The mission of the U.S. Air Force Electronic Systems Center (“ESC”), headquartered at Hanscom Air Force Base, Bedford, Massachusetts, is to serve as the Center of Excellence for command and control and information systems to support the U.S. Air Force and the Department of Defense (“DoD”). ESC provides full spectrum architectures, weapon systems management and technical cognizance throughout the life cycle of communications, intelligence, surveillance, reconnaissance and information systems.

 

We evaluate system requirements, provide software development and test services, integrate products into airborne and ground weapons systems, and provide management services supporting ESC systems program offices, including the Combat Air Forces Command and Control, Military Satellite Communications, Joint Surveillance Target Attack Radar, Global Command and Control, Airborne Warning and Control Systems and Defense Information Infrastructure offices.

 

We are the prime support contractor to the Joint Surveillance Target Attack Radar System (“Joint STARS”) Program Office, which has played a key role in warfare and peacekeeping operations. The

surveillance system is designed to detect, classify and track ground targets in all weather conditions on land or at sea. We support Joint STARS by providing advisory, engineering, logistics and program management services. Under this program, we also support the Multi-Sensor Command and Control Aircraft System, a next-generation airborne integrated ground surveillance system that is intended to eventually supersede Joint STARS.

 

Our contract with the ESC, which provided approximately $20 million, $30 million and $31 million in 2006, 2005 and 2004, respectively, is subject to re-competition. The services provided under our current contract are being procured by the ESC under two new contract vehicles, the Engineering Technical Administration Support Services (“ETASS”) contract and the Professional Acquisition Support Services (“PASS”) contract. Proposals for these contracts have been submitted and are awaiting award. We currently anticipate a single ETASS contract award in the second quarter of 2007 and the award of multiple PASS contracts in the fourth quarter of 2007. We have participated in the competitions for these contracts as a subcontractor. The full year revenue impact of moving from a prime contractor to a sub-contractor role is anticipated to be an approximate $7 million revenue reduction with no material effect on operating profit. There can be no assurance that we will receive these contract awards.

 

U.S. Navy Trident Missile Program

 

For more than forty years we have provided services to the U.S. Navy’s Strategic Systems Programs. We build specialized equipment that tests and validates the accuracy and operability of gyroscopes and other guidance equipment for Trident II submarine-launched ballistics missiles. We also develop and maintain performance, reliability and logistics databases and management systems for the inertial guidance instruments housed in the missile guidance systems.

 

U.S. Air Force Depot Operations

 

In 2005, the Ogden Air Logistics Center, one of three U.S. Air Force Materiel Command Air Logistic Centers, awarded us an Indefinite Delivery-Indefinite Quantity (“ID/IQ”) Design Engineering and Support Program II (“DESP II”) contract to provide the U.S. Air Force and other DoD agencies with design, engineering and technical support services. Task orders under the contract may be received through June 2010 and must be completed by June 2012. We are one of twenty prime contractors that received an award. The contract has a ceiling value of $1.9 billion. DESP II is specifically designed to support the engineering services requirements of the U.S. Air Force logistics and maintenance community, which has been a customer of ours for thirty years.

 

We perform logistics analyses and operations for the U.S. Air Force’s three Air Logistics Centers at Tinker, Robins and Hill Air Force Bases in Midwest City, Oklahoma, Warner Robins, Georgia and Ogden, Utah, respectively. We also provide logistics support, IT management and analysis, system engineering and technical services on programs such as the B-1B, the B-2, the B-52, the KC-135 and the E-3A aircraft repair, maintenance and upgrade programs.

 

U.S. Army Aviation/ Missile Command

 

We provide programmatic consulting, engineering and logistics management to the U.S. Army Materiel Command and U.S. Army program executive officers for acquisition of major weapon systems. Our engineers analyze and review airframe, avionics, aeromechanics and propulsion issues for U.S. Army project managers, provide logistics and fielding support, and prepare electronic technical manuals for rotary and fixed-wing aircraft systems. We also support other U.S. Army activities with acquisition logistics, systems engineering and other related program management services for the U.S. Army Aviation Center, Tank-Automotive and Armaments Command and Communications-Electronics Command.

 

U.S. Army Training

 

In 2006, we were awarded a new ID/IQ contract by the U.S. Army with a potential value of $22 million over five years to support the U.S. Army Training and Doctrine Command Analysis Center (“TRAC”) at

Fort Leavenworth, Kansas with operation analysis, experimentation, war fighting scenarios, combat modeling and simulation, operational effectiveness analysis and planning and decision aids. The contract includes one base year and four option years. We will assist TRAC in conducting major studies and analysis to support U.S. Army doctrine, organization, training, material, leadership, personnel and facilities issues associated with U.S. Army transformation. We will also help TRAC develop, manage, operate, and maintain the tools, scenarios, data and simulation needed to enable analysis.

 

In 2005, the U.S. Army Training, Doctrine and Combat Development Directorate at Ft. Knox awarded us a new ID/IQ contract with a ceiling of $97 million to provide doctrine and training services. Awards received from the ID/IQ will be serviced out of our office in Radcliff, Kentucky. The Training, Doctrine and Combat Development Directorate awarded five prime contracts for these services. Under the scope of the award, we will provide Training, Doctrine, and Combat Development functions associated with modular and Future Combat Systems (“FCS”) equipped forces. Specifically, work would update armor-proponent training products, programs, and strategies in support of the mounted force, and could directly impact mounted combat systems, reconnaissance and security vehicles, command and control vehicles and armed robotic vehicles.

 

In 2003, we were selected, as part of the Boeing-SAIC Lead System Integrator team, under a new seven-year blanket purchase order, to provide training software and documentation to support the U.S. Army’s FCS program. We are developing training support packages for this vital transformation program. Services to be provided include analysis of training requirements and design, media selection and production of training support products. The work is performed in Orlando, Florida, Leavenworth, Kansas and Andover, Massachusetts. We believe that the award of this contract reflects recognition of our proven instructional system development and track record of developing training support packages. In addition, in December 2006 we began work on a subcontractor with IBM Corporation to develop and deploy the FCS Logistics Data Management System.

 

U.S. Air Force Air Mobility Command

 

The U.S. Air Force Air Mobility Command (“AMC”), headquartered at Scott Air Force Base in Belleville, Illinois, has as its primary mission rapid, global mobility and sustainment for America’s Armed Forces. The AMC also plays an important role in providing humanitarian support in the U.S. and around the world. We provide technical and subject matter expertise in support of this mission, providing program planning, decision support, logistics analysis and financial analysis services.

 

In 2005, the AMC awarded us a $7.9 million contract with one base year and four option years. Under the terms of the contract, we will work with the AMC Director of Operations (“A3”), Requirements and Resources Division, on a project to re-engineer processes that will provide AMC a single voice for establishing approved operational capabilities and derived requirements for all of the operational elements of air mobility. Our effort includes supporting the AMC and A3 to leverage the fast pace of technology advancements to significantly enhance the mobility team’s ability to plan, schedule, task and direct the operations of America’s air mobility forces worldwide. The project envisions a common operating picture, real-time situational awareness, and a high degree of collaboration among a wide variety of military personnel.

 

Office of Naval Research

 

We provide engineering and IT services to the Office of Naval Research’s Navy Manufacturing Technology Program, known as MANTECH. This is a contract to continue supporting MANTECH, as well as a related program known as Lean Pathways and the Office of the Secretary of Defense’s own MANTECH initiative. MANTECH’s mission is to reduce costs for U.S. Navy weapons systems through the development of and transition to advanced manufacturing technology. We provide support in the annual strategic planning process, as well as project tracking and benefits analysis. For Lean Pathways, we provide a transformation process to eliminate waste and drive enterprise-wide improvements at small and medium-sized suppliers. It supports programs designed to improve value chain performance and weapon systems affordability.

 

Missile Defense Agency

 

The Missile Defense Agency is chartered with developing the future space-based missile defense capabilities. We currently provide research on manufacturability and research services to this client, under multi-year contracts. In December 2004, we were awarded a cost plus fixed fee contract to engage a diverse set of Ballistic Missile Defense Systems (“BMDS”) customers to develop and utilize a unique transformation process to eliminate waste and facilitate enterprise-wide performance across the entities that make up the BMDS supply chain. The 42-month contract has a total ceiling amount of $25 million and is expected to be completed in January 2008.

 

U.S. Navy Central HIV Program

 

We provide network and database administration, system security and other IT services to support and maintain the U.S. Navy’s HIV Management System (“HMS”) under a $4.8 million contract. The HMS supports clinical and patient management at field, hospital and branch clinical locations worldwide and processes approximately 10,000 records each day.

 

U.S. Air Force Development and Fielding System Group

 

The Weapon Systems Management Information System, a key decision-support tool for assessing the impacts of maintenance, parts and repair status on weapons systems availability, is the responsibility of the U.S. Air Force Development and Fielding System Group (“DFSG”). We provide operations, maintenance and development support services to DFSG for this system.

 

Joint Strike Fighter Program

 

In January 2006, the Joint Strike Fighter Program (“JSF”) Office awarded us a five-year contract, with one base year and four option years, worth $10.5 million if all options are exercised. Our scope of work encompasses a variety of acquisition support services in the areas of autonomics logistics, strategic planning, business operations management and technical assessment and analysis. We will assist in the evaluation and development of acquisition and sustainment strategies, provide analytical support for government validation and verification of the autonomic logistics system and provide technical support for JSF models enhancement, business process improvement initiatives and recommendations for performance-based program metrics that capture operational and supportability requirements.

 

Naval Air System Command

 

In March 2006, we were awarded a five-year ID/IQ subcontract by Avraham Goldratt Institute to support their Naval Air Systems Command AIRSpeed program. The contract provides for training in, and implementation of, Theory of Constraints and Lean/Six Sigma methodologies as applicable to the Naval Aviation Enterprise.

 

U.S. Air Force Directorate of Installations, Logistics, and Mission Support (AF/IL)

 

We have been providing logistics analysis, business intelligence and business process reengineering support to AF/IL for the past twelve years. Our analysts are responsible for the development of the Multi-Echelon Resource Logistics Information Network, deemed the authoritative source for U.S. Air Force logistics data by the U.S. Government Accountability Office. We also support reengineering efforts as part of the U.S. Air Force’s logistics transformation initiatives, migration to logistics support centers, the Base Realignment and Closure, and implementation and sustainment of the logistics readiness officer implementation. Our personnel developed models to reduce the logistics footprint for support equipment deployed into the area of responsibility, and were responsible for a model that enables commanders to evaluate the impacts on their home station operations when personnel are deployed in support of U.S. Air Force expeditionary requirements.

 

U.S. Air Force Air Operation Center

 

In October 2006, we were awarded a subcontract for up to 10 years to integrate, field and sustain the U.S. Air Force’s Air Operation Center (“AOC”) weapon system. We will assist Lockheed Martin in all phases of development from requirements determination through implementation on this critical C4ISR project. The ID/IQ cost-plus-fixed-fee and cost-plus-award fee contract includes funding for operations, maintenance and sustainment. The AOC Weapon System Integrator (“WSI”) program will integrate and standardize the systems and interfaces across the more than 20 U.S. Air Force AOC’s to a common hardware and software baseline. This will facilitate moving to a network-centric environment in which incoming data can flow freely and be managed efficiently. The WSI also will add machine-to-machine interfaces that will increase automation of tasks and provide faster access to incoming intelligence, surveillance and reconnaissance data.

 

Federal Civilian Agency Sector

 

We believe that the U.S. Government federal civilian agencies present an important growth market for us. Growth in spending in this sector is being driven by the threat of domestic terrorism, as well as a high need for modernization.

 

Civilian agencies must also prepare for potential changes in their workforces. According to industry analysts, approximately half of all federal employees engaged in program management are estimated to be eligible for retirement over the next four years. With our core capabilities in the design, development, acquisition, deployment and support of high technology systems, we believe we are well positioned to attract new customers in this sector. Our major customer engagements in this sector are described below.

 

Federal Deposit Insurance Corporation

 

In November 2006, we were awarded a contract valued at nearly $29 million to provide Business Analysis and Management Support Services (“BAMSS”). The BAMSS charter is to ensure that all system development projects adhere to specific development, quality assurance, process improvement, and internal Federal Deposit Insurance Corporation (“FDIC”) requirement guidelines. Through the contract, we will promote, monitor and manage those system development projects to create a more efficient and effective deployment program. The contract is for seven and one-half years, consisting of an eighteen month base period and six one-year option periods. The initial base period task order worth nearly $5 million was awarded during 2006.

 

National Science Foundation

 

The National Science Foundation (“NSF”) has been a customer of ours since 1996. We provide web design and development services that visually convey information about the activities, programs, research results and policies of the NSF. We will directly support NSF’s Office of Legislative and Public Affairs with image and multimedia permission graphic design support, artistic and technical consulting, image library management and web development.

 

National Archives and Records Administration

 

Since 2000, we have provided project management and technical expertise to the National Archives and Records Administration (“NARA”). Initially as a prime contractor and currently as a primary subcontractor on a larger, fully integrated IT contract, we have developed and implemented web-based applications, administered IT networks and systems, provided network security services and conducted all of the software development life cycle activities. Our work includes support at headquarters and at NARA Presidential Libraries and Record Centers throughout the country.

 

Department of Homeland Security

 

In July 2006, we were awarded a new ID/IQ contract by the Department of Homeland Security (“DHS”) to provide IT support services on the Enterprise Acquisition Gateway for Leading Edge Solutions (“EAGLE”)

program. The EAGLE program is intended to provide all contracted IT services for the 22 components and agencies that currently comprise the DHS.

 

U.S. Customs Service National Aviation Center

 

The U.S. Customs Service National Aviation Center in Oklahoma City, Oklahoma trains pilots and other flight personnel for aerial border surveillance. We create electronic training materials for use in classrooms, on stand-alone computers, over the agency’s local area network, and via a secure web site for remote learning.

 

State and Local Government Sector

 

We design, develop, implement, maintain and support automated case management systems, networks and systems for state health and human services agencies and local users of these statewide systems. The decrease in revenues from the state and local government sector in 2006 compared to 2005 was primarily due to a reduction of work performed under our contract with the State of Ohio, under which a significant portion of the development work has been completed. A description of our major customer engagements in this sector follows.

 

State of Ohio

 

In May 2004, we were awarded a $30 million contract by the State of Ohio to develop and implement a web-based Statewide Automated Child Welfare Information System (“SACWIS”). The contract has a three-and-a-half-year base period, plus a one-year option. In 2005, we increased our work on the Ohio SACWIS contract by $4.5 million. In February 2007, the contract scope was expanded bringing the total contract value to $37.5 million. The system is currently in production and state-wide roll-out.

 

State of Colorado

 

The State of Colorado has been a customer of ours since 1997. In 2006, we were awarded a new five-year contract worth $22.5 million by Colorado’s Department of Human Services (“CDHS”) to continue providing infrastructure support and management of the statewide CDHS County Infrastructure. The new contract contains three one-year options with additional potential revenue of $16.4 million beyond the initial five-year contract. The CDHS County Infrastructure supports more than 7,000 county and state workers with web-based access to applications supporting child welfare, eligibility, child support and child care. Infrastructure support services provided by us include operation and maintenance of enterprise wireless and land-based networks, servers and storage, disaster recovery, databases and related software distribution for the thousand of workers using the system.

 

Our original Colorado effort was to develop an integrated statewide child welfare and youth corrections system, known as the Colorado Trails application. We continue to support this application with database and host server maintenance and support.

 

DRC’s SOLUTIONS

 

Systems and Services

 

Our systems and services business provides solutions to our customers that include the design, development, operation and maintenance of business intelligence systems, business transformation services, defense program acquisition management services, training and performance support systems and services, automated case management systems and IT infrastructure services.

 

Business Intelligence

 

We provide business intelligence systems and solutions that help end users make sense of the intelligence buried in their data systems, giving them the actionable information needed to make critical decisions and continuously improve organizational performance. Our dedication to continuous improvement is

reflected in Capability Maturity Model (“CMM”) and Capability Maturity Model Integration (“CMMI”) Level 3 ratings. Developed by the Software Engineering Institute, CMM and CMMI are internationally recognized standards to assess the level of maturity of software development processes in an organization.

 

Employing rapid, iterative development techniques we produce Business Intelligence solutions and effect results. As part of this process, we develop and apply data engineering tools and techniques to extract and integrate information from legacy data systems; and incorporate state-of-the-security features including multilevel security capabilities for military applications. We apply modeling and simulation techniques that provide users with business data to conduct “what-if” analyses and forecast change.

 

Business Transformation

 

We provide our customers with a comprehensive set of services and tools to rapidly transform organizations and to significantly improve their organizational performance. These include applying proven, repeatable processes to the entire life cycle of business transformation; using collaborative decision making tools and methods to rapidly develop “consensus-engineered” solutions; and employing state-of-the-art process simulation tools and methods to conduct “what-if” analyses and predict the impact of changes on performance. We have an established track record in providing our Business Transformation customers with high returns on their investment and/or positive impacts on performance.

 

Acquisition Management

 

We offer a complete set of business, financial, engineering and logistics services to support the acquisition and management of complex systems throughout their life cycle. We provide expertise in all acquisition areas including: Acquisition Program Management; Business, Cost, and Financial Management; Systems Engineering; Software Engineering; Production Sustainment and Readiness; and Acquisition Logistics.

 

We are developing an integrated set of processes to implement the goals of the evolving CMMI Acquisition Model. We assist programs in adopting the CMMI Acquisition Model and, in so doing help get systems to the Warfighter.

 

Training and Performance Support

 

We work with our customers to develop flexible, interactive training and support products to enhance performance on mission-essential operations. Our methodology integrates industry best practices in human performance assessment of organizations, Instructional Systems Development, and Human Systems Integration (“HIS”) of complex systems.

 

Our training solutions include Training/Task Analysis, High Performance Team Training, Web-Based Training and Automated Training Management. We identify, develop and deliver a variety of additional human performance improvement solutions, including: Electronic Performance Support Systems, Job/Task Redesign, User Interface Change, Organizational Redesign, and Resource Reallocation.

 

Automated Case Management

 

We provide integrated case management solutions that help human services agencies better serve clients and communities and integrate and automate information across providers, recipients, and programs.

 

Automated Case Management solutions we developed incorporate: industry best practices for software development, Rapid Requirements Definition processes, Model Driven Architectures coupled with iterative development processes, proven data conversion methods, automated testing processes, and training and performance support solutions.

 

IT Infrastructure Services

 

We provide a full range of services to support the design, development, installation, operation and management of large complex networks and other critical IT infrastructures. Our approach is based on the

Information Technology Infrastructure Library, the leading standard of practice for IT infrastructure development and Service Management. Our IT Infrastructure services, includes staff augmentation, small and large project work, full outsourcing, training, and business transformation. As an experienced integrator, we work with many different companies, types of software, and toolsets.

 

Precision Manufacturing

 

Our Metrigraphics Division’s expertise centers on photolithography, thin film deposition of metals and dielectrics, and electroforming. We believe that Metrigraphics’ superior ability to design and manufacture components and maintain critical tolerances is an important driver for a wide range of high-technology applications. We currently apply these technologies in four distinct applications: (1) inkjet printer cartridge nozzle plates and hard drive test devices; (2) medical applications for micro-flex circuits used in angioplasty and for blood testing; (3) electrical test device for application in flexible interposers and 3-D microstructures; and (4) devices used in the manufacture of fiber optic system components requiring precision alignment and 3-D microstructures.

 

BUSINESS DEVELOPMENT

 

Our business development process is aligned with our operating units to address target markets, expand work with current customers and win new business.

 

We also have a central business development group, which is aligned to our operating units and is charged with identifying and winning significant new business opportunities. The business development group also maintains a proposal development and publication capability. The business development group operates with formal processes that monitor the pipeline of opportunities and align resources to new opportunities.

 

GOVERNMENT CONTRACTS

 

The federal procurement process has changed significantly in recent years. The traditional method of federal government procurement had been to conduct a lengthy competitive bidding process for each award. Today, blanket purchase agreements, agency sponsored multiple award schedules, ID/IQ task order contracts, GSA contracts and other government-wide acquisition contract vehicles are the predominant forms of contracting for IT and technical services. These vehicles have enabled contracting officers to accelerate the pace of awards. Concurrently, under current budgetary pressures, our customers have the flexibility to delay awards, reduce funding or fund work on an incremental basis.

 

Our government contracts fall into one of three categories: (1) fixed-price, including service-type contracts, (2) time and materials, and (3) cost reimbursable. Under a fixed-price contract, the government pays an agreed upon price for our services or products, and we bear the risk that increased or unexpected costs may reduce our profits or cause us to incur a loss. Conversely, to the extent we incur actual costs below anticipated costs on these contracts, we could realize greater profits. Under a time and materials contract, the government pays us a fixed hourly rate intended to cover salary costs and related indirect expenses plus a profit margin. Under a cost reimbursable contract, the government reimburses us for our allowable direct expenses and allowable and allocable indirect costs and pays a negotiated fee.

 

Our state contracts are generally either fixed-price, including service-type contracts, or time and materials. In certain instances, these contracts are subject to annual state legislative funding approval and to termination provisions.

 

Our contracts with the U.S. Government and state customers generally are subject to termination at the convenience of the U.S. Government or the state. However, in the event that a contract is terminated by the respective government, we would be reimbursed for our allowable costs up to the time of termination and would be paid a proportionate amount of the stipulated profit attributable to the work actually performed. Although U.S. Government or state contracts may extend for several years, they are generally funded on an annual basis, or incrementally for shorter time periods, and are subject to reduction or cancellation in the event of changes in U.S. Government or state requirements due to appropriations or budgetary concerns. In

addition, if the federal or state government curtail expenditures for research, development and consulting activities, such curtailment could have a material adverse impact on our revenue and earnings.

 

BACKLOG

 

Our funded backlog was $92.9 million at December 31, 2006, $144.6 million at December 31, 2005 and $165.0 million at December 31, 2004. We expect that substantially all of our backlog at December 31, 2006 will generate revenue during the year ending December 31, 2007. The funded backlog generally is subject to possible termination at the convenience of the contracting party. Contracts are generally funded on an annual basis or incrementally for shorter time periods. Due to current budgetary pressures, we have seen an increase in the application of incremental funding, thereby reducing backlog in proportion to revenue. A portion of our funded backlog is based on annual purchase contracts and subject to annual governmental approval or appropriations legislation and the amount of funded backlog as of any date can be affected by the timing of order receipts and deliveries.

 

COMPETITION

 

Our systems and services business competes with a large number of public and privately-held firms, which specialize in providing government IT services.

 

We also compete with the government services divisions of large commercial IT service firms and with government IT service divisions of large defense weapons systems producers. The competition varies depending on the customer, geographic market and required capabilities. The U.S. Government’s in-house capabilities are also, in effect, competitors, because various agencies are able to perform services, which might otherwise be performed by us. The principal competitive factors affecting the systems and services business are past performance, technical competence and price.

 

In the precision manufacturing business, we compete with other manufacturers of electroform vendors and suppliers of precision management discs, scales and reticles. The principal competitive factors affecting the precision manufacturing business are price, product quality and custom engineering to meet customers’ system requirements.

 

RAW MATERIALS

 

Raw materials and components are purchased from a large number of independent sources and are generally available in sufficient quantities to meet current requirements.

 

GOVERNMENT REGULATION

 

As a defense contractor, we are subject to many levels of audit and review, including by the Defense Contract Audit Agency, Defense Contract Management Agency, the various inspectors general, the Defense Criminal Investigative Service, the General Accountability Office, the Department of Justice and Congressional Committees. These audits and reviews could result in the termination of contracts, the imposition of fines or penalties, the withholding of payments due to us or the prohibition from participating in certain U.S. Government contracts for a specified period of time. Any such action could have a material adverse effect on our business, financial condition, results of operations and cash flows.

 

Governmental awards of contracts are subject to regulations and procedures that permit formal bidding procedures and protests by losing bidders. Such protests may result in significant delays in the commencement of expected contracts, the reversal of a previous award or the reopening of the competitive bidding process, which could have a material adverse effect upon our business, financial condition, results of operations and cash flows.

 

The U.S. Government has the right to terminate contracts for convenience. If the government terminated contracts, we would generally recover costs incurred up to termination, costs required to be incurred in connection with the termination and a portion of the fee earned commensurate with the work performed to termination. However, significant adverse effects on our indirect cost pools may not be recoverable in

connection with a termination for convenience. Contracts with state and other governmental entities are subject to the same or similar risks.

 

Compliance with federal, state and local provisions relating to the protection of the environment has not had and is not expected to have a material effect upon our capital expenditures, earnings or competitive position.

 

EMPLOYEES

 

At December 31, 2006, we had approximately 1,500 employees. Approximately 70% of our employees hold federal government security clearances. We require all employees to annually complete training on compliance subjects. We consider our relationship with our employees to be satisfactory.

 

PROPRIETARY INFORMATION

 

Patents, trademarks and copyrights are not materially important to our business. The U.S. Government and state government have certain proprietary rights in software processes and data developed by us in our performance of government and state contracts.

Item 1A. RISK FACTORS

 

In addition to the other information in this Form 10-K, readers should carefully consider the risks described below before deciding to invest in shares of our common stock. These are risks and uncertainties we believe are most important for you to consider. Additional risks and uncertainties not presently known to us, or which we currently deem immaterial, or which are similar to those faced by other companies in our industry or business in general, may also impair our business operations. If any of the following risks or uncertainties actually occurs, our business, financial condition, results of operations or cash flows would likely suffer. In that event, the market price of our common stock could decline.

 

Our Revenue is Highly Concentrated on the DoD and Other Federal Agencies, and A Significant Portion of Our Revenue is Derived From a Few Customers. Decreases in Their Budgets, Changes in Program Priorities or Military Base Closures Could Affect Our Results.

 

During 2006 and 2005, approximately 91% and 89%, respectively, of our total revenue was derived from U.S. Government agencies. Within the DoD, certain individual programs account for a significant portion of our U.S. Government business. Our revenue from contracts with the DoD, either as a prime contractor or subcontractor, accounted for approximately 80% and 78% of our total revenue in 2006 and 2005, respectively. We cannot provide any assurance that any of these programs will continue as such or will continue at current levels or that military base closures or realignments would not affect such programs or our ability to re-staff such programs. Our revenue could be adversely affected by significant changes in defense spending priorities or declining U.S. defense budgets. Among the effects of this general decline has been increased competition within a consolidating defense industry.

 

Current budget pressures on the U.S. Government caused principally by the war in Iraq may have adverse effects on our business. Because war expenditures are not expected to abate significantly in the near term, we anticipate continual risks related to expenditures on programs we support.

 

It is not possible for us to predict whether defense budgets will increase or decline in the future. Further, changing missions and priorities in the defense budget may have adverse effects on our business. Funding limitations could result in a reduction, delay or cancellation of existing or emerging programs. We anticipate there will continue to be significant competition when our defense contracts are re-bid, as well as significant competitive pressure to lower prices, which may reduce profitability in this area of our business, which could adversely affect our business, financial condition, results of operations and cash flows.

 

We Must Bear the Risk of Various Pricing Structures Associated With Government Contracts.

 

We historically have derived a substantial portion of our revenue from contracts and subcontracts with the U.S. Government. A significant portion of our federal and state government contracts are undertaken on a time and materials nature, with fixed hourly rates that are intended to cover salaries, benefits, other indirect costs of operating the business and profit. Our time and material contracts represented 60% and 55% of total revenue in 2006 and 2005, respectively. The pricing of such contracts is based upon estimates of future costs and assumptions as to the aggregate volume of business that we will perform in a given business division or other relevant unit.

 

We undertake various government projects on a fixed-price basis. Our revenues earned under fixed price contracts have decreased as a percentage of total revenues to approximately 19% in 2006 from approximately 23% in 2005. This decrease was primarily due to the near completion of development work of our contract with the State of Ohio to design, develop and install a statewide automated child welfare case management system. Looking forward, we anticipate an increasing portion of our federal contracts will be available on a fixed price basis. Under a fixed-price contract, the government pays an agreed upon price for our services or products, and we bear the risk that increased or unexpected costs may reduce our profits or cause us to incur a loss. Significant cost overruns can occur if we fail to:

 

 

For fixed price contracts, we must estimate the costs necessary to complete the defined statement of work and recognize revenue or losses in accordance with such estimates. Actual costs may vary materially from the estimates made from time to time, necessitating adjustments to reported revenue and net income. Underestimates of the costs associated with a project could adversely affect our overall profitability and could have a material adverse effect on our business, financial condition, results of operations and cash flows. While we endeavor to maintain and improve contract profitability, we cannot be certain that any of our existing or future fixed-price projects will be profitable.

 

A substantial portion of our U.S. Government business is as a subcontractor. In such circumstances, we generally bear the risk that the prime contractor will meet its performance obligations to the U.S. Government under the prime contract and that the prime contractor will have the financial capability to pay us amounts due under the subcontract. The inability of a prime contractor to perform or make required payments to us could have a material adverse effect on our business, financial condition, results of operations and cash flows.

 

Our Contracts and Subcontracts with Government Agencies are Subject to a Competitive Bidding Process and to Termination Without Cause by the Government.

 

A significant portion of our federal and state government contracts are renewable on an annual basis, or are subject to the exercise of contractual options. Multi-year contracts often require funding actions by the U.S. Government, state legislature or others on an annual or more frequent basis. As a result, our business could experience material adverse consequences should such funding actions or other approvals not be taken.

 

Recent federal regulations and renewed congressional interest in small business set aside contracts is likely to influence decisions pertaining to contracting methods for many of our customers. These regulations require more frequent review and certification of small business contractor status, so as to ensure that companies competing for contracts intended for small business are qualified as such at the time of the competition.

 

Governmental awards of contracts are subject to regulations and procedures that permit formal bidding procedures and protests by losing bidders. Such protests may result in significant delays in the commencement of expected contracts, the reversal of a previous award decision or the reopening of the competitive

bidding process, which could have a material adverse effect on our business, financial condition, results of operations and cash flows.

 

Because of the complexity and scheduling of contracting with government agencies, from time to time we may incur costs before receiving contractual funding by the U.S. Government. In some circumstances, we may not be able to recover such costs in whole or in part under subsequent contractual actions. Failure to collect such amounts may have a material adverse effect on our business, financial condition, results of operations and cash flows.

 

In addition, the U.S. Government has the right to terminate contracts for convenience. If the government terminated contracts with us, we would generally recover costs incurred up to termination, costs required to be incurred in connection with the termination and a portion of the fee earned commensurate with the work we have performed to termination. However, significant adverse effects on our indirect cost pools may not be recoverable in connection with a termination for convenience. Contracts with state and other governmental entities are subject to the same or similar risks. Any such terminations may have material adverse consequences on our business, financial condition, results of operations and cash flows.

 

We Are Subject to a High Level of Government Regulations and Audits Under Our Government Contracts and Subcontracts.

 

As a defense contractor, we are subject to many levels of audit and review, including by the Defense Contract Audit Agency, various inspectors general, the Defense Criminal Investigative Service, the General Accountability Office, the Department of Justice and Congressional Committees. These audits, reviews and the pending grand jury investigation and civil suit in the U.S. District Court for the District of Massachusetts could result in the termination of contracts, the imposition of fines or penalties, the withholding of payments due to us or the prohibition from participating in certain U.S. Government contracts for a specified period of time. Any such action could have a material adverse effect on our business, financial condition, results of operations and cash flows.

 

Loss of Key Personnel Could Limit Our Growth.

 

We are dependent on our ability to attract and retain highly skilled technical personnel. Many of our technical personnel may have specific knowledge and experience related to various government customer operations and these individuals would be difficult to replace in a timely fashion. In addition, qualified technical personnel are in high demand worldwide and are likely to remain a limited resource. The loss of services of key personnel could impair our ability to perform required services under some of our contracts, to retain such business after the expiration of the existing contract, or to win new business in the event that we lost the services of individuals who have been identified in a given proposal as key personnel in the proposal. Any of these situations could have a material adverse effect on our business, financial condition, results of operations and cash flows.

 

Our Failure to Obtain and Maintain Necessary Security Clearances May Limit Our Ability to Perform Classified Work for Government Clients, Which Could Harm Our Business.

 

Some government contracts require us to maintain facility security clearances, and require some of our employees to maintain individual security clearances. If our employees lose or are unable to obtain security clearances on a timely basis, or we lose a facility clearance, the government client can terminate the contract or decide not to renew the contract upon its expiration. As a result, to the extent that we cannot obtain the required security clearances for our employees working on a particular contract, or we fail to obtain them on a timely basis, we may not derive the revenue anticipated from the contract, which could have a material adverse effect on our business, financial condition, results of operations and cash flows.

 

Security Breaches in Sensitive Government Systems Could Harm Our Business.

 

Many of the systems we develop, install and maintain involve managing and protecting information involved in intelligence, national security, and other sensitive or classified government functions. A security

breach in one of these systems could cause serious harm to our business, damage our reputation, and prevent us from being eligible for further work on sensitive or classified systems for federal government clients. We could incur losses from such a security breach that could exceed the policy limits under our errors and omissions and product liability insurance. Damage to our reputation or limitations on our eligibility for additional work resulting from a security breach in one of our systems could have a material adverse effect on our business, financial condition, results of operations and cash flows.

 

Our Employees May Engage in Misconduct or Other Improper Activities, Which Could Harm Our Business.

 

We are exposed to the risk that employee fraud or other misconduct could occur. Misconduct by employees could include intentional failures to comply with federal government procurement regulations, engaging in unauthorized activities, or falsifying time records. Employee misconduct could also involve the improper use of our clients’ sensitive or classified information, which could result in regulatory sanctions against us and serious harm to our reputation. It is not always possible to deter employee misconduct, and the precautions we take to prevent and detect this activity may not be effective in controlling unknown or unmanaged risks or losses, which could have a material adverse effect on our business, financial condition, results of operations and cash flows.

 

We Currently Are Involved in Three Litigation Matters Which, If Not Resolved in Our Favor, Could Harm Our Business.

 

We are currently involved in three litigation matters which could have a material adverse effect on our business, financial position, results of operations and cash flow. These litigation matters are more fully described in Note 13 of our “Notes to Consolidated Financial Statements” in Part II, Item 8 of this Form 10-K and include:

 

 

If Our Internal Controls over Financial Reporting Do Not Comply with Financial Reporting and Control Management Requirements, There Could Be a Material Adverse Effect on Our Operations or Financial Results. Also, Current and Potential Stockholders Could Lose Confidence in Our Financial Reporting, Which Would Harm Our Business and the Trading Price of Our Stock.

 

Effective internal controls are necessary for us to provide reliable financial reports. If we cannot provide reliable financial reports, our business and operating results could be harmed. We have in the past discovered, and may in the future discover, areas of our internal control over financial reporting that need improvement.

 

Although our management has determined, and our independent registered public accounting firm has attested, that our internal controls over financial reporting were effective as of December 31, 2006, we cannot assure you that we or our independent registered public accounting firm will not identify a material weakness

in our internal controls in the future. A material weakness in our internal controls over financial reporting would require management and our independent registered public accounting firm to evaluate our internal controls as ineffective. If our internal controls over financial reporting are not considered adequate, we may experience a loss of public confidence in our reported financial information, which could have an adverse effect on our business and the trading price of our stock.

 

We Operate in Highly Competitive Markets and May Have Difficulties Entering New Markets.

 

The government contracting business is subject to intense competition from numerous companies. The principal competitive factors are prior performance, previous experience, technical competence and price. In our efforts to enter new markets and attract new customers, we generally face significant competition from other companies that have prior experience with such potential customers. As a result, we may not achieve the level of success that we expect in our efforts to enter such new markets.

 

Competition in the market for our commercial products is also intense. There is a significant lead-time for developing such business, and it involves substantial capital investment including development of prototypes and investment in manufacturing equipment. Principal competitive factors are product quality, the ability to specialize our engineering in order to meet our customers’ specific system requirements and price. Our precision products business has a number of competitors, many of which have significantly greater financial, technical and marketing resources than we do.

 

We May Be Subject to Product Liability Claims.

 

Our precision manufactured products are generally designed to operate as important components of complex systems or products. Defects in our products could cause our customer’s product or systems to fail or perform below expectations. Although we attempt to contractually limit our liability for such defects or failures, we cannot assure you that our attempts to limit our liability will be successful. Like other manufacturing companies, we may be subject to claims for alleged performance issues related to our products. Such claims, if made, could damage our reputation and could have a material adverse effect on our business, financial condition, results of operations and cash flows.

 

Economic Events May Affect Our Business Segments.

 

Many of our precision products are components of commercial products. Factors that affect the production and demand for such products, including economic events both domestically and in other regions of the world, competition, technological change and production disruption, could adversely affect demand for our products. Many of our products are incorporated into capital equipment, such as machine tools and other automated production equipment, used in the manufacture of other products. As a result, this portion of our business may be subject to fluctuations in the manufacturing sector of the overall economy. An economic recession, either in the U.S. or elsewhere in the world, could have a material adverse effect on the rate of orders received by the commercial division. Significantly lower production volumes resulting in under-utilization of our manufacturing facilities would adversely affect our business, financial condition, results of operations and cash flows.

 

Our Products and Services Could Become Obsolete Due to Rapid Technological Changes in the Industry.

 

We offer sophisticated products and services in areas in which there have been and are expected to continue to be significant technological changes. Many of our products are incorporated into sophisticated machinery, equipment or electronic systems. Technological changes may be incorporated into competitors’ products that may adversely affect the market for our products. If our competitors introduce superior technologies or products, we cannot assure you that we will be able to respond quickly enough to such changes or to offer services that satisfy our customers’ requirements at a competitive price. Further, we cannot provide any assurance that our research and product development efforts will be successful or result in new or improved products that may be required to sustain our market position.

 

Our Financing Requirements May Increase and We Could Have Limited Access to Capital Markets.

 

While we believe that our current resources and access to capital markets are adequate to support operations over the near term and foreseeable future, we cannot assure you that these circumstances will remain unchanged. Our need for capital is dependent on operating results and may be greater than expected. Our ability to maintain our current sources of debt financing depends on our ability to remain in compliance with certain covenants contained in our financing agreements, including, among other requirements, maintaining a minimum total net worth and minimum cash flow and debt coverage ratios. If changes in capital markets restrict the availability of funds or increase the cost of funds, we may be required to modify, delay or abandon some of our planned expenditures, which could have a material adverse effect on our business, financial condition, results of operations and cash flows.

 

Our Operating Results May Vary Significantly From Quarter to Quarter.

 

Our revenue and earnings may fluctuate from quarter to quarter depending on a number of factors, including:

 

 

We May Not Make or Complete Future Mergers, Acquisitions or Strategic Alliances or Investments.

 

In 2004, we acquired Impact Innovations Group LLC (“Impact Innovations”), and in 2002, we acquired H.J. Ford Associates, Inc. and Andrulis Corporation. We may seek to continue to expand our operations through mergers, acquisitions or strategic alliances with businesses that will complement our existing business. However, we may not be able to find attractive candidates, or enter into acquisitions on terms that are favorable to us, or successfully integrate the operations of companies that we acquire. In addition, we may compete with other companies for these acquisition candidates, which could make an acquisition more expensive for us. If we are able to successfully identify and complete an acquisition or similar transaction, it could involve a number of risks, including, among others:

 

 

We cannot assure that any acquisition will be made, that we will be able to obtain financing needed to fund such acquisitions and, if any acquisitions are so made, that the acquired business will be successfully integrated into our operations or that the acquired business will perform as expected. In addition, if we were

to proceed with one or more significant strategic alliances, acquisitions or investments in which the consideration consists of cash, a substantial portion of our available cash could be used to consummate the strategic alliances, acquisitions or investments. The financial impact of acquisitions, investments and strategic alliances could have a material adverse effect on our business, financial condition, results of operations and cash flows and could cause substantial fluctuations in our quarterly and annual operating results.

 

The Market Price of Our Common Stock May Be Volatile.

 

The market price of securities of technology companies historically has faced significant volatility. The stock market in recent years has also experienced significant price and volume fluctuations that often have been unrelated or disproportionate to the operating performance of particular companies. Many factors that have influenced trading prices will vary from period to period, including:

 

 

Any of these events could have a material adverse effect on the market price of our common stock. In addition, low trading volume in our common stock may cause volatility in stock price.

Item 1B. UNRESOLVED STAFF COMMENTS

 

We have not received any written comments from the staff of the Securities and Exchange Commission regarding our periodic or current reports that (1) were issued not less than 180 days before the end of our 2006 fiscal year, (2) remain unresolved and (3) we believe are material.

 

As of December 31, 2006 we leased all of the facilities used in our operations totaling approximately 415,000 square feet, of which our Metrigraphics segment occupied approximately 45,000 square feet. All other facilities, as well as a portion of our Andover, Massachusetts headquarters facility is used by the Systems and Service segment. On December 29, 2005 we sold our headquarters facility in Andover, Massachusetts of approximately 131,000 square feet and entered into an operating lease for the same property for a ten-year term with multiple renewal options. We believe that our facilities are adequate for our current needs.

 

As a defense contractor, we are subject to many levels of audit and review from various government agencies, including the Defense Contract Audit Agency, various inspectors general, the Defense Criminal Investigation Service, the General Accountability Office, the Department of Justice and Congressional Committees. Both related to and unrelated to our defense industry involvement, we are, from time to time, involved in audits, lawsuits, claims, administrative proceedings and investigations. We accrue for liabilities associated with these activities when it becomes probable that future expenditures will be made and such expenditures can be reasonably estimated.

 

We are a party to or are subject to litigation and other proceedings referenced in Note 13 of our “Notes to Consolidated Financial Statements” in Part II, Item 8 of this Form 10-K. Except as noted therein we do not presently believe it is reasonably likely that any of these matters would have a material adverse effect on our business, financial position, results of operations or cash flows.

 

Our evaluation of the likelihood of expenditures related to these matters is subject to change in future periods, depending on then-current events and circumstances, which could have material adverse effects on our business, financial position, results of operations and cash flows.

 

During the quarter ended December 31, 2006, no matters were submitted to a vote of security holders through the solicitation of proxies or otherwise.

 

Executive Officers of the Registrant

 

The following is a list of the names and ages of our executive officers, all positions and offices held by each person and each person’s principal occupations or employment during the past five years. The officers were elected by the Board of Directors and will hold office until the next annual election of officers and their successors are elected and qualified, or until their earlier resignation or removal by the Board of Directors. There are no family relationships between any executive officers and directors.

 

 

Mr. Regan joined us in 1999 as President, Chief Executive Officer and Director. He was elected Chairman in April 2001. Prior to that, he was President and Chief Executive Officer of CVSI, Inc. from 1997 to October 1999 and served as Senior Vice President of Litton PRC from 1992 to 1996.

 

Mr. Covel joined us as Vice President and General Counsel in December 2000. Prior to that, he was General Counsel, Patent Counsel and Secretary at Foster-Miller, Inc. from 1985 to 2000.

 

Mr. Keleher joined us as Vice President and Chief Financial Officer in January 2000. Prior to that, he was employed by Raytheon Company as Group Controller for the Commercial Electronics Division in 1999 and Assistant Corporate Controller in 1998. Prior to that, he served in several senior management positions in corporate finance and operations at Digital Equipment Corporation from 1981 to 1997.

 

Mr. Wentzell joined us as Senior Vice President and General Manager, Human Resources, in October 2004. Prior to joining us, Mr. Wentzell was Senior Vice President of Human Resources for Brooks Automation, Inc., from 2002 to 2004, following its acquisition of PRI Automation, Inc., where Mr. Wentzell served as Corporate Vice President for Human Resources from 1997 through the acquisition. Prior to that, Mr. Wentzell served as the Corporate Vice President of Human Resources for Dialogic Corporation from 1993 through 1997.

 

Mr. O’Brien joined us in 1978 and has held various senior management positions during this time. In 2006, Mr. O’Brien became Senior Vice President and General Manager, Business Solutions and Business Development. From 2004 to 2006, Mr. O’Brien was Vice President for Business Solutions. Prior to that, Mr. O’Brien was Vice President of Systems Engineer Group from 2001 to 2004.

PART II

 

 

Our common stock is traded on the Nasdaq National Market under the symbol “DRCO”. The following table sets forth, for the periods indicated, the high and low sale prices per share of our common stock, as reported by the Nasdaq National Market. These market quotations reflect inter-dealer prices, without retail mark-up, mark-down or commission and may not necessarily represent actual transactions.

 

 

Number of Shareholders

 

As of March 1, 2007, there were 548 shareholders of record of our common stock.

 

Dividend Policy

 

In September 1984, our Board of Directors voted not to declare cash dividends to preserve cash for our future growth and development. We did not declare any cash dividends between 1984 and 2006 and do not intend to in the near future. In addition, our financing arrangements, as described in “Liquidity and Capital Resources” in Part II, Item 7, and in Note 9 of our “Notes to Consolidated Financial Statements” in Part II, Item 8 of this Form 10-K, restrict our ability to pay dividends.

 

Issuer Purchases of Equity Securities

 

The following table sets forth all purchases made by or on behalf of us or any “affiliated purchaser,” as defined in Rule 10b-18(a)(3) under the Exchange Act, of shares of our common stock during each month in the fourth quarter of 2006.

 

 

 

Securities Authorized for Issuance Under Equity Compensation Plans

 

The following table summarizes, as of December 31, 2006, the number of shares of our common stock to be issued upon exercise of options issued under our equity compensation plans and the number of shares of common stock remaining available for future issuance under these plans.

 

 

 

 

The selected condensed consolidated financial data set forth below should be read in conjunction with “Management’s Discussion and Analysis of Financial Condition and Results of Operations” included as Part II, Item 7 of this Form 10-K, and our consolidated financial statements and notes thereto included in Part II, Item 8 of this Form 10-K. The historical results provided below are not necessarily indicative of future results.

 

 

 

 

 

OVERVIEW

 

DRC, founded in 1955 and headquartered in Andover, Massachusetts, provides IT, engineering and other services focused on national defense and intelligence, public safety and citizen services for government customers. The government market is composed of three sectors: national defense and intelligence, federal civilian agencies, and state and local governments. Our core capabilities are focused on IT, engineering and technical subject matter expertise that pertain to the knowledge domains of our core customers.

 

Recent industry reports, such as the Federal IT Market Forecast published by INPUT, are projecting long-term growth rates in demand by the federal government for professional services of approximately 5%. These estimates are, in general, lower than those made a year ago. We are cognizant of funding challenges facing the federal government and the resulting increase in competitiveness in our industry. Significant contract awards have been and will continue to be delayed and new initiatives have been slow to start. There appears to be recent improvement in contract award and funding decisions with the passage of Federal budgets for fiscal year 2007 for the DoD and DHS. However, contract award and funding decisions for the Federal civilian agencies have been delayed, as these departments are currently operating under a continuing resolution for fiscal year 2007. Customers are moving away from GSA and time and materials contracts toward agency sponsored ID/IQ contract vehicles and fixed price contracts and task orders. The DoD seeks to reduce spending on contracted program advisory and assistance services and often is setting this work aside for small businesses. Concurrently, there is increasing demand from federal customers for engineering, training, business transformation, lean six sigma and business intelligence solutions and services. Many federal customers are seeking to streamline their procurement activities by consolidating work under large contract vehicles. Our competitive strategy is intended to align with these trends.

 

Effective January 1, 2006, we adopted the provisions of Statement of Financial Accounting Standards No. 123 (revised 2004), “Share-Based Payment” (“SFAS 123R”) using the modified prospective transition method. In accordance with that transition method, we have not restated prior periods for the effect of compensation expense calculated under SFAS 123R. We have continued to use the Black-Scholes pricing model as the most appropriate method for determining the estimated fair value of all applicable awards. Compensation expense for all share-based equity awards is being recognized on a straight-line basis over the vesting period of the award. The adoption of SFAS 123R had a pre-tax impact of $0.9 million in 2006, net of a cumulative effect of accounting change of $0.1 million recorded during the first quarter of 2006. During 2006, total share-based compensation was $2.1 million, compared to $0.9 million in 2005 which only included share-based compensation for restricted stock awards. As of December 31, 2006, the total unrecognized compensation cost related to stock options was $1.0 million, which is expected to be recognized over a weighted-average period of approximately 1.4 years, and the total unrecognized compensation cost related to restricted stock awards was $1.4 million, which is expected to be amortized over a weighted-average period of approximately 1.8 years.

 

Total revenue in 2006 was $259.0 million, a decrease of 13.8% over 2005. The decrease was a due to the curtailment of work and the loss of certain contracts.

 

Our gross margin was 13.6% of total revenue in 2006, compared to 16.5% of total revenue in 2005. The decline in the gross margin was primarily a result of an increase in indirect costs including severance costs related to a reduction in workforce, an increase in business development efforts, increased share-based compensation costs, higher provisions for the valuation of our unbilled expenditures and fees on contracts in process and a change in revenue mix.

 

Our operating margin was 3.2% of total revenue in 2006, compared to 7.1% of total revenue in 2005. The decline in the operating margin was primarily due to indirect overhead costs, employee benefit costs and general and administrative expenses decreasing at a slower rate than revenues. During the second quarter of 2006, we implemented a cost reduction plan to bring indirect spending back in line with revenue projections for 2006. As a result, operating margins improved in the second half of 2006.

 

We have two reportable business segments: Systems and Services, and Metrigraphics. The Systems and Services segment accounted for 97.6% of total revenue and the Metrigraphics segment accounted for 2.4% of total revenue in 2006.

 

CRITICAL ACCOUNTING POLICIES

 

There are business risks specific to the industries in which we operate. These risks include, but are not limited to: estimates of costs to complete contract obligations, changes in government policies and procedures, government contracting issues and risks associated with technological development. The preparation of financial statements requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements. Estimates and assumptions also affect the amount of revenue and expenses during the reported period. Actual results could differ from those estimates.

 

The use of alternative estimates and assumptions and changes in business strategy or market conditions may significantly impact our assets or liabilities, and potentially result in a different impact to our results of operations. We believe the following critical accounting policies affect the more significant judgments made and estimates used in the preparation of our consolidated financial statements.

 

Revenue Recognition

 

Our Systems and Services business segment provides services pursuant to time and materials, cost reimbursable and fixed-price contracts, including service-type contracts.

 

For time and materials contracts, revenue reflects the number of direct labor hours expended in the performance of a contract multiplied by the contract billing rate, as well as reimbursement of other billable direct costs. The risk inherent in time and materials contracts is that actual costs may differ materially from negotiated billing rates in the contract, which would directly affect operating income.

 

For cost reimbursable contracts, revenue is recognized as costs are incurred and includes a proportionate amount of the fee earned. Cost reimbursable contracts specify the contract fee in dollars or as a percentage of estimated costs. The primary risk on a cost reimbursable contract is that a government audit of direct and indirect costs could result in the disallowance of certain costs, which would directly impact revenue and margin on the contract. Historically, such audits have not had a material impact on our revenue and operating income.

 

Revenue from service-type fixed-price contracts is recognized ratably over the contract period or by other appropriate output methods to measure service provided, and contract costs are expensed as incurred. Under fixed-price contracts, other than service-type contracts, revenue is recognized primarily under the percentage of completion method in accordance with American Institute of Certified Public Accountants Statement of Position 81-1, Accounting for Performance of Construction-Type and Certain Production-Type Contracts. The risk on a fixed-price contract is that if estimates to complete the contract change from one period to the next, profit levels will vary from period to period.

 

For all types of contracts, we recognize anticipated contract losses as soon as they become known and estimable. Out-of-pocket expenses that are reimbursable by the customer are included in contract revenue and cost of contract revenue.

 

Unbilled expenditures and fees on contracts in process are the amounts of recoverable contract revenue that have not been billed at the balance sheet date. Unbilled expenditures and fees relate principally to revenue that is billed in the month after services are performed. In certain instances, billing is deferred in compliance with contract terms, such as milestone billing arrangements and withholdings, or delayed for other reasons. Billings which are expected to be deferred more than one year from the balance sheet date are classified as noncurrent assets. Costs related to certain U.S. Government contracts, including applicable indirect costs, are subject to audit by the government. Revenue from such contracts has been recorded at amounts we expect to realize upon final settlement.

 

Our Metrigraphics business segment records revenue from product sales upon transfer of both title and risk of loss to the customer, provided there is evidence of an arrangement, fees are fixed or determinable, no significant obligations remain, collection of the related receivable is reasonably assured and customer acceptance criteria have been successfully demonstrated. Product sales are recorded net of sales taxes and net of returns upon delivery. Amounts billed to customers related to shipping and handling is classified as product sales. The cost of shipping products to the customer is recognized at the time the products are shipped and are recorded as cost of product sales.

 

Goodwill and Other Intangible Assets

 

With the acquisition of Impact Innovations in 2004 and other businesses in 2002, we acquired goodwill and other intangible assets. The identification and valuation of these intangible assets and the determination of the estimated useful lives at the time of acquisition, as well as the completion of annual impairment tests, require significant management judgments and estimates. These estimates are made based on, among other things, consultations with an accredited independent valuation consultant and reviews of projected cash flows. As a result of the annual impairment test performed as of December 31, 2006, we determined that the carrying amount of goodwill did not exceed its fair value and, accordingly, did not record a charge for impairment. However, there can be no assurance that goodwill will not be impaired in subsequent periods. As of December 31, 2006, we had recorded goodwill and other intangible assets of $68.7 million in the Consolidated Balance Sheets.

 

Income Taxes and Deferred Taxes

 

As part of our process of preparing consolidated financial statements, management is required to estimate the provision for income taxes, deferred tax assets and liabilities and future taxable income for purposes of assessing our ability to realize any future benefits from deferred taxes. This process involves estimating the current tax liability and assessing temporary and permanent differences resulting from differing treatment of items for tax and accounting purposes. These differences result in deferred tax assets and liabilities, which are included in the Consolidated Balance Sheets. We had a net deferred liability of $10.2 million at December 31, 2006.

 

We must also assess the likelihood that our deferred tax asset will be recovered from future taxable income and, to the extent a recovery is not likely, a valuation allowance must be established. At December 31, 2006, we determined that a valuation allowance was not required.

 

Pension Obligations

 

Accounting and reporting for our pension plan requires the use of assumptions, including but not limited to, the discount rate and expected rate of return on assets. These assumptions are used by independent actuaries to estimate the total benefit ultimately payable to employees and allocate this cost to the service periods. The actuarial assumptions used to calculate pension costs are determined and reviewed annually by management after consulting with outside investment advisors and actuaries.

 

The assumed discount rate, which is intended to be the actual rate at which benefits could effectively be settled, is determined by a spot-rate yield curve method. The spot-rate yield curve is adjusted to match the plan assets cash outflows with the timing and amount of the expected benefit payments. As of the pension plans measurement date, the weighted average discount rate used to determine both the benefit obligations and net periodic benefit costs was 5.75%.

 

The assumed expected rate of return on plan assets, which is the average return expected on the funds invested or to be invested to provide future benefits to pension plan participants, is determined by an annual review of historical plan asset returns and consultation with outside investment advisors. As of the pension plans measurement date, the weighted average expected rate of return was 9.0%. A decrease of 50 basis points in the expected rate of return would increase the annual pension expense by approximately $0.3 million in both 2006 and 2007.

 

During 2006, the assumptions used in determining net periodic cost were consistent to actual results. If these assumptions differ materially from actual results in the future, our obligations under the pension plan could also differ materially, potentially requiring us to record an additional pension liability and record additional pension costs. An actuarial valuation of the pension plan is performed each year. The results of this actuarial valuation are reflected in the accounting for the pension plan upon determination. At December 31, 2006, we recorded a pension liability of $3.9 million in the Consolidated Balance Sheets that represented the unfunded projected benefit obligation.

 

RESULTS OF OPERATIONS

 

Operating results (in millions) and results expressed as a percentage of total revenues are as follows:

 

 

 

 

Revenue

 

We reported total revenue of $259.0 million, $300.4 million and $275.7 million in 2006, 2005 and 2004, respectively. Total revenue decreased by 13.8% in 2006 compared to 2005 resulting from a decline in contract revenue. Total revenue increased by 9.0% in 2005 compared to 2004 due from the revenues added through the acquisition of Impact Innovations on September 1, 2004.

 

Contract Revenues

 

Contract revenues in our Systems and Services segment were earned from the following sectors (in millions):

 

The decrease in revenues from national defense and intelligence agencies in 2006 compared to 2005 was due to curtailment of work with the Air National Guard, reduced work with the U.S. Air Force Electronic Systems Center and the loss of the Office of Assistant Secretary of Defense for Public Affairs work in October 2005. The increase in 2005 compared to 2004 was attributable to revenues added through the acquisition of Impact Innovations.

 

Our contract with the ASC, which provided approximately $48 million, $49 million and $47 million of revenues in 2006, 2005 and 2004, respectively, was subject to re-competition in 2006 as the CAPS contract. In April 2006, ^HMRTech/HJ Ford SBA JV was awarded a CAPS contract, under which task order competition is expected to be completed in 2007. We believe we are well positioned to retain our base of services provided by HJ Ford employees and compete for new business. With the first year re-competitions under the new CAPS contract estimated at 60% complete, annual revenue from the awards to date is anticipated to reach $24 million, growing by more than 10% over the last year of the preceding task order periods, excluding subcontractor revenue. The periods of performance for the task awards range from one to five years. The task orders include a mix of time and material and firm fixed price awards.

 

The new task order awards provide us with the opportunity to continue to expand our presence within the Wings, Groups and Squadrons at ASC and other key U.S. Air Force organizations at Wright-Patterson AFB, Ohio. CAPS is the primary contract vehicle for delivering multi-functional support including Consulting, Program Management, Logistics, Engineering, Financial Management, and Business Transformation services to a variety of ASC, U.S. Air Force Materiel Command, U.S. Air Force Research Laboratory customers and to other Wright-Patterson Air Force Base organizations.

 

Also, related to the new CAPS contract structure, work performed by other contractor team members on these programs, which under the predecessor contract was passed-through our revenue and cost of sales, will be contracted directly between ^HMRTech/HJ Ford SBA JV and the subcontractor and will no longer be included in our financial results. The total annual effect of eliminating the revenue and cost of sales pass-through, estimated at $28 million, prior to the re-competitions, is not included in the $24 million of revenues we have anticipated under the new CAPS contract.

 

Our contract with the ESC, which provided approximately $20 million, $30 million and $31 million in 2006, 2005 and 2004, respectively, is subject to re-competition. The services provided under our current contract are being procured by the ESC under two new contract vehicles, the Engineering Technical Administration Support Services (“ETASS”) contract and the Professional Acquisition Support Services (“PASS”) contract. Proposals for their contracts have been submitted and are awaiting award. We currently anticipate a single ETASS contract award in the second quarter of 2007 and the award of multiple PASS contracts in the fourth quarter of 2007. We have participated in the competitions for these contracts as a subcontractor. The full year revenue impact of moving from a prime contractor to a sub-contractor role is anticipated to be an approximate $7 million revenue reduction with no material effect on operating profit. There can be no assurance that we will receive these contract awards.

 

The decrease in revenues from federal civilian agencies in 2006 compared to 2005 was due to the loss of the Internal Revenue Service contract in 2005, partially offset by higher revenues from new DHS and FDIC contracts that were awarded in the second half of 2006. The increase in 2005 compared to 2004 was also attributable to revenues added through the acquisition of Impact Innovations.

 

The decrease in revenues from state and local government agencies in 2006 compared to 2005 was primarily due to lower revenues under our contract with the State of Ohio, under which a significant portion of the development work has been completed. In May 2004, we were awarded a fixed price contract with the State of Ohio to design, develop and install an automated child welfare case management system. This $37.5 million contract has a three-and-one-half year base period, plus a one-year option. Revenues under this contract were approximately $9 million, $16 million and $8 million in 2006, 2005 and 2004, respectively. The increase in 2005 compared to 2004 was primarily due to a full year effect of revenue in 2005 from the State of Ohio contract.

Revenues by contract type as a percentage of Systems and Services segment revenues were as follows:

 

 

Product Sales

 

Product sales for the Metrigraphics segment were $6.1 million, $6.8 million and $7.1 million for 2006, 2005 and 2004, respectively. The decrease in revenue from product sales for the Metrigraphics segment in 2006 compared to 2005 primarily was due to a decrease in computer peripheral device sales. The decrease in 2005 compared to 2004 primarily was due to a decrease in computer peripheral device sales, partially offset by an increase in medical technology equipment sales.

 

Funded Backlog

 

Our funded backlog was $92.9 million at December 31, 2006, $144.6 million at December 31, 2005 and $165.0 million at December 31, 2004. We expect that substantially all of our backlog at December 31, 2006 will generate revenue during the year ending December 31, 2007. The funded backlog generally is subject to possible termination at the convenience of the contracting party. Contracts are generally funded on an annual basis or incrementally for shorter time periods. Due to current budgetary pressures, we have seen an increase in the application of incremental funding, thereby reducing backlog in proportion to revenue. A portion of our funded backlog is based on annual purchase contracts and subject to annual governmental approval or appropriations legislation and the amount of funded backlog as of any date can be affected by the timing of order receipts and deliveries.

 

Gross Profit

 

Total gross profit was $35.1 million, $49.7 million and $43.0 million resulting in a gross margin of 13.6%, 16.5% and 15.6% for 2006, 2005 and 2004, respectively.

 

Our gross profit on contract revenue was $33.9 million, $48.1 million and $41.1 million in 2006, 2005 and 2004, respectively. The change in gross profit resulted in a gross margin of 13.4%, 16.4% and 15.3% for 2006, 2005 and 2004, respectively. The decline in gross profit in 2006 compared to 2005 was primarily attributable to a decline in revenue and increases in indirect costs including costs related to a reduction in workforce, an increase in business development efforts, share-based compensation, higher provisions for the valuation of our unbilled expenditures and fees on contracts in process and changes in revenue mix. Unusually high severance costs of $1.1 million were recorded in cost of contract revenue in 2006 compared to $0.5 million in 2005. Share-based compensation costs reduced gross profit in 2006 by $1.1 million related to our adoption of SFAS 123R at the beginning of 2006. In the near term, we anticipate continuation of the lower gross margin as a result of a continued high level of investment in business development, bid and proposal activities. The improvement in gross margin on contract revenues in 2005 compared to 2004 resulted from lower employee benefit cost and acquisition integration efficiencies, which resulted in a lower level of indirect overhead costs along with lower sub-contractor and other direct costs, expressed as a percentage of revenues.

 

Our gross profit on product sales was $1.2 million, $1.6 million and $1.9 million 2006, 2005 and 2004, respectively. The slight decline in gross profit in both comparable periods was primarily attributable to a lower

level of revenues. This resulted in a decline in gross margin of 19.7%, 23.1% and 26.3% in 2006, 2005 and 2004, respectively.

 

Selling, General and Administrative Expenses

 

Selling, general and administrative expenses were $24.1 million in 2006, $25.3 million in 2005, and $23.2 million in 2004. The decrease in selling, general and administrative expenses in 2006 compared to 2005 was primarily the result of lower costs for salaries and benefits resulting from the workforce reductions, as well as other cost reduction efforts. This decrease was partially offset by an increase in share-based compensation expenses of $1.2 million in 2006 compared to $0.9 million in 2005. The increase in 2005 compared to 2004 was primarily the result of higher costs resulting from the Impact Innovations acquisition, partially offset by lower employee benefit related expenses. Selling, general and administrative expenses, expressed as a percentage of revenues, were 9.3% in 2006 and 8.4% in both 2005 and 2004. As a percentage of revenue, selling general and administrative expenses have increased in 2006 compared to 2005 due to revenues decreasing at a faster rate than expenses and an increase in share-based compensation costs and severance costs associated with workforce reductions. Reductions in 2005 in finance, IT, benefits and other administrative costs expressed as a percentage of revenues were partially offset by an increased level of investment in business development and an increase in recruiting costs due to higher turnover.

 

Amortization of Intangible Assets

 

Amortization expense, which relates to the amortization of acquired intangible assets, was $2.8 million, $3.0 million, and $2.3 million in 2006, 2005, and 2004, respectively. The increased level of expense in 2005 compared to 2004 was related to a full year of amortization expense from the intangible assets identified with the Impact Innovations acquisition.

 

Interest Expense, net

 

We incurred interest expense totaling $2.1 million in 2006, $4.4 million in 2005 and $2.3 million in 2004. The decrease in interest expense in 2006 compared to 2005 was due to lower average borrowings, partially offset by a higher average interest rate. The increase in interest expense in 2005 compared to 2004 was primarily attributable to a full year of borrowing under the acquisition loan used to fund the September 1, 2004 acquisition of Impact Innovations, coupled with interest on the outstanding balance of our revolving credit facility and the term loan facility. Interest expense in 2004 included only four months of interest on the acquisition term loan and a full year of interest on the outstanding balances on our revolving credit facility and the term loan facility. The interest rate on our current financing vehicle is variable. This vehicle is more fully described in the “Liquidity and Capital Resources” section below. The weighted average interest rates on our outstanding borrowings were 6.87%, 6.27%, and 5.36% at December 31, 2006, 2005 and 2004, respectively. We recorded approximately $0.1 million of interest income in each of 2006, 2005 and 2004.

 

Other Income, net

 

We recorded $0.6 million, $2.3 million and $0.4 million of net other income in 2006, 2005 and 2004, respectively. In 2006 and 2005, we recorded $0.2 million and $2.0 million, respectively, of realized gains resulting from the sale of shares of common shares of Lucent Technologies, Inc. (“Lucent”) during those periods. In accordance with the equity method of accounting, other income includes recognition of our portion of income or loss related to our investments in ^HMRTech and ^HMRTech/HJ Ford SBA JV. We recorded income related to our equity investments of $0.2 million in each of the three years ended 2006. Approximately $0.2 million in 2006 and approximately $0.1 million in both 2005 and 2004, was included in other income attributable to gains on our deferred compensation plan investments.

 

Provision for Income Taxes

 

We recorded income tax provisions of $2.7 million, $7.8 million and $6.3 million in 2006, 2005 and 2004, respectively. The income tax provision was recorded at rates of 40.6% in 2006, 40.5% in 2005, and 40.1% in

2004. These rates reflect the statutory federal rate of 35% in 2006 and 34% in both 2005 and 2004. The 2006 tax rate reflects the implementation of SFAS 123R for certain stock awards and the relative impact of permanent difference due to a lower profit before tax balance, increase in tax rates applied to deferred income taxes, partially offset by favorable state income tax audits and tax credits and adjustment of tax accruals and reserves.

 

Shares Used in Computing Earnings Per Share

 

Weighted average common shares outstanding and common equivalent shares totaled 9.4 million, 9.3 million, and 9.1 million for the years ended December 31, 2006, 2005 and 2004, respectively. The increase in shares in 2006 compared to 2005 was related to 0.3 million additional shares issued, partially offset by a decreased dilutive effect on employee stock options due to a lower average annual stock price. The increase in 2005 from 2004 was primarily attributable to 0.4 million additional shares issued, partially offset by a reduction in the number of employee stock options counted as outstanding common equivalent shares due to their anti-dilutive effect.

 

LIQUIDITY AND CAPITAL RESOURCES

 

The following discussion analyzes liquidity and capital resources by operating, investing and financing activities as presented in our Consolidated Statements of Cash Flows. Our principal sources of liquidity are cash flows from operations and borrowings from our revolving credit facility.

 

Our results of operations, cash flows and financial condition are subject to certain trends, events and uncertainties, including demands for capital to support growth, economic conditions, government payment practices and contractual matters. Our need for access to funds is dependent on future operating results, our growth and acquisition activity and external conditions.

 

Based upon our present business plan and operating performance, we believe that cash provided by operating activities, combined with amounts available for borrowing under the revolver, will be adequate to fund the capital requirements of our existing operations during 2007 and for the foreseeable future. In the event that our current capital resources are not sufficient to fund requirements, we believe our access to additional capital resources would be sufficient to meet our needs. However, the development of adverse economic or business conditions could significantly affect the need for and availability of capital resources.

 

At December 31, 2006 and 2005, we had cash and cash equivalents aggregating $7.9 million and $1.0 million, respectively. The increase in cash and cash equivalents is primarily the result of $17.6 million of net cash provided by operating activities, partially offset by $2.3 million and $8.4 million of cash used in investing and financing activities, respectively.

 

Operating Activities

 

Net cash provided by operating activities of $17.6 million during 2006 was primarily attributable to improved billings and receivable collections and non-cash charges, partially offset by reductions in accounts payable and accrued expenses. Net cash provided by operating activities totaled $24.6 million and $3.2 million in 2005 and 2004, respectively.

 

Total accounts receivable and unbilled expenditures and fees on contracts in process were $64.4 million and $94.7 million at December 31, 2006 and December 31, 2005, respectively. Billed accounts receivable decreased $5.8 million in 2006 and $13.1 million in 2005, while total unbilled amounts decreased $24.5 million in 2006 and increased $11.4 million in 2005. Total accounts receivable (including unbilled amounts) days sales outstanding, or DSO, was 96 days at December 31, 2006 and 119 days at December 31, 2005.

 

At December 31, 2006, the unbilled receivables balance included $9.4 million related to our contract with the State of Ohio. Under the current terms of the contract, this amount is anticipated to be invoiced and collected in accordance with completion of contract milestones. Based on current projected milestone completions, we anticipate payments on this contract of approximately $9 million in 2007.

 

Deferred taxes on unbilled receivables totaled approximately $9 million at December 31, 2006 compared to $19 million at December 31, 2005. The decrease in deferred taxes resulted from a reduction in tax deferred unbilled costs and fees and tax payments related to our settlement of the 2002 and 2003 income tax audits. The Internal Revenue Service (“IRS”) also has initiated an audit of our 2004 income tax return. The IRS continues to challenge the deferral of income for tax purposes related to our unbilled receivables including the applicability of a Letter Ruling issued by the IRS to us in January 1976 which granted to us deferred tax treatment of our unbilled receivables. We have requested and the IRS has agreed to allow this issue to be elevated to the IRS National Office for determination. While the outcome of the audit is not expected to be known for several months and remains uncertain, we may incur interest expense, our deferred tax liabilities may be reduced and income tax payments may be increased substantially in future periods.

 

Share-based compensation increased to $2.1 million in 2006, from $0.9 million in 2005 and $0.5 million in 2004. The increase in 2006 is due to our adoption of SFAS 123R beginning January 1, 2006. During 2005, we realigned our approach to share based compensation by increasing the issuance of restricted stock awards and reducing the issuance of stock options. As a result, higher share based compensation was recorded in 2005 compared to 2004. We anticipate lower share-based compensation in 2007 due to the actions approved by the Board of Directors to amend our Employee Stock Purchase Plan during the fourth quarter of 2006, as more fully described in Note 11 of our “Notes to Consolidated Financial Statements” in Part II, Item 8 on this Form 10-K.

 

Non-cash amortization expense of our acquired intangible assets was $2.8 million, $3.0 million and $2.3 million in 2006, 2005 and 2004, respectively. We anticipate that non-cash expense for the amortization of intangible assets to decrease to approximately $2.6 million in 2007.

 

Our defined benefit pension plan was underfunded by $3.9 million and $11.1 million in 2006 and 2005, respectively. The decrease in the 2006 underfunded amount was due to an additional pension contribution and actions approved by the Board of Directors to amend the plan during the fourth quarter of 2006, which removed the 3% annual benefit inflator for active participants in the plan as of December 31, 2006. This amendment, which freezes each participant’s calculated pension benefit, is anticipated to reduce pension costs, net of other changes in assumptions, by approximately $0.9 million in 2007 compared to 2006. During 2006 and 2005, contributions of $5.2 million and $8.1 million, respectively, were made to fund our pension plan.

 

Investing Activities

 

Net cash used in investing activities of $2.3 million during 2006 was primarily attributable to capital expenditures. Net cash provided by investing activities was $16.5 million in 2005 and net cash used in investing activities was $59.9 million in 2004.

 

Capital expenditures for the purchase of property and equipment were $2.5 million, $4.6 million, and $4.5 million in 2006, 2005 and 2004, respectively. For all years, capital expenditures were primarily for the purchase of computing equipment and for leasehold improvements, other than for the enterprise business system and the Andover facility renovation. Expenditures for the PeopleSoft based enterprise business system, which was initially placed-in-service on January 1, 2004, were $0.1 million and $1.7 million in 2005 and 2004, respectively. Expenditures for the Andover facility renovation were $1.5 million and $1.4 million in 2005 and 2004, respectively. We expect capital expenditures in 2007 to be at similar levels as 2006.

 

During 2006 and 2005, we sold our Lucent shares for $0.2 million and $2.0 million, respectively, realizing a gain on the sale of $0.2 million and $2.0 million, respectively. We currently do not hold any investments classified as available for sale and therefore do not expect any proceeds from the sale of investments in future periods.

 

On December 29, 2005, we sold our headquarters facility in Andover, Massachusetts and entered into a lease for the same property for a ten-year term with two five-year renewal options. Proceeds realized from the sale were $19.3 million resulting in a gain of $6.8 million that will be recognized over the ten-year term of the lease. During 2006, the Company amortized $0.7 million of the deferred gain and estimates a similar benefit in subsequent periods through the end of the lease.

 

In 2004, we expended $54.0 million related to the acquisition of Impact Innovations. The acquisition is more fully described in Note 3 of our “Notes to Consolidated Financial Statements” in Part II, Item 8 on this Form 10-K.

 

We believe that selective acquisitions are an important component of our growth strategy. We may acquire, from time to time, firms or properties that are aligned with our core capabilities and which complement our customer base. We will continue to consider acquisition opportunities that align with our strategic objectives, along with the possibility of utilizing the credit facility as a source of financing.

 

Financing Activities

 

On September 29, 2006, we entered into a new revolving credit facility (the “2006 facility”) with a bank group to amend and restate the then existing credit facility entered into on September 1, 2004. The 2006 facility provides for a $50 million, three-year revolving credit agreement for working capital needs. On an ongoing basis, the 2006 facility requires us to meet certain financial covenants, including maintaining a minimum net worth and certain cash flow and debt coverage ratios. The covenants also limit our ability to incur additional debt, pay dividends, purchase capital assets, sell or dispose of assets, make additional acquisitions or investments, or enter into new leases, among other restrictions. In addition, the 2006 facility provides that the bank group may accelerate payment of all unpaid principal and all accrued and unpaid interest under the 2006 facility, upon the occurrence and continuance of certain events of default. At December 31, 2006, the Company was in compliance with its debt covenants. Additional information related to the 2006 facility is referenced in Note 9 of our “Notes to Consolidated Financial Statements” in Part II, Item 8 on this Form 10-K.

 

During 2006, net cash used in financing activities of $8.4 million represented principal payments under the acquisition term loan of $25.4 million, partially offset by $15.0 million of net borrowings under the revolving credit agreement and $1.9 million of proceeds from the issuance of common stock through the exercises of stock options and employee stock purchase plan transactions. The outstanding balances on our 2004 facility, which consisted of an acquisition term loan balance of $17.2 million and a revolving credit facility balance of $4.5 million, were paid off and re-borrowed under the revolver as part of the 2006 facility. As of December 31, 2006, we had $15.0 million outstanding under our 2006 facility which has been classified as long-term as amounts borrowed under the revolver are contractually due on the maturity of the 2006 facility, however we may repay at any time prior to that date.

 

During 2005, net cash used in financing activities was $41.0 million, which consisted of $26.7 million of repayments under the acquisition term loan, $10.0 million of repayments under the revolver and $7.8 million of repayments under the term loan, partially offset by $3.4 million of proceeds from the exercise of stock options and employee stock purchase plan transactions.

 

During 2004, net cash provided by financing activities was comprised of $55.0 million from the acquisition term loan, $1.5 million of net borrowings under the revolver and $2.6 million of cash proceeds from the exercise of stock options and employee stock purchase plan transactions. We entered into our then existing financing arrangement, of which $55.0 million was related to the acquisition of Impact Innovations. We repaid $1.6 million of the principal borrowed immediately after the initial consideration paid for Impact Innovations was reduced to $53.4 million. Our proceeds from financing activities were partially offset by $2.9 million of acquisition term loan principal payments, including the $1.6 million of principal repaid immediately as discussed above, $0.8 million for deferred financing costs and $0.5 million of principal payments under the term loan.

 

Off-Balance Sheet Arrangements

 

We did not utilize or employ any off-balance sheet arrangements during the three years ended December 31, 2006, defined as (i) an obligation under a guarantee contract, (ii) a retained or contingent interest in assets transferred to an unconsolidated entity or similar arrangement, (iii) an obligation, including a contingent obligation, under a contract that would be accounted for as a derivative instrument or (iv) an obligation, including a contingent obligation, arising out of a variable interest.

 

Commitments

 

Our contractual obligations as of December 31, 2006 consist of the following (in millions):

 

 

The amounts above related to the long-term debt do not include interest payments on the revolver outstanding principal balance, because the interest rates are not fixed.

 

The amounts above related to operating leases are net of sublease rentals of $0.3 million for both periods due less than one year and due two to three years.

 

On December 29, 2005, the Company entered into a purchase and sale agreement and lease in connection with the sale and leaseback of the Company’s headquarters in Andover, Massachusetts, pursuant to which the Company sold and leased back the building, real property and certain items of personal property at the Company’s headquarters, including the Company’s interest in certain contracts pertaining to the building, real property and personal property. The term of the lease is ten years and includes two five year options to renew. The agreement also provides that the Company pay for certain improvements by the end of the third lease year. The Company entered into a $1.0 million letter of credit, which is required to be maintained until 45 days after the completion of the improvements.

 

Contingencies

 

We are a party to litigation and other proceedings as referenced in Note 13 of our “Notes to Consolidated Financial Statements” in Part II, Item 8 on this Form 10-K. Except as noted therein we do not presently believe it is reasonably likely that any of these matters would have a material adverse effect on our business, financial position, results of operations or cash flows.

 

Our evaluation of the likelihood of expenditures related to these matters is subject to change in future periods, depending on then current events and circumstances, which could have material adverse effect on our business, financial position, results of operations and cash flows.

 

RECENT ACCOUNTING PRONOUNCEMENTS

 

In February 2007, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standard (“SFAS”) No. 159, The Fair Value Option for Financial Assets and Financial Liabilities, (“SFAS 159”). SFAS 159 permits entities to choose to measure many financial instruments and certain other items at fair value. The objective is to improve financial reporting by providing entities with the opportunity to mitigate volatility in reported earnings caused by measuring related assets and liabilities differently without having to apply complex hedge accounting provisions. SFAS 159 is effective for financial statements issued for fiscal years beginning after November 15, 2007. We are currently evaluating the impact of adopting SFAS 159 on our financial statements.

 

In September 2006, the FASB issued SFAS No. 158, Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans — an amendment of FASB Statements No. 87, 88, 106 and 132(R) (“SFAS 158”). SFAS 158 requires an employer that sponsors one or more single-employer defined benefit plans to (a) recognize the overfunded or underfunded status of a benefit plan in its statement of financial position (based on the projected benefit obligation for a pension plan), (b) recognize as a component of other comprehensive income, net of tax, the gains or losses and prior service costs or credits that arise during the period but are not recognized as components of net periodic benefit cost pursuant to SFAS No. 87, Employers’ Accounting for Pensions, or SFAS No. 106, Employers’ Accounting for Postretirement Benefits Other Than

Pensions, (c) measure defined benefit plan assets and obligations as of the date of the employer’s fiscal year-end, and (d) disclose in the notes to financial statements additional information about certain effects on net periodic benefit cost for the next fiscal year that arise from delayed recognition of the gains or losses, prior service costs or credits, and transition asset or obligation. SFAS 158 was effective for the Company’s fiscal year ended December 31, 2006. The impact from our adoption of SFAS 158 as of December 31, 2006 is described in Note 8 in our “Notes to Consolidated Financial Statements” in Part II, Item 8 on this Form 10-K.

 

In September 2006, the FASB issued SFAS No. 157, Fair Value Measurements (“SFAS 157”). SFAS 157 clarifies the principle that fair value should be based on the assumptions market participants would use when pricing an asset or liability and establishes a fair value hierarchy that prioritizes the information used to develop those assumptions. Under the standard, fair value measurements would be separately disclosed by level within the fair value hierarchy. SFAS 157 is effective for the Company’s fiscal year beginning January 1, 2007, with early adoption permitted. We do not expect the adoption of SFAS 157 to have a material impact on our financial statements.

 

In September 2006, the Securities and Exchange Commission (“SEC”) issued Staff Accounting Bulletin No. 108, Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements (“SAB 108”). SAB 108 provides interpretive guidance on how the effects of the carryover or reversal of prior year misstatements should be considered in quantifying a current year misstatement. The SEC staff believes that registrants should quantify errors using both a balance sheet and an income statement approach and evaluate whether either approach results in quantifying a misstatement that, when all relevant quantitative and qualitative factors are considered, is material. SAB 108 was effective for our fiscal year ended December 31, 2006. The adoption of SAB 108 did not have a material impact on our financial statements.

 

In July 2006, the FASB issued FASB Interpretation No. 48, Accounting for Uncertainty in Income Taxes (“FIN 48”). FIN 48 sets standards for the accounting for uncertainty in income taxes recognized in an enterprises’ financial statements in accordance with FASB Statement No. 109, Accounting for Income Taxes.  FIN 48 prescribes a recognition threshold and measurement attributable for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. FIN 48 also provides guidance on accounting for tax liability derecognition, classification, interest and penalty recognition, accounting in interim periods, disclosures and transitions. FIN 48 is effective for fiscal years beginning after December  15, 2006. We are currently evaluating the impact the adoption of FIN 48 will have on our financial statements.

 

IMPACT OF INFLATION AND CHANGING PRICES

 

Overall, inflation has not had a material impact on our operations. Additionally, the terms of DoD contracts, which accounted for approximately 80% of total revenue in 2006, are generally one year contracts and include salary increase factors for future years, thus reducing the potential impact of inflation.

 

We are subject to interest rate risk associated with our revolver, where interest payments are tied to either the LIBOR or prime rate. The interest rate at December 31, 2006 on $15.0 million of outstanding borrowings under the revolver was 7.86% under the 90-day LIBOR Rate option elected on October 5, 2006. At any time, a sharp rise in interest rates could have an adverse effect on net interest expense as reported in our Consolidated Statements of Operations. Our potential loss over one year that would result in a hypothetical and instantaneous increase of one full percentage point in the interest rate on our revolver would increase annual interest expense by approximately $0.2 million.

 

We presently have no investments, other than cash investments, which consists primarily of money market accounts with original maturities of three months or less and, accordingly, no exposure to market interest rates on investments. We have no significant exposure to foreign currency fluctuations. Foreign sales, which are nominal, are primarily denominated in U.S. dollars.

PART II

 

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

 

Board of Directors and
Shareholders of Dynamics Research Corporation

 

We have audited the accompanying consolidated balance sheets of Dynamics Research Corporation and subsidiaries (a Massachusetts corporation) (collectively the “Company”) as of December 31, 2006 and 2005, and the related consolidated statements of operations, changes in stockholders’ equity and comprehensive income, and cash flows for each of the three years in the period ended December 31, 2006. These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.

 

We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

 

In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Dynamics Research Corporation and subsidiaries as of December 31, 2006 and 2005, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2006, in conformity with accounting principles generally accepted in the United States of America.

 

As discussed in Note 11 to the consolidated financial statements, the Company changed the manner in which it accounts for share-based compensation in 2006.

 

Our audits were conducted for the purpose of forming an opinion on the basic consolidated financial statements taken as a whole. Schedule II is presented for purposes of additional analysis and is not a required part of the basic consolidated financial statements. This schedule has been subjected to the auditing procedures applied in the audits of the basic consolidated financial statements and, in our opinion, is fairly stated in all material respects in relation to the basic consolidated financial statements taken as a whole.

 

We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of the Company’s internal control over financial reporting as of December 31, 2006, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) and our report dated March 16, 2007 expressed an unqualified opinion on management’s assessment and an unqualified opinion on internal control effectiveness.

 

/s/    Grant Thornton LLP

 

Boston, Massachusetts

March 16, 2007

DYNAMICS RESEARCH CORPORATION

(In thousands, except share data)

 

 

The accompanying notes are an integral part of these consolidated financial statements.

DYNAMICS RESEARCH CORPORATION

CONSOLIDATED STATEMENTS OF OPERATIONS

(In thousands, except share and per share data)

 

 

The accompanying notes are an integral part of these consolidated financial statements.

DYNAMICS RESEARCH CORPORATION

CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS’ EQUITY AND COMPREHENSIVE INCOME

(in thousands)